Speech by SEC Commissioner:
Remarks Before the Investment Advisers Association
by
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
Washington, D.C.
April 11, 2008
Thank you, David [Tittsworth], for that kind introduction. It is good to be back with you. I understand that the Capitol Steps were on your entertainment agenda last night, so I will not even attempt to start with a joke. I will instead start with my standard disclaimer: the views I express here are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
It seems like just yesterday that I was talking with you at your conference in Austin, Texas. Even more astounding than the speed with which the intervening year has passed is the amount that has happened in that year. We are all too keenly aware that much of what has happened is not good. The increase in the rate of home mortgage defaults, the collapse of a world-renowned eighty-five year old investment bank through a classic run on the bank, and the drying up of once deep pools of liquidity are all sober reminders that the year that has passed has had its share of difficulties. The resulting market uncertainties have undoubtedly added an unwelcome layer of complexity to your jobs.
Preoccupied as all of us are with addressing the challenges of the day, however, we cannot forget the resilience of the U.S. economy. The markets have within themselves the wherewithal not only to solve the problems that we are experiencing, but to continue the economic growth that we have enjoyed during the past six years. Investment advisors serve an important role in fostering that growth. During the past several years, I have had the opportunity to conduct investor town-halls at, among other places, military bases here and abroad. At these town-halls, I have seen first-hand that investing can be intimidating for even the bravest Americans. We all know that emotion is one of the worst influences on investing for the professional and for the individual. In times of market uncertainty, advisors play a particularly important role in helping to calm the fears of investors who may be tempted to pull all of their money out of the markets and shove it under their safe and predictable mattresses. Investment advisors can help investors to stay on course towards achieving their investment objectives through difficult market conditions. This, in turn, helps our economy to stay on course by making capital available to those who can put it to use.
Investment advisors’ business is increasingly international. You know that the U.S. economy cannot regain its momentum in isolation from the global economy. We need to keep our borders open to capital flows going in both directions — U.S. investors should not be hindered from diversifying their portfolios with investments outside the United States and foreign investors should find the door to our capital markets open. We can and should work on addressing current problems in the markets at the same time that we think about solutions to longer-term issues. We need to continue the considerable work that has been undertaken during the past two years by various groups on maintaining the competitiveness of the U.S. capital markets. Central to the issue of competitiveness is regulatory effectiveness and efficiency. Investors, ultimately, suffer the costs of lack of effectiveness and efficiency, not only through higher prices but also through constrained investment opportunities, which translate into less diversification and diminished investment performance.
And, no, competitiveness does not mean a race to the bottom, as some contend. Investors need and demand effective recourse to the rule of law and enforceability of contract. They rely on a system of integrity. By maintaining the integrity of our markets, we favorably distinguish ourselves from markets encumbered with insider dealing or lack of transparency. The SEC’s mission to maintain the integrity of our markets is based on a rather simple premise: if investors have confidence that they will be treated fairly, they will invest their money and demand a lesser premium because of a lesser risk. This should yield a lower cost of capital, according to the same principle by which the market does not demand junk bond rates from the US Treasury. In devising and implementing rules to maintain market integrity, however, we must be cognizant of the cost of those regulations. Excessively burdensome, one-size-fits-all regulatory mandates that lower returns, reduce growth, and diminish investment opportunities can drive investors out of our markets.
During the past year, the Treasury Department has been considering these issues of competitiveness, market integrity, and balanced regulation. Last week, the Department of Treasury released its long-awaited Blueprint for a Modernized Regulatory Structure. Given the multiplicity of potentially affected parties, the debate about the proposals will no doubt be an interesting one. Not surprisingly, the Blueprint has spurred Washington’s legions of defenders of existing bureaucracies into action. The Blueprint’s comprehensive consideration of the issues does a good job of setting the stage for the debate over regulatory structure. This debate will be measured in not only months, but years and decades, as the Treasury itself recognized in setting out short, medium, and long-term recommendations. Congress and the President — whether President Bush or his successor — will, of course, be responsible for making the final decisions about what changes to our regulatory structure are warranted. These decisions will not be made overnight, so there is no need for you to skip the next session to run over to the SEC store to buy an SEC-emblazoned coffee mug before the agency disappears. Anyway, even though we are unlikely to see an immediate reconstruction of the financial regulatory structure in the U.S., Treasury’s recommendations do deserve serious consideration.
One recommendation that was included in the Treasury’s Blueprint is likely to catch your attention — the expansion of the SRO model to investment advisors. The Blueprint recommends a shift to an objectives-based regulatory approach, in which regulatory authority would be allocated according to regulatory objective rather than industry segment. The Blueprint identifies three broad categories of regulation: market stability regulation, prudential financial regulation, and business conduct regulation. Treasury envisions an optimal regulatory structure in which the Federal Reserve would be the market stability regulator. A newly created Prudential Financial Regulatory Agency would oversee capital adequacy, impose investment and activity limits, and supervise risk management at institutions that enjoy government guarantees. Finally, business conduct regulation, including most current SEC and CFTC functions, would be carried out by the new, somewhat awkwardly-named Conduct of Business Regulatory Agency. At least that names rolls off the tongue a bit better than “Public Company Accounting Oversight Board.” Plus, if we coin the short-form “COBRA,” it sounds like more of a force to be reckoned with than “Peekaboo.” Because COBRA’s mandate would be broad, the Blueprint envisions an active role for SROs. Treasury “believes that self-regulation of the investment advisory industry should enhance investor protection and be more cost-effective than direct SEC regulation” and “recommends that investment advisers be subject to a self-regulatory regime similar to that of broker-dealers.”1 Those may not be welcome words for many advisors, and the IAA has spoken out against the SRO idea both before and after the Treasury’s Blueprint.
An SRO for investment advisors is not a new suggestion. In fact, the SEC asked for comment on just such an idea five years ago when it proposed the compliance rule. The compliance rule was adopted; but the SEC did not pursue the SRO model. At the time, I expressed concerns both about the SEC’s legal authority for imposing an SRO model and the possibility that an SRO model might simply impose another layer of regulation without commensurate benefits for investors. Authority issues could be addressed through new legislative authority, but concerns about duplicative regulatory obligations could be more difficult to address. I continue to have those concerns, although, frankly, the landscape has changed somewhat in the wake of FPA v. SEC.
Opponents of an SRO model argue that SEC oversight is sufficient. I guess that the least you can say is that it is reassuring to know that that at least some of the firms that we regulate are arguing in favor of SEC oversight! Of course, I recognize that much of the resistance to a regulatory change of this magnitude derives less from loyalty to the SEC than to concern that it would likely require costly adjustments by firms.
The Blueprint, in recommending an SRO for advisors, noted the increasing murkiness of the intersection between broker-dealer and investment advisor activities. Treasury waded into an issue that the SEC has been contemplating with limited success for nearly fifteen years since the Tully Report. As you know, a year ago, the Court of Appeals for the D.C. Circuit sent the SEC back to the drawing board when it threw out the rule governing fee-based brokerage accounts that we had adopted in 2005. In response, the SEC proposed to reinstate certain interpretive positions, and we adopted a temporary rule governing principal transactions with non-discretionary advisory accounts by investment advisors that are dually registered as broker-dealers. The Divisions of Investment Management and Trading and Markets are hard at work considering longer-term options for regulation in this area.
Their work is informed by input from groups like the IAA and by empirical data from the study that the SEC commissioned by the RAND Corporation.2 As many people expected, RAND’s investor testing found widespread uncertainty about the differences between investment advisors and broker-dealers.3 Also not surprising, investors are unlikely to read disclosures that explain what their broker or investment advisor does.4 On the other hand, most of the investors surveyed said that they were satisfied with their own investment professionals and their firms.5 Investors who had worked with their investment professional for more than ten years were even more likely to be satisfied.6 The survey suggested that accessibility and attentiveness were the most important attributes of a financial professional, with cost a distant second.7
However the regulatory issues in this area are ultimately resolved, we must not unnecessarily disrupt relationships between investors and their advisors or brokers that are working effectively. We also need to remember that there is great diversity among retail investors and they do not all desire identical financial services. A diverse body of financial service providers is best able to meet their wide-ranging investment needs.
As the broker-dealer/investment advisor rulemaking illustrates, the rulemaking wheels often turn slowly at the SEC. That is not always bad since deliberation often produces better rules than hasty action. The SEC took a momentous step since we spoke last year — the SEC finally reproposed Form ADV Part 2, which has been eight years in the making. The comment period does not close until mid-May and the proposal was quite long and detailed, so we have not yet received much feedback, but your input will be important as we consider whether and how to refine the proposal.
The most promising aspect of the proposal is that it brings us a step closer to making meaningful information about advisors readily available to investors on the Internet. As we have seen in the mutual fund disclosure context, however, if it is to be successful, disclosure reform must get the balance right. We must ensure that investors have access to the information that they want to make informed decisions, but must not bury that information in a document that is loaded with other information that is not useful to them. If we do not get the balance right, a lot of work will go into creating a document that very few investors actually read.
Proposed ADV Part 2, which replaces the current check-the-box format with a narrative form, requires detailed disclosure about a wide range of subjects including business practices and conflicts of interest. The SEC therefore needs your help in understanding how burdensome it will be for you to provide and update this information. The stakes of getting this wrong are high because, as one commenter explained:
any time the SEC proposes changes, however subtle the changes may be, it is necessary for an advisor to devote numerous executive man hours and legal time to designing, reviewing and finalizing the new forms. For a small advisor, this means time devoted to filling out government forms instead of managing client portfolios and is therefore to the detriment of the client.8
I particularly hope to receive comment on the accuracy of our estimates of the time that it will take to complete Part 2. Are there adjustments that we can make to clarify the nature of the information that we are seeking and the level of detail that we expect advisors to provide? Are we asking for disclosure in the relevant areas? Are there disclosure items that seem to call into question particular practices that may not be inherently problematic?
Along with Part 2, we proposed a Brochure Supplement to provide investors with information about the professionals with whom they work. The Supplement is slightly revised from the one that we originally proposed. Nevertheless, the proposed disclosures about supervised persons’ disciplinary events, compensation, and other business activities sections could pose practical difficulties for advisors, particularly if the intended scope of these items is ambiguous. I look forward to hearing what commenters have to say about the proposed content of the Supplement as well as the delivery and updating requirements.
Another long-deliberated rulemaking project is the mutual fund summary prospectus that the SEC issued for comment at the end of last year. That proposal, too, is long and complicated and, as we have seen from past unsuccessful efforts, getting it right is not easy. Technology developments will, I hope, help the Summary Prospectus to succeed where its predecessor of the 1990s, the Profile Prospectus. The Profile has not been widely used, largely because of liability concerns. With Internet hyperlinking, investors can have the information that they need with the click of a mouse, and mutual funds can have the comfort of knowing that investors have ready access to that information.
The staff is working through the many comments that we received on the Summary Prospectus. These comments will help us to resolve a number of difficult issues, including whether to require quarterly updating and technological implementation issues.
As we look back over the events of the past several years and seek to determine the source of the problems that we are facing today, regulators cannot escape blame. The SEC, for its part, spent a lot of time on rules that sought to solve non-existent problems. Just think of the time and resources spent on the fund governance rules, the hedge fund registration rule, and Regulation NMS. The SEC devoted great time and effort to propose and adopt these rules. In two of the three instances, the SEC expended further efforts to defend these rules in court. Yet in none of these cases was the rule a proper regulatory response to a real market problem. Firms spent considerable resources to come into compliance with all of these rules, particularly Reg NMS. I might add to this list the redemption fee rule, which I supported only after it was reformulated as a voluntary rule as opposed to a mandate. While market timing was a real problem, our rule was not part of the cure and has imposed considerable costs of its own on funds and their intermediaries. In spending money and time to comply with these rules, firms were unable to use that money for other business or compliance purposes.
Firms are not alone in having incurred opportunity costs because of these rules. The SEC, too, faces resource limitations. As a consequence, the SEC has to choose wisely where to spend its rulemaking resources. Instead of mandating that hedge fund advisors register, which did not provide us useful information about hedge fund activities, we could have devoted our resources to collaborative efforts with other regulators to increase our collective information about hedge fund activities. We also could have worked on modernizing valuation guidance. The Commission has yet to provide sufficient clarity on this issue that has been kicking around for twenty years.
The SEC can learn from having gotten its rulemaking priorities wrong in the past. The Division of Investment Management, for example, would do better to defer overhauling Rule 12b-1 and spend its efforts on the many important rulemaking projects that were shoved to the back burner during the hedge fund registration and fund governance years. Investment advisor recordkeeping rules, guidance for investment advisors with respect to soft dollars, and the long-awaited business development company rulemaking all come to mind. In addition, of course, we will have to devote significant resources to mutual fund prospectus reform, ADV Part 2, and determining what to do in response to the RAND study findings.
Resource constraints govern not only SEC rulemaking, but the SEC’s enforcement and compliance programs. In the enforcement program, that means, among other things, closing a matter when it becomes clear that there is not a case. In the compliance area, one of the most important ways in which the SEC can leverage its inspection resources is by assisting firms to improve their compliance programs. Whether the SEC’s examination function remains as a self-standing office or is folded back into the Divisions of Investment Management and Trading and Markets, the number of examiners will always be dwarfed by the number of advisors. The number of SEC registered investment advisors grew from just over 7,300 in 2001 to over 11,000 as of several days ago. Assets under management of SEC-registered advisors have expanded from 20.3 trillion dollars-worth to 42 trillion, give or take a few billion.
Given these numbers, OCIE must work with firms to assist them in developing and maintaining strong compliance programs. OCIE, with its unique perspective on the industry, can help compliance personnel at firms to identify risks and take steps to prevent violations from occurring. Along these lines, OCIE is making a greater effort to let firms know what it is looking for and what it has found in examinations. The theory is that this will help firms to address potential compliance issues on their own. OCIE is also moving forward with its commendable efforts to standardize document request letters and deficiency letter language. In addition, through its CCO outreach programs, the SEC gives concrete and practical guidance to chief compliance officers. This is an important, proactive role that is central to OCIE’s mission. Obviously, where OCIE finds infractions, it should deal with them, but it should not view its role as merely reactive — generating as many enforcement referrals as possible.
In all these efforts, OCIE ought to make clear that it cannot provide one-size-fits-all guidance to firms. Just as a firm cannot adopt an off-the-shelf compliance manual as its own without considering how the manual applies to the unique characteristics of the firm, OCIE cannot assume that all advisors will have compliance programs of identical, breadth, complexity, and sophistication. As the IAA’s Evolution-Revolution report details, today’s advisory industry is made up of advisors that are incredibly diverse in size and in the type of services they offer. Thus, we must continue to allow firms the flexibility to tailor compliance programs to their size and the services that they offer. The IAA put it this way in a recent comment letter to Treasury, “While the task may be difficult, we nonetheless believe it is critical for the SEC to have full knowledge of the many variations among advisory firms in order to fashion appropriate policies and regulations and to implement reasonable inspection programs — all with the overarching goal of protecting investors.”9 Of course, in all of its activities, OCIE must use great care not to exceed its limited mandate. Imposing de facto compliance or recordkeeping requirements for advisors does not fit within this mandate.
Thank you for your attention. I would be happy to take some questions. I understand, however, that I stand between you and lunch, so I fully understand if there is no appetite for questions at the moment. As always, I encourage you to call or stop by my office if there are issues that you would like to discuss in the future.
1 The Department of Treasury, Blueprint for a Modernized Financial Regulatory Structure, at 126 (Mar. 2008) (available at: http://www.treas.gov/press/releases/reports/Blueprint.pdf).
2 RAND Center for Corporate Ethics, Law, and Governance, Technical Report: Investor and Industry Perspectives on Investment Advisers and Broker-Dealers (2008) (available at: http://www.sec.gov/news/press/2008/2008-1_randiabdreport.pdf).
3 Id. at 18-19.
4 Id. at 19.
5 Id. at 98-100.
6 Id. at 99-100.
7 Id. at 101-102.
8 Comment Letter of Adrian Day (Mar. 28, 2008) (available at: http://www.sec.gov/comments/s7-10-00/s71000-84.pdf).
9 Letter from IAA to Chairman Henry Paulson on Review by the Treasury Department of the Regulatory Structure Associated with Financial Institutions, TREAS-DO-2007-0018, at 4 (Dec. 18, 2007) (available at: http://www.investmentadviser.org/public/letters/comment121807.pdf).
http://www.sec.gov/news/speech/2008/spch041108psa.htm
