The migration of stockbrokers into the advisory arena through the marketing of brokers as “trusted advisers” and “financial advisors” over the years has fueled confusion among investors as to the services provided by stockbrokers and investment advisers as well as the level of protection.
The dirty secret is that aside from filling out an Investment Advisory Form registering with the U.S. Securities and Exchange Commission, and perhaps an occasional audit, investment advisors are substantially unregulated (Bernie Madoff was an investment advisor).
The Investment Advisor Act
The Investment Advisor Act does not provide for a private cause of action, meaning that only the securities regulators and noy individuals can bring federal claims for a violation of the rules, and perhaps more importantly, most investment advisor agreements have forum selection clauses requiring their victims to bring their claims before various forums and far away lands most convenient to the investment advisor including before the American Arbitration Association, where the injured investor may have to pay up front and risk tens of thousands of dollars in forum fees, all of which has the calculated and desired effect of stifling these claims.
Financial Industry Regulator Authority
The financial crisis of recent years, as well as high profile Ponzi schemes like Bernie Madoff’s, have led to calls for regulation, and FINRA the Financial Industry Regulator Authority is being proposed as the self-regulatory organization or SRO to replace the Securities and Exchange Commission, or SEC, as investors’ first line of defense against bad investment advisors.
While FINRA does have control over persons that are dually registered as stockbrokers and investment advisors, many investment advisors, some of whom are flunkies, with extensive complaints, or whom have been drummed out of the securities business, resurface as investment advisors.
In May 1998, in Notice to Members 98-38, FINRA observed that “some associated persons,” working in geographically dispersed offices, “are involved in other business enterprises, such as insurance, real estate sales, accounting, tax planning, or investment advisory services activities.” “While the [FINRA] does not encourage or discourage such arrangements… the purpose of this Notice is to remind members of their supervisory obligations for all of their associated persons and offices” and that “Member firm must supervise all of their associated persons – regardless of location, compensation, employment arrangement or registration status – in accordance with the NASD By-Laws and Rules.”
In July 2009, the United States Congress began hearings with respect to the Investor Protection Act of 2009. Since July 2009, leaders of seven organizations representing financial professionals, regulators, and investors sent a joint letter on July 14 to Reps. Barney Frank (D-Massachusetts) and Spencer Bachus (R-Alabama) as chair and ranking member of the House Committee on Financial Services voicing their support for the proposal in the Obama Administration¡¯s White Paper on financial regulatory reform that would impose a fiduciary duty upon anyone who provides investment advice.
North American Securities Administrators Association
The North American Securities Administrators Association (NASAA) has joined several other public interest organizations in expressing strong support for the proposal in the Obama Administration’s White Paper on financial regulatory reform to subject all those who provide investment advice to a fiduciary duty to act in their clients’ best interests.
On October 6, 2009, Denise V.Crawford, the Texas Securities Commissioner and President, The North American Securities Administrators Association, Inc., testified before the House Financial Services Committee that: “The migration of stockbrokers into the advisory arena through the marketing of brokers as ‘trusted advisers’ and ‘financial advisors’ over the years has fueled confusion among investors as to the services provided by stockbrokers and investment advisers as well as the level of protection.” Capital Markets Regulatory Reform: Strengthening Investor Protection, Enhancing Oversight of Private Pools of Capital, and Creating a National Insurance Office (NASAA Oct. 6, 2009); See also, Investment Advisers Should Adhere to a Single, High Fiduciary Standard, Says CFA Institute (Sept 11, 2009).”
U.S. House Financial Services Committee Hearing
However, this week, a subcommittee of the U.S. House Financial Services Committee held a hearing on Sept. 13 to contemplate the question after the SEC issued a study by its Division of Investment Management that revealed an alarming situation: Though the SEC is charged with regulation of investment advisors, scarce resources have meant that such advisors have been barely regulated for years now.
The SEC study was mandated by the Dodd Frank Wall Street Reform and Consumer protection Act of 2010. The study shows that while the number of registered investment advisors swelled by 38.5 percent form 2004 to 2010, the number of these advisors who were examined for compliance with the law fell by half.
It is also useful to note that Mary Shapiro, the Director of the SEC, was also previously the Director of FINRA, from where – several million dollars later – she was appointed to the SEC.
In 2004, 18 percent of registered investment advisers was examined. By 2010, only 9 percent of registered investment advisers was examined.
“At the rate that registered investment advisers were examined in 2010, the average registered adviser could expect to be examined less than once every 11 years, compared to approximately once every six years in 2004,” the study said.
Other statistics flesh out the story: as the assets under management of the advisors grew from $24.1 trillion in 2004 to $38.3 trillion in 2010, the number of SEC staff dedicated to examining these advisors fell from 477 to 460. This number was even lower – 425 – from the third quarter of 2007 to the same quarter of 2008, when assets under management hit their peak of about $43 million.
Another option on the table is the imposition of fees on the advisors. The monies collected would be used to beef up the SEC’s enforcement capacity.
The hearing meant to address this untenable situation considered a draft bill circulated early this month by Sen. Spencer Bachus, R-Ala. The bill would require all registered investment advisors to be members of registered national investment adviser associations that would oversee all members and in turn be subject to the ultimate oversight of the SEC. Some types of entities would be exempt, including funds handling more than $25 million, private funds and venture capital funds.
This legislation, titled the Investment Adviser Oversight Act of 2011, would authorize the registered national investment adviser associations to regulate advisors much the same way FINRA regulates broker-dealers. In other words, they would become self-regulatory organizations, or SROs.
Like FINRA, these SROs would be responsible for setting rules and regulations for the entities they oversee, and the enforcement of those rules, including disciplinary sanctions.
The SEC would conduct “regular and routine inspections, at least annually” of these SROs to ensure compliance with all statutes, rules and regulations. The SEC would also vet and approve any proposed SRO rules, including submitting them for a public comment period. The SROs would also be required to notify the SEC of any sanctions, according the legislation.
Moreover, some discussion at the hearing centered on allowing to FINRA to begin to oversee dual-registered entities, those registered as both broker-dealers and investment advisors. This type of entity is increasingly common, according to the SEC study.
During the hearing, Richard Ketchum, the chairman and CEO of FINRA, testified that his organization’s programs “would be enhanced and investors be better protected if we had the authority to examine the full operations of dually registered firms, where currently we can only see the broker-dealer side of what is typically a fully integrated business.”
Ketchum also seemed to float the idea of taking his organization’s function one step further. He suggested that FINRA could set up a separate but related unit to self-regulate independent investment advisors, not just those also registered as broker-dealers. He stated that the oversight would tailored to the particular characteristics of the investment adviser business.
“FINRA would 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,” Ketchum said, according to a written version of his testimony.
The organization’s experience and its ability to leverage existing technology and personnel lets FINRA “serve as at least part of the solution to this pressing problem,” Ketchum said.
In addition, Ketchum renewed calls for a unified standard of fiduciary duty for both broker-dealers and investment advisors, as the lines between them get blurrier. Such a standard would, for instance, impose a duty on broker-dealers to obtain the best investment vehicle for a customer rather than merely one that is suitable, which is the standard now. This higher standard would make them more like investment advisors, who are already considered fiduciaries.
The SEC and FINRA have been forced to respond “issue by issue, or violation by violation” Ketchum said. “A fiduciary standard would establish a benchmark for the regulator and the regulated, to help ensure that brokers and investment advisers have consistent obligations through each step of their financial advice, and that the first question they must ask is not whether a product is acceptable but whether it is in the best interests of the customer.”
Others who testified at the hearing expressed reservations about SROs taking on an oversight role, regardless of a possible unified standard. For example, David G. Tittsworth, executive director of the Investment Adviser Association, or IAA , emphasized his organization’s support for a robust fiduciary duty standard for advisors, but he also said that SROs are not the best option to enforce that standard.
“The substantial drawbacks to an SRO outweigh any potential benefits,” Tittsworth said in a written version of his statement . “These drawbacks include insufficient transparency, accountability, and oversight by the SEC and Congress, due process issues in disciplinary proceedings, and the absence of any requirement for a cost-benefit analysis for proposed rules.”
Tittsworth also mentioned the cost and red tape of an additional layer of regulation that he said would adversely affect small businesses and job creation.
“For these reasons, we oppose the draft legislation circulated last week,” Tittsworth said, referring to the Bachus bill.
The IAA would like to see the SEC levy fees upon investment advisors as a means to beef up its own regulation, Tittsworth said, citing the SEC study.
“In its analysis of these options, the report finds the greatest number of advantages, and the least number of disadvantages, with respect to user fees,” he said.
The benefits of the user fee approach are many, according to Tittsworth. The approach would provide stable and dedicated funding to strengthen SEC oversight and allow it to examine advisors more frequently.
In addition, “This stable source of funding would enable the SEC staff to conduct long-term strategic planning, especially with respect to technological modernization that could enhance its risk assessment and monitoring capabilities,” Tittsworth added.
The reporting and accountability of a user-fee approach would also provide “substantial transparency and opportunity for congressional oversight and public input,” he said.
One thing is bankable is this situation: the state of affairs in Congress ensures that those of differing opinions will have a long time to argue their points.
Guiliano Law Group
Investors suffering losses or damages from such conduct may be able to recover their investment losses. Our practice is limited to the representation of investors in claims, for fraud in connection with the sale of securities, the sale or recommendation of excessively risky or unsuitable securities, breach of fiduciary duty, and the failure to supervise. We accept representation on a contingent fee basis, meaning there is no cost to you unless we make a recovery for you, and there is never any charge for a consultation or an evaluation of your claim. For more information contact us at (877) SEC-ATTY.
