For many, 2011 will be remembered as the year the broker-dealer model cracked. Scores of independent firms shut down, unable to keep up with rising legal and compliance expenses. Dozens were simply buried under the cost of lawsuits from clients who bought suspect private investments when the market was roaring in the middle of the last decade.
Most notably, Ric Edelman, one of the biggest names in the financial planning industry, said in October that his firm, The Edelman Financial Group Inc., was exiting the independent-contractor brokerage business. The issue was the channel's hurdles that limit profitability, Mr. Edelman said at the time.
“Everyone will draw their own conclusions, but I consider the independent-broker-dealer channel severely flawed and question the sustainability of many of the players in the space,” Mr. Edelman said. “The economics are very challenging in today's environment.”
But it's not all bad news for the industry.
Some firms, both large and small, are holding their own and better in an industry in which chief executives famously complain about the thinness of profit margins.
Top stand-alone independent firms such as Commonwealth Financial Network and LPL Investment Holdings Inc. recently have reported earnings that show, respectively, profit margins of 5% and 6%.
Meanwhile, Raymond James Financial Inc. reported a profit margin of 10% for its private-client group for the one-year period ended Sept. 30, a combination of the results of its independent broker-dealer network and its other retail-securities operations. The firm does not report earnings from the units separately.
Focusing on business that generates fees rather than commissions has given giants such as LPL and Commonwealth the ability to sustain healthy margins. The financial advice industry for years has been touting the fee-based model for its advisers because of the predictability of its recurring stream of revenue in a notoriously volatile industry.
Interest rates have fallen to record lows and have erased the profits from margin interest and money market fund spreads that used to fatten broker-dealers' bottom lines, executives said. Revenue from fees is therefore more important than ever.
“We have very high quality of earnings, with very high levels of recurring revenues and much less volatility than other” financial services companies, said Robert Moore, chief financial officer of LPL. “And the business doesn't require a lot of capital.”
John Rooney, managing principal with Commonwealth, agrees about the impact of recurring revenue from fees on a firm's bottom line. “A big portion of our revenue is recurring — up at 75% to 76%,” he said.
MORE COMPLIANT
Fee-based reps and financial advisers who focus on fees are often less risky from a compliance standpoint, Mr. Rooney said.
“We are fortunate to have few problems on the compliance side,” he said. “Plus, our 1,400 reps are homogenous, meaning that they are higher-end, fee-based guys. If you can help them grow, they are the most valuable advisers to have. And they're compliant.”
Commonwealth last year ranked first in average payout per rep at $377,861.
“There is so much less compliance risk in fee-based business,” Mr. Rooney said. “It's fully disclosed, and there are no conflicts of interest.”
Brokers and advisers run into compliance problems when selling products “where the compensation is significantly above competing products,” Mr. Rooney said. “Where there's smoke, there's sometimes fire.”
Indeed, a handful of independent broker-dealers that sold investments that allegedly were Ponzi schemes — particularly notes of Medical Capital Holdings Inc. and preferred shares of Provident Royalties LLC — managed to survive. But the losses in 2011 proved too much to bear for others.
Securities America Inc., whose executives publicly showed a brave face while privately grappling with hundreds of millions of dollars in liabilities from Medical Capital, last April reported a $115 million loss for the first quarter of 2011 due to crushing legal expenses.
Such losses were too much to bear for Securities America's parent company, Ameriprise Financial Inc. In August, it sold the troubled B-D to another brokerage firm, Ladenburg Thalmann Financial Services Inc.
Meanwhile, other independent broker-dealers that lacked size and scale threw in the cards because they couldn't make money.
Rising compliance costs and low interest rates are crushing firms' margins, many executives said.
But even small firms can make money if they are run prudently, said one executive.
CHEAP LABOR HELPS
“I have an advantage in labor and real estate costs because our firm is in Youngstown, Ohio, which [has] among the cheapest labor costs in the country,” said David Pintaric, CEO of WRP Investments Inc., which produced $44.2 million in total revenue in 2010. “It's 30% cheaper than other places.”
In 2010, the firm reported net income of about $1.5 million, giving it a profit margin of 3%.
WRP also shies away from high-risk products, Mr. Pintaric said. “We stick to our knitting and we don't do a lot of exotic things,” he said.
That means reps' selling “packaged products” such as mutual funds and variable annuities, and avoiding private placements, he said.
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