Letting Sleeping Dogs Lie

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New York-Yesterday we discussed the security industry’s efforts to preserve the exemption of their fee based brokerage business from the Investment Advisors Act.  Today we turn to another exemption from the Advisors Act which is beginning to look a little shaky-research.  For securities firms, the current exemption of their proprietary research from advisor registration is a large sleeping dog they are trying to keep sedated.

Investment Advisor = Research

The definition of an investment advisor is very broad, capturing most investment research in its definition:

“‘Investment adviser’ means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”

In other words, if you provide investment research you are acting as an investment advisor.  Since the definition of an investment advisor is so sweeping, there are numerous exemptions.  Broker/dealers are exempted but current changes in the marketplace are beginning to form cracks in the exemption.  Let’s look at the broker’s exemption more closely.

How Incidental?

The broker exemption to the Advisors Act is based on two conditions: the activity being incidental to the brokerage business and receiving no special compensation for it.  Brokers or dealers “whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor” are exempt.

As the equity commissions are increasingly unbundled, defining the portion of the commission going to execution and the portion going to research, a problem arises.  If brokers are getting a defined compensation for their research, will they still be exempt from the Advisors Act?

Since the SEC’s soft dollar guidance in July 2006, proprietary brokerage research is defined as a form of soft dollar payment.  So, in theory, the question of the exemption was raised at that point.  In practice, the increasing popularity of client commission arrangements (CCAs) creates de facto unbundling which exacerbates the issue.  The more defined the payment, the harder to justify the exemption.  Many of the executing brokers of the CCA programs have insisted that payments for their own proprietary research not go through the CCA program for fear of triggering the investment advisor provision.

Prop Research v. Prop Trading

Why is exemption from the investment advisors act so critical?  After all, many securities firms have asset manager subsidiaries or affiliates.   There are a variety of issues that would be triggered if a securities firm’s broker/dealer operations became subject to the Advisors Act, which has a regulatory regime distinct from the regime that broker/dealers currently follow.  The biggest issue by far is that registration under the Advisors Act would preclude proprietary trading.

Hmm, let’s think about this.  Given a choice between proprietary research and proprietary trading, which way might Goldman go?  How many nanoseconds would the decision take?

The securities firms are working to avoid such a dilemma and it may never come down to it.  Small and mid-sized brokers may be more vulnerable as their execution business wanes.  The SEC could take the view that if brokers evolve more toward research boutiques they are less eligible for the brokerage exemption.  The “incidental” test becomes less valid.

There is a rumor that the SEC is about to issue a letter addressing some of the issues surrounding advisor exemptions.  Stay tuned.

Comment by Rob Tholemeier:
“’Investment adviser’ means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”

Sounds like the Wall Street Journal, CNBC, every newsletter, etc.

I still say the biggest conflict is not between research and investment banking but between proprietary trading and ALL other BD functions including advisory.
Comment by Bill George:
Pinch Me. . . Harder

I find it stunningly peculiar that in the wake of the investigations and revelations about the conflicts-of-interest and other frauds perpetrated by the full-service / investment banking brokerage industry anybody would propose that wire-house employees be considered the same as advisors operating as independent fiduciaries.

Does anybody really believe Global Research Analyst Settlement created deep and lasting reform in the full-service brokerage business?

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