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News May 2, 2005 Issue

Fee-Based Brokerage Rule: The Fun Continues

Who says brokers and advisers have nothing in common? Both sides, it seems, are gnashing their teeth over the SECís new fee-based brokerage rule.

For its part, the Financial Planning Association has sued the SEC over the rule.


In a nutshell, the FPA wants the rule tossed out. This time, however, they plan to challenge the substance of the rule itself, rather than the SECís rulemaking process. In a two-page April 28 filing, the FPA initiated a new lawsuit, telling the U.S. D.C. Court of Appeals that it planned to ask that its outstanding lawsuit (the one held in abeyance pending the outcome of the SECís rulemaking) be folded into the new suit.

At a press conference announcing the suit, FPA President James Barnash said that the SEC "erred in adopting a defective rule" that provides inadequate protection to consumers. The rule, he said, "continues to permit the delivery of two kinds of advisory standards: one by brokers immersed for nearly seven decades in a sales production environment and subject only to a suitability standard, the other by advisers in an embedded fiduciary culture."

Of course, to those in the broker-dealer world, where specific rules govern specific things, that "embedded fiduciary culture" concept might be a bit hard to swallow. As none other than the NASD put it in a memo submitted to the SEC last month responding to an FPA comment letter on the rulemaking: "What, precisely, are the contours of this much-vaunted fiduciary duty?" In contrast to the "well-defined" broker-dealer standards of conduct, they said, "the advisory industryís fiduciary standard is imprecise and indeterminate, and has been developed unevenly over time. This general, implied duty simply cannot afford retail investors with the same level of protection as the NASD Conduct Rules."

As in: My regulatory scheme can beat up your regulatory scheme.

In any event, itís probably too soon to predict whether the FPAís suit will succeed, given that the group hasnít even filed its complaint yet. However, the SECís adopting release clearly was drafted in anticipation of litigation and seems likely to withstand judicial scrutiny.

Ross Dixon partner Merril Hirsh, who is representing the FPA in the lawsuit, downplayed any challenge to the groupís standing to sue. "I kind of doubt the SEC is going to challenge our standing," he said. Hirsh noted that the Advisers Act was passed "not only to protect investors" but also to protect "honest advisers who were stigmatized and forced out of business" by unethical advisers. He noted that the SECís very own release states that back in the 1930ís, the SEC staff testified that an Advisers Act registration requirement was necessary "to advance the interests of legitimate investment counselors by eliminating Ďtipstersí who Ďcrash in on the good will of these reputable organizations . . . by giving themselves a designation of investment counselors.í" As a result, said Hirsh, financial planners are clearly within the "zone of interest" under the Advisers Act. "They are within the group of people that Congress intended to protect by the statute," he said.

From the broker-dealersí perspective, the new rule is raising a variety of implementation issues. Most vexing: where does a broker-dealerís suitability analysis end and financial planning begin? (Even FPA president Barnash described the releaseís treatment of this issue "as clear as mud.") Nor does the release provide guidance on what a "financial plan" is, leaving desperate lawyers to parse the releaseís cost-benefit section, which briefly discusses a "two-tiered" approach to financial planning (see page 84 of the release).

At the recent NRS conference, SEC Division of Investment Management senior advisor Jennifer McHugh acknowledged that the release and rules do not define "financial plan." But, she indicated, there was a reason for that: when making its recommendation to the Commission, the staff was aware of the need to provide regulatory certainty in the rules. On the other hand, she said, "you donít want to be too specific in your rules, because thirty days after the rules become effective, people will have organized their accounts so they just skirt the line and are outside the rule."

Another muddy area: what, exactly, must the brokerage firmís fee-based brokerage "point person" tell inquiring customers about the differences between brokers and advisers? While the SEC spelled out the specific disclosure to be placed in contracts and advertisements, the agency provided virtually no guidance on what the point person should say. Nonetheless, McHugh indicated that the SEC staff will be interested in how firms respond to inquiries. "Our concern is the follow up," she said. "When customers do ask questions, do they get appropriate explanations?"

McHugh noted that the rule does not require that the point person be housed in the firmís compliance department, or any particular department, for that matter. Nor does the rule require that the inquiries, and the firmís responses, be documented (although, of course, any written communications likely will fall within the scope of the firmís required records).

Barbara Brooke Manning of Citigroup Asset Management suggested that firms document all inquiries to protect themselves. "No matter how much you tell people," she said, a disgruntled customer may come back and assert they were misled about the nature of their accounts. She suggested that firms keep "very detailed records" and "probably communicate in writing."

Wilmer Hale partner Harry Weiss pointed to the potential burdens the follow-up disclosure requirement could cause. He noted that firms might prepare "carefully scripted" Q&As to respond to customer inquiries about fee-based brokerage accounts, but added that those disclosures still will have to be tailored to respond to the individual who asked the question.

McHugh noted that brokerage firms with pre-existing fee-based customers do not need to go back and amend contracts to add the new disclosures. However, all new fee-based brokerage accounts opened after July 22 must provide the new disclosures.