Court Rules That Stockbrokers Must Register As Investment Advisers When Paid Asset-Based Fees And Not Commissions

James J. Eccleston, esq.

ecently the U.S. Court of Appeals for the District of Columbia Circuit issued a decision that represents a landmark victory for registered investment advisers and a defeat for major brokerage firms (such as Merrill Lynch, Smith Barney, Wachovia Securities and Morgan Stanley). The Financial Planning Association (FPA) filed the lawsuit against the Securities and Exchange Commission (SEC) arguing that the SEC 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."

First, what is 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, Inc., 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 from a "consensus between industry and the SEC that investment advisers could not completely perform their basic function - furnishing to clients on a personal basis competent, unbiased, and continuous advice regarding the sound management of their investments - unless all conflicts of interest between investment counsel and the client were removed."

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/her own interest. The duty of care, the duty of loyalty and the duty of fair dealing capture much of the essence of what it means to be a fiduciary. Additionally, it is worth noting that the fiduciary duties of investment advisers are governed by rules other than contract rules. Whenever the two conflict, fiduciary rules trump contract rules.

By comparison, the Merrill Lynch Rule allowed brokerage firms, on the one hand, to promote their 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% of investors were unaware that stockbrokers and investment advisers had different levels of responsibilities to their clients.

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. One veteran industry commentator, Bob Veres, opines that the ruling "puts the whole financial services industry in a bit of a bind." He outlines some possible scenarios:

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

Brokerage firms will create separate divisions for their investment advisory businesses, and register their stockbrokers as investment advisers; and/or

Brokerage firms will 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. But for now, investors should rejoice!

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James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.