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

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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

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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