Release No. 34-51523
Release No. IA-2376
File No. S7-25-99

Certain Broker-Dealers Deemed Not to be
Investment Advisers
 

III. DISCUSSION

We are today adopting new rule 202(a)(11)-1 under the Advisers Act for the reasons discussed below and in this rulemaking record. The rule is designed to avoid application of the Advisers Act to broker-dealers merely because they re-price their full-service brokerage or provide execution-only or similar discount brokerage services in addition to full-service brokerage. As discussed in more detail below, we believe the rule draws an appropriate line as to when a broker-dealer’s advisory activities trigger application of the Advisers Act.

A. Fee-Based Brokerage Programs

Commenters on the Reproposal viewed these new fee-based brokerage accounts through entirely different prisms and came to entirely different conclusions. Some saw the introduction of fee-based brokerage programs as a significant migration from a brokerage relationship to an advisory relationship.³¹ They urged, therefore, that we treat all fee-based brokerage accounts as advisory accounts.³² Broker-dealers, on the other hand, viewed the new fee-based programs as providing the same services, including investment advice, that they have traditionally provided to customers.³³ They did not view the change in pricing as significant except insofar as it better aligns the interests of registered representatives with those of their customers.³⁴In order to explain how we have resolved the issues on which the commenters disagree, and consistent with our authority in the Advisers Act,³⁵ we consider Congress’ intent in defining the scope of the Act. We first review the historical context in which Congress passed the Advisers Act, including the broker-dealer exception, in 1940.³⁶

1. Historical Context

Until after World War I, broker-dealers provided investment advice exclusively as a part of the brokerage services for which customers paid fixed commissions (“traditional brokerage services”)³⁷ – in other words, customers did not pay a separate fee for that advice.³⁸ Beginning in approximately 1920, however, some broker-dealers began offering investment advice for a separate and specific fee, typically through “special departments” within their firms.³⁹ By 1940, when the Advisers Act was enacted, broker dealers were providing investment advice in two distinct ways – as an auxiliary part of the traditional brokerage services for which their brokerage customers paid fixed commissions and, alternatively, as a distinct advisory service for which their advisory clients separately contracted and paid a fee.⁴⁰

The advice that broker-dealers provided as an auxiliary component of traditional brokerage services was referred to as “brokerage house advice” in a leading study of the time.⁴¹ “Brokerage house advice” was extensive and varied,⁴² and included information about various corporations, municipalities, and governments;⁴³ broad analyses of general business and financial conditions;⁴⁴market letters and special analyses of companies’ situations;⁴⁵ information about income tax schedules and tax consequences;⁴⁶ and “chart reading.”⁴⁷ The principal sources of auxiliary advice were firm representatives – known as “customers’ men” until 1939⁴⁸ – who served as the main point of contact with brokerage customers,⁴⁹ and the “statistical departments” within firms, which provided research and analysis to customers’ men or directly to the firms’ brokerage customers.⁵⁰

The second way in which broker-dealers dispensed advice was to charge a distinct fee for advisory services, which typically were provided through special “investment advisory departments” within broker-dealer firms that advised customers for a fee in the same manner as did firms whose sole business was providing “investment counsel” services.⁵¹ Through these special departments, broker-dealers offered two types of advisory accounts, one known as “purely advisory” and the other as “discretionary.”⁵² In purely advisory accounts, the “investment counsel undert[ook] to advise the client at stated intervals, or to keep him constantly advised, as to what changes ought, in the opinion of counsel, to be made in his holdings” but left the ultimate decision about such changes to the client.⁵³ Discretionary advisory accounts, on the other hand, provided the broker-dealer – through powers of attorney or otherwise – additional “control over the client’s funds, with the power to make the ultimate determination with respect to the sale and purchase of securities for the client’s portfolio.”⁵⁴ Broker-dealers generally charged for the advisory services provided to these accounts under the same system that had been adopted by the independent investment counseling firms – a fee based on a percentage of the market value of the cash and securities in the account being supervised.⁵⁵ Securities transactions for the discretionary accounts were effected through the broker-dealer, and clients paid a commission on each trade.

Between 1935 and 1939, the Commission conducted a congressionally mandated study of investment trusts and investment companies and in connection with this study surveyed investment advisers.⁵⁶ For those entities that did not engage solely in the business of providing investment advice for a fee, the “study dealt only with the department of the organization engaged in the business of furnishing such service,”⁵⁷including broker-dealers with investment advisory departments.⁵⁸ Following the survey, the Commission held a public hearing at which representatives of the investment counsel industry offered testimony about the history of the investment counsel business, the nature of the services investment counsel provided, and what they saw as the main problems involved in the business of providing investment advice.⁵⁹

In a report to Congress (the “Investment Counsel Report”), the Commission informed Congress that the Commission’s study had identified two broad classes of problems relating to investment advisers that warranted legislation: “(a) the problem of distinguishing between bona fide investment counselors and ‘tipster’ organizations; and

(b) those problems involving the organization and operation of investment counsel institutions.”⁶⁰ Based on the findings of the Investment Counsel Report, representatives of the Commission testified at the Congressional hearings on what ultimately became the Advisers Act in favor of regulating the largely unregulated community of persons engaged in the business of providing investment advice for compensation. As Commission staff explained, a “compulsory census” in the form of a registration requirement for investment advisers was necessary both to protect investors against the unregulated “fringe” offering investment advisory services and to advance the interests of legitimate investment counselors by eliminating “tipsters” who “crash in on the good will of these reputable organizations . . . by giving themselves a designation of investment counselors.”⁶¹

Congress chose to fill this regulatory gap by passing the Advisers Act. Section 202(a)(11) of the Act defined “investment adviser” – those subject to the requirements of the Act – broadly to include “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities . . . .” In adopting this broad definition, Congress necessarily rejected arguments presented during its hearings that legitimate investment counselors should be free from any oversight except, perhaps, by the few states that had passed laws regulating investment counselors⁶² and by private organizations, such as the Investment Counsel Association of America.⁶³ Instead, in responding to such views, congressional committee members repeatedly observed that those whose business was limited to providing investment advice for compensation were subject to little if any regulatory oversight, and questioned why they should not be subject to regulation even though other professionals were.⁶⁴

Conversely, in recognition of the fact that the broad definition of “investment adviser” also captured a number of individuals and entities that were already subject to substantial oversight and regulation,⁶⁵ the Act specifically excepted such persons, among others, to the extent they rendered investment advice as part of their other regular business.⁶⁶ Broker-dealers were among these already-regulated persons, and section 202(a)(11)(C) of the Act excepts 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 therefor.”

2. Our Conclusions

We draw two relevant conclusions from this legislative history as well as from the brokerage customs of 1940. First, as drafted in 1940, the Advisers Act avoided additional and largely duplicative regulation of broker-dealers, which were regulated under provisions of the Exchange Act that had been enacted six years earlier.⁶⁷ Second, the broker-dealer exception in the Advisers Act was understood to distinguish between broker-dealers who provided advice to customers only as part of the package of traditional brokerage services for which customers paid fixed commissions – who werenot covered by the Advisers Act⁶⁸ – and broker-dealers who also provided advisory services (typically through their special advisory departments) for which customers separately contracted and paid a fee – who were covered by the Act.⁶⁹ As the legislative history shows, representatives of the investment counsel industry who participated in the Advisers Act hearings (and cooperated in drafting the version of the bill that Congress ultimately enacted)⁷⁰ understood that broker-dealers offered investment advice both as part of their traditional commission brokerage services and, alternatively, for a separate fee through special departments,⁷¹ and that the Advisers Act was intended to reach only the latter.⁷² The earliest Commission staff interpretations of the Advisers Act also reflect the same understanding, i.e., that the Act was intended to cover broker-dealers only to the extent that they were offering investment advice as a distinct service for which they were specifically compensated (which it was “well known” they were doing through special advisory departments).⁷³

Although, as discussed above, the Advisers Act was written in such a way that it covers fee-based programs because the fee would constitute “special compensation,” we do not believe that it would be consistent with Congress’ intent to apply the Act to cover broker-dealers providing advice as part of the package of brokerage services they provide under fee-based brokerage programs. First, as we have said, one of the reasons Congress enacted the broker-dealer exception was to avoid largely duplicative regulation. If anything, broker-dealers today are subject to a level of regulation far greater than in 1940, as we explain below. Much of that regulation concerns matters pertinent to their advice-giving function.

Second, the Advisers Act was enacted in an era when broker-dealers were paid fixed commission rates⁷⁴ for the traditional package of services (including investment advice) excepted from the Act, and, therefore, Congress understood “special compensation” to mean non-commission compensation.⁷⁵ There is no evidence that the “special compensation” requirement was included in section 202(a)(11)(C) for any purpose beyond providing an easy way of accomplishing the underlying goal of excepting only advice that was provided as part of the package of traditional brokerage services.⁷⁶ In particular, neither the legislative history of section 202(a)(11)(C) nor the broader legislative history of the Advisers Act as a whole suggests that, in 1940, Congress viewed the form of compensation for the services at issue – commission versus fee-based compensation – as having any independent relevance in terms of the advisory services the Act was intended to reach.

To the extent fee-based brokerage programs offer a package of the same types of services that Congress intended the Advisers Act not to cover,⁷⁷ the rule we are adopting today is necessary to prevent the Act from reaching beyond Congress’ intent.⁷⁸ Today, fee-based brokerage programs are offered by most of the larger broker-dealers, and hold over $268 billion of customer assets.⁷⁹ Although this is still a relatively small number, it is estimated that assets in fee-based brokerage programs nationwide grew by 60.9 percent during 2003-2004.⁸⁰ Industry observers expect that fee-based programs will continue to grow as broker-dealers move away from transaction-based brokerage relationships that provide unsteady sources of revenue.⁸¹ Our failure to adopt this rule could eventually result in the extension of the Advisers Act to many brokerage relationships. Such a result would be inconsistent with the intent of the Advisers Act, which, as discussed earlier, was designed to fill a regulatory gap that had permitted firms and individuals to engage in  advisory activities without being regulated.⁸² Moreover, such a result would create substantial regulatory overlap, which the Act was drafted to avoid.⁸³ Far from being aradical departure from existing regulatory policy as suggested by some commenters, we believe the primary effect of rule 202(a)(11)-1 will be to maintain the historical ability of full-service broker-dealers to provide a wide variety of services, including advisory services, to brokerage customers, without requiring those broker-dealers to treat those clients as advisory clients.

The arguments of many commenters opposed to the reproposed rule go to a fundamental set of issues they have with the statutory broker-dealer exception in the Advisers Act. Notwithstanding the statutory exception, these commenters argue that broker-dealers providing any investment advice should be registered as investment advisers under the Advisers Act.⁸⁴ They assert that today, brokerage is incidental to the advisory services provided by full-service broker-dealers,⁸⁵ and point to brokerage advertising that emphasizes the quality of the advisory services provided by the broker-dealer as indicative of this change.⁸⁶ These comments fail to give weight to Congress’ decision to include the exception in the Advisers Act, and fail to recognize the historical role of advice in retail brokerage.

Broker-dealers have traditionally provided investment advice that is substantial in amount, variety, and importance to their customers.⁸⁷ Full-service broker-dealers have always sought to develop long-term relationships with their customers who often come to rely on them for expert investment advice.⁸⁸ And full-service retail broker-dealers have always relied on ancillary services, such as advisory services, to promote and sell their brokerage services.⁸⁹ The nature, amount and significance of the advice broker-dealers provided as part of traditional brokerage services was evident in 1940 when Congress expressly excepted broker-dealers from the Advisers Act to the extent they were providing advice in that context.⁹⁰ A rule or interpretation of the Advisers Act that would apply the Act to broker-dealers merely because their advice is important or valuable to customers, or who market themselves based on their advice, as commenters suggested, would extend the Act to most full-service broker-dealers – a result at conflict with the purpose of the statutory exception.

As a general matter, broker-dealers and investment advisers have, in the past, often provided similar advisory services and competed for similar clients seeking similar advice. Applying the Act to a broker-dealer whenever it provides investment advice would seem to necessarily apply the Act to every full-service brokerage account once advice is provided. Whatever policy advantages one might conclude could be gained by such a result, we believe it would be inconsistent with the conclusions reached by Congress when it passed the Act.⁹¹

Many commenters opposing the proposed rule focused their arguments on additional investor protections that regulation under the Advisers Act provides and argued that the rule would harm investors.⁹² There are differences between the regulatory frameworks provided by the Exchange Act and the Advisers Act, but Congress was well aware of these differences when it passed the Advisers Act and excepted broker-dealers .from the definition of investment adviser.⁹³ Broker-dealers are subject to oversight by the Commission as well as by one or more SROs under the Exchange Act. The Exchange Act, Commission rules, and those of the SROs provide substantial protections for broker-dealer customers.⁹⁴ Given that broker-dealers are today subject to a level of regulation far greater than in 1940, we believe that the rule is consistent with the statute’s intent to avoid largely duplicative regulation of firms already subject to Commission oversight.⁹⁵

Some commenters opposed to the rule asserted that the Commission, by providing the proposed exception in the rule, would relieve broker-dealers of the fiduciary responsibility to clients that the Advisers Act imposes.⁹⁶ Many of these commenters believed that, as a result, we would be denying fee-based brokerage customers an important investor protection. Investment advisers are fiduciaries by virtue of the nature of the position of trust and confidence they assume with their clients. They owe their clients “an affirmative duty of ‘utmost good faith, and full and fair’ disclosure of all material facts.”⁹⁷ In some cases, such as when broker-dealers assume positions of trust and confidence with their customers similar to those of advisers, broker-dealers have been held to similar standards.⁹⁸ As we noted in our Reproposing Release, however, broker-dealers often play roles substantially different from investment advisers and in such roles they should not be held to standards to which advisers are held.⁹⁹ Thus, we believe that broker-dealers and advisers should be held to similar standards depending not upon the statute under which they are registered, but upon the role they are playing.

We acknowledge that the lines between full-service broker-dealers and investment advisers continue to blur. But we do not believe requiring most or all full-service broker-dealers to treat most or all of their customer accounts as advisory accounts is an appropriate response to this blurring. Nor do we believe that Congress would have intended the Advisers Act to apply to all brokerage accounts receiving advice even when that advice is substantial. Congress did not mandate that the nature or amount of the advice rendered by broker-dealers remain static in order for broker-dealers to avail themselves of the statutory exception. Instead, Congress required only that such advice be performed “solely incidental to” a person’s “business as a broker or dealer” and not for “special compensation.” The exception does not foreclose – but, instead, accommodates – the foreseeable likelihood that the “business” of broker-dealers, including the rendition of advice, would evolve. Thus, the emergence of these new fee-based brokerage accounts does not mean that broker-dealers have ceased to offer the general package of brokerage services they have traditionally provided to their customers or to dispense advice as part of that package.¹⁰⁰

That is not to say, however, that broker-dealers can or should be “excluded from the purview of the Act merely because [they] are engaged in effecting market transactions.”¹⁰¹ The rule we are adopting today provides for an exception to the definition of investment adviser for broker-dealers only in circumstances in which the Commission believes that Congress did not intend to apply the Advisers Act, and clarifies certain circumstances in which we believe the Advisers Act is intended to apply.¹⁰²

B. Exception for Fee-Based Brokerage Accounts

Under rule 202(a)(11)-1(a), a broker-dealer providing investment advice to its brokerage customers is not required to treat those customers as advisory clients solely because of the form of the broker-dealer's compensation.¹⁰³ The rule is available to any broker-dealer registered under the Exchange Act that satisfies two conditions: (i) any investment advice it provides to an account must be solely incidental to the brokerage services provided to the account (and thus must be provided on a non-discretionary basis);¹⁰⁴ and (ii) advertisements for and contracts, agreements, applications and other forms governing its accounts must include a prominent statement that the account is a brokerage account and not an advisory account, and that the broker-dealer’s interests may not always be the same as the customer’s. Customers would be encouraged to ask questions about their rights and the broker-dealer’s obligations to them, including the extent of the broker-dealer’s obligations to disclose conflicts of interest and to act in their best interest. This would include information about sales incentives and how a broker-dealer is compensated. In addition, the broker-dealer must identify an appropriate person at the firm with whom the customer can discuss the differences between brokerage and advisory accounts.¹⁰⁵

A broker-dealer receiving special compensation for advisory services provided to customers must satisfy both of these requirements to avoid application of the Advisers Act. The failure of a broker-dealer to meet either of the requirements of the rule will result in loss of the exception, and, unless another Advisers Act exception is available, the broker-dealer will likely violate one or more provisions of the Act.¹⁰⁶

1. Solely Incidental To

Rule 202(a)(11)-1(a) includes the requirement, taken from the statutory broker-dealer exception, that advisory services provided in reliance on the rule must be solely incidental to the brokerage services provided.¹⁰⁷ The rule provides that the advice a broker-dealer provides to any account must be solely incidental to brokerage services provided by the broker-dealer to that account rather than to the overall operations of the broker-dealer. With that one difference, the Commission intends that this provision be interpreted consistently with the statutory provision, which is addressed in paragraph (b) of the rule and discussed in Section III.E of this Release.

As a result (and as proposed), the advice that a broker-dealer provides to fee-based brokerage accounts must be non-discretionary advice.¹⁰⁸ Commenters favoring the rule generally agreed that discretionary accounts that are charged an asset-based fee should be subject to the Advisers Act.¹⁰⁹ These accounts bear a strong resemblance to traditional advisory accounts, and it is highly likely that investors will perceive such accounts to be advisory accounts. Fee-based discretionary accounts were clearly the type of accounts that Congress understood would be covered by the Advisers Act when it passed the Act in 1940.

2. Customer Disclosure

As reproposed, rule 202(a)(11)-1(a) would have required that all advertisements for accounts excepted under the rule and all agreements, contracts, applications and other forms governing the operation of such accounts (“customer documents”) must contain a statement that the accounts are brokerage accounts and not advisory accounts. In addition, the reproposed rule would have required that the disclosure explain that the customer’s rights and the firm’s duties and obligations to the customer, including the scope of the firm’s fiduciary obligations, could differ. Finally, under the reproposed rule, broker dealers would have been required to identify an appropriate person at the firm with whom the customer could discuss the differences.¹¹⁰

As reproposed, the disclosure was designed to put investors selecting a fee-based brokerage account on notice that their account is a brokerage account, with all the legal attributes of a brokerage account, rather than an advisory account. Only a few commenters were satisfied with the disclosure.¹¹¹ Some commenters thought it should be “strengthened” by focusing on what these commenters considered a lack of investor protections associated with a broker-dealer relationship.¹¹² Others expressed a great deal of skepticism about the ability of any disclosure to convey to investors the differences between broker-dealers’ and advisers’ legal obligations to clients in a reasonably succinct way because of the complexity of the issues.¹¹³

Some commenters expressed concern about the usefulness of providing a contact person within the broker-dealer to aid investors with questions about the differences between investment advisers and broker-dealers.¹¹⁴ They thought it would be very unlikely that such a person would accurately describe the differences in legal rights and obligations.¹¹⁵ Some of these commenters urged us to direct investors to a neutral source of information, such as the Commission’s web site, for the information.¹¹⁶

The federal securities laws place disclosure obligations on persons registered with us because they are in the best position to know what is and is not material to their circumstances. Like all registrants, broker-dealers are responsible for the accuracy and veracity of their statements. The legal obligations a broker-dealer owes to a customer vary from firm to firm and account to account depending upon such matters as the terms of the brokerage agreement, the state in which the broker-dealer is located, the SRO of which it is a member, the nature of the relationship between the broker-dealer and its customer, and the product the broker-dealer is selling.¹¹⁷ Thus, we believe broker-dealers are in the best position to make the disclosures most appropriate to their customers.

Recently, we convened focus groups of investors to gauge the impact of this rule. Our investor focus groups found that the proposed disclosure statement alerted them to the fact that differences existed between brokerage accounts and advisory accounts,¹¹⁸although the disclosure did not communicate what those distinctions might mean. Focus group participants viewed the terms such as “duties,” “rights” and “obligations” as important terms that “would prompt [them] to ask questions.”¹¹⁹ The ability to contact a person at the broker-dealer was considered to be a positive factor.¹²⁰ Focus group investors were, however, confused by the use of legal terms in the disclosure, including “fiduciary,” “rights” and “obligations.” They suggested using a “plain-English” approach that would avoid terms such as “fiduciary” and “specify the actual differences between brokerage and advisory accounts.”¹²¹

We believe it is appropriate to inform broker-dealer customers of the nature of the account they are opening.¹²² At the same time, we are concerned about mandating detailed disclosure on complex legal issues, the outcome of which may vary depending upon the nature of the particular customer relationship. Our investor focus groups, however, indicated the need for some language that would help identify the actual differences between brokerage and advisory accounts. Thus, we believe it is most appropriate to emphasize that an investor’s account is a brokerage account and not an advisory account, to provide some information on the nature of the conflicts inherent in the broker-dealer relationship, and to encourage investors to ask questions about their rights and the broker-dealer’s obligations to them. We are also mindful of the need for plain-English disclosure, and accordingly, we are making modifications to the disclosure language to help achieve that goal. As adopted, rule 202(a)(11)-1(a) now requires all customer documents to contain a clear, prominent statement¹²³ as follows:

“Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons’ compensation, may vary by product and over time.”¹²⁴

Finally, broker-dealers must identify an appropriate person at the firm with whom the customer can discuss the differences between brokerage and advisory accounts.¹²⁵

We are aware that this approach to disclosure of the nature of a brokerage account and the differences between such an account and an advisory account addresses many, but not all, concerns about investor confusion. As a consequence, as indicated in Section V of this Release, the Chairman has directed our staff to report to us regarding other options for addressing this confusion, including a study to consider, among other things, the need for additional investor education efforts and limits on broker-dealer marketing.

C. Discount Brokerage Programs

Rule 202(a)(11)-1(a)(2), which we are adopting as proposed, provides that a broker-dealer will not be considered to have received special compensation solely because the broker-dealer charges one customer a commission, mark-up, mark-down or similar fee for brokerage services that is greater than or less than one it charges another customer.¹²⁶ This provision is intended to keep a full-service broker-dealer from being subject to the Act solely because it also offers electronic trading or some other form of discount brokerage. Conversely, a discount broker-dealer would not be subject to the Act solely because it introduces a full-service brokerage program.

The rule supersedes staff interpretations under which a full-service broker-dealer would be subject to the Act with respect to accounts for which it provides advice incidental to its brokerage business merely because it offers electronic trading or other forms of discount brokerage.¹²⁷ These staff interpretations were not compelled by the Act and have led to the odd result that a full-service broker-dealer cannot offer discount brokerage without treating its full-service brokerage accounts as advisory accounts even though the services offered to those full-service accounts remained unchanged. Moreover, the staff interpretations create disincentives for full-service broker-dealers to offer electronic or other types of discount brokerage, and may therefore limit customers’ choices of the types of brokerage service they want from a broker-dealer, and may reduce competition in discount brokerage.¹²⁸ The new rule makes a broker-dealer's eligibility for the broker-dealer exception with respect to an account turn on the characteristics of that account and not other accounts. Commenters discussing this aspect of the proposed rule generally supported it.¹²⁹

D. Scope of Exception

Rule 202(a)(11)-1(c) provides that a broker-dealer that is registered under the Exchange Act and registered under the Advisers Act would be 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.¹³⁰ We received few comments regarding this provision of the rule, and we are adopting it as proposed.¹³¹ The provision codifies our earlier interpretation of the Act that permits a broker-dealer registered under the Advisers Act to distinguish its brokerage customers from its advisory clients.¹³²

E. Solely Incidental To

As discussed above, the exceptions from the Advisers Act provided by section 202(a)(11)(C) and new rule 202(a)(11)-1 are available to broker-dealers only with respect to advice provided that is solely incidental to the broker-dealer’s business (or, in the case of the rule, to the brokerage services provided to the account). In the Reproposing Release, we set forth our views on when advice is solely incidental to brokerage services and solicited comment on our interpretation of section 202(a)(11)(C). We also requested comment on our preliminary conclusions that certain advisory services did not appear to be solely incidental to brokerage services.

In general, investment advice is “solely incidental to” the conduct of a broker-dealer’s business within the meaning of section 202(a)(11)(C) and to “brokerage services” provided to accounts under the rule when the advisory services rendered are in connection with and reasonably related to the brokerage services provided. This is consistent with the language Congress chose and the legislative history of the Advisers Act, including contemporaneous industry practice, which indicates Congress’ intent to exclude broker-dealers providing advice as part of traditional brokerage services.¹³³ It is also consistent with the Commission’s contemporaneous construction of the Advisers Act as excepting broker-dealers whose investment advice is given “solely as an incident of their regular business.”¹³⁴

Several commenters, some of whom examined the statutory language¹³⁵ and legislative history themselves, disagreed with us. They urged us to adopt a very narrow view of the meaning of “solely incidental to,” arguing that it should include only advice that is provided on an “isolated,” “occasional,” “unpredictable”or “limited” basis,¹³⁶advice arising out of specific transactions,¹³⁷ or advice that that is not marketed by a broker-dealer.¹³⁸ We disagree with commenters for several reasons.

First, the view that only minor, insignificant, or infrequent advice is excepted by section 202(a)(11)(C) misapprehends the historical background, including the legislative history of the Act.¹³⁹ It fails to adequately appreciate the fact that the advice broker-dealers gave as part of their traditional brokerage services in 1940 was often substantial in amount and importance to the customer.¹⁴⁰ This has remained true throughout the following decades.¹⁴¹ Indeed, the importance of the broker-dealer’s role as advice-giver in connection with brokerage transactions has shaped how we and the self-regulatory organizations have regulated and continue to regulate broker-dealers.¹⁴²

Second, this narrow reading of section 202(a)(11)(C) urged by commenters would lead to brokers being required to treat many, if not most, full service brokerage accounts as advisory accounts, regardless of the nature of the compensation provided to the broker.

Thus, it would extend the Advisers Act well beyond what we believe Congress intended when it enacted the broker-dealer exception.¹⁴³

Finally, this narrow view would lead to results we believe even these commenters may not have intended. If a broker could give advice only infrequently (unless it registered under the Advisers Act), customers could not obtain advice in connection with each transaction they propose to make, even if that advice is simply seeking assurances of the wisdom of the proposed transaction. If a broker were permitted to give advice only in connection with a transaction, the broker (unless it registered under the Act) would be unable to advise clients to stay out of the market or to refrain from a particular transaction, or to provide generalized market reports to their clients. Yet brokers have long provided such advice as part of their traditional brokerage services, and continue to do so today. We do not believe that Congress in 1940, fully informed of then-extant brokerage practices, would have passed an exception from the Advisers Act that had such limited utility to broker-dealers.

In a new section (b) of the rule, we are identifying three general circumstances under which we believe the provision of advisory services by a broker-dealer would not be solely incidental to brokerage. In addition, we are re-affirming our long-held view that advisory services provided by certain brokers in connection with wrap fee programs are not solely incidental to brokerage. As the rule makes clear, these are, of course, not an exclusive list of advisory services that are not solely incidental to brokerage and thus may lead to the loss of the broker-dealer exception.

1. Separate Contract or Fee

Our rule contains a provision that a broker-dealer that separately contracts with a customer for investment advisory services (including financial planning services) cannot be considered to be providing advice that is solely incidental to its brokerage.¹⁴⁴ A separate contract specifically providing for the provision of investment advisory services reflects a recognition that the advisory services are provided independent of brokerage services and, therefore, cannot be considered solely incidental to the brokerage services. Some commenters agreed that separate contracts provide a sensible approach to dealing with this issue.¹⁴⁵

Similarly, advisory services are not solely incidental to brokerage services when those services are rendered for a separate fee. Charging a separate fee reflects the recognition that such services are provided independently of brokerage services and, therefore, cannot be considered to be solely incidental to brokerage services. Many commenters agreed with this approach.¹⁴⁶ We understand that many broker-dealers already use the payment of a separate fee as a bright line test to distinguish their brokerage activities from their advisory activities.¹⁴⁷

2. Financial Planning

Under rule 202(a)(11)-1(b)(2), a broker-dealer would not be providing advice solely incidental to brokerage if it provides advice as part of a financial plan or in connection with providing planning services and: (i) holds itself out generally to the public as a financial planner or as providing financial planning services;¹⁴⁸ or (ii) delivers to its customer a financial plan; or (iii) represents to the customer that the advice is provided as part of a financial plan or financial planning services. As a result, when the advice described above is provided, a broker-dealer that advertises (or otherwise generally lets it be known that it is available to provide) financial planning services must register under the Act (unless an exemption from registration is available). Further, a broker-dealer that provides such advice and delivers a financial plan to a customer or represents to a customer that its advice is provided as part of a financial plan or in connection with financial planning services must also register under the Act (unless another exemption from registration is available) and treat that customer as an advisory client.

Financial planning services typically involve assisting clients in identifying long-term economic goals, analyzing their current financial situation, and preparing a comprehensive financial program to achieve those goals. A financial plan generally seeks to address a wide spectrum of a client’s long-term financial needs, including insurance, savings, tax and estate planning, and investments, taking into consideration the client’s goals and situation, including anticipated retirement or other employee benefits.¹⁴⁹ Typically, what distinguishes financial planning from other types of advisory services is the breadth and scope of the advisory services provided.

Although most financial planners are registered under the Advisers Act or similar state statutes, financial planners today belong to a distinct profession, and financial planning is a separate discipline from, for example, portfolio management.¹⁵⁰ This development has occurred only relatively recently, over approximately the last twenty-five years – well after the enactment of the Investment Advisers Act in 1940.¹⁵¹

In the Reproposing Release, we expressed the view that the advisory services provided by financial planners and the context in which they are provided may extend beyond what Congress, in 1940, reasonably could have understood broker-dealers to have provided as an advisory service ancillary to their brokerage business.¹⁵² Moreover, we expressed concern that some broker-dealers may have promoted “financial planning” as a way of acquiring the confidence of investors and then offered their brokerage services without providing any meaningful financial planning services. We asked for comment on whether we should take an interpretive position that advice provided in connection with financial planning was not solely incidental to brokerage.¹⁵³

We received many comment letters from firms and individuals with strongly held views on this topic. Advisers, financial planners, and investor groups asserted that financial planning was not solely incidental to brokerage.¹⁵⁴ Broker-dealers, on the other hand, argued that financial planning was an integral part of full-service brokerage, and that our proposed interpretation may interfere with broker-dealers’ suitability obligations.¹⁵⁵ Some commenters were concerned that if the applicability of the Act turned on whether a broker-dealer held itself out as being a financial planner, broker-dealers would simply use a slightly different title, such as “financial consultant,” to create the same impression in the minds of investors.¹⁵⁶

We do not believe that financial planning, as it is understood today, necessarily follows as a consequence of rendering brokerage services. Instead, it is a relatively new service that many brokers provide in a manner essentially independent of their brokerage services. That being said, and as we acknowledged in the Reproposing Release, elements of financial planning have been, are, and should be a part of every broker-dealer’s considerations as to the suitability of their recommendations. We have concluded that it would be unwise for us to attempt to distinguish when a suitability analysis ends and financial planning begins, and we do not want to interfere in any way with a broker-dealer’s fulfillment of its suitability obligations.

We have determined instead to rely primarily on how a broker-dealer holds itself out to the public and its customers in distinguishing the advice provided in connection with financial planning from other types of investment advice, such as transaction-specific advice, which may be solely incidental to brokerage.¹⁵⁷ Our experience generally informs us that investors understand financial plans and financial planning to mean something different from brokerage. Our investor focus groups showed that investors were confused about the differences among financial service providers generally, but in many cases understood financial planning to be a separate category, and assumed financial planners held responsibilities relating to the long-term needs of their clients.¹⁵⁸ Moreover, our approach would provide broker-dealers the certainty they need to determine when their advisory activities will trigger obligations under the Advisers Act because they can control how they hold themselves out to the public and their customers.

Under the rule, a broker-dealer would be subject to the Advisers Act if it portrays itself to the public as a financial planner or as providing financial planning services, whether it uses those particular terms or not. And it must treat as advisory clients all those customers to whom it delivers a financial plan, regardless of what it chooses to call the plan. While we have recognized there are some common elements in a financial plan and a broker-dealer’s advice based on its understanding of a customer’s needs and objectives, which is incumbent in its suitability analysis, we do no not consider this broker-dealer advice alone as constituting a financial plan.

The broker-dealer must also treat as advisory clients those customers to whom it represents that its advice is part of a financial plan even if it uses some other term to describe the plan.¹⁵⁹ Whether a particular document is, under the rule, a financial plan will turn on whether the document or representation bears the characteristics of a financial plan. Whether a communication represents that the services provided are financial planning services will depend on how a reasonable investor would understand the services described in the communication.¹⁶⁰

3. Holding Out

We have decided not to include in rule 202(a)(11)-1 any other limitations on how a broker-dealer may hold itself out or titles it may employ without complying with the Advisers Act. Many commenters argued that we should prohibit broker-dealers from calling themselves financial advisors, financial consultants or other similar names. These commenters asserted such titles are inconsistent with the broker-dealer exception for advice that is solely incidental to brokerage.¹⁶¹ Other commenters, however, argued that, in many instances, such titles are fully consistent with the services provided to brokerage customers, whether fee-based or commission-based, and should not be proscribed.¹⁶²

The statutory broker-dealer exception is a recognition by Congress that a broker-dealer’s regular activities include offering advice that could bring the broker-dealer within the definition of investment adviser, but which should nonetheless not be covered by the Act. The terms “financial advisor” and “financial consultant,” for example, are descriptive of such services provided by broker-dealers. As part of their ongoing business, full service broker-dealers consult with or advise customers as to their finances. Indeed, terms such as “financial advisor” and “financial consultant” are among the many generic terms that describe what various persons in the financial services industry do, including banks, trust companies, insurance companies, and commodity professionals. Moreover, we are concerned that any list of proscribed names we develop could lead to the development of new ones with similar connotations.

We believe the better approach, which we are adopting today, is to require broker-dealers to inform clients clearly that they are entering into a brokerage, and not an advisory, relationship. The customer disclosure requirements, which we discuss above, must be included in all customer documents for fee-based brokerage accounts. We encourage brokers to consider making similar disclosure in other communications.¹⁶³

4. Discretionary Asset Management

Under the rule we adopt today, discretionary investment advice is not “solely incidental to” brokerage services within the meaning of the rule (or to the business of a broker-dealer within the meaning of section 202(a)(11)(C)) and, accordingly, brokers and dealers are not excepted from the Act for any accounts over which they exercise investment discretion as that term is defined in section 3(a)(35) of the Exchange Act¹⁶⁴(except that investment discretion granted by a customer on a temporary or limited basis is excluded). The rule terminates the existing staff approach, under which a discretionary account is subject to the Act only if the broker-dealer has enough other discretionary accounts to trigger the Act.¹⁶⁵ Under the new rule, the exception provided by section 202(a)(11)(C) is unavailable for any account over which a broker-dealer exercises investment discretion, regardless of the form of compensation and without regard to how the broker-dealer handles other accounts.¹⁶⁶

We believe that a broker-dealer’s authority to effect a trade without first consulting a client is qualitatively distinct from simply providing advice as part of a package of brokerage services. When the broker-dealer has discretion, it is not only the source of advice, it is also the person with the authority to make investment decisions relating to the purchase or sale of securities on behalf of the broker-dealer’s clients. This quintessentially supervisory or managerial character warrants the protection of the Advisers Act because of the “special trust and confidence inherent” in such relationships.¹⁶⁷ Most commenters addressing the issue, including those representing investors,¹⁶⁸ advisers,¹⁶⁹ broker-dealers,¹⁷⁰ and others,¹⁷¹ generally agreed with us.

One commenter who disagreed with this provision disputed our interpretation of the Act. This commenter argued that Congress must have been aware that broker-dealers exercised discretionary authority over commission-based accounts and, by not expressly stating that brokers offering such accounts were subject to the Act, Congress indicated its intent to except such broker-dealers from the Act.¹⁷² We disagree. The Advisers Act does not address directly whether a broker-dealer exercising investment discretion over a commission-based account must comply with the Act. The Act applies unless the advisory services are “solely incidental to” the broker-dealer’s business and no special compensation is received. Whether the exercise of investment discretion meets the requirements of the exception depends on the sort of analysis and judgment that we have made in this rulemaking.

This commenter also suggested that our failure to assert the applicability of the Act to commission-based discretionary accounts in the past, implicitly supports the view that the Act should not apply to such accounts.¹⁷³ As we explained in the Reproposing Release, however, we have previously expressed concern that brokerage relationships “which include discretionary authority to act on a client’s behalf have many of the characteristics of the relationships to which the protections of the Advisers Act are important.”¹⁷⁴ Although we determined not to take action in the past on whether discretionary accounts should be treated as advisory accounts, we explained that our staff would continue to examine the applicability of the federal securities laws to discretionary accounts. Our determination that the Act applies to all accounts over which broker-dealers exercise investment discretion (with certain exceptions) instead of only to the discretionary accounts of those broker-dealers whose accounts are almost exclusively discretionary (the staff’s position since 1978) follows that examination and is based on the reasons stated above and in the Reproposing Release. We are not persuaded by certain commenters’ challenge to our determination relating to discretionary commission-based accounts. Indeed, in criticizing our determination that the exercise of investment discretion cannot be “solely incidental to” a broker-dealer’s business, one commenter acknowledges that (apart from the circumstances the commenter identifies) the exercise of investment discretion “would typically be viewed by customers as investment supervisory services where the broker-dealer or investment adviser makes decisions constrained only by investment guidelines or a description of the investment strategy.”¹⁷⁵We remain unable to conclude that in 1940 Congress would have understood investment discretion to be part of the traditional package of services broker-dealers offered for commissions.¹⁷⁶ We are aware of nothing in the legislative history of section 202(a)(11)(C) (or of the Act as a whole) or in the brokerage practices in 1940 that would preclude our interpretation of that section as being unavailable for all accounts over which broker-dealers exercise investment discretion.¹⁷⁷ Given the inherently managerial nature of investment discretion, we see no reason why Congress, as a general matter, would have intended to exclude such services from the reach of the Advisers Act.

Several commenters, however, persuade us that defining “discretionary authority” by reference to section 3(a)(35) of the Exchange Act, would as a practical matter preclude many forms of limited discretion commonly exercised by broker-dealers assisting customers with otherwise non-discretionary brokerage accounts.¹⁷⁸ We believe that such an effect would not benefit brokerage customers, nor would it be necessary to achieve the purpose of the rule. Therefore, the final rule permits broker-dealers to exercise investment discretion on a temporary or limited basis without becoming ineligible for the exception under the rule.¹⁷⁹ In such cases, the customer is granting discretion primarily for execution purposes and is not seeking to obtain discretionary supervisory services. Such discretion must be limited to a transaction or series of transactions and not extend to setting investment objectives or policies for the customer. For example, we would view a broker-dealer’s discretion to be temporary or limited within the meaning of rule 202(a)(11)-1(d) when the broker-dealer is given discretion:

• As to the price at which or the time to execute an order given by a customer for the purchase or sale of a definite amount or quantity of a specified security;
• On an isolated or infrequent basis, to purchase or sell a security or type of security when a customer is unavailable for a limited period of time not to exceed a few months;¹⁸⁰
• As to cash management, such as to exchange a position in a money market fund for another money market fund or cash equivalent;
• To purchase or sell securities to satisfy margin requirements;
• To sell specific bonds and purchase similar bonds in order to permit a customer to take a tax loss on the original position;
• To purchase a bond with a specified credit rating and maturity; and
• To purchase or sell a security or type of security limited by specific parameters established by the customer.¹⁸¹

5. Wrap Fee Sponsorship

Broker-dealers often serve as sponsors of wrap fee programs, under which broker-dealers effect securities transactions for one or more portfolio managers, which may be independent investment advisers. The sponsoring broker-dealer may provide wrap fee program clients with asset allocation models or with advice about selecting one or more of the portfolio managers in the program. The portfolio managers typically have discretionary authority over the client’s assets. Traditionally, we have not viewed the sponsor’s asset allocation or portfolio manager selection advice as incidental to the brokerage transactions initiated by the portfolio manager and executed by the sponsor.¹⁸²In our Reproposing Release, however, we asked whether such broker-dealers may have available the exception provided by rule 202(a)(11)-1 if, among other things, the portfolio manager selection and asset allocation services could be viewed as solely incidental to the sponsor’s business of brokerage.¹⁸³ Commenters urged the Commission to reaffirm its interpretation that portfolio manager selection and asset allocation services involved in wrap fee programs are advisory services that are not solely incidental to brokerage services,¹⁸⁴ and we do so here today.

IV. EFFECTIVE AND COMPLIANCE DATES

Rule 202(a)(11)-1 is effective April 15, 2005, except that paragraph (a)(1)(ii) of the rule is effective May 23, 2005. Consistent with the Administrative Procedures Act, the effective date of rule 202(a)(11)-1 is less than 30 days after publication because the rule recognizes an exemption, relieves a restriction, and contains interpretative rules.¹⁸⁵In addition, the Commission for good cause finds that an effective date later than April 15, 2005 is impracticable, unnecessary and contrary to the public interest because, among other things, temporary rule 202(a)(11)T will expire on that date.¹⁸⁶Beginning on April 15, 2005, broker-dealers may rely on rule 202(a)(11)-1(a)(2) when they offer discount brokerage accounts excluded under the rule. Also beginning on April 15, 2005, broker-dealers may rely on rule 202(a)(11)-1(a)(1) to provide non-discretionary investment advice in conjunction with fee-based brokerage accounts excluded under the rule. Broker-dealers relying on rule 202(a)(11)-1(a)(1) must comply with the disclosure requirements of paragraph (a)(1)(ii) by July 22, 2005. All advertisements for, and contracts, agreements, applications and other forms governing accounts opened after July 22, 2005 in reliance on rule 202(a)(11)-1(a)(1) must include the disclosure required by paragraph (a)(1)(ii). Broker-dealers relying on rule 202(a)(11)-1(a)(1) with respect to fee-based brokerage accounts opened prior to July 22, 2005 are not required to amend existing contracts and agreements governing those accounts.¹⁸⁷

With respect to paragraph (b)(3) of rule 202(a)(11)-1, which provides that exercising investment discretion is not “solely incidental to” brokerage services within the meaning of section 202(a)(11)(C) of the Advisers Act, broker-dealers must treat commission-based discretionary accounts as advisory accounts no later than October 24, 2005. With respect to paragraphs (b)(1) and (b)(2) of rule 202(a)(11)-1, broker-dealers must treat as advisory accounts those accounts to which the broker-dealer provides advice in the circumstances described in paragraphs (b)(1) and (b)(2) no later than October 24, 2005.

V. FURTHER EXAMINATION OF ISSUES

As we noted at the beginning of this release, this rulemaking has raised a number of important issues, implicating policy concerns well beyond the scope of this rulemaking. Although we have concluded that this rulemaking is not the appropriate mechanism for resolving these concerns, we are committed to pursuing the most effective solutions to these vital issues. Accordingly, the Chairman, after consulting with, and considering the views of, the entire Commission, has directed the Commission staff to report within 90 days on ways in which these issues could be addressed. The staff is to provide a detailed description or outline of any rulemaking action that the staff would be prepared to recommend that the Commission undertake in the near term, or to recommend that the Commission ask the NASD or other SROs to undertake in the near term. The staff is also to report on options and recommendations for a study to compare the levels of protection afforded retail customers of financial service providers under the Securities Exchange Act and the Investment Advisers Act, and to recommend ways to address any investor protection concerns arising from material differences between the two regulatory regimes. The scope of the study would include, but not necessarily be limited to, questions such as:

• Should the Commission seek legislation that would integrate the existing regulatory schemes applicable to broker-dealers and investment advisers that provide services to retail clients?
• Should sales practice standards and advertising rules applicable to advice
  provided by broker-dealers be enhanced?
  Should broker-dealers who provide investment advice but who are excepted from the Investment Advisers Act nonetheless be subject to the fiduciary obligations imposed by that Act on investment advisers?
• Should obligations under the Investment Advisers Act applicable to dually-registered broker-dealers be modified or streamlined in order to eliminate regulatory overlap and reduce regulatory burdens?
• Are there areas in which the Commission, alone or in concert with other agencies, can engage in investor education efforts to assist investors to better understand the duties and obligations of their financial service providers?

The staff is to provide options and recommendations concerning:

• The scope of the study;
• Appropriate persons, both within and outside of the Commission, to be involved in the study; and
• Timeframes for providing deliverables to the Commission, and for expected action by the Commission and its staff.

VI. COST BENEFIT ANALYSIS

The Commission is sensitive to the costs and benefits of its rules. In the Reproposing Release, we identified possible costs and benefits of the requirements that now comprise rule 202(a)(11)-1, and requested comment on our analysis.¹⁸⁸ The analysis and the comments we received are discussed below.

A. Fee-based and Discount Brokerage Accounts

Under rule 202(a)(11)-1(a)(1), broker-dealers will not be deemed to be investment advisers with respect to accounts for which they receive asset-based fees, fixed fees, or similar non-commission compensation, provided that their investment advice is solely incidental to the brokerage services provided to the account, and they make certain disclosures in their advertising and agreements for such accounts. In addition, rule 202(a)(11)-1(a)(2) clarifies that broker-dealers are not subject to the Advisers Act solely because, in addition to full-service brokerage services, they also offer discount brokerage services, including execution-only brokerage, for reduced commission rates.

1. Benefits

a. Avoidance of Compliance Costs

The provisions of rule 202(a)(11)-1(a) are designed to permit broker-dealers to offer certain fee-based and discount brokerage programs without triggering regulation under the Advisers Act. Broker-dealers relying on rule 202(a)(11)-1(a) to continue offering these fee-based and discount brokerage programs will benefit in the form of saved costs they would otherwise expend in connection with Advisers Act compliance.

Broker-dealers, even those already dually-registered as investment advisers, will benefit in the form of costs saved by not having to convert their fee-based and full-service brokerage accounts into advisory accounts. For example, these accounts will not be subject to brochure delivery or other disclosure requirements under the Advisers Act, or to the principal trading restrictions under the Act. Other broker-dealers relying on rule 202(a)(11)-1(a) will not be subject to the Advisers Act at all. For these broker-dealers whose fee-based or discount brokerage programs would otherwise require adviser registration, we believe the rule’s benefits will be significant in terms of avoiding an increased regulatory burden incurred as a result of changing the way they charge for their brokerage services. For example, if not excepted under rule 202(a)(11)-1(a), these broker-dealers would be required to prepare, submit and update adviser registration statements,¹⁸⁹ and to prepare and distribute client disclosures under Part II of Form ADV.¹⁹⁰ These broker-dealers would also be required to modify their compliance programs to address the Advisers Act and its requirements,¹⁹¹ and to establish codes of ethics required under the Act’s rules.¹⁹²

Because the costs of satisfying these and other requirements under the Advisers Act vary from firm to firm depending on its size and complexity, the benefits to brokers in the form of cost savings are difficult to quantify. Broker-dealer firms did not comment directly on the extent of these benefits in connection with fee-based or full-service accounts. However, we note that several broker-dealers commented on the costs of applying the Advisers Act in other contexts under our Reproposal, and most of these broker-dealers characterized the costs as significant.¹⁹³ We also note that the popularity of fee-based accounts is growing rapidly, so the extent of these benefits will grow accordingly. One broker-dealer commented that its holdings of fee-based accounts have tripled since 1999, and one consulting firm estimates that assets in fee-based brokerage programs nationwide grew by 60.9 percent during 2003 and 2004.¹⁹⁴

Securities markets will also benefit because the rule would preserve the ability of broker-dealers to engage in principal transactions with these fee-based brokerage customers.¹⁹⁵ Principal transactions are an important source of liquidity in some market sectors.¹⁹⁶ While one commenter pointed out that the current effect on liquidity should be minor because fee-based accounts make up a small percentage of the overall securities markets,¹⁹⁷ continuing growth in fee-based accounts could, absent rule 202(a)(11)-1, eventually extend principal trading restrictions to many brokerage accounts, thereby expanding the effects.¹⁹⁸ Another commenter suggested the Commission could moderate the effects of principal transaction restrictions by creating exceptions as necessary to maintain market efficiency.¹⁹⁹

b. Investor Benefits

By eliminating regulatory disincentives to re-pricing of brokerage services, rule 202(a)(11)-1(a) is expected to yield benefits for individual investors as a result of such re-pricing. Under the fee-based programs discussed above, a broker-dealer’s compensation does not depend on the number of transactions or the size of mark-ups or mark-downs charged, thus reducing incentives for the broker-dealer to churn accounts, recommend unsuitable securities, or engage in high-pressure sales tactics. As such, these programs may better align the interests of broker-dealers and their customers. The rule will also benefit customers by enabling them to choose from among these new programs and other traditional brokerage services to select the program best for them.²⁰⁰ While it is difficult to quantify the value of these benefits, we believe they are substantial. One broker-dealer estimates that, during the last five years, its fee-based account customers would have paid nearly $2 billion more using commission-based brokerage instead of their fee-based accounts.²⁰¹

2. Costs

While we believe the benefits of rule 202(a)(11)-1(a) are substantial, we believe the incremental costs associated with this provision of the rule are small. The only incremental cost associated with this provision of the rule will be the cost of making the disclosure required by the rule. Broker-dealers relying on the rule’s exception will be required to add a prominent disclosure statement to customer communications for accounts covered by the rule’s exception. The disclosure consists of a brief plain-English statement that indicates the account is a brokerage account, not an advisory account, and encourages the customer to ask questions and gain an understanding of his or her rights and the broker-dealer’s obligations, including the broker-dealer’s obligations to disclose conflicts of interest. The disclosure also discusses compensation issues, including the fact that the firm’s profits and salespersons’ compensation may depend on what the customer buys and may include compensation from other persons. The disclosure statement must also direct the customers to a contact person who can discuss with the customers the differences between brokerage and advisory accounts.

The cost of disclosure would be incurred only by those broker-dealers electing to rely on the rule, and as we discuss in our Paperwork Reduction Act analysis, we believe the cost of the disclosure is insignificant.²⁰² In addition, we estimate that the total industry-wide costs for contact persons at broker-dealers to respond to customer questions about their fee-based accounts will be approximately $3.2 million annually.²⁰³

One broker-dealer expressed concern about the cost of litigation that might arise challenging the adequacy of contact persons’ discussion of the differences between accounts, particularly in large firms where it may be necessary to make a number of contact persons available.²⁰⁴ However, broker-dealers have typically encountered similar risks in connection with their operations, and can address these risks through usual measures such as written procedures and personnel training, followed up as necessary with compliance oversight. We recognize that large broker-dealers will incur certain costs to implement these controls, but we do not believe they are burdensome, and commenters generally did not suggest they would be. One large broker-dealer commented that disclosure of the differences between fee-based accounts and advisory accounts is consistent with its existing practice, and supported the contact person requirement as preferable to formulating long and detailed written explanations of the differences between accounts.²⁰⁵

Because it would only operate to except from the Advisers Act certain brokerage accounts, rule 202(a)(11)-1(a) will not increase the regulatory burden borne by investment advisers. Some commenters argued the proposed exception would grant broker-dealers – who give investment advice without complying with the Advisers Act – a competitive advantage over investment advisers subject to the Advisers Act, thereby indirectly imposing costs on investment advisers.²⁰⁶ However, because the rule is restricted to investment advice which is solely incidental to brokerage services (and broker-dealers have long been subject to this solely incidental standard under section 202(a)(11)(C) of the Advisers Act), the rule does not establish new opportunities for broker-dealers to compete with advisers on the nature of their investment advice.²⁰⁷Also, in providing this advice, broker-dealers would remain subject to their own costs of regulation under the Exchange Act.²⁰⁸ One broker-dealer characterized these costs of regulation under the Exchange Act as being so significant that the competitive advantage instead lies with advisers regulated under the Advisers Act.²⁰⁹

Some commenters additionally asserted rule 202(a)(11)-1(a) will impose costs on investors, who would not receive the same treatment afforded a client of an investment adviser under the Advisers Act.²¹⁰ While these commenters argued that the fiduciary duties of an adviser outweigh the duties of a broker-dealer, their comments do not fully recognize the extent of broker-dealers’ obligations.²¹¹ In addition, rule 202(a)(11)-1(a)’s disclosure requirements will put investors on notice that there are differences between fee-based brokerage accounts and advisory accounts, and provide them with a contact person who can answer any questions they may have about the investor protections they will receive in their particular circumstances.

Some commenters asserted that the proposed disclosure statement would be insufficient to dispel customer confusion about the differences between brokerage accounts and advisory accounts, citing surveys in which the majority of respondents believed that financial advice was a significant component of brokerage services and that broker-dealers are obligated to act in investors’ best interests.²¹² Most respondents in these surveys also indicated their choice between a stockbroker and an investment adviser would be affected by the level of investor protection available from each.²¹³ As discussed above, our participants in our investor focus groups found that the disclosure statement, as reproposed, alerted them to the fact that differences existed between brokerage accounts and advisory accounts. While the disclosures did not communicate what those distinctions might mean, focus group participants viewed terms such as “rights” and “obligations” as important terms that would prompt them to ask questions, and they viewed the ability to contact a person at the broker-dealer as a positive factor.²¹⁴

In addition, other commenters argued that it would be unworkable to expand the disclosures to give additional detail about potential differences, since the duties of a broker-dealer are determined by, in large part, a customer’s agreement with the broker-dealer and the circumstances of the relationship.²¹⁵

One commenter urging withdrawal of the rule also encouraged us to assess the costs to investors that could arise if broker-dealers engage in abusive sales practices in fee-based accounts.²¹⁶ While fee-based brokerage accounts are not suitable for all broker-dealer customers, the NASD has issued a notice to members identifying potential problems and indicating that NASD members should have supervisory procedures in place to assess and monitor them.²¹⁷ Given that there are no forms of broker-dealer compensation that are immune to potential abuse, it is necessary to eliminate the costs of such abuse directly through preventative measures and remedial action against abusive market participants, rather than indirectly by banning a particular form of compensation. Importantly, the direct approach allows investors whose accounts are appropriate for fee-based treatment to obtain the benefits of it.

B. Advice That Is Not Solely Incidental to Brokerage

Rule 202(a)(11)-(b) identifies three circumstances in which the provision of advisory services by a broker-dealer is not solely incidental to brokerage, making the broker-dealer ineligible for the exception from the definition of an investment adviser in section 202(a)(11)(C) of the Advisers Act, and making such advisory services ineligible for the fee-based account exception under rule 202(a)(11)-1(a). First, a broker-dealer that charges a separate fee or separately contracts with a customer for investment advisory services may not rely on the exception in the statute or the rule. Second, a broker-dealer that holds itself out generally to the public as a financial planner or as providing financial planning services must generally register as an investment adviser under the Act, and a broker-dealer that delivers a financial plan to a customer or represents to a customer that its advice is part of a financial plan or in connection with financial planning services must also generally register under the Act and treat that customer as an advisory client. Third, a broker-dealer may not rely on the exceptions for any accounts over which it exercises investment discretion.

1. Separate Advisory Services

a. Benefits

Under rule 202(a)(11)-1(b), brokers that enter into separate contracts for, or obtain separate compensation to provide, advisory services to an account will be subject to the Advisers Act with respect to those accounts. This provision will benefit broker-dealers by creating greater transparency with regard to whether particular customer relationships are subject to the Advisers Act. As discussed above, a separate contract or fee reflects the recognition that the advisory services are independent of other brokerage services being provided to the investor.²¹⁸ By clarifying that such separate services are advisory services, the rule will provide certainty for broker-dealers as to whether the Advisers Act applies to their activities.

b. Costs

Broker-dealers entering into separate contracts for, or obtaining separate compensation to provide, advisory services will incur compliance costs under the Advisers Act with respect to the affected accounts. Commenters on the Reproposing Release confirmed, however, that broker-dealers generally treat these kinds of arrangements as advisory activities subject to the Act.²¹⁹ Accordingly, we believe few broker-dealers will incur new compliance costs in connection with this aspect of rule 202(a)(11)-1(b).

For the remaining broker-dealers that may currently be entering into these arrangements without treating them as advisory activities under the Act, compliance costs will be lower if they are dually-registered broker-dealers that have already established a compliance infrastructure under the Advisers Act (or that could shift affected accounts to an affiliated investment adviser), and will be higher for broker-dealers that will have to become newly-registered under the Advisers Act, as discussed below. Because these costs of compliance and registration will vary from firm to firm depending on its size and complexity, these costs are difficult to quantify:²²⁰

• Affected broker-dealers that are already dually-registered as investment advisers will incur the costs of handling these accounts through their existing Advisers Act infrastructure. For example, under the Advisers Act, they will be required to deliver brochures and make other required disclosures with respect to these accounts, and comply with principal trading restrictions. Nonetheless, we believe these costs will be mitigated because, as registered advisers, these broker-dealers already have systems in place to satisfy such requirements, and the costs are account-specific. Dually-registered broker dealers shifting these accounts over to their Advisers Act infrastructure may also incur additional documentation costs to execute new account agreements with affected clients.
• Other affected broker-dealers may not be dually-registered, but may be affiliated with investment advisers. These broker-dealers could implement the requirements of the rule by shifting the advisory activities to their advisory affiliates. In so doing, they will incur the lesser compliance costs similar to dual registrants, rather than the greater costs discussed below for new registrants.
• For affected broker-dealers that will be required to register as investment advisers for the first time, the rule will result in costs associated with registration under the Advisers Act and compliance with the Act’s requirements. Although we acknowledge that the costs of registration and compliance under the Advisers Act are significant,²²¹ we believe that such costs will be mitigated by the fact that these firms can build upon the infrastructure they already have in place as broker-dealers, much of which overlaps with Advisers Act requirements. For example, these broker-dealers are already subject to rules requiring designation of a chief compliance officer, establishment and maintenance of written compliance procedures, maintenance of books and records, and oversight of employee personal securities trading.²²² These broker-dealers will ordinarily also be in compliance with the adviser custody rule.²²³

  2. Holding Out As A Financial Planner

  a. Benefits

  As a consequence of rule 202(a)(11)-1(b), a broker-dealer that holds itself out generally to the public as a financial planner or as providing financial planning services must generally register as an investment adviser under the Act, and a broker-dealer that delivers a financial plan to a customer or represents to a customer that its advice is part of a financial plan or in connection with financial planning services must also generally register under the Act and treat that customer as an advisory client. Rule 202(a)(11)-1(b) will benefit these customers by making these services subject to the protections of the Advisers Act.

  b. Costs

  Broker-dealers that deliver financial plans or make representations to customers causing their firms to fall within the provisions of rule 202(a)(11)-1(b) will incur costs to provide that investment advice to those customers in compliance with the Advisers Act. Commenters’ descriptions of current industry practices lead us to believe this aspect of rule 202(a)(11)-1(b) will impose new costs on relatively few broker-dealers. Several commenters indicated it is existing practice in the brokerage industry to use a two-tiered approach to financial planning activities. In the first tier, broker-dealers use certain tools (often questionnaires) to analyze customer financial situations as an aid to meeting the broker-dealers’ suitability obligations, and broker-dealers also provide full-service brokerage customers with basic financial assessment tools (often computer-assisted evaluations) as an integral part of the brokerage process.²²⁴ In the second tier, broker-dealers offer comprehensive financial plans as a separate option, for a separate fee, and treat this second-tier service as an advisory activity subject to the Act.²²⁵ So long as broker-dealers treat the first-tier activities as an integral part of the brokerage account relationship, and do not represent these activities to be financial plans, financial planning, or financial planning services, they will not be obligated to treat these first-tier activities as advisory services under the Advisers Act.

  Broker-dealers whose operations vary from these industry practices will face increased costs as a result of rule 202(a)(11)-1(b), in the form of costs to comply with the Advisers Act. Similar to the costs discussed above in connection with separately-contracted-for advisory services (in Section VI.B.1.b of this Release, above), these compliance costs will be lower for dually-registered broker-dealers that have already established a compliance infrastructure under the Advisers Act (or that could shift affected accounts to an affiliated investment adviser), and will be higher for broker dealers that will have to become newly-registered under the Advisers Act, as discussed below. Most commenters addressing the costs of treating financial planning activities as an advisory activity under the Act characterized the costs as significant,²²⁶ while other commenters indicated they were not significant.²²⁷ Because these costs of compliance and registration will vary from firm to firm depending on its size and complexity, these costs are difficult to quantify:²²⁸

• To the extent that dually-registered broker-dealers will be required to treat financial planning activities as advisory activities, they will incur costs associated with subjecting such activities to the Advisers Act and its requirements (similar to the costs to dual registrants of separately-contracted-for advisory services, as discussed in Section VI.B.1.b of this Release, above). For example, under the Advisers Act, they will be required to deliver brochures and make other required disclosures with respect to financial planning clients, and comply with principal trading restrictions. Nonetheless, we believe these costs will be mitigated because as advisers, these broker-dealers already have systems in place to satisfy such requirements, and the costs are account-specific. These dually-registered broker-dealers may also incur additional documentation costs to execute new account agreements with financial planning clients.
• Other affected broker-dealers may not be dually-registered, but may be affiliated with investment advisers. These broker-dealers could implement the requirements of the rule by shifting the financial planning activities to their advisory affiliates. In so doing, they will incur the lesser compliance costs similar to dual registrants, rather than the greater costs discussed below for new registrants.
• For broker-dealers whose financial planning activities will require them to register as investment advisers for the first time, the rule will result in costs associated with registration under the Advisers Act and compliance with the Act’s requirements.²²⁹ Although we acknowledge (as discussed above in connection with separately-contracted-for advisory services) that the costs of registration and compliance under the Advisers Act are significant,²³⁰ we believe that such costs will be mitigated by the fact that these firms can build upon the infrastructure they already have in place as broker-dealers, much of which overlaps with Advisers Act requirements. For example, these broker-dealers are already subject to rules requiring designation of a chief compliance officer, establishment and maintenance of written compliance procedures, maintenance of books and records, and oversight of employee personal securities trading.²³¹ These broker-dealers will ordinarily also be in compliance with the adviser custody rule.²³²

3. Discretionary Brokerage

a. Benefits

Rule 202(a)(11)-1(b) also requires broker-dealers to treat discretionary brokerage accounts as advisory accounts under the Advisers Act. The rule will benefit investors to the extent they are confused as to the nature of discretionary brokerage. As previously noted, in many respects discretionary brokerage relationships are difficult to distinguish from investment advisory relationships. By definitively treating such accounts as advisory accounts, the rule will promote understanding by investors of the nature of the service they are receiving. More importantly, we believe that it will ensure that accounts that have the supervisory or managerial character we have identified as warranting Advisers Act coverage are, in fact, covered.

b. Costs

Rule 202(a)(11)-1(b) will entail costs for broker-dealers that maintain discretionary accounts, in the form of Advisers Act compliance costs for these accounts. Similar to the costs discussed above in connection with separately-contracted-for advisory services and financial planning services (in Sections VI.B.1.b and VI.B.2.b of this Release, above), these costs will be lower for dually-registered broker-dealers that have already established a compliance infrastructure under the Advisers Act (or that can shift affected accounts to an affiliated investment adviser), and will be higher for broker-dealers that will be required to register under the Advisers Act.²³³ Commenters addressing the costs of treating discretionary accounts as advisory accounts under the Act characterized the costs as significant.²³⁴ Because these costs of compliance and registration vary from firm to firm depending on its size and complexity, these costs are difficult to quantify:²³⁵

• For broker-dealers already dually-registered as investment advisers, rule 202(a)(11)-1(b) will result in costs to treat discretionary accounts as advisory accounts. Based on staff experience, we believe that many dual registrants currently treat discretionary accounts as advisory accounts, and will be in compliance with the new rule without further action. To the extent that other dually-registered broker-dealers will be required to treat discretionary accounts as advisory accounts, they will incur costs associated with subjecting such accounts to the Advisers Act and its requirements (similar to the costs to dual registrants of separately-contracted-for advisory services and financial planning services, as discussed in Sections VI.B.1.b and VI.B.2.b of this Release, above). For example, under the Advisers Act, they will be required to deliver brochures and make other required disclosures with respect to these accounts, and observe principal trading restrictions.²³⁶ Nonetheless, we believe these costs would be mitigated because as advisers, these broker-dealers already have systems in place to satisfy such requirements, and the costs are account-specific. Several commenters focused specifically on principal trading restrictions, urging that such restrictions would be particularly inconsistent with current practices of certain fixed income institutional investors, who grant broker-dealers discretion in view of the firm’s ability to effect trades on a principal basis.²³⁷ However, we believe the exceptions we discuss above for limited discretion will accommodate these investors, if they wish to grant their broker-dealers limited types of discretion focused on obtaining the benefits of efficient execution or access to types of securities not widely available in the market, as opposed to the kind of supervisory or managerial discretionary authority we have concluded is properly subject to the Advisers Act.²³⁸
• In many instances, broker-dealers that are not dually registered are affiliated with investment advisers. Based on staff experience, we believe that many of these broker-dealers have refrained from engaging in the discretionary brokerage business, and have instead looked to their advisory affiliates to provide portfolio management to investors seeking this kind of service. Other broker-dealers that have not refrained from accepting discretionary brokerage services could implement the requirements of rule 202(a)(11)-1(b) by shifting these customers to their advisory affiliates.²³⁹In so doing, they will incur the lesser compliance costs of the types discussed above for dual registrants, rather than the greater costs discussed below for new registrants.
• For broker-dealers whose maintenance of discretionary accounts will require them to register as investment advisers for the first time, rule 202(a)(11)-1(b) will result in costs associated with registration under the Advisers Act and compliance with the Act’s requirements.²⁴⁰Although we acknowledge (as discussed above in connection with separately-contracted-for advisory services and financial planning services in Section VI.B.1.b and VI.B.2.b of this Release) that the costs of registration and compliance under the Advisers Act are significant,²⁴¹ we believe that such costs will be mitigated by the fact that these firms can build upon the infrastructure they already have in place as broker-dealers, much of which overlaps with Advisers Act requirements. For example, these broker-dealers are already subject to rules requiring designation of a chief compliance officer, establishment and maintenance of written compliance procedures, maintenance of books and records, and oversight of employee personal securities trading.²⁴² These broker-dealers will ordinarily also be in compliance with the adviser custody rule.²⁴³

C. Wrap Fee Sponsorship.

We are re-affirming our current interpretation regarding wrap program sponsorship. Since this does not change existing obligations or relationships, no new costs or benefits result.

³¹See, e.g., Cox Letter, supra note 26; Comment Letter of Public Investors Arbitration Bar Association (Feb. 4, 2005) (“PIABA Letter”); FPA Letter, supra note 27; Joint Letter of Fund Democracy et al., supra note 28; Comment Letter of National Association of Personal Financial Advisors (Feb. 7, 2005) (“NAPFA Letter”); Comment Letter of American Institute of Certified Public Accountants (Feb. 7, 2005) (“AICPA Letter”). See also Comment Letter of Federated Investors, Inc. (Jan. 14, 2000) (“Federated Letter”); ICAA Jan. 12, 2000 Letter, supra note 19; CFA Feb. 28, 2000 Letter, supra note 22; FPA Jan. 14, 2000 Letter, supra note 19; Comment Letter of Joseph Capital Management, LLC (Aug. 30, 2004); Comment Letter of Jared W. Jameson (Sept. 16, 2004); Comment Letter of Geoffrey F. Fosie (Sept. 22, 2004); Comment Letter of the Foundation for Fiduciary Studies (Sept. 12, 2004).

³²See, e.g., Cox Letter, supra note 26; Comment Letter of Anna M. Taglieri (Jan. 9, 2005); Comment Letter of Harrod Financial Planning (Jan. 14, 2005); PIABA Letter, supra note 31; FPA Letter, supra note 27; Joint Letter of Fund Democracy et al., supra note 28; NAPFA Letter, supra note 31; AICPA Letter, supra note 31. See also Comment Letter of Roy T. Diliberto (Aug. 24, 2004); Comment Letter of Don B. Akridge (Sept. 7, 2004); Comment Letter of William K. Dix, Jr. (Sept. 21, 2004) (“Dix Letter”); CFA Jan. 13, 2000 Letter, supra note 19.

³³See, e.g., Merrill Lynch Letter, supra note 29; Morgan Stanley Letter, supra note 29; Wachovia Letter, supra note 29; NASD Letter, supra note 29; Comment Letter of American Express Financial Advisers, Inc. (Mar. 4, 2005) (“American Express Letter”). See also Comment Letter of Paine Webber Incorporated (Jan. 14, 2000); Comment Letter of U.S. Bancorp Piper Jaffray Inc. (Jan. 19, 2000) (“U.S. Bancorp Jan. 19, 2000 Letter”); Comment Letter of Prudential Securities Incorporated (Jan. 31, 2000) (“Prudential Jan. 31, 2000 Letter”); Merrill Lynch Sept. 22, 2004 Letter, supra note 16.

³⁴See, e.g., Merrill Lynch Letter, supra note 29; American Express Letter, supra note 33. See also U.S. Bancorp Jan. 19, 2000 Letter, supra note 33; Prudential Jan. 31, 2000 Letter, supra note 33; CGMI Sept. 22, 2004 Letter, supra note 17; Merrill Lynch Sept. 22, 2004 Letter, supra note 16; SIA Sept. 22, 2004 Letter, supra note 16.

³⁵Section 202(a)(11)(F) excludes from the definition of investment adviser, and thus the Act, “such other persons not within the intent of this paragraph, as the Commission may designate by rules and regulations or order.” See also Section X of this Release, infra.

³⁶In the Reproposing Release, we solicited comments on our reading of the history and background of the Act and, in particular, the broker-dealer exception. Some commenters agreed with our reading (see, e.g., SIA Letter, supra note 29) and others did not (see, e.g., CFA Letter, supra note 28; Joint Letter of Fund Democracy et al., supra note 28; FPA Letter, supra note 27; Comment Letter of Morgan, Lewis & Bockius LLP (Feb 7, 2005) (“Morgan, Lewis Letter”)). Our views about the issues raised by these commenters are set out throughout this Release.

³⁷Then, as now, brokerage services included services provided throughout the execution of a securities transaction, including providing research and advice prior to a decision to buy or sell, implementing that decision on the most advantageous terms and executing the transaction, arranging for delivery of securities by the seller and payment by the buyer, maintaining custody of customer funds and securities, and providing recordkeeping services. See Exchange Act section 28(e)(3), 15 U.S.C. 78bb(e)(3). See also generally Charles F. Hodges, WALL STREET (1930) (“WALL STREET”).

³⁸SEC, REPORT ON INVESTMENT COUNSEL, INVESTMENT MANAGEMENT, INVESTMENT SUPERVISORY, AND INVESTMENT ADVISORY SERVICES (1939) (H.R. Doc. No. 477) (“INVESTMENT COUNSEL REPORT”) at 3. Such investment advice provided by broker-dealers was “an additional incentive to a purchaser or trader in securities to patronize particular brokers or investment bankers with the resultant increase in their brokerage or securities business.” Id. at 4; see INSPECTION REPORT ON THE SOFT-DOLLAR PRACTICES OF BROKER-DEALERS, INVESTMENT ADVISERS AND MUTUAL FUNDS (prepared by the Commission’s Office of Compliance Inspections and Examinations) (Sept. 22, 1998) (available on the Internet at http://www.sec.gov/news/studies/softdolr.htm) (“Since the early days of the brokerage industry, full-service broker-dealers have provided research and other services to customers in addition to executing trades as part of an overall package of services provided to customers. Customers have always paid for this in-house (or proprietary) research, as well as the other services, with commissions; normally no separ