B-Ds, advisory firms likely to clash on "principal trades"

The next battle over how brokerage and investment advisory firms should be regulated is likely to center on the issue of “principal trades.”

Brokers may push for further liberalization of a new rule allowing them to make trades from their own inventories for advisory clients, while some investment advisory firms may push to be allowed to make such trades, as well, industry observers predict.

“Investment advisers are going to say, "Why shouldn’t I be able to take advantage of this principal trading relief, too?’” said Hardy Callcott, a partner in the San Francisco office of Boston law firm Bingham McCutchen LLP. The Securities and Exchange Commission adopted a temporary rule Sept. 19 that allows brokerage firms that are dually registered as investment advisory firms to make principal trades in their fee-based advisory accounts.

The rule is scheduled to expire at the end of 2009.

Brokers are likely to argue that the relief granted by the SEC does not go far enough, said Mr. Callcott, a former assistant general counsel of the division of market regulation at the SEC and a former general counsel for Charles Schwab & Co. Inc. of San Francisco.

Indeed, the brokerage industry, which has long sought to have the principal-trading restrictions loosened, is likely to push for additional accommodations. “Longer term, I think even broader relief from [the principal-trading restrictions] would be appropriate,” said Michael Udoff, managing director and associate general counsel of the Securities Industry and Financial Markets Association of New York and Washington.

The principal-trading restrictions were enacted to try to prevent conflicts of interest by advisers, who are held to a fiduciary standard on behalf of clients. However, “when you consider the transparency of the markets today, the extensive oversight of the industry by the regulators, it’s hard to mess around with these transactions without it being noticed,” Mr. Udoff said.

Investment advisory firms are prohibited from making principal trades under the Investment Advisers Act of 1940 unless they get written permission from clients for each trade, which firms say makes it impractical. The SEC voted to relax those rules for dually registered firms in the wake of an appeals court decision last March rejecting fee-based brokerage accounts.

But the new rule applies only to non-discretionary accounts at firms that are registered as both broker-dealers and investment advisers. That could put investment advisory firms that are not dually registered at a disadvantage, especially investment advisory arms of larger financial services firms that have brokerage units, Mr. Callcott said.

In addition, he added, firms may argue that principal-trading relief should be applied to discretionary accounts, as well. Best-execution rules already apply to client accounts, he noted.

Principal trades are a major part of brokerage industry business, and the restrictions on transacting those trades from advisory accounts has been a driver behind the rise in fee-based brokerage, which accounted for about 1 million customers as of Oct. 1, when the accounts had to be shut down under the court ruling.

Under the “interim rule” adopted by the SEC, dually registered firms will be able to make principal trades in non-discretionary accounts provided the firms receive initial authorization from customers, and provided they get oral consent from customers whenever principal trades are made.

The requirement for oral consent for each trade could prove difficult for brokers. “On the broker side, [the SEC] will get comments saying, "This oral-reminder requirement doesn’t make any sense,’” Mr. Callcott said. “They’ll say it’s time-consuming and impractical.”

Already, the Financial Planning Association, which successfully sued the SEC to overturn the fee-based brokerage rule, is gearing up to fight against loosening the rules governing principal trades by investment advisory firms.

The Denver-based organization last week issued what it called in a release “a consumer-friendly bro-chure describing the potential looming problem with principal trading by brokers.” The brochure stated: “Principal trades represent a unique conflict of interest for the broker,” because brokerage firms usually make more money by selling securities from their own inventories.

Brokers could “dump” stocks or bonds that it doesn’t want, because of a potential decline in value, the FPA brochure said.

“So even if your broker recommends a principal trade that is suitable, it is not necessarily what is best for you,” it stated.

The SEC needs to be vigilant in tracking any conflicts of interest that arise from its new interim rule, said Duane Thompson, managing director of the FPA’s Washington office.

“A lot of the debate will center around any problems that are found with trading under the interim rule,” he said. “A lot of that will depend on how aggressive the SEC is in examining principal-trading practices.”

The SEC also should look for empirical data to show whether retail customers benefit from principal trades, Mr. Thompson said.

The rule could be extended beyond the two-year time period or even made permanent, some industry officials said.

At the Sept. 19 meeting, Paul Atkins and Kathleen Casey, commissioners for the SEC, indicated that there could be a need to ex-tend the rule or make it permanent (InvestmentNews, Sept. 24).

“For these controversial and multifaceted issues, particularly over the last few years, the SEC has shown it’s inclined to take a careful, measured approach,” said Steven Yadegari, general counsel and chief legal officer of New York investment advisory firm Cramer Rosenthal McGlynn LLC.

“That’s why this provision will run through 2009, and there’s a possibility it may be extended,” he said. “The permanent measure may re-semble the interim rule.”

Other industry officials believe that the debate over how brokers and advisers should be regulated has advanced little since the SEC in 1999 first issued its controversial rule exempting brokers from registering as advisers for fee-based accounts.

“With this recent action, we’re not that much further along the road than we were eight years ago,” commented David Tittsworth, executive director of the Investment Adviser Association in Washington, which represents federally registered advisory firms.

“The principal-trading restrictions are in the Advisers Act for a reason,” Mr. Tittsworth said. “You want to prevent self-dealing.”

A study being conducted for the SEC by the RAND Corp. of Santa Monica, Calif., on the differences between broker-dealer and investment advisory recommendations, which will be completed by yearend, could “lay the groundwork for more dramatic change,” Mr. Tittsworth said.

Sara Hansard can be reached at [email protected].