When Bob McCann flew to Washington, D.C., on July 16 to meet with SEC Chairman Christopher Cox, it was a last-ditch effort to save fee-based brokerage accounts from the scrap heap. A few months earlier, the U.S. Court of Appeals for the District of Columbia had thrown out SEC Rule 202—the broker/dealer exemption—that for eight years allowed registered reps (better known these days as financial advisors) to offer fee-based brokerage accounts. The exemption carried certain stipulations, but, at the end of the day, critics of the exemption charged that it gave Series 7 holders the right to position themselves as if they were fiduciaries—that is, investment advisor reps (IARs) of registered investment advisory (RIAs).
Forget the irony in imagining McCann, the president of Merrill Lynch Global Private Client, going to D.C. to try to save the broker/dealer exemption derisively called the “Merrill Lynch Rule.” To McCann, wrap accounts represent client choice, simple as that. Why shouldn’t a client be able to pay his registered rep a fee based on assets instead of trades? In meeting Cox, McCann had hoped to help persuade the industry watchdog to reconsider its position, and to appeal the ruling after all. (In May, the SEC let pass its deadline for challenging the court ruling that overturned the Merrill rule.) “The benefits to investors got lost in a legal and technical argument over how broker-dealers and investment advisors are regulated,” McCann says.
McCann felt the need to go himself, because, for months, Merrill and the securities industry lobby, the Securities Industry and Financial Markets Association (SIFMA), had been aggressively lobbying for Congress to intervene, to somehow recast the rules so that Merrill—and other broker/dealers—could continue to offer fee-based brokerage accounts. At press time, SIFMA had proposed an interim rule that would effectively delay the compliance date to Jan. 1, 2008, and allow for principal trading relief. This would give firms more time to prepare for the new rule, and see the results of a study conducted by the Rand Corporation that examines how different regulatory systems that apply to brokerages and investment advisors affect investors. The study is due out in December.
There is a lot on the line, not just for Merrill, but every b/d that offers fee-based accounts in its brokerage unit. Of course, bear in mind that Merrill has the biggest stake in this battle, with more than $100 billion in assets in these fee-based accounts, representing about one-third of industry assets. (Last year, for example, Merrill opened about 60,000 fee-based brokerage accounts.) Compare that to Morgan Stanley’s $33 billion in brokerage wrap accounts, UBS’ $30 billion and Smith Barney’s $20 billion, according to estimates from estimates research firm Cerulli Associates.
With the 120-day extension for the court ruling about to expire (on Sept. 30), firms apparently have not figured out what to do. Obviously, they’d like to just tweak what they offer now without breaking the law. Otherwise, b/ds face the arduous task of converting approximately 1 million fee-based brokerage accounts worth over $300 billion into regular brokerage accounts, or transfer them to the RIA side of the house. It is thought that the latter would greatly increase the financial advisor’s compliance burden. The demise of fee-based brokerage was a result of the Financial Planning Association’s victory in convincing the federal district court of appeals that the SEC had overstepped its bounds by exempting b/ds in the first place from the fiduciary standard laid out in the Investment Advisers Act of 1940.The Exemption Is Good
That’s a shame, says McCann. He says he told Cox and other commissioners at the agency that the simplicity of pricing on a fee-based account is an attractive feature for many brokerage customers, who find the commission structure confusing and complex. And that for the active trader, a flat fee is a good deal. McCann also pointed out that there could be unintended consequences when customers are switched out of a format they’ve grown accustomed to. But in the end, McCann’s concerns fell on deaf ears, and he returned to New York frustrated and disappointed.
Upon his return to New York, McCann advised his army of 16,000 financial advisors to cease opening new fee-based accounts. At least for now. At press time, the SEC had not provided the firm with further guidance on how to proceed, suggesting that a possible extension to the compliance deadline may be considered. “My expectation is that we will be transitioning our clients to advisory accounts, traditional cash management or brokerage accounts and then perhaps creating a new [kind of] account as well,” McCann says.
“It’s a shame. This is a loss for the investor,” McCann says. “I think choice is good for the clients—as many choices as we can give clients as to how they pay for the services— as long as we make sure they’re in the account that is appropriate for them.”McCann’s Legacy
The killing off of fee-based brokerage eliminates a competitive advantage for Merrill and will force it to spend time, money and resources repapering the accounts and communicating to clients why their account formats will change. Of course, it affects Merrill’s rivals in the same way. “It’s a huge disruption, not only for firms but also their advisors,” says one wirehouse executive, who didn’t want to be quoted by name. “There’s a lot angst over fee-based brokerage because some reps have built their whole business around it.”
What’s more, brokerage firms could face a host of new regulatory booby traps if they allow their reps to dispense advice and act as fiduciaries. “The risk to the b/d is that when [a rep takes] on fiduciary status, or when there seems to be a fiduciary relationship, it opens up the potential for greater litigation if it can be demonstrated that there were conflicts of interest or prohibitive transactions,” says Don Trone, president of Fiduciary 360, a consulting firm.
At Merrill, it represents arguably the biggest test of McCann’s leadership since returning in August 2003 from his brief stint at AXA Financial, where he spent six months before Stan O’Neal lured the then 25-year Merrill veteran back to run the retail brokerage unit. Since then he has done an admirable job at wringing good performance out of the unit: Profits and revenues are at record levels, advisor headcount and revenue per FA are tops in the business and advisor attrition remains at historical lows.
But one analyst questions whether he should be congratulated for that. “The market is moving in his direction. When times are good, you just need a person to administer the thing and make sure that it doesn’t get off track,” says Dick Bove, a research analyst at Punk Ziegel. “The guy hasn’t been tested.”
Indeed, McCann inherited a fairly well-oiled machine from his predecessor, James Gorman, who whipped the business into shape after the market crashed. And he has since had favorable market conditions at his back. The elimination of fee-based brokerage also gives McCann the challenge—and opportunity—to bounce back from a botched Advest acquisition, where Merrill acquired a regional brokerage firm that was a cultural mismatch from the start, as evidenced by the loss of about 80 percent of Advest reps.
The Next Step
McCann didn’t offer much detail concerning what specific changes the firm might make to its account offerings. But Merrill spokeswoman Jennifer Grigas says, “Our non-discretionary program, Merrill Lynch Personal Advisor, will be modified to allow for additional financial services that clients now enjoy in our fee-based brokerage program.” In other words: We’re still working on how to let our reps offer financial advisory as a brokerage product.
In the meantime, it looks like Morgan Stanley may have beat Merrill to the punch. On August 15, Morgan announced the launch of its new non-discretionary advisory account, “Morgan Stanley Advisory.” The accounts will be governed by the Investment Advisers Act of 1940, and will allow advisors who meet the corresponding licensing requirements to offer investment advice for an asset-based fee. The firm would not provide details about what other kinds of criteria reps will have to fill in order to be able to offer the program to clients, but length of service and experience will be factors. “Ultimately, because it’s a non-discretionary account, the client has the last say on all transactions,” says Lule Demmissie, program manager for Morgan Stanley Advisory. (Smith Barney and other firms currently offer wrap account programs that provide “advice” for a fee, but because the actual investment selections are packaged together by third party providers, neither the reps nor the firms assume fiduciary responsibility. Regulators do not seem to be too happy with this approach, however. See our story on page 85.)
McCann says that the fiduciary standard doesn’t keep him up at night, because a large majority of Merrill reps carry both Series 7 and Series 65 licenses (the licenses a Series 7 holder takes to act as an IAR). Depending on whom you ask, this may or may not be sufficient to serve as a fiduciary. “The Series 65 doesn’t even scratch the surface of the body of knowledge that the broker needs to master,” says Trone. (That’s a matter of opinion, and it is legally enough to allow a person to act as a investment advisor representative of a registered investment advisor.)
Dirty Words, Dirty Deeds?
Perhaps unfairly, in the aftermath of the Financial Planning Association’s crusade to get the definition of fiduciary clarified, fee-based brokerage has become a dirty word in the securities industry. “They’ve taken a potentially beneficial account functionality for an investor and made it taboo,” says Lisa Roth, president of consulting firm ComplianceMax. She argues that while the FPA was prudent in seeking clarity on the fiduciary standard, the baby is being thrown out with the bath water. “So [b/ds] are forced to do away with them because they’re taboo now. It’s the path of least resistance. Commercially, it’s unfair,” she says.
The FPA’s lawsuit stems from instances of abuse by certain financial advisors, such as overcharging buy-and-hold customers who would have been better off in a commission-based account. “The point of fee-based brokerage shouldn’t be to annuitize an otherwise buy-and-hold account. That’s inappropriate,” Roth says. But it’s not always that cut and dry. “There may be opportunities where if the only factor of determining whether it’s an investment advisory or brokerage account is the ultimate cost to the investor. Sometimes that’s really difficult to predict,” Roth says.
Industry critics, however, say Merrill brokers aren’t concerned about what’s best for the client but rather their own economic interests, and the argument about choice is more of a red herring. “They want to protect their ability to engage in principal trades,” says Mercer Bullard, founder of Fund Democracy and a former assistant chief counsel at the SEC. Principal trades are prohibited under the investment advisory model unless there is consent before settlement. He also says that Merrill (and other firms) could possibly circumvent the new rules if the SEC looks the other way, which wouldn’t surprise him. “There’s certainly a possibility that they’re going to do an end run on this rule given the SEC’s collusion on [the fee-based brokerage] issue.”
While the debate over fiduciary responsibilities will remain top of mind for Merrill and its advisors, McCann says he’s more focused on driving the retail unit’s growth strategy. In a shrinking business where smaller players are being gobbled up by larger firms (McDonald, Piper Jaffray, A.G. Edwards) “significant and consistent profitability matters because firms need to have the wherewithal to invest back in the business,” McCann says. “We think we can be the beneficiary of this changing shape and consolidation in the industry.”
It’s not hard to take McCann at his word when you consider Merrill’s dominance of the space. In the trailing 12 months through the last quarter, Merrill FAs, on average, generated about $875,000 in production. Revenues and pre-tax profit margins were also among the best in the industry. McCann’s performance, however, may not be judged solely on financials, but how he manages the transition from fee-based brokerage.
|Top 10 Fee-Based Brokerage Programs (in billions):|
|6.||Citigroup (Smith Barney)||$19.0||6.9%|
|Source: Cerulli & Associates|