U.S. state oversight of small investment advisers takes effect; exams and enforcement loom
By Jason Wallace
SAN DIEGO/NEW YORK, June 28 (Thomson Reuters Accelus) – A long anticipated and well-publicized deadline for “the switch‚ÄĚ is here. According to recent estimates, 2,500 investment advisers with less than $100 million of regulatory assets under management will make the switch from the U.S. Securities and Exchange Commission oversight to registration and in one or more states, with the prospect of more frequent exams and vigorous enforcement.
Today‚Äôs deadline requires the firm to be registered in the applicable states and withdraw its SEC registration by the end of the day. Although the proverbial switch has been pulled, the regulatory changes have just begun. Newly transitioned mid-sized advisers will now face an imminent regulatory exam and be required to comply with unique state compliance requirements.The switch is a product of the Dodd-Frank regulatory overhaul and has been in the works for approximately two years. The switch could be considered one of the biggest changes for the advisory regulatory landscape in the last 15 years. The states will now be responsible for approximately 17,000 advisory firms, with the SEC regulating approximately 10,000.
The states have not been shy in touting their record when it comes to prosecution of securities violations. State securities regulators in 2010 conducted more than 7,000 investigations, leading to nearly 3,500 enforcement actions, including more than 1,100 criminal actions, John Morgan, the Securities Commissioner of Texas, told Congress earlier this month. The numbers suggest that the state regulators are up to the job and, according to Morgan, ‚Äústates have been preparing for this switch for two years and look forward to accepting the increased regulatory oversight of mid-sized investment advisers.‚ÄĚ
State exam cycles
The states also have also been busy on the examination front. According to a¬†North American Securities Administrators Association‚Äôs (NASAA) 2010 survey, virtually all states conduct routine or non-cause on-site examinations and the vast majority (89%) of them conduct these exams on a formal cyclical basis. Approximately one-half of the states completing examinations in reoccurring 1-3 year cycles with the remaining half falling within the 3-6 year range. These examinations are often initiated within the first two years of a firm‚Äôs registration, enabling the states to institute a strong culture of compliance from the beginning.
The states‚Äô exam record is vastly different from the SEC. In a study¬†mandated by the Dodd-Frank Act, the SEC staff was ordered to review and analyze the need for enhanced examination and enforcement resources for advisers. The results were a bit astonishing, with the SEC only examining percent of their registered advisers in 2010. At that rate, an adviser can only expect to be examined less than once every 11 years. This lengthy cycle leaves a large percentage of SEC registered advisers that have never been examined at all.
It‚Äôs apparent that a newly transitioned adviser will be examined in the near future and this could be a stressful notion for many. Preparation is imperative at this early juncture for advisers that have never been examined and even those who are exam veterans. Researching the states‚Äô requirements is the best first step. Many states have adopted rules and regulations similar to current SEC rules, although ensuring unique state requirements are fulfilled will be imperative especially when the examiner knocks on the door.
The specific requirements depend on the firm’s home state, but they typically include:
- Net capital or bonding: Advisers registering directly with a state securities regulator will likely be subject to a net capital or bonding requirement. Typically, the level of net worth, net capital or amount of bond is based on the firm’s activities. Many states take the approach of requiring firms with custody of client funds or securities to maintain a net worth of $35,000 and firms having discretionary authority, but not custody, over client funds or securities to maintain a net worth of $10,000. Firms not meeting the net worth requirement often must then obtain a surety bond in the amount of the net worth.If the required net worth is deficient at any time, most states will require notification in a timely fashion, with the time limit specified by each state’s regulations, and in many cases will require the firm to file interim financial reports until told otherwise by the state.
- Annual filing requirements: Firms may be required to make additional state filings beyond submitting the ADV Parts 1 and 2 associated with their annual amendment process. For example, New York-registered firms must submit fiscal year-end financial statements to the Attorney General, and California-registered firms must submit financial documents, but only if they have custody or discretionary authority over client funds.The financial reports typically include a balance sheet, income statement and any specific forms submitted directly to the state. This highlights the importance of the details when registering with a state regulator because each one has its own twist on the general rules.
- Solicitors: Although there is often some reference to¬†rule 206(4)-3 under the Investment Advisers Act of 1940, state laws regarding solicitors who market advisory services to potential clients for a fee vary greatly. Some states require solicitors to be qualified and registered as investment advisory representatives, some only require registration, and some don’t require either.
- Code of ethics: This will vary depending on the state regulator’s investment advisor rules and regulations. Since many states follow the SEC model, state-registered advisers may be required to adopt a code of ethics similar to the requirements of¬†rule 204A-1 under the Advisers Act.
- Written policies and procedures: Don’t throw your procedures away just yet! Requirements for maintaining written compliance policies and procedures vary from state to state, but many states have requirements similar to¬†rule 206(4)-7 under the Advisers Act on written supervisory and compliance policies and procedures.
- Custody: Many states have adopted similar provisions to the recent SEC custody amendments, although a major difference is the amount of net capital required. For example, a firm with custody in California will have to maintain and prove, at least on an annual basis, to having $35,000 in net capital.
State regulators will be out in full force and it could be said they have something to prove. The states don‚Äôt want a Bernard Madoff-type scheme on their watch and they will do everything in their power to ensure of it. Take this as a fair warning, newly transitioned advisers should become familiar with their state specific requirements and prepare for an upcoming onsite examination.
(This article was produced by the Compliance Complete service of Thomson Reuters Accelus.¬†<a href=”http://accelus.thomsonreuters.com/solut ions/regulatory-intelligence/compliance- complete/” target=_new”>Compliance Complete</a> provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and¬†exchanges.)