Aug. 3, 2018
Dear Sir or Madame:
Thank you for the opportunity to comment on these proposals. Since 1999, I have been the President and Chief Compliance Officer (CCO) of Retirement Resources Investment Corporation. We have been an SEC registered investment advisor (IA) since 2005, and from 1999 through 2014, Retirement Resources was also a broker-dealer (BD). As CCO of a dually registered firm for approximately 10 years, I have an informed perspective on the differences between IAs and BDs, the risks they pose, and the appropriate levels of regulation they should face.
I hope the Commission will take into consideration that many investment advisory firms are small businesses, which would be disproportionately burdened by the imposition of net capital, audit and other additional compliance requirements. I have read that the average IA firm has fewer than 9 employees. One could imagine that the industry’s largest investment firms had drafted these proposals as a means of reducing competition so that they could raise fees to investors.
Where’s the beef? What harm is the Commission acting to address? It would seem that IAs with custody of client assets pose completely different sets of potential risks to investors than advisors without custody (within the parameters established in the Commission’s February 2017 guidance). If there are patterns of investor harm associated with IAs having custody of client assets, please address those issues separately from non-custodial IAs. Is there a pattern of harm to investors by non-custodial IAs? If not, the unintended consequence of these proposals will be harm to investors in the forms of higher fees and reduced choices for advice, because many smaller IAs may choose to exit. If there is the likelihood of harm without offsetting benefit, then these proposals should not be adopted.
Please see specific comments in red below:
IV. Request for Comment Regarding Areas of Enhanced Investment Adviser Regulation
In 2011, the Commission issued the staff's 913 Study, pursuant to section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, in which the staff recognized several areas for potential harmonization of broker-dealer and investment adviser regulation.[61] We have identified a few discrete areas where the current broker-dealer framework provides investor protections that may not have counterparts in the investment adviser context, and request comment on those areas. The Commission intends to consider these comments in connection with any future proposed rules or other proposed regulatory actions with respect to these matters.
This line of thought presumes that the “investor protections” embedded in the current broker-dealer framework are both rational and applicable to Registered Investment Advisors. If “harmonization” means, “Let’s let FINRA regulate IAs as if they were BDs”, then this is a misguided idea on two fronts.
1. Having been CCO for a FINRA-regulated BD for 15 years I had a front-row seat to observe FINRA regulation. We were a “fully disclosed introducing BD”, meaning that we did not have custody of client assets, which were all at a large clearing firm. Despite the lack of risk to our clients or the financial system, compliance was tedious, time consuming, costly and not at all risk-based. If applied to non-custodial IAs, many of the more seasoned advisors are likely to retire a little earlier, sell out to larger firms or simply shut down. This would be bad for investors.
2. IAs and BDs are fundamentally different businesses. BDs that have trading operations and proprietary accounts should be regulated differently from a fee-based IA that simply has trade authority to manage an account being held at a third-party custodian.
A. Federal Licensing and Continuing Education
Associated persons of broker-dealers that effect securities transactions are required to be registered with the Financial Industry Regulatory Authority (“FINRA”),[62] and must meet Start Printed Page 21212qualification requirements, which include passing a securities qualification exam and fulfilling continuing education requirements.[63] The federal securities laws do not require investment adviser representatives to become licensed or to meet qualification requirements, but most states impose registration, licensing, or qualification requirements on investment adviser representatives who have a place of business in the state, regardless of whether the investment adviser is registered with the Commission or the state.[64] These qualification requirements typically mandate that investment adviser representatives register and pass certain securities exams or hold certain designations (such as Chartered Financial Analyst credential).[65]The staff recommended in the 913 Study that the Commission consider requiring investment adviser representatives to be subject to federal continuing education and licensing requirements.[66]
We request comment on whether there should be federal licensing and continuing education requirements for personnel of SEC-registered investment advisers. Such requirements could be designed to address minimum and ongoing competency requirements for the personnel of SEC-registered advisers.[67]
· Should investment adviser representatives be subject to federal continuing education and licensing requirements? No. Each IA firm is already obligated to assess areas of risk within their specific business models, and to address them. Continuing education is, thus, tailored to the needs of the firm and its IARs. A broad/general federally-conceived education program would not be beneficial. If a firm or IAR is identified in a regulatory exam as having a knowledge deficiency, a remedial program can be proposed.
Our business is approximately 95% retirement plans. Our continuing education needs are very different from a typical firm. We attend conferences and engage in a variety of other educational pursuits throughout the year in order to do a better job for our clients and to maintain a competitive.
A generic CE requirement would likely take time away from more relevant CE that we are already doing on our own.
Adding a broad, generic education bureaucracy will drain IA resources with no clear investor benefit.
· Which advisory personnel should be included in these requirements? For example, should persons whose functions are solely clerical or ministerial be excluded, similar to the exclusion in the FINRA rules regarding broker-dealer registered representatives? Should a subset of registered investment adviser personnel (such as supervised persons, individuals for whom an adviser must deliver a Form ADV brochure supplement, “investment adviser representatives” as defined in the Advisers Act, or some other group) be required to comply with such requirements?
· How should the continuing education requirement be structured? How frequent should the certification be? How many hours of education should be required? Who should determine what qualifies as an authorized continuing education class?
· How could unnecessary duplication of any existing continuing education requirement be avoided?
· Should these individuals be required to register with the Commission? What information should these individuals be required to disclose on any registration form? Should the registration requirements mirror the requirements of existing Form U4 or require additional information? Should such registration requirements apply to individuals who provide advice on behalf of SEC-registered investment advisers but fall outside the definition of “investment adviser representative” in rule 203A-3 (because, for example, they have five or fewer clients who are natural persons, they provide impersonal investment advice, or ten percent or less of their clients are individuals other than qualified clients)? Should these individuals be required to pass examinations, such as the Series 65 exam required by most states, or to hold certain designations, as part of any registration requirements? Should other steps be required as well, such as a background check or fingerprinting? Would a competency or other examination be a meritorious basis upon which to determine competency and proficiency? Would a competency or other examination requirement provide a false sense of security to advisory clients of competency or proficiency?
· If continuing education requirements are a part of any licensing requirements, should specific topics or types of training be required? For example, these individuals could be required to complete a certain amount of training dedicated to ethics, regulatory requirements or the firm's compliance program.
· What would the expected benefits of continuing education and licensing be? Would it be an effective way to increase the quality of advice provided to investors? Would it provide better visibility into the qualifications and education of personnel of SEC-registered investment advisers?
· What would the expected costs of continuing education and licensing be? How expensive would it be to obtain the continuing education or procure the license? Do those costs scale, or would they fall more heavily on smaller advisers? Would these requirements result in a barrier to entry that could decrease the number of advisers and advisory personnel (and thus potentially increase the cost of advice)?
· What would the effects be of continuing education and licensing for investment adviser personnel in the market for investment advice (i.e., as compared to broker-dealers)?
· What oth
er types of qualification requirements should be considered, such as minimum experience requirements or standards regarding an individual's fitness for serving as an investment adviser representative?
B. Provision of Account Statements
Fees and costs are important to retail investors,[68] but many retail investors are uncertain about the fees they will pay.[69] The relationship summary that we are proposing in a concurrent release would discuss certain differences between advisory and brokerage fees to provide investors more clarity concerning the key categories of fees and expenses they should expect to pay, but would not require more complete, specific or personalized disclosures or disclosures about the amount of fees and expenses.[70] We believe that delivery of periodic account statements, if they specified the dollar amounts of Start Printed Page 21213fees and expenses, would allow clients to readily see and understand the fees and expenses they pay for an adviser's services. Clients would receive account statements close in time to the assessment of periodic account fees, which could be an effective way for clients to understand and evaluate the cost of the services they are receiving from their advisers.
Broker-dealers are required to provide confirmations of transactions with detailed information concerning commissions and certain other remuneration, as well as account statements containing a description of any securities positions, money balances or account activity during the period since the last statement was sent to the customer.[71] Broker-dealers generally must provide account statements no less than once every calendar quarter. Brokerage customers must receive periodic account statements even when not receiving immediate trade confirmations.[72] Although we understand that many advisers do provide clients with account statements, advisers are not directly required to provide account statements under the federal securities laws. Notably, however, the custody rule requires advisers with custody of a client's assets to have a reasonable basis for believing that the qualified custodian sends an account statement at least quarterly.[73] In addition, in any separately managed account program relying on rule 3a-4 under the Investment Company Act of 1940, the program sponsor or another person designated by the sponsor must provide clients statements at least quarterly containing specified information.[74]
We request comment on whether we should propose rules to require registered investment advisers to provide account statements, either directly or via the client's custodian, regardless of whether the adviser is deemed to have custody of client assets under Advisers Act Rule 206(4)-2 or the adviser is a sponsor (or a designee of a sponsor) of a managed account program relying on the safe harbor in Investment Company Act rule 3a-4.
· To what extent do retail clients of registered investment advisers already receive account statements? To what extent do those account statements specify the dollar amounts charged for advisory fees and other fees (e.g.,brokerage fees) and expenses? Would retail clients benefit from a requirement that they receive account statements from registered investment advisers? If clients are uncertain about what fees and expenses they will pay, would they benefit from a requirement that, before receiving advice from a registered investment adviser, they enter into a written (including electronic) agreement specifying the fees and expenses to be paid? For non-custodial advisors, the custodian already provides statements. Having a non-related third-party generate the statements is a good safeguard for clients. Any fees deducted are already itemized. Fees are also clearly displayed within the investment advisory agreement with the client. Is there any reason to believe this isn’t enough disclosure already?
· What information, in addition to fees and expenses, would be most useful for retail clients to receive in account statements? Should any requirement to provide account statements have prescriptive requirements as to presentation, content, and delivery? Should they resemble the account statements required to be provided by broker-dealers, under NASD Rule 2340 with the addition of fee disclosure?
· How often should clients receive account statements?
· How costly would it be to provide account statements? Does that cost depend on how those account statements could be delivered (e.g., via U.S. mail, electronic delivery, notice and access)? Are there any other factors that would impact cost?
C. Financial Responsibility
Broker-dealers are subject to a comprehensive financial responsibility program. Pursuant to Exchange Act rule 15c3-1 (the net capital rule), broker-dealers are required to maintain minimum levels of net capital designed to ensure that a broker-dealer under financial stress has sufficient liquid assets to satisfy all non-subordinated liabilities without the need for a formal liquidation proceeding.[75]Exchange Act rule 15c3-3 (the customer protection rule) requires broker-dealers to segregate customer assets and maintain them in a manner designed to ensure that should the broker-dealer fail, those assets are readily available to be returned to customers.[76] Broker-dealers are also subject to extensive recordkeeping and reporting requirements, including an annual audit requirement as well as a requirement to make their audited balance sheets available to customers.[77] Broker-dealers are required to be members of the Securities Investor Protection Corporation (“SIPC”), which is responsible for overseeing the liquidation of member broker-dealers that close due to bankruptcy or financial trouble and customer assets are missing. When a brokerage firm is closed and customer assets are missing, SIPC, within certain limits, works to return customers' cash, stock, and other securities held by the firm. If a firm closes, SIPC protects the securities and cash in a customer's brokerage account up to $500,000, including up to $250,000 protection for cash in the account.[78] Finally, FINRA rules require that broker-dealers obtain fidelity bond coverage from an insurance company.[79]
Under Advisers Act rule 206(4)-2, investment advisers with custody must generally maintain client assets with a “qualified custodian,” which includes banks and registered broker-dealers, and must comply with certain other requirements.[80] In 2009 the Commission adopted amendments to the custody requirements for investment advisers that, among other enhancements, required all registered investment advisers with custody of client assets to undergo an annual surprise examination by an independent public accountant. SEC-registered investment advisers, however, are not subject to any net capital requirements comparable to those applicable to broker-dealers, although they must disclose any material financial condition that impairs their ability to provide services to their clients.[81] Many investment advisers have relatively small amounts of capital, particularly compared to the amount of assets that they have under management.[82] When we discover a serious fraud by an adviser, often the assets of the adviser are insufficient to compensate clients for their loss. In addition, investment advisers are not required to obtain fidelity bonds, unlike Start Printed Page 21214many other financial service providers that have access to client assets.[83]
In light of these disparities, we request comment on whether SEC-registered investment advisers should be subject to financial responsibility requirements along the lines of those that apply to broker-dealers.
This proposal would create a tremendous burden to IAs, and for what gain to investors? If the main concern is misappropriation, then the Commission may want to differential between firms with custody and those without. We used to be an introducing broker dealer (no custody of customer funds), and our net capital requirement was $6,000. Without custody, we posed no risk to clients’ funds, so why have any capital requirement? Smaller firms often have to hire a contract Financial Operations Principal (FINOP) to certify and submit the net capital calculation every month. A typical cost is $1,000 per month to pay the FINOP. This is crazy -- $12,000 per year to certify that you have $6,000 in net capital!
Regarding a potential audit requirement, what is the benefit of a mandatory audit if a firm does not have custody of customer assets? The annual audit cost for a small firm could easily be in the $5,000 to $10,000 range. Our financial records are available for regulatory exam at any time. During our 15 years as a BD, I oversaw the annual audit process, and it was time consuming, disruptive and costly. For non-custodial IA firms, an annual audit requirement would represent a small business impediment without any offsetting benefit to investors or the system. The average IA firm is a small business, and the time and money it would take to comply with additional requirements will likely lead to fewer IA firms remaining in business and serving the public, which means less choice and likely higher fees.
As small businesses, the equity in their IA firms represents a substantial portion of many owners’ net worth. We carry millions of dollars of E&O to protect our clients and ourselves. I believe that this is generally the case with IA firms, and mandating E&O coverage would be much less disruptive and much more beneficial than imposing a net capital requirement.
· What is the frequency and severity of client losses due to investment advisers' inability to satisfy a judgment or otherwise compensate a client for losses due to the investment adviser's wrongdoing?
· Should investment advisers be subject to net capital or other financial responsibility requirements in order to ensure they can meet their obligations, including compensation for clients if the adviser becomes insolvent or advisory personnel misappropriate clients' assets? [84] Do the custody rule and other rules [85] under the Advisers Act adequately address the potential for misappropriation of client assets and other financial responsibility concerns for advisers? Should investment advisers be subject to an annual audit requirement?
· Should advisers be required to obtain a fidelity bond from an insurance company? If so, should some advisers be excluded from this requirement? [86] Is there information or data that demonstrates fidelity bonding requirements provide defrauded clients with recovery, and if so what amount or level of recovery is evidenced?
· Alternatively, should advisers be required to maintain a certain amount of capital that could be the source of compensation for clients? [87] What amount of capital would be adequate? [88]
· What would be the expected cost of either maintaining some form of reserve capital or purchasing a fidelity bond? Specifically, in addition to setting aside the initial sum or purchasing the initial bond, what would be the ongoing cost and the opportunity cost for investment advisers? Would one method or the other be more feasible for certain types of investment advisers (particularly, smaller advisers)?
· Would the North American Securities Administrators Association Minimum Financial Requirements For Investment Advisers Model Rule 202(d)-1 [89](which requires, among other things, an investment adviser who has custody of client funds or securities to maintain at all times a minimum net worth of $35,000 (with some exceptions), an adviser who has discretionary authority but not custody over client funds or securities to maintain at all times a minimum net worth of $10,000, and an adviser who accepts prepayment of more than $500 per client and six or more months in advance to maintain at all times a positive net worth), provide an appropriate model for a minimum capital requirement? Why or why not?
· Although investment advisers are required to report specific information about the assets that they manage on behalf of clients, they are not required to report specific information about their own assets.[90] Should advisers be required to obtain annual audits of their own financials and to provide such information on Form ADV? Would such a requirement raise privacy concerns for privately held advisers?
Respectfully submitted,
Jim Phillips
Jim Phillips, President
Retirement Resources