By Benjamin Skjold 

It has become increasingly apparent that the system of oversight for investment advisers is lacking.  In 2011, a mere 9% of the country’s 11,539 investment advisers were examined by the SEC, bringing the average number of years in between examinations to eleven. Examinations are a crucial element of any regulatory system both in terms of detecting unscrupulous practices and in deterring advisers from engaging in such behavior in the first place.

While a growing consensus acknowledges that SEC oversight is not working, that is where the consensus ends. The SEC issued a Congressionally-mandated report in January 2011 assessing how to strengthen adviser oversight.  The SEC saw the problem as one of funding, arguing that either their budget should be increased or that they should be allowed to assess user fees for examinations.

Increasing SEC funding has little support in Congress, however. The partisan atmosphere in Washington and general dissatisfaction with the SEC makes it unlikely that Congress would support a substantial increase in funding of the SEC regardless of where the funds come from.

Instead, Congress appears to be embracing the idea of regulatory responsibilities being passed onto a self-regulatory organization (SRO).  House Financial Services Committee Chairman Spencer Bachus, R-Ala., recently drafted legislation that would allow for one or more groups to act as adviser self-regulatory organizations.  The legislation would give the investment adviser SRO, or SROs, broad rule-making authority, subject to SEC authority, as well as responsibility for conducting examinations.  The bill does not state a preference for any particular SRO, raising the possibility that investment advisors may try to create an SRO solely responsible for investment advisers.

The other alternative would be for FINRA to take on responsibility for overseeing investment advisers.  Many investment advisers, especially those not affiliated with a broker-dealer, do not trust FINRA.  Should some version of Bachus’s legislation pass, these advisers may attempt to create a separate SRO rather than submit to FINRA oversight. This would face tremendous obstacles; creating a new SRO would cost hundreds of millions of dollars, plus the new SRO would need to compete directly with FINRA. Given that 88% of investment advisers are affiliated with a broker-dealer already overseen by FINRA, FINRA oversight of those advisers seems to make more sense.  It would be very difficult to sustain an SRO if it only regulates 12% of investment advisers.

Given these hurdles, should Congress choose to transfer regulatory responsibility for investment advisers from the SEC to an SRO, the most likely outcome appears to be that FINRA would regulate investment advisers.

(Benjamin Skjold leads the securities practice at Minneapolis-based Skjold Parrington Business Attorneys).