Wall Street Wants Flat-Fee Accounts Exempted from Investment-Adviser Rules

Last year, the titans of Wall Street, bowing to market pressure, introduced new flat-fee accounts: Rather than coughing up a commission for every trade, investors could instead pay annual fees pegged to the value of their assets. The plans, which knee-capped the incentive to churn client accounts to maximize commissions, have been a hit with consumers. More than $100 billion in assets have been collected in flat-fee accounts, helping Merrill Lynch and other full-service firms hold onto clients who might have strayed to discount brokers.

But now, it turns out, there is a decidedly consumer-unfriendly side to the new accounts. At the urging of the brokerage industry, the Securities and Exchange Commission has proposed a rule that would exempt these accounts from disclosure and suitability rules that have been in place since the Investment Advisers Act of 1940 was enacted. If adopted, the exemption would remove vital safeguards, say consumer advocates.

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"It's going to greatly expand the potential for abuse," said Mercer Bullard, former assistant chief counsel in the SEC's investment management division, who now heads an advocacy group for mutual fund investors. "It is a real step backward for a regime that has focused so heavily on disclosure."

The key issue is whether these new accounts are subject to the Investment Advisers Act, a keystone of the nation's securities laws.

If they are, a raft of investor-protection measures come into play. Among them: Broker-dealers must make detailed disclosures about such things as whether they have a financial interest in anything they recommend, or whether they've been the subject of disciplinary actions; they have a higher duty to clients, and to putting client interests ahead of their own; and they aren't allowed to trade directly with their clients, such as when their firm may have a particular security it wants to push.

But if the new accounts aren't subject to the 60-year-old law, they're instead considered to be ordinary brokerage accounts, and a different standard prevails. Generally, brokers must only make "suitable" recommendations for each client -- a threshold often proven porous in the past.

All this may seem an arcane issue of classification, but it stands to affect a growing number of investors, particularly less sophisticated players who have come into the market only recently.

But where the line is drawn is of great importance to Merrill Lynch, Morgan Stanley Dean Witter, Prudential Securities and Salomon Smith Barney, the firms that are using the new accounts as a successful marketing vehicle. Their point is that the flat-fee plans are a simple repricing, not a change in the fundamental services offered. The plans are based primarily on a fee set as a percentage of assets, but may also include small add-on charges for specific services.

The industry argued, and SEC rule-proposers agreed, that a change in compensation shouldn't trigger the 1940 act. So last November, the SEC proposed its new rule. On Tuesday, May 23, it holds a day-long meeting on the subject as a prelude to enacting a final rule, which could come as early as this summer.

As now written, the rule would exempt the new accounts if three conditions are met:

If the accounts are "non-discretionary," meaning that brokers must get client approval before making any trades.

If advice to clients is "solely incidental" to the straightforward business of buying and selling investments.

If a broker-dealer discloses to customers that their accounts are brokerage accounts -- that is, sales accounts for buying and selling securities, and not the kind of advisory accounts protected by the 1940 act.

"We think the focus should be on the nature of services, not the manner of compensation," said Cynthia M. Fornelli, an architect of the proposed rule and senior adviser to the director of the SEC's investment-management division. "All these new programs do is reprice the services brokers have always offered their clients."

Perhaps, but the condition that advice be "solely incidental" is creating a ruckus, and further raising the question of whether the big firms have been overstepping their bounds for years.

In offering their new accounts, the big firms certainly seem to be pitching advice as a key component, not as some by-the-way afterthought.

How Close to the Line? Under a proposed new rule, Wall Street firms won't have to offer the protections of the Investment Advisers Act to clients of their new fee-based plans if, among other things, any advice provided is "solely incidental" to the account. But so far, the firms certainly appear to be making advice a key selling point. Here's how several plans are being pitched:
Firm	Name of plan	How advice is touted
Merrill Lynch	Unlimited Advantage	"...personal advice and guidance from Merrill Lynch Financial Consultants...our clients are entitled to the personal advice and counsel of professional Financial Consultants..."
Prudential Securities	Prudential Advisor	"...we pride ourselves on providing you with the expertise of a highly trained Financial Adviser dedicated to helping you meet your specific financial needs...for investors who value the personalized one-to-one relationship with a Financial Adviser..."
Morgan Stanley Dean Witter	ichoice	"...serve those clients who wish to conduct their financial services business with the professional guidance of a Financial Advisor...client- tailored professional advice..."
Salomon Smith Barney	AssetOne	"...dedicated, professional and personalized guidance...the benefit of the guidance and resources of a Salomon Smith Barney Financial Consultant..."
Source: Company documents

If this continues, consumer advocates say, the effect will be to allow sales pitches under the guise of objective advice. "If you're going to offer advisory services, you ought to be held to advisory standards," said Barbara Roper, director of investor protection for the Consumer Federation of America.

There's no question that non-commission accounts are a plus for investors, she said. "But in the broader sense, an investor who is misled into receiving what they think is objective advice -- but which is actually a sales pitch -- is not better off. And that's what this allows."

Upsetting consumer advocates even more, the SEC has also given the industry a get-out-of-jail-free card while the proposed rule is under consideration: It won't recommend enforcement actions involving the new accounts until it adopts any final rule.

The SEC's Fornelli says that's because the agency doesn't want to discourage new offerings that would be covered by the rules. But consumer advocates note that even if a strong rule comes down eventually, the industry will still have had plenty of time to build up the new business and making it more difficult to change the rules later.

"It does increase the political difficulty of doing the right thing," said Roper.

Merrill Lynch, for example, which appears to be the most successful of the big firms in this new area, boasts it already has more than $90 billion in its Unlimited Advantage program.

In fact, the proposed rule has even come to be known as "the Merrill rule." People involved in the matter say they don't know precisely how the proposal originated. But it's clear it results from on-going discussions between the SEC and the industry, and that industry executives played a key role in shaping the proposed rule.

Two leading trade groups -- the National Association of Securities Dealers and the Securities Industry Association -- are enthusiastically backing the measure. As the SIA said in a letter to the commission, "We note ... the fact that the SEC had extensive dialogue with SIA and other industry participants. ... Clearly, this approach represents the administrative process at its best, and substantially contributed to the positive end result."

But critics say the industry wants to have it two ways. It insists, on one hand, that its change is merely a repricing maneuver. Yet it also represents the accounts as having full advisory services.

Merrill Lynch's plan, for example, promises that "our clients are entitled to the personal advice and counsel of professional Financial Consultants." Asked whether that would cause clients to think they were getting advisory services, Susan Thomson, a spokeswoman for Merrill Lynch's Unlimited Advantage program, replied: "You'll see the word, 'advice,' not 'advisory.' They're separate and distinct. We're not acting in an advisory capacity. It's not an advisory relationship."

There is some distinction made. Salomon Smith Barney, for instance, while touting "dedicated, professional and personalized guidance," notes in fine print that its AssetOne plan is not "an investment advisory program."

But on the whole, the weight of the industry's sales pitch certainly appears to make advice a pivotal feature.

Prudential Securities, for example, even uses the term in the name of its plan -- Prudential Advisor. And in a letter to the SEC, Prudential executive Laurence S. Godin declares that just as it has been, "investment advice will continue to be an integral part" of the new accounts.

The real complication, of course, is that the SEC has never drawn a hard line between real and incidental advice. Even so, it's not a hard call when it comes to the way the big firms are pitching the new products, critics say.

"There's no way you can say, 'This is incidental,' " said Bullard, the former SEC official. "It's central to the service. It's the reason you'd sign up for it."

Tuesday's day-long meeting will be a high-level affair, at least from the standpoint of the many SEC officials and industry executives lined up to attend.

The SEC's Fornelli acknowledges concern about advertising disclosures, and said that may be addressed in the final rule proposal. Still, she indicated she wasn't prepared to accept all the criticism.

The fact that any accounts exempted will require client approval for trades will quell customer confusion, she said. "I don't think that investors who don't give their money managers discretion necessarily expect to receive the protections of the Investment Advisers Act," she said.