On March 30, 2007, the U.S. Court of Appeals for the D.C. Circuit vacated Rule 202(a)(11)-1 (the “Rule”) under the Investment Advisers Act of 1940 (the “Act”). The Financial Planning Association (the “FPA”) had challenged the Rule, arguing that the Securities and Exchange Commission (the “SEC”) had exceeded its authority in exempting certain broker-dealers from the definition of “investment adviser” under the Act. The Rule was vacated in its entirety even though only portions of the Rule were challenged by the FPA.1
Background of the Rule
Section 202(a)(11) of the Act provides for exemptions of certain industry or professional groups from registration as investment advisers. For broker-dealers, there are two conditions that must be met under subsection (C) of the statute in order to avoid registration: (1) the investment advice given to clients must be solely incidental to its brokerage business and (2) it cannot receive any special compensation for the investment advice.
The SEC first proposed the Rule in November 1999 and recommended a no-action position that allowed brokerage firms to offer fee-based programs without coming under the definition of an “investment adviser” under the Act until the SEC took final action on the Rule. The FPA challenged the no-action position in a lawsuit filed in July 2004, which prompted the SEC to finally adopt the Rule in April 2005. The purpose of the Rule was to clarify the meaning of Section 202(a)(11) of the Act, particularly the meaning of “special compensation”.
The Rule exempted broker-dealers from the definition of an “investment adviser” when offering fee-based brokerage accounts stating that a broker-dealer who receives special compensation will not be deemed to be an investment adviser if the advice provided is solely incidental to brokerage services provided on a client’s account and specific disclosure is made to the client. Further, the Rule provided that broker-dealers who receive different brokerage fees for full service versus discount brokerage services would not be deemed to have received “special compensation” solely because the broker-dealer receives more fees for full service brokerage services, which include the provision of investment advice.
The Court found that the SEC had overstepped its authority when it adopted the Rule. The Court stated that Section 202(a)(11) lists exemptions (A)-(E) from the broad definition of “investment adviser” for several classes of persons. Among the exemptions is subsection (C)’s exemption for “any broker or dealer whose performance of such [investment advisory] services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor.” Beyond the listed exemptions, subsection (F) authorizes the SEC to exempt “such other persons not within the intent of this paragraph, as the [SEC] may designate by rules and regulations or order.” The SEC had claimed it had authority to adopt the Rule under Section 202(a)(11)(F). The Court looked at the Act’s text, structure, overall statutory scheme, and the problem Congress sought to solve in enacting these provisions in order to determine whether the SEC interpretation of subsection (F) was reasonable.
The Court ruled that (1) the legislative intent does not support a broader exemption for broker-dealers, so the requirement that the SEC designate other persons “within the intent” of Section 202(a)(11) was not met; and (2) because broker-dealers are already expressly addressed in subsection (C), broker-dealers are not “other persons” under subsection (F), so the SEC cannot use its authority under subsection (F) to broaden the exemptions for broker-dealers. The Court’s ruling vacated the Rule in its entirety.
On May 15, 2007, the SEC announced that it would not seek review of the Court’s decision, and the decision is final effective May 21, 2007.
Implications for Broker-Dealers
In light of the Court’s ruling, broker-dealers should carefully examine their fee-based brokerage programs, as well as their financial planning business, discretionary practices, discount brokerage lines, and regulatory status. It has been suggested by some that broker-dealers offering fee-based brokerage accounts are in essentially the same position that they were in prior to the adoption of the Rule, which was that many brokerage firms believed that the fees they earned were commissions or fees in lieu of commissions and, therefore, not advisory fees or special consideration. However, dicta in the Court’s ruling suggests that these fees may be considered special consideration. The Court’s ruling also may have affected how customers with multiple account relationships (e.g., an advisory account and a brokerage account) should be treated. We recommend that broker-dealers consider the impact of the Court’s ruling carefully and cautiously, taking into account the Court’s reasoning as well as SEC positions and interpretations that were not addressed by the ruling