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News June 19, 2017 Issue

Investment Adviser Association Urges Clayton to Focus SEC on Existing and Proposed Rules

The Investment Adviser Association wants to point Jay Clayton in the right direction as he begins to settle in to his new role as SEC chairman. That direction includes revisiting a number of existing agency rules, including the Advertising Rule, the Custody Rule and the Pay-to-Play Rule, as well as taking a second look at some proposed rules and asset management industry issues.

It’s never too soon to let the person in charge know where you stand. Just six days after Clayton was sworn in as the agency’s new chairman on May 4, the IAA sent him a 21-page letter (released on the association’s web site early this month). The letter introduces him to the IAA, who it represents and what it does, while also providing the SEC’s new top person with a tour of the waterfront, so to speak, in terms of what the agency thinks he needs to address.

"We would like him to take a fresh look at the way some of the Rules are working and see if we can make some improvements to their effectiveness and to the efficiency of the regulatory regime," said IAA president and chief executive officer Karen Barr about the letter, which she signed.

Noting that the IAA’s 640 member firms manage more than $20 trillion in assets for a wide variety of individual and institutional clients, among them pension plans, trusts, mutual funds, private funds and more, the association urged the SEC to apply "more robust and comprehensive cost-benefit analyses to regulations, both old and new. This approach also includes consideration of alternative approaches to regulation, factoring in the complexity and cumulative effect of all regulations, and accurately assessing the economic impact of SEC regulations."

IAA recommendations

The IAA divided its letter into three parts:

  • Existing rules. The association made recommendations for reviews of a number of existing rules, as well as their economic impact on small firms. Opportunities for sophisticated investors to participate in private offerings should also be reviewed, the IAA said.
  • Proposed rules. Among the measures that the association said need to be reviewed here are proposed rules for business continuity and transition planning, derivative management and incentive-based compensation practices by very larger advisers.
  • Regulatory debates. These include a number of issues currently under debate that have yet to be resolved. Among them are the best ways to provide investment adviser oversight and examinations, and extending a fiduciary duty to broker-dealers.

Mayer Brown partner Stephanie Monaco said she would welcome recommendations that would urge the SEC to "fix the incredibly dysfunctional and ineffective Custody Rule," which the IAA letter does. She added, however, that she would also suggest that the Commission take some steps that the association did not recommend in the letter: "Bring the Books and Records Rule into the middle ages (no hope to bring the Rule into the modern age), and recommend that the SEC no longer pursue ‘broken windows’ infractions but, instead, only cases where there is retail blood on the floor."

Review of existing regulations

"This is an opportune time for the SEC to initiate retrospective reviews of certain core regulations governing investment advisers to ensure that they are effective, efficient, tailored and appropriately targeted to protecting investors and fostering capital formation," the association said. The letter broke down its recommendations as follows:

  • Impact on small businesses. "Small advisers have been significantly affected by ‘one-size-fits-all’ regulations that effectively require fixed investments in infrastructure, technology and systems relating to documentation, monitoring, operations, custody, business continuity planning, cybersecurity and more," the letter said. The IAA noted that the SEC currently defines "small business" to apply only to advisers with less than $25 million in assets under management. Since the basic threshold for SEC registration is $100 million, which ends up meaning that no SEC-registered advisers qualify as "small" for cost-benefit purposes, "even though more than 6,000 . . . employ 10 or fewer non-clerical employees." For that reason, "we recommend that the Commission amend the definitions of ‘small business’ and ‘small organization’ to utilize a more meaningful metric beyond merely AUM," the IAA said, such as by the number of a firm’s employees.
  • Advertising Rule. The existing Rule 206(4)-1, which has not been materially amended since 1961, is "unnecessarily complex, overly broad in reach, unduly prescriptive and no longer functions effectively in the real world," the association stated. Since its adoption, the IAA continued, enforcement actions and staff no-action letters have created "a complex maze," buttressed by changes within the investment advisory profession and its clients in terms of how they communicate. These changes include the use of the internet, social media and mobile devices. The IAA in particular singled out the Rule’s prohibitions on testimonials and past specific recommendations as out of date, given common uses of social media. The Rule "should be amended to make it more effective and flexible," the association said. "We suggest, at a minimum, that the specific prohibitions in the Rule not be considered per se fraudulent," something it said that the SEC staff itself has recognized through its issuance of many no-action letters. Further, the IAA noted, the general anti-fraud section of the Advisers Act and the "catch-all" provision in the Rule itself already effectively prohibit misleading advertising.
  • Custody Rule. The IAA sees the existing Rule 206(4)-2 as "overly complex, unduly burdensome" and something that "has caused unnecessary confusion for advisers." Among the problems, it said, is that "counter to a plain English understanding of the Rule’s ‘custody’ title, the Rule extends far beyond actual physical custody of client assets to include constructive or technical custody, including authority to withdraw client funds or securities, or acting in a capacity that gives the adviser legal ownership of or access to clients’ funds or securities." This has not only caused confusion, but has made it difficult to "articulate requirements for compliance . . . in a clear fashion." Instead, the IAA recommends, "the Custody Rule and the term ‘custody’ should cover only arrangements where the adviser (or related person) has actual physical custody of client assets. The Commission should then catalog situations where the adviser’s authority, access or legal status presents genuine risks to the safety of client assets and assess whether these risks are appropriately addressed by amending existing rules or drafting new rules." More specifically, the IAA called on the SEC to revisit the Custody Rule in terms of how it addresses a custodian’s holding of privately offered securities, additional exceptions for certain assets and services, and whether there are circumstances that do not warrant an annual surprise exam.
  • Pay-to-Play Rule. By the IAA’s view, the existing Rule 206(4)-5, is "unnecessarily complex, costly and burdensome and should be more narrowly tailored to its intended purpose." As examples, it noted the myriad terms that the Rule requires CCOs to parse, among them "covered associate," "contribution," "government entity," "official" and "regulated person." In addition, it said that the costs and compliance burdens imposed under the Rule "are substantial." Instead, the IAA suggested, "we urge the Commission to consider alternative approaches that are more tailored to its underlying objectives." This would have the effect, the letter said, of "materially narrowing the reach of the Pay-to-Play Rule to areas where abuse may be more likely to exist or has in fact occurred." One area in particular that the IAA singled out in this regard is the way the existing Rule imposes "draconian" penalties "for even the most minor violations or ‘foot faults.’" The Commission should consider reducing the current two-year "time out" period, ways to reduce the due diligence burdens associated with the Rule’s look-back provisions, increase the de minimis contribution exceptions, streamline the process for granting exemptive orders, and provide certain self-executing exemptions for inadvertent or minor violations, the association recommended.

Proposed rules

Existing rules were not the only rules for which the IAA offered recommendations. Several proposed regulations were discussed in the letter as well. Among them:

Business continuity and transition plans. The association said it has two "principal criticisms" of the June 2016 proposed rule (ACA Insight, 7/11/16). One is that the association does not believe it was necessary to create "an entirely new anti-fraud rule under the Advisers Act for business continuity planning" since another rule, the Compliance Program Rule (206(4)-7), provides the SEC with what it needs to address this area. The second, the IAA said, is that "we questioned whether the Commission needed to extend those business continuity concepts to transition planning." As a result, "we strongly recommend that the Commission withdraw this proposed rule and consider whether interpretive guidance and Rule 206(4)-7 that covers [business continuity plans] would be an appropriate alternative."

Derivatives management. There was some sturm und drang when the SEC proposed its Derivatives Management Rule in December 2016. While the primary goal of the rule was to modernize guidance regarding investment company use of derivatives and to prevent funds from becoming too speculative, there was reaction from the asset management industry that it went too far (ACA Insight, 12/21/15). The IAA would appear to agree. "While we supported many of the goals of the proposal, we specifically opposed the Commission’s proposed portfolio limitations," it said in the letter to Clayton. "The use of portfolio limits represents a significant change in the Commission’s approach to regulating funds’ use of derivatives, and would supersede decades of guidance – so much so that the Commission states that it would cause some currently operating funds to cease operating as registered investment companies. . . . Should the Commission determine to move forward with this rulemaking, we would urge the Commission to reconsider the imposition of portfolio limits, focusing instead on the other two parts of the proposal."

Regulatory debates

Here the IAA sought to bring Clayton up to date with where matters stand in terms of certain ongoing debates that may affect investment advisers. These include:

  • The fiduciary standard. Advisers are currently held to a fiduciary standard, while broker-dealers currently are not, being subject instead to a lower-level suitability standard. For several years and continuing today, however, there has been a movement to apply a fiduciary standard to broker-dealers, and the debate has been about how to do so, and the effect such a move might have on the fiduciary standard that advisers currently must meet. The Department of Labor’s Fiduciary Rule and related efforts to repeal it are now part of this ongoing debate. "It’s been interesting to observe the IAA’s evolving position on a fiduciary standard," said Proskauer partner Robert Plaze. Barr said that the association, prior to the passage of the Dodd-Frank Act, held the position that broker-dealers, when providing investment advice, should be subject to the Advisers Act fiduciary duty. After Dodd-Frank, however, the discussion turned to "parallel but uniform" fiduciary rules for advisers and brokers. However the debate turns out, she said, the association’s bottom-line position is that it does not want the fiduciary standard that advisers currently meet to be weakened in any way. "The IAA urges the SEC to focus its future efforts in this area on the standard of care for brokers and refrain from rulemaking with respect to the robust fiduciary principles already embodied in the Advisers Act," the association said in its letter. Plaze said he thinks the IAA’s current position is best for the advisory industry.
  • Adviser oversight and examinations. Recognizing that "the need for the SEC to increase the frequency of investment adviser examinations has been a constant theme for many years," the IAA made clear to Clayton what its preference has been: legislation that would impose user fees tied to increasing the examination coverage of advisers. Beyond that, the association said it supports SEC efforts to use existing resources in new ways, such as leveraging technology to streamline on-site examinations and enhance data analytics. What the IAA does not want, the letter made clear, is "subjecting advisers to an SRO [self-regulatory organization]," such as FINRA. Doing so, the association said, "would impose a costly and unnecessary additional layer of regulation and bureaucracy on advisers without providing a commensurate benefit to investor protection."