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Advisers Brace for Increased Regulatory Scrutiny

As the SEC puts forward strengthened regulations and ramps up investigations, RIAs and their legal counsel are getting in gear.

In recent months, the U.S. Securities and Exchange Commission has announced sanctions against dozens of investment advisers, with firms receiving stiff fines for failing to address compliance deficiencies. According to regulatory lawyers, investigations on this front will remain brisk through 2014 as the SEC continues to roll out more rules under increasing political pressure to protect investors. Issues such as less than meticulous recordkeeping and lax supervision in the practices of registered investment advisers (RIAs) are expected to attract harsh penalties going forward.

Attorney James Grand, the founding partner of the Securities Law Group, a San Francisco–based firm that advises RIAs and asset managers, says SEC investigators recently have embarked on so-called sweep, or abbreviated, examinations of advisers who have reported regulated assets under management (RAUM) of about $100 million. Because of the growing influence of social media, another area attracting more SEC scrutiny as of late is RIA advertising.

The issue of correctly calculating RAUM under new SEC standards is proving particularly vexing for some RIAs, as it is substantially different from prior assets-under-management metrics. Under the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010, there is a requirement that advisers report all gross assets under their management, rather than the net investor capital. For multifamily offices that use internal fund vehicles to manage client allocations, this accounting could get particularly complicated. RIAs reporting more than $1.5 billion in gross assets in an investment vehicle defined by the SEC as a hedge fund will now be required to report RAUM on a monthly basis.

Another significant shift resulting from Dodd-Frank is the definition of accredited investors. According to Mark Ruddy, principal of Washington boutique private equity law firm Ruddy Law Office, the SEC is looking into and will release a report on the matter by July 2014. "Most are unhappy with the current definition, at least as it pertains to natural persons," says Ruddy, a former National Futures Association regulator. "The consensus is generally that income and net worth may not be the best indicators of investor sophistication."

Ironically, new rules that are loosening restrictions on investor access to unregulated investments are likely to increase regulatory oversight at the adviser level. On October 23, the SEC proposed rules that would allow private companies to access capital directly from nonaccredited investors through crowdfunding web sites and intermediaries. New guidance to allow advertising by hedge funds and other private investment vehicles are anticipated during the coming months as well. But at the same time, notes Securities Law's Grand, "as the volume of private offerings increases and regulations are relaxed, more potential pitfalls are waiting for investors." This, he says, is much of the reason for the bolstered regulation of RIAs.

Some of the new regulatory changes facing advisers are not even directly related to investment advice or asset management. New SEC rules due to come into effect on November 20 require financial institutions to maintain a written program to detect, prevent and mitigate identity theft. Much of this new regulation stems from recent cases involving these matters, which have become a bigger priority for the regulatory body. GW & Wade, a wealth management RIA based in Wellesley, Massachusetts, with $4.3 billion in assets under management, was recently sanctioned for internal lapses that allowed three fraudulent withdrawals of customer funds totaling $290,000 last year. In consenting to a censure and cease-and-desist order, GW & Wade agreed to pay a $250,000 penalty.

One very common grumble from the adviser and multifamily office community is that regulators appear to be selectively focusing on smaller players. "The [SEC] staff has very limited resources, and they therefore generally bring enforcement actions when they need to make an example," says Grand. "The most cost-effective way for them to do that is to go after the low-hanging fruit."

Consequently, the advisers who will be hardest hit by these changes are those with small staffs. According to industry observers, RIAs that cater to a handful of wealthy families or institutions and outsource legal and administrative functions are likely to see compliance costs rise significantly during the next few years.

Read more about regulation.

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