U.S. Securities and Exchange Commission building in Washington. Sept. 4, 2014. (Photo: Diego M. Radzinschi/ALM)

On June 5, 2019, the Securities and Exchange Commission adopted a rulemaking package that is applicable to investment advisers and broker-dealers. The package includes two final rules and two interpretations — Regulation Best Interest, Investment Adviser Standard of Conduct Interpretation, Form CRS – Relationship Summary, and Solely Incidental Broker-Dealer Exclusion Interpretation. This is the fourth in a series of articles describing the SEC’s rulemaking package.

Section 202(a)(11)(C) of the Investment Advisers Act of 1940 excludes from the definition of “investment adviser” a broker-dealer who provides investment advice that is “solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation.”

As summarized by the SEC, this language illustrates that Congress knew when it passed the Advisers Act that it is not uncommon for broker-dealers to provide investment advice in the course of their business. Congress also acknowledged that the provision of such limited advisory services by broker-dealers should not (generally) subject them to regulation under the Advisers Act.

As the financial services industry has evolved, application of this exclusion has become more difficult to interpret. This uncertainty was confirmed by comments the SEC received during the rulemaking process. Thus, the SEC issued this interpretation to confirm and clarify when a broker-dealer’s performance of advisory activities causes it to become an investment adviser under the Advisers Act.

As a starting point, the SEC explains in the interpretation that “whether advisory services provided by a broker-dealer satisfy the solely incidental prong is assessed based on the facts and circumstances surrounding the broker-dealer’s business, the specific services offered, and the relationship between the broker-dealer and the customer.”

In general, a broker-dealer’s advice about the value and characteristics of securities or the advisability of transacting in securities falls within the “solely incidental” exclusion “if the advice is provided in connection with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions.” While the determination is based on a facts-and-circumstances analysis, the interpretation provides guidance regarding the application of the exclusion in the context of exercising investment discretion over customer accounts and account monitoring.

Exercising Discretion

In the past, the SEC has cautioned that a broker-dealer’s exercise of investment discretion over customer accounts may not be “solely incidental” to the brokerage business.

According to the SEC, “when a broker-dealer exercises investment discretion, it is not providing advice to customers that is in connection with and reasonably related to effecting securities transactions; rather, the broker-dealer is making investment decisions relating to the purchase or sale of securities on behalf of customers on an ongoing basis.” Thus, a broker-dealer’s exercise of unlimited discretion would not be solely incidental to the broker-dealer’s business, and the exclusion would not apply under such circumstances.

The SEC has also previously determined that a broker-dealer’s exercise of limited discretionary authority could be considered a service that is solely incidental to the brokerage business. Therefore, a broker-dealer’s exercise of temporary or limited discretion may indicate that a specific relationship is not “primarily advisory in nature.”

The SEC identified examples in the interpretation that it considers to demonstrate a broker-dealer’s temporary or limited discretion. Those examples include transactions to:

  • Purchase or sell a security or type of security when a customer is unavailable for a limited period of time, if the purchase or sale occurs on an isolated or infrequent basis.
  • Purchase or sell securities to satisfy margin requirements or other customer obligations that the customer has specified.
  • Sell specific bonds or other securities and purchase similar bonds or other securities in order to permit a customer to realize a tax loss on the original position.

Nevertheless, the interpretation reminds broker-dealers that “the totality of the facts and circumstances would be relevant to determining whether temporary or limited discretion is consistent with the solely incidental prong.”

Monitoring Accounts

During the rulemaking process, the SEC received various comments about the applicability of the exclusion when broker-dealers monitor the status and performance of a customer’s account. The SEC disagreed with some commenters’ position that any monitoring of customer accounts is inconsistent with the exclusion. Thus, the interpretation confirms that a broker-dealer’s review of accounts does not automatically fall outside of the exclusion.  However, the SEC declined to establish a threshold about the situations in which monitoring is solely incidental to a broker-dealer’s business.

The interpretation encourages broker-dealers to implement policies and procedures that will help demonstrate whether any monitoring is related to the primary business of effecting transactions. Such policies and procedures may include information such as: whether a registered representative may agree to monitor a customer’s account at specific time frames for the purpose of determining whether to provide a buy, sell or hold recommendation to a customer; and, for dually registered firms, the level and type of monitoring the firm provides in advisory and brokerage accounts.

Because the SEC believes that the interpretation generally confirms the existing scope of the exclusion, it became effective upon publication in the Federal Register on July 12, 2019. As applicable, the SEC will consider further comments on the interpretation and evaluate whether additional guidance is appropriate in the future.

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Beth Miller is an attorney with Spencer Fane LLP in the firm’s Overland Park, Kansas, office. Her practice focuses on helping clients by identifying practical solutions to a wide variety of legal matters in the areas of employer-sponsored retirement plans, executive compensation, fiduciary obligations and advisory services. She can be reached at bmiller@spencerfane.com.