The Financial Planning Association
FPA Government Relations Office
Via electronic mail and messenger
April 17, 2002
Mr. Jonathan G. Katz
Re: Release Nos. IC-25925, IA-2107; File No. S7-03-03; Compliance Programs of Investment Companies and Investment Advisers
Dear Mr. Katz:
The Financial Planning Association ("FPA")1 is pleased to submit comment to the Securities and Exchange Commission ("SEC" or "Commission") in support of a rule proposal (the "Proposed Rule") that would, among other things, require written supervisory procedures for investment advisers. We are also submitting general comment in connection with the Commission's request for feedback on enhancing consumer protection under the Investment Advisers Act of 1940 ("Advisers Act") through private sector compliance audits, a self-regulatory organization ("SRO"), and fidelity bonding.
Our comments follow in the order of discussion in the proposing Release.
I. Rule 206(4)-7 - Internal Compliance Program for Investment Advisers.
a. FPA supports the Proposed Rule. The Proposed Rule would require all advisers registered with the Commission to: 1) develop and implement written compliance policies and procedures; 2) review the program at least annually; and 3) designate a chief compliance officer responsible for administering the policies and procedures. FPA recognizes and supports the best practices concept embodied in the Proposed Rule. Many FPA members regard written compliance procedures as a basic requirement of doing business. As noted by the Commission, written compliance programs have already been adopted voluntarily by approximately half of all adviser firms registered with the SEC. We strongly concur with the Proposing Release comment that firms with effective internal compliance systems are "much less likely to violate the federal securities laws."2 During a long period of persistent market volatility, restoring investor confidence in the capital markets and their regulatory institutions should clearly be a priority of the SEC. Effective compliance programs should help bolster public confidence in the Commission's efforts.
We would note that a state model rule for written supervisory procedures preceded the Proposed Rule by several years, although the state rule does not require annual review or designation of a compliance officer. In 1998, the North American Securities Administrators Association ("NASAA") adopted the model rule requiring investment advisers to maintain written procedures "to supervise the activities of employees and investment adviser representatives that are reasonably designed to achieve compliance with applicable securities laws and regulations."3 It may be helpful to consult with the states that have adopted the NASAA model rule to determine any examination efficiencies achieved under state-adopted requirements.
As noted in the cost-benefit analysis of the Proposing Release, the rule "would impose larger relative costs on [small] firms."4 Most of the 7,000-plus firms registered with the Commission are small in terms of net income, assets under management, and employee numbers. About half of SEC-registered advisers employ one to five individuals and slightly more than half of SEC registrants manage less than $100 million in client assets.5 At the same time, the Proposing Release notes that the cost of developing an effective compliance program for a small firm should be less than a large firm.6 We agree that this should ease the cost for smaller advisers, particularly for financial planning firms that tend to rely primarily on asset allocation investment models, thus eliminating the multiple transactions that would require more detailed and costly supervisory procedures associated with wirehouse and institutional adviser activity.
b. FPA requests SEC guidance on distinctions between basic compliance
programs for large and small advisory firms. While supporting the Proposed Rule, FPA has specific concerns that it requests the Commission consider when reviewing the compliance programs of smaller firms. Clarification in the Adopting Release would help small firms during the initial drafting of supervisory procedures, rather than after the fact in the SEC auditing process.
First, we ask the Commission to provide clear guidance on basic policies and written procedures that are appropriate to all SEC registrants, and to identify certain procedures that may be more relevant to larger or smaller firms.
For example, the Proposing Release suggests that, at a minimum, all firms should address "portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with guidelines established by clients..."7 SEC rules permit or require registration of certain firms that may not have any assets under management. These include financial planning firms that act as investment management consultants and rely on third-party money managers. A small number of financial planning firms also may be registered with the Commission because they are controlled by or affiliated with an SEC-registered asset management firm. In addition, the Advisers Act also accommodates registration of other non-money management firms, including pension advisers, and those with multiple state practices or Internet-based advisory services.8 Guidance in the Adopting Release should note exceptions to basic supervisory procedures where the firm does not manage assets.
Similarly, the Proposing Release suggests written procedures by the adviser describing policies with respect to aggregating trades among clients or the use of soft dollars. Some financial planning firms registered with the Commission simply do not "bunch" orders because they invest in mutual funds. Others do not receive or use soft dollar research from other firms in exchange for directed brokerage or other arrangements. Firms in these situations should be able to point to guidance from the Commission providing exceptions to what otherwise may be construed to be basic compliance requirements under the Rule.
To a certain extent, the problem exists today with a `one-size fits all' approach by SEC examiners auditing small firms. From time to time, financial planners note how they spend considerable time explaining to SEC examiners the distinctions between financial planning and asset management practices when the SEC examiners request documents typically generated by the larger firms. When reviewing a pre-audit checklist from SEC examiners, many financial planners observe that they will probably need to furnish less than half of the items on the generic check list to the examiners, yet are compelled to respond to a number of irrelevant questions by the examiners on why they don't have records for certain services that the examiners assume the small firm also generates. We are concerned that those perceptions could be considered tacit deficiencies in a small firm's compliance manual. For example, the Proposing Release suggests the compliance programs address processes used by the adviser to value client holdings and how it assesses fees based on those valuations. While it is common for many advisers to base their advisory fees on the amount of assets under management, some are increasingly relying on an annual retainer for the financial planning engagement, which bundles together various advisory services including asset management.
Further, with respect to a potential emphasis on describing firm trading practices, the Commission should be aware that most financial planners are not market timers and their "trading blotter" may not look like that of a firm with an active investing strategy. Planners generally embrace modern portfolio theory and rely on asset allocation as the principal means of generating long-term returns and reduced volatility in a portfolio. To determine client suitability, many develop an investment policy statement and use it as a guide for initial asset allocations and quarterly re-balancing. Many financial planners rely upon large, diversified mutual funds as the primary, or only, investment vehicles in client portfolios. Some planning firms do not even trade in sector funds. Personal trades of the adviser in the same broadly held mutual fund held by its clients should not materially affect the client's holdings. Therefore personal transactions having a negligible effect on net asset values of widely traded funds should not require excessive written supervisory procedures if the firm clearly stipulates its investment parameters in a client engagement.
On the other hand, we recognize that certain written policies of small firms may be even more critical to investor protection than large firms. For example, procedures covering business continuity plans and security of client records should be emphasized as essential criteria in a smaller firm's compliance policies.
We ask the Commission to provide guidance in the final Release, or in a frequently asked question format some of the differences involving basic supervisory requirements.
c. FPA urges the Commission to refrain from enforcement actions alleging fraud under the Advisers Act for minor infractions of the Rule. We are concerned with the potential for aggressive enforcement of a policy that is intended to reduce potential violations of the Advisers Act, not create a new set of technical violations with little relevance to consumer protection. We would ask the Commission to keep in mind that a routine SEC audit could evolve from looking for violations of the Advisers Act, to no longer having "to prove that the registered entity violated any of the securities laws. Instead, it would only have to show a material weakness in a compliance policy or procedure," 9 as noted by one securities law firm.
II. Request for Comment on Further Private Sector Involvement.
Last year investors witnessed extensive media coverage of state and federal securities investigations and hearings by the Congress on cases involving auditor and securities analyst conflicts. For the third year in a row, millions of investors reviewed quarterly statements showing significant losses in their retirement plans. A recent survey indicated workers have less confidence today that they will have enough money saved for retirement.10 Given the decline in investor confidence and the continued volatility of the securities markets, it is understandable that the SEC would undertake a comprehensive review of all regulatory systems under its jurisdiction. Given current investor pessimism, we support the SEC's efforts to solicit industry and consumer feedback on whether the rules under the Advisers Act remain fundamentally sound or are in need of change.
It is quite remarkable in one sense that assets under management with SEC-registered advisers have steadily increased uninterrupted after the recent market bubble. In fact, assets under management by SEC-registered advisers exhibited surprisingly strong growth in the down market -- including a 10 percent aggregate increase last year in discretionary assets under management - even though the major domestic stock indices experienced double digit losses.11 Financial planning firms reflected this same growth in assets by continuing to attract more clients in a difficult economy. A 2002 FPA survey indicated those respondents were able to offset a 5.3 percent median decline in the value of their client portfolios by increasing overall assets under management by 16.7 percent because of a larger client base.12
It is no less remarkable, in our view, that the problems highlighted in self-regulatory organizations seem not to have extended to investment adviser firms regulated directly by the Commission. A recent report by the SEC indicated that individuals most frequently found to have violated securities laws were agents affiliated with broker-dealers.13 In reviewing SEC data related to adviser actions for the past four years, the number of serious deficiencies resulting in referrals to the Enforcement Division was relatively unchanged at 3 to 4 percent. For the same period, the Commission has also been successful in maintaining a five-year audit cycle of registered investment advisers.
Absent any empirical data suggesting a serious flaw in the existing regulatory framework or resources available to the Commission in meeting its investor protection mission, we believe the questions posed in the Rule concepts are reasonable in retrospect, but for the most part do not deserve further examination. The Advisers Act, with its basic transparency requirements and a blanket fiduciary standard, seems to have weathered past and current market cycles quite well as a safe harbor for adviser clients. We believe that when the revised Form ADV Part 2 brochure is adopted with a new plain-English narrative format, the disclosure framework of the Advisers Act will be materially strengthened. Perhaps Senate Banking Committee Chairman Richard Shelby best summarized the essence of the recent market scandals by noting that "there is no substitute for transparency and openness,"14 both fundamental, underlying traits of the Advisers Act that are less pervasive in the other securities laws administered by the Commission.
Nonetheless, given the constant pressure by other financial services industry sectors to seek regulatory relief from the Advisers Act, resulting in a potential loss of transparency and fiduciary protections to the consumer, we believe that the SRO concept is worth exploring in connection with financial planning services, of which investment advice is a core component. An optional financial planner PRO, or professional regulatory organization, should be evaluated to help determine whether it is a reasonable alternative to existing regulation as investment advisers.
There is no commonly accepted definition of a PRO, although it could be considered similar to self-regulation by exercising a measure of self-restraint in the conduct of business and performing a policing function of a defined class of individuals. However, a PRO, unlike an SRO, does not necessarily need to have "members;" rather it may regulate a given profession in the public interest, under the oversight of a federal or state-regulated agency. Its primary obligation would be to develop and apply standards which serve the public, but which also advance and maintain professionalism in the field. A PRO may be a non-governmental entity, supported by licensee fees, that sets appropriate standards of competency and ethical practices for a profession.
We are submitting with our written comments the draft of a legislative proposal that was considered by four financial planner organizations15 in 1996 during the congressional review of securities reform. The draft contains the hallmarks of a PRO by registration of a standards board under Section 203A of the Advisers Act. The draft legislation was not endorsed by any of the financial planning organizations or brought to Congress but provides an example of how a PRO might be organized. Similarly, the FPA does not endorse a voluntary PRO for the financial planning profession at this time, but it believes that the concept is worth exploring by the SEC in a cost feasibility study and examining the related investor protection benefits. Investment product sales are increasingly discounted and automated, thus pressuring financial services firms to market financial planning advice as the primary value-added service. The recent market downturn and migration of clients to independent advisers should provide an incentive to the SEC to determine if competency and ethical standards required under a voluntary PRO would enhance investor protection.
Our comments on all of these topics, including fidelity bonding, follow in the order addressed in the Proposing Release.
a. Compliance Reviews. FPA opposes mandatory third-party audits. As noted previously, existing resources of the Commission and regulatory safeguards appear to have provided a stable compliance environment for investors under the Advisers Act. We see no negative trends related to enforcement actions suggesting otherwise.
In 1996, Congress approved legislation16 remanding supervision of small advisers to state securities administrators and retaining registration of larger advisers with the Commission. Prior to the re-allocation of SEC and state resources, the SEC estimated an audit cycle of up to 44 years between inspections of an advisory firm.
Since that time, the examination staff of the SEC has generally met its goal of examining every firm registered with the Commission once every five years. The reduction in number of firms registered with the Commission by nearly two-thirds in recent years has also allowed SEC inspection staff to develop "smart" audits to prioritize advisory activities to be reviewed and at-risk firms to be more thoroughly audited. FPA commends the innovative efforts of the SEC to do more, with less, over the many years since adviser registrations with the Commission accelerated in the 1980s.
FPA also suggests that should the Commission pursue this concept, that it clarify the legal basis under the Advisers Act for its authority to designate compliance reviews by a third party.
In response to other questions posed by Commission staff concerning third party audits:
Should [the SEC] exclude certain types of funds or advisers?
FPA believes that the SEC could use risk assessment tools for "opting in" advisory activities that place the consumer at greater risk, instead of "opting out" certain classes of advisers. Today the SEC may require compliance reviews as part of an enforcement settlement with an adviser. Assessing risk factors such as custody of client funds, past disciplinary history of principals or partners of a firm, or charging performance-based fees, might warrant compliance reviews.
Would the cost of these reviews be prohibitive for smaller advisers?
FPA believes the question is not whether the cost is prohibitive, but whether it is necessary in the first place. Most compliance costs in isolation are not prohibitive, but cumulative requirements become burdensome. These costs are exacerbated for independent financial planning firms whose advisers may hold multiple licenses in the insurance and securities industries, as well as be required to meet ongoing continuing education requirements under state insurance laws, federal SRO rules, and to earn and maintain professional designations.
Some financial planning firms undergo mock audits in anticipation of a pending SEC examination if the firm has not been audited in several years. We support SEC encouragement of best practices, not increasing the fixed costs of doing business where the benefits are not measurable in terms of investor protection.
Even for a smaller firm with specialized advisory services, a mock audit can be unduly burdensome. In discussing with compliance vendors the audit cost of an independent financial planning firm as discussed earlier with respect to written supervisory manuals, estimates of a mock audit ranged from $2,500 to $5,000.
Would some advisers hire the least expensive compliance consultant regardless of the quality of the consultant's work? If so, how could we ensure that a high quality compliance review is conducted?
It is likely that firms sacrificing quality to reduce costs could be listed in at least three categories: those firms with quality in-house compliance systems that believe adding a new audit would be a redundant cost; firms that view compliance expenditures as a low priority in a relatively scandal-free industry; and those firms that object philosophically to what they would view as an unreasonable federal mandate. However, lower fees should not necessarily be associated with lower quality compliance reviews. There are many highly competent compliance professionals who charge less than attorneys providing the same services. Pricing structures may vary and be difficult to compare, since some firms charge by the hour, some a retainer, and others on a project basis. We do not think pricing is necessarily an accurate way of evaluating audit quality.
What criteria should be included in the rule to determine whether a third-party compliance expert is independent?
FPA strongly believes that the third party compliance vendor must be an unbiased, independent party to be qualified to audit investment adviser firms. For that reason, FPA would strongly oppose a self-regulatory organization whose membership and governance structure is made up primarily of sales-oriented firms. Any compliance vendor should be unaffiliated with and completely independent of the financial services industry and the investment products and associated sales records the compliance firm would audit. The potential problems here are analogous to those issues that led to major changes in auditing and corporate governance last year regarding a corporate auditor's conflicts of interest.
b. Self-Regulatory Organizations. FPA opposes an SRO for registered investment advisers; suggests feasibility study of PRO as alternative for financial planning profession. The question of an SRO for investment advisers, and in the past two decades for financial planners, has been debated intermittently since 1962 when the SEC sought feedback from an investment adviser group about serving as an official "industry self-governing body."17 In the 1980s, as the number of new investment adviser registrations increased dramatically, the SEC renewed its efforts to involve the private sector. The former International Association for Financial Planning submitted its own SRO proposal for consideration in 1985.18 The following year the NASD Board of Governors approved a resolution, with the encouragement of the SEC, stating it was willing to be the SRO for investment advisers affiliated with NASD member firms;19 NASAA also approved a motion endorsing the SRO concept for investment advisers in 1989. That same year the SEC submitted a proposal to Congress for creation of an adviser SRO that began an ongoing debate until Congress resolved the resource problem by dividing jurisdiction of small and large advisers between the SEC and the states in the National Securities Markets Improvement Act of 1996 ("NSMIA").
We note that NASAA recently withdrew its 1989 motion supporting the SRO concept for investment advisers.20 FPA concurs because the resource issue has been resolved for the time being. Observing that the NASD denies any further interest in regulating investment advisers, 21 FPA believes it also appropriate for the SEC to encourage the NASD to rescind that motion as well, particularly in light of the historical concerns organizations representing independent investment advisers and financial planners have had regarding broker-dealer oversight.
Further, there have been no calls in Congress for increased regulation of investment advisers or financial planners since the early 1990s. The SEC has also publicly affirmed an SRO would require federal legislation. In designating the NASD several years ago as the administrator of the Investment Adviser Registration Depository, an electronic registration system for advisers, an SEC news release stated that authorizing the NASD to serve as a self-regulatory organization for investment advisers would require an act of Congress.22 From a consumer perspective, there has been no documented increase of fraud in the investment adviser industry to warrant consideration of a SRO at a time when the SEC has been successful in stabilizing its five-year audit cycle for large advisers. An SRO would be costly to operate and would undoubtedly increase the costs of doing business that would be passed on to investors at a time Congress is examining fee expenses and other costs in the brokerage and mutual fund industries.
Notwithstanding the inherent problems with an SRO for investment advisers, FPA remains deeply concerned that the steady consolidation of financial services offered by one holding company, and the increasing potential for conflicts in cross-selling among affiliated firms through a single point-of-sale agent, merits a re-direction of the SRO concept in the Proposing Release of a self-regulatory organization to one with a professional orientation. A new market is rapidly developing for baby boomers seeking unbiased organic advice on their financial goals. Stockbrokers, insurance, banking and credit union agents, accountants, and others in the financial services industry are transforming their transaction-based businesses into advisory platforms. Within all of these industry sectors, there are many individuals and firms providing competent and ethical advice, two critical elements of investor protection that have never been addressed by the Advisers Act or its rules. However, there are far more who lack basic qualifications to provide competent, ethical advice. There are no uniform, basic standards of competency or ethical conduct for individual advisers regulated under banking, insurance, accountancy or securities laws. A prospective client who, for example, is seeking financial security in retirement, may visit a retail adviser in any one of these regulated industries and receive materially different levels of disclosure, fiduciary conduct, and competency in the services provided. The financial solutions may be oriented toward the firm's primary industry or proprietary product, rather than addressing the best interests of the client. The steady client migration to independent advisers cited earlier in this letter attests to a strong undercurrent of dissatisfaction by consumers with sales-generated investment solutions. It is extremely difficult if not impossible to quantify investor losses resulting from incompetent or unethical advisory practices. Yet, short of blatantly misleading or fraudulent advertising, nearly all of the regulated industries are free to heavily market and define financial planning23 in recommending financial solutions that enhance specific product sales or niche services.
So on one level, we support further exploration of the comments in the Proposing Release that "an SRO can require its members to adhere to higher standards of ethical behavior" and minimum education or experience standards.24 Yet as the recent investigations of ethical misconduct and corporate malfeasance demonstrate, the SRO concept is an imperfect model. As noted in a recent FPA white paper on financial planner regulation regarding professionalism, "[n]o regulators, state or federal, have the institutional competence to examine all aspects of financial planning to determine if there are flaws in the plan recommendations beyond the regulators' respective areas of jurisdiction."25 We believe that a PRO concept is more suitable to the discussion of standards in ethics and competency, warranting further concept discussion. By PRO model, we would hold up the CFP Board of Standards, Inc.26 as a suitable private sector example, albeit one without any policing powers except in its capacity under trademark law to restrict use of its certifications to those who pass initial exam, education and experience requirements, and comply with a code of ethics and practice standards.
The SEC cannot, of course, oversee all aspects of the financial planning process under the Advisers Act, in particular the advice provided in connection with the sale of certain insurance products. Nor does it or any other regulatory agency, state of federal, oversee the integrated delivery of advisory services, including certain modular components of financial planning, such as budgeting, cash flow management, tax, college, retirement, small business, divorce and estate planning. The Commission is also prohibited from regulating advisory activities of banks, except with respect to mutual fund managers. However, as noted in the SEC's seminal analysis of financial planning in 1987
This has led many regulators, industry personnel and the public over the years to simply equate financial planning with investment advice. Today probably most individuals marketing financial planning services continue to be regulated as registered investment advisers under SEC or state authority although other players in the financial services industry, as noted earlier, are increasingly developing financial planning platforms.
Given the multiple licensing requirements inherent in the delivery of comprehensive financial planning services that extend beyond the SEC's jurisdiction, it may not be feasible for a PRO to serve as a model for national standards of professionalism in the financial services industry. Moreover, if the costs of creating a voluntary PRO for financial planners as an alternative to investment adviser regulation were prohibitive, financial planners and the FPA might also oppose the PRO concept. We believe nonetheless that a study is warranted to evaluate whether the cost of establishing a voluntary PRO would be of material benefit to and enhance the current SEC mission of promoting investor confidence in the financial markets. Given the fragmented state of the investment adviser industry, it is unlikely the industry itself would be able to agree on uniform standards of professionalism without the support of a federal agency endorsing higher standards of protection for the public.
c. Fidelity Bonding for Advisers. FPA questions cost-effectiveness. We have not surveyed financial planners to determine how many hold surety coverage. Such bonds are typically designed to protect the owners of a company from employee dishonesty such as pilfering money and property, rather than protecting adviser clients from corporate fraud and theft. However, we understand that bonding companies would be able to add riders to a surety policy covering dishonest acts of employers and employees with respect to customers of the firm.
The relevant question is whether fidelity bonds help protect the public or merely add unnecessary costs to doing business. Insurance premiums in all lines have risen dramatically since the events of 9/11, not just property and casualty insurance rates. A bonding company would have to determine premium based on the number of employees, amount of coverage, event history, and current security and compliance controls in place. It is our understanding that annual premiums for a small advisory firm of five to 15 employees, not holding custody of client funds, would cost about $7,000 to $7,500 a year for a $1 million policy. Given the obvious fact that most SEC advisers manage far in excess of $25 million in client assets, the amount of coverage and associated premiums raise the question of what is sufficient coverage? At an absolute minimum, we suggest that the SEC review recent enforcement actions involving fraud or embezzlement by advisory personnel that would have been covered by a firm's surety bond, and how much coverage would have been necessary to redress investor losses. Further, it would be helpful to profile the size and activities of the firm such as custody of client funds to determine whether bonding is an appropriate compliance requirement.
In response to specific questions raised in the Proposing Release:
Should advisers be required to obtain a fidelity bond from a reputable insurance company? If so, should some advisers be excluded?
If bonds were required for advisers, then we believe it would be appropriate to ensure the insurance company is not at risk of default. However, we would strongly object to unreasonable standards limiting the pool of insurance companies and available coverage that would raise premiums to an unreasonable cost.
We believe that bonds may be appropriate for advisory firms with custody, or with an enforcement history. We do not believe fidelity bonds are appropriate for most advisory firms, particularly for financial planning firms that do not manage assets but are nonetheless registered with the Commission for other reasons such as an affiliated firm.
Alternatively, should advisers be required to maintain a certain amount of capital that could be the source of compensation for clients? What amount of capital would be adequate?
The advisory business is not capital intensive and most small advisers do not generate enough income to offset the total loss of client funds managed by the firm. It would be helpful to discuss with NASAA if its minimum capital requirements on the state level are used to redress consumer claims or simply as a fiscal barometer. 28 In a 1998 survey of state requirements by FPA, about 40 percent of the states had net capital or net worth requirements. Those states with net capital requirements, including bonds as alternatives to capital requirements, varied from $1,000 to $25,000, with an average about $5,000. Five states had net worth requirements ranging from $5,000 to $25,000. We believe a net capital requirement has no beneficial effect on consumer protection because of the low capitalization costs, but an arbitrary requirement could serve as a barrier of entry to new firms.
In summary, FPA is generally supportive of Rule 206(4)-7 requiring written supervisory procedures for investment advisers. We object to the concept rules for enhancement of adviser compliance for the reasons stated above, and because those costs, including the written supervisory procedures that we expect the SEC to adopt, could increase overhead for smaller firms by as much as $15,000 a year (not including membership in an SRO). We also encourage the SEC to examine a voluntary PRO concept for persons marketing financial planning services in light of the rapid consolidation of financial services industries offering similar services to the public.
Thank you again for the opportunity to submit comment on the above proposals. In the meantime, please do not hesitate to contact the undersigned if you have any questions.
Duane R. Thompson
cc: The Honorable William H. Donaldson, Chairman
Lori A. Richards
Paul F. Roye