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The Great Reckoning

Oy. What a headache. That's what many Series 7-carrying advisors are saying about the prospect of the end of the Merrill Lynch rule.

Oy. What a headache.

That's what many Series 7-carrying advisors are saying about the prospect of the end of the “Merrill Lynch” rule. In March, a U.S. Court of Appeals for the District of Columbia tossed out SEC Rule 202, the so-called Merrill Lynch rule that, for eight years, had allowed registered reps — formerly known as brokers — to offer fee-based brokerage accounts. Assuming the D.C. Court of Appeals ruling stands — and that's a big assumption since the SEC still has a couple of options for challenging the ruling — reps offering the accounts will have to convert them to another compensation arrangement — or register as investment advisors. (And few large broker/dealers deem that a prudent option, since it bestows on their advisors a fiduciary standard with a concomitant higher legal risk.)

At the time of this writing, the SEC hadn't responded (it has until May 14th). But you can bet it will. Imagine the humiliation felt among the SEC staffers that the lil' ole Financial Planning Association's challenge to SEC Rule 202 actually carried the day. Even if the SEC doesn't appeal, the brokerage industry is not likely to roll over. There is too much money at stake: In the balance is nearly $300 billion in more than 1 million fee-based brokerage accounts, according to Chip Roame of Tiburon Strategic Advisors. That's roughly 22 percent of the $1.5 trillion in all “fee-based” product assets (see chart). Roame estimates Merrill Lynch, a pioneer in these accounts, holds by far the largest chunk of that pie with more than $100 billion; a Smith Barney spokesman says his firm has $20 billion. Other firms contacted declined to provide their asset totals, but Cerulli estimates that Morgan Stanley has $33 billion and UBS Financial Services has $30 billion in assets in fee-based brokerage accounts.

Not surprisingly, most observers say the ruling will be appealed, with the industry going directly to Congress to have the securities laws rewritten, if necessary. For now, brokerage firms remain tight lipped about the effect of the FPA's victory on their businesses. On the ground level — among the reps, branch managers, lawyers and consultants who counsel industry management — most are trying to imagine the paperwork involved in transitioning the accounts. (Despite the awe-inspiring new-account-form filings, one wirehouse spokesperson, who spoke on the condition that he and his firm remain nameless, said, “It isn't really a big deal.”)

What Next?

Whatever the specific business impact the ruling may have, many see the return to pre-1999 rules as a step forward, a chance for the brokerage industry, which has long avoided fiduciary duty for (legitimate) business and regulatory reasons, to overcome those obstacles and embrace it.

“This ruling is the beginning,” says Stephen Winks, an industry consultant and publisher of Senior Consultant, an industry newsletter. “The brokerage industry will slowly and surely evolve to an advisory services format from here. Why? Because it's in everybody's interest to do so — and the pressure to do it is only going to grow.”

While the U.S. Court of Appeals ruling focused on the SEC's power to implement the b/d exemption, the underlying context of the FPA's 2004 lawsuit against the regulator was certainly the increasingly blurry distinction between brokers and advisors — and fee-based brokerage accounts represented that blurring all too well. If a customer is not getting advice with the account (since it's a brokerage account) and little or no trading is occurring, what is the fee for? The court ruled the fee was “special compensation” which, under the Investment Advisers Act of 1940, means the relationship should be advisory. But many brokers freely admit (off the record, of course) that they provide advice to their clients and it isn't always “solely incidental” to their brokerage services, as the Investment Adviser's Act stipulates. Likewise, many reps say they act like fiduciaries — in the “best interest of their clients” — just as investment advisors must do, even providing clients with investment policy statements and extensive disclosures of any and all conflicts of interest. In fact, many say that even if they were IARs, they wouldn't act any differently — which for some is probably true.

But then why not make the leap, become an investment advisor representative (IAR) and accept fiduciary duty? Except for an elite institutional group at many firms, the vast majority of brokers aren't allowed to do so by their firms, for structural, operational and regulatory reasons. This ruling could influence firms to seek ways to do so. There are other forces at work: The Pension Protection Act allows brokers to legally act as fiduciaries on 401(k) plans, technological advances make it much easier for firms to help them meet those obligations and baby boomers — who have been hearing a growing chorus of fiduciary talk — seem to want real advice and are increasingly going to RIAs to get it. Some observers say someone — probably the SEC or Congress — needs to make some changes to help the industry progress, as in rewrite the antiquated laws that govern financial institutions.

Mark Barracca, associate corporate counsel at Raymond James Financial, says the laws, the Securities & Exchange Act of 1934 (regulating reps) and the Investment Adviser's Act of 1940 (regulating RIAs) just don't make sense anymore; stockbrokers no longer consider themselves salesman anymore, rather, sophisticated advisors. “There is not a lot of value added in just trading stocks anymore,” Barracca says.

The brokerage industry's lobbying arm, SIFMA, is taking a similar stance in urging the SEC to request from the Court a rehearing “en banc,” which would require a ruling by the entire D.C. Court of Appeals (the ruling was 2-1 and there are nine judges). The ruling “has the potential to significantly impair an important element of consumer choice for American investors,” said Marc Lackritz, president of SIFMA, in a statement. But the odds aren't in the SEC's favor, according to Hardy Callcott, an attorney with Bingham McCutchen, who puts the likelihood of the Court granting an en banc hearing or a Supreme Court review — the other option — at “less than 10 percent.” But requesting a highly unlikely rehearing brings one big benefit — time. “Just requesting the hearing gives the SEC until the Fall to issue interpretive guidance on the ruling, whereas if they don't the Court will issue its mandate on May 21,” says Callcott. That in turn would give the industry time to adjust, which they'll need. Among other things, Calcott says, customers have to sign new account agreements, Form ADVs have to be drawn up and sent to clients and accounts need to be transferred and recoded as “advisory” not “brokerage.” Another hurdle? Reps — if they want to continue to serve the account and get paid on it — need to get Series 66 licenses. “It won't be easy for them, nor quick,” he says.

Change Is Good

Wholesale change isn't the only solution, says Roame. “I think the ruling will stand but don't count out the creativity of firms' product departments. Who knows, they may charge a smaller transaction fee but with a larger ‘research fee’ attached, there's a lot of untilled gray area left.”

One likely result is the continuation of a trend — moving assets to wrap-account programs, which are advisory accounts. A person familiar with Smith Barney's operations says if the ruling stands the firm will likely migrate its $20 billion in fee-based brokerage accounts to Smith Barney Adviser, the firm's wrap-account program. Because the firm is the fiduciary — it does the asset allocation and portfolio management — the broker is free to sell the accounts and otherwise act as a broker. All the wirehouses offer similar programs, as do many other firms through third-party managers like Envestnet and Lockwood Advisors. The asset growth in wrap programs slowed significantly in 1999 when the Merrill rule was proposed but these accounts have experienced a resurgence, as fee-based brokerage has received negative press in recent years. Roame is now predicting that the more than $130 billion in wrap accounts will reach $170 billion by 2008 and $210 billion by 2010, largely due to outflows from fee-based brokerage accounts.

Consultants and financial planners who've been pushing the brokerage industry to embrace (not avoid) allowing reps to act as fiduciaries, view wrap accounts as a positive — the FPA publicly applauded the trend toward the greater use of these accounts in 2005 — but also see them as a half-measure. “Wrap accounts allow reps to essentially sell advice as a product,” says Don Trone of Fiduciary360, a consulting firm, who'd like the firms to expand their institutional consulting units that, in many cases, allow an elite group of advisors to provide comprehensive advice and act as fiduciaries.

Winks, of Senior Consultant, says that with the technology available today many firms could already provide an audited prudent investment process for their reps that would allow them to fulfill their fiduciary responsibilities. “There are 240 things an advisor must do to be a fiduciary,” according to Winks, who says the number comes from the Society for Fiduciary Advisors, a collection of fiduciary experts who've compiled the list from fiduciary case law. “But 80 percent of that is reporting and disclosure, which can be automated,” he says. The rest of the equation is available: overlay management, which allows reps to continuously monitor all portfolios, and the Pension Protection Act, which allows reps to be fiduciaries. “That the b/ds are not being supported by a fiduciary process is clearly an advantage for RIAs,” he says. “Just look at the assets. Last year, the top 3,000 advisors at Schwab, those with more than $100 million in assets, brought in more net new assets than all the major wirehouse brokers combined.”

But competing on fiduciary status will be difficult for some firms — especially the larger ones — and likely impossible under current laws, according to Bert Schaeffer, founder of VERUS Advisors, a fiduciary consulting firm and a co-founder with Trone of the Foundation for Fiduciary Studies. Before starting VERUS, Schaefer was the former national director of UBS' institutional consulting division; he knows what b/ds are up against. He says brokerage firms would face a regulatory minefield if they were to allow a large number of their brokers to give advice and act as fiduciaries (See sidebar for examples). “I can't see the SEC providing the brokerage firms with any relief from these rules,” he says. “But I can see Congress legislating some kind of very limited exemption — something similar to the Merrill rule.”


Assets in packaged fee-accounts are expected to rise from $1.5 trillion in 2006 to nearly $2.9 trillion by 2010.

Product 2006 assets ($billions) % of current total assets Projected assets by 2010
Separately Managed Accounts & Multiple style Portfolios $720 53 $1.5 trillion
Fee-based Brokerage Accounts $285 22 $330 billion
Mutual Fund Wrap Accounts $305 14 $500 billion
Broker Wrap Accounts $130 7 $210 billion
ETF Wrap/Annuity Wrap/Unified Managed Accounts $30 2 $118 billion
Source: Tiburon Strategic Advisors.

The (Legal) Hurdle

Why you are different from a registered investment advisor.

Say you are a Series 7 holder at a national broker/dealer. Say you are sophisticated and have any number of designations and lots of training. You consult to demanding, high-net-worth clients. Why won't your firm let you become a registered investment advisor? Because securities laws make it tough — compliance-wise — for your firm to allow more than a small number of reps to provide advice and serve as fiduciary counsel to clients. Or so says industry consultant Bert Schaeffer, of VERUS Advisors.

It boils down to “principal transactions.” Under the Investment Advisers Act of 1940, a b/dthat is also serving a clientas an investment advisor may not act as a dealer with the client, by, for example, selling securities from inventory — this is called a “principal transaction,” a no-no unless the b/d gets written consent for each transaction.

And the problem doesn't go away with separately managed accounts: While the b/d doesn't control the activity of the money manager, because the b/d recommended the manager and has the ability to hire and fire him, the manager has an incentive to do business with the b/d. The firm could instruct the manager not to do trades with the b/d, but that could be bad for the client, given the potential missed investment opportunities for the client.

The rules are similar under ERISA — again, no “principal transactions” are allowed between the plan and the fiduciary and all recommendations must be in the exclusive best interest of the client. Absent changes in the law and regulations, b/ds cannot serve as fiduciary advisors without a radical change to their business models (no principal trading and no proprietary products sold to advisory clients). Changing the business model is not feasible, experts say. The securities industry raked in $43 billion in trading profits in 2006, up 85 percent from 2005, according to SIFMA, the industry lobby.

But what about carving out a fiduciary niche, a separate RIA/fiduciary advisor group? Say a b/d has thousands of ERISA clients for which it serves as a broker. But it decides it wants to create a separate RIA/fiduciary advisory group. Schaeffer asks: “Does the b/d have an obligation to advise and disclose to its clients that it has formed this new group that effectively provides similar services to the ones they are receiving from its broker, but as a fiduciary and at possibly lower cost?” While some do, they don't necessarily like to advertise it. Schaeffer asks, “What client wouldn't prefer that option?”

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