• Certain Broker-Dealer Activity Deemed Not to Be Investment Advisory Services
  • December 27, 2005
  • Law Firm: Duane Morris LLP - Philadelphia Office
  • Background

    In November 1999, the SEC first issued a release proposing a new rule under the Investment Advisers Act of 1940 (the "Advisers Act"). The Proposing Release included:

    • a rule that would exclude from the definition of "investment adviser" a broker-dealer providing investment advice to customers, regardless of the form that its compensation takes, as long as: (1) the advice is provided on a nondiscretionary basis; (2) the advice is solely incidental to the brokerage services; and (3) the broker-dealer discloses to its customers that their accounts are brokerage accounts.
    • a provision that a broker-dealer would not be deemed to have received "special compensation" solely because the broker-dealer charges a commission, markup, markdown, or similar fee for brokerage services that is greater than or less than one it charges another customer.
    • a statement granting temporary no-action relief to a broker-dealer that fails to treat accounts over which they do not exercise investment discretion as subject to the Advisers Act, effective until the SEC takes final action on the proposed rule.

    The proposed rule is intended to respond to the introduction of two new types of brokerage programs offered by full-service broker-dealers: "fee-based brokerage programs" and "discount brokerage programs." Subsequent to opening the comment period on the proposal rule, the SEC received numerous comments that raised complex issues, including what is solely incidental to brokerage services and how a broker-dealer may hold itself and its services out to the public. As such, the SEC acknowledged that these issues reach beyond those originally considered by the Proposing Release. Thus, the SEC adopted a temporary rule, which expired on April 15, 2005, and reproposed the rule.

    The Rule Reproposal

    Under the reproposed rule, a registered broker-dealer is excepted from the Advisers Act regardless of whether it charges an asset-based or fixed fee (rather than commissions, markups, or markdowns) for its services if (a) it does not exercise investment discretion over the account from which it receives special compensation; (b) the investment advice is solely incidental to the brokerage services provided to the account; and (c) advertisements for contracts, agreements, applications and other forms governing the account are contained in certain prominent disclosures, and include a statement that the account is a brokerage account and not an advisory account.

    While these requirements are similar to those included in the proposed rule, under the reproposed rule the SEC would increase the amount of required customer disclosure. The original proposal, on the other hand, would have required a broker-dealer to disclose only that the fee-based accounts are brokerage accounts.

    Under the reproposed rule, exercising investment discretion is not solely incidental to brokerage business, and thus, a broker-dealer providing discretionary advice would be deemed to be an investment adviser under the Advisers Act. As such, the reproposed rule would supersede the existing SEC staff interpretation that a limited number of discretionary accounts, wherein commissions were charged, is "solely incidental." Further, under the reproposed rule, a broker-dealer would be prohibited from relying on the exception for any account over which it exercises investment discretion, regardless of how it handles other accounts.

    Additionally, the reproposed rule includes a provision that a broker-dealer would not be subject to the Advisers Act solely because it offers full-service brokerage and discount brokerage services, including electronic brokerage, for reduced commission rates. The reproposed rule would also codify the SEC's interpretation that, if a broker-dealer is dually registered as a broker-dealer and an investment adviser, it would be treated as an investment adviser solely with respect to those accounts for which it provides services or receives compensation that subject the broker or dealer to the Advisers Act. The SEC would also interpret the broker-dealer exception as being available not only to a broker-dealer, but also to its registered representatives.