The SEC’s Guidance on the Solely Incidental Exclusion from the Definition of Investment Adviser: What it Means for Brokers and Dealers
September 19, 2019
On June 5, 2019, the Securities and Exchange Commission (the “SEC”) released the “Interpretation Regarding the Solely Incidental Prong of the Broker-Dealer Exclusion from the Definition of Investment Adviser” (the “Interpretation”). The Interpretation accompanied the following interpretations and guidance from the SEC:
- The enactment of Regulation Best Interest, a suitability standard enhancement for broker-dealers;
- The adoption of Form CRS (Relationship Summary) that requires a brief written disclosure of the services and standard of conduct between an adviser and client or a broker and customer including potential conflicts of interest and the types of compensation charged; and
- The Commission Interpretation Regarding Standard of Conduct for Investment Advisers, that states that an investment adviser’s fiduciary duty under the Investment Advisers Act of 1940 (the “Advisers Act”) is comprised of a duty of care and a duty of loyalty.
Section 202(a)(11)(C) (the “Exclusion”) of the Advisers Act excludes from the definition of “investment adviser” any broker or dealer that provides advisory services when such services are “solely incidental” to the conduct of the broker or dealer’s business and when such incidental advisory services are provided for no special compensation.
The Interpretation is not new regulation. It sets forth the SEC’s views of the limits of the Exclusion that some broker-dealers rely on to avoid being defined as an investment adviser. If a broker-dealer comes within the definition of investment adviser, the broker-dealer is subject to the Advisers Act (including the anti-fraud provisions) and may be required to register with the SEC. The primary focus of the Interpretation is on those broker-dealers that:
- exercise discretion over customer accounts (unless it is limited discretion, you are an investment adviser and need to analyze whether this means you must be registered with the SEC or any states);
- provide a service that includes the review of customer accounts (“continuous” account monitoring makes such a broker an investment adviser); or
- provide advice with respect to securities (e.g., securities recommendations) if, based on facts and circumstances (specific services offered, fees charged, relationship/agreement with customer), this advice is not “reasonably related” to the business of effecting securities transactions.1
Congress adopted the Advisers Act, and, in particular, the Exclusion recognizing that broker-dealers also provide investment advice with respect to securities in connection with their broker-dealer services. The financial services industry has changed since 1940 and the services and compensation arrangements offered by brokers have blurred the line between acting as an agent in effecting securities transactions and providing investment advice, even using the title “adviser” (which is no longer allowed under Regulation Best Interest) and offering fee-based arrangements.
The SEC stated in the Interpretation that broker-dealers who provide investment advice are excluded from the Advisers Act definition of Investment Adviser only if the advice is “in connection with and reasonably related to effecting securities transactions.” The SEC stated that the assessment of whether advice provided by a broker-dealer satisfies the solely incidental prong is “based on the facts and circumstances surrounding the broker-dealer’s business, the specific services offered, and the relationship between the broker-dealer and the customer.” The SEC makes clear, however, that investment discretion over customer accounts and continuous account monitoring are not “solely incidental” to a brokerage business and the Exclusion doesn’t apply. A broker engaged in these activities is an investment adviser.
Investment Discretion. “[W]hen a broker-dealer exercises investment discretion, it is not providing advice to customers that is in connection with and reasonably related to effecting securities transactions; rather, the broker-dealer is making investment decisions relating to the purchase or sale of securities on behalf of customers on an ongoing basis.” A broker-dealer with unlimited discretion (the authority to buy and sell securities for a customer without consulting the customer) over an account is providing advisory services that are not solely incidental to the broker-dealer’s business. Therefore, the Exclusion does not apply.
The Interpretation provides guidance on some forms of limited discretion that are solely incidental and will not result in a broker being considered an adviser:
- discretion as to the price at which or the time to execute an order given by a customer for the purchase or sale of a definite amount or quantity of a specified security;
- discretion on an isolated or infrequent basis, to purchase or sell a security or type of security when a customer is unavailable for a limited period of time;
- discretion over cash management, such as to exchange a position in a money market fund for another money market fund or cash equivalent;
- discretion to buy or sell securities to satisfy margin requirements, or other customer obligations specified by the customer;
- discretion to sell specific securities and purchase similar securities in order for a customer to realize a tax loss on the original position;
- discretion to buy a bond with a specified credit rating and maturity; and
- discretion to purchase or sell a security or type of security limited by specific parameters established by the customer.
Many brokers exercise unlimited discretion for a small number of family and friends without considering that this may make them advisers. They, and all brokers that exercise unlimited discretion, should review the implications of such services under the Advisers Act and analyze the types and number of customers over which they exercise unlimited discretion and the amount of assets in these accounts in order to determine whether SEC adviser registration is required. Brokers may wish to change the discretion they exercise to one or more of the limited discretion options described above to avoid the adviser issue or push out to an investment adviser the unlimited discretion activities.
Account Monitoring. The Interpretation makes clear that a broker-dealer is not acting as an adviser if he or she voluntarily reviews a customer’s account to determine whether to recommend the purchase or sale of a security. Such monitoring is solely incidental to a broker’s primary role of effecting securities transactions. The same reasoning applies if the broker has an agreement with the customer to monitor an account on a periodic basis. The key is that it is clear to the customer (through, in part, disclosure on Form CRS) that the account monitoring is for purposes of providing buy, sell or hold recommendations and that the broker-dealer has clear policies regarding the purposes of the account monitoring, including that continuous account monitoring is not permitted.
A broker that engages in account monitoring who wishes to avoid being an adviser must disclose to its customers that account monitoring is done only on a periodic basis with specific time frames (e.g., quarterly) to determine whether to provide a buy, sell, or hold recommendation to the customer. The broker should adopt and implement clear policies and procedures about account monitoring services, including a restriction on continuous monitoring.
Please contact your Seward & Kissel attorneys if you’d like more information on the Interpretation, Regulation BI, Form CRS or the Fiduciary Duty Release.
1 While not specifically addressed in the Guidance, research provided by broker-dealers that receive a separate fee for the research is not advice reasonably related to the business of effecting securities. Therefore, such broker-dealers are not excluded from the Advisers Act definition of Investment Adviser. The SEC provided no-action relief from the Advisers Act definition of Investment Adviser to broker-dealers selling research to money managers affected by MiFID II (which required managers to unbundle research fees from transaction fees). That relief is set to expire on July 3, 2020. SEC Chairman Jay Clayton and Dalia Blass, Director of the SEC’s Division of Investment Management, have stated that the SEC will likely not extend that relief.