Both Sides Now

“Our interests may not always be the same as yours.” Imagine telling your clients that. And then imagine saying 20 minutes later, “But now that we're discussing your comprehensive planning needs, I'm acting in your best interests, because I've put on my fiduciary hat.” On a subsequent visit, when discussing investment recommendations, you have to remind them that you're once again acting as a registered rep: “Our interests may not perfectly dovetail here.”

Sounds absurd. But under new SEC rules that were set to take effect at the end of January, it could happen. That's because brokers who hold dual licenses — both the “registered rep” (Series 7) and “registered investment advisor rep” (Series 65) licenses — will have to take fiduciary responsibility on some accounts. But they can also sell investments, after they make it crystal clear that they're doing so.

Oh, and just because you're not dually registered, don't think you're off the hook. If you're a registered rep offering financial-planning services or have discretion on an account and want to keep at it, you'll have to get licensed as an investment advisor, too.

An awkward line to walk? Absolutely. But it's real and broker/dealers have been quietly preparing for the new rule, which will subject all discretionary and financial-planning accounts to the Investment Advisers Act of 1940 for the first time. (The rule is essentially an updated version of the Merrill Lynch exemption, covering “Certain Broker/Dealers Deemed Not To Be Investment Advisers”.)

Confusion over what exactly qualifies as financial planning has made it tough for firms to figure out how to evaluate their advisory programs and services, says the Securities Industry Association (SIA). And the SEC didn't offer any answers until Dec. 16. So, in mid-January, the SIA asked the SEC for three more months to comply with the rule. (At press time in late January, the SEC hadn't ruled on the extension.) It's the second extension the brokerage industry trade group has requested since those SEC rules were finalized last April.

“The financial-planning portion needed some more interpretive guidance, which was only forthcoming right before Christmas,” says Michael Udoff, vice president and associate general counsel at the SIA. “Members are working through it and it's helpful,” he says. “But time is needed to get it right.”

Overly Ruled?

The SEC rules issued last April are primarily the result of the lawsuit filed by the Financial Planning Association in 2004 over the “Merrill Lynch rule,” which exempts b/ds that offer fee-based brokerage accounts from registering as investment advisors. That lawsuit, a response to the increasing encroachment of reps onto planner turf, is still pending.

This is no small matter. It's becoming a fee-based, financial-planning world: 33 percent of production at the SIA's member b/d firms came from fee-based business in 2004, up from 13 percent in 1997. Not only do fee-based accounts appeal to many customers, they create a cushion for firms in flat or down markets. In 2002, for example, when the S&P 500 lost nearly 23 percent, Merrill Lynch's retail brokerage business notched pretax operating margins of 15.9 percent, up nearly four percentage points from 2001. At least partial credit went to its growing fee-based revenues. More recently, the firm cited a 14 percent increase in fee business when it reported record fourth-quarter revenues.

Financial planners assert that brokers aren't held to the same elevated fiduciary standard that they are. But, b/d management insists, the regulatory and compliance burden on brokers and their firms is far greater in a quantitative sense. Monitoring suitability, for example, requires detailed record-keeping and constant supervision. And, they point out, brokers are governed by the Securities Exchange Act of 1934, which is over 200 pages long, 12,000 NASD rules and, for NYSE firms, the exchanges rulebook, too. By comparison, the Investment Advisers Act of 1940 runs 31 pages.

On average, NASD brings more than 1,000 disciplinary actions and cashiers 700 unfit brokers and b/ds from the industry every year. By comparison, there were 95 civil actions in federal court and administrative proceedings against RIAs (including asset managers) in 2005.

Few compliance consultants or regulators deny that the sheer volume of rules faced by brokers far outpaces those faced by investment advisors. Yet, the fiduciary standard is pretty serious stuff, too. “Brokers have more do's and don'ts. Advisors have broad duties that have implications,” says Bob Plaze, associate director of the SEC's Investment Management Division. Still, “Everybody would agree that the cost of compliance is greater for brokers than for advisors,” he says

Just take Matt Reynolds, chief compliance officer for Chicago-based US Fiduciary, who manages the compliance for four operations: one independent b/d, one financial-planning RIA and two asset manager RIAs, all of which fall under the US Fiduciary umbrella. Reynolds says he spends 70 percent of his time on the b/d, with the rest of his time split three ways. And that despite the fact that the financial-planning unit manages about 50 percent more assets than the b/d, he says.

Reynolds and others point to daily reviews for the determination of custody requirements, monthly and quarterly financial filings to the NASD, annual audits for each b/d (versus audits once every seven years for RIAs), compliance examinations by multiple regulators, comprehensive supervisory systems, mandatory net capital and bonding requirements, among numerous other things. (Yes, reps say, fiduciary is a strong word, but what brokers do in practice is very similar.)

Layer Cake

Now brokers are having to make adjustments in order to ensure that they are in compliance with investment advisor rules. Though most large b/ds are already registered as investment advisors, their reps generally are not. “For those firms, the question is which accounts to make advisory accounts and which to leave as brokerage accounts,” says Plaze. “For advisory accounts, reps will have to have special training and special state licensing,” he says. Most states require that investment advisors pass the Series 65 exam, though some allow advisors to substitute CFP certification. On the product end, financial-planning offerings will have to be retooled and contracts, brochures and disclosure documents rewritten.

Even before the SEC rule was finalized last April, many firms began taking action in anticipation of the regulatory shift. Last June, Raymond James shut down all 27,000 of its fee-based brokerage accounts, called Passport, and its fee-based brokerage business altogether, converting most of these accounts into advisory accounts and registering 260 brokers managing them as investment advisor reps with state securities regulators. About $5.2 billion was held in the brokerage version of Passport.

Other firms, including State Farm Insurance, are encouraging agents who offer investment advice to limit their use of certain professional designations associated with financial planning, like the certified financial planning credential, on business cards, stationary and other client communications materials. Only reps who register as investment advisors with state securities regulators, undergo an internal training program and make the appropriate ADV disclosures to clients are authorized to use their CFP in client communications materials. And State Farm pays for training, testing and continuing education. Today, out of a total of 16,900 agents at State Farm, just 220 are investment advisor reps and work under the firm's separate registered investment advisor arm. Close to 70, or one-third, of those investment advisor reps were registered and trained in 2005.

When preparation of a financial plan is complete, the rep can tell the client that he would like to help implement the plan, but that he will be doing so as an agent of State Farm and may not always put the client's interest first, says Don Sikora, personal financial-planning program director for State Farm Insurance.

Merrill Lynch, in contrast, has developed a modular approach to the financial plan. Brokers at the firm explain that Merrill has scrapped its former financial-planning program called Financial Foundation, replacing it with four separate free modules: one to assess client goals, one to allocate assets, another to develop the investment proposal and the fourth to conduct portfolio reviews. One broker, who has been using the new system, says clients who subscribe to this service get the SEC's standard disclosure document, stating that the firm may not have the client's best interests at heart.

Just in the past two years, Merrill has also begun awarding an internal designation called the personal investment advisor (PIA), say Merrill reps. Only those with at least five years in the industry, $100 million in client assets and a clean record can become PIAs, and even then they have to win approval from a selection committee. These reps are registered as investment advisor reps, can manage discretionary accounts and have “limited” fiduciary responsibility over the accounts, brokers say. “This is something that Merrill is trying to increase,” says one broker who aspires to get his PIA. He estimates that PIAs now number 1,200, or about 10 percent, of Merrill's brokerage force.

A Merrill Lynch spokeswoman declined to comment on the modular plans or PIAs, saying only that, “We are working diligently to comply with the requirements of the rule and to make sure that clients fully understand the nature of our brokerage services and our financial plans.”

Clearly, some firms are opting to play both sides of the fence with a single client. In other words, once the “financial plan” is completed, an investment advisor, the same rep, can assume a broker role in order to make investment recommendations — as long as the investment advisor explicitly discloses in writing that the fundamental nature of the relationship has changed and that he is removing himself from a position of “trust and confidence.”

Meanwhile, for any fee-based accounts that continue to be operated by a Series 7 holder, the SEC has mandated a new standard disclosure that must be included in client documents. Its language is so scary (see excerpt, p. 30.) that at least one compliance expert thinks these disclosures will be the kiss of death. “The b/ds should be very upset,” says Nancy Lininger, founder and principal of compliance consulting firm The Consortium. “Now you have to give out a disclosure document that says I may not be acting in your best interest. How do you sell against that?”

COMPLIANCE IS COSTLIEST FOR FULL-SERVICE B/DS

Full-service firms have higher compliance costs than their b/d rivals, in part because they do more compliance training of reps than other kinds of firms, says TowerGroup analyst Matt Bienfang. Independent firms “bill back” a lot more of the costs to reps; insurance b/ds can depend on some of the compliance infrastructure in place at the insurance parent company; and bank b/ds tend to have a lot more controls already built into the business, he explains.