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The New Self-Regulator for Advisors: A Taxing Affair for Small Businesses and Small Investors

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.

Mercer Bullard, 05/10/2012

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.

The Bachus bill would make small investors pay again for their regulatory costs through IA-SRO membership dues. However, large investors get a free pass because the Bachus bill exempts from IA-SRO membership any advisor that manages a mutual fund, no matter how small, or that manages assets at least 90% of which are attributable to wealthy clients, including: charitable funds, hedge funds, retirement plans, mortgage pools, investment advisors and broker-dealers, and qualified purchasers (i.e., individuals with at least $5 million in investments). The exemption is intended to eliminate political opposition from the Investment Company Institute, Managed Funds Association, and other special interest groups.

As a result, the small advisors whose clients belong to the "99 percent" will be subject to a new tax in the form of IA-SRO fees to cover their regulatory examinations. Large advisors and their "1 percent" clientele will be tax-exempt. In contrast, large broker-dealers must pay their share of dues to FINRA.

Singling out small advisors will actually increase the cost of examining them. A new IA-SRO will re-create all of the fixed costs of a rulemaking/examination/enforcement structure and spread its fixed costs over a smaller number of advisors. And these advisors will have much smaller asset bases and revenues over which to spread their already higher allocation of fixed regulatory costs. And the new IA-SRO will be more costly to operate because the bill imposes heightened cost-benefit standards on its rulemaking and special information security procedures that exceed that of any other regulatory agency, including the SEC and FINRA.

The worst punishment is reserved for the smallest of the small advisors that have less than $100 million in assets under management. These advisors register with the states, which conduct their own examinations of advisors.

The states had asked that state-registered advisors be exempt from IA-SRO regulation. After all, the impetus for the Bachus bill is the SEC's failure to conduct adequate examinations, not the state's. Nonetheless, state-registered advisors will have to join the IA-SRO. Although there is no publicly available state-by-state data on the frequency of state examinations, the North American Securities Administrators Association found that the routine examination cycle for 89% of the states is 1 to 6 years (for 68%, 3 to 5 years). In some states, more frequent examinations are needed.

The bill provides that the IA-SRO shall not conduct "periodic" examinations of state-registered advisors where the state has "adopted a plan to conduct an on-site examination of all advisors at least once every four years." And it is not clear whether adopting a "plan" requires that states actually conduct examinations every four years.

In addition, the IA-SRO will be free to conduct "for cause" examinations, which, in effect, will open the door for it to examine state-registered advisors any time it chooses. A "for cause" justification can always be found for an examination (and thereby for membership fees). It would make more sense to outsource routine examinations to the IA-SRO, and reserve "for cause" examinations to the SEC and the states.

More to the point, the smallest of the small advisors will pay once for IA-SRO oversight and then again in the form of higher registration fees that states are likely to charge to pay for their new four-year examination cycle. Or the states will ignore the four-year requirement (they have little incentive to follow it), and the smallest of the small advisors will be subject to regular examinations by two different primary regulators applying two different sets of rules.

Ultimately, it will be the 99-percent clientele that pays the higher regulatory taxes because the Bachus bill is so narrowly focused on--and only on--the small advisors willing to serve them.

Sheryl Garrett, whose Garrett Planning Network advises precisely these small advisors, sums up the likely effect of the bill as follows:

If the Bachus bill were to pass as proposed many of these small advisory firms could not afford to continue working with mass market clientele. They would go out of business, substantially increase their fees, or discontinue working with average Americans.

Adding insult to injury, the SEC will get no relief because Congress has not provided funding to cover the cost of overseeing the new IA-SRO. In 2011, the SEC spent over $100 million overseeing FINRA, and its oversight needs improvement, according to a Congressionally mandated study. The Boston Consulting Group estimates that SEC oversight of the IA-SRO will run $90 to $105 million annually--even before accounting for a bill's mandatory annual inspection of the IA-SRO by the SEC.

Let the Gaming Begin
The significant incentives to avoid IA-SRO regulation will trigger new forms of regulatory gaming. Currently, advisors have an incentive to inflate their total assets under management ("AUM") to get them over the $100 million line that is necessary to qualify to register with the SEC rather than with the states.

The Bachus bill further enhances advisors' incentive to inflate AUM that belong to their 1-percent clients in order to push those assets to the 90%-of-total-AUM threshold and thereby avoid IA-SRO regulation. The new twist is that the bill creates an incentive to under-report assets belonging to 99-percent clients in order to keep those assets under 10% of total AUM.

The term "assets under management" refers to accounts over which an advisor has discretionary authority or where the advisor assumes ongoing responsibility for making recommendations. When advisors find their 1-percent AUM hovering just under 90%, they may reduce their small-client AUM by revising contracts so that neither discretionary nor ongoing oversight is provided, or they may simply fire some of those clients outright. An advisor would be foolish to take on a small client if that meant pushing his small-client assets above the 10% limit and thereby triggering IA-SRO oversight.

Other IA-SRO-evasion strategies will include (1) advising a mutual fund (triggering an automatic exemption), or (2) joining a control group of advisors where at least one of them advises a mutual fund or the group has enough 1-percent assets to bring the group's total 1-percent assets up to the 90% threshold.

Solving the Examinations Problem
Notwithstanding the foregoing, there is a method to this madness. First, more frequent examinations of investment advisors are needed, and Chairman Bachus has created a structure that would accomplish this goal.

Second, the Bachus bill's structural focus on small advisors and their 99-percent clients partially reflects a common investor protection policy under the securities laws: The 1 percent are better able to fend for themselves and withstand major financial losses than are the 99 percent. Advisors to the 99 percent therefore should be examined more frequently.

Third, one could reasonably argue that the 99 percent should pay for, i.e., internalize the extra investor protection that they receive. This may be unfair, but that is ultimately a question of redistributional policy about which reasonable minds can disagree.

However, it is hard to imagine a less efficient way to achieve these three goals. If the goal is more examinations to protect investors, then pay the SEC to conduct them. This is the simplest, more efficient solution.

If the goal is to transfer examination costs to the investors they benefit, then collect user fees from investment advisors to be used only for examinations. This is the second most efficient solution and is even supported by the major investor advisor associations.

If the SEC is viewed as incapable of conducting examinations (which no one has argued), then authorize the outsourcing of examinations to private firms that collect fees from the advisors they examine. If privatizing examinations is offensive, then create an SRO for conducting only examinations and of all advisors, which could be FINRA or an independent IA-SRO run by advisors (see also http://www.finra.org/ and http://sroiia-us.org/).

The solution is not to create a new rulemaking and enforcement entity, thereby exacerbating the widely recognized Balkanization of standards that apply to retail financial services.

The solution is not to provide additional protection to the 99 percent only when they use advisory services directly, and provide no such protection when they use advisors through their investments in mutual funds.

The solution is not to require states to conduct on-site examinations every four years, where: (1) the most significant improvements in future examinations are likely to entail off-site monitoring using technology, and (2) SEC underfunding leaves it stuck with an inadequate examination cycle.

The solution is not to impose a tax covering the cost of examinations of small advisors and their 99-percent clients, while granting large advisors and their 1-percent clients a special interest exemption.

The solution is not this bill.

Mercer Bullard is president and founder of Fund Democracy, a mutual fund shareholder advocacy organization, an associate professor of law at the University of Mississippi School of Law, a senior adviser for financial planning firm Plancorp Inc., and a former assistant chief counsel at the Securities and Exchange Commission. He has testified frequently before Congress on regulatory issues. He can be reached at bullardm@funddemocracy.com. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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