January 14, 2000
Mr. Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, NW - - Mail Stop 0609
Washington, D.C. 20549-0609
Re: Certain Broker-Dealers Deemed Not To Be Investment Advisers
File No. S7-25-99
Dear Mr. Katz:
This letter presents the comments of Federated Investors, Inc. ("Federated")1 regarding the Securities and Exchange Commission's (the "Commission") proposed rules on "Certain Broker-Dealers Deemed Not To Be Investment Advisers" (the "Proposals").2 The Proposals would address the application of the Investment Advisers Act of 1940 (the "Advisers Act") to brokers offering certain "fee-based programs" or "execution-only" brokerage services. Specifically, the Proposals clarify when brokers could offer these programs and still rely on Section 202(a)(11)(C) of the Advisers Act. This Section excepts from the definition of "investment adviser" a broker or dealer "whose performance of [advisory] services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor." Our comments focus on the Commission's proposed approach to fee-based programs, and suggest a different outcome.
As described in the Release, fee-based programs generally "offer customers a package of brokerage services - including execution, investment advice, custodial and recordkeeping services - for a fixed fee or a fee based on the amount of assets on account with the broker-dealer." The Release notes the potential benefits of these programs, and expresses concern that the statutory exemption may inhibit their adoption "because fee-based compensation may constitute `special compensation.'" The Commission has historically regarded the receipt by a broker of compensation other than traditional brokerage commissions as potentially "special." However, in an effort to promote the spread of fee-based programs, the Proposals would reverse the Commission's position with regards to these programs.
New rule 202(a)(11)-1 sets forth the Commission's Proposals. Paragraph (b) of the new rule would permit brokers to charge different commissions and mark-ups to customers without registration under the Advisers Act. This exemption would apply even if the higher commission or mark-up applies only to customers receiving investment advice from the broker. For the reasons stated below, Federated believes that such commission structures are consistent with the intent of Section 202(a)(11)(C). We therefore fully support this provision of the proposed rule.
However, Federated is concerned with paragraph (a) of the proposed rule. This paragraph would provide a blanket exemption from the "special compensation" criterion of Section 202(a)(11)(C) so long as three conditions are met:
1) The broker or dealer does not exercise investment discretion, as that term is defined in Section 3(a)(35) of the Exchange Act, over the accounts from which it receives special compensation;
2) Any investment advice provided by the broker or dealer with respect to accounts from which it receives special compensation is solely incidental to the brokerage services provided to those accounts; and
3) Advertisements for, and contracts or agreements governing, accounts for which the broker or dealer receives special compensation include a prominent statement that the accounts are brokerage accounts.
This Proposal assumes that one statutory criterion - special compensation - is present. Notwithstanding this criterion, the Proposal would create an exception based entirely on the other statutory criterion - whether the advisory services are "solely incidental" - and the non-statutory criterion of whether a broker exercises investment discretion.
Federated is concerned that the Commission, by dispensing with the special compensation criterion, will open the way for brokers to offer innovative (and unregulated ) fee programs well beyond those currently envisioned. We are also concerned that allowing both registered investment advisers and unregistered brokers to charge asset based fees will lead to investor confusion and diminish investor protection. Thus, Federated would urge the Commission not to adopt paragraph (a) of the proposed rule.
Fundamentally, Federated is not sure that the Proposals fully reflect the extent to which technological innovation is restructuring relationships in the securities markets. Our uncertainty stems from several aspects of the Proposals. First, Federated does not agree with the premises cited by the Commission to justify the Proposals. Second, Federated believes that technological innovation may make the "no discretion" condition ineffective. Finally, Federated believes that the Proposals will neither significantly further the Commission's goal of encouraging the spread of fee-based programs nor provide much practical guidance to brokers.
1. The Commission Should Reconsider Its Premises
The Release summarizes the concerns prompting the Proposals as follows:
We do not believe, however, that Congress intended these programs, which are not substantially different from traditional brokerage arrangements, to be subject to the [Advisers] Act. While in 1940 the form of compensation a broker-dealer received may have been a reliable distinction between brokerage and advisory services, development of the new brokerage programs suggest strongly that it is no longer. Moreover, we are concerned that, as a result of these new programs, most brokerage arrangements by full service broker-dealers may be subject to regulation under both the Advisers Act and the Exchange Act, a result Congress could not have intended. We are therefore proposing a new rule, described below, that would deem a broker-dealer not to be an adviser solely as a result of receiving special compensation, provided certain conditions are met.
Federated believes that the Commission should reexamine each of these premises. First, the brokerage arrangements involved in most of these programs do represent a significant departure from "traditional brokerage arrangements." In our view "traditional" and fee-based arrangements are quite opposite in nature. In a traditional brokerage arrangement, the broker is paid only if there is trading activity in the account. With fee-based programs, the broker earns (possibly substantial) fees regardless of whether there is any trading in the account (and regardless of whether the broker has discretion). While Congress might not have envisioned brokers' fee-based programs, it strikes us as fanciful to conclude that Congress did not intend these programs to trigger Advisers Act regulation. It seems clear to us that Congress did consider that status of persons who offer (among other services) investment advice, and who would be compensated even if no trades were to take place in the account. Congress concluded that such persons should be subject to the Advisers Act, even if they also happen to be registered brokers. We agree.
Second, Federated contends that the form of compensation remains a good indicator of when investment advice is "incidental" to brokerage, and when the services are no longer "functionally equivalent." Compensation that relates to the number of trades, such as commissions, suggests that the firm is selling, and its clients buying, brokerage services. Although the firm may also provide investment advice, it only receives compensation when the client takes the advice by placing a trade. Under this compensation structure, the advice serves as an inducement to trading, and for that reason properly may be viewed as "incidental."
In contrast, compensation unrelated to the number (or even existence) of trades, such as asset based fees, suggests that the firm is selling, and its clients buying, primarily something other than brokerage services. As a commercial for one fee-based program makes explicit, under these arrangements, when the client succeeds, the firm succeeds. Clients looking to invest "successfully" are probably more concerned with sound investment advice than with the execution of trades. Therefore, investment advice appears far from "incidental" under this compensation arrangement. Viewed in this light, a resulting requirement to register as an investment adviser seems a fair result, and one that would clearly provide greater certainty of status than the approach taken in the Proposals.
Finally, the Commission's concern over dual registration seems one sided. Under the Proposals, brokers with investment discretion, and brokers that do not provide "incidental" advice, would still have to register as investment advisers. Internet service providers may also need to register. The Commission does not explain how these firms are different from the "full service" brokers whom the Proposals would exempt, except that they are perhaps less "traditional." As a result, paragraph (a) of the Proposals would tilt the competitive playing field in favor of "full service" brokers and against providers of fully "unbundled" services. Federated does not see how this result would protect investors. If the Commission has concluded that the provisions of the Advisers Act are no longer necessary for investor protection, then the Commission ought to adopt an exemption covering a broader array of financial service providers. However, Federated remains of the view that investors using advisory services need some degree of Federal protection, no matter how the provider "bundles" its services.
Federated realizes that current fee based programs may benefit investors by removing a broker's incentive to "churn." However, we regard it as short-sighted to focus on today's programs in adopting an open ended exemption. Continued competition, particularly on the Internet, will drive "full service" brokerage firms to develop other innovative fee structures and "value added" service arrangements. Some of these innovations will bear little resemblance to the "traditional" (i.e., before widespread Internet trading) broker/client relationship. The Commission could easily find that some of these innovations warrant registration and supervision under the Advisers Act, even if it remains unconcerned about today's fee-based programs. However, by adopting the Proposals, the Commission will limit itself to the question of whether the advisory activity is "incidental" to brokerage activity, thereby surrendering control over form of compensation. Federated suggests that, given how quickly changes are taking place, this may be premature.
The Commission's proposed approach seems particularly premature, and out-of-step, given the recent enactment of the Gramm-Leach-Bliley Act. This legislation is highly relevant to the Proposals because it will usher in an era of substantial restructuring in the financial services industries, while generally dealing with these changes under the guiding principle of "functional regulation." We are not confident that the Commission can accurately predict at this time what will happen when the types of innovations in products and technology discussed in this letter are combined with heretofore unseen combinations of financial services companies under the same corporate umbrella. Thus, it strikes us that now is a uniquely inopportune time to be changing the rules in this important area. Moreover, as we point out elsewhere in this letter, we believe the Proposals will result in disparate treatment of entities who are all essentially involved in the same types of activities (although, perhaps, in slightly different proportions). Instituting such an approach at this juncture strikes us as fundamentally at odds with the overarching regulatory approach that Gramm-Leach-Bliley mandates.
2. Excluding Investment Discretion Will Not Limit Broker Advisory Activities
Federated also urges the Commission to consider how brokers can use technology to obtain direction from their clients. Under the Proposals, brokers would have a regulatory incentive to avoid the exercise of investment discretion over fee-based accounts. However, technological innovations could make broker "discretion" unnecessary for most investors, essentially nullifying one of the Proposals' key criteria.
Consider, for example, a full service brokerage firm that provides fee-based accounts, and provides an assortment of "do-it-yourself" asset allocation tools. Assume the firm gives clients access to several "suggested" model portfolios and makes available materials (e.g., questionnaires, financial calculators, etc.) that are designed to assist the customers in selecting an appropriate model based on an analysis of their individual financial conditions, needs and experiences. To be even more helpful, the firm has created a system that automatically reviews each such account following any change in the investment models. The system then generates a report for each account, listing the trades necessary to implement the recommended change.
Clearly, if the firm has been given advance authority to execute the recommended trades, it will have discretion over these accounts and could not use the proposed rule to avoid registering as an investment adviser. However, suppose that the firm has its system automatically send an e-mail to each account holder, listing the recommended trades and asking the client for authorization to execute them. The e-mail might even be formatted with check boxes for yes and no, pre-set to yes, so that the client could authorize the trades by pushing a single button. With this system, the firm would no longer exercise discretion over trades in the account. Does this mean that it no longer needs to register as an investment adviser, or to treat the accounts as "advisory" accounts?
The Internet has made, and will continue to make, it less expensive and more convenient for brokers to obtain directions from their clients. This will make it easy for brokers to structure their services in a manner that satisfies the first condition of the proposed rule. Therefore, the Commission should realize that this condition will not constrain brokers in any meaningful manner.
3. The Proposal Will Not Resolve the Dual Registration Issue Because It Does Not Address When Advice Is "Incidental"
Of course, the Commission might still argue, as it has done in the context of wrap fee programs, that registration is required, because the recommendations are not merely "incidental" to brokerage services. However, this may lead the Commission into a quagmire. To rely on this argument, the Commission would be called upon to draw distinctions of ever increasing subtlety (and subjectivity) regarding when the provision of "some non-discretionary advisory services" becomes significant enough to require investment adviser registration (see, text accompanying footnote 21 of the Release). Having conceded that firms offer a bundle of services, including both investment advice and brokerage, how does the Commission propose to determine which services are "primary" and which are "incidental"? The Release raises a number of questions in this vein, which illustrate the difficulty of drawing such distinctions and suggest just how unsatisfying this approach would be in terms of affording predictable regulatory outcomes.
Technological innovation will also affect the application of this criterion because brokers may not control how investors use their advice.. We invite the Commission to consider an investor who uses two "full service" brokers via the Internet. If the investor down loads investment research and advice from the first broker, but uses the information to enter trades with the second broker, does the first broker's service remain "incidental?"3 Would the Commission base its determination on the subjective intent of the registered broker, or on the actual use of the information by investors (over which the broker may have no control)?
The situation would be no better if the Commission were to adopt the view that determinations of whether advice is incidental are so inherently fact-specific that the Staff will not generally consider providing guidance in this area through the "No-Action" letter process. This would leave broker-dealers to wrestle with these questions on their own, with enforcement action a distinct possibility if they reach an incorrect conclusion. It does not appear to us that either alternative would be particularly helpful to brokers who offer these programs. Consequently, we would expect cautious brokers to continue to register and comply with both Acts.
* * * * *
In conclusion, Federated would urge the Commission to adopt proposals that favor "bright lines," even if this sometimes results in dual registration. Compensation can serve as a bright line insofar as it measures the service provided. If compensation measures the amount of trading, then the Commission should not regard it as special and should regard any "bundled" investment advice as incidental. Discretion may also serve as a bright line, but technology will render discretion irrelevant for an ever increasing share of investment activity. Thus, proposals relying on "investment discretion" will lead to increasingly unregulated advisory services.
In contrast, without reference to compensation or utilization, it is difficult to distinguish whether one bundled service is "incidental" to another. So long as this remains the effective criterion for determining whether brokers must also register as advisers, cautious brokers will continue to register under and comply with the Advisers Act. Federated has not seen any evidence that this has unduly impeded innovation by registered broker/dealers, much less that the benefits of exempting brokers will compensate for the loss of investor protection. Therefore, we urge the Commission to adopt paragraph (b) and (c) of proposed rule 202(a)(11)-1, but not adopt the open ended exemption provided in paragraph (a).
Federated very much appreciates having the opportunity to comment on these important Proposals. If you would like to discuss these comments or any other aspects of the Proposals with us, please contact Jay Neuman by phone at (412) 288-7496 or by e-mail at firstname.lastname@example.org.
Stephen A. Keen
Phone: (412) 288-1567
Telecopier: (412) 288-8141
Jay S. Neuman
Phone: (412) 288-7496
Telecopier: (412) 288-8141
1 Federated is one of the largest asset management firms in the United States. Through its investment adviser subsidiaries, Federated manages total assets of more than $130 billion.
2 Release No. IA-1845, November 4, 1999 (the "Release").
3 While this situation could theoretical exist for a commission based account, the first broker would have an economic incentive to restrict access to its investment advice to clients that also traded through the broker. A broker receiving asset-based fees has no such incentive, and would be more likely to permit unrestricted access to its advice.