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SEC Principal Trade Proposal: A Stalling Tactic?

Broker-dealers may get a long wished for break from the burdens of principal trade regulation for the investment advisor side of their businesses—for a little while anyway.

Broker-dealers may get a long wished for break from the burdens of principal trade regulation for the investment advisor side of their businesses—for a little while anyway.

According to SIFMA, the lobbying organization for the b/d industry, the SEC staff has indicated that it intends to relax the disclosure rules related to principal trades for broker-dealers that also act as investment advisors. The proposal is a 2-year “interim rule” which would allow firms like Merrill Lynch and Morgan Stanley, large brokerage firms that also have many other business lines, to meet their fiduciary obligations to customers while still engaging in principal trading activity—selling customers products from their own inventory.

The proposal calls for, among other things, a one-time written disclosure from the firm that it has conflicts of interest, and oral notice of trade intentions and oral approval from customers for any principal trades.

As it stands now, Section 206(3) of the Investment Advisers Act of 1940 requires written notice and written approval by the customer, a requirement SIFMA and the large firms have argued isn’t logistically possible because of the scope and breadth of their business. (For a brief history of the battle over fee-based brokerage accounts read Rep’s May cover story, The Great Reckoning. The story also talks about the fiduciary minefield large firms face because of rules regarding principal trades.)

The Financial Planning Association isn’t so much “backing” the proposal as has been reported in other publications, but it’s a compromise they’re willing to accept, for now and with several caveats. Among other things, the FPA’s letter to the SEC (read it here) suggests the proposal allow clients to confirm principal trading activity with their advisor on an ongoing basis as well as receive a once-a-year summary of all the principal trades and any and all fees and commissions the advisor received in relation to those trades. The FPA’s letter to the SEC says the issue of principal trades should be treated as a separate issue from the provision of interim guidance for firms needing to convert their fee-based brokerage accounts.

For what it’s worth, the FPA’s Duane Thompson thinks this rule has a limited shelf life if adopted. “I think this rule will eventually go away too,” says Thompson, adding that he thinks the 2-year time period will simply give everyone time to digest the impending RAND study (due in December from the SEC) and adjust policy and/or legislate changes to the way advisors and brokers are regulated under current securities laws.

Others object to the proposal outright, including the National Association of Personal Financial Advisors (NAPFA), whose August letter to the SEC was blunt in its rejection of the proposal (read NAPFA’s letter here). Among its points, NAPFA says fiduciary law will still apply in the states despite any proposed change to SEC rules. “The SEC applies the IA Act, but within the individual states fiduciary law still applies,” says Ron Rhoades, chief compliance officer, director of research, and director of estate and asset protection planning for Joseph Capital Management in Hernando, Fla., who agrees with NAPFA’s rejection of the proposal. Rhoades says the lack of “informed consent” on the part of clients under the proposal could be problematic for firms. A blanket disclosure of conflicts of interest won’t cut it, he says. “If there aren’t details of the trade, how much money was made, etc., a customer’s consent can’t be deemed informed,” which is required under fiduciary law, says Rhoades.

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