State Puts Teeth in Rules Covering Investment Advice

Investment advisers in the state of California face tough new rules governing the “fair, equitable and ethical” treatment of their investors.

The regulations took effect June 11, but many financial planners and other independent money managers say they aren’t aware of them. They’d better get aware, though: In its effort to protect individuals from investment fraud and abuse, the state has gotten very specific about what advisers must say and do where clients are concerned.

The rules, written by the state’s Department of Corporations, were completed after a one-year review and public comment period. Supervisory Examiner Maurice Cox in Los Angeles says the department’s aim was to put some teeth in a vague investment “fairness” statute that had been on the books for many years. “There’s been a need to define that statute,” he says.

In one of the most controversial elements of the new regulations, the 2,500 investment advisers registered with the state now can be required to tell clients whether “lower fees for comparable services may be available from other sources.”

Taken literally, that means a financial adviser could be compelled to mention his or her competition to a client, if the competition charges less for the same basic service.

Some advisers believe that’s going too far. “We like the idea of the state being tough, but some of this stuff is really nuts,” argues Dave Wright, whose Santa Monica-based U.S. Fund Timing Inc. manages $40 million for individuals.

Cox says the competition-disclosure clause was adopted in lieu of an earlier proposal that would have put a ceiling on how large a fee investment advisers can charge in California. The proposed cap would have limited advisers’ fees to 3% of clients’ assets annually.

Instead, the state opted to let the market set fees. But to protect investors who may not know a fair money-management fee from a rip-off, the state hinges the legal “reasonableness” of a fee on whether an adviser discusses the competitiveness of his fees in advance.

Cox argues that the disclosure may need not be more than a “one-liner” to clients. But in litigation-crazy California, some money managers believe the only way to protect themselves from potential client lawsuits is to take the letter of the law seriously--which in this case would mean knowing exactly what the competition charges, and ranking yourself accordingly for clients.

Is it fair to require that of money managers? Steve Thel, a Cornell University visiting law professor who follows securities law, agrees that’s a legitimate question. “Nobody (in other professions) ever tells you this kind of thing,” he says. A doctor, after all, isn’t required to tell you that an operation would cost you 40% less at another physician’s shop across town.

What’s more, California’s regulation of money managers isn’t uniform: Individual stock brokers can be exempt from the state disclosure rules that bind personal financial planners, for example, because Wall Street brokerages are in theory heavily regulated by the National Assn. of Securities Dealers and other entities. (A recent series in The Times, however, showed how lax the NASD’s regulation of brokers can be.)

The upshot is that a broker at a large firm such as Merrill Lynch or Paine Webber isn’t required to inform a potential client that he could do his trading for much less at a discount brokerage.

“My biggest complaint (about state regulation) is that there are so many who can avoid all of these rules by not registering with the state,” says Neta Gagen, a financial planner in Garden Grove.

Still, many individuals would probably side with the state on the new disclosure rules. When you’re entrusting someone with your life savings, maybe there’s no such thing as too much information.

Bradley Serwin, an associate at the L.A. law firm Gibson, Dunn & Crutcher, notes that the federal Securities and Exchange Commission has increasingly been forcing large money managers to be more up front with clients about fees and competition. Though federal law doesn’t require it, Serwin says, the SEC often instructs advisers that “we want you to say, ‘You can get it cheaper.’ ”

Also, a bill winding its way through Congress would formalize much of the jawboning the SEC has attempted to do with money managers in recent years regarding fees, disclosure and procedures to assure that an individual’s money is invested only in securities suitable to his or her risk tolerance.

The new California rules also outline investment-suitability standards. Like them or not, they now are must reading for investment advisers in this state.

Meanwhile, in Congress Federal lawmakers are working on a new law to toughen the Securities and Exchange Commission’s oversight of investment advisers. Here are key provisions in a bill that passed the House Energy and Commerce Committee on Tuesday:

* Suitability: The SEC would toughen the language of provisions requiring that advisers invest client funds only in investments that make sense for that individual, given the person’s willingness to take risk. A new record-keeping requirement would verify how suitability was determined by the adviser.

* Inspections: The SEC would be required to inspect new advisers in their first year of operation (many small advisers are virtually never inspected now). Also, the SEC would be required to go after unregistered advisers. All advisers would begin paying annual fees to the SEC, based on assets under management, to pay for better inspections.

* Disclosure: Every adviser would be required to give clients a “generic” disclosure brochure, giving the adviser’s background. Regular disclosure of fees and commissions also would be required.

* Bonding: The SEC would be required to mandate that advisers who take custody of client assets or have discretion over those assets post a fidelity bond.

Source: House Committee on Energy and Commerce