Compliance. It’s the buzzword of the day. Attend an industry conference, and you’ll notice that the compliance sessions are standing room only. It’s no wonder. Over the last year, the Securities & Exchange Commission has bombarded advisors with one new or proposed regulation after another. So how will advisors comply with all these SEC rules?
It won’t be easy–especially for the smaller advisory firms. The added expense and time needed to comply with new regulations are burdensome enough, but even more troubling is the fact that many small firms aren’t even sure what their specific regulatory obligations are. “It’s amazing to me–the number of advisors who aren’t even aware [of what they need to do]. The whole regulatory environment doesn’t sink in,” says Julie Allecta, a partner with the law firm Paul, Hastings, Janofsky & Walker in San Francisco, which represents Charles Schwab, the largest custodian for independent advisors, and is helping Schwab deliver compliance aids to its affiliated advisors.
In the wake of the Wall Street and mutual fund scandals, the SEC has been facing significant pressure from Congress and consumer groups to step up its regulatory oversight. So the securities watchdog has been responding by way of rulemaking and through enforcement actions. (See “Bumper Crop” sidebar on enforcements on right). Indeed, to ensure that the Commission is more proactive in catching wrongdoers, SEC Chairman William Donaldson has created a “risk assessment” initiative whereby different SEC divisions collaborate on ways to handle regulatory issues. For instance, the SEC recently created “multidivisional task forces” to decide how to handle areas of “potential concern,” such as soft-dollar arrangements, bond market transparency, 529 college savings plans, enhanced mutual fund surveillance, and enhanced SRO surveillance.
Too Much, or About Time?
Donaldson deserves accolades for revamping the way the SEC functions. But has the SEC’s newfound enthusiasm for regulation gone too far? Advisors and industry officials complain the regulator is using a one-size-fits-all approach in its attempts to regulate advisors–specifically with its proposal that all advisors appoint a chief compliance officer and adopt formal compliance procedures, including drawing up a compliance manual. “A lot of the [SEC] regs aren’t really market-specific,” says Dennis Gallant, an analyst with Cerulli Associates in Boston. The SEC rules don’t “take into account the various nuances of the investment advisory market; they’re being applied to Fidelity as well as to small providers.” Gallant thinks the onslaught of new SEC rules is putting a lot of additional time constraints on advisors who are already grappling with time management.
Some advisors and industry observers concede, however, that while complying with SEC rules will eat into their time, and their wallets, the new SEC rules may not be unreasonable.
“The whole [investment services] industry is tightening up,” says Tom Grzymala, president and CEO of Alexandria Financial Associates in Alexandria, Virginia. The NASD is pelting broker/dealers with new regulations left and right, he says, which is forcing them “to own up to their responsibility.” (See “Fly Right,” on page 80, for a look at how B/Ds are coping with their regulatory burden.) Grzymala hopes the SEC’s hypervigilance keeps advisors on the straight and narrow. “Fee-only independent advisors have yet to be called on the carpet for anything very serious. We want to keep it that way.”
Donna Skeels Cygan, a planner with Essential Financial Planning in Albuquerque, New Mexico, says that while the new SEC regs aren’t excessive, they are “very extensive and require an enormous amount of time.” For instance, she’s overwhelmed with trying to be her firm’s compliance officer “while also servicing clients, managing staff, and running the firm.” Another planner says that she’s “dramatically” increased the time devoted to complying with SEC regulations.
More Than Just Disclosure
Besides appointing a chief compliance officer and writing up compliance policies and procedures–which all advisors must do by October 5–the SEC is also contemplating new rules for advisors on e-mail retention, soft dollars, and best execution, and may require RIAs to adopt a trading code of ethics.
Rick Cortese, a VP with National Regulatory Services in Lakeville, Connecticut, says that advisors’ regulatory burden historically has been light compared to broker/dealers’. But gone are the days when advisors’ fiduciary status is enough to satisfy the SEC, he warns. “It’s not enough [for advisors] to rely on the fiduciary duty that they have and the requirement that they disclose their conflicts,” he says. Now, by asking that advisors designate a compliance officer and draw up compliance policies and procedures, the SEC is requiring “that there be some sort of compliance infrastructure going beyond just disclosure,” he says. Advisors “are going to have to get used to that.”
Small advisors may have a particularly hard time adjusting, however. Moreover, some small firms may even decide that they’re too small to take on the added compliance load, and either merge with a larger firm or throw in the towel. Compliance is just another force that’s conspiring against small advisors, says Mark Tibergien, partner-in-charge of the Securities & Insurance Niche for Moss Adams in Seattle, and an Investment Advisor columnist. “It may even be the final straw.”
Small advisory firms–those that Tibergien classifies as firms that pull in less than $1 million in revenue, or have less than $100 million in assets under management–are being forced to “redefine what critical mass is.” Tibergien says he prefers a firm’s “critical mass” be closer to $5 million in revenue. “Firms are going to have to get to a certain size in terms of revenue and clients in order to compete effectively, and to generate returns without distraction.”
Like other industries, the nascent investment advisory industry is evolving, Tibergien says. For instance, according to Moss Adams’s 2003 survey of advisors compiled for the Financial Planning Association, 40% of the advisors surveyed outsource their compliance monitoring. “So one way advisors are dealing with [compliance] is on a variable cost basis through outsourcing,” Tibergien notes.
Tibergien says the firms that are having the most problems with compliance and other regulatory issues are those that are “too big or too small.” The smaller firms feel they cannot “afford the cost of compliance, E&O insurance, and management.” The larger firms have to be more vigilant about compliance, since their larger size makes them a bigger target for the SEC.
Not being able to comply with new regulations could result in small firms having to merge with larger ones. “Merger discussions have been happening more actively in the last two years,” Tibergien says. Allecta, the attorney with Charles Schwab’s law firm, agrees, and says the SEC regs “are another barrier to entry,” and “may encourage some [advisors] to retire early.” She adds that the regs “shouldn’t put the small advisors out of business, but [they] will add to their costs.” The rules “will also create more formality [in the way advisors have to conduct their businesses].”
Gallant of Cerulli Associates says one bright spot is that “the regulatory environment is favoring fee-based advisors because it’s putting a spotlight on the various means of compensation.” On the flip side, he says, more regulation “is going to burden everybody with work.” The big question, he says, is whether in the final analysis, “this additional layer of work is really going to benefit the market and consumers.”
How Big a Burden?
There are differing opinions as to how burdensome the compliance officer rule will be for advisors. For instance, Thomas Giachetti, a partner with the law firm of Stark & Stark in Princeton, New Jersey, says most advisory firms already have had a chief compliance officer for years. “They just haven’t called him the chief compliance officer,” he says. “There is now going to be a title. I don’t see this as a major change to any SEC advisor’s operations.”
Mike Leonetti, CEO of Leonetti & Associates, Inc. in Buffalo Grove, Illinois, runs one of those rare firms that has had a compliance officer for some time–since 1997. Leonetti’s reason for hiring a full-time compliance person back then was twofold: the growth in his overall practice and the complexity of his clients’ accounts. “I could see our firm was starting to grow–especially in asset value as the markets took off; we had really good years in 1997-’98-’99.” Leonetti–whose firm manages about $270 million, has 20 people on staff, including nine CFPs, and serves more than 400 clients–thinks of compliance as a “safety valve,” and proudly points out that he hasn’t had to face a lawsuit or an arbitration hearing in 22 years of business.