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News July 26, 2004 Issue

FPA Sues SEC Over Fee-Based Brokerage Rule

After nearly five years of asking nicely, the Financial Planning Association has resorted to more drastic measures.

On July 20, the FPA filed a one-page petition asking the U.S. Court of Appeals for the District of Columbia, which has jurisdiction over the SEC, to review the SECís 1999 fee-based brokerage proposal. As part of its legal challenge, the FPA plans to argue that by embedding a no-action letter in a proposed rulemaking and delaying the adoption of the rule for five years, the SEC effectively adopted a rule without following the procedural requirements of the Administrative Procedures Act (APA). The group also is expected to argue that the SEC misinterpreted its exemptive authority and acted contrary to the intent of Congress by doing away with the "special compensation" prong of the broker-dealer exception.

FPA president Elizabeth Jetton said a "win" for the group would be to see the proposed rule "dropped, or dramatically clarified." The proposal, she said, "was frankly an offense to our core ideology and our core values." Jetton said the SEC has "muddied" the high standards of the financial planning community and the FPA is trying "to defend what we believe the [Advisers Act] was intended to be all about."

FPA outside counsel, Ross Dixon partner Merril Hirsh, explained that the suit "challenges the SECís decision to treat the Advisers Act differently from what it says." He noted that the Advisers Act was passed not only to protect consumers, but to protect "honest investment advisers." In passing the statute, "Congress recognized that you canít operate under two systems of rules, where some people hold themselves to a higher standard than other people do," he said. Such a system, he added, would force out honest people because "dishonest people [would] undercut them." The proposed rulemaking creates a "dual standard, with no idea of how long it will last and what it will be." Hirsh said the FPA is seeking a "high and uniform standard" for everyone who provides investment advice. The idea of the lawsuit "is to get the court system to weigh in" and determine what the SEC should do.

The court is expected to issue an order asking the SEC for a copy of the proposing release, comment letters, and other administrative materials. It will then set a briefing schedule. Hirsh predicted that oral arguments will be heard "about a year from now." He noted that the SEC, in the interim, could adopt a final rule, withdraw the proposal, or do "any number of different things."

The FPA has never abandoned hope that the SEC would withdraw or amend the fee-based brokerage rule. In addition to a campaign of comment letters, the FPA leadership has met with former SEC Chairman Arthur Levitt and Harvey Pitt, as well as current Chairman William Donaldson, about the issue. Incidentally, Levitt is now on record as opposing the fee-based brokerage rule, which was proposed during his tenure. Also of note: current Commissioner Harvey Goldschmid was the SECís general counsel at the time the rule was proposed.

Duane Thompson, the FPAís advocacy director, said that he and other FPA representatives met with the SEC staff earlier this month, after the group filed its third comment letter on the proposal June 21. Thompson said that during that meeting, there was a "a very brief discussion of the letter" but that "nothing of substance" was discussed regarding the FPAís specific comments. "This is a complex issue," he added. The staff of the Division of Investment Management "is certainly aware of all the nuances and, quite frankly, the challenges of trying to define what Ďsolely incidentalí is. That has been their primary interest in revising a final rule because that is the primary criteria that they relied upon in trying to determine what is full brokerage services and what is advice. I think that it is going to be very difficult."

And what do the brokers think?

"We view the FPA action as being contrary to the best interest of investors," Securities Industry Association associate general counsel Michael Udoff told IM Insight. He noted that broker-dealers are subject to rigorous disclosure standards of their own, such as the requirement to disclose third-party compensation on a transaction-by-transaction basis on trade confirms.

"Whatís gotten obfuscated over the years," added Udoff, "is why this rule proposal was made and why the SEC thought it was important to include the no-action position." In 1995, the Tully committee issued a report that characterized fee-based brokerage accounts as a best practice. To wit: "Some firmsí practice of basing a portion of RR compensation on client assets in an account is seen as one way to reduce the temptation for income-seeking RRís to create inappropriate trading activity in an account. Fee-based accounts may also be particularly appropriate for investors who prefer a consistent and explicit monthly or annual charge for services received, and whose level of trading activity is moderate."

"Itís a very compelling argument," said Udoff. Removing the regulatory uncertainty was critical to the development of fee-based brokerage accounts, he explained. "The SEC thought it was important enough to create the regulatory certainty," he added.

Incidentally, a number of consumer-oriented groups participated in the Tully study, including the Consumer Federation of America, which is supporting the FPAís suit.

Udoff said that it was "just totally disingenuous" for the FPA to suggest that the SEC was not adhering to the APA by letting the proposal remain outstanding for five years. The "main reason" the rule is still out for comment, he said, is because of "the efforts of the FPA to try to block it."

So, whatís going to happen?

Fund Democracy founder Mercer Bullard predicted the suit would not be litigated to a conclusion, because the SEC could not risk the court issuing a decision on the merits. If the SEC lost the case, he explained, it would "substantially undermine" the agencyís no-action program. He noted, however, that the SEC may challenge the FPAís standing to bring the case (as it did when Fund Democracy challenged the agency in 2001). Bullard predicted that any standing challenge "probably" would fail either on the merits or because it would simply cause the consumer groups to join as plaintiffs. If that happened, said Bullard, their standing would not be in question. Fund Democracy also supports the FPAís suit.