The SEC is making your chief compliance officer a whistleblower.
If recent Securities and Exchange Commission audits
are any indication of what registered investment advisors will face in
2005, you should expect that the year's greatest regulatory challenge
will come from the SEC's determination to put each firm's chief
compliance officer in the role of watchdog and whistleblower,
especially over the firm's own senior managers.
And that's just the way SEC examiners want it, according to an eight-page document obtained by Financial Advisor magazine. The SEC "Examination Request List" details the extensive audit program the SEC has embarked on against advisors, in the wake of the agency's mandate that beginning last October each firm hire its own chief compliance officer and implement formal compliance policies and procedures.
Now it's check-up time. The SEC is making it clear that it has cast chief compliance officers in the role of watchdog when it comes to ferreting out problems and weaknesses, especially against their firms' own senior managers. "If there is one overriding regulatory issue that advisors have to be wary of in 2005, it's how the SEC will interpret the role of their CCOs and the way they've implemented written policies and procedures," says Robert Stype, a former SEC examiner and founder and managing partner of Adviser Compliance Associates in Washington, D.C.
To say that the agency is interpreting the CCO's role expansively may be an understatement. According to the aforementioned examination request list given to an advisory firm prior to inspection last month, the SEC is asking for a written report from CCOs detailing each infraction and problem they've encountered since assuming their job. The agency also wants to know whether or not principals of the firm are cooperating with their CCOs or standing in their way when the compliance officer seeks resolution, resources and personnel.
Compliance experts agree that the comprehensive and in-depth nature of the materials being requested from advisor firms mark the beginning of what appears to be an era of heightened scrutiny for advisors. "We've seen a number of these requests recently and they all tend to be similar," says Stype. "Examiners are asking lots of questions about the CCO, including whether or not senior management has been cooperative with requests."
According to the SEC exam request list, examiners want the CCO to write and sign, or have the firm's president write and sign, a document on company letterhead that outlines the following:
The nature of each problem or breach the CCO has found at the firm;
How and when the breach was detected;
The people involved;
Any monetary impact on clients;
How the breach or issue was resolved;
How the breach or issue was reported to management;
The documentation available for review.
The SEC is also taking an expansive look into how
responsive the chief compliance officer believes senior management at
his or her firm is to perceived or real challenges. In the exam
document, the SEC makes it crystal clear that if senior management
disagrees with anything the compliance officer is asserting, whether
its the need for greater authority, autonomy or resources, it must be
reported to regulators during the audit.
One former regulator, now a Washington, D.C.-based attorney, conjectures that this is the SEC's way of addressing its long-asked-for budget increase for overseeing investment advisors-"by essentially putting compliance folks in the role of managing the firm's principals."
Indeed, any irregularities in the working relationship between CCOs and senior managers must be reported, along with the CCO's opinions about his or her own autonomy, the competency of the compliance program at the firm and the CCO's authority to administer it. Specifically, the SEC also wants a written description of the "CCO's opinions regarding the adequacy of resources to establish and implement an effective compliance program, along with a list of all the work a CCO would like to do but has not been given the resources to do."
While this creative tension at firms may work well for the SEC, it makes for strange bedfellows at the advisory firms being examined, the former SEC examiner says. "If the compliance officer tells the SEC, 'Well, I asked for these resources and I got them,' the next question has to be, 'So now will I be expected to be perfect?'" says Stype. "Alternately, if the CCO tells the SEC, 'No, senior management hasn't been cooperative,' it puts the compliance person in an extremely awkward position in their own firm."
"This is a pretty difficult rule to deal with, if you're talking about challenges," he says. "And this is just Round One. How the industry responds and how the SEC reacts to those responses will be very telling."
Beyond the books and records the SEC is asking for, it is also requesting all business-related bank and checking accounts, a list of all customer complaints and how each was handled, a list of clients lost during the year and a list of all trade errors.
What the agency is looking for are patterns, or at least instances, where firms are not doing what they are promising clients they're doing, either in written or verbal communications. On the flip side, doing things you haven't informed clients you'll be doing can be equally troubling to regulators. Inadequate disclosure about how firms steer business or what they charge or are being paid, especially by third parties, falls clearly into this category.
"I think it's clear that investment advisors should be looking toward his or her own business for conflicts of interest. That will be the challenge of 2005," says Barry Barbash, a former director of the SEC's Division of Investment Management who is now a partner with the Washington, D.C., office of Shearman & Sterling LLP.
Overpromising and underdeliverng, particularly in the area of separately managed accounts, is another red flag, says Chip Roame, president of Tiburon Strategic Advisors. Roame's recent research has found that only a fraction of firms are providing the customization, tax management and diversification they promise.
The real thrust of regulatory interest in the separately managed account arena may be alarm over the fact that advisor clients may be paying for services they're either not getting or not using. "The big sales pitch at firms is customization, but only about 18% of separately managed accounts are customized today," says Roame. Tax harvesting is another major sales thrust, but only about 30% of advisors do tax harvesting in SMA accounts.
Advisors using separately managed accounts also run aground on the diversification front. While often trumpeting the long list of managers and products that they'll make available to clients, advisors on average put 65% of SMA assets in large-cap growth funds, Roame says. While advisors often promise to use three, four or five different money managers to invest client portfolios, Roame has found that typically 40% of SMA accounts are invested with one manager.
Certainly the trend to fee-based investing is one of the most substantial in the investment business, but if anyone can derail advisors' success, it might be advisors themselves. "Even if regulators can argue that fee accounts are more expensive, they should be," Roame says. "The vulnerability is for people charging fees and not delivering appropriate levels of services and advice. There's nothing wrong with charging, but you have to earn it."
"Advisors success with regulators in 2005 will depend largely on whether they trip themselves up or are able to create a business model that is better aligned with their clients," Roame says.
Still, the heightened regulatory scrutiny is driving some planners who want to convert to a fee-based business into the arms of independent broker-dealers and away from the go-it-alone model. To ease the transition for planners and take advantage of the opportunity, SunAmerica Securities has created six turnkey transition suites and will roll out three more that planners and registered reps can join as they transition their business to an independent, fee-based business model.
"Increasing regulation will be a challenge no matter what side of the aisle you're on, but our transition suites are designed to significantly lighten the load," says SunAmerica President and CEO Jim Cannon. That's because the transition suites take care of the bulk of back-office obligations, including providing a CCO who will oversee compliance policies and procedures. The draw of this model is that it allows the planner to concentrate on transitioning and growing his or her business.
With the lawsuit the Financial Planning Association filed against the SEC hanging in the balance, along with a clear-cut rule that decides whether brokers who offer advice should have to live by advisor rules, the fact that the SEC is ramping up advisor scrutiny is hard to miss.
Laurie Lennox, chief compliance officer at Commonwealth Financial, says that the issue over who is offering advice and where to draw the line when it comes to brokers and advisors becomes one of semantics that is clearly lost on many investors. It also becomes a fine line to walk for brokers and their firms, who are supposed to be offering only "incidental advice," under the SEC's pending rule, in order to qualify for the exemption from advisor regulation. To solve the problem, both SunAmerica and Commonwealth only allow registered investment advisor reps at their firms to offer fee-based products.
While independent broker-dealers seem to have taken the high road, wirehouses continue to fight the loss of the regulatory exemption tooth and nail.
Still, Barbash maintains that it will be scrutiny and not the lawsuit that will define 2005 for advisors. "The SEC will certainly finalize the broker-dealer exemption rule and that will probably be a good thing, so there is closure and the ground rules can be set. But the typical advisor should look at their own business for conflicts of interest, because that's what regulators will be looking for."