Association of Life Insurance Counsel Annual Meeting May 18-20, 2008 The Homestead-Hot Springs, VA

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1 Association of Life Insurance Counsel Annual Meeting May 18-20, 2008 The Homestead-Hot Springs, VA The Status of Broker-Dealers Engaged in Investment Advisory Functions: Muddy Waters Slowly Clearing Carl B. Wilkerson, Vice President & Chief Counsel-Securities & Litigation, American Council of Life Insurers 2008 All Rights Reserved Table of Contents I II III IV V VI VII VIII Scope of Outline and Introduction...2 Investment Advisers Act of 1940: Broad Statutory and Interpretive Scope 3 Rule 202(a)(11)-1: A Long Regulatory, Judicial and Interpretive Saga.13 Reinstated SEC Interpretations on Broker-Dealer Exclusions from the Investment Advisers Act.35 The 2008 RAND Report: Investor and Industry Perspectives on Investment Advisers and Broker-Dealers 39 Revised Ethical Standards Adopted by the CFP Board FINRA Position Regarding Investment Advisory Activities of Registered Representatives..50 The Impact of State Insurance Consulting Laws and Related Provisions on Insurance Producers Performing Financial Planning Services...52 Updated May 8, 2008

2 2 The Status of Broker-Dealers Engaged in Investment Advisory Functions: Muddy Waters Slowly Clearing I. Scope of Outline and Introduction A. When Congress enacted comprehensive laws governing the activities of brokerdealers and investment advisers in the 1930 s, these two professions were largely separate and distinct. With the advent of integrated financial services that began in earnest during the 1990 s, broker-dealers services evolved and migrated into a broader range of functions, including investment advice and financial planning. B. Ultimately, this modern transformation of broker-dealer roles provoked challenges to the template of traditional regulation. An uncertain landscape has witnessed intricate Securities and Exchange Commission (SEC) interpretations, extensive rulemaking, and finally, litigation. C. Collectively, these developments will redefine new boundaries and responsibilities for broker-dealers. Moreover, the SEC has coextensively commissioned a broad evaluation of the different functions and consumer protections governing broker-dealers and investment advisers to determine whether a new blended pattern of regulation may be more appropriate. The final outcome will have profound implications for investors, regulators, broker-dealers and investment advisers that will shape succeeding generations of each. D. In 2005, the SEC had adopted Rule 202(a)(11)-1 addressing the application of the Investment Advisers Act of 1940 to broker-dealers offering certain types of brokerage services. 1. Under the rule, a broker-dealer providing investment advice that is solely incidental to its brokerage services was excluded from the Advisers Act if it charged an asset-based fee for its services, provided it made disclosures about the nature of its services. E. The Financial Planning Association (FPA) subsequently filed suit contesting the validity of this rule, and on March 30, 2007, the U.S. Court of Appeals for the District of Columbia Circuit ruled in favor of the FPA. See Financial Planning Ass n v. SEC, 482 F.3d 481 (D.C. Cir. 2007). 1. The court found, through statutory interpretation, that the SEC had exceeded its authority in promulgating the final rule. 2. The resolution of this case may only be the beginning of an ongoing regulatory evolution addressing those in a function-blended financial services industry. With continued blurring of functions, the courts may find less ambiguity in the Congressional delegation of certain rulemaking authority to the SEC in the future. F. As a postscript to the U.S. Court of Appeals decision, on September 24, 2007, the SEC issued a proposed interpretive rule that would reinstate three interpretive positions

3 3 of the rule vacated by the court. See Investment Advisers Act Rel. No (Sept ). The SEC s proposal is discussed further below. G. In March 2008, the RAND Corporation issued a report on its SEC commissioned study of investment advisers and broker-dealers in the contemporary marketplace that the SEC will use in developing new administrative positions on the appropriate distinctions between broker-dealers and investment advisers in evolving and overlapping services and functions. H. This outline will provide a discussion of the legislative, regulatory and judicial background to these developments, and will evaluate the status of other interrelated regulatory developments that could shape the future status of broker-dealers engaged in providing investment advisory services either independently or as an adjunct to traditional securities functions. II. The Investment Advisers Act of 1940: Broad Statutory and Interpretive Scope A. Statutory: Section 202(a) (11) of the Investment Advisers Act of 1940 (the Advisers Act ) defines the term investment adviser to mean:... any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities, or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities... B. Interpretive: Investment Advisers Act Rel. No (October 8, 1987), 56, 156E Fed. Sec. L. Rep. (CCH) Applicability of Investment Advisers Act to Financial Planners, Pension Consultants, and other Persons Who provide Investment Advisory Services as an Integral Component of other Financially Related Services. 1. Specific facts and circumstances of financial planner s activities must be evaluated to determine status. 2. Three principal considerations in triggering investment adviser definition: a) Does individual provide advice or issue reports or analyses regarding securities? b) Is individual in the business of providing such services? c) Are services provided for compensation? 3. The three part test in greater detail a. Advice or analyses concerning securities: (1) In the view of the SEC, individuals providing advice or issuing analyses which concern securities, but which do

4 4 not relate to specific securities, would generally be investment advisers pursuant to Section 202(a) (11), assuming the services are performed for compensation as part of a business. IAA Rel. No (2) Investment adviser definition includes advice evaluating the relative advantages and disadvantages of investing in securities in general, as compared to other investment media. (3) Advice provided in connection with a financial plan comparing the desirability of investing in securities in relation to coins, stamps or direct commodity ownership would constitute investment advice. (4) Individual advising employee benefit plans on merits of investing in securities, as opposed to, or in addition to insurance products, real estate or other funding media, would be advising within Section 202(a) (11) definition. (5) Significantly, however, individuals providing advice or analyses concerning securities generally may, nonetheless, not be in the business of providing these services, and consequently will not be considered investment advisers under Section 202(a) (11). b. The business standard. (1) In the SEC s view, a person who provides financial services including investment advice for compensation is in the business of providing investment advice under Section 202(a) (11), unless (A) the advice is solely incidental to a non-investment advisory business of a person, (B) is non-specific, and (C) is not rewarded by special compensation for such advice. IAA Rel. No (2) Financial planners are considered to be in the business of providing investment advice if held out as investment advisers or as persons providing investment advice. (3) Individuals not regarded as being in the business of giving investment advice if as part of financial services the advisability of investing in securities is presented in general terms in the context of a discussion of economic matters or the role of securities investments in a client s overall financial plan. See, e.g., Donald F. Pooley (avail. Feb. 8, 1985)

5 5 (4) Planner is in the business of providing investment advice, if on anything other than rare and isolated circumstances the advisability of investing in securities or specific categories of securities (bonds, mutual funds, and technology stocks) are discussed or analyzed. See, e.g., Linda Arnold (avail Aug. 23, 1984) (life, health and annuities agent recommended general investment strategy suitable to client needs, but restricted advice to general recommendation to acquire growth stocks or growth stock funds when client sought tax favored financial objective). (5) The SEC considers the providing of market timing services to constitute the business of investment advice. See, e.g., Suzanne Clark-James (avail. Aug. 30, 1984). (6) Financial planners considered in the business of giving investment advice if they obtain any special compensation therefore or receive any direct or indirect remuneration in connection with client s purchase or sale of securities. c. Compensation (1) Receipt of any economic benefit, whether in the form of an advisory fee, some other fee related to total services rendered, commissions, or a combination of these, satisfies the compensation element. (2) It is not necessary that adviser s compensation be paid directly by the individual obtaining financial services, but only that the adviser receive some source for his services, such as a sharing in brokerage commissions or finders fees. See, e.g., Warren H. Livingston (avail. Mar. 8, 1980). (3) Entity providing variety of services, including investment advice, and obtains single fee or commission upon sale of insurance products or investments, would be providing advisory services for compensation within the meaning of Section 202(a)(11). See, e.g., Jacobs, Willmore, Inc. (Avail. Aug. 20, 1984) (registered representative providing financial plan without fee but receiving compensation indirectly through commission on sale of insurance and mutual funds); St. Louis Financial Planners, Inc. (Avail. Mar. 19, 1984) (commissions on securities sales constitute compensation in free, non-obligatory financial analysis designed to stimulate prospective clients).

6 6 d. Application of three part test to 401(k) Plan marketing and enrollment personnel of life insurers. (1) In a no-action letter issued to MII Life Inc. (publicly available May 1, 1986), life company personnel communicating generalized information regarding a 401(k) plan and its investment options were deemed to trigger the definition of investment adviser under the Investment Advisers Act of (2) According to the interpretive request, the 401(k) plan in questions would provide two investment options : a universal life insurance contract and a guaranteed income fund. The letter further indicates that the plan sponsor intends to add a third option offering shares in a no-load mutual fund. (3) The requestor stated that enrollment personnel would not offer any individualized investment advice to any employer or its employees as to which investment option is best suited for the employer s or its employees individual needs. The necessary description of the investment options provided in the written materials being prepared by the [requestor] for distribution to the employers and their employees is designed to provide simply a generalized description of the investment options under the 401(k) plan and no effort will be made to give individualized investment advice regarding the appropriateness of any one of the investment options over any other investment option. The requestor asserted that in marketing the 401(k) the [requestor] plan will not be providing specific investment advice as its description of the investment options is extremely general in nature as required to simply explain the 401(k) plan and its operations. The general description of the investment options being provided to the employers and employees is solely incidental to the primary business of providing employees with a description of what the 401(k) plan is and how it operates. (4) The SEC determined that the requestor s agents would trigger the definition of investment adviser in Section 202(a)(11) of the Advisers Act because they would be advising the employers and employees as to the value of securities, or would be issuing analyses or reports concerning securities by selecting investment options for the plan, and by recommending participation in the plans by employees. Further, the SEC noted that certain marking materials offered relative comparisons between

7 7 different types of securities. (a) (b) (c) The SEC emphasized the fact that [the requestor] or its agents will not make an effort to give individualized investment advice regarding the appropriateness of any of the investment options over any other investment options does not, in our view, mean that they are not giving advice about securities for purposes of Section 202(a)(11). The SEC also determined that because providing investment advice was central to the marketing of the plans, and because the requestor and its agents will receive a fee for their investment advice, the elements of business and compensation in the definition of an investment adviser are met. The letter further indicated that the requestor and its agents would trigger Section 202(a) (11) s definition of investment adviser because they would be advising employers and their employees as to the value of securities or would be issuing analyses or reports concerning securities by selecting investment options for the Plans (which options include a guaranteed income fund and a specific no-load mutual fund), and by recommending participation in the Plans by employees (participation interests in the Plans being themselves securities). (5) The Division of Market Regulation determined that it would not recommend enforcement action if MII Life and its agents did not register as broker-dealers under section 15(a) of the Securities Exchange Act of 1934 in connection with the 401(k) Plan. (a) Query whether the requestor could have relied upon the broker-dealer exclusion from the definition of investment adviser as unregistered broker-dealers in light of the no-action position on broker-dealer registration. i) The legislative history concerning the 202(a)(11)(C) exclusion does not distinguish between registered and unregistered broker-dealers. ii) The definitions of broker and dealer in

8 8 202(a)(3) and (7), respectively, do not refer to registered broker-dealers. Rather, functional definitions are presented, which parallel the definitions in the Exchange Act. iii) This line of analysis would only survive if the 401(k) activities were solely incidental to the conduct of the brokerdealer s business, and where no special compensation was received. Moreover, while the legislative history is sparse, the broker-dealer exception was established by Congress with knowledge of the comprehensive scheme of regulation confronting registered broker-dealers. C. Exceptions to Investment Adviser Definition Section 202(a)(11) provides that the definition of investment adviser does not include: 1. a bank, or any bank holding company as defined in the Bank Holding Company Act of 1956, which is not an investment company; 2. Any lawyer, accountant, engineer, or teacher whose performance of such [advisory] services is solely incidental to the practice of his profession; 3. 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; 4. the publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation; 5. any person whose advice, analyses, or reports relate to no securities other than securities which are direct obligations of or obligations guaranteed as to principal or interest by the United States, or securities issued or guaranteed by corporations in which the United States has a direct or indirect interest which shall be designated by the Secretary of the Treasury, pursuant to Section 3(a)(12) of the Securities Exchange Act of 1934, as exempted securities for the purposes of that Act. Section 202(a) (11) (G) excepts from the definition of investment adviser such other persons not within the intent of this paragraph, as the Commission may designate by rules and regulations or order. D. Broker-dealer Exemption

9 9 1. The Broker-dealer exemption in Section 202(a)(11)(C) must be carefully evaluated regarding financial planners who are registered representatives of a broker-dealer. 2. Threshold question: is financial planner/registered rep ( FP/RR ) providing advice in its capacity as a registered representative of the broker-dealer with whom it is employed? If not, it cannot rely on the broker-dealer exemption. 3. Assuming FP/RR acts on behalf of the broker-dealer with whom it is employed, if the FP/RR (or its firm) makes an explicit charge for investment advice, it is obtaining special compensation and cannot rely on the exception. See, e.g., Rooney and Co. (avail. Apr. 3, 1985) (financial planning department of broker-dealer staffed by chartered financial planner charged specific fee for planning service). 4. When do brokerage commissions constitute special compensation for FP/RR? a. Commission in and of itself, is not special compensation. See Investment Advisers Act Rel. No. 626 (Apr. 27, 1978) 56,156C Fed. Sec. L. Rep. (CCH) (discussing the applicability of the Advisers Act to broker-dealers after the elimination of fixed commission rates on securities transactions); see also, Investment Advisers Act Rel. No. 640 (Oct. 5, 1978) 56, 156D Fed. Sec. L. Rep. (CCH) (SEC General counsel s views on the meaning of special compensation in various circumstances in which a broker-dealer provided advice solely incidental to the conduct of its business as such) b. Where a portion of total brokerage commissions may be viewed as compensation to a FP/RR for its investment advice, special compensation exists only where the commission includes a clearly definable charge for investment advice or a non-segregated charge. See American Capital Financial Services, Inc. (avail. Apr. 29, 1985). (1) This position reflects the SEC s view that a client who perceives he is paying a specific charge for investment advice is entitled to the protection of the Advisers Act. Id. (2) SEC finds essential distinction determining whether a commission includes special compensation is whether the FP/RR is being specifically compensated for investment advice itself or for brokerage or other services to which the advice is merely incidental. Id. (3) Status of FP/RR commission is inherently factual determination that is not subject to rules of general

10 10 application. Interpretive position in American Capital Financial Services, Inc., (avail. Apr. 29, 1985), however, provides the following general illustrations of the staff s approach in determining whether a specific situation involves special compensation: (a) (b) (c) (d) If the same commission is charged for executing any client transactions, regardless of whether a particular client also receives financial planning advice, the FP/RR is not receiving special compensation. If two general commission schedules are in effect, either formally or informally, the lower without investment advice and the higher with investment advice, and the difference is primarily attributable to this factor, then the FP/RR is receiving special compensation. It is not necessary to look outside the commission structure of an FP/RR s brokerdealer employer to determine whether the FP/RR is receiving special compensation. For example, simply because an FP/RR at a full service firm receives higher commissions than an FP/RR employed by a discount brokerage firm, the additional amount of the former s commissions is not necessarily special compensation. The fact that an FP/RR may negotiate different commissions with its clients for similar transactions does not mean that the difference must be viewed as special compensation, provided the discrimination follows a clear and consistent policy which is not related to the rendition of investment advice. (4) According to the SEC, the qualifying term special in the broker-dealer exemption clearly definable charge for investment advice, regardless of whether the charge is separate from or included within commissions. Without this interpretation, a FP/RR could circumvent Congress intent to exclude from the Advisers Act only a brokerdealer receiving bona fide commissions, by merely incorporating an advisory charge into Commissions. American Capital Financial Services, Inc. (5) A FP/RR advising clients outside the scope of its employment as a registered representative cannot qualify

11 11 for the broker-dealer exception. See Southmark Financial Services (avail. Aug. 23, 1974). (6) American Capital letter reveals that had the Southmark FP/RR instead been providing investment advice in its capacity as a registered rep, its commissions would not have required it to register as an adviser, unless the commissions included a non-segregated charged. (a) Involvement of broker-dealer in FP/RR activities critical to 202(a) (11) (C) exception. E. Antifraud and Conflict of Interest Considerations for Financial Planners 1. Section 206(1) and (2) of the Advisers Act make it unlawful for an investment adviser, directly or indirectly, to employ any device, scheme, or artifice to defraud any client or prospective client or to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client. 2. In SEC v. Capital Gains Research Bureau, 375 U.S. 180, 194 (1963), the Supreme Court construed an investment adviser as a fiduciary owing clients an affirmative duty of utmost good faith, and full and fair disclosure of all material facts. Further, the court found a failure to disclose material facts must be deemed fraud or deceit within its intended meaning, for... the darkness and ignorance of commercial secrecy are the conditions under which predatory practices best thrive. Id. at Financial Planners triggering investment adviser definition have a duty to avoid fraudulent conduct which includes disclosing material facts to clients whenever the failure to do so would defraud or deceive clients. 4. Disclosure of situations involving conflicts of interest or potential conflicts of interest with a client is significant in financial planning activities. 5. Examples of typical situations involving conflicts of interest within the investment adviser s duty to disclose. a. Investment adviser providing financial planning services outside the scope of his employment as a registered representative of a broker-dealer must disclose that the advisory services are independent from the employment with the broker-dealer. See, e.g., Rocky Mountain Financial Planning, Inc. (avail. Mar. 28, 1983); David P. Atkinson (avail. Aug. 1, 1977). b. Financial Planner is restricted to recommending a limited universe of products to implement the financial plan by virtue of employment agreement with insurance company or brokerdealer, or because financial planner lacks particular NASD

12 12 qualification in order to share in commissions upon execution. See, e.g., George E. Bates (avail. Mar. 26, 1979). c. Investment adviser should inform client that execution of the plan can be accomplished through a broker-dealer other than the financial planner or its affiliated broker-dealer. See, e.g., Don P. Matheson (avail. Sept. 1, 1976); Don P. Matheson (avail. May 24, 1979) (evaluates conflicts of interest in adviser s letter of agreement ). d. Financial Planner should fully disclose nature and extent of the planner s interest in any recommendations, including any compensation that would be received on execution of the plan such as commissions or finders fees. See, e.g. Rocky Mountain Financial Planning, Inc. (avail. Mar. 28, 1983). e. An investment adviser must not effect transactions in which he has a personal interest in a manner that could result in preferring his own interest to that of his advisory clients. Kidder, Peabody & Co., 43 S.E.C. 911, 916 (1968). Example could occur when financial planner recommends purchase of real estate limited partnership in which planner is also involved in syndication or distribution. f. Investment adviser must disclose if adviser s personal securities transactions are inconsistent with the advice given to clients. In the Matter of Dow Theory Letters, Investment Advisers Act. Rel. No. 571 (Feb. 22, 1977), 11 SEC Docket No. 13 (Mar. 8, 1977). g. Investment adviser who structures his personal securities transactions to trade on the market impact caused by his recommendations must fully disclose these practices to clients. SEC v. Capital Gains Research Bureau, 375 U.S. 180, 197 (1963). h. Investment adviser should disclose compensation received from the issuer of a security recommended. Investment Advisers Act Rel. No. 701 (Sept. 17, 1979) 18 SEC Docket No. 10 (Oct. 2, 1979). i. Section 206(3) of the Advisers Act generally makes it unlawful for an investment adviser acting as principal for his own account knowingly to sell any security to or purchase any security from a client, or, acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtain the consent of the client to such transaction. The responsibilities of an investment adviser

13 13 dealing with a client as principal or as agent for another person are discussed in Advisers Act Release Nos. 40 and 470 (February 5, 1945 and August 20, 1975 respectively). III. Rule 202(a)(11)-1: A Long Regulatory Saga Overturned by the Courts 1 A. On April 12, 2005, the SEC adopted Rule 202(a)(11)-1 under the Advisers Act. 1. Under this rule, a broker-dealer providing advice that is solely incidental to its brokerage services is excluded from the Advisers Act even if it charges an asset-based or fixed fee rather than a commission, markup or mark-down, so long as it makes certain disclosures about the nature of its services The rule also provided guidance regarding when a broker-dealer is providing advice that is not solely incidental to the conduct of its business. 3. The rule specified that broker-dealers offering discount brokerage services for reduced commission rates also may offer full service brokerage without triggering the application of the Advisers Act. B. Prior Administrative History 1. The rulemaking began on November 4, 1999, as the SEC addressed whether broker-dealers employing fee-based and discount brokerage programs would be able to rely on the broker-dealer exception in the Advisers Act. 3 a) After review of these two newer programs, the SEC concluded that they were not fundamentally different from traditional brokerage services. 4 b) Under the 1999 proposal, a broker-dealer providing investment advice to customers would be excluded from the definition of investment adviser regardless of the form of compensation as long as: (i) the advice is on a non-discretionary basis, (ii) the advice is solely incidental to the brokerage services, and (iii) the broker-dealer discloses to its customers that their accounts are brokerage accounts. 5 c) Additionally, the SEC proposed that a broker-dealer would not be deemed to have received special compensation solely because the broker 1 This outline segment III discussing the administrative, interpretive and judicial history of Rule 202(a)(11)-1 was developed and prepared by Shane M. Wilkerson, University of Maryland Law School (JD May 2008), Brown University (BA 2005), who worked in the SEC s Enforcement Division, and the Office of Compliance Inspections and Examinations in Washington, DC for three summers between Id. at Fed. Reg (Apr. 19, 2005) at Id. at Id. These provisions of the proposed rule were designed to make application of the Advisers Act turn more on the nature of the services provided by the broker-dealer rather than on the form of compensation.

14 14 or dealer charges one customer a commission-type fee that is greater than or less than one it charges another customer. 6 d) Over 1700 comment letters were received in response to this initial proposal, and a primary issue was how solely incidental advisory services can be identified or defined. 7 (1) Comment letters in support of the rule emphasized both the unnecessary double-regulation which broker-dealers would face if the proposed rule were not in place, and the advantage such a rule would confer upon investors who presumably would have greater choice among a wider variety of services that could be provided. 8 (2) Those in opposition to the initial proposal posited that the rule would lead to greater investor confusion regarding the differences between an advisory service and a brokerage service, and that greater clarity should be provided with regards to the term solely incidental in light of the newer compensation packages for broker-dealers. 9 (a) On January 14, 2005, the SEC re-proposed the rule with some modifications based upon the commentary received following the initial proposal. (i) On re-proposal, the SEC expanded the disclosure requirement such that all forms which govern the operation of a fee-based brokerage account contain a prominent statement clarifying that the account is a brokerage account and not an advisory one. 10 (a) Further, the disclosure needs to explain the differences between a brokerage and an advisory account with respect to the customer s rights and the firm s duties, and the broker-dealer would have to identify an appropriate person at the firm with whom the customer could discuss these differences. 6 Id. 7 Id. After the close of the initial comment period, the SEC received hundreds more comment letters and therefore reopened the comment period for the 1999 proposal from August to September For example, discount brokerage programs, which resulted from the unbundling of traditional brokerage services, enhanced customer choice by offering customers who did not want or need investment advice the ability to trade securities at a lower commission rate. SEC Opening Brief, page 6 9 Joel H. Framson, CPA/PFS, CFP, Chair, Personal Financial Planning Executive Committee, American Institute of Certified Public Accountants, September 22, 2004 ( Fed. Reg (Apr. 19, 2005) at

15 15 (b) The SEC also provided some guidance on defining solely incidental. The re-proposal stated that investment advice would be solely incidental to brokerage services provided to an account when those advisory services are in connection with and reasonably related to the brokerage services. 11 (b) Treatment of Special Compensation Under the Reproposed Rule (i) A registered broker or dealer will not be deemed to be an investment adviser based solely on its receipt of special compensation, provided that: (a) Any investment advice provided by the broker or dealer with respect to accounts from which it receives special compensation is solely incidental to the brokerage services provided to those accounts (in particular, that the broker or dealer does not exercise investment discretion over the account) (b) Advertisements for, and contracts, agreements, applications and other forms governing, accounts for which the broker or dealer receives special compensation include a prominent statement that: Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons compensation, may vary by product and over time. (c) A broker or dealer will not be deemed to have received special 11 Id.

16 16 compensation solely because the broker or dealer charges a commission, markup, mark-down, or similar fee for brokerage services that is greater than or less than it charges another customer. (c) Treatment of the Term Solely Incidental (i) Advice that is not solely incidental to brokerage services includes: (a) Charging a separate fee, or separately contracts, for advisory services. (b) Provides advice as part of a financial plan or in connection with providing financial planning services and: (i) holds itself out generally to the public as a financial planner or as providing financial planning services; (ii) Delivers to the customer a financial plan; or (iii) Represents to the customer that the advice is provided as part of a financial plan or in connection with financial planning services (d) Treatment of Investment Discretion in the Reproposal (i) A broker-dealer is an investment adviser solely with respect to those accounts for which it provides services or receives compensation that subject the broker or dealer to the Advisers Act.

17 17 C. The SIA No Action Letter Clarifying Rule 202(a)(11)-1 1. The SEC s Division of Investment Management issued a no-action letter responding to questions regarding the newly adopted rule. 12 a) The SIA had inquired about advertisements, financial planning and brokerage services, dual capacities for dually registered firms, and use of certain education or specialized training credentials in light of Rule 202(a)(11)-1. b) The Division of Investment Management concluded the following: (1) A broker-dealer holding itself out as providing advisory services does not by itself require registration under the Advisers Act. (2) Registration is necessary when the broker-dealer advertises as a financial planner and also provides investment advice as part of a financial plan or in connection with providing financial planning services. (a) Meaning of the Term Financial Planning : (i) A financial plan generally seeks to address a wide spectrum of a client s long-term financial needs, and can include recommendations about insurance, savings, tax and estate planning, and investments. (ii) This is distinct from a financial tool that is used to provide guidance to a customer with respect to a particular transaction or an allocation of customer funds and securities based upon the long-term needs of a client. (b) Duties of Dual Registrants to clients (i) The Advisers Act carves out an exception specifically designed to accommodate dually registered broker-dealers. (a) Under section 206(3), the limitations on principal transactions do not apply if the brokerdealer/investment adviser is not acting in an advisory capacity with respect to a transaction. 12 Securities Industry Association No-Action Letter under Investment Advisers Act of 1940, Section 202(a)(11)(C) and Rule 202(a)(11)-1 (December 16, 2005)

18 18 (c) Impact of Credentials on Holding Out Standard (i) A broker-dealer listing such information, on a business card for example, would not be required to register as an investment adviser unless one or more of its representatives both (a) Provides advice as part of a financial plan or in connection with financial planning services, and (b) Includes such credentials on his business card or letterhead. 2. The FPA v. the SEC a) Background (1) When the SEC originally proposed what became Rule 202(a)(11)-1 in 1999, the SEC s staff had issued a no-action position that some felt enabled broker-dealers to proceed to grow their fee-based business as if the rule were already in place. 13 (a) In the six years following the expression of this position, there was a growth to $268 billion in fee-based brokerage accounts, according to the SEC staff. 14 (b) On July 20, 2004, The Financial Planning Association (FPA) sued the SEC over the proposal and their no-action position, asserting that it constituted a violation of the Administrative Procedure Act (APA) Sec. Reg. & L Rep (BNA) (Oct. 16, 2006) [The FPA urged at a July 2004 briefing at the National Press Club that the SEC has not complied with the Administrative Procedure Act. In short, it argued, the Division of Investment Management effectively implemented the rule by giving brokerage firms "no-action" relief at the time of the proposal, saying that so long as a firm complies with the proposed exemption, the staff will not seek enforcement action against it for violating current rules. BNA July 26, 2004]. 14 Id. ( Until the Commission takes final action on the proposed rule, the Division of Investment Management will not recommend, based on the form of compensation received, that the Commission take any action against a broker-dealer for failure to treat any account over which the broker-dealer does not exercise investment discretion as required under the Investment Advisers Act. 64 Fed. Reg. 61,226 (Nov. 10, 1999).) 15 See Diamond, FPA Challenges Substance of SEC Exemptive Rule for Brokers, Sec. & L Rep (BNA) ( May 2, 2005). The FPA filed suit over the proposed rule, objecting to what it called the "unorthodox process" used by the commission to create an expanded exemption for brokers without formally adopting a rule under the Administrative Procedure Act. FPA President Jim Barnash stated that, the rule unfortunately continues to permit the delivery of two kinds of advisory standards: one by brokers immersed for nearly seven decades in a sales production environment and subject only to a fiduciary standard, the other by advisers in an embedded fiduciary culture." Id.

19 19 (c) The FPA s lawsuit was stayed pending official SEC action. On April 28, 2005, following the formal adoption of the rule, the FPA filed a petition for review of a final order of the Securities and Exchange Commission in the U.S. Court of Appeals for the District of Columbia Circuit. 16 (d) The FPA argued that Rule 202(a)(11)-1 is arbitrary and capricious, that it constitutes an unlawful double standard as applied between investment advisers and certain broker-dealers, and that the rule should be vacated on the ground that it does not comport with Congress intent to protect investors. 17 (2) The FPA s argument: The SEC impermissibly rewrites the Advisers Act b) FPA Arguments (1) In its opening brief filed on March 23, 2006, The FPA argued that Rule 202(a)(11)-1 is arbitrary and capricious, and that it effectively creates a legally unsupportable double standard among investment advisers and certain broker-dealers. 18 (2) The major argument the FPA presents concerns the SEC s alleged improper re-write of the Advisers Act, where the rule is tantamount to legislation which contradicts the text and purpose of the Act itself. (a) First, the FPA notes that this case is about rewriting a statute, not construing one. 19 In construing a statute, the FPA asserts that the Court should principally look to the plain meaning of the text and ought to give effect to every clause and word of the statute. 20 (b) In reference to 202(a)(11)(C), the FPA claims that the term and is not ambiguous and that there are explicitly two requirements of independent significance (solely incidental advice and no special compensation). Both of these requirements need to be satisfied for a broker-dealer to not be considered an investment adviser Fin. Planning Ass'n v. SEC, D.C. Cir., Civil Action No (July 20, 2004) 17 Id 18 Brief of Petitioner at 2-5, Fin. Planning Ass'n v. SEC, ( D.C. Cir. July 20, 2004). 19 Id. at Id. (Citing United States v. Barnes, 295 F.3d 1354, 1359 (D.C. Cir. 2002), and Pub. Citizen v. Dept. of Health and Human Services, 332 F.3d 654, 671 (D.C. Cir. 2003)). 21 Id. at 28.

20 20 (c) The FPA claims that the two statutory conditions are significantly, if not entirely, undermined in such a way that no executive agency deference should be accorded to such a rewrite of the Advisers Act. 22 (3) The FPA noted that in 1978 the SEC itself articulated that if a broker-dealer has in effect two general schedules of fees available to a customer, the Division would regard the extra charge as special compensation for the investment advice. 23 (a) Also in 1978, the SEC stressed that this would be the case even in a situation, then non-existent, in which a current full service firm implements a discount or execution only service. 24 (i) These positions are juxtaposed with the new rule in which the SEC claims that special compensation has no independent legal significance. 25 (ii) The FPA feels the SEC inadequately justifies this total shift from i) historically having special compensation as a statutory requirement, to ii) now having special compensation be, as they argue, irrelevant. (iii) The FPA also objects that the other condition of the statutory exception, that advice be solely incidental, is given no particular definition. (a) They claim that the rule does not say what solely incidental is, or identify any of the other things, that without limitation, could make investment advice something more than solely incidental to providing brokerage services Id. at 29 ( This case does not involve the deference that would apply to an agency s interpretation of ambiguous statutory language It is only if (i) the Court concludes that Congress has not directly addressed the precise question at issue, and the agency has acted pursuant to an express or implied delegation of authority, that the Court ii) reaches the determination of whether the agency s statutory interpretation is sufficiently reasonable to receive deference Here the analysis never reaches step two. ). 23 Id. at 10 (citing 43 Fed. Reg. 19,224). 24 Id. 25 Id. at 19 ( The SEC asserts that there is no evidence that the special compensation requirement was included in 202(a)(11)(c) for any purpose beyond providing an easy way of accomplishing the underlying goal of excepting only advice that was provided as part of the package of traditional brokerage services. ). 26 Id. at 15.