SEC Adopts Rule Excepting Brokers Offering Certain Fee-Based Brokerage Accounts from the Investment Advisers Act

Date: May 01, 2005

Overview

On April 12, 2005, the Securities and Exchange Commission (the “Commission”) adopted long anticipated Rule 202(a)(11)-1 under the Investment Advisers Act of 1940 (the “Advisers Act”).1 Under the new rule, a broker-dealer providing advice that is solely incidental to its brokerage services is excepted from the Advisers Act even if it charges an asset-based or fixed fee rather than a commission, markup or mark-down (i.e., “special compensation”), provided it makes certain disclosures about the nature of its services. Rule 202(a)(11)-1 also provides guidance as to when a broker-dealer is providing advice that is not solely incidental to the conduct of its business. Finally, the rule clarifies that broker-dealers offering discount brokerage services (including electronic brokerage) for reduced commission rates also may offer full service brokerage without triggering the application of the Advisers Act.

New Rule 202(a)(11)-1
Special Compensation

Under Rule 202(a)(11)-1(a)(1), a broker-dealer will not be deemed to be an investment adviser solely because it receives special compensation from an account for its services, provided the following conditions are satisfied:

  • Any investment advice is solely incidental to the brokerage services provided to the account and is provided on a non-discretionary basis; and
  • Advertisements for, and contracts, agreements, applications and other forms governing, the account includes the following 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 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 statement also must identify an appropriate person at the broker-dealer with whom the customer can discuss the differences between brokerage and advisory accounts.2

The failure of a broker-dealer to meet either of these requirements will result in the loss of the exception. Unless another Advisers Act exception is available, the broker-dealer will likely violate one or more provisions of the Advisers Act.3

Discount Brokerage

Rule 202(a)(11)-1(a)(2) provides that a broker-dealer will not be considered to have received special compensation solely because it charges one customer a commission, mark-up, mark-down or similar fee for brokerage services that is greater than or less than it charges another customer. As discussed in the release, this provision is intended to ensure that a full-service broker-dealer does not become subject to the Advisers Act solely because it also offers electronic trading or some other form of discount brokerage. Conversely, a discount broker-dealer will not be subject to the Advisers Act solely because it introduces a full-service brokerage program.

The “Solely Incidental To” Requirement
Separate Contract or Fee

A broker-dealer that charges a separate fee, or separately contracts with a customer, for investment advisory services (including financial planning services) is not considered to be providing advice that is solely incidental to its brokerage business. The Commission stated that separate contracts or fees for the provision of advisory services reflect a recognition that the advisory services are provided independent of brokerage services and, therefore, cannot be considered to be solely incidental to brokerage services.

Financial Planning

A broker-dealer is not providing advice solely incidental to brokerage if the advice is part of a financial plan or in connection with providing financial planning services, and the broker-dealer:

  • Holds itself out generally to the public as a financial planner or as providing financial planning services;
  • Delivers to the customer a financial plan; or
  • Represents to the customer that the advice is part of a financial plan or financial planning services.

A broker-dealer that portrays itself to the public as a “financial planner” or as providing “financial planning services”, or that delivers a “financial plan” is subject to the Adviser Act whether or not it uses those particular terms. Whether a particular document or communication is, under the rule, a “financial plan” or an offer to “provide financial planning services” will turn on how a reasonable investor would understand the services described in the communication and whether the document bears the characteristics of a financial plan.5

Discretionary Asset Management

Under the rule, discretionary investment advice is not solely incidental to brokerage services within the meaning of Rule 202(a)(11)-1 or the business of a broker-dealer within the meaning of Section 202(a)(11)(C) of the Advisers Act. The rule defines the term “investment discretion” by reference to Section 3(a)(35) of the Securities Exchange Act of 1934 (the “Exchange Act”). In general, a person exercises investment discretion over an account if that person, directly or indirectly, is authorized to determine which securities or property will be purchased or sold by or for the account, even in situations where another person may have responsibility for such investment decisions. Rule 202(a)(11)-1 is applied on an account-by-account basis. Therefore, under the rule, the exception provided by Section 202(a)(11)(C) is unavailable for any account over which a broker-dealer exercises investment discretion, regardless of the form of compensation and without regard to how the broker-dealer handles other accounts.6

The rule provides an exception for investment discretion granted by a customer on a temporary or limited basis. In such cases, the discretion must be limited to a transaction or series of transactions and cannot include the setting of investment objectives or policies for the customer. The Commission views a broker-dealer’s discretion to be temporary or limited within the meaning of Rule 202(a)(11)-1 if the broker-dealer is given discretion:

  • As to the price or time to execute an order for the purchase or sale of a definite amount or quantity of a specific security;
  • To purchase or sell a security or type of security on an occasional or infrequent basis when a customer is unavailable for a limited period of time not to exceed a few months7;
  • As to cash management, such as to exchange a position in a money market fund for another money market fund or cash equivalent;
  • To purchase or sell securities to satisfy margin requirements;
  • To sell specific bonds and purchase similar bonds in order to permit a customer to take a tax loss on the original position;
  • To purchase a bond with a specified credit rating and maturity; and
  • To purchase or sell a security or type of security limited by specific parameters established by the customer.8
Wrap Fee Programs

Broker-dealers often serve as sponsors of wrap fee programs, under which the broker-dealer effects securities transactions for one or more portfolio managers, which may be independent investment advisers. The sponsoring broker-dealer may provide wrap fee program customers with asset allocation models or with advice about selecting one or more of the portfolio managers in the program. Traditionally, the Commission has not viewed the sponsor’s asset allocation or portfolio selection advice as incidental to the brokerage transactions initiated by the portfolio managers and executed by the sponsor.9 The release adopting the new rule reaffirms the Commission’s interpretation that portfolio manager selection and asset allocation services involved in wrap fee programs are advisory services that are not solely incidental to brokerage services.

The advice a broker-dealer provides to any account must be solely incidental to brokerage services provided to that account rather than to the overall operations of the broker-dealer. In general, investment advice is solely incidental to the conduct of a broker-dealer’s business or to the brokerage services provided to an account for which it receives special compensation if the advice is in connection with, and reasonably related to, the brokerage services provided.4 The rule and the adopting release specifically state that the broker-dealer activities discussed below are not solely incidental to the conduct of a brokerage business. The release notes that the list of activities is not exhaustive and other activities also could lead to the loss of the broker-dealer exception.

The Customer Disclosure Requirement

The required disclosure statement is designed to put investors selecting a fee-based brokerage account on notice that their account is a brokerage account, with all the legal attributes of a brokerage account, rather than an advisory account. Consequently, the disclosure statement must be prominent. While the rule does not specify a particular font size or placement, the Commission has established general guidelines. To be “prominent”, the statement 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 clearly convey the required information.10

All broker-dealers are required to use the standard disclosure statement specified in the rule. However, the Commission recognizes that it may be appropriate to make minor modifications to the language to fit individual circumstances. For example, the Commission stated that it is permissible to use the product name of the account (e.g., “The XYZ Bank Brokerage Account”) rather than the phrase “your account”. However, modifications cannot be so extensive that they materially alter the substance of the disclosure.

Broker-dealers can provide additional disclosure materials discussing the topics covered by the disclosure statement so long as the additional information does not interfere with the prominence of the disclosure statement and contact information. In addition, additional disclosure, interactive websites, or multimedia software cannot be used as a substitute for the broker-dealer’s obligation to provide a contact person to answer questions about the differences between brokerage and advisory accounts. This document may be considered attorney advertising in some jurisdictions. Some of the design images and photographs in this document may be of actors depicting fictional scenes.

The Scope of Rule 202(a)(11)-1

The rule provides that a broker-dealer registered with the Commission under both the Exchange Act and the Advisers Act is an investment adviser solely with respect to those accounts for which it provides services or receives compensation that subjects the broker-dealer to the Advisers Act. As a result, a broker-dealer’s duties and responsibilities under the Advisers Act only apply to those accounts for which the broker-dealer provides advisory services, and not to its non-advisory accounts. This codifies the Commission’s earlier interpretation of the Adviser Act that permits a broker-dealer registered under the Advisers Act to distinguish its brokerage customers from its advisory clients.

Compliance Dates

Beginning on April 15, 2005, all broker-dealers may rely on Rule 202(a)(11)-1(a)(2) when offering discount brokerage accounts and Rule 202(a)(11)-1(a)(1) when offering non-discretionary investment advice in connection with fee-based brokerage accounts that are excluded under the rule.

Broker-dealers relying on the special compensation provisions in Rule 202(a)(11)-1(a)(1) must include the required disclosure statement in all advertisements for, and contracts, agreements, applications and other forms governing, accounts opened after July 22, 2005. Broker-dealers relying on Rule 202(a)(11)-1(a)(1) with respect to fee-based brokerage accounts opened prior to July 22, 2005 are not required to amend existing contracts and agreements governing those accounts. The SEC nevertheless encourages broker-dealers opening fee-based accounts for customers after April 15, 2005 but before July 22, 2005, to include the disclosure in materials for those accounts.

No later than by October 24, 2005, broker-dealers must treat as advisory accounts commission-based discretionary accounts, as well as other accounts that fail to satisfy the “solely incidental to” conditions in Rule 202(a)(11)-1(b).

Footnotes

  1. See Certain Broker-Dealers Not Deemed to be Investment Advisers , Release Nos. 34-51523, IA-2376 (April 15, 2005). Rule 202(a)(11)-1 was originally proposed in November 1999 and re-proposed in January 2005. The Commission received over 1,700 comment letters on the 1999 proposal and over 300 comment letters on the re-proposal.
  2. The contact person does not have to be specifically named; it is sufficient if a broker-dealer provides customers with a designated contact point that allows customers to speak to a person at the firm who can answer customer questions.
  3. Section 209 of the Advisers Act authorizes the Commission to bring administrative proceedings and initiate civil actions for violations of the Act.
  4. See Release Nos. 34-51523, IA-2376 at p. 47.
  5. Including a disclaimer that comprehensive advisory services offered to customers do not constitute “financial planning services” or is “not comprehensive” would not permit a broker-dealer to avoid the application of the Advisers Act under the rule. See Release 34-51523, IA-2376 at note 160.
  6. The rule terminates the existing staff approach under which a discretionary account is subject to the Advisers Act only if the broker-dealer has enough other discretionary accounts to trigger the Act.
  7. By way of example, the Commission cites the case of a customer who is on vacation or otherwise unavailable for a short period of time and has provided specific instructions as to the handing of his account during this time.
  8. The broker-dealer may purchase or sell a particular security so long as the client specifies all relevant material strategic features (e.g., type of issuer, amount, maturity and yield).
  9. See Disclosureby Investment Advisers Regarding Wrap Fee Programs , Investment Advisers Act Release No. 1401, at n. 2 (Jan. 13, 1994)(proposing amendment to Form ADV); Investment
    Advisers Act Release No. 1411 (April 19, 1994)(adopting amendments to Form ADV).
  10. See Release 34-51523, IA-2376 at note 160.
 
Disclosure

This advisory may be reproduced, in whole or in part, with the prior permission of Thompson Hine LLP and acknowledgement of its source and copyright. This publication is intended to inform clients about legal matters of current interest. It is not intended as legal advice. Readers should not act upon the information contained in it without professional counsel. This document may be considered attorney advertising in some jurisdictions. Some of the design images and photographs in this document may be of actors depicting fictional scenes.