Fiduciary Corner

Blaine F. Aikin

Industry preparing for an adviser SRO

Some already formulating characteristics that self-regulatory organizations should possess

Jun 22, 2014 @ 12:01 am

Self-regulation is a hot topic at many conferences for investment advisers. Most often, sessions on the subject center on the question of whether the Securities and Exchange Commission should continue to provide direct regulatory oversight of advisers or if a self-regulatory organization (namely, the Financial Industry Regulatory Authority Inc.) should assume the role. When I attend one of these sessions, I expect to hear strong opinions about the merits of one approach over the other.

A recent CFA Institute conference was out of the ordinary. It treated the question of direct governmental oversight versus SRO oversight as settled business.

Mary Schapiro, former SEC chairman, headlined the event and opened her remarks by declaring: “The question of whether the government should regulate directly is moot.”

Why bother to debate the issue if there is no chance that legislators will appropriate sufficient funding to the SEC to ramp up adviser examinations to an acceptable level or pass legislation to authorize the SEC to achieve self-funding through fees on advisers?

SROs FUNDED GENEROUSLY

While inadequate funding of primary government regulators is endemic, “private” SROs, such as Finra, are funded generously by fees assessed on the firms they regulate. The merits of the issue aside, the operating assumption at this event was that economic and political realities will dictate increasing reliance on SROs instead of direct regulators. This freed the conversation to focus on how to deal with that reality.

Richard Ketchum, Finra's chief executive, joined former SEC commissioners Schapiro and Roberta Karmel in a panel discussion of how SROs can meet the needs of investors and the financial marketplace. At the outset of his remarks, he noted that “self-regulation” should not be the point of emphasis; rather, “accessible regulation” is the point. SROs have the capacity to grow to assume delegated responsibilities from direct regulators and meet the well-recognized need for greater oversight.

If the growing prominence of SROs is a given, so, too, is the fact that SROs have inherent conflicts of interest and a number of other drawbacks that can pose risks to investors, the regulated firms and the financial system as a whole. Recognizing this, the CFA Institute used the event to announce the release of a document that highlights 10 characteristics that the institute has identified as necessary for a financial SRO to be viewed as credible and effective. These characteristics have been distilled from a 40-page report issued by the institute in August 2013. Both documents are available on the institute's website at cfainstitute.org/selfreg.

The larger report highlights four of the 10 essential characteristics of effective SROs in the form of two defining requirements. First, a credible and effective SRO must have “the ability to maintain effective surveillance, supervision and enforcement powers.” Second, it must possess “the authority to create and enforce its policies and rules.”

Several of the other essential characteristics are intended to address the conflicts of interest inherent in SROs. Strong governance mechanisms are expected to include boards of directors that include independent members (preferably a majority) and processes that assure transparency and public input on rule-making initiatives. Customer dispute resolution processes that are fair and transparent and serve to balance investor protections with the civil rights of persons accused of wrongdoing also are required.

Interestingly, the institute's report notes the lack of a universal definition of an SRO and presents a range of examples of organizations that exhibit self-regulatory qualities. At the same time, it draws a line between self-regulatory versus advocacy organizations.

The distinction focuses upon “authority.” SROs require the “legislative or delegated regulatory authority to create and enforce its own policies and rules, subject to formal government oversight.” Advocacy organizations, on the other hand, generally do not have enforceable rules or disciplinary processes governing members and therefore lack a comparable level of credibility.

Whether from traditional SRO powerhouses like Finra or professional organizations such as the CFA Institute, self-regulation will have a growing impact on financial advisers. It is a trend worth watching closely and the CFA Institute's work provides an important framework for legislators, primary regulators, advisers and other interested parties to evaluate how effective self-regulation and specific SROs are likely to be in providing credible oversight of financial services activities.

Blaine F. Aikin is president and chief executive of fi360 Inc.

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