The Merrill Rule:

1
The Merrill Rule A Legal Perspective
Neal E. Sullivan Partner Bingham McCutchen
LLP and David Bellaire General Counsel Financial
Services Institute
2
Brief History of the Merrill Rule

• Compensation limited to transaction-based
  commissions
• Tully Report recommends fee based compensation as
  a best practice
• Fee based brokerage accounts proliferate
• Distinctions between broker-dealer and investment
  adviser activities continue to erode
• Regulatory clarity sought by broker-dealers
• SEC proposes rule to exempt broker-dealers in
  1999
• Modified rule adopted in April 2005

3
Brief History of the Merrill Rule

• A broker-dealer providing investment advice to
  customers is excluded from the definition of
  investment adviser regardless of the form of
  compensation received as long as
• (i) the advice is non-discretionary,
• (ii) the advice is solely incidental to the
  brokerage services, and
• (iii) the broker-dealer discloses to its
  customers that their accounts are brokerage
  accounts not advisory accounts.

4
Brief History of the Merrill Rule

• Advice is not solely incidental to brokerage
  services if it includes
• Charging a separate fee or separately contracting
  for advisory services.
• Provides advice as part of a financial plan and
• The individual holds himself out to the public as
  a financial planner or as providing financial
  planning services
• Delivers a financial plan to the customer or
• Represents to the customer that the advice is
  provided as part of a financial plan or in
  connection with financial planning services.

5
Brief History of the Merrill Rule

• Financial planning seeks to address a wide
  spectrum of a clients long-term financial needs,
  and can include recommendations about insurance,
  savings, tax and estate planning, and investments
• Financial planning is distinct from a financial
  tool that is used to provide guidance to a
  customer with respect to a particular transaction
  or an allocation of customer funds and securities
  based upon the long-term needs of a client

6
Merrill Rules Impact on IBD Firms

• Fee based brokerage accounts emerge in the IBD
  channel
• For most IBDs, they remain a small portion of
• Discretionary brokerage accounts no longer an
  option
• Accounts are either converted to investment
  adviser relationships or non-discretionary
  brokerage
• Drawing the line between financial planning and
  use of financial tools becomes a challenge with
  significant consequences
• Suitability review and asset allocation
  development versus financial planning services

7
Rule Vacated

• Merrill Rule is vacated in its entirety
• Opinion rests entirely upon statutory
  interpretation
• Court rules that Section 202(a)(11) of the
  Investment Advisers Act was very specific as to
  who could be exempted from the definition of
  investment adviser
• Section 202(a)(11)(C) provides the sole and
  exclusive exemption for broker-dealers
• SECs power to exempt is thus limited by the Act
• Merrill Rule goes beyond the SECs authority

8
Rule Vacated

• SEC announces that it will not appeal the Courts
  decision
• Requests a 120-day stay of the ruling so that
  firms and investors have adequate time to review
  their options
• 300 billion in assets held in an estimated 1
  million fee based brokerage client accounts

9
Effect of Invalidation of the Rule

• Loss of fee-based brokerage account option
• Reduction in investor choice
• Turmoil and uncertainty
• Is financial planning investment advice?
• Is the use of financial tools or analytics
  considered investment advice?
• A race to achieve compliance by the October 1,
  2007 deadline

10
Legal Business Alternatives

• Broker-dealer firms with fee-based brokerage
  accounts were required to either
• Reprice fee-based brokerage accounts into
  commission-based structure so that registered
  representatives can continue to service them
• Transition fee-based brokerage accounts to
  advisory accounts serviced by an investment
  adviser representative of an affiliated
  investment adviser

11
Legal Business Alternatives (Continued)

• Broker-dealer firms with fee-based brokerage
  accounts were required to either
• Maintain the existing fee-based brokerage
  accounts, but strip the services to execution
  only or
• Convert fee-based brokerage accounts to 3rd party
  managed accounts.

12
The Race to Compliance

• Firms struggled with the tension between
• Meeting the deadline of October 1, 2007 and
• Insuring suitable account type recommendations
  for individual clients.
• Single solution for all fee-based brokerage
  accounts runs counter to regulatory guidance
• For example, see NtM 03-68 noting that fee-based
  programs must be appropriate for a client based
  on their needs.

13
Recent Developments Principal Trading

• Temporary Rule allowing investment advisers to
  engage in principal trading on non-discretionary
  advisory accounts provided that
• Proper disclosures are provided to clients
  concerning conflict of interest that may arise
• Customer consent is obtained prior to engaging in
  any principal transactions and
• Customers receive annual reports showing
  principal-trading activity in the account.

14
Recent Developments Guidance

• SEC Proposed Interpretative Rule 202(a)(11)-1
  reinstates guidance from the now-vacated rule,
  specifically
• Broker-dealers do not offer solely incidental
  investment advice if they exercise investment
  discretion or charge separate fees
• Broker-dealers who charge different commission
  rates (full service v. discount) for clients are
  not receiving special compensation
• A broker-dealer is an investment adviser solely
  with respect to accounts that receive advisory
  services.

15
Recent Developments RAND Study

• SEC commissioned the RAND Corporation to conduct
  a study of broker-dealers and investment advisers
  from two perspectives
• Investment advisers and broker-dealers
  practices in marketing and providing financial
  services to individual investors and
• Evaluate investors understanding of the
  differences between investment advisers and
  broker-dealers financial products and services,
  duties, and obligations

16
Recent Developments RAND Study

• Conclusions
• Industry is heterogeneous with firms providing
  a wide range of services through a variety of
  relationships and entities
• Investors fail to distinguish between
  broker-dealers and investment advisers along the
  lines defined by federal regulations
• Disclosures provided to investors are
  ineffective and
• Investors express high levels of satisfaction
  with the services they receive from their own
  financial services provider.

17
Recent Developments RAND Study

• Chairman Cox instructs SEC Divisions of
  Investment Management Trading and Markets to
  develop a list of policy options flowing from the
  RAND Studys conclusions
• FPA calls for a roundtable of consumer and
  industry groups to discuss the RAND Study
• The SEC makes no commitment to organize such a
  roundtable

18
Recent Developments RAND Study

• Investment Adviser Association calls on SEC to
  improve investor education and repropose
  revisions to Form ADV Part II
• SIFMA calls for creation of SRO for investment
  adviser only firms

19
Long Term Impact

• Regulatory review of the suitability of account
  options chosen during the race to compliance
• Arbitration and litigation of cases concerning
  the suitability of account options chosen during
  the race to compliance
• Guidance on financial planning reverts to
  Investment Adviser Release IA-1092

20
Long Term Impact

• Additional incentive for financial advisors to
  drop their securities licenses and exclusively
  offer investment advisory services
• Opportunity to modernize the financial services
  industrys regulatory scheme to promote
  transparency, but the timing may not be right
• Commission Short 2 Commissioners
• Congress Election year politics and Senate
  Banking Committee backlog

21
Resources

• Tully-Levitt report (1995) see at
  http//www.sec.gov/news/studies/bkrcomp.txt.
• Original Proposed Rule - Certain Broker-Dealers
  Deemed Not To Be Investment Advisers, 64 Fed.
  Reg. 61,226 (Nov. 10, 1999).
• Final Rule - Certain Broker-Dealers Deemed Not To
  Be Investment Advisers, 70 Fed. Reg. 20,424
  (April 19, 2005).
• Financial Planning Association v. SEC, 482 F.3d
  481 (D.C. Circuit 2007).

22
Resources

• Investment Advisers Act Rel. No. 2652 (Sept. 24,
  2007)(proposed rule reinstating interpretative
  positions).
• NASD Notice to Members 03-68 (November 2003)
  (noting that fee-based programs must be
  appropriate based on the clients needs).
• RAND Report Technical Report Investor and
  Industry Perspectives on Investment Advisers and
  Broker-Dealers (January 2008) see at
  http//sec.gov/news/press/2008/2008-1_randiabdrepo
  rt.pdf.

23
Resources

• Investment Advisers Act Rel. No. 1092 (October 8,
  1987)(discussing applicability of Act to
  financial planners).