Choppy waters persist

Small IBDs still struggling with compliance and litigation costs

Jan 20, 2013 @ 12:01 am

By Bruce Kelly

Small broker-dealers will continue to face strong head winds in 2013, and dozens will shut down, seek a merger partner or abandon the transaction-oriented style used by securities houses to become registered investment advisers that charge fees rather than commissions.

The difficulties such firms face include higher compliance costs, record low interest rates for money market accounts, competitive commission rates from large or discount broker-dealers and a tax increase that will cut available discretionary funds that investors can put to work in the stock market.

Defined by the industry as any broker-dealer with 150 registered representatives or fewer, small B-Ds make up the overwhelming majority of firms registered with the Financial Industry Regulatory Authority Inc. In the the first 11 months of 2012, pressures on the industry reduced the number of Finra-registered firms to 4,319 — 97 fewer than the year before.

That's a decline of 14% since the end of 2007, when Finra reported 5,005 member broker-dealers, according to its website. The majority of those that have closed have been small independent-contractor broker-dealers — many of them shops with 10 registered representatives or fewer, according to industry executives and analysts.

“The industry is now at 4,300 and change, and it will go to 4,000,” said David Alsup, national director of business development with Compliance Department Inc., a consultant. A net number of 12 to 14 broker-dealers will close per month for the foreseeable future, he said. “At 4,000, it will probably begin to stabilize, but that's still a net loss of 7% to 8% over the next three years.”


Another factor eliminating the number of small firms is “the graying of the broker-dealer,” Mr. Alsup said. Small-firm owners are facing big questions, including those around establishing a succession plan. “I can't see that [type of long-term planning] in a two- to three-man shop.”

Executives at broker-dealers have been complaining for years about overregulation, and the increased costs associated with compliance is making it increasingly difficult for many, executives said.

“There continues to be more pressure on small firms,” Mr. Alsup said. Last year, the Securities and Exchange Commission approved Finra Rule 4524, which requires broker-dealers to file additional financial or operational schedules or reports as Finra deems necessary for the protection of investors and the public. These documents are intended to supplement the broker-dealer filings with the SEC known as Focus reports. “It's a more detailed breakdown of financial information,” and firms had to first file such supplemental reports by the end of October, Mr. Alsup said.

“Broker-dealers can't keep up with the cost of business,” said David Sobel, general counsel with New York broker-dealer Abel/Noser Corp. “Everything is tight. The income is not overpowering the debits. I think everybody is happy if they are able to break a little positive.”

Margins have dropped tremendously, and commissions are still dropping, he said. “It's the race to zero,” he said. “Reps are looking at the commission rate and what it will cost to do a trade.”

“We're waiting to see the next 200 regulations from Dodd-Frank,” Mr. Sobel said, referring to the raft of financial regulations President Barack Obama signed into law in 2010. The SEC is still writing many of those rules. “Regulation is what everyone is afraid of, and how Finra and SEC will approach it.”

“To keep the broker-dealer community alive, there has to be a slight switch in focus of regulators,” Mr. Sobel said. “That's not to say the regulators shouldn't get bad guys. But Finra and the SEC have to decide if it's compliance first or enforcement first,” Mr. Sobel said.


It's not all bad news for small firms, executives noted. The stock market's buoyant beginning of 2013, with the first week of trading seeing the S&P 500 up 3% and closing at a five-year high, signaled a strong year ahead.

And the closing of dozens of broker-dealers in the past few years, many of them small firms that sold private placements that wound up being Ponzi schemes, was ultimately positive, one executive said.

“A lot of firms that have departed we won't particularly mourn,” said Mark Cresap, chairman of Cresap Inc., a small broker-dealer with about 40 affiliated reps and advisers. “They were doing private placements not in the public interest,” he said, alluding to sales of Provident Royalties LLC preferred shares and notes issued by Medical Capital Holdings LLC. Many independent broker-dealers sold those securities, and the SEC charged both private-placement issuers with fraud in July 2009, spurring costly investor lawsuits that forced many of the IBDs to close or be sold.

Still, the hurdles for small firms remain high, Mr. Cresap noted. “We've had a couple of good years,” he said. But fees from Finra last year and the Securities Investor Protection Corp. in the wake of the Bernard Madoff Ponzi scheme revelation in 2008 have hit smaller firms hard, Mr. Cresap added.

Bigger firms have a luxury of larger staff and more revenue to absorb new regulations and fee increases, Mr. Cresap said. Executives at a small shop typically juggle a number of jobs. “These kinds of changes are problematic with small firms because they take up a disproportionate amount of management's time,” Mr. Cresap said. Twitter: @bdnewsguy


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