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The NASD's Power Grab

The NASD is worried that brokers are playing a game of "regulatory arbitrage"--giving up their securities licenses to become investment advisers (IAs) and thereby sidestepping strict SRO oversight for lax adviser supervision. In response, the SRO has asked the SEC for regulatory authority over advisers (which it hasn't gotten, at least not yet).Critics of the NASD's grab for regulatory power point

The NASD is worried that brokers are playing a game of "regulatory arbitrage"--giving up their securities licenses to become investment advisers (IAs) and thereby sidestepping strict SRO oversight for lax adviser supervision. In response, the SRO has asked the SEC for regulatory authority over advisers (which it hasn't gotten, at least not yet).

Critics of the NASD's grab for regulatory power point out that federal statutes make no provision for an adviser SRO. Further, advisory firms must have supervisory procedures similar to those broker/dealers must have. And most importantly, IAs actually have a fiduciary duty to clients--a much higher legal standard than the sales practice rules stockbrokers must follow.

What adviser-related problem is the NASD trying to solve? An NASD spokesperson says fiduciary duty alone "does not provide for the supervision of activities that would enhance investor protection."

Consumer complaints don't appear to be the problem. "Litigation against IAs is miniscule," compared with cases against broker/dealers, says Paul Uhlenhope, a securities attorney at Lawrence Kamin Saunders Uhlenhope in Chicago, who works with brokerage firms and IAs. That's due, in part, to the fact that advisers do not have the temptation of transaction-based compensation, he says.

For example, churning and breakpoint concerns are eliminated with fee arrangements used by advisers. And the use of investment policy statements, advisory contracts and full-performance reporting, together with a fiduciary duty to all clients, makes IA business less prone to problems, advisers say.

SEC enforcement-action data support this claim. The agency concluded 105 enforcement cases against broker/dealers in 1997, the latest year for which numbers are available, compared with just 45 cases against investment advisers. Broker/dealers number about 5,500 versus more than 20,000 investment advisory firms.

The NASD's proposed power grab is not an attempt to get members to supervise IAs employed by broker/dealers. The NASD already requires member firms to record and supervise advisory business done by their brokers.

Some observers speculate that NASD members are worried about the competition from the growing advisory market and about losing top producers who set up their own shops. Replicating NASD rules in the adviser industry, they say, could make going independent as an adviser less attractive and stem broker defections.

The NASD, too, "has an economic stake in making sure it keeps a certain number of people under its jurisdiction," says David Tittsworth, executive director of the Investment Counsel Association of America in Washington, D.C., which represents larger advisory firms.

Adviser growth has been impressive. Fee-based adviser assets grew 36% a year from 1994 to 1996, versus just 12% growth at traditional full-service firms, according to consultant Chip Roame of The Tiburon Group in Belvedere, Calif. Roame estimates that about 1,800 new fee-based advisers went into business in 1996 (on top of an existing 15,000). That high growth probably continued in '97 and '98, he says.

Consulting firm Cerulli Associates in Boston estimates assets under management by independent advisers (20-person firms or smaller) jumped 26% in 1997 to $334 billion.

Alarms RingingSuspicious advisers are alarmed by the NASD's push for more authority. Their anxiety intensified when the SEC tapped the NASD to operate the new CRD-like IA database of SEC advisers.

In a statement last October, SEC officials took pains to assure the adviser community that by simply running the database, the NASDR would not gain regulatory power over advisers. In fact, SEC officials said it would take an act of Congress to create an SRO for advisers.

However, some brokers doing advisory business would like to see the NASD get involved. The fee-based advisory business is relatively young and has yet to see serious fallout from consumers, says one rep who does mostly fee-based business through his broker/ dealer. "Theoretically, we're supervised by the state, but there really isn't much," he says.

Both the states and the SEC, in response to the National Securities Markets Improvement Act of 1996 (NSMIA), have stepped up the pace of adviser exams.

NSMIA split the adviser universe between state and federal regulators. And since the law is just a year and a half old, "it's a little premature" to judge its effectiveness, says Robert Goss, president of the Certified Financial Planner Board of Standards in Denver, which opposes the idea of the securities industry regulating advisers. The CFP board has in the past offered to discuss becoming an SRO for planners.

Goss says the adviser industry would fight tooth and nail against letting the securities industry regulate it. The two camps, notes one securities attorney, are like "Yankees and Southerners."

Aside from the cultural differences, there is a clear legal distinction. Advisers could argue that a truly level playing field would hold brokers and dealers to a full fiduciary standard. If that argument gained influence, the NASD might think twice about its attempts to change the rules.

The word is that when NASD staff met with the SEC in spring 1998 to explore what might be done about regulating investment advisers, the SRO got a cool reception.

Nevertheless, the NASD continues to push for supervisory authority over advisers. Brokers could be giving up their Series 7s "simply to qualify for lower levels of regulatory oversight" as investment advisers, said R. Clark Hooper, an NASDR executive vice president, at an NASDR regulatory conference in November. Hooper has been spearheading the NASD's push to supervise advisers.

In a speech in September, NASD head Frank Zarb also expressed a desire to gain oversight of stock promoters acting as "advisers," and confirmed that he had asked SEC Chairman Arthur Levitt Jr. about obtaining such authority.

An NASD spokesperson says Zarb's comments "reflected the NASD's concern about the lack of supervision of activities, which results in an uneven playing field, and also reflected our belief that the issue needed to have some attention."

In a December 1997 letter and report Hooper sent to the SEC, NASDR officials claimed that securities regulation "appears to be much more comprehensive" than adviser regulation. The SRO complained that there are no explicit suitability standards for advisers; that advisers don't have to be bonded; that advisers don't need to meet standards of training, experience and competency tests; and don't have continuing education requirements.

The "regulatory gap" that exists between advisers and brokers "might encourage a 'race to the bottom' by registered representatives and brokerage firms who would prefer to be subject to lower levels of regulatory oversight," the report warned.

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