In a 2–1 decision issued on March 30, 2007, the U.S. Court of Appeals for the District of Columbia Circuit vacated Rule 202(a)(11)-1 of the Investment Advisers Act of 1940 (the “Advisers Act”).1 The rule expands the category of broker-dealers exempt from the definition of investment adviser under the Advisers Act by exempting broker-dealers who offer fee-based or discount brokerage accounts, provided that certain conditions are met. The Court held that the SEC does not have the authority to expand the category of broker-dealers exempt from the Advisers Act beyond the category of broker-dealers already expressly exempted by Congress in the statute.
Unless the SEC requests a rehearing or appeals the decision, the court’s decision will become effective 45 days after the date of the decision. Although the decision is not yet final and a different result could ensue on rehearing or appeal, broker-dealers who offer fee-based or discount brokerage accounts in reliance on Rule 202(a)(11)-1 should begin now to consider what changes they may need to make to their business model if the court’s decision becomes final.
The Rule. In April 2005, the SEC adopted Rule 202(a)(11)-1 in order to exempt broker-dealers who offered “feebased” and “discount” brokerage programs from the definition of investment adviser.2 Under the rule, a broker-dealer providing advice that is solely incidental to its brokerage services is exempt from the Advisers Act even if it charges an asset–based or fixed fee (rather than a commission) for its services.3 The rule also excludes from the Advisers Act broker-dealers that offer both full service and discount brokerage services to their customers.4 The SEC adopted the rule pursuant to its authority under Subsection (F) of the definition, which gives the SEC the authority to exempt by rule, “such other persons not within the intent of [the definition],” as the Commission may designate.
The Court’s Decision. The Financial Planning Association (“FPA”), an industry group representing financial planners, sought judicial review of the rule, claiming that the SEC had exceeded its authority. In analyzing the SEC’s authority under Subsection (F), the court applied the two-step Chevron analysis, which requires a court to determine first whether Congress has “directly spoken” on the matter, and if not, then to determine whether the agency’s interpretation of the statute is reasonable.
The court found that Congress had directly spoken on the issue when it exempted certain, specified broker-dealers in Subsection (C) of the definition. Subsection (C) of the definition excludes “any broker or dealer whose performance of such [advisory] services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor.” 7 The court held that the SEC exceeded its authority when it expanded the statutory exemption beyond the category of brokerdealers already expressly exempted by Congress.8
The court’s analysis relied principally on the text of the statute. The court noted that the SEC’s exemptive authority under Subsection (F) of the definition only applied to “such other persons not within the intent of [the definition].” The court reasoned that since exemptions for broker-dealers were already expressly addressed under Subsection (C) of the definition, broker-dealers could not be “other persons” for purposes of Subsection (F).9 In addition, the court concluded that an exemption for fee-based brokerage programs was not consistent with the intent of the definition.
Subsection(C) of the definition only exempted broker-dealers if they did not receive special compensation for investment advice. The rule, however, exempted broker-dealers who received special compensation, such as fee-based brokers.
The SEC’s Options. The SEC has not yet said whether it will request a rehearing or appeal the court’s decision. A spokesman for the SEC noted only that the Commission intended to analyze the court’s decision and “proceed appropriately in investors’ best interests.”11 If the SEC does not request a rehearing or seek an appeal to the Supreme Court within 45 days, an order vacating the rule will be issued within 7 days thereafter.12 Given the court’s conclusion that Congress has already identified the categories of broker-dealers exempt from the Advisers Act, we believe that there is little possibility that the SEC can expand the current statutory exemption through a new or revised rule proposal, unless the decision is reversed.
If the SEC does not pursue a rehearing or appeal, we would expect it to offer interim guidance to those broker-dealers who relied on the rule. The FPA has urged the SEC not to appeal the court’s decision and to give brokerage firms who do not register as an investment adviser 90 days to convert their fee-based accounts into commission-based accounts.13
One of the more interesting questions that remain open is whether a full-service brokerage firm will continue to be able to offer a discount brokerage program and vice versa. In its release adopting the rule, the SEC noted that the SEC staff had traditionally taken the view that the twotiered fee structure created when a brokerdealer offered both a full-service and a discount brokerage program involved “special compensation” and triggered application of the Advisers Act.14 The staff noted that this interpretation was not compelled by the statute and led to the odd result that a “full-service brokerdealer cannot offer discount brokerage without treating its full-service brokerage accounts as advisory accounts even though the services offered to those fullservice accounts remained unchanged.”15
The rule was intended, in part, to supersede this earlier staff interpretation.16 It is unclear whether the SEC will reinstate the earlier staff interpretation or adopt an interpretive position consistent with the rule with respect to brokerdealers who offer both full-service and discount brokerage programs.
The decision can be found at: http://pacer.cadc.uscourts.gov/docs/comm on/opinions/200703/04-1242a.pdf