B/D or RIA? The Case for the Registered Investment Advisor

Legal Standards. There are basically two camps of advisors. One consists of brokers or registered reps while the other consists of registered investment advisors. Many advisors are dually registered, meaning they can serve in either capacity. Both groups are subject to entirely different legal standards.

Brokers are subject to FINRA Conduct Rule 2310(a) reading: “In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his security holdings and as to his financial situation and needs.”

What are reasonable grounds? Who’s to say what’s suitable? What if the advisor has the choice of selling two different products, and Product A pays a slightly higher commission but has higher internal fees as compared to Product B. Both may in fact be suitable, but is Product A in the best interest of the client? This requirement seems to be more subjective and weaker than the legal standard an RIA must meet.

An RIA is required to adhere to a fiduciary standard which is defined at uslegal.com as: A fiduciary duty is an obligation to act in the best interest of another party…A fiduciary obligation exists whenever the relationship with the client involves a special trust, confidence and reliance on the fiduciary to exercise his discretion or expertise in acting for the client…A person acting in a fiduciary capacity is held to a high standard of honesty and full disclosure in regard to the client and must not obtain a personal benefit at the expense of the client.

A person’s financial life is extremely important to them and as such, they deserve nothing less than the highest standard of care possible. What if you were faced with major surgery? Which standard of care would you prefer your surgeon be required to adhere to? It’s no surprise that RIAs wholeheartedly agree with this while brokers tend to argue the dissenting view.

Compensation. Someone who is operating strictly as an RIA will probably be fee-only. Someone who is dually registered or is strictly a broker can be compensated either through fees or commissions. The problem here is that commissions greatly influence behavior. On a number of occasions I’ve heard brokers boast of how they sold some high-commission product to a client. What incentive is there for an advisor to focus on exceptional client service if they receive their compensation up front? Perhaps they can receive another large payday on the next trade. I know there is a lot of money to be made in this industry, but too often it comes at the expense of the client. This leads me into my next point, that of disclosure.

Disclosure Requirements. How many advisors would voluntarily choose to tell a client how much they made on a transaction, especially if they used a high-commissioned product? Doesn’t the client deserve to know this? Wouldn’t this be classified as a conflict of interest? The difference in the disclosure requirements of a broker and a registered investment advisor (RIA) are especially significant.

Brian Hamburger, president and founder of the Hamburger Law Firm and Market Counsel, LLC, a regulatory and compliance consulting firm based in Englewood, New Jersey, points out one of those differences. “Broker/dealers are not required to disclose all past disciplinary actions of their registered reps; only those specifically proscribed within Form U-4 and other reports required of broker/dealers by regulators.” Moreover, Hamburger says B/Ds don’t have to disclose “all conflicts of interest; only where required by law, rule, regulation or contract.” In contrast, RIAs, he says, “are required to provide full disclosure in compliance with strict fiduciary law requirements, as well as the Uniform Prudent Investor Act (UPIA), state trust/fiduciary laws, and by the SEC or state regulators.” He argues that RIAs also have “an absolute duty of loyalty to their client and must disclose all conflicts of interest, past disciplinary actions, and even their personal financial information if they are in a precarious position that may impair their ability to meet their contractual commitments to clients.” To sum up, the RIA has a much higher legal obligation to the client than a broker does.

Proprietary Products. An independent advisor has no proprietary products. Firms clearly receive greater profits when selling their own products as compared to third-party offerings. Back when I worked at a large wirehouse, I made a conscious decision not to focus on proprietary products. I reasoned that if I ever decided to leave, I couldn’t take their funds with me because no one else offered them. One day, after noticing I wasn’t selling the company’s funds, I was invited to join my manager in his office for a talk. He used an analogy of a football coach taking his team into the locker room at halftime, behind in the score. He said that if the coach doesn’t make the right adjustments, he doesn’t last long. I understood exactly what he meant and quickly realized that this wasn’t the type of firm that was focused on a client’s best interest.

Production Quotas & Capacity Issues. As an independent you don’t have any production quotas although you may have a minimum requirement to be associated with the broker/dealer if that is your affiliation. However, when you work for a wirehouse, bank, or other large firm, you must continue to bring in new business, even after capacity is reached. How many clients can you properly service anyway? Is it 50, 100, 200, 500? Sure you can leverage your efforts by adding support staff, but there is a number where the quality of service will begin to decline. Clearly if you’re providing fewer services or lower-quality service, you can handle more clients. The independents of this world have the luxury of making this decision without the influence of management.

The Tale of the Salesman and the Perq

In the beginning there were salesmen hired to sell products. Then along came other salesmen, called wholesalers, who were given a budget to entice the first group of salesmen to sell more of their products. They brought gifts such as golf balls, polo shirts, and even vacations to exclusive resorts. They would also treat the salesmen to lunch on a regular basis. They told these salesmen that the gifts were a perq of the job. “Perq”, the salesmen quizzed? “Yes, perq,” came the wholesaler’s reply. And so it was on the morning of the first day.

Sometime later, the company’s compliance department caught wind of this practice and deemed it acceptable. Eventually, it was discovered that some clients were sold products which weren’t suitable for their specific situation. It was also learned that these products were from some of these gift-bearing wholesalers. Because of this, the SEC looked down from above and decided that it wasn’t in the public’s best interest to allow this practice to continue as it was and they modified the rules. They reclassified some of the gifts as soft dollars and reduced the limits on other gifts. Even so, in many places the practice continued unabated because compliance was understaffed and couldn’t monitor it properly. When this was discovered, another type of salesman emerged. They saw the unethical practices of many of the salesmen in the first group and decided there was a need for a new breed of advisors. When the wholesalers approached this new group and offered the same perqs, they quickly declined, saying it would unduly influence their impartiality.

The wholesalers were shocked at this new type of advisor and word began to spread among the general population. This new advisor began to rapidly gain clients’ trust, as well as market share, and so forever changed the advisor landscape. And there you have it.