In the 13 years Beach Financial Advisory Service was registered with the Virginia Division of Securities and Retail Franchising, the RIA was audited five times. Beach Financial's principal Ron Pearson says the state examinations were professional and fair. The audits became a regular occurrence with a visit from state examiners every three years. Then in 2007 Pearson's RIA grew in assets and exceeded the $25 million mark. So, as required, Pearson registered his firm with the Securities and Exchange Commission. Since then, Beach Financial Advisory has not been audited.
To be fair, it's only been three years. But it's not uncommon for a registered investment advisor to go a lot longer without being examined by the SEC. In fact, the SEC examines about 9 percent of the 11,000 or so advisory firms under its jurisdiction annually. All of that is about to change with a little help from regulators at the state level. Under the new Wall Street reform law, about 4,000 or so RIAs will be removed from SEC oversight and redistributed among the individual states in which they are domiciled and, in some cases, in other states where they do business. That's because RIAs with less than $100 million in assets will now be regulated at the state level rather than the federal level — up from the current $25 million threshold. (RIAs in the $25 million to $100 million asset range that do business in a least 15 states will remain under SEC oversight.)
On the one hand, the move frees up the understaffed SEC to regulate just 7,000 or so RIAs instead of 11,000, about a 40 percent cut in its workload. On the other hand, those 4,000 RIAs will now be at the mercy of individual states' rules. And with little guidance on how the transition will play out, some are worried about increasing fees and regulation, and the problem of doing business in multiple states.
“In theory, it's a great idea,” says Paul Glenn, special counsel at the Investment Advisor Association, a not-for-profit organization that exclusively represents the interests of SEC-registered investment adviser firms. “There isn't much information about how this will happen logistically. Right now, the situation leaves investment advisors in that $25 million to $100 million range in bit of a quandary. It could be complex,” he says.
Passing the Buck?
There will be plenty at stake when the 4,000 firms currently registered with the SEC are transferred to state regulators. Between 2008 and 2009 the number of firms with $100 million assets or more dropped. Meanwhile, the number of firms with $25 to $100 million in assets increased by 15 percent. Firms in that range make up 38 percent of all SEC registered investment advisors — larger than any other asset range.
Most consultants, RIA regulators and investment advisors had long expected the new threshold for SEC regulation to make it into the final law because it was one of the least controversial parts of the giant legislative package. But the SEC was somewhat less supportive of the move.
“It's a significant responsibility the states are going to be taking on. There are certain individuals within the SEC and others in the industry who [were] reluctant to fully support the move. They're wondering if the states are capable of taking an influx of this degree,” says one individual who coordinates with state regulators, the SEC and RIAs.
In fact, SEC Chairman Mary Schapiro has expressed some concern over whether states will be able to handle the load of new RIAs. She has said she doesn't want to simply pass the problems onto states. And SEC Division of Investment Management Director Andrew Donohue has raised questions about whether states will have “adequate resources” to take on the additional firms.
Indeed, shrinking state budgets are a problem these days. California, which faces a budget deficit of about $20 billion, currently regulates about 1,400 (worth about $5.5 trillion in assets) of all SEC registered investment advisory firms. New York oversees more than 1,500 RIAs with $7.7 trillion in assets, according to the IAA and National Regulatory Services (NRS), a compliance consultant in Lakeville, Conn. Perhaps most concerning is that 934, or nearly 25 percent, of the 4,000 RIAs that will no longer be registered with the SEC will be disbursed between the two states, according to the NRS. Specifically, California is expected to be the largest recipient with 597 former SEC registered RIAs joining the state. New York will take on the next largest number of RIAs with 337 firms jumping over.
To address the matter, some states are considering increasing the fees levied on RIAs and the investment advisors that run them, says John Gebauer, managing director at NRS. California, for example, is weighing a $25 annual renewal fee. But whether such fees will be enough to cover the expenses of increased oversight is another matter. “I find it hard to believe those extra fees here and there will create enough new revenue to pay for the additional regulation of the new firms,” says Gebauer. According to NRS data, RIA registration fees across the country range from as little as $50 (Hawaii) to $400 (Illinois and Wisconsin).
Although such costs seem minor, some RIA principals say they can add up if your firm does business in multiple states (but fewer than 15, since that puts you back under SEC oversight). Gebauer says there hasn't been any cost assessment by officials just yet. Today, the cost of getting registered in the five states most populated with RIAs totals just $1,100. But while transitioning might not end up being too costly, the actual process could be time-consuming. “Individual states require different documentation up front — some more than others,” says Gebauer. “Some states require firms to submit their policies and procedures. The SEC doesn't, so that's something firms will have to come up with.” The SEC generally reviews Part I of Form ADV at the start. And though it does require that RIAs have such documents as client agreements and written supervisory codes (which are included in Part II of Form ADV), they usually aren't checked until the SEC examination, which might not happen for several years or ever. Registration at the state level requires that RIAs present both Parts I and II.
One current differentiator among states that consultants repeatedly pointed out is the Texas Securities Board's rules about investment advisor registration. RIAs with at least one client in the state of Texas must also have an investment advisor registered with the state. Most states, New York included, do not require individual IAs to be registered. Janaya Moscony, a former SEC regulator and now president and founder of SEC Compliance Consultants, says, “If you're doing business in multiple states, you'll have to learn all other rules like this.” She adds, “Right now, state regulators' rules are somewhat of a hodgepodge. But if the [SEC oversight threshold is raised] then there will likely be more discussion about making the rules more consistent.”
Further, state registration means the RIAs will no longer be able to say they're registered with the SEC — a matter of credibility for some RIAs. “For some advisors, [SEC registration] is a selling point. It shouldn't be because the registration doesn't mean much in terms of qualification but many advisors put it on business cards or letterheads,” Glenn says. Pearson, of Beach Financial, says some principals feel like they are being downgraded. “They feel like their egos are being knocked down because they're now registered at the state level,” he says. Investors buy into the idea, too, says Moscony.
The State Approach
The North American Securities Administrators Association (NASAA), a group that represents the interests of all 50 state regulators, doesn't buy the downgrade concerns one bit. NASAA was fully in favor of increasing the SEC oversight threshold to $100 million. Not only is it willing to take on the 4,000 RIAs coming in from the SEC. It also feels it can do a much better job than the SEC has done. “When examinations are conducted, the SEC has demonstrated a lack of understanding as to the business of these registrants,” NASAA President and Texas Securities Commissioner Denise Voigt Crawford said in Oct. 6, 2009, testimony before the House Financial Services Committee. “An ‘oversight gap’ exists,” she said.
“The SEC has reported that there are 3,000 SEC-registered RIA firms that have never been examined. Somebody's got to do that work,” Crawford said at a June 15 conference call. She added, “We can't do any worse than the SEC because the SEC is not examining these 3,000 firms. If we get the jurisdiction, anything we do will be an improvement in this area. The SEC has also said they're going to focus on the large investment advisors and money managers. The SEC is absolutely better suited to do that.”
According to the SEC and the NASAA, state regulators examine approximately 30 percent of their firms annually while the SEC gets to just 9 percent. And the smallest firms at the SEC can expect to get examined once every five to 14 years (or never, as with the 3,000 firms that have never had an examination). Patricia Struck, head of Wisconsin's Department of Financial Institutions, says RIA candidates at the state level are scrutinized at the onset. “There is a significant amount of due diligence in the registration process right up-front. Plus, new registrants can expect to be examined within the first six months of operation,” she says.
But Struck feels the transition from SEC to state regulation will not be as difficult as some pretend. “It's easy to overstate the burden it will be to firms,'' she says. SEC-registered RIAs are already required to notice file with each state where they maintain a place of business or if the firm has more than five investment advisory clients. (Some states, Texas for example, require firms to notice file if there is just one client.)
Carl von dem Bussche, president of a Palm Harbor, Fla-based RIA with $75 million in assets, doesn't think the change will cause much of a problem for him. His firm, Financial Guidance Group, has been audited by the SEC every five years. Each audit lasted seven to eight days where von dem Bussche had to shut down the firm. “I can't see how any state exam could be worse than that,” he says.
Skip Schweiss, managing director of corporate services for TD Ameritrade, says he's heard no concern from RIAs that custody through the company. “We have about 4,000 RIAs. The change in threshold is going to affect a substantial number of them. They are prepared to accept it,” he says. Peter Mangan, president and chief executive at Shareholders Service Group in San Diego, Calif., says, “It doesn't take an extraordinary amount of effort to register with a state.” About 90 percent of the 600 or so RIAs who custody with Shareholders have less than $100 million in assets.
To help state regulators do their jobs more effectively, NASAA has set up an agreement among its members that allows members to assist one another if necessary. The so-called Memorandum of Understanding states, “In recognition of these mutual interests, to protect the investing public, and to further enhance state effectiveness … NASAA members agree to consult with each other for the purpose of ensuring that examination resources are augmented, when necessary, with the assistance of sister states.” At press time, 44 states had signed the memorandum with Massachusetts, South Dakota, Michigan, New Jersey, Hawaii and Florida yet to join.
Struck says the states have a more cooperative and flexible system in place to manage the RIA upsurge. “At the end of the day, states have the best handle on the advisors in their own state. The SEC will be able to focus on larger RIAs while state regulators can continue to do what they do best — focus on smaller firms within their borders,” Struck says.