July 27, 2012 / 7:58 PM / 7 years ago

COMPLY-A slap by adviser's custodian may be worse than SEC fine

July 27 (Reuters) - Investment advisers spend countless hours worrying about the glare of Washington regulators, but the bigger threat to their business may be closer to home.

So-called “custodians,” or the brokerage firms that hold a client’s securities, who see too many red flags, or questionable transactions may end a business relationship with an adviser. And when they do, they often contact an adviser’s clients to say so.

For advisers, having clients receive notice like that can be more devastating for business than many penalties meted out by states or the U.S. Securities and Exchange Commission.

While the practice is unusual, it does happen.

It happened to Airgead Clann, LLC, a California-based investment adviser, against a unit of Charles Schwab Corp, where clients kept their funds.

According to a regulatory filing, Airgead’s assets under management is $15.25 million.

In an ongoing arbitration, Michael Kelly, Airgead’s principal, said that Schwab abruptly sent letters to his clients saying it was ending its relationship with him, according to a statement of claim he filed with the Financial Industry Regulatory Authority’s arbitration unit. The letter did not include an explanation for the change and scared his elderly clients, he said.

Schwab alleges that Kelly pretended to be a client in response to Schwab’s attempt to “validate a questionable signature” on a client form that Airgead submitted to the brokerage, according to an excerpt from its response in the arbitration. That conversation was taped, Schwab said.

Kelly told Reuters that he took part in a three-way call between Schwab and an elderly client, but he denies impersonating anyone.

For advisers, the extra scrutiny may only become more intense, which makes paying attention to compliance all the more critical.

It is “uncommon” for Schwab to terminate relationships with any of the 7,000 advisory firms who rely on its custodial services, a spokeswoman said. She declined to provide a specific number.


An uptick in online hacking and identity theft are among the reasons financial companies have beefed up account surveillance.

For most advisers, this typically means fielding simple questions from brokerage custodians, such as whether a recent change of address form is legitimate. Other advisers say this surveillance has also led to frequent calls from their custodians about the legitimacy of clients’ wire transfer instructions.

It is, after all, the type of scrutiny that clients and regulators expect. But it also means that sloppy and questionable conduct by some advisers is more likely to be noticed. For example, little things that some advisers do when rushing to finish paperwork, such as cutting a client’s signature off one form and pasting it onto another, are unlikely to be tolerated.

Those practices not only violate securities industry rules, but are often not worth the risk to custodians, said Brian Farmer, a Richmond, Virginia-based lawyer who counsels investment advisers. That is especially true when smaller advisers are involved - typically those managing $100 million in assets or less.

When a custodian does terminate its business relationship with an adviser, it can lead to a blandly worded-letter to the adviser’s clients, that says the relationship with the adviser is over but without explaining why. Not providing an explanation to clients insulates custodians from lawsuits claiming that they disparaged the adviser to clients, Farmer said. Advisers are also sometimes left in the dark.

Still, the last-resort communication, while unusual, can set a tone among clients. “It leads your mind to wander. You go from there and you just imagine the worst,” Farmer said.

Clients must also fill out pages of paperwork to open an account at new custodian and transfer their funds from the previous one. One West Coast adviser told Reuters that the red tape cost him a top client when Schwab terminated his custodial relationship about two years ago. The adviser, who manages about $50-million in assets, said he does not know why the relationship ended.

The West Coast adviser and Kelly both suggest their small totals of assets under management played a role. A Schwab spokeswoman said the company does not consider that amount in reaching its decision.


Custodians for investment advisers say they try to involve advisers in all of their limited communications with clients.

“We go to great lengths to maintain our place,” said John Tovar, managing director of institutional brokerage services for TD Ameritrade Institutional.

For example, TD Ameritrade notifies advisers about its contact with clients even when no problems exist, such as when it sends account and tax statements.

Custodians are permitted - via their agreements with advisers - to reach out to an adviser’s clients in limited situations, such as when such contact is required by regulators. The contract also spells out that an adviser’s clients are the brokerage clients too for certain purposes.

Advisers usually have some advance notice when custodians take the drastic step of terminating the business relationship. Sometimes advisers can transition to a new custodian before the contract ends, as long as no serious misconduct is involved. Other times, they will have some notice that a letter is about to hit their clients’ mailboxes.

But that is not always the case. Kelly alleges that Schwab sent the letter on the same day its lawyer called to tell him about the termination.

That leaves little time to own up to clients.

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