NASD Cautions That Fee-Based Accounts May Be Inappropriate

ASD Notice to Members 03-68 appears innocuous on its face, a simple reminder that fee-based accounts must be appropriate. But viewed more closely, NTM 03-68 may be the start of yet another wide-reaching regulatory initiative sure to shake up Wall Street.

As background, the notice discusses how firms increasingly are offering customers fee-based accounts even though investment advisory services (such as asset allocation, portfolio management, execution and administration) are not offered. Now, fee-based programs simply are offered as an alternative to traditional commission-based charges for brokerage services. There is nothing inherently wrong with that alternative. The NASD cites the 1995 Tully Report on commission practices and its endorsement of fee-based accounts as a "best practice" for certain accounts.

Therein lies the rub. The Tully Report concluded that fee-based accounts would be appropriate for customers who either engage in at least a moderate level of trading activity or who prefer consistent and explicit monthly charges. On the other hand, accounts holding mainly bonds or mutual funds, or accounts with low trading activity because of buy and hold strategies, may be better served in a commission-based program.

NTM 03-68 makes this more than an academic debate. The notice puts teeth into the Tully Report, announcing several ways in which reps and their firms can violate securities rules. They are:

NASD Rule 2110: It is inconsistent with just and equitable principles of trade for a rep and firm to place a customer in a fee structure that can be expected to result in a greater cost to the customer than an alternative fee structure providing the same services and benefits;

NASD Rule 2310: A recommendation otherwise suitable for a customer can be rendered unsuitable if another fee structure would have provided a pecuniary advantage to the customer; and

NASD Rule 2430: All charges for services must be reasonable and fair for each customer and for each transaction.

That's not all. Before opening a fee-based account, reps and firms must do three things. First, make reasonable efforts to obtain information about the customer — suitability-type information such as financial status, account size and the nature of the securities held. Second, reps and firms then should consider what type of account is appropriate in light of the services provided, projected cost, alternatives and customer preferences. Third, reps and firms must disclose all relevant information to the customer, including the fee schedule, services provided and the fact that the program may cost more than paying for the services separately.

NTM 03-68 does recognize that customers legitimately may opt for a fee-structure not in their financial best interest. For example, a customer may believe that fee-based compensation better aligns his or her interest with the interest of the rep. Likewise, a customer may prefer the certain and consistent cost that fee-based programs provide. That is fine. However, the NASD will require that the rep and firm document the non-price reasons for choosing the fee-based account.

Further, NTM 03-68 cautions that even though a customer has consented to a fee-based arrangement, the NASD still may find a violation of Rule 2310 if that arrangement was unsuitable. In that regard, the NASD will find the customer's consent to be "irrelevant."

The remainder of NTM 03-68 outlines the firm's supervisory requirements. They are substantial. First, firms should implement procedures to require a periodic review of each fee-based account to determine whether it remains appropriate for their customers. NASD opines that it would be reasonable to conduct that review annually, perhaps more frequently depending upon the circumstances. The review should consider such factors as whether assumptions about market conditions have changed, as well as the particular customer's objectives and financial circumstances.

Firms also should include guidelines in their training materials concerning the establishment of fee-based accounts. Additionally, firms should review their sales literature and marketing materials to ensure that information regarding fee-based programs is balanced and not misleading. Finally, NASD suggests, but will not require, firms to engage in a hypothetical financial comparison of fee-based charges to commission based charges for customer accounts.

Reps should make every effort to stay ahead of what may be the next headline news about Wall Street practices!

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James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.