US broker-dealers face higher costs from new customer care standard

Uniform fiduciary standard may raise the bar for investment advisers and broker-dealers

When the US Dodd-Frank Act was signed into law in July 2010, one of its key aims was to make the US financial system fairer and clearer for the consumer. Since then, certain sections of the law have been hogging the limelight – Title VII and over-the-counter derivatives reform and the Volcker rule being the most obvious ones. But there are other less-remarked sections of the act that have still been a source of continued debate for Congress and the industry, and which will have wide-reaching effects once implemented – in particular Sections 913 and 914, which cover the obligations of broker-dealers and investment advisers to their clients.

As mandated by these two sections, the US Securities and Exchange Commission (SEC) carried out two studies: the first a study on investment advisers and broker-dealers, as mandated by Section 913 and the second a study on enhancing investment adviser examinations, as mandated by Section 914. Both studies were released in January 2011. One of the main objectives of the study on investment advisers and broker-dealers was to try and understand whether they should both be adhering to the same standards of client care – a uniform fiduciary standard. Debate has raged on the issue since Dodd-Frank addressed it and though no concrete decisions have been made, it is widely expected that at some point in the not-too-distant future, Congress will announce that a uniform fiduciary standard will become law.

To take a step back and understand the context of what this means, it is helpful to look at the current regulation of investment advice in the US. There are presently two types of financial adviser: the first operates as a broker-dealer and the second as a registered investment adviser (RIA). The broker-dealer acts as an agent simply recommending deals that he or she thinks the client should invest in as and when the deals arise. If and when the client makes an investment, the broker-dealer makes a commission on that transaction. An RIA, on the other hand, manages a client's assets and is paid a fee for managing the assets, regardless of how many investments may be made over the course of the year.

Importantly, the two different types of financial adviser are held to different rules and regulations. RIAs have to comply with the US Investment Company Adviser Act of 1940. Broker-dealers do not. The act lays out a fiduciary standard to which all RIAs must adhere, essentially saying that an RIA must operate only in the best interests of their client and make clear to the client any potential conflict of interest that may for any reason mean that the advice given is not in the best interest of the client.

But the 1940 act exempts broker-dealers from the fiduciary standard it lays out. It states that "any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefore" is exempt from the definition of being a registered investment adviser and thus exempt from the fiduciary standard within the act.

What this means is that the standards for RIAs are much higher than those for broker-dealers. The fiduciary standard for an RIA fundamentally says that the adviser is responsible for the recommendations they make to their clients. So the RIA has to have a clear understanding of who their client is and what their client wants. They also need to ensure that all investments made are done so in the best interest of their client, rather than because the RIA might think the investment is a good deal with a high rate of return.

Accordingly, RIAs have had to introduce detailed onboarding process with specific know-your-customer (KYC) processes for each new client. Marcelo Fava, a Charlotte, North Carolina-based principal for Americas wealth management at EY, explains further: "A registered investment adviser will have to undertake a pretty detailed KYC process with all new clients. This means understanding where your client is in their life stage, their investment objectives, time horizon for the investment, risk profile, what the goals are that the client has in mind for investing a specific amount of assets and so on. All of that needs to be properly done by a registered investment adviser."

Known as the suitability process, this requires an RIA to ensure that every investment suggestion it makes to the client matches what is in the client's investment profile. On top of this, the profile needs to be maintained annually in order to document any life changes the client may go through which might alter their investment profile.

Of course, a broker-dealer does not need to do this with the regulations as they currently stand. A broker-dealer technically acts simply as an agent, telling a client that a deal looks good and is worth investing in. The client's needs and risk profile in relation to the deal are up to the client to determine. Thus the standard to which broker-dealers have to adhere is much lower than that of the RIA.

This is not to say that broker-dealers have low standards or indeed that they don't operate with their own, perhaps self-imposed, fiduciary standard, but it does mean that they are not obliged to adhere to the same higher fiduciary standard as RIAs.

As might be expected with such similar business models, over the years the lines between RIAs and broker-dealers have become blurred. An example of this is an increase in discretionary accounts – where a broker-dealer may exercise a certain amount of control over the buying and selling of securities from a client's account without always informing the client – thus managing the assets in more than just the transactional fashion of a traditional broker-dealer. Some broker-dealers also offer a fee-based account, which obviously strays into RIA territory.

On top of this, Fava points out that many of the large broker-dealers also work as RIAs, meaning they already adhere to the RIA fiduciary standard in some capacity. "They have advisers who wear two hats depending on what he or she is talking to the clients about," he explains. "I could be a broker-dealer in one relationship with one client or I could be an investment adviser when I work with some other clients. Most of the folks in the US that work for the large investment management firms or wealth management firms have both licences and requirements."

But when the uniform fiduciary standard comes – and all commentators are certain that it will – here may be significant operational implications for broker-dealers.

"Instead of a point-in-time monitoring of whether an investment you made for a client was the right one, this will be a continuous monitoring which impacts all the way downstream. You have a constant level of responsibility for your client assets and that would be a monumental change," says Robert Dicks, leader of Deloitte Consulting's human capital financial services practice in New York.

Firstly, the uniform fiduciary standard may force broker-dealers to decide how many clients they can cope with at the new continuous level of service, Dicks explains. "There are all kinds of operational and technology implications here," he says.

For example, broker-dealers will have to go through every client and ensure all of the key points relating to the uniform fiduciary standard are covered. This requires documenting the risk profile, the risk appetite, the investment goals, the time horizon and so on, explains EY's Fava. "A key challenge will be to go into more detail. It is worth noting that every client for all these organisations is not really one client. Most of us have multiple financial services relationships with multiple accounts, so you have to do this for the individual, not just for the accounts," he adds.

This householding, as it is called, poses significant operational challenges, not least manpower and changes in documenting processes. On top of this, institutions moving over to the fiduciary standard will have to identify which accounts relate to which investment profile or risk profile, which means trying to match the accounts with the overall investment profile of the client. "This will be quite an undertaking," says Fava. "Going through the documentation processes, having the right tools, the right platforms to get all of that documented, to keep it updated, having the risk checks, balances and controls, then to go back and make sure that none of this is getting out of sync with what I'm recommending to the client and where the client is now based on their different life stages. It will be something significant."

These operational challenges will, of course, have cost implications. In July this year the Securities Industry and Financial Markets Association (Sifma), an industry association, wrote to the SEC, highlighting what some of those costs might be. The first area it pointed out was the costs involved in developing an upfront disclosure document. This was chosen as an example because the SEC has suggested that this might be a requirement it imposes across brokers and advisers once the uniform fiduciary standard is implemented, explains Kevin Carroll, Washington-based managing director and associate general counsel of Sifma.

"We decided to see if we could identify the costs for building that type of upfront disclosure document for broker-dealers, who don't have any documents like that today. We asked our members how to go about building that sort of document and what the cost would be both upfront – meaning there would be more costs initially to develop it and vet it – and secondarily the ongoing costs of updating it and maintaining it."

Carroll explains that the cost components for this would include outside legal fees, outside compliance costs, staff-related costs, out-of-pocket costs and so on. Seventeen of Sifma's significant member firms submitted cost estimates for creating such a document and while there was no clear consensus on what the cost would be, a cluster of those 17 presented estimates between $1.2 million and $4.6 million for the initial cost. An average estimate of ongoing costs from the majority of firms was $630,000 a year. "And that's just for the upfront disclosure document," Carroll points out.

The second area that Sifma looked at was building the compliance and supervisory procedures for broker-dealers to deal with the uniform fiduciary standard. Carroll describes it as a "significant undertaking" to build a system that contemplates all the elements the fiduciary standard would require. "For that piece of it, the average upfront cost was about $5 million and that was to build the system and procedures and then thereafter about $2 million per year to update and maintain it. We got the sense that we were probably in the ballpark with those estimates."

He explains that they asked members to tell them how much they had spent complying with the new Financial Industry Regulatory Authority (Finra) suitability rule – the standard that broker-dealers currently adhere to, enhanced in July 2012. Sifma chose this as a comparison because of its similarity to the fiduciary standard that broker-dealers will be expected to adhere to. "It is similar in that it's the type of rule that you have to build a system around when you're giving advice to a customer. Our members came up with an average of around $4.6 million to comply with that rule, so that's what they are telling us they had actually spent on a rule that is similar to the one we expect this fiduciary standard to be."

It is not just the tangible operational implications or costs that need to be considered where a uniform fiduciary standard is concerned. There will need to be a fundamental shift in the relationship broker-dealers have with their clients. The interaction will change because it will need to be a continuous management of the relationship rather than the as-and-when basis on which most broker-dealers currently manage their client relationships.

Duane Thompson, Maryland-based senior policy analyst at fi360, a service provider for investment advisers, points out that because many brokers are already jointly registered as investment advisers, the transition to a fiduciary standard may not be as difficult as it is sometimes portrayed. He says that broker-dealers are already making the transition by managing assets for a fee as fiduciary advisors under the Investment Advisers Act. "Nearly nine out of 10 investment adviser representatives are dually registered as brokers," he points out.

However, he is clear that there will be significant cultural issues to overcome for broker-dealers when the transition occurs. "It will take time to change the embedded sales culture on the sell side to a client-centric focus," he says.

He highlights the review that was carried out to ascertain how the new and enhanced Finra suitability rule is working. The new rule has some fiduciary aspects to it, for example new suitability factors. "Unfortunately, the most common deficiency Finra noted was a lack of documentation of a broker's ‘hold' recommendations. This illustrates to me the difference between an adviser's way of doing business, in which there are typically fewer transactions on the buy side, and the brokerage industry's need to push product out the door on the sell side."

There is also the question of effectively enforcing a uniform fiduciary standard once it is implemented. Broker-dealers are generally examined by the SEC or Finra once every second year, while RIAs are only examined around once every 10 to 13 years.

In June 2012, Richard Ketchum, chairman and chief executive of Finra, spoke before the US House of Representatives Committee on Financial Services about his concerns on this matter. He pointed out that of 4,800 broker-dealer firms registered with the SEC, 55% were examined annually by the SEC and Finra. However, according to the SEC, only 8% of registered investment advisers were examined in 2011 and approximately 38% of advisers registered with the SEC have never been examined.

He also said that the average SEC-registered investment adviser is looked at by regulators only once every 10 to 13 years, and that the frequency of SEC examinations of investment advisers has decreased 50% since 2004. "No one involved in regulating securities and protecting investors can be satisfied with a system where only 8% of regulated firms are examined each year. It is completely unacceptable and represents a major gap in investor protection," he told the committee.

Sifma's Carroll agrees. His concerns don't lie in broker-dealers' uniform fiduciary standard compliance not being enforced properly, but RIAs not being examined effectively. "I think the issue about compliance and examination to ensure that the standard is being upheld is not really a great concern on the broker-dealer side. Broker-dealers are examined around once every other year by [the SEC or] Finra and so they would get that regular visit and Finra would be familiar with the new standard and they would examine them for compliance with it. A separate issue is on the investment adviser side because they are examined around once every 11 to 13 years and that is where we have an examination shortfall, which represents a risk to investors."

This "dramatic lack of oversight", as Ketchum called it when speaking to the House of Representatives, led to Section 914 of Dodd-Frank requiring the SEC to review and analyse its need for enhanced examination and enforcement resources for investment advisers. The result was gloomy. Released in January 2011, the results state that the SEC "will not have sufficient capacity in the near or long term to conduct effective examinations of registered investment advisers with adequate frequency".

It seems a serious investment is needed in order to facilitate a stricter examination process for investment advisers. While the focus over the coming months may be on the compliance burden the uniform fiduciary standard may bring to broker-dealers, the question of enforcing compliance seems to be more of an issue on the RIA side. Not only that, but the SEC will also have to keep in mind recent history where investment advisers are concerned, in order to ensure compliance enforcement is as effective as it should be.

"Bernie Madoff was technically a fiduciary when the SEC required him to register under the Advisers Act a few years before his Ponzi scheme fell apart," fi360's Thompson points out. "In order to enforce it, Congress will have to give the SEC the funding it needs to boost examinations of advisors. The SEC, in turn, will have to dedicate more resources and attention to fiduciary theory in taking action against market abuse, which is probably harder to prove than explicit rule violations under the Advisers Act."