As a recruiting firm, we deal with compliance issues so frequently that, put in college terms, I majored in recruiting and minored in compliance. The last two years have seen regulators tightening the thumbscrews on broker-dealers and, in turn, advisors. There is little room for error in our industry today—what once might have caused a change of broker-dealer can now put you out of business. Couple this more stringent compliance environment with securities attorneys increasingly expanding their profit centers into our industry and you’re left feeling a bit paranoid.
If you ever find yourself needing to go to arbitration, realize only about 12% of advisors end up winning. If the client is a senior, you can cut the 12% in half. For advisors with multiple compliance marks, it’s become increasingly difficult to find a new home or to even stay at their current broker-dealers as firms try to look good to regulators by shedding themselves of problematic reps. When trying to find a new firm, multiple-mark compliance histories oftentimes require “special supervision” for six months to a year. The problem with special supervision is the added compliance administration that is required; few firms are willing to even consider special supervision unless the advisor has enough production to make the added burden worth the effort.
We’ve put together a list of 10 ways advisors can keep their practice out of jeopardy by building somewhat of a Kevlar protective coating against customer complaints, conflicts with their broker-dealers and securities attorneys looking for mass mediation opportunities.
1. Have a financial plan in place to back up your investment advice. Any client can file a complaint against you, but does the complaint have any merit? If you have a financial plan backing your investment decision, it makes it extremely difficult for the opposing side to win, with these cases often being dismissed.
2. Switch to lower up-front commissions and larger trails on variable annuities. Securities attorneys relish going after variable annuity cases when the rep took a 6% up-front commission with a 25 bsp trail. Why? Because they usually win. Arbitration panels have a strong bias against large up-front commissions, so if you ratchet down to a 3% commission with a 50 bsp trail or 1% commission with a 1% trail, securities attorneys will be much less interested in your case.
3. Align yourself with a broker-dealer that will stand behind you when a customer complaint arises. Broker-dealer responses can vary greatly when it comes to how they treat advisors when customer complaints arise. The ideal firm will stand behind you and fight for you through the process, assuming nothing heinous was done on your part. What you want to avoid are broker-dealers that follow the French mode of law, “Guilty until proven innocent.” Some firms do not even ask your opinion on a case—they assume your guilt and give you 30 days notice along with harsh language piled on your compliance record. For the sake of your business, you want to avoid broker-dealers that are fair-weather friends.
When doing due diligence on a broker-dealer, you might consider talking to securities attorneys for their perspective on a particular broker-dealer. You can also talk to third-party recruiters such as our firm, since we have an objective perspective as to which firms are hostile and which firms are supportive.
4. Do complete asset allocation. One advisor we consulted with recently hired an attorney to do a mass mediation of five clients over improper asset allocation of 401(k) rollovers into variable annuities. The advisor told me that the funds had been allocated in growth, and growth and income sub-accounts, but no bond sub-account. This was because at that time we were in a rising interest rate environment, which would have resulted in losses for bond sub-accounts. At arbitration, the broker-dealer caved in on every complaint due to the lack of bond sub-accounts in the allocation. The advisor was given 30 days notice to find a new firm and five new marks on his compliance record.
5. Don’t make investments for clients that you disagree with. Occasionally, a client will ask an advisor to purchase an investment on their behalf that the advisor knows is not appropriate for their portfolio. Even if the client signs a form acknowledging your disagreement, you’ll still end up being guilty if the investment tanks with the account under your control. Have the client make such purchases in a brokerage account that is outside your control.
6. Paper trail! Paper trail! Paper trail! Document everything and keep detailed notes of client conversations in your contact manager. Maintaining a complete, accurate paper trail—including all necessary disclosure forms—will give you the upper hand at an arbitration hearing. The most common books and records violations include failing to keep client suitability information and not keeping client records and data safe. For you and your staff, it’s also imperative to not have blank signed forms or mismatched paperwork. If you do, you run the risk of a broker-dealer audit resulting in your termination.
7. Convert retail stock and bond trading into fee-based accounts. Doing discretionary advisory with stock and bond trades will alleviate one of the most common customer complaints associated with commission-based active traders—churning. Securities attorneys have an easy time going after commissionable stock and bond traders. Conversion to fee-based accounts will oftentimes diffuse their interest.
8. Know your clients’ heirs. The heir to an advisor’s deceased client filed two customer complaints over universal life policies. After going through arbitration, the advisor was found innocent of any wrongdoing, for the most part because he had a financial plan that backed up his recommendations. The experience motivated the advisor to take a more active role in knowing his clients’ heirs as a hedge to frivolous customer complaints. No matter how well you know your clients, you probably don’t know as much about the people who inherit their estate as you should. They can add an entirely new dynamic to a client relationship, as either a foe or a new client.
9. Alternative investments: Be extremely cautious. Dabbling in the world of alternative investments and private REITs can be like walking through a minefield, making you wonder what will blow up next. Since the landmark years of 2009–2010, problematic alternative investments such as Provident Royalties and Medical Capital have caused numerous broker-dealers to close their doors. Many of these firms approved products with little to no due diligence performed. The advisor assumes the broker-dealer put the products through rigorous criteria before being allowed on their approved list and then later, with great regret and damage to their client relationship, the products cut interest payments in half or completely go bankrupt. In the case of Provident Royalties and Medical Capital, they were found to be fraudulent Ponzi schemes.
If you decide to work in the alternative investments arena, stick with products that have long proven histories, make the investment a very small percentage of the portfolio, invest only with accredited investors and avoid these products with elderly clients because of the illiquid nature. If you are ever in front of an arbitration panel with these products and your client is a retiree, your chances of winning the arbitration are slim to none.
10. Understand what you are selling. Financial representatives rarely read the prospectuses and brochures for the products they’re selling. Instead, they rely on what their wholesalers have told them. Advisors who are unaware of the lack of liquidity associated with many alternative investments, for example, can end up selling them inappropriately, resulting in customer complaints. Structured products, equity-index annuities, equity-linked CDs and other complex products are inappropriately sold with only partial knowledge of the investments.
Early on in the banking meltdown of 2008, an advisor in Florida was selling a large volume of collateralized debt obligations (CDOs), having just enough knowledge of the product to be dangerous. When the price on CDOs plummeted, his losses were so massive that it caused his broker-dealer to close down. The advisor had little experience in the product and was in over his head in terms of his clients’ and broker’s liability exposure.
Protecting your practice from unforeseen problems is paramount to business longevity. The compliance environment is as hostile as we’ve ever seen, so any complacency makes you vulnerable to ruthless securities attorneys, problematic clients or intolerant compliance departments. Make the time to evaluate your current business practices and product mix to avoid the pitfalls that can consume your life’s work.