Responding to competition from online brokers, some traditional brokers are now allowing clients a choice of how they want to pay for services. Instead of insisting that investors pay a commission fee for every trade they make, some brokers are allowing clients to pay them with a percentage of their assets in their accounts.
In fact, a group of professionals in the brokerage industry identified asset-based fees as one of the industry’s best practices in a study it conducted for the U.S. Securities and Exchange Commission in 1994.
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Under current laws, however, the asset-based fee arrangement may automatically qualify the broker as an “investment adviser,” and therefore make him or her subject to the Investment Adviser Act of 1940, a law that carries a slew of regulations.
That quirk in the law should be changed, according to SEC Chairman Arthur Levitt, who argues that those brokers should not be subject to these regulations just because they are moving toward an alternative fee system – a system Levitt and others happen to believe is often better for both the broker and his or her clients.
Levitt and the commission are therefore proposing a new rule on when the adviser act is applied. Under the proposed rule, brokers who have the discretionary authority to trade on their clients’ behalf – without obtaining their permission for every trade – would be considered advisers and would be subject to the advisement law.
Generally, those broker dealers who do not have discretion and cannot act on their client’s behalf would not be subject to the adviser’s act under the proposed rule.
Cynthia Fornelli, an attorney fellow in the SEC’s Division of Investment Management, defined it this way: “If a broker can pull the trigger and buy or sell without the clients’ expressed permission ahead of time, he or she has discretion.”
Levitt said he believes the rule change will make it possible for brokers to offer the asset-based fee system without undue weight of regulatory pressure. At the same time, it would make it clear who counts as an investment adviser and who does not.
“This proposal represents a sensible way to allow full-service brokerage firms to offer pricing choices to their customers without imposing unnecessary regulatory obstacles or sacrificing investor protection,” Levitt said in a statement. “Asset-based fee programs better align the interests of customers and their brokers.”
In the traditional commission system, the broker’s pay is based on the number and type of transactions his or her clients make. Some argue that this system creates a potential for a conflict of interest, since the broker earns a commission on each transaction, whether or not the move was a smart one for his or her client.
That is why Levitt and others believe the asset system aligns the interest of clients and brokers more effectively. Since the broker’s pay is based on the value of the investor’s account only, he or she has no incentive to urge clients to make moves that may not be wise.
The current investment adviser act defines an investment adviser as someone who is paid to tell people which securities they should buy and sell. But the law excludes broker-dealers who are paid by commission and receive no special compensation for the advice that they give. Historically, the SEC has used the term “special compensation” to mean any form of pay that is not a commission.
Levitt and the commission proposed the rule change the week of Nov. 5. It is now in the midst of a 60-day public comment period. After that, the commission will vote on whether the proposal will be enacted as a formal rule.
Fornelli said a number of brokers are changing how they price their services in response to competition from online brokerages. While the SEC is not advocating the end of commission-based fees, which may make sense for people who make only a few trades per year, it does want investors to have the choice of how they want to pay for services, Fornelli said.
“We’re not taking the position that clients are always better off going to an asset-based (system),” Fornelli said. But she added: “We think it’s good for clients to have a choice.”
But Fornelli added that she does not expect the proposed rule change to significantly alter the number of brokers who are affected by the investment adviser act, since the alternative fee programs now being offered by brokers are a relatively new concept.
“My guess is that it will pretty much maintain the status quo,” she said. “Most of those new asset-based fee programs are indeed new. I don’t anticipate a change one way or the other based on the rule.”
