Beginning this month, advisory firms preparing their annual ADV updates will have to calculate and report assets held in accounts that have a standing letter of authorization to move money or pay bills to third parties.
Since most firms are on a calendar year cycle, the majority of advisors will begin the asset reporting in the first quarter of next year for updates due in March.
The new requirements were set out in a February 2017 SEC no-action letter, with a reporting date beginning this month.
Of particular concern are standing letters of authorization that direct transfers to third parties. If these transfers are not handled correctly, advisory firms could find themselves subject to the dreaded surprise-audit requirement for firms that are deemed to have custody of client assets.
The SEC’s new interpretation “sparked a renewed focus on the whole custody issue” and the risk of being on the hook for the audit, said Christopher Winn, chief executive of AdvisorAssist, a compliance consulting firm.
Surprise audits can be avoided if clients and advisors follow specific requirements for authorization letters laid out in the SEC’s no-action letter.
Under that guidance, clients need to provide transfer instructions and other information to custodians in writing. Clients must also authorize their advisors in writing to direct transfers to third parties, and must have the ability to change or terminate transfer instructions. Custodians must verify the instructions and provide notice of transfers.
Advisors cannot change the instructions and must ensure that any third-party payees are unrelated parties.
Most first-party (identical account registration) transfers will avoid the custody implications, with the exception of wire transfers, which might require new documentation because the SEC now requires an account number for the receiving account, said Chris Stanley, a compliance consultant and founder of Beach Street Legal.
Although the SEC hasn’t given specific guidance on the issue, transfers from an individual account to a joint account shared by that same individual will likely be considered third-party transfers. Charles Schwab’s custodial unit, for example, is treating such transfers as a third-party exchange.
“There is some confusion as to what constitutes a first-party and a third-party” transfer, said Cindi Hill of Hill Compliance Advisors.
Dan Bernstein, chief regulatory counsel at MarketCounsel, thinks the biggest change for advisors will be the reporting requirement.
“Advisors do not want to have custody,” he said, and the new guidance might force them to report some “big numbers” for assets under their control, which could spark questions from clients.
“Advisors need to have their stories straight,” Bernstein said, explaining that the custody an advisor has is not like Bernie Madoff holding assets, but simply the result of client requests to make regular payments with a standing letter of authorization.
(Advisors already have custody if they debit fees; they just don’t have to report it that way on the ADV form if those fee deductions are the only reason they have custody.)
Legal observers say the SEC has indicated it will be flexible in allowing RIA firms time to update paperwork and report assets with their next ADV update.
As they adjust to the new policies, advisors would be wise to keep an eye out for any practices that might give them custody over client accounts, Stanley said.
For example, in separate guidance given last February, the SEC warned that other types of existing agreements between investors and custodians may inadvertently create custody by giving advisors some discretionary powers, Stanley said. He suggests advisors contact their custodians to see if this is an issue.
“The SEC is focusing on custody for the foreseeable future [and] ways [advisors] can unintentionally trigger” a custody issue, he said.