Speech by SEC Staff:
2000 and Beyond
SEC Priorities for the Investment Adviser Profession
Paul F. Roye
Director, Division of Investment Management
U.S. Securities & Exchange Commission
Before the Investment Counsel Association of America
April 6, 2000
It is indeed a pleasure to be here this afternoon and I want to thank you for the invitation. In the 16 months that I have been Director of the Division of Investment Management, I have acquired a renewed respect for the efforts of you organization and the manner in which your association represents the interests of the investment advisory industry. While we may not always agree, your positions are well reasoned and principled and reflect a commitment to protecting the interests of your advisory clients. This is undoubtedly due in large measure to the views and cultures of your individual firms, but also to the leadership of the association; I would note in particular your exiting president, James Hollis. You have a great executive director in David Tittsworth and an outstanding general counsel in Karen Barr. I look forward to continuing to work with you as we tackle the challenges that lie ahead.
I thought this afternoon I would focus on the regulatory regime governing investment advisers, the need to update and modernize that regulatory regime and some specific issues we collectively must address at the doorstep of this new millennium.
The five and one-half decades after passage of the Investment Advisers Act were relatively quiet from a regulatory perspective. But we are now in the midst of an intense period of regulatory developments that I believe will truly be viewed as a watershed period for advisers. This period began with passage of the NSMIA legislation and I expect that it will continue for the next couple of years. At the Commission, we are currently engaged in revisiting our regulatory approach on many issues under the Act, in a comprehensive effort to modernize our regulations to respond to the changes that are sweeping across all financial service industries.
We have several pending rule proposals that reflect this effort. We have other ideas that will generate rule proposals in the near future. Today, I want to primarily focus on these proposals, and invite your input on our initiatives. By now, I am sure you are all aware that the Commission is hosting a roundtable on May 23rd for the purpose of eliciting opinions on, and exploring a wide variety of perspectives regarding key issues under the Act. I hope that my remarks today will pique your interest in the roundtable, and I hope that all of you will weigh in with your thoughts, views and ideas. This effort is vitally important, as American investors have put over 18 trillion dollars under the care of investment advisers. You manage the country's pension funds, investment companies, endowments, charitable trusts, and thousands of portfolios for individual investors. Surely, there is no more important group of market professionals over which the Commission has responsibility.
But before I speak about the future of adviser regulation, I want to spend a few minutes reviewing the history of the Investment Advisers Act and the principles embodied in the Act. While much is changing about your business and our regulations, I believe strongly that the future success of the advisory industry and our regulations depend on remaining true to the highest fiduciary standards that are embodied in the Act as adopted in 1940.
History of the Investment Advisers Act
The Advisers Act was the last in a series of federal statutes intended to eliminate abuses in the securities industry that Congress believed contributed to the stock market crash of 1929 and the following Depression. The predicate for the Advisers Act was a congressionally mandated study by the Securities and Exchange Commission. The SEC's report to Congress was a compilation of the views of the SEC and of industry representatives, including the Investment Counsel Association of America. Indeed, your Association played a prominent role in the congressional hearings held prior to the enactment of the Investment Advisers Act and in the drafting of the statute.
The profession of "investment counselor" was relatively new at the time of the congressional hearings in 1940. Generally, investment advice had been furnished by individuals and firms as an ancillary part of their regular businesses or professions. Lawyers, banks, trust companies, brokers and dealers, in the course of their business, furnished investment advice to their clients. The floatation of Liberty bonds during World War I created a general public interest in securities. Consequently, after the War, there was growth in the number of investment counselors unaffiliated with any other form of financial organization. The growth in investment counselors prior to the enactment of the Advisers Act was due, in part, to the increase in the number and complexities of securities, and interest among investors in obtaining competent and unbiased guidance regarding the management of their investments. The losses suffered by investors during the depression years caused many public investors to seek continuous supervision and advice concerning their investments.
A new breed of "investment counsel" emerged to meet this need for unbiased information and guidance. These new professionals were distinguished from others in the securities field by two fundamental principles. First, these professionals limited their actions to providing unbiased investment advice and did not engage in any other activity, such as selling securities or acting as broker-dealers, which might directly or indirectly bias their investment judgment. Second, their compensation for this work consisted solely of definite, professional fees, fully disclosed in advance. The name "investment counsel," then not widely in use, was selected to describe both the work based on these two principles and the persons engaged in that work.
After receiving the SEC report and holding hearings, Congress concluded that federal legislation was necessary because, as stated in Senate Report 1775 (May 28, 1940), "not only must the public be protected from the frauds and misrepresentation of unscrupulous tipsters and touts, but the bona fide investment counsel must be safeguarded against the stigma of the activities of these individuals." With the growth in the number of investment advisers, it was acknowledged that the industry included those without competence and without conscience on one end of the scale, to the capable, well trained, unbiased individual or firm, trying to render a purely professional service, at the other end. Various problems were identified in the SEC report and hearings, such as trading by investment advisers for their personal accounts in securities in which their clients also were invested, the propriety of "performance fees," the need to protect client assets in the possession of the adviser, and "trafficking" in advisory contracts.
The original Advisers Act was modest in the regulatory scheme it imposed. As we complete the year 2000 census, it is interesting to note that one of the Advisers Act's basic purposes was to achieve, through a regulatory and reporting process, a "compulsory census" of advisers. To implement this "census," the Act required advisers to register with the SEC by filing an application containing specific information. Certain advisers were exempted from regulation under the Act; other persons were excluded from the definition of "investment adviser" and were thus not subject to any provisions of the Act. But the Act went beyond a mere registration statute. It also prohibited or limited certain practices. The anti-fraud provisions prohibited certain transactions and practices that defrauded or operated as a fraud or deceit upon clients or prospective clients. Specific provisions were included to address investments in which an adviser dealt with an advisory client as agent for another client, or as principal.
Even though pre-1940, the Investment Counsel Association had adopted a Code of Professional Practice, it recognized that the association could not cope with the fundamental problem of dealing with unethical individuals or organizations who represented themselves as bona fide investment counselors. The Investment Counsel Association supported enactment of the Advisers Act because it was recognized that advisers should be held to tough fiduciary standards when dealing with clients. These fiduciary standards, which are the basic underpinnings of the Advisers Act, must be our guide as the industry seeks to respond to new competitive challenges and as we seek to modernize the adviser regulatory regime. Indeed, it is these fiduciary standards that distinguish you from others in the financial services industry.
Since 1940, the Advisers Act has been periodically amended to strengthen the enforcement of the Act and to extend its coverage. The most significant regulatory development affecting investment advisers in the last decade occurred in 1996 when Congress passed NSMIA, dividing regulatory jurisdiction over investment advisers between the Commission and the states. As a result, investment advisers are no longer required to register with both the Commission and the states. Larger advisory firms (generally those with assets under management of at least $25 million) register only with the Commission and smaller advisers register with one or more states. Today, approximately 8,000 investment advisers are registered with the Commission and another 12,000 are registered with the state securities authorities. NSMIA was a progressive step forward in eliminating duplicative regulation of investment advisers and modernizing the regulatory regime.
The Investment Adviser Registration Depository
Yesterday, the Commission took another step forward in modernizing the adviser regulatory regime in proposing the Investment Adviser Registration Depository, or IARD, system. In NSMIA, Congress authorized the Commission to modernize the investment adviser registration system by developing an electronic filing system. The IARD will be an Internet-based system of electronic filing for investment advisers created by the Commission and the state securities authorities. The system is being built and will be operated for us by NASD Regulation (NASDR). NASDR already operates the Central Registration Depository system for broker-dealers, which in many respects is similar to the system we believe is needed for investment adviser registrations.
The IARD system is the product of several years of intense work by our staff, and is designed to offer numerous benefits to advisers, your clients, and the regulators. For investment advisers, the principal advantage is the one-stop filing feature. Advisers will be able to satisfy their filing obligations under both state and federal laws by making a single electronic filing, thereby reducing the regulatory burden of these filings. The system is being designed to make it easy for the Form to be completed and amended. It also has been designed to provide efficiencies for firms registered with us both as an investment adviser and a broker-dealer through the CRD system. These advisers will be able to link their responses to common items to avoid entering the data twice.
The proposal includes rule amendments regarding advisers' disclosure obligations that are designed to vastly improve the quality and format of the information advisers provide their clients. The proposal requires that all advisers provide clients with a narrative brochure containing disclosure about the advisory firm written in plain English. This approach is designed to build on the success the Commission has had with requiring mutual funds and other issuers to draft prospectuses in plain English. The form specifies the disclosure required in the brochure, but advisers would be generally free to structure the disclosure and order the topics in a manner that best conveys the required information. Our experience with the wrap fee brochure suggests that a narrative firm brochure will provide your clients with better, more understandable disclosure.
We also are proposing to require that the firm brochure be accompanied by a supplement containing important information about the advisory personnel with whom the client will be dealing. We believe that clients want and need information about the individuals on whom they will rely for investment advice. This new approach replaces the current check-the-box/multiple choice format in current form ADV, which does not lend itself to meaningful disclosure about the advisory firm or its personnel.
In addition to the new narrative format, we are proposing that Form ADV be revised to provide additional disclosure that we feel clients need. One of the more important items in Part 2 of Form ADV is the disclosure of conflicts of interest, including personal trading by advisory personnel and interests the adviser may have in securities it recommends to clients. We are proposing that the brochure explain the nature of these conflicts and that the adviser discuss the practices or procedures it uses to prevent these potential conflicts from harming clients. Consistent with the report of our Office of Compliance Inspections and Examinations on soft dollars, the proposed form requires enhanced disclosure of soft dollar practices. Moreover, the proposed form would require advisers to explain whether they vote client proxies and any procedures or practices used in deciding how to vote proxies. Additionally, the new form would require, for the first time, an adviser's brochure to disclose to clients material disciplinary or legal events involving the adviser or its management.
Importantly, information contained in filings made through the IARD will be stored in a database that members of the public will be able to access free of charge through the Internet – giving investors easy access to information about investment advisers. Investors will have access to all current information on file about advisers, including information about advisory fees, conflicts, ownership and control and disciplinary problems. Currently, advisers' filings do not appear on our EDGAR system and are not easily accessible from other sources.
For the Commission, the system will help us better monitor advisers and administer our regulatory program. For example, the system has certain features designed to insure that advisers register with the proper authority, or the system will not accept the filing. Moreover, the new system will enable the Commission to obtain better information to follow trends in the adviser industry, analyze the impact of proposed regulatory changes and anticipate developments that need regulatory attention.
We believe that the new form, which is the first major update of Form ADV since Uniform Form ADV was adopted in 1985, is a major step forward in modernizing the investment adviser registration system. We have worked closely with NASAA in developing the form, as well as with an industry group, including representatives of different types of advisers, on the IARD design. We look forward to your reactions and comments, as we make this step to take advantage of developments in information technology to bring electronic filing to investment advisers and bring you clients access to better information about your operations.
Another one of our pending proposals addresses the circumstances when broker-dealers should also subject to regulation under the Advisers Act. This proposal is perhaps our most fundamental effort at modernizing the regulation of investment advisers, since the proposal seeks, through a functional approach, to identify characteristics which can be appropriately used to distinguish the services advisers provide, from the advice inherent in the provision of brokerage services. The proposed rule creates a distinction between brokerage accounts and advisory accounts based on the nature of the services provided, rather than the form of compensation. Specifically, it provides that if the broker does not have discretionary authority to trade securities in an account, the Advisers Act generally would not apply to that account. If the broker does have discretionary authority and charges an asset-based fee, the account would not qualify for the exemption from the Advisers Act.
In 1940, Congress clearly recognized that the provision of brokerage services inherently included the provision of some investment advice. It intended that brokerage firms not be regulated by the Advisers Act, if the advice they provided was solely incidental to their brokerage services. Because brokerage fees were regulated in 1940, brokerage firms could only charge fixed commissions for their brokerage services. Therefore, by definition, any fees charged by a broker in 1940 other than fixed commissions had to be compensation for services completely distinct from brokerage services. Labeling such fees as special compensation was thus a practical test for determining whether a broker was being paid for something other than brokerage services and, therefore should be regulated by the Advisers Act. But with the introduction of asset-based brokerage fees -- 25 years after the deregulation of brokerage fees eliminated the fixed commission rates for brokerage transactions set by the exchanges, and 60 years after passage of the Advisers Act -- the usefulness of that test is severely diminished.
The Division shares the concern expressed by the ICAA and many others that investors not be misled regarding the nature of the services and the legal protections they receive with asset-based brokerage accounts. In fact, during the development of the proposal we were influenced by the principle that a client who perceives reasonably that he is paying a charge specifically for investment advice is entitled to the protections of the Advisers Act.
The proposed rule would require that all advertisements for the accounts and all agreements and contracts governing the operation of the accounts contain a prominent statement that the accounts are brokerage accounts. This requirement is specifically intended as a reasonable measure to assure that customers are informed that these accounts are not subject to the Advisers Act. Based, in part, on the comments we received that this disclosure was not adequate, we are considering more specific disclosure requirements for the final rule.
Another aspect of the proposed rule on which we received a lot of comment, including from the ICAA, related to the regulatory treatment of commission-based, discretionary brokerage accounts. Currently full-service brokerage firms may charge commissions for their discretionary brokerage accounts, and not be subject to the Advisers Act. The proposed rule does not alter that fact. But because the rule proposes using discretion as the indicia for determining whether asset-based accounts are subject to the Advisers Act, the proposal creates an anomaly: a broker can exercise discretion over an account and not be subject to the Advisers Act if it charges commissions, but not if it charges an asset-based fee. In this respect, a regulatory distinction would continue to be drawn based solely on the pricing of an advisory service. This does not make sense to me and we are considering ways to eliminate this anomaly.
We are carefully analyzing the comments that we received on this rule proposal and expect to focus on the issues it raises at the Roundtable.
There are other statutory exclusions in the Act from the definition of an investment adviser that we also want to discuss at the Roundtable. Our recent enforcement action against Tokyo Joe has demonstrated that the internet, while undeniably a great investment tool, is also a convenient forum for persons operating as unregistered investment advisers. We will be reviewing the bona fide publishers exception and its application to the internet and other activities. In our view, the publishers exclusion in the Advisers Act should not apply when the publisher's advice is not disinterested, in that it is paid for touting stocks or the publisher engages in scalping.
One effect of Gramm-Leach-Bliley is that we now have some jurisdiction over bank advisers, specifically, when the bank acts as investment adviser to an investment company. However, in many respects banks are still excepted from the Act. We will be reviewing that issue also. Similarly, we will be reviewing the accountants' exception in the Act, whose advice must be solely incidental to their professional services in order to avoid application of the Advisers Act.
The need for our broker-dealer rule was precipitated, in part, by developments in the marketplace. Other developments in the markets have created a need for us to revisit the provisions of the Act governing principal transactions. Greater liquidity in certain types of securities and transparency in certain types of transactions minimize the dangers that principal transactions presented when the Act was written. In addition, the rapid pace of today's market transactions often render the consent provisions a de facto prohibition on such transactions. Crafting relief in this area is one of our top priorities. However, I can assure you that the relief we propose will not compromise the fiduciary standards which the Act's authors considered paramount for advisers engaging in these transactions.
Those same fiduciary standards are embodied in the Commission's pending rule proposal addressing pay-to-play practices. I know that most of you here work for firms which do not engage in pay-to-play, but the fact is that the practice exists and the pressures on your firms to engage in it exists. No one disputes that the practice is entirely inconsistent with the fiduciary standards of your profession. We need effective measures to prevent the practice. Effective steps have been taken in the municipal finance industry to curb these practices.
I am sure that you all are familiar with our rule proposal addressing pay-to-play in the investment adviser area and the controversy that it has generated. Despite that controversy, I can assure you that the Commission is committed to adopting a rule for advisers. While we received many comments questioning the approach or scope of the proposed rule, we remain convinced that a rule is needed. The Commission must, and will, act by specific regulation to prevent the practice of buying government business with campaign contributions. It is the right thing to do.
However, we are considering carefully whether the proposed rule's G-37 type approach or some other approach is best suited for the advisory industry. G-37 has worked well to curb pay-to-play in the municipal finance industry, and I am convinced that its approach and provisions are necessary in that context. In fact, it was the success of that rule and our conviction that its provisions were not unnecessarily burdensome for municipal finance professionals that led to a similar proposal for advisers.
But it may be that differences between the municipal finance industry and the adviser industry, many of which were persuasively set forth by the ICAA and other commenters, warrant a different regulatory approach for advisers. We do not want to place unnecessary administrative burdens on advisers. We do not want to unnecessarily impact advisory employees' ability to make legitimate campaign contributions. We do not want to penalize firms disproportionately for inadvertent violations of a rule. These are the goals that we are balancing as we consider a final rule. We are open to alternative approaches, but I will say that after-the-fact disclosure of contributions alone is not enough to accomplish our goal of preventing the practice. I welcome any serious effort by the ICAA to help us achieve that goal.
Advertising and Performance Reporting
Another area in which we welcome the ICAA's input is our planned modernization of the rules governing advertising by investment advisers. The current rule governing adviser advertising – Rule 206(4) – 1, which was adopted in 1962, contains a specific "laundry list" of practices that are defined to be per se fraudulent and therefore are prohibited. This list includes testimonials and partial lists of recommendations. Rather than making certain practices per se fraudulent, I would like to see the rule revised to mirror a general antifraud standard like that set forth in Rule 156 under the Securities Act of 1933, governing investment company advertising. The revised rule could prohibit advisers from using advertising that is materially false or misleading and provide general guidance on factors and kinds of information and statements that may make an advertisement false or misleading, depending on the context in which it is used and how it is presented.
I believe such an approach could improve communications between advisers and clients. Such an approach also would eliminate inconsistent regulatory treatment of advertising practices by investment advisers as compared to other providers of financial services, such as investment companies and broker-dealers.
We also want to explore the issue of performance reporting. We know that many firms use the voluntary guidelines adopted by the Association for Investment Management and Research ("AIMR") in computing and presenting performance, but we want to determine if there is a need for the SEC to standardize performance calculations for advisers. Standardized performance calculations have facilitated investor comparisons of mutual funds and could be beneficial for advisory clients in evaluating potential advisers.
Books and Records Rule
Like the registration system and Form ADV, our rules regarding advisers' maintenance of books and records are in need of modernization to reflect an electronic environment. Updating these rules must be a priority for us.
Rule 206(4)-2, the Custody Rule under the Advisers Act, needs to be substantially revised. Quite frankly, one cannot easily determine when one has custody from reading the language of the rule. We want to explore ways to simplify the rule, clearly define when an adviser is deemed to have custody and to set forth workable standards that provide meaningful protections for advisory clients.
In 1994, the Commission proposed Rule 206(4)-5, which would make express the existing fiduciary duty of investment advisers to make only suitable recommendations to advisory clients. The rule would require that an investment adviser inquire into the client's financial situation, investment experience and investment objectives, as well as periodically update that information, preserve records documenting the inquiry and to make only suitable recommendations based on such inquiry. This proposal has not been adopted. Is it needed or should we rescind the proposal?
Code of Ethics
The ICAA has recommended that its members adopt codes of ethics governing personal trading by advisory personnel and other conflicts of interest. Section 204A of the Advisers Act requires investment advisers to have procedures reasonably designed to prevent and detect employee trading on material, non-public information and Rule 204-2 requires advisers to keep records of their securities transactions and those of their "adviser representatives." Likewise, advisers to investment companies must have codes of ethics dealing with personal trading. We want to explore at the Roundtable whether requiring all advisers to adopt a code of ethics would be a substantial investor protection improvement in adviser regulation.
These are some of the issues that we want to explore as we seek to modernize and improve the investment adviser regulatory regime. The ICAA has an opportunity to provide real leadership on these and other issues that are confronting the industry. David Tittsworth and members of your organization will be participating in our Roundtable and we look forward to your input.
Much has changed since the Investment Counsel Association supported enactment of the Investment Advisers Act in 1940. However, the fundamental business of an investment adviser has not changed. It is still based on a relationship of trust and integrity between a fiduciary and a client. We ask that you work with us in preserving the high fiduciary standards of your profession, that have been, and will continue to be, the keys to your success. Thank you.