The evolution of alternative investment custody has come a long way, with custodians now serving as true partners and support to the industry. These custodians safeguard and record assets, produce necessary tax reporting and statements to individual investors and their financial intermediaries. In many cases, custodians also serve as administrators and facilitate transactions on behalf of their clients. In some cases, however, custody may turn into a significant cost obligation and even a risk factor for the alternative investment community.
The main players in the custodial industry — traditional firms including Fidelity, Charles Schwab, Morgan Stanley and TD Ameritrade — have been focused on becoming full-scale fiduciary institutions. Their responsibilities now reach far beyond recordkeeping and tax compliance. Nowadays, traditional custodians vet and approve investment offerings, and even help place the offerings through the networks of their affiliated advisers and intermediaries.
Excessive control of traditional custodians in the alternative investment space resulted in the emergence and rapid development of so-called self-directed or alternative custodians. These companies historically have served wealthy individuals investing in real estate, commodities and other illiquid assets. Fidelity, Charles Schwab, Morgan Stanley and other large firms would rarely allow such assets on their books.
Over the past decade, self-directed custodians have evolved into full-service warehouses offering custody of a broad range of alternative investments, including non-publicly traded securities, private placement funds and other pooled alternative investment vehicles. The major difference between the traditional and self-directed/alternative custodians is that custodians of alternative assets are prohibited by law from providing any investment advice. As a result, self-directed custodians never vet or conduct due diligence of the investments. Instead, they passively transact on behalf of their individual clients or their authorized representatives.
THE GPB CAPITAL CASE
The situation around GPB Capital caused active discussions in the alternative investment community and has ramifications for the alternative custodial space. The custodian of the GPB assets, NFS (Fidelity), issued a resignation letter to thousands of individual investors, seemingly out of the blue. They were instructed to choose another custodian and transfer their assets out of Fidelity accounts within 90 days. If the transfer of assets was not done properly within that timeframe, the letter warned, Fidelity would report a distribution of assets to the IRS, meaning those who invested their tax-deferred dollars would become liable to the IRS for up to 50 percent of their assets’ value in taxes and early distribution penalties. Investors who had already completed a rollover of their retirement funds in 2019 would be forced to take the distribution, without an option to save their tax-advantaged investments.
What could be done to fix the problem for GPB investors? Very little. The protocol had to be followed. Investors had to open accounts with a new custodian and initiate asset transfers. If they did not complete the transfer in time, they would become liable for taxes to the IRS.
In the self-directed industry, a custodian would never attempt to resign accounts because of the financial or operational issues with an investment vehicle. By the nature of self-direction, operational or investment risks are not the alternative custodian’s responsibility. Alternative custodians would only distribute the assets per the client’s direct instruction, or as directed by their legal representative. This remains true in the case of bankruptcy or receivership. Self-directed custodians work with the sponsor and, if needed, help to seamlessly transition to another custodian through an economical negative consent process.
Now what can be done to better protect the alternative investment industry in the long run? To eliminate future risk, broker/dealers and advisers should consider moving their clients’ alternative assets to self-directed custodians.
Nikita Brodskiy is chief strategy officer at The Entrust Group.