A clause in many custodial account agreements will have troubling ramifications for your RIA firm.
Here’s a shocker: Chances are, your RIA firm has custody of client accounts – and you’ll receive unpleasant news after your next SEC audit.
The SEC deficiency letter will tell you that you have custody if (as is likely) your clients signed the standard Schwab Advisor Services client agreement. That same language is in the client agreements of other custodians, so there is no reason to think that the SEC will treat those situations any differently.
“The SEC is now raising this issue in many deficiency letters,” says compliance attorney Tom Giachetti, of Stark & Stark (offices around New Jersey, in New York and Philadelphia). “The custodians are seeking relief from the SEC,” he says, rather than change the language on their contracts.
That means you will be told that you should have been hiring an accounting firm to conduct surprise audits, and you can expect to face additional regulatory scrutiny. After all, didn’t Bernie Madoff have custody?
Meanwhile, there are hints from examiners that the SEC is about to come out with a significant ruling later this year, declaring that pretty much all RIA firms have custody over client accounts. I contacted the SEC about this issue, and the spokesperson’s response was a masterpiece of noncommittal, but it did confirm the issue. “On background,” I was told that custody includes any arrangement where the advisor is authorized or permitted to withdraw client funds or securities maintained with a custodian upon its instruction to the custodian. The SEC declined to name any particular custodian, but added that, depending on the wording of the custodial agreements, an advisor may have custody even though it did not otherwise intend to have such access
Troubling language
The problem can be traced to the language found on page six of the Schwab Advisor Services account agreement, in a clause which reads as follows:
Trading and Disbursement Authorization. By checking the circle and signing this Application, I authorize Schwab (1) to execute trades in my account at the direction of IA as provided under the Trading Authorization heading in the attached Schwab One® Account Application Agreement; (2) to disburse assets for investment purposes or to me personally, as instructed by IA; (3) to remit checks, wire funds and make certain disbursement of funds held in the account as regulations permit (i) to banks, broker-dealers, investment companies or other financial institutions for credit to an account of identical registration, or (ii) to me at my address of record. This disbursement authorization does not apply to Schwab MoneyLink® distributions or direct, ongoing electronic payments of dividends, interest and money market income. I acknowledge and agree that Schwab cannot confirm the account registration at the receiving financial institution and will rely solely on the representations of my IA as to the identical registration of the receiving accounts. (Note: This option is not available for Estate, Guardianship or Conservatorship accounts in the name of the aforementioned account types.) (emphasis added)
Basically, that clause tells your client that your RIA firm has the authority to have money wired to a third-party account, and the client – not the custodian – is responsible for checking to make sure the RIA firm is sending the money to the right place. “Although the advisor does not have contractual authority to send to third parties,” Giachetti explains, “the SEC’s concern is that the custodian cannot (or will not) verify whether the money is being sent to third parties.” If, for example, the client wanted money wired to an escrow account for the closing on a home purchase, and the RIA firm instead sent the money to a numbered account in the Isle of Man, the custodian (in this case Schwab Advisor Services) is not responsible.
That would seem to be custody. I contacted Schwab Advisor Services about the issue, and through a spokesperson, was told that the company is aware of the issue and “has joined the Investment Adviser Association and three other custodians to ask the SEC to clarify the issue.”
Schwab Advisor Services also told me: “The custodian’s form, whether on the account application or on a separate form, is simply a convenient way for a custodian to get an instruction from the account holder to honor the authority that the account holder has provided to the advisor. SEC exam staff is making clear this is a live issue with the rule interpretation staff in DC.”
Breakdown of protections
As this gets sorted out, what can you do about this? Brenda Gibson, chief executive officer of Gibson Capital, LLC in Wexford, PA, says that the new controversy raises a much larger issue: that the check-and-balance separation of powers between custodian and fiduciary advisor are breaking down, and the RIA community needs to start paying more attention to the client protection issues that are slowly being raised as a consequence.
“This is not regulatory overreach by the SEC,” she says. “The language in the account agreement is very clear. The custodian is expressly not taking responsibility for what custodians are supposed to do, which is to safeguard the client’s money.”
Gibson personally negotiated the asset movement authorization language that now appears in the Fidelity contract, first by insisting that Fidelity institute, as an exception for Gibson Capital, a “level zero” asset movement authorization, which creates a clear separation of authority by expressly not permitting the RIA firm to distribute any assets whatsoever without direct written instructions from the client to the custodian. Eventually, this option was incorporated in Fidelity’s standard client agreement, which is reproduced at the end of this article. Note that it now includes a Level 0, along with Levels 1, 2 and 3 – and the 1, 2 and 3 levels would imply different degrees of custody.
Draconian form
So you have custody. What can you do about it – other, of course, than go to the expense of hiring an outside accounting firm to start imposing surprise audits on yourself?
After talking with Dan Bernstein of the Hamburger Law Firm and Jacqueline Hummel of Hardin Compliance Consulting, it is clear that most RIA firms feel like they don’t have the ability to go back and negotiate, individually, the language on the forms that the custodian puts in front of them. Bigger picture, this is a widespread assumption. We have gotten in the habit of simply clicking on the “agree” button without looking at the many things the companies are legally obligating us to do.
That, Gibson says, is a mistake.
She points to a recent Fidelity document that many RIA firms have already signed (the formal title is Letter of Understanding and Supplement to Investment Advisor Representation and Indemnification Letter) which would require every RIA firm that clears through Fidelity to negotiate separate contracts with all their software and service vendors – specifically prohibiting those vendors from using the data supplied by Bloomberg and CUSIP Global Services for any purpose other than serving clients directly. The document also requires the RIA to institute lawsuits against vendors like Advent, Tamarac, Junxure etc. if, in your monitoring, you detect any such activity. It further requires you and your firm to wipe out all client data if you move to a different custodian – and further, gives Fidelity the right to send its agents into any RIA firm’s office at any time to look through its files and hard drives to ensure compliance with these provisions.
Gibson Capital did not sign this form. “We pushed back, and told them that we can’t be accountable for what any third party will do,” says Gibson. “We said we can’t give them the right, unrestricted, to go through all our computer files. And we pointed out that if we terminate our relationship with Fidelity, the SEC requires us to keep those records for at least five years. Of course, from a business perspective,” she adds, “we want to keep that information for our clients going forward indefinitely. It’s THEIR data.”
After some conversation, Gibson was told that Bloomberg and CUSIP were concerned that some vendor down the chain might use data from the Fidelity data feeds going out to RIAs (and their software providers) for unspecified for-profit motives.
“Fidelity told us that if they didn’t get those forms signed, then CUSIP and Bloomberg would cut off their data feeds,” says Gibson. “We replied that the custodians should be pushing back on our behalf.”
Protection breakdown
Bigger picture, Gibson is concerned that the ancient check-and-balance that once existed between custodians and RIA firms is breaking down, in part due to increasingly sophisticated technology, in part due to an industry that has been paying more attention to operational convenience than to client protection.
Exhibit A is the wire transfer issue, which has been sold to the RIA community as a convenience – a less bureaucratic way for the RIA to move client money around. Gibson recalls when Fidelity rolled out its new integrated cashiering tool, where the RIA firm gets the client to sign a transfer statement and then somebody on the RIA’s staff rekeys the information into Fidelity’s system to trigger the transfer.
“We said, thank you, but we won’t do that,” she says. “We said, because you’re the custodian, it’s YOUR job to process this information on behalf of the client. We’ve done our job. We’ve used the form, we’ve filled it out, and now there is your layer of protection, which is that you look over the form the client filled out and act on it or not. They were also,” Gibson notes, “doubling our workload by requiring us to rekey everything in twice, and saving themselves the extra work.”
Exhibit B is the increasingly convenient deduction of RIA fees from client accounts, which actually precedes the wire transfer issue. Gibson notes that most RIA firms are now using automated processes to deduct client fees automatically, which could certainly be deemed as putting your hands directly on the client’s assets.
“We still give the custodian a list of our fees and the accounts they are to be deducted from, and copies of our invoices, showing our calculations,” says Gibson. “Then we say: now do YOUR job, which is to look at this and, if you see anything funny, reach back out to us. Then YOU go into client accounts and transfer the fees, because we are not going to touch the money.”
Solutions?
For most planning firms, the question is: what can be done about the situation? Most RIA firms can’t change the language of the client forms, and it would take a broad outcry before the profession could push back on the sometimes draconian language that is put in front of them by their custodian. How can they avoid being deemed by the SEC (and, perhaps, state regulators) to have custody of client assets?
Bigger picture, how can they restore the check-and-balance relationship of custodians and fiduciary RIAs in order to protect client assets – before another Bernie Madoff starts wiring client money out to the Isle of Man?
- (short term) You can do nothing. It’s possible – though unlikely – that the SEC will back off of its nascent interpretation and this whole custody issue will go away on its own.
Failing that, there are several possible solutions that the RIA community itself can implement.
- (short term) You can protest to the SEC examiners that your internal procedures protect your clients from unauthorized transfers, and point out that this issue is still being explored by the SEC leadership. Giachetti is responding to his clients’ deficiency letters with the following language: “It is our understanding that no such provision is intended to permit our RIA to transfer any client funds to a third party without the client first executing a Schwab “Standing Letter of Authorization” form; and none of our clients have ever executed any such form providing us with such authority; and regardless, we have never acted, and will not act, upon any such agreement provision.”
He will add, in the response: “We are aware that the Investment Advisor Association and many of the national custodians, Schwab included, are actively lobbying the Commission to revise the Release to address the issue. We believe that this issue would best be addressed by tighter controls at the custodians and required verification of account identities at the receiving financial institutions. By doing so, we, and the entire advisory community, can avoid unintended and unwanted custody determination as a result of a custodian’s inability to verify.”
- (Longer term) Gibson says that financial planning firms need to be willing to vote with their feet if they don’t like certain contract provisions that are being put under their nose without any debate or the possibility for objection. They can take their issue to a rival custodian, point out the problem and ask for a solution. Gibson shopped its firm’s business around to other custodians, and found that TD Ameritrade Institutional was the only one willing to consider revising the asset movement authorizations and institute a Level Zero at some point in the future.
- The RIA community could form a committee (in conjunction with NAPFA?) that will serve as a clearing house for custodial documents and, perhaps, other legal forms that are presented to the RIA community. Initially, the committee would have to develop enough clout to go back to the custodians and negotiate more appropriate language on behalf of RIAs everywhere.
Eventually, the committee could split off into separate advisory boards for each custodian, providing advance input on new contract provisions, the way Gibson Capital has functioned from the past decade and a half with Fidelity.
The alternative – doing nothing – is not good: a breakdown in client protections, more liability gradually, incrementally shifted from the custodial platforms to RIAs, draconian legal provisions with your signature on them, the SEC deciding that you have custody of client assets, and (perhaps most importantly) the potential of another nasty scandal when money is wired in the wrong direction or client accounts wiped out by RIA fees that nobody is monitoring.
Meanwhile, you can take a look at the same clause on transfers to third parties as it appears in Fidelity’s contract (below), and see how a simple change in contract language might make the whole SEC custody issue go away.
Postscript
Since I originally wrote this article, it has become clear that Alternative #4 above is going to be necessary if the RIA profession is going to protect itself from custodial overreach and encroachment. If your firm has more than $1 billion under management with Fidelity, Schwab, TD Ameritrade or Pershing, and someone at your firm is willing to sit on an advisory committee, please contact me directly at [email protected].
The plan is not complicated; the committee will serve as a clearinghouse to review any contract provisions that are put forth by any of the major independent custodians, and the documents to be reviewed can be submitted by any RIA firm affiliated with the custodians. The committee, which would include Brenda Gibson, would make recommendations on how to improve that language. The recommendations would be vetted by a prominent securities attorney (I have Tom Giachetti of Stark & Stark in mind), and re-proposed to the custodian. If necessary, if there’s pushback from the custodian that seems to the committee to be gratuitous, then the committee would make its recommendations known to the advisory community through the journalist community – including my Inside Information service and its 1,500 prominent advisory firms as well as Advisor Perspectives and its distribution list of over 450,000 advisors, and through me to the editors of Investment News and Financial Planning magazines – and perhaps others as well.
I think you’ll agree that this is too important an issue to ignore.
Fidelity’s Asset Movement Authorizations Definitions
Level Zero - You have not authorized Fidelity to accept instructions from your Authorized agent/Advisor to distribute assets from your account without direct written instructions from you.
Level 1 - You have authorized Fidelity to accept instructions from your Authorized agent/Advisor to do the following transactions:
- For all eligible accounts:
- Authorize one time disbursements and establish and make changes to periodic disbursements (PeriodicDistribution Plans) for distributions including the establishment of, and changes to, periodic distributions(Periodic Distribution Plans) from your account/retirement plan account, including:
- Checks made payable to you (registered owner) and sent to your address of record.
- Bank wires and electronic funds transfers (EFTs) to any account You have authorized through standing written instructions and third-party check disbursements to any payee and address you have authorized through standing written instructions.
- For all non-retirement brokerage accounts:
- Transfers of cash or securities from this account to other same-registration accounts at Fidelity Investments or from this account to any third-party account at Fidelity you have authorized through standing written instructions.
- For Individual or Transfer on Death Individual (TODI) accounts.
- Contributions from this account to any IRA you own at Fidelity (accounts owned by you individually):
- For Premiere Select® or Fidelity SIMPLE individual IRAs ("IRAs"):
- Transfers of cash or securities from this account to other same-registration IRAs that are not reported for tax purposes.
- Distributions from this account to Fidelity non-retirement brokerage accounts you own individually.
- Conversions to Roth IRAs.
- Transfers from this account to any third-party account at Fidelity you have authorized through standing written instructions, including distributions to Fidelity non-retirement accounts with different owners and/or registrations.
Level 2 - Includes all Level 1 authorizations, plus:
- For all non-retirement brokerage accounts and for Premiere Select® or Fidelity SIMPLE individual IRAs (“IRAs”):
- Bank wires to any same-registration account outside Fidelity, without direct instructions from you.
Level 3 - Includes all Level 1 and Level 2 authorizations, plus:
- You authorize Fidelity to accept instructions from any Agent as described in Level 1 and Level 2.
- You also authorize Fidelity to accept instruction from the Agent for distributions to third parties without direct written instruction from the Trustee, Custodian, or Plan Sponsor. These distributions can be made by check, wire, or EFT. Fidelity may require, at its discretion, direct written instruction from the Trustee, Custodian, or Plan Sponsor for distributions to third parties over a certain dollar amount.
