Judges grapple with the conflicting interpretations of congressional intent. Last week a three-judge panel turned a spotlight on a Securities and Exchange Commission (SEC) rule that exempts fee-based brokers from the disclosure requirements that govern registered investment advisors (RIAs), according to wire-service reports.

The Financial Planning Association (FPA) is asking the U.S. Court of Appeals for the District of Columbia Circuit to invalidate the so-called Merrill Rule, an SEC rule that allows brokers to offer fee-based accounts without having to register as investment advisers as long as their advice is "solely incidental" to executing trades.

Ye olde lawe

The SEC is defending the Merrill Rule against charges that it ignores the intent of the 1940 Investment Advisers Act, which holds up the question of whether advice is solely incidental to a broker's business as a fundamental point of distinction between brokers and RIAs.

The law additionally stipulates that a broker exempt from the 1940 Act because he renders his clients only "incidental advice" gets "no special compensation" for that advice.

But as the wirehouses started rolling out fee-based brokerage accounts in the late 1990s, the SEC reacted by putting the Merrill Rule into effect. This rule, which was upheld in April 2005, specifically exempts brokers who provide investment advice through fee-based accounts from rules imposed on investment advisers. Significantly, the Merrill Rule came into effect when the brokerage industry was under fire for "churning" accounts - the unethical, and isolated, practice of recommending unnecessary trades in order to generate trading commissions.

According to the SEC, the exemption was necessary because the 1940 Act says that compensation other than trading commissions or "spreads" are special compensation that would subject brokerage firms that were already regulated to additional advisory rules, and it wasn't intent of Congress' -- which the SEC says couldn't have anticipated a world in which fee-based brokerage accounts would blend a mix of both advice and transactional service -- to do that.

Back and forth

Judges Brett Kavanaugh and Merrick Garland wanted the FPA to explain why converting a traditional commission-based brokerage account to a fee-based broker account should trigger advisory rules just because the price structure of the account has shifted.

"Why does one constitute special compensation and the other not?" Kavanaugh asked FPA counsel Merril Hirsh, referring to the difference between charging commissions and charging fees as a percentage of account assets.

Hirsh, an attorney with the Washington, D.C.-based law firm Ross Dixon & Bell said that the SEC itself viewed fees as a form of special compensation that would trigger advisory rules unless an exemption were in place.

Garland said that he would concur with FPA position on fee-based brokerage accounts "if it were true that most of the money is paid for the advice and only a little of the money is paid" for the brokerage services. However, Garland said he saw no evidence that fees on fee-based brokerage services were primarily for advice.

Kavanaugh asked Hirsh if he knew "why Congress would have created the broker-dealer exception in the first place?"

Hirsh replied that it was "to allow a limited amount of advice." Kavanaugh countered: "The statute doesn't really look at how much investment advice is being provided."

The SEC says it had to put the Merrill Rule into effect because the lines between brokerage and advisory services have blurred.

"That would be a reason to go back to Congress," Hirsh said in court. "It wouldn't be a reason to revise the statute."

On that point Kavanaugh asked the SEC where it got "the authority to say we're going to disregard the line that Congress drew by relying on the intent of Congress?" After all, he remarked "broker-dealers were not an unforeseen circumstance" in 1940. -FWR

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