The Investment Counsel Association of America
April 17, 2003
Jonathan G. Katz, Secretary
Re: File No. S7-03-03; Proposed Rule: Compliance Programs of Investment Companies and Investment Advisers
Dear Mr. Katz:
The Investment Counsel Association of America1 appreciates the opportunity to submit comments regarding the Commission's proposed rule that would require investment advisers to adopt written compliance policies and procedures.2 Proposed Rule 206(4)-7 under the anti-fraud provisions of the Investment Advisers Act of 1940 would require advisers to adopt and implement written policies and procedures designed to prevent violations of the Advisers Act, conduct an annual review of such policies and procedures, and designate a chief compliance officer responsible for administering the policies and procedures. Proposed Rule 38a-1 under the Investment Company Act would impose similar requirements on investment companies, with the additional components of fund board approval of the compliance program and compliance officer reports to the board.
The ICAA consistently has promoted the use of written policies and procedures as an integral "best practice" component of an effective investment adviser compliance program. Our organization often has suggested that firms adopt written policies and procedures even though, as a matter of law, such policies and procedures are not specifically mandated. We believe written policies and procedures: (1) can assist an advisory firm in fulfilling its fiduciary responsibility to its clients; (2) help to create an environment within an advisory firm that promotes increased awareness of and compliance with applicable laws and regulations; and (3) reduce the potential liability of an advisory firm for violations of the securities laws.
Accordingly, as a matter of best practices, we support the principles that an adviser should have written compliance policies and procedures appropriate to the nature of the firm and its business, designate personnel responsible for compliance, and conduct an annual review of its compliance program. However, we have serious reservations about the propriety of using an anti-fraud rule to mandate these practices. As set forth in more detail below, we are concerned that: (1) the Commission intends to articulate "minimum" topics for compliance policies and procedures that do not differ based on size or nature of each firm; (2) given the comprehensive nature of such minimum procedures and the anti-fraud rubric of the rule, the cost of compliance, particularly for small firms, will be significant; and (3) any deficiency alleged by examiners and enforcement staff related to policies and procedures could be characterized as a fraud.
We therefore strongly urge the Commission to consider taking a somewhat different approach by issuing an interpretive release under Section 203(e) of the Investment Advisers Act instead of adopting an anti-fraud rule.3 Section 203(e) provides a defense in a failure to supervise action for persons who have established and implemented procedures reasonably designed to prevent and detect violations. We believe this approach will achieve our mutual goals of increased investor protection and adviser compliance but will reduce the possibility of the rule being used inappropriately.
The Commission has also requested comment on additional means to involve the private sector in enhancing compliance by advisers and funds with the federal securities laws. Specifically, the Commission proffers the following approaches: a self-regulatory organization (SRO) for funds and/or advisers; periodic third-party compliance reviews of each fund and adviser; expanded audits by fund accountants; and a fidelity bonding requirement for advisers.
The ICAA strongly opposes an SRO for investment advisers. We believe the current system of regulation has created an effective system of compliance and oversight and that radical change is not needed or appropriate. In addition, there is no compelling evidence that the other approaches proffered by the Commission would be effective at enhancing compliance, although we would not object to further study of these ideas.
I. Overview of the Investment Advisory Profession and the Advisers Act.
The investment adviser profession is a large and extremely diverse industry. On one end of the spectrum, a few large investment advisory firms manage the bulk of total client assets.4 Many of these firms are affiliated with other investment advisers, banks, broker-dealers, and insurance companies. In fact, the 284 largest investment advisory firms manage 82 percent of the $20 trillion in discretionary assets managed by all SEC-registered advisers.5
The vast majority of investment advisory firms, however, are quite small.6 They tend to employ a few highly educated professionals who generally work together in intimate, collegial settings. SEC data reflect that almost 50 percent of all registered investment adviser firms have only one to five employees.7 Indeed, more than 5,000 firms or 67.5 percent of all SEC-registered advisers have ten or fewer employees.8 More than 6,000 firms, or about 82 percent, have ten or fewer employees performing investment advisory functions.9 We believe the SEC should continue to foster an environment that is conducive to supporting the robust and dynamic population of relatively small businesses that dominate the U.S. investment advisory profession.
The law governing the activities of investment advisers, the Investment Advisers Act of 1940,10 is relatively simple, straightforward, and effective. Certain investment advisers are required to register with the SEC and are subject to regulations issued and enforced by the Commission.11 The statute makes it unlawful for any adviser to "employ any device, scheme, or artifice to defraud any client or prospective client" or to engage in "any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client."12 The law authorizes the Commission to promulgate rules and regulations that define and prescribe ways to prevent any act, practice, or course of business by an adviser that is "fraudulent, deceptive, or manipulative."13 Consistent with the other major federal securities laws, the Advisers Act largely relies on full and fair disclosure to effect its purposes.
Of particular note, all investment advisers are subject to a strict fiduciary duty that is intended to eliminate or require disclosure of conflicts of interest and to prevent an adviser from overreaching or taking unfair advantage of a client's trust.14 As a fiduciary, the adviser must act in the best interests of the client and must disclose material information. The fiduciary duty serves as a primary line of defense in protecting clients from adviser misconduct. Among obligations that flow from an adviser's fiduciary duty are: (1) the duty to have an adequate, reasonable basis for its investment advice; (2) the duty to seek best execution for clients' securities transactions where the adviser directs such transactions; (3) the duty to render advice that is suitable to clients' needs, objectives, and financial circumstances; and (4) the duty to make full and fair disclosure to clients of all material facts, particularly regarding potential conflicts of interest.15
Thus, while the legal framework governing investment advisers is relatively uncomplicated, an adviser's legal obligations are rigorous. Disclosures required of advisers in registering with the SEC alone are without precedent in other regulated professions. Each adviser is required to disclose its basic fee schedule (including how fees are charged and whether such fees are negotiable), types of investments and methods of securities analysis used, how the adviser reviews client accounts, the adviser's other business activities, material financial arrangements the adviser has with a wide variety of entities, certain referral arrangements, proxy voting policies and procedures, and numerous other matters that describe activities that may pose potential conflicts of interest with the adviser's clients, including specific disclosures relating to trading and brokerage practices. Also unprecedented is the amount of information regarding each registered adviser - including any disciplinary history - that is available to the public on the Internet via the Commission's Investment Adviser Public Disclosure web site.16
Although currently the Advisers Act does not expressly require an investment adviser to have written policies and procedures in many areas, a number of factors have compelled many advisers to implement such a practice.17 First, an investment adviser has a duty to supervise any person acting on its behalf.18 Under existing law, without reasonably designed policies and procedures, an investment adviser would not be able to avail itself of one of its most effective defense against a failure to supervise action. Second, SEC staff have consistently and clearly commented on the importance of establishing internal controls and have emphasized that written policies and procedures are important elements of a good compliance program.19 Third, good compliance controls are an integral part of a risk management program, which is suggested by sound business practices and demanded by many clients. Given these regulatory and business considerations, investment advisers are highly motivated to create a compliance environment with adequate internal controls and supervisory procedures that protect their clients and their firms.
II. Specific Comments on the Proposed Rule Requiring Compliance Programs.
A. Adoption and implementation of written policies and procedures.
The ICAA generally supports the concept of requiring advisers to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act by the adviser and its supervised persons. We have consistently encouraged investment advisers to establish adequate and appropriate policies and procedures. Indeed, we believe that many firms, particularly larger firms, already have written policies and procedures covering many aspects of their operations. We applaud the Commission for providing substantial flexibility in its proposed rule to enable advisers to "take into consideration the nature of each organization's operations."20 However, we have four general concerns regarding this aspect of the proposal.
First, given the diversity of advisory firms, the ICAA submits that minimum requirements for compliance programs are not appropriate, either as part of a rule or even as articulated in any adopting release. Second, we have serious concerns regarding the cost of establishing and implementing comprehensive written policies and procedures, particularly for small investment advisory firms. These costs could be substantial relative to firm size and resources. Third, the proposal seemingly reflects the Commission's increasing inclination to find that whenever a violation of securities law has occurred, there must have been either a breach of an adviser's policy or procedure or, alternatively, the policies and procedures themselves have been deficient. The proposal, if used aggressively, could turn every adviser deficiency into an enforcement action based on fraud. Finally, with respect to the parallel fund proposal, we recommend that the Commission not require board approval of policies and procedures of independent sub-advisers to mutual funds.
1. Minimum policies and procedures required.
The Commission requests comment on whether the rule or adopting release should specify certain minimum policies and procedures that must be established and implemented. We strongly submit that neither the rule nor the release should specify the minimum areas to be addressed by policies and procedures. To be effective, compliance policies and procedures and the business practices necessary to establish a compliance culture within an advisory firm must be specific to the firm. The firm itself is in the best position to determine the appropriate scope of its formal written procedures.
The proposing release sets forth a lengthy list of areas that policies and procedures of funds and advisers should "at a minimum" address.21 We surveyed a sample of ICAA members of various sizes that approximately mirror the SEC-registered universe of advisers. Although all of these advisers had written policies and procedures addressing at least one area, most of the advisers surveyed did not have written policies and procedures covering every item on the SEC's proposed "minimum" list - and with good reason. A three-person firm that does not have actual custody of client assets probably does not need a written policy for "safeguarding of client assets from conversion or inappropriate use by advisory personnel." A small firm with a limited number of clients probably does not need written policies and procedures to test consistency of portfolios with guidelines. Most firms do not need a written policy to remind them to review and file Form ADV annually; they just do it. A sole proprietor may not need to write down his contingency plan that his backup systems are at his house. Some of the proposed minimum policies would be unnecessary and would add cost with no commensurate benefit.
Accordingly, although it may be useful to provide a suggested list of the types of policies and procedures that a firm could consider adopting, we do not believe that it is necessary or advisable to specify minimum requirements beyond those already required under existing law. Firms vary vastly by size and type; their need for written policies and procedures will necessarily vary. The Commission should allow enough flexibility for each firm to adopt only those procedures that make sense for that firm and its clients.
2. Cost considerations.
The Commission notes that the proposal would impose "larger relative costs" on small firms.22 We share this concern. It is very difficult to quantify the cost of writing policies and procedures for such firms because they do not typically employ a full-time compliance official whose time can be easily allocated to this task. The SEC estimates that implementing this rule would require an average of 80 internal hours for each firm. However, the cost of this time is not clear. In its proxy voting rule proposal, the SEC estimated that a compliance officer's time would cost $60 per hour.23 In a small firm of fewer than five or ten employees, a portfolio manager or even the president of the company might be the compliance officer and the cost of his or her time would probably be much greater than $60 per hour.
Some advisers might consider hiring a third party to write their policies and procedures. The ICAA surveyed several service providers and law firms to determine how much it would cost to prepare compliance policies and procedures for investment adviser firms. The law firms in aggregate reported that writing policies and procedures could involve between 35 and 300 hours and that this amount of time would cost between $10,000 and $120,000, depending on the adviser's size and complexity. Similarly, larger accounting firms that offer consulting services developing customized policies and procedures estimate the cost at $50,000-60,000 for a mid-size advisory firm and at more than $200,000 for large global conglomerates.
We also surveyed several third-party service providers (non-law firm/non-accounting firm) that offer the service of assisting advisers in writing individualized policies and procedures. We found that these firms charge in the range of $2,500 to $3,500 for a small to medium-sized firm. These amounts, though not astronomical, would still represent a significant cost to a small adviser, particularly given that they are only initial costs. They do not include the cost of periodic or annual updating or the cost of actual implementation on a daily basis.
We recognize that firms could purchase an off-the-shelf compliance manual from a third-party provider for under $1,000 as a starting point. However, the adviser would still have to spend a significant amount of time tailoring the manual to its own specific practices and procedures. Further, there are risks in providing an incentive for investment advisers to purchase such manuals because they might fail to tailor them sufficiently to meet the needs of their firm. Obviously, the quality of policies and procedures may vary significantly depending on whether firms use a law firm, an accounting firm, or other consultant experienced with investment adviser regulation to develop them, or simply spend a few hours modifying a purchased template. The implementation cost would have a significant economic impact on a small firm and we question whether the benefit warrants the cost.
3. Violation of the rule should not result in charges of fraud.
Because the Commission has proposed Rule 206(4)-7 under its anti-fraud authority, the failure of an adviser to maintain compliance policies and procedures, to review these policies and procedures annually, or to designate a chief compliance officer could constitute an "act, practice, or course of business which is fraudulent, deceptive, or manipulative" within the meaning of the anti-fraud rule.24 Therefore, an adviser could be found to have violated the fraud section of the Advisers Act for the mere failure to have in place certain policies and procedures that the Commission deemed inadequate without having committed any substantive violation of the Act.
We believe that good compliance is essentially part of the supervisory obligation that is already imposed by law on advisory firms. It seems unfair to mischaracterize a policy drafting decision or breakdown in proper supervision as a fraud. For example, suppose an adviser erroneously charged a client a performance-based fee in violation of Section 205 of the Advisers Act. Also suppose that the proposed rules were adopted and the advisory firm failed to include what the Commission deemed to be an adequate discussion of the rules governing performance-based fees in its compliance manual. It seems fundamentally unfair to charge the firm with a violation of Section 205 for erroneously charging the fee and to add a potentially much more serious fraud charge based on the defect in the compliance manual.25 We suggest that the defect in the compliance manual is better characterized as a defect in supervision, not as a fraud.
In addition, characterizing policy and procedure inadequacies as a fraud may have serious insurance implications. Typical errors and omissions policy forms for advisers include an exclusion for fraud by the insured or its officers or directors. Insurers may attempt to defeat coverage where there is an allegation or finding of deficient policies and procedures under an anti-fraud rule. Indeed, under the wording of some policies, insurers may even attempt to refuse to defend the action, much less cover any judgment against the adviser. Such a result would not benefit investors.
In addition, we have concerns regarding the Commission's ability to implement proposed rule 206(4)-7 in a flexible manner. Compliance policies and procedures are not scalable; the policies, procedures, monitoring, testing, and exception reporting that may be appropriate for large firms do not scale down to a small firm that has few barriers to inter-office communication. The list of potential topics that may be appropriate for written policies and procedures is growing and dynamic. Decisions regarding whether such policies and procedures should apply to any particular firm and its employees and how any such policies and procedures may be drafted involve numerous, complex, and even subjective considerations. Should this proposed rule be adopted, we strongly encourage specific training of the SEC inspection staff regarding the need to focus on overall process rather than specific check-the-box requirements, and to recognize permissible variations in compliance programs depending on the size, nature, and characteristics of firms and their clientele.26
Current statistics cited by officials from the Office of Compliance, Inspections, and Examinations (OCIE) indicate that virtually all (94 percent) investment adviser inspections result in deficiency letters.27 In addition, according to OCIE, about half of all adviser deficiencies involve either: (1) inadequate written compliance policies or procedures, or (2) failure to follow written policies and procedures. We do not believe the rule will be beneficial to either advisers or their clients if it simply is used as the legal basis for "writing up" an additional problem in every deficiency letter or to ease the burden of bringing an enforcement action against an investment adviser. We urge the Commission to avoid allowing the rule, if adopted, to become a weapon that inspection and enforcement staff can use to second-guess and punish any investment adviser, rather than a useful tool that encourages advisers to design and implement effective compliance programs for the benefit of investors.
4. The role of subadvisers.
Although we are not commenting on the proposed investment company rule per se, we take this opportunity to express concern regarding the application of that proposed rule to independent subadvisers to investment companies, particularly for those advisers that act on behalf of more than one fund complex. It would be logistically difficult for subadvisers to submit their policies and procedures to various boards of the various funds they subadvise and incorporate comments received from different boards. In fact, this requirement could easily place the adviser in the difficult, if not impossible, situation of trying to negotiate a policy between one or more boards having different demands. We submit that subadvisers should not be required to maintain separate firm policies and procedures for each fund advised, nor should they be required to only put policies in place that satisfy a single constituency. Subadvisers provide an important service to mutual funds but must retain flexibility to develop procedures appropriate for all of their clients. Accordingly, we request that the Commission clarify that fund boards are not required to approve the policies and procedures of independent, unaffiliated subadvisers.
B. Annual review of policies and procedures.
The Commission proposes that advisers review their policies and procedures annually. Such an annual review can be a useful compliance tool. As a practical matter, most firms already review their policies and procedures at the time they update Form ADV each year to ensure that their prior year disclosures are still consistent with their current practices, policies, and procedures. During this process, firms often reconsider their compliance policies and internal controls as a matter of course to evaluate whether they work as designed and whether changes are necessary to assure their continued effectiveness.
The Commission seeks comment on whether the proposed rule should require more frequent review of the policies and procedures than annually, such as quarterly. The ICAA opposes any formal requirement for firms to review their policies and procedures more frequently than annually. As the Commission issues interpretations of existing requirements and new directives throughout the year, firms typically reassess their policies and procedures to ensure compliance as needed. In addition, many firms' specific policies and procedures inherently require a periodic review. For example, a firm's best execution policy and procedures typically would require a periodic review. A firm's personal trading policies and procedures are continually monitored as employees engage in personal trading throughout the year. Further, because their operations can be quite complex, large firms already review their policies and procedures on a continuing basis to keep pace with internal changes. An annual review would serve as a useful check on these systems to ensure that steps have been taken during the year toward full compliance. A formal quarterly review, however, would add extra cost without adding any meaningful benefit to clients or advisers.
C. Designating a chief compliance officer.
The proposal would require every adviser to designate a chief compliance officer responsible for administering its compliance policies and procedures. We generally support such a requirement, given the Commission's assurance that this designation would not confer a duty on the designee to supervise another person.28 The ICAA member firms we surveyed have one or more employees assigned to be responsible for compliance matters, and many of those firms have taken the additional step of designating a chief compliance officer. Thus, we believe the proposed rule would formalize a step that many firms have already taken. Nevertheless, we suggest that the adopting release emphasize a wide range of flexible approaches that may be appropriate when designating a chief compliance officer. For example, we appreciate the Commission's recognition that a small firm will likely not have anyone dedicated solely to compliance.29 The Commission should also realistically recognize that for sole proprietors and other very small firms, the chief compliance officer designation may not result in significantly strengthened compliance oversight.
The Commission requests comment on whether the chief compliance officer should be required to certify the firm's compliance with its policies and procedures. We strongly oppose such a certification because it places an unfair burden on a single person to be responsible for an entire firm's compliance matters. Most compliance professionals would be reluctant to sign such a certification when 94 percent of SEC inspections result in a deficiency letter. Faced with such a high probability of being cited for a deficiency, few advisory firm employees would risk liability for filing what in hindsight could be deemed a misleading statement of compliance. Similarly, it is unclear as to what the compliance officer would certify. At a recent conference, SEC staff reportedly stated that "every firm has problems and should have examples of problems they have caught and fixed" and firms "that claim not to have had any problems they have caught and resolved could end up being visited once every two years and face exams that last about four weeks, instead of two weeks...."30 Thus, any certification requirement could be a trap for the unwary compliance officer. Indeed, such a requirement could result in an unintended incentive for compliance officers to make procedures less specific and less rigorous in order to provide more comfort in certifying to their implementation.
The Commission also seeks comment on whether multiple persons can act as compliance officers. The ICAA supports allowing firms the flexibility to appoint multiple persons to share the role of chief compliance officer, particularly in a large or global firm. Having multiple compliance officers ensures that those with expertise in a particular area of compliance are responsible for monitoring compliance in that area.
The Commission further requests comment on whether it should require the chief compliance officer to be a member of senior management. It is critical that a chief compliance officer have sufficient authority to implement a firm's compliance program effectively. Moreover, a firm's compliance function will likely cross many departments in a large firm. Therefore, we strongly support a requirement that the chief compliance officer either be a member of senior management or report directly to senior management, to ensure that he or she can effectively oversee the firm's entire compliance program.
III. The ICAA Proposes An Alternative Approach to Proposed Rule 206(4)-7.
The ICAA respectfully submits that its concerns can be addressed, and at the same time good compliance efforts can be encouraged, if the SEC follows a slightly different approach in its rulemaking. Rather than adopting blanket requirements as anti-fraud rules, the SEC could issue an interpretive or concept release stating that the proposed compliance program should be treated as evidence of a firm's efforts to meet its current statutory obligation to properly supervise its employees. When a system of supervision is found to be defective, the violation would be cast more appropriately as a breakdown of supervision, not as a separate fraud.
Section 203(e)(6) of the Advisers Act states:
This provision provides a "statutory affirmative defense to a failure to supervise charge for investment advisers that demonstrate that they have established and complied with procedures reasonably designed to prevent and detect the violations at issue."31 If the adviser has no policies or procedures appropriate to prevent and detect a particular type of unlawful practice that occurs, the adviser will not be able to avail itself of the Section 203(e) affirmative defense and will leave itself more exposed to a failure to supervise charge. Accordingly, the concept of good compliance policies and procedures is more suitably addressed as an interpretation of this provision than as a fraud in and of itself.
The issuance by the SEC of an interpretive or concept release would also have another value. It would permit the SEC more generally to clarify the standards of proper supervision at advisory firms, a subject that is unclear today. We urge the Commission to provide notice and seek public comment before issuing such a release.32
IV. Request for Comment on Further Private Sector Involvement.
Expressing concern about whether its resources will keep pace with growth in the advisory industry, the Commission seeks comment on various approaches to involve the private sector in enhancing compliance with the federal securities laws. The Commission is considering: (1) requiring periodic third-party compliance reviews of each fund and adviser; (2) requiring expanded audits of funds by fund accountants; (3) a fidelity bonding requirement for investment advisers; and (4) establishment of a self-regulatory organization (SRO) for investment companies and/or investment advisers. While we understand the Commission's concerns regarding its resources, we submit that, at a minimum, further study is necessary before the first three of these approaches are seriously considered. In addition, we urge that the SRO approach be eliminated from consideration entirely.
A. Three of the Commission's private sector concepts require further study.
There is no compelling evidence that requiring third-party reviews, expanded audits, or fidelity bonds will be effective in enhancing investor protection or that the benefits would exceed the costs. Fidelity bonding is already required under ERISA and the Investment Company Act.33 It is fairly widely used throughout the advisory industry.34 However, there is little, if any, evidence that bonding enhances compliance programs or even protects the investing public from loss. We understand that in cases of serious misconduct, the insurer may contest coverage on a variety of grounds. This leaves the insured immersed in lengthy and costly litigation when the public would most need the protection of the bond. The ICAA is not necessarily opposed to this proposal, particularly for advisers with physical custody of client assets,35 but does not believe its effectiveness has been demonstrated. An ineffective requirement may harm investor protection by providing a false sense of security.
We have serious concerns with respect to expanded audits and third-party compliance reviews as well. While some advisers have retained third parties to conduct compliance reviews, transforming this business decision into a rigid requirement is inappropriate and would impose substantial mandatory costs on advisers. Compliance reviews or "mock audits" by non-accounting consultants can cost in the range of $5,000 to $25,000 - or higher for large firms, while such audits by accounting-related consulting firms can cost from $30,000 to $100,000 or more per audit. There is no evidence that the level of expertise of every third-party consultant exceeds the expertise of in-house personnel with knowledge of the firm's operations. Further, the SEC is currently in the midst of a sweeping overhaul of the accounting profession to improve its effectiveness. Until that effort is more advanced, and evidence is gathered regarding the marginal utility of expanded audits and third-party review, these proposals will impose needless costs on the industry without corresponding benefits to the investing public and could help to create an illusion of false security.
Accordingly, we submit the Commission should not consider these proposals until evidence is collected to evaluate their effectiveness. Given the absence of a compliance crisis in the industry - and recent enhancements to the Commission's budget and inspections program - a period of informed study appears both prudent and helpful. One possible method to conduct such a study would be for the SEC to require third-party reviews and expanded audits as part of settlements of enforcement actions. Although these proposals have been included in some settlements of SEC actions, the ICAA is unaware of any effort to study the effectiveness of the practices. The SEC could require follow-up reporting, in addition to the new procedures, as part of its settlements so that the evidence could be assembled to assess the effectiveness of these proposals. With respect to fidelity bonds, the SEC could gather and analyze information from the Department of Labor or the states that require such bonding.36
B. The ICAA Strongly Opposes a Self-Regulatory Organization for Investment Advisers.
The ICAA strongly opposes the establishment of a self-regulatory organization for the advisory industry. As discussed above, the investment management industry has a good record of compliance, free from systemic abuse or scandal. The SEC has been remarkably effective in its direct regulation of the industry, particularly since the passage of NSMIA.37 In addition, the investment adviser industry is too diverse and fragmented to benefit from the self-regulatory model. Finally, a self-regulatory organization would be enormously expensive and difficult to create and would require congressional action. The Commission has not demonstrated that this dramatic step is necessary or warranted. To the extent that additional resources are needed by the SEC to oversee the industry, the ICAA strongly supports efforts to obtain those resources so that the SEC can continue its sixty-year role as the direct regulator of the advisory industry.
1. The SEC is an effective direct regulator of advisers.
The current system of direct regulation of investment advisers by the SEC has worked remarkably well. The advisory profession has not experienced the scandals and systemic problems that other industries have faced. To our knowledge, the only major regulatory problem identified during the sixty-plus year history of the Advisers Act was the ability of the Commission to conduct appropriate oversight of the advisory profession in the early to mid-1990s. We strongly believe that enactment of the Investment Advisers Supervision Coordination Act in 1996 (Coordination Act)38 solved this problem and, in fact, has resulted in a virtual revolution in adviser regulation accompanied by a prolific increase in inspection and enforcement activities by the Commission.
The Coordination Act divided regulatory responsibility between the Commission and the states by prohibiting an investment adviser from registering with the SEC unless it has more than $25 million in assets under management,39 is an adviser to a registered investment company, or fits one of the limited exemptions. One of the Act's principal purposes was to leverage state and federal resources by "eliminating overlapping regulatory responsibilities."40 This legislative intent was well summarized in the Commission's proposed rules to implement the law:
The Coordination Act's allocation of regulatory responsibility between the SEC and the states enhances investor protection, provides for more efficient use of limited regulatory resources, and reduces burdensome and unnecessary regulatory costs.
The SEC's regulatory, inspection, and enforcement activities with respect to investment advisers have increased dramatically since implementation of the Coordination Act. Collectively, these efforts represent a revolution in the treatment of investment advisers by the SEC. When the Coordination Act was enacted in 1996, there were approximately 22,500 advisers registered with the SEC. Today, there are fewer than 8,000 advisers registered with the SEC.42 Obviously, this means that the SEC has been able to concentrate its resources on a much smaller universe of advisers.
At the same time, the SEC has devoted increased regulatory resources to the investment adviser area. In 1997, the SEC created the Task Force on Investment Adviser Regulation, which subsequently became the Office of Investment Adviser Regulation (OIAR). During the last six years, the OIAR has taken the lead on a substantial number of rules and initiatives adopted or proposed by the Commission, including:
Additional rules that are likely to be considered include exemptions from restrictions on principal trading under the Advisers Act, as well as rules relating to advertising and performance reporting, books and records, and anti-money laundering.
During the same time, the SEC's inspection activities of investment advisers have increased dramatically, directly addressing one of the major concerns underlying passage of the Coordination Act. In 1996, when the Coordination Act was being debated, the SEC estimated that the average cycle for routine adviser inspections was once every 15-30 years. Today, the SEC's Office of Compliance Inspections and Examinations (OCIE) inspects every registered investment adviser at least once every 5 years. Since enactment of the Coordination Act, the SEC also has stepped up its targeted inspections or "sweeps" of advisers on particular issues of concern, including the soft dollar sweep of 280 investment advisers, a follow-up sweep on best execution practices, a sweep of advisers on performance issues, visits in 1998 to nearly 60% of advisers nationwide regarding Year 2000 readiness, a fact-finding review of advisers that manage hedge funds, and targeted inspections this past summer focusing on proxy voting.
Indeed, the director of OCIE has announced a new inspection plan for investment advisers that would reduce the inspection cycle further to no more than four years, with a two-year cycle for the largest firms that manage the majority of the aggregate assets under management by the industry.55 She also announced a new method of inspection that would evaluate each adviser's risk management and internal control processes.56 Those firms with weak internal controls will undergo a more rigorous and lengthy examination by OCIE staff.
Thus, the record is indisputable that investment advisers are subject to an increasingly complex regulatory environment and are subject to rigorous oversight by the Commission. Direct regulation is working well. There is no demonstrable need for a different regulatory structure.
In the past, a self-regulatory organization for advisory firms has been proposed as a means of committing greater resources to the regulation of that industry, particularly when SEC resources were viewed as inadequate and additional Congressional funding for the SEC was not forthcoming. Every time this crisis has been identified, SEC resources have increased, the burden on the SEC has been reduced (such as through the adoption of the Coordination Act), and a period of effective SEC oversight has followed. Today, the SEC has just received a significant budget increase and is in the midst of hiring new examiners and enforcement lawyers to oversee the industry. It is also in the midst of a review to determine whether it can use its existing resources more effectively. The ICAA supported this budget increase for the SEC and will support future increases if needed. Until the current budget increase is spent, and the current review of SEC operations is completed, there is simply no evidence that the SEC cannot properly oversee the advisory industry with its current resources.
2. The investment management industry is too diverse to benefit from the self-regulatory model.
The investment advisory profession is both diverse and fragmented. The 7,790 advisers registered with the SEC include: small advisers who provide investment counseling and/or financial planning services to individuals, small businesses, and local charitable and educational funds; advisers providing traditional investment counseling and money management services to high net worth individuals, endowments, businesses, and pension funds; advisers that focus principally on managing mutual funds that they have established; advisers that focus on sub-advising funds set up by others; firms that have a large "wrap" or "separately managed account" business involving agreements with numerous program sponsors; advisers focusing on hedge funds; small to medium sized advisers that offer boutique investment styles or strategies; and firms with thousands of employees and offices in various countries that offer a variety of institutional and retail financial products and services (including hedge funds, mutual funds, separately managed accounts, institutional money management, brokerage, and banking) to a diverse group of clients.
Some advisers are completely independent - not owned by or affiliated with any other entity. Others are owned by or affiliated with banks, broker-dealers, insurance companies, holding companies, and other investment advisers. Some SEC-registered advisers are registered through an exemption and do not even directly manage assets, such as nationally recognized statistical rating organizations (NRSROs), pension consultants, and multi-state advisers. There are obvious differences between how such firms conduct their business. Command-and-control requirements of the sort established by SROs do not lend themselves to the widely divergent community of advisers. Indeed, the high level of interconnectivity between broker-dealers and the commonality of technical issues related to settlement, execution, and reconciliation involving broker-dealer transactions that persuaded Congress to authorize the creation of an SRO for broker-dealers simply do not exist in the investment advisory profession.
The current structure of the Advisers Act - and its reliance on disclosure and broad anti-fraud authority rather than specific and rigid regulatory requirements - is appropriate and effective for the investment adviser profession. No additional layer of regulation is required.
3. An SRO would be extremely expensive and difficult to create.
Creating a self-regulatory organization from a blank slate can be exceedingly difficult and expensive.57 The SEC need only reflect on its current efforts in that regard with respect to the accounting profession to appreciate how difficult and expensive this task can be.58 Even more difficult than creating an SRO can be maintaining the effectiveness of that SRO. In recent years, the SEC has taken action against both the NASD and the New York Stock Exchange, two well-established SROs, for failing to enforce their rules and to properly regulate their members.59 Further, the existence of these SROs has not prevented recent regulatory problems in their industries.60 The ICAA questions whether, given this history, the record of effective oversight by self-regulatory organizations has been made.
An SRO would also be extremely costly for advisers. We understand, for example, that NASD membership can cost from at least five thousand dollars annually for the smallest firms to hundreds of thousands of dollars annually for large firms, including annual assessments, registration fees for each applicable employee, examination fees, training fees, and filing fees. In addition to these annual fees are added the continued costs of complying with rigid, detailed requirements. Advisers could better spend these funds to hire and retain high quality compliance personnel and enhance internal controls and risk management processes. In addition, an SRO brings with it the risk of inconsistency of interpretive positions and the potential regulatory and industry costs that accompany such inconsistency.61
4. An SRO would require legislation passed by Congress.
Significantly, the SEC lacks rulemaking authority to create an SRO without Congressional action. The SROs for the brokerage and accounting industries were created by acts of Congress, not by SEC rulemaking. We have been unable to identify any provision of the Advisers Act or the Investment Company Act that would authorize the SEC to create an SRO through rulemaking. More importantly, the Commission and its staff have themselves recognized that the Commission does not have authority to create an SRO without legislation enacted by Congress.62
We concur with the Commission's goal of enhancing compliance programs for investment advisers. Accordingly, we support the SEC's initiative to encourage compliance policies and procedures, with the modifications discussed above. The Commission has done a remarkable job in directly regulating the investment adviser profession and we do not believe radical reform of adviser regulation is necessary or advisable. Thus, we oppose an SRO for investment advisers and find no compelling reason to require third party reviews, expanded audits, or fidelity bonding.
We would be pleased to work with the Commission and its staff to encourage the compliance efforts of investment advisers and to study potential modifications to adviser regulation. Please do not hesitate to contact me if you have any questions or require additional information.
David G. Tittsworth
cc: William H. Donaldson