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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks Before the IA Week Sixth Annual Fall Conference


Commissioner Annette L. Nazareth

U.S. Securities and Exchange Commission

New York, N.Y.
September 25, 2006

Good afternoon. I appreciate the opportunity to speak to you today and thank the staff of IA Week, especially Hugh Kennedy, for this invitation. From a look at the day's agenda, it is clear you will have many opportunities to learn about recent developments in the areas of compliance and regulation. These matters are very important, and I applaud your efforts to attend events such as this where current business practices and their regulatory implications are discussed and considered.

Rather than focus my remarks on the compliance issue du jour, I would like to discuss a broader topic affecting your business: the frameworks under which broker-dealers and investment advisers operate, including the sales practices, disclosures, and investor protections applicable under each regulatory regime. Before I begin, however, let me remind you that my remarks represent my own views and not necessarily those of the Commission, my fellow Commissioners, or members of the staff.1

As you all know, ours is a business that is in a constant state of innovation, and much of that innovation has led to changes and improvements across various types of financial intermediaries. These are very positive developments. In order to compete, intermediaries — whether broker-dealers or investment advisers — must provide superior service and a myriad of choices for the investors they serve. We are now seizing an opportunity to analyze these changes in our marketplace and to consider how these innovative industry practices have benefited investors, where our regulations can provide further opportunity for investor benefits, and what, if any, gaps exist that can be filled.

IA/BD Study

Earlier this year, Chairman Cox announced a Commission study that will analyze current industry practices and explore the levels of protection afforded retail customers of financial service providers regulated under the Securities Exchange Act and the Investment Advisers Act. Given the importance of this project and the amount of data to be considered, the study will be conducted in stages. The first stage will involve extensive data gathering and analysis. As you may know, the Commission has published a request for proposal in order to retain an outside consultant to assist us with data gathering. This vendor will also analyze the data, working collaboratively with Commission staff from the relevant divisions, and summarize the findings in a report to the Commission. My expectation is that the consultant will be announced in the next few days and that the project will commence immediately thereafter. During the second stage, the Commission will use the findings as factual background for evaluating the current legal and regulatory environment for the provision of financial products, accounts, programs, and services to individual investors by broker-dealers and investment advisers. It will also use the findings for determining the most effective legal and regulatory approach to regulating investment professionals in today's marketplace.

One core objective of the study, which we refer to as the "IA/BD Study," is to identify the information provided to individual investors regarding the products, accounts, programs, and services provided by broker-dealers and investment advisers. This information would include the nature of the responsibilities that the broker-dealer or investment adviser owes to the investor and any contractual limitations on those responsibilities. Other core objectives of the study include evaluating individual investors' understanding of the marketing and other information provided to them, as well as their expectations regarding the obligations owed by the investment professional who provided them.

The IA/BD Study stems from the Commission's desire to address concerns raised by certain commenters when we proposed our rule specifying when broker-dealers would not be deemed investment advisers. You may recall that, among other things, the "IA/BD Rule," as I will refer to it, provides an exception from the Advisers Act to broker-dealers receiving asset-based or fixed-fee compensation for investment advice, provided the advice is solely incidental to brokerage services and that certain disclosures are made. In adopting the IA/BD Rule, the Commission also provided guidance on when advice is solely incidental to brokerage and specifically addressed activities such as financial planning.

The comments on the IA/BD Rule raised important policy issues that were in fact outside the scope of the rulemakings. More specifically, the commenters astutely observed that the distinctions between broker-dealers and investment advisers have become blurred. They noted that broker-dealers have sometimes marketed their services in a manner similar to advisers. For example, some broker-dealers refer to their registered representatives as "financial consultants."

Given the history of the securities markets, the conversion of the business models of broker-dealers to include asset-based compensation should come as no surprise. In fact, it is arguably the inevitable result of the unfixing of commission rates in the mid-1970s. You may recall that until the mid-1970s, broker dealers charged a fixed commission in connection with their brokerage services, which traditionally included acting as an agent and providing investment advice. With the advent of unfixed commissions, broker-dealers, facing both ever-tightening margins on commission rates and the cyclicality of the business, naturally sought fee structures that would stabilize revenues. In other words, the competition that arose following the unfixing of commission rates led to an opportunity for broker-dealers to use different compensation structures. This did not mean, however, that the nature of the services they provided changed. Instead, brokers sought to provide the same services, including investment advice considered incidental to brokerage, that they had traditionally provided to their customers — it was just that they were compensated for doing so under a different compensation structure. This is an important point — compensation structures should not, in my view, define how we treat an entity for regulatory purposes.

Long before Congress determined to regulate investment advisers — and to this day — broker-dealers have provided investment advice, often as a consequence of facilitating customer trades. Even when Congress adopted the Advisers Act in 1940, it continued to permit broker-dealers to provide investment advice incidental to brokerage without being subject to the Act. This now longstanding exception to investment adviser regulation recognized both that broker-dealers were already comprehensively regulated and that there was a natural interrelationship between brokerage and providing information and advice about investments.

In 1995, the Report of the Committee on Compensation Practices, known as the "Tully Report," examined the compensation practices of broker-dealers to consider ways to minimize the conflicts between brokers and their customers. The Tully Report concluded that fee-based programs in some cases might better align broker-dealer and client interests than traditional commission-based programs. Around the same time, broker-dealers began offering these accounts.

In 1999, responding to concerns that these programs might not fit the terms of the statutory exception from investment adviser regulation, the Commission proposed by rule to except the persons offering these accounts from the Advisers Act, provided they gave only non-discretionary advice and certain disclosures were made. The proposal reflected the Commission's view that Congress would not have intended the Act to reach these programs. The Commission reasoned that, as long as the nature of these brokerage services — including advice — remained fundamentally the same, Congress would not have intended to subject them to the Advisers Act just because the compensation had changed. The Commission also concluded that these programs were consistent with investor protection. A different compensation structure permits investors to have more choice when shopping for the services that brokers have always offered. Responding to consumer demand for competitive pricing for brokerage services by using different compensation structures, however, does not make a broker-dealer into an investment adviser.

Also, the Commission has taken the view that advice incidental to brokerage services is that provided in connection with and reasonably related to brokerage. This is a broad standard that permits brokers to provide advice, and does not limit them to providing advice relating only to transactions or when the advice is minor in scope or importance. As a policy matter this makes good sense. Broker-dealers should be incented to provide the highest quality of investment service they can, without the risk that doing so will subject them to another, arguably largely duplicative, regulatory regime. Our goal should be to motivate broker-dealers to maintain the highest industry standards in the provision of investment advice. Indeed, as the Tully Report stated, advice-giving is the most important role of a broker-dealer.

Let's stop at this point, however, to take a step back and focus on the larger picture. We know that the blurring of broker-dealer and investment adviser services certainly raises some important questions. It also perhaps provides us with certain opportunities regarding the application of the statutory regimes under which broker-dealers and investment advisers have operated for more than sixty-five years. To better understand these opportunities, it is instructive to take a look at the histories of the Exchange Act and the Advisers Act.

Regulatory History

When Congress adopted the Exchange Act in 1934, it was concerned about establishing a regulatory scheme for the sale and secondary trading of securities and for overseeing market participants engaged in this business, such as brokers, dealers, market makers, investment bankers, securities exchanges, and the like. Broker-dealers in particular are engaged in sales and give advice about securities, either in person or through research provided to their customers. Hence, many aspects of broker-dealer regulation naturally concern investor protection issues that arise in a sales context and address concerns raised where broker-dealers hold customer funds and securities and extend credit.

Broker-dealers are subject to broad anti-fraud provisions under which the Commission has adopted rules, issued interpretations, and brought enforcement actions.

They also are subject to SRO rules and regulations. These two levels of regulation, together with agency principles, obligate broker-dealers to deal fairly with customers, execute orders promptly, obtain best execution, disclose material information when making recommendations, charge prices reasonably related to the prevailing market, and disclose material conflicts of interest. Moreover, broker-dealers naturally have extensive financial responsibility obligations to ensure minimum amounts of liquid assets, safeguard customer funds, and keep accurate books and records. Broker-dealers are also required, among other things, to craft written compliance policies and procedures, appropriately supervise employees, and disclose disciplinary history.

Both federal anti-fraud provisions and SRO rules impose specific suitability obligations, and sales practice rules, on broker-dealers to address conflicts of interest in securities recommendations arising from how broker-dealers are compensated. Suitability gives rise to a legal obligation concerning fair dealing under the federal antifraud provisions as well as an ethical duty based in just and equitable principles of trade under SRO rules. SRO rules affirmatively require brokers to obtain customer information and to make recommendations that have a reasonable basis in the customer's financial situation and investment objectives.

On the other hand, the Advisers Act grew out of congressional concern about problems in the then-largely unregulated investment advisory business. One group of unregulated advisers called themselves "investment counselors." Typically, investment counselors' only business was providing advice for a fee. Other persons, such as broker-dealers, also provided some advice in this way, typically through separate departments or subsidiaries.

In the late 1930s, Congress surveyed the investment counsel business and identified in the resulting Investment Counsel Report two broad problems necessitating legislation. The first problem was distinguishing bona fide investment counselors from the more scurrilous tipster organizations. The second problem concerned identifying organizational and operational weaknesses of investment counsel institutions, such as arrangements for contingent compensation.

The Advisers Act is based primarily on the premise that investment advisers are fiduciaries of their clients. Based on state common law, fiduciary duty requires advisers to act in the best interest of their clients at all times. As a result, the Advisers Act focuses on activities and arrangements that amount to self-dealing or otherwise potentially conflict with an adviser's fiduciary duty. For example, the Act limits certain conduct such as principal trading with a client without disclosure and consent. The rules and forms under the Act mandate disclosure with respect to an adviser's business, manner of providing advice, allocation practices, compensation arrangements, affiliations, and disciplinary history so that clients are informed of potential conflicts.

One thing that becomes apparent from this exercise is that the two statutes have different focal points: the Exchange Act is primarily concerned with regulating the entire relationship between a broker and its customers, and the Advisers Act with advice. To my way of thinking, however, both statutes provide a significant amount of protection for investors, albeit from different angles. Put more simply, they are two different means of arriving at the same end of investor protection. And that's the point.

To the extent that there are differences in the application of the two regulatory regimes, I believe that the IA/BD Study presents the opportunity for the Commission to fill in the gaps. It is my hope that through the study, the Commission will be able to examine the regulatory regimes carefully and ensure that investor protection prevails, regardless of whether it is under the Exchange Act or the Advisers Act.

My principal concern is that investors should enjoy equivalent legal protections and receive consistent and effective material disclosures for what may be fundamentally similar financial services. Therefore, I hope the IA/BD Study looks closely at communications to investors about things such as the status of the financial services provider, the nature of the account, the scope of their duties, and material information about the products and strategies recommended, including potential conflicts related to the product, compensation, or the financial consultant's affiliations.

I also hope that you, as practitioners, will provide vital input to the IA/BD Study by sharing your experiences and your firm practices, as appropriate. We are particularly interested in your understanding of the subtleties that separate broker-dealer and investment adviser practices and the impact of those distinctions on the investing public.

I look forward to working with you on this most important undertaking.

Thank you.


1 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission, any other Commissioner, or the staff.


Modified: 09/27/2006