There has been much talk recently of creating a self-regulatory organization for investment advisers. Whether this will ever actually happen remains to be seen. But we thought it would be a worthwhile exercise to review the current state of play.
Of course, to create such an entity would require an act of Congress. So, on September 8, 2011, U.S. Rep. Spencer Bachus (R-Ala.), chairman of the House Financial Services Committee, introduced a discussion draft of the Investment Adviser Oversight Act of 20111 (the Bachus Proposal), which proposes allowing one, or potentially multiple, self-regulatory organizations (SROs) to oversee investment advisers. If adopted, subject to certain exclusions, all investment advisers registered with the Securities and Exchange Commission (SEC) and the states would be required to register with an investment adviser SRO.
But, before we get ahead of ourselves, some background is in order.
Section 914 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) mandated that the SEC conduct a study to review and analyze the need for enhanced examination and enforcement resources for investment advisers (the Study).2 Section 914 also required, among other things, an examination of the extent to which having Congress authorize the SEC to designate one or more SROs to augment the SEC’s efforts in overseeing investment advisers would improve the frequency of examinations of investment advisers and current and potential approaches to examining the investment advisory activities of dually registered broker-dealers and investment advisers that are affiliated with a broker-dealer.
The Study, released in January 2011, concluded that "[w]hile the Commission’s resources and the number of [Office of Compliance Inspections and Examinations (OCIE)] staff may increase in the next several years, the number of OCIE staff is unlikely to keep pace with the growth of registered investment advisers. As a result, 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."
As discussed in the Study, while 18 percent of registered investment advisers were examined in 2004, only 9 percent of registered investment advisers were examined in 2010. At this rate, the average registered adviser could expect to be examined less than once every 11 years. The SEC has stated that the decrease in both the number and frequency of examinations is attributable, in part, to the growth in the number of registered investment advisers and the decline in the number of OCIE staff. The SEC has also noted that the decrease also is attributable to other changes in the SEC’s examination program (i.e., the focus on higher-risk advisers).
The Study further discussed three options that it believed that Congress should consider in order to strengthen the SEC’s investment adviser examination program: (1) authorizing the SEC to impose user fees on SEC-registered investment advisers to fund their examinations by OCIE; (2) authorizing one or more SROs (in the SEC’s view, a single SRO would be preferable to multiple 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.
The Bachus Proposal
Under the Bachus Proposal, federal- and state-registered investment advisers would be required to maintain membership with a national investment adviser SRO unless exempt. Exemptions would be provided for any investment adviser that has 90 percent or more of its assets under management attributable to one or more of the following types of clients:
(a) investment companies registered under the Investment Company Act of 1940 (the 1940 Act)
(b) non-U.S. persons
(c) super-accredited clients that, in the aggregate, own at least $25 million in investments
(d) religious, educational, benevolent, fraternal, charitable, or reformatory entities – (entities defined in
Section 3(c)(10) of the 1940 Act)
(e) stock pension plans and collective trusts – (entities defined in Section 3(c)(11) of the 1940 Act)
(f) "private funds" as defined in Section 202(a)(29) of the Investment Advisers Act of 1940 (Advisers Act) – issuers that would be investment companies under Section 3 of the 1940 Act but for the exclusions from the definition of "investment company" under Section 3(c)(1) or 3(c)(7) of the 1940 Act – i.e., hedge funds and private equity funds, and
(g) venture capital funds.
Exemptions would also be provided for any registered investment adviser that is controlling or under control of another registered investment adviser exempt from SRO registration for one of the above reasons, if the SEC finds "that the compliance programs, operations and businesses of such investment advisers are sufficiently integrated that membership in a [SRO] would necessitate inappropriate duplicative examination by [the SEC and the SRO], or otherwise would not be necessary in the public interest and for the protection of investors or in furtherance of the purposes of [the Investment Advisers Act]." Finally, the SEC would be given authority to exempt any other adviser or class of adviser.
Under the Bachus Proposal, more than one SRO could be registered with the SEC. However, the SEC would first have to determine that each applicant is organized so that it has the "capacity" to enforce compliance with its rules and that its regulations and rules meet the following criteria:
- they assure a "fair representation" on its board of directors of the public and the investment adviser industry (a majority of the board must not be associated with any member of the SRO or any investment adviser or broker-dealer)
- they are designed to prevent fraudulent acts and to protect investors
- they are necessary and consistent with the Advisers Act and the rules thereunder and the fiduciary standards applicable to investment advisers under the Advisers Act or state law, and do not duplicate, overlap or conflict with those laws
- they do not pose "any burden on the business of investment advisers" or their ability to compete in the market "that is not necessary or appropriate in the public interest or for the protection of investors or otherwise in furtherance of the provisions of the ... Advisers Act"
- they provide for periodic exams of its investment adviser members, consultation with the SEC in the development of an exam program, and for the coordination of exams with examinations by the SEC and state securities regulatory authorities
- they provide for equitable allocation of member dues and charges
- they provide for issuance of an annual financial report to the SEC and Congress
- they establish criteria for investment advisers to become members, and
- they establish disciplinary procedures for violations of rules and regulations.
Upon filing of an application for SRO status, the SEC would publish notice and submit the application for public comment, although the SEC would be the final arbiter of whether to grant registration of an investment advisory SRO. As is the case with current SROs, each investment adviser SRO would file proposed rules with the SEC for public comment – subject to an exception for situations in which the SEC believes that more immediate action is necessary for the protection of investors or the safeguarding of securities or funds. As with current SROs, proposed rule changes would have to be approved by the SEC.
A "Bachus Proposal SRO" would have disciplinary authorities similar to that of FINRA. Summary powers would include the authority to suspend the membership of or limit the services of a member that has been expelled by any SRO, or of a member experiencing serious financial or operational difficulty. An SRO could also summarily limit or prohibit the services of any investment adviser that does not meet SRO qualification requirements or other prerequisites for membership – however, the SEC could stay a summary action on its own or upon application by an aggrieved party. The SRO would also file notice with the SEC of all final disciplinary sanctions – a party subject to discipline would have the right to file for a review of a sanction with the SEC, which could cancel, reduce or revoke the sanction.
FINRA as a/the Investment Adviser SRO?
As discussed in the SEC Study, the concept of an SRO for investment advisers is not new – various proposals have been considered by Congress, the SEC and members of the investment industry for more than 45 years.
Currently, the Securities Exchange Act of 1934 (the Exchange Act) provides FINRA with authority to enforce its members’ compliance with the Exchange Act (and rules the SEC has adopted under that Act), but does not provide it with express authority to enforce compliance with the Advisers Act. Thus, OCIE staff conducts examinations of dual registrants for compliance with the Advisers Act in addition to, and separate from, FINRA’s examinations of broker-dealers.
While only about five percent of investment advisers registered under the Advisers Act are broker-dealers and thus members of FINRA, most of the largest retail broker-dealers are dually registered. These dual registrants have a substantial portion of retail advisory clients and employ a significant number of investment adviser representatives.
The SEC stated in its Study that authorization of FINRA to enforce the Advisers Act would free existing SEC resources spent examining dual registrants to be re-directed to other investment advisers. Moreover, such a move "would partially address the inefficiencies that result from subjecting a dual registrant to two separate examinations, one by FINRA and the other by OCIE" and allow a single regulator, subject to SEC oversight, with "a more holistic view of dual registrants’ client activities and compliance environment, to conduct a more effective examination of a dual registrant" and a more cost-efficient examination. The Exchange Act already grants FINRA broad discretion when determining its funding level, subject to the requirement that FINRA be "so organized and [have] the capacity to be able to carry out the purposes" of the Exchange Act and "to comply, and ... to enforce compliance by its members, and persons associated with its members, with the provisions" of the Exchange Act.
In the past, FINRA has suggested that it be given authority to act as the SRO not only for its members that are investment advisers, but also for advisers that are affiliates of its members. As seen by FINRA, such an approach would preclude a broker-dealer from reorganizing its advisory services to escape FINRA oversight but would also extend the jurisdiction of FINRA to large money managers, many of which have affiliated broker-dealers to, for example, distribute interests in mutual funds or hedge funds they manage, but otherwise have nothing to do with retail advisory services. One approach suggested by the SEC to address this concern would be to limit FINRA’s jurisdiction to affiliates that provide advisory services to clients in connection with brokerage services also provided to them.3
FINRA seems especially interested in obtaining authority over the investment adviser side of dual registrants, and has stated, "current programs would be enhanced and investors be better protected if [FINRA] had the authority to examine the full operations of dually registered firms, where currently [FINRA] can only see the broker-dealer side of what is typically a fully integrated business."4 FINRA has also suggested that it should become the SRO for all SEC registered advisers (or possibly all state- and SEC-registered investment advisers).
As noted by FINRA before Congress,5 if FINRA were to become an SRO for investment advisers, it intends to establish a separate entity with separate board and committee governance to oversee any adviser work, and would plan to hire additional staff with expertise and leadership in the adviser area. In terms of the governance structure of potential investment adviser SROs, FINRA believes that public representatives should form a majority of any governing body, and members of the investment advisory industry should be allocated a number of the remaining seats to ensure adequate industry representation.
Opposition to a National SRO for Investment Advisers
Of course, under the current regime, in general, larger investment advisers are regulated and registered directly by the SEC, and smaller ones by the states themselves. Others are excluded from registration requirements and many, but not all, investment advisory regulations.
One concern that has been expressed is that if a national SRO is established, there may be a cookie-cutter approach and perhaps a high threshold for initial compliance for advisers that may have a limited business model. Such a concern has been expressed in the brokerage world by parties that effectively act as enhanced "finders" with a business model of connecting company A to potential investor B, while also providing some extra deal facilitation services.
The Bachus Proposal has also drawn a fair amount of criticism directed toward the possibility that FINRA (or an entity affiliated with FINRA) may become a national investment adviser SRO. As noted by David Tittsworth, executive director of the Investment Adviser Association, "[t]he discussion draft appears to be tailor-made for FINRA"6 and that the Investment Adviser Association opposes "FINRA’s efforts to expand its turf, due to its lack of accountability, its lack of transparency, its poor track record, the costs involved and its bias favoring the broker-dealer model."
State securities regulators have also criticized the Bachus Proposal for not being sufficiently clear in delineating the state role in adviser oversight. The Bachus Proposal would put most state-registered advisers under an SRO overseen by the SEC. The North American Securities Administrators Association (NASAA) has been especially vocal.7 As stated by Pennsylvania Securities Commissioner Steve Irwin, NASAA opposes the creation of a self-regulatory organization for state-regulated investment advisers. "Moreover, NASAA reiterates its significant and longstanding concerns regarding any effort to establish a self-regulatory organization for investment advisers."8
NASAA’s position regarding investment adviser regulation is that regulation should continue to be the responsibility of state and federal governments, and that these regulators must adequately carry out their responsibilities. As NASAA puts it, they see "little benefit in constructing a new layer of bureaucracy, with its incumbent expense. If the goal is strengthening investor protection through improvements to the oversight of SEC-regulated investment advisers, then the shortest distance to the goal is to ensure that federal regulators are adequately funded and have the resources to properly oversee investment advisers for the protection of main-street investors. Most importantly, government regulators are answerable to our constituents, and not to a Board of Directors."
NASAA has expressed a special concern for small and mid-sized firms, especially ones primary located in a single state, that might experience increased costs under an SRO "without substantially enhancing investor protection." NASAA also sees state securities regulators as local "cops on the beat" who are "more likely to be visiting the offices in the small towns and cities across America, than the SEC or a large organization headquartered in New York or Washington, D.C."
As stated by NASAA "[t]he existing securities industry SRO model – as typified by FINRA – is replete with conflicts of interest. Members of the industry serve on the SRO’s board and occupy other positions of prominence such as serving on various advisory committees. Even where there is an independent Board of Directors, SROs remain organizations built on the premise of self-rule and are, as a matter of first principle, accountable to their members, not the investing public. Any SRO that depends on its members as its primary funding source faces a heightened susceptibility to industry capture. If FINRA denies an application, or expels a member in an enforcement matter, FINRA loses money."
Because SROs are private corporations that do not have subpoena power, member firms are required to "voluntarily" cooperate with SRO investigators and provide testimony and documents to a SRO. This has given rise to concerns by FINRA that when it cooperates with governmental regulators, by providing information, testimony, or documents related to its members, it is acting as a quasi-governmental actor, or "state-actor." In certain instances, FINRA has cited the "state-actor doctrine" as a basis for non-cooperation with state securities regulators and the restriction of the release of information to state authorities.
SROs are also not subject to the Freedom of Information Act (FOIA) or other similar public records requirements, as are state securities regulators and the SEC. Even where there is public disclosure by SROs regarding members, as in the case of BrokerCheck, an SRO often places limitations and filters on regulatory records in excess of FOIA provisions, which may result in less public disclosure of information, compared to the information that state securities regulators make publicly available.
FINRA Response to Objections
As noted by FINRA’s Executive Vice President for Corporate Communications Howard Schloss, FINRA believes that the solution to the SEC’s inspection issues, given the current budget realities, is to authorize one or more SROs to examine investment advisers. As stated by Mr. Schloss, "We believe we are well-positioned to fill that role."9
FINRA’s Vice Chairman Stephen Luparello also has spoken recently about the issues raised by FINRA potentially being the SRO for the investment advisory world.10 As expressed by Mr. Luparello, many advisers fear that an SRO – particularly FINRA – would not be sufficiently sensitive to the different regulatory risks of advisers and that investment advisers would be forced to live under a broker-dealer regime.
As noted by Mr. Luparello, FINRA agrees that there are important differences between broker-dealers and investment advisers and any entity that would be empowered to oversee investment advisers would need to recognize that and regulate accordingly. As presented by Mr. Luparello, FINRA would not force broker-dealer requirements on investment advisers. Any investment adviser SRO – FINRA or any other – would need to implement regulatory oversight that is tailored to the particular characteristics of the investment adviser business. As stated by Mr. Luparello, were FINRA the SRO for investment advisers, the primary regulatory structure for advisers would remain where it is today – under the fiduciary standard incorporated in the Advisers Act and related SEC rulemaking and interpretations, and from the developed body of state law, with the SRO needing only limited rulemaking authority over investment advisers.
Another criticism related to FINRA serving as an investment advisory SRO is that FINRA’s governance structure only reflects broker-dealer interests and does not have representation from investment advisers. FINRA has represented, including in testimony to the House of Representatives, that if FINRA were to become the SRO for investment advisers, FINRA’s governance structure would reflect investment advisers. This would be carried out most effectively by setting up a separate affiliate that would have a board comprised of a majority of public representatives, with members of the investment adviser industry allocated the remaining seats.11
While FINRA acknowledges that its staff may lack the necessary expertise to adequately regulate investment advisers, it believes that it can become an effective SRO through hiring additional staff, "especially those with expertise and leadership in the adviser area, and implement[ing] a rigorous training program to make sure [FINRA’s] existing examiner corps are up to speed on the differences."12
FINRA believes, based on its experience and existing resources, it is uniquely positioned to build a cost-effective SRO for investment advisers. As FINRA sees it, while there would be some incremental cost to implementing an investment adviser program, much of that cost is embedded in its existing infrastructure – including district offices, regulatory technology and registration functions through the Investment Adviser Registration Depository (IARD).
Current Prospects for the Bachus Proposal
As reported on October 13, 2011,13 the Senate Banking Committee Chairman Tim Johnson (D-S.D.) believes the issue deserves further exploration before moving forward with any legislative proposals. As noted by David Tittsworth, executive director of the Investment Adviser Association,14 the Senate may be moving slower deliberately.
There is a saying in Washington: Never waste a good crisis. The economic crisis of 2008-2009 gave us the Dodd-Frank Act. The Dodd-Frank Act has reinvigorated the possibility of creating an SRO for investment advisers. Is there enough momentum this time around to get it done? Who knows? Is it a good idea? Maybe, and maybe not. But there is one thing we can all agree on: It makes for great theater.
1 The draft legislation is available at http://financialservices.house.gov/UploadedFiles/BACHUS_017_xml.pdf.
2 The results of the SEC Section 914 Study are available at http://www.sec.gov/news/studies/2011/914studyfinal.pdf.
3 See the SEC Section 914 Study.
4 Testimony of Rick Ketchum, Chairman and CEO, FINRA before the House Subcommittee on Capital Markets and Government Sponsored Enterprises Committee on Financial Services on September 13, 2011, available at http://www.finra.org/Newsroom/Speeches/Ketchum/P124416.
5 See testimony of Rick Ketchum on September 13, 2011.
6 See September 11, 2011 article, "Adviser SRO bill to be aired at hearing," by Mark Schoeff Jr. on Investmentnews.com, available at http://www.investmentnews.com/article/20110911/REG/309119970.
7 See http://www.nasaa.org/5590/state-securities-regulators-outline-opposition-to-investment-adviser-sro/.
8 See September 13, 2011 testimony of Steven D. Irwin, Pennsylvania Securities Commissioner and Chairman of the Federal Legislation Committee of the North American Securities Administrators Association, Inc., before the House Subcommittee on Capital Markets and Government Sponsored Enterprises on the topic of "Ensuring Appropriate Regulatory Oversight of Broker-Dealers and Legislative Proposals to Improve Investment Adviser Oversight," available at http://www.nasaa.org/5587/ensuring-appropriate-regulatory-oversight-of-broker-dealers-and-legislative-proposals-to-improve-investment-adviser-oversight.
9 See "Adviser SRO bill to be aired at hearing" article of September 11, 2011.
10 See speech of October 5, 2011 by FINRA Vice Chairman Stephen Luparello at FSI Advocacy Summit, available at http://www.finra.org/Newsroom/Speeches/Luparello/P124599.
11 See testimony of Rick Ketchum on September 13, 2011.
12 See speech of Vice Chairman Stephen Luparello.
13 See October 13, 2011 article, "RIAs lobby Bachus on SRO proposal: Constituent gets the congressman’s ear, hoping to modify legislation," by Mark Schoeff Jr. on Investmentnews.com, available at http://www.investmentnews.com/article/20111013/FREE/111019957.
14 See "RIAs lobby Bachus on SRO proposal: Constituent gets the congressman’s ear, hoping to modify legislation" article of October 13, 2011.
Ivan B. Knauer and Matthew R. Silver