Addressing a perceived gap in the effective regulation of investment advisers, on April 25, 2012, House Financial Services Chairman Spencer Bachus, R-Ala., and Rep. Carolyn McCarthy, D-N.Y., introduced bipartisan legislation in the U.S. House of Representatives to amend the federal Investment Advisers Act of 1940 to provide for the creation of, and mandatory membership in, one or more “national investment adviser associations.” The newly introduced legislation --dubbed the Investment Adviser Oversight Act of 2012-- would in practical terms establish for investment advisers and their associated persons the self-regulatory organization (SRO) analog of the Financial Industry Regulatory Authority (FINRA) for securities broker-dealers. The investment adviser SRO would be tasked with formulating rules and enforcing compliance with those rules by its members and associated persons, designed to prevent fraudulent and manipulative acts and practices, to protect investors and the public interest, and to promote business conduct standards for members consistent with their obligations to investors.
Under the proposed legislation, subject to certain exemptions, it would be unlawful for any investment adviser registered with the U.S. Securities and Exchange Commission, or that is regulated or required to be regulated under the law of a state in which the adviser maintains its office and principal place of business, to engage in business in interstate commerce as an investment adviser unless the adviser is a member of a national investment adviser association registered with and overseen by the SEC.
A DODD-FRANK PRODUCT
In the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), Congress directed the SEC to review and analyze the need for enhanced examination and enforcement resources for its oversight of investment advisers, and report to Congress on issues specifically including whether a self-regulatory organization should be established for investment adviser oversight and examination. In January 2011, the SEC Staff made its Report, and concluded, among other things, that an SRO for registered investment advisers having the authority to adopt rules, examine member firms for compliance with those rules and the federal securities laws, and enforce those rules and laws, could effectively augment the SEC regulatory function, and in particular meet challenges faced by the SEC in strengthening its investment adviser examination program. The SEC Staff recommended that Congress consider three approaches to deal with the challenges, specifically including the authorization of one or more SROs to examine all registered investment advisers.
Against this backdrop, and focusing specifically on the need for more effective examinations of investment advisers, with the introduction of the Investment Adviser Oversight Act, Congressman Bacchus emphasized that it is essential that the SEC’s oversight of advisers be augmented and supplemented, particularly to markedly increase the examination rate for investment advisers with retail clients.
ESTABLISHING AN INVESTMENT ADVISER SRO
Proposals to create an investment adviser SRO are not new. Several proposals to create one or more SROs for investment advisers have previously been considered by Congress, the SEC, and the investment advisory industry itself. However, Dodd-Frank thrust it into the spotlight in the face of clear evidence that the SEC oversight process suffered from a lack of sufficient resources dedicated to oversight examinations. FINRA has often been suggested as a likely SRO for investment advisers based on its existing membership and rule structure, and history in the securities industry generally. The proposed legislation, however, speaks only of establishing one or more1 registered national investment adviser associations. For whatever association(s) may be created, the key considerations, among other things, are mandated rules that:
- Are consistent with the Advisers Act and fiduciary duties under the Act and state law;
- Do not impose any burden on advisers that is not in the public interest or for investor protection;
- Provide for periodic examinations of members and their related persons, and for coordination of those examinations with the SEC and state securities authorities;
- Assure a fair representation of the public interest and the investment adviser industry in its selection of directors and administration of its affairs, and provide that a majority of its directors do not come from the securities industry; and
- Provide for equitable allocation of dues and fees and establish appropriate disciplinary procedures for members and their associated persons that violate the Advisers Act, SEC rules or the association’s rules.
Required membership in whatever investment adviser SROs may be established would be subject to certain exemptions. For example, the membership requirement would not apply to an investment adviser who has one or more clients that is an investment company registered under the federal Investment Company Act of 1940. Nor would it apply to an investment adviser having total assets under management 90 percent or more of which are attributable individually or in the aggregate to certain persons with which the adviser has entered into a written agreement. These persons include foreign clients, registered investment companies, “qualified purchasers” as defined in the Investment Company Act of 1940, private funds, and several others. The exemption for advisers to private funds is particularly significant in the wake of Dodd-Frank provisions which have required registration under the Investment Advisers Act for advisers to private funds, and the exemption reflects the special character and scope of advisory activity relative to private funds. The effect of the exemptions from mandated SRO membership is to focus attention on retail clients, where the perceived need for effective regulation is greatest.
As written, the proposed federal legislation imposes the association membership requirement not only on SEC registered advisers, but also state-only registered advisers that make use of the mail or any means of interstate commerce in connection with their business. As a practical matter, the federal jurisdictional “means” qualifier captures all investment advisers. Regarding state regulatory authority over investment advisers and their associated persons generally, the proposed federal legislation makes clear that nothing is intended by the new requirements to limit or detract in any way from, or to preempt the authority of state securities regulators to adopt rules, investigate violations of state law, initiate enforcement proceedings, or otherwise regulate any investment adviser that is subject to state authority. That said, Jack E. Herstein, President of the North American Securities Administrators Association (NASAA), responded to the introduction of the new federal legislation with immediate criticism of the mandate that state-regulated investment advisers become members of a national SRO, calling the Bill an “astonishing attack on our system of federalism with no demonstrated justification.”2
Consistent with the approach taken in the Securities Exchange Act of 1934 regarding national securities associations, of which FINRA is the only one, an association of investment advisers created under the amended Investment Advisers Act of 1940 would be required to be registered with the SEC. Registration would be based not only on rules designed to achieve the objectives noted above, but also a structure to establish appropriate procedures to register persons associated with members, to require supervisory systems for members and their associated persons, and to discipline members and associated persons. SEC oversight of an association would follow the same model, such that association rulemaking would be subject to SEC approval, association disciplinary action may be reviewed by the SEC, and overall, the association would be subject to regular and routine inspections, at least annually, to ensure compliance with the law and its rules. Ultimately, under the proposed legislation, the SEC could suspend, censure or place limitations on investment adviser associations, and expel members.
THE ROAD AHEAD
The bipartisan initiation of legislation in the House of Representatives to create an investment adviser SRO is obviously no guarantee of smooth sailing in the further legislative process. NASAA’s immediate response, noted above, portends a robust debate. It may, however, simply be time to bring investment advisers, who play an undeniably significant role as financial market intermediaries today, fully into the tripartite market regulatory structure in the United States based on federal law, state law and self-regulation. In Dodd-Frank, Congress quite deliberately called for a new examination of the need for bringing investment advisers within the critical self-regulatory piece of market intermediary regulation. The SEC Staff study clearly supports the conclusion that designation of one or more SROs to augment the Commission’s oversight of investment advisers and their associated persons is an effective means of addressing the challenge presented with the current regulatory structure. This conclusion was reached in light of the fact that the SEC will likely not have sufficient capacity in the near or long term to conduct effective examinations of registered investment advisers with adequate frequency.
The structure of investment adviser regulation in the 21st century has also significantly changed, with the states taking on regulatory responsibility for many more investment advisers who now fall below the assets under management threshold for SEC registration and direct regulation. The NASAA response to introduction of the Bill notwithstanding, state resources are today taxed to no less an extent in expanding capacity to handle the increased regulatory burden that has fallen directly on the them regarding smaller and mid-sized investment advisers formerly regulated by the SEC. The FINRA model of a national association for self-regulation of broker-dealers and their associated persons has long been in place, and is thoroughly incorporated into and consistent with state regulation of these intermediaries through licensing and antifraud enforcement authority. The FINRA model for broker-dealers has likewise encompassed the full spectrum of broker-dealers, large and small. It remains to be seen, then, whether adding investment advisers to the established tripartite structure of intermediary regulation in the United States would fundamentally alter the role of state regulation or lead to regulatory inefficiencies or redundancy.
Dodd-Frank called for multiple studies relating to broker-dealers and investment advisers. The proposed Investment Adviser Oversight Act of 2012 follows from one of them. Later this year, however, the Capital Markets and Government Sponsored Enterprises Subcommittee of the House Financial Services Committee will take up all of the Dodd-Frank mandated studies on the effectiveness of standards of care applicable to broker-dealers and investments advisers, and specifically on the need for enhanced examination and enforcement resources for investment advisers.