Why the SEC has it wrong on adviser signing bonuses

SEC Chairman Mary Schapiro’s objections to broker recruitment programs that feature signing bonuses do not reflect the reality of today’s broker compensation programs.

Contrary to her comments that such programs “compensate and incentivize people who take short-term risks at the expense of the long-term franchise and at the expense of investors,” sign-on bonuses actually are models of well-crafted hiring practices.

The bonuses reward advisers who contractually commit themselves to act as good corporate citizens over nine or 10 years by building their businesses in accordance with industry best practices. What’s more, these revamped and redesigned recruiting packages align the long-term interests of advisers, clients and firms, and are far ahead of the compensation programs in trading and investment banking.

Let’s look at history and at today’s facts.

In the bad old days, brokers were awarded with upfront packages based largely on their levels of gross production, with scant reference to levels of client assets under management. These were largely three- and four-year deals, and encouraged rampant job hopping.

Today, at any mainline brokerage firm, it is virtually impossible for an adviser to trade excessively in client accounts to jack up his or her commissions prior to getting an offer based on the “trailing 12” gross commissions.

From a compliance standpoint, the retail side of today’s Wall Street firm is a tightly run ship. Once the “turn” — the ratio of commissions to assets under management — starts to approach 2%, compliance fire alarm bells go off. Firms scrutinize high-turn advisers with all the tact and subtlety of drug enforcement agents pursuing a major bust. It would be difficult for any adviser to overtrade accounts and remain employed for long at any major wirehouse or regional firm.

Despite Ms. Schapiro’s concern that adviser recruiting packages cause churning of client accounts, numbers from the Financial Industry Regulatory Authority Inc. tell a different tale.

From 2007 to 2009, investor complaints rose to 5,067, from 4,552. While that’s an 11% increase, remember that it came against the backdrop of the most severe market meltdown in a generation. It was a remarkable achievement and certainly not what might have been expected.

Consider, also, that complaints in 2009 were below the high-water mark of 5,671 in 2006 and that disciplinary actions were essentially flat — to 1,158 in 2009, from 1,177 in 2007 — all while the size of recruiting packages rocketed up to unprecedented, stratospheric levels. (Ms. Schapiro ran Finra during that time and must certainly be familiar with these numbers.)

Let’s look at the structure of today’s deals and consider the types of behavior they reward.

Major wirehouses typically pay upfront signing bonuses of 100% to 140% of trailing-12-month commissions, with back-end bonuses extending from three to five years. Contracts extend from nine to 10 years. Bonuses typically require that an adviser transfer in 70% or more of their assets within the first 14 months in order to qualify for a back-end bonus. Bonuses can be 40% or more of the onboard gross.

Back-end bonuses typically are based on hitting asset and production goals, and many are solely asset-based. As mentioned, “turn” is watched scrupulously. Advisers typically are required to bring in more than 70% of assets from their previous affiliation during the first year and/or do 70% of onboard gross in the first 14 months of employment, with 90% expected at the end of the second year and 110% at the end of the third.

Since firms want to make sure that new hires don’t feel pressure to overtrade accounts, they are given three years to get back to their level of production and assets at their old firm. Back-end bonuses in the first three years can add as much as 150% in bonuses, meaning that advisers who qualify can earn up to 250%.

Firms typically require advisers to increase assets and production by 25% at the end of year four and 150% at the end of year five. Total packages for those who are successful then can range up to more than 300%.

In the real world, it is extremely unlikely that advisers with shaky client relationships or those who overtrade their accounts will sign up for these deals.

Advisers who haven’t satisfied their clients and as a result cannot bring client assets with them to hit back-end performance bogeys won’t get the full value of the deals. So why move?

FAST-BUCK ARTISTS

What about fast-buck artists who want to take big risks with their practices so that they can quickly cash out? For such a broker, today’s brokerage recruiting deals are not compelling, because Mr. Churn “em would still be on the hook to produce at his new firm for about a decade.

The advisers who are eligible for these deals are some of the highest-caliber people in the industry. Their business is typically 30% to 40% fee-based, with a ratio of commissions to assets of 1.5 or less. Production is in the first or second quintile and they do not have compliance issues.

These top advisers have no problem committing contractually to a back-end deal that requires them to build their businesses with an appropriate ratio of commissions to assets at the new firm.

This is not a sticking point for these quality advisers, who just stick to the sound business practices that they always have used.

The structure and requirements of today’s recruiting deals are widely known by advisers and brokerage firm executives. The details are regularly splashed across the pages of a variety of industry publications. Everyone understands how these recruiting packages mandate decade-long adherence to industry best practices.

So why do these basic, well-known facts seem to elude the Securities and Exchange Commission?

This is an agency with at best a foggy understanding of the industry that it is charged with regulating. It is the same agency that didn’t understand why allowing a money manager named Bernard Madoff to hold securities in custody and issue his own reports on their valuation might be a problem.

[Mark Elzweig heads an eponymous national executive search firm in New York that provides recruiting services to the asset-management community.]

Related Topics: Securities and Exchange Commission