Corporate malfeasance. After-hours trading. Mutual fund misdeeds. Breakpoints. A market that lost more than 40% of its value in the last three years. Rampant consumer mistrust. And a Presidential election year.

What do these issues add up to for the independent broker/dealer and its reps? A veritable tsunami of regulations, according to Jerry Singleton of Signal Securities in Fort Worth, Texas. “Every time you open a notice to members or pick up a newspaper, there’s another change en route,” he says. He characterizes the flood of rules as “overbearing, overburdensome, and overdone.” Of course, “we all support compliance,” Singleton says, but he complains that the compliance pendulum has swung far too much to one side.

As regulatory issues move front and center for independent broker/dealers, most agree that the burden of additional rules, supervision, paperwork, and compliance add up to a drop in profits and a threat to the very existence of smaller firms. The cost of hiring additional staff to handle reporting, oversight, and compliance issues, as well as the question of whether mutual fund companies and variable annuity companies will be allowed to compensate broker/dealers for “shelf space” is one major burden. So is the rising difficulty in finding errors and omissions insurance and the rising cost of E&O coverage. Add to that the expense of technology to track how well companies are following regulators’ demands, and the overall climate has become much more expensive.

Changes within the industry, particularly the increased regulatory burden, have already led the FPA to spin off a separate organization for its broker/dealer members. Many B/Ds themselves see the future as filled with a rising tide of consolidations among firms, with smaller firms going under entirely, or conversely, independent-minded reps splitting off to form their own B/Ds in an effort to avoid being stifled at existing firms. But that’s down the road; right now, they’re all trying to cope with the constant change in what the regulators expect of them.

There are a few bright spots in the landscape, of course; it’s a bleak picture indeed that offers no hope of better times ahead. You may recall that the Chinese symbol for “danger” also can be read as “opportunity.” But there’s a rough road ahead in the short term, despite the improving market picture; short-term problems abound.

Higher Costs, Lower Revenue

Chief among the short-term problems cited by B/D executives interviewed for this article is the matter of margins. Already narrow in the B/D business, margins face further shaving in the face of questions over a number of issues, according to Roland Brecek, head of Brecek & Young in Folsom, California.

The matter of shelf space is under regulators’ scrutiny, he points out, and that could cause problems. Most B/Ds, he says, receive soft dollars or payment for shelf space from product providers. “Many [B/Ds] negotiate basis point overrides on certain products, or negotiate some kind of fee for the fund companies to present [their products] at sales conferences. The B/Ds use those [monies] as part of their operating budget.” B&Y last year got $800,000 in fees of that type–a sizable portion of the company’s revenue. Those dollars, says Brecek, can make the difference for a firm between profitability and operating in the red. Moreover, loss of those dollars can translate into lower commissions being paid to reps, Brecek says, “because that difference has to be made up somewhere.” Shelf space fees are not, he says, being passed along to reps. “We’re not allowed to pass them down, so it’s a true hit to the bottom line if we can’t continue to [collect them],” he points out. “It will be a windfall for mutual fund companies and variable annuity companies [if that kind of compensation is halted], because it’s coming out of their operating expenses as well.”

Then there are the additional business expenses generated by regulators’ requirements. “All of that regulatory scrutiny is translating to more costs for B/Ds so that they can track whether clients are receiving proper [discounts], and [so they can] enforce issues,” says Brecek. Art Grant, of Cadaret, Grant, in Syracuse, New York, goes further. “The regulators keep telling us how and why we need to reduce our compensation for our relationship with the clients,” he says indignantly. “It’s no longer our choice; it’s the regulator’s choice. It’s not a free market. It’s the regulators who are determining that, tinkering with our business model.” He points out that when the airlines were deregulated, fares came way down, and the same happened with telecommunications, “yet in the investment business we have the NASD telling us how much we can charge and when we can charge it. It doesn’t make sense.” Grant argues that NASD should tell investors to pay attention to what they’re paying, and make sure they want to be paying those charges, “but don’t tell us what we should be charging.” After three down years in the market, Grant says, regulators should not look to overly regulate the industry, but rather to tell investors to open their eyes.

Another cost factor is E&O insurance. Bud Bigelow, president and CEO of Cambridge Alliance, a managing general agent for E&O insurance in Burlington, Vermont, says the current situation is “ugly.” E&O insurance has seen some upheavals, as B/Ds know well, with policies soaring in price and becoming ever scarcer as companies leave the marketplace. “If you go back to the late or mid-1990s, you had a breadth of availability of coverage that was stunning,” Bigelow says. Many carriers offered the coverage, but they “did not price or underwrite it properly; you have to have a very long-term view of the business cycle in order to know that when things are going great, there will then be a period of things not going great.” During the late ’90s, says Bigelow, carriers would write policies based on what the “guy down the block” was writing. If one wrote it for 10% less, the next would write it for 12% less. “Sooner or later you’re not even covering the gross, let alone making a profit,” he points out.

E&O insurers could operate this way for a while because they were able to make up for a lack in reserves by investment returns. But when a chain of catastrophic events began in 2001 with a dramatic increase in claims from reps and B/Ds due to the deterioration of the investment markets, things began to fall apart. A reserve deficiency that had built up over 15 years, the decline of available investment income to offset underwriting losses, and the losses associated with September 11, 2001, combined to create a climate like none the market had seen. “9/11 was the biggest catastrophic loss in history,” says Bigelow, “Over $65 billion dollars. It was the largest catastrophic loss in every line of investment: Comp, property, life, and reinsurers.”

Cover Me

B/D insurance is a complicated business, says Bigelow, pointing out that there’s a supervisory relationship over individual reps that’s complicated by B/Ds not having a huge amount of control over what their reps do; the reps are in some sense independent actors. Failure to do the proper underwriting for policies meant that as the market worsened and claims increased, losses increased exponentially. As businesses began to experience losses, marginal companies began to exit the market, some closing their doors.

Also, he points out, reinsurance companies suddenly became aware of the true potential of loss, and decided that they were not interested in insuring that type of business any more. The few companies remaining raised their rates and tightened their underwriting, and premiums soared from between $4,000 and $5,000 to $70,000, putting E&O out of the reach of many small B/Ds, Bigelow says.

So now some B/Ds are going bare. And in this field, reps can’t go out and get their own policies. “B/D policies are group programs,” explains Bigelow, “like group health. So if a B/D goes without, and the rep wishes to retain a relationship with that B/D, he’s basically uninsured and uninsurable.” There have been carriers who would insure individual reps, he says, but coverage–and the carriers–doesn’t last for long. Bigelow puts it this way: “In an OSJ office with 10 guys, if one has an account that touches on four or five others, from the insurer’s point of view, the liability flows to where the money is. If there’s a lawsuit, the ones without coverage will end up saying, ‘It’s Fred’s fault,’ if Fred is the only one with coverage.” There’s reluctance on the part of insurers to insure someone who is just a registered rep, and for good reason.

Bigelow compares it to another lawsuit-fraught field–medicine. A doctor is an agent of a hospital, he says. In a lawsuit, the doctor gets named, the hospital gets named, but each has his own separate coverage and each insurance company defends its own client. But with a B/D policy, it’s the reps who pay. The B/D divides the cost of the policy by the number of reps, and the reps will each pay a share. Some B/Ds, says Bigelow, even use the insurance as a profit center and may charge more per rep than the policy costs. “But when a claim comes in, the reps from the insurance company will try to keep the B/D happy, and the individual rep gets mauled,” he says. In fact, when that claim arrives, the rep may be asked to sign a waiver of conflict-of-interest.

B/D policies, says Bigelow, suffer from four problems. The first is conflict of interest. Second is that when a rep leaves a B/D, coverage evaporates immediately. The third problem is that the policy will cover the business a rep does through his B/D, but not all that he does. And the fourth is that policies are written with an account aggregate limit–”it’s not unusual to see a thousand-man firm written with a $2 million aggregate limit,” notes Bigelow. Claims against someone else within the B/D could use up the coverage and leave the clean practices and reps bare.

Circling the Wagons

While one B/D executive who wished to remain anonymous suggested that the rising tide of regulations is at worst a minor inconvenience to wirehouses, since they have far larger staffs and greater financial resources to deal with compliance and paying any fines (“they can just write out checks,” he says of the wirehouses found guilty of violations), those regulations can be crippling to smaller B/Ds–and perhaps even benefit wirehouses by serving to eliminate independent B/D rivals. The need for additional staff to handle compliance issues, greater technological resources to supervise and monitor, and additional time spent handling oversight has led to a cry for advocacy among the independents, who say that regulators don’t understand the way they do business.

Tony Batman of 1st Global Capital Corp., a B/D in Dallas, says that Federal and state regulators must be educated on how independent B/Ds operate. All reputable B/Ds, he stresses, feel that regulation is absolutely necessary to protect consumers against unscrupulous providers, but there has to be fair and balanced regulation “and not this overreaching, cascading, paralyzing momentum that can actually imperil commerce.” To support his call for education, he cites the case of a former senior executive from NASD who was recently hired for 1st Global’s compliance staff. This executive had served for 14 years at the NASD, and after three months watching 1st Global implement rules from NASD, he apologized: “I had no idea how costly and difficult we make your lives when we put out a pronouncement as we often do.’”

The Financial Planning Assocation has fired the first salvo in the war of education by splitting off its B/D members into a new independent organization designed for advocacy on behalf of the industry. Headed by Dale Brown, former associate executive director of the FPA and executive director of the Foundation for Financial Planning, the as-yet-unnamed organization has, as two of its stated goals, advocacy for independent B/Ds and education of regulators. In fact, it has begun its life with an impressive set of objectives (see sidebar on page 74).

According to Nancy Johnson, a CFP in Indianapolis and compliance coach and member of the FPA’s board of directors involved in the new organization, one of the benefits of the new organization will be to give smaller firms the opportunity to let regulators know who they are and what their concerns are. This can be an invaluable opportunity, since so many issues before regulators today are being “solved” in a way that stretches the resources of smaller B/Ds beyond the breaking point. Johnson points out, for instance, that small firms “don’t have the technology [for] when an SEC regulator walks in and thinks you have this whole list of exception reports and can just print it out. I doubt if there’s a compliance department anywhere that’s not at least somewhat understaffed at least part of the year.” She also points out that small firms don’t have in-house general counsel. She adds that there’s a lot of room for interpretation; it’s hard to figure out sometimes what the regulators have in mind. A chance to bring some of these issues before the people generating them could have a substantial effect.

The Price of Admission

But then there’s the cost factor. While several executives we spoke with said their firms would remain members of the FPA as well as joining the new B/D group, Roland Brecek says that Brecek & Young will not. He feels that while the FPA was a good haven for advisors, it has not been a good organization for B/Ds. “I don’t mind paying a lot if I get a lot in return,” he says, “but if I don’t get a lot out of belonging and they don’t represent my interests . . . the interests they’re advocating at the FPA are not consistent with what’s important to me as a B/D.” On the other hand, Shawn Dreffein, president of National Planning Holdings in Santa Monica, California, the B/D network affiliated with Jackson National Life Insurance Company, says that “many of our reps are involved in the FPA, and so it makes some sense to keep our foot in there as well for the time being.” Lobbying is another strategy that has been suggested for the new organization, and the cost of that is a factor members of the group will have to consider.

According to John Rooney, managing principal, San Diego, for broker/dealer Commonwealth Financial Network, there’s another cost affecting shrinking margins. “A lot of B/Ds are finding that smaller producers are almost not profitable at any payout level,” because the regulatory environment is so much bigger a burden now. He cites the Patriot Act as one major factor in this expense–money-laundering issues, know-your-client rules, and other requirements have resulted in B/Ds adding departments that didn’t exist a year ago. He sees this development pushing smaller B/Ds out of the business entirely. “The ones that have traditionally fed off smaller producers have got to be saying, ‘This is not a profitable business any more,’” adding that producers with $40,000 to $50,000 in annual production will have no place to go. He points to the recent shutdown of VeraVest as an example of where the industry is going.

VeraVest, the one-year-old broker/dealer of Allmerica Financial in Worcester, Massachusetts, was scheduled to be completely shut down by mid-December, leaving 850 reps to find another place to roost. While many of those reps have found other homes, the fact that Allmerica chose to focus its attention on the property and casualty side of its business rather than deal with the apparently tighter margins in the B/D business, says Rooney, is a sign of where the industry is headed. Some reps will undoubtedly find it harder to sign up with a new B/D.

The margins, says Rooney, are “really scary.” B/Ds are looking at this challenge in one of two ways, he says. Either they push paperwork and compliance down to the LSJ and rep level, where they’ve got to do a lot more work on their own to fill out forms and comply, or they can try to do it at the B/D level, which is what he says Commonwealth has tried to do, but notes that it’s “extremely expensive to do it at the B/D level.” Rooney points out that if a B/D is paying out 90% and “pushing all this work on the guys instead of doing it at the home office, and I’m doing it at 85 and doing it in the home office, there’s a crossover point.” He questions whether there’s room left in the industry for the $50,000 producer, given compliance, E&O, and other costs. “Some will jump and some will be pushed” out of the business, he theorizes.

So Tell Me the Good News

Yes, Virginia, there is a bright side. The market is turning. Business is up. Higher volume may not make the difference for those who survived so far, but it will help companies keep going as they decide whether their business model fits the new regulatory atmosphere.

There are other bright spots, as well. The new B/D organization offers the opportunity not just for lobbying and advocacy, but a discussion of common causes. Roland Brecek says he’s interested in what kinds of common technologies could be used to meet regulators’ demands. “I’m interested in a sharing of ideas on how we enforce breakpoints so we don’t have to invent the technology ourselves. I’d like to find out how others are dealing with certain issues.”

Another source of possible good news is adding new products and services to increase B/D revenues, such as liability management (see sidebar on page 76).

For those who wonder if the B/D industry will survive, there’s really not much question. Some of the most forceful spokesmen for the future of the industry are quite sanguine. Take Tony Batman of 1st Global, who believes that B/Ds are “extraordinarily significant and relevant to American society.” Or Jerry Singleton of Signal Securities, who predicts that 2004 looks “really, really phenomenal, coupled with the fact that it’s an election year.” Or Art Grant of Cadaret Grant, who argues that the best way to deal with the added regulatory and business burdens is “to do more business, and we expect to do more business. There’s nothing we can do about those negative influences on our business, and we have to work harder to grow our business. We’ll be able to deal with it.”

Marlene Y. Satter is a freelance financial journalist who can be reached at msatter@erols.com.