By Jim McConville
Instead of the Securities And Exchange Commission (SEC) or the Financial Industry Regulatory Authority (Finra) examining RIA firms, the firms themselves should foot the bill for their own periodic compliance examination by using an outside body.
That's the novel solution that James J. Angel, professor of finance at the McDonough School of Business at Georgetown University, is proposing. To solve the ongoing debate over how investment advisors should be effectively regulated, the most effective approach would be to outsource the task to outside accounting or consulting firms, he says.
TD Ameritrade Institutional commissioned the 36-page report, titled On the Regulation of Investment Advisory Services: Where Do We Go From Here? Angel presented his findings to TD Ameritrade Institutional's advisor panel of 30 members on October 31.
Angel suggests that RIA exam frequency can be increased by requiring RIAs to engage independent auditors such as accounting or consulting firms or perhaps a self-regulatory organization (SRO) to examine their regulatory compliance on a more frequent basis.
Angel's proposal essentially provides a fourth choice to conducting RIA advisor exams. In its own own advisor study, the SEC has offered three options: advisors pay user fees; create a self regulatory organization (SRO); Finra oversees hybrid groups.
Angel contends that there are regulatory precedents for requiring RIAs to hire -- and pay for -- an independent auditor, including the SEC requiring corporate issuers to provide audited financial statements and the SEC's proposal to require broker-dealers to submit independently audited compliance reviews. Angel's argument is that such an RIA fee-based approach would free up scarce SEC resources for larger work, and that it would provide the benefits of competition in the provision of examination services by RIAs.
Traditionally, larger RIAs have been regulated by the SEC and smaller ones by the states. Brokers, on the other hand, are regulated by a self-regulatory organization, Finra, as well as by the SEC. In recent years, the boundaries between RIAs and brokers have become blurred as brokers offer more advisory services, and there is substantial confusion among consumers as to the differences between brokers and RIAs.
In 2003, the SEC proposed an annual internal compliance review for financial advisors that could be outsourced to third parties. The SEC mandated internal reviews at the end of 2003, however, without requiring the use of outside auditors, Angel said.
In a study mandated under the 2010 Dodd-Frank act, the SEC has documented that it examines RIAs at a rate of approximately once every 11 years, and recommended the study of additional means to increase the frequency of examinations, including user fees to fund more examinations by the SEC, or requiring RIAs to become part of an SRO.
However, Angel asserts in his study that the SEC has assigned fewer employees to its Office of Compliance, Inspections, and Enforcement (OCIE) in 2010 than in 2004 despite an increase in overall exam frequency over the period. This SEC diversion of resources presumably reflects its belief that RIA examinations are less important than other SEC activities.
Angel also contends that two alternatives proposals to increase the frequency of examinations -- stepping up the numbers of SEC reviews and shifting a segment of RIAs over to state regulation -- are equally ineffective at solving the problem.
"It is unlikely in the current political environment that the SEC will be able to charge user fees to RIAs or to get the budgetary resources it needs," writes Angel. "Moving more RIAs from federal to underfunded state regulatory agencies is likewise unsatisfactory."
If exams and other functions are not outsourced, the other possibility would be that a new self-regulatory organization for advisors would be created.
"The problem is that RIAs are not being examined frequently enough," Angel says. "No other serious deficiencies in RIA regulation have been documented."
The SEC and Finra habitually hire recent college or law school graduates as examiners, yet these examiners often lack industry experience, according to Angel's report. Audits then become perfunctory "check the box" events that are unlikely to uncover wrongdoing, according to Angel. It is better to end the practice of hiring examiners with little industry experience and upgrade the skills of existing ones.
As for the audits themselves, Angel suggests examiners should verify the information in the Form ADVs that companies file with the SEC, and verify that a given firm has procedures in place to comply with U.S. securities laws. Each firm's regulatory history and risk profile would determine its frequency of exams, so that larger firms with more complex businesses would be examined more often than smaller firms.
Richard S. Brown, CEO of Minneapolis-based JNBA Financial Advisors, contends that Angel's proposal might not solve every problem, but it is more intriguing than some of the conflicting ideas now circulating through the industry and Congress.
Brown, who has a seat on the TDAI advisor panel, and listened to Angel's presentation, suggested that audits could be more streamlined, as well. This could make the process for routine questions less cumbersome, helping regulators and firms alike use their resources more efficiently.
"The SEC now has a uniform process for what they look for," Brown said. "If I sat down and looked at that list [of procedures], there are things that could be done electronically, I bet."
Angel estimates that the all-in costs of one examiner, including wages, benefits and overhead, is about $200,000. If the SEC examined RIA firms once every five years, the annualized cost per firm would be $8,500.
Angel suggests that any user fees charged to RIAs be related to the cost of examining the firm, based on its size and complexity. The firm's number of representatives, branches, complexity of products and assets under management would all be considered.
Angel's report included a fee schedule based on a firm's assets under management. Firms with less than $25 million in AUM would pay a proposed annual fee of $300. The fee schedule increases proportionately, with firms with more than $500 million in AUM paying a proposed $5,000.
User fees might make perfect sense to some in the industry, but getting the idea past Congress has always been a tough sell. In 1992, Angel said in his report, the House passed the Investment Adviser Regulatory Enhancement and Disclosure Act, which called for user fees from RIAs for examinations. It died in the Senate that year, however.
Angel's report follows on the heels of a proposal in April by two University of Mississippi law students and one of their professors to create an SRO for independent RIAs. Students T.J. Collins and Tyler Roberts came up with the idea for the "Self-Regulatory Organization for Independent Investment Advisors,'' or SROIIA, as part of a project with the Business Law Society, an organization started by Professor Mercer Bullard, a former SEC assistant chief counsel and advocate on securities and compliance issues.
"I think the odds are that there will be will be an SRO for investment advisors,'' Bullard told Financial Advisor magazine in April. "Then there's the question of whether non-dual-registrants RIAs would be happy having to join Finra, which is what they'll be stuck with if there's no alternative."