Change principal-trade rule with caution

The Securities and Exchange Commission must carefully monitor its temporary proposed principal-trade rule, which took effect Sept. 30. It’s obviously important to see whether the rule works because there are evidently some folks in the industry looking to pressure the SEC to make this principal-trade rule permanent.

For now, the temporary rule is set to last until Dec. 31, 2009.

Under the SEC rule, brokerage firms that are dually registered as investment advisory firms will get limited relief from restrictions on principal trades for two years, as long as they meet certain conditions, including the requirement that the trades 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.

Several organizations that represent financial planners and investment advisers maintain that allowing principal trades in advisory accounts would weaken consumer protections by allowing brokers and advisers to unload unwanted securities and by raising the prospect that they would sell securities to clients at inflated prices.

The main difference between current regulations and the new rule is that brokers will no longer have to provide written notice to a client each time they make a principal trade. Instead, the client only needs to give oral authorization before a trade is made.

Brokers will still have to give clients one-time advance notice in writing that they may engage in principal trades and get the client’s written consent. In the request for consent, the broker must describe conflicts of interest and how the conflicts will be handled.

Clients can, without penalty, revoke their consent at any time.

Confirmations of principal trades will have to be provided to clients, and brokers will have to send clients annual reports listing all principal trades made in their accounts for the prior year.

In addition, brokers cannot make principal trades to clients for any securities the brokerage firm or its affiliates underwrite.

The SEC must be sure that the proposed rule’s provisions are being followed by brokers, and that the door hasn’t been opened for brokers to take advantage of investors, especially unsophisticated investors with no professional guidance.