RIAs should be forced to hire outside examiners: Gallagher

Afraid of another Madoff scandal, SEC member says proposal would increase oversight of advisers

By Mark Schoeff Jr.

May 20, 2014 @ 2:35 pm (Updated 4:21 pm) EST

SEC, Finra, SRO, dually registered advisers, adviser examination
(Bloomberg News)

Securities and Exchange Commission member Daniel Gallagher wants registered investment advisers to be forced to hire third-party contractors to conduct examinations.

In a remarks at the Financial Industry Regulatory Authority Inc.'s annual conference in Washington, Mr. Gallagher recommended that the SEC write a regulation that would require advisers to hire an examiner to review their operations.

The rule would be similar to one the agency adopted in 2009 that forces advisers who maintain custody of client assets to bring in an auditor to verify that the funds are safe.

“How we examine advisers would be the subject of the rule I'm talking about,” Mr. Gallagher told reporters on the sidelines of the Finra conference.

In a Q&A afterward with Finra chairman and chief executive Richard G. Ketchum, Mr. Gallagher said he is worried that the SEC might miss the next huge investor rip-off along the lines of the multibillion-dollar Ponzi scheme perpetrated by Bernard Madoff.

The problem, Mr. Gallagher said, is that the agency lacks the resources to oversee the roughly 11,000 registered investment advisers. The SEC annually examines about 9% of them.

“We have no Rick Ketchum on the adviser side and no SRO,” Mr. Gallagher said. “We are sitting there with our chins out, waiting to get pummeled.”

Finra, the industry-funded broker-dealer regulator, which oversees approximately 4,300 firms, in the past pushed legislation to extend its authority to include investment advisers. It is no longer pursuing such a measure.

Under the rule Mr. Gallagher has in mind, the third-party auditor could be an existing SRO or it could be a private-sector firm. The competition between SROs and other firms would bring prices down, he said.

“That will be a much more competitive and efficient marketplace, I think in particular for the dual-hatted registrants,” Mr. Gallagher said, referring to investment advisers who also are registered as brokers. “They will be inclined to say, 'Let's go with what we know'” and select Finra for examinations.

Mr. Gallagher is one of five SEC commissioners and one of two Republicans on the body. At least three members have to agree to propose a rule.

In 2012, a bill that would establish an SRO to oversee investment advisers died without coming to a committee vote, despite strong Finra support. That measure would have required advisers to register with an SRO.

Congress does not need to weigh in on the rule that he supports, Mr. Gallagher said. The rule would not give the third-party auditor rule making or enforcement authority, as the 2012 legislation would have.

Mr. Ketchum applauded Mr. Gallagher's idea as a way to increase oversight of investment advisers.

“This is a creative alternative,” Mr. Ketchum told reporters at a press conference at the Finra meeting. “There's a huge disparity of oversight with regard to investment advisers. It's not an OK environment when you can go decades without being examined. That creates a risk for investors that's not appropriate.”

He was quick to add that Finra has no intention of lobbying to revive a bill that would expand its regulatory reach. He also pointed out that all he knew of Mr. Gallagher's proposal was based on what Mr. Gallagher said in a recent speech and his comments at the Finra meeting.

“This is his proposal, not ours,” Mr. Ketchum said. “It's a decision for the commission to make, not for Finra.”