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Double trouble? SEC ups scrutiny of dual registrants

Dually registered brokers and advisors already operate in a more complex regulatory world than firms that only wear one hat. But as the SEC takes a harder look at how those shops operate, are they ready for the spotlight?

"There are a number of firms that were born as broker-dealers and have registered or continued to convert their business to the fee-based model ... but don't necessarily build the infrastructure on the IA side. They really just rely on the supervisory structure on the BD side," Jennifer Klass, a partner with the law firm Morgan Lewis, said during a recent conference in New York that was broadcast online. "If you're a dual registrant, then you're subject to all of the requirements of the Advisers Act with respect to your advisory activity."

One of those requirements — perhaps among the most challenging for compliance officers — are the provisions of the custody rule that require advisors to conduct audits and surprise exams, work with a qualified custodian, and issue clients written statements when the advisor is considered to have custody of the client's assets.

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"It is probably the most complicated rule in the Advisers Act, and there's a big push to get clarification," said Clifford Kirsch, a partner with the law firm Eversheds Sutherland in New York.

Quite often, new entrants in the space mistakenly assume that they aren't covered by the Custody Rule if they don't have physical control of the client's assets, according to Kirsch.

"It's much more than that," he said. "It's mere access. And if you have mere access to funds — not just actual physical custody — you're deemed to have custody."

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A guard stands outside the headquarters of the U.S. Securities and Exchange Commission (SEC) in Washington DC May 27, 2004. Photographer: Chris Kleponis/ Bloomberg News.

Klass urges firms to take a close look at how they communicate with their clients to determine whether they are covered by the custody rule. It is common for dually registered firms to unknowingly engage in activities that trigger the rule's requirements.

"I think the primary thing to keep in mind for dual registrants is that you can trip over the Advisers Act custody rule pretty easily just by virtue of taking instructions from a client to distribute money or having information about passwords, etc.," Klass said.

Sometimes that can simply be a case of a firm trying to accommodate its clients, according to Walter Booker, director of client experience at law firm MarketCounsel.

"It's that inadvertent custody that you really need to be careful about," Booker said. "Sad but true, there are often very positive motivations, and yet you get yourself in a real challenge if you do that. It is a real issue for RIAs out there because there's some clarity, but there's also some gray area."

Other areas of ongoing interest for regulators: share classes, compensation, and how the determination is made to place a client in an advisory or brokerage account.

Observers think that the SEC will soon begin releasing information about the settlements it reached with advisors who came forward with the admission that they placed clients in a high-fee class of mutual fund shares when a cheaper option would have served them just as well.

Those revelations will be telling, as the SEC continues to closely scrutinize how firms are making the call between one class of shares and another.

For dual registrants, SEC examiners will also expect firms to justify the determination to place clients in the advisory or brokerage wing of the practice, taking into consideration factors such as the investor's objectives, the anticipated volume of trading activity, and the provision of other financial planning services.

"Bottom line: it's just is the client better off in the wrap fee program than in the brokerage account," said Cheryl Haas, a partner at the law firm McGuireWoods. "That's just going to be a constant focus that the SEC is going to be asking about."

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