August 30, 2007
By Evelyn Juan
DOW JONES NEWS WIRES
The so-called “Merrill Lynch rule” may be dying soon, but for Merrill Lynch & Co. (MER) and Morgan Stanley (MS) its spirit lives on.
As the Oct. 1 deadline near to the ending of fee-based brokerage accounts, both firms are mulling a new platform that would enable clients to maintain paying a fixed fee based on their level of trading activity.
The new account, according to people familiar with the plan, will be brokerage in nature but clients would pay a fixed commission based on trading frequency rather than a fee based on their assets.
A spokesman at Merrill said it is premature to discuss the issue. A spokesman at Morgan Stanley declined to give details on the so-called “World Wise” project the firm is actively developing.
Both firms’ move is seen as a clever attempt to skirt a March ruling by the U.S. Court of Appeals for the D.C. Circuit against fee-based brokerage programs under the Securities and Exchange Commission’s rule 202.
The so-called Merrill rule allowed brokers to charge fees based on client assets and offer investment advice on brokerage accounts without being subject to the
Investment Advisers Act that holds advisors to a higher standard of client protection than that required of brokers.
With the court ruling forcing the closing of those accounts, Merrill’s and Morgan Stanley’s upcoming brokerage platforms could allow them to have similar pricing structures to the fee-based brokerage model that the court declared illegal.
The new platform could also preserve access to investment products that will be restricted from clients if they are simply switching accounts into an advisory platform, which is the current popular option for Merrill’s and Morgan Stanley’s rival firms.
Preserving the key attributes of the fee-based brokerage platform is important for keeping the hundreds of billions of dollars in client assets that are tied to these accounts, which will soon be shuttered.
These accounts, which allowed clients to pay an annual fixed rate, have been popular as part of brokerage firms’ transition into generating a steadier source of revenue based on annual fees rather than commissions.
Merrill, one of the most vocal opponents of abolishing these accounts, holds one-third of the $300 billion in clients assets tied to fee-based brokerage, while Morgan Stanley oversees around $30 billion.
“The fee-based (brokerage) business is too large to walk away from,” said James Eccleston, a securities lawyer dealing with Wall Street firms. If Merrill’s and Morgan Stanley’s alternative brokerage platform work, Eccleston expects other firms to “hop on the bandwagon.”
As Merrill Lynch and Morgan Stanley develop their alternatives, Citigroup Inc. (C) unit Smith Barney has SB Advisor while UBS Wealth Management US of UBS AG (UBS) has Strategic Advisor as alternative advisory programs.
Alex Samuelson, a Citigroup spokesman, said the firm isn’t developing a similar program to Morgan Stanley’s or Merrill Lynch’s. However, clients can still access brokerage products that are restricted from Smith Barney’s advisory program by maintaining dual accounts in brokerage and advisory.
As of July, half of Smith Barney’s more than 15,000 financial advisors opened at least one SB Advisor account, representing over $20 billion in client assets across 65,000 accounts. “We anticipated a possible problem with fee brokerage and our regular interaction with FAs helped to develop this solution,” Samuelson said.
Legal experts warn of tricky challenges tied to Merrill’s and Morgan Stanley’s upcoming programs, particularly on the issue of providing advice.
Both firms may argue that brokers are not compensated for giving advice in a brokerage account, which excuses them from being subject to the Investment Advisers Act of 1940.
However, clients should be able to expect fiduciary care no matter what type of account they have, said Lawrence Klayman, a securities lawyer who represented clients suing firms over fee-based brokerage accounts. After all, clients typically go to a full-service brokerage firm to get advice they can’t get from discount brokerages, he said.
Advice in transactional accounts could be about whether to buy, hold, or to sell a stock, bond or mutual fund.
Advice in advisory platforms could include estate planning, saving for retirement and other comprehensive plans for the clients’ long-term goals. Brokers, once known only as stock jockeys, have been moving towards this type of advisory relationship with clients as part of the industry’s transformation towards fee-based business over the past 15 years.
“If a firm holds itself out as giving advice, they are subject to suitability no matter if it’s per-transaction or comprehensive,” Klayman explained.
The Financial Planning Association, which sued the SEC over the fee-based brokerage program, said Merrill and Morgan Stanley should ensure that either is not bundling transactions for a certain fee while providing “free” comprehensive advice under the new program.
If both firms start marketing free financial plans under the new program, “then that flies in the face of the court’s decision,” said Duane Thompson, managing director for FPA’s Washington office.
Additionally, the fixed annual commission could encourage churning by unscrupulous brokers who could use this practice to be paid more if their clients fall under a higher level of trading activity.
Both Merrill and Morgan Stanley are still drafting details of the plan but people familiar with them said the rates might be based on different tiers of trading levels.
“The devil is in the details, and that’s what we’ve yet to see,” Eccleston said.