SEC’s principal trade proposal raises new fears

WASHINGTON — Some financial advisers fear that a proposal backed by the Financial Planning Association that would allow brokers to make principal trades in their fee-based accounts would result in a new loophole that brokers can use to skirt investment adviser regulations.
Last week, the National Association of Personal Financial Advisors of Arlington Heights, Ill., sent a letter to the Securities and Exchange Commission expressing “strong reservations” about granting relief for broker-dealers for principal trades.
The proposal, which was outlined in large part in a July 27 letter from the Denver-based FPA to the SEC, is expected to be adopted by the commission as an interim final rule as early as next month. It has gained the acceptance of the Securities Industry and Financial Markets Association, which posted the proposal on its website.
Limited relief
Under the proposal, brokerage firms that are dually registered as investment advisory firms would get limited relief from restrictions against principal trades for two years as long as the firms met certain conditions, including the requirement that the trades could be done only in non-discretionary accounts.

Principal trades, in which investment advisory firms are prohibited from engaging under the Investment Advisers Act of 1940, are sales of securities from a brokerage firm’s inventory.
“The FPA just sued because of the broker-dealer exemption,” said Bedda D’Angelo, president of Fiduciary Solutions Inc. in Durham, N.C. “It looks to me like they’re carving out another exemption.”
The FPA successfully sued the SEC in the U.S. Court of Appeals for the District of Columbia Circuit to overturn the SEC’s rule exempting brokers from registering as investment advisers for fee-based accounts.
Broker-dealers have 1 million of the fee-based accounts, and brokers have been looking to the SEC for guidance about how to shift those accounts to investment advisory accounts, which they must do by Oct. 1 under the court’s mandate.
Principal trades have been the central issue in the matter, because a large part of the brokerage business comes from firms selling their own inventory to clients.
“When you get right down to it, that’s the element of being an investment adviser that is the stumbling block for broker-dealers,” said Barry Barbash, a partner with Willkie Farr & Gallagher LLP. Mr. Barbash, who works in the firm’s Washington office and New York headquarters, formerly headed the SEC’s division of investment management and now represents brokerage firms and other companies in the financial services industry.
“That’s going to be the trick, to come up with a balanced rule to allow principal trades to go forward in a way that protects investors. If the SEC can do that, it gets out of this quagmire,” Mr. Barbash said.
“The devil is in the details,” said Duane Thompson, managing director of the FPA’s Washington office, who signed the July 27 letter to the SEC. “But we’re heartened that it does seem to address a lot of our concerns.”
The main difference between current regulations and the proposal is that brokers wouldn’t have to provide written notice before they made principal trades, Mr. Thompson said. Instead, they could give clients oral notice, and the clients would have to give them permission orally before each trade were made.
“Brokers have wanted relief from this for decades,” said Robert Plaze, associate director of the SEC’s division of investment management. “The relief that is going to be drafted is very modest.”
While the brokerage community had wanted fee-based brokerage accounts to remain a viable option, “we feel this preserves many of the most important benefits for many of the 1 million consumers who hold them,” said Travis Larson, Washington-based spokesman for SIFMA, which also has an office in New York.
But NAPFA doesn’t agree. Even though securities markets have become more transparent, “the inherent conflicts of interest and risks to individual investors involving principal trades have not changed,” NAPFA said in its Aug. 14 letter to Mr. Plaze, which was signed by chairman Richard Bellmer and chief executive Ellen Turf.
“Loosening principal-trading rules lessens fiduciary duties, which should be preserved as the highest standard under the law,” the NAPFA letter said. “The real reason behind principal-trading relief is to preserve the profits of Wall Street firms at the expense of individual investors.”
Lots of consent
In addition to getting oral consent before each principal trade, brokers would have to give clients one-time advance notice in writing and get written consent that they may engage in principal trades, and describe conflicts of interest and how the conflicts would be handled. Clients could revoke their consent at any time without penalty under the draft proposal.
Confirmations of principal trades would have to be provided to clients, and brokers would have to send clients annual reports listing all principal trades made in their accounts for the prior year. In addition, brokers couldn’t make principal trades to clients for any securities the brokerage firm or its affiliates underwrite.
The interim rule would take effect Jan. 1 and would sunset after two years. That would give the SEC time to consider the results of a study being conducted by RAND Corp. of Santa Monica, Calif., which the commission plans to use to determine what changes should be made to regulations that govern broker-dealers and investment advisers.