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Is Dual Registration the Cause of Opposition to the Fiduciary Standard?

April 17
01:15 2012

(This is the first installment of a three part series on Dual Registration)

Does the opposition to a universal fiduciary standard stem from a big-time Wall Street company’s ingenious ploy and a Washington regulator’s botched response? In 1999, an upset but wily Merrill Lynch sought to prevent itself from becoming exposed to the onerous regulation of the Securities and Exchange Commission (SEC). In a series of Keystone Kops maneuverings, the SEC blundered through a series of missteps through two administrations, each flying under the banner of a different political party. The absent regulator allowed the birth of an entirely new industry until, almost a decade later, a harsh court ruling sent the entire house of cards tumbling down.

Oddly, though, the quite definitive court ruling, which, despite being 2-1, the SEC chose not to appeal, nothing really changed. The growth of this now fugitive industry continued unimpeded, protected, according to an SEC sponsored report, by a shield of ineffective disclosure. Without its largess, would there even be a debate on the adoption of a universal fiduciary standard.

For those without the benefit of several decades experience in the industry, here’s a quick recap of the major events:

We pick up the story as told by Mercer Bullard (“Proposed SEC Rule on Brokers Makes No Sense,”, May 15, 2001). For years, Arthur Levitt, at the time SEC Chairman until the Clinton administration, had unsuccessfully tried to persuade the brokerage industry to move to an asset-based fee format. According to Bullard, “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.” In 1999, Merrill Lynch launched a product called “Unlimited Advantage.” The broker proposed to offer unlimited no-commission trading and investment advice for a 1% fee. Bullard maintains Merrill didn’t want to subject itself to the regulation regime of the Investment Advisers Act, so, in a “misguided quid pro quo,” Levitt offered Merrill an exemption from the rigors of the Act. Officially “Proposed Rule 202(a)(11)-1” as promulgated by the SEC in November, 1999, the industry quickly adopted “the Merrill Rule” as its name.

This fairly aggressive decision on the part of Levitt did not go unnoticed. Bullard cited, among others, 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 as offering stiff opposition to what had quickly been dubbed “the Merrill Rule.” Tellingly, its main proponents were brokerage firms and their trade group allies. In July 2004, the FPA sued the SEC to force the government to rescind the then still proposed Merrill Rule “For nearly five years the SEC has permitted brokerage firms to comply with a rule that was never adopted,” said FPA President Elizabeth Jetton. “We believe that,” continued Jetton, “at a minimum, the SEC should comply with the rules under which federal regulations are adopted and to act promptly by withdrawing a poorly conceived regulation.” Jetton summarized the FPA’s position by stating, “We believe the public would be better served by requiring brokers to operate under the higher standards of investor protection afforded by the Adviser Act.” (“FPA Sues SEC Over Broker Exemption,” Financial Advisor, July 19, 2004).

In response, under a new Chairman in a new administration, the SEC unanimously approved the Merrill Rule in the Spring of 2005. “Today’s action is a victory for investors,” said Marc Lackritz, then-president of the industry trade group then-called Securities Industry Association (SIA). Reports published at the time stated that, during it “proposed” state and prior to its formal approval, “Approximately $280 billion in client assets currently reside in fee-based accounts, according to the SIA.” (“SEC Adopts Broker-Dealer Exemption,”, April 6, 2005).

But the FPA suit lingered and, on March 30, 2007, nearly two years to the date it was approved by the SEC, the United States Court of Appeals for the D.C. Circuit overturned the Merrill Rule in a 2-1 decision. Rather than seek to appeal the decision, the SEC merely asked for a 120-day stay, which the court granted. During this stay, the SEC commissioned an independent study, now known as the “Rand Report” although officially titled “Investor and Industry Perspectives on Investment Advisers and Broker-Dealers.” The report, released by the SEC on January 3, 2008, had three primary conclusions. First, “focus-group participants with investments acknowledged uncertainty about the fees they pay for their investments, and survey responses also indicate confusion about the fees.” Second, “many survey respondents and focus-group participants did not understand key distinctions between investment advisers and broker-dealers—their duties, the titles they use, the firms for which they work, or the services they offer… In general, the roles of broker-dealers and investment advisers are confusing to most survey respondents and focus-group participants… respondents and participants are unclear on the role of financial professionals who use generic titles, such as financial advisor and financial consultant.” Third, the majority of respondents felt “disclosures do not help protect or inform the investor, primarily because few investors actually read the disclosures.” Fourth and perhaps most telling, “Survey respondents indicated that they are about equally likely to seek services or investment advice from a broker as from an investment adviser.”

In the end, the SEC adopted Temporary Rule 206(3)-3T gave brokers until December 31, 2009 to convert their Merrill Rule clients. Although the industry complained at the time, most now agree this transition, especially for mutual fund accounts, went smoother than expected (“Industry Guide to Managed Investment Solutions,” The Money Management Institute, 2009).

Or did it?

Stay tuned as Part II of this story, “Will Broker Evolution Obviate the Fiduciary Standard Debate?” explores the potentially ironic consequences of this progeny of the Merrill Rule.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


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