Facing Off: The 2016 Broker-Dealers of the Year

For the 26th year, the editors of Investment Advisor met with the leaders of the Broker-Dealers of the Year, as identified by their own reps, to discuss the trends and issues the broker-dealer industry will face in 2016 and in the future, with one major change. After six long years, the specter of the Department of Labor’s fiduciary rule has finally taken shape, although as one BD leader put it, the industry is still in a “state of flux” as it determines how to comply with all aspects of the rule.

(See additional coverage on the 2016 Broker-Dealers of the Year home page.)

That includes looking at the products they offer clients through their reps. In fact, as the industry unloads some product lines that are too tricky to navigate under the new rule, some product manufacturers may “be wiped out much faster than broker-dealers will,” as another BD leader put it.

Technology is one tool firms are using to drive growth while managing the compliance burden, and it’s working: One firm’s digital platform is growing like “gangbusters.” However, there’s some disagreement about what — and how much — technology should do for your firm.

The leaders were optimistic about the future of the industry. The DOL rule has increased opportunities to retain reps who don’t want to manage the extensive compliance burden on their own, they said, while one firm has even had former reps leave their own RIAs to return to the corporate business.

Among the winners is Lion Street Financial, which was founded in 2010, the same year the DOL first proposed its rule redefining who is a fiduciary on retirement accounts. Visit ThinkAdvisor.com for more from John Burmeister, president and COO of Lion Street, on how that has shaped the firm.

We asked reps at the firms listed in the 2016 Broker-Dealer Reference Guide to rate their BD in 15 categories. Votes were counted in July, and the winners met in early August in Chicago. What follows is an edited transcript of the discussion in the form of responses to four proposed scenarios. You can find longer versions online at ThinkAdvisor.com, as well as video interviews with the winners.

Click here to learn more about how we choose the winners, and to be notified when we begin work identifying the 2017 Broker-Dealers of the Year. 

The DOL Fiduciary Rule

Scenario 1: The various lawsuits against the DOL’s rule have been thrown out and revenues are falling as firms work to meet the rule’s compliance dates. What are your reactions to the final rule? Is it less or more cumbersome than you expected?

Brian Murphy, Lion Street Financial: I thought [the rule] was inevitable with all of the chatter coming out of Washington from various regulators.

That said, there certainly are complexities and surprises to the rule. The private right of action [the ability of clients to sue instead of using arbitration] certainly was a surprise.

Our industry is overall very adaptive. While we’re going to have to play catch-up in the early days, this will help the industry evolve to catch up to the consumer.

After almost 40 years in the business, I’ve seen regulations, some as big as this, and the industry goes through five stages. It retrenches, pulls in the oars. It resets, and I think that’s where we are right now; for manufacturers and us, we’re resetting. We reposition for future opportunities, and I believe there will be future opportunities for good companies. It retools — a lot of product manufacturers are going to have to do that, even if it’s because I don’t think the BICE is a long-term solution for advisors. How do you ask your client to sign something that says ‘Best Interest Contact Exemption’? It flies in the face of logic. Then the final thing is you rebuild.

I’m very bullish about this industry, extremely bullish about how advisors are going to be able to help consumers. Consumers need advisors and product manufacturers more than ever. Ultimately this will be something that we comply with, but I don’t believe it’s going to be the death knell, if you will, of broker-dealers or advisors.

Lon Dolber, American Portfolios: If you want to get a feel for what could happen, you should look at the British system. Commissions are not permitted in Great Britain any longer. Forty percent of the advisors left the business, but for the advisors that stayed, they’re actually doing very well.

This is the classic innovator’s dilemma, which is when you’re stuck to a certain model of revenue and you’re used to that model and you’re making most of your money that way, how do you change, and when do you change?

You can look at examples of the innovator’s dilemma. Look at AOL: They stuck to their subscription model. They saw what was happening, they knew that was going to change; why didn’t they change?

The question is, are firms prepared to change? Are they prepared to walk away from an existing revenue model? Are they prepared to accept DOL?

Ralph DeVito, The Investment Center: Years back, when ‘RIA’ became the buzzword, we went out and said, ‘Everybody needs to get on this bandwagon.’ A number of the reps who resisted, who wanted to remain the old transactional guy, they’re all gone now.

But I think the DOL rule is going to be very confusing for the investor. It’s obviously had all of us scrambling to figure out what it actually means. I think we’re all waiting for the DOL’s frequently asked questions to get some sort of interpretation.

We’re all a little bit in a state of flux, but we will get through it. It’s not going to be the end of the world for anybody.

Though on the other hand, maybe it will. I’ve always felt that product manufacturers have come out with stuff that is, for lack of a better term, too exotic, too complicated. Maybe this will rein some of that in.

Jamie Green, Investment Advisor: Who has more of the burden here? Is it you or is it the reps who bear the burden of complying with the DOL rule?

DeVito: It’s definitely our burden. It’s creating and fixing or maneuvering or manipulating or changing our product message — how we do it and how the programs work and how we present it to the clients and the reps. As you said, Brian, the Best Interest Contract Exemption — how do you explain that to somebody? ‘I’m doing the best thing for you but here are all the disclosures that go with it.’ It flies in the face of reasonableness.

Eric Schwartz, Cambridge Investment Research: It’s certainly the job of a good broker-dealer to carry the load on this. Certainly, cost wise. Our current estimate’s about $10 million over a two-year period. The cost for advisors will be relearning something new and having a little more paperwork to do but your goal is, obviously, to make all this as automated as possible, just like when any other new regulation comes in.

The really good broker-dealer is going to use this to their advantage by solving the problems better than their competitors. If a bunch of competitors say they’re not going to do X, Y and Z, then those advisors may leave [their current broker-dealer] and find us, which will be partly the way many of us in this room will offset the loss of revenues.

The tricky part, and one of the issues is, “Is there enough time to actually get this done by April?” If the rule was clear and said what you actually had to do, then we probably could have gotten it all done by April.

The problem is most broker-dealers are only still thinking about what they’re actually going to do. [The DOL has] rules like that section about compensation, where it has to be ‘reasonable.’ Is 1.5% a year reasonable? Is 1% reasonable? Is 20 basis points too high because reasonable is zero? What’s the definition of reasonable?

My view is that what we come out with as of April will not be the same as what we have two years later, because we’ll learn along the way what’s reasonable and how it all works.

Dolber: There’s a natural conflict of interest between the buyers and sellers in the capitalistic system. I don’t think it’s a fiduciary issue. The fact is that the buyer always wants to have a lower price if they can get it, and the seller always wants a higher price for their services.

Disclosure, transparency, yes, but why don’t we let the market dictate price? The end result is, this is the business we’re in. I can’t focus on the things that I don’t control. I don’t control what the government is going to do.

Schwartz: I don’t think there is anybody in the industry sitting around saying, “Well, we’ll wait and see how it goes.” There’s just not time to wait and see at this stage.

Also, knowing that the SEC is now going to put together similar rules for the entire industry, [...] it just seems to be a little burdensome without real rationale. I would look at it favorably if this got pushed back a bit, and the SEC came in, and took over, and made one set of rules that apply to everything.

Products and the Regulatory Burden

Scenario 2: You sell a lot of untraded REITs through your rep force, but with the DOL fiduciary rule, it turns out you can’t continue to sell them without incurring a BICE. Are you spending more to meet these requirements? Where are you making up the lost revenue?

Murphy: The big risk is being defined by legal action. The risk of ‘reasonable’: If we were all told to drive a reasonable speed limit that will be judged by a police officer on each highway, [...] tickets are going to tell you whether it’s reasonable or not. Not you.

BICE is going to be something that’s ripe for Monday morning quarterbacking. Was [the contract] extensive enough? When was it signed? Who signed off on it? Being a former product manufacturer, I wouldn’t take that risk.

DeVito: The manufacturers are dusting off their fee-based products on the annuities side. A big question for me is if company A says one is ‘reasonable,’ is company B going to fall in line with that? Is there going to be an industry standard?

What if you have an IRA, and you do the BICE, and you can buy one VA that’s at X percent, and another one at Y percent, how do you do that? It’s going to be up to [the product manufacturer], I believe, to deal with their interpretation of the rule.

Schwartz: A true fee-based variable annuity, where there is no trail and then you’re charging a fee, now you’ve separated the manufacturer from this, and it’s what you decide to charge on the fee. If the internal cost of one is higher than the other, you have to justify why you’re paying more.

DeVito: How do you justify that?

Schwartz: Theoretically, if you have two identical VAs, and one was 2% a year and another was 1%, you’d better be ready before selling it to describe why [it meets the suitability standard]. If you say, ‘Well, this one’s 20 basis points more, but the company is A-plus rated,’ then you have your reasons. The biggest companies — the LPLs, Ameriprise, proprietary wire firms — have already talked to their core product manufacturers.

We have talked with a number of our vendors. They are happy to create products that the industry wants, of course. They are, in some cases, much more scared than we are, especially with variable annuities, where they’re seeing massive declines in sales already. They’re very anxious to figure out what they want. They just don’t want to build a different one for all 100 independent broker-dealers.

Dolber: What also concerns me is the data side of all of this. The data is still not uniform.

They pass these rules, but they don’t look at the data. You have one high-definition TV signal in the United States, but you don’t have a standard for financial services data in the United States, which makes it hard for even the biggest broker-dealer to manage and audit and surveil what advisors are doing.

We were asked by a regulator, ‘Show us every client that has an income rider on a variable annuity that’s past age 65.’ Now is an income rider a field that we get from our aggregator? No. Yeah, it’s in the contract on the paper [and] some insurance companies do have fields that will describe an income rider, but they’re all different. There’s no standard.

DeVito: Did [the regulator] drive down I-95 from me to you? They asked me that same thing! [American Portfolios is based on Long Island; the Investment Center in New Jersey].

Schwartz: Historically, the regulators don’t do much related to product manufacturing. You can create a VA with a 37% commission and it’s fine, but the person that sells it is the one that is in trouble.

I don’t know whether they don’t have the authority, or they just don’t consider it their problem. It’s our problem because we made the mistake of selling a product that wasn’t good. It wasn’t the problem of the person that actually manufactured it.

DeVito: I’ve always had that issue. I’ve always complained about that. Why are the manufacturers allowed to create that 37% product?

Schwartz: It’s based somewhat on the belief in the capitalist system that you were describing earlier, Lon. [Regulators say,] ‘We’re not going to tell everybody what they can and can’t do. They can manufacture any product they want, and you can sell it. Later on we’ll come back and bite you on it, but you can manufacture whatever you want. You can manufacture Lamborghinis, but you’ll get in trouble if you try to sell it to somebody with an income of $20,000.’

Clearly this is going to affect manufacturers hugely, in some cases more than us. If we can’t sell any REITs ever again, we will still have other things we can do for our clients, but if you were solely in the business of manufacturing REITs, this is a scary time, with a 75% decline in sales even before DOL happened.

Green: It sounds like responsibility, meaning both cost and legal liability, is going to be spread around.

Schwartz: The liability is going to mostly stop with us and the advisor, but the need to change and perhaps the margin squeeze is definitely going to impact clearing firms and manufacturers.

Murphy: The near-term risk is that product manufacturers electively overlay this beyond the regulations. I won’t use the name of the manufacturer, but their approach on indexed annuities is that they’re going to apply this rule to qualified and unqualified plans.

That’s going to create confusion and risk, but I think ultimately it is going to accelerate some trends. There has been a trend over the last 10 to 15 years to separate manufacturing and distribution. There are still some [firms] that play on both sides. They’re going to have to make a Sophie’s choice.

Technology

Scenario 3: Say you launch a digital advice platform, but growth has been stagnant. Who’s using — or not using — the platform? What are they using it for? What are the challenges in implementing it?

DeVito: We used to partner with a third party. We looked at a whole bunch of them and picked the one that we thought was the most compliant and had enough infrastructure.

It’s not just an algorithm. There’s actually people behind the management underneath the digital part of it, and we’re growing like gangbusters. It’s not stagnant at all.

[Consumers can invest] on their own, but they’re working in concert with the advisor. We’re taking that smaller account that’s going to be affected or dismissed by this DOL rule. They’re not serviced, and the reps are using it to augment that process, get prepared, and it’s growing leaps and bounds.

I don’t have the demographics of it — is it millennials or older people — but it is, in general, the smaller accounts.

[The platform] wasn’t just going to be one of the big names that we see on TV. You can open up that account the way we used to open a brokerage account in 1970 — name, address, [Social Security number]. I said, ‘There’s no way I’m going to allow that kind of product.’

We do a little bit more of an in-depth look at the client for suitability. The reps are embracing it, and they’re using that also to transition those accounts that might be just strictly advice accounts to the advisory model.

Dolber: A key decision [of ours] was to acquire an advisory platform company called TrustFort, so I could manage the development schedules. Inevitably the technology is going to give us the leverage that we need to compete no matter what happens. To me, it’s not really about DOL as much as it is having that independence to move.

Schwartz: Clearly, technology is the backbone of the information business, which is what we’re in. We are not interested in having a robo platform that competes with our advisors.

We have put together a committee of about 20 advisors, most of whom are somewhat younger and are more interested in having this platform available to their clients. We are continuing to figure out exactly how they would use it and what they would want, so we can complete the final pieces of it and make it available for clients.

For example, what many advisors want is [that] the client can go in, look at everything. They could make trades, but before that trade went through, the advisor would look at it and say, ‘Yes,’ and push a button in order to [complete the trade]. The client will know that the advisor’s going to take a look before it happens and the trades might be delayed. It’s not designed for someone else who wants to trade actively.

We know that even today, and certainly 10 years from now, the client with $20 million isn’t going to do business with you if you don’t have a pretty sophisticated interface that looks a little bit more like a Betterment, combined with the stuff we already have. It’s really a question of building what the advisors want and that’s what we’re doing.

Dolber: You sometimes have to step out and say, ‘What is the advisor going to need?’ You’ve got to look forward. I do believe I see some changes in there. We built our platforms so that it doesn’t make a difference where the asset’s held.

[Advisors will] plug into the network, be able to illustrate, propose, model, bill, execute [and] invoice, end to end. ‘You want to be in my network? Yeah, you can put your products in my network.’

The challenge, of course, is to calculate where you make your money with that, but first things first. You can’t have a network without having a client portal. I don’t mean what most broker-dealers have right now where a client can go to the broker-dealer’s site, and they can log in to Albridge, log in to Morningstar. I’m talking about a real client portal, which the banks have. The client portal that TD [Ameritrade] has because they deal directly with the public.

The independent broker-dealer has not really built true handshake portals with the client, where the client is logging in the way a broker logs in to a portal, and then being directed to services, and they see things in a unified, secure way.

Schwartz: Historically, it wasn’t done because it was the rep’s client; [they] didn’t want them dealing directly with us. The rep would say, ‘Why are you selling him services that I don’t even know why you’re selling them to them?’

Obviously, with a robo client portal, that’s why we’re trying to figure out with the advisors how they stay in the loop, so nothing happens without them being aware of it. It’s a value-add to them, not a competition.

DeVito: What’s going to allow JP [Morgan] or any other firm [to give] you access to their accounts when there’s a rep on that side? What about the regulatory side of it where you need to be registered to do it? Unless you’re going to go completely RIA, and then they’re just a trusted advisor on that side of the business only. Right now there’s too many things in your way to do that.

Dolber: It’s going to take some regulatory change. I’ll give an example: Your medical records. Every time I go to the doctor they make me fill out another bloody thing. I’m saying, ‘Don’t you have this stuff online?’ HIPAA rules have to be changed.

That’s why you have Yodlee and CashEdge because the only way you can get that data is by having the institution for the advisor log in as the client and screen scrape the data.

DeVito: Not only will [you need] regulatory change, you’re going to need regulatory complete reversal and change.

Green: In what way?

DeVito: They’re adding more regulations for our own clients, so they’re tightening up all the regulations for what you have control over. Imagine them now saying [I have] to give up control of that asset theoretically to a trusted advisor who’s not with you. Why would I take the risk when I have my advisor already in it? Who’s going to be the supervisor? Who’s going to be the DOL?

Dolber: Where the asset is held is immaterial.