By John Filar Atwood
The Investment Adviser Association (IAA) has asked the SEC to conduct a rulemaking to change the definition of “small entity” under the Investment Advisers Act to base it on number of employees rather than on assets under management (AUM). In its rulemaking petition, the IAA explained that the current definition—an adviser with less than $25 million in AUM—precludes the Commission from analyzing the impact of its regulations on smaller advisers since only advisers with at least $100 million in AUM can register with the SEC.
The IAA’s specific request is that the SEC amend Investment Company Act Rule 0-7 to state that for purposes of Commission rulemaking the term “small business” or “small organization” under the Investment Advisers Act will mean an investment adviser registered with the Commission that has 100 or fewer employees as of the investment adviser’s most recent fiscal year. The IAA proposed that “employee” be defined as any person that is included in determining the number of employees reported by the adviser under Item 5.A of Form ADV.
The IAA said that it shares the Commission’s goals of protecting investors through effective regulations, but noted that those regulations must be appropriately tailored to balance their burdens and benefits, and take into account size differences and resource constraints of the regulated entities. The IAA believes that a more realistic measure of what constitutes a smaller adviser would help the SEC develop more effective regulations.
Flawed approach. The IAA noted that when the current AUM-based definition was adopted by the SEC in 1982 the Small Business Administration specifically advocated for an employee-based standard. The Commission rejected that approach because “neither the investment company nor the adviser industry is labor intensive, and investment companies are generally externally managed and operated by their investment advisers so that most investment companies have few employees.”
The IAA believes this reasoning is flawed because it does not follow that because an investment company may have few employees, an investment adviser will also have few employees. Moreover, the IAA pointed out that there is no doubt that regulatory compliance depends heavily on human resources, and is in fact increasingly labor intensive.
The IAA is of the view that using an assets-based size standard that is tied to the SEC registration threshold as the measure for being considered “small” does not accurately reflect the burdens of regulations being imposed on smaller advisers. While advisers with lower AUM are likely to be small businesses, those advisers comprise only a subset of the larger group of advisers that are small businesses facing small-business challenges, the IAA stated.
Significant burdens. According to the IAA, regulations imposed by the Commission often require substantial fixed investments by advisers in infrastructure, personnel, and technology. In addition, the SEC increasingly expects that advisers will incur the bulk of the costs associated with compliance of new regulations initially, rather than on an ongoing basis.
The IAA said that while initial undertakings are likely to pose a greater burden on smaller advisers that may not have as much capacity to take on the immediate costs, it disagrees with the Commission’s assessment that the costs will be transitory. On the contrary, the IAA argued, the costs relating to ongoing compliance will continue to impose substantial burdens on smaller advisers.
Smaller advisers typically have fewer resources to spend than larger firms, have limited access to the services of third parties and service providers, and have little ability to recognize savings through in-house leveraging of resources or scaling, the IAA noted. They have a limited number of personnel, many of whom perform multiple functions within the adviser, and face increasing challenges attracting and retaining qualified personnel, including for compliance roles. Consequently, the IAA said, smaller advisers face significant challenges to address their increasing regulatory burdens.
Speed and scale of rulemaking. The IAA stated that its concerns about the current definition of small advisers have been exacerbated by the scale and speed of the Commission’s rulemaking activities over the past two years. The SEC has proposed or adopted more than a dozen consequential regulations during the past two years that will significantly alter the regulatory regime for advisers on an unprecedented scale, according to the IAA.
The IAA claimed that this has created implementation problems for advisers who will be forced to re-allocate the time and resources that are already budgeted to their compliance programs to implement the new regulations concurrently and in a compressed time frame. Making matters worse, the IAA said, is the Commission’s departure from a principles-based approach to more prescriptive regulation for advisers which makes it more challenging for smaller advisers to scale regulatory requirements to their specific circumstances.
Accordingly, the IAA asked that the Commission amend Rule 0-7 to adopt an employee-based standard for defining small advisers. In addition to the reasons already outlined, the IAA believes that basing the size standard on number of employees will be more “evergreen” in comparison to asset-based standards that are more susceptible to fluctuation and will likely be distorted over time.