Internalization Lives After SEC Issues Temporary Rule

The Securities and Exchange Commission delivered temporary relief to retail broker-dealers and their trading desks grappling with the demise of the SEC’s so-called “Merrill Lynch” rule.

That rule permitted brokerages to trade on a principal basis against orders for securities sitting in discretionary fee-based accounts. The two-year-old rule was shot down by the U.S. Court for the District of Columbia Circuit this spring. That forced brokers to convert these accounts, which make up a large part of the retail brokerage industry’s assets, into either regular brokerage accounts or non-discretionary fee-based accounts.

The industry’s mass conversion of an estimated 1 million fee-based accounts holding $300 billion in assets was to have been completed by October 1.

Many broker-dealers preferred to switch the accounts to non-discretionary fee-based accounts. The problem is that broker-dealers offering such accounts become subject to rules of the Investment Advisers Act of 1940 if they trade on a principal basis with orders in those accounts. They would have to inform their customers in writing of their intentions to trade against the orders each and every time they do so.

The industry, including the Securities Industry and Financial Markets Association, complained to the SEC that such notification would be largely impossible to carry out before each trade. The industry lobbied the SEC to render broker-dealers exempt from the principal-transactions rules.

The regulator declined to make firms exempt, but did offer a solution. It has proposed a temporary rule permitting broker-dealers to trade against orders in non-discretionary fee-based accounts as long as they give their clients verbal notification of their intentions. The rule will expire at the end of 2009.

This “sunset provision” gives the SEC “an opportunity to observe how firms comply with their disclosure obligations under the rule, and whether, when they conduct principal trades with their clients, they serve their clients’ best interests,” Andrew Donohue, a director in the SEC’s Division of Investment Management, said in a recent speech.