Advisors take notice: Regulators might look askance if you’re charging clients higher fees than what they earn in idle funds at banks and brokerages.
Max Mejiborsky, vice president at Comply, a compliance services provider, says that if advisors are indeed charging more, it could raise red flags with regulators.
Mejiborsky began working with clients on the issue in 2021, and he found that in some cases the yields on sweep accounts were so low that advisors had begun charging more than what the clients would earn on these accounts, “which really put this in the spotlight,” he says. Mejiborsky currently consults with 50 advisory firms on compliance.
Both RIAs and advisors with securities licenses have potential exposure here. “A lot of our clients custody at Fidelity, Schwab and Pershing, so even before rates began to rise, we began working with clients to take a closer look at how large a percentage of client assets they leave in sweep accounts,” he says.
For decades broker-dealers have used the cash investors leave idle to earn the highest rate available for the firm, while paying investors much lower rates. With the recent significant run-up in interest rates, the difference meant big profits. But such profits are dwindling, according to a new report from Moody’s, which found that many investors are “cash sorting” and moving most of their money out of low-rate sweep accounts into money markets, CDs and bond funds that pay as much as 5.25%.
Since advisors negotiate what sweep account they’ll use for clients when signing up with a broker-dealer or custodian, leaving clients in a low-rate sweep may draw regulatory scrutiny, according to Mejiborsky.
Brian Hamburger, the president and CEO of MarketCounsel Consulting, agrees.
“This is definitely a red flag,” he says. “Where we’ve generally seen liability is with reverse churning, where a client is paying for the management of an account, but an advisor is leaving an account dormant.
“The top-level issue for advisors is whether there is a conflict of interest and whether they’re paid on cash positions,” Hamburger adds. “Either way, that needs to be disclosed.”
Financial Advisor reached out to the Securities and Exchange Commission and asked if examiners are seeing sweep account practices that violate Regulation Best Interest or fiduciary rules. The agency said it had no comment.
In a report called “2020 Examination Priorities,” the SEC stressed advisors’ responsibility “for making best interest evaluations, including those for reviewing reasonably available alternatives, evaluating costs and risks and identifying and addressing conflicts of interest.”
In 2020, the Financial Industry Regulatory Authority issued a risk monitoring and examination priorities letter in which it mentioned cash management and bank sweep programs. The letter specifically requires advisors to “clearly communicate the alternatives for cash management available to customers, the terms provided by the bank sweep program and any alternative.”
Mejiborsky says that if advisors are not actively shopping for competitive sweep accounts, they should include language in their disclosures along the lines of “This may not be the best interest rate in the market. We are not going to be shopping around or re-evaluating these sweep accounts to find which one is offering the best rate.”
“That strengthens the disclosures even more,” he says.
Mejiborsky says that Reg BI and fiduciary standards already require advisors to collect and routinely re-evaluate investors’ goals, risk tolerance and priorities to determine how much cash is left in sweep accounts in the first place.
“We always say as a practical matter, you set some allocation parameters with clients, in equities, fixed income and cash. We’ll target for cash not to be above 5% or 10%, depending on the client. That gives the advisor a measuring stick,” he says.
He also recommends that advisors who find they are keeping more cash in sweep accounts than what is discussed and disclosed to clients “should send written communications to the client saying ‘We’re deviating from our target on cash, and this is why.’”
Advisors should also document client discussions and communications to demonstrate they are exercising their duty of care and loyalty under Reg BI, he says.
“You don’t want to set it and forget it, but as long as you can show documents that demonstrate that the client was informed, you discussed it with them and re-evaluated it, that should meet best practice standards,” he says. Mejiborsky notes that he is seeing advisors routinely move client cash account balances to CDs and money markets paying higher rates, depending on the client’s cash needs.
Hamburger says that not all larger balances kept by advisors in a sweep account raise red flags. For instance, some clients with larger balances may want to obtain overnight FDIC insurance from a multitude of banks. “This type of sweep account may be more valuable and a better product for some clients,” he adds.