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Regulation and Compliance > State Regulation

Is There Really an Advisor Exam Problem?

By Melanie Waddell

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On advisor regulation, the new year has seen a continuance of the ongoing head scratching over what to do about increasing the number of SEC advisor exams. Meanwhile, there’s a growing debate about whether there is an advisor exam-deficiency dilemma at all—or that the so-called problem is just another political football.

Industry participants, regulators and lawmakers continue to toss out ideas on how to increase the number of exams—boost Securities and Exchange Commission funding (which did happen with the year-end passage by Congress of the continuing resolution omnibus spending bill), charge advisors user fees, use third-party audits or push more exams onto the states—yet no real solutions have been solidified after years of grappling over the issue (sounds a lot like the fiduciary debate).

Industry trade groups will put quite a bit of their lobbying efforts this year into trying to secure Senate support for a bipartisan bill that allows the SEC to levy user fees on advisors to help boost the number of advisors that do get examined.

California Democrat Rep. Maxine Waters attempted to get her user-fee bill, H.R. 1627, the Investment Adviser Examination Improvement Act of 2013, reintroduced by attaching it to H.R. 37, the package of 11 bills intended to roll back Dodd-Frank that passed the House in mid-January, but it was quashed by House Republicans.

It’s safe to say that the issue that perplexes the industry most is why the SEC spends half of its exam budget on broker-dealers when examining BDs is the Financial Industry Regulatory Authority’s primary job.

The obvious conclusion: SEC Chairwoman Mary Jo White believes that broker-dealers present more risks than advisors do. When House Financial Services Committee lawmakers directed her to reallocate more of the agency’s Office of Compliance Inspections and Examinations’ resources toward that endeavor, she said she’s not confident in FINRA’s ability to police BDs alone.

“If there are more advisors than there are BDs, and the BDs already have a first layer of regulation under FINRA, what is this gargantuan organization called FINRA doing?” asked Brian Hamburger, founder of the New Jersey-based Hamburger Law Firm and its affiliate, MarketCounsel, which offers RIA compliance services.

Hamburger is among a growing body of industry observers who are questioning whether there really is an advisor exam problem. Are advisor exams “just an issue that is a politically polarizing [one] … because people are scared about rogue advisors?” he wondered. If the low advisor exam rate is a “real risk, then the SEC would be acting in accordance with that risk—but they’re really not,” Hamburger said. The second biggest portion of OCIE’s budget goes to investment companies, he noted.

“I don’t think there is a major exam deficiency problem,” agreed Duane Thompson, senior policy analyst at fi360. “To confirm whether there is indeed a problem,” Thompson argued that it “might be helpful to have the Government Accountability Office undertake a facts-based review and avoid the [Bernie] Madoff histrionics that set off the whole [advisor exam] controversy.”

Looking “objectively at the last 30 years,” the advisor “exam cycle today of about 10% is not that far off the historic 11% average,” Thompson said. “So why the sudden fuss?”

What About Third-Party Exams?

Thompson suggested that the SEC may be better off considering independent third-party reviews—that is, reviews performed by “independent fiduciary analysts or compliance firms,” not self-regulatory organizations like FINRA—instead of relying on sporadic funding from Congress.

An SEC spokesperson did say that the $150 million budget increase the agency recently received would permit it to increase its exam coverage.

But the SEC continues to be “very opaque in the resources that it brings to advisor exams,” Hamburger said. Indeed, OCIE chief Andrew Bowden remains tight-lipped about exactly how he’ll use those newly allocated funds to boost advisor exams, declining to comment when I inquired recently.

Thompson believes a “significant” amount of the increase could be used to hire more examiners, albeit not the 250 the agency usually requests each year.

White did tell lawmakers that she’s directed staff to study the third-party exam concept. However, some advisory groups and compliance pros question whether the costs related to these types of audits outweigh the benefits.

Analysis by the compliance firm RIA in a Box noted that the SEC can implement a third-party compliance review program without congressional authority, giving “the SEC … a lot more flexibility in regard to creating such a program.” But such audits could prove costly for smaller advisory firms, would require the SEC to hire additional staff to oversee such audits and could open the door for an SRO like FINRA “to get directly involved with the regulation of RIA firms,” RIA in a Box said.

The States Solution

While third-party exams have resurfaced again as a viable alternative, RIA in a Box favors off-loading more advisor exams onto state securities regulators.

Under the Dodd-Frank “switch,” 2,100 RIA firms with less than $100 million in assets under management transitioned from SEC to state registration. RIA in a Box suggested that it’s time for yet another “switch,” recommending that the “vast majority” of RIA firms with $500 million or less in AUM be required to undergo state exams.

William Beatty, president of the North American Securities Administrators Association and Washington state securities director, said that both NASAA as well as the industry believe the switch “went well” and “demonstrated the efficiency of state securities regulators and their ability to effectively regulate mid-sized investment advisors.”

However, the number of advisors under state oversight “has grown since the switch” he said, “including an almost doubling of the number of mid-sized advisors.”

While Beatty said that NASAA has “consistently held that the regulation of investment advisors should continue to be the responsibility of state and federal governments,” these regulators “must be given sufficient resources to carry out this mission.”

Hamburger worries that shoveling more advisor exams onto the states is overkill in light of statements made by NASAA that just over half of states hired additional examiners after the switch. “While it may be the case that SEC examiners can be confused by some of the smaller firms and their business, the states are very inconsistent on the rules that they have in place and also the interpretation of those rules.”

Many states, he continued, “still don’t have any custody rules on the books, but they’ll tell advisors on the phone what they expect them to do in the area of custody.”

While there’s nothing wrong with RIA in a Box’s argument that more advisors should be examined by the states, “it’s hard to believe that the states could absorb another 7,200 firms.”

Added Hamburger: “All along, our big fear with state regulation is that we will create tremendous inconsistency among the states, where some states will do an admirable job and others will be asleep at the wheel.” Increasing state examiners’ workload could, he said, create jurisdictions “where advisors who want to do harm can find a safe haven and not be accountable for their actions.”

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