April 1, 2000

Indecent Proposal

In my ongoing efforts to keep you informed of the latest important regulatory developments in Washington, I've been reading through a turgid stack of SEC proposals and comment letters. This worthy exercise has led me to raise several questions:

How come nobody ever writes about important regulatory developments in plain English?

Why do the SEC and securities lawyers spell the word "advisor" with an "e" ("adviser") instead of an "o" like everybody else?

Will the SEC allow Wall Street firms into the financial advice business without the same client protections required of independent advisors?

And, is there some reason why the large securities firms should be treated differently, from a regulatory standpoint, than the average financial planning firm? I mean, shouldn't an organization that sold wheelbarrows full of derivatives to Orange County, California, until that county went virtually bankrupt be watched at least as closely as a fee-only advisor who has a fiduciary relationship with her clients and mostly recommends no-load mutual funds with low expense ratios?

I am speaking here of SEC Release No. 34-42099, File No. S7-25-99, which proposes what has become famously, if colloquially, known as the Merrill Lynch Rule, I think because somebody at Merrill dreamed up the idea originally and suggested that the SEC put it out for public comment. What idea? The SEC release talks about how traditional brokerage arrangements are beginning to mutate into all kinds of different compensation schemes, where customers can pay fixed-dollar fees or a percentage of assets under management to their broker.

Anybody watching TV these days can hardly miss this trend: The big brokerage houses are telling us to think of brokers more like advisors, and customers are suddenly realizing (on the air, where there coincidentally happens to be a TV camera recording the epiphany) that when they benefit, only then does the firm benefit. The proliferation of these "fee-based programs," the release says, is a good thing, because when people pay fees, it (in the words of the release) "reduces incentives for registered representatives to churn accounts, recommend unsuitable securities, or engage in high-pressure sales tactics."

Since I've been saying the same thing in this column for most of the previous century, I can hardly disagree with this logic. But then the discussion turns ugly. There's a broker/dealer exemption to the Investment Advisers [sic] Act which says, basically, that broker/dealers don't have to register with the SEC, or comply with such Act provisions as the Brochure Rule and the Prohibition Against Testimonials, if the advice is "solely incidental" to brokerage activities. But with these "fee-based" programs, and all this repricing and prime time advertising of advisory services going on, is the advice still "solely incidental?" Or do these new pricing alternatives represent "special compensation," the existence of which, according to the Act, means that you have an investment advisory relationship?

The explanation here is clear as mud, but it seems to have to do with the idea that fees have traditionally been a sign that advice was offered, while commissions were kind of a clue that the broker wasn't in the business of providing totally impartial advice. "Fee-based compensation may constitute special compensation under the Act," the release tells us, "because it involves the receipt by a broker of compensation other than traditional brokerage commissions. In addition, the introduction of execution-only services at a lower commission rate may trigger application of the Act to the full service accounts for which the broker provides some investment advice. This is because the difference between full-service and execution-only commission rates represents a clearly definable portion of a brokerage commission that is attributable, at least in part, to investment advice. We have viewed such a two-tiered fee structure as an indication of 'special compensation' under the Advisers [sic] Act."

This is apparently not what Merrill Lynch wants to see happen, so it (and, with some prompting, the SEC) has suggested that simply repricing these services doesn't make the services fundamentally different from traditional full-service brokerage programs.

So, to put a lot of legalism in a nutshell, SEC Release No. 34-42099, File No. S7-25-99 proposes that these "fee-based" services be exempted from the Act (and regulation under the Act, including the Brochure Rule and the Prohibition Against Testimonials, not to mention the inspections and other regulatory obligations) as long as they meet a couple of tests:

1) They are not discretionary accounts that charge an asset-based fee. That means if the brokerage firm does the trading for the client without the client pre-approving the trades, and the trades are paid for by commission or flat fee rather than by a fee based on the assets under management, then it is not subject to the Act.

2) The advice given to the customer is incidental to the brokerage services that are offered. Your first immediate reaction here is: "How do you define 'incidental?'" And that, of course, is what virtually every comment letter wondered as well.

3) All advertisements for the accounts contain a prominent statement saying that the accounts are brokerage accounts. The SEC apparently watches the same TV shows that we do, because in the release it noted that "we have observed that some broker/dealers offering these new accounts have heavily marketed them based on the advisory services provided rather than the execution services, which raises troubling questions as to whether the advisory services are not (or will be perceived by investors not to be) incidental to the brokerage services." Indeed.

The proposal would also exempt discount brokers from having to register just because they offer execution services at one price to some customers, and at another price to other customers. "Thus," the release tells us, "a broker/dealer would be able to offer both full-service and execution-only brokerage without losing the broker/dealer exception."

I don't think you have to look very hard to see what's going on here. The larger securities firms make way more money these days on their mutual funds and private asset management fees than they do on broker-sold transactions, and have noticed (yes, it took them a while) that the general public prefers to pay for unbiased advice rather than (even expert) salesmanship. So, presto! Your broker is now an advisor, and the service we provide is financial guidance. Brokers can "gather assets" (to use the industry term that is currently in vogue) through the provision of sound advice. To protect the reader from cynicism, I should note that some of these firms seem to have a number of really good people out in the field who are actually providing advice, under structured programs that pay for the advice from the assets that are gathered.

But, well, if you're in the business of providing advice, shouldn't you, like all the rest of us, be regulated under the rules and laws that were created to govern the provision of investment advice? Just because you're a broker/dealer, should you get to provide, not just testimonials, but actually hire actors to pretend they are happy, satisfied clients on TV - while the rest of us are prohibited from allowing our happy, satisfied clients to share their actual, real experiences? Should you not have to provide relevant parts of your Form ADV to your clients?

The answer, it seems to me, is that to the actual customer (we call them "clients" in the financial planning world) this advice is far from incidental to what he is buying; it is, in fact, the thing he or she wants, first and foremost, out of the relationship. But to the company executives who run these brokerage firms, it must seem like this advice is incidental because it is not where the money is. That means, to put it bluntly, that they don't "get it."

Reading through the comment letters, you get hit in the face with this "get it or don't" distinction over and over again. The CFP Board, for all that I've criticized it in the past, "gets it." As evidence, look at relevant parts of its comment to the proposal:

"The advice-driven business broker/dealers are facing is not a new method of providing financial guidance. The trend towards obtaining objective financial advice has developed over the last several decades and has furthered the development of the financial planning profession . . . Investment advisers provide their customers with advice under a fiduciary responsibility and therefore have certain disclosure and principal trading obligations. The Advisers Act also prohibits testimonials, while the applicable NASD brokerage account rules do not. Regulation in this area will best serve consumers by ensuring those protections exist wherever consumers receive substantive advice. Regulation should not allow brokerage accounts to serve as advisory accounts with less protection."

Right on! Now let's look at what Salomon Smith Barney has to say about the proposal. "Broker/dealers," its corporate counsel says, "should be precluded from relying on the Rule if they market brokerage accounts in such a way as to suggest that they are investment advisory accounts. We believe that broker/dealers should be able to reflect in advertising and contracts for brokerage accounts what is often a relevant fact for many brokerage customers: that investment advice is a component (albeit no more than incidental) of the services provided in connection with brokerage accounts."

Right off! Does that mean that when these ads sell investment advice and tell us that we should regard brokers as advisors, this is just "a component" of the relationship?

What does the Charles Schwab organization have to say about all this? "Schwab supports the Rule," its comment letter says. "We believe that the Commission's proposal represents an important step toward regulation that allows innovation in the offering and pricing of investment services to meet changing investor preferences. At the same time, the Rule would preserve an appropriate recognition of the functional differences between core brokerage services and core investment advisory services. Schwab appreciates the Commission's efforts to timely address this important issue."

Later in the document the company says: "Non-discretionary advice provided to customers has traditionally been part of a broker's ordinary business and does not alter the transactional nature of the broker's services. Differences in the form of the broker's compensation alone (for example, charging a bundled asset-based fee or an unbundled fee plus transaction charges) do not change the nature of the broker's services and should not alter the customer's perception of those services or his or her relationship with the broker."

Yes, but is this advice "incidental" by any definition of the word to the new services that are being advertised?

The best comment, in my view, came from the Financial Planning Association. This is interesting, because, in an early comment draft, the IAFP wrote favorably about the proposal, but the FPA's final draft is wickedly on point.

For example: "Implicit in the Rule is the erroneous conclusion that the nature of a broker's advisory services today compared to the Great Depression has not fundamentally changed, even though brokers are increasingly marketing financial planning services as a means of additional compensation. As a consequence of this faulty reasoning, the Rule requires one to conclude, in the face of strong industry trends to the contrary, that the recent, unprecedented decrease in commission rates has not pressured broker/dealers to offer comprehensive fee-based advisory services (for 'special compensation'). The irony of that logic is that in reality, instead of advisory services being 'incidental' to a broker's business, all transactions are rapidly becoming 'incidental' to the advisory services."

Yes! This, it seems to me, is actually far closer to the trend that the general public has finally stirred itself to foster. In the future, broker/dealers will have to provide their services, to the extent that they want to charge any premium over the cheapest discounted clearing price, in the context of investment advice that has value to the consumer.

The comment also draws on a recent survey to clearly identify the trend, and then turns the words of Merrill Lynch's chairman back on the cynical premises of the so-called Merrill Lynch Rule:

"Other surveys confirm this obvious trend. Registered representatives believe that fees will become a larger part of their compensation structure, according to a recent joint survey of the industry by the Institute of Certified Financial Planners and Morningstar, Inc. The only logical conclusion one can reach is that broker/dealers have had to provide advisory services to augment their brokerage-related compensation to remain competitive . . . As a result, the brokerage industry has been compelled to expand the scope of its advisory services to justify the same restructuring in compensation, forcing it to replicate many of the same services offered by registered investment advisers. The same broker/dealers who were forced to augment reduced transaction costs with fees now intensively market comprehensive financial planning services. Indeed, the Chairman and Chief Executive Officer of Merrill Lynch, David H. Komansky, recently stated that the mantra of the largest securities firm in the world is now a 'total financial relationship.' He also said, 'We're focused on financial planning and all of its components - investment, savings, checking, insurance, mortgage and other credit, retirement, estate planning, trusts, and more.'"

The point of all this, so clearly spelled out by the people who "get it," is that the larger securities firms want to have the same relationship with their customers as financial planners have with their clients. They just don't want to be regulated in the same way.

One of two things is going to happen here in the 21st Century. I think there may be a small chance that this proposal will become the SEC's official position, which will create a weirdly unlevel playing field.

If that happens, then I think the profession of investment advisors, who are regulated as such, should point out at every opportunity, to our clients and to the press, that even though these large securities firms are offering investment advice, this advice is really only incidental to their brokerage activities. Furthermore, it should be noted that not only do they admit this, they have actually filed in this way with the regulatory agencies. Do you want real advice, or advice that is incidental to asset gathering and selling you stuff?

On the other hand, there seems a much greater chance that the SEC will reject this nonsensical argument that financial planners who work for Merrill Lynch are somehow in need of less regulation than financial planners who are already registered as advisors. In that case, I think it should be remembered that some of the larger brokerage houses brought up this "incidental" argument in the first place. Are they serious members of our community, or are they asset gathering organizations that view investment advice and fiduciary standards dismissively?

Either way, the brokerage industry has (perhaps cluelessly) handed a powerful marketing weapon to all the independent financial planning firms that have no problem living under SEC rules. Until I see evidence that the large financial services firms "get it" about quality of advice, and its central importance to our professional offer to the public, I don't want to hear how these companies are going to come into our market and eat our lunch. Nor do I care how many actors I see on TV posing as satisfied customers. When their advice becomes much more than incidental, these companies will learn what it feels like to have real satisfied customers. Only then will they recognize that doing best by your clients isn't such an onerous regulatory burden.

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