What's Happening?

Let's begin with some mile-high background on fee-based (non-advisory) brokerage accounts. For several years, these accounts have been an important and fast-growing part of the "fee-based wave" in financial services. According to Cerulli Associates, they held $270 billion in total assets at the end of 2004, representing about one-quarter of all fee-based (non-institutional) assets in the U.S.

The average fee-based brokerage account has about $200,000 of assets and pays a fee of about 1.0% to 1.5% ($2,000 to $3,000 per year) in lieu of commissions on brokerage transactions. Typically, the broker provides only "incidental" investment advice to these accounts and must obtain client approval for each trade.

There are several advantages embedded in fee-based brokerage accounts that work to the advantage of both financial professionals and clients. For example:

• These accounts do not offer brokers incentive to trade excessively (i.e., "churn"), since compensation is linked to assets, not transactions or commissions. The only way the broker can earn more is to help clients grow assets over time
• These accounts have enabled financial firms to expand investment choices. For example, it can make sense to include buy-and-hold bonds, no-load mutual funds and exchange-traded funds (ETFs) in these accounts. In commission-based accounts, these choices may not be offered because they don't generate attractive commissions.
• By having a predictable flow of fee-based income, financial professionals can offer clients more consistent services, such as annual or semi-annual portfolio reviews, in addition to recommending investment purchases and sales.

The securities industry created these accounts to expand client services at a time when traditional commission revenues were under pressure. In 1995, an industry committee published a series of recommendations on broker compensation in a document called the "Tully Report." Among them was the finding that an asset-based fee for brokerage account services could represent "best practices" by better aligning interests of clients and brokers. In June of 1999, Merrill Lynch took the initiative by launching the first such account, which it called Unlimited Advantage. It just three months, Unlimited Advantage captured $40 billion of assets – mostly from transaction-based Merrill clients who willingly switched to fees. This was perhaps Merrill's most aggressive effort to protect its retail system from the emerging threat of low-cost online discount brokers. Today, Merrill continues to lead the industry in fee-based brokerage assets. The top four participants – Merrill, Morgan Stanley, UBS, and Smith Barney – together hold more than half of all fee-based brokerage assets.

While large wire houses were the first to move, recent asset growth has been driven by regional member firms, independent broker-dealers, and bank broker-dealers.

Regulatory Clouds

Over their six-year existence, fee-based brokerage accounts have lived under regulatory clouds on two horizons:

• Exemption from RIA requirements - From the inception of these accounts, the SEC has shown concern about whether they should be offered subject to terms of the Investment Advisers Act of 1940, including the registration and fiduciary requirements that apply to Registered Investment Advisers (RIAs). One section of that Act provides an exemption for broker-dealers who perform advisory services that are "solely incidental" to their normal business. In a rule first proposed in November of 1999, and later re-proposed in January of 2005, the SEC gave a tentative green-light to the practice of offering non-advisory fee-based brokerage accounts. However, the SEC's re-proposal would require these accounts to be advisory if the broker exercises any discretion over the account. The SEC also indicated that it might restrict firms' ability to offer financial planning services in non-advisory fee-based accounts. You can read that SEC release here:

http://www.sec.gov/rules/proposed/34-50980.htm

For several years, the Financial Planning Association (FPA) has argued that the exemption from RIA rules should not apply to fee-based brokerage accounts. Also, the FPA has aggressively lobbied for the SEC to create a bright line of distinction in the public's mind between full-service brokerage accounts and fee-based RIA advisory business, whether delivered by an investment adviser or financial planner. You can read their position here:

http://www.fpanet.org/member/govt_relation/federal/securities/120701_bd_letter.cfm

http://www.nasd.com/web/idcplg?IdcService=SS_GET_PAGE&ssDocName=NASDW_013876

Raymond James' press release of the same day noted that this matter affected only fee-based brokerage accounts, not its fee-based advisory services – to which the firm remains committed. You can read it here:

http://www.raymondjames.com/pr/050427.htm

Why You Should Stop and Consider

Raymond James said its combined firms have 5,000 financial advisors serving 1.3 million accounts, and fee-based brokerage represented just 2% of its clients. Yet, if you divide $5.5 billion by 5,000 advisors, fee-based brokerage represented more than $1 million per Raymond James advisor – a meaningful amount.

Making a commitment to a fee-based business model is one of the most important decisions a financial advisor can make. It's not something you should attempt by "cherry-picking" one client at a time. Also, it is well known that the "transition process" from commissions to fees requires financial sacrifice on the part of advisors – because commissions dry up right away, yet it takes time to build fee-based assets. Some Raymond James brokers who made the sacrifice now face another setback with the dissolution of the firm's fee-based brokerage business.

Of course, the NASD's investigation of fee-based brokerage practices is far from over. The scrutiny announced by Morgan Stanley has yet to culminate, and no securities firm in this market can say with certainty what will happen next.

It is clear that the news is spreading to the investing public, and more arbitration cases are focusing on unhappy clients who were converted to fee-based brokerage at higher cost. A chillingly honest account of a securities attorney who represents plaintiffs in these actions was published recently by Business Week Online and can be accessed here:

• http://www.businessweek.com/magazine/content/05_19/b3932117_mz020.htm

In this environment, it may be risky to tell clients (new or existing) that it's in their best interest to convert from transaction brokerage to fee-based. At some firms, fee-based brokerage ultimately may become a concept that sounded good but just didn't fly.

Even if you still believe in the concept and are delivering it professionally, and even if your clients are happy with it – it's time to consider your strategic options.

What Are Your Options?

Suppose you already have several million dollars in fee-based brokerage, representing some of your best client relationships. The best solution is to be honest about what's happening and explain the alternatives, as follows:

1. Go back to commissions - This will cost you more than clients. It's a well known fact that you can sell a practice based on recurring fee income for up to twice annual revenues. For a commission-based business, you'll be lucky to get one-times revenues. However, it's important to be open with clients and maintain relationships now. Otherwise, you may not have a viable business to sell later.
2. Convert assets to separate accounts or advisory accounts - In a separate account, the clients will pay an RIA to manage assets, and you can earn a portion of the advisory fee. Your role in providing investment ideas may be limited, but you can still offer planning, analysis, and ongoing portfolio monitoring. This is a way to maintain the value of fee-based assets you've already captured. It's the way that Raymond James and several other large firms are expected to go. Of course, you also could become an RIA yourself and charge a fee for advice. Some individual brokers may see this as an attractive way to maintain fee-based assets under management.
3. Keep the business and boost the activity - The NASD is focusing close attention on so-called "reverse churning" fee-based brokerage accounts. In these accounts, investors basically buy-and-hold, with few trades. It doesn't mean the advisor isn't executing investment strategy professionally, but it is risky business in light of recent regulatory actions. To protect yourself, make sure that any fee-based brokerage accounts execute several trades per year. Create sound investment strategies that can benefit from frequent trading.
4. Keep the business and build the relationship - It is not (and never will be) known how many of Raymond James 27,000 fee-based brokerage clients were happy. Having some satisfied clients didn't spare the firm a disciplinary hit. However, if you do nothing more after reading this column – make a pledge to work harder than ever providing service to fee-based brokerage clients. Ask them if they are happy with all facets of the relationship. If not, offer one of the three choices above.

It's not easy making a living as a professional financial advisor these days, and your compensation is not a priority concern of regulators. This is just another example of a regulatory obstacle that will have greatest impact on financial advisors who can't adapt to a changing environment. The strongest advisors will make necessary changes in their fee-based business models quickly and, as always, they will survive and prosper.