Interesting Times

Sweeping changes are whirling across the independent broker/dealer landscape in 2007, with major changes at, and coming from, the NASD, SEC, and potentially, Congress. Although broker/dealers may have a fair amount of direct and indirect input as to how a newly combined NASD/NYSE self-regulatory model with a unified set of rules will play out, some other changes may take longer to coalesce. When these changes are combined with the morphing demographics of the investing public, increasing global competition and global investing, and continuing margin compression, the stage is set for interesting times.

As these changes create opportunity–and uncertainty–executives at independent B/Ds seem, for the most part, to be optimistic about the industry, their representatives’ prospects, and their ability to serve the investing public. One touchstone of the changes of the past 12 months for independent broker/dealers is the new leader at NASD, CEO Mary Schapiro, who will also be CEO of the super-SRO when the NASD/NYSE Regulation deal closes, sometime in the second quarter. Her leadership and the unified rulebook that comes out of the new SRO will have a vast influence on how B/D executives structure and conduct business at their firms–probably for a very long time.

However, perhaps nothing has more potential to change how B/Ds do business than what happens over the short and long term at the Securities and Exchange Commission, particularly in the wake of the March 30 ruling by the U.S. Court of Appeals in Washington, D.C. that vacated the broker/dealer exemption rule. The SEC announced on May 14 that it would “not seek further review” of the decision, but did request a four month stay to allow “investors and their brokers to respond in light of a court decision affecting an estimated one million fee-based brokerage accounts.” The overturn of the exemption rule, also known as the Merrill Lynch rule, will undoubtedly create enormous changes at some B/Ds, but not so much at the independent B/Ds. In fact, according to a new element of the annual IA Broker/Dealer Directory this year, the inaugural IA Presidents’ Poll, in which 72 independent B/D presidents provided their opinions on a range of B/D issues, 90% said they did not expect that doing away with the rule would significantly change the structure of their firm (see sidebar “Voices of Authority” for more on the Presidents’ Poll).

In this Special Report on the state of the B/D world, we will consider the state of the independent B/D industry: giant changes in rules and regulators; how some firms are coping with margin pressure; and the opportunity for B/Ds to address the changing demographics of their customers. (The Special Report includes the annual IA Broker/Dealer Directory, online at www.investmentadvisor.com, and a report on recent B/D technology developments.)

As for regulation, for the most part there seems to be a simultaneous, collective sigh of relief among independent B/D executives indicating that having a single rulebook will be easier–and less costly–to comply with, but the executives also seem to be holding their breath to actually see how the new rules are defined and enforced. Compliance is still a very big issue for most independent B/Ds, with firms spending an average of 10% of their gross revenues on compliance, according to a white paper, Independent Broker-Dealers: Building a Culture of Compliance, published in April by the Financial Services Institute (FSI).

One issue that may have a dramatic effect on B/Ds is the SEC’s ongoing study of financial professionals and their functional relationships with the investing public. Chairman Christopher Cox announced May 14 that he “has approved additional emergency funding to accelerate an ongoing outside study of the marketing, sale, and delivery of financial products and services to investors in this area.” That study, being conducted by the Rand Corporation, is to be “delivered to the Commission no later than December 2007, several months ahead of schedule.”

Regulatory Insight

For her part, NASD’s Schapiro has stressed in public speeches and private interviews that the NASD is moving away from “one-size-fits-all rulemaking,” and toward more risk-based examinations, a change that likely would be welcomed by B/Ds of all kinds. In order for broker/dealers to have the flexibility to innovate and grow their businesses, and to allow rules to cover firms of all sizes, the NASD has been adopting some alternative ways of making–and enforcing–rules, and that may make some B/D executives uncomfortable. They include “principles-based regulation,” “tiered regulation” based on a firm’s size, and distinguishing more clearly the rules for institutional versus retail investors, according to remarks by Schapiro at the compliance conference of the Securities Industry and Financial Markets Association (SIFMA) in March. She also stressed then the importance of the NASD being more proactive instead of reactive, and not automatically responding to “emerging issues,” by simply writing new rules. Schapiro argues that, “in addition to or in lieu of rule-making,” the NASD “must consider a range of options, including best practices, guidance, education, and task forces,” to understand and address new industry issues.

Schapiro is well aware of the balance necessary to encourage innovation at B/Ds, the impact of global competition, and especially, demographic changes in the U.S. surrounding retirement for the bulge bracket of boomers. Those preparing for retirement are “very much on their own, given the declining defined benefit plans, the rising healthcare costs, the questions about Social Security; the length of their retirement periods,” and the power of the B/D industry to influence how well many Americans are prepared to retire, she told IA. Her message to broker/dealers with clients in that position is that a “focus on doing what’s right for the client takes you a long way; it’s not enough just to focus on that, but what a great start, and you’re nowhere if you don’t at least start there. Making sure your interests and the client’s interests are absolutely aligned is one of the best ways to ensure that investors are well protected and that the relationship is an honest and fair one between the broker and the client.” However, Schapiro also had advice for regulators, especially when it comes to such hot potato products as equity-indexed annuities, where jurisdiction can, at the very least, be ill-defined. For example, investors have been confused because variable and equity-indexed annuities appear to be similar. When it comes to investor protection and who regulates these investments, why would it occur to an investor that there is national regulation for one but not for the other? “I’m increasingly of the view that regulators need to think about what they do, standing in the shoes of the investor, and annuities are a great example where we’ve absolutely lost the investor in our process of thinking things through.”

“This is a historic opportunity to revisit the whole business of regulation and enforcement,” says Raymond James Financial Services (RJFS) Chairman and CEO Dick Averitt, “not necessarily to take the load off of the financial advisor or the firm, but to ask yourself: If our job is to protect the investing public, what rules should we have? For example, why should insurance agents be able to sell equity-indexed annuities that are horrific, and to do so with impunity, because there’s no national regulatory body to supervise that?”

FSI: Relevant and Powerful