Banking & Finance

VOICES FROM THE INDUSTRY: Court decision could change future of brokerage firms

May 14, 2007

On March 30, a U.S. Court of Appeals issued a decision that represents a tremendous victory for registered investment advisers, individual investors and a defeat for big brokerage firms such as Merrill Lynch, Smith Barney, and Goldman Sachs.

The Financial Plan-

Association filed the lawsuit against the Securities and Exchange Commission, arguing that the SEC in 1999 had exceeded its authority in creating an exemption from investment adviser registration under the Investment Advisers Act for stockbrokers who charge asset-based fees for their services.

Let's examine three key questions relating to the court decision in FPA v. SEC striking down the so-called "Merrill Lynch Rule" and how it affects you.

The Investment Advisers Act

In 1940, Congress enacted the Investment Advisers Act to provide for registration and regulation of investment advisers. As the Supreme Court recognized in an often-cited case, SEC v. Capital Gains Research Bureau, the fundamental purpose of this and other legislation adopted at the time was to "substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry."

The Investment Advisers Act in particular arose when the SEC determined that investment advisers could not completely perform their basic function-furnishing to individual clients competent, unbiased advice financial advice-unless all conflicts of interest between investment advisor and the client were removed. Sounds like something all financial professionals should do, not only the registered investment advisors.

Lost in the fine print

Second, what is the significance of being registered as an "investment adviser?" The law is clear that investment advisers are fiduciaries. As a fiduciary, the investment adviser must place the client's interest ahead of his or her own. This is a much higher bar to reach than the suitability rule that governs stockbrokers.

Instead of requiring your best interest to be placed first, the Merrill Lynch Rule allowed brokerage firms, on the one hand, to promote their so-called full-service expertise and encourage their clients to trust and rely upon them, yet, on the other hand, to supply this "fine print" disclosure:

"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."

Nevertheless, a study by TD Ameritrade found that 74 percent of investors were unaware that stockbrokers (no matter what their title) and investment advisers had different levels of responsibilities to their clients.

What's the impact?

Third, what will be the effect of the court's decision striking down the Merrill Lynch Rule?

The effect, moving forward, is that stockbrokers who provide investment advice in return for asset-based fees must register as investment advisers and, accordingly, will be deemed to be fiduciaries.

In response to this court decision (and assuming the Supreme Court does not reverse it on appeal), it remains to be seen how brokerage firms will react. Here are some possible scenarios:

Brokerage firms could suspend their asset management and fee-based services, and instead return to charging only commissions for trades.

Brokerage firms could create separate divisions for their investment advisory businesses and register their stockbrokers as investment advisers.

Brokerage firms could lobby Congress to change the Investment Advisers Act to create an explicit exemption from investment adviser registration for stockbrokers charging asset-based fees.

If one follows the money, it is doubtful that brokerage firms will retreat from what has become an especially lucrative business model-charging asset-based fees instead of commissions.

Likewise, with a Democratic Congress, brokerage firms will have little chance legislating away fiduciary protections for investors. On the other hand, conflicts of interest between brokerage firms and their customers (arising from even more lucrative business areas such as investment banking, mutual fund "shelf space" sales promotions and sales of brokerage firm "proprietary products" may convince brokerage firms to do everything in their power to avoid widespread registrations of their stockbrokers as investment advisers.

Only time will tell. So individual investors would be wise to make sure their investment professional is an "F" word-Fiduciary.

Coan is managing partner with Wealth Planning & Management LLC, a fee-only registered investment advisor, and author of Asset Protection and Wealth Preservation. Views expressed here are the writer's.
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