Congress, Industry Explore Self-Regulation for Investment Advisers

Most everyone in the financial word agrees on one point: The Securities and Exchange Commission does an inadequate job overseeing investment advisers. How to best fix that longstanding problem, however, is a far more contentious matter.

By the SEC's own tally, only 8 percent of registered investment advisers were examined in 2011 and approximately 38 percent of them have never been examined. The average SEC-registered investment adviser is inspected by regulators only once every 10 to 13 years, and the frequency of examinations has decreased 50 percent since 2004. On the other hand, broker-dealers—which are subject to oversight by the SEC and the Financial Industry Regulatory Authority, a self-regulatory organization—are typically inspected biannually.

Citing the lack of oversight of investment advisers, the Dodd-Frank Act required the SEC to review its examination and enforcement resources. The resulting study, in 2011, found that the SEC “will not have sufficient capacity in the near or long term to conduct effective examinations of registered investment advisers with adequate frequency.” The report suggested a few potential remedies, including giving the SEC more money to hire more examiners through user fees on registered investment advisers and drafting legislation that empowers the SEC to designate one or more self-regulatory organization (SRO) to monitor and regulate financial advisers.

The latter concept led House Financial Services Chairman Spencer Bachus (R-Ala.) to co-author the Investment Adviser Oversight Act of 2012. A hearing on the legislation was held on June 6, but a markup has yet to be scheduled. If crafting a final version is delayed beyond July, it is likely to stall until after the upcoming presidential election.

Rep. Maxine Waters ( D-Calif.) opposes the self-regulatory idea and promised a counter-proposal to the so-called “Bachus Bill”  that would mandate the SEC to collect needed fees to cover the cost of examining a greater number of investment advisers. The Government Accountability Office would be tasked with an audit of the SEC every two years to ensure that the fees are used for the intended examinations.

Opponents of Bachus' SRO proposal argue that the result would be a costly, non-transparent approach laden with conflicts of interest.

An analysis by the Boston Consulting Group found that the annual costs of authorizing FINRA (considered the frontrunner for expanded examination powers) to oversee investment advisers would range from $550 million to $670 million, compared to an the annual cost of between $100 million to $270 million it would take to enhance the SEC's capacity to examine investment advisers.

The Consumer Federation of America (CFA), an association of nearly 300 non-profit consumer organizations, has long opposed delegating investment adviser oversight to an SRO. It now, rather reluctantly, has dropped that opposition, although it will not support the Bachus Bill.

“We took the ‘just say no' approach to SROs for years and instead supported increased appropriations,” says Barbara Roper, CFA's director of investor protection. “We've supported user fees, we've supported self-funding, and we've gotten absolutely nowhere. We recently said, ‘OK, we think the problem is serious and we think it is only going to get worse, so we will be open-minded and consider that an SRO would be an improvement over the status quo.' As imperfect as FINRA may be, I think they bring an added level of investor protection.”

“The legislation likely will encourage regulatory arbitrage as firms restructure their businesses and/or dismiss individual and small business clients to avoid the costs and additional regulatory burdens of an SRO.”

—David Tittsworth,

Executive Director,

Investment Adviser Association

That doesn't mean that the CFA is ready to support Bachus' plan. According to Roper, the legislation, as written, “creates an unworkable approach” by adding in exemptions that would help “game the system.” Exempt from SRO oversight: any investment adviser that manages a mutual fund, even if they also have a retail client base, and any adviser for whom 90 percent of their assets under management (AUM) are attributable to charitable funds, hedge funds, retirement plans, mortgage pools, investment advisers and broker-dealers, and individuals with at least $5 million in investments.

“The legislation likely will encourage regulatory arbitrage as firms restructure their businesses or dismiss individual and small-business clients to avoid the costs and additional regulatory burdens of an SRO,” says David Tittsworth, executive director of the Investment Adviser Association. “Many investment advisers that would otherwise be subject to SRO regulation may decide to establish or sub-advise a small mutual fund. Advisers may choose to affiliate with other investment advisers that either advise a mutual fund or manage sufficient ‘institutional' assets to absorb the adviser within its aggregated 90 percent AUM threshold for exemption from SRO membership.”

Roper says a likely outcome is that the largest advisers, and those with the wealthiest client base, will continue to receive direct SEC oversight at no additional cost, while the smaller advisers will be subject to a new added expense for regulatory oversight. Without the ability to spread a portion of those costs to larger, wealthier firms, the costs for small firms could be considerable.

Joe Russo, chairman of the Financial Services Institute, a trade organization that includes broker-dealers among its membership, says that having an SRO like FINRA oversee registered investment advisers is the only viable solution, politically and practically. “Everyone in D.C. knows that this Congress is never, ever, going to give the SEC more money” and “anyone who claims the SEC is a viable alternative isn't being intellectually honest in terms of political reality,” he says.

EXAMINATION DATA

The following excerpt looks at the number and frequency of SEC-registered investment advisers through 2004 to 2010:

The number and frequency of examinations of Commission-registered investment advisers is a function of factors, including the number of Commission-registered investment advisers and the number of OCIE staff. As the number of Commission-registered investment advisers has increased and the number of OCIE staff has decreased over the past six years, there has been a decrease in the number and frequency of examinations of Commission-registered investment advisers.

The number of Commission-registered investment advisers has grown significantly over the past six years. Between October 1, 2004 and September 30, 2010, the number of Commission-registered investment advisers increased 38.5 percent, from 8,581 advisers to 11,888 advisers. That represents an average annual growth rate of 5.7 percent. The assets managed by Commission-registered investment advisers have grown even faster than the number of Commission-registered investment advisers. Over the past six years, assets managed by these advisers grew 58.9 percent, from $24.1 trillion to $38.3 trillion. This represents an average annual growth rate of 9.1 percent.

The growth of the investment advisory industry over the past six years has not been matched by a corresponding growth in Commission resources committed to examining Commission-registered investment advisers, but rather, there has been a decline in Commission resources. Specifically, between October 1, 2004 and September 30, 2010, the number of OCIE staff dedicated to examining Commission-registered investment advisers decreased from 3.6 percent, from 477 staff to 460 staff, falling as low as 425 staff at certain points during the period September 30, 2007 to September 30, 2008.

Other relevant metrics highlight the growth of Commission-registered investment advisers relative to the resources committed to examining them. For example, the ratio of the number of Commission-registered investment advisers to the number of OCIE staff committed to examining such firms, which is a proxy for the relative changes in the resources available to examine investment advisers, increased 43.3 percent over the past six years, from 18.0 to 25.8. Viewed based on assets managed, rather than based on the number of Commission-registered investment advisers, the ratio increased 65 percent over that period, from $50.6 billion to $83.2 billion per examiner.

As the number of Commission-registered investment advisers and the assets managed by them have increased and the number of OCIE staff committed to examining Commission-registered investment advisers has decreased over the past six years, the number of examinations of Commission-registered investment advisers has decreased. The number of examinations of Commission-registered investment advisers conducted each year between 2004 and 2010 decreased 29.8 percent, from 1,543 examinations in 2004 to 1,083 examinations in 2010.

The percentage of Commission-registered investment advisers examined each year has also decreased over the past six years. While 18 percent of Commission-registered investment advisers were examined in 2004, only 9 percent of Commission-registered investment advisers were examined in 2010. At the rate that Commission-registered investment advisers were examined in 2010, the average registered adviser could expect to be examined approximately once every 11 years, compared to approximately once every six years in 2004. The decrease in both the number and frequency of examinations is attributable, in part, to the growth in the number of Commission-registered investment advisers and the decline in the number of OCIE staff.

Source: SEC.

Too Close for Comfort?

Yet some see FINRA as too cozy with those it is tasked to regulate to provide effective oversight. In a letter to the House Committee on Financial Services, Angela Canterbury, director of public policy for the Project on Government Oversight which bills itself as a non-partisan government watchdog, and investigator Michael Smallberg wrote that “industry regulation is most effective when carried out by a governmental agency that is transparent, independent, ethical, and accountable.”

According to the group, oversight by FINRA would not provide those objectives. “FINRA's regulatory effectiveness is undermined by its inherent conflicts of interest, its lack of transparency and accountability, its lobbying expenditures, and its executive compensation packages, among other issues,” they wrote. In 2010, FINRA's top 10 executives received nearly $13 million in pay and benefits. The group says these pay packages could lead officials to become “even more indebted to the industry they are supposed to oversee.”

Nor are state regulators keen on having SROs step onto their regulatory turf. During the June 6 congressional hearing, John Morgan, securities commissioner for the state of Texas, spoke against the bill on behalf of the North American Securities Administrators Association.

Since the passage of the National Securities Markets Improvement Act in 1996 and the more recent Dodd-Frank Act, the division of federal and state regulatory responsibility over investment advisers has been delineated according to the amount of assets under management by the firms. As of June 28, the Dodd-Frank Act will expand state oversight to advisers with $100 million in assets under management, up from $25 million. The switch “is one of the largest regulatory events involving a coordinated effort by the states and the SEC,” says Morgan.

He sees the Bachus Bill as a reversal of that shift and an affront to the principles of federalism and state sovereignty. “States, like the federal government, are statutory regulators and accordingly should not be subordinated to an industry self-regulator,” he says. Morgan adds that the bill offers “an unnecessary, expensive, and duplicative layer of regulation.” 

Not so, says Richard Ketchum, FINRA's chairman and CEO, who pitched FINRA as uniquely qualified for the task. “Self-regulatory organizations have more flexibility than their government counterparts to devote and direct resources to large, multi-year technology development efforts that can support a variety of regulatory programs,” he says.

Ketchum also disputes the cost projections in the Boston Consulting Group study as “inaccurate and based on flawed methodology.” “It is evident their analysis was meant to be a political document rather than a serious attempt to explore costs,” he says. FINRA claims its one-time start up cost would be approximately $12 to $15 million and that ongoing annual costs would total approximately $150 to $155 million.

Chet Helck, chairman of the Securities Industry and Financial Markets Association and CEO of Raymond James Financials' Global Private Client Group, supports the bill “because its purpose is not to foist new regulatory oversight on retail investment advisers, but to restore the oversight that is already supposed to be happening, but is not.”