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News July 18, 2011 Issue

GAO Study Concludes Private Fund SRO Benefits Are Questionable

It would take a lot of work, a lot of money, and may ultimately cause more problems than it solves.

Thatís hardly a ringing endorsement.

However, those were the Government Accounting Officeís conclusions in its report delivered to Congress July 11 on the feasibility of forming an SRO to oversee private funds. The reportís title said it all: "Private Fund Advisers - Although A Self-Regulatory Organization Could Supplement SEC Oversight, It Would Present Challenges And Trade-offs."

The report resulted from a study mandated by Section 416 of the Dodd-Frank Act (DFA). The GAO report concluded that while technically feasible, establishing an SRO would require among other things, further legislation, start-up capital, and agreement on fee and governance structures. The report also noted that a private fund SRO would fragment regulation among advisers and "could lead to regulatory gaps, duplication, and inconsistencies." (Just the thing the DFA sought to eradicate.)

A private fund adviser SRO could supplement SEC oversight and potentially alleviate some of the regulatorís "capacity challenges" in the oversight of advisers, said the report. However, any SRO would require its own SEC oversight, and the pool of advisers to private funds that would be subject to SRO oversight is only a "fraction of all registered investment advisers."

The report noted that of the 11,505 advisers registered on April 1 2011, 2,761 advised private funds and other types of clients. Of the 2,761 private fund advisers, only 863 exclusively advised only private funds.
As a result of other changes mandated by the DFA, the SEC estimates that approximately 750 private fund advisers are expected to register with the SEC, another 700 advisers will register with the SEC as the result of growth, and approximately 3,200 SEC-registered advisers are expected to transition to state registration. It is unclear what impact those changes would have on the number of SEC registered advisers that would be subject to any private fund SRO, versus all SEC registered advisers, said the report.

As part of the study, the GAO consulted with the SEC, SROs, other regulators, investment advisers and various market participants and observers, including securities law experts.

Industry and regulators largely oppose a private fund adviser SRO.

The report noted that all the investment funds and adviser associations the GAO spoke with "opposed forming a private fund adviser SRO, indicating that their members would not voluntarily form or join one." NASAA (North American Securities Administrators Association) officials and some industry representatives told the GAO that no basis exists for forming an SRO, and that the DFA requirement for certain private fund advisers to register with the SEC "obviates the need for an SRO for these advisers because the SEC and state securities regulators are in the best position to oversee them," said the report.

SEC already has access and authority over private fund advisers, and the expertise to oversee them.

The report observed that the DFA amended the Advisers Act to give the SEC examination authority over the records and reports of private funds advised by SEC-registered advisers. The DFA also requires private fund advisers to register with the SEC. The records and reports of private funds are now deemed to be the records and reports of the adviser, and thus available to the SEC.

The report also observed that, in the SEC study pursuant to Section 914 of the DFA regarding the need for enhanced examination and enforcement resources for investment advisers, the SEC offered user fees as a possible solution to increase its currently limited resources for adviser examinations.

SRO would require further legislation by Congress.

SEC staff and two securities law experts told GAO that legislation would be required to allow the formation of a private fund adviser SRO under the securities laws. The legislation would have to authorize the SRO to register with the SEC, and the SEC to delegate any applicable regulatory authority to the SRO.

The report observed that the adviser SRO concept is not new, and has been considered and abandoned repeatedly over the past almost 60 years. The SEC first considered creating an SRO for advisers in 1963, and sought public comment on the idea in 1983 and again in 2003. Congress introduced bills in 1989 and 1993 to authorize designating one or more SROs, without result.

Costs of forming an SRO would be significant.

None of the regulators or associations consulted could quantify an SROís start-up costs in light of many unknown variables, such as whether all private fund advisers or exclusively private fund advisers would be members, and what the scope of the SROís regulatory functions would be. However, representatives from two industry associations noted that the cost would be "considerable," and "would exceed the cost of providing resources to the SEC to conduct additional examinations of investment advisers to private funds."

FINRA and the NFA (National Futures Association) told GAO that an existing SRO could draw from existing infrastructure and "may have access to internal funds" to help finance start-up costs of a private fund adviser SRO. However, industry representatives observed to GAO that "no organization other than the SEC has experience and expertise regulating investment advisers." FINRA said an SRO may be able to leverage some of its staff and staff development programs. The industry noted that any existing SRO "would still face the challenges of hiring new staff or training existing staff to examine advisers for compliance with the Advisers Act, given that no SRO currently has such responsibility and skills."

Reaching agreement on a governance model and fees would be difficult.

Private fund advisers differ in terms of their business models, investment strategies and amounts of assets under management, said the report. According to several industry associations and firms, those differences could make it difficult to reach key agreements. For example, larger advisers paying greater fees may seek a larger allocation of seats on any board of directors. The CFTC told the GAO that consensus among private fund advisers could be complicated by their very competitive and secretive nature, and their "general unwillingness to share their data with each other."

A rules-based approach is inapt in a principles-based world.

The GAO report observed the challenges presented by imposing the rules-based governance of an SRO on the principles-driven advisory profession. The report noted specifically that fiduciary duty is not defined by rules. The fiduciary duty has been interpreted through, among other things, case law and enforcement actions depending on the facts and circumstances of specific situations, said the report. "According to SEC staff and industry representatives, adopting detailed or prescriptive rules to capture every fact and circumstance possible under the fiduciary duty would be difficult," it said, especially given the wide diversity among advisers.

NASAA officials and industry representatives also observed that such a rules-based approach could result in loopholes that would weaken the fiduciary standard.

A private fund adviser SRO would fragment adviser oversight, cause duplication of efforts, and inconsistent application of the securities laws.

Such an SRO could create regulatory gaps, said the report. Securities regulators, industry representatives, and others told GAO that an SRO focused on private fund advisers only would not be able to oversee and understand the full scope of activities of advisers with private and other clients.

Trade allocation policies of an adviser managing private funds and other clients provided an example of the gap. One industry association observed that an SRO with jurisdiction over only an adviserís private fund activities might not be able to detect trade allocation abuses involving an adviserís private fund and other clients. The SEC would remain responsible for detecting such abuses and in doing so may need to examine the adviserís private fund activity Ė duplicating the SROís efforts.

A private fund SRO could create conflicting or inconsistent interpretations of regulations, said the report. An industry association observed to GAO that it would require significant time from SEC staff to ensure the SRO and SEC staffs applied regulations consistently, "which would include written guidance on interpretations beyond what is normally done."

The report noted a private fund adviser SRO could result in duplicative examinations of investment advisers. As the report had earlier observed, many advisers with large portfolios manage assets for multiple types of clients, including private funds, and "have certain functions that serve all of their clients." Securities regulators and industry representatives alike noted that the advisersí shared functions could be examined by both a private fund adviser SRO and the SEC.

Are there any clear advantages to a private fund adviser SRO?

In a word, no, although the report did not explicitly say that. The report devoted parts of two paragraphs out of its 22 pages to the possible advantages of forming a private fund adviser SRO.

The advantages are common to any SRO, said the report, and could include the potential to free a portion of the SEC staff and resources for other purposes.

However, the SEC specifically noted to GAO that "available information suggests that a private fund adviser SRO may free little, if any, SEC staff and resources for other purposes." The pool of private fund advisers is small, and the SRO itself would require oversight. As a result, the GAO observed that the SEC may need to maintain much, if not most, of the resources it currently uses to oversee advisers.

Another SRO advantage, observed GAO, could be the ability to impose higher standards of conduct and ethical behavior on its members.

FINRA officials noted to GAO that as an SRO, it "is able to raise the standard of conduct in the industry by imposing ethical requirements beyond those that the law has established or can establish." (Isnít that the fiduciary duty under which advisers already operate?)

Without attribution or further support, the report said an SRO can provide greater industry expertise and knowledge than the SEC, "given the industryís participation in the SRO."

The GAO reported that through its membership fees, an SRO could have "scalable and stable" resources for funding oversight of its member advisers. The GAO also noted elsewhere in the report the DFA Section 914 study observing that user fees would accomplish the same goal within the SECís existing, experienced infrastructure.

The GAO noted that SEC commissioner Elise Walter stated that through self-funding, an SRO would have available the necessary resources to develop and employ technology to strengthen the examination program. Readily available resources would also provide the examination program with increased flexibility to address emerging risks associated with advisers, she told GAO, and to direct staffing and strategic responses that may help address critical areas or issues.

The GAO also noted that any advantages achieved would ultimately still cover only a fraction of SEC registered advisers. The "SEC still would have oversight responsibility for over 10,600 registered investment advisers that do not solely advise private funds," based on figures as of April 1, 2011, said the report.

The GAO said that other DFA changes will alter the ultimate number of SEC-registered advisers and the number of those advisers that advise private funds. However, the number of SEC-registered non-private fund advisers will still be disproportionately higher that SEC-registered private fund advisers.