[Federal Register Volume 70, Number 10 (Friday, January 14, 2005)]
[Proposed Rules]
[Pages 2716-2741]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-603]



  Federal Register / Vol. 70, No. 10 / Friday, January 14, 2005 / 
Proposed Rules  

[[Page 2716]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 275

[Release Nos. 34-50980; IA-2340; File No. S7-25-99]
RIN 3235-AH78


Certain Broker-Dealers Deemed Not To Be Investment Advisers

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission is reproposing a rule 
addressing the application of the Investment Advisers Act of 1940 to 
broker-dealers offering certain types of brokerage programs. Under the 
reproposed rule, a broker-dealer providing nondiscretionary advice that 
is solely incidental to its brokerage services is excepted from the 
Investment Advisers Act regardless of whether it charges an asset-based 
or fixed fee (rather than commissions, mark-ups, or mark-downs) for its 
services. The rule would also state that exercising investment 
discretion is not solely incidental to brokerage business, and thus, a 
broker-dealer providing discretionary advice would be deemed to be an 
investment adviser under the Investment Advisers Act. In addition, 
under the rule, broker-dealers would not be subject to the Investment 
Advisers Act solely because they offer full-service brokerage and 
discount brokerage services, including electronic brokerage, for 
reduced commission rates. Finally, the Commission is proposing to issue 
a statement of interpretive position that would clarify when certain 
broker-dealer advisory services, including financial planning, are 
solely incidental to brokerage business.

DATES: Comments should be received on or before February 7, 2005.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to [email protected]. Please include 
File Number S7-25-99 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609.
    All submissions should refer to File Number S7-25-99. This file 
number should be included on the subject line if e-mail is used. To 
help us process and review your comments more efficiently, please use 
only one method. The Commission will post all comments on the 
Commission's Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments are also available for public inspection and copying 
in the Commission's Public Reference Room, 450 Fifth Street, NW., 
Washington, DC 20549. All comments received will be posted without 
change; we do not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly.

FOR FURTHER INFORMATION CONTACT: Robert L. Tuleya, Senior Counsel, or 
Nancy M. Morris, Attorney-Fellow, at 202-942-0719, or [email protected], 
Office of Investment Adviser Regulation, Division of Investment 
Management, Securities and Exchange Commission, 450 Fifth St., NW., 
Washington, D.C. 20549-0506.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission 
(``Commission'' or ``SEC'') is proposing rule 202(a)(11)-1 under the 
Investment Advisers Act of 1940 (``Advisers Act'' or ``Act'').\1\ We 
are also requesting comment on interpretive positions under section 
202(a)(11)(C) of the Act.
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    \1\ 15 U.S.C. 80b. Unless otherwise noted, when we refer to the 
Advisers Act, or any paragraph of the Act, we are referring to 15 
U.S.C. 80b of the United States Code in which the Act is published.

Table of Contents

I. Background
II. Discussion of Reproposal
    A. Fee-Based Brokerage Programs
    B. Exception for Fee-Based Brokerage Accounts
    C. Discretionary Asset Management
    D. Discount Brokerage Programs
    E. Scope of Exception
III. Proposed Statement of Interpretive Position
    A. Holding Out As an Investment Adviser
    B. Financial Planning Services
    C. Wrap Fee Sponsorship
    D. Other Interpretive Questions
IV. General Request for Comment
V. Cost Benefit Analysis
VI. Effects on Competition, Efficiency and Capital Formation
VII. Paperwork Reduction Act
VIII. Initial Regulatory Flexibility Analysis
IX. Statutory Authority Text Of Rule

I. Background

    The Advisers Act regulates the activities of certain ``investment 
advisers,'' which are defined in section 202(a)(11) as persons who 
receive compensation for providing advice about securities as part of a 
regular business.\2\ Section 202(a)(11)(C) of the Advisers Act excepts, 
from the definition, a broker or dealer ``whose performance of 
[advisory] services is solely incidental to the conduct of his business 
as a broker or dealer and who receives no special compensation 
therefor.'' The broker-dealer exception ``amounts to a recognition that 
brokers and dealers commonly give a certain amount of advice to their 
customers in the course of their regular business and that it would be 
inappropriate to bring them within the scope of the [Advisers Act] 
merely because of this aspect of their business.'' \3\
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    \2\ For a discussion of the scope of the Advisers Act, see 
Applicability of the Investment Advisers Act to Financial Planners, 
Pension Consultants, and Other Persons Who Provide Investment 
Advisory Services as a Component of Other Financial Services, 
Ivnestment Advisers Act Release No. 1092 (Oct. 8, 1987) [52 FR 38400 
(Oct. 16, 1987)] (``Advisers Act Release No. 1092'').
    \3\ See Opinion of the General Counsel relating to Section 
202(a)(11)(C) of the Ivnestment Advisers Act of 1940, Investment 
Advisers Act Release No. 2 (Oct. 28, 1940) [11 FR 10996 (Sept. 27, 
1946)] (``Advisers Act Release No. 2'').
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    Many securities firms currently are registered with us under both 
the Securities Exchange Act of 1934 \4\ (as broker-dealers) and the 
Advisers Act (as advisers), but treat only certain of their accounts as 
subject to the Advisers Act. We have viewed the Advisers Act, and the 
protections afforded by the Act, as applying only to those accounts to 
which the broker-dealer provides investment advice that is not solely 
incidental to brokerage services or from which the firm receives 
special compensation (or both).\5\
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    \4\ 15 U.S.C. 78a (``Exchange Act'').
    \5\ Final Extension of Temporary Rules, Investment Advisers Act 
Release No. 626 (Apr. 27, 1978) [43 FR 19224 (May 4, 1978)] 
(``Advisers Act Release No. 626'') (``A broker or dealer who is 
registered as an investment adviser is not by reason of that fact an 
ivnestment adviser to those of his brokerage clients to whom he 
provides advisory services on a solely incidental basis and without 
special compensation.'').
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    On November 4, 1999, the Commission issued a release proposing for 
comment a new rule under the Advisers Act in response to the 
introduction of two new types of brokerage programs offered by full-
service broker-dealers ``fee-based brokerage programs'' and ``discount 
brokerage programs.'' \6\ The rulemaking addressed whether, as a result 
of introducing these programs, broker-

[[Page 2717]]

dealers would be unable to rely on the broker-dealer exception of the 
Advisers Act. If so, some broker-dealers would be required to register 
under the Act, while those already registered would be required to 
treat customers with such accounts as advisory clients and also as 
brokerage customers.
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    \6\ In the Proposing Release, we referred to what we not term 
``discount brokerage'' programs as ``execution-only'' programs. 
Proposing Release, supra note 5. ``Discount brokerage'' more fully 
describes the programs referenced in this Release.
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    Fee-based brokerage programs provide customers a package of 
brokerage services `` including execution, investment advice, custodial 
and recordkeeping services `` for a fee based on the amount of assets 
on account with the broker-dealer (i.e., an asset-based fee) or a fixed 
fee. Asset-based fees generally range from 1.10 percent to 1.50 percent 
of assets.\7\ A broker-dealer receiving fee-based compensation may be 
unable to rely on the broker-dealer exception because the fee 
constitutes ``special compensation'' under the Act--that is, it 
involves the receipt by a broker-dealer of compensation other than 
brokerage commissions or dealer compensation (i.e., mark-up, mark-down, 
or similar fee).\8\
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    \7\ The Cerulli Edge, Managemed Accounts Edition (1st Quarter 
2004) at 2 (``Cerulli Edge 1st Quarter''.)
    \8\ See S. Rep. No. 76-1775, 76th Cong., 3d Sess. 22 (1940) 
(``S. Rep. No. 76-1775'') (section 202(a)(11)(C) of the Advisers Act 
applies to broker-dealers ``insofar as their advice is merely 
incidental to brokerage transactions for which they recieve only 
brokerage commission.'') (emphasis added). See also Disclosure by 
Investment Advisers Regarding Wrap Fee Programs, Investment Advisers 
Act Release No. 1401 (Jan. 13, 1994) at n.2. Our references in this 
release to ``commission-based brokerage'' include transactions 
effected on a prinipal basis for which the broker-delaer is 
compensated by a mark-up or mark-down.
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    Discount brokerage programs, including electronic trading programs, 
give customers who do not want or need advice from brokerage firms the 
ability to trade securities at a lower commission rate. Electronic 
trading programs provide customers the ability to trade on-line, 
typically without the assistance of a registered representative, from 
any personal computer connected to the Internet. Customers trading 
electronically may devise their own investment or trading strategies, 
or may seek advice separately from investment advisers. The 
introduction of electronic trading and other discount services at a 
lower commission rate may trigger application of the Advisers Act to 
any full-service accounts for which the broker-dealer provides some 
investment advice. This is because the difference in the commission 
rates represents a clearly definable portion of the brokerage 
commission that may be primarily attributable to investment advice. Our 
staff has viewed such a two-tiered fee structure as involving ``special 
compensation'' under the Advisers Act.\9\
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    \9\ Advisers Act Release No. 626, supra note 5; Advisers Act 
Release No. 2, supra note 3; Robert S. Strevell, SEC Staff No-Action 
Letter (Apr. 29, 1985) (``Strevell No-Action Letter'') (``If two 
general fee schedules are in effect, either formally or informally, 
the lower without investment advice and the higher with investment 
advice, and the difference is primarily attributable to this factor 
there is special compensation.'').
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    After reviewing these new programs, we concluded that they were not 
fundamentally different from traditional brokerage programs. As a 
general matter, fee-based brokerage programs offer the same general 
package of services as commission-based brokerage programs. Electronic 
and other discount brokerage programs, for their part, do not offer any 
advisory service, but merely make visible that which has always been 
understood: A portion of the commissions charged by full-service 
broker-dealers compensate the broker-dealers for advisory services. 
Thus, we viewed broker-dealers offering these new programs as having 
re-priced traditional brokerage programs rather than as having created 
advisory programs.\10\
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    \10\ For a discussion of ``traditional brokerage services'' and 
``traditional brokerage programs'' see infra note 42 and 
accompanying text.
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    We were concerned that application of the Advisers Act to broker-
dealers offering these new programs would inhibit the development of 
these programs, which we viewed as potentially providing important 
benefits to brokerage customers. Most importantly, we believed Congress 
could not have intended to subject full-service broker-dealers offering 
these programs to the Advisers Act when, in conducting these programs, 
broker-dealers offer advice as part of traditional brokerage services.
    Under the 1999 proposed rule, a broker-dealer providing investment 
advice to customers would be excluded from the definition of investment 
adviser regardless of the form that its compensation takes as long as: 
(i) The advice is provided on a nondiscretionary basis; (ii) the advice 
is solely incidental to the brokerage services; and (iii) the broker-
dealer prominently discloses to its customers that their accounts are 
brokerage accounts. These provisions of the proposed rule were designed 
to make application of the Advisers Act turn more on the nature of the 
services provided by the broker than on the form of the broker's 
compensation.
    In addition, we proposed that a broker or dealer would not be 
deemed to have received special compensation solely because the broker 
or dealer charges a commission, mark-up, mark-down, or similar fee for 
brokerage services that is greater than or less than one it charges 
another customer. This provision was designed to permit full-service 
broker-dealers to offer discounted brokerage, including electronic 
trading, without having to treat full-price, full-service brokerage 
customers as advisory clients.\11\
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    \11\ We also proposed an amendment to the instructions for 
Advisers Act Form ADV [17 CFR part 279] regarding calculation of 
assets under management for investment advisers dually registered as 
broker-dealers. Proposing Release, supra note 5, at II.B. This 
proposal was effectively incorporated into the instructions of the 
new Form ADV adopted by the Commission in September 2000, and is, 
therefore, not further addressed in this release. See Electronic 
Filing by Investment Advisers;Amendments to Form ADV, Investment 
Advisers Act Release No. 1897 (Sept. 12, 2000) [65 FR 57438 (Sept. 
22, 2000)].
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    These new brokerage programs responded to changes in the market 
place for retail brokerage.\12\ They also responded to concerns we have 
long held about the incentives that commission-based compensation 
provides to churn accounts, recommend unsuitable securities, and engage 
in aggressive marketing of brokerage services. These concerns led to 
the formation, in 1994, of a broad-based committee (``Tully 
Committee'') whose mandate was to identify conflicts of interest in 
brokerage industry compensation practices and ``best'' practices in 
compensating registered representatives.\13\ The Tully Committee found 
that fee-based compensation would better align the interests of broker-
dealers and their clients and would allow registered representatives to 
focus on their most important role--providing investment advice to 
individual clients, not generating transaction revenues.\14\
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    \12\ See Patrick McGeehan, The Media Business: Advertising, 
Schwab Takes Another Kind of Swipe at the Big Wall Street Firms in a 
New Campaign, N.Y. TIMES, Aug. 28, 2000, at C11; Jack White and Doug 
Ramsey, A Belle Epoque for Wall Street, BARRON'S, Oct. 18, 1999, at 
54; John Steele Gordon, Manager's Journal: Merrill Lynch Once Led 
Wall Street. Now It's Catching Up, WALL ST. J., June 14, 1999, at 
A20.
    \13\ Report of the Committee on Compensation Practices (Apr. 10, 
1995) (``Tully Report''). The committee was formed in 1994 at the 
suggestion of Commission Chairman Arthur Levitt.
    \14\ Id.
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    Over the years, many of our enforcement cases and many investor 
losses can be traced to individual representatives responding to the 
need to generate commissions rather than service customers.\15\ These 
new fee-

[[Page 2718]]

based programs offered at least a partial solution to an age-old 
problem facing investors, the Commission, and the securities firms 
themselves. We included in the Proposing Release a statement that our 
staff would not recommend, based on the form of compensation received, 
that the Commission take any action against a broker-dealer for failure 
to treat any account over which the broker-dealer does not exercise 
investment discretion as subject to the Advisers Act.\16\
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    \15\ See, e.g., In the Matter of the Application of Michael T. 
Studer, Securities Exchange Act Release No. 50543 (Oct. 14, 2004) 
(churning customer account); In the Matter of Robert H. Wolfson, 
Securities Exchange Act Release No. 41831 (Sept. 2, 1999) (consent) 
(churning customer account and making unsuitable recommendations); 
In the Matter of J.B. Hanauer & Co., Securities Exchange Act Release 
No. 41832 (Sept. 2, 1999) (consent) (churning customer accounts and 
making unsuitable recommendations); In the Matter of John M. 
Reynolds, Securities Exchange Act Release No. 30036 (Dec. 4, 1991) 
(engaging in excessive trading and purchasing unsuitable 
securities); In the Matter of Victor G. Matl, Securities Exchange 
Act Release No. 22395 (Sept. 10, 1985) (consent) (churning customer 
accounts and making unsuitable recommendations). Individual 
investors may also bring private claims. See, e.g., Saxe v. E.F. 
Hutton & Company, Inc., 789 F.2d 105 (2d Cir. 1986).
    \16\ Proposing Release, supra note 5. In a companion release we 
are today adopting a temporary rule under which a broker-dealer 
providing non-discretionary advice to customers would be excluded 
from the definition of investment adviser under the Advisers Act 
regardless of the form its compensation takes, as long as the advice 
is solely incidental to the brokerage services. As a result of the 
adoption of this temporary rule, the staff no-action position 
announced in the Proposing Release has terminated.
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    Twenty-five letters were submitted during the comment period. 
Following the close of the comment period, however, we received 
hundreds more letters, most of which opposed the rule, and many of 
which appeared to be form letters. Some commenters wrote multiple 
letters. In view of ongoing and significant public interest in the 
proposal, and in order to provide all persons who were interested in 
this matter a current opportunity to comment, we reopened the period 
for public comment on the proposed rule in August 2004.\17\ In all, we 
have received over 1,700 comment letters on the proposal.\18\
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    \17\ Investment Advisers Act Release No. 2278 (Aug. 18, 2004) 
[69 FR 51620 (Aug. 20, 2004)]. The reopened comment period closed on 
September 22, 2004. In our release reopening the comment period, we 
also noted that The Financial Planning Association had filed a 
petition for judicial review of the proposal. Financial Planning 
Ass'n v. SEC, No. 04-1242 (D.C. Cir.) (case docketed on July 20, 
2004).
    \18\ These comment letters are generally available for viewing 
and downloading on the Internet at http://www.sec.gov/rules/proposed/s72599.shtml. Letters are otherwise available for 
inspection and copying in the Commission's Public Reference Room, 
450 Fifth Street, NW., Washington, DC 20549 (File No. S7-25-99).
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    Most commenters discussed only the provisions of the rule that 
addressed fee-based brokerage programs. Broker-dealers commenting on 
the rule strongly supported it.\19\ They asserted that fee-based 
brokerage programs benefited customers by aligning the interests of 
representatives with those of their customers.\20\ According to some of 
these broker-dealers, the application of the Advisers Act would 
discourage the introduction of fee-based programs by imposing what 
these brokerage firms viewed to be a duplicative and unnecessary 
regulatory regime.\21\ Other commenters argued that investors do not 
lose relevant protections when they deal with a brokerage firm instead 
of an advisory firm.\22\
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    \19\ See, e.g., Comment Letter of Merrill, Lynch, Pierce, Fenner 
& Smith Incorporated (Sept. 22, 2004) (``Merrill Lynch Sept. 22, 
2004 Letter''); Comment Letter of Raymond James Financial, Inc. 
(Sept. 21, 2004); Comment Letter of Northwestern Mutual Investment 
Services, LLC (Sept. 22, 2004); Comment Letter of Smith Barney 
Citigroup (Jan. 14, 2000) (``Smith Barney Letter''). See also 
Comment letter of Securities Industry Association (Sept. 22, 2004) 
(``SIA Sept. 22, 2004 Letter'') (representing broker-dealers).
    \20\ Comment Letter of Citigroup Global Markets Inc. (Sept. 22, 
2004) (``CGMI Letter''); Comment Letter of Charles Schwab & Co. 
(Sept. 22, 2004) (``Charles Schwab Sept. 22, 2004 Letter''); Comment 
Letter of Securities Industry Association (Sept. 13, 2000); (``SIA 
Sept. 13, 2000 Letter''); Comment Letter of Securities Industry 
Association (Aug. 5, 2004).
    \21\ CGMI Letter, supra note 20, Merrill Lynch Sept. 22, 2004 
Letter, supra note 19; Comment Letter of Securities Industry 
Association (Jan. 13, 2000).
    \22\ E.g., Comment Letter of Hardy Callcott (Aug. 23, 2004); SIA 
Sept. 22, 2004 Letter, supra note 19.
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    A large number of investment advisers--in particular, financial 
planners--and a few consumer groups submitted letters strongly opposed 
to the proposed rule.\23\ Some of these commenters took issue with our 
conclusions that the new programs do not differ fundamentally from 
traditional brokerage programs.\24\ These and other commenters argued 
that the broker-dealers that would be affected by the rule are 
providing advisory services similar to, or the same as, those that 
investment advisers provide and thus should be subject to the Advisers 
Act.\25\ Many of these commenters asserted that the adoption of the 
rule would deny investors important protections provided by the Act, in 
particular, the fiduciary duties and disclosure obligations to which 
advisers are held.\26\ Another theme among many opponents of the rule 
was the perceived competitive implications for financial planners, 
which would generally be subject to the Act, while broker-dealers would 
not.\27\
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    \23\ E.g., Comment Letter of Carl Kunhardt (Dec. 28, 1999); 
Comment Letter of Pamela A. Jones (Jan. 4, 2000) (``Jones Letter''); 
Comment Letter of Investment Counsel Association of America (Jan. 
12, 2000) (``ICAA Jan. 12, 2000 Letter'') (representing SEC-
registered investment advisers); Comment Letter of Consumer 
Federation of America (Jan. 13, 2000) (``CFA Jan. 13, 2000 
Letter''); Comment Letter of The Financial Planning Association 
(Jan. 14, 2000) (``FPA Jan. 14, 2000 Letter'') (representing 
financial planners); Comment Letter of AARP (Nov. 17, 2003) (``AARP 
Letter''); Comment Letter of PFPG Fee-Only Advisors (June 21, 2004); 
Comment Letter of Timothy M. Montague (Sept. 10, 2004); Comment 
Letter of William S. Hrank (Sept. 20, 2004); Comment Letter of 
Marilyn C. Dimitroff (Sept. 21, 2004) (``Dimitroff Letter'').
    \24\ E.g., FPA Jan. 14, 2000 Letter, supra note 23.
    \25\ See, e.g., Comment Letter of Arthur V. von der Linden (May 
10, 2000); CFA Jan. 13, 2000 Letter, supra note 23; FPA Jan. 14, 
2000 Letter, supra note 23; ICAA Jan. 12, 2000 Letter, supra note 
23.
    \26\ See, e.g., Comment Letter of American Institute of 
Certified Public Accountants (Sept. 22, 2004) (``AICPA Sept. 22, 
2004 Letter''); CFA Jan. 13, 2000 Letter, supra note 23; FPA Jan. 
14, 2000 Letter, supra note 23.
    \27\ See, e.g., Comment Letter of Dan Jamieson (June 1, 2000); 
Comment Letter of Joel P. Bruckenstein (May 31, 2000); Comment 
Letter of Margaret Lofaro (May 8, 2000); Comment Letter of Shawnee 
Barbour (Sept. 13, 2004); Comment Letter of Roselyn Wilkinson (Sept. 
13, 2004); Comment Letter of Robert J. Lindner (Sept. 14, 2004); 
Comment Letter of Robert Lawson (Sept. 16, 2004); Comment Letter of 
Linda Patchett (Sept. 20, 2004) (``Patchett Letter''); Comment 
Letter of John Ellison (Sept. 20, 2004); Comment Letter of Connie 
Brezik (Sept. 18, 2004); Comment Letter of Keven M. Doll (Sept. 20, 
2004); Comment Letter of Phoebe M. White (Sept. 20, 2004); Comment 
Letter of Eric G. Shisler (Sept. 20, 2004); Comment Letter of Jami 
M. Thornton (Sept. 20, 2004); see also Comment Letter of Consumer 
Federation of America (Feb. 28, 2000) (``CFA Feb. 28, 2000 
Letter'').
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    Some opponents of the rule urged that the form of compensation 
remained a good indicator of whether an account should be treated as an 
advisory account.\28\ Others, however, agreed with the Proposing 
Release that compensation was no longer a valid distinction.\29\ Many 
commenters focused on whether and when advisory services can be 
considered ``solely incidental to'' brokerage and urged us to provide 
guidance on the meaning of the ``solely incidental to'' 
requirement.\30\ In this regard, these and other commenters urged us to 
focus on how broker-dealers held themselves out to investors.\31\

[[Page 2719]]

Some commenters suggested that broker-dealers relying on the rule 
should be prohibited from advertising their advisory services 
entirely.\32\ In a related vein, many commenters urged us to strengthen 
the disclosure required of broker-dealers availing themselves of the 
exception.\33\
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    \28\ Comment Letter of Investment Counsel Association of America 
(Sept. 22, 2004) (``ICAA Sept. 22, 2004 Letter''); CFA Feb. 28, 2000 
Letter, supra note 27; Comment Letter of Federated Investors, Inc. 
(Jan. 14, 2000) (``Federated Letter'').
    \29\ See, e.g., Comment Letter of Gilmond & Gilmond Financial 
Consulting Associates, Ltd. (Dec. 31, 1999).
    \30\ AICPA Sept. 22, 2004 Letter, supra note 26; Comment Letter 
of The Financial Planning Association (June 21, 2004) (``FPA June 
21, 2004 Letter''); Comment Letter of Consumer Federation of America 
(Nov. 4, 2004); ICAA Jan. 12, 2000 Letter, supra note 23.
    \31\ Comment Letter of National Association of Personal 
Financial Advisors (Sept. 21, 2004) (NAPFA Letter''); Comment Letter 
of Charles O'Connor (Sept. 14, 2004); Comment Letter of Abbas A. 
Heydri (Sept. 16, 2004) (``Heydri Letter''); Patchett Letter, supra 
note 27; Comment Letter of Henry L. Woodward (Sept. 21, 2004); 
Dimitroff Letter, supra note 23; Comment Letter of North American 
Securities Administrators Association, Inc. (Oct. 6, 2004) (``NASAA 
Letter''); AICPA Sept. 22, 2004 Letter, supra note 26; ICAA Sept. 
22, 2004 Letter, supra note 28; CFA Jan. 13, 2000 Letter, supra note 
23; Jones Letter, supra note 23.
    \32\ E.g., AARP Letter, supra note 23.
    \33\ E.g., Comment Letter of the CFP Board (Jan. 13, 2000); FPA 
Jan. 14, 2004 Letter, supra note 23; FPA Letter June 21, 2004, supra 
note 30; ICAA Jan. 12, 2000 Letter, supra note 23. See also NAPFA 
Letter, supra note 31. Some commenters also took issue with the 
policy judgment underlying the rule, arguing that it departs from 
the design of the securities laws to protect investors. FPA Jan. 14, 
2000 Letter, supra note 23; Comment Letter of the Financial Planning 
Association (June 24, 2004); Comment Letter of T. Rowe Price 
Associates, Inc. (Jan. 14, 2000) (``T. Rowe Price Jan. 14, 2000 
Letter''). Other commenters challenged our authority to adopt the 
rule, arguing that it is inconsistent with the Congressional intent 
embodied in section 202(a)(11) of the Advisers Act. Comment Letter 
of The Financial Planning Association (Dec. 7, 2001) (``FPA Dec. 7, 
2001 Letter''); CFA Jan. 13, 2000 Letter, supra note 23; Comment 
Letter of Joseph Capital Management, LLC (Aug. 30, 2004).
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II. Discussion of Reproposal

    The many comments we received have caused us to re-consider our 
proposed rule. We share commenters' concern that investors are confused 
about the differences between brokerage and advisory accounts and, as 
discussed below, we are proposing stronger disclosure. We are 
requesting comment on whether broker-dealers have contributed to this 
confusion when they refer to their representatives as ``financial 
advisors,'' ``financial consultants'' or similar titles, and we are 
requesting comment on this issue. We agree with the many commenters who 
urged us to develop better and clearer guidance on when a broker's 
advisory activities are ``solely incidental to'' its brokerage 
business, and are seeking additional comment on guidance we might 
provide.
    We continue, however, to believe that fee-based brokerage has the 
potential to provide significant benefits to brokerage customers. Our 
reproposal therefore reflects our belief that when broker-dealers offer 
advisory services as part of the traditional package of brokerage 
services, broker-dealers ought not to be subject to the Advisers Act 
merely because they re-price those services. The reproposal also 
reflects our belief that broker-dealers should be permitted to offer 
both full-service brokerage and discount brokerage services without 
triggering application of the Advisers Act. The reproposal also 
reflects our belief that a broker-dealer providing discretionary advice 
would be deemed to be an investment adviser under the Advisers Act. We 
look forward to learning commenters' views on these matters.

A. Fee-Based Brokerage Programs

    Commenters on our original proposal generally fell into two 
groups--one representing broker-dealers and the other representing 
investment advisers, including financial planners. These two groups 
viewed the development of fee-based brokerage accounts through 
different lenses, and came to entirely different conclusions. Advisers 
saw the introduction of fee-based brokerage programs as the culmination 
of a migration from a relationship primarily characterized by customers 
paying for brokerage transactions to one in which advisory services 
predominate--a shift they viewed as dramatic.\34\ They held up broker-
dealers'' marketing of these accounts based on the quality of advisory 
services as evidence that these were, in essence, primarily advisory 
accounts and urged that we, therefore, treat them as advisory 
accounts.\35\ Broker-dealers viewed the new fee-based programs as 
providing the same services, including investment advice, they have 
traditionally provided to customers.\36\ While they acknowledged that 
these programs have generally been marketed based on the advice 
involved, some of these commenters pointed out that broker-dealers have 
long sold retail brokerage by promoting ancillary services such as 
advice.\37\ They were concerned that a view of the broker-dealer 
exception that turned on whether full-service brokerage accounts were 
marketed to any extent based on the provision of advice would require 
that we treat all full-service accounts as advisory accounts. Broker-
dealers did not view the change in the pricing of brokerage accounts as 
significant except insofar as it better aligns the interests of 
registered representatives with those of their customers.\38\ We 
request further comment on these differing views of the practices of 
broker-dealers and the implications for our rulemaking. As discussed 
below, we believe that commenters have raised important issues that 
concern us and should concern all market participants. We are therefore 
reproposing the rule. Before we discuss the elements of the reproposed 
rule, however, we draw attention to five areas that we consider to be 
important to our decision whether to adopt a final rule.
---------------------------------------------------------------------------

    \34\ See, e.g., Federated Letter, supra note 28; ICAA Jan. 12, 
2000 Letter, supra note 23; CFA Feb. 28, 2000 Letter, supra note 27; 
FPA Jan. 14, 2000 Letter, supra note 23; Comment Letter of Jared W. 
Jameson (Sept. 16, 2004); Comment Letter of Geoffrey F. Fosie (Sept. 
22, 2004). See also CFA Jan. 13, 2000 Letter, supra note 23; Comment 
Letter of the Foundation for Fiduciary Studies (Sept. 12, 2004).
    \35\ See, e.g., Comment Letter of Roy T. Diliberto (Aug. 24, 
2004); Comment Letter of Don B. Akridge (Sept. 7, 2004); Comment 
Letter of William K. Dix, Jr. (Sept. 21, 2004) (``Dix Letter''). See 
also CFA Jan. 13, 2000 Letter, supra note 23.
    \36\ See, e.g., Comment Letter of Paine Webber Incorporated 
(Jan. 14, 2000) (``Paine Webber Letter''); Comment Letter of U.S. 
Bancorp Piper Jaffray Inc. (Jan. 19, 2000) (``U.S. Bancorp 
Letter''); Comment Letter of Prudential Securities Incorporated 
(Jan. 31, 2000) (``Prudential Letter''); Merrill Lynch Sept. 22, 
2004 Letter, supra note 19.
    \37\ See, e.g., U.S. Bancorp Letter, supra note 36; Prudential 
Letter, supra note 36. One commenter opposed to the rule pointed to 
specific advertising campaigns as evidence that ``over at least the 
last decade'' broker-dealers have, in their view, inappropriately 
been permitted to market themselves as though their primary service 
offered was advice. CFA Jan. 13, 2000 Letter, supra note 23.
    \38\ See, e.g., U.S. Bancorp Letter, supra note 36; Prudential 
Letter, supra note 36; CGMI Letter, supra note 20; Merrill Lynch 
Sept. 22, 2004 Letter, supra note 19; SIA Sept. 22, 2004 Letter, 
supra note 19.
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1. History of the Broker-Dealer Exception
    Broker-dealers have traditionally provided investment advice that 
is substantial in amount, variety, and importance to their 
customers.\39\ This was well understood in 1940 when Congress passed 
the Advisers Act. The broker-dealer exception in the Act was designed 
not to except broker-dealers whose advice to customers is minor or 
insignificant, but rather to avoid additional and duplicative 
regulation of broker-dealers,\40\ which were regulated under provisions 
of the Exchange Act that had been enacted six years earlier.\41\ The 
exception also differentiated between advice provided by broker-dealers 
to customers as part of a package of traditional brokerage services 
\42\ for

[[Page 2720]]

which customers paid fixed commissions `` which was not covered by the 
Advisers Act,\43\ and advice provided through broker-dealer's special 
advisory departments for which customers separately contracted and paid 
a fee `` which was covered by the Act.\44\ Although, as discussed 
above, the Advisers Act was written in such a way to cover fee-based 
programs because the fee would constitute ``special compensation,'' it 
does not appear to have been Congress'' intent to apply the Act to 
cover broker-dealers providing advice as part of the package of 
brokerage services they provide under fee-based brokerage programs.
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    \39\ Charles F. Hodges, WALL STREET (1930) (``WALL STREET'') at 
253-85; Twentieth Century Fund, The SECURITY MARKETS (``SECURITY 
MARKET'') (1935) 633-43.
    \40\ Research Department of the Illinois Legislative Council, 
Statutory Regulation of Investment Advisers (prepared by the 
Research Department of the Illinois Legislative Council) reprinted 
in Investment Company Act: Hearings Before a Subcomm. of the Senate 
Committee on Banking and Currency, at 1007 (1940), 76th Cong. 3d 
Sess.; The Advisers Act: Hearings on H.R. 10065 Before a Subcomm. of 
the House Comm. on Interstate and Foreign Commerce, 76th Cong., at 
88 (1940) (``Hearings on H.R. 10065'').
    \41\ 48 Stat. 881, Pub. L. 73-291 (June 6, 1934). Four years 
later in the Maloney Act, Congress amended the Exchange Act to 
authorize the Commission to register national securities 
associations. Pub. L. 75-719, 52 Stat. 1070 (June 25, 1938).
    \42\ Then, as now, brokerage services included services provided 
throughout the execution of a securities transaction, including 
providing research and advice prior to a decision to buy or sell, 
implementing that decision on the most advantageous terms and 
executing the transaction, arranging for delivery of securities by 
the seller and payment by the buyer, and maintaining custody of 
customer funds and securities. Exchange Act Release No. 27018 [54 FR 
30087-88] (July 18, 1989). See Exchange Act section 28(e)(3), 15 
U.S.C. 78bb(e)(3). See also generally WALL STREET, supra note 39. 
When we refer to ``traditional brokerage programs'' we mean those 
programs that offer traditional brokerage services for commissions. 
As a general matter, when we refer to ``new fee-based programs'' we 
mean those programs that offer traditional brokerage services for 
fees other than commissions. See supra notes 7--8 and accompanying 
text.
    \43\ See S. REP. NO. 76-1775, supra note 8, at 22; H.R. REP. NO. 
76-2639, at 28, 76th Cong. 3d Sess. (``H.R. REP. NO. 76-2639''). See 
also Thomas P. Lemke & Gerald T. Lins, REGULATION OF INVESTMENT 
ADVISERS Sec.  1:19 (``The exception in section 202(a)(11)(C) was 
included in the Advisers Act because broker-dealers routinely give 
investment advice as part of their brokerage activities, yet are 
already subject to extensive regulation under the 1934 Act and 
possibly state law''); Thomas P. Lemke, Investment Advisers Act 
Issues for Broker-Dealers, SECURITIES & COMMODITIES REGULATION at 
214 (Dec. 9, 1987) (``While most broker-dealers initially will come 
within the definition of an investment adviser, it is clear that 
Congress did not intend brokerage activities to be regulated under 
the 1940 Act [citing S. REP. NO. 76-1775]. Rather, such activities 
were intended to be regulated under the 1934 Act without the 
additional and often duplicative requirements under the 1940 
Act.'').
    \44\ See Hearings on S. 3580, supra note 40, at 711 (testimony 
of Douglas T. Johnston, vice-president of Investment Counsel 
Association of America) (``The definition of 'investment adviser' as 
given in the bill * * * would include * * * certain investment 
banking and brokerage houses which maintain investment advisory 
departments and make charges for services rendered * * *''). The 
earliest Commission staff interpretations of the Advisers Act also 
reflect the same understanding, i.e., that the Act was intended to 
cover broker-dealers only to the extent that they were offering 
investment advice as a distinct service for which they were 
specifically compensated. See Advisers Act Release No. 2, supra note 
3 (``[T]hat portion of clause (C) which refers to `special 
compensation' amounts to an equally clear recognition that a broker 
or dealer who is specially compensated for the rendition of advice 
should be considered an investment adviser and not be excluded from 
the purview of the Act merely because he is also engaged in 
effecting market transactions in securities. It is well known that 
many brokers and dealers have investment advisory departments which 
furnish investment advice for compensation in the same manner as 
does an investment adviser who operates solely in an advisory 
capacity.'').
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    The Advisers Act was enacted in an era when broker-dealers were 
paid fixed commission rates for the traditional package of services 
(including investment advice), and Congress understood ``special 
compensation'' to mean non-commission compensation.\45\ There is no 
evidence that the ``special compensation'' requirement was included in 
section 202(a)(11)(C) for any purpose beyond providing an easy way of 
accomplishing the underlying goal of excepting only advice that was 
provided as part of the package of traditional brokerage services.\46\ 
In particular, neither the legislative history of section 202(a)(11)(C) 
nor the broader history of the Advisers Act as a whole, considered in 
light of contemporaneous industry practice, suggests that, in 1940, 
Congress viewed the form of compensation for the services at issue--
commission versus fee-based compensation--as having any independent 
relevance in terms of the advisory services the Act was intended to 
reach.
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    \45\ At the time the Advisers Act was enacted, Congress 
understood ``special compensation'' to mean compensation other than 
commissions. S. REP. NO. 76-1775, supra note 8, at 22.
    \46\ Of course, the absence of ``special compensation'' was 
necessary but not sufficient for the section 202(a)(11)(C) 
exception. But the other requirement--that the advice be provided 
``solely incidental to'' the conduct of the brokerage business--has 
always required a judgment based on the facts and circumstances and 
was not the sort of ``bright-line'' test that non-commission 
``special compensation'' was.
---------------------------------------------------------------------------

    Thus, our reading of the legislative history in the context of 
brokerage industry practice at the time the Act was passed suggests 
that in drawing the line to determine when broker-dealers should be 
subject to the Advisers Act, we should focus our attention on the 
package of services offered by broker-dealers, including advisory 
services, rather than on the significance or importance of those 
advisory services within the context of that package. Because fee-based 
brokerage programs offer substantially the same package of services 
offered as part of traditional full service brokerage programs as they 
were understood in 1940, we believe that it would be appropriate for us 
to propose a rule allowing brokers to offer these programs without 
being subject to the Advisers Act.
    In the Proposing Release, we expressed concern that, should these 
fee-based brokerage programs gain wide-spread acceptance, most full-
service brokerage arrangements might eventually be subject to 
regulation under both the Exchange Act and Advisers Act if we were not 
to except from the Advisers Act broker-dealers offering these programs. 
The intervening years have substantiated that concern. Today fee-based 
brokerage accounts are offered by most larger broker-dealers, and hold 
over $254 billion of customer assets.\47\ Industry observers expect 
that fee-based programs will continue to grow as broker-dealers move 
away from transaction-based brokerage relationships that provide 
unsteady sources of revenue.\48\
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    \47\ The Cerulli Edge, Managed Accounts Edition (3rd Quarter 
2004) (``Cerulli Edge 3rd Quarter'').
    \48\ Cerulli Edge 1st Quarter, supra note 7.
---------------------------------------------------------------------------

    Would our failure to adopt this reproposed rule eventually result 
in the extension of the Advisers Act to most brokerage relationships? 
Would such a result be inconsistent with the intent of the Advisers 
Act, which was designed to fill a regulatory gap that permitted firms 
and individuals to engage in advisory activities without being 
regulated at the same time as it excepted broker-dealers from 
duplicative regulation? \49\ We request comment on our reading of the 
legislative history of the broker-dealer exception. Do commenters agree 
that our reproposed rule is necessary to preserve the scope of the 
Advisers Act as Congress had intended it?
---------------------------------------------------------------------------

    \49\ See Hearings on S. 3580, supra note 40, at 716-18, 736-753 
(Advisers Act filled a regulatory gap in which firms and individuals 
engaged in advisory activities without being regulated.).
---------------------------------------------------------------------------

    Would application of the Advisers Act to a potentially large number 
of brokerage accounts interfere with the market-making role of broker-
dealers and the efficiency of the capital markets? For example, section 
206(3) of the Advisers Act restricts the ability of advisers to engage 
in principal transactions with clients. How would such a restriction 
affect broker-dealers' market making and other principal activities? 
What would be the consequences to the liquidity of the securities 
markets?
2. Investor Protections
    Many commenters opposing the proposed rule focused their arguments 
on additional investor protections that regulation under the Advisers 
Act provides and argued that the rule would harm investors.\50\ Most of 
these comments assumed that clients of advisers received substantially 
more protections from the federal securities laws than do customers of 
broker-dealers.
---------------------------------------------------------------------------

    \50\ See e.g., CFA Jan. 13, 2000 Letter, supra note 23; FPA Jan. 
14, 2000 Letter, supra note 23; see also ICAA Jan. 12, 2000 Letter, 
supra note 23.
---------------------------------------------------------------------------

    To some extent, these comments amount to criticisms of the broker-
dealer exception in section 202(a)(11)(C), which permits broker-dealers 
to provide advice without

[[Page 2721]]

subjecting them to the Advisers Act. We acknowledge that there are 
differences between the regulatory frameworks provided by the Exchange 
Act and the Advisers Act, but Congress was well aware of these sorts of 
differences when it passed the Advisers Act and excepted broker-dealers 
from the definition of investment adviser.\51\
---------------------------------------------------------------------------

    \51\ Many of the commenters focused on the conflicts under which 
brokers function. Congress, however, was well aware of these 
conflicts. See, e.g., Hearings on S. 3580, supra note 40 at 736 
(``Some of these organizations using the descriptive title of 
investment counsel were in reality dealers or brokers offering to 
give advice free in anticipation of sales and brokerage commissions 
on transactions executed upon such free advice''); REPORT ON 
INVESTMENT COUNSEL, INVESTMENT MANAGEMENT, INVESTMENT SUPERVISORY, 
AND INVESTMENT ADVISORY SERVICES (1939) (H.R. DOC. NO. 477) 23-25 
(quoting testimony of investment advisers regarding ``vital 
conflicts'' in broker-dealers providing investment advice when they 
were at the same time intending to sell particular securities they 
owned); Statutory Regulation of Investment Advisers, reprinted in 
Hearings on S. 3580, supra note 40 at 1010 (``This might give rise 
to questions as to whether a counselor who is also a dealer or 
broker can be relied upon always to give unbiased advice.''); SEC, 
REPORT ON THE FEASIBILITY AND ADVISABILITY OF THE COMPLETE 
SEGREGATION OF THE FUNCTIONS OF DEALER AND BROKER, AT XV (June 20, 
1936) (submitted to Congress pursuant to section 11(e) of the 
Securities Exchange Act of 1934) (``A broker who trades for his own 
account or is financially interested in the distribution or 
accumulation of securities, may furnish his customers with 
investment advice inspired less by any consideration of their needs 
than by the exigencies of his own position.''). Despite such 
conflicts, Congress nonetheless determined to except brokers 
providing investment advice from the Advisers Act as set out in 
section 202(a)(11)(C).
    Contrary to the perception of many commenters, broker-dealers 
are under obligations to disclose conflicts of interest. Those 
obligations derive from many sources, including agency law, the 
shingle theory, antifraud provisions of the securities laws and the 
rules and regulations of the Commission and the SROs.
---------------------------------------------------------------------------

    Moreover, the differences on which many commenters focused may not 
be as great as they asserted. Broker-dealers are subject to extensive 
oversight by the Commission and one or more self-regulatory 
organizations under the Exchange Act. The Exchange Act, Commission 
rules, and SRO rules provide substantial protections for broker-dealer 
customers that in many cases are more extensive than those provided by 
the Advisers Act and the rules thereunder.\52\
---------------------------------------------------------------------------

    \52\ Beginning in 1937, the Commission adopted rules to regulate 
broker-dealers' activities in the over-the-counter market. See 
Exchange Act Rule 15c1-1 [17 CFR 240.15c1-1], et seq. These rules, 
adopted under antifraud authority, complement other antifraud rules 
governing broker-dealers' activities. See Exchange Act Rule 10b-1 
[17 CFR 240.10b-1], et seq. The Commission also has set out detailed 
requirements for information that broker-dealers must provide their 
customers at or before the completion of securities transactions. 
See id. And the Commission has adopted heightened sales practice and 
disclosure requirements for sales of penny stocks. See Exchange Act 
Rule 15g9-1 [17 CFR 240.15g9-1], et seq. In addition to the general 
rules governing the over-the-counter market, which were adopted in 
1937, other rules have been adopted to prevent fraud and 
manipulation, as well as establish qualification standards for 
broker-dealers. See Exchange Act Rule 15c2-1 [17 CFR 240.15c2-1], et 
seq., Rule 10b-5 [17 CFR 240.10b-5], Rules 15b7-1 [17 CFR 240.15b7-
1], and Rule 19h-1 [17 CFR 240.19h-1]. The self-regulatory 
organizations (``SROs'') have also adopted rules increasing their 
supervision of broker-dealers since 1940. For example, NASD 
established a clear suitability obligation for broker-dealers that 
recommend securities to investors, as well as extensive rules 
governing communications with the public, advertising standards for 
broker-dealers, and requirements for fair pricing in the over-the-
counter market. See NASD Rule 2310, Rule 2210, and Rule 2440. As 
broker-dealers' business models continue to evolve, SROs continue to 
respond by adopting targeted new rules and providing other forms of 
guidance. Through these efforts, SROs can ensure that the sales 
practice requirements keep pace with their members' activities and 
address any resulting investor protection concerns. For example, 
recently NASD published a Notice to Members concerning fee-based 
compensation programs, reminding members that they must have 
reasonable grounds for believing that a fee-based programs, 
reminding members that they must have reasonable grounds for 
believing that a fee-based program is appropriate for a particular 
customer, taking into account the services provided, the cost, and 
customer preferences. See NASD Notice to Members 03-68 (Nov. 2003). 
Also, in February 2004, the NYSE filed with the Commission a rule 
proposal governing non-managed fee-based accounts. See SR-NYSE-2004-
13.
    The Exchange Act also provides significant investor protections, 
and, since 1940, the Exchange Act has been amended numerous times 
to, among other things, subject broker-dealers to increasingly 
detailed regulatory oversight. For example, in 1964, the Exchange 
Act was amended to provide for improved qualification and 
disciplinary procedures for registered broker-dealers and to expand 
substantially the responsibilities of the NASD under more intensive 
Commission oversight. Pub. L. No. 88-467, 78 Stat. 580, (Aug. 20, 
1964). Later, the Securities Acts Amendments of 1975, considered the 
most significant securities legislation since the Exchange Act, end 
fixed commission rates, initiated action toward development of a 
national market system, and granted the Commission final authority 
in the adoption and amendment of SRO rules. Pub. L. No. 94-29, 89 
Stat. 97 (June 4, 1975). In addition, the Penny Stock Reform Act of 
1990 enhanced regulation of broker-dealers that sell penny stocks to 
investors. Pub. L. No. 101-429, 104 Stat. 931 (Oct. 15, 1990). More 
recently, the Gramm-Leach-Bliley Act of 1999 limited the extent to 
which commerical banks may act as brokers or dealers without broker-
dealer registration. Pub. L. No. 106-102, 113 Stat. 1138 (Nov. 1, 
1999).
---------------------------------------------------------------------------

    Many commenters asserted that the Commission, by providing the 
proposed exception, would relieve broker-dealers of the fiduciary 
responsibility to clients that is imposed by the Advisers Act.\53\ In 
some cases, such as when broker-dealers assume positions of trust and 
confidence with their customers similar to those of advisers, broker-
dealers have been held to similar standards.\54\ However, broker-
dealers often play roles substantially different from investment 
advisers and in such roles they should not be held to standards to 
which advisers are held. For example, an investor who engages a broker-
dealer to sell certain stocks should not be heard to complain a week 
later that the broker-dealer should have advised him to hold on to 
those stocks in order to take advantage of a tax benefit. Thus we 
believe that broker-dealers and advisers should be held to similar 
standards depending not upon the statute under which they are 
registered, but upon the role they are playing.
---------------------------------------------------------------------------

    \53\ AICPA Sept. 22, 2004 Letter, supra note 26; CFA Jan. 13, 
2000 Letter, supra note 23; FPA Jan. 14, 2000 Letter, supra note 23.
    \54\ See, e.g., Arleen W. Hughes, 27 S.E.C. 629 (1948) (noting 
that fiduciary requirements generally are not imposed upon broker-
dealers who render investment advice as an incident to their 
brokerage unless they have placed themselves in a position of trust 
and confidence), aff'd sub nom. Hughes v. SEC, 174 F.2d 969 (D.C. 
Cir. 1949); Leib v. Merrill Lynch, Pierce, Fenner & Smith, Inc. 461 
F. Supp. 951 (E.D. Mich. 1978), aff'd, 647 F. 2d. 165 (6th Cir. 
1981) (recognizing that broker who has de facto control over non-
discretionary account generally owes customer duties of a fiduciary 
nature; looking to customer's sophistication, and the degree of 
trust and confidence in the relationship, among other things, to 
determine duties owed); Paine Webber, Jackson & Curtis, Inc. v. 
Adams, 718 P.2d. 508 (Colo. 1986) (evidence ``that a customer has 
placed trust and confidence in the broker'' by giving practical 
control of account can be ``indicative of the existence of a 
fiduciary relationship''); MidAmerica Federal Savings & Loan v. 
Shearson/American Express, 886 F.2d. 1249 (10th Cir. 1989) 
(fiduciary relationship existed where broker was in position of 
strength because it held its agent out as an expert); SEC v. 
Ridenour, 913 F.2d. 515 (8th Cir. 1990) (bond dealer owed fiduciary 
duty to customers with whom he had established a relationship of 
trust and confidence); C. Weiss, A Review of the Historic 
Foundations of Broker-Dealer Liability for Breach of Fiduciary Duty, 
23 Iowa J. Corp. Law 65 (1997). Cf. De Kwiatkowski v. Bear, Stearns 
& Co., 306 F.3d 1293, 1302-03, 1308-09 (2d Cir. 2002) (noting that 
brokers normally have no ongoing duty to monitor nondiscretionary 
accounts but that ``special circumstances,'' such as a broker's de 
facto control over an unsophisticated client's account, a client's 
impaired faculties, or a closer-than-arms-length relationship 
between broker and client, might create extra-contractual duties).
---------------------------------------------------------------------------

    We request comment generally on the investor protection 
implications of a rule excepting fee-based brokerage accounts from the 
Advisers Act. What investor protections would be lost or gained under 
the rule? Commenters should address how fee-based brokerage offers 
brokerage customers the potential for additional protections over 
commission-based brokerage. Are broker-dealers' and their 
representatives' interests better aligned with those of their customers 
in such arrangements? Would the realignment of economic incentives 
accomplish substantially more for these customers than application of 
an additional investment advisory regulatory regime with its attendant 
costs?
    While fee-based brokerage accounts eliminate certain conflicts of 
interest that broker-dealer representatives have with their customers, 
we recognized

[[Page 2722]]

that they create certain other conflicts. Fee-based brokerage accounts 
are not suitable for all broker-dealer customers, particularly those 
customers who rarely purchase or sell securities. Moreover, investors 
with large cash positions or investments in mutual funds (for which a 
customer may pay multiple fees) may wish to avoid them. In November 
2003, the NASD issued a notice to members identifying these conflicts 
and indicating that NASD members should have supervisory procedures in 
place to determine whether a fee-based brokerage account is appropriate 
for a customer and to periodically review the customer's account to 
determine whether a fee-based account continues to be appropriate.\55\ 
Would broker-dealers' lack of compliance with the NASD notice suggest 
that we ought not adopt this rule? On the other hand, does the NASD's 
action suggest that appropriate actions are being taken?
---------------------------------------------------------------------------

    \55\ NASD Notice to Members (Nov. 23, 2004). Our staff 
examinations of broker-dealers offering fee-based programs suggest 
that not all NASD members may be complying with the advice provided 
by this notice and may be in violation of NASD rules identified in 
the notice. The NASD is addressing these matters.
---------------------------------------------------------------------------

3. Package of Services
    In our Proposing Release, we suggested that broker-dealers offering 
fee-based brokerage were merely re-pricing their existing brokerage 
accounts. Information provided to us by our staff indicates, however, 
that some broker-dealers today offer a different mix of services within 
the traditional package of services (including, for example, a 
different level of investment advice) to fee-based accounts than they 
offer to commission-based accounts. When brokers re-price traditional 
commission-based brokerage accounts, they create a different set of 
incentives for their registered representatives. Thus, it is not 
surprising to us, nor is it inconsistent with the design of the rule we 
are today reproposing, that customers with fee-based brokerage accounts 
may obtain a different level or quality of services, within the 
traditional package of services (including a different level or quality 
of advisory services), than do customers with commission-based 
brokerage accounts. Indeed, one of the aims of the Tully Committee, as 
articulated in its report, was to create incentives for brokers to 
improve the quality of the advisory services provided their 
customers.\56\
---------------------------------------------------------------------------

    \56\ See Tully Report, supra note 13, at 11.
---------------------------------------------------------------------------

    If commission-based brokerage accounts receive differing levels of 
service depending upon the extent to which customers trade securities, 
it would seem to follow that fee-based brokerage accounts would receive 
varying levels of service depending upon the amount of assets held in 
the accounts. We request comment on this observation. Should 
differences in the nature of services provided be relevant to our 
consideration in deciding whether to adopt the rule?
4. Competitive Implications
    As we noted above, many financial planners expressed concern for 
the competitive implications of the rule because they would generally 
be subject to the Advisers Act, while broker-dealers would not.\57\ 
Broker-dealers and investment advisers have historically provided 
similar advisory services and competed for similar clients seeking 
similar advice. The steps many commenters urged us to take--such as 
prohibiting broker-dealers from advertising advisory services 
entirely--would restrict the ability of broker-dealers to compete for 
customers based on advisory services the customers may be seeking.
---------------------------------------------------------------------------

    \57\ See, e.g., Comment Letter of Dan Jamieson (June 1, 2000); 
Comment Letter of Joel P. Bruckenstein (May 31, 2000); Comment 
Letter of Margaret Lofaro (May 8, 2000); Comment Letter of Shawnee 
Barbour (Sept. 13, 2004); Comment Letter of Roselyn Wilkinson (Sept. 
13, 2004); Comment Letter of Robert J. Lindner (Sept. 14, 2004); 
Comment Letter of Robert Lawson (Sept. 16, 2004); Patchett Letter, 
supra note 27; Comment Letter of John Ellison (Sept. 20, 2004); 
Comment Letter of Connie Brezik (Sept. 18, 2004); Comment Letter of 
Keven M. Doll (Sept. 20, 2004); Comment Letter of Phoebe M. White 
(Sept. 20, 2004); Comment Letter of Eric G. Shisler (Sept. 20, 
2004); Comment Letter of Jami M. Thornton (Sept. 20, 2004); see also 
Comment Letter of Consumer Federation of America (Feb. 28, 2000) 
(``CFA Feb. 28, 2000 Letter'').
---------------------------------------------------------------------------

    Broker-dealers are subject to our oversight under the Exchange Act, 
as well as oversight by one or more self-regulatory organizations, to 
which they must pay membership dues. The SRO rules require broker-
dealers to comply with numerous detailed regulatory requirements, as 
well as general requirements that brokers treat their customers 
fairly.\58\ Although, as commenters pointed out, the Advisers Act 
contains some restrictions, and thus imposes some costs on investment 
advisers that are not a part of broker-dealer regulation, broker-dealer 
regulation is much more detailed and involves significantly more 
regulatory costs than investment adviser regulation.
---------------------------------------------------------------------------

    \58\ See supra note 52.
---------------------------------------------------------------------------

    We seek comment on the competitive implications of the rule for 
investment advisers as well as broker-dealers. To what extent should we 
be guided by those competitive considerations? To what extent should 
broker-dealers be permitted to compete for business based on the 
advisory services they provide that are incidental to their brokerage 
business?
5. Regulatory Approach
    Our reproposed rule would deem broker-dealers offering fee-based 
brokerage accounts not to be investment advisers because they are not 
intended to be covered by the Advisers Act.\59\ As a result, broker-
dealers, at least with respect to accounts covered by the rule, would 
not be subject to any of the provisions of the Act. We request comment 
whether we should take an alternate approach under which we would use 
our authority in section 206A to exempt broker-dealers from provisions 
of the Act, such as the registration requirements, with respect to 
these accounts.\60\ What advantages do commenters view this alternative 
approach as providing? Are there costs? If we were to adopt a rule 
based on this approach, from which provisions of the Act or rules 
thereunder, such as the registration requirements of section 203 of the 
Act, should broker-dealers offering fee-based brokerage accounts be 
exempt with respect to those accounts? For example, should broker-
dealers offering fee-based accounts be exempted from the principal 
trading prohibitions in the Act?
---------------------------------------------------------------------------

    \59\ We are reproposing rule 202(a)(11)-1 pursuant to our 
authority under section 202(a)(11)(F) to except ``such other persons 
not within the intent of'' the definition of ``investment adviser'' 
in section 202(a)(11). We are also relying on our authority under 
section 211(a) of the Act ``to classify persons and matters within 
[our] jurisdiction and prescribe different requirements for 
different classes or persons or matters.'' A new classification we 
are making here is broker-dealers who provide investment advice 
solely incidental to traditional brokerage services for a fee--a 
group which, as discussed above, could not have existed at the time 
Congress enacted the Advisers Act because, in 1940, broker-dealers 
were paid only fixed commissions for traditional brokerage services. 
Such broker-dealers are therefore ``other persons'' within the 
meaning of section 202(a)(11)(F) or ``different * * * persons'' 
within the meaning of section 211(a). In addition, section 206A of 
the Act permits us to exempt persons, conditionally or 
unconditionally from any provision of the Act or our rules to the 
extent such exemption is ``necessary or appropriate in the public 
interest and consistent with the protection of investors and the 
purposes fairly intended by the policy and provisions of this 
title.''
    \60\ Under this approach, broker-dealers offering fee-based 
brokerage programs would be investment advisers within the meaning 
of section 202(a)(11) of the Act, although exempt from certain 
provisions of the Act, such as the registration provisions.
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B. Exception for Fee-Based Brokerage Accounts

    Under reproposed rule 202(a)(11)-1(a), a broker-dealer providing

[[Page 2723]]

investment advice to its brokerage customers would not be required to 
treat those customers as advisory clients solely because of the form of 
the broker-dealer's compensation. The rule would be available to any 
broker-dealer registered under the Exchange Act that satisfies three 
conditions: (i) The broker-dealer must not exercise investment 
discretion over the account from which it receives special 
compensation; (ii) any investment advice must be solely incidental to 
the brokerage services provided to the account; and (iii) 
advertisements for and contracts, agreements, applications and other 
forms governing the account must contain certain prominent disclosures, 
including a statement that the account is a brokerage account and not 
an advisory account. These are similar requirements to those included 
in the proposed rule, except that we would expand the required customer 
disclosure.
1. Investment Discretion
    Under the reproposed rule, a broker or dealer relying on the 
exception may not ``exercise investment discretion,'' as that term is 
defined in section 3(a)(35) of the Exchange Act,\61\ over the accounts 
from which it receives special compensation.\62\ Discretionary accounts 
that are charged an asset-based fee or a flat fee would be considered 
advisory accounts because they bear a strong resemblance to traditional 
advisory accounts, and it is highly likely that investors will perceive 
such accounts to be advisory accounts. Fee-based discretionary accounts 
were clearly the type of accounts that Congress understood would be 
covered by the Advisers Act when it passed the Act in 1940.
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    \61\ 15 U.S.C. 78c(a)(35). Under section 3(a)(35) of the 
Exchange Act, a person exercises ``investment discretion'' with 
respect to an account if, ``directly or indirectly, such person (A) 
is authorized to determine what securities or other property shall 
be purchased or sold by or for the account, (B) makes decisions as 
to what securities or other property shall be purchased or sold by 
or for the account even through some other person may have 
responsibility for such investment decisions, or (C) otherwise 
exercises such influence with respect to the purchase and sale of 
securities or other property by or for the account as the 
Commission, by rule, determines, in the public interest or for the 
protection of investors, should be subject to the operation of the 
provisions of this title and the rules and regulations thereunder.''
    \62\ Rule 202(a)(11)-1(a)(1).
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    Most broker-dealer commenters thought that the rule drew the 
appropriate line, although one commenter expressed concern that the 
rule's exclusion of fee-based discretionary accounts would provide a 
disincentive for brokers to offer a fee-based alternative to 
commission-based discretionary accounts that could be offered without 
subjecting the broker-dealer to the Advisers Act.\63\ Many commenters 
opposed to the proposed rule were concerned that the Commission would, 
in effect, abandon the ``bright-line'' test that ``special 
compensation'' provided for when an account should be treated as an 
advisory account.\64\
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    \63\ Paine Webber Letter, supra note 36.
    \64\ T. Rowe Price Jan. 14, 2000 Letter, supra note 33; 
Federated Letter, supra note 28; FPA Jan. 14, 2000 Letter, supra 
note 23. See also FPA Dec. 7, 2001 Letter, supra note 33.
---------------------------------------------------------------------------

    As we discuss above, we do not believe that ``special 
compensation'' was included in section 202(a)(11)(C) for any purpose 
beyond readily identifying advice that was clearly not provided as part 
of the package of traditional brokerage services, i.e., advice that was 
clearly not incidental to the brokerage services.\65\ In 1940, broker-
dealers were paid only fixed commissions for the traditional package of 
services (including investment advice) that Congress intended to except 
from coverage of the Act.\66\ Because Congress understood ``special 
compensation'' to mean non-commission compensation,\67\ the ``special 
compensation'' limitation in section 202(a)(11)(C) reliably identified 
advisory services that Congress intended the Advisers Act to cover. 
That is no longer true. Unlike in 1940, broker-dealers are no longer 
prohibited by SRO rules from charging a fee for the same package of 
brokerage services (including investment advice) that formerly could be 
paid for only by commissions and only recently have broker-dealers 
started charging these new sorts of fees. These developments could not 
have been foreseen in 1940, and the ``bright line'' that Congress 
identified 60 years ago has ceased to accomplish its original purpose. 
Permitting broker-dealers to provide nondiscretionary advice may 
provide a workable ``bright line,'' and it will not operate to extend 
the exception beyond the intent of Congress because in all 
circumstances this advice must be solely incidental to the brokerage 
services provided.
---------------------------------------------------------------------------

    \65\ See supra note 46.
    \66\ Until 1975, the New York Stock Exchange and the other stock 
exchanges required their members to charge a fixed commission on 
every transaction. See generally Securities Exchange Act Release No. 
11203 (Jan. 23, 1975) [40 FR 7394 (Jan. 23, 1975)] (adopting 
Exchange Act rule 19b-3 [17 CFR 19b-3] which eliminated the fixed 
commission rate structure on national securities exchanges).
    \67\ S. REP. NO. 76-1775, supra note 8, at 22; H.R. REP. NO. 76-
2639, supra note 43, at 28.
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    We request comment on this condition of the rule. Is 
``discretionary authority'' a workable ``bright line'' test? Are there 
alternate tests that would be more appropriate? What are they?
2. Solely Incidental To
    Reproposed rule 202(a)(11)-1 would require that the advisory 
services provided in reliance on the exception must be solely 
incidental to the brokerage services provided.\68\ The provision, which 
was included in our original proposal from 1999, was designed to 
preserve the ``solely incidental to'' requirement in section 
202(a)(11)(C), although it is somewhat narrower in that it would 
require that advice the broker-dealer provides must be solely 
incidental to brokerage services provided by the broker-dealer to each 
account rather than the overall operations of the broker-dealer. 
Commenters did not disagree with this element, but urged that we 
provide more guidance on when advice is solely incidental to brokerage 
services. Section III of this Release includes a discussion of when 
advice is ``solely incidental to'' brokerage and requests comment on 
the application of this analysis to particular broker-dealer practices.
---------------------------------------------------------------------------

    \68\ Rule 202(a)(11)-1(a)(1)(ii).
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3. Customer Disclosure
    We propose to require that all advertisements for an account 
excepted under rule 202(a)(11)-1(a) and all agreements, contracts, 
applications and other forms governing the operation of a fee-based 
brokerage account contain a prominent statement that the account is a 
brokerage account and not an advisory account. In addition, the 
disclosure must explain that, as a consequence, the customer's rights 
and the firm's duties and obligations to the customer, including the 
scope of the firm's fiduciary obligations, may differ. Finally, broker-
dealers must identify an appropriate person at the firm with whom the 
customer can discuss the differences.
    Our original proposal would have required broker-dealers to 
disclose only that the fee-based accounts are brokerage accounts. We 
received a great deal of comment that this disclosure was inadequate to 
permit customers and prospective customers to understand the 
differences between advisory and brokerage accounts, including the 
differences in fiduciary duties owed to investors by advisers and 
brokers.\69\ In

[[Page 2724]]

response, we have reproposed significantly expanded disclosure in order 
to focus investors on the differences between the two types of 
accounts.
---------------------------------------------------------------------------

    \69\ E.g., ICAA Sept. 22, 2004 Letter, supra note 28; AICPA 
Sept. 22, 2004 Letter, supra note 26; FPA Jan. 14, 2000 Letter, 
supra note 23; ICAA Jan. 12, 2000 Letter, supra note 23; Comment 
Letter of Walter R. Greenfield (Jan. 4, 2000).
---------------------------------------------------------------------------

    We recognize that there may be a tension between the amount of 
information required in a legend and the likelihood of investors 
reading and understanding the information. Shorter disclosure may be 
more effective. Because it is impracticable to include all of the many 
possible differences between advisory and brokerage accounts in a brief 
disclosure, we have proposed an approach to encourage investors to 
discuss the differences with appropriate brokerage personnel. Is our 
proposed disclosure appropriate? Will it effectively serve its intended 
purposes? Should we require additional information to be disclosed? If 
so, what should that information be? Is the proposed disclosure too 
long to be practicable in an advertisement? If so, what should we omit? 
Will investors understand the terms we have used and their 
significance? If not, what terms should we use? Should materials 
specify who the appropriate person at their firm is who can discuss the 
differences between an advisory and a brokerage account? Should we 
designate the level of seniority the person should have? Given the 
complexity of the concepts involved, should we consider alternatives to 
disclosure? If so, what alternatives should we consider?
    The legend would be required only on documents offering fee-based 
brokerage programs because only broker-dealers offering those programs 
would be relying on the rule. But many commenters suggested to us that 
the confusion between brokerage and advisory accounts is not limited to 
fee-based brokerage. If that is the case, what is the appropriate 
vehicle to address this confusion? For example, should we request the 
broker-dealer self regulatory organizations to consider disclosure 
requirements that have broader application, including requiring 
disclosure on broker-dealer documents that do not offer or govern fee-
based brokerage accounts?

C. Discretionary Asset Management

    As discussed above, the exception for broker-dealers offering fee-
based brokerage accounts would be available only if the broker-dealer 
does not exercise discretionary authority over the account. We 
recognized in the Proposing Release the existence of a regulatory 
anomaly that the proposed rule would create. Broker-dealers that manage 
discretionary accounts for which they receive commissions or dealer-
based compensation may not receive any ``special compensation.'' If 
managing a discretionary account can be viewed as solely incidental to 
the brokerage business, then a broker-dealer paid through commissions 
or dealer-based compensation could rely on the statutory exception and 
need not treat the account as an advisory account. Under this view, a 
regulatory distinction would continue to be drawn based solely on the 
form the broker-dealer's compensation takes. This result seemed 
inconsistent with our intent in designing the proposed rule. In the 
Proposing Release, we requested comment on whether we should require 
broker-dealers to treat all discretionary accounts as advisory 
accounts, without regard to the form of the broker-dealer's 
compensation.\70\
---------------------------------------------------------------------------

    \70\ Proposing Release, supra note 5. The Commission received 
over 50 comment letters in response to this request for comments.
---------------------------------------------------------------------------

    Many broker-dealers who responded to this request for comment urged 
that we continue to permit broker-dealers offering discretionary 
brokerage accounts for commissions or dealer-based compensation to 
avail themselves of the statutory broker-dealer exception.\71\ Some 
argued that these accounts were made available as an accommodation to 
customers who understood the nature of the accounts, and that any 
additional regulatory protections provided by the Advisers Act would be 
redundant to those already provided by broker-dealer regulation.\72\ 
Many other commenters, however, including those representing investment 
advisers, argued that discretionary brokerage accounts are 
indistinguishable from advisory accounts and urged us to apply the 
Advisers Act and the rules thereunder to both.\73\ Some, including one 
large broker-dealer, asserted that discretion was a key distinguishing 
feature of an advisory account and therefore all discretionary accounts 
should be regulated as advisory accounts.\74\ Others argued that 
broker-dealers exercising discretionary authority would actually be 
providing advice that is not solely incidental to brokerage, and thus 
should not have available the broker-dealer exception in section 
202(a)(11)(C).\75\
---------------------------------------------------------------------------

    \71\ E.g., Comment Letter of Paine Webber Incorporated (Jan. 14, 
2000) (``Paine Webber Letter''); Comment Letter of Smith Barney 
Citigroup (Jan. 14, 2000) (``Smith Barney Letter''); Comment Letter 
of First Dallas Securities'' (Jan. 13, 2000) (``First Dallas 
Letter''); Comment Letter of Stephens, Inc. (Jan. 12, 2000) 
(``Stephens Letter''). See also Comment Letter of Securities 
Industry Association (Jan. 13, 2000); Comment Letter of National 
Association of Securities Dealers (Feb. 24, 2000). But see Comment 
Letter of Charles Schwab & Co. (Sept. 22, 2004); Comment Letter of 
TD Waterhouse Investor Services, Inc. (Sept. 22, 2004).
    \72\ See Stephens Letter, supra note 71; First Dallas Letter, 
supra note 71; Smith Barney Letter, supra note 71.
    \73\ E.g., Comment Letter of T. Rowe Price Associates, Inc. 
(Jan. 14, 2000) (``T. Rowe Price Jan. 14, 2000 Letter''); FPA Jan. 
14, 2000 Letter, supra note 23; Comment Letter of North American 
Securities Administrators Association, Inc. (Jan. 14, 2000) (``NASAA 
Jan. 14, 2000 Letter''); ICAA Jan. 12, 2000 Letter, supra note 23. 
See also AICPA Sept. 22, 2004 Letter, supra note 26.
    \74\ Charles Schwab Sept. 22, 2004 Letter, supra note 71. See 
also T. Rowe Price Jan. 14, 2000 Letter, supra note 73; NASAA Jan. 
14, 2000 Letter, supra note 73; ICAA Jan. 12, 2000 Letter, supra 
note 30.
    \75\ See, e.g., Comment Letter of AARP (Nov. 17, 2003) (``AARP 
Letter''); FPA Jan. 14, 2000 Letter, supra note 23; T. Rowe Price 
Jan. 14, 2000 Letter, supra note 73. See also ICAA Jan. 12, 2000 
Letter, supra note 23; NASAA Jan. 14, 2000 Letter, supra note 73.
---------------------------------------------------------------------------

    We have not previously interpreted the scope of section 
202(a)(11)(C) to preclude a broker-dealer from exercising discretionary 
authority over the accounts of a limited number of its customers as 
long as the customers did not pay special compensation for these 
services. In 1978, however, we expressed concern that brokerage 
relationships ``which include discretionary authority to act on a 
client's behalf have many of the characteristics of the relationships 
to which the protections of the Advisers Act are important,'' and we 
requested comment on whether we should take action to require that 
these accounts be treated as advisory accounts.\76\ After considering 
the issue, we determined not to take action at that time on whether 
discretionary accounts should be treated as advisory accounts but 
explained that our staff would continue to examine the applicability of 
the federal securities laws to discretionary accounts.\77\ We further 
stated that ``the staff would continue to take the position that 
brokers or dealers who exercise discretion over a limited number of 
their customers' accounts, but do not receive special compensation for 
such services, can rely on the exception in section 202(a)(11)(C).'' 
\78\
---------------------------------------------------------------------------

    \76\ Investment Advisers Act Release No. 626, supra note 5.
    \77\ Applicability of the Investment Advisers Act to Certain 
Brokers and Dealers, Investment Advisers Act Release No. 640 (Oct. 
5, 1978) [43 FR 47176 (Oct. 13, 1978)] (``Advisers Act Release No. 
640'').
    \78\ Id.
---------------------------------------------------------------------------

    After reviewing the many comment letters we received on this 
matter, and exploring this issue anew in the context of this 
rulemaking, we are proposing a rule stating that discretionary 
investment advice, as that term is defined in section 3(a)(35) of the 
Exchange Act, is not ``solely incidental

[[Page 2725]]

to'' brokerage services within the meaning of section 202(a)(11)(C). 
The exercise of investment discretion seems to us to be qualitatively 
distinct from simply providing advice as part of a package of brokerage 
services, because a broker-dealer with such discretion is not just a 
source of advice, but has authority to make investment decisions 
relating to the purchase or sale of securities on behalf of clients. In 
this way, discretionary accounts have a quintessentially supervisory or 
managerial character that we previously have recognized as a critical 
indicator of services that warrant the protection of the Advisers Act 
because of the ``special trust and confidence inherent'' in such 
relationships.\79\
---------------------------------------------------------------------------

    \79\ Adoption of Amendments to Rule 206A-1(T) under the 
Investment Advisers Act of 1940 Extending the Duration and Limiting 
the Scope of the Temporary Exemption from the Advisers Act for 
Certain Brokers and Dealers, Investment Advisers Act Release No. 471 
(Aug. 20, 1975) (``Advisers Act Release No. 471'').
---------------------------------------------------------------------------

    Although we did not require that all discretionary accounts be 
treated as advisory accounts when the issue was presented in 1978, we 
and our staff have long acknowledged that a broker-dealer's exercise of 
investment discretion over customer accounts raises serious questions 
about whether such accounts must be treated as subject to the Advisers 
Act--even where no special compensation is received.\80\ Since at least 
1978, the staff has viewed the exercise of investment discretion in 
commission-based accounts as a critical factor in determining whether a 
broker-dealer could rely on the exception provided by section 
202(a)(11)(C).\81\ Indeed, broker-dealers have known for decades that 
``if the business of a broker or dealer consists almost exclusively of 
managing accounts on a discretionary basis, the [Division of Investment 
Management] would not regard such broker or dealer as providing 
investment advice solely incidental to his business as a broker or 
dealer and therefore the broker or dealer would not be eligible for the 
[exception] in section 202(a)(11)(C).'' \82\
---------------------------------------------------------------------------

    \80\ See supra note 76 and accompanying text.
    \81\ Advisers Act Release No. 640, supra note 76.
    \82\ Id.
---------------------------------------------------------------------------

    The rule we propose today would supersede this existing staff 
approach, under which a discretionary account is subject to the 
Advisers Act only if the broker-dealer has enough other discretionary 
accounts to trigger the Act. Under proposed rule 202(a)(11)-1(b), the 
exception provided by section 202(a)(11)(C) would be unavailable for 
any account over which a broker-dealer exercises investment discretion, 
without regard to how the broker-dealer handles other accounts. We 
believe that such an approach may be preferable for several reasons. 
First, it better ensures that the Advisers Act is applied where 
investors have the sort of relationship with a broker-dealer that we 
have long recognized the Act was intended to reach.\83\ Second, it is 
consistent with the longstanding view, which would be codified in 
reproposed rule 202(a)(11)-1(c), that a broker-dealer is an investment 
adviser solely with respect to those accounts for which the broker-
dealer provides services or receives compensation that subject the 
broker-dealer to the Advisers Act. Third, unlike the existing staff 
approach, the proposed rule provides a bright-line test for the 
availability of the section 202(a)(11)(C) exception. It thereby 
clarifies that provision at a time when the line between advisory and 
brokerage services is blurring and the original ``bright line'' of 
special compensation has ceased to function as a reliable indicator of 
the services the Act was designed to reach. Finally, the proposed 
interpretation would result in all discretionary accounts being treated 
as advisory accounts without regard to the form of broker compensation 
and would therefore be consistent with the design of reproposed rule 
202(a)(11)-1 as a whole.
---------------------------------------------------------------------------

    \83\ Advisers Act Release No. 471, supra note 79.
---------------------------------------------------------------------------

    We understand that, on occasion, a broker-dealer may exercise 
limited discretion over a customer account for a brief period of time 
(e.g., when a customer is on vacation). Should such an isolated or 
occasional exercise of discretion cause a broker-dealer to lose its 
ability to rely on the exception? Should we consider other exceptions? 
\84\ Should we include any or all exceptions in the rule text?
---------------------------------------------------------------------------

    \84\ We note, for example, that NASD Rule 2510(d) sets forth 
certain exceptions to the NASD rule governing discretionary accounts 
(e.g., discretion as to the price at which or the time when an order 
given by a customer for the purchase or sale of a definite amount of 
a specified security shall be executed not subject to rules 
governing discretionary accounts).
---------------------------------------------------------------------------

    We request comment on this interpretation, and the use of 
``discretionary advice'' as a bright line test to identify those 
brokerage accounts that must be treated as advisory accounts. We 
propose to use the definition of investment discretion in section 
3(a)(35) of the Exchange Act and we request comment on using this 
definition. Is some other definition more appropriate? If so, what 
definition should we use?
    We understand that many broker-dealers today treat discretionary 
accounts as advisory accounts. Is this understanding correct? Do many 
broker-dealers also treat discretionary accounts as brokerage accounts? 
Do broker-dealers maintain both types of accounts, and if so, what are 
the determinative factors for classifying an account as an advisory or 
brokerage account? What impact on broker-dealers would our 
interpretation have? We are particularly interested in learning whether 
most broker-dealers that do not treat discretionary accounts as 
advisory accounts are already registered under the Advisers Act for 
other reasons.
    We are also interested in understanding the impact on investors of 
these distinctions. As we acknowledged in the Proposing Release, 
investors are often confused by the differences between advisory and 
brokerage accounts. Would the distinction we propose to draw between 
discretionary and non-discretionary accounts resolve at least some of 
that that confusion?
    Does the legislative history of section 202(a)(11)(C) support our 
proposed rule? Although in 1940 many broker-dealers exercised 
discretion over the accounts they serviced for a fee through separate 
advisory departments in their firms, broker-dealers were generally 
disinclined to accept such discretionary advisory accounts,\85\ and the 
extent to which broker-dealers were exercising discretion over 
commission-based customer accounts outside of separate advisory 
departments is unclear. As a result, we are unable to conclude that in 
1940 Congress would have understood investment discretion to be part of 
the traditional package of services broker-dealers offered for 
commissions. We are aware of nothing in the legislative history of 
section 202(a)(11)(C) (or of the Act as a whole) or in the brokerage 
practices in 1940 that would preclude our interpretation of that 
section as being unavailable for all accounts over which broker-dealers 
exercise investment discretion.\86\ There is no

[[Page 2726]]

evidence that Congress directly considered this question, and, given 
the inherently managerial nature of investment discretion, we see no 
reason why Congress would have intended to exclude such services from 
the reach of the Advisers Act.
---------------------------------------------------------------------------

    \85\ SECURITY MARKETS, supra note 39, at 649-650.
    \86\ In the decade preceding the enactment of the Advisers Act, 
both the New York Stock Exchange and the Commission promulgated 
measures designed to regulate and, in the case of the NYSE rules, to 
significantly limit the exercise of investment discretion by broker-
dealers. The NYSE prohibited customers' men from handling 
discretionary accounts; with few exceptions, only partners were 
authorized to handle such accounts. SECURITY MARKETS, supra note 39, 
at 638-40. See also Wall St. Problem in Customers' Men, N.Y. Times, 
Jan. 14, 1934, at N7 (``[T]he Stock Exchange has approved rules 
prohibiting customers' men from handling discretionary accounts, 
which powers are now delegated with few exceptions, only to partners 
in Stock Exchange firms.''). In 1937, the Commission adopted 
Exchange Act Rule 15cl-7 [17 CFR 240.15cl-7], which deals with 
discretionary accounts maintained by broker-dealers, but does not 
distinguish between commission-based brokerage accounts and the 
advisory accounts broker-dealers serviced for a fee through their 
separate advisory departments.
---------------------------------------------------------------------------

    Commenters asserting that discretionary authority is not an 
appropriate means of drawing a line in the case of commission-based 
accounts should address whether it draws an appropriate line for fee-
based accounts. Is reproposed rule 202(a)(11)-1 as a whole appropriate 
in light of our reliance in the rule on the distinction between 
discretionary and non-discretionary authority?

D. Discount Brokerage Programs

    We are also reproposing, as part of rule 202(a)(11)-1, a provision 
that a broker-dealer will not be considered to have received special 
compensation solely because the broker-dealer charges a commission, 
mark-up, mark-down or similar fee for brokerage services that is 
greater than or less than one it charges another customer.\87\ This 
provision is intended to keep a full-service broker-dealer from being 
subject to the Advisers Act solely because it also offers electronic 
trading or other forms of discount brokerage. Conversely, a discount 
broker-dealer would not be subject to the Act solely because it 
introduces a full-service brokerage program.
---------------------------------------------------------------------------

    \87\ Rule 202(a)(11)- 1(a)(2).
---------------------------------------------------------------------------

    The rule, if adopted, would supersede staff interpretations under 
which a full-service broker-dealer is subject to the Advisers Act with 
respect to accounts for which it provided advice incidental to its 
brokerage business merely because it offers electronic trading or other 
form of discount brokerage.\88\ These staff interpretations led to the 
odd result that a full-service broker-dealer cannot offer discount 
brokerage without treating its full-service brokerage accounts as 
advisory accounts even though the services offered to those accounts 
remained unchanged. Moreover, these staff interpretations may create 
disincentives for full-service broker-dealers to offer electronic or 
other types of discount brokerage, and thus may limit customers' 
choices of types of brokerage service, and may reduce competition in 
discount brokerage. The reproposed rule makes a broker-dealer's 
eligibility for the broker-dealer exception with respect to an account 
turn on the characteristics of that particular account and not of other 
accounts the broker-dealer may also service. Commenters discussing this 
aspect of the proposed rule generally supported it,\89\ and we are 
reproposing it without change. Do commenters continue to support this 
provision? Should we consider any modifications to this provision?
---------------------------------------------------------------------------

    \88\ See Advisers Act Release No. 2, supra note 3.
    \89\ Federated Letter, supra note 28; Comment Letter of Charles 
Schwab & Co. (Jan. 14, 2000); Comment Letter of NASD (Feb. 24, 
2000).
---------------------------------------------------------------------------

E. Scope of Exception

    Reproposed rule 202(a)(11)-1 would also provide that a broker-
dealer that is registered under both the Exchange Act and the Advisers 
Act is an investment adviser solely with respect to those accounts for 
which it provides services or receives compensation that subject the 
broker or dealer to the Advisers Act.\90\ This provision would codify 
our earlier interpretation of the Act that permits a broker-dealer 
registered under the Advisers Act to distinguish its brokerage 
customers from its advisory clients.\91\ We received few comments 
regarding the scope of the proposed exception, which we are reproposing 
without change.
---------------------------------------------------------------------------

    \90\ Rule 202(a)(11)- 1(c).
    \91\ Advisers Act Release No. 626, supra note 5.
---------------------------------------------------------------------------

    Finally, the Commission would interpret the broker-dealer exception 
as being available not only to a broker-dealer, but also to any of its 
registered representatives, i.e., those employees and other persons 
whose investment advisory activities are subject to the control and 
supervision of the broker-dealer.\92\ A registered representative who 
provides investment advice independent of his broker-dealer employer 
(e.g., by establishing an independent financial planning practice or 
providing advisory services outside his capacity as a registered 
representative, without the control, knowledge and approval of his 
broker-dealer employer) could not rely on the exception because his 
investment advisory activities would not be solely incidental to the 
broker-dealer's business.\93\
---------------------------------------------------------------------------

    \92\ The staff's views on this matter were set forth in Advisers 
Act Release No. 1092, supra note 2. See also Strevell No-Action 
Letter, supra note 9; Brent A. Neiser, SEC Staff No-Action Letter 
(pub. avail. Jan. 21, 1986) (``Neiser No-Action Letter'').
    \93\ The staff's views on this matter were set forth in the 
Strevell No-Action Letter, supra note 9 and the Neiser No-Action 
Letter, supra note 92.
---------------------------------------------------------------------------

III. Proposed Statement of Interpretive Position

    Many commenters urged us to provide greater guidance on when advice 
is solely incidental to brokerage services, observing that, in the 
past, most questions arising under section 202(a)(11)(C) have involved 
the meaning of ``special compensation.'' \94\ A number of commenters 
offered suggestions of how we might further develop the interpretation 
of ``solely incidental to.'' Some supported very narrow views of what 
``solely incidental to'' means, suggesting that it should include only 
advice that is a minor or insignificant part of a broker-dealer's 
business,\95\ or advice that is not marketed by the broker.\96\ Because 
reliance on both the rule and statute turn on whether advice provided 
by a broker-dealer is solely incidental to the brokerage business (or, 
in the case of the rule, to the brokerage services provided to the 
account), it is a question of substantial significance to broker-
dealers.
---------------------------------------------------------------------------

    \94\ E.g., Comment Letter of Consumer Federation of America 
(Jan. 14, 2000); ICAA Jan. 12, 2000 Letter, supra note 23; T. Rowe 
Price Jan. 14, 2000 Letter, supra note 32; Comment Letter of 
Investment Company Institute (Jan. 14, 2000); U.S. Bancorp Letter, 
supra note 36; Letter of Connecticut Department of Banking (Jan. 20, 
2000)(``Connecticut Department of Banking''); Letter of Certified 
Financial Planner Board of Standards (Sept. 22, 2004); Charles 
Schwab Sept. 22, 2004 Letter, supra note 20; NASAA Letter, supra 
note 31.
    \95\ ICAA Jan 12, 2000 Letter, supra note 23, Comment Letter of 
T. Rowe Price Associates, Inc. (Sept. 22, 2004).
    \96\ CFA Jan. 13, 2000 Letter, supra note 23, Connecticut 
Department of Banking, supra note 94, ICAA Sept. 22, 2004 Letter, 
supra note 28.
---------------------------------------------------------------------------

    In general, we understand investment advice to be ``solely 
incidental to'' the conduct of a broker-dealer's business within the 
meaning of section 202(a)(11)(C) when the advisory services rendered to 
an account are in connection with and reasonably related to the 
brokerage services provided to that account. This understanding is 
consistent with the legislative history of the Advisers Act, which 
indicates Congress' intent to exclude broker-dealers providing advice 
as part of traditional brokerage services.\97\ It is also consistent 
with the Commission's contemporaneous construction of the Advisers Act 
as excepting broker-dealers whose investment advice is given ``solely 
as an incident of their regular business.'' \98\
---------------------------------------------------------------------------

    \97\ See supra notes 40-46 and accompanying text.
    \98\ See Investment Advisers Act Release No. 1 [11 FR 10996 
(Sept. 23, 1940)] (``Release No. 1'')(emphasis added). It is also 
consistent with how our staff has construed section 202(a)(11)(B) of 
the Act, which provides an exception for lawyers, accountants, 
engineers and teachers ``whose performance of such services is 
incidental to the practice of [their] profession.'' See Hungerford, 
Aldrin, Nichols & Carter, SEC Staff No-Action Letter (Dec. 10, 
1991)(accountant); Myers Krauss, & Stevens, SEC Staff No-Action 
Letter (Aug. 31, 1988)(lawyer); Jan L. Warner, Esq., SEC Staff No-
Action Letter (Dec. 27, 1988)(lawyer); Hauk, Soule & Fasani, SEC 
Staff No-Action Letter (Feb. 20, 1986)(accountant); Trejo & 
Associates, SEC Staff No-Action Letter (Dec. 19, 1985)(accountant); 
Marvin Drabinsky, SEC Staff No-Action Letter (Oct. 3, 
1984)(accountant); David A. Hendelberg, SEC Staff No-Action Letter 
(Apr. 5, 1984)(accountant); LaManna & Hohman, SEC Staff No-Action 
Letter (Feb. 18, 1983)(accountant); Pros. Inc., SEC Staff No-Action 
Letter (June 22, 1973)(lawyer).

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[[Page 2727]]

    We propose to read section 202(a)(11)(C) more broadly than some 
commenters suggest. Those commenters read the words ``solely 
incidental'' to mean that the advice provided must be only 
``incidental'' in the sense of ``minor,'' ``insignificant,'' 
``periodic,'' ``episodic,'' or ``advice about specific 
securities.''\99\ This reading is based on the view that the statute 
excepts ``solely incidental'' advisory services instead of advisory 
services that are ``solely incidental to'' a broker-dealer's business, 
i.e., advisory services that are ``liable to happen as a consequence 
of'' or ``follow[] as a consequence'' of the conduct of a broker-
dealer's business.\100\ Moreover, the view that only minor or 
insignificant advice is excepted by section 202(a)(11)(C) ignores the 
fact that the advice broker-dealers gave as part of their traditional 
brokerage services in 1940 was often substantial in amount and 
importance to the customer.\101\ This has remained true throughout the 
following decades.\102\ Indeed, the importance of the broker-dealer's 
role as advice-giver in connection with brokerage transactions has 
shaped how we and the self-regulatory organizations have regulated and 
continue to regulate broker-dealers.\103\ On the other hand, some 
commenters would interpret ``solely incidental to'' a broker-dealer's 
business to permit broker-dealers to rely on section 202(a)(11)(C) 
broadly to provide any or all types of advisory services as part of a 
brokerage account. This interpretation would have the effect of 
negating any limitation inherent in the ``solely incidental'' standard, 
and we propose not to read ``solely incidental to'' so broadly. Do 
commenters agree with our view? Those who disagree with us should 
suggest alternative interpretive approaches that find support in the 
intent of Congress and the legislative history of the Advisers Act, and 
in contemporaneous industry practice.
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    \99\ See, e.g., Comment Letter of Consumer Federation of America 
(Sept. 4, 2000); ICAA Sept. 22, 2004 Letter, supra note 28.
    \100\ See Compact Oxford English Dictionary (2004) (available on 
the Internet http://www.dictionary.com) (listing as synonyms of 
``incidental to'' the words ``accompanying,'' ``attendant,'' and 
``concomitant''). Prior to the Act's enactment, the term 
``incidental'' was defined to include: ``Liable to happen or to 
follow as a chance feature or incident.'' Webster's New Int'l 
Dictionary 1257 (unabridged 2d ed. 1934). The same dictionary 
defined ``incident'' to include ``[d]ependent on, or appertaining 
to, another thing'' or ``directly and immediately pert[inent] to, or 
involved with, something else, though not an essential part of it.'' 
Id.; cf. Fowler, A Dictionary of Modern English Usage 264 (Oxford 
Press 1937)(stating that ``while incidental is applied to side 
occurrences with stress on their independence of the main action,'' 
the word ``incident''--particularly ``with `to' as the link''--``is 
mostly used in close combination with whatever word may represent 
the main action or subject'' and ``implies that, though not 
essential to it, [the side occurrences] not merely happen to arise 
in connection with [the main action] but may be expected to do so'' 
(emphasis in original).
    \101\ See supra note 40-46 and accompanying text. It is also 
inconsistent with section 202(a)(11)(C) read as a whole. Following 
the broad description of the type of services rendered by advisers 
in paragraph (11)(i.e., ``advising others * * * as to the value of 
securities or as to the advisability of investing in, purchasing or 
selling securities''), the provision in subparagraph (C) excepts 
broker-dealers ``whose performance of such services is solely 
incidental to the conduct of the broker-dealer's business and for no 
special compensation'' (emphasis added). This structure also 
supports our conclusion that the words ``solely incidental to'' do 
not operate to limit the ways in which broker-dealers can amrket 
their services.
    \102\ See, e.g., Robert Bendiner, Current Quotations on 
Stockbrokers, N.Y. TIMES, May 10, 1953, at SM19 (``[W]hen the Korean 
War began * * * [c]ustomers then wanted to know whether to expect 
confiscatory taxes that would reduce corporate profits, how price 
controls might effect their securities, and whether some businesses 
would be squeezed out entirely for lack of materials. `You have to 
talk to them,' one broker said. `Buying and selling is the least 
part of the service we give them for our commissions.' ``); SEC, 
SPECIAL STUDY OF THE SECURITIES MARKETS (1963) at 330 (``SPECIAL 
STUDY'') (``Both the volume and the variety of the written 
investment information and advice originated by broker-dealers, who 
for the most part furnish it free to their customers as part of 
their effort to sell securities, are impressive.''); id. at 386 
(terming investment advice furnished by broker-dealers an ``integral 
part of their business of merchandising securities'' even if only 
``incidental'' to that business); Interpretive Releases Relating to 
the Securities Exchange Act of 1934 and General Rules and 
Regulations Thereunder: Future Structure of Securities Markets (Feb. 
2, 1972) [37 FR 5286, 5290 (Mar. 14, 1972)] (``In our opinion, the 
providing of investment research is a fundamental element of the 
brokerage function for which the bona fide expenditure of the 
beneficiary's funds is completely appropriate, whether in the form 
of high commissions or outright cash payments.''); TULLY REPORT, 
supra note 13, at 3 (``The most important role of the registered 
representative is, after all, to provide investment counsel to 
individual clients, not to generate transaction revenues.'').
    \103\ Thus, for example, under the rules of self-regulatory 
organizations and consistent with Commission precedent, a broker 
must render advice that is based on a knowledge of the security 
involved and that is suitable for a customer in light of the 
customer's needs, financial circumstances, and investment 
objectives. See NASD Rule 2310; NYSE Rule 405. In addition, under 
certain circumstances, such as when a broker-dealer assumes a 
position of trust and confidence with its customer, it has been held 
to a fiduciary standard with its customer, akin to that of an 
adviser and a client. See supra note 54 and accompanying text.
---------------------------------------------------------------------------

    Many commenters urged that we declare certain current practices to 
be inconsistent with advice being offered solely incidental to 
brokerage. They believed that the Advisers Act ought to apply more 
broadly to full-service brokerage that is, among other things, marketed 
based on advisory services. \104\ Before we provide any interpretive 
guidance that could have an effect on brokerage practices, we believe 
it is appropriate and useful to seek additional comment from all 
interested persons.
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    \104\ Letter of North American Securities Administrators 
Association, Inc. (Oct. 6, 2004) (``NASAA Letter''); AICPA Sept. 22, 
2000 Letter, supra note 26; ICAA Sept. 22, 2004 Letter, supra note 
28; Comment Letter of National Association of Personal Financial 
Advisors (Sept. 21, 2004) (``NAPFA Letter''); Comment Letter of 
Henry L. Woodward (Sept. 21, 2004); Dimitroff Letter, supra note 23; 
Patchett Letter, supra note 27; Heydri Letter, supra note 31; 
Comment Letter of Charles O'Connor (Sept. 14, 2004); Comment Letter 
of Consumer Federation of America (Jan. 13, 2000) (``CFA Jan. 13, 
2000 Letter''); Comment Letter of Pamela A. Jones (Jan. 4, 2000).
---------------------------------------------------------------------------

    The Commission is considering issuing an interpretive position or 
including some or all of its interpretations relating to ``solely 
incidental to'' in a rule when it acts on reproposed rule 202(a)(11)-
1.\105\ The interpretations would address the application of the 
``solely incidental to'' requirement of section 202(a)(11)(C) of the 
Act and paragraph (a)(1)(ii) of rule 202(a)(11)-1 to certain common 
broker-dealer practices described below. Commenters should address 
whether, in their view, our proposed interpretations or any alternative 
interpretations find support in the Act or its legislative history. 
They should also address the costs and benefits of the proposed or any 
alternative interpretations. Where possible, commenters should quantify 
such costs and benefits. Should we apply the Advisers Act in the 
circumstances that we describe below in light of protections afforded 
investors by the Exchange Act?
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    \105\ We note that reproposed rule 202(a)(11)-1 already contains 
one interpretation regarding the scope of section 202(a)(11)(C). 
Paragraph (c) of the rule explains that under the exception, a 
broker-dealer is an investsment adviser only with respect to those 
accounts for which it provides services or receives compensation 
that subject the broker-dealer to the Advisers Act.
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A. Holding Out as an Investment Adviser

    In the Proposing Release we expressed concern that many broker-
dealers offering fee-based brokerage accounts have marketed them 
heavily based on the advisory services provided rather than securities 
transaction services,\106\ and we expressed concern about whether 
investors would perceive these accounts to be advisory accounts

[[Page 2728]]

rather than brokerage accounts. In August 2004, when we reopened the 
comment period on proposed rule 202(a)(11)-1, we asked for comment on 
whether the rule should be unavailable to a broker-dealer that uses 
terms such as ``investment advice'' or ``financial planning'' to 
promote its services.\107\
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    \106\ Proposing Relese, supra note 5.
    \107\ Investment Advisers Act Release No. 2278 (Aug. 19, 
2004)[69 FR 51620 (Aug. 20, 2004)]. See Investment Advisers Act 
Release, supra note 2 (A lawyer or accountant who holds himself out 
to the public as providing financial planning, pension consulting, 
or other financial advisory services would not be able to rely on 
the exclusion in Section 202(a)(11)(B) of the Advisers Act.)
---------------------------------------------------------------------------

    A large number of commenters expressed substantial concern that 
broker-dealer marketing efforts contribute to investor confusion about 
the differences between broker-dealers and advisers, and urged us to 
deny broker-dealers the ability to rely on the broker-dealer exemption 
if they held themselves out based on their advisory services.\108\ Some 
of these commenters asserted that any marketing of advisory services by 
a broker-dealer, whether for a fee-based account or an account paying 
commissions, is inconsistent with those services being solely 
incidental to the brokerage business. These commenters expressed the 
view that broker-dealers should stop calling their registered 
representatives ``financial consultants,'' ``financial advisors,'' or 
similar names.
---------------------------------------------------------------------------

    \108\ E.g., NASAA Letter, supra note 104; AICPA Letter, supra 
note 26; ICAA Sept. 22, 2004 Letter, supra note 28; Comment Letter 
of Financial Services Institute (Sept. 22, 2004); NAPFA Letter, 
supra note 104; FPA June 21, 2004 Letter, supra note 30; Joint 
Comment Letter of Consumer Federation of America, Certified 
Financial Planner Board of Standards, Investment Counsel Association 
of America and the National Association of Personal Financial 
Advisors (May 31, 2000); FPA Jan. 14, 2000 Letter, supra note 23); 
CFA Jan. 13, 2000 Letter, supra note l104.
---------------------------------------------------------------------------

    We are addressing these concerns in our reproposal of rule 
202(a)(11)-1 by proposing to require broker-dealers offering fee-based 
brokerage to include a prominent statement on all advertisements for, 
and contracts, agreements, applications and other forms governing fee-
based brokerage accounts. The statement must disclose that the accounts 
are brokerage accounts and not advisory accounts, that, as a 
consequence, the customer's rights and the firm's duties and 
obligations to the customer, including the scope of the firm's 
fiduciary obligations, may differ, and must identify an appropriate 
person at the firm with whom the customer can discuss the 
differences.\109\ Does this approach address investor confusion 
concerns? Will the disclosures make sense to investors if broker-
dealers continue to refer to their registered representatives as 
``financial consultants'' or ``financial advisors''? Should we instead 
conclude that use by a broker-dealer of such terms is inconsistent with 
the broker-dealer exception?
---------------------------------------------------------------------------

    \109\ Rule 202(a)(11)-1(a)(1)(iii).
---------------------------------------------------------------------------

    The Advisers Act also provides an exception for lawyers and 
accountants, and our staff has viewed the availability of that 
exception as turning on whether the lawyer or accountant has held 
himself out as providing financial planning, pension consulting, or 
other financial advisory services.\110\ Should we apply a similar 
standard to broker-dealers? Would such an approach address confusion 
among investors as to the differences between advisory accounts and 
brokerage accounts? On the other hand, would applying such an approach 
to broker-dealers ignore salient distinctions between broker-dealers 
and other professionals in terms of their advice-giving role?
---------------------------------------------------------------------------

    \110\ See Advisers Act Release No. 1092; supra note 2.
---------------------------------------------------------------------------

B. Financial Planning Services

    Financial planning services typically involve preparing a financial 
program for a client based on the client's financial circumstances and 
objectives. A financial planner generally seeks to address a wide 
spectrum of the client's long-term financial needs, including 
insurance, savings, and investments, taking into consideration 
anticipated retirement or other employee benefits.\111\ A financial 
planner also may develop tax or estate plans for clients or refer 
clients to attorneys, accountants or other professionals. In most 
cases, financial planners who provide advice about the advisability of 
investing in securities, advice about market trends, or advice about 
retaining an investment manager are subject to the Advisers Act.\112\
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    \111\ See Jonathan R. Macey, Regulation of Financial Planners: A 
White Paper Prepared for the Financial Planning Association (Apr. 
2002) at 5 (``In short, a financial planner develops plans that 
address all financial aspects of an individual's life. The breadth 
and scope of the advice given by financial planners is what 
distinguishes them from other, more specialized participants in the 
financial services industry. Unlike stock brokers, insurance 
salesmen, accountants, tax planners, lawyers, and trust and estate 
experts, financial planners may give advice on investments, savings, 
taxes, insurance, retirement, estate planning, trusts, and real 
estate. In addition to a broad rangae of technical advice, typically 
important components of financial planning are the initial 
assessment of a clinet's overall financial, familial, personal, and 
professional needs and goals as well as further monitoring and 
revision of the client's financial plan.'').
    \112\ See Advisers Act Release No. 1092, supra note 2. In 
advisers Act Release No. 1092 we published the views of our staff as 
to the applicability of the Advisers Act to financial planners and 
other persons who provide investment advice as a component of other 
financial services.
---------------------------------------------------------------------------

    The advisory services provided by financial planners and the 
context in which they are provided may extend beyond what Congress, in 
1940, reasonably could have understood broker-dealers to have provided 
as an advisory service ancillary to their brokerage business.\113\ We 
are concerned that some broker-dealers have promoted ``financial 
planning'' as a way of acquiring the confidence of customers to promote 
their brokerage services without actually providing any meaningful 
financial planning.\114\
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    \113\ Our staff has expressed similar views in the past. See 
Townsend and Associates, SEC Staff No-Action Letter (Sept. 21, 1994) 
(advice is not incidental that is provided ``as part of an overall 
plan that addresses the financial situation of a customer and 
formulates a financial plan.'') See also Investment Management & 
Reserach, Inc., SEC Staff No-Action Letter (Jan. 27, 1977). It is 
also consistent with views expressed in two of the leading treatises 
on invesstment advisers, See Thomas P. Lemke & Gerald T. Lins, 
REGULATION OF INVESTMENT ADVISERS Sec.  1:20 (2004); Clifford E. 
Kirsch, INVESTMENT ADVISER REGULATION (May 2004) at 2:5:1. It may, 
however, be inconsistent with statements made in a few of our 
staff's other letters. See, e.g., Nathan & Lewis Securities, SEC 
Staff No-Action Letter (Mar. 3, 1988) (``Nathan & Lewis No-Action 
Letter''); Elmer D. Robinson, SEC Staff No-Action Letter (Dec. 6, 
1985).
    On the other hand, the brokerage business has evolved 
significantly since 1940, and it may be appropriate to consider 
financial planning to be part of the traditional package of services 
broadly understood.
    \114\ In the Matter of Haight & Co., Inc., Securities Exchange 
Act Release No. 9082 (Feb. 19, 1971).
---------------------------------------------------------------------------

    We request comment on whether we should interpret financial 
planning as not solely incidental to the brokerage business. We 
understand that most broker-dealers that today offer financial planning 
services for a separate fee treat the customers receiving such services 
as advisory clients. Is our understanding correct? Should we limit our 
interpretation to circumstances where investors separately contract for 
financial planning services? If so, would such an approach discourage 
the use of separate contracts by broker-dealers? Should we limit our 
interpretation to circumstances where a separate fee is charged? Should 
our interpretation turn on whether the financial planning services are 
ongoing?
    Many financial planners registered under both the Advisers Act and 
Exchange Act are compensated exclusively from commissions received on 
the sale of securities, including mutual fund shares. Would an 
interpretation that financial planning is incidental to brokerage 
business permit those many financial planners to withdraw their 
registration under the Advisers Act? Would an interpretation

[[Page 2729]]

that yielded such a result serve to protect investors?
    We recognize that full-service broker-dealers must consider some 
aspects of financial planning when determining that their 
recommendations are suitable.\115\ We would not want our interpretation 
to interfere in any way with a broker's suitability analysis. In order 
to avoid this result, how should we draw the line between planning 
services that are incidental to brokerage and those that are not? Can 
such a line be drawn? Are there other ways to distinguish a broker-
dealer's suitability analysis from an adviser's financial planning 
services?
---------------------------------------------------------------------------

    \115\ A broker must have a reasonable basis for believing that a 
recommendation to buy or sell a particular security is suitable for 
the broker's customer considering the customer's risk tolerance, 
other securities holdings, financial situation, financial needs, and 
investment objectives. See supra note 52.
---------------------------------------------------------------------------

    At present we propose to address financial planning by issuing an 
interpretation stating that if a broker-dealer holds itself out as a 
financial planner or as providing financial planning services,\116\ it 
cannot be considered to be giving advice that is solely incidental to 
brokerage. Is this approach workable? Should we also (or alternatively) 
attempt to identify specific types of financial planning services that 
would or would not be incidental to the brokerage business? We solicit 
comment on whether we should include any interpretation regarding 
financial planning in rule text. If so, are there any particular 
concerns raised by codification? If so, how should they be addressed? 
We solicit comment on these and other approaches we could take as well.
---------------------------------------------------------------------------

    \116\ See supra note 110.
---------------------------------------------------------------------------

C. Wrap Fee Sponsorship

    Broker-dealers often serve as sponsors of wrap fee programs, under 
which broker-dealers effect securities transactions for one or more 
portfolio managers, which may be independent investment advisers.\117\ 
Although a ``wrap fee'' involves the receipt of ``special 
compensation,'' such broker-dealers may have available the exception 
provided by rule 202(a)(11)-1 if, among other things, the portfolio 
manager selection and asset allocation services typically provided by 
the broker-dealer sponsor could be viewed as solely incidental to the 
business of brokerage.\118\ However, we have not viewed the asset 
allocation or portfolio manager selection advice as incidental to the 
brokerage transactions initiated by the portfolio manager.\119\ Does 
this interpretation continue to make sense? Should we re-affirm it? We 
understand that broker-dealer sponsors of wrap fee programs are today 
registered under the Advisers Act and treat wrap fee customers as 
advisory clients. Is our understanding correct?
---------------------------------------------------------------------------

    \117\ Under some wrap fee programs, the broker-dealer sponsor 
retains discretionary authority and thus must treat its wrap fee 
customers as advisory clients because the broker-dealers receive 
special compensation and would not have available the exception 
provided by proposed rule 202(a)(11)-1, which is limited to non-
discretionary accounts. Wrap fee programs are today often referred 
to as ``separately managed accounts'' or ``separate accounts.''
    \118\ With regard to portfolio manager selection, our staff has 
viewed this to be so regardless of whether such services were 
carried out through a wrap fee program or provided as separate 
services. See FPC Securities Corporation, SEC Staff No-Action Letter 
(Nov. 1, 1974)(staff viewed broker's advice about selection of 
investment advisers and monitoring advisers' performance not 
incidental to business of broker-dealer).
    \119\ We have viewed broker-sponsored wrap fee programs as being 
subject to the Advisers Act. Disclosure by Investment Advisers 
Regarding Wrap Fee Programs, Investment Advisers Act Release No. 
1401 (Jan. 13, 1994) [59 FR 3033 (Jan. 20, 1994)], at n.2 (proposing 
amendments to Form ADV); Investment Advisers Act Release No. 1411 
(Apr. 19, 1994)(adopting amendments to Form ADV)[59 FR 21657 (Apr. 
26, 1994)].
---------------------------------------------------------------------------

D. Other Interpretive Questions

    Finally, we request comment whether there are other interpretive 
questions that have arisen under section 202(a)(11)(C) and, in 
particular, whether there are any questions regarding any particular 
advisory service that we might address in an interpretive statement.

IV. General Request for Comment

    The Commission requests comment on the rule and interpretations 
proposed in this release, suggestions for other additions to the rule 
and interpretations, and comment on other matters that might be 
affected by the proposals contained in this release. For purposes of 
the Small Business Regulatory Enforcement Fairness Act of 1996, the 
Commission also requests information regarding the potential impact of 
the proposed rule and interpretations on the economy on an annual 
basis. Commenters should provide empirical data to support their views.

V. Cost Benefit Analysis

A. Background

    The Commission is sensitive to the costs and benefits of its rules. 
Under the proposed rule, broker-dealers would not be deemed to be 
investment advisers with respect to accounts for which they receive 
asset-based fees, fixed fees, or similar non-commission compensation, 
provided that: (i) They do not exercise investment discretion over the 
account, (ii) their investment advice is solely incidental to the 
brokerage services provided to the account, and (iii) they make certain 
disclosures in their advertising and agreements for such accounts. The 
rule would also clarify that broker-dealers are not subject to the 
Advisers Act solely because, in addition to full-service brokerage 
services, they also offer discount brokerage services, including 
execution-only brokerage, for reduced commission rates. These 
provisions of the proposed rule are designed to permit broker-dealers 
to offer these new types of fee-based and discount brokerage programs 
without triggering regulation under the Advisers Act.
    The proposed rule would also specify that broker-dealers exercising 
investment discretion over customer accounts are not providing advice 
that is solely incidental to their business as brokers or dealers, 
regardless of the form of compensation. Thus, broker-dealers providing 
discretionary brokerage would not be eligible for the Advisers Act 
broker-dealer exception with respect to discretionary accounts, and 
would be subject to the Act and its requirements for those accounts.
    The Commission is also proposing to interpret the application of 
the ``solely incidental to'' requirement of section 202(a)(11)(C) of 
the Advisers Act to certain broker-dealer practices. A broker-dealer 
holding itself out as a financial planner would not be considered to be 
providing advice that is solely incidental to its brokerage services, 
and thus would be subject to the Advisers Act with respect to accounts 
offering such advisory services.
    We have identified certain costs and benefits, which are discussed 
below, that may result from the proposed rule and interpretations.\120\ 
We request comment on the costs and benefits of the proposed rule and 
interpretations.
---------------------------------------------------------------------------

    \120\ In 1999, our Proposing Release also analyzed the costs and 
benefits of our first proposal to keep broker-dealers from being 
subject to the Advisers Act solely as a result of re-pricing their 
full-service brokerage services. As discussed below, the comments on 
our 1999 proposal have informed our analysis in preparing this cost 
benefit analysis.
---------------------------------------------------------------------------

B. Discussion

1. Fee-based and Discount Brokerage Accounts
a. Benefits
i. Avoidance of Compliance Costs
    Proposed rule 202(a)(11)-1(a) would keep broker-dealers from being 
subject to the Advisers Act as a result of charging asset-based fees 
instead of commissions for accounts receiving the

[[Page 2730]]

kinds of services they have traditionally provided to brokerage 
customers, or in the case of discount brokerage, as a result of 
charging different commission rates for full-service accounts. To the 
extent they offer fee-based brokerage programs that fit within the 
activities excepted under the new rule, broker-dealers would not be 
subject to the Advisers Act with respect to such accounts. Similarly, 
under the proposed rule, broker-dealers offering both full-service 
brokerage services and discount brokerage services would not be deemed 
to have received special compensation solely because they charge 
reduced commission rates for their discount services.
    Broker-dealers relying on the proposed rule with respect to these 
fee-based and discount brokerage programs would benefit in the form of 
saved costs they would otherwise expend in connection with Advisers Act 
compliance.\121\ Broker-dealers, even those already dually-registered 
as investment advisers, would benefit in the form of costs saved by not 
having to convert their fee-based and full-service brokerage accounts 
into advisory accounts. For example, these accounts would not be 
subject to brochure delivery or other disclosure requirements under the 
Advisers Act. Similarly, such accounts also would not be subject to the 
principal trading restrictions under the Act. Securities markets would 
also benefit because the rule would preserve the ability of broker-
dealers to engage in principal transactions with these fee-based 
brokerage customers, and principal transactions are a major source of 
market liquidity.\122\ Commenters responding to our Proposing Release 
noted a large increase in the number of fee-based brokerage programs in 
the years since the Proposing Release.\123\ The benefits of these 
compliance cost savings and market liquidity are difficult to 
quantify.\124\
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    \121\ In the alternative, broker-dealers could revert to 
charging commissions instead of asset-based fees, and cease offering 
discount brokerage services, thereby avoiding compliance costs under 
the Advisers Act. Given the growing popularity of these accounts, 
however, as discussed infra note 123, and the fact that most broker-
dealers offering these accounts have already established (or an 
affiliate has established) a compliance infrastructure under the 
Advisers Act, we expect that, absent the exception that would be 
provided under proposed rule 202(a)(11)-(1)(a), broker-dealers would 
continue offering fee-based accounts and treat the accounts as 
advisory accounts.
    \122\ See Section II.A.1. of this Release, supra.
    \123\ Although commenters on our Proposing Release did not 
quantify this increase, one consulting firm estimates that assets in 
fee-based brokerage programs grew by 33.7% from the second quarter 
of 2003 to the second quarter of 2004. Cerulli Edge 3rd Quarter, 
supra note 47.
    \124\ Commenters on our 1999 Proposing Release did not provide 
data quantifying the potential costs of treating such a large number 
of accounts as advisory accounts.
---------------------------------------------------------------------------

    Other broker-dealers relying on the proposed rule would not be 
subject to the Advisers Act at all. For these broker-dealers whose fee-
based or discount brokerage programs would otherwise require adviser 
registration, we believe the rule's benefits would be significant in 
terms of avoiding an increased regulatory burden incurred as a result 
of changing the way they charge for their brokerage services. For 
example, if not excepted under the proposed rule, these broker-dealers 
would be required to prepare, submit and update adviser registration 
statements,\125\ and to prepare and distribute client disclosures under 
Part II of Form ADV.\126\ These broker-dealers would also be required 
to modify their compliance programs to address the Advisers Act and its 
requirements,\127\ and to establish codes of ethics required under the 
Act's rules.\128\ Because the costs of satisfying these and other 
requirements under the Advisers Act vary from firm to firm depending on 
its size and complexity, they are difficult to quantify.
---------------------------------------------------------------------------

    \125\ Advisers registered with the Commission must prepare Part 
1A of Form ADV and file it with the SEC on the IARD system. Since 
Part 1A requires advisers to answer basic questions about their 
businesses, and can be completed using information readily available 
to the registrant, costs to prepare the form are typically small, 
but for some larger registrants with complex operations and many 
employees and affiliates, the costs may be somewhat higher, and may 
include professional fees. Adviser registrants submitting their Form 
ADVs through the IARD are required to pay filing fees to the 
operator of the system which range from $150 to $1,100 initially and 
$100 to $550 annually. See Designation of NASD Regulation, Inc. to 
Establish the Investment Adviser Registration Depository; Approval 
of IARD Fees, Investment Advisers Act Release No. 1888 (July 28, 
2000) [65 FR 47807 (Aug. 3, 2000)].
    \126\ Rule 204-3 [17 CFR 275.204-3].
    \127\ Rule 206(4)-7 [17 CFR 275.206(4)-7].
    \128\ Rule 204A-1 [17 CFR 275.204A-1].
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ii. Investor Benefits
    By eliminating regulatory disincentives to re-pricing of brokerage 
services, proposed rule 202(a)(11)-1 is expected to yield benefits for 
individual investors as a result of such re-pricing. Under the fee-
based programs discussed above, a broker-dealer's compensation does not 
depend on the number of transactions or the size of mark-ups or mark-
downs charged, thus reducing incentives for the broker-dealer to churn 
accounts, recommend unsuitable securities, or engage in high-pressure 
sales tactics. As such, these programs may better align the interests 
of broker-dealers and their customers. The rule would also benefit 
customers by enabling them to choose from among these new programs and 
other traditional brokerage services to select the program best for 
them. While it is difficult to quantify the value of these benefits, we 
believe they are substantial.
b. Costs
    While we believe the benefits of proposed rule 202(a)(11)-1(a) are 
substantial, we believe the incremental costs associated with this 
provision of the proposed rule are small. The only incremental cost 
associated with this provision of the rule would be the cost of adding 
a disclosure statement to the affected account agreements and 
advertisements. As discussed in our Paperwork Reduction Act analysis, 
we believe this cost is insignificant.\129\ We believe the proposed 
disclosure is necessary to prevent investor confusion. Furthermore, the 
cost of the disclosure would be incurred only by those broker-dealers 
electing to rely on the rule.
---------------------------------------------------------------------------

    \129\ See Section VII.A. of this Release, infra. Broker-dealers 
would be required to include prominent statements that the account 
in question is a brokerage account, not an advisory account, and 
that, as a consequence, the customer's rights and the firm's duties 
and obligations to the customer, including the scope of the firm's 
fiduciary obligations, may differ. The firm would also be required 
to direct the customers to a person who can discuss with the 
customers the differences between the accounts.
---------------------------------------------------------------------------

    Because it would only operate to except from the Advisers Act 
certain brokerage accounts, proposed rule 202(a)(11)-1(a) would not 
increase the regulatory burden borne by investment advisers. Some 
commenters responding to our Proposing Release argued the proposed 
exception would grant broker-dealers--who give investment advice 
without complying with the Advisers Act--a competitive advantage over 
investment advisers subject to the Advisers Act, thereby indirectly 
imposing costs on investment advisers. However, because the proposed 
rule would be restricted to investment advice which is solely 
incidental to brokerage services (and broker-dealers have long been 
subject to this solely incidental standard under section 202(a)(11)(C) 
of the Advisers Act), the rule would not establish new opportunities 
for broker-dealers to compete with advisers on the nature of their 
investment advice. Also, in providing this advice, broker-dealers would 
remain subject to their own costs of regulation under the Exchange 
Act.\130\
---------------------------------------------------------------------------

    \130\ See supra note 58 and accompanying text.
---------------------------------------------------------------------------

    Some commenters responding to the Proposing Release additionally 
asserted the proposed exception would impose

[[Page 2731]]

costs on investors, who would not receive the same treatment afforded a 
client of an investment adviser under the Advisers Act. While these 
commenters argued that the fiduciary duties of an adviser outweigh the 
duties of a broker-dealer, their comments do not fully recognize the 
extent of broker-dealers' obligations.\131\ Just as we do not believe 
that the congressional exception for certain broker-dealers from the 
Advisers Act harms investors, so too we do not believe that proposed 
rule 202(a)(11)-1(a) would result in investor harm. In addition, we 
have enhanced the proposed rule's disclosure requirements, and these 
would, at a minimum, put broker-dealer customers on inquiry as to the 
nature of the account.\132\
---------------------------------------------------------------------------

    \131\ As we discuss supra in notes 52--54 and accompanying text, 
broker-dealers are subject to their own obligations to disclose 
conflicts, and are subject to an extensive investor protection 
regime.
    \132\ See supra note 129.
---------------------------------------------------------------------------

2. Discretionary Accounts

a. Benefits
    Under proposed rule 202(a)(11)-1(b), broker-dealers providing 
discretionary investment advice would not be able to rely on the 
broker-dealer exception under the Advisers Act, and would be subject to 
the Act with respect to their discretionary accounts. Proposed rule 
202(a)(11)-1(b) would benefit investors to the extent they are confused 
as to the nature of discretionary brokerage. As previously noted, in 
many respects discretionary brokerage relationships are difficult to 
distinguish from investment advisory relationships.\133\ By 
definitively treating such accounts as advisory accounts, the proposed 
rule would promote understanding by investors of the nature of the 
service they are receiving. More importantly, we believe that it may 
ensure that accounts that have the supervisory or managerial character 
we have identified as warranting Advisers Act coverage are, in fact, 
covered.
---------------------------------------------------------------------------

    \133\ Indeed, it is in part this potential for confusion that 
counsels us to exclude discretionary accounts from the exception in 
proposed rule 202(a)(11)-1(a), above.
---------------------------------------------------------------------------

b. Costs
    Proposed rule 202(a)(11)-1(b) would entail costs for broker-dealers 
that maintain discretionary accounts, in the form of Advisers Act 
compliance costs for these accounts. These costs would be lower for 
dually-registered broker-dealers that have already established a 
compliance infrastructure under the Advisers Act (or that could shift 
affected accounts to an affiliated investment adviser), and would be 
higher for broker-dealers that would have to become newly-registered 
under the Advisers Act. Because these costs of compliance and 
registration would vary from firm to firm depending on its size and 
complexity, these costs are difficult to quantify.
    For broker-dealers already dually-registered as investment 
advisers, the proposed rule would result in costs to treat 
discretionary accounts as advisory accounts. Based on staff experience, 
we believe that many dual registrants currently treat discretionary 
accounts as advisory accounts, and would be in compliance with the 
proposed rule without further action. To the extent that other dually-
registered broker-dealers would be required to treat discretionary 
accounts as advisory accounts, they would incur costs associated with 
subjecting such accounts to the Advisers Act and its requirements.\134\ 
For example, under the Advisers Act, they would be required to deliver 
brochures and make other required disclosures with respect to these 
accounts, and observe principal trading restrictions. Nonetheless, we 
believe these costs would be mitigated because as advisers, these 
broker-dealers already have systems in place to satisfy such 
requirements, and the costs are account-specific. Dually-registered 
broker dealers converting discretionary accounts may also incur 
additional documentation costs to execute new account agreements with 
affected clients.
---------------------------------------------------------------------------

    \134\ As discussed below, there are approximately 900 dually-
registered broker-dealers that engage in types of broker-dealer 
activities that might involve discretionary accounts. We do not 
collect data from broker-dealers on whether or how they maintain 
discretionary accounts for their customers, so we cannot estimate 
how many of these dual registrants would be affected by the proposed 
rule. The staff interpretations on which broker-dealers have relied 
to hold discretionary accounts not subject to the Advisers Act apply 
only to broker-dealers who hold a limited number of such accounts. 
To the extent that broker-dealers have limited their acceptance of 
discretionary accounts accordingly, there would be a correspondingly 
limited impact on broker-dealers if we adopt the proposed rule.
---------------------------------------------------------------------------

    In many instances, broker-dealers that are not dually registered 
are affiliated with investment advisers. Based on staff experience, we 
believe that many of these broker-dealers have refrained from engaging 
in the discretionary brokerage business, and have instead looked to 
their advisory affiliates to provide portfolio management to investors 
seeking this kind of service. Other broker-dealers that have not 
refrained from accepting discretionary brokerage services could 
implement the requirements of the proposed rule by shifting these 
customers to their advisory affiliates. In so doing, they would incur 
the lesser compliance costs of the types discussed above for dual 
registrants, rather than the greater costs discussed below for new 
registrants.
    For broker-dealers whose maintenance of discretionary accounts 
would require them to register as investment advisers for the first 
time, the proposed rule would result in costs associated with 
registration under the Advisers Act and compliance with the Act's 
requirements. Although we acknowledge that the costs of registration 
and compliance under the Advisers Act are significant,\135\ we believe 
that such costs would be mitigated by the fact that these firms could 
build upon the infrastructure they already have in place as broker-
dealers, much of which overlaps with Advisers Act requirements. For 
example, these broker-dealers are already subject to rules requiring 
designation of a chief compliance officer, establishment and 
maintenance of written compliance procedures, maintenance of books and 
records, and oversight of employee personal securities trading.\136\ 
These broker-dealers will ordinarily also be in compliance with the 
adviser custody rule.\137\
---------------------------------------------------------------------------

    \135\ As discussed above in Section V.B.1.a. of this Release, 
these costs include preparing and submitting Part 1 of Form ADV, the 
adviser registration form; preparing and distributing client 
disclosures under Part II of Form ADV; modifying their compliance 
programs to address the Advisers Act and its requirements, and 
establishing adviser codes of ethics.
    \136\ 136 See, e.g. NASD Conduct Rule 3013 (chief compliance 
officer); NASD Conduct Rule 3010(b) (compliance procedures); NASD 
Conduct Rule 3050 (personal trading); NASD Conduct Rule 3110 (books 
and records). See also Exchange Act rule 17a-3 [17 CFR 240.17a-3] 
(records to be maintained by brokers and dealers); Exchange Act rule 
17a-4 [17 CFR 240.17a-4] (records to be preserved by brokers and 
dealers); Exchange Act rule 17a-7 [17 CFR 240.17a-7] (records of 
non-resident brokers and dealers); New York Stock Exchange Rule 342 
(personal trading).
    \137\ Rule 206(4)-2. See Custody of Funds or Securities of 
Clients by Investment Advisers, Investment Advisers Act Rel. No. 
2176 (Sept. 25, 2003) [68 F.R. 56692 (Oct. 1, 2003)] at n.23 and 
n.49, and accompanying text.
---------------------------------------------------------------------------

    In addition, the number of broker-dealers that would be required to 
register as investment advisers as a result of the proposed rule should 
be small. Based on information submitted by broker-dealers on Form BD, 
approximately 40 percent of all broker-dealer firms engage exclusively 
in specialized types of broker-dealer activities that are extremely 
unlikely to involve discretionary customer accounts.\138\ Although 
approximately

[[Page 2732]]

3,850 remaining broker-dealers engage in types of broker-dealer 
activities that might involve discretionary accounts, approximately 900 
of these firms are already dually-registered as investment advisers, 
leaving a pool of 2,950 broker-dealers that are not registered 
advisers. Based on its experience, the staff believes it is rare for a 
broker-dealer that is not also dually-registered as an investment 
adviser to accept discretionary accounts, and the staff estimates that 
no more than five to ten percent of these 2,950 broker-dealers (or 
approximately 145-290 firms) maintain discretionary accounts.\139\ We 
expect that several of these firms could convert all their 
discretionary accounts to nondiscretionary accounts, thereby avoiding 
the obligation to register under the Act.\140\ We further estimate that 
one-third of these 145-290 firms that are not dually-registered have 
affiliations with investment advisers,\141\ and would transfer these 
accounts to their advisory affiliates.\142\
---------------------------------------------------------------------------

    \138\ These estimates are based on information reported on Form 
BD by broker-dealers whose registrations had been approved by the 
Commission as of December 15, 2004.
    \139\ 139 We do not collect data from these broker-dealer firms 
specifically addressing whether they maintain discretionary 
accounts.
    \140\ We expect that the discretionary basis of these accounts 
has been a matter of convenience for the account customers, but that 
in the future, the broker-dealer and the customer would agree that 
the broker-dealer will obtain customer approvals before effecting 
transactions for these accounts. These broker-dealers would incur 
limited costs to contact these customers and, if necessary, change 
their account agreements from discretionary ones to nondiscretionary 
ones.
    \141\ 141 For the group of 2,950 broker-dealers, approximately 
one-third currently report on Form BD that they are affiliated with 
an investment advisory organization. For purposes of this estimate, 
we infer that the same one-third affiliation rate will apply in the 
case of the 145-290 broker-dealers that we estimate accept 
discretionary accounts.
    \142\ 142 For these firms that transfer their discretionary 
accounts to advisory affiliates, costs would be similar to those 
faced by dual registrants in converting discretionary accounts from 
brokerage accounts to advisory accounts.
    For Paperwork Reduction Act purposes, we have estimated that 220 
broker-dealers that are not dually-registered have discretionary 
brokerage accounts. This is approximately the midpoint of the range 
discussed above. We have further estimated that 50 of these firms 
would convert all their discretionary brokerage accounts to 
nondiscretionary accounts; that 75 firms would transfer all their 
discretionary accounts to existing advisory affiliates; and that the 
remaining 95 firms would register under the Advisers Act. We have 
requested comments on our assumptions in reaching this estimate. See 
infra 162--166, and accompanying text.
---------------------------------------------------------------------------

3. Interpretation of ``Solely Incidental''
    The Commission is also reviewing the application of the ``solely 
incidental to'' requirement of section 202(a)(11)(C) of the Advisers 
Act to certain broker-dealer practices in three additional areas, as 
discussed below:
a. Holding Out as an Investment Adviser
    In the Proposing Release we expressed concern that many broker-
dealers offering fee-based brokerage accounts marketed them heavily 
based on the advisory services provided rather than securities 
transaction services, and we expressed concern about whether investors 
would perceive these accounts to be advisory accounts rather than 
brokerage accounts. As discussed above, proposed rule 202(a)(11)-1(a) 
is designed to address these concerns by requiring prominent 
disclosures putting investors on inquiry as to the differences between 
these types of accounts.
i. Benefits
    Some commenters responding to our Proposing Release urged the 
Commission to formulate an advertising ban for fee-based brokerage 
accounts, arguing it would benefit investors by eliminating customer 
confusion as to the nature of these accounts. However, this benefit 
would be obtained at the cost of prohibiting broker-dealers from 
marketing themselves based on services they are legally authorized to 
provide. We believe our proposal to require disclosure with respect to 
these accounts may be a better way of addressing potential customer 
confusion.
ii. Costs
    As discussed in Section V.B.1.b. of this Release, above, the costs 
of disclosures for fee-based accounts under proposed rule 202(a)(11)-
1(a) would be insignificant. The marketing ban suggested by commenters, 
however, could effectively prohibit broker-dealers from marketing these 
accounts in a fashion designed to appeal to interested investors, 
unless these broker-dealers were willing to treat them as advisory 
accounts and forego the benefits of the proposed rule as described in 
Section V.B.1.a. of this Release, above. The cost of being unable to 
attract new fee-based account customers through marketing, though not 
readily susceptible to being quantified, could potentially be 
significant, given the popularity of fee-based accounts as demonstrated 
by their recent growth.\143\
---------------------------------------------------------------------------

    \143\ See supra note 123.
---------------------------------------------------------------------------

iii. Holding Out
    We also request comments on the potential benefits and costs of 
applying a ``holding out'' standard to broker-dealers, similar to the 
one our staff has applied to lawyers and accountants.\144\ Would such 
an approach offer greater benefits by reducing investor confusion as to 
the differences between advisory accounts and brokerage accounts? Would 
it impose costs on broker-dealers, by denying them the ability to 
compete with investment advisers on the basis of various advisory 
services that broker-dealers otherwise provide to their customers 
without registering under the Advisers Act?
---------------------------------------------------------------------------

    \144\ See supra note 110, and accompanying text.
---------------------------------------------------------------------------

b. Financial Planning Services
    The Commission is also requesting comment whether to interpret 
financial planning as not solely incidental to brokerage. Because full-
service broker-dealers must consider aspects of financial planning when 
determining that their recommendations are suitable, we are requesting 
comment whether our interpretation should turn on whether a broker-
dealer holds its financial planning or other advisory services out to 
clients and prospective clients.
i. Benefits
    Customers who obtain financial plans from broker-dealers that hold 
themselves out as financial planners may be confused as to the nature 
of the financial planning services they receive. The proposed 
interpretation would clarify to these customers that the financial 
planning services they receive are governed by the Advisers Act and its 
rules.
ii. Costs
    If we interpret the Advisers Act to require broker-dealers holding 
themselves out as financial planners to treat preparation of financial 
plans as an advisory activity, affected broker-dealers would incur 
costs to comply with the Advisers Act. These costs would be lower for 
dually-registered broker-dealers that have already established a 
compliance infrastructure under the Advisers Act (or that could shift 
affected accounts to an affiliated investment adviser), and would be 
higher for broker-dealers that would have to become newly-registered 
under the Advisers Act. Because the costs of compliance and 
registration vary from firm to firm depending on its size and 
complexity, these costs are difficult to quantify.
    To the extent that dually-registered broker-dealers would be 
required to treat financial planning as an advisory activity,\145\ they 
would incur costs

[[Page 2733]]

associated with subjecting such activities to the Advisers Act and its 
requirements (similar to the costs to dual registrants of our 
discretionary accounts proposal, as discussed in Section V.B.2.b. of 
this Release, above). For example, under the Advisers Act, they would 
be required to deliver brochures and make other required disclosures 
with respect to financial planning clients, and observe principal 
trading restrictions. Nonetheless, we believe these costs would be 
mitigated because as advisers, these broker-dealers already have 
systems in place to satisfy such requirements, and the costs are 
account-specific. These dually-registered broker dealers may also incur 
additional documentation costs to execute new account agreements with 
financial planning clients.
---------------------------------------------------------------------------

    \145\ Approximately 320 dually-registered broker-dealers report 
on their Form ADVs that they provide financial planning services. 
This represents approximately one-third of all dually-registered 
broker-dealers. We do not collect data that would allow us to 
determine how many of these 320 broker-dealers actually hold 
themselves out as financial planners.
---------------------------------------------------------------------------

    In many instances, broker-dealers that are not dually registered 
are affiliated with investment advisers, as discussed above. These 
broker-dealers could shift financial planning clients to their advisory 
affiliates. In so doing, they would incur the lesser compliance costs 
of the types discussed above for dual registrants, rather than the 
greater costs discussed below for new registrants.
    For broker-dealers whose financial planning activities would 
require them to register as investment advisers for the first time, the 
proposed rule would result in costs associated with registration under 
the Advisers Act and compliance with the Act's requirements. Although 
we acknowledge (as discussed above in connection with discretionary 
accounts) that the costs of registration and compliance under the 
Advisers Act are significant,\146\ we believe that such costs would be 
mitigated by the fact that these firms could build upon the 
infrastructure they already have in place as broker-dealers, much of 
which overlaps with Advisers Act requirements. For example, these 
broker-dealers are already subject to rules requiring designation of a 
chief compliance officer, establishment and maintenance of written 
compliance procedures, maintenance of books and records, and oversight 
of employee personal securities trading.\147\ These broker-dealers will 
ordinarily also be in compliance with the adviser custody rule.\148\
---------------------------------------------------------------------------

    \146\ As discussed in Section V.B.2.b. of this Release, supra, 
these costs include preparing and submitting Part 1 of Form ADV, the 
adviser registration form; preparing and distributing client 
disclosures under Part II of Form ADV; modifying their compliance 
programs to address the Advisers Act and its requirements, and 
establishing adviser codes of ethics.
    \147\ See supra note 136.
    \148\ See supra note 137.
---------------------------------------------------------------------------

    We do not collect data from broker-dealers describing whether they 
hold themselves out as financial planners, so it is difficult to 
estimate the extent to which broker-dealers would be required to 
register under the proposed interpretation. Based on information 
submitted by broker-dealers on Form BD, approximately 40 percent of all 
broker-dealer firms engage exclusively in specialized types of broker-
dealer activities that are extremely unlikely to involve any financial 
planning activities.\149\ Of the approximately 3,850 remaining broker-
dealers that engage in types of broker-dealer activities that might 
involve financial planning, approximately 900 are already dually-
registered as investment advisers, and approximately 1,000 others are 
affiliated with investment advisers and could shift financial planning 
clients to the affiliates instead of registering. We do not collect 
data that would allow us to determine how many of the remaining 1,950 
broker-dealers hold themselves out as financial planners. As discussed 
above, among dually-registered broker-dealers, only one-third report 
providing financial planning services (although this does not 
necessarily mean that they also hold themselves out as financial 
planners).\150\ Applying the same ratio to these remaining 1,950 
broker-dealers would yield 650 firms, but it seems likely the ratio 
would be significantly lower for firms that are not dual registrants, 
and even lower for those that hold themselves out as financial 
planners. Further, it seems likely some portion of these broker-dealers 
would find that the costs of registration outweigh the benefits to the 
firm of holding themselves out as financial planners, and would cease 
doing so.\151\
---------------------------------------------------------------------------

    \149\ See supra note 138.
    \150\ See supra note 145.
    \151\ For Paperwork Reduction Act purposes, we have estimated 
that 100 broker-dealers would register, and requested comment on our 
assumptions in reaching this estimate. The estimate is based on 
assumptions that approximately ten percent of the 1,950 broker-
dealers (or 195) currently hold themselves out as financial 
planners, and that approximately half of the 195 would choose to 
stop holding themselves out rather than register under the Advisers 
Act. See infra notes 167-168, and accompanying text.
---------------------------------------------------------------------------

c. Wrap Fee Sponsorship
    We are proposing to re-affirm our current interpretation regarding 
wrap program sponsorship. Since this would not change existing 
obligations or relationships, no new costs or benefits would result.

C. Request for Comment

    The Commission requests comments on the costs and benefits 
identified in this release.
     Are there other costs or benefits that may result from the 
proposed rule and interpretation?
    We request commenters to identify, discuss, analyze, and supply 
relevant data regarding these or any additional costs and benefits. In 
particular, we request data regarding the following:
     How many broker-dealers would be required to register 
under the Advisers Act absent proposed rule 202(a)(11)-1(a)? How many 
would not face new registration obligations, but would be required 
(absent proposed rule 202(a)(11)-1(a)) to begin treating these accounts 
as advisory accounts, or arrange for brokerage accounts to be shifted 
to advisory affiliates to be handled under the Advisers Act? What 
amount of costs would each of these different groups of broker-dealers 
incur?
     What is the value of the benefits we have identified under 
proposed rule 202(a)(11)-1(a) for investors, including better alignment 
between their interests and the interests of their broker-dealers and 
greater choice in paying for brokerage services? What is the value of 
liquidity that would be made available in the securities markets if the 
principal trading restrictions of the Advisers Act did not apply to 
fee-based accounts under rule 202(a)(11)-1(a)?
     What proportion of broker-dealers currently treat their 
discretionary accounts as advisory accounts? How many broker-dealers 
would be required to register under the Advisers Act as a consequence 
of proposed rule 202(a)(11)-1(b)? How many would not face new 
registration obligations, but would be required to begin treating these 
accounts as advisory accounts, or arrange for brokerage accounts to be 
shifted to advisory affiliates to be handled under the Advisers Act? In 
preparing our estimates of the number of broker-dealers that would be 
affected by proposed rule 202(a)(11)-1(b), have we drawn appropriate 
inferences from the limited data available to us? What amount of costs 
would each of these different groups of broker-dealers incur?
     What proportion of broker-dealers that currently hold 
themselves out as financial planners treat financial planning as an 
advisory activity? How many would be required to register as a 
consequence of the proposed financial planning interpretation? How many 
would not face new registration obligations, but would be required to 
begin treating these accounts as advisory accounts, or arrange for

[[Page 2734]]

brokerage accounts to be shifted to advisory affiliates to be handled 
under the Advisers Act? In preparing our estimates of the number of 
broker-dealers that would be affected by the proposed interpretation, 
have we drawn appropriate inferences from the limited data available to 
us? What amount of costs would each of these different groups of 
broker-dealers incur?

VI. Effects on Competition, Efficiency and Capital Formation

    Section 202(c) of the Advisers Act mandates that the Commission, 
when engaging in rulemaking that requires it to consider or determine 
whether an action is necessary or appropriate in the public interest, 
to consider, in addition to the protection of investors, whether the 
action will promote efficiency, competition, and capital 
formation.\152\
---------------------------------------------------------------------------

    \152\ 15 U.S.C. 80b-2(c).
---------------------------------------------------------------------------

A. Fee-Based and Discount Brokerage Programs

    Proposed rule 202(11)(a)-1(a) would provide that a broker-dealer 
providing nondiscretionary advice that is incidental to its brokerage 
services can retain its exception from the Advisers Act regardless of 
whether it charges an asset-based or fixed fee (rather than 
commissions, mark-ups, or mark-downs) for its services. The proposed 
rule would also provide that broker-dealers are not subject to the Act 
solely because in addition to offering full-service brokerage they 
offer discount brokerage services, including execution-only brokerage, 
for reduced commission rates.\153\
---------------------------------------------------------------------------

    \153\ Rule 202(a)(11)-1(c) further provides that a registered 
broker-dealer is an investment adviser solely with respect to those 
accounts for which it provides services or receives compensation 
that subjects it to the Advisers Act.
---------------------------------------------------------------------------

    Proposed rule 202(11)(a)-1(a) is not expected to negatively affect 
competition. Many commenters addressing our Proposing Release raised 
concerns that the proposed rule would grant broker-dealers who give 
investment advice without registering under the Advisers Act a 
competitive advantage over investment advisers subject to the Advisers 
Act. However, as discussed in Section II.A.1. of this Release, above, 
broker-dealers have historically provided advisory services to their 
brokerage customers. As discussed in Section II.A.2 of this Release, 
above, broker-dealers do so subject to the cost implications of 
compliance with broker-dealer regulation. Because the proposed rule 
would not change the types of advice broker-dealers may provide (which 
advice must continue to be solely incidental to brokerage) or 
materially change their compliance costs, it is not expected not create 
a competitive advantage.
    Proposed rule 202(a)(11)-1(a) could increase efficiency by removing 
impediments to fee-based brokerage programs. Fee-based brokerage 
programs, as we discuss above, respond to changes in the market place 
for retail brokerage, and concerns that we have long held about the 
incentives that commission-based compensation provides for broker-
dealers to churn accounts, recommend unsuitable securities, and engage 
in aggressive marketing.\154\ The availability of fee-based brokerage 
programs may better align the interests of broker-dealers and their 
customers. The availability of fee-based and discount brokerage 
programs should also enable brokerage customers to choose these new 
programs when they represent a more efficient alternative than 
commission-based brokerage.
---------------------------------------------------------------------------

    \154\ See supra notes 13-16 and accompanying text.
---------------------------------------------------------------------------

    If proposed rule 202(a)(11)-1(a) has any affect on capital 
formation, it would be indirect, and positive. By removing impediments 
to fee-based and discount brokerage programs which may be more 
desirable for customers than commission-based programs, the proposed 
rule may open the door to greater investor participation in the 
securities markets.

B. Discretionary Brokerage and Financial Planning

    Proposed rule 202(a)(11)-1(b) would specify that broker-dealers 
exercising investment discretion over customer accounts are not 
providing advice that is solely incidental to their business as a 
brokers or dealers. The Commission is also proposing an interpretation 
under which broker-dealers holding themselves out as financial planners 
would not be considered to be providing advice that is solely 
incidental to brokerage. Thus, broker-dealers providing discretionary 
brokerage or holding themselves out as financial planners would not be 
eligible for the Advisers Act broker-dealer exception with respect to 
these activities, and would be subject to the Act and its requirements 
for them.
    The proposed rule and interpretation would not negatively affect 
competition. Some broker-dealers would be required to begin treating 
discretionary or financial planning customers as clients under the 
Advisers Act. However, as discussed above, we believe the majority of 
broker-dealers already apply the Advisers Act to these relationships, 
so we expect the effects of the proposed rule and interpretation will 
not be widespread.\155\ If the proposed rule and interpretation were 
adopted and remaining firms began applying the Advisers Act to these 
relationships as a result, they would be competing on a more even 
footing with broker-dealers who already do so. We do not believe the 
proposed rule and interpretation would have any effect on efficiency or 
capital formation.
---------------------------------------------------------------------------

    \155\ See supra Sections V.B.2.b and V.B.3.b.ii. of this 
Release.
---------------------------------------------------------------------------

VII. Paperwork Reduction Act

    Proposed rule 202(a)(11)-1(a) contains ``collection of 
information'' requirements within the meaning of the Paperwork 
Reduction Act of 1995.\156\ The title of this new collection is ``Rule 
202(a)(11)-1 under the Investment Advisers Act of 1940--Certain Broker-
Dealers Deemed Not To Be Investment Advisers,'' and the Commission has 
submitted it to the Office of Management and Budget (``OMB'') for 
review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. OMB has 
approved, and subsequently extended, this collection under control 
number 3235-0532 (expiring on October 31, 2006).
---------------------------------------------------------------------------

    \156\ 44 U.S.C. 3501 to 3520.
---------------------------------------------------------------------------

    Additionally, rule 202(a)(11)-1(b) would have the effect of 
requiring certain broker-dealers providing discretionary brokerage to 
register under the Advisers Act. The Commission's proposed 
interpretation of section 202(a)(11)(C) of the Advisers Act would also 
have the effect of requiring certain broker-dealers to register under 
the Advisers Act if they hold themselves out as financial planners. The 
proposed rule and interpretation would therefore increase the number of 
respondents under several existing collections of information, and, 
correspondingly, increase the annual aggregate burden under those 
existing collections of information. The Commission is submitting to 
OMB, in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11, the 
existing collections of information for which the annual aggregate 
burden would likely increase as a result of proposed rule 202(a)(11)-
1(b) and the proposed interpretation. The titles of the affected 
collections of information are: ``Form ADV,'' ``Form ADV-W and Rule 
203-2,'' ``Rule 203-3 and Form ADV-H,'' ``Form ADV-NR,'' ``Rule 204-
2,'' ``Rule 204-3,'' ``Rule 204A-1,'' ``Rule 206(4)-3,'' ``Rule 206(4)-
4,'' ``Rule 206(4)-6,'' and ``Rule 206(4)-7,'' all under the Advisers 
Act. The existing rules that would be affected by

[[Page 2735]]

proposed rule 202(a)(11)-1(b) and the proposed interpretation contain 
currently approved collection of information numbers under OMB control 
numbers 3235-0049, 3235-0313, 3235-0538, 3235-0240, 3235-0278, 3235-
0047, 3235-0596, 3253-0242, 3235-0345, 3235-0571 and 3235-0585, 
respectively.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a 
currently valid OMB control number.

A. Certain Broker-Dealers Deemed Not To Be Investment Advisers

    Under proposed rule 202(a)(11)-1(a), broker-dealers would be deemed 
not to be ``investment advisers'' as defined in the Advisers Act with 
respect to certain accounts. With respect to these accounts, such 
broker-dealers would not be subject to the provisions of the Advisers 
Act, including the various registration, disclosure and recordkeeping 
requirements under the Act. Under proposed rule 202(a)(11)-1(a), a 
broker-dealer would not be deemed to be an investment adviser with 
respect to an account for which it receives special compensation, 
provided that: (i) It does not exercise investment discretion over the 
account, (ii) its investment advice is solely incidental to the 
brokerage services provided to the account, and (iii) it makes certain 
disclosures in its advertising and agreements for such accounts.
    In the Proposing Release, we noted that broker-dealers taking 
advantage of the proposed exception would need to maintain certain 
records that establish their eligibility to do so, but that rules under 
the Exchange Act already require the maintenance of those records.\157\ 
Therefore, we concluded that this facet of the proposed exception would 
not increase the recordkeeping burden for any broker-dealer.
---------------------------------------------------------------------------

    \157\ See Proposing Release at Section IV. Specifically, the 
proposed rule would limit its application to accounts over which a 
broker-dealer does not exercise investment discretion. Proposed rule 
202(a)(11)-1(a)(1)(i). The proposed rule would also require a 
prominent statement be made in agreements governing the accounts to 
which the rule applies. Rule 202(a)(11)-1(a)(1)(ii). Under Exchange 
Act rules, broker-dealers are already required to maintain all 
``evidence of the granting of discretionary authority given in any 
respect of any account'' [17 CFR 240.17a-4(b)(6)] and all ``written 
agreements * * * with respect to any account'' [17 CFR 240.17a-
4(b)(7)].
---------------------------------------------------------------------------

    To rely on the proposed rule with respect to a particular brokerage 
account, advertisements \158\ and contracts or agreements for the 
account would be required to contain a disclosure, including a 
prominent statement that the account in question is a brokerage 
account, not an advisory account. This disclosure must explain that the 
customer's rights and the firm's duties and obligations to the 
customer, including the scope of the firm's fiduciary obligations, may 
differ. The firm would also be required to identify an appropriate 
person at the firm with whom the customer can discuss the 
differences.\159\ This information is necessary to prevent customers 
and prospective customers from mistakenly believing that the account is 
an advisory account subject to the Advisers Act, and will be used to 
assist customers in making an informed decision on whether to establish 
an account. The collection of information requirement under the 
proposed rule is mandatory. In general, the information collected 
pursuant to the proposed rule would be held by the broker-dealers. 
Staff of the Commission, self-regulatory organizations, and other 
securities regulatory authorities would gain possession of the 
information only upon request. Any collected information received by 
the Commission would be kept confidential subject to the provisions of 
the Freedom of Information Act [5 U.S.C. 552].
---------------------------------------------------------------------------

    \158\ As discussed in the Proposing Release, broker-dealers 
already are required to maintain records regarding their 
advertisements under existing self-regulatory organizations' rules.
    \159\ Rule 202(a)(11)-1(a)(1)(iii).
---------------------------------------------------------------------------

    The burden to comply with this provision of the proposed rule would 
be insignificant. In preparing model contracts and advertisements, for 
example, compliance officials would be required to verify that the 
appropriate disclosure is made. In the Proposing Release, we estimated 
that the average annual burden for ensuring compliance is five minutes 
per broker-dealer taking advantage of the proposed rule.\160\ We 
estimated that if all of the approximately 8,100 broker-dealers 
registered with us took advantage of the rule, the total estimated 
annual burden would be 673 hours.\161\ As proposed in 1999, the rule 
only required a prominent statement that the account is a brokerage 
account. The rule we are proposing today modifies this provision to 
require that the prominent statement also indicate that the account is 
not an advisory account; that the firm's obligations with respect to 
such accounts may differ; and that, as a consequence, the customer's 
rights and the firm's duties and obligations to the customer, including 
the scope of the firm's fiduciary obligations, may differ. The firm 
would also be required to identify an appropriate person at the firm 
with whom the customer can discuss the differences. However, this 
modified disclosure will not increase the estimated paperwork burden 
for this collection.
---------------------------------------------------------------------------

    \160\ See Proposing Release.
    \161\ 0.083 hours x 8,100 broker-dealers = 673 hours.
---------------------------------------------------------------------------

B. Broker-Dealers Providing Discretionary Advice or Financial Plans

    As discussed above, under proposed rule 202(a)(11)-1(b), broker-
dealers providing discretionary advice will be deemed advisers subject 
to the Advisers Act for their discretionary accounts. Broker-dealers 
holding themselves out as financial planners would, under the 
Commission's proposed interpretation of section 202(a)(11)(C) of the 
Advisers Act, be deemed advisers subject to the Advisers Act with 
respect to their financial planning clients. This proposed rule and 
proposed interpretation would therefore increase the number of 
respondents under the existing collections of information identified 
above, and, correspondingly, increase the annual aggregate burden under 
those existing collections of information. All of these collections of 
information are mandatory, and respondents in each case are investment 
advisers registered with us, except that (i) respondents to Form ADV 
are also investment advisers applying for registration with us; (ii) 
respondents to Form ADV-NR are non-resident general partners or 
managing agents of registered advisers; (iii) respondents to rule 204A-
1 include ``access persons'' of an adviser registered with us, who must 
submit reports of their personal trading to their advisory firms; (iv) 
respondents to rule 206(4)-3 are advisers who pay cash fees to persons 
who solicit clients for the adviser; (v) respondents to rule 206(4)-4 
are advisers with certain disciplinary histories or a financial 
condition that is reasonably likely to affect contractual commitments; 
and (vi) respondents to rule 206(4)-6 are only those SEC-registered 
advisers that vote their clients' securities. Unless otherwise noted 
below, responses are not kept confidential.
    We cannot quantify with precision the number of broker-dealers that 
will be new registrants with the Commission under the Advisers Act if 
proposed rule 202(a)(11)-1(b) is adopted. Based on information 
submitted by broker-dealers on Form BD, approximately 40 percent of all 
broker-dealer firms engage exclusively in specialized types of broker-
dealer activities that are extremely unlikely to involve

[[Page 2736]]

discretionary customer accounts.\162\ Although approximately 3,850 
remaining broker-dealers engage in types of broker-dealer activities 
that might involve discretionary accounts, approximately 900 of these 
firms are already dually-registered as investment advisers, leaving a 
pool of 2,950 broker-dealers. Based on its experience, staff believes 
it is rare for a broker-dealer that is not also dually-registered as an 
investment adviser to accept discretionary accounts, and staff 
estimates that no more than five to ten percent of these 2,950 broker-
dealers (or approximately 145-295 firms) maintain discretionary 
accounts.\163\ Of those 220 broker-dealers (which is the midpoint of 
the range), we estimate approximately 50 will have so few discretionary 
accounts that they will make a business decision to cease to offer them 
and transform existing accounts into nondiscretionary accounts to avoid 
having to register under the Act.\164\ We further estimate that one-
third of these 220 broker-dealers, or 75 firms, will transfer their 
discretionary accounts to existing investment advisory affiliates.\165\ 
Thus, for purpose of this analysis, we have estimated 95 new firms 
would be required to register with the SEC as investment advisers as a 
result of proposed rule 202(a)(11)-1(b).\166\
---------------------------------------------------------------------------

    \162\ These estimates are based on information reported on Form 
BD by broker-dealers whose registrations had been approved by the 
Commission as of December 15, 2004.
    \163\ We do not collect data from these broker-dealer firms 
specifically addressing whether they maintain discretionary 
accounts.
    \164\ We expect that the discretionary basis of these accounts 
has been a matter of convenience for the account customers, but that 
on a going-forward basis, the broker-dealer and the customer will 
agree that the broker-dealer will obtain customer approvals before 
effecting transactions for these accounts.
    \165\ For the group of 2,950 broker-dealers that might 
potentially maintain discretionary accounts subjecting them to 
adviser registration under the rule, approximately one-third 
currently report on Form BD that they are affiliated with an 
investment advisory organization. For purposes of this estimate, we 
infer that the same one-third affiliation rate will apply in the 
case of the 145-295 broker-dealers that we estimate accept 
discretionary accounts.
    \166\ 220 broker-dealers - 50 converting to nondiscretionary 
accounts - 75 transferring discretionary accounts to existing 
investment adviser affiliates = 95 broker-dealers.
---------------------------------------------------------------------------

    In addition, we cannot quantify with precision the number of 
broker-dealers that would be new registrants with the Commission under 
the Advisers Act if the Commission adopts its proposed interpretation 
of section 202(a)(11)(C) of the Advisers Act concerning broker-dealers 
that hold themselves out as financial planners. Based on information 
submitted by broker-dealers on Form BD, approximately 40 percent of all 
broker-dealer firms engage exclusively in specialized types of broker-
dealer activities that are extremely unlikely to involve any financial 
planning activities.\167\ Of the approximately 3,850 remaining broker-
dealers that engage in types of broker-dealer activities that might 
involve financial planning, approximately 900 are already dually-
registered as investment advisers, and approximately 1,000 others are 
affiliated with investment advisers and could shift financial planning 
clients to the affiliates instead of registering. We do not collect 
data that would allow us to determine how many of the remaining 1,950 
broker-dealers hold themselves out as financial planners. For purposes 
of the following analysis, we estimate that 10 percent of these firms, 
or 195 broker-dealers, hold themselves out as financial planners.\168\ 
Further, for purposes of the following analysis, we estimate that 
approximately half of these 195 broker-dealers would find that the 
costs of registration outweigh the benefits to the firm of holding 
themselves out as financial planners, and would cease doing so. Thus, 
for purposes of this analysis, we have estimated 100 new firms would be 
required to register with the SEC as investment advisers as a result of 
the proposed interpretation.
---------------------------------------------------------------------------

    \167\ See supra note 162.
    \168\ Among dually-registered broker-dealers, only one-third 
report providing financial planning services (although this does not 
necessarily mean that they also hold themselves out as financial 
planners). See supra note 145. Applying the same ratio to these 
remaining 1,950 broker-dealers would yield 650 firms, but it seems 
likely the ratio would be significantly lower for firms that are not 
dual registrants, and even lower for those that hold themselves out 
as financial planners. Accordingly, for this analysis, we estimate 
that 10 percent of these 1,950 broker-dealers hold themselves out as 
financial planners.
---------------------------------------------------------------------------

    We request comment on the number of broker-dealers that would be 
subject to the applicable collections of information as a result of 
proposed rule 202(a)(11)-1(b) and the Commission's proposed 
interpretation of section 202(a)(11)(C) of the Advisers Act.\169\
---------------------------------------------------------------------------

    \169\ For purposes of the following analyses, we have assumed 
that all 195 of these broker-dealers will register with the 
Commission. However, some may be ineligible to register with us as a 
result of section 203A of the Advisers Act [15 U.S.C. 80b-3A], which 
generally prohibits investment advisers from registering with the 
Commission unless they have at least $25 million of client assets 
under management. We request public comment on how many of these 
broker-dealers will be ineligible to register with the Commission.
---------------------------------------------------------------------------

1. Form ADV
    Form ADV is the investment adviser registration form. The 
collection of information under Form ADV is necessary to provide 
advisory clients, prospective clients, and the Commission with 
information about the adviser, its business, and its conflicts of 
interest. Rule 203-1 requires every person applying for investment 
adviser registration with the Commission to file Form ADV. Rule 204-1 
requires each SEC-registered adviser to file amendments to Form ADV at 
least annually, and requires advisers to submit electronic filings 
through the IARD. This collection of information is found at 17 CFR 
275.203-1, 275.204-1, and 279.1. The currently approved collection of 
information in Form ADV is 102,653 hours.\170\ We estimate that 195 new 
respondents will file one complete Form ADV and one amendment annually, 
and comply with Form ADV requirements relating to delivery of the 
adviser code of ethics. Accordingly, we estimate the proposed rule and 
interpretation would increase the annual aggregate information 
collection burden under Form ADV by 5,840 hours \171\ for a total of 
108,493 hours.
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    \170\ We have previously submitted to OMB a request to increase 
the number of respondents to this collection. See Registration Under 
the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers 
Act Release No. 2333 (Dec. 2, 2004) [69 FR 72,054 (Dec. 10, 2004)]. 
OMB has not yet approved this request.
    \171\ 195 filings of the complete form at 22.25 hours each, plus 
195 amendments at 0.75 hours each, plus 6.7 hours for each of the 
195 broker-dealer/advisers to deliver copies of their codes of 
ethics to 10 percent of their 670 clients annually who request it, 
at 0.1 hours per response. (195 x 22.25) + (195 x 0.75) + (195 x 
(670 x 0.1) x 0.1) = 5,840.
---------------------------------------------------------------------------

2. Form ADV-W and Rule 203-2
    Rule 203-2 requires every person withdrawing from investment 
adviser registration with the Commission to file Form ADV-W. The 
collection of information is necessary to apprise the Commission of 
advisers who are no longer operating as registered advisers. This 
collection of information is found at 17 CFR 275.203-2 and 17 CFR 
279.2. The currently approved collection of information in Form ADV-W 
is 578 hours. We estimate that the 195 broker-dealer/advisers that 
would be new registrants will withdraw from SEC registration at a rate 
of approximately 16 percent per year, the same rate as other registered 
advisers, and will file for partial and full withdrawals at the same 
rates as other registered advisers, with approximately half of the 
filings being full withdrawals and half being partial withdrawals. 
Accordingly, we estimate the proposed rule and interpretation would 
increase the annual aggregate information collection burden under

[[Page 2737]]

Form ADV-W and rule 203-2 by 16 hours \172\ for a total of 594 hours.
---------------------------------------------------------------------------

    \172\ 32 filings (195 x 0.16), consisting of 16 full withdrawals 
at 0.75 hours each and 16 partial withdrawals at 0.25 hours each. 
(16 x 0.75) + (16 x 0.25) = 16.
---------------------------------------------------------------------------

3. Rule 203-3 and Form ADV-H
    Rule 203-3 requires that advisers requesting either a temporary or 
continuing hardship exemption submit the request on Form ADV-H. An 
adviser requesting a temporary hardship exemption is required to file 
Form ADV-H, providing a brief explanation of the nature and extent of 
the temporary technical difficulties preventing it from submitting a 
required filing electronically. Form ADV-H requires an adviser 
requesting a continuing hardship exemption to indicate the reasons the 
adviser is unable to submit electronic filings without undue burden and 
expense. Continuing hardship exemptions are available only to advisers 
that are small entities. The collection of information is necessary to 
provide the Commission with information about the basis of the 
adviser's hardship. This collection of information is found at 17 CFR 
275.203-3, and 279.3. The currently approved collection of information 
in Form ADV-H is 11 hours. We estimate that approximately one broker-
dealer/adviser among the new registrants would file for a temporary 
hardship exemption and one would file for a continuing exception. 
Accordingly, we estimate the proposed rule and interpretation would 
increase the annual aggregate information collection burden under Form 
ADV-H and rule 203-3 by 2 hours \173\ for a total of 13 hours.
---------------------------------------------------------------------------

    \173\ 2 filings at 1 hour each.
---------------------------------------------------------------------------

4. Form ADV-NR
    Non-resident general partners or managing agents of SEC-registered 
investment advisers must make a one-time filing of Form ADV-NR with the 
Commission. Form ADV-NR requires these non-resident general partners or 
managing agents to furnish us with a written irrevocable consent and 
power of attorney that designates the Commission as an agent for 
service of process, and that stipulates and agrees that any civil suit 
or action against such person may be commenced by service of process on 
the Commission. The collection of information is necessary for us to 
obtain appropriate consent to permit the Commission and other parties 
to bring actions against non-resident partners or agents for violations 
of the federal securities laws. This collection of information is found 
at 17 CFR 279.4. The currently approved collection of information in 
Form ADV-NR is 17 hours. We estimate that approximately one broker-
dealer/adviser among the new registrants would make this filing. 
Accordingly, we estimate the proposed rule and interpretation would 
increase the annual aggregate information collection burden under Form 
ADV-NR by one hour \174\ for a total of 18 hours.
---------------------------------------------------------------------------

    \174\ 1 filing at 1 hour each.
---------------------------------------------------------------------------

5. Rule 204-2
    Rule 204-2 requires SEC-registered investment advisers to maintain 
copies of certain books and records relating to their advisory 
business. The collection of information under rule 204-2 is necessary 
for the Commission staff to use in its examination and oversight 
program. Responses provided to the Commission in the context of its 
examination and oversight program are generally kept confidential.\175\ 
The records that an adviser must keep in accordance with rule 204-2 
must generally be retained for not less than five years.\176\ This 
collection of information is found at 17 CFR 275.204-2. The currently 
approved collection of information for rule 204-2 is 1,724,870 hours, 
or 191.78 hours per registered adviser. We estimate that all 195 
broker-dealer/advisers that would be new registrants would maintain 
copies of records under the requirements of rule 204-2. Accordingly, we 
estimate the proposed rule and interpretation would increase the annual 
aggregate information collection burden under rule 204-2 by 37,397 
hours \177\ for a total of 1,762,267 hours.
---------------------------------------------------------------------------

    \175\ See section 210(b) of the Advisers Act [15 U.S.C. 80b-
10(b)].
    \176\ See rule 204-2(e).
    \177\ 195 broker-dealer/advisers x 191.78 hours per adviser = 
37,397 hours.
---------------------------------------------------------------------------

6. Rule 204-3
    Rule 204-3, the ``brochure rule,'' requires an investment adviser 
to deliver to prospective clients a disclosure statement containing 
specified information as to the business practices and background of 
the adviser. Rule 204-3 also requires that an investment adviser 
deliver, or offer, its brochure on an annual basis to existing clients 
in order to provide them with current information about the adviser. 
The collection of information is necessary to assist clients in 
determining whether to retain, or continue employing, the adviser. This 
collection of information is found at 17 CFR 275.204-3. The currently 
approved collection of information for rule 204-3 is 6,089,293 hours, 
or 694 hours per registered adviser, assuming each adviser has on 
average 670 clients. We estimate that all 195 broker-dealer/advisers 
that would be new registrants will provide brochures as required by 
rule 204-3. Accordingly, we estimate the proposed rule and 
interpretation would increase the annual aggregate information 
collection burden under rule 204-3 by 135,330 hours \178\ for a total 
of 6,224,623 hours. We note that the average number of clients per 
adviser reflects a small number of advisers who have thousands of 
clients, while the typical SEC-registered adviser has approximately 76 
clients. We request comments on the number of advisory clients of the 
average broker-dealer registering because the firm maintains 
discretionary brokerage accounts for customers or holds itself out to 
its financial planning customers.
---------------------------------------------------------------------------

    \178\ 195 broker-dealer/advisers x 694 hours per adviser = 
135,330.
---------------------------------------------------------------------------

7. Rule 204A-1
    Rule 204A-1 requires SEC-registered investment advisers to adopt 
codes of ethics setting forth standards of conduct expected of their 
advisory personnel and addressing conflicts that arise from personal 
securities trading by their personnel, and requiring advisers' ``access 
persons'' to report their personal securities transactions. The 
collection of information under rule 204A-1 is necessary to establish 
standards of business conduct for supervised persons of investment 
advisers and to facilitate investment advisers' efforts to prevent 
fraudulent personal trading by their supervised persons. This 
collection of information is found at 17 CFR 275.204A-1. The currently 
approved collection of information for rule 204A-1 is 1,060,842 hours, 
or 117.95 hours per registered adviser. We estimate that all 195 
broker-dealer/advisers that would be new registrants will adopt codes 
of ethics under the requirements of rule 204A-1 and require personal 
securities transaction reporting by their ``access persons.'' 
Accordingly, we estimate the proposed rule and interpretation would 
increase the annual aggregate information collection burden under rule 
204A-1 by 23,000 hours \179\ for a total of 1,083,842 hours.
---------------------------------------------------------------------------

    \179\ 195 broker-dealer/advisers x 117.95 hours per adviser 
annually = 23,000.
---------------------------------------------------------------------------

8. Rule 206(4)-3
    Rule 206(4)-3 requires advisers who pay cash fees to persons who 
solicit clients for the adviser to observe certain procedures in 
connection with solicitation activity. The collection of

[[Page 2738]]

information under rule 206(4)-3 is necessary to inform advisory clients 
about the nature of a solicitor's financial interest in the 
recommendation of an investment adviser, so the client may consider the 
solicitor's potential bias, and to protect investors against 
solicitation activities being carried out in a manner inconsistent with 
the adviser's fiduciary duties. This collection of information is found 
at 17 CFR 275.206(4)-3. The currently approved collection of 
information for rule 206(4)-3 is 12,355 hours. We estimate that 
approximately 20 percent of the 195 broker-dealer/advisers that would 
be new registrants would be subject to the cash solicitation rule, the 
same rate as other registered advisers. Accordingly, we estimate the 
proposed rule and interpretation would increase the annual aggregate 
information collection burden under rule 206(4)-3 by 275 hours \180\ 
for a total of 12,630 hours.
---------------------------------------------------------------------------

    \180\ 39 respondents (195 x 0.2) x 7.04 hours annually per 
respondent = 275.
---------------------------------------------------------------------------

9. Rule 206(4)-4
    Rule 206(4)-4 requires registered investment advisers to disclose 
to clients and prospective clients certain disciplinary history or a 
financial condition that is reasonably likely to affect contractual 
commitments. This collection of information is necessary for clients 
and prospective clients in choosing an adviser or continuing to employ 
an adviser. This collection of information is found at 17 CFR 
275.206(4)-4. The currently approved collection of information for rule 
206(4)-4 is 11,383 hours. We estimate that approximately 17.3 percent 
of the 195 broker-dealer/advisers that would be new registrants would 
be subject to rule 206(4)-4, the same rate as other registered 
advisers. Accordingly, we estimate the proposed rule and interpretation 
would increase the annual aggregate information collection burden under 
rule 206(4)-4 by 255 hours \181\ for a total of 11,638 hours.
---------------------------------------------------------------------------

    \181\ 34 respondents (195 x 0.173) x 7.5 hours annually per 
respondent = 255.
---------------------------------------------------------------------------

10. Rule 206(4)-6
    Rule 206(4)-6 requires an investment adviser that votes client 
securities to adopt written policies reasonably designed to ensure that 
the adviser votes in the best interests of clients, and requires the 
adviser to disclose to clients information about those policies and 
procedures. This collection of information is necessary to permit 
advisory clients to assess their adviser's voting policies and 
procedures and to monitor the adviser's performance of its voting 
responsibilities. This collection of information is found at 17 CFR 
275.206(4)-6. The currently approved collection of information for rule 
206(4)-6 is 119,873 hours. We estimate that all 195 broker-dealer/
advisers that would be new registrants would vote their clients' 
securities. Accordingly, we estimate the proposed rule and 
interpretation would increase the annual aggregate information 
collection burden under rule 206(4)-6 by 3,257 hours \182\ for a total 
of 123,130 hours.
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    \182\ We estimate that 195 broker-dealer/advisers would spend 10 
hours each annually documenting their voting policies and 
procedures, and would provide copies of those policies and 
procedures to 10 percent of their 670 clients annually at 0.1 hours 
per response. (195 x 10) + 195 x (0.1 x 67) = 3,257.
---------------------------------------------------------------------------

11. Rule 206(4)-7
    Rule 206(4)-7 requires each registered investment adviser to adopt 
and implement written policies and procedures reasonably designed to 
prevent violations of the Advisers Act, review those policies and 
procedures annually, and designate an individual to serve as chief 
compliance officer. This collection of information under rule 206(4)-7 
is necessary to ensure that investment advisers maintain comprehensive 
internal programs that promote the advisers' compliance with the 
Advisers Act. This collection of information is found at 17 CFR 
275.206(4)-7. The currently approved collection of information for rule 
206(4)-7 is 701,200 hours, or 80 hours annually per registered adviser. 
We estimate all 195 broker-dealer/advisers that would be new 
registrants would be required to maintain compliance programs under 
rule 206(4)-7. Accordingly, we estimate the proposed rule and 
interpretation would increase the annual aggregate information 
collection burden under rule 206(4)-7 by 15,600 hours \183\ for a total 
of 716,800 hours.
---------------------------------------------------------------------------

    \183\ 195 broker-dealer/advisers at 80 hours per adviser 
annually = 15,600.
---------------------------------------------------------------------------

12. Request for Comment
    Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits 
comments with respect to the collections described in Section VII.B. of 
this Release to:
     Evaluate whether the proposed collections of information 
are necessary for the proper performance of the functions of the 
Commission, including whether the information will have practical 
utility;
     Evaluate the accuracy of the Commission's estimate of the 
burden of the proposed collections of information;
     Determine whether there are ways to enhance the quality, 
utility, and clarity of the information to be collected; and
     Determine whether there are ways to minimize the burden of 
the collections of information on those who are to respond, including 
through the use of automated collection techniques or other forms of 
information technology.
    Persons wishing to submit comments on the collection of information 
requirements described in Section VII.B. of this Release should direct 
them to the Office of Management and Budget, Attention: Desk Officer 
for the Securities and Exchange Commission, Office of Information and 
Regulatory Affairs, Room 3208, Washington, DC 20503, and also should 
send a copy to Jonathan G. Katz, Secretary, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-0609 with 
reference to File No. S7-25-99. OMB is required to make a decision 
concerning the collections of information between 30 and 60 days after 
publication, so a comment to OMB is best assured of having its full 
effect if OMB receives the comment within 30 days after publication of 
this release. Requests for materials submitted to OMB by the Commission 
with regard to these collections of information should be in writing, 
refer to File No. S7-25-99, and be submitted to the Securities and 
Exchange Commission, Records Management, Office of Filings and 
Information Services, 450 Fifth Street, NW., Washington, DC 20549.

VIII. Initial Regulatory Flexibility Analysis

    The Commission has prepared the following Initial Regulatory 
Flexibility Analysis (``IRFA'') in accordance with section 3(a) of the 
Regulatory Flexibility Act.\184\ It relates to proposed rule 
202(a)(11)-1, and to the Commission's proposal to interpret the 
application of the ``solely incidental to'' requirement of section 
202(a)(11)(C) of the Act to certain broker-dealer practices.
---------------------------------------------------------------------------

    \184\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------

A. Need for the Rule and Amendments

    Sections I through III of this Release describe the reasons for and 
objectives of proposed rule 202(a)(11)-1. As discussed in detail above, 
proposed rule 202(a)(11)-1(a) is designed to permit broker-dealers to 
offer new types of accounts, which charge asset-based fees for full-
service brokerage services or make discounts available for execution 
services, without unnecessarily triggering regulation under the 
Advisers

[[Page 2739]]

Act. Proposed rule 202(a)(11)-1(b) would subject all discretionary 
brokerage accounts to the Advisers Act. Under the proposed 
interpretation, the Commission would not consider broker-dealers 
holding themselves out as financial planners to be providing advice 
that is ``solely incidental to'' brokerage; these broker-dealers thus 
would be subject to the Investment Advisers Act with respect to 
accounts including a financial plan.

B. Objectives and Legal Basis

    Sections II through III of this Release discuss the objectives of 
the proposed rule and interpretation. As we discuss in detail above, 
these objectives include fostering the availability of fee-based and 
discount brokerage programs to brokerage customers and reducing 
investor confusion as to whether they are receiving brokerage services 
or advisory services. Section IX of this Release lists the statutory 
authority for the proposed rule and rule amendments.

C. Small Entities

    The proposed rule and interpretation under the Advisers Act would 
apply to all brokers-dealers registered with the Commission, including 
small entities. Under Commission rules, for purposes of the Regulatory 
Flexibility Act, a broker-dealer generally is a small entity if it had 
total capital (net worth plus subordinated liabilities) of less than 
$500,000 on the date in the prior fiscal year as of which its audited 
financial statements were prepared and it is not affiliated with any 
person (other than a natural person) that is not a small entity.\185\
---------------------------------------------------------------------------

    \185\ 17 CFR 240.0-10(c).
---------------------------------------------------------------------------

    The Commission estimates that as of December 31, 2003, 
approximately 905 Commission-registered broker-dealers were small 
entities.\186\ The Commission assumes for purposes of this IRFA that 
all of these small entities could rely on the exceptions provided by 
rule 202(a)(11)-1(a), although it is not clear how many would actually 
do so. Additionally, it is not clear how many of these small entities 
would be affected by proposed rule 202(a)(11)-1(b), which provides that 
discretionary brokerage accounts are not exempt from the Advisers Act, 
or by the proposed interpretation of section 202(a)(11)(C), which would 
subject broker-dealers that hold themselves out as financial planners 
to the Advisers Act with respect to accounts including a financial 
plan. Therefore, for purposes of this IRFA, the Commission also assumes 
that all of these small entities could be affected by the proposed rule 
and interpretation.
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    \186\ This estimate is based on the most recent data available, 
taken from information provided by broker-dealers in Form X-17A-5 
Financial and Operational Combined Uniform Single Reports filed 
pursuant to Section 17 of the Exchange Act and Rule 17a-5 
thereunder.
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D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements

    The provisions of proposed rule 202(a)(11)-1(a), pertaining to the 
new types of brokerage accounts, would impose no new reporting or 
recordkeeping requirements, and would not materially alter the time 
required for broker-dealers to comply with the Commission's rules. 
Proposed rule 202(a)(11)-1(a) is designed to prevent unnecessary 
regulatory burdens from being imposed on broker-dealers. Broker-dealers 
taking advantage of the proposed rule with respect to fee-based 
brokerage accounts would be required to make certain disclosures to 
customers and potential customers in advertising and contractual 
materials. Under Exchange Act rules, however, broker-dealers are 
already required to maintain these documents as ``written agreements * 
* * with respect to any account.''\187\
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    \187\ 17 CFR 240.17a-4(b)(7). As previously discussed, although 
proposed rule 202(a)(11)-1(a) would also limit its application to 
accounts that a broker-dealer does not exercise investment 
discretion over, under Exchange Act rules, broker-dealers are 
already currently required to maintain all ``evidence of the 
granting of discretionary authority given in any respect of any 
account.'' 17 CFR 240.17a-4(b)(6). Thus, this provision of the 
proposed rule would not create an additional recordkeeping 
requirement for broker-dealers.
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    Under proposed rule 202(a)(11)-1(b), advice provided by a broker-
dealer to accounts over which it has investment discretion would be 
outside the broker-dealer exception from the Advisers Act. Under the 
proposed interpretation of section 202(a)(11)(C), broker-dealers that 
hold themselves out as financial planners would be subject to the 
Advisers Act with respect to financial planning clients. Thus, broker-
dealers providing discretionary advice or holding themselves out as 
financial planners would be subject to the Advisers Act. Although some 
broker-dealers providing discretionary accounts or holding themselves 
out as financial planners are already registered as investment 
advisers, the proposed rule and interpretation would result in other 
broker-dealers having to newly register as advisers, and would subject 
these brokers to the reporting, recordkeeping, and other compliance 
requirements under the Advisers Act.\188\ For these broker-dealers, 
registration under the Advisers Act and compliance with its 
requirements would constitute new reporting, recordkeeping, and other 
compliance requirements. For broker-dealers already registered as 
investment advisers, the proposed rule and interpretation would require 
that broker-dealers treat affected accounts as advisory accounts. Thus, 
for these broker-dealers, the proposed rule and interpretation would 
impose new reporting, recordkeeping, and other compliance requirements 
with respect to these accounts.
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    \188\ For Paperwork Reduction Act purposes, we have estimated 
that approximately 195 broker-dealers could be required to register 
as investment advisers as a result of the proposed rule and 
interpretation. See supra Section VII.B. of this Release.
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    Small entities registered with the Commission as broker-dealers 
would be subject to these new reporting, recordkeeping, and other 
compliance requirements to the same extent as larger broker-dealers. In 
developing these requirements over the years, we have analyzed the 
extent to which they would have a significant impact on a substantial 
number of small entities, and included flexibility wherever possible in 
light of the requirements' objectives, to reduce the corresponding 
burdens imposed.

E. Duplicative, Overlapping, or Conflicting Federal Rules

    The Commission believes that there are no rules that duplicate or 
conflict with the proposed rule or interpretation.

F. Significant Alternatives

    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that would accomplish the stated objectives, 
while minimizing any adverse impact on small entities.\189\ In 
connection with the proposed rule, the Commission considered the 
following alternatives: (i) The establishment of differing compliance 
or reporting requirements or timetables that take into account the 
resources available to small entities; (ii) the clarification, 
consolidation, or simplification of compliance and reporting 
requirements under the rule for such small entities; (iii) the use of 
performance rather than design standards; and (iv) an exemption from 
coverage of the rule, or any part thereof, for such small entities.
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    \189\ 5 U.S.C. 603(c).
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    With respect to the first alternative, the Commission presently 
believes that establishment of differing compliance or reporting 
requirements or timetables for small entities would be inappropriate in 
these circumstances. The provision of proposed rule 202(a)(11)-1(a) 
requiring prominent disclosures to customers and potential customers is 
designed to

[[Page 2740]]

prevent investors from being confused about the nature of the services 
they are receiving. To specify less prominent disclosures for small 
entities would only serve to diminish this investor protection to 
customers of small broker-dealers. Such a course would be inconsistent 
with the purposes of the Advisers Act. With respect to rule 202(a)(11)-
1(b) and the proposed interpretation of section 202(a)(11)(C), the 
compliance and recordkeeping requirements are those generally 
applicable to any adviser registered under the Act. In developing these 
requirements over the years, the Commission has analyzed the extent to 
which they would have a significant impact on a substantial number of 
small entities, and included flexibility wherever possible in light of 
the requirements' objectives, to reduce the corresponding burdens 
imposed. It would be inconsistent with this design, and contrary to its 
purpose, to create special rules for small broker-dealers who would be 
subject to the Act as a result of proposed rule 202(a)(11)-1(b) or the 
proposed interpretation of section 202(a)(11)(C).
    With respect to the second alternative, the Commission presently 
believes that clarification, consolidation, or simplification of the 
compliance and recordkeeping requirements under proposed rule 
202(a)(11)-1 for small entities unacceptably compromises the investor 
protections of the rule. As discussed above, the rule's prominent 
disclosure requirement is designed to prevent investor confusion. We 
believe this requirement is already adequately clear and simple for 
those seeking to make use of the rule's exception for fee-based 
accounts. To further consolidate this requirement would potentially 
impede our objective of preventing investor confusion. With respect to 
rule 202(a)(11)-1(b) and the proposed interpretation of section 
202(a)(11)(C), clarification, consolidation, or simplification would 
involve modification of the compliance and recordkeeping requirements 
generally applicable to registered investment advisers under the Act. 
As discussed above in connection with the first alternative, the 
Commission, in developing these requirements over the years, has 
included as much flexibility as can be introduced in light of the 
investor protection objectives underlying them.
    With respect to the third alternative, the Commission presently 
believes that the compliance requirements contained in the proposed 
rule and the proposed interpretation already appropriately use 
performance standards instead of design standards. The proposed rule 
and interpretation are crafted to make regulation under the Advisers 
Act turn on the services offered by a broker-dealer rather than 
strictly on the type of compensation involved. Thus, eligibility for 
proposed rule 202(a)(11)-1(a)'s exception hinges on the services 
offered by the broker-dealer. Likewise, the treatment of discretionary 
accounts as advisory accounts under proposed rule 202(a)(11)-1(b), as 
well as the treatment of financial planning under the proposed 
``holding out'' interpretation of section 202(a)(11)(C), also focus on 
the activities offered. The reporting, recordkeeping, and other 
compliance requirements stemming from these provisions of the proposed 
rule and interpretation are triggered by the performance of the entity 
in question, including small businesses.
    Finally, with respect to the fourth alternative, the Commission 
presently believes that exempting small entities would be 
inappropriate. To the extent proposed rule 202(a)(11)-1(a) eliminates 
unnecessary regulatory burdens that might otherwise be imposed on 
broker-dealers, small entities, as well as large entities, will benefit 
from the rule. Small broker-dealers should be permitted to enjoy this 
benefit to the same extent as larger broker-dealers. Furthermore, the 
Commission believes the provisions of proposed rule 202(a)(11)-1(b) 
concluding that broker-dealers providing discretionary brokerage may 
not rely on the Adviser Act's broker-dealer exception for those 
accounts, and the proposed interpretation of section 202(a)(11)(C) that 
broker-dealers holding themselves out as financial planners may not 
rely on the exception with respect to accounts that include a financial 
plan, should apply to small entities to the same extent as larger ones. 
This proposed provision and interpretation are grounded in the view 
that such advice is not solely incidental to brokerage. Because the 
protections of the Advisers Act are intended to apply equally to 
clients of both large and small advisory firms, it would be 
inconsistent with the purposes of the Advisers Act to exempt small 
entities further from the rule.

IX. Statutory Authority

    We are proposing rule 202(a)(11)-1 based on our authority set forth 
in section 202(a)(11)(F) of the Advisers Act, which expressly allows 
the Commission to except persons--in addition to those already excepted 
by sections 202(a)(11)(A)-(E)--that the definition of investment 
adviser was not intended to cover.\190\ We are also acting pursuant to 
section 211(a) of the Advisers Act, which gives us the authority to 
classify, by rule, persons and matter within our jurisdiction and to 
prescribe different requirements for different classes of persons, as 
necessary or appropriate to the exercise of our authority under the 
Act. Additionally, section 206A of the Advisers Act authorizes us, by 
rules and regulations, to exempt any person or transaction, or any 
class or classes of persons or transactions, from any provision or 
provisions of the Act or of any rule or regulation thereunder, if such 
exemption is necessary or appropriate in the public interest and 
consistent with the protection of investors and the purposes of the 
Act.
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    \190\ Because we are proposing to use our authority under 
section 202(a)(11)(F), broker-dealers relying on the rule would not 
be subject to state adviser statutes. Section 203A(b)(1)(B) of the 
Act provides that ``[n]o law of any State or political subdivision 
thereof requiring the registration, licensing, or qualification as 
an investment adviser or supervised person of an investment adviser 
shall apply to any person * * * that is not registered under [the 
Advisers Act] because that person is excepted from the definition of 
an investment adviser under section 202(a)(11).'' (emphasis added).
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Text of Rule

List of Subjects in 17 CFR Part 275

    Investment advisers, Reporting and recordkeeping requirements.

    For the reasons set out in the preamble, Title 17, Chapter II of 
the Code of Federal Regulations is proposed to be amended as follows:

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

    1. The authority citation for Part 275 continues to read as 
follows:

    Authority: 15 U.S.C. 80b-2(a)(11)(F), 80b-2(a)(17), 80b-3, 80b-
4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless otherwise noted.
* * * * *
    2. Section 275.202(a)(11)-1 is added to read as follows:


Sec.  275.202(a)(11)-1  Certain broker-dealers.

    (a) A broker or dealer registered with the Commission under section 
15 of the Securities Exchange Act of 1934 (15 U.S.C. 78o) (the 
``Exchange Act''):
    (1) Will not be deemed to be an investment adviser based solely on 
its receipt of special compensation, provided that:
    (i) The broker or dealer does not exercise investment discretion, 
as that term is defined in section 3(a)(35) of the Exchange Act (15 
U.S.C. 78c(a)(35)), over accounts from which it receives special 
compensation;

[[Page 2741]]

    (ii) Any investment advice provided by the broker or dealer with 
respect to accounts from which it receives special compensation is 
solely incidental to the brokerage services provided to those accounts; 
and
    (iii) Advertisements for, and contracts, agreements, applications 
and other forms governing, accounts for which the broker or dealer 
receives special compensation include a prominent statement that the 
accounts are brokerage accounts and not advisory accounts; that, as a 
consequence, the customer's rights and firm's duties and obligations to 
the customer, including the scope of the firm's fiduciary obligations, 
may differ; and must identify an appropriate person at the firm with 
whom the customer can discuss the differences.
    (2) Will not be deemed to have received special compensation solely 
because the broker or dealer charges a commission, mark-up, mark-down 
or similar fee for brokerage services that is greater than or less than 
one it charges another customer.
    (b) A broker or dealer that exercises investment discretion, as 
that term is defined in section 3(a)(35) of the Exchange Act (15 U.S.C. 
78c(a)(35)), over customer accounts provides advice that is not solely 
incidental to the conduct of its business as a broker or dealer within 
the meaning of section 202(a)(11)(C) of the Advisers Act (15 U.S.C 80b-
2(a)(11)(C)).
    (c) A broker or dealer registered with the Commission under section 
15 of the Exchange Act is an investment adviser solely with respect to 
those accounts for which it provides services or receives compensation 
that subject the broker or dealer to the Advisers Act.

    Dated: January 6, 2005.

    By the Commission.
J. Lynn Taylor,
Assistant Secretary.
[FR Doc. 05-603 Filed 1-13-05; 8:45 am]
BILLING CODE 8010-01-P