Ask any advisor what their biggest bugaboo is these days and they’re sure to utter one word: compliance. Over the past few years, the SEC and NASD have kept advisors and their broker/dealers and custodians on their toes by issuing one rule after another. This year alone, three SEC rules go into effect–hedge fund advisor registration; the so-called Merrill Lynch rule, which exempts certain brokers from registering as advisors under the Investment Advisers Act of 1940; and the annual compliance review.
The Merrill Lynch rule and hedge fund manager registration are two of the most contentious rules to come out of the SEC. Let’s look at the Merrill rule first. The securities regulator has received scads of comment letters from advisors and industry officials arguing that the Merrill rule, aka the broker/dealer exemption rule or SEC rule 202(a)(11)-1–which became effective January 31–is fraught with problems and ambiguities, and that it fails to clearly distinguish when a broker is acting in a fiduciary capacity. As Lou Stanasolovich, president and CEO of the RIA Legend Financial Advisors in Pittsburgh, puts it: “the rule doesn’t go far enough to create a level playing field” between brokers and advisors. Stanasolovich, like others in the industry, argue that legislation that governs fee-based advice is the only way to create a level playing field. Melanie Lubin, Maryland’s securities commissioner, told a group of lawyers in Washington recently that legislation is the only way to “recognize that there’s a new reality.” Unlike years ago when investors’ only option was to execute trades through a broker, today investors can choose to go it alone and execute a $5 trade through the Internet. However, by choosing to use a full-service broker today to decide which investment is appropriate, the investor automatically presumes the broker is a fiduciary, she maintains. “Investors expect an ongoing relationship no matter who they see [an advisor or broker]; they get this idea through advertising,” Lubin said.
Lubin and Tom Giachetti, a securities lawyer with Stark & Stark in Princeton, New Jersey, both believe the Merrill rule will spark a slew of litigation and arbitration cases. Giachetti, who has many advisors as clients, says that realistically there’s no clear and concise way to delineate for clients “in what role or capacity” an advisor or broker is acting. Under the law, he says, an investment advisor is a fiduciary. When a broker recommends a product, however, NASD rules require that he or she must only determine whether the product is suitable for the client’s needs, so the broker is not acting as a fiduciary, he adds. “A fiduciary would have to determine not only whether the product is suitable, but if there are other products out there that are more suitable and/or less expensive because as a fiduciary, the advisor would have to have an undivided duty of loyalty to the client,” Giachetti says. “The broker is not held to that duty or standard.”
David Tittsworth, executive director of the Investment Adviser Association (IAA) in Washington, which represents SEC-registered advisors, says that while “there is a massive amount of confusion” among investors “about who are brokers and who are advisors and the differences between the two,” what’s equally troubling is the fact that advisors, brokers, and other officials in the industry “are mixed up, too.” Results of an SEC focus group that was conducted less than a year ago confirmed the broadly held belief that “there is massive confusion among investors about what a broker is and an advisor is and their respective obligations,” Tittsworth says. After giving a speech to an audience of mainly brokers in which he addressed the Merrill rule, Tittsworth said he was bombarded with requests from brokers asking him to explain, “What’s going on.” Tittsworth says his “rallying cry” to the SEC now is to “enforce the rule and educate investors about whatever the rule is.” Giachetti adds that he doesn’t have “a clue as to how [the rule is to be] communicated properly, supervised, and/or enforced if there’s any violation.” The rule is “asking way too much from the B/D and also putting too much of an onus on the end client.”
The independent broker/dealer community is of two minds on the issue of compliance. Many B/D executives–particularly at the larger independent B/Ds–say compliance is merely a cost of doing business, and that they’re handling it without much fuss–at least in conversations with the media. But smaller B/Ds express more frustration with the amount of time, energy, and money that they must spend to stay compliant (see “The Price of Being Small” sidebar).
Not Always Black and White
One of the SEC’s primary missions is to protect investors, but Tittsworth says he’s yet to find any information on the SEC’s Web site, “except for a few things that are misleading, that explain the difference between brokers and investment advisors, and that talks about this issue in an intelligent fashion.”
Under the SEC’s rule, broker/dealers who provide non-discretionary advice that’s solely incidental to their brokerage services regardless of the form of compensation are exempt from registering as investment advisors. Industry officials and advisors are still scratching their heads as to what “solely incidental” actually means. The SEC has made attempts to clarify “solely incidental,” but, for the most part, the definition is still “messy,” says Lubin, the Maryland Securities Commissioner. The SEC now says that if a broker has discretionary authority, which means she has the ability to make investments for clients without first getting their permission, that is not solely incidental, Tittsworth says. “That’s an improvement,” he adds. The SEC has “put some meat on ‘solely incidental,”‘ but “is it as far as I would like it to go? No.” For instance, say a broker does not have discretionary authority and he’s talking to his client about general asset allocation–60% in stocks, 40% in bonds. “Where does that run on the continuum of either providing investment advice or financial planning activities?” Tittsworth asks. While it’s probably, in and of itself, not a scenario that would trigger the Investment Advisers Act of 1940, it depends on the other variables that are involved, he says. “It’s not always black and white.”
If a broker is merely talking to a client about a particular product, then it seems that’s when the exclusion would apply, adds Giachetti. However, when a broker is talking about a “client’s entire portfolio–the planning or investment management–that’s where the problems occur.”
The Securities Industry Association (SIA) asked the SEC last December to clarify the differences between a “financial plan” that falls under compliance with the Investment Advisers Act, as opposed to “financial planning services” provided as part of a brokerage relationship subject to the Securities Exchange Act of 1934. Robert Plaze, associate director of the SEC’s Division of Investment Management, responded in a no-action letter that same month. He said whether a particular document or financial tool is a “financial plan” depends on whether the document or tool is used in the context of delivering advice that bears the characteristics of a financial plan. “A financial plan generally seeks to address a wide spectrum of a client’s long-term needs,” he said, “and can include recommendations about insurance, savings, tax and estate planning, and investments.” Plaze said that this comprehensive type of financial planning is “distinct from a financial tool that is used to provide guidance to a customer with respect to a particular transaction or an allocation of customer funds and securities based on the long-term needs of the client.”
But Darla Main, a dually registered advisor with Main Advisory Inc. in Pittsburgh, says a problem she’s running into is that there are “vast differences” in the way broker/dealers are interpreting the Merrill rule. She’s now trying to figure out how her firm’s RIA “plays into the guidelines being established by the broker/dealer” she uses, Multi Financial Services in Denver. She says her B/D has been issuing weekly guidance on complying with the rule, but “some of it is open to interpretation, or it’s never been tried or tested.” (See Playing Field column.)
The Dually Registered Advisor
To ensure they’re complying with the rule, some industry officials have suggested that dually registered advisors–who are registered with the NASD as part of their broker/dealer affiliation and with the SEC as a registered investment advisor–explain to the client upfront that they can work with them in one of two capacities–as an advisor or a broker. But it’s not that simple, Main argues, because rarely does a client come to an advisor looking for help with only one need. Clients “want to be guided through their journey–their financial planning journey or their savings journey or their [retirement] withdrawal issues,” she says.