Published Memo Number 05-51

Information Memo  05-51  is available for viewing or printing with Adobe Acrobat
Number 05-51 07/26/2005

On June 22, 2005, the Securities and Exchange Commission (the “Commission”) issued an order1 approving new NYSE Rule 405A (“Non-Managed Fee-Based Account Programs – Disclosure and Monitoring”). Rule 405A is effective immediately, however, the Exchange will allow 90 days from the approval date (September 22, 2005) for the membership to fully adopt and establish the procedural and systems changes required by the Rule. Note, however, that during this period, the membership is in no way relieved of its existing and ongoing obligations to monitor, review, and supervise Non-Managed Fee-Based Account Program(s) (“NMFBA Program(s)”) pursuant to all other applicable NYSE rules including Rules 342 (“Offices – Approval, Supervision, and Control”) and 405 (“Diligence as to Accounts”).


In keeping with the evolving interests and needs of the investing public, members and member organizations have increasingly been offering a wider variety of account types beyond traditional brokerage accounts. One such account type is the NMFBA Program. The primary advantage to customers of NMFBA Programs is that they can provide a “volume discount” from traditional transaction-based commission charges.

As defined by Rule 405A, NMFBA Programs refer to arrangements between a member or member organization and a customer in which no investment advisory services are provided by the member or member organization and in which the customer is charged a fixed fee and/or a percentage of account value, rather than transaction-based commissions.2

Rule 405A Requirements

Generally, new Rule 405A (see Exhibit A) requires informational disclosure to customers, ongoing monitoring of transactional account activity, and follow-up with certain identified NMFBA Program customers. The following discusses these requirements in greater detail.

General Disclosures Required

Rule 405A(1) requires that each customer, prior to the opening of an account in a NMFBA Program, be provided with a disclosure document describing the types of NMFBA Programs available to such client. The document shall disclose, for each such Program type, sufficient information for the customer to make a reasonably informed determination as to whether the Program is appropriate to suit their anticipated needs. Specifically, such disclosures must include, at a minimum: a description of the services provided, eligible assets, fees charged, an explanation of how costs will be computed and/or the provision of cost estimates based on hypothetical portfolios, any conditions or restrictions imposed, and a summary of the Program’s advantages and disadvantages.

In other words, it is expected that plain language disclosures be provided that will allow customers to estimate their costs given certain levels of trading activity, including “break-point” type fee discounts based on progressively higher levels of account activity or account assets. Notice should likewise be given if a premium would be paid or a penalty assessed if account activity or assets fall below prescribed levels. If fees in a given Program are dependent on a particular type of activity being conducted (e.g., options only, equities only) that too should be made clear to the customer.

Disclosures required pursuant to Rule 405A(1) may, where appropriate, be included as part of a “Welcome Letter Package” provided to new clients. If included as part of a Welcome Letter Package, the disclosures must be presented in a designated section, clearly and specifically dedicated to NMFBA Program-related issues. If an existing client is considering an NMFBA Program, members and member organizations may not rely solely on previously furnished disclosure materials. In such cases, the disclosure material must either be provided in a separate document, or the client must be specifically directed to the disclosure materials previously provided, prior to the NMFBA Program being opened.

Opening of Accounts

NYSE Rule 405 requires members and member organizations to “[u]se due diligence to learn the essential facts relative to every customer, every order, [and] every cash or margin account… .” While NMFBA Programs are fully subject to the existing provisions of Rule 405 and all other applicable NYSE rules, they raise regulatory issues that warrant a specifically tailored approach. For instance, as a general matter, a fee-based approach may be considered appropriate for customers who engage in moderate to high levels of trading activity since the cost per trade is reduced as the number of trades increases. A fee-based arrangement may not be appropriate for customers who anticipate engaging in a lower level of trading activity, as substantially greater transaction cost savings might be realized in the context of a traditional pay-per-trade commission structure.

Cost, however, may not be the only factor in determining whether a NMFBA Program is appropriate. Other services or factors associated with NMFBA Programs should also be considered, in the context of a customer’s overall investment philosophy, when making an appropriateness determination. For instance, a particular customer may place value on considerations such as alignment of their interests with those of the registered representative, links to other accounts, or other features that may not be available in other account types.

Accordingly, Rule 405A(2) requires that members and member organizations make a determination, prior to opening an account in a NMFBA Program, that such Program is appropriate for each customer taking into account the services provided, anticipated costs, and the customer’s investment objectives.

Monitoring of Accounts

Rule 405A(3) requires that members and member organizations establish and maintain systems and procedures adequate to monitor, on an ongoing basis, transactional activity by customers in NMFBA Programs. Such systems and procedures must include specific written criteria for identifying customers whose level of account activity may be inappropriate in the context of the Program. The purpose of these requirements is to identify NMFBA Program customers who might be better served in a traditional commission arrangement or in another type of NMFBA Program. While activity levels are not the only criteria to be used when determining whether a particular NMFBA Program is in a customer’s best interests, activity levels provide a good basis for initiating customer contact to get a better idea of what the customer’s best interests are. This ongoing determination should take into consideration not only costs incurred, but also Program services, customer investment objectives, and customer preferences.

Automated exception reports (e.g., active account reports) have, for some time, been a standard means utilized by many members and member organizations to monitor customer activity for potential regulatory problems. Given the large and growing number of NMFBA Program accounts, it is not unreasonable to expect that for many members and member organizations such reports would be an appropriate, if not necessary, means to adequately monitor such Programs for inappropriate levels of activity. However, Rule 405A(2) does not specifically require each member and member organization to develop or acquire such an automated system. Rather, it requires the development of systems and procedures adequate to their purpose in the context of each member’s and member organization’s business model.

“Householding” of Accounts

Members and member organizations should be cognizant of issues related to “householding.” Householding, in this context, is the practice of grouping or aggregating the assets of various related accounts (e.g., accounts of the customer’s spouse, children, or other household members) within an NMFBA Program. Such aggregation of assets may be appropriate if, for instance, the higher asset level lowers the Program’s annual fee and the activity level in the aggregated accounts is otherwise appropriate within the context of the Program. Householding of assets might not be appropriate if, for instance, it is done primarily to meet the NMFBA Program’s initial minimum asset requirements and the Program is otherwise inappropriate for the individual accounts that have been aggregated. In this regard, each constituent account must be reviewed individually with regard to its investment objectives and its account activity.

Further, member organizations should carefully monitor the practice of charging each aggregated account a standardized fixed fee, regardless of the amount of assets in the account, as this could result in the fee representing an inappropriately high percentage of account value (see “Fixed Fees” below).

The terms relating to arrangements involving the householding or aggregation of assets, including but not limited to the fee-structure arrangements attendant to such arrangements, must, if applicable, be disclosed to customers prior to opening a NMFBA Program pursuant to Rule 405A(1). Further, any such advantages or disadvantages must be taken into account when making the initial appropriateness determination required by Rule 405A(2), as well as when making ongoing determinations of appropriateness required by Rule 405A(3).

Fixed Fees

Members and member organizations should be aware that NMFBA Programs that charge a fixed fee may give rise to appropriateness issues not associated with Programs that charge a percentage of account assets. If, for instance, a customer opens a fee-based account with $100,000 in assets that charges a fixed annual fee of $5,000, the fee would represent 5% of the account holdings. Any diminution of such assets (due, for example, to devaluation of holdings, withdrawal of funds, or transfer of securities) would increase the percentage of assets represented by the fee. For example, if the value of the account fell to $75,000, the annual fee would represent over 7% of the account assets. If the value fell to $50,000, the figure would be 10%, and so on. Such changes in the fee/asset ratio should be considered when making ongoing appropriateness determinations.

Appropriateness of Assets

The nature of customer assets should be taken into consideration when making NMFBA Program appropriateness determinations. For instance, mutual fund positions might be inappropriate in the context of a NMFBA Program if they are included in the overall eligible assets used to assess customer fees in that they are not generally considered products to be actively traded. If mutual fund positions are considered eligible assets that are counted towards the Program fee, any load fees associated with the mutual funds could be considered a duplicative charge to the customer. One way to address these concerns would be to consider mutual funds ineligible assets for purposes of assessing Program fees. If, on the other hand, mutual funds are considered eligible assets of a NMFBA Program, it is expected that member organizations be cognizant of any associated fees or charges and take steps to mitigate their impact on customers (e.g., waiving sales charges or only including “no-load shares” as eligible assets). The determination of whether the assets are appropriate within the context of a NMFBA Program will ultimately depend both on the terms of the Program and the effect of such assets on the customer’s cost and overall investment strategy.

Attention should also be paid to the presence of “restricted” stock assets that cannot be freely traded by the customer but that comprise eligible assets within a NMFBA Program, thus increasing the fee paid by the customer.

Review and Follow-Up

Rule 405A(4) requires the maintenance of written procedures for contacting and following-up, as appropriate, with those customers whose level of activity in a NMFBA Program over a specified period of time has been identified, vis a vis the member’s or member organization’s transactional parameters or other criteria established pursuant to Rule 405A(3), as possibly inconsistent with the Program’s costs and benefits. While no “bright line” or de facto standards of appropriateness are prescribed, the intent is that NMFBA Program customers, identified pursuant to reasonable review and follow-up criteria, be contacted and provided with a basis upon which to consider whether it is appropriate for them to remain in the Program, or possibly consider other account types (e.g., another NMFBA Program or a conventional transaction-based account).

The timeframe for identifying such customers is, at minimum, a rolling 12-month period. More frequent contact is required should circumstances warrant. The minimum 12-month standard for identifying customers in potentially inappropriate Programs reflects the Exchange’s intention to require supervisory focus on a reasonably considered time-frame, while recognizing that, due to a number of variables, a NMFBA Program’s appropriateness may not be determinable except over a relatively extended period of time. Such variables could include, among others, general economic or market conditions, variations in customer trading patterns, changes in customer investment objectives, or the types of services/benefits included in a given Program. Note that the intent behind Rule 405A(4) is not to require that every customer who appears on an NMFBA Program exception report be contacted every 12 months on an ongoing basis. Once customer contact is made, the necessity for any subsequent follow-up customer contact is to be based upon a review of subsequent activity, an ongoing analysis of the customer’s overall trading history, and the customer’s expressed intentions regarding his or her investment objectives or philosophy.

Rule 405A does not prescribe specific procedures for identifying, contacting, and following-up with customers since the variety of NMFBA Programs, customer investment profiles, and member or member organization supervisory structures, allow for numerous effective alternate methods. However, the means (e.g., letter, phone call, or e-mail) and general content of each follow-up customer contact (including any customer response) must be documented and retained in an easily accessible place. At a minimum, the substance of such contact must include notification that the level of account activity for a specified time-frame may be inconsistent with the Program costs incurred by the customer. One approach to effect meaningful notification in this regard would be to provide a comparison of NMFBA Program fees paid over a specified period of time versus the estimated cost of the activity had it been charged on a commission basis.

While a “negative consent letter” (i.e., a written notification to a customer requiring no response) may be appropriate, under certain circumstances, as an initial means of customer contact, the intent of the Rule is that members and member organizations implement a more proactive supervisory approach that includes direct customer contact when, for instance, a NMFBA Program appears to be particularly inappropriate for a given customer, or where a customer remains in an apparently inappropriate Program over a period of time. Consideration may be given to utilizing an “affirmative consent letter” if a customer insists upon remaining in a NMFBA Program that seems to offer little or no rational benefit. Where a member or member organization is unable to make direct contact with a customer who has been in a clearly inappropriate Program over an extended period of time, the member or member organization, as a matter of good business practice, should consider switching the assets into a traditional transaction-based account.

Supervision of Registered Representatives

As noted above, in addition to compliance with the prescribed requirements of Rule 405A, NMFBA Programs are subject to all applicable NYSE Rules including those relating to the supervision of registered representatives. Members and member organizations are advised to take note of registered representatives who seem to have a disproportionate number of customers in NMFBA Programs, as this may increase the likelihood that such Programs may be inappropriate for a number of such customers. Registered representatives should also be monitored for improper behavior in connection with NMFBA Programs, such as temporarily transferring assets into a fee-based account on, or shortly before, the day a percentage-based fee is assessed.

Applicability of Rule 405A

Because Rule 405A is essentially intended to protect the interests of retail clients, it contains an exception for accounts opened on behalf of “Qualified Investors” as that term is defined in Section 3(a)(54)3 of the Securities Exchange Act of 19344 (see Exhibit B). For example, excepted from the Rule’s provisions are accounts of registered investment companies, banks, insurance companies, and certain employee benefit plans subject to ERISA.

As noted above, Rule 405A neither applies to arrangements in which a fixed fee and/or a percentage of account value is charged as payment for investment advisory services. Most such accounts are subject to the Investment Advisers Act of 19405 and are thus subject to its regulatory scheme. However, Rule 405A does apply to NMFBA Program accounts that are otherwise controlled by a third party pursuant to a separate, properly executed power of attorney. In such instances, the requirement to make an initial determination, pursuant to Rule 405A(2), as to whether a particular NMFBA Program is appropriate for customers whose accounts are controlled by the third party could be satisfied by receipt from the third party of a “letter of attestation” making such a representation. Required follow-up contact, pursuant to Rule 405A(4), would be directed to the designated third party controlling the NMFBA Program account.

Questions regarding this Memo may be directed to Stephen Kasprzak at (212) 656-5226.

Donald van Weezel
Vice President
Member Firm Regulation

1 See Release No. 34-51907 (June 22, 2005)
70 FR 37485 (June 29, 2005) (File No. SR-NYSE-2004-13).
2 NMFBA Programs are distinguished from “wrap accounts” in which investment advisory services are provided by a broker-dealer. NMFBA Programs are directed by the customer or by an agent of the customer pursuant to a separate agreement. The NMFBA Program definition is not intended to exclude arrangements where a broker-dealer provides customer advice that is solely incidental to its brokerage services.
3 15 U.S.C. 78c(a)(54).
4 15 U.S.C. 78a.
5 15 U.S.C. 80b-1 et seq.

Exhibit A.DOC
Exhibit B.DOC