On August 3, a former staff attorney for the Office of General Counsel in the U.S. Securities and Exchange Commission came back to the place where he was first employed after graduation from St. John’s Law School in 1968. In the intervening years, he had represented the New York Stock Exchange, Big Five accounting firms, and various Wall Street trade groups. Now, after taking the official oath of office, Harvey L. Pitt came to take the helm of the SEC.
“There are several goals I would pursue, if I am confirmed and become the next SEC Chair,” Pitt testified during his confirmation hearing on July 25 before the Senate Banking Committee. There were three goals: 1) “vigilant enforcement of sound rules that protect all investors against fraudulent, deceptive, and manipulative misconduct”; 2) to “focus on the agency’s mission to nurture a climate that is conducive to, and encourages, the creation of capital”; 3) to “lead a review of the requirements [the SEC] administers, and the regulations it imposes, to be certain they are sound, reasonable, cost-effective, and promote competition.”
The devil, of course, is in the details. Which securities rules will be first on that list of SEC regulations that, in the opinion of Mr. Pitt, are antiquated and “reflect a time, and a state of technology, light-years away from what we now confront daily”? It will be a little while before we know for certain. In the meantime, Wall Street’s choice for priority review is relatively easy to predict. They’d like to see Regulation F-D (fair disclosure) revisited soon. The “independence of stock analysts” is probably another Wall Street top pick for the SEC to jettison.
But what about the financial planner? What issues would the small registered investment advisor like to see Pitt give his attention to first?
Plain as Mud
How about starting with improved SEC guidance for completing Form ADV? Especially burdensome is Part II of Form ADV dealing with the “brochure rule.” Part II is a written disclosure statement or a written brochure that provides information about the RIA’s business practices, fees, and conflicts of interest with his or her clients. At present, Part II must be completed in paper format because, according to the SEC, the Investment Adviser Registration Depository (IARD) cannot accept an electronic filing of Part II at this time. Closer to the heart of the matter is the fact that the comment letters–many, if not most of them, being negative–have been voluminous. Thus the SEC has decided to defer adopting its proposed changes to Part II of the ADV. While we await a final rule on the proposed changes, advisors are still required to steer like Ulysses between Scylla and Charybdis when completing the form.
The SEC proposed in April 2000 that RIAs be required to replace the current ADV Part II “check-the-box” format with a new narrative brochure in “plain English.” The SEC proposed that this “plain English” brochure be “more detailed than Form ADV currently requires,” and be filed with the SEC. The SEC stated that “drafting a brochure to describe the advisor’s business practices and disclose conflicts of interest need not be a long or expensive process.”
But in lieu of having the SEC pre-approve his “plain English” brochure, how is the RIA to know whether the required detail he discloses is too long or too short? Figuring out the cost to the advisor of this “plain English” brochure process is a little easier; undoubtedly the advisor’s attorney will be more than happy to send him a hefty bill. In short, the advisor continues to think to himself, “There’s got to be a better way,” and hopes that it comes soon.
But whether the SEC decides to stay with the old check-the-box format or move over to the new “plain English” narrative format, the fundamental problem for the advisor remains unchanged. The RIA needs to communicate meaningful information about his practice that benefits him as well as his client. A brochure that has too much detailed information or one that is too long and complicated only overwhelms a client who is likely to be already overwhelmed with information. In this situation, a client (and equally important, the prospective client) is likely to be discouraged from looking at, let alone carefully reviewing, the brochure. This result does nothing to benefit the client. It certainly doesn’t benefit the RIA looking for the client to assess him fairly and choose him as advisor based on the brochure in question. And it also doesn’t benefit the SEC in its mission to protect investors against manipulative conduct while nurturing the creation of capital.
Clearing the Air
In Part 1A, the advisor is required to calculate the number of accounts and the dollar value of the assets for which he provides continuous and regular supervisory or management services to securities portfolios. But if an advisor’s discretionary authority allows him to buy or sell “investment-related” products, such as annuities that are not securities (equity-indexed or other fixed annuities, for example), should these be included in the calculation of continuous and regular supervisory or management services? The SEC’s meaning of “securities portfolios” should be refined more here.
In a related matter, does “financial planning” include portfolio management? (According to the Financial Planning Association, approximately 42% of financial planners consider portfolio management to be an integral part of financial planning, whereas at least 50% see portfolio management as an activity that is distinct from financial planning.) Is “financial planning” part of the SEC’s understanding of portfolio management?
In Part 2A, Item 4, the advisor is required to report the amount of discretionary assets under his management. However, ambiguity is likely to arise when an advisor has authority to execute trades on behalf of the client after the client has approved all trades. Should the advisor consider this a “discretionary” account for purposes of Part 2A?
In its proposed changes to Form ADV, the SEC requires the RIA to describe (in Part 2A, Item 7) the method of analysis that he employs and the investment strategies he uses when formulating investment advice or managing assets. In a single-method analysis or strategy, the SEC would require disclosure of the specific risks involved. Disclosure of the effects of transaction costs and taxes would be required in a method or strategy that involves frequent trading of securities. At first blush, this all seems straightforward. But any given number of trades might be “frequent” to one client but “not frequent” to a different client. “Frequent trading” is a term that is relevant to the individual client and to the individual security. So what does “frequent trading” mean to the SEC? Guidance from the SEC would be very helpful here.
Related to this, how much detail is “too much” or “too little” when the RIA attempts to disclose specific risks when a client has multiple accounts? Cash balances in client accounts vary considerably according to types of accounts and trading instructions given by the client. Trading securities out of long margin and short margin accounts has risk to cash balance that is very different from trading out of cash accounts. Minimum maintenance margins for stock trades are different for trades of corporate debt, which are different from municipal bond trades, which are different from option trading. A customer instruction to effect a “good until cancelled” order poses a risk that is different from a day order. A “fill or kill” instruction poses a risk that is different from an “all or none” instruction or an “immediate or cancel” order, and these pose risks that are different from a delivery vs. payment instruction. Once more, how does the RIA give meaningful disclosure to the client without overwhelming the already overwhelmed client? Does the RIA need to address all these variations on the theme of risk in a kind of “enhanced disclosure”? Again, SEC guidance would be extremely useful here.