By U.S. Mail and Electronic Filing
January 14, 2000
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Release Nos. 34-42099 and IA-1845; File No. S7-25-99; Certain Broker-Dealers Deemed Not To Be Investment Advisers
Dear Mr. Katz:
The Financial Planning Association ("FPA")1 provides the following comments on Release Nos. 34-42099 and IA-1845 (the "Rule"), in which the Securities and Exchange Commission (the "SEC" or "Commission") seeks to clarify the regulatory status of certain brokers and dealers providing advisory services. The FPA represents more than 27,000 financial planners in the United States. Approximately 75 percent of FPA's members maintain securities licenses and would be affected by the Rule.2
FPA agrees in part with the premise of the Rule, that changes in the securities industry over the last several years have altered the way in which broker-dealers are compensated for brokerage services. Blended commission-and-fee arrangements have in part replaced traditional commission compensation arrangements. FPA strongly disagrees, however, with the conclusion implicit in the Rule: that the nature of the compensation received is no longer indicative of the type of services provided, and that advisory services now being heavily marketed by the brokerage industry remain solely incidental to the brokerage firms' primary business.
Accordingly, FPA strongly opposes the Rule as written because it would broaden the broker-dealer exemption in the Investment Advisers Act of 1940 (the "Advisers Act") well beyond the scope of the exemption Congress intended. The Rule also would have the effect of eliminating certain protections that the Advisers Act was designed to provide for a large number of investors receiving investment advisory services.
I. As Written, The Rule Would Expand The Broker-Dealer Exemption Beyond The Scope Congress Intended
In the Advisers Act, the term "investment adviser" is defined as a person who "for compensation" either (1) "advis[es] others . . . as to the value of securities or as to the advisability of" holding securities, or (2) "as part of a regular business, issues or promulgates analyses or reports concerning securities . . . ."3 The Advisers Act exempts from the definition of "investment adviser" a broker-dealer whose "performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor . . . ."4 In short, the Advisers Act is intended to exempt broker-dealers only "insofar as their advice is merely incidental to brokerage transactions for which they receive only brokerage commissions . . . ."5
Based on the foregoing, it is evident that Congress intended that two conditions related to the provision of investment advice be satisfied for the exemption to apply:
"(1) The provision of investment advice only as an incident of the broker-dealer function; and
(2) The absence of special compensation for the advice. . . .
[B]oth conditions must be satisfied for the exclusion to operate because Section 202(a)(11)(C) lists them conjunctively."6
In explaining the meaning of the "special compensation" requirement of the exemption, the SEC General Counsel, in an early Advisers Act Release, stated:
that portion of clause (C) [of Section 202 (a)(11)] which refers to "special compensation" amounts to an equally clear recognition that a broker or dealer who is specially compensated for the rendition of advice should be considered an investment adviser and not be excluded from the purview of the Act merely because he is also engaged in effecting market transactions in securities.7
The General Counsel also evaluated four hypothetical situations in the release, applying the two-prong test to determine whether the broker-dealer would be exempt from the registration requirement. In Situation 2, a broker-dealer charges customers extra for giving advice. The General Counsel stated that the broker-dealer would be considered to be an "investment adviser," because "the charge is directly related to the giving of advice."8
Congress, accordingly, did not intend to exclude from the Advisers Act's coverage certain persons who were specially compensated for providing investment advice merely because those services were "solely incidental" to their brokerage business. The Rule, however, would do just that; it would permit certain broker-dealers to be exempt from the Advisers Act even if they receive special compensation for providing incidental financial planning services.
Until the release of the current proposal, the Commission's position was consistent with the above-described statutory standards. In 1981, in Investment Advisers Release No. 770, the Commission said, "the exception for brokers or dealers contained in Section 202 (a)(11)(C) would not be available to a broker or dealer . . . if such person receives any special compensation for the provision of investment advisory services."9 In 1987, relying on Investment Advisers Release No. 770, the Commission in Investment Advisers Release No. 1092 (applicability of the Investment Advisers Act to financial planners, among others) emphasized that "[a] person relying on an exclusion from the definition of investment adviser must meet all of the requirements of the exclusion." "[T]he exclusion for brokers or dealers contained in Section 202(a)(11)(C) would not be available to a broker or dealer, or associated person of a broker or dealer . . . if the person receives any special compensation for providing investment advisory services."10 This approach is further supported by the Commission's view of when a person is deemed to be "in the business" of an investment adviser: "The staff considers a person to be `in the business' of providing advice if the person . . . receives any separate or additional compensation that represents a clearly definable charge for providing advice about securities, regardless of whether the compensation is separate from or included within any overall compensation, or receives transaction-based compensation if the client implements the investment advice . . . ."11
The Rule would substantially diminish the two-prong test under the Advisers Act with respect to the broker-deal exemption.12 It would narrow the special compensation requirement by making it effective only in situations in which the broker-dealer maintains fee-based discretionary accounts on behalf of its clients or provides investment advice that is more than "solely incidental" to the brokerage services provided. The Rule would also result in too much reliance on the "solely incidental" test, a requirement on which there is little interpretive guidance and which has proven extremely difficult to define.13
II. "Solely Incidental" Standard vs. Traditional Broker Services
The Rule de-emphasizes the special compensation standard by characterizing the new fee arrangements merely as "price restructuring." Changes to broker compensation are clearly quantifiable, and the commentary on the Rule admits these changes on their own may require adviser registration. 14 As a result, the Rule then attempts to minimize the solely incidental test as a factor by concluding that the new programs are a continuation of "traditional" brokerage services. Under this reasoning, then, the two-prong test remains intact because the new brokerage programs and compensation structures are not significant enough to require Adviser Act registration. The Rule, however, does not attempt to provide practical examples of what advisory services since 1940 have been historically offered, only that "these new programs are not . . . fundamentally different from traditional brokerage programs not subject to the Advisers Act."15 Nor does the Rule provide any examples of what advisory services are `solely incidental' to a broker's business and therefore also exempted from the definition of "investment adviser." In providing FPA's perspective on the dramatic changes currently underway in the securities industry, we suggest that the Rule fails to distinguish between the two types of advisory services for the reasons set forth below.
Implicit in the Rule is the erroneous conclusion that the nature of a broker's advisory services today compared to the Great Depression has not fundamentally changed, even though brokers are increasingly marketing financial planning services as a means of additional compensation. As a consequence of this faulty reasoning, the Rule requires one to conclude, in the face of strong industry trends to the contrary, that the recent, unprecedented decrease in commission rates has not pressured broker-dealers to offer comprehensive fee-based advisory services (for "special compensation"). The irony of that logic is that in reality, instead of advisory services being "incidental" to a broker's business, all transactions are rapidly becoming "incidental" to the advisory services.16
In fact, one need not look far from Wall Street to confirm that the most significant change in the compensation structure for brokerage services since the Commission discontinued flat commission rates in 1975 has lead to a corresponding restructuring in the services rendered to achieve similar levels of compensation. A recent Wall Street Journal article on the subject noted that the move to lower execution costs for securities transactions "is massively threatening to brokers who rely on trades for a hefty part of their income."17 According to a report by Morgan Stanley Dean Witter & Co., the trend is "just the beginning of a slippery slope as commissions head toward zero" with at least a 50 percent drop in commission revenue over the next few years.18 A former director of the SEC Division of Market Regulation, Brandon Becker, agrees. "I see tremendous pressure on commissions. People don't want to pay commissions," he said in a recently published interview. "With a discrete segment of the industry now capable of offering you very cheap executions, [a broker-dealer's] ability to build into the execution costs other features that you provide people is limited." 19
Other surveys confirm this obvious trend. Registered representatives believe that fees will become a larger part of their compensation structure, according to a recent joint survey of the industry by the Institute of Certified Financial Planners and Morningstar, Inc. The only logical conclusion one can reach is that broker-dealers have had to provide advisory services to augment their brokerage-related compensation to remain competitive.
As a result, the brokerage industry has been compelled to expand the scope of its advisory services to justify the same re-structuring in compensation, forcing it to replicate many of the same services offered by registered investment advisers. The same broker-dealers who were forced to augment reduced transaction costs with fees now intensively market comprehensive financial planning services. Indeed, the Chairman and Chief Executive Officer of Merrill Lynch, David H. Komansky, recently stated that the mantra of the largest securities firm in the world is now a "total financial relationship." He also said, "We're focused on financial planning and all of its components - investment, savings, checking, insurance, mortgage and other credit, retirement, estate planning, trusts, and more."20 Further, the Merrill Lynch Unlimited Advantage Account21 markets comprehensive advisory services for a single fee, rendering highly questionable the "solely incidental" and "traditional brokerage programs" premise for the proposed Rule. Marketing materials for the Unlimited Advantage Account emphasize a "simple, annual asset-based fee [to] access a broad range of resources designed to help you meet your financial needs." These services are at the heart of comprehensive financial planning and account for virtually all of the primary testing areas in the comprehensive CFP exam, as well as other professional designations that test an individual's competency in financial planning.
The Rule, however, claims that "the new programs essentially re-price traditional full service brokerage programs but do not fundamentally change their nature."22 Nowhere does the legislative history of the Advisers Act and later SEC interpretations suggest that asset allocation, tax reduction, estate preservation and insurance liability-management, among others - which are routinely listed as new services provided by the wire houses - were traditional services offered by broker-dealers in 1940, when Congress adopted the broker-dealer exemption. Rather, such services were clearly identified with, and offered separately, by money managers, CPAs, attorneys and insurance agents. Now many of these other non-advisory firm/financial service providers are increasingly foregoing the "solely incidental" exemption previously afforded to them under the Advisers Act23 because such services are no longer a casual client accommodation as envisioned under the statutory exemptions with respect to the definition of "investment adviser." Of course, when financial planners first came to the attention of the SEC in the late 1970's and early 1980's, the Commission correctly determined that providing investment advice was not incidental to the financial planning process. As such, it determined that holding out as a financial planner required registration as an investment adviser because the financial planner title would imply the offering of advice on securities as part of a regular business.24
III. Investor Protection Will Be Reduced, Not Enhanced, Under the Rule
While minimizing the pricing "restructuring" effect on the broker-dealer exemption under the Advisers Act, the Rule nonetheless suggests that approval of the new fee-based programs will improve brokerage best practices, "by better aligning [the customers'] interests with those of their broker-dealers" as suggested in the Tully Report.25 We certainly agree. However, we also would note that the Tully Report only confirms the investor protection benefits that accrue from fee arrangements as required under the Advisers Act. It is the compensation element, as evidenced in the Tully Report, that is a significant causal factor leading to concerns about conflicts of interest.
The Rule would allow broker-dealers without discretionary authority over client assets to be able to offer nearly the same scope of advisory services provided by registered investment advisers, but without the same protections for the client that Congress intended when it adopted the Advisers Act. Many brokers do not contest the fact that they want to avoid certain requirements that arise from registration under the Advisers Act. These include the prohibitions and disclosure requirements related to self-dealing; prohibition on testimonials in advertising; and, perhaps most importantly, the fiduciary duty standard toward clients.
In Securities and Exchange Commission v. Capital Gains Research Bureau, Inc.,26 the Supreme Court case that confirms the existence of an adviser's fiduciary duty, the Supreme Court held that the Advisers Act "reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship, as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest . . . . " The case centered on the adviser's duty to a client if the adviser engaged in "scalping," or purchasing shares of securities for the adviser's own account before recommending the same securities to a client. The fiduciary responsibility of an adviser is perhaps the most important distinction between the Advisers Act and the "know your customer" requirement for sales transactions under the Securities Exchange Act of 1934 (the "Exchange Act"). The fundamental distinction is the duty of loyalty of the adviser to the client, and the registered representative's lesser responsibilities to the customer because of the transactional nature of its business.
Merely labeling an account as a "brokerage account" does not provide any investor protection. For example, confusion still reigns as to what is a financial plan and the obligations of the provider. A recent consumer survey by the CFP Board of Standards, Inc. suggests that many consumers continue to have fundamental misconceptions about the financial planning process.27 More than one-third of respondents to a recent survey mistakenly expect financial planners to promise to place them into the best-performing stocks and mutual funds before providing them with specific financial recommendations; and a surprising 17 percent expect to be assured that the financial planner can make them rich. Clearly, if the average consumer is not aware of the suitability obligations of an adviser, or the anti-fraud provisions that prohibit performance guarantees, why should they be aware of the differences between a brokerage account and an advisory account? It is highly questionable whether most consumers would understand the significance of accounts labeled "brokerage accounts, " including the practical and legal distinctions between a brokerage account and an advisory account and the investor protections that apply with respect to each such account.
As the big wirehouses prepare marketing campaigns for 2000, the consumer will become increasingly confused as to who's offering transaction and advisory services. The Wall Street Journal reports the largest brokerage firm, Merrill Lynch & Co., expects to spend a record $150 million on advertisements "as part of its image makeover." A critical feature of the new advertisements, according to the Journal, will feature "real-life clients talking about how they have prospered financially because of their relationship with their Merrill broker." The commercials will prominently feature client testimonials, which are prohibited under the Advisers Act.28 Many brokers will take advantage of this inequity in securities laws to market the same advisory services through client testimonials. If the Rule is approved as written, will these commercials be required to do more than simply flash the brokerage account disclaimer, and if so, how will advisory and brokerage services be differentiated?
The hemorrhaging in commission compensation now underway in the brokerage industry, and the industry's concomitant move to embrace comprehensive advisory services, threaten to eviscerate the core statutory definition of "investment adviser" in the Advisers Act, and perhaps the Act itself over time, if the Rule is adopted. The result will be:
After reviewing the broad implications of the Rule, the rationale behind exempting an industry whose compensation base and corresponding transactional services under the Exchange Act are steadily eroding should be questioned as the same firms move to augment their transactional services. These firms now provide advisory services as a principal, and not incidental, part of their business. It seems highly implausible that Congress would have intended flat fees and comprehensive financial advice to be outside the scope of the "special compensation" and "merely incidental advice" standards of the law. To claim that the fundamental nature of brokerage services has not changed over the past 60 years, that only the new assortment of fee arrangements have been "re-priced,"30 and, by implication, that financial plans currently offered are "solely incidental" to the brokerage business, simply stretches credulity.
Just as the Commission supported functional regulation of the brokerage business in banks during the recent debate on financial services modernization, it should support functional regulation of the advisory business under the Advisers Act. For more than 30 years, financial planners have been required to comply with a myriad of regulatory requirements based on the nature of the services provided.31 In other words, the Depression-era laws that were established to provide functional regulation of different financial services should not be eroded simply because a major industry segment has migrated to a different area of functional regulation in reaction to market pressures.
The Commission's proposal comes at a critical juncture when the financial services industry has belatedly recognized what the financial planning profession attributed to its rapid growth more than a decade ago -- that investors generally desire comprehensive advisory services from a single source and are willing to pay fees for those services.32 There is, of course, long-standing evidence of this enormous growth trend in advisory services in assets under management and the registration of investment advisers with the Commission over the past 20 years. Recognition of the increasing fundamental importance of the Advisers Act because of this immense consolidation of financial services, and the decreasing utility of the Exchange Act as commission compensation dwindles, should encourage the Commission to support functional regulation of other industry groups when they act as investment advisers.
IV. If the Commission Adopts the Rule, the Commission Should Revise the Rule To Enhance Investor Protection and Provide Regulatory Clarity
FPA strongly recommends that the Commission not adopt the Rule. But in the event a Rule is adopted, the FPA recommends the following modifications:
1. The Rule should subject all accounts giving discretion to the broker the protections of the Advisers Act.
2. The Rule should create a bright line standard quantifying the terms "special compensation" and "solely incidental." For example, if the fee portion of a brokerage firm's annual gross income (including the fee portion derived from a blended compensation arrangement) exceeded 5 percent, then the advisory services were no longer incidental, and special compensation was therefore received.
3. Broker-dealers who are not registered under the Advisers Act should be prohibited from marketing advisory services that are not "solely incidental" to their securities sales activities. Such restrictions should prohibit the use of the terms "comprehensive" or "total" financial services or relationships, as well as a prohibition on use of the specific terms "financial planning" or "financial planners," consistent with the holding out standard set forth in Investment Advisers Release No. 1092.
4. The Commission should re-examine SRO rules permitting the use of client testimonials and provide consistency among all of the securities acts as the financial services industry continues its trend toward consolidating services.
5. The brokerage account disclaimer should be significantly strengthened by having the purpose of brokerage transactions, and distinctions between customer suitability under NASD rules and fiduciary responsibilities under the Advisers Act, clarified and amplified. Broker-dealers who claim an exclusion from the Advisers Act should require agents to make certain disclosures, including the following: that he or she is an agent of a broker-dealer; that the broker-dealer is not subject to the Advisers Act and the basis therefore (e.g., that the broker-dealer provides advisory services that are only incidental to brokerage services); that the broker-dealer does not have to satisfy certain requirements provided in the Advisers Act, including additional disclosure of potential conflicts of interest; and most importantly, the fiduciary responsibility that requires the adviser to place the client's best interest ahead of its own.
FPA greatly appreciates the opportunity to submit comments on this critical issue to the public, the regulators, the financial planning profession and the securities industry. FPA would be more than happy to address any questions or comments in connection with the Rule.
Duane R. Thompson
Director of Government Relations
Financial Planning Association
ccs: The Honorable Arthur Levitt
The Honorable Isaac C. Hunt, Jr.
The Honorable Norman S. Johnson
The Honorable Paul R. Carey
The Honorable Laura S. Unger
Paul F.Roye, Esq.
1 The Financial Planning Association is the largest organization in the United States representing financial planners and affiliated firms. FPA was formed on January 1, 2000 as a result of the combination of two existing non-profit financial planning associations, the Institute of Certified Financial Planners (ICFP) and the International Association for Financial Planning (IAFP). FPA is domiciled in Washington, D.C., with administrative offices in Atlanta and Denver. FPA also represents 120 broker-dealers that are members of the Broker-Dealer Division of FPA.
2 See "First Annual CFP Practitioner Survey," CFP Board of Standards, Inc., Summer 1999.
3 Section 202(a)(11) of the Advisers Act.
4 Section 202(a)(11)(C) (emphasis added).
5 S. Rep. No. 76-1775, 76th Cong., 3rd Sess., at 22 (emphasis added).
6 Bines, The Law of Investment Management, ¶ 2.05[b] (1978) (emphasis added).
7 Op. SEC Gen. Counsel, Adv-2 (1940) (emphasis added).
8 Op. SEC Gen. Counsel, Adv-2 (1940).
9 Investment Advisers Rel. No. 770 (Aug. 13, 1981) (emphasis added). Although several other groups of individuals and entities are exempted from the definition of "investment adviser" in Section 202(a)(11)(C), the exemption for brokers and dealers is the only one that has both requirements.
10 Investment Advisers Rel. No. 1092 (Oct. 8, 1987) page 12 (emphasis added).
11 Id. (emphasis added).
12 Section 202(a)(11)(C).
13 See Townsend and Associates, Inc. (Sept. 21, 1994) (the determination of whether investment advice is "solely incidental" is "fact-specific").
14 Release Nos. 34-42099; IA-1845, page 7. The Rule acknowledges that the new brokerage programs would fail to meet the compensation test. According to the Release, "fee-based compensation may constitute special compensation under the Act because it involves the receipt by the broker of compensation other than traditional brokerage commissions."
15 Id., page 8.
16 The reduction in commission rates is attributable to the rise of electronic communication networks, or ECNs, which today make up more than 15 percent of daily trading volume. (Statistic from speech by U.S. Rep. Michael Oxley, R-Ohio, before the National Society of Compliance Professionals, Washington, D.C., October 14, 1999.)
17 "Online Trading Fees Headed Lower," Wall Street Journal, page E1, November 18, 1999 (emphasis added).
19 "BDs Should Monitor After-Hours Markets, Educate Clients About Them, Becker Cautions," Broker/Dealer Compliance Report, Vol. 1, No. 4, page 120, Nov. 10, 1999. Published by the Bureau of National Affairs, Inc.
20 "Repositioning in a Rapidly Changing Industry," a speech by David H. Komansky, Chairman and Chief Executive Officer of Merrill Lynch, Merrill Lynch Banking & Financial Services Conference, New York, New York, September 13, 1999.
21 "Unlimited Advantage from Merrill Lynch, A Comprehensive Financial Approach Powered by The Full Resources of Merrill Lynch," a 1999 marketing brochure.
22 Release Nos. 34-42099; IA-1845, page 3.
23 The American Institute of Certified Public Accountants recently opened an investment adviser information center for its members, indicating an increased interest in registering as advisory firms and no longer attempting to use the exemption as a safe harbor from investment adviser registration. Also recognizing the need to offer new advisory services to its insurance clients, the National Association of Life Underwriters recently changed its name to National Association of Insurance and Financial Advisors. The brokerage industry, of course, no longer refers to its registered representatives as stockbrokers but as "financial consultants." This leads one to the conclusion that they brokered stocks in 1940, but began offering more comprehensive advice at a later point.
24 See, e.g., SEC IA Release Nos. 770 and 1092.
25 Release Nos. 34-42099; IA-1845, page 6.
26 84 S. Ct. 275 (1963).
27 Bruskin/Goldrin Research on behalf of the CFP Board of Standards, Inc., weekend telephone survey, February 12-14, 1999, of 1,016 respondents.
28 "Merrill Hopes New Ads Can Integrate Its Image As Full-Service Firm, Leading Online Broker," Wall Street Journal, January 3, 2000, page C2.
29 The proposed rule ignores the Commission's own long-standing support for functional regulation of the financial services industries during the recent and decisive round of debate on Glass-Steagall reform. See Gramm-Leach-Bliley Act of 1999.
30 Release Nos. 34-42099 and IA-1845, page 3.
31 Comprehensive financial planners who provide full advisory and execution of services are not regulated per se by any public agencies in the United States as financial planners. Instead they are functionally regulated under the Exchange Act; the Advisers Act or corresponding state securities law; state insurance laws; the Employee Retirement Income Securities Act of 1974; state accounting laws; and others as broker-dealer representatives, investment advisers, insurance agents, accountants, etc.
32 The financial planning process incorporates advisory services to an individual or family spanning a number of the traditional and separate areas of financial services regulation, including tax, securities, banking and insurance advisory services as well as, in certain instances, sale of the products associated with those services.