Untangling Financial Planning Association v. Securities and
Exchange Commission : The Future of Fee-Based Brokerage
Accounts
By
Diane E. Ambler
+1.202.778.9886
diane.ambler@klgates.com
C. Dirk Peterson
+1.202.778.9324
dirk.peterson@klgates.com
Elaine A. Lindenmayer
+1.415.249.1042
elaine.lindenmayer@klgates.com
David Dickstein
+1.212.536.3978
david.dickstein@klgates.com
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 ruling1 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, thenSEC 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
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, 2007 | 2
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, 2007 | 3
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, 2007 | 4
NOTES
Fin. Planning Ass’n v. Securities & Exch. Comm’n, 482 F.3d 481 (D.C. Cir. 2007) (“FPA Case”).
1
Rule 202(a)(11)-1 under the Investment Advisers Act of 1940, as amended (“Advisers Act”).
2
Report of the Committee on Compensation Practices (April 10, 1995) (“Tully Report”), available at http://www.sec.gov/news/studies/bkrcomp.
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.
3
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.
4
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 15-16 (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. 34-37850 (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-2310-3 (suitability obligations for institutional clients); NASD Proposed Rule 2821 (sales of
deferred variable annuities); and NASD Notice to Members 99-35 (May 1999) (reminding members of suitability in sales of variable annuities).
5
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.
6
Certain Broker-Dealers Deemed Not to Be Investment Advisers, SEC Rel. No. 34-42099 (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.
7
Certain Broker-Dealers Deemed Not to Be Investment Advisers, SEC Rel. No. 34-50980 (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. 34-50979 (Jan. 6, 2005).
8
Certain Broker-Dealers Deemed Not to Be Investment Advisers, SEC Rel. No. 34-51523 (April 12, 2005) (“Adopting Release”).
9
10
Fin. Planning Ass’n v. Securities & Exch. Comm’n, No. 04-1242, available at 2007 U.S. App. LEXIS 15169 (D.C. Cir. June 25, 2007).
“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 03-68 (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.
11
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.
12
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.
13
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.
14
See NASD Notice to Members 03-68 (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.
15
July 12, 2007 | 5
NOTES
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.
16
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.
17
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).
18
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.
19
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 60-65. 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.
20
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.
21
22
FPA Case, 482 F. 3d at 491.
23
See Adopting Release, note 9, above, at 9.
24
See note 15, above.
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