SEC Proposes Rule To Exempt New Brokerage Arrangements From The Advisers Act

On November 4, 1999, the Securities and Exchange Commission ("SEC") proposed new rule 202(a)(11)-1 under the Investment Advisers Act of 1940 ("Advisers Act") and a related amendment to Form ADV. (please see endnote 1) The new rule would provide an exemption from the definition of "investment adviser" for broker-dealers that provide alternative pricing options for brokerage services, such as asset-based fees and two-tiered fee structures with lower charges for on-line trading. The rule would keep broker-dealers from being subject to the Advisers Act -- including, notably, Section 206(3) -- solely as a result of the form of compensation they receive. The proposed rule also clarifies that broker-dealers that are also registered as investment advisers are subject to the Advisers Act only with respect to their advisory accounts. The proposed form amendment clarifies how broker-dealers registered as investment advisers are to treat discretionary and non-discretionary accounts when calculating assets under management.

Comments on the proposal are due January 14, 2000.

Section 202(a)(11) of the Advisers Act broadly defines an "investment adviser" as a person who, for compensation, engages in the business of advising others about securities, subject to several exceptions. Broker-dealers fall within the broad definition, because they typically provide advice as part of their services. Section 202(a)(11)(C), however, excepts a broker-dealer from the definition of investment adviser if the performance of investment advice is "solely incidental" to the conduct of its business as a broker-dealer and if it receives no "special compensation" for that advice.

Early staff positions had suggested, with limited analysis, that forms of compensation other than traditional commissions, such as asset-based fees, might be special compensation. In addition, after the unfixing of brokerage commissions in 1975, the staff considered the possibility that brokerage firms might "unbundle" execution from research. In a 1978 release, the staff discussed a hypothetical situation in which a broker-dealer might have different fee schedules, with higher charges for services including advice, and lower charges for execution only, and concluded that such a situation would involve the receipt of special compensation. (please see endnote 2) The staff emphasized, however, that the release contained the staff’s "current" views, that those views might change as the staff gained experience with specific situations, and that the staff would seek to promote price competition among broker-dealers.

Brokerage services and pricing have changed dramatically since the publication of those views. Investment companies have used asset-based fees under rule 12b-1 plans as compensation for brokerage services, especially for the sale of so-called "B" and "C" shares, without any apparent question by the SEC or its staff. Brokerage firms have received asset-based fees for their execution and administrative services to wrap programs they sponsor. Brokerages have offered asset-based pricing for execution, initially for a specified number of transactions, and more recently for an unlimited number of transactions. Finally, in response to the rapid development of low-cost, on-line trading, traditional full-service brokerage firms have announced programs allowing customers to place securities trades over the Internet at a lower commission rate than is paid by full-service customers. Although some language from the old staff positions could, if taken literally, suggest that some of these developments involve special compensation, many members of the industry and bar have concluded that, under the general principles previously enunciated by the SEC and the staff, these pricing alternatives do not involve special compensation.

As a matter of general policy, regulators have supported the development of broker compensation alternatives such as asset-based pricing. A Committee on Compensation Practices, chaired by Daniel Tully of Merrill Lynch, issued a report in April 1995 that recommended various best practices aimed at aligning the interests of customers, brokerages, and representatives. Those included basing a portion of representatives’ compensation on client assets, rather than transaction activity. Those recommendations have received the endorsement of Chairman Levitt and other members of the SEC.

The proposal does not undertake to re-examine old interpretive positions about what is special compensation. Instead, proposed rule 202(a)(11)-1 would provide a clean solution to any questions about the applicability of the term "special compensation" by providing exemptions from the definitions of "investment adviser" and "special compensation" for asset-based compensation for certain brokerage services, and for differentials in brokerage compensation. The SEC explained that it did not believe that Congress intended the new programs, which are not substantively different from traditional brokerage arrangements, to be subject to the Advisers Act.

Paragraph (a) of proposed rule 202(a)(11)(C) would allow a registered broker or dealer to provide customers investment advice, regardless of whether the broker-dealer receives special compensation for doing so. The rule provides that a registered broker or dealer would not be considered to be an investment adviser based solely on its receipt of special compensation, provided three conditions are satisfied:

• No discretion. The broker-dealer must not exercise investment discretion over any account from which it receives special compensation. The SEC explained that discretionary accounts that are charged a fee based on the amount of assets in the account strongly resemble traditional advisory accounts, and customers are likely to perceive them as such.

• Advice solely incidental to brokerage services. Any advice provided by the broker-dealer must be solely incidental to the brokerage services provided by the broker-dealer to the accounts from which it receives special compensation. The SEC did not revisit any old SEC or staff positions on when services are considered "solely incidental," which presumably will continue to apply. This provision is intended to clarify that advice must be solely incidental to the brokerage services provided to each account, rather than to the overall operations of the broker-dealer.

• Prominent disclosure. Advertisements and customer agreements for the accounts from which a broker-dealer receives special compensation must clarify that the accounts are brokerage accounts.

The release briefly discussed the status of wrap fee programs. The SEC stated that broker-dealer sponsors of wrap fee programs would have to continue treating wrap accounts as advisory accounts. To the extent that broker-dealer sponsors provide discretionary portfolio management services to wrap clients, they could not rely on the proposed rule. In the cases in which the sponsors do not have discretionary authority, but execute transactions and provide limited non-discretionary services to wrap clients (e.g., asset allocation, selection of portfolio managers), the proposed rule also would be unavailable, because those non-discretionary advisory services would not be deemed incidental to the brokerage services provided.

Paragraph (b) of the proposed rule provides that a registered broker or dealer would not be considered to have received special compensation solely because it charges a commission, mark-up, mark-down or similar fee for brokerage services that is greater than or less than the amount it charges another customer. Under the rule, the broker-dealer exception would be available to broker-dealers with a two-tiered fee structure charging higher fees to full-service accounts and lower fees to what the SEC termed "execution-only" accounts. The term "execution-only" used in the release is inexact, inasmuch as customers with such accounts, while they do not receive ongoing, personalized services, generally do have access to research, analytical tools and other financial services. The text itself of paragraph (b), however, is broad enough that broker-dealers offering such accounts as well as full-service accounts would not be deemed to receive special compensation.

Paragraph (c) of the proposed rule provides that a broker-dealer "is an investment adviser solely with respect to those accounts for which it provides services or receives compensation that subject the broker or dealer" to the Advisers Act. This is intended to codify the view that the Advisers Act applies only to those customers who receive advice that is not incidental to brokerage services provided or from whom special compensation is received.

The SEC also proposed to amend Schedule I of Form ADV, on which advisers report their assets under management for purposes of determining eligibility for SEC registration. Under the amendment, broker-dealers registered as investment advisers may include in their calculation of assets under management the value of any brokerage accounts that receive continuous and regular supervisory or management services on a discretionary basis; they would not include non-discretionary brokerage accounts. The release also noted that, during investment adviser examinations, the staff may request broker-dealers that are registered investment advisers to provide information related to the brokerage accounts over which they exercise investment discretion so that the staff can evaluate a firm’s reported figures for assets under management.

Until the SEC acts on the proposal, the Division of Investment Management will take a no-action position under which it will not recommend enforcement action if broker-dealers treat non-discretionary accounts as not subject to the Advisers Act.

If you would like a copy of the release or have any questions, please contact Marianne K. Smythe, Jeremy N. Rubenstein, Robert G. Bagnall or Marticha L. Cary.

This letter is for general informational purposes only and does not represent our legal advice as to any particular set of facts, nor does this

letter represent any undertaking to keep recipients advised as to all relevant legal developments.

1. Certain Broker-Dealers Deemed Not To Be Investment Advisers, Investment Advisers Act Release No. 1845 (Nov. 4, 1999), available at http://www.sec.gov/rules/proposed/34-42099.htm.
2. Final Extension of Temporary Exemption from the Investment Advisers Act for Certain Brokers and Dealers, Investment Advisers Act Release No. 626 (Apr. 27, 1978).