Will Broker Evolution Obviate the Fiduciary Standard Debate?
(This is the second installment of a three part series on Dual Registration)
As we explained in Part I of this series, the origins of the growth in RIA/broker-dealer dual registration date back to the onset of the Merrill Rule in 1999, but the explosive growth didn’t occur until after the U.S. Court of Appeals rescinded the Rule in 2007. Since then, the dual registration business model has become the de facto standard in the brokerage industry. But does it merely represent the final stages of a dying breed, long surpassed by a more agile business model. Will large brokerage firms soon go the way of those once fanciful streamlined steam locomotives of yore?
According to the SEC commissioned Rand Report released in early 2008, from 2001 through 2006 “the number of dually registered firms grew as a proportion of all broker-dealers, and these dually registered firms grew substantially in terms of mean reported revenues, expenses, and, generally, net incomes over the entire period.” In another report issued a year later (“Industry Guide to Managed Investment Solutions,” The Money Management Institute, 2009), the impact of the court ruling became clear. This report, which refers to dual registrants as “reps acting as portfolio manager” or “RAPM” stated the “assets associated with RAPM programs have grown by 88% over the last 11 quarters. One of the key drivers behind RAPM asset growth was the decision to rescind Rule 202 (also known as the ‘Merrill Rule’). The RAPM program segment benefited by the decision, due to the transfer of fee-in-lieu assets to advisory accounts.” An October 2011 study released by Cerulli Associates showed growth in dual registrants grew by 10.2%
The data proves, at the very least, an apparent relationship between the Merrill Rule and dual registration. The various reports also show, if you look at their underlying data, the often fluid definition of “dual registration.”
“There are two ways in which advisors end up being dually registered (FINRA and SEC),” says Philip Palaveev, currently President of Fusion Advisor Network in Seattle, Washington but formerly one of the leading researchers in the area of dual registration. Palaveev explains, “In one model, the advisors own and operate a registered investment advisor (RIA) and conduct the majority of their business through that RIA but the advisors are also registered reps of a broker-dealer (BD) and conduct some commission business through that BD. This is often called the ‘hybrid model’ and this model has been quite popular with independent advisors (i.e., those that own their business).”
In the other dual registration model, Palaveev says, “a registered rep of a broker-dealer also practices as an investment advisory representative of a corporate RIA owned by the broker-dealer. The difference here is that the BD, not the advisor, owns the RIA. This is the typical set up for all of the large broker-dealers – both independent and traditional.”
Palaveev believes if you consider these two models, “almost every broker-dealer rep is ‘dually registered’ – either through their BD’s RIA or an RIA of their own.” He maintains “there are very few remaining commission-only reps in business today.” Indeed, he says, “10 years ago [advisory] fees accounted for less than 10% of the revenue of most broker-dealers. Today, they comprise more than 50% of the revenue in many cases and certainly more than 50% of the profits. In fact, there is a clear trend for broker-dealers to encourage and look to grow the advisory business of their reps – which is why dual registration is so prominent.”
This fee mixture poses its own problems in terms of confusing clients regarding the difference between broker services and adviser services. Palaveev admits “We have seen much evidence that clients do not always see the difference between the different terms, registrations and regulations.”
This confusion becomes more significant in terms of the prohibited transaction language in the Investment Advisers Act of 1940. While there are legal ways for an RIA to charge a transaction-based fee, Elliott J. Orsillo, CFA, a portfolio manager at Season Investments in Colorado bluntly states the prohibition was placed into the 40 Act “to reduce conflicts of interest.” He says, “Being dually registered adds conflicts of interests to the fiduciary model as opposed to being purely asset fee-based. I’m not saying that someone that isn’t dually registered can’t act as a fiduciary, it’s just harder and should require more disclosure.”
Kenneth Hart, CEO at Cornerstone Advisors of Bellevue, Washington agrees. He says, “I do not believe holding yourself out as a ‘true fiduciary’ to your clients and one that is purely objective, fully aligned with their best interests, and not swayed to partiality by self-serving economic bias is possible with dual registration.”
Orsillo and Hart aren’t alone in this assessment, and that might be trouble for large brokers hoping to maintain their vast stable of employees. Scott B. Smith, Associate Director at Cerulli Associates in Boston says, “After years of growth we actually saw dual registrants drop off in 2009 as many decided to drop their independent broker-dealer affiliation.”
Which brings us to the illustrative story of William D. Pitney, a financial coach for Focus YouNiversity, LLC, located in Foster City, CA. Like many new entrants who came into the industry post Merrill Rule by joining a large established brand-name firm, Pitney says, “I came into the industry in 2003 by affiliating with a large insurance broker-dealer that required me to pass my Series 7, Series 66 and obtain a life insurance license. I assumed at that time everyone had to pass the same exams. Only after being in the industry a few years and reading various industry publications, did I recognize and understand that a difference existed. Like others who have gone independent, once I recognized the difference in the standards, I had no other choice than to accept my fiduciary obligations to my clients.”
Pitney points out that maintaining a dual registration “gives broker/advisors flexibility in the types of products they can ‘sell’ and/or recommend and in how they ‘price’ their services. While this may be good for the broker/advisor, it does not necessarily mean it’s good for the client or customer.”
As a living example of how a broker can successfully transition to an RIA, Pitney has first-hand experience in all the arguments of those who oppose the fiduciary standard. “The trade associations that argue against applying the current fiduciary try to get us to focus on cost, rather than the clients’ best interest,” he says. Pitney believes all investment-related accounts, including annuities, can be converted to asset-based or advisory fees. “Unfortunately,” he says, “unless an advisor has some B-D affiliation, variable products are off the table.” But that didn’t stop him. “In my own practice,” says Pitney, “it took a couple of years to make the transition with my clients, but we did it. As I explained the differences to my clients, we slowly migrated their assets from brokerage-type accounts to advisory accounts.”
Pitney was dually registered until Feb 4, 2011. Since then, he’s been operating his own RIA. He doesn’t need the big brand name behind him anymore. And, based on the data from Cerulli Associates, neither do a lot of other former brokers. Perhaps, as a harbinger, it should be noted that Merrill Lynch, the apparent instigator of this model, itself no longer exists as an independent entity. In September of 2008, at the height of the credit crisis many say it helped create, and six years short of the 100th anniversary of its founding, Merrill Lynch was bought by Bank of America.
Still, the dual registration phenomenon remains a bull in the china chop. How might this impact the ongoing debate on the fiduciary standard? The third and final installment of this series suggests the answer.