Proposed SEC Rule on Brokers Makes No Sense

Complaints against brokers reached an all-time high in 2000. Never slow to address problems in the industry, the Securities and Exchange Commission recently announced plans to adopt a long-dormant rule that would provide less regulation for brokers.

Earlier this month, Paul Roye, head of the SEC division that oversees investment advisers, announced that his staff would recommend that the agency adopt a rule exempting brokers from rules that apply to investment advisers -- regardless of whether they are providing investment advice.

One Good Turn

The rule is the result of a misguided quid pro quo. The story began in 1999, when Merrill Lynch announced a new program, Unlimited Advantage, that would charge a percentage of assets for investment advice and unlimited trading.

Former SEC Chairman Arthur Levitt celebrated the news. For years he had unsuccessfully exhorted brokers to adopt asset-based fees. Commission-based compensation, Levitt argued, created an inherent conflict of interest between brokers and clients because brokers had an incentive to churn client accounts and generate commission payments, regardless of how well the accounts performed.

But Merrill wasn't so happy. Its new advisory program would be subject to rules governing investment advisers. As the SEC data discussed below demonstrate, brokers can't even comply with the few rules they must follow currently. Expecting them to comply with the same rules that have applied to advisers for decades would be asking too much.

Particularly annoying to Merrill was a rule dealing with advisers who recommend securities that they then sell to their clients out of their own inventories. This practice, somewhat akin to a doctor writing a prescription to be filled from his own pharmacy, is illegal for mutual funds. But it's allowed for non-mutual fund clients -- with their consent. But Merrill didn't want to ask permission.

Investment advisers also must provide clients with extensive disclosure about their fees, services, disciplinary history and conflicts of interest. The SEC is putting the finishing touches on a revolutionary program that will put all of this information on the Internet. But Merrill didn't want to reveal its secrets.

So Levitt decided to reward Merrill's embrace of asset-based fees by proposing to exempt its advisory activities from regulation.

The Market Rules

What Levitt did not appreciate was that Merrill's move to asset-based fees was not driven by his sermonizing, but by an unforgiving marketplace that simply wouldn't pay full-service-brokerage commissions any longer.

Some brokers were charging less than $10 per trade, and others were even paying to have orders routed to them, a practice known as payment for order flow. Morgan Stanley Dean Witter predicted that commissions were "headed toward zero," The Wall Street Journal reported.

Merrill, realizing that it had to shift its pricing structure in order to survive, began offering $29.95 trades through Merrill Lynch Direct and offering asset-based accounts for personal financial advice and unlimited brokerage activity through Merrill Lynch Unlimited Advantage.

Just Rewards

The timing of Roye's announcement could not have been worse. In January, the SEC announced that complaints against brokers hit an all-time high. Complaints totaled 13,599, a 9% jump from 12,463 in 1999. Sales practice abuses, including misrepresentations to investors and unauthorized transactions, increased 8%.

Brokers' conduct worsened in the first quarter of this year. Complaints about sales practices continued to grow, with the number of complaints of unsuitable recommendations rising 58% from the first quarter of 2000, according to The Wall Street Journal.

With public dissatisfaction with brokers setting records, why would the SEC subject brokers who provide investment advice to less regulation than other advisers?

This question is at the heart of the public reaction to the Merrill rule, which has triggered more intense opposition than any rule in recent memory. Of the 88 comments on the rule posted on the SEC's Web site, 79 oppose it, many with a degree of passion and depth of analysis rarely seen in public comment letters.

In addition to dozens of individuals, the opposition includes: the AARP, Consumer Federation of America, Certified Financial Planner Board of Standards, Investment Counsel Association of America, National Association of Personal Financial Advisors, and Financial Planning Association.

Supporting the rule, of course, are brokers Charles Schwab and Salomon Smith Barney; lawyers who represent brokers; and the trade group for brokers -- the Securities Industry Association, or SIA.

With the SIA as Your Friend...

When the SIA, known for attacking anything that smells of investor protection, describes a rule as representing "the administrative process at its best" and applauds the SEC for doing "an outstanding job of drafting a proposed rule," you know something is very wrong.

What's wrong is that the rule will leave investors who receive advice from brokers unprotected. An investment adviser is a fiduciary, legally bound to act in the client's best interests. A broker is a salesman required only to make "suitable" recommendations.

Congress and the SEC enacted rules specifically governing advisers that were designed either to prevent or prominently disclose advisers' conflicts of interest. These rules require not only that this information be provided to every client, but also that advisers record the date on which each client received it.

Brokers traditionally have been exempt from adviser rules if the advice they gave was "incidental" to their brokerage services. Now that discount brokerage has made brokerage the "incidental" service, it's become obvious what Merrill's high fees are paying for: investment advice.

Merrill's Unlimited Advantage marketing materials make it clear that it's advice that they are selling. One magazine ad doesn't even mention trading until the third of four paragraphs. The ad and Merrill's online information materials focus on developing a financial plan. Brokerage services are a distant thought.

Merrill boasts that a "Financial Consultant" will "help you develop investment strategies," including "retirement planning, saving for college, estate preservation and liability-management strategies." Your consultant will "explore tax-smart investments ... and investigate hedging techniques to help protect your nest egg from fluctuating interest rates."

Sound like investment advice? Can't be. As a footnote in the ad states, Unlimited Advantage is a "non-discretionary brokerage service." This statement is absurd in the context of Merrill's advice-focused ads, but it will be required by the new rule.

In fact, for someone who was looking for brokerage services, Unlimited Advantage would make no sense. If you had a $1 million account, for instance, you would pay 1.5% of assets, or $15,000, annually. That would cover 500 $29.95 trades, assuming you paid full price for such an active account.

If you want access to a Merrill Financial Consultant, you would be better off opening a $100,000 account, paying the $1,500 minimum for the advice, and doing all of your trades through Merrill Lynch Direct.

The Walking Dead

For a while, it looked like the overwhelmingly negative response to the Merrill rule had brought the SEC to its senses. The staff stopped talking about the rule, and it seemed to have been given a quiet, well-deserved and bureaucratic burial.

But what is obvious to so many people is apparently lost on the SEC. Roye's announcement, which incredibly makes no reference to opposition to the Merrill rule, may be a wake-up call as to what the SEC staff believes will be the highest priority for a Bush-appointed SEC chairman.

This column has identified numerous regulatory problems over the last year, but none compares with the Merrill rule for its potential to harm investors and undermine confidence in financial services professionals.

With markets declining and broker complaints rising, this is the worst possible time to give investors another reason to withdraw from our capital markets. Visit Fund Democracy's Web site to find out what you can do to stop the Merrill rule.