Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Saturday, March 5, 2011

Tenth Circuit Addresses Broker-Dealer Exemption from Definition of Investment Adviser

The Investment Advisers Act of 1940 excludes from its broad definition of "investment adviser" broker-dealers that provide advice "solely incidental to" their conduct as broker-dealers and receive no "special compensation" for their service.  Despite much controversy over the scope of the exemption, there is little caselaw interpreting it: hence, the importance of a recent 10th Circuit opinion Thomas v. Metropolitan Life (No. 09-6257, 02/02/11).

In this purported class action, plaintiffs allege that a Met representative conducted a suitability analysis and subsequently recommended a variable life insurance policy, for which he received a $500 "production credit."  Disappointed with the product, they assert that the representative was an "investment adviser" who purchased his fiduciary duty by failing to disclose the strong financial incentives to sell Met's proprietary products.  The Court of Appeals affirmed the district court's grant of summary judgment to the defendants on the basis of the statutory exemption:

Specifically, the district court held that the phrase "solely incidental to" means "solely attendant to" or "solely in connection with," as opposed to "solely a minor part of" or "solely an insignificant part of." ...Thus, the court held that applicability of the exemption depends not on the quantum or importance of the broker-dealer's advice, but rather on whether the broker-dealer gives advice in connection with the sale of a product. ... With regard to the second prong, the district court held that "special compensation" requires a clearly definable charge attributable to investment advice. ... Thus, according to the district court, compensation in the form of brokerage commissions—which is received for the sale of a product—is not "special compensation," even when the transaction leading to the sale involved investment advice.

On appeal, the plaintiffs argued that the advice was not "solely incidental to" the broker-dealer's business when it comprised an important part of it.  Like the district court, however, the Court of Appeals rejected this interpretation:

Dictionary definitions of the word "incidental" differ somewhat. However, all definitions establish that the word "incidental" has  two components. To be considered incidental, two actions or objects must be related in a particular way—the incidental action or object must occur only as a result of or in connection with the primary. Additionally, the incidental action or object must be secondary in size or importance to the primary.

Plaintiffs emphasize the second component of the definition, arguing that "dictionary definitions of 'incidental' universally support Plaintiffs' interpretation of the term as 'inconsequential,' 'non-central,' or 'non-mandatory.'" Yet, the relational aspect is equally important and cannot be ignored—to be considered incidental, an action or object must be of lesser size or importance and be undertaken in connection with the primary action or object. The district court's interpretation acknowledges both components of "incidental," while the Plaintiffs' proposed interpretation would have us focus on the quantum or importance of the advice without regard to its relationship with the broker-dealer's business.

Further, the phrase "solely incidental to," when read as a whole, makes more sense under the district court's interpretation. "Solely," of course, means "exclusively or only." Webster's Unabridged Dictionary 1815 (2d ed. 2001). This compliments the relational aspect of "incidental": "solely" modifies "incidental to," and the phrase as a whole renders  the exemption applicable only when the broker-dealer gives advice in connection with the sale of a product. Under Plaintiffs' proposed reading, application of the exemption would hinge upon the quantum or importance of the broker-dealer's advice. Besides creating a difficult problem of line-drawing—how much advice is too much, and how could we measure the importance of the advice?—under Plaintiffs' interpretation "solely" would not meaningfully modify "incidental to" and would be superfluous. We are unwilling to adopt such an interpretation.

The Court also found that SEC interpretations and legislative history supported this construction.

With respect to the "special compensation" prong, the Court interpreted it to mean:

compensation received by a broker-dealer  is "special" only when (1) the compensation is received specifically in exchange for giving advice, as opposed to some other service, and (2) the compensation takes a form other than a commission or analogous transaction-based compensation received for the sale of a product.

The unfortunate outcome, therefore, is that the court did not address any disclosure obligation imposed on the broker to disclose specifically and upfront the financial incentives in selling the product.  (The prospectus did disclose the payment of a percentage of the premium as a sales fee.)  It is hoped that the SEC study on professional standards of care for both broker-dealers and investment advisers will result in improved disclosure of costs and fees sometime soon.

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When a person has a strong reliance on the advice being given and that advice influences a purchase (or sale) decision, it defies logic that the advice is solely incidental and not a primary part of the decision-making process. Once the advice is key to the decision to make a transaction, I believe that the advice giver should have a duty to alert the advice receiver that no fiduciary duty exists with respect to that advice (ie there is no duty to give advice that is solely in their best interests), or alternately, it should trigger a fiduciary duty. That is crux of the confusing financial advisory system we have today;a consumer has little understanding of these differences.

Posted by: Jan Sackley, CFE Twitter@FidFore | Mar 6, 2011 9:41:12 AM

For those trying to find the case, there's a typo above: it is actually order # 09-6207, not 09-6257.

Posted by: Shannon | Apr 18, 2011 6:51:16 AM

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