House Financial Services Committee Chairman Spencer Bachus (R-Ala.) introduced H.R. 4624, the “Investment Adviser Oversight Act of 2012” (“IA SRO Bill” or “Bill”), on April 25, 2012. The Bill would require investment advisers registered either with the Securities and Exchange Commission or one or more state securities authorities to become members of an investment adviser self-regulatory organization (“SRO”), with several exemptions for advisers to mutual funds, private funds, and other institutional and high net worth clients. The Bill is based in part on the Maloney Act — the 1938 law that amended the Securities Exchange Act of 1934 that led to the creation of NASD (now FINRA) — and in part on a draft SRO bill that Rep. Bachus circulated in September 2011 (“2011 Draft Bill”).
In January 2011, the SEC staff completed a study on investment adviser examination, enforcement and oversight, as mandated by Dodd-Frank Wall Street Reform and Consumer Protection Act. The SEC staff study suggested three alternatives to Congress: 1) allowing the SEC to charge user fees to fund an expanded investment adviser examination program, 2) creating an SRO for investment advisers, or 3) giving FINRA authority to examine the investment adviser operations of “dual-registrant” investment adviser/broker-dealer entities. Since then, the investment advisory industry has weighed in on the appropriateness of an SRO to oversee investment advisers. Many dual-registrants have expressed support for an SRO, while investment advisers that are not affiliated with a broker-dealer have generally opposed the additional regulation that an SRO would bring.
FINRA previously recommended to the SEC that an SRO be established to regulate the investment adviser industry. FINRA stated that an investment adviser SRO should have a majority of public representatives on the SRO board and, if FINRA were to seek to become the SRO for investment advisers, it would create a separate affiliate with its own board of governors “to ensure that the SRO establishes programs appropriate to the investment adviser industry.”1 FINRA recently released a cost estimate for its startup and ongoing expenses should it become the investment adviser SRO of estimated one-time startup costs of approximately $12 million to $15 million with ongoing costs would of approximately $150 million to $155 million annually.2
Advisers Required to Obtain SRO Membership
The IA SRO Bill would amend the Investment Advisers Act of 1940 (“Advisers Act”) by requiring each SEC-registered and state-registered adviser, unless exempt, to become a member of an SRO that has been approved by the SEC. Although the Bill provides for the possibility of multiple investment adviser SROs, an adviser would only have to become a member of one SRO.
Exemption from SRO Membership for Advisers to Investment Companies
The Bill would exempt from SRO membership advisers having primarily institutional or very high net worth clients. Of significance, an investment adviser with one or more clients that is a registered investment company would not be required to become an SRO member for any of its investment advisory business, regardless of the nature of its non-registered investment company clients or the percentage of its total assets under management that are attributable to its investment company client(s). This exemption for advisers to investment companies is broader than in the 2011 Draft Bill because it would exempt an investment adviser with a single investment company client that comprised a de minimis percentage of the adviser’s total assets from SRO registration, even if all of the adviser’s other business was individual retail advisory accounts. The 2011 Draft Bill would have exempted advisers to investment companies from SRO registration only if the adviser had at least 90 percent of its assets attributable to registered investment companies, non-US persons, clients investing at least $25 million with the adviser and other enumerated institutions.
Other Exemptions from SRO Membership
The IA SRO Bill also would exempt an adviser from SRO membership if 90 percent of its total assets under management are attributable to one or more of the following types of clients with which the adviser has a written investment advisory agreement:
- Non-US clients;
- Qualified purchasers under the Investment Company Act of 1940 (“Investment Company Act”) (e.g., natural person clients that in the aggregate own at least $5 million in investments);
- Private funds (such as hedge funds, private equity or venture capital funds) that are excepted from investment company regulation under Section 3(c)(1) or 3(c)(7) of the Investment Company Act;
- Collective trust funds as defined under Section 3(c)(11) of the Investment Company Act;
- Charitable investment funds as defined under Section 3(c)(10) of the Investment Company Act and/or
- Other specified institutional clients, such as mortgage REITs (Investment Company Act Section 3(c)(5)), issuers of asset-backed securities (Investment Company Act Rule 3a-7), employee securities companies, business development companies, SEC-registered or state-registered advisers, and SEC-registered broker-dealers.
If the IA SRO Bill is enacted, an adviser that does not act as an adviser to a registered investment company and relies on the exemption from SRO membership described above would need to monitor its client base and its assets under management to assure that its client assets attributable to the above institutional and high net worth clients remain above the 90 percent threshold. Advisers that act as subadvisers would be exempt because their clients would only be other investment advisers but might be dissuaded from expanding their business to include other clients that are outside of the exemptions.
Affiliates of Investment Advisers Subject to Separate SRO Registration Requirements If They are “Independent Affiliates”
In addition to the exemptions listed above, an investment adviser that is controlling, controlled by or under common control (i.e, an affiliated adviser) with an adviser with combined assets under management 90 percent or more of which are attributable to one or more of the types of clients above, the affiliate can aggregate its client assets under management with the exempt adviser. If the exempt adviser and the affiliated adviser(s) have combined assets under management 90 percent or more of which are attributable to one or more of the types of clients above, the affiliate can also claim an exemption from the SRO requirements unless the affiliated adviser is an “independent affiliate.”
An “independent affiliate” is any affiliated adviser with “compliance programs, operations and businesses that are sufficiently independent” from those advisers exempted from SRO membership as described above such that SRO membership by the affiliated adviser is necessary for the protection of investors. The SEC would have to determine by order that an adviser is an independent affiliate and therefore subject to SRO registration. Accordingly, under the IA SRO Bill, a large diversified firm with multiple investment advisory affiliates could have several investment advisers that are subject to SRO membership.
Investment Advisory SROs
The IA SRO Bill would empower an IA SRO to conduct periodic examinations of advisers that are members of the SRO, with one exception. A state-registered adviser would be excused from examination by the SRO if it maintains its principal office and place of business in a state that has adopted a plan to conduct on-site investment adviser examinations at least once every four years. Each state securities authority would likely be required to certify periodically to the SRO or SEC that it maintained an examination schedule that met the four-year requirement. In addition, the IA SRO could conduct “for cause” examinations of any investment adviser that is a member of the SRO even if located in a state that has adopted a four-year examination cycle, or conduct any routine examination of an adviser that is a member of the SRO and dually-registered as a broker-dealer. In response to the IA SRO Bill, NASAA, the association of state securities administrators, has stated that it believes its members have sufficient authority and resources to examine state-registered investment advisers and therefore state-registered investment advisers should not be required to join an IA SRO.
The IA SRO Bill does not name FINRA as the SRO for investment advisers but rather states that any SRO for advisers would have to be organized as an SRO and have “the capacity to enforce compliance by its members” to its rules. Although FINRA has stated that it would be amenable to serving as the SRO for investment advisers, it remains unknown whether another organization is capable of meeting the requirements for SRO designation as outlined in the IA SRO Bill. If there are multiple SROs for investment advisers, each SRO would have to provide for “substantively equivalent regulation and oversight” of members.
In a change from the 2011 Draft Bill, the IA SRO Bill would require that any SRO for advisers would have to maintain a “comprehensive information security program” that meets those standards established by the SEC and that contains “strong and risk-based information security controls” to protect information from unauthorized internal or external disclosure or dissemination. In addition, the SRO would be required to pay for an independent examiner to review the system every three years. This information security requirement was included presumably to address concerns expressed by the private fund community regarding protection of proprietary or confidential information.
The IA SRO Bill also requires that any SRO must “assure a fair representation of the public interest and the association's members” among its board and that the majority of the board for the investment adviser SRO could not be associated with any “other” SRO. This separation is consistent with a proposal made by FINRA in which an SRO for advisers would be a legally separate entity with its own board separate and apart from the SRO overseeing the broker-dealer industry.
Under the revised IA SRO Bill, an IA SRO’s rules must be designed to promote “business conduct standards” for its members consistent with their obligations to investors. These standards must be consistent with the fiduciary standards applicable to investment advisers under the Advisers Act or state law and cannot unnecessarily duplicate, overlap or conflict with such laws. The SRO’s rules must provide for regular examinations of the business of the advisers that are SRO members and adviser’s associated persons. In addition, an IA SRO must “establish appropriate procedures to register persons associated with members, to require supervisory systems for members and their associated persons, and to discipline its members” and associated persons.
Under the IA SRO Bill, the SRO would have authority to enforce the Advisers Act and the rules thereunder and any rules of the SRO and would have to establish disciplinary procedures to do so. SRO rules would have to be approved by the SEC after notice and opportunity for comment and a cost-benefit analysis conducted by the SRO. By contrast, FINRA's rule-making process for broker-dealers currently does not require a cost-benefit analysis.
The SEC would also have to conduct annual inspections of the SRO to ensure it complies with the Advisers Act and its rules and regulations. This oversight presumably would be similar to the process the SEC uses currently to examine and inspect FINRA and the other SROs.
The debate over the IA SRO Bill, as with the debate regarding investment adviser examination and oversight generally, is likely to be contentious. In addition, leading House Democrats have already expressed opposition to the concept of investment adviser self-regulation,3 and there currently has been no companion legislation introduced in the Senate. Media reports indicate that the House Financial Services Committee could mark-up the IA SRO Bill as early as May 2012.
*This alert was co-authored by W. Hardy Callcott, Jeffrey Himstreet and Amy Natterson Kroll.
Letter from Richard Ketchum, FINRA Chairman and CEO, to Elizabeth Murphy, SEC Secretary (Nov. 2, 2010) (avail. at http://www.finra.org/Industry/Regulation/Guidance/CommentLetters/
FINRA, Planners Slug It Out Over Adviser SRO Cost, Investment News (Apr. 26, 2012) (avail. at investmentnews.com
). The estimates released by FINRA are considerably lower than estimates previously released by the Boston Consulting Group, which estimated startup costs projected at $200 million to $255 million and an ongoing cost of $460 million to $510 million. See
Boston Consulting Group, Investment Adviser Oversight; Economic Analysis of Options (Dec. 2011) (avail. at https://www.investmentadviser.org/eweb/docs/Public/111215_BCG_IAO_Analysis.pdf
Rep. Frank (D-Mass.) was quoted as saying “I’m opposed to it.… This notion of self-regulation is inherently dubious.” See Adviser SRO Cost, supra