June 6, 2002 Jonathan G. Katz, Secretary U.S. Securities and Exchange Commission 450 Fifth Street NW Washington DC 20549-0609 Re: Exemption for Certain Investment Advisers Operating Through the Internet Release No. IA-2028; File No. S7-10-02 Dear Mr. Katz: The North American Securities Administrators Association, Inc. (NASAA) appreciates the opportunity to comment on Release No. IA-2028, "Exemption for Certain Investment Advisers Operating Through the Internet." We understand there are specific regulatory issues related to companies conducting their business over the Internet with no physical presence in an individual state. However, we have a number of reservations about the proposal, as detailed below. Not the least of these is the concern that an unscrupulous adviser could be encouraged to tinker with its business model to conform to the rule and thereby subject itself to limited regulation. The Proposal Proposed Rule 203A-2(f) would expand the list of those entities that may register with the SEC, thus preempting state regulation, to include any adviser that "conducts substantially all of its advisory business through an interactive website on the Internet." "Interactive website" for the purposes of the rule means "a website in which computer software-based models or applications provide investment advice to clients based on information each client supplies through the website." "Substantially all" means "that at least 90 percent of the investment adviser's clients obtain their investment advice from the adviser exclusively through the interactive website." The background information accompanying the proposed rule notes correctly that under section 203A of the Advisers Act, state securities regulators generally have responsibility for regulating investment advisers with assets under management of less than $25 million (15 U.S.C. § 80b-3a(1)(A)). Investment advisers with assets under management of more than the specified amount (raised to $30 million by 17 C.F.R. § 275.203A-2(e)) register with the SEC. The Commission is authorized to permit other classes of advisers to register with it where subjecting such advisers to continuing state authority would be "unfair, a burden on interstate commerce, or otherwise inconsistent" with section 203A. The Commission has prescribed five exemptions to state registration, included in 17 C.F.R. § 275.203A-2(a)-(e): Nationally recognized statistical organizations, pension consultants, advisers controlling or under common control of existing SEC filers, advisers otherwise expecting to qualify for SEC registration within 120 days, and advisers otherwise required to register in at least 30 states. The current proposal would add a sixth exemption for qualified "Internet Investment Advisers." These provide substantially all of their investment advice to clients interactively over the Internet using computer-based software algorithms. The Commission seeks comments on the adequacy of the criteria proposed to qualify for the exemption, as well as the number of advisers presently and potentially affected, then asks generally whether there should be additional exemptions from state registration. The Commission Is Taking on More Responsibility When the Number of Investment Adviser Exams are Dropping Effective investment adviser regulation is a partnership between the states and the SEC. Regulators need to work closely together to leverage limited resources, as well as minimize the regulatory burden on the industry. The Commission's proposed action is highly significant because it would preempt state regulators from exercising authority over the exempted Internet Investment Advisers except in the case of fraud. See 15 U.S.C. § 80b-3a(b). Although the [number of SEC-registered advisers and] amount of funds under management has increased in recent years, the Commission is reducing the number of annual examinations of investment advisers it conducts. Compare BUDGET OF THE UNITED STATES FOR FISCAL YEAR 2003, APPENDIX at 1180, with BUDGET OF THE UNITED STATES FOR FISCAL YEAR 2001, APPENDIX at 1200 (showing the number of investment adviser exams dropping from 1508 actual in FY 1999 to an estimated 1350 in FY 2003). The expansion of the Commission's regulatory authority to these web-based advisers appears imprudent at a time when Commission resources already appear strained. Information About Affected Advisers is Incomplete The proposal indicates it was initiated by Internet advisers who would prefer to register with the SEC, but are ineligible to do so. However, the proposal lacks important information, such as how many requests were made, how many clients exist or are anticipated, the number of states that would be involved, the advisers' size based on assets under management, or the advisers' economic status and projected rate of growth. The only assumption expressed is the Commission's "estimate that as many as 20 advisers may currently be eligible" for the exemption. [Emphasis added.] We do not believe that such an uncorroborated estimate provides a sound basis for rulemaking. The Proposal Ignores Existing Commission Rules The statement in the proposal that "Internet Investment Advisers, as a practical matter, would have to register in all states and then wait until their registration obligations are triggered in at least 30 states" before registering with the SEC does not appear to have considered the Commission's own rules. Under 17 C.F.R. § 275.203A-2(d), an adviser expecting to qualify for Commission registration within 120 days may register with the Commission without having to register in any state. Thus, if the adviser determines that it would be obligated to register in at least 30 states, it could take advantage of an existing preemption. The Cost-Benefit Analysis Is Flawed The Cost-Benefit Analysis is flawed in three major areas: the cost of compliance with state requirements is unsubstantiated, the costs of registering in states is extrapolated beyond logical bounds, and no consideration was given to investor protection benefits flowing from state regulation. Release No. IA-2028 says that the cost of complying with the registration and other regulatory requirements of 49 states is estimated to be $50,000 - or $1,020 per state - annually, and that the benefit of the rule for the estimated 20 advisers would approximate $1 million annually. NASAA challenges that conclusion. Besides not substantiating the base cost, the benefits flowing from the rule are inflated. An Internet Investment Adviser would not have to comply with 50 states' requirements, only 29, since SEC registration could occur at 30 states. Using the Commission's unsubstantiated figure of $1,020 per state, the benefit for 20 advisers thus would be less than $600,000. In addition, under the proposed rule Internet advisers will face legal and compliance costs in dealing with the SEC. The cost-benefit analysis does not take these expenses into consideration. Furthermore, there is no evidence that the Commission staff considered the benefits to investors resulting from greater oversight by multiple state regulators. The Cost-Benefit Analysis is Misleading The analysis accompanying the proposed rule does not clearly identify the basis for the cost estimate, nor the elements constituting the per adviser cost of $50,000. This amount is said to be an estimate of the costs of responding to multiple states' comments on filings and complying with "multiple and often disparate state regulations." We were told at this year's 19(c) Conference that this staff estimate is based on consultations with a small number of law firms and those advocating adoption of the rule. No member of the SEC Investment Management staff contacted NASAA or a NASAA member in developing this number, nor is there any evidence that the staff performed any analysis of the true extent to which state investment adviser regulations are "disparate." In contravention to NSMIA and the resulting MOU between the SEC and NASAA, the SEC failed to approach the implementation of pre-emptive regulation in consultation with the states. The $50,000 figure now is repeated without question by the news media as a registration cost. Again, this number is highly misleading. While not including legal and compliance costs, our estimate is that annual registration fees for all U.S. jurisdictions total $8,000 to $10,000. Moreover, if a firm registers with the SEC and notice files in every jurisdiction, the registration cost remains $8,000 to $10,000. See the "IA Firm State Registration / Notice Filing Fee Schedule" at http://www.iard.com/fees.asp. The development and implementation of the Investment Adviser Registration Depository (IARD) actually has reduced costs for multi- state investment advisers in recent years by eliminating multiple paper filings. "Substantially All" and "Exclusively Through the Website" NASAA has specific policy concerns with the proposal as released by the Commission that warrant modification. First, setting the percentage of an adviser's business done over the Internet at anything less than 100 percent is unlikely to discourage unscrupulous advisers from modifying their business models with the objective of avoiding state regulation. For example, as suggested by the Pennsylvania Securities Commission in a separate comment letter on this proposal, an adviser could provide oral advice to high net-worth individuals while using the Internet to craft financial plans for less lucrative clients. Thus, "substantially all" should mean that 100 percent of an adviser's clients obtain their advice exclusively through the website, with a de minimis safe harbor in urgent situations initiated by a client, such as a technology breakdown. Further, we point out that Internet websites now can be used for e-mail communications, instant messaging and, in growing instances, in the same manner as a telephone for voice communications. The rule as drafted fails to specify that "exclusively through the interactive website" excludes client advice that is oral or in the form of e-mail or instant messaging. Further Study is Warranted The background discussion accompanying the proposed rule acknowledges the congressionally mandated allocation of responsibility between state regulators and the SEC. In the words of the proposal, these Internet advisers would be relieved "from the burdens of multiple state regulation." In fact, the word "burden" is used throughout the document 36 times without any empirical evidence of what constitutes the supposed burden. It may well be that the proposed rule has merit and should eventually be adopted. However, the legal and factual analysis that accompanies the proposal is deficient. Speculation is not an appropriate basis for the Commission pre-empting state investor protections. Rather than promulgating the rule in final form, NASAA recommends the Commission remand it to the staff for further assessment and development in conjunction with the states. Alternatively, the Commission could utilize its authority under Section 203A(c) to exempt, on an individual basis, Internet advisers that make application. This approach could serve as a pilot project to determine whether rulemaking in this area is warranted. Thank you for your consideration of these views. Sincerely, /S/ Joseph Borg NASAA President Director, Alabama Securities Commission