U.S. Securities & Exchange Commission
SEC Seal
Home | Previous Page
U.S. Securities and Exchange Commission

Speech by SEC Staff:
Opening Statements at December 22, 2004 Open Meeting


Paul F. Roye

U.S. Securities and Exchange Commission
Director, Division of Investment Management

Washington, D.C.
December 22, 2004

Thank you Chairman Donaldson and good morning Commissioners.

The rulemaking proposal before you this morning addresses the difficult question of when a broker-dealer's advisory activities trigger application of the Investment Advisers Act. This has been a contentious rulemaking with broker-dealers favoring the rule and investment advisers, including financial planners, strongly opposing the rule. This dispute is very much like others that have arisen when lines established in statutes enacted long ago become outdated as a result of the blurring of distinctions between financial service providers. Our recommendation to you attempts to sort out this dispute in a manner that we believe is consistent with Congressional intent in framing the exemption for broker-dealers in the Advisers Act.

As you indicated, Mr. Chairman, in 1999 the Commission proposed a rule to address the application of the Investment Advisers Act to broker-dealers offering "fee based brokerage programs and discount brokerage programs". In view of the passage of time since the rule was proposed, and issues raised by commenters, the Commission reopened the comment period on the rule proposal in August. After analyzing the comments received, we recommend that the rule proposal be modified and that important interpretative issues be addressed in connection with the rulemaking. In view of the nature of these proposed changes, we believe it is appropriate to solicit additional public comment on the revised version of the rule and the proposed interpretative positions. To minimize disruption to the businesses of those broker-dealers currently offering fee based brokerage and discount brokerage programs, we recommend that the Commission adopt a temporary rule pending the Commission's consideration of a final rule in this area and that the no-action position set forth in the original proposing release be withdrawn.

In the late 1990s, several large broker-dealers initiated fee based brokerage programs. Under these programs, broker-dealers and their registered representatives' compensation no longer depended on the number of transactions or the size of mark-ups or mark-downs charged, thus reducing incentives for registered representatives to churn accounts, recommend unsuitable securities or engage in high pressure sales tactics, areas where there have been numerous enforcement and disciplinary actions. These programs were directly responsive to recommendations in the Report of the Tully Committee formed to identify best practices in the brokerage industry. Today, broker-dealers hold approximately 250 billion dollars of customers' assets in fee based brokerage accounts.

Another development was the "unbundling" by some full service brokerage firms of their brokerage services, giving customers the option of purchasing discount brokerage services, including electronic execution services, at reduced commission rates. These programs offer customers who do not want or need investment advice the ability to trade securities at a lower cost.

The Commission recognized that these new programs raised issues as to whether broker-dealers offering these programs would have to register under the Advisers Act and not be able to avail themselves of the broker-dealer exception in the Advisers Act. The Investment Advisers Act 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". Traditionally, the Commission has viewed fee based compensation as special compensation because it was compensation other than traditional brokerage commissions or mark-ups or mark-downs. Discount brokerage programs do not themselves involve special compensation, but when offered by a full service broker-dealer, result in the broker-dealer receiving special compensation from its regular full service brokerage accounts, since the Commission has indicated that if a broker-dealer charges customers different commission rates, one with advice and one without, the difference between the two rates is "special compensation".

The broker-dealers offering these new programs contended that relief should be provided from application of the Advisers Act because these programs were simply a re-pricing of existing brokerage arrangements. The Commission determined to propose a rule exempting broker-dealers from the Advisers Act to the extent they offered these programs. The view was that these programs provided important benefits to brokerage customers and that Congress did not intend that full service broker-dealers offering a package of traditional brokerage services be covered by the Advisers Act.

The proposed rule provided that, a broker-dealer would be excluded from the definition of investment adviser regardless of the form that its compensation takes as long as: (i) the broker-dealer's advice is provided on a non-discretionary basis, (ii) the advice is solely incidental to the brokerage services and (iii) the broker-dealer declares to its customers that their accounts are brokerage accounts. The provisions of the proposed rule were designed to make application of the Advisers Act turn more on the nature of the services the broker-dealer provides rather than the form of compensation. The rule proposal also would permit a full-service broker-dealer to offer discount brokerage, including electronic trading, without having to treat full-price, full-service brokerage customers as advisory clients.

We received over 1700 comments on the rule proposal. Virtually all of the letters supporting the rule came from broker-dealers and those opposing the rule came mostly from investment advisers, financial planners and consumer groups. While broker-dealers viewed the new programs as providing the same services that broker-dealers have traditionally provided to their customers, investment advisers, including financial planners, saw the switch to a fee-based compensation scheme as a transformational event - no longer were customers paying for brokerage transactions, but for a client relationship in which advisory services predominate. They argued that the rule, if adopted, would deny the account holders important protections provided by the Advisers Act. Many commenters also urged that the Commission provide greater guidance on when advice is incidental to brokerage.

On balance, we continue to believe that fee-based brokerage programs should be treated as brokerage accounts rather than advisory accounts. We believe that Congress could not have intended the Advisers Act to apply to a broad class of broker-dealers and brokerage accounts that receive the same package of services (including investment advice) as traditional full service brokerage accounts. 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 fee-based programs suggests strongly that this is no longer the case.

We therefore recommend that you re-propose the rule for additional comments with the following modifications:

First, we believe the disclosure that would be required by the rule should be substantially expanded to address the confusion that exists regarding differences between brokerage and advisory accounts. We recommend that the proposal require all advertisements for an account exempted under the rule and all agreements, contracts, applications and other forms governing the operation of such an account contain a prominent statement that it is a brokerage account and not an advisory account, that the firm's obligation with respect to such accounts may differ, that an important difference is that broker-dealers may or may not have a fiduciary relationship with their clients, whereas investment advisers do have such a relationship, and that the customers be directed to an appropriate person at the firm for a full discussion of these differences. We believe this additional disclosure will assist investors in understanding the obligations attendant to a brokerage account and confirms the responsibility of the broker-dealer to explain to its customers the differing nature of brokerage and advisory accounts.

Second, we believe that the Commission should provide more guidance on when advice is incidental to brokerage and provide examples of advisory services that are not incidental. We believe that advice is "incidental to" the brokerage business if it is provided in connection with and reasonably related to the brokerage services provided. We believe an interpretation of incidental advice should reflect the fact that in 1940 the advice broker-dealers gave as a part of their traditional brokerage services was substantial in amount and importance.

However, there are limits as to when advice is solely incidental and we recommend asking for comment on whether certain common broker-dealer practices are inconsistent with advice offered solely incidental to brokerage. For example, we suggest requesting comment on whether we should interpret financial planning as not incidental to the brokerage business. We recognize that full service broker-dealers must consider some aspects of financial planning when determining that their recommendations are suitable. We certainly would not want a Commission interpretation to in any way interfere with a broker's suitability analysis. Accordingly, we ask for comment on whether, to avoid this result, our interpretation turn on how and whether a broker-dealer holds out its financial planning services to clients.

Additionally, we recommend incorporating into the rule text and requesting comment on a propose requirement that broker-dealers treat all discretionary accounts as advisory accounts without regard to the form of the broker-dealer's compensation. Such an interpretation would provide a bright line test for the availability of the broker-dealer exception based on the exercise of discretion at a time when the line between advisory and brokerage services is blurring and the original "bright line" of "special compensation" has ceased to function as a reliable indicator of the services the Advisers Act was intended to reach.

We believe the rule as we recommend it be re-proposed with additional interpretive guidance will help delineate the differences between advisers and brokers in a manner consistent with Congressional intent.

We would be pleased to answer any questions.



Modified: 12/22/2004