In 2010, Albridge, an affiliate of Pershing, a BNY Mellon company, commissioned Beacon Strategies LLC, a strategy and tactical consulting firm that focuses on the broker-dealer market, to systematically examine the state of broker-dealer compliance and interaction with sales practice management. The results were published in November 2010 in a report entitled “Broker-Dealer Sales Practices Oversight: Secrets of Their Success.”

Albridge believes it is important for the broker-dealer community to have a continuous, updated perspective on this topic. Based on positive feedback to the 2010 survey, we made the commitment to help broker-dealers identify consistent industry standards, as well as gain new perspective on trends and changes.

To that end, Albridge commissioned Beacon to update this study in January 2012. In this process, Beacon Strategies conducted personal interviews and in-depth surveys with 53 broker-dealer firms representing diverse business models and distribution channels. The original study and the update each represent the synthesis of our field work and dialogues with regulators, as well as a diverse cross-section of broker-dealer circumstances and experiences.

Both the original report and the update uncovered gaps and highlighted best practices in broker-dealer compliance practices. In general, our updated findings have reinforced many key points emphasized in the original report. We have briefly summarized many of those points in this update. In this document, we also will draw attention to specific areas and issues where changes are occurring based on our research.

Top Five Industry Challenges—Then and Now

The original study identified the top five challenges of broker-dealers, based on survey responses, as shown in the table on page 59. In the update, the same top four issues continue to weigh on the minds of executives, but the order has changed, with suitability review moving from third into first place. Also, one new issue has moved onto the list at No. 5—social media.

In general, broker-dealers appear to be making slow but steady progress in meeting their biggest oversight challenges. Suitability review is the only one of the original top five challenges to register an increase in response percentage. The increased focus on suitability review is being driven, in part, by increased emphasis on this area by the Financial Industry Regulatory Authority (FINRA). FINRA reported 106 cases that involved suitability allegations in 2011, twice the 53 cases reported in both 2009 and 2010. Suitability-related FINRA fines more than doubled from 2010 to 2011, from $3.75 million to $7.7 million.

It is not surprising that social media now appears on the top-five list, and it could go higher in future updates. Other Beacon research indicates a strong trend toward broker-dealer adoption and approval of social media during 2011, due mainly to increased regulatory clarity from FINRA on supervisory review and records retention; and the success of leading software suppliers who are partnering with broker-dealers to address review and retention issues. We believe the major challenge broker-dealers face with social media relates to FINRA standards for supervisory review of advertising, which generally require compliance pre-approval.

Compliance Gaps

The original study concluded that bank and wirehouse broker-dealers had made more progress in adopting modern, efficient sales practice oversight standards compared to their independent and insurance company counterparts. However, we attributed most of the difference to compliance gaps (“weak areas”), rather than to the firm’s structure or type.

In the original report, we found a high correlation between firms that have two or more of these weak areas and firms with difficulties in upgrading or modernizing sales practice surveillance.

The update reveals a widening disparity between manual and automated firms in the intervening period. The percentage of broker-dealers using manual processes remained about the same—37% in the original study versus 40% now (the difference is within sampling error). However, results also showed a meaningful shift toward fully automated systems and away from combination systems that blend automation with eyes-on compliance reviews. In the charts below, note that the combination percentage decreased by 15%, roughly comparable to the 12% increase in the automated percentage.

A Beacon Strategies survey of 300 broker-dealers conducted in first-quarter 2012 found that, in general, broker-dealers that were in the process of moving to automated systems in 2010 have continued to advance, while many of those that relied on manual processes have not. As a result, the gap between the “haves” and “have-nots” appears to have widened. We think a major difference between them is the commitment of senior management to upgrading systems and putting more business through brokerage platforms, rather than placing it directly with mutual fund and annuity companies. Also, larger firms appear to have made more progress since 2010 than smaller firms, although there are exceptions.

Regulatory Hotspots

The original study identified several “hotspot” issues that regulators were focusing on in 2010, and we believe they all remain at the forefront today. They include:

  • Sensitivity to fraud. According to regulators, broker-dealers’ ability to aggregate and monitor all of an investor’s holdings and activities is a key to fraud prevention oversight.
  • Increased protection for elderly investors. Regulators want to ensure a fair market for seniors, in which sales practices are responsible, the facts are clear and products are suitable.
  • Convincing the public. As expected, FINRA has adopted a rule that gives all investors the right to dispute resolution through an all-public arbitration panel.
  • Interconnected suitability analysis. FINRA’s enforcement activities indicate that suitability is no longer sufficient when transactions are considered in a narrow or isolated manner, apart from a client’s other holdings.
  • Concentration risk. Regulators want to know that broker-dealers can monitor the impact of each recommendation on an investor’s overall concentration. They are skeptical that “silo systems” or paper-based processes can adequately address aggregate risk concentrations.
  • Variable annuity (VA) suitability and exchanges. Federal and state regulators are concerned about VA suitability issues, especially those involved in exchanges.
  • Mutual fund breakpoints and trails. Broker-dealers and investment professionals must monitor fund purchases and breakpoints and convert trail-based shares to A shares when cumulative fee levels are reached. In these areas, regulators believe manual review processes are notoriously time-consuming and prone to error.

The list of regulatory hotspots that we identified in 2010 remains intact two years later, perhaps with some reshuffling in priority. However, one new hotspot, social media, has come to the forefront only in the past two years, and it is rapidly moving up the list of regulators’ priorities.

In 2010, we predicted an increased focus on suitability issues related to elderly investors, and recent trends indicate that this foresight was accurate. We think this issue is heating up for a simple, intuitive reason—the elderly investor population keeps growing, as do their regulatory issues and complaints. Broker-dealers would be wise to devote extra suitability emphasis on any client over a certain age, such as age 65. Ideally, suitability supervision should also periodically revisit the accounts of the elderly to make sure investment strategies remain appropriate at higher ages.

Update on Best Practices for Sales Practice Monitoring

The original report identified several of the industry’s best practices in sales practice oversight, including:

Electronic data entry at the source. Real benefits exist when investor information and orders are entered digitally at the source. This step eliminates errors, duplication and delays compared to paper-based and hard-copy systems, or orders placed over the phone and through “check-and-application” correspondence. Entering data electronically at the source is an important step in a broker-dealer’s transition from separate “data silos” to a centralized system for managing investor account data.

Elimination of paper. Our original study indicated that more than 60% of broker-dealers are systematically converting paper—at the point of entry—into PDF and TIFF files, and more than 30% said they are using tools to convert scanned documents into digitized data. Significantly, this process integrates with surveillance tools that combine KYC suitability data with compliance reviews of specific recommendations. A few broker-dealers are taking the next step in this evolution by adopting “electronic folder” systems that organize and digitize documents at the source on centralized servers of third-party partners, so they do not need to be mailed or faxed.

Use of a centralized books and records repository. Historically, the technology needs of some broker-dealers (predominantly independents) revolved around one application, the commission payment system. As new compliance needs emerged, legacy systems were retrofitted to meet them. Even now, client data captured by some broker-dealers on check-and-application business is stored in commission payment systems that were not designed for this purpose.

Reduced reliance on exceptions processing. This best practice goes beyond the conversion of paper to digital data. It consolidates electronic data in ways that serve the needs of compliance departments and regulators, such as identifying unusual sales practices or employing risk scoring systems. It requires compliance officers and staffers to creatively rethink one-off review processes.


When broker-dealers focus on measuring the productivity and cost-efficiency of their compliance departments, we have found that other best practices generally follow. Conversely, reliance on outdated processes and legacy systems creates extra costs and often results in lower service levels, increased risks, longer processing times and higher error rates.

Our original study found that most broker-dealers were not attempting to measure how much value the compliance department or individual employers added in relation to cost and productivity. Centralizing data and eliminating paper and one-off review processes can increase productivity and make it easier to set productivity goals and measure progress.

In the original study, two-thirds of broker-dealers surveyed said there was an overall trend of growth in compliance staff. For more than half (53%), staff size had been increasing by more than 10% annually over the past three years.

Beacon Strategies found in the first-quarter 2012 study that 63% of firms said there had been a recent trend toward a growing compliance staff. The graph above illustrates the percentage of firms that indicated various rates of compliance staff growth.

In almost half of firms (45%), the growth rate is a modest 0%–10%, which can be attributed primarily to either increased business volumes or a broker-dealer’s response to increased regulatory scrutiny.

As a qualitative measure of compliance growth, Beacon Strategies asked firms to rate the compliance department’s visibility and power within the firm. Twenty-three percent said visibility is high, 44% said it is medium and 33% said it is low.

Finally, as a measure of cost and efficiency, Beacon Strategies asked firms to estimate their overall compliance expenses versus firm revenues. The graph below shows the distribution of responses.

Of course, we would expect average costs to be higher (as a percentage of revenue) in small firms than in larger ones. For the industry as a whole, Beacon Strategies concludes a well-automated compliance department should be capable of bringing costs under 7% of revenue. Thus, the update indicates there is still plenty of room for automation-driven compliance cost savings.

What Regulators Are Saying (and Doing)

In 2011, leading securities regulators were emphasizing:

• A combination of “carrots and sticks” (incentives and sanctions) to ensure that all broker-dealers adhere to uniform compliance oversight practices

• Increased regulatory staffing to enforce compliance with financial regulatory reform and related compliance initiatives

• A Securities and Exchange Commission (SEC) focus on multi-disciplinary regulatory reviews, including specialists with expertise in trading, risk, operations and technology

• “Reasonable basis” due diligence and suitability analysis of the investor

• A shift toward risk-based FINRA examinations of broker-dealers

More recently, we are seeing regulators put bite behind their bark. In 2011, FINRA filed 1,488 disciplinary actions, a 13.6% increase over 2010, and it levied $68 million in fines, a 51% increase over 2010.

Anecdotally, we are hearing from broker-dealers that the regulatory reach of FINRA has grown steadily over the past two years. Examinations are delving into more details, with less tolerance for deviations from regulations and norms. In the words of one industry observer: “FINRA is turning over more rocks, looking for smaller bugs.”

Although the focus of regulators tends to change slowly, we believe regulators are increasingly concerned about problems relating to direct business, with dual or multiple books and records systems. Regulators are connecting the dots between the percentage of a firm’s business that goes direct to manufacturer, as opposed to through a brokerage platform, and compliance oversight gaps and shortcomings. Based on our 2012 broker-dealer survey, we conclude regulators may soon begin devoting increased scrutiny to firms with the heaviest dependence on direct business.

For the most part, our 2012 update has confirmed concepts and verified trends identified in the original 2010 study. As one general observation, it has demonstrated the truth of Isaac Newton’s first law of motion, “the velocity of a body remains constant unless the body is acted on by an external force.”

There is velocity in the securities industry toward automated sales practice oversight. But in 2012, the velocity is most visible and constant in firms that had some momentum in 2010. The same law of physics explains inertia, and this also is apparent in the industry. Old habits die hard, especially “eyes-only” manual compliance review processes and patterns of directed business that result in dual or multiple sets of books and records. We observe that a trend toward placing securities transactions through brokerage accounts versus direct business has been inching forward now for 15–20 years. Yet, it is hard to detect any acceleration in this trend over the last two years, despite more regulatory scrutiny and increased FINRA filings and fines.

It is clear that when Newton’s first law is applied to securities sales practices, broker-dealers are being acted on by a meaningful external force—regulators. The increase in regulatory staffs, multi-disciplinary expertise and scrutiny that we predicted in 2010 has become real, and perhaps recently it has begun to accelerate. We believe regulators will hasten the traditionally sluggish pace of change in some critical compliance areas, and they will also continue to use both carrots (cost savings) and sticks (sanctions) to force changes that increase automation while addressing regulatory hotspots.

Cost pressures are another external force driving change. Only a few years ago, broker-dealers of all sizes were enjoying robust revenue growth and healthy profit margins. Some firms did not watch their bottom lines very closely because there was always more money to be made on the top line. Now, of course, brokerage firm executives live on the bottom line, and it is not far from their pillows at night.

By nature of business cycles and the changing needs of investors, brokerage firms have limited ability to control fluctuations in top-line revenues, but all broker-dealers have the ability to control costs, thereby exerting positive influences on their bottom lines.

We see more firms coming around to the idea that old habits of the past, especially high volumes of direct business, have an intrinsic cost factor attached. Although these costs show up in the compliance department’s budget, they also have significant ancillary impacts in areas such as operations, trading, account administration, advisor recruiting and retention, and client service and communication.

Modern, integrated sales practice oversight technologies and systems (and the qualified people to manage them) do require spending and commitment. But the industry’s experience in the past has been that these expenses are more than compensated by savings from increased efficiencies, avoidance of regulatory actions and fines, and the ability to keep employees focused on productive pursuits rather than compliance and associated impacts.

We think Newton would like what he sees in today’s broker-dealer industry. The two big external forces of regulation and cost pressure are causing most broker-dealers to acquire more velocity toward automation and change. Some are moving faster than others, but perhaps even that gap will narrow in the future.