Making the Switch to State RIA Regulation

The following is an edited transcript of the webcast “Making the Switch to State RIA Regulation,” held Oct. 26 in New York. It was moderated by news editor Bruce Kelly and reporter Mark Schoeff Jr.

Panelists were Denise Voigt Crawford President, North American Securities Administrators Association, Inc. Commissioner, Texas Securities Board; Patricia D. Struck, Chair, North American Securities Administrators Association, Inc., Investment Adviser Section Administrator, Division of Securities Wisconsin Department of Financial Institutions; and Brian S. Hamburger, JD, CRCP, AIFA Brian S. Hamburger, JD, CRCP, AIFA Founder and Managing Director, Market Counsel LLC, Founder and Managing Member, Hamburger Law Firm.

InvestmentNews: Let’s begin with some background on the state regulation issue from Denise Crawford.

Ms. Crawford: I call this The Switch 101, and it basically allows you to put into context what’s now going on.

Back in 1996, Congress enacted a law called the National Securities Markets Improvement Act, which pre-empted states from regulating investment advisers managing more than $25 million in assets. Heretofore, the states and the [Securities and Exchange Commission] had shared jurisdiction over the entire universe of investment advisers. This was a significant change in the world as we knew it at that time.

I considered it to be an experiment, and unfortunately, the experiment did not go well. By its own admission, the SEC has never examined more than 3,000 investment advisory firms that fall into this universe. That is really unacceptable on a going-forward basis.

This past year, when Congress was looking at Dodd-Frank, they realized that the states had been doing the job. They commended us on a number of occasions, sort of offline. And they realized that for a variety of reasons — not the least of which was limited resources on the part of the SEC — these firms were not being looked at and that it was time to end that experiment from 1996, and do something different.

Under the Dodd-Frank Wall Street Reform and Consumer Protection Act [of 2010], the states now have what we call a “higher assets under management” cap. It went from $25 million of assets under management to $100 million.

This was done to be sure that these firms that had not been looked at are looked at on a going-forward basis. This restoration of authority was a direct result of the failed experience we all had under NSMIA.

InvestmentNews: Is there real interest, concern and demand for knowledge about the switch from investment advisers or are they perhaps not paying so much attention to it at the moment?

Ms. Struck: At the state level, we’re getting lots more questions from advisers and from their consultants and attorneys — as well as a lot of calls from the media. The more times the questions are asked and answered, the better informed advisers can be about their regulatory compliance issues.

Ms. Crawford: Some firms appreciate the opportunity to fall under the jurisdiction of states. One reason they like it is because they feel that they can have a better sort of relationship with their regulator if that regulator is more localized.

On the other hand, there is a group of investment advisers that are very concerned about falling under state regulation, because for some time, they’ve not really had to worry too much. For example, they haven’t had to worry about being examined, because as we mentioned earlier, there haven’t been a lot of SEC examinations of these firms to date. Now that they are going to fall under state regulation and the states are clearly going to make examinations of these new entrants into their regulatory universe a priority, all that changes. So I think there is some angst about getting examined for the first time. The other things pale in comparison, based upon what I’ve heard.

Ms. Struck: This is a big opportunity for advisers to have their fears allayed. Change is a source of consternation for anybody in the regulatory area, so having webcasts like this, having articles published in the media and hearing directly from advisers, all of those are really going to set people’s concerns to rest.

Mr. Hamburger: I couldn’t agree more. Unfortunately, the way the system works is that Dodd-Frank goes into effect, and before the states and the SEC are able to provide the type of guidance advisers need, all of these questions crop up. Speculation begins around the timing and impact, and all the finer points, such as what to do if assets go above $30 million or if advisers start at the SEC level and then have to revert to state regulation. There just are so many smaller questions that have to be answered. Our ability to furnish those answers in a timely manner will restore advisers’ confidence that the regulatory system they are going to fall under is a good one.

InvestmentNews: A participant says he has heard that the SEC will come out with more detail this month regarding the following: If a registered investment adviser has $95 million in assets under management this year, $105 million in 2011 and $96 million in 2012, does the RIA have to toggle between SEC and state filing every other year or is there a band or range of assets under management to account for these annual fluctuations?

Ms. Crawford: There are a lot of questions that are waiting on guidance from the SEC in order to answer. We have regular conference calls with the SEC staff on these issues, and of course, this is one of them. We have effectively solved that problem with regard to toggling back and forth between $25 million assets under management and, say, $30 million or $35 million. So I don’t have any reason to think [there won’t be] a mechanism in place well before the deadline or switching has actually come to pass.

Ms. Struck: Since the beginning of August, a team from the states — several of us from [the North American Securities Administrators Association Inc.] — and a team at the SEC have been holding conference calls every two weeks. Remember that those portions of Dodd-Frank don’t take effect until July of next year. And everybody is aware of the SEC’s announcement back in September of the timetable for Dodd-Frank implementation rulemaking, which is scheduled to take place sometime before the end of this year.

When we began our conference calls, we agreed that we want to streamline the process for the switch for advisers on the border. We are recommending that advisers wait to switch until they see consistent guidance coming out from the SEC and from the states. It will be collaborative guidance. And the most likely recommendation we will make is going to be that if you are an adviser, you wait until renewal season before you start switching.

But what you do need to do now, and what we can advise that you start doing, is update your [Form] ADV Part 2 and post it on the [Investment Adviser Registration Depository]. You can find the form on the NASAA website and on the SEC’s website; statements of guidance from various states on the timetables are being added right now. Basically, you’ve got a timetable that says that beginning in January of 2011, new applicants will be filing the new Part 2 only and current registered advisers will have to include the new Part 2 with their next amendment or their annual updating amendment to Form ADV.

And a number that might be surprising to a lot of people is that a little over 14,000 advisers are registered with the states across the board. Of those, more than 40%, or about 6,000, have already filed the old Part 2 on IARD. The best way to get a head start on making your switch from federal to state regulation is to get that ADV Part 2 done.

Mr. Hamburger: To Denny’s point — and I’m certainly not speaking on her behalf — is that the issues are already contained within documents as simple as the Form ADV Part 1 instructions, where they instruct advisers how to calculate securities portfolios and then how to calculate their assets under management.

With regard to that hypothetical situation about an adviser flip-flopping between federal and state regulation, it would be really helpful if the SEC and NASAA can identify and agree on that band of cushion, if you will. However, that really doesn’t impact any adviser until, at the earliest, their first annual updating amendment in 2012. So we’ve got quite a while to worry about the issue of a band.

Based on their current obligation, investment advisers most likely will have to evaluate their assets under management when they file that annual updating amendment. They must be able to report that number on the IARD, and at that point, they can make the registration decision.

InvestmentNews: Denise and Patricia, can you explain why you are so confident that states are going to be able to handle the switch when almost every state is in some kind of budget crisis right now?

Ms. Crawford: It’s not so much that I think we’re going to be perfect right out of the chute, because regulation doesn’t work that way. But my feeling about this all along has been that it’s far more preferable in terms of protecting the investing public to have a regulatory regime that actually does something to protect the investing public. The absence of examinations by the SEC on this particular group of investment advisory firms has always been greatly disturbing. I don’t want to push the analogy too far by talking about [Bernard] Madoff or [R. Allen] Stanford or those kinds of colossal failures. But just on a day-to-day basis, it’s very worrisome to think that hundreds of millions of dollars can be held for the assets under management for these investment advisory firms, and nobody, not a single regulator, has ever looked at the books and records of that firm.

That why, from my perspective as a regulator, anything we do with regard to looking at those 3,000 firms that have never been examined at all is a step forward. I see victory at the outset.

Having said that, I’m sure we’ll have some isolated glitches along the way. But the states are ab-solutely committed to work with firms to make this a smooth switch.

The last thing that we want is for our authority to be restored and then have it not go well. That’s certainly not in our interest. As much as anything else, there’s the commitment and the will to make this work well.

Ms. Struck: The long lead time is one of our huge advantages in this switch. We’ve had an inkling that the asset-under-management cap was about to go up for more than a year. That gave us the opportunity to get reports of IARD that identify midsize advisers in every state. And we’ve been able to use that information on a state-to-state basis to assess what our staffing needs might be after July of next year and to make plans for reallocating our current staff. It many cases, it also allowed us to formulate requests for additional exam staff in our budget process, because for so many of us, the budget process is beginning now.

Having advance notice also enabled us to draft a memorandum of understanding — signed by every state and by the District of Columbia — in which we agreed to support one another by performing exams and training staff as the need might arise. We’ve also been able to adjust our multistate training priorities so that NASAA will be providing examiner training not just as we’ve always done on an annual basis, but also creating web-based examiner training, which is going to be available on demand to all examiners at any time.

Mr. Hamburger: What concerns folks the most is that by our estimations — and we’ve got a decent subset of investment advisers that we work with, probably about 1,000 firms — about half of the states we work with don’t have a real examination program.

Denny mentioned there are these 3,000 advisers the SEC hasn’t examined. The truth is, some of the most populous states in the country have never gone out and conducted a random investment adviser examination. If that’s going to change, I think it’s great. But what happens if certain jurisdictions simply don’t go out and examine their investment advisers? Any kind of wrongdoing that occurs within those jurisdictions is an embarrassment to everyone doing business the right way, as well as the states themselves.

InvestmentNews: How could state exams differ from SEC exams? And will the SEC increase its exam frequency with larger firms because it will eventually — supposedly — have more freedom and manpower to do so?

Ms. Struck: The one thing that we know at the state level is that because we have responsibility primarily for examining the advisers that are in our jurisdiction, we know, based on our pre-registration activity, a lot about the advisers.

When we get an application for registration of an investment adviser, we review the ADV. We ask questions about the ADV. Before the adviser can become registered, we know a lot about that adviser. And based on the information we have, we are going to: A) determine the exam priority for that adviser and B) determine what kinds of books and records review might be suitable. In other words, we don’t have a sort of one-size-fits-all regulation. We tailor the exam program that we administer to what we know about the individual adviser, based in large part on the upfront review of the application. For existing advisers and existing registrants, we know a lot from prior exams. In the future, we are going to have the exam results from any exams that might have been done by the SEC.

Ms. Crawford: As Patty indicated, we use a risk-based matrix to decide who we are going to examine and when. And the way we differ from the SEC — although the SEC is beginning to change on this point — is that by and large, most state examinations are unannounced. It is extraordinarily useful to come in during regular business hours unannounced and look at the books and records.

Brian expressed concern about pockets of the country that may not have rigorous examination tools or programs. Let me take this opportunity to disabuse listeners and readers of the notion that simply because they’re located in New York or Wyoming or somewhere else they’ve heard has no examination program in place — or heretofore has had an inactive examination program — that they are going to be off the hook. Nothing could be further from the truth.

Patty talked a minute ago about the memorandum of understanding committing states to help each other. The truth of the matter is that we don’t need a formal memorandum of understanding; we work together all the time. We do enforcement cases, we do sweeps, we have task forces and we have working groups where a select group of our members take responsibility for doing a variety of things on behalf of all our members. Some of our global settlements have been done in that fashion.

We have that kind of history of working together to address issues so that every jurisdiction doesn’t have to reinvent the wheel. That history is going to be very, very helpful once the switch takes place, because we can work together and go into jurisdictions and do examinations together if necessary. It’s going to be covered as a result of this [memorandum of understanding].

InvestmentNews: Brian, which states do you consider particularly weak on exams, if that is the right way to phrase it?

Mr. Hamburger: Because it’s very important for us to maintain good relations with these states, I don’t feel comfortable calling them out. But I think it’s not states like New York or Wyoming, which have admitted or have identified themselves as being states that don’t have formal examination programs in place. I am more concerned with those states that say they do examinations but in practicality don’t. I think that NASAA leadership is relying upon information that these states are giving them about the number of examinations they are conducting that’s completely off base.

Everyone has the very best of intentions, but at the end of the day, when there’s a significant number of investment advisers that are generally going to fall outside the scope of an examination, that creates the type of environment that breeds fraud and affects people’s perception of all state regulation.

Ms. Crawford: You have just explained the rationale for why we are doing this switch. There have been no examinations on the part of the SEC. So the fact that there may be fewer than we would like in a perfect world is really not a good argument for not having done this. As time goes on, we will get better and better.

InvestmentNews: A listener is wondering about states such as New York that don’t have an examination infrastructure or require IARD usage.

Ms. Crawford: I want to clarify that New York does have a securities office. There is a division within the New York attorney general’s office that, in effect, is the securities regulatory office for the state.

InvestmentNews: It is very un-derstaffed, isn’t it?

Ms. Crawford: I would say that every securities regulator in the country, including the SEC, is understaffed.

InvestmentNews: But can we all agree that New York has fewer resources per adviser than Texas, for example?

Ms. Crawford: What New York is actually going to end up doing vis-à-vis investment advisory exams in setting up a program or relying on some different approach, I don’t know yet. When we find out who the attorney general of New York is going to be and who will be running the securities division of that office, we’ll be in a better position to dispense information.

InvestmentNews: The concern of many advisers is that if they are doing business in New York, then their regulation as an investment adviser is now subject to state elections. The decision as to whether to somehow figure out a way to go out and install an examination program and therefore raise the dollar threshold to $100 million, or to opt out and have the threshold down at somewhere around $25 million, is in flux. That inconsistency is what has cost investment advisers. At the last NASAA conference, there were statistics that around eight states don’t yet have a firm resolution as to whether they can show an effective examination program.

Ms. Crawford: I am not so sure that it’s worth getting extremely agitated about, given that we have a full year within which to work through this issue. Somebody is going to be examining these firms. Whether it is their home state or a group of securities regulators that come in and assist their home state, we don’t know. But we will know in plenty of time for every listener to prepare.

InvestmentNews: What is the expectation, if any, for uniform state filing procedures or requirements and timing? If advisers expect to register in 15 states, can they use one form?

Ms. Struck: The reason there is an ADV 1 and 2, which is consistent from state to state and from the states to the SEC, is that together, we have developed that form. Advisers are going to be using one form and one database, regardless of whether they are a federal adviser or a state adviser, and this is why we have such a high degree of confidence that we are going to be able to streamline the switch process. So the question is, “Can I use one form?” Absolutely, advisers can use one form; it’s the ADV.

InvestmentNews: Regarding the number of advisers that you supervise right now, Patty and Denny, how is this actually going to increase, and what will be the effect on staffing?

Ms. Crawford: Right now, we oversee about 1,200 advisers in the state of Texas, and it looks like that’s going to double to about 2,400. Of the additional 1,200, our best information right now is that approximately 300 will be based in Texas. Our intention is to add staff, and it’s on our appropriations request when the Legislature convenes in January. The Legislature is well aware of what has happened and what the needs are, and we are hopeful that we are going to have additional staff.

Ms. Struck: Today, we have approximately 280 state-registered advisers under Wisconsin jurisdiction. When we do the reporting on IARD to see how many SEC advisers are in the category of midsize advisers — and will become state advisers in Wisconsin — the number we come up with is approximately 50, so that will take us to a total of 330 advisers that will be under Wisconsin jurisdiction.

In terms of staffing, we have six professionals who are responsible for all aspects of the regulation of investment professionals, and that includes investment advisers and broker-dealers. That would include the upfront application review that I described previously, the form, the client contracts, particularly Form ADV, as well as the ongoing exam program of advisers.

Finally, the staff provides outreach to advisers on the new law and how to comply. I think I speak for Wisconsin and for most other states when I say we are really going to be stepping up performance on that outreach element within the next few months. We’ll help advisers understand the peculiarities of the registration system, what they can expect under the new law, when they can expect to be examined, and answer other questions they might have.

Advisers also may post questions on the NASAA website at nasaa.org, which will be answered by state regulators. So if an adviser hasn’t already bookmarked that website, he or she should do it.

InvestmentNews: A question from an attendee: If a firm conducts business in multiple states, does the new legislation require filing with each state?

Mr. Hamburger: The new laws do require you file in each and every state. However, no state in which you are registered in can impose upon an adviser more-burdensome requirements than their home state. So every investment adviser has an obligation to identify their principal place of business, which is typically the office where their principal executive officers are located. That will determine the set of regulations the adviser must pay attention to most. Beyond that, however, they still are going to have registration requirements in those other states.

InvestmentNews: We have a follow-up question regarding Denise’s comment that jurisdictions are going to help one another out. Is Texas, for example, going to do exams or audits in other states, such as Wyoming? Denise or Patricia, do you have any sense of how that all is going to work?

Ms. Crawford: If there is an issue in another state and we have the expertise or the people to take a look at that issue, we would weigh in if asked. That issue could involve enforcement, a broker-dealer matter or an investment adviser matter; we do this all the time and nothing is going to change. The only thing that has changed is that it now will be formalized. We wanted to be able to wave that [memorandum of understanding] in front of folks so they wouldn’t think that the job won’t get done if one particular jurisdiction, or maybe a handful of jurisdictions, don’t have sufficient budget or staff or any other reason to get the job done the way the job should be done.

Ms. Struck: We already engage in this kind of collaborative regulation. For example, if a state is just implementing an exam program, it might send its examiners down to Texas or up to Wisconsin for some experience in actually conducting an exam. That will just accelerate under the [memorandum of understanding].

Mr. Hamburger: There has long been this myth out there that advisers can’t do it on their own, and I know it seems odd hearing this from a service provider, but if advisers choose to really spend the time to get to know their business holistically and try to identify where potential conflicts of interest lie, it can be a wonderful exercise.

In order for an examination to be effective, advisers are going to have to participate in the dialogue of who they are, what their investment strategy is and where their conflicts of interest lie. Advisers should first try to assess what their own capabilities are and then go out and get the training necessary to educate themselves for the exam or obtain the assistance necessary to bring those resources in-house. But thereafter, they really need to take a good look at their business and figure out who they are in identifying this. People shouldn’t have unreasonable expectations that they can simply offload this responsibility to a disinterested party. I don’t think that’s possible.

Ms. Struck: That’s a really good point. When the state examiners walk into your office, they are going to expect that you would have done that kind of self-exam — even if you are relying on a consultant.

The audio webcast and slide -presentation are archived at -InvestmentNews.com/riareg.

Related Topics: RIA Marketplace, Securities and Exchange Commission, Webcast Transcript