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!