INVESTMENT ADVISER SRO – Is an IA SRO workable or right? Part Two

Written by: Phil Feigin

My former state securities regulatory brethren must be steamed. Having seemingly assured themselves of a Congressionally recognized role in national investment adviser regulation for the next millennium in Dodd-Frank, I can appreciate the angst they must be feeling now. After gaining important, seemingly indelible ground in Dodd-Frank, they are then preemptively aced out of what they see as core functions involving private placement and small securities offerings in the JOBS Act, and now, the IA SRO boogeyman returns. They must, understandably, be having a federalist conniption fit.

The division of state and SEC authority over IAs instituted in 1996 was a bit of a crazy quilt to begin with, dreamed up at the last minute at 1:30 in the morning in a staff office. In Dodd-Frank, Congress added a bunch of “polka dots” and “paisley swirls” to the quilt. Confusing as that all is, Rep. Bachus would now apply yet another layer (or layers) of SRO rules, regulators, process and examination, cutting across everything else. The states have a good case to make that the IA SRO concept is a bad one. I do not profess to speak for them in any way, but, unless things have changed dramatically since my days in NASAA, state regulators will not be keen on the idea of surrendering the lion’s share of their IA responsibilities, let alone reporting, to what they perceive as a private, opaque, industry club, whether it be FINRA or some other group, existing or to be formed.

Allow me to “review the bidding” on the history of SROs and why we have them. Back in 1934:  (i) exchanges were a given; (ii) self-regulation was a favored theme of the New Deal across all industries; (iii) given the times, the OTC market was too far flung geographically for any authority, be it governmental or self-regulatory, to oversee effectively (rather the industry try and fail than hang the SEC for it); (iv) the SROs combined both regulatory and market functions; and (v) there was a reluctance on the part of the SEC to get into the minutiae of trying to regulate what they termed the “ethics” of industry, at least in 1934 terms.

The idea of an SRO for investment companies and investment advisers has been considered, rejected or simply ignored rather consistently, at some point during almost every decade since 1934. I think there are some fundamental reasons why.

Not one profession. As I perceive it, I think it a fair and workable means of classification to divide the profession into three general groups: 

(i)      money managersthey manage investment portfolios for mutual funds, hedge funds, institutional clients and the like, are paid advisory fees based on the assets under their management (“AUM”), but sell no products, and tend to be concentrated in urban money centers;

(ii)     retail advisors—they are paid advisory fees based on AUM and also serve as securities reps and insurance agents, selling products like securities and insurance on a commission basis—they tend to be affiliated with regional and national firms, with offices of all sizes located all over the country; and

(iii)    fee-only planners—they are paid exclusively by fees based on AUM and sell no products—they tend to be local, unaffiliated, and in single offices usually located in one state alone.

“Investment advisers” may be united by a definition, but that is about as far as it goes. My characterizations are surely imperfect. Certainly, dozens of mutual funds are affiliated with brokerage firms. But generally, money managers and fee-only planners are distinguished by the nature of their clients—essentially, the difference between those who manage the funds of institutions and those who deal directly with consumers. Those who both sell securities for commissions and also advise for fees as fiduciaries are already generally regulated for both functions by FINRA, as well as by the government regulators. (FINRA may take the position it does not have regulatory jurisdiction over their firms and member reps that are also IAs and IA reps, but try to convince brokerage firms and associated persons that have been the subject of FINRA “involvement” in their strictly advisory conduct as to that alleged lack of authority.)

They don’t sell anything. Many investment advisers sell nothing but their advice. They are compensated by the fees they charge alone. Even those that do also sell products do so as registrants/licensees under another regulatory regime, like securities brokerage or insurance regulation. The interests of fee-only advisers are virtually aligned with those of their clients. If the clients make money, the fee-only advisers make money, and vice versa. Are there opportunities for wrongdoing? Surely, but they are significantly fewer and rarer than when selling is involved.

It’s all about ethics. Back in 1938, SEC Chairman William O. Douglas expressed his belief that an organization of brokerage companies themselves was suited far better than the SEC to set and police the ethical standards of the industry. That notion appears quaint now. Neither did it seem to bother Congress in the enactment of the Investment Company and Investment Advisers Acts of 1940, less than two years later. Ethical considerations such as conflict of interest regulation abound in the Investment Company Act. In the Capital Gains case, the Supreme Court found that, in the Advisers Act, the Congressional definition of “investment adviser” meant IAs are fiduciaries, about the highest legal and ethical standard there is. Neither the SEC nor the states have had any difficulty crafting a regulatory scheme to impose and oversee investment advisers based on the concepts of fiduciary duty and statutory fraud. It is from those two pillars that virtually all IA regulation flows. The entire regulatory regime is based on ethical standards.

Not your father’s NASD. Today’s FINRA is a private army of regulating professionals, policing the securities industry for violations of a well-honed code designed to regulate selling and buying by its members and their staffs. FINRA is an army separate and apart from its broker members. It is an amalgamated clone of the SEC’s Divisions of Trading and Markets and Enforcement, and the Office of Compliance, Inspections and Examinations (“OCIE”). Today’s real differences between FINRA, and the SEC and the states: 

  • FINRA has more people, money, and other resources;
  • FINRA’s inner workings, deliberations and decisions are cloaked in secrecy;
  • the SEC and states have subpoena power that reaches beyond their registrants, and can investigate and pursue unregistered violators in court;
  • as governments, the SEC and state securities agencies are subject to direct oversight by and are accountable to Congress, state legislatures, elected officials, public records laws and general requirements for transparency.

What follows in Part Three are the reasons I think an IA SRO is unnecessary and inappropriate today, and what I perceive as a huge problem with the Bachus proposal.

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