More On Legal & Compliancefrom The Advisor's Professional Library
- Nothing but the Best Execution Along with the many other fiduciary obligations owed by RIAs, firms owe a duty to seek best execution of clients transactions. If they fail to do, RIAs violate Section 206 of the Investment Advisers Act.
- Agency and Principal Transactions In passing Section 206(3) of the Investment Advisers Act, Congress recognized that principal and agency transactions can be harmful to clients. Such transactions create the opportunity for RIAs to engage in self-dealing.
Some Wall Street firms belonging to the Protocol for Broker Recruiting, commonly referred to as “the Protocol,” are responsible for a troubling trend: They are creating “exceptions” to the Protocol’s original mandate in order to stem the tide of breakaway brokers.
Patrick Burns of the Los Angeles law firm that bears his name knows just about everything there is to know about the Protocol—from its launch in 2004 by UBS Financial Services, Merrill Lynch and Citigroup/Smith Barney, to its current state—and he says the original code of conduct language under the Protocol was designed to be “pretty straightforward.” It states that when reps of member firms leave to go independent, “as long as they take their basic client information with them, and leave one protocol member firm and join another, they won’t get sued or have any other type of legal action initiated against them as part of the departure,” Burn says.
Burns recently released a white paper called “Opening the Floodgates to Independence: A Brief History and Impact of the Protocol for Broker Recruiting,” that details the effect the Protocol is having on Wall Street and registered investment advisors (RIAs). The paper notes that the Protocol membership has grown to 650 firms, and includes broker-dealers and independent advisory firms. Burns notes that joining the Protocol is really quite easy. Firms must only notify the Securities Industry and Financial Markets Association (SIFMA) that they wish to become members.
The Protocol has not only become an excellent recruiting tool, but also a “backdoor” for breakaway brokers to easily depart a firm. It is this ability to break away that has Wall Street “more than concerned,” Burns says in the paper, “with several hundred independent RIAs and numerous independent broker-dealers now part of their once 'exclusive’ club.”
Burns writes that Discovery Database has found that 12% of advisors change firms each year, and the Protocol has “streamlined this process by removing a majority of the uncertainty, costs and fear from both advisors and member firms.” Burns calls the Protocol “a double-edged sword,” because while it “works fantastically” as a recruiting tool for members, it can also provide an easy way for brokers to head the other way and depart from member firms.
“Wall Street firms need the Protocol to keep their recruiting engine functional,” he says. Yet “some Protocol members have qualified their membership status by establishing provisions designed to weaken the Protocol and tilt the playing field back into their favor.”
Of U.S. Trust and ‘Garden Leaves’
The paper notes that one recent diversion from the Protocol was the U.S. Trust unit of Bank of America Merrill Lynch creating a “Garden Leave” policy requiring departing advisors to provide 60-days notice before leaving. While U.S. Trust is not a member of the Protocol, Merrill Lynch is a member. Burns notes that during this Garden Leave period, “contact with clients must be consistent with the firm’s policies and most likely would hinder” the departing advisor’s ability to convince clients to follow the advisor to a new firm, due to the length of time of the transition and the uncertainty that might arise in the client’s mind.
As Burns explains, the reps that left U.S. Trust “had their underlying securities licenses with Merrill, and then they went over to Dynasty Financial in New York.” After their departure, “they ended up getting restraining orders and other legal actions initiated against them.” The reps “contended they were covered by the Protocol because their licenses were with Merrill, and they were registered reps of Merrill, but U.S. Trust felt otherwise.” Observers, Burns says, believe that the U.S. Trust policy was initially instituted because a high-profile, multibillion-dollar broker defected to an independent RIA firm.
The wirehouse firms, Burns notes in his paper, all have extremely high goals for advisor recruiting to ensure their continued profitability. As a competitive result, those firms continue to offer “stratospheric deals to steal advisors from each other, creating a vicious circle they cannot escape.” Placing such “Garden Leave” policies on brokers like U.S. Trust did, he says, or attempting to create “self-dealing carve-outs,” will sharply limit those firms’ ability to recruit advisors in the future.
Burns also points to a letter sent some time ago from Ameriprise to its reps “that talked about advisors that had sold their practice being subject to a non-compete” agreement. “Perhaps that one [exception] is more understandable because if the [advisor] sold their practice, then they don’t have any clients to bring with them,” he says.
Should There Be a Protocol Cop?
While the exceptions by some Wall Street firms may not yet be a major problem, Burns says that the diversions from the original Protocol mandate could spark other brokerage firms to follow suit. He believes that some sort of formal ruling body to police the Protocol should be considered. “If nobody is taking up these exceptions with some of the firms that have initiated them, what’s to stop other firms from coming up with their own exceptions?” he asks. “Does one exception lead to many more? Does that destroy a simple agreement that was put in place and get us back to the bad old days where anytime a rep leaves, you have a restraining order, start suing [them], or filing arbitrations against them?”
As it stands now, disputes involving the Protocol are handled in court or decided in a FINRA arbitration action, assuming that FINRA has jurisdiction over the arbitration, Burns explains. “There’s nothing in the Protocol that mentions what you can and can’t do,” regarding exceptions to the original rule, Burns says. “It’s just not addressed at all.” That why Burns thinks there should be formal rules as to how such exceptions are handled, and some structure put in place for dealing with these exceptions and to the objections against them. Perhaps, he continues, the industry should go a step further so that those firms that “only like the Protocol when they recruit, but don’t like to follow [its rules] when people leave,” would face some type of disciplinary mechanism.