Stealth Anti-Churning Measure?

Bill Sjostrom —  18 January 2006

Butter ChurnThe W$J had an article last week about a new rule under the Investment Advisers Act of 1940 that goes into effect on January 31, 2006 (click here for the article [$], here for a post on the W$J blog concerning the article, and here for the SEC adopting release). This posts takes a different angel on the new rule.

For background, the Advisers Act generally requires any person providing investment advice to others for compensation to register with the SEC as an investment adviser. The Advisers Act, however, specifically provides that brokers are not required to register if they provide investment advice “solely incidental� to their brokerage business and receive no “special compensation� for the advice, i.e., no compensation other than commissions for executing a trade. The legislative history of this exclusion indicates it is to avoid unnecessarily duplicative and costly regulation of brokers (brokers are subject to extensive regulation under the ’34 Act and by the NASD).

The SEC recently adopted a new rule effective January 31, 2006 that expands the above exclusion. The rule was prompted in part by the widespread introduction in the late 1990s of fee-based brokerage programs. Under a fee-based program, instead of charging a commission on trades, brokers charge a fee based on the amount of assets on account with the broker. The SEC has recognized that such a fee structure may constitute “special compensation� making the above exclusion unavailable. The SEC, however, favors fee-based programs over commission based compensation (they better align interests of the brokers and their clients by removing broker incentives to churn accounts and recommend unsuitable securities in an effort to generate additional commissions). It therefore does not want to hamper the development of these programs by requiring brokers who offer them to register as investment advisers subjecting themselves to an additional layer of regulation. Thus, the new rule expands the above exclusion so that brokers can offer fee-based programs without having to register as investment advisers.

But the SEC giveths with one hand and takeths away with the other. In a reversal of position, the new rule establishes that any broker who exercises investment discretion over a customers account must register as an investment adviser. In response to this provision, many brokers have simply opted to convert discretionary accounts to non-discretionary accounts. Note that discretionary accounts are the most susceptible to churning, hence, the title of this post.