Charles Schwab & Co., Inc.
101 Montgomery Street
San Francisco, California 94104
January 14, 2000
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: File No. S7-25-99: Certain Broker-Dealers Deemed Not To Be Investment Advisers
Dear Mr. Katz:
Charles Schwab & Co., Inc. ("Schwab")1 appreciates the opportunity to comment on the Securities and Exchange Commission's ("Commission" or "SEC") recent proposal to adopt Rule 202(a)(11)-1 (the "Rule") under the Investment Advisers Act of 1940 (the "Advisers Act").2 The Rule would exclude a broker-dealer providing investment advice to customers from the definition of investment adviser under the Advisers Act provided that (a) the broker-dealer does not exercise investment discretion over the customers' accounts, (b) the advice is solely incidental to brokerage services, and (c) the broker-dealer discloses to customers that their accounts are brokerage accounts.
Schwab supports the Rule. We believe that the Commission's proposal represents an important step toward regulation that allows innovation in the offering and pricing of investment services to meet changing investor preferences. At the same time, the Rule would preserve an appropriate recognition of the functional differences between core brokerage services and core investment advisory services. Schwab appreciates the Commission's efforts to timely address this important issue. Our comments are intended to improve the Rule through clarification and reinforce the premise that the nature of the services provided, rather than the form of compensation, should primarily determine whether the Advisers Act applies.3
The issue addressed by the Rule is important to Schwab. Schwab pioneered discount brokerage services for which customers paid significantly reduced commissions for trade execution only. In response to increasing customer demand over the past few years, Schwab has begun to make incidental advice available to its customers when they want it. Schwab's discount commission rates do not support the cost of satisfying customers' demand for advice. As discussed below, these customers do not want unsolicited recommendations or advice in connection with every trade, and they will not pay full commissions that reflect an imbedded charge for advice they don't use. This large middle of the market demands unbundled, or à la carte, pricing for trade execution and incidental advice. Current regulation hinders Schwab's ability to price its services the way our customers want.
The Rule Would Preserve Appropriate Recognition Of the Functional Differences Between Core Brokerage Services And Core Investment Advisory Services
Schwab believes that the proposed rule maintains the integrity of the Advisers Act and the legislative intent of Congress. By making the nature of the service, rather than the form of compensation, determine whether the Advisers Act applies to advice rendered by a broker-dealer in the ordinary course of its business, the proposed Rule preserves appropriate recognition of the functional differences between core brokerage services and core investment advisory services.
Core brokerage services are generally transactional and episodic. In contrast, core investment advisory services are generally ongoing and supervisory. Non-discretionary advice provided to customers has traditionally been part of a broker's ordinary business and does not alter the transactional nature of the broker's services. Differences in the form of the broker's compensation alone (for example, charging a bundled asset-based fee or an unbundled fee plus transaction charges) do not change the nature of the broker's services and should not alter the customer's perception of those services or his or her relationship with the broker. Thus, there is no policy rationale for maintaining the form of compensation as a factor in determining the scope of the Advisers Act.
Current Compensation-Based Regulation Limits the Availability of Advice To Most Investors
Before the Commission proposed the Rule, the form of a broker-dealer's compensation determined the regulation applicable to its provision of incidental advice. Broker-dealers providing incidental advice and charging anything other than brokerage commissions could be subject to the Advisers Act. As a result, brokers were discouraged from offering fee-based accounts or unbundling the pricing of their transaction execution services and their incidental advice. Charging an asset-based fee or unbundled pricing for the broker's customary services would burden the broker-dealer with regulation under the Advisers Act in addition to broker-dealer regulation under the Securities Exchange Act of 19344 and the rules of self-regulatory organizations.
As the Commission has observed, brokerage firms have begun offering their services for fees that, unlike customary brokerage commissions, are not tied to transactions.5 Although fee-based bundled service programs6 avoid some of the conflicts of interest presented by commission-based compensation systems for registered representatives of "full service" brokers7, those programs do not meet the needs of a significant portion of the investing public. Many investors today are demanding unbundled, or à la carte, pricing.
A significant segment of investing households in the United States may be characterized as "validators."8 Validators generally handle their investments themselves, but they are not entirely self-directed. They do not want unsolicited recommendations or advice in connection with every trade, and they do not want to pay full commissions that reflect an imbedded charge for advice they don't use. But from time to time, they do want some advice, and they seek it out. They are also not delegators and their portfolios are not large or complex enough for them to want or be willing to pay for continuous portfolio supervision or discretionary investment management. Validators want to do their own investing but with some help and advice. They want advice provided only upon their request and on their terms. They want the control and choice to decide what services and how much of them they need and to pay only for what they use. Validators are not satisfied with or well-served by traditional "full service" brokers' higher commission rates or by fee-based accounts with broker determined bundles of services. The large middle of the market comprised of validators demands unbundled, or à la carte, pricing.
The Commission Should Make Clear that the Rule Allows Unbundled Pricing of Execution and Incidental Non-discretionary Advice
The plain language of the Rule permits a broker-dealer rendering incidental, non-discretionary advice to receive any form of compensation without triggering application of the Advisers Act. To the extent that an asset-based or flat fee plus transaction charges constitute special compensation, the broker could charge those fees and charges and still be within the safe harbor provided by the Rule. The Proposing Release, however, allows an inference that unbundled pricing would not be within the Rue's safe harbor.
The Commission's Proposing Release discusses only brokerage firms charging a single bundled fee for both execution and advice or two commission schedules-one for execution and advice and a lower one for execution only.9 Therefore, the Rule might be read to permit receipt of special compensation only in those forms and not in the form of unbundled pricing. The plain language of the Rule, however, does not limit the availability of its safe harbor to any particular form of special compensation. The Rule provides that:
(a) Will not be deemed to be an investment adviser based solely on its receipt of [any form of] special compensation, provided that..." [Emphasis supplied.]
As discussed above, the Proposing Release also indicates that the nature of the service offered, rather than the form of compensation, should determine the applicable regulation:
"Under the proposed rule, a broker-dealer providing investment advice to customers, regardless of the form of its compensation, would be excluded from the definition of investment adviser..." [Emphasis supplied.]10
Customers' choice of unbundled, or à la carte, pricing does not change the nature of the service offered by the brokerage firm. Customers are still getting execution and incidental advice. But rather than a broker-determined bundle of services for a fixed price, customers are deciding how much of each they want and paying accordingly. This choice in pricing is good for and desired by investors.
Schwab recommends that the Commission modify the text of the Rule to make clear that it permits any form of compensation, including unbundled, or à la carte, pricing. We have attached as an Appendix to this letter the text of the Rule marked to show our suggested modifications. In addition, we recommend that the Commission's adopting release for the final rule clarify that the Rule is intended to operate as a non-exclusive safe harbor and that the safe harbor's coverage is not limited to any particular form of special compensation.
The Commission Should Modify the Rule to Require That Broker-Dealers "Clearly Disclose" the Nature of the Customer Account Relationship
As proposed, the Rule would require that advertising and contracts for a broker-dealer's incidental advice for which special compensation is received include a "prominent statement that the accounts are brokerage accounts."11 This disclosure requirement is intended to assure that investors do not misperceive that their accounts will be investment advisory accounts.
Schwab agrees with the intent of this requirement to prevent investor confusion. We are concerned, however, that the proposed requirement may not achieve its purpose. The "prominent statement" requirement is rigid. It appears to require a stand alone, declarative sentence such as, "Your account will be/is a brokerage account." We believe that this disclosure would be boilerplate that may not be effective in assuring that investors understand the nature of the services and the broker-customer relationship being offered.
We recommend that the Commission modify the Rule to require that broker-dealers "clearly disclose that the accounts are brokerage accounts and not investment advisory accounts." The Appendix to this letter shows our recommended modification to the text of the Rule. We believe that this clear disclosure requirement is broader than the proposed requirement and better reflects the Commission's intent to prevent investor confusion. We also believe that it is a more flexible standard that can be practically applied in the context of various advertising media.
Schwab supports the Rule and commends the Commission for proposing it. Our suggested modifications to the Rule are intended to clarify it. We believe that those clarifications will help the Rule achieve the desirable purpose of allowing innovation in the pricing of investment services while preserving an appropriate recognition of the functional differences between core brokerage services and core investment advisory services.
If you have questions about this letter, please contact the undersigned at 415-636-1064 or at firstname.lastname@example.org.
CHARLES SCHWAB & CO., INC.
Vice President and
Senior Corporate Counsel
cc: Paul F. Roye, Director, Division of Investment Management
Annette Nazareth, Director, Division of Market Regulation
Catherine McGuire, Associate Director/Chief Counsel, Division of Market Regulation
Cynthia M. Fornelli, Attorney Fellow, Division of Investment Management
J. David Fielder, Senior Counsel, Task Force on Investment Adviser Regulation
§275.202(a)(11)-1 Certain broker-dealers deemed not to be investment advisers.
A broker or dealer registered with the Commission under Section 15 of the Securities Exchange Act of 1934 (15 U.S.C. 78o) (the "Exchange Act"):
(a) Will not be deemed to be an investment adviser based solely on its receipt of
(1) The broker or dealer does not exercise investment discretion, as that term is defined icompensation other than brokerage commissions, provided that:n Section 3(a)(35) of the Exchange Act (15 U.S.C. 78c(a)(35)), over the accounts from which it receives compensation other than brokerage commissions;
(2) Any investment advice provided by the broker or dealer with respect to accounts from which it receives compensation other than brokerage commissions, is solely incidental to brokerage services offered to those accounts; and
(3) Advertisements for, and contracts or agreements governing, accounts for which the broker or dealer receives compensation other than brokerage commissions, must clearly disclose that the accounts are brokerage accounts and not investment advisory accounts.
(b) Will not be deemed to have received special compensation solely because the broker or dealer charges a commission, mark-up, mark-down or similar fee for brokerage services that is greater than or less than one it charges another customer; and
(c) Is an investment adviser solely with respect to those accounts for which it provides services that subject the broker or dealer to the Act.
1 Schwab is registered with the Commission as both a broker-dealer and an investment adviser. Schwab serves 6.4 million active accounts with $725 billion in customer assets. Through its Schwab Institutional Services for Investment Managers enterprise, Schwab renders brokerage, custody and related services to over 5,600 independent investment advisers whose clients' accounts with Schwab total over $200 billion. Schwab is the market leader in providing these services to independent investment advisers.
2 Certain Broker-Dealers Deemed Not To Be Investment Advisers, Release Nos. 34-42099; IA-1845; File No. S7-25-99 (November 4, 1999)(the "Proposing Release").
3 See Proposing Release, Part II.A.1. at p.10.
4 15 U.S.C. §§78a-78jj, as amended.
5 See Proposing Release, Executive Summary at p.2.
6 The introduction of these programs by some "full service" brokerage firms prompted the Commission to propose the Rule. See Proposing Release, Part I at p.5.
7 These programs are consistent with the recommendations of the Tully Report. See Report of the Committee on Compensation Practices, April 10, 1995. Schwab's representatives are not compensated on a commission or other transaction basis. In addition, the 5,600 independent registered investment advisors that manage over $200 billion in client assets held in Schwab brokerage accounts primarily charge asset-based fees and render investment supervisory or discretionary portfolio management services.
8 Schwab's research estimates that validators comprise approximately 61% of all U.S. investor households and hold approximately 60% of the assets of all of those households.
9 See Proposing Release, Part I at pp.6-7.
10 See Proposing Release, Executive Summary at p.3.
11 Proposed Rule §202(a)(11)-1(a)(3).