Executive Summary
When it originated, the Investment Advisers Act of 1940 sought to create a clearer line between stockbrokers who were primarily in the business of selling securities (for commission), and investment advisers who provided ongoing advice (for a fee). In fact, the ’40 Act declares that anyone who is in the business of providing investment advice for compensation must register as such. Registered representatives of broker-dealers could be exempt, but only if they received no special compensation for advice and any advice they did provide was “solely incidental” to their brokerage services.
Yet as the financial services industry has evolved over the nearly-75-years since the ’40 Act was passed, the lines between brokers and investment advisers have blurred, culminating in the SEC’s proposal in 1999 that “Certain Broker-Dealers [Could Be] Deemed Not To Be Investment Advisers” and not be treated as receiving special compensation even though they were offering fee-based wrap accounts. Ultimately, though, the FPA sued the SEC on the basis that this exemption was broader than what Congress intended with the ’40 Act, and the courts agreed, vacating the rule in 2007.
Yet ironically, when the Broker-Dealer exemption was vacated, so too was an expansion of the definition of “solely incidental” advice, including the recognition by the SEC that providing financial planning services, or holding out to the public as a financial planner, would mean the advice being provided was no longer solely incidental. Although these were merely clarifications of what constituted “solely incidental” advice, the end result is that the SEC has since allowed more and more brokers to hold out as financial planners and offer such services, without requiring them to register as investment advisers. In turn, this raises the question: with all of the fiduciary debate today, do we really need a new/different fiduciary standard for advice, or is the reality simply that the Financial Planning Coalition needs to lobby the SEC to finally step up and enforce the “solely incidental” rules as Congress originally wrote yet?
The Investment Adviser Act of 1940 And The Fiduciary Standard
The Investment Advisers Act of 1940 (“the ’40 Act”) was born in the aftermath of the stock market crash of 1929 and the Great Depression that followed. Recognizing the significant impact that investment advisers could have on the financial system – because of how their advice was followed as trusted advisors – the ’40 Act aimed to crack down on abuses of the era, including investment advisers who gave “hot stock tips” and/or charged questionable performance fees. More generally, the law also simply sought to require all investment advisers to register as such, so that regulators could monitor their formation and gather information about their activity.
Accordingly, then, the ’40 Act had to define who is to be considered an investment adviser, and did so in Section 202(a)(11) of the law, generally declaring that an investment adviser was anyone who:
1) Provides investment advice;
2) For compensation; and
To avoid an overly broad scope, though, the ’40 Act also enumerated a long list of exclusions – situations where the above conditions might apply, but the subject was still not required to register as an investment adviser. Just some of these exclusions included:
- Lawyers, accountants, engineers, or teachers whose performance of such services were solely incidental to the practice of his/her profession;
- Certain banks and bank holding companies;
- Publishers of a bona fide newspaper, magazine, or business/financial publication of general and regular circulation; and
- any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor.
This latter exclusion, in particular, was the one that maintained a separation between investment advisers, and registered representatives of broker-dealers. If the broker’s investment advice was “solely incidental” to the implementation of brokerage services, the broker didn’t have to register. If there was no “special compensation” – i.e., a payment beyond stock trading commissions or dealer markups that would impliedly be for investment advice – the broker didn’t have to register. But if there was any advice given beyond the scope of being solely incidental, OR the broker received any additional/special compensation beyond that normal of brokerage services, then investment adviser registration would be required.
Notably, though, the ’40 Act actually did not directly impose a fiduciary duty on such investment advisers. Technically, Section 206 of the Act – also known as the “anti-fraud” provision – merely requires that investment advisers not engage in any acts that are fraudulent, deceptive, or manipulative. It was only later, in the 1963 Supreme Court case of SEC v. Capital Gains Research Bureau, Inc., that these provisions were interpreted to mean that investment advisers owed a fiduciary duty to their clients.
The Evolution Of Advisor Compensation And The Rise Of Financial Planning Since The Investment Advisers Act Of 1940
During the era in which the ’40 Act was created, it was relatively straightforward to separate investment advisers from brokers. Compensation alone was often a driving factor, as brokers sold the securities in their dealer inventory for a markup or brokered them for a commission, while investment advisers gave ongoing advice and charge a(n AUM or similar) fee for the ongoing service.
In the 1970s and 1980s, though, the landscape began to shift. With the deregulation of brokerage commissions in 1975, it was increasingly difficult for stockbrokers to even be paid for the business envisioned for them when the ’40 Act was created, marking a shift towards the sale of mutual funds, and more generally a wider range of financial services products. Coinciding with this trend was the birth of financial planning in 1969 (and the first class of CFP certificants in 1973), as brokers increasingly shifted away from pure product pitches (“stock tips”) and towards a process of consultative selling. In other words, the lines between investment advisers and brokers were beginning to blur, as brokers were increasingly compelled to adopt other products to sell and implemented an advice-based process to sell them.
Over the next 20 years, the scope of brokers providing advice expanded even further, and in an effort to cut down on brokerage industry conflicts of interest the SEC-directed 1995 Tully Committee on Compensation Practices recommended that brokers begin to shift compensation towards ongoing AUM fees, leading the SEC in 1999 to propose the now-infamous rule for “Certain Broker-Dealers Deemed Not To Be Investment Advisers” (finalized in 2005). This so-called “Merrill Lynch” rule would have allowed brokers to offer fee-based accounts – otherwise a form of “special compensation” – but without being required to register as investment advisers, as long as any advice they gave was still solely incidental to the brokerage services and the account was disclosed to be a brokerage and not advisory account.
Ultimately, the Broker-Dealer Exemption was overturned in 2007 (in a lawsuit originated by the Financial Planning Association), as the courts concluded that if Congress had intended for such an exemption from the special compensation rules it would have written the law accordingly, and that the SEC had overreached in providing such an exemption for broker-dealers on their own. As a result, advisors who wanted to charge AUM fees would be required to register as investment advisers, accelerating the boom in RIAs and hybrid-RIAs that has been continuing to unfold ever since.
Yet while the crux of the broker-dealer exemption rule was whether brokers could offer fee-based “wrap” accounts charging AUM fees without being considered to receive the “special compensation” that would trigger registration as an investment adviser, the SEC has not otherwise addressed the fact that the brokerage industry is increasingly advice-based even while claiming that the advice provided is “solely incidental to the conduct of business as a broker.”
Is The SEC Failing To Enforce The “Solely Incidental” Rule As Written?
While the focus of the broker-dealer exemption rule was on whether fee-based accounts would be deemed special compensation that triggered registration as an investment adviser, also embodied in the final rule were important updates and clarifications to the “solely incidental” provisions.
The final rule had declared that advice would be solely incidental only when it was in connection with and reasonably related to actual brokerage services. While the SEC did emphasize that throughout history “the advice broker-dealers gave as part of their traditional brokerage services [even] in 1940 was often substantial in amount and importance to the customer” the rule was still the most in-depth explanation of what did and did not constitute “solely incidental”.
Furthermore, the SEC included in its rule the statement that having a separate contract or paying a separate fee for advice (including for financial planning services) would no longer be solely incidental. More directly, the rule also stipulated that a broker-dealer would not be providing advice solely incidental to brokerage if it provided advice as part of a financial plan or in connection with providing planning services and held out as doing so. In fact, because of the murkiness in where determining suitability ends and financial planning begins, the SEC explicitly indicated that it would rely primarily on how a broker-dealer (and its registered representatives) held out to the public in determining whether financial planning was being done. In other words, a broker holding out as a financial planner would mean that advice was no longer solely incidental, and investment adviser registration would be required (though notably, the SEC stated that broader terms like “financial advisor” and “financial consultant” would not alone trigger registration, though such individuals who then delivered a financial plan theoretically would).
Ironically, then, when the FPA won its lawsuit against the SEC and had the broker-dealer exemption rule vacated, these definitions of what does and does not constitute “solely incidental” advice were thrown out along with it, due to the lack of any severability provisions in the rule that might have allowed the court to reject some parts of the rule but not others. As a result, interpretations of the '40 Act reverting to the prior-and-now-still-current status where the “solely incidental” provision remains substantially unenforced, despite an even-more-dramatic expansion of financial planning (and the CFP marks) into brokerage firms.
So perhaps it’s time for the Financial Planning Coalition to re-assert itself in lobbying, not around proposing new fiduciary rules or a uniform fiduciary duty, but simply to push the SEC to promulgate updated rules and actually enforce the “solely incidental” clause of the ’40 Act as written today. In other words, perhaps all we need to ensure that consumers receive financial planning subject to a fiduciary duty is for the SEC to recognize again – as it did once already – that the delivery of financial planning services itself expands the scope of advice beyond being “solely incidental” to brokerage services, and enforce those rules accordingly.
