January 12, 2000
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Release No. 34-42099: Certain Broker-Dealers
Deemed Not to be Investment Advisers (File No. S7-25-99)
Dear Mr Katz:
Stephens, Inc. appreciates the opportunity to comment on SEC Release No. 34-42099, Certain Broker-Dealers Deemed Not To Be Investment Advisers (the Release). We are a full service brokerage firm based in Little Rock, Arkansas registered as a broker-dealer with the Securities and Exchange Commission (SEC). We are also a New York Stock Exchange member firm. We currently maintain approximately 15,000 active brokerage accounts, two-thirds of which are retail-oriented. We manage approximately 700 of these accounts on a discretionary basis (primarily for retail customers), and we are currently in the process of expanding our discretionary brokerage business.
The Release
Like virtually all other companies in the financial services sector today, we must meet the challenge of adapting our business to the changing needs and desires of our customers. We see two particular trends emerging among our brokerage customers. Many of them want one-stop shopping; they want us to provide them with a full package of investment services ranging from execution services to investment information to investment advice. Many of our customers at the same time express a desire to pay a fee for the services they receive that is a fixed dollar amount or is based on a percentage of assets held in the customers account (an Alternative Fee), rather than a traditional commission-based fee. This type of fee appears not only to be the favored choice of many of our customers, but has been cited by the Commissions
Chairman and the 1995 Tully Report1 as potentially better serving the interests of brokerage customers than traditional brokerage commissions.
The two trends that we see among our customers seem to mirror those among brokerage customers generally in the United States. The two trends set the context for the Release.
A brokerage firms charging an Alternative Fee raises the issue under the Investment Advisers Act of 1940 (Advisers Act) of whether the firms offering that kind of fee arrangement causes the firm to need to register under the Advisers Act. The Advisers Act specifies that a broker-dealer providing investment advice to its customers is excluded from the Acts definition of investment adviser and not subject to its substantive provisions if the broker-dealers advice is solely incidental to the conduct of its brokerage business, and if the broker-dealer receives no special compensation for providing the advice (the Broker-Dealer Exclusion).2 The Release addresses whether a broker-dealer would be unable to rely on the Broker-Dealer Exclusion in offering customers execution services, related advice, and other services, for an Alternative Fee. The Commission notes in the Release its view that a broker-dealers charging an Alternative Fee may involve the receipt by the broker-dealer of special compensation, within the meaning of the Broker-Dealer Exclusion.
In the Release, the Commission proposes a rule (the Proposed Rule) under which a broker-dealer would not be deemed to be an investment adviser based solely on its receipt of special compensation, so long as: (1) the broker-dealer did not exercise investment discretion over the account from which it receives special compensation; (2) any advice provided by the broker-dealer is solely incidental to the brokerage services provided to the account; and (3) the broker-dealer clearly discloses in advertisements and other materials relating to the account that the account is a brokerage account.
By its terms, the proposed exclusion would not be available to broker-dealers that receive Alternative Fees in connection with discretionary brokerage accounts. Under the Proposed Rule, a brokerage firm would be considered an investment adviser subject to the provisions of the Advisers Act with respect to any account for which it could exercise investment discretion and for which it was compensated through the means of an Alternative Fee. In the Commissions view this position is appropriate because an account with these characteristics bear[s] a strong resemblance to [a] traditional advisory account[ ] and it is highly likely that investors will perceive such [an] account[ ] to be an advisory account[ ].3 According to the Commission in the Release, a brokerage firm would not become subject to the provisions of the Advisers Act in charging a discretionary client traditional commissions. The SEC acknowledges that by limiting the Proposed Rule in this way it is drawing a regulatory distinction based solely on the pricing of the service, rather than based on the underlying nature of the account.4
Summary of Comments
In the Release, the Commission seeks comment on all aspects of the Proposed Rule and specifically asks for the views of commentators on, among other things, the distinction the Commission draws in the Proposed Rule with respect to treatment under the Advisers Act of discretionary brokerage accounts. In our view, the Commission is to be commended for publishing the Proposed Rule, which quite correctly reflects the need to adapt interpretations of the Act to changing trends in the brokerage business. Nonetheless, we are troubled by the position taken in the Release regarding discretionary brokerage accounts. We believe that the position is not only contrary to the interest of brokerage customers, but it also appears to be most inconsistent with the underlying logic of the Tully Report and statements of the Commissions Chairman. We believe that the characterization of a brokerage account for regulatory purposes should, consistent with the principles set out by the Commission in the Release, be based on the nature of the underlying account, rather than the form of the brokers compensation, and that customers who choose to maintain discretionary accounts should be able to receive the benefits of Alternative Fees, without their account being deemed an advisory account. We recommend that the Proposed Rule be modified to include within its scope broker-dealers otherwise meeting the provisions of the Proposed Rule that charge Alternative Fees in connection with discretionary accounts.
Specific Comments
Characterization of the Account
The underlying premise of the Proposed Rule is that the nature of the services provided by a brokerage firm and not the nature of the firms compensation, should be the primary factor determining whether the firms activities are subject to the requirements of the Advisers Act.5 We agree that this principle is an appropriate means for addressing the application of the Act. The Commission has determined, however, not to apply the principle in the context of discretionary brokerage accounts, which are specifically excluded from the coverage of the Proposed Rule. As suggested above, this decision by the Commission reflects concern that discretionary brokerage accounts tied to an Alternative Fee would be perceived by customers to be advisory accounts.
We believe that the position reflected in the Proposed Rule with respect to discretionary brokerage accounts would lead to an anomalous result. Under the Proposed Rule, a broker-dealer may provide brokerage services on a discretionary basis without registering as an investment adviser under the Advisers Act so long as the broker-dealer charges the customer on a commission basis. If the broker-dealer provides the same services to its customers for an Alternative Fee, however, the broker-dealer would become subject to the provisions of the Advisers Act, although the services received by its customers are identical. This result seems most inconsistent with the Commissions own observation in the Release that, for regulatory purposes, the form of compensation that a broker-dealer receives is not a reliable means of distinguishing between advisory and brokerage accounts.6 We submit that no clear policy reason exists to subject a broker-dealer that charges an Alternative Fee in connection with discretionary accounts to the provisions of the Advisers Act. The decision to impose the provisions of the Advisers Act on a broker-dealer should, we believe, be based on whether the particular services the broker-dealer is providing necessitate the protections of the Advisers Act, rather than the form of compensation the broker-dealer receives for those services.
In our experience, the Commissions concern that brokerage firm customers will perceive discretionary accounts tied to an Alternative Fee to be advisory accounts is unwarranted. We believe that the Commissions observation in the Release that charging Alternative Fees essentially re-price[s] traditional full service brokerage programs but do[es] not fundamentally change their nature applies equally to discretionary brokerage accounts.7 In our view, a reasonable investor would perceive a discretionary brokerage account as being primarily a trading account, and not an advisory account, regardless of the form of compensation that the broker-dealer receives in connection with the account. We have a sizable number of customers who choose to establish discretionary brokerage accounts. In our experience, these customers prefer not to direct the trading in their accounts for a variety of reasons. Many of these customers do not have the time or resources to actively manage their accounts, or simply prefer not to be consulted on each trading decision. In many cases, particularly in regional brokerage firms such as ours, a customer will choose to maintain a discretionary brokerage account because the customer has a close professional relationship with an individual broker and is comfortable allowing that broker to make and execute trading decisions on the customers behalf. In any event, any risk that a customer could confuse a discretionary brokerage account subject to an Alternative Fee with an advisory account would be eliminated through disclosure that the account is a brokerage account, and not an advisory account.
All Brokerage Customers Should Have the Opportunity
to Benefit from Alternative Fees
As the Commission quite clearly acknowledges in the Release, Alternative Fees can benefit a brokerage firms customers by aligning their interests with those of the firm and its registered representatives. By not tying the firms compensation to the number of transactions or the size of mark-ups or mark-downs charged, such fees may reduce the incentives for the firm to churn a customers account, recommend unsuitable securities, or engage in high pressure sales tactics.8 Customers who choose to open discretionary brokerage accounts should have the same opportunity to obtain the benefits of Alternative Fees as do customers opening non-discretionary accounts.
Commission-based fee programs have recently been criticized by a number of commentators as placing at odds the best interests of the customer and the interests of brokerage firms. The Tully Report concluded that [i]f the retail brokerage industry were being created today from the ground up, a majority of the Committee that developed this report would not design a compensation scheme based only on commissions paid for completed transactions. The most important rule of the broker is, after all, to provide investment counsel to individual clients, not to generate transaction revenues. The prevailing commission-based scheme inevitably leads to conflicts of interest among the parties.9 The Chairman of the Commission has expressed strong support for the positions taken in the Tully Report and has even gone so far as to urge investors to seek out brokers that offer customers the choice of paying Alternative Fees for brokerage services. As the Chairman recently said: Commissions reward a broker for the quantity of the trades, not necessarily the quality. . . .The extra compensation may encourage the broker to sell that stock. Thats in his interest. It may be in the firms interest. But it may not be in [the customers] interest.10
Excluding discretionary accounts from the scope of the Proposed Rule strikes us as clearly contradictory to the conclusions of the Tully Report and the Chairmans recent statements. Discretionary brokerage customers should have the same opportunity as non-discretionary customers to pay Alternative Fees if they so choose. Firms offering discretionary accounts are unlikely to convert those accounts to advisory accounts in the absence of changes in the nature of the services provided to the holders of the accounts. We submit that, as a result, excluding discretionary accounts from the scope of the Proposed Rule is likely to result in broker-dealers not making Alternative Fees available to discretionary customers. Exclusion of discretionary accounts from the scope of the Proposed Rule is in turn likely to result in discretionary brokerage customers, who may most benefit from Alternative Fees, not having the choice of such fee arrangements.
One other unintended result of the Commissions distinction between discretionary and non-discretionary accounts is that it may favor larger, national firms over small, regional firms. It is our understanding that national brokerage firms have, for various reasons, not emphasized discretionary brokerage accounts in recent years. Our experience is that customers of regional firms such as ours continue to open discretionary brokerage accounts. Thus, to the extent the effect of the proposed rule is to make discretionary brokerage accounts less viable to offer in connection with Alternative Fees, it will have a more significant effect on regional brokerage firms than national firms.
Prior Consideration of the Issue
The Release is not the first time the Commission has publicly considered the regulatory implications under the Advisers Act of discretionary broker-dealer accounts. In the late 1970s, the Commission sought comment on the question of whether a broker-dealer should be deemed to have lost the Broker-Dealer Exclusion when offering these accounts. At that time, the Commission decided not to subject broker-dealers offering discretionary accounts to the provisions of the Advisers Act.11 We believe that the Commissions decision was correct, and we are aware of no events that have occurred in the industry since that time that would justify a different conclusion.12
Conclusion
For the reasons set out above, we believe that excluding discretionary accounts from the scope of the Proposed Rule would be inconsistent with both the best interests of customers of brokerage firms and the key policies the Proposed Rule is designed to achieve. In our view, all brokerage customers, regardless of whether they choose to open discretionary or non-discretionary accounts, should have the option of choosing to pay Alternative Fees for brokerage services. We submit, therefore, that the Commission should, in finalizing the terms of the Proposed Rule, expand its scope so that a broker-dealer would be able to rely on the Broker-Dealer Exclusion in offering its customers discretionary accounts tied to Alternative Fees.
* * * * *
We thank the Commission for this opportunity to comment on the Release. Please call me at (501) 377-2573 if you have any questions regarding this letter.
Very truly yours,
David A. Knight
1 Report of the Committee on Compensation Practices (Apr. 10, 1995) (Tully Report).
2 Section 202(a)(11)(C) of the Advisers Act.
3 Release at 13.
4 Release at 10.
5 Id.
6 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 suggests strongly that it is no longer. See Release at 11.
7 Release at 1.
8 Release at 6.
9 Tully Report, supra note 1.
10 Arthur Levitt, Chairman, Securities and Exchange Commission, Financial Self-Defense Tips from an SEC Insider, Remarks at Boston Globes Moneymatters Personal Finance Conference (Oct. 16, 1999).
11 Investment Advisers Act Release No. 626, Final Extension of Temporary Exemption from the Investment Advisers Act for Certain Broker-Dealers (April 27, 1978) (the SEC requested comment on whether it should take action, by rule or otherwise, to interpret the scope of the exclusion provided by Section 202(a)(11)(C) of the Advisers Act so that it is not available to a broker-dealer who exercises investment discretion . . . and so that all customers of a broker-dealer whose accounts are managed on a discretionary basis would be considered advisory clients).
12 We also note our understanding that many brokerage firms have relied upon the Commissions position and have offered discretionary accounts that have not been operated in accordance with the substantive provisions of the Advisers Act.