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News January 3, 2005 Issue

The SEC’s Fee-Based Brokerage Surprise

It was almost a forgone conclusion that the SEC would finally adopt its 1999 fee-based brokerage proposal at its December 22 open meeting. Sure, we expected a few tweaks here and there on the disclosure part of the rule. But, as the SEC itself promised the U.S. Court of Appeals for the District of Columbia in an August 25 motion in the Financial Planning Association v. SEC litigation, the Commission was expected to make a "final decision" and take "final action" on the rule by the end of the year.

It didnít.

Of course, technically speaking, the Commission did take "final action" ó albeit on a "temporary" rule. In a bit of creative lawyering, the SEC formally adopted the fee-based brokerage exemption in a temporary rule described as an "interim accommodation" for broker-dealers that have been relying on the no-action position embedded in the 1999 proposal. During the SECís open meeting, general counsel Giovanni Prezioso said that the adoption of the temporary rule, and the Commissionís accompanying instruction to the staff to withdraw the embedded no-action position, were designed to allow the Commission to meet its commitment to the court "to the best of its ability."

The reality, however, is that things are still very much in the air.

With the temporary rule on the books to appease the court and the FPA, the SEC announced that it was reproposing the fee-based brokerage rule, with several significant changes from the 1999 version. The new release is expected this week and will carry a 30-day comment period. And, unlike the first go-round, where the proposal remained outstanding for over five years, we should see an adoption in less than four months: the SEC gave itself until April 15, 2005 to adopt a "permanent" final rule. During the open meeting, Commissioners Cynthia Glassman and Roel Campos indicated that they would not be willing to grant any extension of the self-imposed April 15 deadline. With that in mind, it seems unlikely that the FPA will challenge the notion that the temporary final rule adopted last week is not really "final action" for purposes of the SECís August 25 motion.

In any event, hereís where things really get interesting: The reproposal contemplates several significant changes to the 1999 version of the rule, each of which should be viewed favorably by advisers concerned with competition from broker-dealers.

Discretionary brokerage accounts. The reproposed fee-based brokerage rule would treat all discretionary brokerage accounts ó even traditional commission-based ones ó as advisory accounts. In effect, there would be no such thing as a "discretionary brokerage account."

Score one for the Investment Counsel Association of America: theyíve been asking for that change for years. Early on, Division of Investment Management director Paul Roye indicated that heíd be inclined to make the change. In a 2000 speech, Roye agreed that treating discretionary fee-based accounts as advisory and discretionary commission-based accounts as brokerage was an "anomaly." Nonetheless, last weekís move by the SEC to bring discretionary commission-based brokerage accounts to the adviser side of the line came as a surprise to several observers, given the relatively small number of those accounts believed to be in existence.

During the SECís open meeting, SEC Chairman William Donaldson asked the staff how common discretionary commission-based brokerage accounts actually are. "Our sense is that many broker-dealers do still have these types of accounts," responded Roye. "In many cases, however, I think they have treated them as advisory accounts," noting that "a lot of brokers" are dually-registered as advisers and that the management of discretionary accounts involves additional duties and obligations. However, Roye added, treating discretionary commission-based accounts as advisory accounts "will be a change for some broker-dealers."

Commissioner Glassman indicated that she supported the treatment of discretionary brokerage accounts as advisory accounts, saying that it "seems appropriate." Interestingly, she asked that the reproposing release solicit comment on whether other types of brokerage accounts or services should be considered as offering more than "solely incidental" advisory services (i.e., whether other brokerage products and services should be brought over to the adviser side).

Disclosure about fiduciary status. Under the reproposal, brokers would have to accompany their fee-based brokerage accounts with prominent disclosures that while advisers are fiduciaries, brokers may or may not be. Specifically, fee-based brokerage advertisements, contracts, and account opening documents would have to prominently state that:

  • the account is a brokerage account and not an advisory account;
  • the firm's obligation with respect to brokerage accounts and advisory accounts may differ; and
  • an important difference between the two types of accounts is that broker-dealers "may or may not have a fiduciary relationship with their clients," whereas advisers do have such a relationship.

Moreover, the documents would have to direct customers to "an appropriate person" at the firm for a full discussion of the differences between advisory and brokerage accounts. These disclosures, said Roye, will assist investors in understanding brokerage accounts and "confirms the responsibility of the broker-dealer to explain to its customers the differing nature of brokerage and advisory accounts."

Again, Glassman made an interesting request: that the proposal ask for comment on whether the disclosure requirements "should be applied to all brokerage accounts," not just fee-based accounts. She said that the purpose of the disclosure "should not be to suggest that one regulatory regime is better or more comprehensive than another," but rather to encourage investors to discuss with their brokers the nature of the relationship and to be clear about their brokerís obligations to them. Glassman said that she would ask the SECís Office of Investor Education and Assistance to conduct investor outreach on this point.

Financial planning. The reproposing release, but apparently not the actual rule text, will raise the issue of whether brokers that market their financial planning services as a separate service should be required to treat those services as advisory (something that the FPA undoubtedly would love to see).

Specifically, the reproposal will ask for comment on whether the SECís interpretation of "solely incidental" should turn on "how and whether a broker-dealer holds out its financial planning services to clients." Put another way, the SEC is looking for comment on whether brokers that hold themselves out as providing a separate financial planning service should be required to register as investment advisers and treat those financial planning services as advisory accounts.

"This is one that is particularly tricky," said Roye, adding that he looked forward to public comment on this point. Donaldson agreed, calling it the "$64,000 question."

Why is it so tricky?

To fulfill their suitability obligations, brokers have to know a bit about their customerís financial circumstances. Roye acknowledged that fact, stating that "we certainly would not want a Commission interpretation to in any way interfere with a brokerís suitability analysis." The question, he explained, is how to determine whether a brokerís financial planning is "solely incidental" to its brokerage services, in the sense of collecting financial information about a customer for purposes of the brokerís suitability obligation, or whether it constitutes more than solely incidental advice. Marketing the financial planning services as a separate service, he said, might be the factor to look at.

Itís clear where Commissioner Harvey Goldschmid is coming out. "In my view," he said, "if broker-dealers hold themselves out to be financial planners, and not broker-dealers properly acting under suitability standards, they should be held to 1940 Act standards." Goldschmid also called for a special study of the fundamental functions of broker-dealers and advisers. He noted that although advisers and brokers have "moved closer together" in terms of functions, they continue be regulated under different statutes and by different SEC divisions. He said the agency should give "more thoughtful consideration" of where different adviser and broker-dealer rules should continue to exist.

In addition, the reproposal will discuss when advice is incidental to brokerage and will provide examples of advisory services that are not incidental. "We believe that advice is Ďincidental toí the brokerage business if it is provided in connection with and reasonably related to the brokerage services provided," said Roye.