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News January 2, 2006 Issue

IM Staff Issues Guidance on Fee-Based Brokerage Rule

In a December 16 letter to the Securities Industry Association, the staff of the SECís Division of Investment Management confirmed that after delivering a financial plan, a dual registrant (a firm thatís both a broker-dealer and investment adviser) can take off its adviser hat and implement the plan wearing only its broker hat.

However, in a twist, the staffís letter made the hat-switching process a bit painful: a firm canít simply say "Weíre a broker now" and be done with it. According to the staff, the extent to which a firm has limited the scope of its fiduciary obligations to a former advisory client will turn on whether the firm has provided "full disclosure" about the change in the relationship, so that the client understands that the firm "is removing itself from a position of trust and confidence with its client."

Donít look for firms to tell clients, "Weíre acting as a broker now, so donít trust us." Undoubtedly, lawyers will take a more subtle approach, perhaps echoing the language set out in the fee-based brokerage rule itself: "Our interests may not always be the same as yours."

However, the SEC staffís loaded "removing itself from a position of trust and confidence" statement calls to mind the equally-loaded statements made by NASD executive vice president Elisse Walter, in the NASDís April 2005 comment letter on the fee-based brokerage rule. Remember how Walter downplayed the significance of the adviserís fiduciary duty to clients? "What, precisely, are the contours of this much-vaunted fiduciary duty?" she had asked. "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."

And now we have the IM staff implying that brokers canít be trusted and donít deserve their customersí confidence? Hmmm . . .

In any event, why would a dual registrant want to discontinue an advisory relationship with a financial planning client and act only as a broker when implementing a plan?

Most obviously, taking off the IA hat allows a dual registrant to use principal trades to implement the financial plan. In its letter, however, the staff noted that under the literal terms of Advisers Act Section 206(3), a dual registrant already is free to engage in principal trades as long as it does not act as an adviser when doing so. Section 206(3), which prohibits advisers from engaging in principal trades absent trade-by-trade notice and consent, "carves out an exception specifically designed to accommodate dually registered broker-dealers," said the staff (technically, Section 206(3)ís prohibitions do not apply to any transaction with a dual registrantís client where the firm is not acting as an adviser). When a client initiates a transaction and the firm has not advised the client to buy or sell the security, explained the staff, the limitations of Section 206(3) do not apply. For example, if a financial plan provides generalized, non-specific advice, such as "invest a portion of your account in equity securities," a dual registrant that subsequently effects transactions in specific equity securities at the direction of the client would not be acting in an advisory capacity, according to the staff.

Thereís another reason why dual registrants may want to terminate the advisory nature of their financial planning client relationships once a plan has been delivered: the heightened liability that comes from the adviserís fiduciary status. If a firm is not acting as an adviser when implementing the financial plan, it (arguably) faces decreased liability.

The hat-switching process. So, how does a dual registrant go about switching hats? The staff explained that "as a general matter," a dual registrant "may discontinue its advisory relationship with its client and then assume a brokerage relationship," based on certain factors. Whether an advisory client relationship exists between a dual registrant and an individual "will turn on the terms of the contract the client has entered into with the [BD/IA] as well as the course of dealing between the parties and the reasonable expectations of the customer/client that arise from that course of dealing." The staff stated that the firm and the client may agree that the advisory relationship terminates with the delivery of the clientís financial plan. The staff confirmed that either party (the firm or the client) may initiate the termination of the advisory relationship.

However, itís not enough to simply tell a financial planning client that the firm is no longer acting as an investment adviser. The firm also must explain what that means. "The extent to which the [BD/IA] would . . . limit the scope of its fiduciary obligations to the client would turn, in our view, on whether the [BD/IA] has provided the client full disclosure about the change in the relationship and any consequent change in the obligations assumed by the broker-dealer," said the staff. "Disclosure by a broker to a customer should be sufficient to enable the client to reasonably understand that the [BD/IA] is removing itself from a position of trust and confidence with its client." The staff went on to observe, in a footnote, that "there are circumstances under which broker-dealers have been held to fiduciary standards similar to advisers."

What happens a year from now when the rep wants to meet with the client to update the financial plan? Presumably, using the factors set out in the staffís letter, a rep would be free to put on the IA hat for the limited purpose of updating the plan, and then could remove it immediately thereafter.

Whatís a plan, Stan? The staff provided some much-needed guidance as to when, exactly, a glossy brochure filled with numbers and projections will be deemed a "financial plan," triggering Advisers Act status, and when it will be viewed as merely a "financial tool," part of the brokerage relationship.

A financial plan, said the staff, "generally seeks to address a wide spectrum of a clientís long-term financial needs, and can include recommendations about insurance, savings, tax and estate planning, and investments." In contrast, they said, financial "tools" are used to provide guidance to a customer with respect to a particular transaction or an allocation of funds and securities based upon the customerís long-term needs, but not in the context of a more comprehensive plan. The staff said it would view financial tools as part of a broker-dealerís brokerage relationship with its customers.

The distinction is key: if a firm generally advertises that it provides financial planning services, the advisory relationship will be triggered any time a rep delivers a "financial plan" to a customer.

The fact that a broker discloses to the customer that the financial tool is a brokerage service, rather than a financial plan, said the staff, "can be helpful in determining whether the broker-dealer is providing brokerage services."

Holding out and the CFP designation. The staffís letter explained that advertising a broad range of investment advisory and financial planning services does not, by itself, trigger advisory status. As long as the firm does not actually provide advice as part of a financial plan or in connection with providing financial planning services, it wonít be providing more than "solely incidental" advice. The upshot: a brokerage firm can advertise to a client that financial planning and other advisory services are available, but need not don the IA hat vis a vis that client unless it actually provides those services to the client.

Along the same vein, the staff said that while a registered repís use of a credential such as "Certified Financial Planner" on his business card or letterhead constitutes "holding out" for purposes of the rule, that fact alone would not trigger Adviser Act status. However, if the firm also provides investment advice to a customer in connection with financial planning services, Advisers Act status would be triggered.

Wilmer Cutler Pickering Hale and Dorr partner Marianne Smythe assisted the SIA in obtaining the relief.