On September 19, 2007, the Securities and Exchange Commission (the "Commission" or "SEC") adopted a temporary rule ("Temporary Rule") that provides limited relief to firms registered as investment advisers under the Investment Advisers Act of 1940 ("Advisers Act") and as broker-dealers under the Securities Exchange Act of 1934 ("Exchange Act") from the principal trading limitations of Section 206(3) of the Advisers Act.1
In addition, the Commission approved interpretive guidance ("Interpretive Guidance") that seeks to clarify the application of the Advisers Act to certain activities of broker-dealers under Section 202(a)(11)(C) of the Advisers Act.2
The "Fee-Based Rule" and the Repercussions of the FPA Decision
On March 30, 2007, the U.S. Court of Appeals for the District of Columbia Circuit, in Financial Planning Association v. SEC ("FPA Decision"), vacated Rule 202(a)(11)-1 of the Advisers Act ("Fee-Based Rule") in its entirety.3 Rule 202(a)(11)-1 generally provided relief under the Advisers Act to broker-dealers that offered fee-based brokerage accounts. In the release adopting the Fee-Based Rule, the SEC also provided interpretive guidance on other related issues.
As a result of the court’s decision, fee-based brokerage accounts have to be converted either to investment advisory accounts, or to commission-based brokerage accounts. The conversion of fee-based accounts to advisory accounts raises various possible collateral issues. In particular, fee-based accounts that are converted to advisory accounts would become subject to, among other things, the principal trading limitations of Section 206(3) of the Advisers Act. In addition to vacating the Fee-Based Rule, the FPA Decision also created uncertainty regarding other rule-making and interpretive guidance previously promulgated by the Commission. In particular, the FPA Decision called into question the status of other interpretive guidance issued by the Commission regarding the treatment of certain broker-dealer activities under Section 202(a)(11)(C) of the Advisers Act.
The Temporary Rule and the Interpretive Guidance are an attempt by the Commission to provide clarity in the aftermath of the FPA decision.
The Temporary Rule
The Temporary Rule only applies to entities that are registered both as broker-dealers and investment advisers ("Dual Registrants"); it does not provide any principal trading relief to entities registered only as investment advisers. Under the Temporary Rule, the Commission provides Dual Registrants with an alternative means of complying with the principal trading restrictions of Section 206(3) of the Advisers Act. In particular, the Temporary Rule provides relief from the trade-by-trade written notice requirement of Section 206(3) of the Advisers Act if a Dual Registrant adheres to the following conditions:
1. Eligible Securities. The Temporary Rule applies to any principal trade with a non-discretionary client that does not involve:
- a transaction in which the Dual Registrant (or an affiliate of the Dual Registrant) acts as underwriter, other than offerings involving investment grade debt securities; or
- a security issued by the Dual Registrant.
2. Written Consent and Other Disclosures. Dual Registrants will be required to obtain prior global written consent from each non-discretionary investment advisory customer and must disclose the potential conflicts of interest that may arise from principal transactions with the Dual Registrant. The customer must agree, in writing, to the possibility of effecting trades with the Dual Registrant as principal and the written consent must be revocable by the customer at any time without penalty. In addition, Dual Registrants will only be required to obtain the written consent from the customer once and the consent may be part of the account application or initial customer agreement. A Dual Registrant relying on the Temporary Rule will be required to obtain the customer's written consent by December 31, 2007.
3. Trade-by-Trade Oral/Written Disclosure. Under the Temporary Rule, Dual Registrants are required to inform the client orally or in writing at the time of each trade that the firm may trade with the client on a principal basis in the transaction.
4. Confirmation Disclosure. Transaction confirmations provided by the Dual Registrant must indicate that it acted as principal.
5. Annual Report. Dual Registrants must provide customers with an annual statement of all principal trades effected in their accounts during the prior year.
The SEC staff indicated that the Temporary Rule will be effective on September 30, 2007 and expire on December 31, 2009.
Section 202(a)(11)(C) Interpretive Guidance
In addition to adopting the Temporary Rule, the Commission also approved Interpretive Guidance under Section 202(a)(11)(C) of the Advisers Act.4 Section 202(a)(11) of the Advisers Act sets forth the definition of an "investment adviser" and provides, among other things, that a broker-dealer will not be deemed to be an "investment adviser" if the broker-dealer’s advisory services are "solely incidental" to its broker-dealer business and it receives no "special compensation" for such services.5 The Interpretive Guidance addresses this definitional exclusion with respect to a number of common broker-dealer practices. In particular, the Interpretive Guidance discusses the following broker-dealer practices and the treatment of such practices under Section 202(a)(11)(C):
1. Separate Contract or Fee for Investment Advisory Services. If a broker-dealer enters into a separate contract with a customer or charges a separate fee for investment advisory services, such services will not be considered to be "solely incidental" to the broker-dealer’s brokerage business under Section 202(a)(11)(C) of the Advisers Act. If a Dual Registrant charges such a separate fee, it should treat the advice as subject to the Advisers Act.6
2. Exercise of Investment Discretion. The exercise of investment discretion over an account by a broker-dealer will not be deemed to be "solely incidental" to the broker-dealer’s brokerage business under Section 202(a)(11)(C) of the Advisers Act, so fully discretionary accounts will continue to be required to be treated as investment advisory accounts.
3. Price Differential. A broker-dealer that charges different fees for various brokerage services — such as a higher fee for full-service brokerage and a lower fee for online brokerage — will not be viewed as receiving "special compensation" merely because of the price difference, and thus may continue to treat those accounts as brokerage accounts.
In addition, the Interpretive Guidance clarifies that if a broker-dealer is subject to the provisions of the Advisers Act, the broker-dealer will only need to comply with the Advisers Act with respect to the broker-dealer’s investment advisory accounts and not the broker-dealer’s brokerage accounts.
The Commission decided not to address financial planning services under the new Interpretive Guidance. Rather, the Commission elected to wait to address this issue until the completion of the RAND study on the regulatory regimes that apply to broker-dealers and investment advisers. As a result, there remains considerable uncertainty about whether a broker-dealer may produce a financial plan for brokerage account customers.
Footnotes
1. See 15 U.S.C. § 80b-6(3) (2007).
2. See 15 U.S.C. § 80b-2(a)(11)(C) (2007).
3. See Financial Planning Ass'n v. S.E.C., 482 F.3d 481 (D.C. Cir. 2007); 17 C.F.R. §275.202(a)(11)-1 (2007).
4. See 15 U.S.C. § 80b-2(a)(11)(C) (2007).
5. See 15 U.S.C. §§ 80b-2(a)(11) and 80b-2(a)(11)(C) (2007).
6. The Commission did not consider during the open meeting or in the Temporary Rule or Interpretive Guidance the treatment under the Advisers Act of broker-dealers that receive a fee for issuing research reports.
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