Is it a good time to buy stock in a large wirehouse firm? Perhaps not, unless they alter their business model. For now, independent investment advisers continue to take market share from the large, multi-faceted wirehouse firms. Survey after survey reveals that high-net-worth clients, who are especially prized by financial services firms, prefer to work with firms that sell no proprietary products and with those advisors who provide objective, fiduciary advice.
It is not only client departures that are troubling the large firms. The wirehouses face trouble on seven fronts, by my count. That doesn’t mean they won’t adapt: Wall Street is famous for its ability to reinvent itself. In fact, here’s why they must.
1. The chief protector of the wirehouse business model is under fire
Registered representatives complain of FINRA’s many rules, which are always evolving in reaction to new “work-arounds” devised by broker-dealer firms. Yet, increasing attention is now being given to FINRA’s failures as a regulator. FINRA was the primary overseer of the investment banks, whose risk-taking activities in large part triggered the current financial crisis.
While President Obama has recently renewed calls to break up banks “too big to fail,” it remains politically challenging (especially in a global arena) to break up large financial services firms. It is far easier to take apart FINRA and transfer its oversight of market conduct back to the SEC, the states, and perhaps other regulatory organizations. Given President’s Obama plans to fix “Wall Street,” look for a possible move to disband the very organization whose largest members are “Wall Street firms.” That’s the nature of the blame game, even if – in this instance – the criticism of FINRA is rightfully deserved. FINRA’s regulatory lapses in dealing with auction-rate securities, stock analyst conflicts of interest, mutual fund late trading practices, the mid-90’s collusion among market makers, and the recent Madoff-Stanford inspection failures, will no doubt add fuel to this fire.
In FINRA’s place will likely come a regulator far more attuned to challenging future emerging business practices (and profit-seeking activities) of wirehouse firms. Future regulation will likely mandate true (and quantified) disclosures of all fees and costs borne by individual investors, even in the broker-dealer business model.
2. Court decisions are swinging against wirehouses
There has been a continued assertion by individual financial advisors, across all business models, that the clients are “theirs” and not clients of the firm. Courts have increasingly become hesitant to enforce non-compete agreements. Non-solicitation agreements, while generally enforced, are seldom valid when it comes to attempts to ban general advertising in order to secure, by departed advisors, re-engagement of their clients. As experienced advisors depart from wirehouse firms, the client’s loyalty usually flows with the advisor, not the firm. In a Schwab Institutional survey released on Nov. 29, 2009, 80% of the registered representatives surveyed believed that, if they left their current employer, their clients would follow them. Registered representative departures en masse will occur in spurts, as departing brokers weigh the benefits of their deferred compensation and/or retention packages (often tied to the value of stock options) against the benefits of the investment adviser model.
3. Most people prefer to work without conflicts of interest
Other departures of registered representatives are not fueled by compensation, but rather by the attractiveness of the investment adviser business model itself. Time and time again I have spoken to registered representatives turned into fee-only investment advisors, and they opine on how much more they enjoy going to work. It’s not “escaping FINRA oversight” that is the driver of such joy. Rather, it is the realization that it is far easier to enjoy a conversation with a client (and develop an ongoing relationship) when you are on “same side of the table” and free of the multiple conflicts of interest found in many wirehouse firm investment programs.
4. More regulation will eat into wirehouse revenue
Can anyone really claim that 12b-1 fees of the 1% variety are not, in reality, “advisory fees in drag”? Even testimony by wirehouse firm representatives confirmed that the 1% annual 12b-1 fee pays for ongoing investment advice in most instances. See: http://www.sec.gov/spotlight/rule12b-1.htm; See also Ron’s comment letter to the SEC on this, at http://www.fiduciarynow.com/RhoadesCommentstoSECon12b1Fees06182007.pdf. As such, it constitutes “special compensation” – thereby making the broker-dealer exclusion from registration as an investment adviser unavailable. If the 12b-1 fees do not compensate for ongoing investment advice, and if such annual fee continues indefinitely, then the 12b-1 fees constitute unreasonable compensation. (Why should a brokerage firm receive 1% a year, for decades, for doing nothing past the point of sale?) As a result, Class C mutual fund shares constitute a poor choice for many individual investors.
If you are a registered representative who built a “book” using the 1% 12b-1 fee, consider these and other challenges to the continuity of 12b-1 fees. Think the scandal over Class B mutual fund shares was hard to endure? Wait to see what is coming. No doubt many a U-4 will be tarnished when this next scandal breaks. These same concerns – unreasonable compensation and or “special compensation” violations – will thereafter likely filter into other forms of ongoing compensation, including the often-indefinite trails received for sales of variable and fixed annuities.
And what of the often “hidden” forms of compensation the wirehouse firms receive, not reflected in a mutual fund’s annual expense ratio? Soft dollar payments, revenue-sharing payments, and even the sharing of securities lending revenue (in arrangements between investment companies, their investment advisers, and custodial firms) are likely to come under greater scrutiny, further challenging part of the revenue stream which supports the current wirehouse business model.
5. Financial planning is more complicated than wirehouses recognize
Today’s “financial consultants” must be more highly educated and trained at inception, and they also need ongoing education and support. Spotting financial planning issues, and conveying financial advice, require much greater training than the product sales-oriented training programs which have long dominated training in many wirehouse firms. Wirehouse firms must invest more of their revenue in training programs (such as the CFP® Certification, now the preferred designation from the standpoint of the consumer) and in continuing education offerings, in order to equip their advisors with the skills needed to compete in a world of consumers who expect to receive comprehensive advice. And, without good training and oversight, greater exposure to liability is more likely to result. It is far easier for a poorly trained financial advisor to subject his or her firm for liability for improper financial planning advice than for an investment product recommendation.
Compliance burdens are likely to continue to mount for wirehouse firms. For example, financial planning itself is likely to become far more regulated in future years. Even if current financial services reform efforts in Congress don’t succeed, state legislatures will likely step in to fill the void. If individual Americans don’t make better financial planning decisions, state governments will likely be burdened further with a future populace woefully unprepared to meet their own needs in retirement years. Americans need to save more, and make better financial planning and investment decisions, today – in order to not strain the resources of our government in the future.This thought alone will accelerate the prospects for the regulation of financial planning, perhaps under a professional regulatory organization model. Policy makers now realize that if they can get individual consumers to receive good financial advice now, government resources will be less strained in the future.
6. A principles-based regulatory regime is incompatible with the business model
With or without the demise of FINRA, a principles-based regulatory regime, grounded in the bona fide fiduciary standard of conduct, is increasingly likely to be applied to all financial advisors. It is far easier to find a way around a specific rule (as exists currently under FINRA’s rules-based regulatory regime) than to engage in conduct that fails to comply with the broad fiduciary duties of due care, loyalty, and utmost good faith.
Federal and state securities regulators are just beginning to realize just how powerful fiduciary status, and its imposition, can be in their efforts to protect consumers. Look for better questions from regulators during upcoming inspections, questioning the lack of compliance with the Advisers Act, state securities acts, and/or state common law. A greater number of questions will be directed at firms on how they comply with their fiduciary duty of care (including due diligence). Securities examiners’ long-standing exclusive focus on books, records, and disclosures will give way to much more meaningful examinations.
Wirehouse brokers will likely fail in their multi-decade effort to deny fiduciary status when providing ongoing investment advice and/or financial planning. Furthermore, the recently advanced notion that one can “turn off” fiduciary status by “hat switching” will disappear from the regulators’ lexicon, as policy makers increasingly realize that under any reasonable view of fiduciary law the fiduciary duties of due care and loyalty apply to the entirety of the relationship with a client and cannot be so easily disclaimed or renounced.
7. Investors are no dummies
Fee-only and other investment advisers gain most of their new clients from the large wirehouse firms. In fact, the large broker-dealer firms’ customer base is viewed as “easy picking.” Many investment advisers I speak with inform me that they don’t even need to market, as an ever-increasing number of prospective clients call independent investment advisers and ask, “Do you sell any products?” And these prospects are very pleased when the answer is a resounding “no.” Where do these prospective clients come from? Referrals from the independent investment advisers’ current ever-expanding base of clients.
Prospective clients are now often presented with sophisticated analysis by an increasing number of investment advisers of the “total fees and costs” of the investments sold to them by the wirehouse firms. Such an analysis might include a breakdown of soft dollar compensation and other brokerage commissions paid by product providers (often in significant amounts to the broker-dealer firm which sold the product), as well as bid-ask spreads, principal mark-ups and mark-downs, market impact costs, and various opportunity costs
Further education of prospective clients involves the huge negative consequences to the clients of their current tax-inefficient investment portfolio design and management. In contrast, most independent investment advisers have sought out education on how to best minimize the tax drag upon portfolio returns, as a value-add for their clients. The wirehouse response to these planning issues largely remain a denial which clients don’t like to hear at all – the “we don’t give tax advice, at all” disclosures found in many broker-dealer client agreements.
Advisors, beware: The writing is on the wall
In summation, the wirehouse business model is broken. Sure, more years may pass until the effects of disintermediation fully occur. In the meantime, the large wirehouse firms may be able to extract total revenue from their customer base – perhaps upward of 2% of the amount of investments their customers hold. But maintaining such a big portion of the total pie still results in a smaller slice, when the pie itself shrinks and shrinks and shrinks again as clients increasingly depart the wirehouse firms.
Is there a solution for the large broker-dealer firms? Certainly. Act now to embrace a fiduciary, client-centric business model. The firms that move rapidly in this direction will see some initial loss of revenue, but thereafter will see their growth explode as clients and financial advisors are both attracted and retained. The transition challenge is a great one – for each service offering and operational system must be examined in light of a client-centric model.
New investments in systems and training must be undertaken, and systems that no longer add value to the client must be discarded. Chinese walls will need to be erected to segregate out, as is proper in a fiduciary environment, those affiliated operations (such as principal trades) that pose far too great reputational and operational risk.
Other conflicts of interest are best avoided altogether, in the race to prove that the advice now provided is truly objective. Some firms, as a result, will need to shed their investment product affiliates. Huge investments will need to be made in retraining and technical support for business development teams.
Of course, perhaps we independent investment advisers don’t really want the large broker-dealer firms to understand the flaws in the wirehouse business model. We might well prefer that wirehouse firms continue to sell expensive, often tax-inefficient investment products. It just makes our business development efforts that much easier.
Ron A. Rhoades, JD, CFP® serves as Director of Research and CCO for Joseph Capital Management, LLC, an investment advisory firm with offices in Florida, New York, Georgia and North Carolina. This article does not necessarily represent the views of any organization to which Ron Rhoades may belong.