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Rules, Rules, Rules

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Two proposed rule changes by the Securities and Exchange Commission are catching the attention of the investment advisor community. The first amendment–proposed a few weeks ago–is a new custody rule dealing with Rule 206(4)-2 under the Investment Advisers Act of 1940, which governs the custody of client funds or securities. And the second rule, which the Financial Planning Association (FPA) has been battling for years, would ease disclosure requirements for broker/dealers.

David Tittsworth, president of the Investment Counsel Association of America (ICAA) in Washington, D.C., says that very few investment advisors actually have custody of client funds or securities, “but if you have an arrangement where you can deduct advisory fees in advance–which a lot of advisors do–you are deemed to have custody. Therefore you have to produce an audit balance sheet every year, and you are subject to a surprise inspection by the SEC every year.” While the new proposal doesn’t change the broad definition of custody, Tittsworth explains, it states that “so long as the funds and securities are custodied at a qualified custodian, which is someone who is regulated and sends monthly account statements to the client, then you don’t have to” produce an audit or be inspected by the SEC. “In the world of custody, that’s a fairly major change.”

John Baker, a securities lawyer with Stradley, Ronan, Stevens & Young in Washington, says “the proposed rule would not apply these custody requirements to the accounts of hedge funds or other pooled investment vehicles that provide audited financial statements annually to investors.” This isn’t such a good thing, he says, considering the number of “high-profile frauds committed in recent years against hedge funds with audited financial statements.” Baker says “a rigorous custody requirement would provide assurance to private fund investors substantially greater than that given by an audit and should reduce the number of fraud cases.”

Comments on the custody proposal are due by September 25.

The FPA recently sent a letter to the SEC opposing, once again, the regulator’s proposed changes to its rule called “Certain Broker-Dealers Deemed Not to be Investment Advisors.” The FPA says the rule “helps move broker/dealers toward asset-based compensation, while allowing representatives to bypass the higher standard of the Investment Adviser Act of 1940.”

Roy Diliberto, president of RTD Financial Advisors in Philadelphia and former president of the FPA, has been fighting the rule since the SEC proposed it several years ago. He says the rule is not only unfair, but it’s also bad for consumers. “If you are an advisor of a broker/dealer and you’re doing fee-based business, as long as you don’t have discretion [over client assets], you don’t need to register as an [independent] investment advisor,” Diliberto says. “As a result, [the B/D] doesn’t have the disclosure requirements, [it's] not a fiduciary, and there are things that the broker/dealer can do that [independent] advisors can’t, particularly in principal dealing and selling stocks and inventory and marking them up without disclosing the fact that you’re doing so. And making extra money on certain trades that the B/D is putting in a fee-based account to make people believe that the B/D giving them objective advice when, in fact, it has got some conflicts of interest that don’t need to be disclosed.”

What’s most troubling now, Diliberto says, is that while the SEC has said it won’t enforce the rule until it has been formally adopted, the SEC is already acting as if the rule is in place by allowing broker/dealers to circumvent the Adviser Act.

Dan Moisand, president of Optimum Financial Group in Melbourne, Florida, says Charles Schwab is trying its best to exploit the “broker/dealer rule” by moving to a non-discretionary type of business model. “Schwab is still going after the do-it-yourself investor, and now they are trying to carve out a niche for the guy who wants some help, but doesn’t really want somebody to take responsibility for the management of the assets.” Schwab is relying on the exemption for certain broker/dealers as proposed in the SEC’s rule “very heavily; they are almost as aggressive about it as Merrill Lynch.”

As long as Schwab and the other firms label the account as a “brokerage account,” and not an “advisory account,” they don’t have to comply with the Adviser Act of 1940.

Washington Bureau Chief Melanie Waddell can be reached at [email protected].


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