Keynote Address at the National Society of Compliance Professionals National Meeting

Thank you, Lee [Augsburger], for your very kind introduction and for inviting me to speak this morning. I’d like to take a moment to congratulate the NSCP on the occasion of its 25^th anniversary, which I understand you celebrated last night. Coincidentally, tomorrow marks the first anniversary of my Senate confirmation. They say a “dog year” is equal to seven human years. Given the pace and volume of the SEC’s rulemaking in this post-Sarbanes-Oxley, post-Dodd-Frank era, sometimes it feels like my first “Commissioner year” was equal to about 25 years as well.

Before I begin, I must tell you that my remarks today are my own and do not necessarily reflect the views of the Commission or my fellow Commissioners.

In January 2011, the Commission, with Commissioners Casey and Paredes dissenting, issued a staff report on a study, conducted pursuant to Section 913 of the Dodd-Frank Act, of the effectiveness of the existing regulatory standards of care that apply when brokers and investment advisers provide personalized investment advice to retail customers.¹ In addition to mandating that study, Section 913 authorized, but did not require, the Commission to adopt rules establishing a duty of care for brokers identical to that which applies to investment advisors – in other words, a uniform fiduciary duty for brokers and investment advisors – and to undertake further efforts to harmonize the two regulatory regimes.

Earlier this month, at SIFMA’s Market Structure Conference, I noted that in order to address the market structure issues we currently face, we need to understand not just the present state of affairs, but also how things came to be the way they are today – the evolution of law, regulation and market practices. I believe the same principle should apply in the context of considering harmonizing our rules imposing conduct requirements on brokers with our rules that do the same for investment advisers. It’s important to understand the reasons why Congress decided over 70 years ago to regulate investment advisers through the Investment Advisers Act of 1940, which was separate and distinct in time, form, and substance from the Securities Exchange Act of 1934 that established a regulatory framework for brokers and dealers.

The regulation of investment advisers does not appear to have been on Congress’s agenda at all in the 1930s.² Following the market collapse of 1929 and the onset of the Great Depression, the Senate Committee on Banking and Currency established the Pecora Commission to investigate the causes of the stock market collapse. The Pecora Commission stayed true to its mandate, focusing only on the entities that contributed to the crash and laying the groundwork for specific, targeted legislation, including the Securities Act of 1933 and the Exchange Act, designed to address the actual causes of the crisis. This is notably different than the process surrounding the Dodd-Frank Act, in which Congress created a Financial Crisis Inquiry Commission to analyze the causes of the 2008 financial crisis, but issued the resulting report months after the legislation was passed.³

The business of providing investment advice had not surfaced as a viable, stand-alone profession until after World War I, and, although the profession began to expand more rapidly in the 1930s, the total number of advisers was still small during this period – perhaps less than a thousand nationwide. And there does not appear to be a record of pervasive fraud in the investment adviser industry leading up to the Great Depression. Consequently, there was little, if any, demand for regulation of the profession.⁴ And so, well into the latter part of the decade, Congress continued to focus on broker-dealer regulation.

The Maloney Act of 1938 authorized, and required the registration of, national securities associations to oversee OTC market participants, building upon the self-regulatory framework for broker-dealers established in the Exchange Act. In a speech delivered to the Annual Convention of the Investment Bankers Association of America exactly 74 years ago today, almost to the hour – 10:30am – SEC Commissioner George C. Matthews noted that the Maloney Act “has been placed upon the statute books to the end that [the broker-dealer] industry as appropriately organized may, subject to the Congressional directives, assume as important a role in the conduct of its own affairs as it has the will to undertake and as its natural genius will permit.” Later in his speech, Commissioner Matthews directly addressed the Maloney Act’s approach to regulating broker-dealer conduct through a combination of SEC oversight and self-regulatory activity, noting, “[T]he Act is clearly predicated upon the assumption that the vast majority of individuals and firms engaged in transacting business in securities are honest and honorable. In that assumption we steadfastly believe. On any other promise a cooperative program, such as that provided for in the Act, would be absurd.”⁵ Had investment advisers been on the Commission’s radar in October 1938, perhaps he would have said the same about that industry, with even more comfort in its accuracy.

The Advisers Act, on the other hand, appears to have been largely the by-product of an SEC study conducted pursuant to Section 30 of the Public Utility Holding Company Act of 1935, which neither contemplated federal regulation of investment advisers nor, for that matter, referenced “investment advisers” in its text.⁶ Section 30 directed the Commission to conduct a study of the “functions and activities of investment trusts and investment companies” – now generally referred to as mutual funds – “and the influence exerted by interests affiliated with the management of such trusts and companies upon their investment policies.”⁷ Incidental to its main study, the Commission also undertook a limited review of the investment adviser profession after finding that some advisers had investment trusts and investment companies as clients. The resulting report included only a brief discussion of what the Commission referred to as “some of the problems which appear to be present or inherent” in the investment adviser industry, such as, among other things, the emergence of “tipster” organizations and the use of “heads I win, tails you lose” profit-sharing arrangements.⁸

In response to the Commission’s full report, beginning in March 1940, the Senate held four weeks of hearings on companion bills in the House and Senate to regulate investment companies and investment advisers. During those hearings, the industry emphasized how investment advisers differed from brokers. For example, industry representatives testified that the bona fide investment adviser typically did not act as a broker in securities transactions involving clients, charge transaction-based fees, or take custody of securities or cash balances, all of which might bias the adviser’s judgment and advice. In contrast, they described the continuous, comprehensive, and personalized nature of the advisory services they provided, and explained that the foundation of their profession rested on a relationship of trust, confidence, and confidentiality with their clients. Ultimately, the industry opposed the investment adviser bill, expressing its concern that strict federal regulation of investment advisers, particularly through the anticipated use of the Commission’s enforcement powers, could potentially destroy the fundamental nature of the adviser-client relationship.⁹

In response to the industry’s initial opposition, Congress directed the Commission and the industry to work together on a draft proposal for the regulation of investment advisers. The proposed bill that resulted from this effort was, with some changes, enacted into law as the Investment Advisers Act.¹⁰ The Advisers Act in its original form – only 21 sections, covering a mere three pages in the Congressional Record– was later described by the Commission in a 1988 report to Congress on financial planners as “modest in the regulatory scheme it imposed.”¹¹ For the first 20 years of its existence, the basic purpose of the Advisers Act was considered to be a “compulsory census” of the investment adviser industry through a registration and reporting provision that was modeled on a similar provision in the Exchange Act for OTC broker-dealers.¹²

As stated in the House report on the Advisers Act, the intent of the legislation was also “to protect the public from the frauds and misrepresentations of unscrupulous tipsters and touts and to safeguard the honest investment adviser against the stigma of the activities of these individuals by making fraudulent practices by investment advisers unlawful.”¹³ This result was to be achieved primarily through a handful of broad antifraud provisions aimed at eliminating conflicts of interest through full disclosure.¹⁴ Yet, the Advisers Act did not clearly define a standard of care owed by investment advisers to their clients, let alone use the term “fiduciary duty.” In a 1963 case, however, the Supreme Court interpreted the Advisers Act as, in fact, establishing federal fiduciary standards for investment advisers. Drawing on the Act’s “broad proscription against any practice which operates as a fraud or deceit upon” the client, as well as Congress’s intent to “preserve the personalized character of the services of investment advisers” and to “eliminate conflicts of interest between the adviser and the clients,” the Court concluded that the Advisers Act “reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship[.]”¹⁵

Aside from its registration provisions, the Advisers Act shared little in common with the regulatory regime then applicable to broker-dealers. Notably, Congress explicitly exempted from the Advisers Act brokers who provided investment advice that was merely incidental to brokerage transactions for which they received only brokerage commissions. Unlike the legislation establishing a regulatory scheme for brokers, the Advisers Act contained few substantive provisions governing conduct. Moreover, despite the fact that voluntary self-regulation was discussed in the Commission’s 1939 report to Congress on investment advisers as well as during the Congressional hearings on the proposed legislation, Congress did not provide for the creation of self-regulatory organizations for investment advisers. As a result, whereas the regulatory regime for broker-dealers has been for decades based on SRO oversight and substantive rules of conduct, the investment adviser industry has evolved over time under a more principles-based disclosure regime grounded in the fiduciary duty owed by advisers to their clients.¹⁶

It bears mentioning that Section 913 of Dodd-Frank does not represent the first time Congress has considered efforts to harmonize the regulatory regimes of investment advisers and broker-dealers. To highlight a pair of examples, in 1960, the Senate Committee on Banking and Currency described the Advisers Act as a “continuing census” and the “most inadequate” of the five securities laws administered by the Commission.¹⁷ Drawing upon the regulatory program for broker-dealers established under the Exchange Act, Congress passed amendments to the Advisers Act, including, among other things, new provisions requiring investment advisers to maintain books and records and providing the Commission with authority to inspect such records as well as providing the Commission with rulemaking power to prohibit fraudulent, deceptive, and manipulative conduct.

Congress again considered amendments to the Advisers Act in 1976 based on the by then well-established regulatory regime for broker-dealers, including, among other things, establishing national qualifications and financial responsibility standards for investment advisers, as well as a provision requiring that the Commission conduct a study on the feasibility of establishing investment adviser self-regulatory organizations. In minority comments included with the Senate report, one senator noted, in opposition to the licensing and examination provisions in the proposed legislation, “Investment advisers are not stockbrokers or securities dealers; they cannot buy and sell on the exchanges.”¹⁸ Those comments cited testimony from the then-president of the Investment Company Institute during hearings on the proposed bill stating that “an NASD-type of regulatory agency” would not “apply in the investment adviser area” because “[t]here is no commonality of interests” between advisers and because the adviser-client relationship is a fiduciary one.¹⁹ Ultimately, although the proposed bill was reported favorably out of the Senate Subcommittee on Securities, Congress declined to take any action, and the proposed amendments were shelved.

The landscape for investment advisers and brokers today looks much different than it did in 1976 or 1960, much less 1934 or 1940. Over the past 20 to 30 years, there has been a significant rise in the number of brokers marketing themselves as financial advisers, offering financial planning services, and implementing two-tier pricing arrangements and fee-based compensation structures more common to the investment adviser industry, thus blurring the distinction between brokers and investment advisers.²⁰ In addition, with the recent rise of automated trading and discount and online brokerage services, the role of the broker, at least in its interpersonal form, is no longer what it was in the 1930s and 40s. Over the past five years the number of registered broker-dealers has declined by 11% and the number of registered representatives has declined by 6%.²¹ Conversely, the assets managed by the 11,000 registered investment advisers currently stand at a record high of $49 trillion.²²

The convergence of the roles of brokers and investment advisers has led to calls for new efforts to harmonize the two regulatory regimes, as exemplified by the new mandates and regulatory authority set forth in Section 913 of Dodd-Frank. As we review today’s landscape and consider whether and to what degree to harmonize the broker-dealer and investment adviser regulatory regimes, however, we need to be cognizant not only of the very different histories of those regimes but also of the fact that we’re not the first to consider the issue. In striving to obtain the best outcome for investors, whether clients of broker-dealers, investment advisors, or both, we should bring to bear our historical experience and approach the subject with a certain regulatory humility that places our efforts in the context of eight decades of securities regulation. And it is important to note that the Commission is not compelled to promulgate rules pursuant to Section 913 – Congress granted the Commission authority to write rules, but left it to our discretion. Any rulemaking pursuant to Section 913 must, then, be supported by Commission findings that such rules are necessary, as well as a detailed understanding and analysis of the economic consequences of such rules.

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One area where the Exchange Act and the Advisers Act are in accord is in their treatment of failure to supervise liability for compliance and legal personnel. The Advisers Act authorizes the Commission to impose sanctions on a person associated with an investment adviser if such person “has failed reasonably to supervise, with a view to preventing violations of the provisions of [the] statutes, rules, and regulations, another person who commits such a violation, if such other person is subject to his supervision.” The Exchange Act includes nearly identical language granting the Commission the same authority with respect to associated persons of broker-dealers. In fact, in a speech at the annual “SEC Speaks” conference earlier this year, I made this same point by quoting the text of the Exchange Act and noting the nearly identical language in the Advisers Act. I’ll repeat now what I said in that speech: the devil is in the details of the “if” in the final clause of the statutory language: “if such person is subject to his supervision.”

So, at the risk of repeating some of the points I made in that February speech, I’d like to conclude my remarks today with a few words about failure to supervise liability.

I imagine many of you don’t consider yourselves to be “supervisors.” Others of you may be unsure as to whether you are, in fact, supervisors, and, if so, what that means. Frankly, while the line of cases addressing alleged failure to supervise liability provides some guidance on the subject, many questions still remain with regard to what makes a person a “supervisor” as well as the actions such a person must take in order to satisfactorily carry out his or her supervisory duties.

In addition, it’s important to note that failure to supervise jurisprudence has developed almost exclusively through cases involving associated persons of broker-dealers, as there are relatively few investment adviser failure to supervise cases. As a result, as unclear as failure to supervise liability is on the broker-dealer side, it’s even less clear for investment advisers.

In recognition of the complexity of the subject and the resulting need for flexibility, however, we should be cognizant of the limitations of establishing a rigid set of expectations based on bright-line rules. Optimal supervision requires a framework that encourages in-house legal and compliance officers to depart, when necessary, from the safety of black and white categorizations of who is and who is not a supervisor as well as what a supervisor is expected to do. Our failure to supervise regulatory regime should be a series of guideposts and safe harbors, not a minefield. The last thing we want is a system that by setting rigid standards discourages legal and compliance personnel from acting at all out of fear of being liable for any “wrong” actions they may take.

What does this mean? It means that the individual who fails to act at all in a potentially supervisory role should be more worried about being held liable for the actions he or she should take but doesn’t than should the individual who steps in and takes action in good faith, even if the results of those actions ultimately prove to be less than optimal. We need to avoid a system which, in effect, by saying you are a supervisor and are therefore liable for failure to supervise if you perform actions X, Y, or Z, discourages anyone from performing those actions at all. Instead, we need a regulatory regime that discourages negative inaction and encourages positive action.

It means that we need failure to supervise liability to mean what it says - we should be more concerned with addressing the failure to supervise at all than with second-guessing those who act. It should be riskier to do nothing in bad faith than to take action in good faith. To quote Theodore Roosevelt, “The only man who makes no mistakes is the man who never does anything.” We don’t want a world in which legal and compliance personnel are in such fear of being held liable for mistakes that they keep an impeccable record by standing back and doing nothing when the occasion calls for a supervisor to step in and make a tough call.

I don’t want to overstate the point I’m making today. In the overwhelming majority of cases, the questions of who is a supervisor and what that person’s responsibilities are will be clear. It is the handful of cases where there is less clarity, however, that require the sort of flexibility I’m describing today.

Our capital markets are based on risk and reward. Over the past several years, we’ve downplayed the unavoidability - indeed, the necessity - of risk and, in fact, have come dangerously close to actively discouraging taking risks. In some cases, we’ve practically criminalized taking actions that result in losses. It’s worth pondering how much of our stagnant growth is attributable to purposeful inaction taken as the rational response to an environment in which making the wrong decision in good faith results not just in absorbable financial losses but in Congressional subpoenas as well.

That’s not what smart regulation should do. The choice between, on the one hand, a system in which the response to a crisis is to generate thousands of pages of legislation and tens of thousands more of regulations and, on the other hand, a system that allows a supposedly unfettered, Hobbesian laissez-faire market to wreak havoc on less-informed investors is a false one, and it’s time we put that straw-man argument to rest. Smart regulation is about understanding the world as it is, not how we want it to be or how we fear it could become, and aligning incentives and establishing defaults in a manner that encourages positive action and discourages negative action.

Once again, you may ask, what does this mean? What it means is that as compliance personnel, your job involves risks - and our job, as regulators, is to set incentives and disincentives to encourage you to take the right kind of risks and discourage you from taking the wrong kind. Specifically, our job on the failure to supervise front is to ensure that when you’re confronted with a difficult situation that requires making tough calls, the risk that worries you isn’t the risk of liability for potentially making a less-than-perfect decision but instead the risk of incurring failure to supervise liability for declining to step in at all. To once again quote Theodore Roosevelt: “In any moment of decision the best thing you can do is the right thing, the next best thing is the wrong thing, and the worst thing you can do is nothing.”

I remain hopeful that the Commission can and will provide more clarity on this issue in the near term.

Thank you for your attention this morning, and congratulations once again on the NSCP’s 25th anniversary. I wish you a productive and successful conference.

¹ See U.S. Sec. and Exch. Comm’n, Staff Study on Investment Advisers and Broker-Dealers (2011); Kathleen L. Casey and Troy A. Paredes, Commissioners, U.S. Sec. and Exch. Comm’n, Joint Statement Regarding Study On Investment Advisers And Broker-Dealers (Jan. 21, 2011).

² See 1 James E. Anderson, Robert G. Bagnall, and Marianne K. Smythe, Investment Advisers: Law and Compliance § 1.01 (Matthew Bender, rev. ed. 2012).

³ See generally Fin. Crisis Inquiry Comm’n, The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (2011). See also id. at 443 (Dissenting Statement of Peter J. Wallison) (“Without waiting for the Commission’s insights into the causes of the financial crisis, Congress passed and the President signed the Dodd-Frank Act..., far reaching and highly consequential regulatory legislation. Congress and the President acted without seeking to understand the true causes of the wrenching events of 2008, perhaps following the precept of the President’s chief of staff — ‘Never let a good crisis go to waste.’”).

⁴ See U.S. Sec. and Exch. Comm’n, Report on Investment Trusts and Investment Companies: Investment Counsel, Investment Management, Investment Supervisory, and Investment Advisory Services, H.R. Doc. No. 477, 76th Cong., 2d Sess., at 2, 5 (1939) (“SEC Investment Advisers Report of 1939”); Investment Trusts and Investment Companies: Hearings on S. 3580 Before a Subcomm. of the Senate Comm. On Banking and Currency, 76th Cong. 717, 736, 763 (1940) (“Hearings on S. 3580”).

⁵ George C. Matthews, Commissioner, U.S. Sec. and Exch. Comm’n, Address at the Annual Convention of the Investment Bankers Association of America: A Discussion of the Maloney Act Program (Oct. 23, 1938).

⁶ See Philip A. Loomis, Jr., The Securities Exchange Act of 1934 and the Investment Advisers Act of 1940, 28 Geo. Wash. L. Rev. 214, 244 (1959–60); Anderson et al., Investment Advisers § 1.01.

⁷ Hearings on S. 3580, at 51.

⁸ SEC Investment Advisers Report of 1939, at 1, 27–30. As the Commission made clear when it transmitted the resulting supplemental report on investment advisers to Congress in 1939, because its jurisdiction under Section 30 centered on investment trusts and investment companies, its review of investment advisers was comparatively narrower in scope and comprehensiveness. Notably, the Commission’s efforts to gather basic information on the investment adviser profession were primarily limited to only those investment advisers with investment trust or investment company clients. See id. at 1; Hearings on S. 3580, at 47, 49, 51. See also Anderson et al., Investment Advisers § 1.01.

⁹ See, e.g., Investment Trusts and Investment Companies: Hearings on H.R. 10065 before a Subcommittee of the Committee on Interstate and Foreign Commerce of the U.S. House of Representatives, 76th Cong. 92 (1940) (“Hearings on H.R. 10065”); Hearings on S. 3580, at 713–25, 736–44, 758, 760. See also Lowe v. S.E.C., 472 U.S. 181, 201 n.44 (1985); Anderson et al., Investment Advisers § 1.01, 2.03.

¹⁰ See S. Rep. No. 1775, 76th Cong., 3d Sess., at 21 (1940); H.R. Rep. No. 2639, 76th Cong., 3d Sess., at 27 (1940). See also Anderson et al., Investment Advisers §§ 1.01, 2.03.

¹¹ Financial Planners: Report of the U.S. Securities and Exchange Commission to the House Committee on Energy and Commerce’s Subcommittee on Telecommunications and Finance, at A-7 (1988) (“SEC Financial Planners Report of 1988”). See also Anderson et al., Investment Advisers § 1.01.

¹² See, e.g., S. Rep. No. 86-1760, 86th Cong., 2d Sess. (1960), reprinted in 1960 U.S.C.C.A.N. 3502, 3503; Hearings on S. 3580, at 48; Charles C. Cox, Commissioner, U.S. Sec. and Exch. Comm’n, Keynote Address at the Investment Adviser Operations and Regulation Conference: The Commission and the Regulation of Financial Planners (Oct. 29, 1984); Anderson et al., Investment Advisers § 1.01; Arthur B. Laby, Reforming the Regulation of Broker-Dealers and Investment Advisers, 65 Bus. Law. 395, 403 (2010).

¹³ H.R. Rep. No. 2639, at 28.

¹⁴ See SEC Financial Planners Report of 1988, at A-7. See also Arthur B. Laby, Looking Beyond National Boundaries: Models of Securities Regulation in the U.S., 23 Fordham Int’l L.J. 20, 21 (2000).

¹⁵ S.E.C. v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191–92 (1963) (internal quotations and alterations omitted). See also Transamerica Mortg. Adv., Inc. v. Lewis, 444 U.S. 11, 17 (1979) (“As we have previously recognized, § 206 [of the Investment Advisers Act of 1940] establishes ‘federal fiduciary standards’ to govern the conduct of investment advisers.”) (citations omitted).

¹⁶ See S. Rep. No. 86-1760, 1960 U.S.C.C.A.N. at 3503; H.R. Rep. No. 2639, at 28; S. Rep. No. 1775, at 22; Laby, Models of Securities Regulation, 23 Fordham Int’l L.J at 22–23.

¹⁷ S. Rep. No. 86-1760, 1960 U.S.C.C.A.N. at 3503.

¹⁸ S. Rep. No. 94-910, at 17 (1976).

¹⁹ Id. at 18.

²⁰ See Laby, Reforming the Regulation of Broker-Dealers and Investment Advisers, at 404–07.

²¹ See Bruce Kelly, FINRA Outlines Expansion, Investment News, May 27, 2012, available at http://www.investmentnews.com/article/20120527/REG/305279998.

²² See U.S. Sec. and Exch. Comm’n, Dodd-Frank Changes to Investment Adviser Registration Requirements – Preliminary Results (2012), available at http://www.sec.gov/divisions/investment/imissues/df-iaregistration.pdf (last visited Oct. 22, 2012).