SEC’s `Merrill Lynch rule’ divides advisers over brokerage loophole

Investment advisers are at odds over a proposed federal regulation that puts their main trade organization between a rock and a hard place.

The issue dividing them is the so-called “Merrill Lynch rule,” a Securities and Exchange Commission proposal drafted in response to Merrill Lynch’s launch this summer of an asset-based fee program.

Under current rules, brokerage employees who charge fees as opposed to commissions must register with the SEC and comply with strict fiduciary standards just like other fee-based investment advisers.

Full-service brokers are especially concerned about registering because they would be prohibited from making “principal transactions” — selling clients’ securities from their own inventory — a standard practice in their industry.

The new rule would waive that requirement regardless of how broker-dealers are paid as long as they do not have discretion over investing their clients’ money.

But other investment advisers believe that puts them — and the public — at a distinct disadvantage.

“The brokerage firms are clearly promoting their services as if they’re providing advice, and unfortunately the public is not well served to have them exempted from the rule,” says Gary Schatsky, president of IFC Personal Money Managers Inc. in New York and chairman of the fee-only National Association of Personal Financial Advisors.

Brokerage officials declined to comment for this article, but Daniel Michaelis, spokesman for the Securities Industry Association, which represents them, said they are ” generally pleased” with the proposal.

Both the Institute of Certified Financial Planners and the International Association for Financial Planning declined comment. But their silence is far less surprising.

The two trade groups recently agreed to merge into an entity called the Financial Planning Association, which does not come into existence until January.

“I think this is one they still have to sort out a little bit,” says Arthur Grant, president of Cadaret Grant & Co. Inc., a Syracuse, N.Y.-based broker-dealer and advisory firm with $750 million under discretion.

“I don’t think this one is going to be a defining moment, but I do think that it opens the door to things that are just going to have to be thought about,” says Mr. Grant, an IAFP board member who spoke on his own behalf.

In another unusual twist, SEC Chairman Arthur Levitt has long argued against commissions, believing they create an incentive for brokers to recommend transactions simply to make money.

Now, brokers are using his clarion call to argue that the SEC should essentially maintain the status quo. And, that’s exactly what the new rule does, says Paul Roye, director of the SEC’s Division of Investment Management.

“It’s not designed to allow broker-dealers to escape adviser regulation… It just allows brokers to adjust the pricing of the product from commission-based to an asset-based charge,” he says.

He points out that brokers could not advertise advisory services and they must prominently disclose the fact that the accounts are brokerage accounts.

But investment advisers complain that brokers are increasingly sounding like financial planners, a situation that is bound to confuse the public.

“It’s precisely because the marketing materials and advertisements are suggesting that advice is in fact what you’re purchasing that is attracting the interest,” Mr. Schatsky says of Merrill’s new service.

Adds Susan John, his group’s government affairs liaison: “A whole lot more disclosure is required in this area… Specific disclosure of compensation practices inside the firm is important to the consumer.”

Ms. John, president of Financial Focus in Wolfeboro, N.H., is less concerned that brokers would escape registration requirements. “It’s just a restatement of what is already going on… We really have kind of won the war on this. Everybody now is charging fees.”

Most major brokerages are registered as investment advisory firms as well. But the SEC proposal would allow brokers to avoid treating their brokerage accounts as investment adviser accounts.

“We need clearer rules so the firms know where they’re at,” says Stuart Kaswell, the SIA’s general counsel.

“One might conclude that [registration] puts you over on the other side of the fence. Then, all of a sudden, you can’t sell out of inventory without prior permission, and it gets cumbersome.”

But Bob Barry, president of Barry Capital Management, Inc., a broker-dealer affiliated investment adviser in Hackettstown, N.J., asserts that brokers should have the same requirement, if they are “dealing with the public, and effectively dispensing or providing ostensibly the same services.”

New Milford, Conn., adviser Morris Armstrong also questions why discretion should trigger whether a broker has to register.

matter of discretion

“I don’t understand how they come up to that little benchmark,” he says. “Does that mean all investment advisers have (to have) discretionary authority?”

Many, including Mr. Armstrong, do not.

On the flip side, Susan Freed, whose Washington, D.C., firm has $75 million under discretion, believes the proposal needs to be clarified, but generally supports it.

She says it should specify how brokers must be registered if they have non-discretionary accounts but provide their clients with financial plans.

“It’s a very positive ruling because it allows the CFP who is doing more than selling wrap programs to differentiate themselves from the registered representative who is engaged primarily in the sale of securities,” she says.

But Ms. Freed appears to be in the minority among financial planners.

“When you take fees… you strongly suggest that you’re in a fiduciary relationship,” says Lewis Altfest, whose New York firm has more than $100 million under discretion.

“Take the same person and have them be an independent adviser and they register and then they take their business along with them to Merrill Lynch and all of a sudden they don’t have to register as an investment adviser, he says. “Why?”

“What are they? Are they product purveyors? I would allow them to not register with the SEC if they disclose to the clients that they’re product purveyors for their company.”