The examiner cometh

Private equity firms are bracing themselves for the expenses and headaches of becoming Registered Investment Advisors, just one of the requirements of the Dodd-Frank Wall Street Reform Act.

Ever since this bill was signed into law, those private fund managers not already registered with the SEC (and that would be most of them) have been feverishly learning about what it means to be an RIA. For one, you need to have a chief compliance officer. And you need to be prepared for periodic surprise SEC audits.

There is another requirement of Dodd-Frank that many of these managers have not yet thought through. It calls for a study on whether or not private fund managers need a self-regulating organization (SRO) to keep themselves in line. The answer is probably going to be “yes”. And if so, it may mean that being a private fund manager will be even more expensive and painful than mere SEC oversight would inflict.

David Snow

Dodd-Frank also ordered the SEC to see whether or not an SRO might augment its ability to examine and enforce actions against RIAs. The SEC has already answered this question. “For the love of God, please give us more money or have someone else look after all these advisors,” the SEC said (I’m paraphrasing).

The population of hedge funds, private equity firms, real estate firms and the their ilk about to be brought under the regulatory umbrella is large – so much so that it will outstrip the SEC’s already weak ability to effectively oversee them all. Even if the SEC is given a bigger budget, it will struggle to do all the things that Dodd-Frank is asking for.

Which is why placing investment advisors, including private funds, under an SRO might find broad support from Congress. Almost everybody likes SROs, at least conceptually (except perhaps the entities regulated by them). SROs are financially supported by dues collected from the regulated, meaning no new taxes. “Congress just loves SROs,” says Stephen Nelson, founder of The Nelson Law Firm and an expert on securities law and SROs.

The best known example of an SRO is the Financial Industry Regulatory Authority, or FINRA. If a body were created to self-regulate private funds, it would probably look and act a lot like FINRA. In fact, it is highly likely that it will be FINRA. We know this because FINRA essentially has already raised its hand and offered to do the job. In a November letter to the SEC, FINRA chairman and CEO Richard Ketchum wrote, “If FINRA were to seek authorisation as an investment advisor SRO, we would create a separate affiliate. . . to ensure that the SRO establishes programs appropriate to the advisor industry.”

Broker-dealers and fund managers may be different, but FINRA believes both will benefit from exacting and frequent examination. In his letter, Ketchum warns that “no matter how rigorous their regulatory requirements, an advisor’s obligations may provide only hollow protection to investors absent rigorous examination and enforcement”.

Well resourced FINRA out-examines the SEC by a wide margin. While roughly 9 percent of investment advisors are examined each year by the SEC, about 55 percent of all broker-dealers get the FINRA treatment, producing about 1000 disciplinary actions and $50 million in fines annually.

FINRA used to be a friendlier organisation – some complained it was too friendly. When Mary Schapiro (now running the SEC) rose to the top of FINRA in the early 2000s, “All of a sudden audits became brutal interrogations, much more antagonistic,” says Nelson, who helped clients through several such audits. “Fines on things went way up. Firms that had never seen a fine in history were suddenly getting fined. FINRA was really starting to look like snarling regulators.”

If the SEC does decide that a private fund and/or investment advisor SRO is a good idea, another group may throw its hat into the ring – the Investment Company Institute, which represents the interests of mostly mutual funds on Capitol Hill. If this happens the ICI may argue that it is better suited to overseeing investment advisers because it understands them and their business-plan variations. But FINRA has something that ICI doesn’t have – years of experience busting heads and taking names.

The choice between sending much more money to the SEC or simply having FINRA step in to help may be an easy one for Congress to make.