In a recent conversation with an advisor at an independent broker-dealer, I brought up a few issues of concern regarding his BD. They included a pattern of disparaging press the firm had experienced over the last few years, the loss of numerous advisors, several large fines that had been imposed and their financials running at a loss in the most recent focus filing.
The advisor went to the president of the broker-dealer, who assured him that everything was fine, that they had not lost numerous reps and all was in excellent order. The advisor then shared his feedback with me with an attitude that appeared to imply that either I was misinformed or had not been telling him the truth.
About a month later, I mailed him a news article showing that one of the BD’s advisors was being fined almost $1 million, as well as a copy of the firm’s focus filing, which reflected a loss of more than $500,000 for the most recent reporting period. From my experience conducting broker-dealer due diligence since 1999, and seeing the number of broker-dealers fall from 5,100 to 3,950 in that time, I can say with confidence that broker-dealer management will rarely share any problems that are going on at the firm until it’s too late for advisors to do anything proactive.
As an advisor, you don’t want to be blindsided by the prospect of your broker-dealer closing.
For example, let’s say that your broker-dealer falls into a net capital violation. The broker-dealer is closed, all accounts are frozen and you are left with the prospect of scrambling to find a new broker-dealer. From the time you start your due diligence for a new broker-dealer to switching your accounts, several months can pass. During that time, you’re unable to service your clients until their accounts are switched to another broker-dealer.
Another common scenario is when your broker-dealer decides to sell the advisors and their assets to a larger broker-dealer, often leaving you powerless to voice your opinion on the matter as a new owner is thrust into your life.
The best way to avoid potential problems is to be proactive, so here are several ways you can check on your broker-dealer to determine if issues exist and how problematic those issues might be. The need to do financial and regulatory due diligence is greatest when looking at small to mid-sized broker-dealers,unless the broker-dealer has a deep-pocket parent company as financial backing.
Step 1: Use the FINRA Website/ BrokerCheck
BrokerCheck offers information on all current and many former registered securities brokers and all current and former registered securities firms:
- Go to http://brokercheck.finra.org
- Click on “Firm” box
- Type in “Firm Name” and hit “return” or “enter”
- Go to bottom of page and click on “Download Full Report PDF”
Just as broker-dealers look at patterns with advisor compliance history when doing due diligence before extending an offer to join their firm, so should you look at broker-dealer compliance patterns. Red flag patterns to keep an eye out for include:
- Net capital violations (last five years)
- Disclosures reflecting a lack of supervision system
- Large fines paid out over the last five years for any of the categories (regulatory, arbitration, bond)
Firms that have been around since the 1970s will likely have more marks than a firm formed in the 2000s.
Merrill Lynch, formed in 1958, currently shows 1,527 disclosures with 1,000 of those being arbitrations. Are we concerned that Merrill will be closing their doors? Of course not, but for small and mid-sized independent broker-dealers, a pattern of several large fines paid over the last couple of years can be enough to spur a death spiral.
Step 2: Check the Timing of FINRA Audits
FINRA prioritizes their broker-dealer audits based on risk. What the self-regulator means by this is that higher-risk firms will be audited more frequently and, often, earlier in the year. Broker-dealers are audited once a year, every other year or once every four years. Broker-dealers that don’t do municipal bonds and have a good compliance history may be audited only once every four years, otherwise the frequency will be once a year or every other year. A broker-dealer with a good compliance record may be audited by FINRA every other year with those visits scheduled in the second half of the year.
When a broker-dealer receives annual visits in the first quarter of the year, it can be a strong indicator of a problematic firm that is in the cross hairs of FINRA. There are exceptions to this, such as broker-dealers that are geographically close to a FINRA branch office, in which case it may be visited earlier than normal simply because their location is convenient.