ARTICLE IV - THE BEDROCK PRINCIPLE FOR INVESTMENT ADVISERS

Broker-Dealer or Investment Adviser

Effective April 15, 2005, the Commission adopted Rule 202(a)(11)-1 under the 1940 Act. The purpose of the rule was to differentiate on a functional basis the broker-dealer from the investment adviser in order to determine which statutory scheme applied. The rule articulates the conditions under which certain broker-dealers are not deemed to be investment advisors so that securities regulation will not be operating at cross purposes. This is not all the rule does in that it provides a sharper focus upon what investment advisers do compared to broker-dealers and highlights the need to center investment adviser regulation on fiduciary duties and a specific articulation of what are those duties. Further there has to be a heightened regulatory and investment adviser community consciousness to pragmatically develop from experience textually clear and workable rules.
In the adopting release the Commission stated the guidelines as follows:

"... Under the rule, a broker-dealer providing advice that is solely incidental to it brokerage services is excepted from the Advisers Act if it charges an asset based or fixed fee (rather than a commission, mark up or mark down) for its services, provided it makes certain discloses about the nature of its services. The rule also states that a broker or dealer provides investment advice that is not solely incidental to the conduct of its business as a broker or dealer or its brokerage services if the broker or dealer charges a separate fee or separately contracts for advisory services ... [T]he rule states that when a broker-dealer provides advice as part of a financial plan or in connection with providing planning services, a broker-dealer provides advice that is not solely incidental if it: (i) holds itself out to the public as a financial planner or as providing financial planning services; or (ii) delivers to its customer a financial plan; or (iii) represents to the customer that the advice is provided as part of a financial planning services ... [B]roker-dealers are not subject to the Advisers Act solely because they offer full service brokerage and discount brokerage services (including electronic brokerage) for reduced commission rates ... [T]he rule states that exercising investment discretion is not solely incidental to (a) the business of a broker or dealer within the meaning of the Adviser Act or (b) brokerage services within the meaning of the rule (except for investment discretion granted by a customer on a temporary or limited basis."

An adviser is an advisor within the regulatory framework when it exercises principally an advisory function or when it so controls the account and the securities in it that the highest standards must be adhered to because the level of trust and confidence is at the highest level.

The rule has sound logic to it. While broker-dealers can charge a wrap or fixed fee and it is highly unlikely that the customer will be prejudiced by that fact alone, investment advisers will be highly suspect if their income is transaction based. Where the client pays "special compensation" for the advice, and the advice is frequently the sole service provided, the advice giver has to be beyond approach. Broker-dealer customers have to be vigilant to a degree by reviewing disclosure documents, trade confirmations, and account statements. The complete degree of dependency of the clients upon their investment adviser is recognized in the law and certainly not accepted in the broker-customer relationship, as evidenced by the bona fides of the broker-dealer’s typical defenses in an arbitration or suit.

Accordingly, the new fee structures for typical broker-dealers does not transform the relationship into an investment advisory one. The Commission in the commentary to its final rule stated:

"We were troubled that application of the Advisers Act to broker-dealers offering these new brokerage programs would discourage their development, which we viewed as potentially providing benefits to brokerage customers. After reviewing these new fee-based brokerage programs, we concluded that they were not fundamentally different from traditional brokerage programs. We viewed broker-dealers offering these new programs as having repriced traditional brokerage programs rather than as having created advisory programs."

Regulatory differentiation is not made on the basis of what the organization primarily does in the regular course of its business but how the specific account is serviced. The commentary stated "... the protections afforded by the Act ... [apply] only to those accounts to which the broker-dealer provides investment advice that is not solely incidental to brokerage service or for which the firm receives special compensation."

The focus of the new rule is on two categories of advisory accounts and accordingly some broker-dealers because of their fiduciary duties as to the customers of these accounts require, assuming the minimum number of clients, investment adviser registration. The release promulgating the final rule noted:

"... [B]roker-dealers offered two types of advisory accounts, one known as ‘purely advisory’ and the other as discretionary. In purely advisory accounts, the ‘investment counsel undert[ook] to advise the client at stated intervals, or to keep him constantly advised, as to what changes ought, in the opinion of counsel, to be made in his holdings’ but left the ultimate decision about such changes to the client. Discretionary advisory accounts, on the other hand, provided the broker-dealer - through powers of attorney or otherwise - additional ‘control over the client’s funds, with the power to make the ultimate determination with respect to the sale and purchase of securities for the client’s portfolio.’ Broker-dealers generally charged for the advisory services provided to these accounts under the same system that had been adopted by the independent investment counseling firms - a fee based on a percentage of the market value of the cash and securities in the account being supervised. Securities transactions for the discretionary accounts were effected through the broker-dealer, and clients paid a commission on each trade."

The nature of the services rendered to the client-customer rule what regulatory framework applies. Compensation is not necessarily congruent with the role played and services rendered. The focus is now where it should be, not on the type of compensation earned but what in essence defines an investment adviser; financial services where there is complete cheat dependency. Now the task for further enlightened rule making should be to set clear standards that fit the adviser in contrast to the broker-dealer.

Key Considerations
The key factors of consideration of whether to bring a case and what sanctions to impose were articulated by Chief Administrative Law Judge, Brenda P. Murray in In re Coxon, Sergy, and World Money Managers, et al.
"The factors to be considered in determining whether it is in the public interest to assess a penalty are (i) whether the illegal activities involved fraud, deceit, manipulation or deliberate or reckless disregard of a regulatory requirement; (ii) the harm caused to other person(s); (iii) the extent to which any person was unjustly enriched; (iv) a person’s prior disciplinary history; (v) deterrence; and (iv) such other matters as justice may require." (Emphasis added.)

The above factors are also points of concern for counsel. The lawyer’s regulatory clients have to have a heightened consciousness of regulatory requirements as well as take corrective measures. Counsel, whether participating in the Wells process or in the sanction stage of an administrative proceeding, have to shape their advocacy in the light of the above factors and that requires being able to meaningfully distinguish between different types of conduct.

Statutory provisions and rules with textual clarity will also make it possible if not easier to apply the above stated criteria, and certainly as justice requires.

Calling conduct that is not fraud, fraud and then requiring the final order deciding the case to be distributed is realistically to destroy an adviser’s business. It is antithetical in this context to the remedial purpose of the securities laws which is to protect and prevent, not destroy. There are other alternatives such as those recommended by the United States Chamber of Commerce. For this reason also the distinction between truly fraudulent conduct and what in reality is professional malpractice should be clearly incorporated into the statute and rules, and the "catch-all" provisions which are meaningless exercises of rule-making authority should be erased.

Reconsideration and Reform
A fair review by both the lawyers for the SEC and other regulators as well as the private bar will show both the 1940 Act’s anti-fraud provision and the SEC’s rules are fundamentally sound, with the exceptions of the "operative fraud" language in Section 206(2) and "catchall" provisions such as Rule 206(4)1(a)-(5) of the advertising rule. It is a sine qua non of our regulatory system that the statutes and rules are not merely to be effective but to be fair and accord due process by giving educative notice to those who are and should be subject to regulation. Investment Advisers are truly professionals and fiduciaries in the terms of what Chief Judge Benjamin Cardozo described as persons who are expected to and must possess "morals above the marketplace". Investment Advisers are not to merely adhere to minimal ethical and competency standards, but to the highest ones. To achieve these goals it is incumbent upon legislative and regulatory bodies to give clear definition as to what are those standards. It is more important to draft statutes and rules to clearly define conduct and of lesser importance to give agencies broad regulatory reach.
For the reasons stated above, we would recommend that Congress amend the 1940 Act, repeal Section 206(2) and substitute in its place a separate statutory section. The provision shall clearly mandate that Investment Advisers act in accord with specifically defined statutory sections; rules and regulations of the SEC, state regulators, and self-regulatory organizations; and the well recognized and accepted standards of their profession. It is suggested that the proposed statutory provision grounded in concepts of fiduciary duty should read as follows:

Investment Adviser Professional Responsibility
1. No Investment Adviser, whether registered under this Act or not, shall violate any applicable Federal or State statute, rule or regulation of the SEC; other regulatory and self-regulatory agencies, and the recognized and accepted standards of their profession by a failure to exercise reasonable due care or adherence to the published ethical standards. Proof of the standards of conduct for Investment Advisers should be in the form of presenting published written standards of conduct or by expert testimony in accord with Rule 702 of the Federal Rules of Evidence.

1. There shall be a private right of action against any investment adviser who by violation of duly recognized professional standards proximately causes actual loss to the client. Nothing contained in this or any other provision of this statute or the rules thereunder negates any other right of action including, but not limited to, the clients rights to rescind the investment adviser contract and to recover fees paid and costs incurred.

Where scienter is not required, the SEC and other rule-making bodies should publish clear standards. "Catchall" provisions such as Rule 206(4)-1(a)(5), should be repealed because such provisions do not give educative notice, which makes the law unfair in its application and meaningless as an effective deterrent since well intentioned persons will only be able to guess at its meaning.
Fraud is and should not be the core concept for the Investment Advisor regulatory regime. The bedrock principle should be and has to be based on the Investment Adviser’s fiduciary relationship with his clients and his significant professional responsibilities as clearly articulated by the regulators and self-regulators, as well as the investment adviser community itself.

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