Incidental services

What Are Incidental Services?

Incidental services refer to investment advisory services provided by a financial professional as an integral, but secondary, part of their primary business. This concept is most commonly discussed within the realm of financial regulation, specifically concerning the distinction between a broker-dealer and an investment adviser. Historically, a broker-dealer whose investment advice was "incidental" to their main business of executing securities transactions and who received no special compensation for that advice, was excluded from the definition of an investment adviser under the Investment Advisers Act of 1940. This exclusion meant they were not subject to the same registration requirements and fiduciary duty that applied to registered investment advisers.

History and Origin

The concept of incidental services is rooted in the legislative intent behind the Investment Advisers Act of 1940. When Congress passed this act, it aimed to regulate those whose primary business was providing investment advice. However, it recognized that certain professionals, such as broker-dealers, lawyers, accountants, and teachers, might offer investment-related guidance as a minor component of their main professional duties. Therefore, the Act included specific exclusions for such activities, provided they were solely incidental to the primary business and no separate compensation was received for the advice.

Over time, as the financial services landscape evolved and the lines between various financial professionals blurred, the scope of this exclusion became a point of regulatory focus. In 1987, the Securities and Exchange Commission (SEC) issued SEC Release IA-1092, which provided interpretive guidance on the applicability of the Investment Advisers Act to financial planners, pension consultants, and other individuals who provided investment advisory services as a component of other financial services¹². This release clarified what activities could still be considered incidental, particularly emphasizing the nature of the advice and the form of compensation. A key aspect was that if a broker-dealer held themselves out as providing investment advice or received specific fees for advice, they might lose the incidental exclusion and be required to register as an investment adviser¹⁰, ¹¹.

More recently, the SEC's Regulation Best Interest (Reg BI), effective in 2020, further addressed the standard of conduct for broker-dealers when making recommendations to retail customers⁸, ⁹. While Reg BI did not eliminate the statutory broker-dealer exclusion, it significantly elevated the standard of care for broker-dealers beyond the traditional suitability standard, requiring them to act in the retail customer's best interest when making securities recommendations, even if those recommendations are part of incidental services⁶, ⁷.

Key Takeaways

• Incidental services refer to investment advice provided as a secondary part of a primary financial business.
• Historically, this allowed broker-dealers an exemption from registration under the Investment Advisers Act of 1940.
• The distinction hinges on whether the advice is truly secondary, and how compensation is structured.
• Regulatory changes like SEC Release IA-1092 and Regulation Best Interest have clarified and elevated standards related to incidental services.
• The concept highlights the differing regulatory frameworks for broker-dealers and investment advisers.

Interpreting Incidental Services

The interpretation of incidental services largely revolves around the facts and circumstances of the advice being rendered. Regulators examine several factors to determine if investment advice is truly incidental to a broker-dealer's primary business of executing transactions in securities. These factors include how the firm or individual presents themselves to clients, whether separate or specific compensation is charged for the advice itself, and the frequency and nature of the investment advice provided.

If a broker-dealer, for instance, promotes themselves as offering comprehensive financial planning services, or charges a specific fee for a financial plan, their activities might no longer be considered incidental, even if they also execute trades. This scenario would typically trigger the requirement for them to register as an investment adviser and adhere to the associated fiduciary duty. The goal of regulatory oversight is to ensure that clients receive the appropriate level of investor protection based on the type of services they are actually receiving, rather than solely on the professional's traditional title.

Hypothetical Example

Consider "TradeQuick Inc.," a brokerage firm where "Mr. Smith" is a licensed broker-dealer. A client, Ms. Jones, contacts Mr. Smith to place an order to buy shares of a particular company. During the conversation, Ms. Jones casually mentions she's considering selling some other shares to fund a down payment on a house, and asks Mr. Smith if it's "a good idea." Mr. Smith briefly comments that the market has been volatile for that particular sector and suggests she review her overall financial situation before making a decision, but he does not provide specific advice on which shares to sell or when to sell them. He then proceeds to execute her initial buy order.

In this scenario, Mr. Smith's brief comment could be considered an incidental service. His primary role was to execute a transaction, and the advice was unsolicited, general, and directly related to the execution of the trade. He did not charge a separate fee for this brief discussion, nor does TradeQuick Inc. market itself as providing ongoing investment advisory services. If, however, Ms. Jones hired Mr. Smith to create a detailed portfolio allocation strategy and paid him a fee for this specific service, it would likely move beyond incidental services and require Mr. Smith or TradeQuick Inc. to register as an investment adviser.

Practical Applications

The concept of incidental services has significant practical applications, primarily in defining the regulatory obligations of financial professionals. It helps determine whether an individual or firm falls under the purview of the Investment Advisers Act of 1940 or the Securities Exchange Act of 1934, which govern investment advisers and broker-dealers, respectively. This distinction impacts the standard of care owed to clients, the disclosure requirements, and the scope of permissible activities.

For broker-dealers, understanding the limits of incidental services is crucial to avoid inadvertently triggering investment adviser registration requirements. Firms and individuals must carefully review their business practices, marketing materials, and compensation structures to ensure compliance. The Financial Industry Regulatory Authority (FINRA), as the self-regulatory organization for broker-dealers, also plays a role in establishing rules that affect how broker-dealers can interact with clients, particularly concerning advice and related activities⁵. The SEC has also conducted studies highlighting the differences in regulatory regimes and investor confusion regarding investment advisers and broker-dealers⁴.

Limitations and Criticisms

While the incidental services concept was intended to provide a practical exemption, it has faced criticisms for contributing to regulatory ambiguity and potential investor confusion. Critics argue that the distinction between a broker-dealer's "incidental" advice and a full-fledged investment adviser's guidance can be difficult for a retail customer to discern, leading to misunderstandings about the standard of care they are owed. A 2011 SEC staff study noted that investors often do not recognize the differences in legal obligations between broker-dealers and investment advisers and expect advice to be in their best interest regardless of the professional's designation³.

Before the implementation of Regulation Best Interest (Reg BI), this concern was particularly acute because broker-dealers operating under the incidental exemption were generally held to a suitability standard, which is a lower bar than the fiduciary duty applied to investment advisers. This disparity created a regulatory gap where similar-looking services could be provided under different legal obligations, potentially exposing investors to undisclosed conflicts of interest. Even with Reg BI, which introduced a best interest standard for broker-dealers, the underlying statutory distinction and the "incidental" nature of advice for certain exclusions remain a subject of ongoing discussion in financial regulation². Academic papers have also explored the challenges of this regulatory framework in terms of investor protection¹.

Incidental Services vs. Investment Adviser

The core distinction between "incidental services" provided by a broker-dealer and the services of a dedicated investment adviser lies in the primary nature of their business and their respective regulatory standards.

Confusion often arises because both types of professionals may offer advice regarding securities. However, an investment adviser's business is giving advice for compensation, subjecting them to a higher fiduciary duty. While broker-dealers providing incidental services under Reg BI must now act in a client's best interest, the foundational regulatory frameworks and the primary nature of their businesses differ significantly.

FAQs

What does "incidental" mean in the context of financial services?

In financial services, "incidental" means that providing investment advice is a secondary, supportive activity to a professional's primary business, such as a broker-dealer's main role of executing securities transactions. The advice is not the main service for which the client is paying.

How did the Investment Advisers Act of 1940 address incidental services?

The Investment Advisers Act of 1940 included a specific exclusion for broker-dealers and other professionals whose investment advisory services were "solely incidental" to their main business and for which they received no special compensation. This meant they were not required to register as investment advisers.

Has Regulation Best Interest changed the concept of incidental services?

Regulation Best Interest (Reg BI) did not eliminate the statutory exclusion for incidental services under the Investment Advisers Act. However, it significantly enhanced the standard of conduct for broker-dealers when providing any securities recommendations to retail customers, requiring them to act in the customer's best interest, regardless of whether the advice is considered "incidental."

Why is the distinction between incidental services and investment advice important for investors?

The distinction is crucial because it traditionally determined the legal standard of care owed to the investor. Registered investment advisers are subject to a fiduciary duty, requiring them to put their client's interests first. While broker-dealers providing incidental services are now subject to the Reg BI "best interest" standard, understanding the professional's primary registration helps clarify their obligations and the scope of services provided.

Can a financial professional offer both incidental services and investment advisory services?

Yes, a firm or individual can be "dually registered" as both a broker-dealer and an investment adviser. In such cases, they must adhere to the respective regulations and standards of care based on the specific services they are providing to a client at any given time.