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Regulation and Compliance > Federal Regulation > SEC

What Advisors Can Teach the SEC

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The SEC is back. Or so the agency would like Wall Street to believe. But the new teeth are false. For all its roar, the Securities and Exchange Commission remains out of touch with the practices of its quarry.

Nothing illustrates this better than the ominous if vague letter SEC Chair Mary Schapiro sent late last month to brokerage chiefs warning against the dangers of up-front bonuses and “enhanced commissions” for financial advisors switching firms. “Recent press articles have reported that some broker-dealer firms may be engaging in a vigorous recruiting program,” she intoned.

As any teen-ager might say, “Uh, du-uh.”

Not only have recent press reports been describing in excruciating detail the ever-changing twists on compensation for brokers who jump ship – but so have press reports in various trade publications from last year, the year before that, and well, the entire decade or so before that.

Back in 1996, there was the SEC’s own Tully Commission, headed by former Merrill Lynch CEO Dan Tully. The group studied the perils of upfront money and promoted the virtues of fee-based business, not so coincidentally, then a key new area for the pride of the herd.

Former SEC Chair Arthur Levitt considered banning upfront money, but backed down, arguing instead for transparency. All this happened while Schapiro ran the Financial Industry Regulatory Authority (Finra), so that makes her letter even more puzzling.

More recently, as the SEC letter put it, stories have focused on how financial advisors are in hot demand because until the market rally in March they were virtually the only profit centers on Wall Street. And here’s the real rub: A recruitment story that throws around big numbers is at least superficially easier to understand and politically more useful than stories detailing the ins and outs of financial instruments backed by subprime mortgages.

Even the SEC lawyers who couldn’t understand the reports by Bernie Madoff whistleblowers like Henry Markopoulos could probably understand how the comp packages work. No fancy derivatives involved. (And, please note, not a single customer working with registered reps on Wall Street lost any money to Madoff – they didn’t give any client assets to him.)

Contrary to regulators’ fears and warnings, abuse isn’t exactly rampant on Wall Street.

While not every single reps is completely and necessarily pure, abuse isn’t exactly rampant: According to Finra data, in 2008 the self-policing agency received 5,405 complaints against a workforce of 664,975 reps – less than one percentage point. 363 individuals were expelled from the industry and 321 were suspended; in all, 1,073 disciplinary actions were taken.

Believe it or not, even Goldman Sachs and Bank of America get the same A+ rating that Procter & Gamble sports from the Better Business Bureau. Last year, securities lawyers grumbled to reporters that more people weren’t suing their brokers after the misery of the last two years. “Tougher compliance and improved industry practices” are part of the reason, according to one story. In 2003, Finra complaints peaked at 8,945 following a market plunge.

Who are the advisors getting these big deals anyway?

The advisors who command the big bucks are top-tier entrepreneurs with a loyal following. They typically manage at least $50 million to $70 million in client assets. And if they lose assets, they relinquish much of the advantage of the multi-year contracts.

In fact, the SEC should began to examine how the industry has moved ahead of the curve to re-shape recruitment packages to tie performance and asset retention to their bonuses over a period close to a decade.

Yes, you read that correctly. If only investment banker and trader compensation even remotely resembled advisor deals. Most packages require brokers to stay with a firm for seven to nine years and to meet performance goals that are not just commission-oriented but asset-based. If brokers leave before their contracts end, they don’t get the full value of the deal.

The bonuses are no sure-thing in other ways. Changing firms usually costs advisors: It’s a huge paperwork hassle and some accounts don’t come along. In my experience, most advisors typically bring 75 percent to 80 percent of desired assets to a new firm. Since the new contract is usually based on what is known as trailing 12-months’ production, the new firm usually gives the advisor three years to build back to the prior trailing-12 level. Sometimes the deal pays a bonus for bringing over a certain percentage of assets.

Schapiro worries about churning. Firms worry about that as well, which is why the back-end bonus is often asset-based. Transactions don’t even play a role. Many contracts make the back-end based partially on commissions and partially on asset retention and growth. Occasionally I see a back-end that is linked to asset growth only.

Churning is a much smaller problem for elite brokers for another reason: most are fee-based leaders – they manage about 30 to 40 percent of client money on a fee basis. Trading turnover on their commission business is low on average, at most 1.5. Further, after the market crack-up, a number of clients are switching from fees to commissions: quarterly bills for a shrinking portfolio are hard to swallow.

And consider this: In the 1980s and 1990s, the brokerage industry cleaned up its practices extensively: sales contests bit the dust; proprietary product-pushing were killed, and compliance departments expanded.

Compliance departments for retail investors have strengthened technology and personnel to police the brokerage force. They are constantly scrutinizing asset/commission ratios, suitability and documentation. In my recruiting practice, I now find firms are very selective in taking even top producers if they don’t like the asset base or compliance history. Not just anyone can get upfront money.

In his report on the SEC bungling of the Madoff investigation, Inspector General David Kotz says “inexperience” tripped up the numerous opportunities to nab Madoff.

In my view it was in fact a lack of in-depth understanding of the industry itself. Why was a small money manager like Bernie Madoff allowed to custody client assets? In my view, the SEC letter is disheartening because it shows how little the agency has come in grasping the inner workings of Wall Street.

And here’s one last thought on that epistle to the CEOs of Wall Street: It’s ironic that Schapiro is in a dither about upfront money and the dangers of churning. Senator Chuck Schumer (D-NY) is about to propose a winner-take-all deal for the SEC: The watchdog can keep all the fees it snares from Wall Street bad guys for its own coffers.

Now, that’s what I call teeth. After all, isn’t that the perfect fodder for regulatory churning? You could call it the bad-guy commission.

Mark Elzweig is president of New York-based Mark Elzweig Company, an executive search consultancy that relies on cutting-edge technology to aid clients. He has worked with financial advisors and investment managers for more than two decades.


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