Earlier this month, TD Ameritrade did a survey study of breakaway brokers – specifically asking those who were breaking away why they were leaving – and overwhelming, the top challenge that breakaway brokers cited for the broker-dealer world is the current regulatory environment. In essence, the compliance and regulatory burden of working at a broker-dealer is slowly but steadily driving advisors to the independent RIA channel. Which is interesting given that the broker-dealer community maintains that a fiduciary rule (e.g., from the Department of Labor) is unworkable due to the regulatory and compliance burdens it creates... even as leading advisors at broker-dealers continue to leave and transition to the fiduciary RIA model!?
In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we look at the interesting trend of advisors leaving broker-dealers to become fiduciary RIAs, why fiduciary regulation is actually easier to comply with than broker-dealer suitability, and why the real problem at broker-dealers is not the compliance burden of a fiduciary rule but the lax recruiting standards at many broker-dealers (which have brought them reps that don't have the requisite training and experience to be fiduciary advisors!
There has been much discussion in the industry in recent years about how the fiduciary standard is a higher standard than "just" suitability. There’s more scrutiny on conflicts of interest, and an RIA’s Form ADV has a lot more required disclosures and cost details than typical broker-dealer agreements. And the Department of Labor’s fiduciary rule outright bans a lot of conflicted compensation arrangements. But indirectly… that’s the point of why it's actually easier to comply with a fiduciary rule! When firms are required to disclose more details about their conflicted compensation, many simply stop doing it, and the result is business model that is much simpler to comply with the regulations. In fact, under principles-based fiduciary regulation, it's not exactly clear where the line is between appropriate and inappropriate behavior... so advisors tend stay far away from that line, which ironically leads to fiduciary advisors often having lower E&O insurance costs than brokers. By contrast, under rules-based suitability regulation, in which FINRA lays out a clear line, brokers are invited to get really close to the line, and even allowed to be incentivized to step over the line. Which then means FINRA must focus a huge amount of its regulatory energy in trying to keep people right on that line, and punishing them whenever they do respond to incentives and step over the line.
In the end, there are actually two problems with this kind of regulatory approach. The first is that the industry is inevitably going to have a lot of people who do step over the line, which means a lot of regulatory fines, lawsuits that go to arbitration, and higher E&O costs. The second problem that crops up with this kind of regulatory approach, though, is what I call the lowest common denominator (LCD) compliance problem. In the broker-dealer context, lowest common denominator compliance means the compliance department writes all their rules and regulations for the lowest common denominator. Basically, whatever the one biggest idiot under the entire broker-dealer umbrella could possibly do to cause harm… the broker-dealer writes compliance rules to ensure that one person is "properly" overseen. Which means for everyone else – all the normal, high-quality honest and ethical advisors – are stuck complying with the rules written for the biggest idiot in the organization! And this problem is exacerbated by the fact that as the best advisors are driven away by LCD compliance standards, the quality of the average rep that stays behind is reduced, which means the broker-dealer has to tighten the compliance screws even further, and the problem just spirals downward.
Fortunately, I don’t think this necessarily means we’re at the beginning of the end of the broker-dealer model. While historically (and from a legal perspective) broker-dealers only exist to serve as an intermediary to facilitate the sale of commission-based brokerage products, broker-dealers have increasingly provided a second value proposition as well – they’re essentially "advisor support networks". Many advisors are not interested in building their own business from scratch, and broker-dealers can continue to fill this void by providing tools, resources, and a platform. However, it will require broker-dealers to improve their recruiting standards, so that LCD compliance standards don't make it so miserable for good advisors to stay in a broker-dealer!
But the bottom line is just to recognize that the regulatory woes of the broker-dealer environment aren’t really about the potential for a fiduciary standard to apply to them. What it’s really about is the fact that many broker-dealers have cast such a wide net in their recruiting process, that they’ve brought in some very low-quality reps. Which compels their compliance department to make lowest common denominator compliance rules, that make the lives of their best advisors miserable, and leads those advisors to leave and find “advisor support networks” that don’t come with the broker-dealer’s regulatory baggage. Which means broker-dealers need to find ways to screen out low-quality reps, get rid of bad ones, and lift themselves to a higher standard, so that they can retain good advisors who don’t like to be dragged down to LCD compliance standards!
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Welcome, everyone! Welcome to Office Hours with Michael Kitces.
For today's Office Hours, I want to talk about some of the regulatory challenges of broker-dealers. Earlier this month, TD Ameritrade did an interesting survey of breakaway brokers. They asked more than 100 brokers who were breaking away and leaving broker-dealers about why they were leaving, and the overwhelming top challenge that breakaway brokers cited for the broker-dealer world is the current regulatory environment. Essentially some combination of the ongoing challenges of broker-dealer oversight in general and the ripple effects of the Department of Labor's fiduciary rule.
And it was striking to me because the concerns about broker-dealer regulatory environment trumped even the changing compensation structures, reputation issues in the brokerage industry. Simply put, the regulatory burden of working at a broker-dealer is slowly but steadily driving advisors to the independent RIA channel, particularly as more and more advisors shift to fee-based compensation, which means they're doing less and less commission-based business and therefore have less of a need for a broker-dealer to facilitate commissions in the first place.
Fiduciary Regulation Is EASIER To Comply With Than Broker-Dealer Suitability? [Time - 1:21]
But here's the fascinating part of this challenge to me about the regulatory and compliance burden of broker-dealers driving advisors to the independent RIA channel: Broker-dealers are subject to the suitability standard, whereas RIAs are subject to the higher fiduciary standard.
Now, the line that's been coming from the broker-dealer community regarding the Department of Labor's fiduciary rule is that a fiduciary rule for advisors is unworkable, and particularly because they claim it will raise compliance costs and strangle out small advisory firms trying to serve smaller households, yet we have this strange paradox.
The broker-dealer community claims that fiduciary regulation is too burdensome yet advisors are leaving broker-dealers to become fiduciary RIAs, which kind of raises the question: if the fiduciary standard is so unmanageable, why are so many advisors leaving broker-dealers to go into the fiduciary world?
I mean, we're business owners. Most business owners don't choose to switch their businesses to higher cost, more burdensome regulatory environments, so how do we reconcile the fact that broker-dealers say a fiduciary rule is unworkable and yet the top advisors at those broker-dealers are leaving to become fiduciary RIAs anyways? Is fiduciary regulation actually easier to comply with than broker-dealer's suitability? In essence, the answer is basically yes.
The fiduciary standard itself is a higher standard. There's more scrutiny on conflicts of interest, an RIA's Form ADV has a lot more in required disclosures and details than a typical broker-dealer agreement, and the Department of Labor's fiduciary rule just outright bans a lot of conflicted compensation. But indirectly, that's the point. Because you know what happens when firms are required to disclose more details about behind-the-scenes revenue-sharing agreements or conflicted compensation? A bunch of them stop doing it. And if they don't, some of it may be banned anyway under DOL's fiduciary rule. And do you know what you're left with? Regulations that are actually simpler to comply with.
Think of it this way. Fiduciary regulation is principles-based regulation. It says in essence that you have to act in the client's best interest, you owe a fiduciary duty of loyalty, and you also have a fiduciary duty of care to only give advice in areas where you're competent. Now, because it's about the principle of the standard, it's not always exactly clear where the line is about what's appropriate versus inappropriate behavior, so if you're an advisor doing things over here and you know the line is somewhere over there but you can't really be entirely certain where it is because ultimately it's up to a jury or an arbitrator to decide whether you met your duty of loyalty and care. So if you want to be safe, you just don't go anywhere near that line. You stay way over here where it's crystal clear that you're doing the right thing.
And then it gets pretty easy to actually figure out who's violating the fiduciary rule because most advisors have incentive not to go anywhere near that line, and it's pretty straightforward to identify those who engage in wrongdoing because it tends to be big stuff like fraud on the wrong side of the line, which is actually illegal in any regulatory environment.
Contrast this with broker-dealer regulation. The current FINRA approach to regulation of broker-dealers and their suitability is to create a whole bunch of rules that draw a whole bunch of lines in the sand about what is and is not permitted. So in the broker-dealer regulatory environment, we have this line in the sand here that says you can come all the way up to this point right up next to the line and stand there safely, but if you go one step over the line then you're in trouble.
Because the problem in the real world is that when you invite everyone to stand this close to the line and then give them compensation incentives to step over the line, guess what happens? A whole bunch step over the line. In other words, a huge portion of all these compliance challenges are about making sure that the registered rep is here, on this side of the line, and not one step further over on the other side of the line.
And that's the distinction of these different regulatory environments. The FINRA broker-dealer structure invites people to get really close to the line by making really specific rules that state exactly where the line is, and allows registered reps to be incentivized to step over the line, and then focuses all its regulatory energy on punishing anyone who actually steps over the line because they were standing right next to it and had an incentive to go over but they weren't really supposed to.
The Problem With LCD Compliance In A Large Broker-Dealer [Time - 5:39]
Ultimately, there are really two kinds of problems with this sort of regulatory approach. The first is that by inviting registered reps to step right up to that line and allowing them to continue to have incentives for stepping over the line, it's inevitable that they're going to be a lot of people who continue to step over the line, which means you've got lots of regulatory fines. Which is good for FINRA, because that's part of how they're funded, but a lot of lawsuits that go to arbitration in a world where ironically most broker-dealers find that their E&O insurance goes down when they leave the lower broker-dealer standard and go to a higher fiduciary standard. Think about that. E&O insurance is often cheaper with the higher fiduciary standard because of how inefficient the suitability standard is from a regulatory perspective when you invite everybody to stand right next to the line and encourage them to cross it and then punish them when they do.
The second problem that crops up with this kind of regulatory approach, though, is what I call the LCD compliance problem. LCD stands for lowest common denominator. And in the broker-dealer context, lowest common denominator compliance means the compliance department writes all the rules and regulations for the lowest common denominator. Basically, whatever the one biggest idiot in your entire broker-dealer could possibly do to cause harm to a consumer, the broker-dealer writes compliance rules to ensure that one person is properly overseen. Which means everyone else, all the normal high-quality honest and ethical advisors, you're stuck complying with the rules written for the one biggest idiot in your entire organization. And the bigger the broker-dealer, the more potential idiots that make their way into the tent with you, and thus why typically the bigger the broker-dealer, the more burdensome the compliance feels.
I don't blame the compliance department for this. If I was a compliance officer and my butt, my backside, and my job was on the line, I'd write rules to cater the lowest common denominator too, because that idiot is the person whose rule-breaking is going to get you fired if you're the compliance officer. But when broker-dealers are so lax about their recruiting standards in the first place and they invite low-quality registered reps in the tent and then have to write LCD compliance rules to manage them, then you make it miserable for everyone else and the good advisors start to leave. Which I think is exactly what we're seeing now in the broker-dealer world.
Reinventing The Broker-Dealer Model With Higher Screening Standards [Time - 7:59]
In other words, this combination of low suitability standards from FINRA and lax recruiting standards from broker-dealers has brought us to this point where overwhelmingly, as the TD Ameritrade survey shows, breakaway brokers cite the broker-dealer LCD compliance and regulatory environment as their primary concern, and then voluntarily leave for higher, more stringent fiduciary standards instead to relieve their regulatory burden.
In essence, broker-dealers have made themselves too big to manage to such low standards, and the LCD compliance environment is driving away their best advisors, which then reduces the quality of the average rep that stays behind because of course, the bad ones stay, only the good ones leave, and then the lower average quality as the good ones leave means the broker-dealer has to tighten the screws of compliance even further. The lowest common denominator gets lower and the problem just spirals downwards.
All this being said, I actually don't think that it necessarily means we're at the beginning of the end of the broker-dealer model, or at least not what the broker-dealer model can become. Historically, and still from a regulatory perspective, broker-dealers exist for one reason, and that's to serve as an intermediary to facilitate the sale of commission-based brokerage products. Because any time you get paid an advisory fee for financial planning or investment advice, you have to be an RIA anyway. In fact, any time you give financial advice that's more than solely incidental to the sale of brokerage products, you have to register as an investment advisor.
But the reality is that for years, broker-dealers have increasingly provided a second value proposition as well. They're essentially advisor support networks. And it's no coincidence I think that when advisors do breakaway, a material number of them join some kind of support network groups like HighTower, Dynasty Financial, our own XY Planning Network, some tuck into larger RIAs, to each their own. But the fundamental point is that not every advisor wants to actually be responsible for building their entire firm from scratch. From being responsible for every possible technology platform and other decision that needs to be made. That's a void that broker-dealers fill with their practice management support, the technology tools, and the platform solutions.
But right now you can only get the broker-dealer version of an advisor support network if you accept all the LCD compliance baggage that comes along with it, for which a lot of advisors are voting with their feet by walking out of the door. And too many broker-dealers continue to be lax in their recruiting standards, which I think they feel desperate to do because they're watching good advisors leave and they're trying to recruit to replace them, but there aren't that many good advisors to recruit.
And that's ultimately where I think the biggest area for improvement still lies in the broker-dealer community. It's the recruiting standards. Because unfortunately, the reality is that all it takes to become a financial advisor these days is a 2-3 hour regulatory exam and a high school diploma, and the diploma is technically optional. That's all it takes to give a consumer advice on their entire life savings with a conflicted compensation model and a low regulatory standard. And then we wonder why LCD compliance has made it so miserable for good advisors to stay in a broker-dealer.
And to make matters worse, some broker-dealers continue to hire those problem brokers, which led to the big study last year finding that 73% of advisors with material misconduct events are still employed by broker-dealers a year later. Simply put, I don't think this gets any better until we as advisors collectively lift our own standards about what it takes to become a financial advisor in the first place.
Now, I'm not talking about most of you who are listening to this Office Hours segment. You're the good ones who try to learn and do well by your clients. That's why you do things like read Nerd's Eye View and listen to this Office Hours. I'm talking about the other financial advisors you meet maybe when you go to your own broker-dealers conference. You know the ones I'm talking about. They tell you a little bit about their business and the latest big sale they made to a recent client, and what sounds to you like a horrifically inappropriate circumstance and you're trying to figure out why they're not already getting rung up by your compliance department, and you basically want to take a shower after the conversation. But they've got the company name on their business card, just like you do, and they're subject to the same compliance rules that you are, which means the compliance department writes all those burdensome rules to deal with that broker and you're dragged down to their level for compliance purposes.
Indirectly, this is the reason why compliance often seems so much easier on the RIA side of the line, because RIAs are much smaller businesses, so even a large RIA often only has a few dozen advisors. You know, for a large broker-dealer that can be one branch office. But it means that even much larger RIAs have a much smaller span of oversight. There aren't that many advisors to manage. The chief compliance officer tends to know them all personally, and when the owners know it's their fiduciary backsides on the line, they tend to just not hire as many low-quality reps as some broker-dealers do. And once you eliminate the low-quality salespeople, it's actually a lot easier to comply with a higher fiduciary standard for the rest.
But the bottom line here is just to recognize that the regulatory rules of the broker-dealer environment aren't really about the potential for a fiduciary standard to apply to them. What it's really about is the fact that broker-dealers have cast such a wide net in their recruiting process that they've brought in some very low-quality reps, which compels compliance department to make lowest common denominator compliance rules, and then those LCD compliance rules make the lives of their best advisors miserable, and encourages those advisors to leave and find external advisor support networks that don't come with the broker-dealer regulatory baggage. That makes the broker-dealers more desperate to recruit, lowers their standards further, and they're stuck on a downward spiral.
And so the only path forward I see for the broker-dealer world is some combination of doing a better job screening out the low-quality reps and just removing all together those with misconduct records or lifting themselves up to a higher standard so they don't have to spend so much time doing all that fighting right near the line about whether someone's over the line or not. When everyone operates under a fiduciary standard and they just stay way over here, it's actually a lot easier to handle the compliance. Because otherwise, I don't see any end to the ongoing departures of good advisors leaving broker-dealers. Not because advisors don't need the support that broker-dealers provide, but because good advisors don't want to be dragged down to a broker-dealer's low screening standards and the LCD compliance that comes with it.
In any event, I hope this is some food for thought about the broker-dealer regulatory environment. This is Office Hours with Michael Kitces. We're normally 1 p.m. East Coast time on Tuesdays, but a little bit disrupted with the holidays this week. Thanks for joining us, everyone, and have a great day!
So what do you think? Have low recruiting standards created an LCD compliance problem for broker-dealers? Is fiduciary regulation easier to comply with than suitability regulation? Can the broker-dealer model be reinvented with higher recruiting standards? Please share your thoughts in the comments below!
III Financial says
I can say with certainty that the PITA compliance rules were what started me looking outside the B/D world in 2011. If I wanted to write a mass email to my clients (seen by 3+ people), I had to get it approved first. This required a two-week turnaround on the review, which usually led to little corrections that had to be made (and re-submitted). 4 weeks to write my clients. Don’t even think about a blog, social media, etc.!
The last I heard, they had put a minimum GDC requirement to be able to submit things to Compliance.
In the RIA world, I am treated like an adult instead of a would-be criminal.
There were many reasons I ultimately left (thank God I did!!), but that headache was what started the snowball rolling.
Mr. Iced Tea says
*In the RIA world, I am treated like an adult instead of a would-be criminal.*
Amen to that.
Robert Louis Franer III says
I would say there’s zero question B/Ds are drowning advisors. But that’s partly FINRA’s fault. Unless my normal reviewer is straight up lying to me FINRA calls “I will help you sleep better at night” a guarantee of performance.
William Miller says
Spot on Michael. The limitations imposed by FINRA and in turn the B/D’s are so ridiculous that it actually inhibits communication with clients. This is especially true with communicating with the public. I write a quarterly newspaper column and thankfully my BD supports that. BUT, I can’t even mention the word mutual fund since FINRA construes that as a recommendation. Can you imagine a car dealer not being able to use the word “car” or “auto” in an ad due to US DOT rules or some silly self regulator?!? The whole business model for bringing in “advisors” and regulating them really needs to be turned on its head.
Mr. Iced Tea says
Yup. FINRA is the wildcard in this discussion. The ultimate over regulator, doing more busy work than good for consumers.
Tunc Tanin says
This is very good. To bad your audience is not the BD world. I think the standards may be lower at some BD’s. Can he pass the FBI fingerprint test, does he have permission to work in USA. Can he memorize about 500 questions and answers and pass a test. If yes to all hired, Pretty similar to how we choose our presidential candidates these days.
Mr. Iced Tea says
The testing for a series 65 is much less rigorous than a series 7, and at best about the same as a combined series 63 and 66. So making assumptions on testing as a criteria does not make your point, Tunc. Let’s bring the comments and humor (ex. presidential candidates) up a few levels to plausible.
Michael Kitces says
Indeed, I find the Series 65 as the minimum standard for Investment Adviser registration to also be severely deficient. But that’s a whole other discussion about the RIA side of the industry. Perhaps a future Office Hours. 🙂
Mr. Iced Tea says
It is not true that all broker dealers feel that Fiduciary is unworkable. That is not fair. I am not a BD exec and find myself frustrated by the layers of BD oversight. But in fairness, some BDs are taking on Fiduciary as a standard and a milestone rather than a nuisance.
I would also add that the standards and requirements for most BDs are higher than RIAs. It does not make sense that an RIA would create a regulatory environment more rigorous than one they left from, especially since the reason they are saying they are leaving the BD is because of a rigorous compliance environment. I have always found that part of the discussion ironic.
Also, the point about compliance departments creating rules to get advisors right to “the line” might be true for smaller BDs. But the larger BDs would find this a problem. And then to think that there is an incentive created by these same BDs that would cause some brokers to cross the line is hard to believe. I know there are a small pct of advisors who do not care and will step over the line anywhere that will take them. But to paint the picture where the BD gets advisors to the line and also gives them an incentive to step over is not fair, and does not make sense for larger BDs.
Michael is generally on the mark. I think in this case, he might have stepped over the line with these over statements.
Meg Bartelt says
Two points that stood out for me in this discussion (suppose it’s more a “soliloquy” than a discussion, but I digress!):
1) E&O insurance premiums go down when you move from the B/D world to the RIA world. I don’t need to know or believe any theories at all about the various incentives and behaviors in each world…if the actuaries have decided the RIA world is less likely to call on their E&O insurance, that’s proof enough for me that behavior is better in the RIA world.
2) Michael, you mentioned that RIAs are, generally, much much smaller than B/Ds. Do you think that if the sizes were equalized, the compliance stuff would be a lot more similar? If RIAs employed thousands upon thousands of advisors, the LCD problem would surely surface. Conversely, if B/Ds had the same compliance person-to-advisor ratio that RIAs do (I mean, in a 10-person RIA, you have a 1:10 CCO:Advisor ratio), I imagine the LCD problem might diminish (a lot).
Michael Kitces says
Obviously lots of factors that go into compliance for large RIAs, but yes at least some of the dynamics that B/Ds struggle with from a compliance perspective are just a sheer size issue. A multi-thousand-advisor RIA would also have to implement a lot of structured policies and procedures, and would have challenges if they didn’t maintain hiring/recruiting standards. Though I do think you’d still find that the principles-based fiduciary regulatory structure would make it less onerous than how FINRA standards have played out over time. (For instance, there are large law and accounting firms that have their own fiduciary standards, but they don’t drown in their own compliance with their standards.)