SMAs Face Stiffer Regulatory Scrutiny
September 27, 2004
DALLAS -- Separately managed accounts, now with a combined $529 billion in assets under management, appear headed for a more stringent regulatory landscape. While the tax-efficient investment vehicles geared toward the high net worth have enjoyed tremendous growth in the last five years with little agitation from regulators, the industry sees rougher terrain ahead.
Chris Davis, executive director of the Money Management Institute, speaking at a conference here last week, noted that while SMAs are in a "relatively benign regulatory environment," it is only a matter of time before the Securities and Exchange Commission comes knocking on their door looking for abuses. Depending on when regulators tidy up their ongoing sweeps of the mutual fund and annuity businesses, it could be anywhere from six to 18 months, Davis said.
One of the biggest regulatory developments for banks looking to penetrate the SMA marketplace is the latest version of Regulation B, a proposal put forth by the SEC in June that would implement the key broker/dealer provisions of the Gramm-Leach-Bliley Act. The new rule would draw a line of distinction between securities transactions permitted at banks and those that would have to be pushed out to a bank's registered affiliate. Essentially, the act permitted securities companies, banks and insurers to get into each other's businesses.
Specifically, the new rule would define various terms in GLBA and broaden a number of exemptions already available to banks, savings associations and savings banks that sell securities. Historically, banks could engage in transactions for custody accounts only for qualified investors and still be exempt from the definition of broker. But GLBA sought to regulate banks by function, with their banking transactions governed by bank regulators and their securities activities regulated by the SEC.
After granting an extension over the summer, the SEC closed its comment period Sept. 1, having received more than 100 comments on the proposal. The rule has its share of detractors, with many banks fearful that it would put an end to some incentive programs for employees, limit the types of clients banks could attract and force them to collect most of their fees from annual charges as opposed to commissions. Bankers strongly objected to restrictions on employee bonus programs.
"We believe the Commission's assertion of jurisdiction may cause financial institutions to overhaul bonus programs, causing disruption, expense and confusion in vast areas of business that bear little relation to the referral programs governed by the networking exception," wrote Ronald Mayer, senior vice president and associate general counsel at JP Morgan Chase.
Another stipulation of the proposed rule is that banks pass a "chiefly compensated" test, which evaluates their methods of compensation based on a bankwide basis, account-by-account-basis or by each line of business. In the case of the line of business variety, the lines of business must be comprised of similar types of accounts for which the bank acts in a similar capacity. If the ratio of sales compensation to relationship compensation exceeds 1:9, then the evaluation must be done on an account-by-account basis.
Melody Bohlman, senior vice president, risk management and compliance manager at The Trust Company cited examples of which types of compensation were "good" and which ones were "bad." Fees derived from assets under management, administrative fees and flat or capped fees per order were cited as acceptable forms of compensation. Any combination of the three is also acceptable, she noted.
Examples of bad compensation include finder fees, 12b-1 fees and commissions. In other words, if a bank were chiefly compensated through the latter methods, it would fail the test. "If you fail the [chiefly compensated'] test, you are operating as an unregistered broker, a pretty serious violation," Bohlman warned attendees. "You still have to prove compliance, even if you don't accept the examples of bad compensation," she added.
As for third-party brokers, they must register as an investment advisor, unless using the registration purely for distribution services. They also are required to have a networking agreement in place and meet the interagency guidelines. Perhaps more significantly, there are "serious limitations on compensation," according to Bibb Strench, a partner at law firm Stradley Ronon Stevens & Young. Under the new rule, there must be a nominal fee of $25 for referring customers to a broker/dealer affiliate. Alternatives being considered include charging one hour of the employees' rate of pay or $15 adjusted for the rate of inflation. "The paperwork can be kinda scary," Strench conceded.
Bohlman told attendees the SEC's top priority is Regulation B but said that it will address other issues as well, including front-running, insider trading and trade allocation. Strench stressed the importance of meeting the Oct. 5 deadline for the new compliance rule for investment advisors. It requires firms to hire a chief compliance officer, put additional compliance policies and procedures into place and conduct an annual review of their policies and procedures. The rule was part of the collateral damage from the mutual fund scandal, in which mutual funds "got totally faced by Spitzer."
Given the transgressions at mutual funds and the "sausage factory" of regulatory proposals that have followed, Strench warned attendees, particularly representatives from third-party vendors, to be careful when considering a revenue-sharing agreement. "Quid-pro-quo arrangements are going to raise red flags," he said. Another area the SEC is looking at closely is performance advertising, calling for a "detailed description" of an advisor's performance calculation process. The SEC also wants the names and titles of those individuals responsible for the calculations and the software used, whether proprietary or otherwise.