One of my summertime readings was John Stossel’s book, “No They Can’t: Why Government Fails—But Individuals Succeed.” Stossel, a journalist, Fox cable network host and avid libertarian, delves into a multitude of examples of how we intuitively run to government to solve problems.
In Stossel’s book, he argues that we should abandon our beliefs that a government can cure all national ills and instead “retrain our brains to look at only the facts, to rethink our lives as independent individuals—and fast.”
As I read through Stossel’s take on some of our social issues and why our intuitions about them are wrong, it was apparent to me that there are many similarities in the financial services industry. Here are a few examples of intuition gone wrong as applied to the independent broker-dealer channel:
Intuition tempts me to believe that having extensive paperwork will protect reps and their broker-dealer. Reality taught me the only thing they’ll be protected from is the ability to successfully recruit new advisors.
Efficient paperwork is becoming increasingly important to representatives. One rep we talked to, who holds a Ph.D. in financial planning, told us that his primary motivation in making a move to a new broker-dealer was to minimize paperwork.
He explained, “I sit down with a client, placing a large pile of forms in front of them. We go through each of the forms, but they don’t read any of it; they sign where their signature is required. They sign the forms because they trust I have their best interest in mind. They don’t want to read the forms because they’re long and written in legalese. Ideally, I want my clients to be able to read and understand what they are signing rather than simply trusting me.”
Excessive paperwork can make clients suspicious that someone is trying to either screw them over or confuse them, which makes the representative’s job of building trust more difficult. The broker-dealers that “get it” keep most client account forms in the two- to four-page range.
Intuition tempts me to believe large broker-dealers are better able to supervise their reps because they have more compliance resources. Reality taught me reps are more likely to slip through the cracks at larger firms.
Smaller firms have the ability to know their reps much more intimately than larger firms do. We’ve heard numerous stories of smaller broker-dealers uncovering Ponzi schemes, flakey OBAs and similar fraudulent arrangements before they became big problems. We have yet to hear a similar story from a large firm—or from FINRA for that matter. This intimate relationship enables small and mid-sized broker-dealers to more readily uncover problems before they become news headlines.
Intuition tempts me to believe reps will make the most at a firm that offers the highest payout. Reality has taught me they’ll make the most at a firm where they “net” the most.
You’d think this was common sense. However, reps are often blinded by payout rather than seeing the big picture. A lower administration fee on rep-directed advisory platforms is just one area where reps can net considerably more. Other savings can come from general costs such as E&O insurance, technology fees, whether the firm passes through SIPC/FINRA assessment fees, and audit fees.
The mind-set is so strong for reps to choose a 90% payout that when we come across broker-dealers that cap payout at 85%, we actually encourage them to raise expenses so they can afford to offer 90%, even though the rep would net more at the 85% payout with the broker-dealer’s current cost structure. When recruiting, overcoming the lesser payout can be extremely difficult—intuition overrules the fact of netting more with the slightly lower payout.
Intuition tempts me to believe broker-dealer company policies will protect reps. Reality has taught me company policies protect broker-dealers from their own reps.
Company policies are often knee-jerk reactions to large arbitrations, or implemented because a FINRA audit went poorly. Experience shows that firms with extensive company policies are firms that have been in trouble with regulators frequently. Thus, to appease regulators, they come up with policies that will supposedly prevent current problems from reoccurring. Ideally, reps are better off with a firm that does what FINRA requires of them, but not much more. Reps are also better off with a firm that is not under FINRA’s microscope, which is the environment where such policies are given birth.
Intuition tempts me to believe regulations can stop Ponzi schemes. Reality has taught me regulation will never be able to stop people motivated by deceit and chicanery.
Good markets will give rise to Ponzi schemes, and poor markets will lay naked such schemes. No matter what obstacles you put in place, someone will always figure out a way around the rules. Should we in turn have to supervise to the lowest common denominator and make everyone suffer for the few who choose to deceive? You would hope not, but that’s the environment we are operating in today.
Intuition tempts me to believe the best way to assess a broker-dealer’s compliance risk is to look at its compliance history on FINRA’s website. Reality has taught me that looking at the compliance records of the reps at a firm will give a better picture of its compliance risk.
In a recent conversation with a broker-dealer president, the topic of broker-dealer acquisition surfaced. The firm was looking to acquire a small broker-dealer with a compliance record that was spotless. When they looked at the compliance record of the reps at the firm, a much different picture was revealed, as many of the advisors had multiple marks on their compliance record. Analysis of the reps at a firm can be a daunting task, especially for larger broker-dealers. To save time, focus first on looking at the reps in the home state of the broker-dealer. Representatives with numerous marks who require heightened supervision are more likely to get in with a firm in their home state. You can get lists of reps at a particular broker-dealer through lead companies such as SIE Stockbroker (www.siestockbroker.com). You can also look up reps with FINRA’s BrokerCheck tool on its website (www.finra.org).
In doing one such analysis, I recently looked at a firm with more than 300 advisors. I focused on only the reps in their home state. The intent was to count the number of reps with three or more compliance marks (because three marks is a brick wall at many firms). The number came to 32. I had heard rumors over the years that this firm had numerous reps with problematic compliance histories, and this analysis more than confirmed the rumors.
Intuition tempts me to believe errors and omissions insurance will protect reps. Reality has taught me detailed paper trails, notes on conversations and financial decisions backed by a financial plan will do a much better job.
When customer complaints or trade errors occur, your broker-dealer often must battle with the errors and omissions carrier to cover you. Frequently, we hear of reps with a somewhat benign issue such as a trade error not getting covered by the E&O carrier, let alone something more serious like an unauthorized trade. A few firms still opt for a legal slush fund as an alternative to E&O insurance, with the premise that they can count on money set aside to cover reps’ legal expenses. Being proactive with those things that are under your control will offer you much better protection in the big scheme of potential liability.
Intuition tempts me to believe that when most things are equal, reps should join the firm offering the most transition money. Reality has taught me unusually high forgivable notes equate to a pending sale of the broker-dealer or proprietary products and platforms.
When you see forgivable notes much above 20% of trailing 12-months production, what you are really seeing is a broker-dealer that will not be profitable on your business for six or more years. For this model to be fiscally worthwhile, the firm either needs to be sold in the next few years or it will make up the shortfall through proprietary product sales or platforms.
In their book “The Invisible Gorilla,” authors Christopher Chabris and Daniel Simons assert that intuitive beliefs are often mistaken ones that mask critically important limitations on our cognitive abilities. Benjamin Franklin’s observation about extremely hard things suggests that we should question the intuitive belief that we understand ourselves well. Franklin expounds, “As we go through life, we act as though we know how our minds work and why we behave the way we do. It is surprising how often we really have no clue.”