Monday, April 02, 2007

Federal Appeals Court Strikes Down SEC Fee-Based Broker Exemptive Rule

By James Hamilton, J.D., LL.M.

A federal appeals court has vacated an SEC rule exempting brokers who receive fee-based compensation for incidental advisory services from regulation under the Investment Advisers Act. A split panel of the DC Circuit Court of Appeals ruled that the SEC exceeded its authority and flouted six decades of consistent understanding when it broadened the existing statutory exemption for brokers. (Financial Planners Association v. SEC, No. 04-1242, March 30, 2007).

The Advisers Act exempts brokers whose performance of advisory services is solely incidental to the conduct of their brokerage business and who receive no special compensation for the advisory services. A catch-all exemption allows the SEC to exempt other persons; and that exemption is the crux of the case since the SEC adopted Rule 202(a)(11)-1 to exempt brokers whose provide incidental investment advice but receive a fee-based compensation keyed to the amount of assets in the customer’s account.

The appeals panel said that legislative intent does not support an exemption for brokers that is broader than the statutory exemption. Congress identified the specific persons that it wished to exempt from the Act, said the court, and the SEC cannot expand that category by using the catch-all exemption. When the statute is clear, reasoned the panel, the SEC cannot use general clauses to redefine the statutory boundaries.

Judge Rogers said that Congress, in the Advisers Act, intended to broadly define investment adviser and create only a precise exemption for brokers. Moreover, Congress established a broad federal fiduciary standard governing the conduct of investment advisers. This statutory regime is inconsistent with a construction of the SEC’s authority under the catch-all exemption enabling persons that Congress said should be subject to the Advisers Act to escape the Act’s restrictions.

Rejecting the SEC’s assertion that Congress was also concerned about the regulation of broker-dealers under both the Advisers Act and the Exchange Act, the court noted that Congress enacted the Advisers Act at a time when broker-dealers were already regulated under the Exchange Act and Congress expressly acknowledged that the brokers it covered could also be subject to other regulation.

The court also emphasized that the rule flouts six decades of consistent SEC understanding of its authority under the catch-all exemption, which does not authorize the Commission to rewrite the statute. Rather, the SEC has historically invoked the catch-all to exempt persons not otherwise addressed in the specific exemptions established by Congress. According to the court, the catch-all exemption serves the clear purpose of authorizing the SEC to address persons or classes involving situations that Congress had not foreseen in the statutory text; and not to broaden the exemptions of the classes of persons, such as brokers, that Congress had expressly addressed.

Similarly, the court rejected the SEC’s suggestion that broker-dealer marketing developments fall within the scope of its authority under the catch-all since this ignores the Commission’s own contemporaneous understanding of congressional intent to capture such developments. Although an agency may change its interpretation of an ambiguous statute, instructed the panel, all elements of the traditional tools of statutory interpretation confound the SEC’s effort to walk away from its long-settled view of the limits of its authority under the catch-all exemption.

Being unable to derive an unambiguous meaning from the statute in question, Judge Garland, in dissent, would therefore defer to the SEC’s reasonable interpretation of the statute it administers and uphold the Commission’s fee-based brokerage rule.

I think that Judge Garland's dissent makes it clear that, in the end, it all comes down to whether one believes that the statute is ambiguous or clear. If ambiguous, you can go forward and determine the reasonablesness of the SEC's rulemaking. If clear, the inquiry is at an end.