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Regulation and Compliance > Federal Regulation > SEC

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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.

It surely makes sense to require the RIA to disclose whether his services are tailored to the client’s individual needs, or whether restrictions may be imposed on individual investments. But let’s return to risk disclosures. Should specialized advisors have to make additional risk disclosures? The SEC suggests that these advisors should. The clear implication is that a specialized advisor–an RIA who holds himself out to the public as a financial planner, for instance, even if he is not a CFP–poses a greater risk to the client than an advisor who isn’t specialized. But is this necessarily true? If not, then it is misleading. Once again, neither client nor advisor benefits. The SEC could lend guidance here by refining which kinds of specialized services warrant additional risk disclosures.

The Cost of Doing Business

“Specialized service” invariably gives rise to another related issue: commissions and fees. Fee schedules are anything but uniform on a national or regional basis. There can be as many different fee schedules as there are different kinds or categories of clients. Clearly, it is a matter of justice to require fair disclosure of your fee schedule to your clients. But it is doubtful that justice requires you to effectively disclose your fee schedule to your competitors. Yet if the SEC implements these proposed rule changes, the electronic IARD could become a medium for broadcasting your fee schedule to the world on a daily basis. A fee that is negotiated, in contrast to a “shelf” fee schedule, is usually considered to be proprietary information; thus, all the more reason not to put it in the public domain. If the SEC decides to finalize its proposed rules changes to Form ADV, shouldn’t the SEC decline to require “negotiated” (and other) fee schedules to be electronically entered into the IARD?

And then there is the question of how fees should be disclosed. There is the advisory fee and then there are costs–the custodian fees, brokerage commissions, mutual fund expenses, and related additional costs. Should an RIA’s “fees” be stated in a single specified amount that encompasses both advisory fees as well as costs in excess of advisory fees? What about allowing the RIA to provide ranges, as opposed to specified amounts? And what if the RIA doesn’t know exactly what these fees are or will be at the point of establishing a relationship with a client or at another future date?

Consider the analogy of an attorney trucking down to the courthouse to file a deed only to find that the tax assessment ratios changed since he filed a deed last month, increasing the amount of real estate transfer taxes he should have quoted to the client. While the attorney may cover the difference at the time of filing, surely every reasonable person expects the client to reimburse the attorney. The lawyer’s client is not entitled to a windfall over an expense that the lawyer has no control over. Why should an advisory client enjoy a greater advantage just because a cost or expense changed since the RIA filed his ADV? The real issue here is how to effectively manage fair disclosure with things that can change at a moment’s notice, keeping in mind that the ultimate purpose of the IARD should be to establish and maintain trust between the advisor and his client.

Sometimes it simply benefits everyone, professional and client alike, to provide nothing more than a general statement describing these non-advisory costs and expenses without getting into express dollar amounts or even ranges that the clients will have to incur when receiving advisory services. Once more, clarity rather than ambiguity in guidance from the SEC greatly serves the client and his advisor.

A Matter of Discipline

The SEC has sought comment from RIAs about how to report disciplinary history, asking whether this information should appear in a separate written document apart from the brochure. Obviously, this serves the regulator’s cause of making this information appear significant when the client sees it. It therefore comes as no surprise that most commentators urge the SEC to make disciplinary hearing reporting part of the Part II brochure.

But maybe the more significant issue is what kinds of arbitration liability should be included. The SEC proposes that the RIA disclose “all material facts about any legal or disciplinary event” about the firm or its “management person.” Advisors know this, and in theory, it seems simple. In practice, however, it is more complicated. For instance, would the RIA be in compliance if the disciplinary information he provides is a summary, rather than a play-by-play of the details? That is, can the advisor leave out of the brochure any information that must be included in a Disciplinary Reporting Page (DRP)?

In addition, what is “material”? The clear area is SRO [self-regulatory organization] disciplinary events that touch on market conduct violations and other violations of the securities laws. Clearly, felony convictions are material. The more difficult question is: What about investment-related criminal proceedings that are only pending? Should presumption of innocence be given its full due here? And should the appeal process following conviction be considered “pending”? Acquittals are great for feelings of personal vindication, but how does the RIA undo the long-term harm done to his practice during the period of time that the pending proceedings appeared on his ADV? The adage about being unable to unring a bell once it’s rung applies here.

Should an advisory firm be allowed to remove disciplinary information for advisory associates who are no longer associated with the firm? If the disciplinary information relates to “suitability” issues (where advisor supervision and oversight policies and procedures contributed to the infraction), the answer seems obvious. But if, for example, the associate’s disciplinary information relates to a “selling away” issue (where associate was acting as a maverick and successfully concealed his activity from the firm), should the RIA be required to report disciplinary action that comes to light after the associate has left the firm? Conventional consensus seems to favor inclusion. But doesn’t this force the advisor to take on liability for information that his employee has done everything in his power to withhold?

Should awards of arbitrators be included? Clearly, SRO decisions dealing with market conduct issues present an obvious need to disclose. But, then again, not all arbitration awards are evidence of wrongdoing. If wrongdoing on the part of the RIA was never an issue in this particular arbitration, then does the arbitration award speak to the advisor’s integrity? There is another important fact to consider: The securities industry does not require arbitrators to publish their findings. Only the award (the equivalent of a verdict or a judgment) is generally published. Without the rationale behind the decision, it is not so easy and indeed may not be possible at all to glean from the arbitrator’s award whether the decision reflects adversely on the integrity of the advisor.

Consider this claim brought by a customer. The client instructs his advisor that he wants to “chase” a particular stock in a buy limit order trade. After “chasing” this stock for a while as the stock continued to move upwards, the frustrated client calls his advisor and says, “I no longer want to chase this stock.” Later, the stock drops through the last limit order price that the client instructed. The stock is bought in–except now, the stock continues to dive instead of rebounding as the client expected. The client now looks for an avenue to recapture from the professional what he lost in the market. The client now says, “When I said I no longer wanted to chase the stock, I meant for you, my advisor, to cancel the buy limit order.” Whatever outcome arbitrators might reach in this kind of dispute, there is surely no wrongdoing that implicates the integrity of the RIA.

But should the RIA be required to report this kind of incident? Is it the customer’s complaint alone that should trigger the requirement to disclose? Is only the outcome of the decision (the award) of the arbitrators what should dictate the need to disclose–”yes” if favorable to the customer, “no” if favorable to the RIA? If the RIA is required to disclose an arbitration award even when it favors him, should the RIA then be allowed to fully explain the case in his IARD brochure in order to “defend his integrity”? If the RIA does so, will he then tread into “no man’s land” where there is too much detail that overwhelms the already overwhelmed client?

Of course, there are many other issues and questions, such as disclosing conflicts of interest, that remain to be resolved; certainly it is hoped that Chairman Pitt will address these as soon as possible. Until then, investment advisors join their colleagues in the securities industry in welcoming Mr. Pitt back to the SEC.


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