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News September 6, 2004 Issue

The Fee Based Brokerage Brou-ha-ha

The SEC is going to adopt a final fee-based brokerage rule by the end of the year. And despite the current hullabaloo, there’s a good chance that the final rule is going to closely resemble what was proposed back on November 4, 1999. The SEC’s adopting release probably will discuss what "solely incidental" is supposed to mean and the final rule may even add a general prohibition on "holding out" as an investment adviser (maybe we’ll hear what the SEC thinks about wirehouses calling their Series 7 reps "financial advisors").

But the betting money is that the SEC is not going to tell brokers exactly where on the continuum solely incidental ends and full-blown investment advice begins. As Dechert partner Stuart Kaswell, the Securities Industry Association’s former general counsel, put it: "Advice incidental to brokerage is as old as the brokerage business is." Any line-drawing around "financial planning" would be particularly difficult, as the term encompasses a range of services from a simple questionnaire, asset allocation, and delivery of a shiny booklet (which is how many wirehouses would define it) up to comprehensive asset management and insurance and estate planning.

In case you’ve been on vacation (or immersed in work), here’s a chronology of events:

On July 20, after years of comment letters and letter-writing campaigns, the Financial Planning Association sued the SEC over the fee-based brokerage proposal. The group said that the SEC violated the Administrative Procedures Act by embedding a no-action position in the proposing release. The FPA also claimed that the SEC exceeded its rulemaking authority by exempting broker-dealers that offer fee-based brokerage accounts from the definition of "investment adviser" under the Advisers Act.

The SEC reacted (relatively) quickly. On August 18, the SEC issued a release reopening the comment period on the proposal. Additional comments are due September 22. The agency specifically asked for comment on whether fee-based accounts better align the interests of investors and brokers than commission-based accounts, and what the practical impact on brokers would be if the SEC decided not to adopt the rule as proposed. Most interesting: the SEC asked if it should require broker-dealers to register as advisers if they market fee-based accounts based on the quality of investment advice they provide. "For example," asked the SEC, "should brokers be precluded from using certain terms like ‘investment advice’ and ‘financial planning’ in advertising these services, or is prominent disclosure that an account is a brokerage account sufficient to alert an investor to the nature of the account?"

In the release, the SEC said it plans to reach a final decision on the proposal by December 31.

By "coincidence," according to an NASD spokesperson, the NASD weighed in on the topic a few days later. In a series of questions and answers on Notice to Members 03-68, which discusses brokers’ obligations to ensure that fee-based accounts are appropriate for their customers, the NASD signaled its support for a fee-based brokerage rule. "Is NASD of the view that fee-based accounts outside of an advisory relationship are inappropriate?" the regulator asked itself. The answer: "No." The Tully report, noted the NASD, described fee-based programs as a best practice.

Then, on August 25, the SEC asked the court hearing the FPA’s suit to push the pause button. In an motion for an abeyance, the SEC promised that its final action, expected by the end of the year, would moot certain procedural issues raised by the FPA’s suit. It also noted that depending on whether the rule is adopted, adopted with modifications, or withdrawn, its final action "may change other issues that may be raised before [the] Court or eliminate them entirely."

The FPA quickly issued a statement that it would not oppose the abeyance. "Once the legal dispute over the rulemaking process itself is resolved, FPA can then determine whether the substance of the rule, if one is adopted, should be challenged in a court of law," said FPA president Elizabeth Jetton.

On August 27, the court issued an order holding the case in abeyance "pending further order of the court." Interestingly, the court ordered to the SEC to file "status reports" every 45 days, perhaps to make sure that the SEC would keep its word about taking final action on the rule by the end of the year.

So, as you read this, the SEC staff and Commission are deciding what to do about fee-based brokerage. They’ve gotten lots of new comments to digest: after the SEC reopened the comment period on August 18, about 650 additional comments flooded in. The FPA sent out an August 23 alert to its members asking them, and their clients, to comment. The FPA’s challenge has been covered in the national press.

Like dog and cat people debating which species is better (answer: cats), folks in the broker and adviser worlds simply see things differently. Take, for example, the comment letter submitted by Hardy Callcott, a partner with Bingham McCutchen and formerly the general counsel of Charles Schwab. Callcott urged the SEC to adopt the rule, arguing that brokers are subject to their own unique set of regulations: the net capital rule, SRO oversight, duties under the shingle theory, etc. "[I]n practice, broker-dealers are subject to a substantially higher degree of regulatory scrutiny than are investment advisers," Callcott asserted.

Admittedly, that goes farther than the separate, but equal, view of adviser and broker-dealer regulation espoused by the SIA. As Kaswell put it: "By the time you get through with the legal requirement that brokers have to adhere to, you are in the land of angels on the head of a pin. . . . When you look at the NASD requirements of just and equitable principals of trade and treating customers properly . . . when you total up the list on the broker-dealer side versus the adviser side, they are different but they get you to the same place. The example I use is that a belt holds up your pants just as well as suspenders. They work differently, but your pants don’t fall down."

The planners have heard it before.

"It’s sales regulation," said FPA advocacy director Duane Thompson. "What else can I say?"

To which Kaswell retorted: "Many broker-dealer regulations such as the net capital rule have nothing to do with sales and have everything to do with customer assets."

For more on the differences between the species, check out the April 5, 2004 letter by Ron Rhoades, the CCO for Joseph Capital Management, LLC.

Interestingly, Callcott asked the SEC to treat brokerage accounts that receive fully discretionary asset management services as advisory accounts. It’s unlikely, however, that the SEC will follow this suggestion. Already, brokerage firms generally discourage the opening of fully discretionary brokerage accounts because of the heightened liability that they carry, as well as the knowledge that if they open the same account as an advisory account, they can probably charge more for it. And it’s unlikely that the SEC will take the trouble to alter the relative handful of "old-school" discretionary brokerage accounts knocking around out there.

Kaswell noted that discretionary brokerage accounts have been around "since the beginning of time," but that he hasn’t seen any evidence that would justify treating those accounts as advisory accounts. "Why should I have to be in an advisory account instead of a brokerage account just because I choose to give my broker discretion?" he asked.

Kaswell supports that adoption of a final fee-based brokerage rule. He noted that fee-based brokerage accounts have worked well for investors and that there has not been a "record of abuse and bad acts" that would cause the SEC to say, well, "we tried this and this has been a failure." Why, he asked, would the SEC "take an option away from investors that has worked well?"

Why the push back from the wirehouses, nearly all of which are dual registrants? There are two main theories: the hassle of getting all those reps licensed as IARs, and the fact that brokerage firms would not be able to do principal trades in fee-based accounts if they were treated as advisory. (A ban on principal trades in fee-based accounts could affect brokers’ ability to maintain liquidity in the markets, say some at the SEC.)

In all likelihood, the FPA is thinking ahead to whether, and how, it will sue the SEC if it adopts a final fee based brokerage rule. For example, it could sue the SEC by writing out, by rule, the "special compensation" element of the statutory broker-dealer exclusion from the definition of adviser.

Here’s a fairly safe prediction: the SEC’s adopting release will spend an unusual amount of time defending the agency’s rulemaking authority.