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News April 30, 2018 Issue

SEC Seeks Comments on Adviser Licensing and CE, Account Statements, Finances

Will investment adviser employees in the not-too-distant future need to be federally licensed and seek continuing education credits, required to provide account statements to clients, and meet new "financial responsibility" measures? It’s quite possible, given that the Commission this month requested comments on these specific subjects.

The request for comments, attached to a proposed SEC standard of conduct intepretation for advisers, was part of a larger proposed package approved by the Commission April 18. That package included proposals to create a best interest rule for broker-dealers, require advisers and broker-dealers to provide clients with summaries of their services that do not run more than four pages, and limit the use of the word "adviser" or "advisor" to only SEC-registered entities.

All these proposals are significant and are expected to generate significant comments. The Commission’s request for comments on future areas of regulation for advisers, however, may generate particular interest among advisory firms and their representatives, given that the case has been made that current advisory firm rules and regulations appear to be working well.

Potential dangers

"If pursued, these potential requirements – licensing and continuing education, delivery of account statements irrespective of custody, and the imposition of capital requirements on advisers – could substantially increase costs and perhaps run some smaller advisers out of business," said Willkie Farr partner and former SEC deputy chief of staff James Burns. "More fundamentally, they would further diminish some of the functional differences between investment advisers and broker-dealers, and erode some of the remaining state law prerogatives around regulation of adviser personnel."

"Capital requirements are not necessary for investment advisers," said Investment Adviser Association president and chief executive officer Karen Barr. "We do not hold assets, we act as agents for our clients." As for account statements, she noted that delivery of these from advisers to clients "is already a widespread practice. This seems to be a solution in search of a problem." The request for comments in terms of licensing and continuing education "leaves me a bit puzzled," Barr said. "The Commission didn’t say what the education would be about and the issues involved. Many of our members’ personnel are already licensed at the state level."

The Commission justified its potential regulation of advisory firms in these new areas with Section 913 of the Dodd-Frank Act and the agency’s own subsequent 913 Study, in which the staff suggested several areas for "potential harmonization" of broker-dealer and investment adviser regulation.

"We have identified a few discrete areas where the current broker-dealer framework provides investor protections that may not have counterparts in the investment adviser context, and request comment in those areas," the SEC said. It added that it "intends to consider these comments in connection with any future proposed rules or other proposed regulatory actions with respect to these matters." The comment period will last 90 days from publication of the proposal in the Federal Register.

While harmonization may be the concept that brought about this request for comments, it should also be remembered that advisers and broker-dealers are different, said Shearman & Sterling partner Nathan Greene. "Broker-dealers are more direct dealers in the financial markets, often acting on their own and routinely taking custody of client funds."

He also suggested ways in which adoption of new requirements may be problematic. "The most obvious risk would be intervening without good cause in what is already a well-functioning market." For example, he said, the financial resources and efforts necessary to comply with new requirements involving licensing, continuing education, providing account statements, and financial responsibility measures "may prevent new small firms from entering the market. These kinds of changes, if adopted, may prove to be a drag on innovation and a drag on choice." That’s fine if warranted, but troubling if not, Greene said.

Following is a breakdown of what the SEC wants to learn from public comments in regard to federal licensing and continuing education, provision of account statements, and financial responsibility.

Federal licensing and continuing education

Federal securities laws do not currently require investment adviser representatives to be licensed or meet qualification requirements, as they do broker-dealers. Most states do require registration, licensing or qualification requirements for adviser reps that have a place of business in their state, whether the adviser is registered with the Commission or the state, according to the SEC. The state qualification requirements typically mandate that the adviser reps register and pass certain securities exams or hold certain designations.

"The staff recommended in the 913 Study that the Commission consider requiring investment adviser representatives to be subject to federal continuing education and licensing requirements," the agency said.

Now, with the Commission’s approval of the adviser interpretation proposal, "we request comment on whether there should be federal licensing and continuing education requirements for SEC-registered investment advisers," the SEC said. "Such requirements could be designed to address minimum and ongoing competency requirements for the personnel of SEC-registered advisers."

Questions for which the SEC is seeking comment in this area are listed below. Those in like areas are grouped together.

  • Should investment adviser representatives be subject to federal continuing education and licensing requirements?
  • Which advisory personnel should be included in these requirements? Should persons whose functions are solely clerical or ministerial be excluded, as they are in FINRA? Should a subset of registered investment adviser personnel (such as supervised persons, individuals for whom an adviser must deliver a Form ADV brochure supplement, or "investment adviser representatives" as defined in the Advisers Act) be required to comply with such requirements?
  • How should the continuing education requirement be structured? How frequent should the certification be? How many hours of education should be required? Who should determine what qualifies as an authorized continuing education class?
  • If continuing education requirements are a part of any licensing requirements, should specific topics or types of training be required? For instance, the Commission asked should there be required training on topics like ethics or the firm’s compliance program?
  • What would the expected benefits of continued education and licensing be?
  • What would the expected costs of continuing education and licensing be?
  • What would the effects of continuing education and licensing be for investment adviser employees in the market for investment advice, for instance, as compared to broker-dealers?

Provision of account statements

The Commission, in the request for comments section of its proposal, said that although it understands that many advisers already provide clients with account statements, advisers "are not directly required" to do so under the federal securities laws. Broker-dealers, it said, "generally must provide account statements no less than once every calendar quarter."

"We believe that delivery of periodic account statements, if they specified the dollar amounts of fees and expenses, would allow clients to readily see and understand the fees and expenses they pay for an adviser’s services," the SEC said. "Clients would receive account statements close in time to the assessment of periodic account fees, which could be an effective way for clients to understand and evaluate the cost of the services they are receiving from their advisers."

With these concerns in mind, the Commission requested comment "on whether we should propose rules to require registered investment advisers to provide account statements, either directly or via the client’s custodian." It said it would seek comments regardless of whether the adviser is deemed to have custody of client assets under Rule 206(4)-2, the Custody Rule, or is a sponsor of a managed account program relying on the safe harbor in Investment Company Act Rule 3a-4.

Among the specific questions in regard to the provision of account statements that it would like comment on are:

  • To what extent do retail clients of registered investment advisers already receive account statements? To what extent do those account statements specify the dollar amounts charged for advisory fees and other fees and expenses? Would retail clients benefit from a requirement that they receive account statements from registered investment advisers?
  • What information, in addition to fees and expenses, would be most useful for retail clients to receive in account statements? Should any requirement to provide account statements have prescriptive requirements as to presentations, content and delivery? Should they resemble the account statements required to be provided by broker-dealers, under NASD Rule 2340 with the addition of fee disclosure?
  • How often should clients receive account statements?
  • How costly would it be to provide account statements? Does that cost depend on how those account statements could be delivered (e.g., via U.S. mail, electronic delivery, notice and access)? Are there any other factors that would impact cost?

Financial responsibility

Again comparing adviser requirements to broker-dealer requirements, the Commission noted that "broker-dealers are subject to a comprehensive financial responsibility program," and that they are "required to maintain minimum levels of net capital designed to ensure that a broker-dealer under financial stress has sufficient liquid assets to satisfy all non-subordinated liabilities without the need for a formal liquidation proceeding."

While advisers with custody typically have to maintain client assets with a qualified custodian and meet specific custody requirements in regard to those assets, SEC-registered advisers "are not subject to any net capital requirements comparable to those applicable to broker-dealers," the SEC said, "although they must disclose any material financial condition that impairs their ability to provide services to their clients."

Further, the agency said, "many investment advisers have relatively small amounts of capital, particularly compared to the amount of assets that they have under management. When we discover a serious fraud by an adviser, often the assets of the adviser are insufficient to compensate clients for their loss." The Commission also noted that advisers, "unlike many other financial service providers that have access to client assets," are not required to obtain fidelity bonds.

These disparities, the SEC said, lead it to "request comment on whether SEC-registered investment advisers should be subject to financial responsibility requirements along the lines of those that apply to broker-dealers." Specifically, the Commission said it would like comments on a number of questions, including the following:

  • What is the frequency and severity of client losses due to investment advisers’ inability to satisfy a judgment or otherwise compensate a client for losses due to the investment adviser’s wrongdoing?
  • Should investment advisers be subject to net capital or other financial responsibility requirements in order to ensure they can meet their obligations, including compensation for clients if the adviser becomes insolvent or advisory personnel misappropriate clients’ assets? Do the Custody Rule and other rules under the Advisers Act adequately address the potential for misappropriation of client assets and other financial responsibility concerns for advisers? Should investment advisers be subject to an annual audit requirement?
  • Should advisers be required to obtain a fidelity bond from an insurance company? If so, should some advisers be excluded from this requirement?
  • What would be the expected cost of either maintaining some form of reserve capital or purchasing a fidelity bond?