New Rule Requires Special Care for Fee Based Brokerage Accounts

by James J. Eccleston, Esq.

New Rule Requires Special Care for Fee Based Brokerage Accounts

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awyers should note that the New York Stock Exchange (NYSE) has issued a new, important rule regarding fee-based brokerage accounts. Fee-based brokerage accounts have become popular alternative pricing structures compared to traditional, commission-based compensation. The NYSE, like the National Association of Securities Dealers (NASD), has sought to ensure that such fee-based programs are suitable for customers and that customers are aware of both the positives and the negatives of those programs.

The new NYSE Rule 405A, effective September 22, 2005, will cover nearly 400 of the largest brokerage firms in America, servicing accounts for 92 million customers, or 90% of the total public customer accounts. The NASD guidance will cover those same firms plus the vast majority of other firms.

As background, in 2003 the NASD issued a notice to its member firms, NTM 03-68. This notice "reminded" firms and reps that fee-based account programs must be appropriate, and comply with existing rules addressing good faith (Rule 2110), suitability (Rule 2310) and fair pricing (Rule 2430). In a nutshell, the NASD cast doubt on the appropriateness of recommending fee-based accounts for customers with low trading volume, and required firms to conduct periodic reviews to determine whether fee-based pricing continued to be appropriate. An inappropriate fee structure, the NASD cautioned, would cause an otherwise suitable investment recommendation to be deemed unsuitable.

Thereafter, the NASD issued "Fee-Based Account Questions and Answers." One Q&A clarifies that the NASD's notice to members does not apply to separately managed accounts with third party managers (sometimes referred to as "WRAP accounts") subject to the Investment Advisers Act of 1940. Another Q&A is helpful because it relates to "particular problems or issues" that the NASD has detected. The NASD enumerates several worth noting. First, the NASD has found that, "it is not always clear that customers receive adequate disclosure", including the fact that fees probably will be higher in a fee-based account if the level of activity is "modest". Second, the NASD is concerned that customers may purchase mutual funds and other similar products for a sales load outside of a fee-based account, but shortly thereafter will switch to a fee-based account, in which they are charged a fee. Third, the NASD concludes that there have been instances in which documentation supporting the appropriateness of a fee-based account is "non-existent or weak."

The NYSE has gone a step further in issuing a new rule to address these concerns. The new rule "requires informational disclosure to customers, ongoing monitoring of transactional activity, and follow-up with certain identified [non-managed fee-based account program] customers." Let's examine the key provisions of the new rule.

First, prior to opening the account for a new customer, or prior to participating in the program for an existing customer, each customer must be provided with a disclosure document that describes the fee-based program. At a minimum, firms must disclose the services, the eligible assets, the fees charged, an explanation of how costs will be computed or provision of cost estimates, conditions and restrictions, and a summary of the program's advantages and disadvantages. All of this must be communicated in "plain language."

Second, more than mere risk disclosure is required. That is, the firm must determine that the fee-based program is appropriate for the customer. Like the NASD guidance, the NYSE opines that fee-based programs may be appropriate for customers with moderate to high levels of trading activity, since the cost per trade is reduced as the number of trades increases. The fee-based program still may be appropriate for customers who trade less, but in those instances the firm must determine that the customer wanted the program because of benefits other than cost.

Third, firms must monitor fee-based accounts to ensure that they continue to be appropriate. Firms must, if warranted, contact customers to discuss the appropriateness of the fee-based program. The firm's monitoring, review, contact and follow-up all must be documented.

Fourth, the NYSE notes that two types of assets will be suspect because it may be inappropriate for customers to pay a fee-based upon the value of those assets. First, like the NASD the NYSE is concerned about mutual funds. The NYSE states that mutual funds may be inappropriate assets in a fee-based account because they are not generally considered to be products to be actively traded. Should there be such positions in a fee-based account, the NYSE suggests waiving the sales loads. Likewise, "restricted" stock assets concern the NYSE. The NYSE cautions brokerage firms to pay "attention" to these assets because they cannot be freely traded.

The NYSE and the NASD have served customers well in implementing this new rule and guidelines.