Legal Ethics and Reform

Smothering Regulation Will be the Death of the Small, Low Pressure Broker Dealer

The nation has approximately 5000 small broker dealers, often called a B/D, with fewer than 150 sales people. These firms sell a variety of products: stocks, options, muni bonds, mutual funds, self directed IRA’s, alternative investments (in the energy, leasing, real estate, etc.) , bonds, ETF’s, etc. Many are also registered as insurance agencies and under that license sell: life insurance, fixed annuities, long term care, equity indexed annuities, etc. Still others are also registered as Investment Advisors where they offer: wrap accounts, individually managed accounts, consulting services, etc. Some are also introducing brokers offering futures and options on futures.

All the foregoing products are offered through (or are created by ) other much larger organizations such as securities clearing firms, Futures Clearing Merchants, Money Managers, mutual fund companies, insurance companies, packagers of alternative investments, etc. These larger organizations process all transactions and hold all customer funds and securities not held by the customer himself. The small firms only handle customer contact and point of sale activities.

These are all regulated products, activities, and entities with which the small broker dealer has to deal as they try to offer the public a full array of products and services. The B/D is faced with direct national regulation from the SEC, FINRA, CFTC, SIPC, MSRB, and NFA. Additionally this B/D’s is regulated by the insurance and securities department in each state where they have clients. With the modern mobility of Americans a typical small Broker Dealer is usually registered in 20 to 30 states after just a few years of operation. So the typical broker dealer answers to perhaps fifty regulators. Many of these regulators are relatively inactive only interested in collecting their annual registration fees unless of course they receive a customer complaint. But the state where each firm is domiciled is likely to be an active regulator along with the SEC, FINRA, CFTC, and NFA. So each firm can count on five to seven fairly active regulators.

Since the small B/D has to depend upon others for the products and services it offers its clients. It must cope with the regulatory impact flowing through from these larger organizations. These larger organizations also have their own “in house” legal departments that like to demonstrate how “smart” they are so regulatory requirements are oftentimes given different twists by the various large organizations the small B/D has to deal with.

For instance, an SEC regulation that every mutual fund assure itself that each B/D selling its funds has current Anti Money Laundering Regulations in place will mean that (the thirty mutual fund families the small B/D does business with will developed its own method of getting the certification). Some require that the small B/D log onto the internet and check a couple of boxes, some require a form be completed and mailed back (original signature required) other will allow a fax’d copy, etc. This is a small example of the work load generated by a well meaning SEC regulation. No one seemed to notice that every B/D regardless of size has already sent certified documentation directly to the SEC certifying compliance on this exact point, it is somehow important that every organization , no matter how slightly or deeply involved, obtain the same certification.

This AML situation is only one example of the array of regulatory requirements imposed on all B/D’s regardless of size or situation. Here are several more:

1) every outgoing letter, fax, e-mail, instant mail, tweets, etc made by a broker is suppose to be reviewed by the firm compliance dept before it is sent copies retained and a record of that review created,

2) copies of every check received and forwarded to the clearing firm needs to be saved but also a blotter entry recording the receipt needs to be created and the copy and blotter entry need to be reviewed and approved by a compliance manager and saved for six years,

3) every incoming fax, e-mail, and letter needs to be copied, stored, and reviewed by a compliance manager,

4) every broker at the firm must be subjected to (not one but ) two “on going” continuing education regimes, one organized by the regulators and one organized by the B/D where the broker is registered. The organization and content of a firm’s CE has to be justified by an annual CE requirements review which is approved by management and retained for six years,

5) the B/D must produce a monthly blotter of all transactions which is used to compare to the blotter which each clearing firm is required to prepare for the small firm’s transactions as well (it is not acceptable for the small firm to simply compare individual tickets to the clearing firm’s blotter),

6) any complaint or rules violation has to be electronically reported to regulators by the compliance manager via ( not just one but) two electronic systems. (The manager is not allowed to use any judgement about whether or not the complain is frivolous; the manager is not allowed to wait to see how an alleged rules violation might clarify itself before “blackening” the record of the broker involved for the rest of his life. (The reader should note that it is far easier to get a court record adjusted or purged than it is to get regulators to adjust or purge a record in the regulators registration computer. Generally the regulatory history for a broker can only be adjusted by bringing a federal legal action and getting a judge to order the revision.))

7) all new accounts which include client financial and suitability factors must be reviewed and approved by the firm’s compliance manager

8) All subsequent transactions must also be approved in light of these financial and suitability factors, if a client varies from the list of suitable transactions, the regulators can hold the compliance manager and broker responsible for the client’s variations from “suitable”.

9) the compliance manager is to keep a copy of every written communication he sends to his broker such an “update memo” or “periodic update” for later review by regulators,

10) all advertising must be given prior approval by the compliance manager and approved copies kept, new B/Ds are required to have their advertising approved by the requlators in advance of use and pay an extra fee to get this review. (This approval requirement extends to even a congratulatory ad bought by the broker in the event program for his daughter's high school graduation.)

11) B/D’s are required to keep track of political contributions by brokers if the contribution is to a candidate who if elected would have the ability to effect the issuance of a municipal bond. This regulation effects such local offices as school board member and town council member as well as most state level office seekers.

12) B/Ds are required to track and record and retain with compliance approval records of each broker’s trades. This is required so any broker trading using insider information can be caught by doing future reviews of price movement by acquired stocks in the months following their purchase. .

13) B/Ds are required to check at random but regularly the quality of price execution done by the small firm’s clearing firm. This checking requires going into trade execution histories and finding the exact trade at the exact time and printing out copies of same and attaching that to the original trade report from the clearing firm getting compliance approval and retaining both documents for six years for possible future review by regulators.

14) Policy and Procedures manual must be updated annually with all the regulatory changes coming out of the various regulators and the compliance manager must review these changes with each broker and obtain their signatures certifying this review as well as statements from each broker regarding their outside activities, loans from clients, other sources of income, etc.

15) Annually an outside auditor must be hired to review and approve the firm’s Anti Money Laundering procedures, and to certify that such procedures are being followed of the firms compliance management,

16) preparation of financial reports by the 17th business day of each month with electronic filing of same required every third month, and

17) the contracting for and preparation of an audited CPA certified set of statements once each year.

The forgoing is not an exhaustive list. It is intended to give an idea of the degree of education and sophistication a compliance manager needs and the number of tasks daily, weekly, and monthly that have to be addressed.

It has been estimated that to provide facilities, support staff, and compliance support for a sales person at a B/D the annual cost is about $90,000. Most of this cost is brought on by compliance requirements rather than the facilities and basic sales support. This assertion needs a little more detail to give fuller understanding.

For comparison purposes, look at two widget salesman working on commission. These salesman with a moderately capable assistant might have a computer system and a pleasant office. The ass’t making $40,000 and with the offices, phones, computers, and furniture costing $24,000 per year. That’s about it for the widget sales office. Of course the three of them have health insurance (they pay for their family but the company pays for them) so the company has an additional cost of $16,000. Then there is the withholding on the sales ass’t of $5,000. So the total for this three person office is (24,000 + 40,000 + 16,000 + 5,000 = 85,000 divided by 2 =) 42,500 per salesman.

But in the brokerage industry the cost per broker is 90,000 plus. So how does the cost in the brokerage industry more than double the widget sales office’s cost?

1) the first difference is the addition talent level required of the sales ass’t. A sales ass’t in a brokerage office has to be a series 7 licensed person, such a person can’t just be pleasant and efficient, she has to be substantially brighter than average and able to pass a difficult six hour test that has a seventy percent failure rate. Such a person can and does command a premium salary perhaps $70,000 instead of $40,000. So why does the sale ass’t need to be so talented. Well the regulators don’t want non-registered people giving quotes and reading news items to clients or entering their orders, even occasionally, without being so registered. The additional overhead cost per broker of this regulation alone is $15,000 per year.

2) all tickets, e-mail, faxes, and letters both in and out have to be approved by a compliance manager so the continual attention of a compliance manager is required to keep these two salesmen operating; assuming one compliance manager can keep compliance documents current on six active sales people, 1/3 of the time of $100,000 per year compliance manager. That’s $16,500 per salesman,

3) Of course the back office that processes the transactions generated by these two salesman have extra work (that would not be needed if they were processing orders for widgets) This work is generally keeping many extra blotters in addition to the actual ticket, wire transfer requests, certificate receipts, check request, etc. all with review and the initialed approval of another compliance person. Say $10,000 per year per salesman,

4) then there is the two tiered CE program (“firm” level and “industry” level CE) required by the regulators for both the sales ass’t and two salesman. Cost 6,000 for all three (3000 per salesman per year),

5) finally there is the direct regulatory charges (fees) required to keep the three registered people registered in say ten states, plus insurance registration to sell annuities, plus E & O insurance, plus bonding insurance, plus federal registration fees, etc.; all this comes to $3000 for each of these three (two brokers and a sales ass’t.). Adding the extras brought on by being in the brokerage industry the total goes from $42,500 per salesman to (42,500 + 15000 + 16500 +10000+3000+ 3000 = 90,000) to $90,000.

But the analysis does not stop here. The company in order to have a salesman on staff that cost $90,000 before any payout is made to the salesman himself or any profit is made by the firm has to “back into” the sales volume required of the broker to keep him around. If the salesman is to be paid 50% more than his sales ass’t he will need to do at least $200,000 of gross commission. The $200,000 would be divided as follows: $90,000 to support staff, back office, compliance, $10,000 to firm profit, and $100,000 to the salesman. Most companies are not going to go to the trouble to organize all that’s been described here for a 5% gross profit margin ($10,000 profit on $200,000 of revenue) before top management is compensated etc. So the number has to go up from $200,000 to say $250,000 or $300,000 to interest an American capitalist in setting up such an operation.

Recall this is happening in the retail brokerage industry in a country where median household income is about $42,000 per year and median individual income is about $27,000 per year. It is obvious that compliance expense is the most significant cost driver causing compensation distortions in the retail brokerage industry. Some further study is needed to understand other aspects of this distortion.

How much selling is needed to generate $300,000 in commission per year? A broker has to generate $1250 per business day in “buy or sell” commission. Since commission on transactions generally run 1% of the amount of the trade, that means the broker has to find $125,000 dollars to move through in buy and/or sell transactions each day. If a broker had clients that did an average profolio turn of 1 times per year, that broker would have to have about $15,000,000 in client accounts. If a broker plans to have an average turnover in his accounts of once every three years rather than every year, he would need $45,000,000 in client account in order to generate the $300,000 threshold for keeping his job. (Of course, it is important to know if a one year or three year turnover is more appropriate, Warren Buffet is a fan of the Value Line Investment service and that service leans toward a three to five year investing horizon in equity investing.)

Other brokers might put the $15,000,000 in fee based accounts at 2% or 3% per year and generate the $300,000 or $400,000 in fee income in that way. (The long term cost of such fees is frightening. Consider if the S & P Index averages 8.5% total return per year over long periods, removing 2.5% in annual fees cuts the return to 6% per year, that’s a reduction of 30% in total return versus simply buying and holding an S & P Index ETF.) .

Of course, managers want to keep $300,000 per year producers happier than the $200,000 producers, so they develope differential payout percentage structures where the larger producers get a higher percentage and the smaller producers get a lower percentage. This causes the small producers to press clients for trades that are perhaps inappropriate simply to get their production numbers up and therefore get to a better payout percentage. Under these payout structures a $200,000 producer might get a 35% payout so his associate down the hall doing $300,000 can receive a 50% payout. Of course, when this concept is spread over the range of gross commissions from $150,000 to $900,000 the percentage usually range between 22% to 65%. This system generates intense pressure on the smaller producers to:

1) work at “stealing” accounts from other firms to get more assets,

2) do inappropriate trades (sometimes called churning), .

3) mislead clients and prospective clients regarding the risks in various investment suggestions, etc.

They will do almost anything to get off the lower rungs of the ladder where the payout is depressed because of the regulatory overhead and payout tiering brought about by a company’s need to deal with regulation and its desire to retain large producers.

With the forgoing in mind it is good to make some observations about the trend in regulation and its effects on the industry:

1) When regulators see the client complaints generated by the misbehavior of brokers and firms trying to cope with the costs of all this existing regulation, their response is to layer on more regulation. This makes the slope of the payout curve more problematic and is likely to generate even more problems later.

2) When regulators set up such systems of records keeping blotter maintenance, storage of records all with compliance manager’s approvals throughout, they seem to be trying to assure that not only will the broker be “nailed” if some wrongdoing is recorded in these materials, but to also assure that the B/D's compliance manager is “nailed” as well.

3) Regulators also feel no reticence about imposing many new regulation each year adding to the existing 8000 page rule book. In fact regulators have established a monthly publication called Notices to Member just to document new requirements. Each year approximately two dozen new regulations are thus forced on the B/D community.

4) Regulators do no cost/benefit analysis before issuing new regulations.

They ask for comments on the proposed new regulations, but few except the large firms have the necessary staff to read and assess the legalese presented. They just layer these regulations on and when they come to do their next exam they expect to see the new rules implemented. Lately regulators have been stretching out the time between exams just as the number of new regulations is increasing. The effect is horrendous because the number of rules violations found by each exam is skyrocketing, creating very long “exception reports” at the end of the exams.

But what of the small low pressure B/D that is mentioned in the title of this essay? A small B/D that wants to avoid problematic behavior is:

1) likely to have a flat percentage payout schedule, so smaller producers don’t press for additional production by doing inappropriate trades for clients just to get into a higher payout bracket, and

2) likely to use open area offices where small producers can serve as each others sales assistants thus avoiding the extra cost of hiring trained sales assistants.

This low pressure approach to organizing a small office has proven itself useful better servicing clients, but to date firm’s that follow this approach have not been able to get their overhead cost per broker down to the point where an older, semi-retired, licensed person doing $40,000 or $50,000 per year in commissions can both cover his compliance costs, give the firm a little profit, and take home $15,000 or $18,000 per year. Such a broker generally knows his clients very well, is very experienced, is able to spend extensive blocks of time with clients that want edcation on products, does not feel pressure to “do business at all costs” because he usually has considerable personal savings. However, the trends in the industry are wiping out these brokers and the firms where they have traditionally done business.


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