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Nothing was settled, really, when the SEC rubberstamped the revised so-called Merrill Lynch rule. That rule took effect last year and provided an exemption for broker/dealers from the Investment Advisers Act of 1940. But the age-old debate between the b/d and investment advisor (RIA) industries over who should be able to provide advice and when, and whose regulatory regime offers better investor protections,

Nothing was settled, really, when the SEC rubberstamped the revised so-called “Merrill Lynch rule.” That rule took effect last year and provided an exemption for broker/dealers from the Investment Advisers Act of 1940. But the age-old debate between the b/d and investment advisor (RIA) industries over who should be able to provide advice and when, and whose regulatory regime offers better investor protections, is far from over.

The Financial Planning Association, which represents investment advisors and financial planners, sent a formal letter to the SEC in mid-March requesting regulatory guidance concerning the differences between financial planning and fee-based brokerage services under that rule, saying there are continued problems with interpretation as well as violations of the rule. In the meantime, the FPA is still waiting for a federal appeals court ruling on its lawsuit against the SEC that challenges the exemption entirely.

More recently, an uproar has exploded over revisions that the CFP Board made to its Code of Ethics. The sticking point was that the revised ethics code would have lent further support to the b/d exemption — giving b/d advisors a green light to offer RIA-like advice without adhering to the RIA fiduciary standard. The CFP Board published a second round of revisions in mid-March, and it is now accepting industry comments. (For more on this see page 26).

In the midst of the continued controversy, we thought it was worth revisiting the arguments and the regulatory differences between the two sides. The revised Merrill Lynch rule basically states that b/ds that offer advice are now exempt from complying with the Advisers Act, provided that the advice is solely incidental to the b/ds' brokerage business; that asset-based or fixed fees are charged; and that specific disclosures are made telling the client he or she is purchasing a brokerage account — and that the firm may not have the same interests as the client.

Why does this matter? As trading and stockpicking have turned into less lucrative businesses in recent years, b/d advisors have begun offering more advice through fee-based brokerage programs, and the bright lines that used to separate the b/d and RIA industries have become more and more blurred. B/d advisors are increasingly hard to distinguish from RIA investment advisors and financial planners.

Investment advisors have warned that the incursion of b/ds into the advice business could result in the dilution of the investor protections offered by the Advisers Act. “Why are b/ds so dead set against being subject to these rules?” asks David Tittsworth, executive director of the Investment Adviser Association in Washington, D.C. “People doing the same thing, engaged in the same activities, should be governed by the same rules.”

Tittsworth claims that b/ds want to avoid the Advisers Act because they don't want to be held to fiduciary duty, which requires investment advisors to act in the best interests of their clients at all times. (By comparison, a b/d advisor can put his own interests or his firm's interests first, as long as his recommendation is “suitable” for the client, rather than the best or most cost-effective solution.) B/ds also want to avoid the Advisers Act's prohibitions on self-dealing, such as the rule prohibiting principal trading, says Tittsworth.

The counterargument made by b/ds is that investment advisors' opposition to the Merrill Lynch rule reflects concerns about competition rather than the existence of a regulatory disparity. “It's simply a matter of competition for managing assets,” says Michael Unger, a partner at Rubin and Rudman in Boston, who frequently represents b/ds. B/ds have gone head to head with investment advisors in competing to provide clients fee-based services, he says. If RIAs can get the word out to investors that b/ds are biased, or prevent them from providing advice altogether, they will have a powerful edge with clients. The latter seems unlikely, but they have had some success with the former.

Not surprisingly, b/ds largely support the Merrill Lynch rule, arguing that the imposition of the Advisers Act would be an unnecessary and duplicative regulatory overlay. In the course of debate over the Merrill Lynch rule, the NASD responded to the concerns raised by RIAs saying that the detailed, preventive rules governing b/ds, in fact, offer better investor protections than the Advisers Act.

Who's Right?

Each side's claims are supported by a tangle of legal and regulatory matters that can be hard to sort out; there is simply no apples-to-apples comparison.

The Advisers Act contains broad standards requiring investment advisor reps to act as fiduciaries, and it's comprised of 34 separate rules. “If you compare the two standards, the standard for investment advisors is shorter, but it basically says, ‘Do the best for the client and if you don't act in the best interests of the client, you are going to get in trouble,'” says Ron Rhoades, chief compliance officer at the advisory firm Joseph Capital Management in Hernando, Fla. In other words, an advisor cannot choose an investment for his client that pays him or his firm a little bit more if there is another investment that would be a little bit better for the client — and less lucrative for the advisor or firm.

In contrast, the laws governing b/ds — the Securities Exchange Act of 1934, as well as NASD and NYSE rules — lay out explicitly detailed standards for firms and their reps, and collectively number in the tens of thousands. “The rule requirements for b/d and registered rep conduct are far more intense and extensive, and, accordingly, there are fewer gray areas,” says Unger.

There are also a lot more cops on the job in the b/d world. B/ds are subject to three levels of oversight — the SEC, the self-regulatory organizations (NASD and NYSE) and the states. “It's the cops on the beat that keep people walking on the straight-and-narrow path,” says Hardy Callcott, partner at Bingham McCutchen in San Francisco.

RIAs and their advisor reps, by comparison, are subject to just a single layer of regulation — either the state or the SEC. And where all b/d firms are subject to inspection at least once every four years, if not more frequently, it is only those RIA firms that are deemed “high risk” that are regularly inspected by the SEC. In all, the NASD conducts approximately 2,300 routine inspections of b/ds per year, while the SEC carries out around 1,500 inspections of RIAs per year.

Compliance Headache

Comparing the two regulatory regimes inevitably also comes down to a contest over which regime poses larger compliance challenges to the firms and their reps. On the b/d side, critics charge the rules have become so numerous and duplicative, that it is often difficult to determine exactly how firms are expected to comply.

Some streamlining of b/d rules will result from the consolidation of the NASD and NYSE regulatory functions, which is still pending SEC approval. But that's not necessarily a big consolation for NASD members, since the new combined rulebook is expected to adopt the tougher standards of the NYSE, says Callcott.

But while the number and specificity of rules governing RIAs may lag behind those governing b/ds, RIAs say the SEC has increased its regulation of them directly through new rules, and indirectly through more intrusive inspections. For example, over the last few years, the SEC has written rules requiring RIAs to adopt written compliance policies, to review those policies internally and to have codes of ethics.

Ultimately, the SEC may need to settle the debate. The regulator is conducting a study to evaluate whether the RIA and b/d regulatory regimes offer individual investors equivalent protections, and whether there are gaps that need to be filled. But the results may be a long time coming. A report on the first leg of the study is not expected until early next year.


RIAs talk a big game about fiduciary duty, but rule-wise, broker/dealers are as heavily regulated (well, almost) as the firearm industry. But that is changing as RIAs are getting hit with more rules and more inspections. Below is a brief comparison of the compliance obligations of registered investment advisors (regulated by the SEC or the states) and b/ds (regulated by the NASD).

Registration SEC registration: File Form ADV Part I electronically; Part I lists information about the advisor's business, owners of the advisor and whether the advisor or its personnel have violated securities or other laws. NASD registration: File Form BD at district office; fingerprint card for every associated person; business plan;documentation of the firm's financing; description of supervisory and recordkeeping systems; list of the associated persons and description of the qualifications of principals and supervisors.
Keep paper Form ADV Part II current; rule proposing electronic Form ADV Part II expected in 2007. Membership interview.
State registration: Form ADV Part I filed electronically; state registration mandatory for advisors with $25 million or less assets under management and with five clients or more in the state. Employees file Form U4.
Fiduciary Obligation Investment advisors, both registered and unregistered, required to act in the best interest of clients at all times. B/ds sometimes found to be subject to a fiduciary duty, e.g., when courts have found b/ds had discretion over client accounts.
Supervision Required to reasonably supervise persons who act on behalf of the advisor with a view toward preventing violations of securities laws. Establish and maintain written supervisory procedures; designation of offices of supervisory jurisdiction and assignment of registered principal to each OSJ; participation of each rep and principal in annual compliance meetings; periodic internal inspections.
Recordkeeping Requirement to maintain specific books and records; no formal guidance on email retention. Requirement to maintain specific books and records, including retaining email and instant messages related to firm's business.
Compliance Inspections Subject to SEC and state inspections; SEC has risk-based inspection program; firms regarded as high risk examined every three years; SEC conducts approximately 1500 IA examinations per year. Subject to inspections by SEC, state, NASD and other SRO; NASD conducts 2,300 routine examinations per year, on a two-year and four-year cycle, based on firm's risk profile, with lower-risk firms examined every four years.
Disclosure of Conflicts of Interest and fees Form ADV Part I discloses compensation arrangements; Form ADV Part II discloses business practices and conflicts of interest. Part II provided to new investors and periodically to existing investors. Point-of-sale disclosure of fee arrangements and conflicts; disclosure related to potential conflicts related to valuations; disclosure of compensation in connection with sales of mutual funds; research conflicts disclosure.
Anti-Money Laundering Requirement for mutual funds to have AML procedures and file suspicious activity reports (SARs); no final requirements for investment advisors. Required to file SARs; implement customer identification procedures; designate AML compliance officer; implement ongoing training and independent audits.
Business Continuity Plan Requirement to address BCP in written compliance program. Required to create BCP and review annually; notify clients of how BCP addresses potential business disruptions; provide emergency contact information.
Gift and Entertainment Reporting Recommendation in code of ethics rule to limit acceptance of gifts received by the advisor or its employees. NASD $100 limit on providing gifts or payments, where the provision of the gift or payment is in relation to the business of the employer of the recipient; interpretive material on business entertainment pending SEC approval.
Registration No SEC education requirements for advisory reps. Required to pass NASD qualification examination appropriate to the category of registration; Form U4; fingerprinting; background check.
State registration: Most states require Series 65 or Series 7 examination but grant waivers from examination requirements to holders of CFP, CFC, PFS, CFA and CIC designations; some states require fingerprinting. State registration: Series 63 examination or Series 66 and Series 7 examination.
Supervision Required to reasonably supervise persons acting on advisor's behalf. Written supervisory procedures; participation in annual compliance meeting; periodic internal inspections; transactions and correspondence subject to review by principal; written approval by principal of customer activity for suitability analysis.
Subject to the anti-fraud rules under the Investment Advisers Act; required to reasonably supervise employees or others acting on advisor's behalf, e.g., SEC proceeding against Robert Littell and Wildred Meckel, December 2003. Subject to capital-raising restrictions; under strictly limited circumstances, a finder may avoid b/d registration, e.g., Paul Anka, SEC no-action letter, July 24, 1991.
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