The Hidden Risk In Your Custodial Agreements
by Bob Veres
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
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.”
Read the full article here.