1. Financial Planning Association v. SEC: Fee Based Brokerage Securities Industry and Financial Markets Association General Lunch May 15, 2007 Lori A. Martin

2. WilmerHale Overview Financial Planning Association v. SEC, No. 04-1242, 2007 U.S. App. LEXIS 7356 (D.C. Cir. Mar. 30, 2007), held that ruled that the SEC exceeded its authority under the Investment Advisers Act when it promulgated Rule 202(a)(11)-1 exempting certain broker-dealers providing fee-based brokerage accounts from registering as investment advisers Approximately $300 billion in fee-based brokerage accounts Regulatory framework for fee-based accounts now clearly the Investment Advisers Act

3. WilmerHale Industry Innovations A tremendous shift has occurred in the securities industry from commission-based to asset-based compensation: customized reporting services to brokerage customers; financial planning by broker-dealers; wrap accounts; the expansion of asset-based brokerage accounts; and the expansion of advisory services offered by broker-dealers to their customers.

4. WilmerHale Broker-Dealer Regulation Securities Exchange Act of 1934: The Exchange Act extended federal regulation to trading in securities that already have been issued. Section 15 requires broker-dealers to register with the SEC and grants the SEC authority to discipline registered broker-dealers. “Maloney Act” of 1938: Enacted to supplement the Exchange Act by extending regulation to the previously unregulated interstate non- exchange, or over-the-counter, securities market and authorized the establishment of “national securities associations.”

5. WilmerHale Investment Adviser Regulation Investment Advisers Act of 1940 (“IAA” or “Advisers Act”): Federal regulation over investment advisers. Among other provisions, the Advisers Act requires investment advisers to register with the SEC, and it grants the SEC authority to discipline advisers who violate the law or the regulations promulgated by the SEC under the Advisers Act.

6. WilmerHale Definition of an Investment Adviser Section 202(a)(11) of the Advisers Act defines “investment adviser” as a person who, for compensation, engages in the business of advising others about securities. The Advisers Act excludes from the definition of “investment adviser” a broker-dealer who: o provides investment advice which is “solely incidental” to the conduct of its business as a broker-dealer, and o receives no “special compensation” for that advice.

7. WilmerHale Consequences of the Classification Financial services firms began to offer both brokerage and investment advisory services. Many firms are dually registered with the SEC as investment advisers and as broker-dealers, and are subject to two different, and sometimes overlapping regulatory schemes. The application of these laws to a dually registered firm depends on whether the firm was acting as a broker-dealer or as an investment adviser with respect to a particular client, product or transaction.

8. WilmerHale Investment Adviser Duties Relationship of trust and confidence with clients; Supreme Court stated that advisers have broad fiduciary duties. Transamerica Mortgage Advisors v. Lewis, 444 U.S. 11, 17 (1979). These duties are enforceable by the SEC under Section 206. Duties of an adviser include:  Disclosure  Act in the Client’s Best Interests  Fairness  Best Execution  Suitability

9. WilmerHale Broker-Dealer Duties Broker-dealers’ duties to their customers generally are considered less stringent than the fiduciary duties of an investment adviser to advisory clients. Duties include:  Suitability (NASD Rule 2310 and NYSE Rule 405)  Fair Dealing with Clients  Best Execution  Reasonable Care for Non-discretionary Accounts

10. WilmerHale Broker-Dealer Duties (State Law) Additional duties when acting in a position of trust and confidence, e.g. supervising a client’s discretionary account or engaging in principal transactions. A minority of states have case law suggesting that broker-dealers are fiduciaries. These states are California, Missouri, South Carolina, and South Dakota. Other states have held that the “scope” of the broker’s duty is “undefined.” E.g., Alabama, Alaska, Idaho, Iowa, Kentucky, Nebraska, New Mexico, Nevada, Oklahoma, Utah, Virginia, West Virginia.

11. WilmerHale Trading Restrictions for IAs Although Section 206(3) refers to transactions in which the IA acts as principal or broker, the SEC applies the section to transactions in which any person controlling, controlled by, or under common control with the IA, acts as principal or broker. Principal Trading. Trading as principal with clients requires disclosure that the IA is trading as principal and written consent before each transaction. Agency Cross Transactions. IAs may cause clients to trade with each other with blanket consent if the adviser meets the requirements of the safe harbor for agency cross trades in 206(3)-2.

12. WilmerHale Trading Restrictions for BDs Broker-dealers often engage in principal and agency cross transactions on behalf of clients, and generally only provide disclosures on the trade confirmations. Principal Trading. Broker-dealers may trade for their own account with their clients without obtaining client consent for each trade; disclosure that the BD acted as principal on the trade confirmations. Agency Cross Transactions. Broker-dealers are not required to obtain blanket consent to cause two customers to trade with each other; need only disclose the clients’ trade confirmations.

13. WilmerHale Determining Which Requirements Apply to Dual Registrants Dual-hatting of IA and BD services. These questions arise most often with respect to principal transactions. Whether IA or BD Rules Will Apply. Which hat is the broker wearing? See, e.g., In re IFG Network Securities, Inc., Admin. Proc. Initial Decision (Feb. 10, 2005) (finding that “there is no case precedent that holds that an associated person of an investment adviser cannot change hats…and act in the capacity of a broker-dealer without the higher obligations of an adviser”).

14. WilmerHale Rule 202(a)-11 (Adopted 2005) The Rule exempted from the requirements of the Advisers Act, broker- dealers providing nondiscretionary advice solely incidental to its brokerage service, regardless of the form of compensation, so long as: (1) the broker-dealer does not have investment discretion over the account; (2) the investment advice is given “solely incidental” to brokerage services; and (3) the broker-dealer prominently discloses to its customers that their accounts are brokerage accounts. The SEC promised guidance re: “solely incidental” and additional disclosures for fee-based accounts.

15. WilmerHale “Solely Incidental” Requirement The advice that a broker-dealer provides must be solely incidental to the brokerage services that the broker-dealer provides to each account, not solely incidental to the operations of the broker-dealer as a whole. o Advisory services are generally “solely incidental” to brokerage services when such services are rendered to an account “in connection with and reasonably related to the brokerage services provided to that account.” o The SEC requested further comments regarding the meaning of “solely incidental.”

16. WilmerHale Solely Incidental Excluded: The following services are not “solely incidental” to brokerage services and would require the broker-dealer to treat the account as an investment advisory account: Discretionary Brokerage Accounts; and Financial Planning

17. WilmerHale Fee Based Brokerage Accounts Until recently, a broker-dealer offering a fee-based brokerage account was required to include the following prominent disclosure on all advertisements and forms governing the account: (1) a statement that the account is a brokerage account and not an advisory account; (2) an explanation that the customer’s rights and the broker- dealer’s responsibilities (including fiduciary duties) may differ from rights and responsibilities with an advisory account; and (3) identification of the person at the firm that the customer can speak with about the differences between brokerage and advisory accounts.

18. WilmerHale Holding Out as an IA The purpose of the disclosures was intended to address the financial planning associations’ claim that broker-dealers could “hold themselves out” to the public as investment advisers, thereby causing customer confusion about the difference between fee-based brokerage accounts and advisory accounts.

19. WilmerHale Fee Based Brokerage o Special compensation must be “solely incidental” to the brokerage services provided to that account, rather than to the overall operations of the broker-dealer. o “Solely incidental” advice does not include providing advisory services for a separate contract or fee, providing financial planning, or providing discretionary brokerage. o Disclosure. Advertisements for, and contracts, agreements, applications and other forms governing the account must disclose that the account is a brokerage account and not an advisory account. A broker-dealer that is registered under the Exchange Act may rely on the exclusion from the definition of an investment adviser whether or not it charges an asset-based or fixed fee (rather than commissions, mark-ups or mark-downs) for its services if it satisfies several conditions.

20. WilmerHale Financial Planning Association Case brought by the Financial Planning Association, which viewed fee based brokerage as competition The Association purported to act in the public interest because the associations’ members had to comply with the IAA, but brokers offering fee-based brokerage accounts complied only with the Exchange Act. On March 30, 2007, the D.C. Circuit vacated Rule 202(a)(11)-1.

21. WilmerHale Financial Planning Association (cont.) The DC Circuit reasoned that Congress intended to define “investment adviser” broadly and created a precise exemption for broker-dealers The statutory scheme was inconsistent with the SEC’s construction of its exemptive authority SEC rule also “flouts six decades of consistent SEC understanding of its authority” under subsection F of the IAA, which authorizes the SEC to exempt “such other persons not within the intent of this paragraph” from the IAA

22. WilmerHale Financial Planning Association The decision vacating the rule has created enormous uncertainty; in particular, because the rule addressed more than fee-based brokerage: Financial planning services Discretionary accounts Multiple commission pricing levels

23. WilmerHale Potential Responses by the Industry Emergency Rulemaking under Section 206A of the IAA to permit broker dealers to continue to offer services pursuant to Rule 202(a)(11)-1 for a discrete period of time. Section 206A grants the Commission authority to exempt by rule any person or transaction from any provision of the IAA if the exemption “is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy” the Act Intervention in the Lawsuit Motion for Stay of Mandate

24. WilmerHale Fee-Based Brokerage Litigation Horizon and Potential Defenses Breach of fiduciary duty claims No private right of action under Section 206 of the Investment Advisers Act  Remedy under Section 215 is limited to rescission of the contract  Section 211 safe harbor (no liability if Company acts in conformity with SEC rule)  Consider whether the state law claims are preempted by the Investment Advisers Act

25. WilmerHale Fee-Based Brokerage Litigation Horizon and Potential Defenses Fraud Based Claims  Not related at all to the D.C. Circuit’s decision  Analogous precedent would be the NYAG’s action against the UBS fee-based brokerage program  Claim premised on view that the fee-based brokerage account was not suitable (or material omissions) for investors whose transactions and anticipated commissions were less than the fee charged on assets under management

26. WilmerHale Fee Based Brokerage Litigation Horizon and Potential Defenses Highly fact specific; may not be subject to template defenses May want to emphasize some of the thematic justifications for a shift to fee-based brokerage “reducing incentives for registered representatives to churn accounts, recommend unsuitable securities, or engage in high- pressure sales tactics” and “better aligning their interests with those of their broker-dealers” “reduc[ing] substantially conflicts between broker-dealers and their customers.”

27. WilmerHale Questions and Discussion