Between now and July 21, 2011, some 4,200 registered investment advisors regulated by the U.S. Securities and Exchange Commission will switch to oversight by state authorities. This will not be as straightforward as it sounds. In fact, you have to wonder how the states can possibly pull it off.

In the past three years, the credit markets have imploded, the banking system has been effectively nationalized, hundreds of banks became insolvent, thousands of families were financially ruined by a $50 billion Ponzi scheme, and dozens of brokers and investment advisors were prosecuted for fraud. An unprecedented crisis of confidence threatens America's financial system and institutions-a crisis largely caused by the failure of regulators.

How has our government responded? By passing the 2,319-page Dodd-Frank Wall Street Reform and Consumer Protection Act.
Under this act, the SEC has been saddled with more onerous responsibilities-even though its failures helped cause the financial crisis. The agency must now regulate 10,000 hedge funds and several thousand private equity firms, and it has been charged with conducting more studies about how to regulate the markets. And yet the agency will remain underfunded-it was denied the right to fund itself by charging corporations fees (likely because legislators didn't want to jeopardize the political contributions they need from Wall Street).

In addition to the other massive changes the act has imposed on the financial regulatory system, Dodd-Frank is turning over regulation of registered investment advisors with less than $100 million to state governments, even though the states themselves are starved for cash, in some cases insolvent, and cutting their budgets as they see revenue from income taxes, sales taxes and other sources decline in the recession.

According to a report released in August by the Center on Budget and Policy Priorities, at least 46 states have imposed cuts, which have hurt both their residents and their economies. "The cuts enacted in at least 46 states plus the District of Columbia since 2008 have occurred in all major areas of state services, including health care (31 states), services to the elderly and disabled (29 states and the District of Columbia), K-12 education (33 states and the District of Columbia), higher education (43 states), and other areas," says the CBPP study. And yet the need for these services did not go away. In fact, it increased with the number of families facing economic difficulties.

Virtually all states are legislatively required to balance their operating budgets annually or every two years. Unlike the federal government, states cannot operate at a deficit. So handing over the regulatory authority of RIAs to states when they are already starved for cash is like asking a drowning man for a glass of water. It could further erode investor confidence in American markets.

State regulators are not to be blamed for this mess. Perhaps they could be faulted for seizing the opportunity to regulate more investment advisors without also insisting on securing proper funding. But many states zealously protect investors and are known for being more diligent in regulating Wall Street and ferreting out fraud than federal authorities. It was not so long ago that New York Attorney General Eliot Spitzer upstaged the SEC by prosecuting mutual funds for front-running and other illegal activities and cleaned up conflicts of interest posed by Wall Street firms in dishing out biased research about their investment banking clients. (Spitzer rode his reputation as Wall Street's toughest cop to the New York governor's mansion before being forced to resign in disgrace after a 2008 prostitution scandal, and he is now remaking himself as a cable TV commentator.)

Until July 8, 1997, when the National Securities Market Improvement Act of 1996 (NSMIA) went into effect, the SEC shared the regulatory oversight of RIAs with state securities authorities, but the SEC was usually looked upon as the primary regulator and top cop under the Securities and Exchange Act of 1934. It prosecuted the highest profile civil cases. The states could move against an RIA for malfeasance, but most state regulators played a secondary role.

NSMIA amended the Investment Advisers Act of 1940 by mandating that RIAs with less than $25 million be regulated by state securities departments. RIAs managing more than $25 million of client assets were to be regulated by the SEC, allowing the federal agency to focus on larger firms. At the time, the main reason was that the SEC was overburdened; the agency was examining about 10% of RIAs annually, which meant on average they were being examined only once every ten years.

While the main goal of NSMIA was to create a clear line divvying up regulatory responsibilities between states and the SEC, the law gave states responsibility for approving IA representatives regardless of how much money was managed by their RIA. This confused the regulatory roles: NSMIA gave states the right to examine all IA reps but not all RIAs. The SEC was responsible for examining IA reps but rarely did so.

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