This article reviews the SEC’s adoption of a final rule (the " Final Rule") addressing when broker-dealers that provide advisory services to their customers must register under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), a potentially significant issue for broker-dealers whose services include an element of investment advice. Registration under the Advisers Act subjects a broker-dealer to the full scope of regulation under the Advisers Act including, among other things, additional disclosure, reporting and recordkeeping obligations, as well as other limitations and prohibitions, such as the prohibition on principal transactions under Advisers Act Section 206(3). Section 202(a)(11) of the Advisers Act provides for a "broker-dealer exception" from the definition of "investment adviser" that has been described by the SEC as "a recognition that brokers and dealers commonly give a certain amount of advice to their customers in the course of their regular business and that it would be inappropriate to bring them within the scope of the [Advisers Act] merely because of this aspect of their business." Section 202(a)(11)(C), in essence, states that any broker-dealer (a) whose performance of advisory services is solely incidental to its brokerage services and (b) who does not receive special compensation for those advisory services, is not an investment adviser for purposes of the Advisers Act. In the late 1990s, the SEC concluded that developments in the brokerage industry had begun to raise questions about the adequacy of existing SEC interpretations of the two elements of the broker-dealer exception. For example, fee-based brokerage programs, where full service brokerage customers pay a fee that was a fixed dollar amount or a percentage of assets held on account with the broker-dealer could have been deemed "special compensation" under Section 202(a)(11)(C) because the programs’ fees differ from the traditional transaction based compensation, e.g., commissions and mark-ups, cited in earlier SEC guidance.
In order to address these issues, in 1999, the SEC proposed a new rule designed to avoid application of the Advisers Act to broker-dealers solely because they re-price their full service brokerage or provide execution-only services in addition to full service brokerage. Substantial response from the securities industry to this initial proposal and a subsequent reproposal led the SEC to broaden its focus to include issues such as wrap accounts and financial planning. The Final Rule was the result of these efforts. In adopting the Final Rule, however, the SEC noted that the intensive process of arriving at the Final Rule had raised a number of additional questions regarding the regulatory treatment of broker-dealers that provide investment advice that fell outside the scope of the original rulemaking mandate, e.g., broker-dealer sales practice and advertising guidelines. As a consequence, the SEC ordered its staff to comment on how these issues could be addressed and provide any rulemaking recommendations in a forthcoming report. Thus, the Final Rule may be only part of a broader re-interpretation of the SEC’s treatment of broker-dealers that provide investment advice as part of their brokerage services.
The Initial Rule Proposal
In November 1999 the SEC proposed a new rule under the Advisers Act that provided for an exclusion from the definition of investment adviser for a broker-dealer providing investment advice to customers, regardless of the form the broker-dealer’s compensation took, provided that (i) the advice was provided on a nondiscretionary basis; (ii) the advice was solely incidental to the brokerage services, and (iii) the broker-dealer disclosed to its customers that the accounts were brokerage accounts (the "Initial Rule Proposal"). The Initial Rule Proposal also provided guidance on fee-based brokerage accounts by stating that a broker-dealer providing advisory services as part of a traditional package of brokerage services, would not be deemed to have received special compensation solely because the broker-dealer charged a commission, mark-up, mark-down or similar fee for brokerage services that was greater or less than the amount charged to another customer. In addition, concurrently with the Initial Rule Proposal, the SEC granted no-action relief to broker-dealers that failed to treat accounts over which they did not exercise investment discretion as subject to the Advisers Act pending final SEC action on the Initial Rule Proposal. The SEC re-opened the comment period on the Initial Rule Proposal in August 2004.
The Reproposal
In January 2005 following additional public comment, the SEC (a) adopted a related temporary rule under the Advisers Act addressing the status of broker-dealers under the Advisers Act (the "Temporary Rule"), (b) issued a reproposed rule based on the Initial Rule Proposal (the "Reproposed Rule") and (c) proposed an interpretive statement addressing when advice is solely incidental to brokerage services.
The Temporary Rule. Temporary Rule 202(a)(11)T (which expired on April 15, 2005) provided that (i) a broker-dealer providing investment advice that was solely incidental to the brokerage services it provided to non-discretionary accounts would not be deemed to be an investment adviser with respect to those accounts regardless of the nature of the compensation it received from them; (ii) a broker-dealer would not be subject to the Advisers Act solely because it charged different fees for different kinds of brokerage services and one or more of those services included an advisory component (absent the Temporary Rule, a broker-dealer that offered full service brokerage including an advisory services component and also offered discount brokerage or electronic trading under a different fee schedule might, as a result of the differences in fees for these services, have been deemed to receive special compensation and thus have been unable to rely on the exclusion in Advisers Act Section 202(a)(11)(C)); and (iii) a broker-dealer was an investment adviser solely with respect to those accounts for which it provided services or received compensation that subjected the broker-dealer to the Advisers Act.
The Reproposed Rule. The Reproposed Rule included the provisions of the Temporary Rule, but also required enhanced advertisement and account document disclosure designed to ensure that a customer being offered a non-discretionary brokerage account including advisory services was informed that the account being offered differed from an advisory account in terms of the customer’s rights and the offering firm’s duties to the customer. In addition, under the Reproposed Rule, advisory services provided to a discretionary account would not have been treated as solely incidental to the conduct of a broker-dealer’s brokerage business. This aspect of the Reproposed Rule would have subjected a broker-dealer to the Advisers Act with respect to all discretionary accounts, regardless of the kind of compensation the broker-dealer received.
The Proposed Interpretive Statement. The Proposed Interpretive Statement addressed when advisory services, such as financial planning, were "solely incidental" to the conduct of business as a broker or dealer for purposes of Section 202(a)(11)(C).
The Final Rule
On April 6, 2005 the SEC acted to adopt the Final Rule, which largely reflects the Reproposed Rule. The Final Rule does, however, provide for additional circumstances under which a broker-dealer’s advisory services would not be solely incidental to its brokerage services, e.g., (a) when the broker-dealer charges or contracts separately for advisory services or (b) in connection with certain financial planning activities. These and other important features of the Final Rule along with interpretive positions taken by the SEC in the adopting release for the Final Rule (the "Adopting Release") are discussed below.
Discretionary Accounts. The Final Rule provides that (subject to certain narrow exceptions discussed below), exercising investment discretion over any customer accounts is not solely incidental to the conduct of a broker-dealer’s business as such, regardless of the form of compensation. For purposes of the Final Rule, "investment discretion" has the same meaning as under Section 3(a)(35) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), which generally provides that a person exercises investment discretion with respect to an account if directly or indirectly, such person (A) is authorized to determine what securities or property shall be purchased or sold by or for the account, (B) makes investment decisions as to what securities or other property shall be purchased or sold by or for the account even though some other person may have responsibility for such investment decisions, or (C) as otherwise determined by SEC rule.
A broker-dealer would not, however, be deemed to have investment discretion under the Final Rule if that discretion were granted by a customer on a temporary or limited basis. The Adopting Release includes the following examples of when a broker-dealer’s discretion would be temporary or limited within the meaning of the Final Rule:
- As to the price at which or the time to execute an order given by a customer for the purchase or sale of a definite amount or quantity of a specified security;
- On an isolated or infrequent basis, to purchase or sell a security or type of security when a customer is unavailable for a limited period of time not to exceed a few months;
- As to cash management, such as to exchange a position in a money market fund for another money market fund or cash equivalent;
- To purchase or sell securities to satisfy margin requirements;
- To sell specific bonds and purchase similar bonds in order to permit a customer to take a tax loss on the original position;
- To purchase a bond with a specified credit rating and maturity; and
- To purchase or sell a security or type of security limited by specific parameters established by the customer
In summary, under the Final Rule, if a broker-dealer’s registered representatives exercise investment discretion, other than on a limited or temporary basis, over customer accounts, then the broker-dealer may be subject to registration as an investment adviser and its relationship with those accounts may be subject to the Advisers Act. The Final Rule expressly provides, however, that a broker-dealer is subject to the Advisers Act solely with respect to accounts for which the broker-dealer provides services or receives compensation that subject the broker-dealer to the Advisers Act. (The view that the Advisers Act applies to all discretionary brokerage accounts, absent an exception, instead of only to the discretionary accounts of a broker-dealer whose accounts are almost exclusively discretionary represents a change from the SEC staff’s prior position.) As a consequence, a broker-dealer is subject to the Advisers Act with respect to its discretionary brokerage accounts, regardless of the form of compensation it receives with respect to those accounts and without regard to how the broker-dealer handles other accounts. This division of advisory versus brokerage functions may give rise to uncertainty in certain situations, such as whether a broker-dealer who prepares a financial plan for a client, is no longer an adviser when executing transactions pursuant to that plan.
Special Compensation. Under the Final Rule, a broker-dealer that provides investment advice to an account will not be an investment adviser for purposes of the Advisers Act solely because it receives special compensation from the accounts (except when the broker-dealer charges a separate fee, or separately contracts, for the investment advice), provided that (i) any investment advice the broker-dealer provides is solely incidental to the brokerage services it provides the account and (ii) the broker-dealer meets certain disclosure obligations (as discussed in greater detail below). In addition, the Final Rule provides that a broker-dealer will not be considered to have received special compensation solely because the broker-dealer charges different fees for different brokerage services – this provision is designed to keep a full service broker-dealer from being deemed to receive special compensation if it decides to offer discount brokerage and, similarly, for a discount broker-dealer that introduces full service brokerage.
- Disclosure. The Final Rule requires specific disclosure to appear in advertisements for, and contracts, agreements, applications and other forms governing, accounts for which the broker or dealer receives special compensation, as follows:
"Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons’ compensation, may vary by product and over time."
This disclosure must be prominent and must identify with whom the customer can discuss the or placement for this disclosure. The SEC declined to specify the size or placement for this disclosure but did indicate in the Adopting Release that to be prominent, the statement should be included, at a minimum on the front page of each document or agreement in a manner clearly intended to draw attention to it and that in a televised or video presentation a voice overlay must clearly convey the required information.
Advisory Services for Separate Fee/under Separate Contract. The Final Rule also states that a broker or dealer provides investment advice that is not solely incidental to the conduct of its business as a broker or dealer or to its brokerage services if the broker or dealer charges a separate fee or separately contracts for advisory services.
Financial Planning. The Final Rule states that a broker-dealer provides advice that is not solely incidental to its brokerage services if the broker-dealer provides advice as part of a financial plan or in connection with providing planning services and either: (i) holds itself out to the public as a financial planner or as providing financial planning services; (ii) delivers to its customer a financial plan; or (iii) represents to its customer that the advice is provided as part of a financial plan or financial planning services. Under the Final Rule, a broker-dealer must treat as advisory clients all those customers to whom it delivers a financial plan, regardless of what the broker-dealer chooses to call the plan.
Wrap Fee Programs. In the Adopting Release, the SEC re-affirmed its interpretive position that advisory services, such as asset allocation or portfolio manager selection advice, provided by a broker-dealer sponsoring a wrap fee program, are not solely incidental to the brokerage services provided by the broker-dealer in executing the customer portfolio transactions initiated by the wrap fee program’s portfolio managers. Under this interpretation, a broker-dealer sponsoring a wrap fee program is deemed an investment adviser with respect to any account to which the broker-dealer provides non-discretionary advisory services such as advice regarding asset allocation or selection of portfolio managers even though the broker-dealer does not have discretionary authority with respect to the account’s portfolio transactions.
Compliance/Effective Dates. Since April 15, 2005, broker-dealers have been able to rely on the Final Rule’s provisions holding that they are not deemed to have received special compensation solely because they charged different fees for different kinds of brokerage services. In addition, since April 15, 2005, broker-dealers have also been able to rely on the provisions of the Final Rule regarding special compensation to provide non-discretionary investment advice in conjunction with fee-based brokerage accounts; the Final Rule’s disclosure requirements for advertisements, contracts, agreements, applications and other forms covering accounts opened in reliance on this aspect of the Final Rule must include the disclosure required for accounts opened on or after July 22, 2005. While the SEC is not requiring broker-dealers relying on this aspect of the Final Rule to amend existing contracts and agreements for accounts opened prior to July 22, 2005, it nevertheless encourages broker-dealers opening fee-based brokerage accounts including non-discretionary investment advice to provide the disclosure required by the Final Rule when opening accounts prior to July 22, 2005. No later than October 25, 2005, broker-dealers must comply with the Final Rule’s provisions addressing whether exercising investment discretion with respect to an account is solely incidental to the brokerage services provided to an account for purposes of Section 202(a)(11)(C), i.e., beginning on that date broker-dealers must treat (a) discretionary accounts, (b) accounts charged a separate fee for advisory services, or for which such services are separately contracted and (c) accounts with the requisite nexus to financial planning activity as advisory accounts. The remaining provisions of the Final Rule, including the provision that treats the broker-dealer as an investment adviser solely with respect to the accounts that caused the broker-dealer to be subject to the Advisers Act, generally became effective April 15, 2005.
Goodwin Procter LLP is one of the nation's leading law firms, with a team of 650 attorneys and offices in Boston, New York and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.
This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. (c) 2005 Goodwin Procter LLP. All rights reserved.