Advisers win reprieve in battle with Schwab

The Charles Schwab Corp. is giving a reprieve to advisers upset with its decision to stop taking custody of hedge funds, real estate assets, private equity and other forms of alternative investments, but it will not reverse the ban.

After consulting with some of its largest registered investment adviser clients, the San Francisco-based discount-brokerage giant last week said it will extend the April 30 custody cutoff it announced last month until later this year when it expects to have set up a “long-term servicing relationship” with a custodian specializing in alternative assets.

RIAs will be permitted to add to existing funds at Schwab under certain conditions, but the firm’s ban on offshore assets and any new alternative investment vehicles remains. Those bans went into effect late last month when they were announced.

“Our general approach remains intact, and we are no longer accepting any offshore [alternative investments] or any new domestic [alternative investments],” Schwab spokeswoman Alison Wertheim wrote in an e-mail when asked about modifications. “But because we understand that market demands are placing unprecedented pressure on advisers, and we want to be as flexible as possible, we are creating an interim process.”

Several advisers said that the ban on offshore assets is particularly troublesome because they allocate substantial individual retirement account assets to offshore funds that must be held in custody to avoid taxes. Non-IRA investments in hedge funds can be made without support of a broker-dealer custodian, they said.

Even Schwab’s decision to accept additional assets in existing alternative investments temporarily comes with strings attached because of new “acceptance criteria,”according to Ms. Wertheim.

The criteria are still being established, but advisers have been told that Schwab will require them, as well as fund managers and third-party valuation auditors, to indemnify the firm against securities fraud or other violations related to all but administrative, custodial and reporting duties.

Schwab announced its ban last month without first consulting with clients, a move that many RIAs said was uncharacteristically rash for a company known for its client-service skills. Schwab, whose RIA platform is its fastest-growing business, said that it was reacting to anticipated regulation and “emerging reform efforts [that] are likely to focus on the role of custodians and the need for more transparency in this segment of the market.”

The company didn’t mention recent scandals involving Bernard Madoff and R. Allen Stanford, but just last week the Securities and Exchange Commission said that it plans to focus on safekeeping and custody procedures as part of a stepped-up examination program of RIAs. Examiners, who will initially target advisers with dual registrations or broker-dealer affiliations, will be required to get third-party verification from custodians and others on the value of assets that advisers report to clients, an SEC official said.

On Feb. 25, just days after Schwab issued its alternatives ban, 22 of its RIA clients collectively sent a letter to founder Charles Schwab and other top executives, threatening to move other assets to rival custodians if the firm didn’t modify its edict.

The signers included several firms that Schwab honored in recent years with its Impact awards for best business, technology and industry practices. In interviews and in the letter, the RIAs said that they were reluctant to leave Schwab and eager to work with the company on an in-house solution that wouldn’t disrupt their client arrangements.

The Schwab spokeswoman said that the firm appreciates that alternative investments “can represent an opportunity for more sophisticated end clients.”

Schwab had initially suggested that advisers move their assets to two small trust banks specializing in IRA self-directed investments, but RIAs objected to fees at the banks that are much higher than the nominal setup and maintenance charges that Schwab assesses, as well as to the logistical and servicing burdens of a transfer.

ADVISERS SYMPATHETIC

Advisers say that they are sympathetic to Schwab’s concerns about assuming additional risks under intensified regulatory scrutiny, but worry that the firm’s decision will send a message to their clients that all alternative investments are suspect.

“This precipitous blanket decision during a time of extreme market stress places a crushing burden on your RIA partners at a time when few of us can afford to add more uncertainty to our client relationships,” the joint RIA letter said.

One signer of the letter, Timothy Kochis, chief executive of Aspiriant, a San Francisco-based RIA with $3.5 billion of discretionary assets, said that he has told Schwab Institutional head James McCool that he would be willing to pay more to Schwab for taking custody of alternatives to help it offset its growing regulatory burden. “I’ve told them that we’re business people who understand that you can pass costs through if you’re providing a valuable service,” he said, noting that the firm hasn’t directly responded to his suggestion.

As many as 20% of Aspiriant’s clients have alternative asset allocations, Mr. Kochis said.

Another signer, Greg Friedman of Friedman & Associates, who in 2007 won an Impact best-technology award, said that he remains flabbergasted at Schwab’s decision, the way it was communicated and the effect that it will have on clients if assets have to be transferred.

“The last thing my clients want to hear from me is that, by the way, you’re going to have some assets moved,” he said.

Mr. Friedman said that about one of five clients of his Novato, Calif.-based firm, which manages $195 million in assets, are invested in an audited real estate mortgage fund that is managed locally.

Several advisers, meanwhile, said they have been getting calls from representatives of Fidelity Investments’ institutional business, which is now led by former Schwab Institutional head Charles Goldman. “We are committed to continue investing in our support of alternatives on behalf of our clients, and are currently talking to more advisers than ever about their alternative asset needs,” said Fidelity spokes-man Stephen Austin.

E-mail Jed Horowitz at [email protected].