SEC to ‘seriously consider’ expanding principal-trade rule

The Securities and Exchange Commission is considering whether to expand the controversial principal-trade rule it adopted in September to include advisory firms affiliated with brokers.

The SEC’s position concerns state regulators and financial advisers who think that expanding the rule to include advisory firms would not be in the best interests of investors.

In a mid-October speech in New York, Andrew “Buddy” Donohue, the director of the agency’s division of investment management, assured members of the Money Management Institute that he would “seriously consider” expanding the interim final rule.

The temporary rule, which expires in 2010, loosens restrictions that have been in place for nearly 70 years on investment advisory firms’ selling clients securities owned by those firms. That practice, known as principal trading, has long been a backbone of the brokerage business. Some broker-dealers have separated their investment advisory business from the brokerage firms for reasons of liability.

The rule was proposed by the SEC to permit dually registered broker-dealer/investment advisory firms to make -principal trades for their non–discretionary accounts with fewer restrictions than in the past.

It came in response to an appeals court decision last March that made fee-based brokerage accounts illegal.

In addition, expanding the relief to include discretionary advisory accounts, such as separately managed accounts, will be considered, Mr. Donohue said. The Washington-based MMI is a trade organization for SMAs.

“Part of what we look for when we have new rules that come out … is to get good comment from a lot of different areas so we have a sense of whether or not we’ve accomplished what we should or whether, in this case, it goes far enough,” Mr. Donohue said in an interview.

His speech, coupled with re-marks Commissioners Paul Atkins and Kathleen Casey made at the September SEC meeting about ex-tending the sunset date of the rule or making it permanent, are being read as an encouragement to brokerage firms that would like to see a broadening of the rule.

“It doesn’t shock me that some people would like to see this thing expanded,” said David Tittsworth, executive director of the Investment Adviser Association in Washington. The IAA, which represents federally registered advisory firms, wants to see the rule applied narrowly rather than expanded.

Michael Udoff, associate general counsel of the Securities Industry and Financial Markets Association of New York and Washington, thinks it’s a good idea to consider expanding the rule to include advisory firms. “There are some smaller broker-dealers that may not be dually registered,” he said. For those firms, the cost of registering their brokers and hiring a chief compliance officer could be a burden, Mr. Udoff said.

Furthermore, he doesn’t believe that the discretionary-account requirement is necessary. The fee-based brokerage accounts eliminated by the decision of the U.S. Court of Appeals for the District of Columbia Circuit were non- discretionary, and the new rule still requires that clients be contacted orally before a principal trade is conducted, Mr. Udoff noted.

State regulators and financial advisers are disturbed at the possibility that the rule could be expanded. “It is certainly not in the investor’s best interest to have a principal-trading exemption on the retail side,” said Rex Staples, general counsel of the North American Securities Administrators Association Inc. in Washington, which represents state and provincial securities regulators.

Although oral disclosures must be given to investors that an adviser who is a broker is selling them securities as a principal trade, “when you’re sitting across from Ma and Pa on the other side of the kitchen table, it’s probably impractical,” Mr. Staples said.

The National Association of Personal Financial Advisors in Arlington Heights, Ill., which represents fee-only advisers, has taken particular issue with the loosened rules on principal trades, and that group is soliciting NASAA and the Denver-based Financial Planning Association to join it in opposition, said NAPFA chairman Tom Orecchio.

“NAPFA’s problem with this is that since the disclosure only has to happen at the outset of the relationship [with advisory clients], the investor won’t know when principal trades are being conducted and when they aren’t later on in the relationship,” said Mr. Orecchio, who is also a principal and executive vice president with Greenbaum & Orecchio Inc. of Old Tappan, N.J.

“The lack of transparency is problematic,” he added.

Mr. Orecchio cited contract language for Merrill Lynch Personal Advisor accounts, regarding principal trades as an indication of the types of conflicts that can arise.

The contract, as reported in The Insider newsletter, published by Bob Veres of Mars Hill, N.C., includes the statement: “We may have an incentive to recommend a transaction in a security that we maintain in our inventory that is otherwise difficult to sell. The receipt of additional compensation and an incentive to recommend a transaction involving Merrill Lynch’s inventory present conflicts between our interest and yours.”

A spokesman for Merrill Lynch & Co. Inc. of New York did not return a call and e-mail for comment.

Conflicts of interest that can arise from principal trades to retail customers, including selling poor-quality securities that a broker wants to unload, as well as pricing the securities too high, said Michael Rosella, New York-based chairman of the global-investment-management practice at Paul Hastings Janofsky & Walker LLP in Los Angeles.

“For liability reasons, many firms separate their investment advisory business from their broker-dealer business,” he said. “Having a rule in place that only applies to broker-dealers that are themselves investment advisers is well intended but somewhat limited,” Mr. Rosella said.

The comment period on the rule closes Nov. 30.

Sara Hansard can be reached at [email protected].