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version February 7, 2005 Securities and Exchange Commission To Commission Members and Staff: Re: File Number: S7-25-99, Release Number: 34-50980 CERTAIN BROKER-DEALERS DEEMED NOT TO BE INVESTMENT ADVISERS I would like to respectively submit comments from Farm Creek, LLC (Farm Creek). Farm Creek, which opened about one year ago, is a registered broker-dealer and a member of NASD. This rule making is important to us as we use an asset-based fee structure and are working to develop a competitive firm. For clarity I will write in the third person plural. Summary Farm Creek agrees with most of the Securities and Exchange Commission Release addressing the application of the Investment Advisers Act of 1940 to broker-dealers. In particular:
Before proceeding we would like to briefly review the dynamics of the relationship between investors and financial professionals. Understanding this interaction is important for framing the issues before us. In particular, everyone needs to focus on the investor when he or she asks: "What should I do or buy?" Our experience is that the same question is asked worldwide, from the smallest investor to the largest and most sophisticated. Everything advisers and brokers do flows from this fundamental question. The issue facing the Commission is how does it want financial professionals to respond? Does it want brokers to answer in one way and advisers in another? Discussion Fee Structures We agree with the Commission's position in Section 202(a)(11)T that just because a broker-dealer uses an asset-based fee structure it should not lose its exemption from the Advisers Act. Farm Creek uses an asset-based fee structure and strongly believes this is in line with investor interests. The fee structure grew somewhat organically from how we believe investors are best served when they ask: "What should I do," balanced with our desire to run a for-profit business. Our basic fee is 25 basis points per year on assets plus a ticket charge of $15 per transaction. For a complete discussion and description of our fee structure, please see Appendix I on page 9. We request that the Commission remove some confusion with respect to proposed Section 202(a)(11)-1. We think the Commission should be clear - asset-based fees are not, in and of themselves, "special compensation" and will not affect a broker-dealer's exemption from the Advisers Act. With this clarity, a broker-dealer using asset-based fees receives its exemption relying on Section 202(a)(11)(C) without reaching 202(a)(11)-1. And therefore, it looks like these fee-based accounts will not be subject to the additional disclosure in 202(a)(11)-1(a)(1)(iii). We think that this is a mistake and that fee-based accounts should receive additional disclosures. But, we think it makes more sense for the Commission to use its direct regulatory power of broker-dealer disclosures rather than running it through the Advisers Act. In any case, Farm Creek only offers one type of account and therefore by definition can not receive "special compensation" as there is no other account to which it can be compared. Therefore, it appears that Farm Creek will continue to obtain its exemption from the Advisers Act from Section 202(a)(11)(C) and will not be covered by the disclosure Section 202(a)(11)-1(a)(1)(iii). Is this what the Commission intended? Please see Appendix II to review Farm Creek's current disclosure which we devised in conjunction with our clearing firm. We think the important issues of fees, discretion and advice are discussed in a clear and concise manner. Scope of Solely Incidental Broker-Dealer Services We think the Commission will be marching into an abyss if it proceeds with its proposal to "clarify" what services are solely incidental to being a broker-dealer. We have grouped our comments into 5 categories.
A. Authority Issues We realize that the Commission can regulate broker-dealers in numerous ways and that it has many avenues open to it. But it is not clear how the Commission gains regulatory authority over the scope of broker-dealers' services from Section 202(a)(11) of the Advisers Act. It appears that this section is focused on exemptions to the Act, not limitations of the various professions mentioned. If the Commission gains authority to limit broker-dealer activities from this section does it also gain authority to limit banks and newspapers? How about lawyers, accountants, engineers and teachers? These professions were referred to in a very similar fashion to broker-dealers. The issue of "clarifying" what activities are solely incidental to the broker-dealer profession is a red-herring. It detracts from the goal of assuring that investors are protected and receive good advice. Why does the Commission feel it needs to define "solely incidental" when Congress chose not too. It had plenty of opportunities to limit broker-dealer's thoroughness and sophistication. It appears the Congress knew it fool-hardy to predict how lawyers, accountants, engineers, teachers and broker-dealers might give advice to investors. So they exempted them from the Act in a broad and open-ended fashion. B. Comparison of Advisers and Broker-Dealers Some of the comments the Commission receives may argue that either advisers or broker-dealers are more qualified to help retail investors answer their fundamental question of "what should I do?" But we think these assertions divert attention from the more important question of how the Commission ensures that both groups are capable of helping investors. Congress knew in 1940 that brokers and advisers shared the same profession and it appears investors still feel that way. If the Commission does get caught up in a discussion of the respective qualifications of brokers and advisers, we offer a few thoughts. First, we are astounded by the lack of requirements or continuing education for advisers when compared with brokers at both the "firm" and the "representative" levels. The barriers to entry seem pretty low, especially for "representatives." This is borne out in the Commission's cost/benefit analysis. In discussing the benefits to broker-dealers avoiding the costs of complying with the Advisers Act, the release lists all sorts of costs saved, but nothing about broker training or testing. On the flip side, in the cost section for the broker-dealers that will need to register as Advisers, there is nothing about training or testing. This is very curious. If advisers are more capable and/or better trained in providing investment information, we would have expected to see a significant cost for brokers upgrading their competency to the level of advisers. But there are no costs because no upgrading is necessary. Imagine if the tables were turned and the costs involved if advisers had to register as brokers and take the Series 7 and their bosses the Series 24? We think that limiting broker-dealers with respect to advisers in how thorough they advise investors is ridiculous. In the release the Commission indicated broker-dealers are well regulated, so where is the problem. C. Market Structure Issues We are surprised the Commission wants to micro-manage the structure of the financial services industry. And we are even more surprised the commission wants to become embroiled in these issues due an exemption in the Advisers Act. We would have thought it would have wanted a clear mandate to restructure the industry. Are Brokers a Subset of Advisors or an Independent Group? Let us start by discussing the field of financial professionals and the spatial relationship between broker-dealers and advisers. Specifically, is the broker-dealer group independent of the adviser group or subset of it? This distinction is critical since which premise is accepted significantly shapes the discussion. For example, if an exempted group (RRs) is independent of a "regulated" group (Advisers), no explanation for the exemption is expected or required. However, when a subset (RRs) is exempted from its larger group (Advisers), a reasonable explanation is rightly demanded. In this context, we think broker-dealers are clearly independent of advisers. We are concerned that if the Commission accepts the false premise - that broker-dealers are a subset of advisers, it may find itself trying to offer a "reasonable" explanation for the exemption. If the Commission accepts the correct premise - that brokers are independent from advisers, no explanation of the exemption is required. What do Brokers and Advisers Do? Let us examine the relationship between what brokers and advisers actually do? There is substantial overlap as both groups give advice while brokers can exclusively execute orders and advisers have the exclusive on managing money. Which group spends more time giving advice? We are not sure, but we think it takes more time to manage money than it does to execute orders and that most RRs spend much of their day giving advice to investors. If the Commission believes it is in investors' interest to limit advice from broker-dealers, where does its market structuring authority come from? If the Commission does get drawn into an explanation, we suspect it will end up drawing all sorts of artificial boundaries on the ever-changing competitive landscape limiting growth and evolution. Farm Creek is proof that new ideas are being tried all the time. The Commission's ultimate goal should be assuring investors get good answers when they ask: "What should I do" and let the marketplace determine if investors go to a broker or an adviser. D. Practicality We wonder how the Commission might limit brokers' freedom and responsibility to offer good advice. How does it want brokers to respond when investors ask, "What should I do?" One indication that appears encouraging is the SEC approval of NASD IM-2210-6. But this also makes it to very difficult how the SEC will navigate the issue. It is somewhat surprising that the issue of brokers helping and advising investors make the right long-term decisions, is even on the table. The Commission and the SROs let broker-dealers publish extremely thorough, in-depth analyses of individual companies and securities for their clients. Yet it questions if broker-dealers have the competence to help investors plan and invest for the long-term. There are other practical problems with restricting broker-dealers' advice. Will the Commission look at the percentage of time a broker spends advising his clients to determine if he has been too thorough? We think this is unworkable as it assumes other work stays constant. For instance, trade processing continues to become more automated. By making order entry and booking keeping more efficient, should brokers fear that they have freed up too much time to advise their clients? It will be interesting if on one side of a broker-dealer, the SEC insists security analysts be more thorough while simultaneously restricting its brokers' thoroughness. We also encourage the Commission to clear up some of the confusion with labels and titles. Our suggestion is that financial professionals serving retail clients fall into three categories.
Getting down to Farm Creek's particulars, why would the Commission want to limit the thoroughness of our inquiry and advice to clients? Is the Commission suggesting that if a broker gets too much experience or training, they have to become an adviser? That seems wrong. Should brokers with the CFA designation, use only Level I knowledge in discussions with investors and suppress the lessons of Levels II and III? Should CFAs be barred from being brokers? Here is a practical test. In Appendix III we have attached a new report designed to advise customers on how to separate their investments between their taxable and tax-qualified accounts in order to maximize after-tax returns. The report clearly flows from customer interest on where to hold certain investments. Does it help customers plan better? We hope so. Is this report incidental to being a broker-dealer? Of course it is. Is it planning and advice? You bet it is. Is it against the law? We hope not! E. Investor Protection Does the Commission really want a rule that limits brokers' thoroughness or sophistication when servicing investors? As long as a broker-dealer stays within their competence, how are investors' interests served by such limitations? None of this is to argue that the Commission should not be very concerned if broker-dealers:
But broker-dealers already have rules to address these problems and the Commission has plenty of authority to protect investors from broker-dealers without the cover of the Advisers Act. As we have made clear, we do not see a good reason to limit the advice brokers give investors, but, we will be even more concerned if the Commission decides to go half-way. We think partially limiting a broker's advice could potentially be worse for investors than banning broker advice. If a partial course is used it will be fuzzy and confusing. How will investors know when the broker has reached his limit and they should call an adviser for further information? It seems that the only way to protect the investor in these circumstances is for the Commission to ban all advice. Another issue if the Commission only imposes partial restrictions on advice is the likely chilling affect on the quality of the dialogue between RRs and investors. Not only will individual brokers be overly cautious but well-intended compliance departments will get into the act and restrict RR's activities even further. The reality on the street is that when the Commission draws a line in the sand, compliance departments keep employees "two feet from the line." The unfortunate fact is that a compliance department's incentives are not always perfectly correlated with an investor's best interests. Page 24 Problems We have disagreements and quibbles with a few statements on page 24. The release says fee-based accounts are not suitable for customers who rarely purchase or sell securities. Our understanding is that cost, not the form of pricing, determines reasonableness and suitability. Farm Creek believes its fee structure is very suitable for relatively inactive traders and in fact we encourage our customers to be inactive for their own good. Next, why is the Commission suggesting investors with large mutual fund positions avoid fee-based accounts? The Commission's premise here is that fee-based accounts must be expensive, which is false. We also recommend investors avoid most actively managed mutual funds. The "average" mutual fund under-performs their benchmark by a large margin and broad-based ETFs generally under-perform by much less. NASD's Notice to Members 03-68 - November 2003 Lastly, the Commission refers to NASD's Notice to Members (NTM) 03-68 of November 2003 and we think it is generally good. Here are a few observations.
Information on Farm Creek Ed Hynes is the founder and President of Farm Creek, LLC. He has over 20 years of experience in the securities business including fundamental equity research, institutional sales and trading; program trading sales, OTC equity derivative sales and various management positions. He has worked for top firms (Lehman Brothers, CS First Boston and Swiss Bank/UBS) in financial centers such as New York, Tokyo, London, Chicago and San Francisco. His current registrations are Series 4, 7, 8, 24 and 63. He completed the requirements to use the Chartered Financial Analyst (CFA) designation in 2001. In 1977 he earned a B.A. in Political Science from The George Washington University. Please call or write if you have any questions or comments. Sincerely, "Signed" Ed Hynes, CFA Appendix I - Farm Creek's Fee Discussion Farm Creek rejected the traditional broker-dealer revenue model for a few reasons. The most important reason being that if clients followed our recommendations they would generate very little revenue from commissions, loads/fees and/or margin fees. For example:
Farm Creek wants to help investors implement their strategy in a low-cost, tax-efficient manner. For many US investors a portfolio of two broad-based Exchange-Traded Funds (ETFs) would give them a well diversified and balanced retirement portfolio. One ETF would track the S&P 1500 (ISI) and the other the Goldman Sachs Corporate Bond Index (LQD). The difficult question for investors (and their broker and/or adviser) is how they should allocate their assets between the two. (We do not recommend a separate allocation to international equities for a number of reasons. See Farmcreeksecurities.com for more information.) Tying this all together we decided on a fee structure with an asset-based fee of 25 basis points a year and a flat $15 ticket charge per transaction. We wanted to have a small ticket charge to discourage trading. Investors hurt themselves by overtrading, so we did not want it to be free. Interestingly, a number of very desirable side benefits flow from this fee structure such as:
This next section was not part of the letter: Before investing in any fund investors should carefully consider the investment objectives, risks, and charges and expenses of any fund. This information is contained in the prospectus which should be read carefully before investing. Prospectuses for iShares products are available at (800) 474-2737 or www.iShares.com. Also, remember past performance is no indication of future performance and that there are risks to investing including the loss of principal. Appendix II Addendum to Farm Creek' New Account Opening Form We are asking all customers to read and sign the following statement when opening an account which will confirm your understanding of Farm Creek's fee structure.
Appendix III - Save
Money by Carefully Deciding How Your Investments Should be Separated
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