United States: FUND ALERT - January 2000 - SEC Proposes Exempting Certain Broker-Dealers From Investment Advisers Act

The SEC proposed new Rule 202(a)(11)-1 on November 4, 1999. This rule would exempt certain brokerage firms from regulation under the Investment Advisers Act of 1940 (the "Advisers Act"). Upon adoption of the rule, a broker-dealer would be excluded from the definition of "investment adviser" if:

(1) the broker-dealer does not exercise investment discretion over the accounts from which it receives special compensation;

(2) any investment advice provided is incidental to the provision of other brokerage services; and

(3) the broker-dealer discloses prominently in advertisements and in agreements governing the account that it is a brokerage account.

Comments on the proposal are due January 14, 2000.

The definition of "investment adviser" in Section 202(a)(11) of the Advisers Act includes persons who receive compensation for providing advice about securities as part of their regular business. The definition does not include broker-dealers, however, if their performance of such services is solely incidental to the conduct of their business as a broker or dealer and if they receive no special compensation for the services. Under SEC interpretations, a broker-dealer is deemed subject to the Advisers Act under this definition if it either provides an account with investment advice that is not incidental to its brokerage services or if it receives "special compensation" in relation to the account.

In recent years, broker-dealers have introduced alternative compensation arrangements. For example, they offer full service brokerage services (including advice) for an asset-based or fixed fee ("fee-based programs"). They also proffer "unbundled" service programs, which give the customer the option to purchase, for example, "execution-only" services at a reduced rate. Questions arise as to whether or not customers who choose fee-based programs must be treated as "advisory" clients, and whether or not, for each type of program, the fees constitute "special compensation" under the Advisers Act.

The SEC states in the proposal that fee-based programs better align the interests of a broker-dealer with a customer. Since compensation under the programs does not rely on the number of transactions or on the size of mark-ups or mark-downs charged, broker-dealers have less incentive to churn accounts or recommend unsuitable investments. Similarly, "unbundled" "execution-only" service programs afford an investor the opportunity to trade freely over the Internet without incurring additional costs for ancillary brokerage services.

Fee-Based Programs: Although the SEC acknowledged that, in fact, a broker-dealer may be receiving some form of "special compensation" when it offers fee-based programs, it stated that the mere receipt of such fees should not be enough to bring the broker-dealer under the ambit of the Advisers Act. The SEC reasoned that such accounts are not fundamentally different from the traditional brokerage accounts that are not subject to the Advisers Act. Therefore, under the proposal, broker-dealers offering fee-based programs would not have to register under the Advisers Act except in those cases where the accounts are deemed "advisory."

The SEC proposed that accounts be categorized as "advisory" based on the nature of the services provided, rather than the form of the broker-dealer’s compensation. For example, accounts that are discretionary and charge asset-based fees would be deemed advisory not only because they closely resemble traditional advisory accounts, but also because customers are likely to perceive the accounts as advisory. Less clear is the treatment of broker-dealers who offer discretionary accounts that do not charge any special compensation. The SEC requests comment on whether or not it makes sense to exempt broker-dealers from registration under the Advisers Act for offering such accounts.

The SEC noted that broker-dealer sponsors of wrap-fee accounts, discretionary or not, could not use the new rule to exempt themselves from the definition of investment adviser. In wrap-fee accounts, even non-discretionary services cannot be viewed as "incidental" to the provision of the investment advisory services.

Unbundled Service Accounts: The SEC proposed that a full-service broker-dealer not become subject to the Advisers Act solely because it receives reduced commission rates for execution-only services. Similarly, a broker-dealer that receives reduced commission rates would not be subject to the Advisers Act solely because it offers full-service brokerage accounts. Thus, under the proposed rule, a broker-dealer is exempt even if it handles both full-service and execution-only accounts. The SEC will look to the characteristics of each account separately to determine whether or not registration under the Advisers Act is necessary.

Calculation of Assets Under Management: The SEC also proposed an amendment to Schedule I of Form ADV. The purpose of the amendment is to make clear that a broker-dealer need only include the value of accounts over which it exercises investment discretion in its calculation of assets under management. This proposed amendment is significant because the SEC only requires federal registration of investment advisers if they have at least $25 million in assets under management.

In an attempt to relieve issuers and broker-dealers from the significant financial burdens attendant to multiple prospectus delivery, the SEC adopted new rule 154 under the Securities Act of 1933 (the "Securities Act"). The new rule, adopted in early November, permits issuers to send just one prospectus to each household in which multiple shareholders reside ("householding.") The delivery of one set of materials now will satisfy the prospectus delivery requirements of the Securities Act. The SEC also announced corresponding amendments to the rules under the Securities Exchange Act of 1934 (the "Exchange Act") and the Investment Company Act of 1940 (the "1940 Act") to permit issuers to send just one shareholder report to each household.

The SEC, in a companion release, also proposed to extend the rule to proxy and information statements delivered under the Exchange Act. However, if the SEC adopts the rule, it will require delivery of multiple proxy cards and voting instructions to each household to enable individual investors to possess their own materials and to vote separately. The rule also will require the sender to notify the investor of the opportunity to request separate informational materials. Finally, the SEC proposed that the rule be extended to cover combination proxy statement-prospectuses delivered for business combinations, exchange offers, and reclassifications of securities. The rule currently does not cover these combination statements.

In its release, issued in November of 1997, the SEC noted that investors increasingly own securities through brokerage accounts, individual retirement accounts and custodial accounts for minors. This has resulted in the delivery of duplicate documents to single households, and therefore in an unnecessary expenditure of company resources. The problem is evident particularly with respect to shareholders in open-end investment companies. These companies deliver annual and semi-annual reports and frequently send updated prospectuses.

The new rule provides that issuers and broker-dealers satisfy the federal requirements for prospectus delivery by delivering one set of materials to a household in which multiple security holders reside. The SEC deems it appropriate for the materials to be addressed either to the household as a group (e.g., "Jane Doe and Household") or to individually-named investors on the same label ("Jane Doe and Bob Jones"). In both cases, the SEC concluded that such delivery actually would result in increased scrutiny of informational materials by investors. The delivery requirements will apply equally to entities and natural persons. Issuers and broker-dealers hoping to take advantage of the new rule should familiarize themselves with the requirements outlined below.

Written or Implied Consent of Investors: All investors must consent to the householding arrangement. This may be accomplished either by written or implied consent. If the investors consent in writing, householding may take place even if the investors are not related. With written consent, issuers can deliver a single report to the investors’ shared residential, commercial or electronic addresses. Implied consent exists if:

(1) the investors at the shared address have the same last name or the issuer/broker-dealer reasonably believes they are members of the same family;

(2) the sending party has given the investor 60 days written notice with an opportunity for the investor to "opt out" via pre-paid mail or a toll-free number;

(3) the investors have not opted-out after being given the opportunity; and

(4) the sending party delivers the materials to either a residential address or post office box.

The sender can assume that a street address is a residence unless it has information that indicates it is a business.

Notice of Opportunity to Revoke Consent: At least once a year, all open-end management investment companies must explain to investors who have consented to householding, how they can revoke their consent. The notice to this effect may be supplied through any means reasonably designed to reach the fund's investors, such as in a prospectus, shareholder report or investor newsletter.

Form of Notification: All notices to investors under the rule must:

(1) be written in "plain English;"

(2) state clearly that, absent instruction to the contrary, one set of materials will be delivered to a household;

(3) state how long the consent will remain in effect;

(4) explain how an investor may revoke consent and include a toll-free telephone number or a prepaid reply form for this purpose;

(5) specify that the investor will be sent individual copies of documents within 30 days if he or she "opts out"; and

(6) contain a prominent statement on the outside envelope (or on the notice if it is delivered with other materials) that reads "Important Notice Regarding Delivery of Shareholder Documents."

Electronic Delivery: The SEC will permit materials to be delivered collectively to investors via electronic means only if each investor specifically consents to electronic delivery. Householding by electronic delivery may only take place under the rule if the several investors share an identical electronic mail address.

The rule became effective on December 20, 1999. Comments on the SEC’s proposal to extend the rule to the delivery of proxy statements — including those for business combinations, exchange offers, and reclassifications of securities — are due January 18, 2000.

John M. Baker 202-261-3512

Jana L. Cresswell 215-564-8048

Diane J. Drake 215-564-8067

Lisa A. Duda 215-564-8143

Steven M. Felsenstein 215-564-8074

Robert K. Fulton 215-564-8042

Alan R. Gedrich 215-564-8050

Nadia M. Jannetta 215-564-8014

Lisa M. King 215-564-8077

Stephen W. Kline 610-640-5801

Duane L. Lassiter 215-564-8010

Bruce G. Leto 215-564-8115

Lisa L. B. Matson 215-564-8003

Barbara A. Nugent 215-564-8092

Michael P. O’Hare 215-564-8198

Mark H. Plafker 215-564-8024

Jennifer M. Rogers 215-564-8128

Mark A. Sheehan 215-564-8027

Merrill R. Steiner 215-564-8039

Bibb L. Strench 202-261-3580

Sinclair A. Ziesing 215-564-8055

Zachary P. Alexander 215-564-8043

Rekha D. Packer 215-564-8096

William S. Pilling, III 215-564-8079

William P. Zimmerman 215-564-8124

John J. Hunter 215-564-8072

James F. Podheiser 215-564-8111

David F. Scranton 610-640-5806

Sheela P. Dattani 302-576-5852

Ellisa Opstbaum Habbart 302-576-5851

With other offices in:

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Washington, DC

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Information contained in this publication should not be construed as legal advice or opinion, or as a substitute for the advice of counsel. The enclosed materials may have been abridged from other sources. They are provided for educational and informational purposes for the use of clients and others who may be interested in the subject matter.