The Merrill Rule: A Legal Perspective

1. The Merrill Rule: A Legal Perspective Neal E. Sullivan Partner Bingham McCutchen LLP and David Bellaire General Counsel Financial Services Institute

2. Brief History of the Merrill Rule • Compensation limited to transaction-based commissions • Tully Report recommends fee based compensation as a best practice • Fee based brokerage accounts proliferate • Distinctions between broker-dealer and investment adviser activities continue to erode • Regulatory clarity sought by broker-dealers • SEC proposes rule to exempt broker-dealers in 1999 • Modified rule adopted in April 2005

3. Brief History of the Merrill Rule A broker-dealer providing investment advice to customers is excluded from the definition of investment adviser regardless of the form of compensation received as long as: (i) the advice is non-discretionary, (ii) the advice is solely incidental to the brokerage services, and (iii) the broker-dealer discloses to its customers that their accounts are brokerage accounts – not advisory accounts.

4. Brief History of the Merrill Rule • Advice is not solely incidental to brokerage services if it includes: • Charging a separate fee or separately contracting for advisory services. • Provides advice as part of a financial plan and: • The individual holds himself out to the public as a financial planner or as providing financial planning services; • Delivers a financial plan to the customer; or • Represents to the customer that the advice is provided as part of a financial plan or in connection with financial planning services.

5. Brief History of the Merrill Rule • “Financial planning” seeks to address a wide spectrum of a client’s long-term financial needs, and can include recommendations about insurance, savings, tax and estate planning, and investments • Financial planning is distinct from a financial tool that is used to provide guidance to a customer with respect to a particular transaction or an allocation of customer funds and securities based upon the long-term needs of a client

6. Merrill Rule’s Impact on IBD Firms • Fee based brokerage accounts emerge in the IBD channel • For most IBDs, they remain a small portion of • Discretionary brokerage accounts no longer an option • Accounts are either converted to investment adviser relationships or non-discretionary brokerage • Drawing the line between financial planning and use of financial tools becomes a challenge with significant consequences • Suitability review and asset allocation development versus financial planning services

7. Rule Vacated • Merrill Rule is vacated in its entirety • Opinion rests entirely upon statutory interpretation • Court rules that Section 202(a)(11) of the Investment Advisers Act was very specific as to who could be exempted from the definition of investment adviser • Section 202(a)(11)(C) provides the sole and exclusive exemption for broker-dealers • SEC’s power to exempt is thus limited by the Act • Merrill Rule goes beyond the SEC’s authority

8. Rule Vacated • SEC announces that it will not appeal the Court’s decision • Requests a 120-day stay of the ruling so that firms and investors have adequate time to review their options • $300 billion in assets held in an estimated 1 million fee based brokerage client accounts

9. Effect of Invalidation of the Rule • Loss of fee-based brokerage account option • Reduction in investor choice • Turmoil and uncertainty • Is financial planning investment advice? • Is the use of financial tools or analytics considered “investment advice”? • A race to achieve compliance by the October 1, 2007 deadline

10. Legal & Business Alternatives • Broker-dealer firms with fee-based brokerage accounts were required to either: • Reprice fee-based brokerage accounts into commission-based structure so that registered representatives can continue to service them; • Transition fee-based brokerage accounts to advisory accounts serviced by an investment adviser representative of an affiliated investment adviser;

11. Legal & Business Alternatives (Continued) • Broker-dealer firms with fee-based brokerage accounts were required to either: • Maintain the existing fee-based brokerage accounts, but strip the services to execution only; or • Convert fee-based brokerage accounts to 3rd party managed accounts.

12. The Race to Compliance • Firms struggled with the tension between: • Meeting the deadline of October 1, 2007; and • Insuring suitable account type recommendations for individual clients. • Single solution for all fee-based brokerage accounts runs counter to regulatory guidance • For example, see NtM 03-68 noting that fee-based programs must be appropriate for a client based on their needs.

13. Recent Developments – Principal Trading • Temporary Rule allowing investment advisers to engage in principal trading on non-discretionary advisory accounts provided that: • Proper disclosures are provided to clients concerning conflict of interest that may arise; • Customer consent is obtained prior to engaging in any principal transactions; and • Customers receive annual reports showing principal-trading activity in the account.

14. Recent Developments – Guidance • SEC Proposed Interpretative Rule 202(a)(11)-1 reinstates guidance from the now-vacated rule, specifically: • Broker-dealers do not offer “solely incidental” investment advice if they exercise investment discretion or charge separate fees • Broker-dealers who charge different commission rates (full service v. discount) for clients are not receiving “special compensation” • A broker-dealer is an investment adviser solely with respect to accounts that receive advisory services.

15. Recent Developments – RAND Study • SEC commissioned the RAND Corporation to conduct a study of broker-dealers and investment advisers from two perspectives: • Investment adviser’s and broker-dealers’ practices in marketing and providing financial services to individual investors; and • Evaluate investors’ understanding of the differences between investment advisers’ and broker-dealers’ financial products and services, duties, and obligations

16. Recent Developments – RAND Study • Conclusions • Industry is “heterogeneous” with firms providing a wide range of services through a variety of relationships and entities; • Investors fail to distinguish between broker-dealers and investment advisers along the lines defined by federal regulations; • Disclosures provided to investors are ineffective; and • Investors express high levels of satisfaction with the services they receive from their own financial services provider.

17. Recent Developments – RAND Study • Chairman Cox instructs SEC Divisions of Investment Management & Trading and Markets to develop a list of policy options flowing from the RAND Study’s conclusions • FPA calls for a roundtable of consumer and industry groups to discuss the RAND Study • The SEC makes no commitment to organize such a roundtable

18. Recent Developments – RAND Study • Investment Adviser Association calls on SEC to improve investor education and repropose revisions to Form ADV Part II • SIFMA calls for creation of SRO for investment adviser only firms

19. Long Term Impact • Regulatory review of the suitability of account options chosen during the race to compliance • Arbitration and litigation of cases concerning the suitability of account options chosen during the race to compliance • Guidance on financial planning reverts to Investment Adviser Release IA-1092

20. Long Term Impact • Additional incentive for financial advisors to drop their securities licenses and exclusively offer investment advisory services • Opportunity to modernize the financial services industry’s regulatory scheme to promote transparency, but the timing may not be right • Commission – Short 2 Commissioners • Congress – Election year politics and Senate Banking Committee backlog

21. Resources • Tully-Levitt report (1995) see at http://www.sec.gov/news/studies/bkrcomp.txt. • Original Proposed Rule - Certain Broker-Dealers Deemed Not To Be Investment Advisers, 64 Fed. Reg. 61,226 (Nov. 10, 1999). • Final Rule - Certain Broker-Dealers Deemed Not To Be Investment Advisers, 70 Fed. Reg. 20,424 (April 19, 2005). • Financial Planning Association v. SEC, 482 F.3d 481 (D.C. Circuit 2007).

22. Resources • Investment Advisers Act Rel. No. 2652 (Sept. 24, 2007)(proposed rule reinstating interpretative positions). • NASD Notice to Members 03-68 (November 2003) (noting that fee-based programs must be appropriate based on the client’s needs). • RAND Report – “Technical Report: Investor and Industry Perspectives on Investment Advisers and Broker-Dealers” (January 2008) see at http://sec.gov/news/press/2008/2008-1_randiabdreport.pdf.

23. Resources • Investment Advisers Act Rel. No. 1092 (October 8, 1987)(discussing applicability of Act to financial planners).