National Association of Personal Financial Advisors
April 10, 2003
Via Electronic Filing
Jonathan G. Katz
Re: Proposed Rule: Compliance Programs of Investment Companies and Investment Advisers, File No. S7-03-03, Release Nos. IC-25925, IA-2107
Dear Mr. Katz:
The National Association of Personal Financial Advisors (NAPFA) is submitting comments about the SEC's proposal for new Compliance Programs of Investment Companies and Investment Advisers, File No. S7-03-03. NAPFA is a trade association representing more than 900 Fee-Only financial advisors in the United States.1 By and large, NAPFA members operate small financial planning practices; more than two-thirds of our member firms have one planning professional, and fewer than 10% have more than three. For NAPFA-member firms, new regulations would represent a substantial financial and recordkeeping burden.
NAPFA concurs with the SEC that protection of consumers and investors is paramount, and we affirm our commitment to working within regulatory structures that promote the public interest. For 20 years, NAPFA has been recognized as upholding the highest standards of education, training, and professional conduct in the financial services industry. As such, NAPFA has an interest in seeing that new regulations serve the public interest without unduly burdening the small businesses that comprise our membership.
However, NAPFA opposes several elements of the SEC's proposals - namely, creating a new self-regulatory organization (SRO) for financial planners and advisors, and mandating a written compliance program.
Before explaining of our points of agreement and disagreement, NAPFA would like to differentiate between different types of investment advisors who fall under the SEC's definition of Registered Investment Advisor (RIA). It is important to understand the distinctions because RIAs that operate differently should be regulated differently. The difference is that some RIAs take custody of clients' assets, similar to broker-dealers. Some RIAs have discretion to conduct trades of equities and other assets for their clients. But many RIAs do not take custody of assets nor conduct trades on clients' behalf, and it is NAPFA's belief that these types of advisors present a significantly lower risk of misconduct and client harm.
In the case of NAPFA members, there is a further distinction that should be noted. While some NAPFA members do conduct discretionary trades on behalf of their clients, NAPFA members do not earn commissions on those trades. Thus, NAPFA members cannot increase their compensation by trading more actively for their clients, and it is very unlikely that a NAPFA member would "churn" a client's account, as has been a recurring problem in other sectors of the industry. Again, regulation of RIAs should reflect the fact that the business model adopted by some advisors eliminates churning as an incentive for actions harmful to clients.
Current Programs Are Effective
First, NAPFA would like to emphasize that we support the SEC's vigorous enforcement of current laws designed to stop unscrupulous business practices and dishonest operators. In fact, NAPFA believes that the SEC's current programs to examine RIAs are highly effective.
Yet, NAPFA recognizes that the SEC is concerned about improving the general capability of the great majority of investment advisors and financial advisors who are honest. We also recognize that the public's demand for greater oversight of investment advisors and financial advisors is on the rise. We, too, share the public's concern that some financial professionals are inadequately trained and supervised.
Furthermore, NAPFA believes that even competent advisors can be induced into giving advice that is not in their clients' interests because of the incentives embedded in the commission structure under which they operate. This is why NAPFA was founded 20 years ago on the principle that its members cannot accept commissions or other forms of compensation that are dependent on a client purchasing a particular financial instrument. We refer to this as "Fee-Only" financial planning.
In the following comments, we enumerate the following: 1) our specific reasons for supporting a continuation of the current examination program and opposing an SRO as an alternative or supplement; 2) our concerns about the proposal for new compliance rules related to written programs and compliance officers; and 3) appropriate exemptions for requirements for fidelity bonding and capital requirements.
1. Impact of the SRO Plan
NAPFA does not believe that an additional layer of compliance oversight, as represented by an SRO, is necessary. The SEC's compliance examinations today are very effective. For the vast majority of RIAs, including NAPFA members, the examinations uncover minor, technical violations. Most RIAs are eager to fix those violations as they strive to improve their operations. The SEC's experience with RIAs should indicate that the "problem" of non-compliance in the RIA community is not significant, as compared to the incidents of improper activity from broker-dealers.
NAPFA also sees multiple difficulties arising from implementation of an SRO program. Three issues are discussed below:
Who will perform the oversight?
A fundamental issue is which organization would lead the SRO. Selecting the wrong oversight body would waste precious resources without solving problems. NAPFA cannot identify an organization today that combines a record of working in the consumers' interest with the resources to create and operate a compliance program.
For example, the NASD has been mentioned as the possible SRO for RIAs (although the SEC's proposal does not name the NASD). Yet, as the experience of the past several years shows, the NASD has been very slow to resolve the numerous conflicts of interest that have arisen among the financial professionals whom it oversees.
The other problem with selecting a single organization to oversee advisors is that the group would, by its nature, create programs that serve the majority of its constituency. The issues that broker-dealers face are quite different than those faced by RIAs, and broker-dealers' "sell-side" orientation makes it appropriate that they should be regulated differently than RIAs. It is unlikely that the NASD, which oversees approximately 800,000 broker-dealers in the United States, would adapt its SRO model to accommodate the 7,800 RIAs that the SEC oversees today.
Would the SRO be effective?
The record of SROs has been inconsistent. Consider the performance of the accounting industry's SRO in overseeing corporate auditors, or the NASD's failures to address conflicts of sell-side analysts. These programs have had significant, high-profile failures. How can the SEC be confident that a new SRO, perhaps operated by the same organizations that have failed in the past, will be successful?
What will it cost?
Cost of the SRO is undetermined and would likely be substantial. Yet the SEC acknowledges that the costs of all of its compliance proposals would be disproportionately greater for small, independent financial planners.
In short, NAPFA questions why a regulatory system for RIAs that isn't broken needs such a radical "fix." NAPFA finds no evidence that the current RIA examination system is ineffective at protecting the public interest. Equally notable, the SEC does not seem to suggest in its request for comment that its examination system is inadequate. It has been the experience of NAPFA members who are RIAs that the SEC's examinations are quite comprehensive.
The issue that the SEC does raise is that the frequency of its examinations may be on the decline. However, that seems to be a funding issue, not a matter of the inadequacy of the examinations. NAPFA supports maintaining the SEC's current ability to have a regular examination schedule of RIAs. We also support increasing the SEC's examiner staff concurrent with growth in the number of RIAs.
2. Compliance Programs Mandate
The SEC proposes to mandate that RIAs create an internal compliance program, update it annually, and designate a compliance officer. NAPFA does not believe that this type of compliance mandate is warranted at this time and in this industry sector.
It should be noted that many NAPFA-member firms do have written compliance procedures, and they update them on a regular basis. SEC examiners review these procedures, when available. NAPFA encourages all of its members to create and monitor compliance programs that reflect their unique business models.
However, the compliance proposal outlined by the SEC would not provide an additional layer of protection for clients of most RIAs. In NAPFA's view, it is a solution to a problem that does not exist. Our reasons are discussed below.
First, although the SEC issues deficiency letters in almost all of its RIA examinations, few of those deficiencies are deemed "serious" by the Commission. In the SEC's 2002 Annual Report, the Commission stated that it issued deficiency letters in 90% of RIA inspections, but that 3% were in the "serious" category. In other words, the violations of most advisors are technical in nature and not causing actual harm to clients. NAPFA members report that these technical violations are readily corrected. The proposed compliance program, in which examinations would rely on an exacting reading of each company's compliance procedures, will surely uncover more of these technical violations. But NAPFA does not believe that it will serve the law's true intent - which is to ensure that advisors are working in the best interests of their clients.
Second, although the SEC states that each company's compliance program would reflect its particular business model, NAPFA is highly concerned that, in fact, the new compliance program would be similar to the broker-dealer model. Most of the examples of compliance issues cited by the SEC in its proposed rulemaking are associated with broker-dealers: trading; allocating investment opportunities; soft dollars; conversion of client assets; and so on. But many RIAs do not have access to clients' funds and do not perform those types of activities. Thus, compliance procedures designed to safeguard against improper conduct in these areas would be irrelevant for many RIAs. In other words, it is crucial for the SEC to distinguish between RIAs who take custody of clients' finances or conduct trades on their behalf, and those who do not.
In the specific case of NAPFA members, the necessity to fit compliance rules to how a practice is operated is even more pronounced. Because NAPFA members are prohibited from accepting compensation based on their clients actually purchasing a financial product, the abuses that occur in other advisor-client relationships are very unlikely to arise in these situations. A compliance program that treats all RIAs alike is inappropriate and unfair.
Third, the fiduciary responsibilities placed on RIAs through the Investment Advisers Act of 1940 already create a legal requirement that advisors work in the best interests of their clients. This fiduciary standard is an effective framework for the current compliance examination system used by the SEC. NAPFA strongly supports the concept of an advisor's fiduciary duty, and NAPFA's fiduciary oath is widely considered to be the strictest in the financial services industry.2
Fourth, the SEC claims that firms that do not have compliance programs today can create them inexpensively. NAPFA submits an opposite perspective: Some firms, particularly new or very small firms, lack these programs precisely because they are costly to create. Under the SEC's plan, those firms will face a difficult choice to either incur a large financial burden to develop a program that reflects their true operations, or to purchase a low-cost, generic program that does not truly improve client security.
Finally, NAPFA believes that the requirement that a firm have a compliance officer "competent and knowledgeable regarding the applicable federal securities laws" is not a realistic expectation for sole proprietorships and small firms, unless an assumption is made that the principal of the firm also can be its compliance officer. More than two-thirds of NAPFA members are sole proprietors or are the only financial advisor on their staff. Fewer than 10% of NAPFA-member firms have three or more staff members who have earned a certification in financial planning or a related field.
3. Fidelity Bonding and/or Capital Requirements
The SEC requested comments on whether the Commission should impose a requirement that all RIAs be required to purchase fidelity bonds or have a minimum level of capital invested. The fidelity bond or the net capital would be available to attempt to make clients whole when they have been subject to fraud and other forms of abuse.
NAPFA agrees with the proposal in principle, based on a belief that that purchasing a bond will cost a small financial advisory firm $500 to $800 per year. However, we suggest that an exemption be created for financial advisors who do not take custody of their clients' funds. In returning to the distinction explained earlier, RIAs without custody or discretionary trading are not in a position to misappropriate clients' money. These advisors might recommend particular investments, but their clients ultimately make the decisions and control how their assets are invested. Thus, the situations for which bonds or net capital requirements are necessary do not arise.
The SEC's proposal seems to indirectly refer to this issue, in a statement: "Investment advisers are among the only financial service providers handling client assets that are not required to obtain fidelity bonds." But this is exactly the heart of the matter for many NAPFA members and other financial advisors. There are many "investment advisors" or "financial advisors" who do not custody client assets. They should not be subjected to the same requirements as advisors who do custody assets.
NAPFA recognizes that there is a difference between taking custody of funds and having trading discretion. The possibility for malfeasance in discretionary accounts is less than in custodial situations, but greater than in non-discretionary situations. Perhaps a compromise position can be developed for advisors who undertake discretionary trading.
Conclusion and Summary
NAPFA believes that the SEC's current examination program is effective, both at finding intentional violations of the law and at pinpointing minor, inadvertent violations by honest practitioners. NAPFA also believes that the SEC's examination procedure is seen as credible, both within the RIA community and by the public. Furthermore, the record of RIAs overseen by the SEC is excellent, notwithstanding the exceptional growth in the profession in the last decade. Therefore, NAPFA believes that new oversight and compliance programs are unnecessary. Instead, NAPFA supports sufficient funding of the SEC so that its staff can continue its current examination and oversight program.
NAPFA believes that the problems that individuals and families face when they seek financial advice arise because most financial professionals are compensated only after their clients purchase one type of financial product or another. This type of compensation creates pressure for sales commissions, and destroys the objectivity of those professionals who are giving advice. Many of the investment scandals of the past several years indicate how pernicious the conflicts of interest are when compensation is linked to persuading clients to make a purchase or to transfer assets.
NAPFA believes that a lack of objectivity, pervasive throughout most of the financial services industry, is the true problem that consumers face today. NAPFA also believes that the SEC can address this problem without undermining the commission system. By instituting stronger requirements for disclosure of compensation on all financial advisors and investment advisors, the SEC can have a truly significant pro-consumer impact. NAPFA strongly supports tougher disclosure requirements that would mandate that clients and prospective clients be given information about the sources of individual compensation and potential conflicts of interest prior to making any investment decision recommended by or initiated by a financial advisor.
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NAPFA appreciates the opportunity to respond to the SEC's proposal and to express our support of current oversight programs. We hope that our explanation of the business model of a NAPFA member provides greater understanding of the role that Fee-Only financial planners are playing in today's consumer-finance industry. NAPFA representatives would be pleased at any time to provide additional information about our organization or the ideas that we have presented in this comment letter.
cc: The Honorable William H. Donaldson