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Financial Planning Association v. SEC: Fee Based Brokerage
Securities Industry and Financial Markets Association General Lunch
May 15, 2007
Lori A. Martin
WilmerHale
Overview
• Financial Planning Association v. SEC, No. 04-1242,
2007 U.S. App. LEXIS 7356 (D.C. Cir. Mar. 30, 2007),
held that ruled that the SEC exceeded its authority
under the Investment Advisers Act when it promulgated
Rule 202(a)(11)-1 exempting certain broker-dealers
providing fee-based brokerage accounts from
registering as investment advisers
• Approximately $300 billion in fee-based brokerage
accounts
• Regulatory framework for fee-based accounts now
clearly the Investment Advisers Act
WilmerHale
Industry Innovations
A tremendous shift has occurred in the securities industry from
commission-based to asset-based compensation:
• customized reporting services to brokerage customers;
• financial planning by broker-dealers;
• wrap accounts;
• the expansion of asset-based brokerage accounts; and
• the expansion of advisory services offered by broker-dealers to their
customers.
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Broker-Dealer Regulation
Securities Exchange Act of 1934: The Exchange Act extended federal
regulation to trading in securities that already have been issued. Section
15 requires broker-dealers to register with the SEC and grants the SEC
authority to discipline registered broker-dealers.
“Maloney Act” of 1938: Enacted to supplement the Exchange Act by
extending regulation to the previously unregulated interstate non-
exchange, or over-the-counter, securities market and authorized the
establishment of “national securities associations.”
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Investment Adviser Regulation
Investment Advisers Act of 1940 (“IAA” or “Advisers Act”):
Federal regulation over investment advisers.
Among other provisions, the Advisers Act requires investment
advisers to register with the SEC, and it grants the SEC authority
to discipline advisers who violate the law or the regulations
promulgated by the SEC under the Advisers Act.
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Definition of an Investment Adviser
Section 202(a)(11) of the Advisers Act defines “investment adviser” as a
person who, for compensation, engages in the business of advising
others about securities.
The Advisers Act excludes from the definition of “investment adviser” a
broker-dealer who:
o provides investment advice which is “solely incidental” to the conduct
of its business as a broker-dealer, and
o receives no “special compensation” for that advice.
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Consequences of the Classification
Financial services firms began to offer both brokerage and
investment advisory services.
Many firms are dually registered with the SEC as investment
advisers and as broker-dealers, and are subject to two different,
and sometimes overlapping regulatory schemes. The application
of these laws to a dually registered firm depends on whether the
firm was acting as a broker-dealer or as an investment adviser
with respect to a particular client, product or transaction.
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Investment Adviser Duties
Relationship of trust and confidence with clients; Supreme Court stated
that advisers have broad fiduciary duties. Transamerica Mortgage
Advisors v. Lewis, 444 U.S. 11, 17 (1979).
These duties are enforceable by the SEC under Section 206.
Duties of an adviser include:
Disclosure
Act in the Client’s Best Interests
Fairness
Best Execution
Suitability
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Broker-Dealer Duties
Broker-dealers’ duties to their customers generally are considered less
stringent than the fiduciary duties of an investment adviser to advisory
clients.
Duties include:
Suitability (NASD Rule 2310 and NYSE Rule 405)
Fair Dealing with Clients
Best Execution
Reasonable Care for Non-discretionary Accounts
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Broker-Dealer Duties (State Law)
Additional duties when acting in a position of trust and confidence, e.g.
supervising a client’s discretionary account or engaging in principal
transactions.
A minority of states have case law suggesting that broker-dealers are
fiduciaries. These states are California, Missouri, South Carolina, and
South Dakota.
Other states have held that the “scope” of the broker’s duty is
“undefined.” E.g., Alabama, Alaska, Idaho, Iowa, Kentucky, Nebraska,
New Mexico, Nevada, Oklahoma, Utah, Virginia, West Virginia.
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Trading Restrictions for IAs
Although Section 206(3) refers to transactions in which the IA acts as
principal or broker, the SEC applies the section to transactions in which any
person controlling, controlled by, or under common control with the IA, acts
as principal or broker.
Principal Trading. Trading as principal with clients requires disclosure that
the IA is trading as principal and written consent before each transaction.
Agency Cross Transactions. IAs may cause clients to trade with each other
with blanket consent if the adviser meets the requirements of the safe
harbor for agency cross trades in 206(3)-2.
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Trading Restrictions for BDs
Broker-dealers often engage in principal and agency cross transactions
on behalf of clients, and generally only provide disclosures on the trade
confirmations.
Principal Trading. Broker-dealers may trade for their own account with
their clients without obtaining client consent for each trade; disclosure
that the BD acted as principal on the trade confirmations.
Agency Cross Transactions. Broker-dealers are not required to obtain
blanket consent to cause two customers to trade with each other; need
only disclose the clients’ trade confirmations.
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Determining Which Requirements Apply to Dual RegistrantsDual-hatting of IA and BD services. These questions arise most often
with respect to principal transactions.
Whether IA or BD Rules Will Apply. Which hat is the broker wearing?
See, e.g., In re IFG Network Securities, Inc., Admin. Proc. Initial Decision
(Feb. 10, 2005) (finding that “there is no case precedent that holds that
an associated person of an investment adviser cannot change hats…and
act in the capacity of a broker-dealer without the higher obligations of an
adviser”).
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Rule 202(a)-11 (Adopted 2005)
The Rule exempted from the requirements of the Advisers Act, broker-
dealers providing nondiscretionary advice solely incidental to its
brokerage service, regardless of the form of compensation, so long as:
(1) the broker-dealer does not have investment discretion over
the account;
(2) the investment advice is given “solely incidental” to
brokerage services; and
(3) the broker-dealer prominently discloses to its customers
that their accounts are brokerage accounts.
The SEC promised guidance re: “solely incidental” and additional
disclosures for fee-based accounts.
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“Solely Incidental” Requirement
The advice that a broker-dealer provides must be solely incidental to the
brokerage services that the broker-dealer provides to each account, not
solely incidental to the operations of the broker-dealer as a whole.
o Advisory services are generally “solely incidental” to brokerage
services when such services are rendered to an account “in
connection with and reasonably related to the brokerage services
provided to that account.”
o The SEC requested further comments regarding the meaning of
“solely incidental.”
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Solely Incidental Excluded:
The following services are not “solely incidental” to brokerage
services and would require the broker-dealer to treat the account
as an investment advisory account:
Discretionary Brokerage Accounts; and
Financial Planning
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Fee Based Brokerage Accounts
Until recently, a broker-dealer offering a fee-based brokerage account
was required to include the following prominent disclosure on all
advertisements and forms governing the account:
(1) a statement that the account is a brokerage account and
not an advisory account;
(2) an explanation that the customer’s rights and the broker-
dealer’s responsibilities (including fiduciary duties) may differ
from rights and responsibilities with an advisory account; and
(3) identification of the person at the firm that the customer can
speak with about the differences between brokerage and
advisory accounts.
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Holding Out as an IA
The purpose of the disclosures was intended to address the
financial planning associations’ claim that broker-dealers could
“hold themselves out” to the public as investment advisers,
thereby causing customer confusion about the difference
between fee-based brokerage accounts and advisory accounts.
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Fee Based Brokerage
o Special compensation must be “solely incidental” to the brokerage
services provided to that account, rather than to the overall operations
of the broker-dealer.
o “Solely incidental” advice does not include providing advisory services
for a separate contract or fee, providing financial planning, or providing
discretionary brokerage.
o Disclosure. Advertisements for, and contracts, agreements,
applications and other forms governing the account must disclose that
the account is a brokerage account and not an advisory account.
A broker-dealer that is registered under the Exchange Act may rely on the exclusion from the definition of an investment adviser whether or not it charges an asset-based or fixed fee (rather than commissions, mark-upsor mark-downs) for its services if it satisfies several conditions.
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Financial Planning Association• Case brought by the Financial Planning
Association, which viewed fee based brokerage as competition
• The Association purported to act in the public interest because the associations’ members had to comply with the IAA, but brokers offering fee-based brokerage accounts complied only with the Exchange Act.
• On March 30, 2007, the D.C. Circuit vacated Rule 202(a)(11)-1.
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Financial Planning Association (cont.)• The DC Circuit reasoned that Congress intended to
define “investment adviser” broadly and created a
precise exemption for broker-dealers
• The statutory scheme was inconsistent with the SEC’s
construction of its exemptive authority
• SEC rule also “flouts six decades of consistent SEC
understanding of its authority” under subsection F of
the IAA, which authorizes the SEC to exempt “such
other persons not within the intent of this paragraph”
from the IAA
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Financial Planning Association
The decision vacating the rule has created enormous
uncertainty; in particular, because the rule addressed
more than fee-based brokerage:
• Financial planning services
• Discretionary accounts
• Multiple commission pricing levels
WilmerHale
Potential Responses by the Industry
• Emergency Rulemaking under Section 206A of the IAA to
permit broker dealers to continue to offer services pursuant to
Rule 202(a)(11)-1 for a discrete period of time. Section 206A
grants the Commission authority to exempt by rule any person
or transaction from any provision of the IAA if the exemption
“is necessary or appropriate in the public interest and
consistent with the protection of investors and the purposes
fairly intended by the policy” the Act
• Intervention in the Lawsuit
• Motion for Stay of Mandate
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Fee-Based Brokerage Litigation Horizon and Potential DefensesBreach of fiduciary duty claims
• No private right of action under Section 206 of the
Investment Advisers Act Remedy under Section 215 is limited to rescission of
the contract Section 211 safe harbor (no liability if Company acts in
conformity with SEC rule) Consider whether the state law claims are preempted
by the Investment Advisers Act
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Fee-Based Brokerage Litigation Horizon and Potential Defenses Fraud Based Claims Not related at all to the D.C. Circuit’s decision Analogous precedent would be the NYAG’s action
against the UBS fee-based brokerage program Claim premised on view that the fee-based brokerage
account was not suitable (or material omissions) for
investors whose transactions and anticipated
commissions were less than the fee charged on assets
under management
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Fee Based Brokerage Litigation Horizon and Potential DefensesHighly fact specific; may not be subject to template defenses
May want to emphasize some of the thematic justifications for a shift to
fee-based brokerage
• “reducing incentives for registered representatives to churn
accounts, recommend unsuitable securities, or engage in high-
pressure sales tactics” and
• “better aligning their interests with those of their broker-dealers”
• “reduc[ing] substantially conflicts between broker-dealers and
their customers.”
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Questions and Discussion