An End to Fee-Based Brokerage


New York – A letter/advertisement from Bob McCann, President of Merrill Lynch Global Private Client Group, was posted in the Wall Street Journal this morning. The letter is entitled “The Needless Death of Fee-Based Brokerage”. There are two broad ways to pay for brokerage—traditional commissions or a fee-based charge. Arguably, those that are concerned about churning may be more likely to opt for the fee-based brokerage fees.

Merrill has the largest share of the fee-based brokerage business, having about 400,000 accounts worth a total of $100 billion (or about 25% of the total market).

Fee-based accounts were allowable under rule 202 of the Securities and Exchange Commission. This rules deals with the potential fiduciary responsibility of brokers that provide information to their accounts. At issue is whether the advice offered by a broker is “solely incidental” to its brokerage business. If this is the case, then the brokerage firm is not deemed to have fiduciary responsibility to the client and therefore need not be a registered investment advisor.

However, in March of this year, a federal court vacated rule 202, which means that the fee-based brokerage business could be determined to be advisory in nature and require that the brokers are investment advisors with fiduciary responsibilities to their clients.

Rather than risk this outcome, the Street’s expected response—confirmed by the Merrill letter—is to stop offering fee-based accounts altogether.

Since the letter is an advertisement in the print version of the paper, we are unable to present it below. However, we have included the FPA Executive Summary for Rule 202(a)(11)-1 for reference:


FPA Executive Summary

SEC Rule 202(a)(11)-1

“Certain Broker-Dealers Deemed Not To Be Investment Advisers”

I. Background

The Investment Advisers Act of 1940 provides for exemptions of certain industry or professional groups from registration as investment advisers. In the case of brokerdealers, there are two conditions that a brokerage firm must meet in order to avoid registration as an advisory firm: 1) the advice must be “solely incidental” to its brokerage business; and 2) the firm must receive no “special compensation” for the advice. For nearly 60 years, from 1940 to 1999, the regulatory distinctions between brokers and advisers were fairly distinct, with industry and regulators relying primarily on the “special compensation” prong, and the general understanding that if a broker received a fee for advice, it was special compensation and would require registration as an adviser.

On April 6, 2005, the SEC adopted a highly controversial rule, originally proposed in November 1999, that broadens the exemption from broker-dealers from the Investment Advisers Act of 1940 where brokerage firms offer fee-based advisory programs. In its analysis, the SEC stated that the fee-based programs were merely re-pricing of traditional full-service brokerage programs and not special compensation, and the rule served as a way to reduce churning and suitability problems. Under an unusual procedure, SEC staff in 1999 also recommended a ‘no-action’ position, meaning that, until the SEC took final action on the rule, brokerage firms could offer fee-based programs without triggering Adviser Act registration.

The SEC’s long-delayed action was prodded by the lawsuit filed by FPA on July 20, 2004, in the D.C. Circuit Court of Appeals challenging the no-action position. The SEC in August reopened the proposed rule for a second round of public comment; told the Circuit Court that it would take action by December 31, 2004; and adopted the final rule on April 6th. The rule was effective on April 15th, with two additional phases of implementation scheduled: no later than July 22, 2005, brokers must fully comply with the disclosure requirements; and commission-based discretionary accounts, with minor exceptions, must be converted to advisory accounts by Oct. 24th, 2005.

II. Changes to the Broker-Dealer Exemption in Final Rule

The original proposed rule has been modified slightly in the final rule, allowing brokerage firms to continue to offer comprehensive, fee-based advisory services without triggering registration under the “special compensation” requirement of the Advisers Act. The two primary changes to the original proposal are an expanded disclosure statement by brokers and clarification of advisory activities that are not solely incidental to brokerage services, including financial planning.

i. Disclosure Statement.

With respect to disclosure, the SEC determined that, instead of simply disclosing the account is a “brokerage” account, as it had under the original rule, brokerage firms must also provide customers with the following language in a “prominent” statement:

“Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits and our salespersons’ compensation, may vary by product and over time.”

The rule also directs brokerage firms to make available to consumers a contact person at the firm to answer questions about the differences in broker and adviser regulation.

SEC staff comments during adoption of the final rule suggested that general advertisements by a broker-dealer not directly referencing “financial planning” services would not need to include the above warning label. To comply with the rule’s requirement that the statement be “prominent,” the adopting release suggests the disclosure should be included, at a minimum, on the front page of each document or agreement “in a manner clearly intended to draw attention to it.” In a televised or video presentation, a voice overlay must convey the same information.

ii. Solely Incidental Restrictions.

The new requirements include the following three situations where brokerage activity would not be considered “solely incidental” advice:

1. A broker-dealer charges a separate fee for, or separately contracts with a customer for “investment advisory” services;

2. A broker-dealer holds out to the public as a financial planner or as providing financial planning services (including delivering a financial plan to a customer);

3. A broker-dealer exercises investment discretion over an account, fee-based or commission, except in very limited situations.

Unless and until further clarification is provided by the SEC, it is unclear as to what restrictions would be imposed on a brokerage firm continuing to use a registered representative to collect data for, and deliver financial plans generated by a brokerdealer’s affiliated registered investment adviser firm without having the account treated as an advisory, not brokerage account. Nor is the current regulatory status under the final rule clear at this point on the regulatory treatment of certain fee-based brokerage accounts where a financial plan or financial planning was provided prior to adoption of the rule. A broad interpretation of the rule could conceivably require such accounts to be deemed advisory accounts subject to the fiduciary protections of the Advisers Act.

It is also not clear at this point whether a brokerage firm might continue to provide comprehensive advisory services as part of a fee-based program if it carefully avoided use of the terms “advisory service” or “financial planning” in the delivery of such services. Future interpretation will depend on how narrowly or broadly the SEC interprets the financial planning process. While the SEC continues to consider the titles “financial counselor” and “financial advisor” to be generic terms used in the financial services industry, and not subject to the solely incidental restriction, the adopting release also states that, “whether a particular document is, under the rule, a financial plan will turn on whether the document or representation bears the characteristics of a financial plan.” In a footnote to the release, the SEC also notes that a disclaimer on the account form stating that comprehensive advisory services would not constitute “financial planning services” or the advice is “not comprehensive” would not allow a brokerdealer to avoid application of the Advisers Act under the rule.

III. SEC Study

The adopting release states that the final rule would address “many, but not all, concerns about investor confusion” and that the blurring of broker/adviser activities was beyond the scope of the rulemaking. As a result, the SEC said it would report on options within 90 days addressing these issues, including parameters for a study and any additional rulemakings to be undertaken by SEC staff or recommended rules to NASD or other SROs. The scope of a study would address, among other things, the following questions:

• Whether the SEC should recommend legislation to integrate existing broker/adviser regulation where both provide retail services;

• Whether sales practice standards and advertising rules applicable to advice provided by broker-dealers should be enhanced;

• Whether broker-dealers should be subject to the fiduciary obligations of the Advisers Act if they provide investment advice but are excepted from registration;

• Whether the SEC should streamline requirements of the Advisers Act to brokerage firms that are dually registered to avoid overlap and reduce regulatory burdens; and

• Whether the SEC should enhance investor education efforts to help investors better understand the differences in broker/adviser regulation.

SEC staff also would provide options and recommendations on the scope of the study; appropriate persons within and outside the Commission to be involved in the study; and time frames for concluding the study and expected action by the SEC and staff.

IV. Lawsuit Status

FPA’s lawsuit remains pending in federal court. However, the Board of Directors plans to determine whether to pursue additional legal action, which would based on challenging the merits of the rule, prior to the 60-day deadline for challenging an agency action in court.


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