DC Circuit Vacates SEC Rule Dealing with Scope of Exemption under Advisers Act for Broker-Dealer Activities

March 30, 2007

Earlier today (March 30, 2007), the United States Court of Appeals for the District of Columbia Circuit vacated Rule 202(a)(11)-1 under the Investment Advisers Act of 1940 (the “Advisers Act”). The Rule, which was adopted by the Securities and Exchange Commission in its current form in 2005, generally provided that a broker-dealer would not be deemed an investment adviser subject to Advisers Act registration if the broker-dealer (i) did not charge a separate fee or have a separate contract for the advice, have investment discretion or offer certain financial planning services and (ii) received asset-based or similar compensation for advisory services that was solely incidental to the broker-dealer’s brokerage services. The Rule also provided that a broker-dealer would not be deemed an adviser solely because it charged one brokerage customer a different fee than another (for example, due to the difference in fees between fee-based brokerage programs and discount brokerage).

The Rule sought to address difficulties in the application of Advisers Act Section 202(a)(11)(C) in light of the movement away from fixed commission rates. That section provides an exception from the definition of “investment adviser” under the Advisers Act for broker-dealers who provide investment advice to customers (i) that is “solely incidental to the conduct of his business as a broker or dealer” and (ii) for which such broker-dealer does not receive any “special compensation.” However, brokers offering full-service brokerage services for an asset-based fee or charging a different fee for discount brokerage could be deemed to be receiving “special compensation” and thus be considered investment advisers for purposes of the Advisers Act. The SEC determined that the fee-based programs “do not differ fundamentally from traditional brokerage programs” and adopted the Rule to ensure that such programs would not result in a broker-dealer being deemed an adviser. The SEC claimed authority under Advisers Act Section 202(a)(11)(F), which excepts from the “investment adviser” definition “such other persons not within the intent of [Section 202(a)(11)], as the Commission may designate by rules and regulations or order,” and its general rule-making authority under Advisers Act Section 211(a).

In vacating the Rule, the Court found that the SEC did not have authority to broaden the exception from the definition of “investment adviser” for broker-dealers under Section 202(a)(11)(C). The Court concluded that “the text of subsections (C) and (F) is unambiguous” and that Congress intended subsection (C) to be a “precise exemption” from the adviser definition applicable to all broker-dealers. Accordingly, “because broker-dealers are already expressly addressed in subsection (C), they are not ’other persons’ under subsection (F)” and the SEC cannot use such authority “to establish new, broader exemptions for broker-dealers.” In addition, the Court noted that the SEC’s general rule-making authority under Section 211(a) could not ignore the requirements of subsections (C) and (F).

The Court’s decision may result in many broker-dealers having to register as investment advisers under the Advisers Act unless the SEC appeals the decision or takes other action.

The Court’s opinion (Financial Planning Assoc. v. SEC, No. 04-1242) is attached.

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