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An Endangered Species – Are You One?

By Douglas Schriner, Pres. faRisk Management Copyright 2012

Since 2000 the number of Broker Dealers has been shrinking. The then 5200 members were primarily small firms with most having fewer than 10 reps. Not surprising is that most of these firms (over 4000) were “nickel” BDs (firms with $5,000 capital requirements). These firms are fiercely independent. They set their policies based on their interests, talents and markets. This was the last bastion of financial entrepreneurs and mavericks with limited financial resources. Today there are fewer than 4200 firms and the trend continues. The industry has been losing firms in record numbers. In fact since the end of 2010, firms have been closing at rate of almost one a day. This is a bad thing. Small companies are the backbone of employment, innovation and growth. Small firms are the segment of the financial industry where small and growing companies get funding (risk capital). At a time when our economy needs fresh investment capital most, this part of our industry is shrinking. Why is this happening? Please follow along as I discuss the most significant reasons. How we deal with risk has evolved from essentially compliance and supervision to more regulatory oversight. The burden of this shift has become oppressive. Definitions, expertise, rules, forms, concentration, diversification, disclosures, verification, due diligence, errors and omissions insurance and legal scrutiny have made the purchase of risk capital (especially Regulation D) securities increasingly treacherous. Where once an environment of coordination existed between firms and regulators, today the market is dominated by an adversarial tension. The general perception that more is better permeates regulation and infects compliance. More staff, more Written Supervisory Procedures, more reviews, more training, more disclosures and disclaimers, etc. Regulation is responding to the market. The market is responding to the information available. The firms must adjust to remain compliant and competitive. It is a seemingly never ending downward spiral. Margins are getting squeezed and the only real innovations coming from this are new ways to extract income from the reps directly and their clients indirectly. This can sustain itself until a significant event occurs…and one is always on the horizon. The roots of our industry problems are cultural and societal - something for nothing. We live in era when someone is always “making it big” on some magical event. A neighbor or cousin sold his business for millions; the guy at the club bought some obscure security and made millions; a co-worker knows a guy that knows a guy that got a million dollar settlement through litigation; and the most damaging is the volume of law firms soliciting investors, promising restitution from investment losses by attacking the E&O policies of the BD. This has created an environment where the actual risks of the investment are shifted from the client to the rep and BD. It’s a pretty good model for the clients, their attorneys and regulation – but devastating to the industry. In fact one in 12 Americans believes their retirement asset will come from a litigious settlement. Are you the target? Certainly. FINRA has built a dispute resolution system that caters to plaintiffs’ attorneys at the expense of the rep and BD. There appears to be no such thing as a frivolous complaint. When documentation is available demonstrating compliance, evidence of acceptance and suitability of transaction are made available to all parties – the complaints should be dropped – but they continue to arbitration. In arbitration, even though these same documents demonstrate compliant and righteous transactions, there is still a strong possibility of an award against the rep and BD, not to mention the expenses accrued for defense and arbitration fees. The net result is heads you lose, tails you lose. It is a zero sum game and the rep and the BD pay at every turn. Settlement has become the norm. The attorneys know this. The basic cost of arbitration has jumped to almost$100,000 for a full-on defense. The E&O carriers quickly settle and then rewrite the policies or drop the insured.

FINRA and the SEC have adopted FAS 5, the financial hammer of complaints. This is the regulation stating inclusion of an amount in the firms’ quarterly financial statements reserving for complaint settlements or expenses. This is real area of concern today. How do you know what the costs are going to be? The FinOp and the CEO have to sign off on this amount. You can get a letter from your attorney estimating a cost or you can reserve the full amount of the claim. This has an immediate and dramatic effect on the condition of the BD and its’ ownership/management team. If the reserved amount is available as a deposit or pledge, it emboldens plaintiffs’ counsel to settle for the full reserved amount. If additional funds can’t be readily made available, the “risk” amount identified by counsel or the full complaint amount become contingent liabilities of the BD. Is the firms’ net capital sufficient to support these liabilities? If not, time to contact the SEC and FINRA and inform them of a capital inadequacy. If you don’t contact FINRA or the SEC and don’t include the “potential” settlement or expenses on your latest quarterly filing, the firm and its management team are in violation of FAS 5 and are subject to regulatory penalties and closure of the firm. The same is true of a settlement or adverse award, except the amount is a direct obligation which reduces net capital (dollar for dollar) and is immediate. If you don’t have the cash available now, you must cease operations until the funds are available.

Plaintiffs’ counsel is aware of these risks to the BD. This creates an unfair negotiating advantage for the clients. Either the rep and BD pay the settlement, the firm reserves significant funds for the defense, or hope the E&O provider will honor its agreement. If the E&O provider comes through, it may exclude certain products or services from future coverage. Today it is very common for 1031/TICs, REITs, drilling programs, promissory notes and fiduciary activities to be excluded from coverage. Simultaneously, deductibles have taken a significant jump up. Then you have a policy that protects the insurance carrier and not the rep and BD.

Small BDs can’t compete and remain compliant in the risk capital markets given these circumstances. Margins that were razor thin are now non-existent. More and more, small BDs are moving to the RIA platform, selling out or just closing their doors.  What does this mean? The Risk Capital market is losing sponsorship. Worthy companies seeking funding between $5,000,000 and$25,000,000 have fewer and harder choices. These companies are the engines of growth in America. Their fuel is money. Who will replace the small BD? Perhaps we should ask our Congressmen.