From the June 2017 issue of Investment Advisor • Subscribe!

As Indie BDs Dwindle, Is FINRA Outdated?

Brad Bennett, former head of FINRA enforcement, said that some brokers are becoming investment advisors to “minimize their regulatory burden”

Some brokers have switched to an RIA model to avoid more stringent examinations. Some brokers have switched to an RIA model to avoid more stringent examinations.

It's a question that caused even former Securities and Exchange Commission Chairwoman Mary Jo White to scratch her head: Why are the number of broker-dealers dwindling?

White told members of Congress during her tenure as SEC chief that the agency was probing the likelihood that broker-dealers were shifting to the advisory world to avoid inspections by the Financial Industry Regulatory Authority — their primary regulator — so they could face a less frequent exam schedule by the SEC.

(Related: Under Pressure: The 2017 Broker-Dealer Reference Guide)

Indeed, Brad Bennett, former head of FINRA's enforcement division, told me in a recent interview that it does “appear that some brokers are transitioning to investment advisors as a kind of regulatory arbitrage to minimize their regulatory burden.”

The regulatory obligations of a broker-dealer “have not been reduced. It is difficult to comply with the broad array of compliance responsibilities if a broker-dealer does not have scale,” said Bennett, who's now a partner at Baker Botts in Washington. “There is no doubt that the regulatory burden is more manageable from a business perspective if you are an investment advisor.”

As of April, the number of broker-dealers totaled around 3,900, said David Alsup, director of business development at Fishbowl Strategies, which compiles a monthly snapshot of FINRA member brokerage firms’ comings and goings from the business. The number of firms is “going to go down to 3,500,” he told me recently. There's a “net loss [of indie BDs] almost every month.”

FINRA examines the vast majority of large and high-risk firms annually, Bennett said. The SEC, which is also under a risk-based exam regime, covered 11% of advisors last year through its exams.

In April, there were 131 new RIA firms. “Brokers are looking at the constraints of making investments for their customers and they are going to the advisory side as opposed to the rep side,” Alsup said. “That's why you’re seeing the surge in RIAs. ... I don't see any lessening of new RIA formations.”

The 131 new RIAs “branched off out of existing BDs and decided not to do securities business,” opting mostly for mutual funds and insurance, Alsup said.

Indeed, the number of SEC-registered RIAs continues to rise, with 12,172 firms registered with the SEC in April, compared to 11,847 firms as of the same time last year.

As it stands now, there are at least 1,000 IBDs with under 10 reps, Alsup said, “and they don't have the capability to bring in a full-time compliance officer.” The “whole aspect of the way that the securities industry” operates is changing, he continued. “The stock jockey is all but dead.”

Chip Roame, head of Tiburon Strategic Advisors, agrees the number of IBDs are dwindling “for many reasons, most of them logical competitive business issues.” Those include: “the movement to fee-based investing, higher compliance costs associated with FINRA, and more financial advisors going fee-only, not requiring a broker-dealer.”

Financial advisors who stay with IBDs “will have more of their assets on the advisory platforms of those IBDs,” Roame opined. “The surviving IBDs will look more like custodians.”

What Does All This Mean for FINRA?

“One of the most troubling developments for FINRA is the migration of assets from brokerage accounts to advisory accounts resulting from the [Labor Department's] fiduciary duty rule covering retirement assets,” Bennett said.

That's troubling because FINRA “does not have primary jurisdiction over advisory assets and thus its mission gets smaller because there are fewer assets under its direct regulatory control. A firm that is in the BD space is overseen by the SEC and FINRA. Advisory firms are only examined by the SEC,” he explained.

The shift of assets away from FINRA's jurisdiction raises the question: What does this mean for FINRA's self-regulatory structure? “The fact is that the vast majority of registered reps work for the 20 largest firms,” Bennett said. “If the fiduciary duty rule has the effect of shifting a significant portion of the assets that [BDs] service to fee-based accounts, this is not a positive development for FINRA.”

Alsup maintains the shifting of assets trend will continue “regardless of DOL fiduciary — this is the trend. People in the securities business are finding other ways to do business.”

Roame asserted that FINRA is “yesterday's regulator.” The BD industry regulatory structure “needs to evolve to recognize the nearly universal shift toward fee-based accounts. FINRA's existing structure was built to police commission brokers,” the consultant said.

Roame added that he doesn't necessarily believe that “those using fee accounts are somehow inherently more ethical, but I do think that fee accounts eliminate many (not all) of the conflicts that the commission business fosters.”

FINRA, therefore, “should regulate fee-based business or the SEC should replace FINRA as the regulatory [body] for all financial advisors.”

The FINRA360 Initiative

Roame sees FINRA CEO Robert Cook's launch of the FINRA360 initiative earlier this year, which allows for a comprehensive probe of the self-regulator's operations and programs, as his way of acknowledging that times are changing.

“I believe Cook senses the movement away from the traditional role of FINRA, and is appropriately considering options,” he said.

Indeed, during a meeting in January at the Harvard Club in New York, Cook said he believes “that while we [FINRA] do a lot today, we have an opportunity to take a fresh look at whether we can improve our engagement and transparency.”

Being an effective self-regulatory organization “that protects investors while promoting vibrant capital markets requires that FINRA engage member firms and the public in meaningful dialogue,” Cook said.

“FINRA invests significant resources in its current engagement programs, and we are exploring how these programs can be made more effective without compromising our regulatory responsibilities. Requesting comment is an important part of that evaluation,” he explained.

Cook also noted that while he has “argued for the benefits of engagement and transparency, I also believe our thinking on these matters will need to be thoughtful and nuanced, taking into account our unique regulatory model.”

FINRA, he continued, “operates under a variety of rules and limitations created by Congress, the SEC and our own organizational documents that are designed to make us both a membership organization and a credible regulator — in other words, an effective self-regulatory organization.”

Member engagement in the regulatory process “is both enabled and limited by various checks and balances, such as having a majority public board, limited powers, and continuous and extensive oversight of our regulatory operations by the SEC to provide ongoing accountability that we are acting in the public interest,” Cook said.

Bennett noted that Cook sees the FINRA360 program as “an important part of his initiative to make FINRA more efficient and more responsive to membership.”

The initiative consists of two parts: “an internal review led by senior managers to identify opportunities for improving FINRA's work streams,” Bennett said, and “the solicitation of membership feedback on how to improve the responsiveness and usefulness of FINRA's outreach efforts.”

Under the 360 initiative, FINRA is now seeking feedback on the self-regulator's advisory and ad hoc committees, rulemaking process, member relations programs, and the information it provides regarding its programs and operations.

Another request seeks comment on the capital formation process, proposed amendments to rules for underwriting arrangements and a proposed safe harbor from equity and debt research rules for desk commentary.

--- Read Destination Unknown: The 2017 Broker-Dealer Presidents Poll on ThinkAdvisor. 

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