New SEC Rule Regarding Broker-Dealer Registration May Impact Claims for Mishandling Accounts

By Robert J. Mendes

In April 2005, the Securities and Exchange Commission ("SEC") issued a rule affecting whether a broker-dealer must register as an "investment advisor." Financial professionals fought about the rule in public comment. In general, broker-dealers were in favor of the rule, while financial planners and public interest groups were against it. This article examines whether the rule will impact claims for damages for mishandling accounts.

BACKGROUND

In the early 20th century, there were two primary ways for investors to obtain investment advice from financial professionals – either as part of the services provided by a commission-based broker-dealer, or as part of a separate contract for investment advisory services. The first group was initially regulated by the Securities Exchange Act of 1934 (the "Exchange Act"). Today, there are also industry self-regulatory organizations like the National Association of Securities Dealers that provide additional regulation for commission-based broker-dealers. However, the Exchange Act left the second group of non-broker-dealer investment advisors unregulated.

The Investment Advisors Act of 1940 (the "Advisors Act") solved this problem. The Advisors Act required the registration and regulation of "investment advisors." In recognition of the fact that broker-dealers were already regulated by the Exchange Act, the Advisors Act provided an exception for registered broker-dealers who provided investment advice that was solely incidental to being a broker-dealer and for which no "special compensation" was received. This meant that any broker-dealer who was getting paid by traditional commissions could continue to provide investment advice without having also to register as an investment advisor.

This is an important distinction because the regulations that apply under the two acts are not the same. The financial advisor community complains that broker-dealers are not required to give objective advice that is in the best interests of the client. The broker-dealer community (and the SEC) responds by pointing out that the Exchange Act has robust consumer protections from a wide array of bad acts. The bottom line is that the Advisors Act is a separate regulatory scheme that broker-dealers seek to avoid.

WHY THE NEW RULE?

By the late 1990s, broker-dealers had developed two new products – fee-based brokerage programs and discount brokerage programs. Fee-based brokerage programs were largely an industry response to ongoing SEC concern about traditional problems like churning. In a fee-based brokerage program, a flat fee is charged for brokerage services including investment advice and the execution of trades. Because the Advisors Act was written at a time when all brokerage services were paid for by commission, anything other than a commission had always been thought of as "special compensation," which in turn required registration under the Advisors Act.

The new rule is intended by the SEC to encourage fee-based brokerage programs. Specifically, the new rule is designed to ensure that broker-dealers who have simply re-priced traditional brokerage services to a flat fee will not be required to register as investment advisors.

The SEC has a similar objective regarding discount brokerage accounts that are offered with electronic trading programs. The rule seeks to keep the full rates changed to traditional accounts from being considered "special compensation," which would require registration.

SUMMARY OF THE NEW RULE

The new SEC rule states that a broker-dealer registered under the Exchange Act is not considered an investment adviser solely as a result of receiving special compensation if the investment advice is provided on a non-discretionary basis, and it is solely incidental to the brokerage services provided to the customer. The rule also requires broker-dealers to make disclosures to their customers to avoid registration as investment advisors. These disclosures must include: (1) statements that the account is a brokerage account and not an advisory account; (2) an explanation that, as a consequence, the scope of the firm's fiduciary obligations may differ; and (3) identification of a person with whom the customer can discuss the differences between brokerage accounts and advisory accounts.

In reviewing public comment before the rule was implemented, the SEC concluded that it should provide some guidance regarding the sorts of things that would not be "solely incidental" to providing brokerage services. So, the new rule makes it clear that, if the broker-dealer is exercising investment discretion, is providing financial planning services, or charges a separate fee for advisory services, its investment advice is not "solely incidental" to brokerage services, and it is required to register under the Advisors Act.

The fallout is that broker-dealers who provide traditional brokerage services, which focus on the execution of trades but also include investment advice, will continue to be regulated by the Exchange Act and their own industry self-regulatory organizations. However, broker-dealers who provide separate advice, financial planning services, or who exercise trading discretion will be deemed investment advisors and must register.

The SEC views the rule largely as an exercise in making sure that the Advisors Act keeps pace with developments in how the market provides investment advice and brokerage services. The financial planning community continues to push for greater regulation of broker-dealers. Broker-dealers have their own complaint, however. By focusing on the substance of whether discretion is exercised rather than the form that payment takes, there are additional broker-dealers that will need to register under the Advisors Act. They must do so by October 24, 2005.

WHAT DOES IT MEAN FOR INVESTORS WITH CLAIMS AGAINST BROKER-DEALERS

The new rule should clarify the law by focusing more on the substance of the relationship between the parties, and less on the name given to the services provided or the fees charged.

For a long time, the law has been that a "simple" broker-customer relationship usually is not fiduciary in nature. There is general agreement, however, that a broker may acquire fiduciary duties in a particular case depending on the manner in which investment decisions have been reached and transactions executed for the account. Specifically, where an account is non-discretionary, meaning that the customer makes the investment decisions and the broker merely receives and executes a customer's orders, the relationship generally does not give rise to general fiduciary duties.

In recent years, this analysis has become blurred. By calling accounts non-discretionary, and by using expansive disclaimers of liability, some broker-dealers and financial advisors exercise significant control over customer assets in the context of an ostensibly non-discretionary account. Then, when litigation erupts, the financial professionals often oppose liability on the basis of long-standing case law that there are no fiduciary obligations in connection with non-discretionary accounts. On the other hand, the customers argue that, despite the label on the account, the financial professional really was exercising discretion or control over the account. In the end, the courts are left to figure out which square peg to put in a round hole.

The new SEC rule, which focuses attention on the substance of the actual services being provided – whether they are traditional brokerage services or financial planning and advisory services – rather than the label or the fee structure, should help courts cut through the form of the relationship and focus on the substance of it. In this way, the new rule should benefit everyone by adding clarity to the law.