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

Certain Broker-Dealers Deemed Not to be
Investment Advisers

VII. EFFECTS OF COMPETITION, EFFICIENCY AND CAPITAL FORMATION

Section 202(c) of the Advisers Act mandates that the Commission, when engaging in rulemaking that requires it to consider or determine whether an action is necessary or appropriate in the public interest, consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation.²⁴⁴

A. Fee-Based and Discount Brokerage Programs

Rule 202(11)(a)-1(a) provides that a broker-dealer providing advice that is incidental to its brokerage services can retain its exception from the Advisers Act regardless of whether it charges an asset-based or fixed fee (rather than commissions, mark-ups, or mark-downs) for its services. The rule also provides that broker-dealers are not subject to the Act solely because in addition to offering full-service brokerage they offer discount brokerage services, including execution-only brokerage, for reduced commission rates.²⁴⁵

We do not anticipate that rule 202(11)(a)-1(a) will negatively affect competition. Many commenters addressing our 1999 Proposal and our Reproposing Release raised concerns that the proposed rule would grant broker-dealers who give investment advice without registering under the Advisers Act a competitive advantage over investment advisers subject to the Advisers Act. However, as discussed in Section III.A.1 of this Release, above, broker-dealers have historically provided advisory services to their brokerage customers. As discussed in Section III.A.2 of this Release, above, broker-dealers do so subject to the cost implications of compliance with broker-dealer regulation. Because the rule does not change the types of advice broker-dealers may provide (which advice must continue to be solely incidental to brokerage) or materially change their compliance costs, we do not anticipate it will create a competitive advantage.

Rule 202(a)(11)-1(a) may increase efficiency by removing impediments to fee-based brokerage programs. Fee-based brokerage programs, as we discuss above, respond to changes in the market place for retail brokerage, and concerns that we have long held about the incentives that commission-based compensation provides for broker-dealers to churn accounts, recommend unsuitable securities, and engage in aggressive marketing.²⁴⁶The availability of fee-based brokerage programs may better align the interests of broker dealers and their customers. The availability of fee-based and discount brokerage programs should also enable brokerage customers to choose these new programs when they represent a more efficient alternative than commission-based brokerage. One commenter agreed, arguing that pricing flexibility generally promotes economic efficiency.²⁴⁷

If rule 202(a)(11)-1(a) has any effect on capital formation, it will be indirect, and positive. By removing impediments to fee-based and discount brokerage programs which may be more desirable for customers than commission-based programs, rule 202(a)(11)-1(a) may open the door to greater investor participation in the securities markets.

B. Discretionary Brokerage and Financial Planning

Rule 202(a)(11)-(1)(b) specifies three situations in which the provision of advisory services by a broker-dealer is not solely incidental to brokerage, and such advisory services are thus ineligible for the fee-based account exception under rule 202(a)(11)-1(a) or the exception from the definition of an investment adviser in section 202(a)(11)(C) of the Advisers Act. First, a broker-dealer that charges a separate fee or separately contracts with a customer for investment advisory services may not rely on the exceptions. 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 it is a financial planner or providing a financial plan or 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.

Rule 202(a)(11)-1(b) will not negatively affect competition. Some broker-dealers would be required to begin treating as advisory clients those customers with whom they make separate contractual or compensation arrangements for advisory services, or to whom they provide certain financial planning or discretionary account services. However, as discussed above, we believe the majority of broker-dealers already apply the Advisers Act in the circumstances covered by rule 202(a)(11)-1(b), so we expect the effects of the rule will not be widespread.²⁴⁸ As the remaining firms begin applying the Advisers Act to these relationships as a result, they will be competing on a more even footing with broker-dealers who already do so. We do not believe rule 202(a)(11)-1(b) will have any measurable effect on efficiency or capital formation.

VIII. PAPERWORK REDUCTION ACT

Rule 202(a)(11)-1(a) contains “collection of information” requirements within the meaning of the Paperwork Reduction Act of 1995.²⁴⁹ The title of this new collection is “Rule 202(a)(11)-1 under the Investment Advisers Act of 1940—Certain Broker-Dealers Deemed Not To Be Investment Advisers,” and the Commission, at the time of its 1999 Proposal, submitted it to the Office of Management and Budget (“OMB”) for review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. OMB has approved, and subsequently extended, this collection under control number 3235-0532 (expiring on October 31, 2006).

Rule 202(a)(11)-1(b) will have the effect of requiring certain broker-dealers to register under the Advisers Act.²⁵⁰ Rule 202(a)(11)-1(b) will therefore likely increase the number of respondents under several existing collections of information, and, correspondingly, increase the annual aggregate burden under those existing collections of information. The Commission has submitted to OMB, in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11, the existing collections of information for which the annual aggregate burden would correspondingly increase as a result of rule 202(a)(11)-1(b). The titles of the affected collections of information are: “Form ADV,” “Form ADV-W and Rule 203-2,” “Rule 203-3 and Form ADV-H,” “Form ADV-NR,” “Rule 204-2,” “Rule 204-3,” “Rule 204A-1,” “Rule 206(4)-3,” “Rule 206(4)-4,” “Rule 206(4)-6,” and “Rule 206(4)-7,” all under the Advisers Act. The existing rules that will be affected by rule 202(a)(11)-1(b) contain currently approved collection of information numbers under OMB control numbers 3235-0049, 3235-0313, 3235-0538, 3235-0240, 3235-0278, 32350047, 3235-0596, 3253-0242, 3235-0345, 3235-0571 and 3235-0585, respectively.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a currently valid OMB control number.

A. Certain Broker-Dealers Deemed Not To Be Investment Advisers

Under rule 202(a)(11)-1(a), broker-dealers will be deemed not to be “investment advisers” as defined in the Advisers Act with respect to certain accounts. With respect to these accounts, such broker-dealers will not be subject to the provisions of the Advisers Act, including the various registration, disclosure and recordkeeping requirements under the Act. Under rule 202(a)(11)-1(a), a broker-dealer will not be deemed to be an investment adviser with respect to an account for which it receives special compensation, provided that the broker-dealer’s investment advice is solely incidental to the brokerage services provided to the account and the broker-dealer makes certain disclosures in its advertising and agreements for such accounts.

In the Reproposing Release, we noted that broker-dealers taking advantage of the proposed exception would need to maintain certain records that establish their eligibility to do so, but that rules under the Exchange Act already require the maintenance of those records.²⁵¹ Therefore, we concluded that this facet of the proposed exception would not increase the recordkeeping burden for any broker-dealer.

To rely on the rule 202(a)(11)-1(a) with respect to a particular brokerage account, advertisements²⁵² and contracts or agreements for the account must contain a prominent disclosure statement. 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.²⁵³ This information is necessary to prevent customers and prospective customers from mistakenly believing that the account is an advisory account subject to the Advisers Act, and will be used to assist customers in making an informed decision on whether to establish an account. The collection of information requirement under rule 202(a)(11)-1(a) is mandatory. In general, the information collected pursuant to the rule will be held by the broker-dealers. Staff of the Commission, self-regulatory organizations, and other securities regulatory authorities would gain access to the information only upon request. Any collected information received by the Commission will be kept confidential subject to applicable law, including the provisions of the Freedom of Information Act [5 U.S.C. 552].

The burden to comply with this provision of rule 202(a)(11)-1(a) will be insignificant. In preparing model contracts and advertisements, for example, compliance officials will be required to verify that the appropriate disclosure is made. In the Reproposing Release, we estimated that the average annual burden for ensuring compliance is five minutes per broker-dealer taking advantage of the rule.²⁵⁴ We estimated that if all of the approximately 8,100 broker-dealers registered with us took advantage of the rule, the total estimated annual burden would be 673 hours.²⁵⁵ In our 1999 Proposal, the rule only required a prominent statement that the account is a brokerage account. In our Reproposing Release, we proposed to add disclosures that the account is not an advisory account; that the firm’s obligations with respect to such accounts may differ; and that, as a consequence, the customer’s rights and the firm’s duties and obligations to the customer, including the scope of the firm’s fiduciary obligations, may differ. We also proposed to require the broker-dealer to identify an appropriate person at the firm with whom the customer can discuss the differences. The rule today modifies the prominent statement slightly to put the prominent disclosure statement into plain English, and to discuss broker compensation issues briefly. However, these modifications to the disclosure obligations under rule 202(a)(11)-1(a) do not increase the estimated paperwork burden for this collection.

B. Broker-Dealers Providing Discretionary Advice or Financial Plans

As discussed above, under rule 202(a)(11)-1(b), broker-dealers providing advisory services in three scenarios will be deemed advisers subject to the Advisers Act.²⁵⁶ Rule 202(a)(11)-1(b) will therefore increase the number of respondents under the existing collections of information identified above, and, correspondingly, increase the annual aggregate burden under those existing collections of information. All of these collections of information are mandatory, and respondents in each case are investment advisers registered with us, except that (i) respondents to Form ADV are also investment advisers applying for registration with us; (ii) respondents to Form ADV-NR are non-resident general partners or managing agents of registered advisers; (iii) respondents to rule 204A-1 include “access persons” of an adviser registered with us, who must submit reports of their personal trading to their advisory firms; (iv) respondents to rule 206(4)-3 are advisers who pay cash fees to persons who solicit clients for the adviser; (v)respondents to rule 206(4)-4 are advisers with certain disciplinary histories or a financial condition that is reasonably likely to affect contractual commitments; and (vi)respondents to rule 206(4)-6 are only those SEC-registered advisers that vote their clients’ securities. Unless otherwise noted below, responses are not kept confidential.

We cannot quantify with precision the number of broker-dealers that will be new registrants with the Commission under the Advisers Act as a result of Rule 202(a)(11)-1(b). In the Reproposing Release, we set out our analysis that an estimated 195 broker-dealers would be required to register, and requested public comments.²⁵⁷ We received no comments on this analysis, and have encountered no information since the time of the Reproposing Release that would cause us to re-evaluate it. Thus, for purposes of this analysis, we have estimated 195 new firms would be required to register with the SEC as investment advisers as a result of rule 202(a)(11)-1(b).

1. Form ADV

Form ADV is the investment adviser registration form. The collection of information under Form ADV is necessary to provide advisory clients, prospective clients, and the Commission with information about the adviser, its business, and its conflicts of interest. Rule 203-1 requires every person applying for investment adviser registration with the Commission to file Form ADV. Rule 204-1 requires each SEC-registered adviser to file amendments to Form ADV at least annually, and requires advisers to submit electronic filings through the IARD. This collection of information is found at 17 CFR 275.203-1, 275.204-1, and 279.1. The currently approved collection of information in Form ADV is 131,611 hours. We estimate that 195 new respondents will file one complete Form ADV and one amendment annually, and comply with Form ADV requirements relating to delivery of the adviser code of ethics. Accordingly, we estimate rule 202(a)(11)-1(b) will increase the annual aggregate information collection burden under Form ADV by 5,792 hours²⁵⁸ for a total of 137,403 hours.

2. Form ADV-W and Rule 203-2

Rule 203-2 requires every person withdrawing from investment adviser registration with the Commission to file Form ADV-W. The collection of information is necessary to apprise the Commission of advisers who are no longer operating as registered advisers. This collection of information is found at 17 CFR 275.203-2 and 17 CFR 279.2. The currently approved collection of information in Form ADV-W is 578 hours. We estimate that the 195 broker-dealer/advisers that will be new registrants will withdraw from SEC registration at a rate of approximately 16 percent per year, the same rate as other registered advisers, and will file for partial and full withdrawals at the same rates as other registered advisers, with approximately half of the filings being full withdrawals and half being partial withdrawals. Accordingly, we estimate the rule 202(a)(11)-1(b) will increase the annual aggregate information collection burden under Form ADV-W and rule 203-2 by 16 hours²⁵⁹ for a total of 594 hours.

3. Rule 203-3 and Form ADV-H

Rule 203-3 requires that advisers requesting either a temporary or continuing hardship exemption submit the request on Form ADV-H. An adviser requesting a temporary hardship exemption is required to file Form ADV-H, providing a brief explanation of the nature and extent of the temporary technical difficulties preventing it from submitting a required filing electronically. Form ADV-H requires an adviser requesting a continuing hardship exemption to indicate the reasons the adviser is unable to submit electronic filings without undue burden and expense. Continuing hardship exemptions are available only to advisers that are small entities. The collection of information is necessary to provide the Commission with information about the basis of the adviser’s hardship. This collection of information is found at 17 CFR 275.203-3, and 279.3. The currently approved collection of information in Form ADV-H is 11 hours. We estimate that approximately one broker-dealer/adviser among the new registrants will file for a temporary hardship exemption and one will file for a continuing exception. Accordingly, we estimate the rule 202(a)(11)-1(b) will increase the annual aggregate information collection burden under Form ADV-H and rule 203-3 by 2 hours²⁶⁰ for a total of 13 hours.

4. Form ADV-NR

Non-resident general partners or managing agents of SEC-registered investment advisers must make a one-time filing of Form ADV-NR with the Commission. Form ADV-NR requires these non-resident general partners or managing agents to furnish us with a written irrevocable consent and power of attorney that designates the Secretary of the Commission, among others, as an agent for service of process, and that stipulates and agrees that any civil suit or action against such person may be commenced by service of process on the Secretary of the Commission. The collection of information is necessary for us to obtain appropriate consent to permit the Commission and other parties to bring actions against non-resident partners or agents for violations of the federal securities laws. This collection of information is found at 17 CFR 279.4. The currently approved collection of information in Form ADV-NR is 17 hours. We estimate that approximately one broker-dealer/adviser among the new registrants will make this filing. Accordingly, we estimate the rule 202(a)(11)-1(b) will increase the annual aggregate information collection burden under Form ADV-NR by one hour²⁶¹ for a total of 18 hours.

5. Rule 204-2

Rule 204-2 requires SEC-registered investment advisers to maintain copies of certain books and records relating to their advisory business. The collection of information under rule 204-2 is necessary for the Commission staff to use in its examination and oversight program. Responses provided to the Commission in the context of its examination and oversight program are generally kept confidential.²⁶² The records that an adviser must keep in accordance with rule 204-2 must generally be retained for not less than five years.²⁶³ This collection of information is found at 17 CFR 275.204-2. The currently approved collection of information for rule 204-2 is 1,724,870 hours, or 191.78 hours per registered adviser. We estimate that all 195 broker-dealer/advisers that will be new registrants will maintain copies of records under the requirements of rule 204-2. Accordingly, we estimate rule 202(a)(11)-1(b) will increase the annual aggregate information collection burden under rule 204-2 by 37,397 hours²⁶⁴for a total of 1,762,267 hours.

6. Rule 204-3

Rule 204-3, the “brochure rule,” requires an investment adviser to deliver to prospective clients a disclosure statement containing specified information as to the business practices and background of the adviser. Rule 204-3 also requires that an investment adviser deliver, or offer, its brochure on an annual basis to existing clients in order to provide them with current information about the adviser. The collection of information is necessary to assist clients in determining whether to retain, or continue employing, the adviser. This collection of information is found at 17 CFR 275.204-3. The currently approved collection of information for rule 204-3 is 6,089,293 hours, or 694 hours per registered adviser, assuming each adviser has on average 670 clients.²⁶⁵ We estimate that all 195 broker-dealer/advisers that will be new registrants will provide brochures as required by rule 204-3. Accordingly, we estimate rule 202(a)(11)-1(b) will increase the annual aggregate information collection burden under rule 204-3 by 135,330 hours²⁶⁶ for a total of 6,224,623 hours.

7. Rule 204-1

Rule 204-1 requires SEC-registered investment advisers to adopt codes of ethics setting forth standards of conduct expected of their advisory personnel and addressing conflicts that arise from personal securities trading by their personnel, and requiring advisers’ “access persons” to report their personal securities transactions. The collection of information under rule 204A-1 is necessary to establish standards of business conduct for supervised persons of investment advisers and to facilitate investment advisers’ efforts to prevent fraudulent personal trading by their supervised persons. This collection of information is found at 17 CFR 275.204A-1. The currently approved collection of information for rule 204A-1 is 1,060,842 hours, or 117.95 hours per registered adviser. We estimate that all 195 broker-dealer/advisers that will be new registrants will adopt codes of ethics under the requirements of rule 204A-1 and require personal securities transaction reporting by their “access persons.” Accordingly, we estimate rule 202(a)(11)-1(b) will increase the annual aggregate information collection burden under rule 204A-1 by 23,000 hours²⁶⁷ for a total of 1,083,842 hours.

8. Rule 206(4)-3

Rule 206(4)-3 requires advisers who pay cash fees to persons who solicit clients for the adviser to observe certain procedures in connection with solicitation activity. The collection of information under rule 206(4)-3 is necessary to inform advisory clients about the nature of a solicitor’s financial interest in the recommendation of an investment adviser, so the client may consider the solicitor’s potential bias, and to protect investors against solicitation activities being carried out in a manner inconsistent with the adviser’s fiduciary duties. This collection of information is found at 17 CFR 275.206(4)-3. The currently approved collection of information for rule 206(4)-3 is 12,355 hours. We estimate that approximately 20 percent of the 195 broker-dealer/advisers that will be new registrants will be subject to the cash solicitation rule, the same rate as other registered advisers. Accordingly, we estimate rule 202(a)(11)-1(b) will increase the annual aggregate information collection burden under rule 206(4)-3 by 275 hours²⁶⁸ for a total of 12,630 hours.

9. Rule 206(4)-4

Rule 206(4)-4 requires registered investment advisers to disclose to clients and prospective clients certain disciplinary history or a financial condition that is reasonably likely to affect contractual commitments. This collection of information is necessary for clients and prospective clients in choosing an adviser or continuing to employ an adviser. This collection of information is found at 17 CFR 275.206(4)-4. The currently approved collection of information for rule 206(4)-4 is 11,383 hours. We estimate that approximately 17.3 percent of the 195 broker-dealer/advisers that will be new registrants will be subject to rule 206(4)-4, the same rate as other registered advisers. Accordingly, we estimate rule 202(a)(11)-1(b) will increase the annual aggregate information collection burden under rule 206(4)-4 by 255 hours²⁶⁹ for a total of 11,638 hours.

10. Rule 206(4)-6

Rule 206(4)-6 requires an investment adviser that votes client securities to adopt written policies reasonably designed to ensure that the adviser votes in the best interests of clients, and requires the adviser to disclose to clients information about those policies and procedures. This collection of information is necessary to permit advisory clients to assess their adviser’s voting policies and procedures and to monitor the adviser’s performance of its voting responsibilities. This collection of information is found at 17 CFR 275.206(4)-6. The currently approved collection of information for rule 206(4)-6 is 119,873 hours. We estimate that all 195 broker-dealer/advisers that will be new registrants will vote their clients’ securities. Accordingly, we estimate rule 202(a)(11)-1(b) will increase the annual aggregate information collection burden under rule 206(4)-6 by 3,257 hours²⁷⁰ for a total of 123,130 hours.

11. Rule 206(4)-7

Rule 206(4)-7 requires each registered investment adviser to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act, review those policies and procedures annually, and designate an individual to serve as chief compliance officer. This collection of information under rule 206(4)-7 is necessary to ensure that investment advisers maintain comprehensive internal programs that promote the advisers’ compliance with the Advisers Act. This collection of information is found at 17 CFR 275.206(4)-7. The currently approved collection of information for rule 206(4)-7 is 701,200 hours, or 80 hours annually per registered adviser. We estimate all 195 broker-dealer/advisers that will be new registrants will be required to maintain compliance programs under rule 206(4)-7. Accordingly, we estimate rule 202(a)(11)-1(b) will increase the annual aggregate information collection burden under rule 206(4)-7 by 15,600 hours²⁷¹ for a total of 716,800 hours.

IX. REGULATORY FLEXIBILITY ANALYSIS

The Commission proposed rule 202(a)(11)-1 and related proposed interpretations of section 202(a)(11)(C) of the Advisers Act, in a release on January 6, 2005 (“Reproposing Release”). An Initial Regulatory Flexibility Analysis (“IRFA”) was published in the Reproposing Release. No comments were received specifically on the IRFA. The Commission has prepared the following Final Regulatory Flexibility Analysis (“FRFA”) in accordance with section 3(a) of the Regulatory Flexibility Act.²⁷² It relates to rule 202(a)(11)-1.

A. Reasons for Action

Sections I through III of this Release describe the reasons for and objectives of rule 202(a)(11)-1. As discussed in detail above, rule 202(a)(11)-1(a) is designed to permit broker-dealers to offer new types of accounts, which charge asset-based or fixed fees for full-service brokerage services or make available discount brokerage services, without unnecessarily triggering regulation under the Advisers Act. Rule 202(a)(11)-1(b) identifies three situations in which provision of investment advisory services to broker-dealers’ customers is not “solely incidental to” brokerage business within the meaning of the broker-dealer exception from the definition of an investment adviser in section 202(a)(11)(C) of the Advisers Act or within the exception provided by rule 202(a)(11)1(a), 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).²⁷³ Our objectives with rule 202(a)(11)-1 include fostering the availability of fee-based and discount brokerage programs to brokerage customers and reducing investor confusion as to whether they are receiving brokerage services or advisory services.²⁷⁴

B. Significant Issues Raised by Public Comment

We received no comments on our IRFA. We discuss comments we received on the substantive rulemaking above.²⁷⁵

C. Small Entities

Rule 202(a)(11)-1 applies to all brokers-dealers registered with the Commission, including small entities. Under Commission rules, for purposes of the Regulatory Flexibility Act, a broker-dealer generally is a small entity if it had total capital (net worth plus subordinated liabilities) of less than $500,000 on the date in the prior fiscal year as of which its audited financial statements were prepared and it is not affiliated with any person (other than a natural person) that is not a small entity.²⁷⁶

The Commission estimates that as of December 31, 2003, approximately 905 Commission-registered broker-dealers were small entities.²⁷⁷ The Commission assumes for purposes of this FRFA that all of these small entities could rely on the exceptions provided by rule 202(a)(11)-1(a), although it is not clear how many would actually do so. Additionally, it is not clear how many of these small entities would be affected by proposed rule 202(a)(11)-1(b), which results in certain advisory services not being exempt from the Advisers Act.²⁷⁸ Therefore, for purposes of this FRFA, the Commission also assumes that all of these small entities could be affected by the new rules.

D. Reporting, Recordkeeping, and Other Compliance Requirements

The provisions of rule 202(a)(11)-1(a), pertaining to fee-based and discount brokerage accounts, impose no new reporting or recordkeeping requirements, and will not materially alter the time required for broker-dealers to comply with the Commission’s rules. Rule 202(a)(11)-1(a) is designed to prevent unnecessary regulatory burdens from being imposed on broker-dealers. Broker-dealers taking advantage of rule 202(a)(11)-1(a) with respect to fee-based brokerage accounts will be required to make certain disclosures to customers and potential customers in advertising and contractual materials. Under Exchange Act rules, however, broker-dealers are already required to maintain these documents as “written agreements . . . with respect to any account.”²⁷⁹

Under rule 202(a)(11)-1(b), advisory services provided by broker-dealers will be outside the broker-dealer exception from the Advisers Act under three scenarios. Thus, broker-dealers providing advisory services as described in any of these three scenarios will be subject to the Advisers Act.²⁸⁰ Although some broker-dealers providing advisory services as described in one or more of these three scenarios are already registered as investment advisers, rule 202(a)(11)-1(b) will result in other broker-dealers having to newly register as advisers, and will subject these brokers to the reporting, recordkeeping, and other compliance requirements under the Advisers Act.²⁸¹ For these broker-dealers, registration under the Advisers Act and compliance with its requirements will constitute new reporting, recordkeeping, and other compliance requirements. For broker-dealers already registered as investment advisers, rule 202(a)(11)-1(b) will require that broker-dealers treat affected accounts as advisory accounts. Thus, for these broker-dealers, rule 202(a)(11)-1(b) will impose new reporting, recordkeeping, and other compliance requirements with respect to these accounts.

Small entities registered with the Commission as broker-dealers will be subject to these new reporting, recordkeeping, and other compliance requirements to the same extent as larger broker-dealers. In developing these requirements over the years, we have analyzed the extent to which they would have a significant impact on a substantial number of small entities, and included flexibility wherever possible in light of the requirements’ objectives, to reduce the corresponding burdens imposed.

E. Duplicative, Overlapping, or Conflicting Federal Rules

The Commission believes that there are no rules that duplicate or conflict with rule 202(a)(11)-1.

F. Significant Alternatives

The Regulatory Flexibility Act directs the Commission to consider significant alternatives that would accomplish the stated objectives, while minimizing any adverse impact on small entities.²⁸² In connection with rule 202(a)(11)-1, the Commission considered the following alternatives: (i) the establishment of differing compliance or reporting requirements or timetables that take into account the resources available to small entities; (ii) the clarification, consolidation, or simplification of compliance and reporting requirements under the rule for such small entities; (iii) the use of performance rather than design standards; and (iv) an exemption from coverage of the rule, or any part thereof, for such small entities.

With respect to the first alternative, the Commission presently believes that establishment of differing compliance or reporting requirements or timetables for small entities would be inappropriate in these circumstances. The provision rule 202(a)(11)-1(a) requiring prominent disclosures to customers and potential customers is designed to prevent investors from being confused about the nature of the services they are receiving. To specify less prominent disclosures for small entities would only serve to diminish investor protection to customers of small broker-dealers. Such a course would be inconsistent with the purposes of the Advisers Act. With respect to rule 202(a)(11)-1(b), the compliance and recordkeeping requirements are those generally applicable to any adviser registered under the Act. In developing these requirements over the years, the Commission has analyzed the extent to which they would have a significant impact on a substantial number of small entities, and included flexibility wherever possible in light of the requirements’ objectives, to reduce the corresponding burdens imposed. It would be inconsistent with this design, and contrary to its purpose, to create special rules for small broker-dealers who would be subject to the Act as a result of proposed rule 202(a)(11)1(b).

With respect to the second alternative, the Commission presently believes that clarification, consolidation, or simplification of the compliance and recordkeeping requirements under proposed rule 202(a)(11)-1(a) for small entities unacceptably compromises the investor protections of the rule. As discussed above, the rule’s prominent disclosure requirement is designed to prevent investor confusion. We believe this requirement is already adequately clear and simple for those seeking to make use of the rule’s exception for fee-based accounts. To further consolidate this requirement would potentially impede our objective of preventing investor confusion. With respect to rule 202(a)(11)-1(b), clarification, consolidation, or simplification would involve modification of the compliance and recordkeeping requirements generally applicable to registered investment advisers under the Act. As discussed above in connection with the first alternative, the Commission, in developing these requirements over the years, has included as much flexibility as can be introduced in light of the investor protection objectives underlying them.

With respect to the third alternative, the Commission presently believes that the compliance requirements contained in rule 202(a)(11)-1 already appropriately use performance standards instead of design standards. The rule is crafted to make regulation under the Advisers Act turn on the services offered by a broker-dealer rather than strictly on the type of compensation involved. Thus, eligibility for rule 202(a)(11)-1(a)’s exception hinges on the services offered by the broker-dealer. Likewise, under rule 202(a)(11)-1(b), the treatment of the advisory activities in question also focus on the services offered.²⁸³ The reporting, recordkeeping, and other compliance requirements stemming from these of rule 202(a)(11)-1 are triggered by the performance of services by the entity in question, including small businesses.

Finally, with respect to the fourth alternative, the Commission presently believes that exempting small entities would be inappropriate. To the extent rule 202(a)(11)-1(a) eliminates unnecessary regulatory burdens that might otherwise be imposed on broker-dealers, small entities, as well as large entities, will benefit from the rule. Small broker-dealers should be permitted to enjoy this benefit to the same extent as larger broker-dealers. Furthermore, the Commission believes the provisions of rule 202(a)(11)-1(b) should apply to small entities to the same extent as larger ones. Rule 202(a)(11)-1(b) is grounded in the view that the advice described in the rule’s three scenarios is not solely incidental to brokerage. Because the protections of the Advisers Act are intended to apply equally to clients of both large and small advisory firms, it would be inconsistent with the purposes of the Advisers Act to exempt small entities further from the rule.

X. STATUTORY AUTHORITY

The Commission is adopting rule 202(a)(11)-1 pursuant to sections 202(a)(11)(F) and 211(a) of the Advisers Act.²⁸⁴

TEXT OF RULE
List of Subjects in 17 CFR Part 275

Investment advisers, Reporting and recordkeeping requirements.

For the reasons set out in the preamble, Title 17, Chapter II of the Code of Federal Regulations is amended as follows:

PART 275 -- RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF

1. The authority citation for Part 275 continues to read in part as follows:

AUTHORITY: 15 U.S.C. 80b-2(a)(11)(F), 80b-2(a)(17), 80b-3, 80b-4, 80b-4a,

80b-6(4), 80b-6a, and 80b-11, unless otherwise noted. * * * * *

2. Section 275.202(a)(11)-1 is added to read as follows:

§ 275.202(a)(11)-1 Certain broker-dealers.

(a) Special compensation. A broker or dealer registered with the Commission under section 15 of the Securities Exchange Act of 1934 (15 U.S.C. 78o) (the “Exchange Act”): (1) Will not be deemed to be an investment adviser based solely on its receipt of special compensation (except as provided in paragraph (b)(1) of this section), provided that:

(i) Any investment advice provided by the broker or dealer with respect to accounts from which it receives special compensation is solely incidental to the brokerage services provided to those accounts (including, in particular, that the broker or dealer does not exercise investment discretion as provided in paragraphs (b)(3) and (d) of this section); and

(ii) Advertisements for, and contracts, agreements, applications and other forms governing, accounts for which the broker or dealer receives special compensation include a prominent statement that: “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.” The prominent statement also must identify an appropriate person at the firm with whom the customer can discuss the differences.

(2) Will not be deemed to have received special compensation solely because the broker or dealer charges a commission, mark-up, mark-down or similar fee for brokerage services that is greater than or less than one it charges another customer.

(b) Solely incidental to. A broker or dealer provides advice that is not solely incidental to the conduct of its business as a broker or dealer within the meaning of section 202(a)(11)(C) of the Advisers Act or to the brokerage services provided to accounts from which it receives special compensation within the meaning of paragraph (a)(1)(i) of this section if the broker or dealer (among other things, and without limitation): (1) Charges a separate fee, or separately contracts, for advisory services;

(2) Provides advice as part of a financial plan or in connection with providing financial planning services and:

(i) holds itself out generally to the public as a financial planner or as providing financial planning services;

(ii) delivers to the customer a financial plan; or

(iii) represents to the customer that the advice is provided as part of a financial plan or in connection with financial planning services; or

(3) Exercises investment discretion, as that term is defined in paragraph (d) of this section, over any customer accounts.

(c) Special rule. A broker or dealer registered with the Commission under section 15 of the Exchange Act is 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.

(d) Investment discretion. For purpose of this section, the term investment discretion has the same meaning as given in section 3(a)(35) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(35)), except that it does not include investment discretion granted by a customer on a temporary or limited basis.

By the Commission.
Jill M. Peterson Assistant Secretary
April 12, 2005

²⁴⁴15 U.S.C. 80b-2(c).

²⁴⁵Rule 202(a)(11)-1(c) further provides that a registered broker-dealer is an investment adviser solely with respect to those accounts for which it provides services or receives compensation that subjects it to the Advisers Act.

²⁴⁶See supra note 12 and accompanying text.

²⁴⁷ Northwestern Mutual Letter, supra note 29.

²⁴⁸See supra Sections VI.B.1.b, VI.B.2.b, and VI.B.3.b of this Release.

²⁴⁹44 U.S.C. 3501 to 3520.

²⁵⁰ Rule 202(a)(11)-1(b) describes three scenarios in which a broker-dealer may not rely on the broker-dealer exception from the definition of an “investment adviser” under the Advisers Act and 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 exceptions. Second, a broker-dealer that holds itself out generally to the public as a financial planner or as providing financial planning services may not generally rely on the exceptions to avoid registration 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. See rule 202(a)(11)-1(b).

²⁵¹See Reproposing Release, supra note 6, at Section VII. Specifically, rule 202(a)(11)-1(a)(i) and rule 202(a)(11)-1(b)(3) have the effect of limiting the application of rule 202(a)(11)-1(a) to accounts over which a broker-dealer does not exercise investment discretion. Rule 202(a)(11)-1(a)(1)(ii) also requires a prominent statement be made in agreements governing the accounts to which the rule applies. Under Exchange Act rules, broker-dealers are already required to maintain all “evidence of the granting of discretionary authority given in any respect of any account” [17 CFR 240.17a-4(b)(6)] and all “written agreements . . . with respect to any account” [17 CFR 240.17a-4(b)(7)].

²⁵²As discussed in the Reproposing Release, broker-dealers already are required to maintain records regarding their advertisements under existing self-regulatory organizations’ rules.

²⁵³ Rule 202(a)(11)-1(a)(1)(ii).

²⁵⁴See Reproposing Release, supra note 6, at Section VII.

²⁵⁵0.083 hours x 8,100 broker-dealers = 673 hours.

²⁵⁶See supra note 250.

²⁵⁷ See Reproposing Release, supra note 6, at Section VII.

²⁵⁸ 195 filings of the complete form at 22.25 hours each, plus 195 amendments at 0.75 hours each, plus 6.7 hours for each of the 195 broker-dealer/advisers to deliver copies of their codes of ethics to 10 percent of their 670 clients annually who request it, at 0.1 hours per response. (195 x 22.25) + (195 x 0.75) + (195 x (670 x 0.1) x 0.1) = 5,791.5.

²⁵⁹32 filings (195 x 0.16), consisting of 16 full withdrawals at 0.75 hours each and 16 partial withdrawals at 0.25 hours each. (16 x 0.75) + (16 x 0.25) = 16.

²⁶⁰2 filings at 1 hour each.

²⁶¹1 filing at 1 hour each.

²⁶²See section 210(b) of the Advisers Act [15 U.S.C. 80b-10(b)].

²⁶³See rule 204-2(e).

²⁶⁴195 broker-dealer/advisers x 191.78 hours per adviser = 37,397 hours.

²⁶⁵We note that the average number of clients per adviser reflects a small number of advisers who have thousands of clients, while the typical SEC-registered adviser has approximately 76 clients.

²⁶⁶195 broker-dealer/advisers x 694 hours per adviser = 135,330.

²⁶⁷195 broker-dealer/advisers x 117.95 hours per adviser annually = 23,000.

²⁶⁸39 respondents (195 x 0.2) x 7.04 hours annually per respondent = 275.

²⁶⁹34 respondents (195 x 0.173) x 7.5 hours annually per respondent = 255.

²⁷⁰ We estimate that 195 broker-dealer/advisers would spend 10 hours each annually documenting their voting policies and procedures, and would provide copies of those policies and procedures to 10 percent of their 670 clients annually at 0.1 hours per response. (195 x 10) + 195 x (0.1 x 67) = 3,257.

²⁷¹195 broker-dealer/advisers at 80 hours per adviser annually = 15,600.

²⁷²5 U.S.C. 603(a).

²⁷³First, a broker-dealer that charges a separate fee or separately contracts with a customer for investment advisory services may not rely on the exception. Second, a broker-dealer that holds itself out generally to the public as a financial planner or as providing financial planning services may generally not rely on the exceptions to avoid registration 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. See rule 202(a)(11)-1(b).

²⁷⁴Section X of this Release lists the statutory authority for the proposed rule and rule amendments.

²⁷⁵See Sections II and III of this Release, supra.

²⁷⁶17 CFR 240.0-10(c).

²⁷⁷This estimate is based on the most recent data available, taken from information provided by broker-dealers in Form X-17A-5 Financial and Operational Combined Uniform Single Reports filed pursuant to section 17 of the Exchange Act and Rule 17a-5 thereunder.

²⁷⁸See supra note 273 for a description of these three categories of advisory services.

²⁷⁹17 CFR 240.17a-4(b)(7). As previously discussed, although rule 202(a)(11)-1(a) would also limit its application to accounts that a broker-dealer does not exercise investment discretion over, under Exchange Act rules, broker-dealers are already currently required to maintain all “evidence of the granting of discretionary authority given in any respect of any account.” 17 CFR 240.17a-4(b)(6). Thus, this provision of the rule would not create an additional recordkeeping requirement for broker-dealers.

²⁸⁰ See supra note 273 for a description of these three scenarios.

²⁸¹ For Paperwork Reduction Act purposes, we have estimated that approximately 195 broker-dealers could be required to register as investment advisers as a result of the proposed rule and interpretation. See supra Section VIII.B of this Release.

²⁸² 5 U.S.C. 603(c).

²⁸³ Rule 202(a)(11)-1(b)(1) focuses on whether the broker-dealer separately contracts for the advisory services or charges a separate fee. Rule 202(a)(11)-1(b)(2) focuses on how the broker-dealer holds itself out generally to the public or represents its services to a customer. Rule 202(a)(11)-1(b)(3) focuses on whether the broker-dealer exercises investment discretion over customer accounts.

²⁸⁴ Because we are using our authority under section 202(a)(11)(F), broker-dealers relying on the rule would not be subject to state adviser statutes. Section 203A(b)(1)(B) of the Act provides that “[n]o law of any State or political subdivision thereof requiring the registration, licensing, or qualification as an investment adviser or supervised person of an investment adviser shall apply to any person . . . that is not registered under [the Advisers Act] because that person is excepted from the definition of an investment adviser under section 202(a)(11).” (emphasis added).

We also have authority under section 206A, which is available as an alternative ground, because the rule we are adopting is in the public interest and consistent with the protection of investors and the purposes intended in the Act.