Untangling Financial Planning Association v. Securities and Exchange Commission: The Future of Fee-Based Brokerage Accounts

Transcription

1 Untangling Financial Planning Association v. Securities and Exchange Commission: The Future of Fee-Based Brokerage Accounts By Diane E. Ambler C. Dirk Peterson Elaine A. Lindenmayer David Dickstein July 12, 2007 Today, an estimated $300 billion in client funds are invested through over a million fee-based brokerage accounts, in which broker compensation is not directly tied to transaction-based commissions. As a result of the recent DC Circuit Court ruling 1 that vacated the Securities and Exchange Commission ( SEC ) rule permitting brokers to receive fee-based compensation without also registering as investment advisers, 2 retail brokerage firms that offer fee-based accounts are grappling with a legal identity crisis that triggers regulatory and business implications for themselves and their clients. I. Brokerage Accounts: The Regulatory Problem Historically, brokerage account compensation has been structured on the basis of commissions paid for each transaction. As concerns developed about actual and perceived conflicts of interest in the retail brokerage industry in the early 1990 s, then- SEC Chairman Arthur Levitt formed a Committee on Compensation Practices to review brokerage industry compensation practices, identify conflicts of interest, and establish best practices for reducing such conflicts. The 1995 report of this Committee, known as the Tully Report, concluded that traditional transaction-based commissions created incentives for brokers to increase securities trading in brokerage accounts potentially in conflict with the best interests of the client. 3 The Tully Report advocated, among other things, a fee-based compensation system as a model of best practices to better align the interests of registered representatives, brokerage firms and investors. 4 Since publication of the Tully Report, fee-based brokerage accounts have markedly increased in popularity. Along with this increasing prevalence of fee-based accounts has developed deepening confusion regarding their legal and regulatory status, particularly as the focus on investor suitability obligations of brokers has overlapped and blurred with the role of investment advisers under the Advisers Act. 5 The nature of these accounts called into question the extent to which the advisory activities attendant to fee-based full service brokerage accounts were solely incidental to the brokerage services provided and/or potentially involved special compensation, either of which could also require the broker to register as an investment adviser under the literal terms of Section 202(a) (11) of the Advisers Act. 6 II. Rule 202(a)(11)-1: A Resolution Now Unresolved The brokerage industry sought clarity from the SEC on the availability of the brokerdealer exclusion in Section 202(a)(11)(C) for its fee-based brokerage programs. The SEC responded in November 1999 by proposing a rule excluding broker-dealers from the definition of investment adviser in connection with certain fee-based brokerage accounts. 7 In proposing the rule, the SEC stated that the staff would not recommend enforcement action against a broker-dealer for failure to treat any non-discretionary feebased account as subject to the Advisers Act based on the form of compensation received. It was not until 2005 that the SEC acted again on the rule proposal, after reopening it for further comment, by reproposing a revised rule. 8 In April 2005, the SEC adopted Rule 202(a)(11)-1. 9

2 The Financial Planning Association challenged the SEC s development of this exclusion and brought an action in court based principally on a perceived difference between the broker-dealer client relationship and fiduciary responsibilities of registered investment advisers to their clients. On March 30, 2007, the DC Circuit Court issued a divided opinion in which the majority determined to vacate the Rule under a strict statutory construction concluding that the SEC had exceeded its rulemaking authority under Section 202(a) (11)(F). On May 14, 2007, the SEC announced it would not appeal the decision and would seek a 120-day stay of the Court ruling. On June 25, 2007, the DC Circuit granted the SEC s request for the stay, until October 1, 2007 when the Court s mandate vacating Rule 202(a)(11)-1 would take effect. 10 Even with the additional 120-day stay, October 1, 2007 looms large, and broker-dealers face a number of hard choices and practical problems in light of the Court s ruling. The SEC staff has informally indicated that it or the SEC expects to issue guidance on potential effects of, and regulatory issues raised by, the Court s vacating Rule 202(a)(11)-1. The SEC does not appear likely to revisit an interpretation of special compensation nor to invoke its alternative authority under Section 206A of the Advisers Act to grant blanket exceptions, at least with respect to fee-based compensation. In any event, broker-dealers can and should not wait for this guidance to evaluate and determine their next steps, particularly given the necessary time required to institute possible structural changes to their existing fee-based programs. III. Implications for Fee-based Full Service Accounts Implicit in both the majority and dissenting opinions of the FPA Case is the presumption that fee-based compensation, in contrast to commission-based compensation, constitutes special compensation, as conceded by the SEC in adopting the now-vacated Rule. In the absence of a rule clarifying the status of full service fee-based brokerage accounts, broker-dealers are left to consider how to adjust or manage existing accounts that were developed in reliance on the SEC s prior positions, under the assumption they would now trigger a requirement to register under the Advisers Act. Below we discuss three possible options together with practical issues to be addressed and resolved in pursuing each option. 11 Option 1. Maintain the fee-based brokerage accounts and add registration and regulation as an investment adviser under either federal or state law Regulation of broker-dealers under the Securities Exchange Act of 1934 ( 1934 Act ) and oversight by the SEC, state securities regulators and self regulatory organizations ( SRO ), such as the NASD, is far more rigorous than Advisers Act regulation of investment advisers. 12 Brokerdealers will need to consider an appropriate regulatory structure, whether to dually register the broker-dealer as an investment adviser, and become subject to regulation both as a broker-dealer and investment adviser, or network with an affiliated or third party adviser. 13 Firms that do not have advisory entities or that elect to establish a separate one for these accounts will need to pursue state or federal investment adviser registration. 14 Broker-dealers that are dually registered will be subject not only to regulation applicable to broker-dealers, including SRO rules, but also the standards applicable to registered investment advisers. Appropriateness of Fee Structure. SRO know your customer rules require broker-dealers to have reasonable grounds to believe that a fee-based account is appropriate for that particular client. 15 Firms must continue to fulfill these responsibilities in determining whether to move a client to a fee-based advisory account or other available fee structure and should not necessarily assume that a single alternative will be appropriate for all fee-based clients. Registration and Regulation of Investment Adviser Representatives. Given the retail nature of these accounts, firms would need to address possible state regulation of so-called investment adviser representatives, even though the firm itself may qualify for Advisers Act regulation at the federal level. State regulations govern the qualification and licensing requirements for employees of registered advisers who are considered to be investment adviser representatives. Although some states grandfather seasoned securities professionals with Series 7 or other securities licenses, the rules vary from state-to-state. Brokerdealers will need to review the requirements of each state in which they operate and their representatives respective licenses to determine the qualification requirements for their personnel. July 12,

3 Documentation Necessary to Convert. Each client agreement will dictate, in the first instance, what client approvals may be needed to convert the account to an advisory account. Typically, client agreements contain broad provisions permitting a change in services absent affirmative client consent typically through a notice and opt out process. Of course, practical regulatory considerations, and possible resistance by the states or SROs, may require client consent for material changes in client services. Whether the conversion will operate as a material change or otherwise trigger affirmative client consent requirements will depend on the details of the changes effected. Firms will need to carefully review the terms of their account agreements and analyze the nature of the changes they intend to make to determine what will be required to effectively revise the account agreement with the client, as well as the practicalities of accomplishing the changes. If the only change to the client agreement is the additional status of the broker-dealer as adviser, and none of the services, pricing or other terms change, perhaps amendment by notice would be sufficient if the existing agreement contains a negative consent clause. As described below, however, the Advisers Act requires advisory contracts to contain certain provisions that are not necessarily included in brokerage agreements. The practicalities in this situation make affirmative consent of all clients effectively impossible, even if the October deadline were extended indefinitely. Moreover, the consequences of failure to obtain consent either operate out of compliance with the Advisers Act, breach the terms of client agreements or close the accounts are untenable. The SEC staff, in the context of revisions to investment advisory agreements under the Advisers Act, has authorized a process of obtaining consent where the practicalities effectively prevent obtaining affirmative consent from all clients. 16 The SEC or its staff could possibly authorize a similar procedure here, although even that procedure involves multiple costly notices to all affected clients and a lengthy time frame for client response. Restrictions on Principal and Agency Cross Trades. Among the most troublesome implications for broker-dealers choosing this route are the principal trading restrictions under Advisers Act Section 206(3), which prohibits an adviser from engaging in a principal transaction with a client without the client s prior affirmative consent based on written disclosure. These restrictions could be triggered where the broker-dealer fills client orders from securities held in its own inventory or effects mutual fund transactions in which the broker-dealer serves as principal underwriter for the fund. Principal transaction considerations would apply if the broker-dealer is dually registered or affiliated with an investment adviser. 17 Under Advisers Act Rule 206(3)-2, prior written consent from the client is also required for agency cross trade transactions but blanket consent for all trades is permissible. The SEC has not as yet permitted similar blanket consent for principal trades in general. The significance of this issue now, in light of the Court s action to vacate Rule 202(a)(11)-1, might well be motivation for the SEC or its staff to grant administrative relief in this context. In any event, relief of this sort would likely require firms to incorporate blanket consents into client agreements (as is the practice for agency cross trades), which complicates the effect on existing relationships. Investment Advisory Agreements. Advisers Act Section 205 sets forth requirements that must be in any agreement between an adviser and the client, such as restrictions on assignments, exculpatory language and waivers, which would not be part of existing client agreements. Additional Investment Adviser Compliance Obligations. Assuming eligibility to register with the SEC, rather than the states, and depending on the structure chosen, registration under the Advisers Act would trigger ongoing compliance responsibilities. 18 Among the more significant of the additional Advisers Act requirements are the following: Initial Delivery and Annual Updating of Form ADV Compliance Policies and Procedures and Code of Ethics Custody of Client Funds or Securities Proxy Voting Policy Advertising Rules and Document Retention Rules Fiduciary Duty Option 2. Maintain the existing brokerage accounts but reprice them from fee-based accounts into commissionbased accounts Because this option requires no structural changes, it avoids in the short term many of the complications of Advisers Act registration. Implementing a change from fee-based to commission-based pricing, however, contemplates a change to the client arrangement that calls for an assessment of how the existing client agreement addresses repricing and whether affirmative client consent would be required. Even July 12,

4 absent a clear requirement for affirmative client consent, practical client relations and reputation issues may dictate that such a change not be made unilaterally. Administrative relief from the SEC or its staff, along the lines discussed above, may reduce or simplify some of the concerns. Special care would be needed with these accounts, however, to assure that any advice provided is solely incidental to the brokerage services provided. 19 In the wake of the FPA Case, the parameters of the solely incidental limitation are unclear, both in the context of the due diligence surrounding a broker-dealer s suitability review and recommendation as well as in commission-based discretionary accounts. 20 Because both aspects of the exclusion must be satisfied, converting the fee structure of a full service account to a commission-based structure only serves to highlight the question of what constitutes solely incidental investment advice. Moreover, where a firm offers multiple commission rate structures, 21 the higher priced accounts might be deemed to entail special compensation by virtue of the existence of a multiple tier compensation structure. The majority opinion in the FPA Case suggests this would be the case, 22 although the SEC s interpretation when it adopted Rule 202(a)(11)-1 was clearly that a broker-dealer will not be deemed to have received special compensation solely because the broker-dealer charges a commission, mark-up, markdown or similar fee for brokerage services, that is greater than or less than one it charges another customer. 23 The implications of concluding that a higher fee for full service brokerage constitutes special compensation relative to some accounts that do not include advice would seem to effectively eliminate full service brokerage at a firm that also offers an execution-only alternative. Similarly, this conclusion would create the anomalous result that a firm that offered both full service and execution-only brokerage would be required to perform the full service brokerage in an advisory entity, while another firm that offered the identical full service brokerage services but no execution-only alternative could do so within the broker-dealer. It would be helpful for the SEC or its staff to confirm the continuing viability of its prior interpretation. Option 3. Maintain the existing fee-based brokerage accounts but strip the services to execution-only In many respects this option may be the simplest and most expedient to implement. Where a broker-dealer provides only execution services and no investment advice, there is no need for the broker-dealer exclusion, since the activities do not invoke the definition of investment adviser in the first instance. The broker-dealer would make no recommendations, provide no analysis and no advice; it would operate purely as an order taker. This form of account could benefit individuals looking for consistency of fees in a predictable expense structure and could be particularly economical for individuals with substantial online trading activities. 24 This option also requires no structural changes. Although it does not contemplate a change in fee structure, it does suggest a possibly significant change in client services, which could raise issues under the terms of existing client agreements and the possible need for client consent, as discussed above. V. Looking Forward Clearly, brokerage firms offering fee-based accounts face difficult choices, each of which carries serious business, operational and client relations implications. The SEC appears to be sensitive to the significant confusion in the brokerage industry resulting from the FPA Case and the pressing need for guidance on the treatment of fee-based brokerage accounts. It appears that the SEC or its staff intends to issue guidance in the coming months to clarify at least some of the legal and regulatory ramifications attending brokerage firms decisions on the fate of these accounts. July 12,

5 NOTES 1 Fin. Planning Ass n v. Securities & Exch. Comm n, 482 F.3d 481 (D.C. Cir. 2007) ( FPA Case ). 2 Rule 202(a)(11)-1 under the Investment Advisers Act of 1940, as amended ( Advisers Act ). 3 Report of the Committee on Compensation Practices (April 10, 1995) ( Tully Report ), available at txt. The Tully Report acquired its name from the Committee Chairman, Daniel P. Tully, then the Chairman and Chief Executive Officer of Merrill Lynch & Co., Inc. 4 The best practices recommended in the Tully Report for reducing actual and potential conflicts of interest among client, broker-dealer and registered representative included (i) compensation policies that align the interests of registered representatives, broker-dealer firms and investors; (ii) compensation policies that encourage long-term relationships between broker-dealer firms, registered representatives and investors; (iii) registered representatives who understand client investment objectives, experience, and financial position, and give advice consistent with that understanding; (iv) education and training that enhance the quality of advice to clients; (v) compensation plans that encourage appropriate supervision and behavior by branch managers; and (vi) greater education of clients of markets, risks and their own responsibilities as investors. 5 One theme of the Tully Report was to encourage broker-dealers and their registered representatives to focus on providing investment counsel to clients. Tully Report, note 3, above, at (noting that a best practice would be to provide brokerage representatives with financial planning tools). This theme of including within broker-dealer suitability determinations a greater level of client management has been developing momentum since the Tully Report. There have been a number of rule proposals in that regard by the SEC, in response to pressure by the states to impose more active client account management by broker-dealers, and by the NASD, in a number of particularized situations requiring brokerdealers to show diligence in obtaining sufficient client information to justify recommendations to both retail and institutional clients. See, e.g., SEC Rel. No (Oct. 22, 1996) (proposing amendments to SEC Rules 17a-3 and 17a-4 that would, among other things, impose obligations on broker-dealers to maintain ongoing account management by annually updating client investment objectives and treating certain objectives deemed risky or speculative with higher duties); NASD IM (suitability obligations for institutional clients); NASD Proposed Rule 2821 (sales of deferred variable annuities); and NASD Notice to Members (May 1999) (reminding members of suitability in sales of variable annuities). 6 Section 202(a)(11)(C) of the Advisers Act excludes from the definition of investment adviser for broker-dealers whose advisory services are solely incidental to the brokerage services provided and who receive no special compensation for the advisory services. In 1940, when the Advisers Act was adopted, transaction-based brokerage commissions were the only form of compensation paid for brokerage services. As this structure gave way under the conclusions of the Tully Report, and as suitability determinations have become more complex, questions have arisen regarding, among other things, whether fees for full service brokerage accounts that are asset-based, rather than commission-based, constitute special compensation and whether the expanded services provided by broker-dealers are solely incidental to the brokerage services provided. 7 Certain Broker-Dealers Deemed Not to Be Investment Advisers, SEC Rel. No (Nov. 4, 1999). Wrap fee accounts, as discretionary fee based accounts, were not excluded as brokerage accounts by this rule proposal. At that time, the SEC considered commission-based discretionary accounts as within the exclusion. Id. at 5. 8 Certain Broker-Dealers Deemed Not to Be Investment Advisers, SEC Rel. No (Jan. 6, 2005). The SEC contemporaneously terminated the staff s prior no action position and adopted a temporary rule, 202(a)(11)T. Certain Broker-Dealers Deemed Not to Be Investment Advisers, SEC Rel. No (Jan. 6, 2005). 9 Certain Broker-Dealers Deemed Not to Be Investment Advisers, SEC Rel. No (April 12, 2005) ( Adopting Release ). 10 Fin. Planning Ass n v. Securities & Exch. Comm n, No , available at 2007 U.S. App. LEXIS (D.C. Cir. June 25, 2007). 11 Know your customer and suitability rules require broker-dealers to have reasonable grounds to believe that the form of account is appropriate for that particular client. See NASD Conduct Rule 2310 and related Notice to Members (November 2003); NYSE Rule 405A. Firms must continue to fulfill these responsibilities in determining whether to move a client to a fee-based advisory account or other available fee structure brokerage account and should not necessarily assume that a single alternative will be appropriate for all fee-based clients. 12 For example, broker-dealers are regulated and subject to oversight at three levels SEC review and oversight, state review and oversight and SRO review and oversight. In addition, broker-dealers are subject to capital and financial responsibility obligations commensurate with the potential risk to investors and the marketplace posed by their activities. SRO rules impose client fairness rules both as a general matter, via a business conduct rule, and in more particular cases, via fair price and best execution rules. Moreover, the requirement to satisfy suitability or know your customer requirements for each client as to the appropriate structures going forward, in the short time provided by the stay of the Court order in the FPA Case makes this option particularly attractive in that there will be little direct impact to the client on the pricing and services provided. 13 This type of structure is common in wrap fee programs, and in some cases it may be appropriate to convert a brokerage account into a discretionary wrap fee account where the client would prefer or benefit from the discretionary aspect. 14 The following discussion is based on requirements for federally registered advisers. Although many state adviser regulations mirror the federal regulatory scheme, state-registered firms will need to ascertain the rules applicable for each of the states in which they do business. To be eligible for registration with the SEC, an adviser must have $25 million or more of assets under management or qualify for one of several express rule exceptions, such as the multi-state exception for advisers whose activities would require them to register in at least 25 states. 15 See NASD Notice to Members (November 2003) (noting that fee-based programs must be appropriate for a client based on the client s needs); NASD Rule 2110; NYSE Rule 405A. July 12,

6 NOTES 16 See, e.g., Jennison Associates Capital Corp., SEC No-Action Letter, 1985 SEC No-Act. LEXIS 2823 (pub. avail. Dec. 2, 1985). The SEC staff permitted an assignment of the advisory agreement (which requires client consent under Section 205(a)(2) of the Advisers Act) to be effectuated through a series of staged notices, at least at 60 days prior to the transaction, with another reminder at 30 days. After the final notice, clients that had not previously responded would be deemed to consent to the assignment. 17 These requirements would apply only when the broker-dealer is acting as an adviser with respect to the transaction, and generally would not apply where the broker-dealer is participating in a wrap-fee program and it does not recommend, select or play a role in the selection of particular securities. See, e.g., Morgan, Lewis & Bockius LLP, SEC No-Action Letter, 1997 SEC No-Act. LEXIS 529 (Apr. 16, 1997); Securities Industry Association, SEC No-Action Letter, 2005 SEC No-Act. LEXIS 853 (Dec. 16, 2005). Additional issues exist under the Investment Company Act of 1940 where the broker-dealer (whether or not also registered as an investment adviser) is principal underwriter for a mutual fund being recommended as an investment in a client account. 18 In many respects the regulations applicable to broker-dealers are more onerous than comparable Advisers Act regulations and will not significantly impact broker-dealer operations. For example, broker-dealers are generally prohibited from making projections under NASD rules that do not apply to investment advisers. See NASD Conduct Rule 2210(d)(1)(D). Also, the books and records requirements that apply to brokerdealers are much broader than those that apply to investment advisers. See Rule 17a-3(a) under the 1934 Act). 19 For example, this option would not appear to be available to discretionary accounts because by definition they would seem to include investment advice to the client. The SEC clarified that broker-dealers that exercise investment discretion on a temporary or limited basis would still fall within the Advisers Act broker-dealer exclusion, such as (but not exclusively) for purposes of (i) execution as to time and price of a specified security or if a client is unavailable for a limited time, (ii) cash management functions, (iii) margin maintenance obligations or activities or (iv) tax planning. 20 The SEC in the Adopting Release reversed its prior position on commission-based discretionary accounts (see note 7, above) and concluded that advice in connection with discretionary accounts (except where the discretion is confined to a temporary or limited basis ) is not solely incidental, even where compensation is commission-based. Adopting Release, note 9, above, at 40 and In light of the Court s action vacating the rule, it is possible that the SEC may revisit the status of commission-based discretionary accounts. 21 Such structures often vary commission rates based on a variety of factors, including the extent of the client s relationship with the firm, the level of assets in the account, the nature of services the client obtains from the firm (exclusive of advice) and other factors. 22 FPA Case, 482 F. 3d at See Adopting Release, note 9, above, at See note 15, above. K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name Kirkpatrick & Lockhart Preston Gates Ellis LLP qualified in Delaware and maintaining offices throughout the U.S., in Berlin, and in Beijing (Kirkpatrick & Lockhart Preston Gates Ellis LLP Beijing Representative Office); a limited liability partnership (also named Kirkpatrick & Lockhart Preston Gates Ellis LLP) incorporated in England and maintaining our London office; a Taiwan general partnership (Kirkpatrick & Lockhart Preston Gates Ellis) which practices from our Taipei office; and a Hong Kong general partnership (Kirkpatrick & Lockhart Preston Gates Ellis, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office. This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Data Protection Act 1998 We may contact you from time to time with information on Kirkpatrick & Lockhart Preston Gates Ellis LLP seminars and with our regular newsletters, which may be of interest to you. We will not provide your details to any third parties. Please london@klgates.com if you would prefer not to receive this information Kirkpatrick & Lockhart Preston Gates Ellis LLP. All Rights Reserved. July 12,