Speech by SEC Commissioner:
"The Globalization of Investment Advisers — How Will Regulators Respond?"
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
International Institute for the Regulation and
Inspection of Investment Advisers
June 23, 2009
Good morning and thank you for inviting me to speak today. I am delighted that this forum brings together regulators from around the world to discuss the regulation and inspection of investment advisers. It is important for all of us to remember that we live and operate in a larger world. At the start, I would like to state that my remarks today represent my own views and not necessarily the views of the Commission, the other Commissioners or of the Commission staff.
I am particularly pleased to be with you today because, while much of my professional career has been involved in capital formation though public and private offerings, I've spent a substantial portion of my professional career working in the investment management industry. During my 30 years as a practitioner in the securities industry, I spent most of the 90's and the early part of this decade as General Counsel and Head of Compliance of a large global asset manager with offices throughout the world.
As a lawyer, I've worked with regulators from around the world on various investment adviser issues. I've had clients operating as investment advisers in a number of countries — including Argentina, Bermuda, Canada, Cayman Islands, Hong Kong, Japan, and the United Kingdom, to name just a few. I myself have been on the business side of an international investment adviser when I had the opportunity to serve as the CEO of the Latin American Division for INVESCO — and had the opportunity to establish INVESCO's operations from the ground up in Puerto Rico and Argentina, and lead INVESCO's participation in the privatization of the Bolivian Social Security System. Trust me — I have some great stories.
The investment management industry has seen explosive growth worldwide. Beyond just the growth experienced within the borders of our respective countries, there has been tremendous growth in the number of cross-border investment managers. In the United States, we have certainly seen increases in the number of U.S. managers offering their services abroad, as well increases in the number of foreign advisers offering services in the United States.
As securities markets around the globe continue to evolve, many investment advisers will continue to seek access to an international client base, as well as to enhance their abilities to make cross-border investments. Because many of the advisers in each of our jurisdictions also operate in other countries, as regulators, knowledge of regulatory schemes around the world is essential for us to do our jobs well.
The U.S. Investment Adviser Industry
The U.S. investment adviser industry has seen enormous growth over the years — growing from 6,650 registered advisers in 1999, managing approximately $18 trillion, to over 11,300 registered advisors managing approximately $43 trillion in assets by the end of fiscal year 2008. The actual numbers of advisers in the United States is actually much larger. First, because under U.S. law the licensing authority is divided between the SEC and the various states, not all investment advisers have to register with the SEC. And, second, this is because many advisers are not required to register with either the SEC or the states, including most managers of private pools of capital.
Under the U. S. Investment Advisers Act of 1940, advisers are not permitted to register with the SEC unless they have at least $25 million in assets under management, advise a registered investment company, or are co-located with a SEC-registered adviser. Advisers below the threshold are regulated by state securities authorities.
As to managers of private pools of capital, such as hedge fund managers, many rely on the exemption from SEC registration on the basis that they have 14 or fewer clients, and do not hold themselves out to the public as investment advisers. In December 2004, the SEC promulgated a rule to effectively require certain of these managers to register — but in June 2006, a Federal court overturned this rule. However, it is expected that there will be legislation this year to require that such managers — particularly hedge fund managers — to register with the SEC.
Foreign Advisers in the U. S.
As to foreign advisers, there are very few barriers applicable to investment advisers wishing to register in the United States — and foreign advisers find that it is relatively simple to register under the Advisers Act. For example, there are no residency requirements, and an adviser located outside the United States is not required to establish a U.S. subsidiary. In addition, there are no minimum educational requirements, and there are no capital requirements. The most significant barrier to registration is whether the adviser has been the subject of certain disciplinary actions.
In addition, many foreign advisers can be exempt from registration in the United States if they have 14 or fewer U.S. clients, do not hold themselves out to the U.S. public as an investment adviser and do not serve as an adviser to an investment company registered under the Investment Company Act. Moreover, the Advisers Act makes certain accommodations for foreign advisers. For example, in determining whether an adviser qualifies for the 14 or fewer clients exception from the definition of investment adviser, foreign advisers are permitted to count only U.S. clients, while U.S. advisers must count all clients.
Furthermore, if a foreign adviser chooses, or is required, to register in the United States, it may do so regardless of the amount of assets it has under management. Unlike domestic advisers that are required to have $25 million or more in assets under management, all advisers with principal offices outside the United States are required to register with the SEC rather than the states. This single regulator approach eases administrative difficulties for foreign advisers.
Fiduciary Standard — Fundamental Investor Protection
I know that over the next two days there will be a number of programs discussing the various aspects of how the United States regulates the investment advisory industry. You will be hearing from some very knowledgeable people and I know you will learn a great deal.
Today, I want to focus my remarks on the fiduciary relationship between an investment adviser and its client. In the United States, the fiduciary relationship is a bedrock principle that underpins the Investment Advisers Act. As described by the United States Supreme Court in 1963, it is a fundamental investor protection.
In SEC v. Capital Gains, the U. S. Supreme Court stated "The Investment Advisers Act of 1940 thus reflects a congressional recognition 'of the delicate fiduciary nature of an investment advisory relationship' as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to render advice which was not disinterested."1
The principles of a "fiduciary" are well known in most of the common law countries. The common law fiduciary duty originates from the law of trusts, arising as a legal consequence of entrusting a trustee with the interests of a beneficiary. However, the concept of "fiduciary duties" can also be broken down into the "duty of care" and the "duty of loyalty" — duties which exist in many civil law countries and are often found in contracts where one party (the agent) undertakes to manage the interest of the other party (the principal). Despite the different origins of the fiduciary concept in common law and civil law, today there seems to be a trend towards convergence.
Perhaps the biggest difference between these concepts in our respective countries isn't so much whether the concept of a fiduciary duty exists, but what types of enforcement mechanisms are in place, and what ability the judiciary has to interpret the law, that determine how effectively the concept protects interests of investors. Those differences, however, are beyond the scope of my remarks today.
Getting back to the principle of the fiduciary standard as it has developed in this country, those of us who have worked in the investment advisory industry, as I have, know that the fiduciary standard a dynamic, living principle that provides investors with true protection. The fiduciary standard means that a fiduciary has an affirmative obligation to put a client's interests above his or her own.
For example, in making an investment decision for a client, an investment adviser subject to a fiduciary duty would be required to make investment decisions that are in the best interest of the client. Additionally, if the investment decision poses any conflict of interest such as where a financial benefit accrues to the adviser in recommending a particular investment, the adviser (as a fiduciary), must seek to fully disclose the conflict to the client.
A fiduciary standard is considered to have real teeth because it is an affirmative obligation of loyalty and care that continues through the life of the relationship between the adviser and the client, and it controls all aspects of their relationship. The SEC and the investment adviser community have historically stood for the principle that investment advisers could not "completely perform their basic function — furnishing to clients on a personal basis competent, unbiased, and continuous advice regarding the sound management of their investments — unless all conflicts of interest between the investment counsel and the client were removed."2
I agree totally with that view.
As the Supreme Court recognized, it was clear from the abuses that gave rise to the Advisers Act that there was a real necessity for investors to be protected by a fiduciary standard. For those of us who have spent time in the investment adviser industry, it is clear that the fiduciary relationship is the foundation of the adviser-client relationship.
Trend for Broker-Dealers to Provide Investment Advice
Let me briefly compare investment advisers to broker-dealers.
I mentioned earlier that the fiduciary relationship is a bedrock principle underlying the Investment Advisers Act of 1940. The Advisers Act is the cornerstone of U.S. federal investment adviser regulation. In this statute, adopted nearly 70 years ago, Congress defined an "investment adviser," in part, as "any person who, for compensation, engages in the business of advising others . . . as to the value of securities or as to the advisability of investing in . . . securities." Congress also provided for a number of exemptions from the "investment adviser" definition, including an exemption for broker-dealers.
Historically, broker-dealers that simply effected transactions as directed by their clients were not considered to provide investment advice. It was in this context that broker-dealers were excluded from the definition of "investment adviser" in the Advisers Act when their performance of advisory services were "solely incidental" to their broker-dealer activities and where they did not receive any "special compensation."
One aspect of the growth in the investment advisory industry in the U.S. has been the move by broker-dealers toward more actively providing investment advice, and in being actively involved in the management of client assets. With the advent of fee-based brokerage accounts in the 1990s, broker-dealers have been increasingly selling programs that provide "investment advice" in exchange for an asset-based fee. As a consequence, it is hard to say that broker-dealers are not acting as investment advisers in this context.
Before the advent of these fee-based accounts, broker-dealers received transaction-based compensation — a commission — for executing a transaction. In comparison, an investment adviser receives an asset-based advisory fee for providing investment advice on an on-going basis. Thus, the different compensation structures reflected fundamental differences in the two industries and in the protections available to investors.
As a result of this movement toward asset-based fees by broker-dealers, here in the United States there has been a great deal of discourse about whether broker-dealers who provide investment advice and investment advisers should be held to the same standard. And what that standard should be.
In the U.S, broker-dealers traditionally have been required to meet certain "suitability" requirements when dealing with their customers. Generally speaking, this means that they can't sell a customer an investment that is not appropriate for that particular customer. In essence, they need to make a judgment about the suitability of any recommendation to any specific customer. At a minimum, prior to making any recommendation, the broker-dealer needs to make certain inquiries to determine that the investment is suitable. This inquiry generally involves finding out about the customer's financial and tax status, investment objectives, and any other factors that may be relevant.
The suitability standard is generally considered to be a lower standard of responsibility than the fiduciary standard. Under a fiduciary standard the investment is required to be — not just suitable — but must be in the client's best interest.
In his speech entitled, "Building a Fiduciary Society," John Bogle provided his thoughts on the standard that should apply to the provision of investment advice, when he stated ". . .the fiduciary standard must be extended to other financial advisors, including broker-dealers who elect to act as advisors." He went on to remark that
"it should be made clear to clients whether they are relying on (1) trained investment professionals, paid solely through fully-disclosed fees to oversee their investments; or (2) sales representatives who sell the products and services of the companies that they represent, whether life insurance, annuities, mutual funds, or anything else. Simply put, the first group is representing its clients; the second group is representing its employers. And each firm's advertising and promotion should make this distinction clear."3
As Mr. Bogle illustrates, the primary purpose of many broker-dealers is to distribute and sell securities, as compared to an investment adviser whose primary purpose is to provide on-going advice to their clients. These are fundamentally different client interactions and have always been governed by different regulatory regimes in the United States. However, there is a significant conflict of interest that results from serving as an agent in selling a security while at the same time serving as an investment adviser to an investor. This conflict has broad ramifications for investor protection.
To the extent that securities firms that were predominantly broker-dealers are now entering into on-going relationships with clients by emphasizing the offer of investment advice in exchange for a fee based on assets under management, the brokerage industry is moving closer to the investment adviser industry.
As broker-dealers increasingly provide advisory services to their clients, I believe that the higher standards and fiduciary duties of advisers should also be applied to these broker-dealers. I applaud those of you that may already have this standard in place — and I encourage others to advocate for this standard in your jurisdictions.
I have been calling for this adoption of the fiduciary standard since I became a Commissioner. I am pleased to report that the Obama Administration just last week proposed to hold broker-dealers to this standard. Moving from a "suitability" standard to a "fiduciary" standard will require broker-dealers to rethink how they deliver the affected services and I'm sure it will not be easy — but it's the absolutely right thing to do for investors. I hope that Congress will look favorably on this proposal.
U.S. Regulation of the Investment Adviser Industry
As I mentioned earlier, the investment advisory industry in the U.S. has grown significantly in recent years. Recently, however, following the revelation of the Madoff and Stanford Ponzi schemes, the regulatory environment has come under attack and questions have been raised about how to strengthen oversight over the investment adviser industry as a whole.
To that end, the SEC staff is looking at the developments in the investment advisory industry and will be making recommendations to the Commission as to how to improve the regulatory regime. As you will hear later on today, one of the staff's initial recommendations recently resulted in a proposal by the Commission to strengthen the custody rules that govern how investment advisers with custody of a client's assets must safeguard those assets.
Like many other regulators throughout the world, the SEC is also looking as to how best to keep up with the phenomenal growth in the entities it regulates. For example I mentioned earlier that SEC-registered investment advisers have grown from 6,650 in 1999 to over 11,300 today. At the same time as we've experienced this growth, the SEC examination staff responsible for investment advisers has decreased — more recently going from 489 in 2003 to a current staff of 425. Clearly, not a good trend.
I can assure you, however, that the SEC will be working to address how best to obtain the resources and funding to keep up with the dramatic growth in the advisory industry, both in terms of the numbers of new advisers and their increasing complexity. The SEC is committed to vigorously work to strengthen the regulatory regime to make sure that investors are protected.
In the U.S., there is only one capital markets regulator charged with protecting investors, promoting capital formation, and maintaining fair and orderly markets — and that is the SEC. The SEC is the only public agency in the U.S. charged with regulating our capital markets and maintaining a keen sense of the entire market on behalf of investors. It's a job all of us at the SEC take seriously.
International Cooperation and Challenges
We should also note that with the growth in the number of truly global money managers, the SEC is also looking to how best to protect investors when issues arise across borders. As a result, the SEC has entered into a number of arrangements with foreign regulators to coordinate information sharing regarding these firms. For example, the SEC has entered into several bilateral Memoranda of Understanding (MOUs) that cover supervisory cooperation with respect to investment advisers. These include supervisory MOUs entered into with the UK Financial Services Authority (March 2006), the German Bundesanstalt für Finanzdiestleistungsaufsicht (BaFin) (April 2007) and the Australian Securities and Investments Commission (2008), as well as the 1995 MOU with the Hong Kong Securities and Futures Commission. As the SEC continues its work in this area, IOSCO has also taken steps in this direction with the establishment earlier this month of an IOSCO task force to develop international principles on supervisory cooperation of market participants whose operations cross borders — including investment advisers.
In addition to the information shared under the auspices of the recently formalized supervisory MOUs, the SEC has for many years conducted joint inspections of investment advisers and otherwise participated in cross-border outreach. Joint examinations, which have also been carried out with non-MOU partners on an ad hoc basis, have allowed the SEC and its foreign counterparts to coordinate for maximum efficiency for both the regulators and inspected firms. The joint exam process has also encouraged cross-border sharing of information about local market practices and concerns. In the recent past, the SEC's Office of Compliance, Inspections and Examinations has also conducted seminars for SEC-registered investment advisers in Asia and Europe.
As the recent Stanford and Madoff Ponzi schemes have highlighted, international cooperation in combating fraud is more crucial than ever before. Mutual legal assistance is increasingly critical to regulators' ability to bring enforcement actions.
Fortunately, the multilateral approach to international enforcement cooperation has shown progress. In recent years, regulators have been able to more aggressively pursue cross-border fraud because of the IOSCO MMOU. Over 50 jurisdictions around the world have joined the IOSCO MMOU since its creation in 2002. This greatly expands the MOU members' ability to bring cases because they are now able to obtain bank records and other information from counterpart regulators in foreign jurisdictions where it could not previously obtain assistance. In addition, in part due to the required pre-approval review, aspiring MMOU members have undertaken significant legislative changes that not only improve the ability of local authorities to cooperate internationally but also to combat securities fraud in their local markets.
Although I welcome the recent developments in international supervisory cooperation, I caution that we should not lose sight of the equally important goal of continuing to expand and deepen enforcement cooperation.
It is clear that governments and regulators can improve how best to address the global growth of the investment advisory industry. These efforts are enhanced by conferences like this. This is particularly timely considering the financial pain being felt by many throughout the world.
I am pleased you are here and I look forward to the positive developments that will come from the information to be shared during this conference. You can count on my support for your efforts to strengthen the regulatory framework for governing investment advisers and for protecting investors.
As regulators of investment advisers, we have a critical role to play. Investors place their trust in us to work diligently to protect their interests. As you consider how best to fulfill these goals in your home jurisdictions, please remember that we at the SEC stand ready to support your efforts.
Thank you for your attention and best wishes for a successful conference.