Sunday, March 17, 2013

Registered Investment Advisers: A New Paradigm for Regulation and Enforcement

Table of Contents
1. The SEC's Flawed Examination Process
2. A Call for Sound Principles-Based Regulation
3. Professional Involvment in Developing Professional Standards of Conduct
4. The Necessity of Professional Peer Review


Why are registered investment advisers (RIAs) and their investment adviser representatives (IARs) treated like criminals? Other professionals - attorneys and CPAs for example - don't receive the intense scrutiny during examinations which RIAs receive. Other professionals are not bound to observe a host of rules and regulations which add substantially to the cost of doing business. While there does exist one distinction - i.e., RIAs may possess control over "other people's money," in this post I submit that there are far sounder ways of protecting the public than those currently utilized.

It's easy to criticize the U.S. Securities and Exchange Commission (SEC) and state securities regulators. Over the years they have imposed more and more rules and requirements on registered investment advisers (RIAs) and their investment adviser representatives (IARs). The onsite examinations of small- and mid-size firms often last several days, or several weeks, with a "deficiency letter" following detailing minor transgressions in observing procedures required by the regulators. Very few onsite examinations uncover serious fraud ... rather, theft of client assets is usually uncovered via a complaint from a client or from a disgruntled employee.

I have previously written of the need for the SEC to focus upon actual fraud, in this era of limited funding of government operations. What should an examination look like? First, much of it should be done via an information request, with records electronically delivered to an SEC examiner for a cost-efficient review. The onsite examination should be focused on the detection of actual fraud - i.e., theft or misuse of client assets.

During onsite examinations, SEC and/or state securities examiners should go around to each and every employee of the company, hand out their business cards, and even inform employees of the availability of making an anonymous complaint against the firm. All employees should be required to attest to the fact that theft of clients' funds is not occurring, and that all funds are properly custodied. That's the way to detect fraud!

Of course, most smaller RIA firms don't possess custody of their clients' assets - the client assets are harbored in accounts with a discount broker (custodian). Hence, firms without custody are low-risk. But frequent inspections are still required - in order to verify that no custody actually exists.

In those circumstances where RIA firms take on custody, then a greater onsite review would be required. The essential role of government oversight of RIAs (and Wall Street, generally) is that of asset verification - i.e., ensuring that the client's/customer's assets are in fact there. And firms that take on custody should pay higher fees, due to the necesssity for more intrusive oversight (and the costs thereof).

We must realize that most Ponzi schemes are not "planned" months in advance of their commencement by the perpetrators. Rather, a registered representative or RIA/IAR gets into financial trouble, and he or she begins to "borrow" from client accounts. Slowly the situation balloons, ever-bigger. Self-justification of transgressions becomes the norm. As the fraud grows ever-bigger, most Ponzi artists actually want to get caught.

Hence, frequent inspections of all RIA firms are necessary - to prevent transgressions from escalating into situations where national press reports a multi-million dollar theft. But such examinations do not need to last for many days, or many weeks, in most instances.

By undertaking far more focused examinations, securities examiners can examine all RIA firms far more often. They can ensure that firms accurately report whether they possess custody. They can seek out employees who can whistelblow. They can inspect those RIA firms who possess custody of client assets, with the focus of the inspection on asset verification. In this manner, they would be able to detect frauds before they blossom until large, multi-million dollar (or billion-dollar) frauds. In essence, the securities examiners would be doing the core of their job - protecting the public from thievery. And, by reducing the number of actual frauds, greater consumer confidence will occur in our financial services system.


The fiduciary standard imposed upon RIAs and their IARs is beautiful in both its simplicity and its adaptability. Unlike a bevy of rules designed to prevent specific actions (which are often circumvented by new schemes falling outside the specific rules), the fiduciary standard is principles-based regulation.

This does not mean, however, that RIAs should not understand their fiduciary obligations. Guidance is required, and much more so that the simple statement that "RIAs have to act in their clients' best interests." Even the common (in the U.S.) triparte recitation of the fiduciary standard - that it consists of the duty of due care, the duty of loyalty, and the duty of utmost good faith - is insufficient to furnish adequate guidance to RIAs.

What is needed is a more comprehensive set of Standards of Professional Conduct for all individuals who practice as RIAs/IARs. Notice I say all individuals, not firms. Professional regulation does not involve setting standards for firms, but rather for the individual in those firms. In this manner, the development of standards is far more likely to evolve properly, by keeping the standards at the highest level. Otherwise, the economic interests of for-profit firms would, over time, negate the elevation of standards. (This has happened under the Maloney Act and with FINRA - where the creators of the Act desired to raise the standards of broker-dealer firms and their registered representatives to the "highest levels" over time, but due to the protection of the economic interests of its broker-dealer members FINRA has kept the standard to that of the very low standard of "suitability".)


From where might we discern a comprehensive set of Standards of Professional Conduct? There are many models to choose from, and sources of information. I tend to favor the American Bar Association's Model Rules of Professional Conduct as an illustrative template. But other existing standards can be looked at, including those found in ISO 22222, the CFP Board's Standards of Professional Conduct, the standards for CPA/PFS, and those of the CFA Institute for its members. Of course, existing state common law, FINRA arbitration decisions, SEC regulations and no-action letters and regulations, and those decisions and rules of other agencies should be consulted during this process.

(For an illustration of just what a principles-based set of professional standards of conduct might look like, view pages 49 ff. of my prior submission to the DOL, located at

Who should develop these new Standards of Professional Conduct? The answer is clear ... the professionals themselves. Only those with a thorough knowledge of the profession can envision how proposed rules are likely to be applied. Hence, I call upon the U.S. Securities and Exchange Commission (SEC) and the state securities regulators (through their association, the North American Securities Administrators Association, or NASAA) to form, together with the U.S. Department of Labor (DOL/EBSA), the Commodities Futures Trading Commission (CFTC), and the Municipal Securities Rulemaking Board (MSRB), an Advisory Board for the purpose of establising Standards of Professional Conduct for those individuals who practice as RIAs/IARs.

The members of such an Advisory Board should be wholeheartedly committed to the fiduciary standard of conduct. They should be leaders of the profession. Aided by competent staff, these members should, over a period of time, develop the Standards of Professional Conduct for RIAs. As part of this process, existing regulations requiring RIAs to undertake various actions or maintain certain records should be examined and, where appropriate after applying a cost-benefit analysis, either retained, modified, or discarded.


One of the reasons that securities regulators tend to focus on minitae, as well as the adequacy of disclosures, is the fact that enforcement violations relating to inadequacy of procedures, or inadequacy of disclosures, are easy to detect for examiners, many of whom have never worked in the industry.

The lack of experienced professionals being involved in disciplinary actions often leads to harsh results. Many an RIA has spent tens of thousands of dollars (or hundreds of thousands of dollars, or millions of dollars) defending itself against an assertion by a securities examiner, where in the end no violation of the RIA's fiduciary duties has occurred.

Part of the difficulty lies in enforcing the fiduciary duty of due care. We must first decide if it is appropriate for the government to enforce this duty. I personally would opine "yes." Although private rights of action exist for breach of this duty, all professional organizations also take action upon complaints involving the duty of due care.

If we conclude that the fiduciary duty of due care is to be enforced, then peer review is a necessity. Both at the stage where probable cause for a violation is found (or not found), and thereafter during the hearing process. Only fellow professionals, with substantial experience, can responsibily adjudicate the many different types of situations arising under an IARs duty of due care.

Hence, I also call upon our government regulators to augment the current enforcement process with peer review - to aid examiners in determining whether violations exist and in determining the severity of transgressions - when a breach of fiduciary duty is alleged.


The time has come for investment advisors (and, more broadly, financial planners) to be regulated under structures befitting their status as professionals. It is time for examinations to focus on the detection of actual fraud, and for professionals to otherwise be treated as such (not as suspects). It is time for professionals to be involved in the development of regulation and oversight procedures, as well as be involved through the necessary step of peer review of their fellow professionals when a potential transgression is noted.

As professionals this will require our time, energy, and perseverence to attain. But, if we are ever to be treated as the professionals we know we are, then it is time to make this transition happen. Why?

  • For the betterment of consumers of our professional advice and services. Consumers deserve professional advice provided under true professional standards of conduct.
  • For the enhancenment of the trust of consumers in our profession, through proper government oversight (enhanced frequency of more targeted examinations, and peer review). The resulting elevation of trust will no doubt lead to an explosion of demand for professional investment and financial planning advice.
  • For you, and for me, to join together in a true profession. To be proud to call our peers fellow members of this profession. To be more knowledgeable, through the developed Professional Standards of Conduct, of the obligations we assume on behalf of our clients under the highest principle set forth in the law - the fiduciary standard.
Thank you.

Ron A. Rhoades, JD, CFP(r)
February 25, 2012

Ron Rhoades is the Curriculum Coordinator for the Financial Planning Program at Alfred State College, Alfred, New York, and a practicing investment adviser representative. He also currently serves as Chair of the Steering Committee of The Committee for the Fiduciary Standard. To contact Ron, please e-mail him at:  Thank you.

1 comment:

  1. Thanks! for sharing this important information carry on !! All The Best...

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