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Expect SRO For Advisers, Fiduciary Fix For Brokers

The SEC must deliver two Dodd-Frank reports to Congress by January 17 and January 21. Compliance consultants, securities lawyers and lobbyists expect the regulator to recommend an SRO for investment advisers in the first and a fiduciary standard for brokers in the second.

There is still a lot of internal wrangling at the SEC over two Dodd-Frank reports due to Congress by January 17 and January 21. The first will address whether the SEC recommends outsourcing investment adviser oversight to an industry-run group (SRO); the second will address, among other things, whether the SEC recommends extending the fiduciary standard to brokers when they provide personalized advice.

Compliance consultants, securities lawyers and lobbyists overwhelmingly agree that the SEC will recommend both. Bigger questions remain about who would take on the SRO job and what responsibilities the group would have—just examinations, or rulemaking and enforcement, too? It also remains to be seen what kind of fiduciary standard the SEC might recommend, and what other measures it will suggest to harmonize regulation of investment advisers and broker/dealers in its report.

“I think there would be a fair amount of shock and surprise if it didn’t recommend an SRO and if it didn’t recommend a fiduciary duty for brokers,” said Duane Thompson, former FPA lobbyist and now a Washington-based consultant who is collaborating with Fi360, a consulting firm focused on fiduciary issues.

John Gebauer, managing director of compliance consultant NRS, and Barbara Roper, director of investor protection at the Consumer Federation of America, agreed that an SRO recommendation is highly likely at this point, pointing to an article in Compliance Reporter’s Jan. 10 issue, which cites an unnamed SEC official. “The word is already out that the SEC is going to recommend that Congress enact legislation to create one or more SROs for investment advisers,” said Roper.

The Compliance Reporter story says SEC staff is circulating a draft report among the commissioners that recommends an SRO, without naming a specific group, to see if the commissioners will back the plan. Before a report can be sent to Congress is must be supported by a majority of the commissioenrs, but SEC Chairman Mary Schapiro, who worked at FINRA before taking over the SEC, has recused herself from that vote. That means three of the four remaining commissioners must vote in favor of it. While Commissioner Elise B. Walter publicly expressed her support for an SRO solution in speech she made last June, Commissioner Luis A. Aguilar stated opposition to outsourcing or fragmenting the SEC's examination functions in an April, 2009 speech before the Investment Adviser Association. “I don’t think anyone knows where the other two commissioners stand on it,” said David Tittsworth, executive director of the Investment Adviser Association.

If an SRO is created, many industry watchers think FINRA is the most likely candidate for the job. The broker/dealer industry group has been pretty vocal about its interest in the position. Even Tittsworth, who is an opponent of a FINRA SRO for his membership, thinks the broker/dealer regulator tops the list.

“FINRA has a leg up on everybody because they have $1 billion in the bank; offices all over the country, and technology,” said Tittsworth. “A lot of people have asked the IAA why don’t you act as the SRO? If I get the authority, I’d be happy to. I could put that organization together, but who’s going to put up the seed money on the chance that the IAA could become the SRO for investment advisers?” Another group that has been floated as a possible SRO for investment advisers is the CFP Board, and a survey of members of the Financial Planning Association (FPA) suggests they prefer it over FINRA for the job.

There is still a possibility the SEC will recommend user fees to shore up its funding instead, so it can do the job itself, said Tittsworth, Roper and others. Investment advisers have indicated they would prefer to pay fees to the SEC, rather than answer to an SRO. That preference was voiced in comment letters from the IAA (Investment Advisers Association), the AICPA (American Institute of Certified Public Accountants) and the MFA (Managed Funds Association). They and other groups argue that SROs are inherently conflicted, and that FINRA in particular would be biased in favor of its b/d membership, and against investment advisers, in examinations. The SEC report could also recommend that an SRO be created only if user fees are not approved by Congress.

But most lobbyists and consultants agree that the current Congress is unlikely to support self-funding for the SEC. Without it, the agency could have a hard time taking on the job itself. The SEC had already said it would need to hire an additional 800 staff in order to successfully implement all of the rules called for under Dodd-Frank. But following Republican wins in Congress in the fall elections, the SEC’s budget has been frozen at 2010 levels, while some legislators are calling for cutting it back to 2008 levels instead of giving the regulator the increases that were called for under Dodd-Frank.

The F Word

As for the fiduciary standard, industry observers and experts say the SEC is very likely to recommend a fiduciary standard for brokers who provide personalized financial advice. The question is whether it will be the same kind of fiduciary standard that investment advisers currently adhere to or one that is “watered down.”

Gebauer says he does not expect the study will specify what the harmonized fiduciary standard will look like. “So it could be a really long time before those rules are written.” According to the SEC calendar of Dodd-Frank implementation, it plans to propose rules “as may be appropriate” relating to the fiduciary standard (or b/d and investment adviser obligations) between April and July of this year. But it could be a long time after a rule is proposed before it is implemented.

One sticking point may be principal trading, said Roper. “I think the SEC will come up with a way to deal with principal trading that will preserve the broker/dealer model. The whole notice and consent approach is unwieldy and not that effective,” she said. In late December, the SEC extended its temporary rule on principal trading, which requires that a financial advisor get written consent every time he conducts a principal trade in an investor’s account. The rule would have expired on Dec. 31, 2010 but will now expire on Dec. 31, 2012.

Commission-based business and proprietary trading should not be hurdles, considering the language used in Dodd-Frank, says Roper. On Nov. 1, SIFMA came out with an impact study that suggested commission-based compensation would be compromised under the fiduciary standard. But many pro-fiduciary groups immediately called the results of the study into question. In fact, there is explicit language in Dodd-Frank that state that payment by commissions and sale of proprietary products will not be deemed violations of the fiduciary standard. Below is the specific Dodd-Frank language, found on page 453 of the legislation:

‘‘(1) IN GENERAL.—Notwithstanding any other provision of
this Act or the Investment Advisers Act of 1940, the Commission
may promulgate rules to provide that, with respect to
a broker or dealer, when providing personalized investment
advice about securities to a retail customer (and such other
customers as the Commission may by rule provide), the
standard of conduct for such broker or dealer with respect
to such customer shall be the same as the standard of conduct
applicable to an investment adviser under section 211 of the
Investment Advisers Act of 1940.The receipt of compensation
based on commission or other standard compensation for the
sale of securities shall not, in and of itself, be considered
a violation of such standard applied to a broker or dealer.
Nothing in this section shall require a broker or dealer or
registered representative to have a continuing duty of care
or loyalty to the customer after providing personalized investment
advice about securities.

a broker or dealer sells only proprietary or other limited range
of products, as determined by the Commission, the Commission
may by rule require that such broker or dealer provide notice
to each retail customer and obtain the consent or acknowledgment
of the customer. The sale of only proprietary or other
limited range of products by a broker or dealer shall not,
in and of itself, be considered a violation of the standard set
forth in paragraph (1).

Other issues in sections 913 of Dodd-Frank that should be addressed in the Jan. 21 report include investment adviser examinations and compensation and incentives. Today, investment advisers regulated at the federal level are not subject to a qualifying examination nor to continuing education requirements. The series 65 exam is a state requirement.

Separately, also on the 17th, the Government Accountability Office is due to issue a report that will discuss how to best regulate financial planners, as there currently is no definition under federal law of financial planner. A second report is also due on the 21st will address how information about investment advisers and brokers can be made more readily available to investors through the CRD and IARD systems, and whether additional information should be made publicly available.

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