SEC Seeks Comment on Potential RIA Financial Responsibility Requirements

On April 18, 2018 the Securities and Exchange Commission (“SEC”) released a new request for comment “on whether SEC-registered investment advisers should be subject to financial responsibility requirements along the lines of those that apply to broker-dealers.” This request for comment comes in tandem with a new rule proposal that would introduce a new Form ADV Part 3 known as the Form CRS and additional requests for comment relating to “licensing and continuing education requirements for personnel of SEC-registered investment advisers” and “delivery of account statements to clients with investment advisory accounts.”

The SEC is concerned about the disparity of financial responsibility requirements for registered investment adviser (“RIA”) firms compared to broker-dealers. With this backdrop, the SEC notes:

SEC-registered investment advisers, however, are not subject to any net capital requirements comparable to those applicable to broker-dealers, although they must disclose any material financial condition that impairs their ability to provide services to their clients. Many investment advisers have relatively small amounts of capital, particularly compared to the amount of assets that they have under management. When we discover a serious fraud by an adviser, often the assets of the adviser are insufficient to compensate clients for their loss. In addition, investment advisers are not required to obtain fidelity bonds, unlike many other financial service providers that have access to client assets.

As it relates to potential financial responsibility requirements for SEC-registered RIA firms, some questions posed by the SEC during the 90 day public comment period include:

• Should investment advisers be subject to net capital or other financial responsibility requirements in order to ensure they can meet their obligations, including compensation for clients if the adviser becomes insolvent or advisory personnel misappropriate clients’ assets?
• Do the custody rule and other rules under the Advisers Act adequately address the potential for misappropriation of client assets and other financial responsibility concerns for advisers? Should investment advisers be subject to an annual audit requirement?
• Should advisers be required to obtain a fidelity bond from an insurance company? If so, should some advisers be excluded from this requirement?
• What would be the expected cost of either maintaining some form of reserve capital or purchasing a fidelity bond? Specifically, in addition to setting aside the initial sum or purchasing the initial bond, what would be the ongoing cost and the opportunity cost for investment advisers? Would one method or the other be more feasible for certain types of investment advisers (particularly, smaller advisers)?
• Would the North American Securities Administrators Association Minimum Financial Requirements For Investment Advisers Model Rule 202(d)-189 (which requires, among other things, an investment adviser who has custody of client funds or securities to maintain at all times a minimum net worth of $35,000 (with some exceptions), an adviser who has discretionary authority but not custody over client funds or securities to maintain at all times a minimum net worth of $10,000, and an adviser who accepts prepayment of more than $500 per client and six or more months in advance to maintain at all times a positive net worth), provide an appropriate model for a minimum capital requirement? Why or why not?
• Although investment advisers are required to report specific information about the assets that they manage on behalf of clients, they are not required to report specific information about their own assets. Should advisers be required to obtain annual audits of their own financials and to provide such information on Form ADV? Would such a requirement raise privacy concerns for privately held advisers?

The full list of questions for public comment begins on page 35 on the request for comment.

What are the potential outcomes of this new SEC proposal?

The SEC is rightfully concerned about the financial resources of an investment adviser being insufficient to compensate clients for losses. Given that the vast majority of state-registered RIA firms are already subject to financial responsibility requirements, it seems reasonable for SEC-registered firms to also be subject to similar requirements. While difficult to speculate, it does seem plausible that some form of financial responsibility requirements will ultimately be codified as a new regulatory requirement. As far as how such potential requirements could be implemented, some potential outcome(s) include:

• Implement a rule similar to the NASAA model rule with potential modifications based on the RIA firm’s size and characteristics
• Require SEC-registered firms to obtain audited financials based on the RIA firm’s size and characteristics
• Allow for the potential use of a fidelity bond to meet this potential new requirement

We believe this effort should be supported by the investment adviser industry and would serve to address key concerns related to a potential regulatory gap as it relates to the ability for an SEC-registered RIA firm to properly compensate clients when necessary. Be sure to check back soon as we continue to further analyze and follow the latest developments of a potential investment adviser financial responsibility or net capital requirement.