Wake-up call for RIAs: It’s time to fix exams before it’s too late

Imagine a town where things are quiet and so the cop doesn’t walk the beat as often as he used to, yet this absence of police presence can fuel a sense of insecurity.

Registered investment advisers find themselves in a similar pickle: infrequent regulatory examinations can create uncertainty and give rise to perceptions by some that the RIA business may be a safe haven for bad guys.

We’ve all seen the stats: A Securities and Exchange Commission study mandated by Dodd-Frank determined that it examined RIAs on average once every 11 years, while 40% of firms have never been examined. Even in the absence of other regulatory deficiencies, this lack of oversight leaves the industry vulnerable to reputational risk, such as we saw in the story, “Breaking away for the wrong reason.”

CRISIS AHEAD?

A Financial Industry Regulatory Authority Inc. official, speaking at a public event this year, warned her audience of an emerging “regulatory arbitrage” trend, suggesting more than a few breakaway brokers were bad guys fleeing to what she depicted as the less-regulated realm of RIAs. We at TD Ameritrade Institutional think these generalizations should serve as a wake-up call for RIAs to move forward with a greater sense of urgency on the issue of exam frequency.

We also think investors are better off when they work with an adviser committed to the fiduciary standard of due care and loyalty under the Investment Advisers Act of 1940, someone obligated to always put the interests of their clients first. For more than a decade, investors have voted with their wallets, leaving the higher conflicts of commissioned brokers and making RIAs the fastest-growing channel in the financial advice industry.

Still, the RIA examination frequency issue remains a troubling weak point. It’s time for the RIA business to find a solution, work together and resolve this issue.

While RIAs and their trade associations value their independence of thought, most RIAs agree on one thing: they don’t want Finra as their regulator. Yet in almost every other regard, RIAs are a house divided, where competing views and agendas undermine efforts to get behind one solution.

At TD Ameritrade Institutional’s third annual Advocacy Leadership Summit last month in Washington, several attendees warned that the RIA industry is “one crisis away” from falling under the authority of Finra. The suggestion is that a major scandal involving an RIA could force rule-makers to move exam frequency to the front burner and, when they do, choose to impose a regulatory regime RIAs won’t like.

The problem has been that RIAs have a hard time agreeing on what they do want.

RIA OVERSIGHT LACKING

While many advisers would like to see the SEC perform more exams, facilitated with more funds allocated by Congress, that is unlikely in the current political environment. The commission has acknowledged that its RIA oversight is lacking, and it has requested increased funding for exams. Indeed, the SEC’s budget has increased roughly 9% a year for the past 20 years, but the agency has not directed those incremental dollars toward increasing the frequency of RIA exams.

In other words, our quiet town’s tax revenues are rising, but those dollars aren’t going to more police patrols.

The challenge has been finding a viable alternative. The SEC in 2011 recommended further study of different means for increasing frequency, including user fees to fund more examinations by the SEC. Another consideration was requiring RIAs to become part of a self-regulatory organization, whether an expanded Finra or a new body created from scratch.

Eager to see what impact these ideas would have on advisers, the RIA industry’s leading trade organizations along with TD Ameritrade Institutional commissioned a study by The Boston Consulting Group. The 2011 report found that creating an SRO to oversee RIAs would cost at least twice as much as adequately funding an enhanced SEC examination program. More than four years later, we’re still no closer to a solution, and the industry’s reputation is still at risk.

Legislation has been proposed to authorize user fees, paid by RIAs to fund more frequent examinations by the SEC. That proposal stalled in Congress. One draft bill mandated that the user fee revenue be earmarked for increased RIA exams.

THIRD-PARTY EXAMS

There are some who would shift more oversight responsibility from Washington to the 50 states by raising the threshold for SEC registration from $100 million, or perhaps a hybrid approach, where firms between $250 million and $1 billion get third-party exams and firms with more than $1 billion are examined by the SEC. This plan has its own potential weaknesses, namely the ability of every state to take on more regulated entities.

The latest thinking on the topic has turned to third-party exams, in which the SEC would require RIAs to engage independent auditors to examine RIAs’ compliance on a more frequent basis. For many decades, the SEC has relied upon private-sector auditing firms for its oversight of publicly traded companies, rather than the agency auditing every issuer’s financial statements.

In the third-party RIA exam scenario, private firms would stand in for the SEC and conduct exams on a standard, SEC-approved basis. Enforcing the law when wrongdoing is detected would remain the purview of the SEC. For years now, don’t forget, the SEC has required RIAs that hold custody of customer assets to have annual surprise audits by an authorized third party.

A 2011 independent academic study found third-party exams to be the most cost effective solution and the easiest to implement. Given the political and fiscal environment, this may be the most viable option and something the industry should explore in greater detail. Clearly there’s no shortage of ideas, and each has its pros and cons; we just need to take action.

More investors are choosing fiduciary advisers precisely because they inspire trust and confidence. Let’s reinforce that reputation by fixing the exam frequency issue before investors are harmed, before the reputation of the RIA industry is tarnished and before Washington imposes a solution not of our choosing.

Skip Schweiss is managing director for RIA advocacy and industry affairs at TD Ameritrade Institutional.