SEC’s custody rules may complicate life for advisers

Financial advisers will have to stop serving as trustees or face auditing costs of $10,000 or more for each of their custodial clients as a result of new rules adopted by the Securities and Exchange Commission.

The regulations, which went into effect last month, impose a more stringent definition of when advisers are deemed to have custody of client assets, and require them to hire an independent auditor to conduct a surprise exam. Even having what some are calling “incidental” custody triggers the requirement.

The tougher stance was taken by the SEC in the wake of the fraud perpetrated by Bernard Madoff.

To avoid the financial burden of an audit, some advisers will have to stop serving as trustees, change how they access client 401(k) plans and stop paying bills for clients.

Those who accept incidental custody, which is determined on an account-by-account basis, have to begin the auditing exams by the end of the year. In its final rule, the SEC estimated that 1,859 advisory firms will be subject to the surprise-examination requirement.

“In my opinion, regulators are really missing the mark on this,” said Chris Winn, a managing principal of MainStay Consulting Group LLC, a compliance consultant. “Yes, there are more controls, but … you’re [forcing] clients to take less service and forcing advisers to charge more.”

Advisers are now shopping for auditors — and encountering sticker shock.

“The first time advisers get a quote [from an auditor], you’re going to see more people dropping their trustee role,” said Saverio “Sam” Paglioni, a partner at Integer Wealth Advisors Group LLC, which manages about $250 million and serves as a trustee on three accounts.

He said he received a cold call from a Florida accounting firm, which quoted him a price of “an estimated $8,500 to $12,500, [plus] travel and other costs,” he said.

“Either we find someone locally who’s reasonably priced or we’re going to have to resign and find a corporate trustee” for clients, Mr. Paglioni said.

The new rules “have opened up a new revenue stream for CPAs, and they’re all excited about it,” said Christopher Casdia, compliance and operations manager at Homrich & Berg Inc., which manages $1.9 billion for high-net-worth clients.

Mr. Casdia, whose firm is trustee on a number of accounts, said he has yet to retain an auditor.

For important clients, advisers may be hard-pressed to resign as trustees, he said.

“To say to a sophisticated client with complex needs that you’re no longer going to serve as trustee could do damage to the relationship,” Mr. Casdia said.

The cost of an audit will depend on the number of accounts and the types of securities held, said Karen Barr, general counsel at the Investment Adviser Association. The more accounts with more complicated or illiquid investments, the higher the auditing costs will be, she said.

The SEC had anticipated that the average cost would be about $8,000, “but we said that would be way too low,” she said.

Advisers should expect auditor bills of between $10,000 and $20,000, said Jane Stafford, founder of the Stafford Law Firm LLC, which represents advisory firms.

Her adviser clients “are not happy about it,” Ms. Stafford said.

Another hot issue is how advisers will manage clients’ 401(k)s and variable annuity subaccounts under the new rules.

Advisers use various methods to access these assets, which are typically not held at advisers’ custodial firms.

To access some of these accounts, advisers have been logging in as clients, using their user names and passwords. In other cases, they can log in as advisers.

Many clients like help with their retirement account dollars, advisers said, because these accounts may hold the bulk of an investor’s assets.

But such access gives advisers clear control over the funds, legal observers said.

Beyond just making investment changes, advisers could, in theory, also control disbursements and change addresses — opening the door to potential fraud.

“The word we’ve received … is that it’s the SEC staff’s opinion that having a password [to a 401(k) account] constitutes custody if there’s the ability [to] change the address on the account,” said Ron Rhoades, chief compliance officer at Joseph Capital Management LLC, which manages about $100 million.

He has been active among members of the National Association of Personal Financial Advisors in discussing issues arising from the new rules. NAPFA members will be asking the SEC for clarification on this issue, Mr. Rhoades said.

“We know that Americans need advice to make the right decisions, and to impose this [auditing] burden on a lot of financial advisers … will cause many of them to [stop] providing service to this [401(k)] segment,” he said.

Logging on as the client “is not going to work,” Ms. Stafford said. Advisers are “going to have to change that” if they want to avoid custody, she said.

“The only thing [advisers] should be able to do is change the investments,” Ms. Stafford said.

Custodial firms, which have physical custody of the assets, limit adviser control to the managing of investments, she said.

If access to outside retirement accounts is somehow limited, advisers might be able to advise clients without accepting custody, Ms. Barr said.

“We understand there are some setups that limit access sufficiently,” she said, but the SEC hasn’t addressed this specific issue.

“The problem the SEC faces is that it can’t go to custodians and tell them what to do [to limit access by advisers], because a lot of them aren’t under SEC jurisdiction,” Mr. Rhoades said.

“A lot of them are banks and insurance companies.”

E-mail Dan Jamieson at [email protected].

Related Topics: Securities and Exchange Commission