Brooke’s note: Sean Kernan is an LPL rep based in Coppell, Texas (in the Dallas-Fort Worth area), who also has an office of supervisory jurisdiction that is used by 12 other LPL reps, and he has been independent for the past two years after careers at Edward Jones and Morgan Stanley. He hasn’t named his new businesses yet, partially because he has a 3-month-old in the house. He is wondering whether it really makes a difference to start a registered investment adviser practice, considering that his heart is in the right place as an independent-broker-dealer rep.

Kernan is also concerned about some of the technical hurdles. When he expressed these views on RIABiz, he found himself engaged in a deep conversation with Jeff McClure, an advisor with The Personal Wealth Coach, an RIA firm in Salado, Texas, about 50 miles north of Austin. What caught my attention was how much McClure was willing to share and how receptive Kernan was to hearing him out. Here is that edifying conversation that I pulled from the comments section of : How RIAs describe exactly what they do in a few choice words

Sean Kernan:

I submit that one reason many investors don’t know the difference (between an RIA and an IBD rep) is because it is actually possible to do the right thing by people with your brokerage/suitability hat on (gasp!). Philosophically and very hypothetically, is there any difference between someone who puts their client’s interest first because they are legally bound to and someone who does it because it is right (and not to mention, good business in the long run)? I do agree that when you work for yourself, your ability to work best for the client is vastly improved—but I think this is true at an IBD almost as much as at a pure RIA.

Jeff McClure:

I was a representative of independent broker-dealers [Mr. Kernan’s IBD] for over 25 years. I too was convinced that what I was doing was at least as good or even better than those folks that insisted their “fiduciary” position was better [RIAs]. Then I was sued along with my b-d. In the process, I found far more about the independent-broker-dealer community than I had wanted to know. I discovered the “under-the-table” (but legal) payments that enabled a product sponsor to become an “approved” provider. I also discovered that if I had truly looked hard at the investments available on the open market and built a portfolio from them, my brokerage customers would have done far better over the past couple of decades than they did by utilizing my commission-producing “best of class” products from my broker-dealer.

I have gone head to head with more than a few traditional financial-planners and financial advisors who have insisted that their commissioned products were the best that could be done. When we have put it to the test using Morningstar’s Hypothetical Illustration program [which takes actual monthly data on the investments involved] the advisory model wins.

Indeed, I took a 75% pay cut to become a principal at an RIA and even after building it up to the level of invested assets I had as a broker-representative, I still only have half the net income I had as a broker-rep, but it is a very reliable and consistent income. More importantly, I am extremely confident that I can access the very best available investments for my clients now rather than having to pass up the no-loads and institutional funds.

By the way, I was exonerated in the lawsuit, but the process of being briefed on what the litigator (a close relative of alligator) might raise and the nine hours I spent on the stand as he attempted to assail my character and practice was a real eye-opener. My attorneys argued successfully that as a broker-dealer representative I was not required to find the best price, best execution, or even best product. All I was required to do was offer only “suitable” investments and deliver a prospectus. Had the litigator been able to show that in any way I was in a fiduciary position, I would have been toast. He did demonstrate that there were less expensive ways I could have provided the products and that had I been in an investment advisory position and a fiduciary, the customer would have done better; actually much better.

I had taken the courses and attended the b-d education sessions. I had heard the wholesalers’ pitches. I knew how to sell product that was good for me, good for the broker-dealer, and highly suitable for the customer. With 20:20 hindsight I now know I could have done a lot better for the customer (whom I called a “client” before I learned the difference). Yes, it would have involved making a lot less money for myself and for my broker-dealer. It would have meant that I would not have been provided those annual all-expense-paid “educational conferences” with my wife at five-star resorts, where again I was “educated” on how to offer the “right” product.

I now live in a house that is about half the value of the house I owned as a very successful b-d rep. I drive a six-year-old “pre-owned” car. I also have eight full-time employees whereas before I had three. Yes, the regulatory burden is a pain, but I vastly prefer it to the FINRA rules I had before. I don’t have to worry about commissions slanting my views. See: Why advisors see FINRA as the devil.

By the way, you may be an exception, but I have looked a quite a few portfolios put together by IBD investment adviser reps, and the percentage of the portfolio invested in funds paying a 12(b)-1 fee is both high and consistent. Factually there is no correlation between paying out a 12(b)-1 and higher performance. That extra expense in the vast, vast majority of funds I have seen in those accounts is an interesting phenomenon. In more than a few cases I have noted that the rep gets credit toward an “annual conference” for choosing funds or private managers who pay the b-d to fund conferences for those who sell their wares. Perhaps the most interesting thing I have noticed about the b-d affiliated IARs is the number of investment products on which they received a full commission and then moved into the RIA account and began to draw fees. It is a heck of a revenue enhancer, but I question whether it is in the best interest of the client.

Sean Kernan:

Jeff—great points. I admit that I probably “don’t know what I don’t know” about the inner workings of a large independent b-d. I may well be in the middle of my personal evolution to an RIA-only business someday. I spent time at two of the largest employee firms and the first did not offer any fee-based platforms while I was there. Within the first two to three years I came to understand that the “preferred” funds were preferred for some of the reasons you point to (namely, revenue sharing that wasn’t fully explained to me, the newbie). I wholeheartedly agree that advisory relationships are far and away the best client solution in most cases. I moved to a major wirehouse (before ending up at an IBD) which had more offerings but obviously has its own warts.

Maybe I am an exception, but I hope I am not a rare one at IBDs (but maybe I am). Sounds like I saw what you saw, but fairly early in my career. In my advisory accounts — as an IAR — I use [exchange-traded funds] for just about everything, unless I can’t find an ETF that fulfills the same objective (I have just one mutual fund in my core allocation, for 10% of a portfolio). ETFs appeal to me as the cleanest, most efficient, lowest-cost way to get exposure to various asset classes and make tactical and strategic changes as necessary.

Anyway, I didn’t mean to interject that discussion as much to the topic at hand: My main observation is that I could use most of the original comments that describe an “RIA” when talking about my practice—even though I also have some brokerage business. Perhaps I still naively assume that doing the right thing for the client is (or should be) inherent in doing business, no matter what the legal and regulatory framework. Madoff, as we know, was a “fiduciary” too.

Jeff—I’m confused. You’re not subject to FINRA’s rules but get to hold a Series 7 license through [independent broker-dealer] Next [Financial Group Inc.]

Jeff McClure:

Sean, I hold a Series 24 and am technically a branch office manager and an OSJ. Yes, I would be subject to FINRA if I sold anything. Since I sell nothing, there is very little I have that is subject to FINRA restrictions. Yes we maintain FINRA accounts, but there is a person in our office who is the representative of record on those accounts. She also does not sell anything and we maintain the accounts so as to be able to offset our fees with the 12(b)-1 and trail commissions on accounts where it would be not in the client’s best interests to move the money. See: How the new 12b(1) fee restrictions could transform the financial advisory industry.

Examples include old variable annuities where the annuitant/owner has a guaranteed death benefit that is substantially higher than the cash value or a variable universal life insurance policy. In those cases, particularly where the insured is in poor health, it is clearly in the client’s best interests to retain the policy. Since the policy is paying out a fee each year to some broker/dealer, being able to use that to offset the fees we would otherwise charge to manage their accounts is, again, in the client’s best interests.

We make a serious effort to keep the FINRA side of what we do entirely separated from the RIA side. As I wrote, there are absolutely no product sales allowed, so it is strictly a maintenance issue. We, as required by both entities, keep our books and records for the RIA separate from the FINRA related books and records as well. We pay Next a fairly substantial fee each quarter to utilize their services and that works both for them and for us. They, in turn, allow access to the enterprise level IT and other services that we could not get on a cost-effective basis and provide us with an audit each year both on the FINRA and the RIA side. They also monitor our trades and retain records for us.

Neither I nor anyone in the office is an IAR of Next. First, that would be a regulatory violation in some states, but more importantly it would be, in my opinion, a very serious conflict of interest. We do most of our custodial work at Pershing Advisor Solutions LLC, from which we receive no commissions or 12(b)-1 fees. We do have a couple of other custodians, but again are not compensated by the custodians. If you read our online Form ADV Part II, you will see that we currently have a branch in Connecticut where there is a person who is dually registered. That relationship is being terminated for that reason.

Our arrangement with Next is certainly unusual, but we have discussed it with [Securities and Exchange Commission] representatives and they have uniformly been very pleased with it. Initially they did not understand why I did not just sever the relationship, but when I explained that we were able to offset fees as well as provide agent services for our clients, the light came on.

Next has been very supportive of our relationship, which is likely in no small part due to the checks we write to them each quarter! We do, of course, fully disclose the relationship, and it has seemed to date to be one that is cost saving to all concerned. Next, in essence, serves as a service provider to us in exchange for fees we pay them. Because we so carefully separate our FINRA and SEC areas of responsibility, we are able to operate as a pure RIA on that side of our business.

Sean Kernan:

Jeff—very useful and interesting to understand how that plays out. If you are able to maintain existing brokerage accounts as long as you don’t do any new business, that removes much of the potential roadblock (in my mind at least) in making the move from IBD to RIA. It is far easier to envision not doing any more commission based business, versus moving every last dollar out of those accounts or choosing to give up all revenue associated with them. Sounds like it is not something every firm would facilitate, but it is good to know that can be and is being done.

Jeff McClure:

The transition from a high-producing rep of a brokerage firm, no matter how “independent,” is a rough one. It is critical to understand that if a rep is working “through” an indie b-d and is a representative of that firm, each and every account officially belongs to the company, and not to the rep. Those accounts are a form of property and there is no question in the law or in the rules about who owns that relationship. It is the b-d firm that is the owner.

You must have permission from your b-d, in writing, to register as an independent RIA or to have an ownership interest in an independent RIA firm. I recommend that you be completely out in the open on what you are trying to do and why. If the firm objects or wants to entangle you in a set of agreements and directives that give them control, you then have to make some decisions about what you want to do and where.

With regard to what you do as an independent fiduciary, there are only a couple of rules. The first is that you must operate in your clients’ best interests. That is easy to say, but for a longtime brokerage firm rep, it is a hard thing to practice. The second rule is to disclose all potential conflicts of interest, not just in lawyerese buried in a hundred-page document, but prominently and in such a way that your clients both understand and clearly acknowledge those conflicts.

There are some big, really big, potential conflicts of interest in our relationship with Next, as there would be with any such broker-dealer. NEXT has placed some restrictions on what we do, but the restrictions are in areas where we would never go (use of third party money managers). Still the relationship is tenuous. The key to it from our point of view is that it is clearly in our clients’ best interests, but we do need to reveal in great detail the potential for conflict.

It is also considerably less expensive than going it alone.

All that may change in the future; if so, we have a backup plan. As I mentioned we have a person in our office who is a part owner in the RIA but does not provide advice. She previously was an administrative registered representative. We have moved all the non-RIA accounts to her. She receives from those accounts enough 12(b)-1 and trail income to do well and pay rent and for admin support from the firm’s staff. All she would need if I were no longer an OSJ is to find one that would supervise her, and given the low risk profile of a non-selling rep, that would not be hard.

The administrative/legal details of making that relationship work across FINRA and SEC rules is a bit complex, but we have found a legal and proper way to do it. Above all, the concept is quite simple: Do whatever we do in the clients’ best interests and with full and understandable disclosure. I have been pleasantly surprised at how cooperative regulators can be once they conclude that that is the intent.