United States: SEC Staff Delivers Study on Enhancing Investment Adviser Examinations to Congress
Financial Services Alert - Developments of Note - Part 2

SEC Staff Delivers Study on Enhancing Investment Adviser Examinations to Congress

On January 19, 2011, the SEC staff delivered to Congress its Study on Enhancing Investment Adviser Examinations. The study is designed to fulfill a Dodd-Frank Act mandate that the SEC conduct a study to review and analyze the need for enhanced examination and enforcement resources for registered investment advisers. The study discusses (a) the general examination process for registered advisers, (b) the number and frequency of examinations of registered advisers over the last six years, (c) the impact of the Dodd-Frank Act on registered adviser examinations, particularly the Act's provisions affecting adviser eligibility to register with the SEC, (d) options for addressing the SEC staff's capacity constraints with respect to adviser examinations and (e) the staff's recommendations. In broad terms, the study reports that the number of registered investment advisers ("RIAs") and the assets that they manage have grown significantly over the past several years, while the number of staff in the SEC's Office of Compliance Inspections and Examinations ("OCIE") has declined over the same period. The SEC staff further reports that while the SEC's resources and the number of OCIE staff may increase in the next several years, the number of OCIE staff is unlikely to keep pace with the growth of RIAs. Accordingly, the SEC staff believes that the SEC likely will not have sufficient capacity to conduct effective examinations of RIAs with adequate frequency and that the SEC's RIA examination program needs an adequate source of stable funding. The SEC staff recommends that Congress consider the following three approaches in order to strengthen the RIA examination program:

• Authorize the SEC to impose user fees on RIAs to fund their examinations by OCIE;
• Authorize one or more SROs to examine, subject to SEC oversight, all RIAs; and
• Authorize FINRA to examine dually registered broker-dealers and RIAs for compliance with the Investment Advisers Act of 1940.

The study also analyses the ability of user fees and one or more SROs to augment the SEC's efforts in overseeing RIAs and improve the frequency of RIA examinations. The study further analyzes alternatives to the current approach of examining dually registered broker-dealers and RIAs and RIAs that are affiliated with a broker-dealer.

While the Commission has not officially expressed a view about the study, Commissioner Elisse Walter released a statement expressing her disappointment with the results of the study. In sum, she stated that she wanted to ensure that Congress is aware of the resource constraints under which the SEC and OCIE operate currently and will operate in the future as a result of, for example, unfunded mandates and various elements of the Dodd-Frank Act such as (i) the creation of additional classes of SEC registrants who must also be examined by the SEC and (ii) the increased complexity of the advisory organizations that will be registered with the SEC. Commissioner Walter also argued that the description and weighing of the alternatives outlined in the Study is not balanced or objective. She noted, in particular, that the SRO option was given short shrift.

SEC Delivers Study on Uniform Standards for Investment Advisers and Broker-Dealers

On January 21, 2011, the SEC delivered to Congress a study on investment advisers and broker-dealers required by Section 913 of the Dodd-Frank Act (the "Study"). The Study, available here, recommends that broker-dealers and investment advisers be subject to a uniform fiduciary standard of conduct in providing personalized investment advice about securities to retail investors, and that the standard be no less stringent than that currently applied to investment advisers. The Study, prepared by the SEC Staff, also notes other differences in the regulatory schemes applicable to investment advisers and broker-dealers, and recommends that the SEC consider whether to more broadly harmonize the regulatory schemes applicable to the two groups.

Harmonization. The changes recommended in the Study would have an increased regulatory impact not only on broker-dealers but also on investment advisers. The recommendations, in addition to the uniform fiduciary standard, include:

• Adopting uniform standards on advertising and customer communications regarding similar services and harmonizing internal pre-use review requirements for marketing materials or requiring advisers to designate employees to review and approve marketing materials, as broker-dealers are currently required to do;
• Imposing licensing, examination and continuing education standards on investment adviser representatives similar to those applicable to registered representatives of broker-dealers;
• Modifying the books and records requirements for investment advisers, including by adding a general requirement to retain all communications and agreements related to an adviser's "business as such," consistent with the standard applicable to broker-dealers; and
• Requiring broker-dealers to provide a document disclosing the terms of their relationships with other broker-dealers and investment advisers, including material conflicts of interest, akin to the new Form ADV Part 2A that advisers deliver at the time of providing investment advice.

Dissenting Commissioners. Two of the Commissioners, Kathleen Casey and Troy Paredes, issued a dissent from the Study (available here). They wrote that in their view, "the Study's pervasive shortcoming is that it fails to adequately justify its recommendation that the Commission embark on fundamentally changing the regulatory regime for broker-dealers and investment advisers providing personalized investment advice to retail investors." They further stated that the Study's recommendation of a new uniform fiduciary duty standard and harmonization of two disparate regulatory schemes was made without adequate articulation or substantiation of the problems that would be addressed by the regulation, or recognition of the risk that the recommendations could adversely impact investors. The two Commissioners acknowledged that the Staff had had only a short time to conduct its study, but expressed the hope that the SEC would conduct further studies before proposing regulations.

What Happens Next. Section 913 of the Dodd-Frank Act provides that the SEC "may" engage in rulemaking with respect to the fiduciary standard, but does not set a deadline for the adoption of regulations. The SEC has not formally invited comment on the Study. Any proposed rulemaking will include an opportunity for comment.

SEC Proposes Permanent Rules and Forms for Municipal Advisor Registration

On January 6, 2011, the SEC published a release ("Proposing Release") proposing permanent rules and forms for registration of municipal advisors pursuant to Section 15B of the Securities Exchange Act of 1934 (the "1934 Act"). Comments on the proposal are due by February 22, 2011.

Background. Section 15B of the 1934 Act was amended by the Dodd-Frank Act to require registration of municipal advisors. Temporary rules of the SEC implementing the registration requirement have been in effect since October 1, 2010. Municipal advisors currently register by filing Form MA-T electronically with the SEC. The proposed rules and forms contemplate that municipal advisors registered on Form MA-T will be required to re-register on the new forms.

What is a Municipal Advisor? A municipal advisor is defined by Section 15B as a person (other than a municipal entity or an employee of a municipal entity) that:

• Provides advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities, including advice with respect to the structure, timing, terms, and other similar matters concerning such financial products or issues, or
• Undertakes a solicitation of a municipal entity.

"Municipal financial product" means municipal derivatives, guaranteed investment contracts and investment strategies. "Investment strategies" is defined, in turn, to include "plans or programs for the investment of the proceeds of municipal securities that are not municipal derivatives, guaranteed investment contracts, and the recommendation of and brokerage of municipal escrow investments." "Solicitation of a municipal entity or obligated person" means a direct or indirect communication with a municipal entity or obligated person made by a person, for direct or indirect compensation, on behalf of a broker-dealer, investment adviser, municipal dealer or municipal advisor for the purpose of obtaining or retaining an engagement by a municipal entity or obligated person of a broker, dealer, municipal securities dealer, or municipal advisor for or in connection with municipal financial products, the issuance of municipal securities, or of an investment adviser to provide investment advisory services to or on behalf of a municipal entity. The definition provides an exception for a person making such a solicitation on behalf of an affiliate. Even though the statute does not specifically state that a person who undertakes solicitation of an obligated person is a municipal advisor, the SEC has concluded, in part from the fact that the statute defines "solicitation of a municipal entity or obligated person," that Congress intended to include solicitation of obligated persons as an activity requiring registration as a municipal advisor.

The law provides that a person may be a municipal advisor if the person advises a municipal entity with respect to the investment of the "proceeds of a municipal securities." In the Proposing Release, the SEC stated it would not limit the identification of "proceeds of municipal securities" to funds a municipal entity received from a municipal securities offering, but would instead interpret the term to mean all funds of a municipal entity, from any source. However, the SEC did distinguish the situation where a municipal entity invests its funds in a pooled investment vehicle (like a hedge fund) alongside investors that are not municipal entities. Persons providing advice to such pooled investment vehicles would not have to register as municipal advisors solely on that basis.

What Is a Municipal Entity? A municipal entity is any state, political sub-division of a state, or municipal corporate instrumentality of a state, including, among other things, any plan, program or pool of assets sponsored or established by the state, political sub-division or municipal corporate instrumentality. This would cover state and local government employee retirement systems as well as college savings plans that comply with Section 529 of the Internal Revenue Code, since they are sponsored by states, state agencies or state educational institutions.

What Is an Obligated Person? An "obligated person" is defined in section 15B as a person that is either generally or through an enterprise, fund, or account of such person, committed by contract or other arrangement to support the payment of all or part of the obligations on the municipal securities to be sold in an offering of municipal securities. SEC Rule 15Ba1-1 would add an exclusion for providers of municipal bond insurance, letters of credit, or other liquidity facilities. An example of an obligated person would be the recipient of the proceeds of an industrial revenue bond offering that is obligated to make regular payments of, for example, rent, usage fees or principal and interest on a loan, the proceeds of which are used by the municipal entity to make payments on the bonds. Although the definition of municipal advisor would not be expected to include persons who advise obligated persons with respect to matters outside of their obligations relating to the municipal securities offering, further guidance of the SEC will need to be sought on this point.

Exclusions for Certain Persons. Section 15B provides limited exclusions from classification as a municipal advisor to the following persons:

• Registered investment advisers -- applies only to the extent that the investment adviser is engaged in advisory activities for which registration as an investment adviser is required.
• Registered broker-dealers and municipal securities dealers -- applies only to the extent that the broker or dealer is serving as an underwriter.
• Registered commodity trading advisers and their associated persons -- applies to their activities providing advice related to swaps;
• Attorneys offering legal advice or services of a traditional legal nature; and
• Engineers providing engineering advice.

Neither Section 15B nor the proposed rules provide an exception for accountants. However, the Proposing Release states that the SEC does not consider the preparation or audit of financial statements, or the issuance of comfort letters for underwriters, to constitute the provision of advice of the type that would make accountants municipal advisors. The SEC also declined to provide an exclusion for banks providing "traditional banking services," as requested by a commenter, but is seeking further comment on this point. The SEC also seeks comment on whether it should permit registration of only separately identifiable departments or divisions of a bank.

Forms. The Proposing Release provides the following proposed forms:

• Form MA, for registration of entities as municipal advisors;
• Form MA-I, for registration of individual municipal advisors;
• Form MA-NR, for designation by non-resident municipal advisors of a U.S. agent for service of process; and
• Form MA-W, for withdrawal of registration.

Form MA is based in part on Form ADV, used to register investment advisers. One significant difference from both Form ADV and Form BD is that Form MA requires disclosure of the disciplinary history of all associated persons of the municipal advisor. Associated persons include any affiliate, any partner, officer, director or branch manager, and any other employee who is engaged in the management, direction, supervision, or performance of any municipal advisory activities.

SEC Staff Issues No-Action Letter Modifying Relief that Permits Broker-Dealers to Rely on Registered Advisers to Perform AML Customer Identification

The staff of the SEC's Division of Trading and Markets (the "staff") issued a no-action letter (the "2011 Letter") to the Securities Industry and Financial Markets Association ("SIFMA") that extends—and modifies—previously granted relief that allows broker-dealers to rely on registered investment advisers ("RIAs") to satisfy the broker-dealers' customer identification program ("CIP") obligations for shared customers under certain conditions.

CIP Reliance Rule. The applicable customer identification rule (31 C.F.R. §103.122, the "CIP Rule") requires broker-dealers to either adopt and maintain a CIP for purposes of risk-based customer identification or rely on the CIP of certain other financial institutions in the case of shared customers. Reliance on the CIP of another financial institution is permissible where (i) the reliance is reasonable under the circumstances; (ii) the relied-upon financial institution is regulated by a Federal functional regulator and is required to maintain an anti-money laundering program ("AML Program") in accordance with a rule applicable to the institution ("AML Program Rule"); and (iii) the relied-upon financial institution enters into a contract requiring it to certify annually to the broker-dealer that it has implemented an AML Program and that it (or its agent) will perform the specified requirements of the broker-dealer's CIP. Under the strict terms of these conditions, broker-dealers may not rely on the CIP of RIAs because RIAs are not currently subject to an AML Program Rule.

Previous SEC Relief. On February 12, 2004, the staff issued a no-action letter permitting broker-dealers to rely on RIAs to satisfy the requirements of the CIP Rule with regard to shared customers so long as (i) such reliance is reasonable under the circumstances; (ii) the RIA is regulated by a Federal functional regulator; (iii) the RIA enters into a contract requiring it to certify annually to the broker-dealer that (a) it has implemented an AML Program in satisfaction of the Bank Secrecy Act (31 U.S.C. sec. 5518(h)) and (b) the RIA will perform the specified requirements of the broker-dealer's CIP in accordance with Section 326 of the USA Patriot Act. The SEC extended this relief in subsequent no-action letters, most recently on January 11, 2010 (the "2010 Letter") (as discussed in the January 12, 2010 Alert.)

Modified SEC Relief. The 2011 Letter qualifies the position set forth in previous no-action letters by:

• specifying that reliance on the RIA must be "reasonable," i.e., a broker-dealer must at the outset of the relationship "undertake appropriate due diligence" on the RIA "commensurate with the broker-dealer's assessment of the anti-money laundering risk" presented by the RIA and the RIA's customer base and update such diligence as appropriate; and
• amending the terms of the contractual agreement between the broker-dealer and RIA to include (i) that the RIA will update its AML Program to conform with changes in applicable law and guidance; (ii) the RIA will "promptly disclose suspicious or unusual activity" identified through its CIP on behalf of a broker-dealer so that the broker-dealer may file a suspicious activity report as appropriate; (iii) the RIA will certify that the representations made in the contractual agreement are accurate and that the RIA is in compliance with such representations; and (iv) that the RIA will promptly provide books and records in connection with its performance of a broker-dealer's CIP obligations to the SEC, a self-regulatory organization ("SRO") that maintains jurisdiction over the broker-dealer, or to authorized law enforcement agencies, either directly through such broker-dealer or at the request of (a) the broker-dealer, (b) the SEC, (c) the SRO maintaining jurisdiction over such broker-dealer, or (d) an authorized law enforcement agency.

The SEC states that it anticipates that broker-dealers may cease to enter into reliance agreements pursuant to the terms set forth above and that in such cases the broker-dealer is permitted to discontinue obtaining further forward-looking certifications regarding the activities of RIAs with whom it had previously entered into contacts. The SEC notes that a broker-dealer that chooses not to avail itself of the relief granted in the letter may still contractually delegate the implementation and operation of its CIP to an investment adviser; however, the broker-dealer will "remain solely responsible for assuring compliance with the CIP Rule" and therefore must "actively monitor the operation of its CIP and assess its effectiveness."

SIFMA, in the request for no-action to which the 2011 Letter responds, stated: "We understand from our discussions that the Staff does not intend, by the addition of these new conditions, to 'impose any supervisory obligations on the broker-dealer' with respect to the RIA."

Effective Date. The 2011 Letter extends the previous relief granted by the 2010 Letter until May 11, 2011 to permit broker-dealers time to become compliant with the modified relief; thereafter, the 2010 Letter is withdrawn without further action and the terms of the 2011 Letter are effective.

OTHER ITEMS OF NOTE

New ERISA Litigation Update Available

On January 20, 2011 Goodwin Procter's ERISA Litigation Practice published the latest edition of its quarterly ERISA Litigation Update. The Update discusses recent developments in a number of retirement cases, including a decision holding that the adviser to a fund containing Madoff investments could be held liable as an ERISA fiduciary, and another decision dismissing claims against an adviser for investing ERISA plan assets in mortgage-backed securities. The Update also reports on recent appellate developments in class actions challenging the holding of employer securities in 401(k) plans, and a district court decision involving a plan holding employer securities where the employer had received TARP funds.

SEC Proposes Rules Regarding Acknowledgement and Verification of Securities-Based Swap Transactions

The SEC issued a release proposing rules regarding trade acknowledgment and verification of security-based swap transactions ("SBS Transactions"), which would require security-based swap dealers and major security-based swap participants ("SBS Entities") to provide trade acknowledgments and to verify those trade acknowledgments in security-based swap transactions. SBS Entities would be required to provide trade acknowledgments to their counterparties within a prescribed time-frame (which would be less than 24 hours in all circumstances) and to obtain acknowledgement from them. Clearing agencies would be expected to adopt verification procedures for SBS transactions subject to clearing, but SBS Entities would be required to establish their own verification procedures for SBS Transactions not subject to clearing. The SEC is seeking comment on a variety of questions regarding the proposed procedures; comments must be received on or before February 22, 2011.

CFTC Proposes Rules and Guidance for Derivatives Clearing Organizations

The CFTC issued a release proposing rules and guidance regarding core principles for Derivatives Clearing Organizations ("DCOs"). The proposed rules are designed to implement Title VII and Title VIII of the Dodd-Frank Act and would establish the regulatory standards for compliance with DCO core principles, including participant and product eligibility, risk management, default rules and procedures and system safeguards. The proposal addresses DCOs' credit exposure to participants and related margin requirements. The CFTC is seeking comment on the proposed rules; comments are due on or before March 21, 2011.

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