Close Close
Popular Financial Topics Discover relevant content from across the suite of ALM legal publications From the Industry More content from ThinkAdvisor and select sponsors Investment Advisor Issue Gallery Read digital editions of Investment Advisor Magazine Tax Facts Get clear, current, and reliable answers to pressing tax questions
Luminaries Awards

Regulation and Compliance > Federal Regulation > SEC

Tall Order

Your article was successfully shared with the contacts you provided.

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.

The most important aspect of the compliance rule, Giachetti says, is that advisors ensure they have appropriate compliance policies and procedures. “Canned policies and procedures will not work,” he says. “That’s the most important issue. The policies and procedures [manual] must reflect the advisor’s operations.” The SEC wants advisors to have policies and procedures relating to new client intake procedures, how they determine suitability for clients on the initial and subsequent investment decisions they make, their allocation of trades, and so on, he says.

Planner Skeels Cygan has already taken Giachetti’s advice. Her firm is working with a compliance legal firm to update its compliance documents. “I have chosen not to use a cookie-cutter form and to make sure the documents are all customized to my practice.” She’s so on the ball that she expects to be fully compliant within a month.

Cortese of National Regulatory Services, which sells compliance manuals and other compliance products and services to advisors, says the SEC did give advisors some wiggle room to “tailor their [compliance] programs to their businesses, the risks that they present, and the types of clients that they have.” As for having written policies and procedures, Cortese believes advisors should already have done this. “It isn’t too much to ask,” he says. “If you’re going to look at risk management and best practices, advisors should have had [written policies and procedures] already.”

In designating a chief compliance officer, firms won’t necessarily have to hire a new person, but it will mean “someone will have to be more fully dedicated to compliance, and make it a significant part of their work,” Cortese says. However, the new CCO can’t be the secretary. “It has to be someone with the requisite authority within the organization,” he says, “from either a tenure standpoint or skillset standpoint.” The CCO in most firms wears a number of hats, but the SEC will expect the CCO’s “biggest hat to be compliance,” Cortese says.

What Will It Cost?

Cerulli Associates argues in the most recent edition of The Cerulli Edge, Advisor Edition, that the cost of a chief compliance officer won’t be a big deal for firms with more than $1 billion in assets under management. But a CCO “poses a serious challenge” for retail RIA firms with $50 million or less in assets under management. Small firms may have to hire a new person to handle compliance issues, Cerulli says. The firm warns, moreover, that “the prospect of adding staff will only exacerbate the challenges of controlling compensation costs, which already account for 70% of the average retail RIA’s expenses.”

What about retaining and archiving e-mail? That’s another issue that garners mixed forecasts. Cortese with NRS says retaining e-mails “could be a real burden for all advisors,” while Giachetti with Stark & Stark asks, “What’s all the fuss about e-mails?” Electronic correspondence, Giachetti says, “has to be maintained just like any other correspondence under the books and records rule.” But deciding which e-mails must be kept, especially for small advisors, is a pain in the neck, Cortese says, because the e-mails have to be organized and screened, and then retained for five years. If advisors “don’t want the SEC to see everything, they will have to screen the e-mails on a systematic basis, separate them, and have a destruction policy where they get rid of e-mails they don’t have to keep,” Cortese says. Even though there is no formal SEC rule on e-mails, “there is some expectation [from the SEC] that advisors should do surveillance on employee e-mails, and that means implementing supervisory controls”–another pain in the neck. Cortese believes e-mail retention could potentially be “the most burdensome issue for small advisors” because of the monitoring that’s required and the software that’s needed. He argues that small advisors must decide what type of program they need to maintain and sort their e-mail, and to purge it.

The SEC has two ways to get at advisors’ e-mail. The books and records rule says that correspondence with clients that relates to investment recommendations must be preserved and maintained for five years, Cortese says. “Other types of e-mail may not fall under that definition, but if the SEC comes in to [an advisor's] shop and they have [those e-mails], the SEC has a right to look at” them. So the quandary for advisors is whether to keep all of the e-mails, or purge some.

That question has been dogging Sam Hull, a planner with Northstar Financial Planning in Bedford, New Hampshire. “We’re not quite sure which e-mails to keep,” he admits. To help with sorting e-mails, Hull says a planner that he knows set up two different e-mail addresses–one for business and another for personal use.

Cortese says the “SEC is working on interpretive guidance about e-mail retention, which would be very helpful.” An SEC spokesman says that “SEC staff is aware of [the questions that advisors have about e-mail] and is currently reviewing” the issue.

Lou Stanasolovich, president and CEO of Legend Financial Advisors in Pittsburgh, says that for his firm–which has $600 million in assets under management–compliance is “more time-consuming than expensive.” The one area of compliance that he’s been struggling with for the last three years is the SEC’s rule on best execution. “How do we actually determine what best execution is?” he asks. “I am so skeptical of that.” Pricing of trades is easy, he says, because his firm can choose which broker/dealer offers the best deal. “The problem is [determining] the speed and efficiency of trades,” he says. “And what is best execution when you’re talking about mutual funds?”

Where to Get Help

Faced with all of these SEC regulations, what are small advisors to do? One option is to ask their custodian for help. Mitch Nichter, a partner with Paul, Hastings, Janofsky & Walker, says that he expects the SEC to say to custodial firms serving advisors: “We expect you to assist [advisory firms] with their regulatory obligations.” The good news is that most custodians already do.

Schwab, Nichter says, has turned to its law firm Paul, Hastings, to create a series of free training modules and handouts on compliance issues. The idea, he says, is to tell the advisor, “Here is the subject matter you have to cover. Find out what is pertinent and what your procedure is. If it’s not written down, write it down.” The law firm is also conducting Web-based compliance seminars for advisors. Next month, TD Waterhouse Institutional will conduct a series of compliance workshops in New York City, Chicago, and Los Angeles for advisors.

Advisors can get compliance help from Fidelity through the firm’s PracticeAdvantage, which is a suite of practice management solutions providing business-building programs and third-party resources. As part of PracticeAdvantage’s risk management/compliance service, Fidelity has built relationships with a variety of independent product and service providers and consultants.

James Wangsness, senior VP and head of custody and clearing at Ameritrade, says he’s currently focusing on negotiating discounts for RIA clients on compliance services. Advisors are asking Ameritrade to provide a library of compliance information on its Web site, Wangsness says.

Most custodial firms don’t want to take on the role of being responsible for RIA compliance, as a broker/dealer would do for its representatives. “Custodians don’t want the exposure, the risk,” Wangsness says. This has prompted Ameritrade to vet RIAs extremely carefully before taking their business, he adds. If an advisor “has a mark on their U4 or CRD, they’ll have to go to [Ameritrade's] risk review committee,” which will decide whether the client will be accepted. “We vet every single advisor.” Wangsness says Ameritrade has rejected 50 advisors in the past year because of regulatory concerns.

Wangsness says that while he does not think that the new burden of regulation will prompt RIAs to move back to becoming registered reps in order to take advantage of the broker/dealer compliance umbrella, he does think that the flow of folks from the independent B/D arena to the RIA area will slow.

Compliance will continue to be a hassle for entrepreneurial advisory firms, of which there are many. In fact, NRS found that in 2003, 5,500 advisors out of a total of 7,852 firms reported assets under management between $25 million and $1 billion. The best advice for dealing with the SEC’s new fervor for regulating advisors? Get used to it. Going forward, the SEC is saying advisors must “have a culture of compliance to be in this business,” Cortese says. “If you’re not prepared to do that, it’s not the right business for you.”

Washington Bureau Chief Melanie Waddell can be reached at [email protected]. Editor James J. Green and Editorial Director William Glasgall contributed reporting for this article.


© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.