Taking Sides – Memo to the SEC: Scrap Merrill rule

The decision by Merrill Lynch & Co. Inc. to pay $100 million, and change how it monitors and pays its stock analysts, may have put out one fire, but the deal that ended the investigation by New York state Attorney General Eliot L. Spitzer has started several others.

A number of class actions are pending against the New York company, and the settlement of the attorney general’s case won’t stop the Securities and Exchange Commission from pursuing its probe. But the piling-on doesn’t end there.

The Financial Planning Association jumped into the fray last week when it urged the SEC, the National Association of Securities Dealers and state securities regulators to reconsider a pending SEC rule that would exempt stockbrokers from registering as investment advisers.

You may recall that the SEC took up consideration of the proposed rule two years ago at the behest of Merrill Lynch and other major Wall Street brokers. The measure became known as the Merrill Lynch rule.

GROUPS OPPOSED

The FPA, other major investment adviser groups and consumer organizations have opposed the rule because it would not subject brokers to the same fiduciary requirements as registered investment advisers.

The SEC hasn’t taken any action on the broker-dealer exemption, but the FPA is irked by the fact that the agency, in the meantime, has pledged to not take action against broker-dealers who comply with a minimal disclosure requirement labeling accounts as “brokerage” accounts.

Basically, that means the SEC is giving the benefit of the doubt to the major brokerage houses, assuming that they are seeing to it that their brokers are operating free of any conflicts of interest. In effect, the brokerage houses have been able to operate as if the rule has been approved.

But the FPA has seized on the attorney general’s investigation as evidence that the proposed SEC rule and the SEC’s stance on it may be shielding disclosure of broker conflicts of interest from investors.

“We are concerned that the consumer may well be misled into thinking the stockbroker is placing the client’s interests first, just as consumers were misled into thinking the Wall Street analysts were providing objective investment advice on the same stocks that its investment banking colleagues were underwriting,” Bob Barry, the FPA’s president, said in a prepared statement.

Ouch. That’s a sweeping indictment. But under the circumstances, it’s hard to dispute the possibility.

The FPA asserts that brokers, under the cover of the proposed SEC rule, known formally as “Certain Broker-Dealers Deemed Not To Be Investment Advisers,” are heavily marketing financial planning programs without the disclosure of conflicts of interest, such as selling from inventory.

“In essence, the brokerage ads are touting `objective’ advice and implying a financial planning relationship instead of a common securities sale,” said Mr. Barry.

The FPA would like the SEC, the attorney general and other regulators to at least review the extent to which conflicted analyst recommendations were used by brokerage firms to sell stocks from inventory to customers of their fee-based brokerage programs.

“At a minimum, we believe that the SEC and NASD should conduct a sweep of broker-dealer compliance with the proposed rule. We encourage Attorney General Spitzer and other state regulators to do likewise,” said Mr. Barry.

DISCLOSURE NEEDED

“As registered investment advisers, stockbrokers would be required to act in a fiduciary capacity to the client and to affirmatively disclose extensive information on their qualifications, disciplinary history and business affiliations.”

The brokers have long argued that the rule was intended to reduce paperwork, and that many brokers are also registered advisers.

We opposed the Merrill rule long before the current scandal over analysts surfaced. Our opposition stands.

Whether a similar conflict of interest exists, as the FPA alleges, is certainly a valid question. But it shouldn’t take another investigation to put a stake in the heart of the proposed rule.

If we’ve learned anything from the current scandal over analysts, it’s to err on the side of more disclosure. The SEC should take the measure off the table.