Registered Advisers Often Confused by Custody Reporting

Form ADV includes a number of questions about the custody of client assets; these questions continue to be a source of widespread confusion and inconsistent interpretations in the asset management industry.

The Investment Adviser Association (IAA) and National Regulatory Services (NRS) released their 18th annual “Evolution Revolution” report, highlighting robust growth in the investment advisory industry.

According to the report, the universe of Securities and Exchange Commission (SEC) registered investment advisers continues to grow at a steady pace, creating a record number of investment advisory positions.

The analysis also includes a snapshot of the “typical” registered adviser, generated by taking a median average of various key practice metrics. Generally speaking, most of the typical adviser’s clients are individuals, but he is also highly likely to have at least one pension or profit sharing retirement plan as a client. At the median, the report shows, SEC-registered advisers consult on nearly $360 million in assets while relying on an average of nine staff employees.

According to IAA and NRS, advisers broadly exercise discretionary authority over most assets and accounts served—but only rarely do registered advisers have actual physical custody of client assets or securities.  

The research suggests the industry’s recent focus on the Department of Labor’s (DOL) fiduciary rule is ostensibly reflected in the decrease in the number of firms charging commissions, which dropped to 3.6% of all SEC-registered advisers in 2018, down from 4.1% and 4.5% in 2017 and 2016, respectively. While the DOL fiduciary rule has been vacated by a federal appeals court, the reporting suggests commissions are still likely to remain unpopular.

“Another, perhaps related, trend is the increase in the number of advisers reporting charging fixed fees,” the analysis states. “Many factors are potentially contributing to this increase in fixed fees, including generational turnover as younger investors may prefer a subscription-like model when paying for financial advice.”

The report goes on to warn that advisers broadly seem to have some misconceptions about how to define asset custody.

“Form ADV includes a number of questions about the custody of client assets,” the report points out. “These questions—and the investment adviser custody rules—appear to continue to be a source of widespread confusion and inconsistent interpretations in the asset management industry.”

As the report explains, back in 2013, a Risk Alert published by the SEC’s Office of Compliance Inspections and Examinations (OCIE) emphasized that non-compliance with the custody rule, as amended in 2009, “was one of the most common issues found in routine investment adviser examinations and that, in fact, many advisers failed to realize they even had custody as defined in the rule.”

“These issues persist today,” the report warns. “The confusion stems from the fact that while advisers, in general, are prohibited from having physical custody of client assets, advisers are also deemed to have custody under certain other circumstances. Many of the questions in Form ADV relate to advisers that are deemed to have custody, although to complicate matters further, advisers that are deemed to have custody for certain types of reasons (such as the ability to deduct fees) are not required to answer certain custody questions on Form ADV.”

The report concludes the regulatory framework under the Advisers Act custody rule is “overly complex, unduly burdensome, and has caused unnecessary confusion for advisers.”

“We are encouraged that amendments to the custody rules for investment companies and investment advisers were added to the SEC’s Regulatory Flexibility Agenda in the spring of 2018 as a long-term action,” the report states. “Generally, long-term actions are items for which agencies expect to take regulatory action more than 12 months after publication of the agenda.”

The full 2018 Evolution Revolution report is available on the IAA website  and on the NRS website.