Tag: Self-Regulatory Organization

Bill Backs SRO for RIAs

Financial Services Committee Chairman Spencer Bachus and Rep. Carolyn McCarthy, a member of the Committee, introduced legislation that would create a Self Regulatory Organization for retail investment advisers. The legislation would amend the Investment Advisers Act of 1940 to provide for the creation of National Investment Adviser Associations (NIAAs), registered with and overseen by the SEC. Investment advisers that conduct business with retail customers would have to become members of a registered NIAA.

The bill exempt private fund managers from having to belong to a NIAA. It looks like it uses the current definition of “private fund” as a company exempt under Section 3(c)(1) or 3(c)(7) of the Investment Company Act. For real estate fund managers still wondering if the SEC cares about you, the bill also include those funds relying on the exemption under Section 3(c)(5)(C) of the Investment Company Act for real estate funds to be exempt from the NIAA requirement.

For investment advisers that have a combination of retail and fund management, the bill sets the the threshold at 90% fund management for the exemption.

The question for investment advisers is what organization will try to be a (the?) NIAA. FINRA is an obvious candidate and one that will upset many.

As for fund managers, presumably they would remain subject to SEC oversight and examination instead of NIAA oversight.

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The Cost of Regulating Fund Managers and Investment Advisers

A group of organizations with Investment Adviser stakeholders engaged the Boston Consulting Group to conduct an economic analysis of IA oversight scenarios (.pdf) in the Securities and Exchange Commission’s study released in January 2011. The analysis came down solidly in favor of increased funding of the SEC as the solution for increased oversight of investment advisers.

BCG looked at the three options in the SEC’s 914 study: (1) enhancing the SEC’s ability to oversee advisers (2) allowing FINRA to oversee RIAs and (3) creating a new IA-only SRO. The first option was examined in two segments: (a) giving the SEC enough examiners to do the job and (b) full resources. The costs represented what it would take for each option to examine every registered investment adviser firm at least once every four years.

Estimates from BCG study of costs for 3 top choices for examining RIAs

Topic Enhanced SEC FINRA New IA SRO
Annual cost per RIA $11,300-$27,300* $51,700 $57,400
Set-up costs $6m-$8m (Increasing OCIE) $200m-$255m $255m-$310m
Set-up time 6-12 months 12-18 months 18-24 months
Mandate costs from fees $100m-$270m $460m-$510m $515m-$565m
SEC Oversight of SRO $0 $90m-$100m $95m-$105m
Total annual costs $100m-$270m $550m-$610m $610m-$670m

The study provides some interesting insight as to staffing. The average examiner productivity is assumed to be 3.0 examinations per examiner per year, based on the five year SEC average of 3.0 IA examinations per examiner per year.31 In order to achieve an average examination frequency of once every four years, with examiner productivity of 3.0 examinations per examiner per year, 787 examiners are required.

The parties who requested the study are the Investment Adviser Association, Certified Financial Planner Board of Standards, the Financial Planning Association, the National Association of Personal Financial Advisors and TD Ameritrade Institutional in commissioning the study.Given that the vast majority of investment adviser firms do not want FINRA as their regulator/examiner it should come as no surprise as to the results of the study.

I expected to see the additional costs of SEC oversight of an SRO. It’s a bit unfair that the SEC costs are only for examination and not enforcement. The SRO figures include that additional cost.

It should also come as no surprise that FINRA disputed the findings. Rumor has it that they are pushing hard to become the SRO for investment advisers.

In any event, it will take legislation from Congress to implement any of these scenarios. The typical Congressman’s knee-jerk reaction to this seems to be “Madoff.” That does not bode well for increased resources for the SEC.

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Report on Self-Regulatory Org. for Private Fund Advisers

Section 416 of the Dodd-Frank Act require the Government Accountability Office to study the feasibility of forming a Self-Regulatory Organization to oversee private funds. With the removal of the 15 clients exemption, many private fund managers will have to register for the first time by March 30, 2011. The GAO beat Congress’s deadline by 10 days when it released the report on July 11.

In Private Fund Advisers: Although a Self-Regulatory Organization Could Supplement SEC Oversight, It Would Present Challenges and Trade-offs (.pdf), the GAO does not break any new ground. The big problem is obvious: the SEC lacks the resources to examine advisory firms on a regular basis. Congress seems to be willing to put a chokehold on funding as a way of limiting the effectiveness of the Securities and Exchange Commission.

Of the 11,505 investment advisers registered with the SEC on April 1, 2011, 2,761 advisers had private funds. But only 863 of those exclusively had private fund clients.  These numbers will change dramatically on April 1, 2012 when mid-sized advisers get kicked out of SEC registration and private fund advisers are dragged in.

Challenges

Legislation would be needed to create an SRO for advisers. I think most players are unsure whether it would be a good thing or a bad thing. Given that the SRO has no form, functions, membership or governance, it’s hard to have an opinion. Private fund advisers may not like registration with the SEC, but at least it’s a known regulatory regime.

“Some of the challenges of forming a private fund adviser SRO may be mitigated if the SRO were formed by an existing SRO, such as FINRA, but other challenges could remain,” the GAO states. As for FINRA, no private fund adviser I’ve spoken to wants to be under their oversight. They don’t like the overly rule-based approach.

Rules versus principles

The GAO report highlights one of the big differences between FINRA’s approach and the SEC’s approach. SROs, like FINRA, traditionally use a rules-based approach, in part, to address the inherent conflicts of interest that exist when an industry regulates itself by minimizing the degree of judgment an SRO needs to use when enforcing its rules. The SEC regime for investment advisers is primarily principles-based, focusing on the fiduciary duty that advisers owe to their clients. That fiduciary duty has been interpreted through case law and enforcement actions. Given the diverse business models among private funds, adopting detailed or prescriptive rules to capture every fact and circumstance possible under the fiduciary duty would be difficult.

Advantages of private fund adviser-only SRO

Through its membership fees, a private fund adviser SRO could have “scalable and stable resources for funding oversight” of its members. That would mean it could conduct earlier examinations of newly registered advisers and more frequent examinations of seasoned advisers than SEC could do with its current funding levels. With improved resources, an SRO could better technology to strengthen the examination program, provide the examination program with increased flexibility to address emerging risks associated with advisers, and direct staffing and strategic responses that may help address critical areas or issues.

Theoretically, the SRO could impose higher standards of conduct and ethical behavior on its members than are required by law.  It could also provide expertise and knowledge than SEC, given the industry’s participation in the SRO.

Disadvantages of private fund adviser-only SRO

The GAO listed these disadvantages:

  1. An increase the overall cost of regulation by adding another layer of oversight.
  2. Conflicts of interest because of the possibility for self-regulation to favor the interests of the industry over the interests of investors and the public.
  3. Limited transparency and accountability, as the SRO would be accountable primarily to its members rather than to Congress or the public.

Although the formation of an SRO could increase demand for CCOs, making it potentially good for me personally, I think it would be a terrible idea for the industry.

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