SEC's custody rule will simmer a little longer for advisor input

Advisors are getting more time to chew over an SEC-proposed safeguarding-assets rule that's already been the subject of extensive criticism.

The Securities and Exchange Commission, the federal watchdog of the advisory industry, announced Wednesday that it's giving the public roughly another two months to comment on proposed changes to its custody rule, which generally requires advisors to hold clients assets such as stocks, bonds and mutual funds at banks, brokerages and other qualified third parties. Under a proposal introduced in February, the SEC would extend that mandate to more sophisticated investment vehicles such as cryptocurrencies, real estate and derivatives.

The SEC's current custody rule, added to the Investment Advisers Act in 1962, seeks to provide another layer of investor protection by placing third-party custodians in a position to detect any unscrupulous transactions wealth managers might be carrying out unbeknownst to their clients. The rule was last amended in 2009 in response to frauds like the $65 billion Ponzi scheme perpetrated by Bernie Madoff, a registered advisor who exercised direct control over his clients' assets. 

Of the latest proposed change's many provisions, the one that's garnered the most criticism from advisors and their representatives is one that would make the SEC's custody rules apply to advisors authorized to engage in "discretionary trading" — complete transactions without first obtaining their clients' express permission. 

The SEC estimates that most advisors have discretionary authority over investor assets. The arrangement is often seen as convenient by clients who don't want to be bothered with having to authorize every individual trade done for their benefit. According to the SEC's proposed 432-page rule, about $117.57 trillion of the $128.96 trillion in assets advisors were managing by June 2022 was in discretionary accounts. 

The trouble for advisors with discretionary authority comes in the proposed rule's requirement that they enter into elaborate written agreements with any bank, brokerage or other third party they have a custodial relationship with. Among other things, the rule would have advisory firms get custodians to agree to provide records on investor assets on request. As a protection against bankruptcy, custodians would also have to agree to set investor assets aside in funds that would be shielded from creditors.

Read more: SEC charges Fundrise Advisors for paying finfluencers $8M to solicit clients

The big concern is that independent advisors and other small firms won't have the heft to extract these sorts of conditions from the mainstays of the custodian industry. Those tend to be big-name firms like Charles Schwab, Fidelity, Pershing and LPL Financial.

Jonathan Chiel, the general counsel for Fidelity Investments, wrote in a letter to the SEC dated May 8 that the proposal threatens to disrupt a long-established way of doing business in the advisory and custodial industries. Under the current system, he explained, it's individual investors who enter into separate written agreements with both advisory firms and custodians. 

Shifting the burden for custodial contracts away from investors and giving it to advisors will, according to Chiel, "require drafting, negotiating, re-executing and organizing the custodian relationships for the vast majority of the 15,000 SEC-registered investment advisers — essentially all registered investment advisers that provide any kind of portfolio management." 

Rather than go through all that hassle, some custodial firms might decide to work with fewer advisory firms or simply exit the business altogether, Chiel warned. With decreased competition, "Custodial costs will increase, thus increasing investor costs," he wrote.

Carolyn Jayne, an associate general counsel at LPL Financial, noted in a letter to the SEC also dated May 8 that the U.S. has gradually been moving away from a system in which mainly professional pension managers were responsible for retirement planning to one in which individual workers are expected to do it themselves. These savers "often lack the expertise, time, and discipline to make optimal investment decisions and benefit from discretionary investment management services," she wrote.

"The Proposal generally makes the provision of discretionary advice more expensive to deliver and preferences affiliated advisers over independent advice," according to Jayne.

Read more: Advisors O'Neal and Archer opt for Arkadios before Osaic consolidation

The SEC's decision to reopen the comment period on its custodial rule came the same day that it approved a sweeping overhaul of its rules for private equity and hedge funds. The SEC noted Wednesday that the new regulations, approved the same day in a 3-2 vote, would require registered investment advisors to obtain an audit once a year for every private fund they work with. 

That requirement, the SEC said, stems in part from an audit provision in the current custody rule. According to the federal regulator, "reopening the comment period will allow interested persons additional time to assess the proposed amendments to the current custody rule's audit provision in light of the private fund adviser audit rule."

The Investment Adviser Association, which represents private-fund managers as well as independent advisors, commended the SEC for reopening the comment period on the proposed custodial rule in response to the new rules for private equity and hedge funds.

"The IAA has pressed the SEC to consider its current rulemaking activity holistically and cumulatively and also provide meaningful opportunity for public feedback on how the various proposals interact with one another," wrote IAA general counsel Gail Bernstein in an email statement.