Industry groups have taken aim at a Tennessee regulator’s proposal that would establish a custodial arrangement any time an advisor transfers assets or securities between a customer’s accounts, even with a standing authorization from the customer.
A cohort of industry groups has asked a Tennessee regulator to rewrite a proposed custody rule they say has been costing the state’s investment advisors tens of thousands of dollars in compliance expenses. And the regulator’s response suggests that they’ve at least made their point.
The Financial Planning Association, the XY Planning Network, the Certified Financial Planner Board of Standards and the National Association of Personal Financial Advisors, in a June 10 letter to Tennessee Department of Commerce and Insurance Commissioner Carter Lawrence, “urged” the regulator to revise or rescind a year-old policy statement that, according to the groups, breaks with Securities and Exchange Commission guidance on custody.
The TDCI’s policy statement, issued on May 29, 2024, involves custody and standing letters of authorization. According to the cohort’s letter, the TDCI has declined to follow SEC guidance that treats first-party asset transfers by an investment advisor on behalf of a client as not creating a custodial arrangement, whether effected via a standing letter of authorization or otherwise. Transfers to third parties can create a custodial arrangement absent certain safeguards, the SEC said in guidance issued in February 2017.
The TDCI’s stance means that a Tennessee-based investment advisor is in custody of a client’s assets if the advisor effects a transfer of funds or securities between client accounts, even if the client has provided a standing written request that includes the names and identification numbers of the accounts involved, the cohort says. Tennessee “makes no distinction between first-party asset transfers and third-party asset transfers for purposes of enforcing Tennessee’s custody rule,” the regulator said in its May 2024 policystatement.
All other states apply a custodial relationship tag only in instances in which such transfers are made to a third party’s account, according to the cohort. In the year since the policy statement, Tennessee-based advisors have reported for the first time being subject to “costly” audit and surprise-exam rules as a result of these transfers, the cohort says.
“Such audits and exams come with never-before seen compliance costs between $20,000 – $30,000, which forces advisers to either pass some of these costs on to their clients or obtain signed authorizations tocomplete each first-party transaction,” the cohort wrote in its letter, adding that the TDCI’s proposal does not provide “any noted benefit to consumers.”
“While we recognize the potential risk that comes with an adviser having standing authority to engage in third-party transfers, research conducted by XYPN, examining prior orders, actions, complaints, or issued guidance across jurisdictions from recent years, revealed no examples of fraudulent activity or evidence of investor harm resulting specifically from an adviser’s limited authority to engage in first-party transfers onbehalf of the client, upon the adviser’s instructions to the custodian,” the cohort wrote.
The cohort has asked the TDCI to retract the proposed rule or include an amendment to specify that “[a]ninvestment adviser’s authority to transfer client assets between a client’s accounts at the same qualified custodian or between qualified custodians that both have access to the sending and receiving account numbersand client account name … does not constitute custody and does not require further specification of client accounts in the authorization.”
In its policy statement issued last May, the TDCI wrote that applying custodial rules differently to first- and third-party transfers “focuses only on the payee. However, there is no focus on the payee in determining whether an investment adviser has custody of a client’s funds or securities,” the TDCI wrote.
“The determining factor is only whether there is an arrangement under which the investment adviser isauthorized or permitted to withdraw the client’s funds or securities,” the regulator said. However, the TDCI’s associate counsel, Jacob Strait, to whom the cohort’s letter was addressed, told Financial Advisor IQ last week that the regulator, during a previously scheduled rulemaking hearing conducted the day following the cohort’s letter, received feedback requesting “to exempt certain transactions, commonly referred to as ‘1st party transaction’ from the definition of ‘custody,’ which triggers certain obligations upon an investment adviser when making such transactions under a Standing Letter of Authorization.”
“The Division has reviewed those comments and is currently considering adopting language as an amendment to the rulemaking package in response to the public comments received,” Strait said in an emailed statement.
Securities-industry attorney David Harrison told FA-IQ that the TDCI, in its written proposal, invited controversy by failing to include the preamble that regulators customarily use to provide reasoning and context for proposals. Although Harrison, whose firm represents customers in claims involving the financial services industry, suggested that the regulator’s position could reflect an uptick in identity fraud, he concluded that the proposal lacks a “demonstrated benefit to investors.”
“I don’t think there’s a history of investor harm from an advisor’s limited authority to simply move money between a client’s own accounts at qualified custodians,” said Harrison, of Studio City, California–based
Bakhtiari & Harrison.
Harrison also said that the proposal’s reported compliance costs of as much as $30,000 “could even be on the cheap side,” if remedial measures are factored in, and he said that the rule, if passed, could disadvantage Tennessee’s smaller investment advisors, who may not have the financial resources to meet the compliancecost.