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Editor: Eric C. Chaffee
Univ. of Toledo College of Law

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Saturday, September 10, 2011

Who Should Regulate Investment Advisers?

In previous posts I described the debate over a uniform fiduciary duty standard for investment advisers and broker-dealers.  Another significant difference between investment advisers and broker-dealers is their regulatory framework.  The SEC or the states, in the case of small and mid-sized firms, regulate investment advisers, while FINRA is the primary regulator of broker-dealers, with the SEC providing oversight of the SRO.   A longstanding controversy is whether the principal regulator for investment advisers should continue to be the SEC or whether a self-regulatory organization should be established for the industry along the line of the FINRA model.   The Investment advisory industry has long opposed creation of an SRO, but interest in this issue was renewed, in part because of the SEC’s failure to uncover Bernard Madoff’s  Ponzi scheme. 

This post describes recent developments, in particular the SEC staff’s study mandated by  Section  914 of the Dodd-Frank Act.   On Sept. 13, 2011 the Capital Markets Subcommittee of the House Financial Services Committee will hold a hearing on “Ensuring Appropriate Regulatory Oversight of Broker-Dealers and Legislative Proposals to Improve Investment Adviser Oversight.”  It has released a discussion draft of a bill that would provide for the registration and oversight of national investment adviser associations.

The SEC Staff’s Section 914 Study.  Section 914 mandated an SEC study to review and analyze the need for enhanced examination and enforcement resources for investment advisers.  The statute required the examination of: (1) the number and frequency of examinations of investment advisers by the Commission over the past five years;  (2) the extent to which having Congress authorize the Commission to designate one or more self-regulatory organizations to augment the Commission’s efforts in overseeing investment advisers would improve the frequency of examinations of investment advisers; and (3) current and potential approaches to examining the investment advisory activities of dually-registered broker-dealers and investment advisers (“dual registrants”) and registered investment advisers that are affiliated with a broker-dealer.  The statute also directed the study to include recommendations to address the concerns identified in the Study.

On Jan. 19, 2011 the SEC released the Study, which is a product of the Staff of the Division of Investment Management.  The Commission officially expressed no view regarding the Study's analysis, findings or conclusions, although, as discussed below,  Commissioner  Elisse Walter expressed her views independently.

The SEC staff reports that while the number of registered investment advisers (RIAs) and the assets managed by them have grown significantly over the past six years, the number of OCIE staff has declined over the same period.  As a result, the number and frequency of examinations have also declined during this period.  While OCIE examined eighteen percent of RIAs in 2004, only nine percent were examined in 2010.   While the anticipated decline in the number of RIAs (resulting from the increased numbers of investment advisers that will be regulated by the states) could result in a greater percentage of RIAs being examined, in fact the staff believes that, because of new examination obligations created by Dodd-Frank, the SEC will not likely have sufficient capacity to conduct effective examinations of RIAs with adequate frequency without an adequate source of stable funding.  The study’s bottom line:

the Staff believes that the Commission likely will not have sufficient capacity in the near or long term to conduct effective examinations of registered investment advisers with adequate frequency. The Commission’s examination program requires a source of funding that is adequate to permit the Commission to meet the new challenges it faces and sufficiently stable to prevent adviser examination resources from periodically being outstripped by growth in the number of registered investment advisers (i.e., it requires resources that are scalable to any future increase ― or, for that matter, decrease ― in the number of registered investment advisers).

The study went on to discuss three options for Congress to consider:

(1) imposing user fees on SEC-registered investment advisers to fund their examinations by OCIE;
(2) authorizing one or more SROs to examine, subject to SEC oversight, all SEC-registered investment advisers; and
(3) authorizing the Financial Industry Regulatory Authority (“FINRA”) to examine dual registrants for compliance with the Advisers Act.

With respect to the user fee option, the study noted that many other federal agencies impose user fees as an important source of revenue and suggested that this option may be less expensive than establishing one or more SROs.  It also observed that OCIE has already invested resources into improving the examination program that presumably would be lost if the responsibility was delegated to an SRO.

With respect to establishing one or more SROs, the staff noted that the SEC would still have costs associated with SRO oversight and that the costs of designing and implementing one or more SROs would be considerable.  It also noted the opposition of industry leaders.

Finally, with respect to the option of FINRA regulating dual registrants, the study recognized that authorizing FINRA to conduct examinations of dual registrants would free up SEC resources.  The study, however, saw disadvantages because the SEC staff would lose experience examining the large retail firms that are dual registrants as well as insights gained in the field.

The Study concluded by recommending that Congress consider the three options outlined above.

Commissioner Walters's Statement.  SEC Commissioner Elisse Walter released a separate statement at the time the study was publicly released, in which she expressed her disappointment with it:

it is necessary for me to write separately in order to clarify and emphasize certain facts, and ensure that Congress knows that the current resource problem is severe, that the problem will only be worse in the future, and that a solution is needed now.

In her view, "unfortunately, the study's description and weighing of the alternatives is far from balanced or objective," because it attributed virtually no disadvantages to the user fee option, but many disadvantages to the SRO and FINRA dual registrant options.  She went on to advocate for the SRO model and concluded:

Through NSMIA we have precedent, albeit limited, indicating that periodic reallocation of responsibilities for the regulation of investment advisers from the Commission to the states is not a long-term solution to enhancing the Commission’s examination and enforcement resources. We also have precedent, spanning more than seven decades, that SROs can significantly enhance the Commission’s examination and enforcement resources relating to its regulated entities. And this can and has been done through a structure in which the Commission retains and exercises comprehensive oversight and supervision of SROs. The SRO model can also be used to buttress scarce resources at the state level.
We need to address this issue now. It must not be relegated to another day—as has happened in the past. For far too long, in the investment advisory area, the Commission has been unable to perform its responsibilities adequately to fulfill its mission as the investor’s advocate, and investment advisory clients have not been adequately protected. This must change.

FINRA’s Advocacy.  Richard Ketchum, FINRA’s CEO, has made clear that the SRO is willing and able to take on the regulation of investment advisers.  In a March 22, 2011 speech, Mr. Ketchum addressed the opposition of investment advisory industry based on its concern that FINRA was not sensitive to the different regulatory risks of investment advisers:

If FINRA became the SRO for some or all investment advisers, we would have no intention to force the full suite of specific broker-dealer requirements on investment advisers.  That would not be appropriate or in the public interest.  The regulatory concerns regarding investment advisers primarily relate to the lack of examination resources, which places advisory clients at unacceptable risk….That’s a service FINRA is well-positioned to provide.

CFA’s Testimony.  The investment advisory industry and investor advocates have long opposed creation of an SRO to regulate investment advisers and, in particular, have opposed FINRA’s taking on this responsibility.  However, the tide may have turned this summer when Barbara Roper, Director of Investor Protection,  Consumer Federation of America, testified before  the Senate Banking Committee.   Ms. Roper stated

In the past, CFA has categorically opposed delegating investment adviser oversight to an SRO, particularly one dominated by broker-dealer interests and particularly if that SRO were given rule-making authority. We continue to believe the user-fee approach outlined in the SEC report offers the best option for funding enhanced inspections in a way that promotes investor protection while minimizing added costs to industry.
However, having spent the better part of two decades arguing for various approaches to
increase SEC resources for investment adviser oversight with nothing to show for our efforts, we have been forced to reassess our opposition to the SRO approach. Specifically, we have concluded that a properly structured SRO proposal would be a significant improvement over the status quo.

Discussion Draft: “Investment Adviser Oversight Bill of 2011.”  As noted earlier, in connection with its Sept. 13, 2011 hearing on “Ensuring Appropriate Regulatory Oversight of Broker-Dealers and Legislative Proposals to Improve Investment Adviser Oversight,”   the House Financial Services Committee released a discussion draft of a bill that would provide for the registration and oversight of national investment adviser associations.  The bill would amend the Investment Advisers Act of 1940 to require any investment adviser (either registered with the SEC or with state authorities) to be a member of a registered national investment adviser association.  In turn, the act provides a procedure for an association of investment advisers to register with the SEC as a national investment adviser association and sets forth requirements for registration.  The SEC would provide oversight of the SRO, similar to existing SROs, including approval of SRO rules.  In a press conference accompanying release of the draft bill, Senator Bachus spoke highly of FINRA.

Stay tuned for later developments!

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