New York, NY – On Friday, March 30th, the U.S. Court of Appeals for the District of Columbia Circuit Court in Washington overturned the Security and Exchange Commission’s so-called “Merrill Lynch rule” 2 to 1 in a move that will force brokerage firms that charge asset-based fees to register as investment advisors. Unfortunately, this change is likely to cause a great deal of consternation among brokers as they face the significant costs of such an unexpected development.
The ruling, written by Judge Judith Rogers, said that the SEC exceeded its authority by exempting brokerage firms that charge asset-based fees from regulation under the Investment Advisers Act of 1940.
“The rule is inconsistent with the Investment Adviser’s Act,” Judge Rogers wrote, because it fails to meet the law’s requirements for exemptions. She added that under that law, brokers can only be exempt from advisory regulation if they do not receive “special compensation” for giving advice.
Judge Merrick Garland, who dissented, said that the SEC’s interpretation of the IAA was reasonable, and courts are bound by legal precedent to give government regulators the benefit of the doubt in interpreting the law.
Background of this Rule
The Court of Appeals’ ruling reversed a unanimous 5 to 0 vote in 2005 by the SEC that allowed broker-dealers to offer fee-based accounts without registering as investment advisers.
This rule was temporarily in force since 1999, allowing brokers to offer fee-based accounts to clients on a nondiscretionary basis, as long as any investment advice provided was “solely incidental” to their order-taking brokerage services.
The Financial Planning Association has vigorously fought the “Merrill Lynch rule” since its passage, arguing that it would cause confusion in the marketplace over who is a broker agent and who is a fiduciary investment adviser.
This fear was backed by a 2004 study by TD Waterhouse which revealed that more than 84% of investors believed that everyone providing financial advice was subject to the same industry regulations.
In addition, the FPA consistently argued that these brokers did not regularly disclose the various conflicts of interest they faced to their retail customers. Many opponents of the “Merrill Lynch rule” also added that brokers, though they are subject to substantial regulation, are not regulated with the same consumer-oriented protections as investment advisers.
For example, under the Investment Advisor Act of 1940, investment advisers have a fiduciary obligation to act solely in a client’s best interests, or face a fiduciary breach lawsuit in a court of law.
However, brokers are held to a much less stringent “suitability standard”. As a result, opponents of the rule note that brokers aren’t required to act solely in the interests of their clients as fiduciaries do.
Based on these developments, the Court of Appeal’s decision is a big win for the Financial Planning Association of Denver, which challenged the SEC when it issued its rule in 2005 exempting brokerage firms that charge asset-based fees from investment advisory regulations under specified conditions.
However, overturning this rule is more than a mere nuisance for the brokerage industry. In fact, many bulge bracket brokerage firms have been extremely aware — and quite concerned — about making sure they do not cross the “solely incidental” standard regarding providing investment advice.
This is the very reason why many investment banks and brokerage firms have staunchly refused to accept cash payments for their investment research and advisory services from their asset management clients (like what took place between Lehman Brothers and Fidelity in their highly publicized “unbundling” deal).
Many brokerage firms have publicly acknowledged that they were concerned that accepting large cash payments for their research, including the individual recommendations and analysis provided by their analysts and salespeople, might prove that they were breaching the “solely incidental” threshold in providing investment advice to their clients. As a result, these firms might be forced to become registered investment advisors.
As an investment adviser, brokers would be required to obtain “best execution” pricing for client trades, and they would be precluded from engaging in obvious “conflicts-of-interest” such as selling a similarly-suitable fund that has higher expenses but provides the broker with additional commissions or satisfies sales production requirements.
Not only would this force brokers to adopt a higher fiduciary standard when dealing with their clients, but becoming an investment adviser would also prohibit them from conducting principal trading with their customers due to the inherent conflicts of interest inherent in these transactions. Of course, such a development could prove extremely costly for many large bulge bracket brokerage firms that have built up extremely profitable proprietary trading businesses in recent years.
It is highly likely that the U.S. Court of Appeals’ decision will raise a tremendous hue and cry from the securities industry as the impact of this recent decision could be widespread.
Consequently, we would not be surprised if Congress were convinced to re-examine this, and other securities laws, in light of tremendous changes that have taken place in the financial services industry since these laws were enacted following the Depression.
Unfortunately, we suspect that many in the brokerage industry could be forced to scurry to come up with near-term solutions to address the consequences of this ruling and the potential duty to operate under the fiduciary requirements outlined under the Investment Advisers Act of 1940.
Comment by Rob Tholemeier:
The bigger question that needs to be addresses is the propriety of giving advice and then excuting on that advice on behave of clients out the the firm’s inventor.
Just the way the chinese wall was fortified between banking and research, a new an impervious wall needs to be erected between trading profits and advice.
I suspect that is what is coming.