I can’t guarantee much from my personal crystal ball, but looking across the regulatory horizon into 2016 there is one undeniable certainty: Securities attorneys will be just fine. The sheer volume of complicated rulemaking that is pouring out of Washington bodes well for billable hours but not for bottom lines. Only time will tell which (if any) of my other predictions below come to pass, but don’t fret about your JD friends…they’ll be anything but bored.
Robo-Advisors: Skepticism and Scrutiny by the SEC
Regulators’ skeptical attitude toward robo advice (and bias, some may argue) first reared its head in May when both FINRA and the SEC issued an Investor Alert that urged investors to be wary of “automated investment tools” for those ‘tools’ potentially conflicted advice, faulty assumptions, misguided outputs, lack of suitability and privacy misdeeds. It wasn’t exactly an endorsement of innovation.
Fans were further flamed after attorney Melanie Fein published “Robo-Advisors: A Closer Look” in June, in which she concluded (after reviewing a sample of ADVs and client contracts) that robo-advisors “do not provide investment advice that is necessarily in the customer’s best interest, are not free from conflicts of interest, do not necessarily minimize investment costs, and do not comply with the fiduciary standard of care under well-established fiduciary principles.”
Commissioner Kara Stein may have tipped the SEC’s hand during her November 9th remarks at Harvard Law School’s Fidelity Guest Lecture Series (available here), or at the very least strongly suggested that robo advisors have made enough noise to catch the regulator’s attention. Her concerns centered primarily on an algorithm’s ability to fulfill traditional notions of the fiduciary standard, and she openly questioned whether inhuman investment advice “can be neatly placed within our existing laws.”
My guess is that the running assumption behind closed doors at 100 F Street NW is a resounding ‘No!’ and the burden of proof will be on robo advisors to prove otherwise. I wouldn’t be surprised if representatives from multiple divisions within the SEC “ask” to visit the major robo players’ offices to – if nothing else – learn how exactly everything works.
Fiduciary Rulemaking: An Unmitigated Politicized Mess
But let me tell you how I really feel…
There are currently two heavyweight Washington bureaucracies trying to figure out this whole fiduciary thing. In one corner we have the Department of Labor, which received literally thousands of comment letters in response to its proposal to amend the ERISA definition of fiduciary, carve out a new best interest contract exemption, and tinker with various conflict requirements. The proposal resulted in nothing short of an industry maelstrom, with pundits, prognosticators and politicians all pounding the pulpit for their particular positions.
A final rule is expected out of the DOL by mid-year 2016.
In the other corner is the SEC, which has until recently been deflecting pressure to give a specific timetable for its much-anticipated uniform fiduciary standard rulemaking. That rulemaking – authorized by Section 913 of the Dodd-Frank Act – would elevate the standard of care due retail customers by broker-dealer representatives providing personalized investment advice to at least the standard imposed upon investment advisers. Such a proposal now appears to be officially on the 2016 SEC agenda, according to documents recently published through the Office of Management and Budget.
In a nutshell, a final DOL fiduciary rule and a proposed SEC fiduciary rule are both expected in 2016. Buckle up folks, the regulatory turf wars are only just beginning and the industry is caught in the middle.
There are those who say the DOL jumped the gun and should have waited to collaborate with the SEC before railroading its fiduciary vision into law. There are others who say the SEC simply took too long to act on its fiduciary vision and has only itself to blame for being late to the party.
Both arguments may have some merit.
But the bottom line is that this is a turf war without a winner, and it will take far too many billable hours to understand the conflicting and cumbersome knot that’s being wrung around the industry’s neck.
P.S.: If you want to read a much more eloquent and thoughtful perspective on these fiduciary shenanigans, check out SEC Commissioner Daniel Gallagher’s comment letter to DOL Secretary Thomas Perez.
Anti-Money Laundering Program: An RIA Requirement
This one has been a long time coming – as in since 2003. Believe it or not it’s been over a decade since the Financial Crimes Enforcement Network (FinCEN) originally proposed to subject investment advisers to the anti-money laundering provisions of the Bank Secrecy Act, but this time it looks like the rule will stick. In its current form, the proposal will require most federally registered IAs to establish a written anti-money laundering program, file suspicious activity reports with FinCEN and maintain certain related books and records.
The comment period for FinCEN’s proposal ended in early November, so a final rule should be submitted for approval well before the next year is out.
Form ADVs: They’ll Get Longer; Clients Will Get More Overwhelmed
In May the SEC issued a rule proposal to broaden the scope of information collected from advisers on Form ADV Part 1A, which is the non-narrative check-the-box part of the ADV (i.e., not the brochure that’s provided to clients). Additional information is sought for separately managed accounts (types of clients and assets as well as use of derivatives and borrowings), social media pages, office locations, outsourced chief compliance officers and other more technical data points. The SEC also proposes to permit “umbrella registration” for multiple affiliated private fund advisers conducting a single advisory business.
The ostensible rationale for the added data grab is three-fold: it aids the SEC in preparing for and executing its risk-based examination program, it allows for the monitoring of census data and industry trends, and it protects investors by providing information to them about advisers.
I certainly believe the first two justifications, but I have my doubts that most clients take the time to pore over an ADV Part 1A (let alone the brochure). I’m not arguing against the ADV Part 1A amendments, but am simply using it as a pivot to the bigger question: Is the regulatory thirst for data the tail that wags the dog of investor protection?
Let’s take a simple example: a client that engages the services of an investment adviser, opens an account at a custodian and purchases a mutual fund. In this most basic of examples, the client would be presented with an investment advisory contract, a custodial account opening form (including pages of disclosure and CYA), a mutual fund prospectus (and access to the mutual fund’s statement of additional information), three privacy policies and the adviser’s Form ADV Part 2 (and access to Form ADV Part 1).
If the account happens to be subject to ERISA, add the 408(b)(2) disclosure document. If the client happens to have other accounts or purchases other funds, add additional custodial forms and prospectuses.
I also suspect that the Form ADV Part 2A brochure will continue to get longer not due to official rulemaking, but as a byproduct of enforcement actions that cite insufficient brochure disclosure. Regulatory counsel will likely err on the side of including everything but the kitchen sink in the form of brochure disclosure, lest their clients get dinged for misleading investors.
When will clients have enough information at their disposal? Haven’t we already reached the point of information paralysis?
Third-Party Compliance Reviews: Will Become Extremely Controversial
It’s no secret that the SEC has been working on a proposal to require investment advisers to undergo “third-party compliance reviews” (i.e., not conducted by the SEC or an SRO). Both SEC Chair Mary Jo White and Division of Investment Management Director David Grim have testified to this effect.
The concept has thus far received relatively little press attention, but a Wall Street Journal op-ed by Norm Champ (the former Director of the Division of Investment Management) stands out for its decided opposition to the idea. I expect this proposal to become very controversial very quickly once all of the potential consequences are flushed out (and once the SEC releases an actual proposal).
Stay tuned.
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This article originally appeared on December 4, 2015 in ThinkAdvisor.