This is the second in a two-part posting on how excessive compliance costs, in addition to other factors, place many smaller, generalist independent broker-dealers’ survival at risk. In part one, we set the stage for the discussion and suggested which broker-dealers will survive. In this posting, we look at which BDs are most at risk.
Which Small BDs Will Falter?
We’ve seen some other specializations fall flat over the years, resulting in broker-dealer closures. Examples include those who focus on internal financial planning and on fee-based advisors without having anything unique to offer. Without something to set them apart, the generalist broker-dealer is going to find that competing with larger firms is increasingly difficult.
Lacking up-front money, a broad array of services, leading technologies or deep pockets to offer financing help with succession planning or marketing expansion, the generalist broker-dealer has little more to offer than personal service and, for larger producers, the management attention that comes with being a big fish in a small pond. Besides recruiting competition from the large broker-dealers, we also see additional regulatory burdens impacting the small broker-dealer’s ability to recruit.
Risk Assessment Reports Affect Recruiting
Since 2008, the Financial Indistry Regulatory Authority has supplied broker-dealers with quarterly risk assessment reports. These reports let BDs know how their firm compares with industry averages on topics such as:
- Reps registered with three or more firms in the last two years
- Number of terminated reps
- Reps with one or more disclosures
- Reps with customer complaint disclosures
- Reps previously employed by a severely disciplined firm
For example, in a given quarter the industry average of reps with one or more disclosures may be 11.5%, and the broker-dealer’s average may be at 23%. The broker-dealer may wonder, “Is that a problem?” FINRA is usually quite vague on such matters.
If you are among the lucky ones, FINRA may hint that they’d like to see you stay under two times the industry average. Otherwise, you might simply need to guess. It stands to reason that FINRA would refer to these risk assessment reports when they are tailoring their inspections of firms. It is during and after such inspections that broker-dealers must quickly make a host of policy changes.
We’ve received feedback from small broker-dealers that they can no longer bring on reps with credit issues or compliance marks because their percentage on the risk assessment report is too high already. Some firms keep a list of severely disciplined firms handy in order to weed out candidates from those firms so their own average isn’t raised above a certain threshold.
In order to grow, smaller broker-dealers are usually forced to take on greater risk in the form of reps with higher frequency of disclosure events as well as lower producers in order to build scale. As these firms grow toward midsize level, they can then let go of higher-risk reps and low producers because they now have the scale to afford to do so. The risk assessment reports adds an additional dynamic that prevents small broker-dealers from being able to recruit because now “beggars have to be choosy.”
FINRA Tightens Thumb Screws on Small Firms
We are also witnessing small and midsize broker-dealers being singled out by regulators on representative credit issues. When broker-dealers are auditing reps, some firms are looking at their tax returns and bank statements. In our survey of larger (noninsurance) broker dealers, we came across none that look at their reps’ tax returns. However, with numerous small and midsized firms, the frequency went full spectrum: from checking the tax returns of only those reps where it was warranted, to as frequent as annual inspections of tax returns of all reps.
A recent prospect shared with us that a small broker-dealer he considered joining required review of his tax returns in order to join, with further inspections each year thereafter. For the rep, it communicated, “We don’t trust you.” The heavy-handed approach was a deal breaker for this rep.
Changed Perceptions, Entitled Attitudes
How small broker-dealers are perceived has changed dramatically since 2009, which is evident when we interview representatives looking to switch BDs. “I want a larger firm so I don’t have to worry about a couple of arbitrations putting them out of business,” is now commonplace thinking. Smaller firms also have to contend with the fact that bigger producers increasingaly feel entitled to a substantial transition note when making a move. If a firm can’t offer 10% to 20% or more of trailing 12-month production to defer their transition expenses, as well as cover production loss from transition downtime, that firm is out of contention.
The Canary in the Coal Mine
Small broker-dealers can least afford compliance costs or compliance mistakes, making the future of the generalist small broker-dealer look grim indeed. Large firms may be gloating over their advantages now, but that exhilaration may be short lived. With the closure of many small BD firms, and a decline in the number of new broker-dealer formations, this segment of our industry is like the canary in the coal mine.
With ever-increasing regulation, what is ailing small-broker dealers today will affect midsize firms tomorrow and eventually work its way up to the larger firms.
Excessive regulation has a trickle-up poverty effect that hurts everyone.
We invite you to read part one of this two-part posting, which includes suggestions as to which smaller broker-dealers will survive.