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Managers Learn To Live Without The "Merrill Lynch Rule"

In May, the SEC announced that it would not fight a March 30 ruling by the Washington D.C. Court of Appeals to vacate Rule 202—the broker/dealer exemption (a.k.a. the “Merrill Lynch Rule”

In May, the SEC announced that it would not fight a March 30 ruling by the Washington D.C. Court of Appeals to vacate Rule 202—the broker/dealer exemption (a.k.a. the “Merrill Lynch Rule”). They did, however, ask for a little mercy. On May 21, the SEC was granted a 120-day stay to give firms more time to adapt.

That stay has now expired. And while the securities industry was hoping that the SEC would somehow come up with a new plan to keep the fee-based brokerage account (or something like it) from coverage by the Investment Advisers Act of 1940 (which mandates that to offer financial advice you have to be a fiduciary), that simply isn’t happening.

For eight years, the "Merrill Lynch Rule,” as it was pejoratively called, allowed registered reps to offer fee-based brokerage accounts. Now the game has changed.

In the balance is $300 billion, invested via 1 million fee-based brokerage accounts, according to Chip Roame, who heads Tiburon Strategic Advisors, a Calif.-based industry research and consulting firm. Reps offering these accounts have to convert them to another compensation arrangement—or register as investment advisors.

“Advisors are moving the bulk of their accounts—around 80 percent—into firm-based advisory programs, where they act as representatives of the firms’ RIA,” says Roame. “The remaining 20 percent is going into pure commission accounts.” He notes, “What branch managers have to do is make sure their reps are Series 65 licensed—and that they get adequate fiduciary training,” he says, since they will be offering advice as fiduciaries.

Having brokers register as investment advisor representatives (IARs) with the broker/dealer’s RIA side of the house does not thrill many firms, since it bestows a fiduciary standard on the reps. That could translate into greater litigation risk, since fiduciary status carries a much higher legal responsibility than does suitability (the standard of care that registered reps have to adhere to). Plus, there are some securities laws that make it difficult for broker/dealers to allow too many of their reps to provide advice and fiduciary counsel.

“This is definitely increasing their reps’ liability,” says Roame. “We’re going to see firms losing more and more lawsuits.” Moreover, a mountain of paperwork required to convert fee-based brokerage accounts awaits. “The repapering is going to be a big headache,” Roame concurs. Reps have to send out all new forms, and make sure everything is spelled out properly. “That will take a lot of time away from their production,” he says, “if only for a limited period of time.”

And BOMs are charged with the task of making sure that their reps are doing all of this—and doing it properly, he says.
Nevertheless, the BOMs we asked feel that most firms are essentially able to get around the ruling. “I think it's just a hollow victory for the CFPs,” says a Wachovia BOM in the Midwest who asked to remain anonymous.

Indeed, many firms have developed non-discretionary advisory accounts as alternatives to fee-based brokerage offerings. With an advisory account, reps can charge fees for advice without worrying about how much trading is done in that account.

The Wachovia BOM says that his firm has Envision, a computer-based, asset-advisory system, that as one of the firm's West Coast reps put it, “makes mince meat out of the ‘Merrill Lynch Rule.’” Clients are not charged for the output of the firm's own, real-time version of the Monte Carlo calculator version, he explains.

Non-RIA Wachovia reps can simply convert their “Pilot Plus” accounts—which have flat-fee pricing—to asset-advisor accounts by using Envision, which meets the fiduciary requirements of the rulings, the Wachovia manager says. “We don't have much of a problem, because we're able to beat them at their own game.” And, most other wirehouses have developed similar programs as a way of “getting around” the ruling, he says.

One Smith Barney rep in New York, who requested anonymity, is equally optimistic: “This firm is converting its fee-based accounts [which the firm itself estimates hold some $20 billion in client assets] to Smith Barney Advisor, our non-discretionary advisory account program,” he says. “Since Smith Barney is the fiduciary—doing the asset allocation and portfolio management—brokers are free to sell the accounts.”

An independent OSJ in New Jersey who clears through LPL is still worried about increased vulnerability to legal action: “A registered investment advisor (and its IAR) is held to a higher standard than a broker, having to act in a client's best interest rather than simply ensuring that a trade is suitable.” That, he says, opens the door to “all kinds of lawsuits.”

But the majority of managers we spoke with weren’t overly concerned. Reps do have some fiduciary responsibility to make sure investments are in line with the asset-allocation parameters set with their clients in writing. However, the SB rep notes there are strong checks in place to make sure brokers don’t veer from this—and get into trouble. “Our managers get automated reports if anything is done that seems out of line with our written client plans. Then we contact the client, and spell out everything again. Yes, there is a fiduciary responsibility for us,” he says, “but we feel very supported and protected by these systems.”

“We’re charged with making sure that everything is done in the best interest of our clients, ” the rep’s BOM added. “But, that is something we’ve always stressed, and have always tried to do.”

Several other firms appear to be following suit. A UBS branch manager in the Northeast, who asked not to be named, says the firm is close to rolling out “strategic advisor,” an advisory version of its InsightOne fee-brokerage account.

At present, Merrill Lynch and Morgan Stanley do not have advisory versions of their fee-based brokerage programs, but insiders tell us Morgan Stanley is working on one that could debut in January. As of press time, officials at these firms did not respond to our request for comment.

A legacy Smith Barney BOM from the South who oversees 25 FAs, and also wished to remain anonymous, says that over the last five years, all of his reps have become licensed RIAs. “I’ve seen a mad rush over the last two years among brokers to do so—largely of their own volition—in anticipation of this ruling.” he says. “The greatest difficulty seems to be convincing older brokers with large books that they have to sit down and take tests for this.”

But, if necessary, they—or anyone else—can always opt for a commission-based payment arrangement, he says. Roame agrees: “There may have been a lot of skepticism and unhappiness about the possibility of the ‘Merrill Lynch Rule’ being overturned.” Nevertheless, firms have been preparing for it anyway by creating special platforms that allow brokers to act as representatives of their firms’ RIAs, he says. And most young reps become Series 65 licensed in the training process, he adds. In fact, a vast majority of reps already hold the license: According to Cerulli Associates’ analyst Bing Waldert, the average percentage of Series 65 holders at the seven largest national firms is now 84 percent.

“Overall, I'm not sure this is really a big deal to branch managers, says Rob Brown, founder of, a consulting firm for financial advisors, branch managers and their firms. “If anything, they feel hassled. They just have to play with the cards they've been dealt. Given the tight timelines for closing these accounts, it's simply a procedural process that's driven by the regulators. And good managers are helping their advisors turn this ‘required client’ contact into opportunities for new business.”

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