Time for RIAs to set transition plans as SEC steps up focus

Mary Jo White, chairwoman of the Securities and Exchange Commission, recently discussed potential regulatory reforms that would lay the foundation for regulating the risks arising from portfolio composition and operations of investment advisers and funds.
Specifically, she defined operational risk as risk emanating from inadequate or failed internal processes and systems.
According to Ms. White, the SEC plays an important role in addressing systemic risk, which is the risk inherent to the overall market or an entire market segment. Systemic risks potentially impact the financial system as a whole, not just a particular stock or industry.
It may be difficult for an investment adviser representative at a small registered investment adviser to imagine how the firm’s asset management practices can impact the financial system as a whole. Looking at the big picture, however, there were more than $63 trillion in regulatory assets under management reported on Form ADV, according to Investment Adviser Registration Depository data on Dec. 1, 2014. Risks arising from RIAs’ asset management might cascade throughout the economy.
The Dodd-Frank financial reform law required the SEC to establish methodologies for stress testing large financial companies — such as RIAs, registered investment companies and broker-dealers — with $10 billion or more in total consolidated assets. Pursuant to Dodd-Frank, the SEC is evaluating what protocols are appropriate for financial companies whose assets exceed the $10 billion threshold.
TRANSITION PLANS
According to Ms. White, the SEC is developing a recommendation to require investment advisers to create transition plans to prepare for a major disruption in their business. Planning ahead will better prepare RIAs and their clients for the actual transition process and the attendant risks.
While there has been no formal rule enacted regarding business continuity plans, SEC examiners have criticized RIAs in the past for failing to address disaster recovery and succession planning in their policies and procedures.
Ms. White made the following statement in her speech:
A third focus of our regulatory enhancements is on the impact on investors of a market stress event or when an investment adviser is no longer able to serve its clients. There are several risks associated with such events. For example, during an adviser’s dissolution or following the departure of key personnel, an adviser may face challenges in serving its clients’ needs while also swiftly transferring its asset management services to another firm.
Ms. White pointed out that the risks associated with winding down an RIA are different from those associated with other types of financial firms. In particular, client assets do not represent the assets of the RIA. Furthermore, RIAs routinely exit the market without significant market impact. However, those exits from the market create challenges, which might differ depending upon the types of clients the firm has.
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“For example, if there are restrictions on investors’ ability to access or move assets away from an adviser — or, more generally, de facto limitations imposed by illiquid assets or market conditions — a clear transition plan for that adviser could benefit investors and the market,” Ms. White observed.
In response to this risk, the SEC is developing a recommendation to require RIAs to create transition plans to prepare for a major disruption in their business. The SEC is also considering how to tailor these requirements for different kinds of firms. Presumably, transition planning for small RIAs will be less burdensome than it will be for larger firms. State securities regulators are also developing business continuity rules to guard against these risks.
OTHER CHANGES
Norm Champ, the former director of the SEC’s Division of Investment Management, also highlighted the SEC’s regulatory concerns in a speech on Dec. 10, 2014. Mr. Champ pointed out that the safeguarding of client assets continues to be a priority, along with emerging issues such as cybersecurity and social media.
In addition, the SEC is considering whether to strengthen the accredited investor definition. An advisory committee has expressed the opinion that income and assets by themselves might not be the best way to determine who is an accredited investor. The current definition of an accredited investor includes:
• Any natural person whose individual or joint net worth with a spouse exceeds $1 million; or
• Any natural person who had an individual income of more than $200,000 in each of the two most recent years, or had joint income with a spouse that exceeded $300,000 and has a reasonable expectation of reaching the same income level in the current year.
Section 413(a) of the Dodd-Frank Act amended the definition of accredited investor to exclude the value of a natural person’s primary residence from the $1 million net worth calculation.
ENFORCEMENT
No matter what regulatory enhancements are implemented, vigorous enforcement proceedings are likely to follow at a brisk pace in 2015. Fiscal year 2014, which ended last September, was a landmark year for the SEC as it filed a record 755 enforcement actions and obtained orders adding up to over $4 billion in disgorgement and penalties.
By way of comparison, the agency filed 686 enforcement actions during fiscal year 2013 and obtained orders amounting to $3.4 billion in disgorgement and penalties.
In a news release last October, Ms. White said: “The innovative use of technology — enhanced use of data and quantitative analysis – was instrumental in detecting misconduct and contributed to the Enforcement Division’s success in bringing quality actions that resulted in stiff monetary sanctions.”
The SEC now uses advanced quantitative techniques to analyze data relating to all RIAs and conducts on-site examinations of those firms that pose the highest risk. For example, the Enforcement Division’s Asset Management Unit utilizes proprietary risk analytics to uncover hedge funds with suspicious returns in view of their investment strategies. The SEC is likely to investigate whether those returns are accurate.
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RIAs should be proactive in dealing with some of these potential regulatory changes. Firms should begin working on their transition plans and considering how to implement them.
With hacking incidents and cyber threats in the news each day, RIAs should make certain their insurance policies provide the necessary coverage. Many policies only provide limited coverage for the damage arising from cyber breaches and might not cover fines, penalties and other costs related to the occurrence.
Les Abromovitz is a senior consultant at National Compliance Services.