Give States Oversight And Examination Authority Over RIAs Managing $1 Billion Or Less To Solve The RIA Regulatory Mess

Tuesday, February 26, 2013 16:13
Give States Oversight And Examination Authority Over RIAs Managing $1 Billion Or Less To Solve The RIA Regulatory Mess

Tags: compliance | Dodd-Frank | RIA compliance | RIAs

The number of RIAs regulated by the Securities and Exchange Commission has surged, and the amount of money managed by newly-regulated RIAs has exploded. While the Financial Planning Coalition, Investment Adviser Association and other groups representing RIAs have proposed increased funding for the SEC and “user fees” to pay for an RIA exam program, across the board cuts in federal spending mandated by law make decreased SEC funding to regulate investment advisors  more likely.


What’s the solution?


Assign regulation of RIAs with less than $1 billion to state regulators. Instead of outsourcing the job to a new self-regulatory body under FINRA, outsourcing inspections and regulation of RIAs with less than $1 billion to the states helps solve the regulatory problems faced by the SEC.

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Like FINRA, states already have systems to regulate RIAs. In fact, based on recent history, the states are probably far more efficient than FINRA at regulating RIA. The states and NASAA have done an exemplary job of handling “the switch” that began in 2010. It’s an example where government has worked well. Moreover, it avoids the need  to create a new self-regulatory organization and leverages existing regulatory structure for RIA oversight, whichs keeps the cost of regulation down. 


The switch, a term I coined in September 2010 to describe the regulatory shift set in motion in July 2010 by the Dodd-Frank Act, moved 2,500 RIAs managing $115 billion from SEC oversight to state oversight. The Act was an effort to ease the burden on the SEC.


According to Bob Webster, spokesman for the North American Securities Administrators Association (NASAA), states have handled the switch much more easily than expected.


Last week, a letter went out to 20 RIAs that states identified for failing to make the switch to state regulation, marking the final chapter in completing the three year process. The switch of the 2500 RIAs has been completed and it has gone well. According to Webster, “the impact was not as great as anyone expected.”


“We originally had planned for about 4,000 RIAs to come over to state regulation, but only about 2,400 actually made the switch,” says NASAA’s Webster. “It’s not placed a tremendous burden on any individual state. Members prepared for it and those that needed additional staff and have gotten staffing, and I have not heard of any state being swamped or deluged because of the switch.”


Since the states have assumed oversight responsibility for these 2,400 RIAs without so much as a hiccup, why not let them regulate RIAs with less than $1 billion AUM? Doing so would materially simplify the regulatory burden on the SEC and allow the SEC to focus resources on hedge funds and private partnerships, and more faithfully fulfill the intent of the Dodd-Frank Act.



Passed in July 2010, the Dodd-Frank Act, was supposed to clean up regulation of financial services. Instead, it has heaped more responsibility on an already-strained SEC, which is responsible for nothing less than assuring investor trust.


Before Dodd-Frank became law, the SEC’s Office of Compliance Inspection and Examinations (OCIE) inspected an RIA, on average, once every 10 years or so. A guy like Bernie Madoff could play the odds that he’d never get inspected. If you wanted to be a crooked RIA, the SEC’s lax inspection system made it pretty easy. Dodd-Frank was intended to fix that. It switched 2,500 small RIAs to state regulation to ease the SEC’s burden. The SEC would oversee RIAs with more than $100 million AUM instead of $25 million. 


Trouble is, the 2,500 RIAs switched over to state regulation have been replaced by a new class of RIA registrants: hedge funds and private equity funds. According to Congressional testimony from SEC Chair Elisse Walter recently, the 2,500 RIAs managing $115 billion have been replaced with 1,500 private equity funds managing $3 trillion. These new registrants are arguably 25 times more complex than 2,500 RIAs with $115 AUM. Creating a credible exam program for them is far more chllenging.


The upshot: Dodd-Frank, which was supposed to fix regulatory weaknesses that contributed to the financial crisis, has actually made RIA regulation a much bigger problem than it was before the financial crisis.


But you can’t fault lawmakers or the law. Dodd-Frank is necessary. Unregulated financial activities were a major cause of the financial crisis, which started in the U.S. and almost brought down the world financial system as well as the U.S. economy.


Helping The SEC

Separating “mom and pop” RIAs advising individuals from much institutional investment advisors makes sense because RIAs managing money for individuals are in a totally different business than hedge funds and private equity firms that now command the SEC’s attention. Examiners need totally different forensic skills to examine this new class of RIAs. Meawnhile, states have proven adept at handling the increased responsibility of mom and pop RIAs.


Keep in mind, the SEC is a profit center for the federal government. Uncle Sam makes money on fees and penalties imposed on entities it regulates. Problem is, Congress doesn’t give the SEC back much of the money it raises in fees and penalties. The SEC is always starved for cash to pay for doing its job.  That’s the way Congress wants it.


States are not hogtied by Congress and Wall Street influence. While the SEC was handicapped by the federal government’s need for revenue, states are more free to make money on regulating RIAs. Allowing the states, instead of the SEC, to collect fees and penalties associated with regulating RIAs could efficiently finance the regulation of RIAs. Registration fees and penalties from RIAs could easily offset the cost of a team of hiring five or 10 young lawyers to police a state’s RIAs while creating a credible deterrent that protects consumers from crooked advisors. 


More complex RIAs with less than $1 billion would remain under SEC purview if they conduct business in 15 or more states. That rule, already in place, seems to be working well and could continue to keep RIAs with far flung operations under SEC supervision.


What do you think? Would putting states in charge of regulating RIAs with less than $1 billion help solve the RIA regulatory mess?


Would state regulation be a better alternative than leaving the job to the SEC and making SEC-regulated RIAs pay user fees, which has been proposed by the groups representing RIAs?


Based on the states' track record in implementing the switch, it sure looks that way.



Comments (7)

Good idea, in general. Not exactly sure what the number should be. Would have to deal with the de minimus rule and multi-state advisors. And maybe have notice filing, rather than actual registration, for advisors who meet the de minimus rule, up to some larger number.
stvnrsmth , February 26, 2013
Andy, in my mind it's a good idea, but only with a few changes to the system of state securities regulation.

Why is it a good idea? The SEC has its handful with national issues. We don't need to be tying up SEC Commissioners' time with RIA appeals proceedings. Unless the "user fee option" is successful, prospects for adequate SEC funding are remote, at best.

First, there should be one uniform and consolidated registration - to the home state. There should be no need for securities regulators in multiple states to each get a shot at reviewing Form ADV and other documents, and often having different interpretations.

Second, an annual fee should be available for "national registration" (i.e., registration in all 50 states). The fee can be divided up among the states based upon the number of clients in each state, as determined from ADV Part 1 filings (with a slight modification to the form, to break out the number of clients by state). This is easy to accomplish ... "we have the technology!"

Third, state securities regulators should be aided by peer review in cases involving alleged breach of the fiduciary duty of care, and possibly other forms of breach. Before an RIA/IAR is forced to spend hundreds of thousands of dollars (or millions) defending itself, fellow professionals should make the judgment call that a "case" actually exists. CPAs and attorneys have peer review systems for probable cause hearings - why not RIA/IAR professionals?

Fourth, state securities regulators, and the SEC, should form an advisory board of RIAs to come up with Professional Standards of Conduct for RIAs/IARs. While the triparte fiduciary duties of due care, loyalty, and utmost good faith are principles-based standards, it is possible to come up with an elaboration of these standards through professional standards of conduct, in order that all RIAs/IARs understand their duties more fully.

Fifth, and most important, RIAs/IARs should not be treated as criminals. Why are attorneys and CPAs not subject to examinations (except in cases of when a complaint is filed)? The only difference is custody (which many RIA-only firms don't possess, but many others do). Hence, to protect the investing public, exams should focus on the issue of custody and seek to detect thefts of client assets. Each and every employee should be required to sign an attestation, each year, relating to the protection of client assets. Examinations onsite should ordinarily last no more than one day. (Especially in this era of electronic records.) Exams should be more frequent, and targeted, to identify small frauds before they grow bigger. (Where firms have custody, more detailed examinations, directed at the essential role of government in "asset verification," should be undertaken.)

All in all, a good idea. If phased in, over time, I could even see justification for an even higher AUM limit - why not $5B? Or $10B?

Keep up the insightful commentary! Ron
RonRhoades , February 27, 2013
Never forget the root cause of underfunding at the SEC is the agency's FAILURE TO PLAN FOR THE RESOURCES NECESSARY TO DO ITS JOB. The Securities Exchange Act of 1933 authorized the SEC to charge fees to the industry to fund its work. THERE IS NO GOVERNMENT FUNDING INVOLVED, BECAUSE THE SEC CHARGES THE INDUSTRY FOR ITS COSTS AND REIMBURSES THE GOVERNMENT FOR ANY FUNDING ADVANCED. The SEC has yet to fulfill it's legal obligation to plan the budget it needs to carry out its responsibilities as prescribed by law, and to ASK CONGRESS to authorize it to set the estimated periodic fee, transaction volume, and estimated cost per transaction to fund the ACTUAL BUDGET PROPOSAL TO DO THEIR JOB. Instead, they cry they are poor and underfunded. If they made a proper business plan, presented it congress, they would likely gain congressional permission to charge the industry the fees it needs to perform its job.
FreeTrader , February 27, 2013
It's not up to the SEC to set its budget. Congress does that.

SEC staff said this in its Dodd-Frank mandated report on RIA regulation two years ago, when SEC staff recommended that agency retain responsibility for regulating RIAs with more than $100 million AUM but left it to Congress to provide funding.

Incidentally, Dodd-Frank authorized an increase in the SEC’s budget from the $1.11 billion appropriated in FY 2010 to $1.3 billion in FY 2011, $1.5 billion in FY 2012, and $2.25 billion by FY 2015--a doubling in funding over five years.

But assets under SEC supervision among RIAs has far outpaced budget growth because of the addition of hedge fund and private partnerships.

agluck , February 27, 2013
Andy, while I applaud your creative thinking I'm not in favor of the proposed "solution." Although I am not particularly familiar with state regulation my conversation with practitioners who have been under that regulatory system tell me that the states are anything but "far more efficient than FINRA at regulating RIA." The term I most remember is "clueless." Second, we're currently registeded in 8 states. If I had any hair left I'd be losing it just thinking about having to deal with 8 different regulators. Finally, firms between 1/2 and a billion dollars are likely to be anything but "mom-and-pop."

PS - good response to FreeTrader
hevensky , February 27, 2013
Chris Winn
As the owner of a compliance consulting firm, I can appreciate the comments from all sides here. It is virtually impossible to provide an apples to apples comparison of the effectiveness of states vs. FINRA.

I do think it is fair to say that many (perhaps not all) states have upped their game. They were forced into the plain-english ADV2 and then had to contend with countless SEC to State transitions. While some states struggled with the sharp increase in volume, many used it as an opportunity to enhance their teams and their exam methodologies. Many states have increased the number of exams and the depth in which they cover during an exam. We have experienced significantly more exams in 2012 than in any prior year.

That said, hevensky's comment is an important one to reflect on...

No one wants 8 (or more) regulators. From a practical standpoint, we are not seeing out of state regulators making a trip to advisors. To make state regulation truly work, they need to continue to align regulations and leverage the home state.

My trouble with FINRA (or any SRO) as an examiner, is that their existence in itself is a conflict of interest. If you can only stay viable and attract talent by fining members, I find it hard to see how you can oversee the fiduciary advisor?

IMO, the states (though NASAA) and the SEC should work together to develop a true uniform standard of rules. We should not have differences in rules between SEC advisors and State advisors nor differences between states. The SEC should continue to develop and implement the rules and the states should be there to guide and enforce.

Chris Winn , March 03, 2013
Andy, I believe this idea has merit and would support a move in this direction. Texas does a good job of regulating advisors with a once per three year track record. They also have a reputation of working with advisors to help them meet state expectations instead of treating them like the enemy. I can't speak for other states, but whatever issues may exist in that respect could be addressed by those state's advisors. Since the vast majority of RIAs would fit the less than $1B level, FINRA would likely give up trying to take over the fee only advisory world. And we could stop talking about "harmonizing" rules, which is just a euphemism for treating everyone like a broker with custody. Harmonizing just eliminates one more hurdle for FINRA and is the next big worry fee-only advisors under the SEC need to worry about. And it is coming fast.
cblackman , March 04, 2013

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