From the September 2003 issue of Investment Advisor • Subscribe!

B/Ds' Compliance Burden Gets Heavier

Federal legislation and a hypervigilant NASD are making the compliance departments at many broker/dealers see red

Ask any broker/dealer what their biggest headache is nowadays, and they'll tell you it's complying with the deluge of new and proposed regulations by the National Association of Securities Dealers (NASD). Since the bear market unleashed its first growl more than three years ago, the NASD, as well as the Securities and Exchange Commission and Congress, have been throwing out rules left and right aimed at protecting investors and restoring faith in the markets.

While the regulators' actions are understandable, says Terry Lister, general counsel at Cambridge Investment Research, Inc., in Fairfield, Iowa, the compliance burden the rules are placing on B/Ds is becoming somewhat unbearable. B/Ds "are scrambling to comply with the various new rules," he says. And some smaller B/Ds are so certain they won't be able to comply that they're contemplating throwing in the towel, he says. "Smaller B/Ds aren't going to be able to create the [technology] systems that will be required to comply with the various regulatory provisions like books and records and breakpoints, and some will not be able to survive." Lister has seen signs of this already. "Some small B/Ds have actually contacted Cambridge's recruiters, saying, 'We want to be a branch [of yours] and shut down.'"

Rick Cortese, VP of National Regulatory Services (NRS) in Lakeville, Connecticut, says that a few of NRS's B/D clients who are also advisors have said they're thinking of closing their brokerage firms' doors and "focusing on their money management business." These advisors say "the overlay of rules, even for SEC advisors, is much more manageable, at least from their viewpoint, than the ongoing avalanche of rules that the NASD is putting out," Cortese says. That's "topped off by the anti-money laundering rules that apply to B/Ds, and will soon apply to advisors." Cortese says small B/Ds "are between a rock and a hard place" in attempting to comply with the NASD rules, "because their compliance staffs are small," and the B/Ds can't pony up the capital to add more help.

Does NASD Not Understand?

Larry Papike, president of Cross-Search, a broker/dealer recruiting firm in San Diego, California, who's a former owner of a brokerage firm, says brokerage firms' compliance personnel are calling him and "fussing" about the onslaught of NASD rules. He doesn't blame them, as he sees the laundry list of rules as "somewhat unfair." Papike says that in his daily ritual of helping brokers move from one B/D to another, he's noticed that most reps are oblivious to the strain the firms are under.

Mark Tibergien, partner in charge of the Securities & Insurance Niche for Moss Adams LLP, and an Investment Advisor columnist, says that today, "One of the most important roles that an independent B/D serves is in the area of compliance and due diligence." He says the NASD doesn't seem to understand how heaping more rules on B/Ds' affects their business, though he believes the NASD's "heart is in the right place since they are trying to protect the consumer." That said, however, Tibergien wonders if the NASD is "differentiating between the traditional retail broker/dealer and those that serve the insurance and independent markets--their business approach is somewhat different."

The cost of providing services to advisors, Tibergien says, "is making it virtually prohibitive for small and mid-size broker/dealers to compete and produce a return and, for that matter, have enough money to attract the right kind of people to their organizations, especially a return in proportion to the risk that now seems even higher than ever."

The Patriot Act

To comply with the Patriot Act's anti-money laundering provision, Cambridge's Lister says the B/D now has to continually match its customer list against the Treasury Department's OFAC list of foreign nationals. To do this, Cambridge had to create its own technology, which cost the firm $10,000. "It's time consuming and expensive," he says. Yet another daunting part of the Patriot Act is the customer identification procedure, which requires B/Ds to obtain an approved ID such as a drivers license or passport. "It sounds simple enough," Lister says, "but when you have an independent sales force where customers don't come into the office, it's hard to get hold of those documents." And when reps are involved in financial planning, he says, "they often go out to the client's house, and don't have the means to copy this data."

Cambridge also has an anti-money laundering program in place, which Lister says has to be monitored each year to ensure it can detect money laundering, among other things. These new rules, Lister says, "require more manpower and outlay of capital." In the last year alone, Cambridge has added five new employees to its compliance department, which brings the department's staff to 15. The new employees will cost Cambridge $200,000 per year.

Papike says that, unfortunately, such investments are necessary if a B/D expects to keep pace with the rules. B/Ds "have to add more compliance personnel," he says. But it's likely some portion of the business will have to suffer. "If your revenues are down, and you have to add more staff, something has to give. Either you have to cut commission payouts to reps, which is going to result in revolt, or you'll have to win the lottery to stay in business."

Breakpoints and Block Transfers

Besides having to deal with the Patriot Act, Lister says NASD's new rules are making B/Ds' lives "more complicated." Take, for instance, NASD's rule on breakpoints. The regulator claims that broker/dealers and mutual fund companies have failed, in some cases, to give the proper discounts to clients on purchases of mutual funds that are sold with front-end sales charges. The burden is on the B/D to "put technology in place to find out whether a person, or their family, has a breakpoint issue," says Papike with Cross-Search. Broker/dealers "have to know what their brokers are doing, and make sure they're giving the breakpoints to customers when they should." Lister says the likely result of this rule is that there will be lots of changes in how B/Ds sell mutual funds.

Lister says Cambridge is currently building "automated exception reports" to perform surveillance on breakpoints, mutual fund switching, and 1035 variable annuity exchanges.

Then there's NASD rule 02-57, which seeks to eliminate "block transfers." When a registered rep moves from one B/D to another, they usually take their clients with them. "We look at the clients as belonging to the rep," Lister says. "Because the client knows the rep, we move the client with the rep," which is called a block transfer. "But the NASD has said that that may not always be in the best interest of the client." Now, brokerage firms have "to get an affirmative answer from the client before we move them," he says. The rule makes the transfer process slower and more complex for the customer, according to Lister.

As it stands now, the block transfer rule only applies to brokerage accounts, not mutual funds, says Papike. Lister says he's "certain that NASD will apply the [block transfer rule] to mutual funds at the mutual fund company and insurance products held at the insurance company."

Compliance Certification

Lister says he's particularly concerned, as are other brokerage firms' compliance chiefs, about NASD rule 03-29--a direct spin-out of the 2002 Sarbanes-Oxley bill--which would require a B/D's chief executive officer and compliance officer "to annually certify that their compliance program is adequate to detect violations and customer problems that may evolve out of the type of business that particular B/D is doing."

The rule is potentially troublesome, Lister says, "because it's going to create a potential for more regulatory enforcement action and more civil litigation against chief compliance officers. Compliance will be fraught with more potential liability."

Cortese with NRS says he doesn't think 03-29 will be adopted in its current form. "There is some discussion that it has to be more flexible," he says. In its current form, the proposal "would make it difficult for smaller B/Ds to retain experienced compliance personnel," he says, because "any time you have to think of certification that has any legal ramifications to it, people become very sensitive to the exposure that they take on." Cortese says compliance departments would also "be very inflexible in dealing with minor violations, and [compliance personnel would] be less flexible in working out compliance problems with their reps in a way that makes sense from a business perspective because [no one] is going to want to compromise the certification or be perceived as compromising the certification."

But the 03-29 certification proposal does have an upside: "senior management will have to be more sensitive to the needs of the compliance department," Lister says.

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