Inadequate examinations of advisors is a real problem, but it is hard to imagine a less efficient or less fair way to solve it than the proposal in a recent House bill.
Last month, House Financial Services Committee Chairman Spencer Bachus proposed legislation to create a self-regulatory organization for investment advisors ("IA-SRO"). He presented the bill as the solution to the underfunded Securities and Exchange Commission's record of examining advisors only once every 11 years. "That lack of oversight, particularly in the aftermath of the Madoff scandal," Bachus stated, "is unacceptable."
The problem is that Madoff and others like him would not have had to register with the new IA-SRO. It will not have jurisdiction over advisors like Madoff with institutional or high net worth clients. In fact, the bill exempts so many advisors that the IA-SRO would examine only a small fraction of SEC-regulated advisors. The overwhelming majority of managed assets would continue to be examined by the SEC while providing no additional funding to improve upon its 11-year cycle. The SEC's program may deteriorate even further with the recent addition of hedge funds to the ranks of registered advisors. At the same time, the bill would impose a tax on small advisory businesses and, indirectly, the mainstream investors they advise, from which large advisors and their high net worth clients would be exempt.
Inadequate examinations of advisors is a real problem, but it is hard to imagine a less efficient or less fair way to solve it.
A Madoff Solution That Would Not Have Covered Madoff
Using Madoff to sell the IA-SRO is a well-worn tactic. When the Madoff scandal broke, the SRO for broker-dealers, FINRA, misleadingly cast the Madoff fiasco as a failure of investment advisor regulation. However, as discussed before, Madoff was regulated as a broker-dealer for almost the entire period of his fraud. FINRA was primarily responsible for examining Madoff. He did not become an investment advisor subject to SEC advisor examinations until 2006.
Nonetheless, when Madoff popped up on the SEC's investment advisor rolls with $17 billion under management, he should have been examined immediately. The Madoff scandal reflects both a failure of self-regulatory oversight and of the SEC's examination program. Chairman Bachus is correct that increasing advisor examinations would help detect and deter future Madoffs.
But special interest carve-outs from the proposed IA-SRO's jurisdiction would leave future Madoffs still subject only to the SEC's anemic examination cycle. The bill exempts advisors from IA-SRO regulation if at least 90% of their assets are attributable to institutional and high net worth clients. Madoff's client list shows that he would easily have satisfied this test.
Just as the custody rules adopted by the SEC in response to the Madoff scandal would not apply to a Madoff today, the bill proposed by Chairman Bachus would not subject a future Madoff to more examinations. In the political marketplace, however, Madoff can be used to sell anything.
A New Tax on Small Businesses and Mainstream Investors
In this case, the price of the Madoff solution for small advisors and mainstream investors will be punitive. Currently, taxpayers pick up the bill for the regulation of advisors, although the fees collected by the SEC and contributed to the general treasury must match Congress' annual allocation to the agency. So small and large investors alike could be said to pay for the costs of securities regulation, including examinations of advisors, through the payment of various SEC fees.