The June 1 roll-out of Merrill Lynch's new fee-based service is rocking the market, even as Prudential and others advertise their newfound conversion to asset-based compensation. While these developments might have profound implications, there is no reason they should cause fundamental shifts in the way investment advisers are regulated.
The regulatory arm of the National Association of Securities Dealers -- the self-regulatory organization for the brokerage industry -- sent an extensive memorandum to the Securities and Exchange Commission in December 1997. It states that:
* financial services are undergoing dramatic change;
* services provided by brokers and advisers often bear close resemblance to each other;
* and the "lack of clear and current regulatory standards will encourage firms to adopt subtle modifications to their activities in order to avoid the important requirements of the Securities Exchange Act of 1934" -- the primary law regulating brokers.
Last September, Frank G. Zarb, NASD chairman and chief executive officer, said he was collecting information to make a case for NASD regulation of investment adviser practices. And last month, Mary Schapiro, president of the NASD regulatory committee, expressed "concern" that brokers are fleeing their side of the securities business to become investment advisers. The NASD's conclusions are questionable at best and reflect a fundamental misunderstanding about how most investment adviser firms operate and how they are regulated.
There is a definite trend by brokers toward fee-based compensation. For large full-service firms, a major impetus is electronic communication networks that allow investors to trade on-line at much lower prices. As profits from brokerage commissions are squeezed and because their embedded costs remain relatively high, full-service brokers are looking for alternative sources of income. And the emergence of the "new investor" -- a more independent generation of market players armed with an arsenal of technological tools -- is another major factor. Given their enormous economic clout, these investors can demand a higher level of fiduciary responsibility from financial service providers.
Increasingly complex issues require greater time and effort from regulators. In fact, given the scope of the changes occurring, it might be time for the SEC to review and update its positions defining the differences between investment advisers and broker-dealers.
Various regulators must coordinate their efforts. The NASD should be looking to work with the SEC, the states and other regulators to ensure regulatory and legal standards are updated and enforced -- but without creating unnecessary regulatory burdens. The main question is determining who should take the lead.
The SEC and the states are the primary regulators of investment advisers. Advisers with more than $25 million in assets under management primarily are regulated by the SEC. Advisers with less than $25 million in assets under management are regulated exclusively by the states.
The SEC Task Force on Investment Adviser Regulation is reviewing and revising most existing adviser regulations, as well as proposing new requirements. The SEC also conducts full-scale regular inspections of investment advisers once every five years. Newly SEC-registered investment advisers are inspected within their first year of business. And the SEC is conducting a number of sweeps of investment advisers on targeted issues, including a large-scale and well-publicized effort related to soft-dollar practices, and inspections last year of more than 60% of registered advisers on Y2K issues. State regulators are taking similar actions to strengthen and improve their regulatory, inspection and enforcement activities. One can only wonder, therefore, why additional regulation by the NASD of advisers is necessary or desirable.
Everyone who deals with investment advisers and brokers knows there are key differences between them and that a different culture exists at the core of each industry. The primary factor separating advisers from brokers is the fiduciary duty advisers owe to their clients.
Brokers typically have custody of client assets, while advisers do not. Brokers typically engage sales forces that employ a variety of aggressive tactics, while advisers do not. Brokers typically execute trades, while advisers do not. And the history of abuses in the broker-dealer industry is well-documented. No comparable history exists for investment advisers. After all, how many times have you been interrupted during dinner by a cold call from an investment adviser?
A decade ago, the SEC submitted legislation to Congress that would have authorized the formation of a self-regulatory organization for the investment adviser industry. The ICAA and other groups strongly objected to it and Congress rejected it. Today, the NASD obviously is concerned that recent industry trends present problems for its membership base and that extending its reach toward investment advisers -- whether through a self-regulatory organization or otherwise -- might be one way of preserving its long-term viability.
The reasons that persuaded Congress to authorize the creation of a self-regulatory organization for brokers -- the high level of interconnectivity between broker-dealers; the number of documented cases involving investor fraud, conflicts of interests and overly aggressive sales practices; as well as the highly technical issues related to settlement, execution and reconciliation issues -- simply do not exist in the investment adviser industry. And remember that investors ultimately would end up footing the bill.
The NASD seems to have its hands full in dealing with problems that exist at the core of the broker-dealer industry. Instead of worrying about extending its reach to another industry, it would do well to stick to its core mission of regulating brokers and to coordinate with the SEC and other regulators in addressing any novel issues that may be created by recent changes in financial services.
David Tittsworth is executive director of the Investment Counsel Association of America, Washington, a non-profit trade association comprising federally registered investment adviser firms.
