On March 30, 2007, the U.S. Court of Appeals for the D.C. Circuit (the “Court”) vacated Rule 202(a)(11)-1 (the “Rule”) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), which provides an exception from the definition of investment adviser to certain broker-dealers. The Securities and Exchange Commission (the “SEC” or “Commission”) adopted the Rule to provide an exception from the definition of “investment adviser” for broker-dealers who receive “special compensation” provided the broker-dealers met certain conditions. The Rule enabled broker-dealers to provide fee-based brokerage programs to clients without registering as investment advisers provided they met the conditions outlined in the Rule.
The Commission has not yet issued a response to the Court’s decision, which becomes final on May 21, 2007. Unless the SEC is successful in any rehearing or appeal, broker-dealers will need to evaluate their fee-based brokerage programs to determine whether they fall under the jurisdiction of the Advisers Act.
Exception for Broker-Dealers Who Receive “Special Compensation”
Why did the SEC adopt the Rule?
Section 202(a)(11) defines “investment adviser” broadly to include any person who, for compensation, advises others on the value of or the advisability of investing in securities. Section 202(a)(11)(C) provides an exception from the definition for broker-dealers whose “performance of such services is solely incidental to the conduct of [its] business as a [broker-dealer]” and that do not receive special compensation for those services. Broker-dealers who receive transaction-based compensation and provide only incidental advice generally can rely on this exception and are not subject to investment adviser registration. However, the proliferation of fee-based brokerage accounts, as well as two-tiered brokerage offerings (discount and full service) where the primary difference between the two offerings is the provision of advice began to raise investment adviser status concerns. These issues were compounded by previous SEC guidance to the effect that any charges “directly related to the giving of advice” would be considered special compensation for purposes of Section 202(a)(11).
Who does the Rule exclude from the definition of investment adviser?
In response to these concerns, on April 12, 2005, the SEC adopted Rule 202(a)(11)-1, which, in relevant part, provides an exception from the definition of investment adviser for broker-dealers who receive special compensation provided such arrangements satisfy the following conditions:
• Any investment advice the broker-dealer provides to accounts for which it receives special compensation is solely incidental to the brokerage services it provides to those accounts; and
• Any advertisements, contracts and other forms governing accounts for which the broker-dealer receives special compensation contain the disclosure specified in the Rule regarding the nature of the brokerage relationship.
The Rule also provides non-exclusive examples of when investment advice would not be “solely incidental” (e.g., the broker-dealer has discretionary authority over the account, or the broker-dealer charges separately for advisory services).
The Rule is designed to provide relief from investment adviser registration to broker-dealers that provide incidental advice to customers and charge those customers a single fee for advice and brokerage services. It, in essence, eliminates the second prong of the broker-dealer exception provided by Section 202(a)(11)(C).
T he Court’s Ruling
On what basis did the Court vacate the Rule?
Soon after the SEC adopted the Rule, the Financial Planning Association (the “FPA”) petitioned the Court to vacate the Rule on the grounds that the SEC had exceeded its authority under the Advisers Act. In adopting the Rule, the SEC relied on the authority provided to it by Section 202(a)(11)(F) to grant exceptions from the definition of investment adviser. This section permits the SEC to grant exceptions to “such other persons not within the intent of [Section 202(a)(11)]….” The FPA claimed that the SEC had gone beyond the authority provided by this provision when it adopted Rule 202(a)(11)-1.
In its decision, the Court focused on its interpretation of two provisions of the Advisers Act, namely Section 202(a)(11)(F) and Section 202(a)(11)(C), the broker-dealer exception referenced above. In the Court’s opinion, the plain language of the statute, the legislative history of Section 202(a)(11) and the purpose behind the adoption of the Advisers Act all indicate that the SEC exceeded its authority in adopting the Rule. According to the Court, the authority granted to the SEC by Section 202(a)(11)(F) extends only to persons other than those already covered by Section 202(a)(11) that are not within the intent of that section.
According to the Court, because Congress, in Section 202(a)(11)(C), had already specifically addressed the precise conditions under which broker-dealers could be excluded from the definition, broker-dealers do not constitute other persons not within the intent of Section 202(a)(11). As a result, the SEC exceeded the authority granted to it by Congress by adopting a Rule that eliminated the “no special compensation” requirement of the broker-dealer exception thereby broadening the category of broker-dealers excepted from the definition of investment adviser.
What effect will the Court’s decision have?
If the SEC elects not to challenge the Court’s decision or if the decision withstands any subsequent rehearing or appeal, the case could have a significant effect on the brokerage industry. Broker-dealers may be forced either to eliminate fee-based brokerage programs through which customers receive advice, even incidental advice, for the fee they pay or to register as an investment adviser. Furthermore, broker-dealers may be unable to continue offering both discount and full service brokerage programs where advice is a component of the full service offering, if they are not registered as investment advisers.
One additional conclusion to be drawn from the Court’s decision is that the problems associated with the Rule adopted by the SEC cannot be cured by revisions to the Rule. Because the Court held that the SEC did not have the authority under Section 202(a)(11)(F) to expand the category of broker-dealers excepted from the definition of investment adviser, the result sought through the enactment of Rule 202(a)(11)-1 may only be able to be achieved through congressional legislation. The only other possible avenue for the SEC to pursue would be a rulemaking based on the broader exemptive authority granted to it by Section 206A under the Advisers Act. Because the SEC had disavowed reliance on this section, the Court did not express an opinion on the SEC’s authority under that provision.