PICKARD AND DJINIS LLP
ATTORNEYS AT LAW
1990 M STREET, N.W.
WASHINGTON, D.C. 20036
(202) 223-4418 (202) 331-3813
April 18, 2003
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Mail Stop 6-9
Washington, D.C. 20549
Re: Commission File No. S7-03-03;
Dear Mr. Katz:
We submit these comments in connection with the above-referenced proposal regarding investment adviser and investment company compliance matters. Pickard and Djinis LLP is a law firm specializing in securities regulation relating to investment advisers, broker-dealers and service providers thereto. Our investment adviser client base ranges from federally registered firms with billions of dollars of assets under management to state-regulated solo practitioners. This letter reflects the opinions of a number of our federally registered adviser clients. Although the primary focus of these comments is on the Commission's investment adviser proposals, these views apply to the fund proposals as well.
For the reasons explained herein, we believe that the proposed amendments to the Investment Advisers Act of 1940 ("Advisers Act") should do no more than codify current best industry practices, and should not impose new costs on advisers that are not offset by real gains in investor protection. To achieve this goal, we believe the formal compliance program requirement should be located somewhere other than in the antifraud provision of the Advisers Act, and that the requirement for the annual compliance program review should be eliminated or modified substantially. We further believe that the Commission should clarify the fact that the amendments do not require firms that are registered both as investment advisers and as broker-dealers to maintain separate advisory and broker-dealer compliance programs.
In addition, we believe there is no evidence to suggest that the private-sector initiatives propounded by the Commission are either necessary or appropriate. First, we find no evidence of systemic compliance problems in the investment adviser industry. Moreover, in light of the dramatic decline since 1997 in the number of advisers subject to federal oversight, the substantial increase in SEC funding and examination staff, and the recent introduction of a new "smart" examination program for investment advisers, we have every confidence that the Commission can effectively regulate this industry.
We turn our attention to each of these matters individually.
Proposed Advisers Act Amendments
The Commission proposes to require advisers to (i) adopt and implement policies and procedures designed to prevent violations of the Advisers Act, (ii) review these policies and procedures at least annually for their adequacy and the effectiveness of their implementation, and (iii) designate a chief compliance officer responsible for administering the policies and procedures.1 For the most part, these proposals are consistent with current best practices in the industry, and should not impose substantial new burdens on advisers. However, there are three areas that we believe merit further attention.
First, we are concerned that relying on the Advisers Act's anti-fraud provision (section 206(4)) to mandate formal compliance programs may have unintended consequences. If deficient procedures alone are deemed to be grounds for a finding of fraud, an adviser could face serious collateral consequences for shortcomings in its compliance program, even where those shortcomings do not result in any substantive misconduct.2 To avoid this problem, we endorse the Investment Counsel Association of America's ("ICAA's") suggestion that the Commission address the issue of adviser compliance programs by means of an interpretive release under Section 203(e)(6) of the Advisers Act.3
The second area of concern is the requirement that every compliance program be reassessed on an annual basis, even in the absence of changed circumstances. Without an identified need for a reassessment, there is a danger that such reviews will simply add to the compliance staff's work load without affording any concomitant benefit to advisory clients. By definition, a duty to maintain procedures reasonably designed to prevent, detect and correct violations of the Advisers Act incorporates the concept of periodic reassessments. It would appear redundant, therefore, to formally mandate such reviews.4
However, should the Commission decide to adopt this aspect of its proposals, we respectfully submit that the requirement should be modified so that it achieves its stated purpose without imposing unnecessary burdens on advisers. In this regard, we suggest that after an initial annual review, an adviser should be obliged to formally reassess its compliance program only where there has been: (i) a material change in the adviser's business; (ii) a material change in the adviser's compliance program; (iii) a substantive change in legal or regulatory requirements; or (iv) a material infraction requiring remedial action. Furthermore, in each case, the scope of the formal reassessment should be limited to those policies and procedures that relate to the changed circumstances.
Finally, the proposals do not adequately address the circumstances of dual registrants. Many (if not most) advisers who are also registered as broker-dealers maintain compliance programs that integrate all aspects of their regulated activities. Requiring such entities to separate their advisory policies and procedures from their broker-dealer policies and procedures and requiring them to designate two separate chief compliance officers would substantially increase their administrative costs without in any way enhancing client protection.
To address this concern, we suggest that the Commission amend its proposals to provide that any compliance program maintained by a dual registrant in accordance with the Securities and Exchange Act of 1934 or applicable self-regulatory organization ("SRO") rules will be deemed to satisfy the investment adviser requirements as well, so long as that compliance program is reasonably designed to prevent violations of the Advisers Act.5
Private Sector Initiatives
In addition to proposing new rules under the Advisers Act, the Commission also seeks comment on whether it should consider subjecting advisers to various new forms of private regulation and oversight. The Commission's suggestions in this regard include (i) the formation of one or more SROs for advisers, (ii) requiring periodic third-party compliance reviews, and (iii) instituting a fidelity bonding requirement for advisers. For the reasons explained below, we respectfully submit that none of these steps is necessary or appropriate at this time.
There Is No Evidence That The Current
Regulatory Scheme for Advisers Is Deficient
The current regulatory regime for investment advisers is built around the notion that investment advisers are fiduciaries of their clients. A central feature of this regime is the adviser's duty to make full disclosure to its clients of all material facts and circumstances relating to the adviser's services and to its ability to meet its fiduciary obligations to clients. For example, advisers must provide clients with disclosure brochures at the outset of the advisory relationship and must offer updates to those brochures annually thereafter. On an ongoing basis, advisers must also inform clients about any disciplinary event that is material to an evaluation of the adviser's integrity or ability to meet contractual commitments to clients. Advisers who have discretion over or custody of their client's assets must also advise clients of certain adverse developments affecting the adviser's financial condition.6 In order to further protect investors, the SEC maintains an internet-based public disclosure system that delivers extensive information about registered advisers at the click of a button. In many ways, therefore, the investment adviser regulatory system is more client-focused than that which applies to other registered entities.
All available evidence indicates that this regulatory regime is working. Although a series of recent scandals in the financial world has shaken the confidence of the American investor, it is important to recognize the fact that investment advisers have not been responsible for any of these unfortunate events. The SEC's own experience confirms this.
For example, in the Commission's 2002 Annual Report, the Enforcement Division's sampling of last year's significant actions does not include even one matter involving investment advisers.7 In the same document, the Investment Management Division reports that serious deficiencies were found in only three percent of investment adviser examinations.8 Finally, an examination of the SEC's website reveals that only about 8 percent of the administrative proceedings instituted and/or settled during 2002 involved alleged violations of the Advisers Act.9
The inescapable conclusion is that there is no reason to launch expensive new private or quasi-governmental initiatives to repair deficiencies in investment adviser regulation because there simply is no problem here to fix.
The SEC Alone Can Effectively
Regulate Federal Investment Advisers
As the Proposing Release notes, the idea of imposing a layer of private or quasi-governmental regulation on investment advisers has been around for more than a decade.10 Concluding that it had no statutory authority to take such steps, the Commission formally approached Congress for relief in this area in the late 1980s. In doing so the Commission argued that supplemental measures were necessary because the growth in the number of registered advisers, coupled with modest resources made it increasingly difficult for the agency to oversee advisers' activities. Indeed, by the time this problem was solved, the Commission was struggling to monitor more than 23,000 registered advisers on an annual budget of approximately $300 million, and the average length of the exam cycle for smaller advisers was close to 40 years.11
In 1993, the House of Representatives passed a bill that among other things, authorized the SEC to designate one or more "inspection-only" SROs for advisers and required the agency to impose a fidelity bonding requirement on most advisers.12 This legislation was never enacted,13 but three years later, Congress did pass the National Securities Markets Improvement Act of 1996 ("NSMIA")14 which effectively corrected the perceived deficiencies in investment adviser oversight.
Designed to optimize the use of government resources and ease the burden of duplicative regulation, NSMIA divided investment advisers into two broad categories: those whose activities were deemed to be national in scope, who were to be regulated primarily by the SEC, and those whose activities were of a more local nature, who were to be regulated primarily by the states. As a result of this common-sense legislation, the number of investment advisers registered with the Commission dropped by roughly two-thirds. As it stands today, approximately 7700 investment advisers are subject to SEC oversight.15
Concomitant with this dramatic reduction in the regulatory burden investment advisers impose on the Commission has been a dramatic increase in the Commission's resources. The Commission's budget authority for FY 2003 tops $700 million, and the President's budget request for the SEC for next year is almost $850 million.16 We understand that the Commission intends to use this enormous increase to hire more than 175 new examiners and to raise staff salaries, thereby helping to retain experienced examiners who otherwise might be lost to the private sector.
A third factor relevant to our analysis is the introduction of a new examination process that will dramatically increase the efficiency and effectiveness of the Commission's efforts to police investment advisers. Under this new "smart exam" process, the frequency and intensity of adviser exams will be directly related to the perceived risk the advisers pose to the investing public.17 One measure of perceived risk is the size of the adviser.
As a result of industry consolidations, the largest 100 advisers now account for 60% of the total amount of assets under management.18 Therefore, these advisers will be subject to more frequent exams than the rest of the federal registrants. The top 20 advisers in this group (as measured by assets under management) are now on a two-year inspection cycle, while the next 80 advisers (by size) are to be examined every two to four years. The precise frequency of SEC visits to this second group of advisers will depend on other risk factors, such as the quality of their compliance procedures, the likelihood that these procedures will be able to prevent or detect violations of the Advisers Act, and the firms' history of dealing with compliance problems.
The rest of the federally registered advisers are to be examined on a two to five-year cycle, the precise length of which depends on the risk factors discussed above. In addition, SEC staff now conducts risk assessments of all newly registered firms based on the information contained in their Forms ADV. An adviser that appears to pose a higher risk of harm to its clients is inspected within twelve months after registration, while the rest are worked into the normal exam cycle.
Not only the frequency of investment adviser inspections but also the content of those inspections has improved. In this latter regard, adviser exams have been restructured into two parts. In the first part, advisers are expected to demonstrate the effectiveness of their compliance programs and to provide supporting documentation of same. If the SEC inspection staff is satisfied with this presentation, the examination terminates; if they are not, they conduct a more extensive review of the adviser's operations and records. This process allows the staff to focus their energies on advisers who are most likely to violate the federal securities laws, and spares the advisers with strong internal controls from unnecessary inspection burdens.
Finally, in addition to routine matters, all investment adviser exams conducted during a particular year now include spot checks of various "focus" issues which may relate to new rules, new services or identified problem areas. This aspect of the revised exam process further strengthens the effectiveness of the Commission's inspection program.
The combination of the reduction in the number of federally registered advisers, the increase in Commission resources and the more efficient use of those resources provides ample proof of the Commission's ability to regulate investment advisers. That coupled with the fact that investment advisers as a group have a history of general compliance with the securities laws belies the need for drastic new forms of regulation. Indeed, this is a particularly inopportune time to consider such measures, because it is not yet possible to assess the effect of the recent augmentation in the SEC's budget and improvements in the exam process on the existing regulatory structure.
Nevertheless, although we believe that any consideration of private sector initiatives is unwarranted at this time, we address below the specific suggestions the Commission made in the Proposing Release.
SROs for Advisers
At the outset of this discussion we note that calling a self-regulatory organization a "private sector" initiative is somewhat of a misnomer. In fact, an SRO for advisers would be a new, national, quasi-governmental bureaucracy, with the power to regulate, inspect and punish advisers, to the point of depriving them of their livelihoods.19 In this regard, the Commission's current suggestion goes far beyond the historic discussions of advisory SROs, which were to be "inspection-only" entities.
As for the question of whether the SEC has the authority to establish an advisory SRO through rulemaking, we note that the Commission itself answered that question in 1989 when it sought such authority from Congress. Congress' consideration of new legislation in this area in 1989 and again in 1993 indicates that they, too, must have concluded that such authority did not already exist. Moreover, in September 2000, the Commission made clear that the NASD's appointment as the operator of the Investment Adviser Registration Depository ("IARD") did not elevate them to the status of an SRO for advisers, adding that only Congress could authorize such an appointment.20
We respectfully submit that there is no reason for the SEC to again seek Congress' permission to establish an advisory SRO. For the reasons already discussed, there is no need for additional regulatory oversight in this area, and even if there were, an SRO is the least desirable way to provide it.
Subjecting investment advisers to regulation by a new, quasi-governmental body would obliterate one of the primary benefits of NSMIA -- reducing the costs imposed directly on advisers and indirectly on their clients as a result of overlapping and duplicative regulation.21 Moreover, in adopting implementing rules under NSMIA, the Commission carefully considered the degree to which supervised persons of federally registered advisers needed to be regulated. In so doing, the Commission concluded that such regulation (by state agencies in that case) was not appropriate if the supervised person's clientele was composed predominantly of institutions and high-net-worth individuals.22 The rest of a federal adviser's supervised persons were subjected to state registration and education or experience standards. That being the case, there is no reason to grant an SRO the power to regulate any of a federal registrant's supervised persons.
Finally, we note that although the Proposing Release indicates that industry organizations and other commenters have from time to time supported the idea of an SRO for advisers, all the support the Commission cites occurred pre-NSMIA.23 Since that time, the tide has distinctly turned in the opposite direction. For example, this issue was thoroughly vetted at the Roundtable on Investment Adviser Regulatory Issues that the SEC's Division of Investment Management hosted in May, 2000.24 The clear consensus of the panelists at this meeting was that an adviser SRO was unwarranted.25 Among the reasons advanced for this position were the absence of systemic compliance failures in the investment adviser industry; the fact that SROs are designed for groups like broker-dealers who frequently interact with each other, whereas advisers generally do not conduct business with other advisers; and the enormous cost. On this last point, the views of R. Clark Hooper, Executive Vice President of the NASD, were particularly instructive:
A real downside to an SRO or to establishing one, is the enormous cost, which I think would be a real disincentive to having an SRO. . . . I don't think one can overstate what it would cost, not only to start up an organization like this, but the cost to the membership of providing [it].26
More recently, the North American Securities Administrators Association ("NASAA"), the trade group for state securities regulators, passed a resolution officially withdrawing its 1989 support for the establishment of an adviser SRO.27
We agree with the views of these industry experts, and we respectfully urge the Commission to drop the idea of an adviser SRO once and for all.
Requiring investment advisers to undergo periodic compliance reviews by private third parties who would produce reports of their findings and recommendations is problematic for a number of reasons. First, the costs of such a requirement would be enormous, and in fact, could be prohibitive for small advisers.28
Furthermore, there is no demonstrated need for such third-party examiners. As explained above, the Commission's own inspection staff is more than capable of monitoring the activities of registered advisers without any help from private parties.29 A third problem with this initiative is that there is no proven correlation between such "mock audits" and enhanced investor protection. Although such audits might be a sensible adjunct remedy for the small number of advisers who are found to have violated the federal securities laws, they are unlikely to produce any tangible benefits to the clients of the overwhelming majority of advisers who behave lawfully. Because investment advisers are subject to such an extensive array of specific regulatory requirements, private audits undoubtedly would uncover technical or procedural deficiencies, but such minor deficiencies rarely lead to actual customer harm.
Finally, unless the Commission directly or indirectly regulates the compliance auditors, there would be no assurance that the reports these auditors produce would be of any real value. Cost-conscious advisers might be inclined to select examiners based on audit price rather than audit quality, while the examiners might be inclined to produce favorable reports to ensure repeat business.
For all of these reasons we conclude that costs of mandatory compliance audits by independent consultants would outweigh the benefits derived therefrom.
As with the other private sector initiatives on which the Commission seeks comment, we believe that a fidelity bond requirement would not produce sufficient benefits to investors to justify the cost. First, the risk of loss from fraud or embezzlement by advisory personnel is extremely low, and advisers rarely hire employees with criminal or poor disciplinary records.30 In those few dramatic cases in which rogue employees do commit fraud or embezzlement, it is unlikely that a fidelity bond would be sufficient to make the clients whole anyway.
Furthermore, we believe the Commission overstates the amount of investment adviser oversight bonding companies would provide. Our experience with the fidelity bonds required under the Employee Retirement Income Security Act of 1974 ("ERISA")31 and some state laws is that while insurance companies may look at advisers' claims histories, they do not undertake any substantive review of the advisers' internal controls or compliance procedures.
Although the collective benefit to investors from a fidelity bonding requirement would be quite low, the collective costs would not be. The costs of comprehensive coverage could impose a substantial hardship on advisers, particularly smaller firms. Thus we believe that a bonding requirement would impose a burden on competition that is not necessary or appropriate to further the purposes of the Advisers Act.
The recent wave of business scandals and the post-September 11 focus on homeland security have resulted in an almost unprecedented volume of new securities legislation and regulation. The combined impact of the new proxy vote disclosure rules, Regulation AC (for advisers registered as or affiliated with broker-dealers) and the SRO analyst rules (for dual registrants) is substantially taxing many advisers' compliance resources. The impending money laundering rules for investment advisers will strain these resources further. We respectfully submit that the cost-benefit analysis of the Commission's proposed compliance rules and the suggested private initiatives cannot take place in a vacuum; rather, such analysis must consider the cumulative burden that any new regulation and existing requirements will impose on advisers.
Judged by this standard, it appears that costs of the private initiatives discussed herein far exceed the benefits to be derived from such measures. While we believe that the costs of a mandatory compliance program can be justified under some circumstances, we conclude that the modifications to the current proposals discussed earlier in this letter are necessary to achieve this result.
We commend the Commission for undertaking this examination of the need for enhanced compliance measures in order to protect investment advisers' clients. However, for the reasons explained herein, we believe this examination shows that while codifying current industry best practices relating to adviser compliance programs could be beneficial to investors, there is no justification for imposing substantial new burdens on advisers. In particular, we believe that the private-sector initiatives that the Commission has suggested are neither necessary nor appropriate at this time.
We very much appreciate the opportunity to comment on these important issues.
cc: (By Hand)
Hon. William H. Donaldson
Hon. Paul S. Atkins
Hon. Roel C. Campos
Hon. Cynthia A. Glassman
Hon. Harvey J. Goldschmid
|1||SEC Rel. Nos. IA-2107 and IC-25925 (Feb. 5, 2003) [68 Fed. Reg. 7038 (Feb. 11, 2003)] (hereafter, the "Proposing Release").
|2||For example, an adverse fraud ruling against an adviser typically renders that adviser ineligible for hire by many pension funds and other large, institutional clients. Furthermore, under state blue sky laws, an SEC finding of fraudulent or deceptive conduct against an adviser might be relied upon in a state proceeding as grounds to deny, suspend or revoke that entity's broker-dealer license. See, e.g. Illinois Securities Law of 1953, 815 Ill Comp. Stat. 5/8 E(1)(k).
|3|| Letter of David G. Tittsworth, Executive Director, ICAA to Jonathan G. Katz (Apr. 17, 2003) (hereafter, "ICAA Comments").
|4|| Moreover, if during the course of an exam, the SEC staff determines that an adviser's compliance procedures are insufficient, it really does not matter whether the adviser undertook a documented annual assessment or not.
|5|| This approach is consistent with the one taken in Advisers Act rules 204-2(h)(1) (pertaining to recordkeeping) and 206(4)-2(b) (pertaining to custody).
|6|| Advisers Act rule 206(4)-4.
|7|| Annual Report at 2-11. On the contrary, almost all the defendants identified by the Division were issuers, business executives and auditors.
|8|| Id. at 62-72. The rate for investment companies was an also low 5 percent.
|10|| 68 Fed. Reg. at 7044.
|11|| See www.sec.gov/foia/docs/budgetact.htm. See also transcript of the SEC Roundtable on Investment Adviser Regulatory Issues (May 23, 2000), which is available at www.sec.gov/divisions/ investment/roundtable/uadvrndt.htm (hereafter "Roundtable Transcript").
|12|| §§4 and 7 of H.R. 578, 103rd Cong., 1st Sess.
|13|| An earlier legislative attempt in this area also went nowhere. S.1410 and H.R. 3054, 101st Cong., 1st Sess. (1989).
|14|| Pub. L. No. 104-290, 110 Stat. 3416.
|15|| Although we understand that 7850 advisers were registered with the SEC as of March 31, 2003, we are informed that 148 of these registrants indicated in their 2003 annual updates that they no longer qualify for registration under the Advisers Act.
|16|| See www.sec.gov/foia/docs/budgetact.htm.
|17|| Lori A. Richards, Address at the Compliance and Inspection Issues for Investment Advisers and Investment Companies Conference (Oct. 30, 2002), available at www.sec.gov/news/speech/spch597.htm.
|19|| While it is true that the subject of an adverse SRO disciplinary decision may -- after exhausting internal SRO appeals -- appeal the decision to the SEC and eventually, the courts, in many cases, the high cost of such multiple layers of review renders the right to appeal meaningless.
|20|| SEC Rel. No. IA-1862 (Apr. 5, 2000) [65 FR 20524 (Apr. 17, 2000)] n. 12 and accompanying text.
|21|| S. Rep. No. 293, 104th Cong., 2d Sess. 2-4 (1996).
|22|| SEC Rel. No. IA-1633 (May 15, 1997) [62 Fed. Reg. 28112 (May 22, 1997)]. See also, Advisers Act, Section 203A-3(a).
|23|| 68 Fed. Reg. at 7044, n. 71.
|24|| See Roundtable Transcript, supra, note 11.
|25|| See generally Roundtable Transcript. "We have concluded that no SRO is needed," Phyllis Bernstein, Director of Personal Financial Planning, American Institute of Certified Public Accountants; "I concur that we probably don't need an SRO for investment advisers," Roy Dilberto, President, the Financial Planning Association; "So I hope maybe today we can all agree that an SRO is absolutely unwarranted," Bradley W. Skolnik, President North American Securities Administrators Association.
|27|| April 6, 2003. This resolution is available on NASAA's website at: www.nasaa.org.
|28|| The ICAA estimates that consulting reviews by non-accounting consultants can range from $5,000 to $25,000, while such reviews by accounting-related consulting firms can range from $30,000 to $100,000. ICAA Comments, supra.
|29|| See pp. 5-7, supra.
|30|| See discussion at pp. 3-4, supra. When it proposed to add a series of Disciplinary Reporting Pages to Form ADV, the Commission concluded that the cost of compliance with this requirement would be low because "most advisers do not have disciplinary events to report." SEC Rel. No. IA-1862 (Apr. 5, 2000) [65 FR 20524 (Apr. 17, 2000)] at n. 248.
|31|| 29 U.S.C. § 1112.