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Broker-Dealer Fee-Based Compensation; New Rule Requires Broker-Dealers with Investment Discretion to Register as Investment Advisers

Client Advisory

March 2005

Background

Brokers and dealers are excluded from the definition of “investment adviser” if they offer advice that is “solely incidental” to their business as brokers or dealers and they receive no “special compensation” for such services.[1]

Since 1999, many broker-dealers have been able to charge customers asset-based or fixed fees rather than commissions or mark-ups and mark-downs, without having to register as investment advisers.[2] Although these broker-dealers were deemed to be receiving “special compensation,” they were excluded from the definition of “investment adviser” if they did not exercise discretion over the customer accounts in question, the advice was “solely incidental” to the brokerage services provided, and any advertisements, contracts, or other documents relating to the accounts clearly specified that the accounts were brokerage accounts. The SEC also took the position that a broker-dealer that has a two-tier commission or mark-up (for example, a full-service rate including advice and a discount rate for customers who don’t want or need advice) would not thereby be receiving “special compensation.”

New Rule

Fee-based compensation. The SEC has adopted a final version of Rule 202(a)(11)-1, which essentially follows the 1999 proposal, with a few exceptions.[3] The new rule, in general, permits broker-dealers who provide investment advice which is solely incidental to their brokerage services to be exempt from registering as investment advisers, even if they receive asset-based fees, fixed fees or other special compensation.

Discretionary brokerage accounts. In addition, the new rule provides that broker-dealers who exercise investment discretion over customer accounts will, with certain exceptions, be treated as investment advisers subject to regulation under the Advisers Act, regardless of the type of compensation charged.[4]  Broker-dealers who exercise discretion over customer accounts have until October 24, 2005 to register as investment advisers unless they otherwise are exempt from, or ineligible for, such registration. One basis for eligibility for SEC investment adviser registration is that the adviser have at least $25 million of client assets under management.

Fee-Based Accounts

The introduction by broker-dealers in recent years of fee-based and discount brokerage programs increased the uncertainty of when a broker-dealer using these programs would be deemed to be conducting advisory activities subject to the Advisers Act. Fee-based brokerage programs provide customers with a package of brokerage services for a fee based on the assets held in the account or a fixed fee. If such fees constitute “special compensation,” the broker-dealer would generally be subject to regulation as an investment adviser. Similarly, where a broker-dealer offers discount brokerage programs which have a two-tier fee structure (lower fee for execution only, higher fee if advice is provided), this structure may also involve “special compensation,” triggering regulation as an investment adviser.

Under the new rule, a broker-dealer providing investment advice that is solely incidental to its brokerage services will not be subject to the Advisers Act if it charges an asset-based fee, a fixed fee or other special compensation (as distinguished from commissions, mark-ups or mark-downs), provided that it makes certain disclosures. Both of these requirements must be satisfied: the advice must be solely incidental to the brokerage services, and the broker-dealer must make the necessary disclosures. The failure to meet either of these requirements will result in the loss of the exclusion from the definition of “investment adviser.”

In order to meet the first requirement, the investment advice must be solely incidental to brokerage services provided to the specific account, rather than the overall operations of the broker-dealer. The advisory services must be provided in connection with and reasonably related to the brokerage services which the broker-dealer provides to that customer.

A broker-dealer cannot treat investment advice as solely incidental to its brokerage if:

1. it separately contracts with the customer for advisory services;

2. advisory services are rendered for a separate fee; or

3. it provides advice as part of a financial plan and holds itself out as a “financial planner” or as providing “financial planning” services, delivers a financial plan or represents that the advice is part of a financial plan or financial planning services. Use of other words that denote “financial planning” would also result in the loss of the exclusion from the definition of “investment adviser.” However, the SEC would not object to a broker-dealer calling itself a “financial advisor” or “financial counselor.”

The customer documents governing the operation of special compensation accounts must contain a statement that the accounts are brokerage accounts and not advisory accounts. Specifically, the following language has been mandated by the adopting Release:

“Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons’ compensation, may vary by product and over time.”

The broker-dealer must also identify an appropriate person at the firm with whom the customer could discuss these differences. The disclosure can include other information such as the nature of the fee-based account, customers’ rights, etc., or minor modifications, such as referring to “the ABC Account” rather than “your account.” Subject to these exceptions, the broker-dealer must follow the format above, and the additional language should not interfere with the prominence of the required disclosure statement.

The final rule also reaffirms the position that a two-tier fee structure would not result in “special compensation” and that providing asset-allocation services in connection with wrap accounts managed by a registered investment adviser would not, per se, result in the broker-dealer being an investment adviser. Entities registered as both broker-dealers and investment advisers are subject to the new requirements only with respect to their brokerage business.[5]

This part of the final rule became effective April 15, 2005, except for the new disclosure requirements that go into effect May 23, 2005.

Investment Discretion Triggers Adviser Status

The foregoing guidelines are not materially different from the 1999 proposal. However a significant new provision of the rule is that any broker-dealer that has investment discretion over a customer’s account will be treated as an investment adviser regardless of the type of compensation it receives.

The rule defines discretionary investment advice as not being “solely incidental" to brokerage services. The SEC treats the ability to effect a trade without first notifying or consulting a customer as qualitatively distinct from providing advice as part of brokerage services. The rule allows for exceptions from the definition of “investment adviser” only if the customer grants discretionary authority on a temporary or limited basis. This discretion must be limited to a transaction or series of transactions and not extend to setting investment objectives or policies for the customer.

Broker-dealers who exercise discretionary authority over customer accounts must register as investment advisers no later than October 24, 2005, unless they are otherwise exempt from, or ineligible for, SEC investment adviser registration.

If you have questions about how the new rule affects your business as a broker-dealer, or about registration as an investment adviser, do not hesitate to get in touch with any of us listed below:


Alan Bernstein, Partner
bernstein@clm.com
212-238-8795
Faith Colish, Counsel
colish@clm.com
212-238-8873
Andris Vizbaras, Partner
vizbaras@clm.com
212-238-8698
Paulette Smith, Legal Assistant
smith@clm.com
212-238-8616

Endnotes

[1] Investment Advisers Act Section 202(a)(11)(C). This statute is referred to as the “Advisers Act.”

[2]  Proposed Rule 202(a)(11)-1, Release No. 34-42099. Although this was only a proposed rule, the proposing release included a blanket “no-action” position covering any broker-dealer that conducted business in accordance with the terms of the proposal.

[3] Release Nos. 34-51523, IA-2376, April 12, 2005.

[4] Rule 202(a)(11)-1(b)(3). This does not include a customer’s grant of discretion on a temporary or limited basis. Rule 202(a)(11)-1(d).

[5]  The SEC Release requests comments within 90 days on a number of related subjects, including whether broker-dealer and investment adviser regulation should be integrated, and how to streamline the dual registration process.



Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2017 Carter Ledyard & Milburn LLP.
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