Rising legal costs, tougher regulation and strained capital resources are making broker-dealers more vulnerable than ever.
About two dozen B-Ds have shut down over the past year, and when that happens, everyone suffers — especially advisers and their clients. When QA3 Financial Corp. ceased operations, for example, about 400 advisers had just a week to find and transition to a new broker-dealer. Under normal circumstances, that process takes between six and eight weeks.
Since the environment is uncertain, even advisers who have no intention of leaving their broker-dealer should keep up their antennae. Here are some steps every adviser should take to help ensure the viability of their practice in case of B-D failure.
Don't ignore signs of trouble. While some QA3 advisers sensed something was wrong and started planning a few months in advance, even more were so loyal that they failed to acknowledge any signs of distress. When the news of the firm's closing hit, these advisers were thrust into a crisis. While loyalty and
trust may be the best policy in any relationship, protecting yourself and your clients can be just as important.
We recognize that most advisers don't want to move their practices. And today, when advisers are busy putting greater amounts of money into a market that has finally regained a measure of investor confidence, it's easy to turn away from warning signs. But don't bury your head in the sand. If you read reports of distress at your broker-dealer, check out the news. Often, where there is smoke, there's fire, which is why it's so important to pay attention. While you want your marriage with your broker-dealer to be long and harmonious, you must be realistic if things look like they're turning south.
Look into your firm's potential regulatory and/or arbitration problems in relation to its financial strength. The increased legal vulnerability of broker-dealers means that advisers must be aware of the B-D's strength and stability. A broker-dealer without a solid financial base may not be able to survive potential regulatory problems or major arbitration.
Advisers who see or hear signs of distress should look at their firm's excess-net-capital figure: Does the firm have enough in reserves to cover current or pending arbitration costs? Depending on the kind of business a firm engages in, is there an adequate capital cushion? Advisers can assess a firm's risk by checking for any arbitration against the broker-dealer on the website of the
Financial Industry Regulatory Authority Inc. (finra.org). They also can check the firm's financials at the Securities and Exchange Commission's website (sec.gov).
QA3 advisers, for example, could have been tipped off to trouble ahead had they investigated and found that their firm had only $118,000 of excess net capital at the end of 2009. This was the reserve against $42 million in legal liabilities, a precarious situation regardless of any extenuating circumstances.
Look into your B-D's errors-and-omissions-insurance coverage. Advisers should understand both their own and their brokerage firm's E&O policies, and what is and isn't covered in each. The landscape for E&O insurance is enormously complicated, and one of the reasons QA3 ultimately went out of business was because its E&O carrier did not cover the multiple claims filed against the firm charging wrongdoing in the sale of private placements and real estate investments.
Recently, several broker-dealers sued their insurers over issues of coverage. If the suits are decided in favor of the insurance companies, even more broker-dealers could find themselves in trouble.
Start formulating a backup plan. This means doing research on your own or finding a search firm to help you become comfortable with a possible “backup” broker-dealer in case there is a transition. Having such a plan in place in the event of broker-dealer failure serves as an insurance policy against last-minute scrambling and stress.
While no one wants to think this can happen to them, advisers must be prepared. If your best-case scenario of staying with your broker-dealer for the long term doesn't work out as planned, having a worst-case scenario in place will save you time, energy and stress.
Jodie Papike is executive vice president of Cross-Search, an adviser placement firm that serves financial advisers and independent broker-dealers.
