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6 Overlooked Criteria for Broker-Dealer Due Diligence

When investigating a new BD, you may not be looking at the following criteria—but you should

It’s not surprising that when the majority of registered reps look to change their broker-dealer, they tend to focus on short-term factors and immediate satisfaction. Quick relief in the form of better technology and payout, ticket charges, expenses and transition support can be very attractive. However, focusing on the long-term benefits will go a lot further in securing a new broker-dealer relationship that will last.Illustrations by Shaw Nielsen

Here are six criteria worth investigating to help ensure that when you make a broker-dealer change, it’s the right one.

1. Check the firm’s profitability and financials.

Since the 2008 market downturn, the bottom line comes down to, “Is the firm consistently profitable?” Average broker-dealer profitability is surprisingly modest: approximately 4% of revenue, with half of that historically coming from money market interest. With money market accounts earning virtually nothing, half of the firm’s profit spread is now gone. Besides lack of money market revenue, margin squeeze has become an increasingly large issue with increased compliance cost to satisfy Dodd-Frank requirements (See “Time to Consider Alternatives to Money Market Funds,” Investment Advisor, October 2012).

While publicly traded firms are transparent on their financials, private firms are not. These privately owned firms have been hesitant to release financial information in the past, but that has been changing now that the management at many firms has realized that reps need more assurances when choosing a new home.

You can request to see a quarterly focus report that will give you a clear picture of a firm’s financial accounting. Also, ask to see what their profits and losses have run annually since 2008. Don’t hold the weight of the world on excess net capital, since some firms will purposely keep a lower amount of excess net capital to discourage securities attorneys from targeting their firm for frivolous claims. Do be concerned, though, if the firm has a history of net capital violations. Another beneficial gauge of financial viability is to look at a firm’s aggregate indebtedness to net capital. In the following table, compare the low debt ratio of SCF Securities to that of Brookstone Securities (data as of March 31, 2012), which recently closed its doors.

2. Review alternative investment legacy and concentration.

If you had told me five years ago that alternative investments would have a devastating impact on independent broker-dealers, I wouldn’t have believed it, but that’s where we stand today. Firms such as QA3, CapWest, E-Planning, GunnAllen, Workman Securities and Pacific West have all closed due to troublesome alternative investments, while numerous other firms sift through mountains of arbitrations, hoping for favorable rulings from judges in order to stay in business. To compound problems, six notable non-traded REIT companies have experienced steep devaluations, which will likely set off a new wave of customer complaints.

We will certainly see more firms close due to crushing amounts of arbitration as their errors and omissions insurance is exhausted. To help you steer clear of firms in dubious situations due to these investments, look at the FINRA website to see the number and type of customer complaints that have been registered, as well as how many pending regulatory sanctions related to alternative investments there may be.

For broker-dealers that offer an extensive alternative investment selection, make sure to get a product breakdown from the broker-dealer that shows percentages of different investments. If the concentration of alternatives is over 25% of their mix, also look to see if the alternative mix itself is diversified among many different vendors and types of alternatives. In 2008 and 2009, Pacific West had over 50% of the firm’s revenue in alternative investments, with a large percentage of those in 1031 tenants-in-common exchanges. A high concentration in one particular type of alternative investment brings higher risk as well as the potential for larger troughs in a broker-dealer’s profit cycle.


3. Be aware of what’s being said in the press.

It can be embarrassing when your client brings up a disparaging article on your broker-dealer that you knew nothing about. In our tech-savvy society, clients may do their own due diligence by Googling the name of your firm to see what comes up. For example, we consulted a representative with clients who were very focused on social media. We discussed a few broker-dealer options with her, and then she did her own investigation. She did an Internet search on the broker-dealers and found that one of the firms was in the news due to a rep embezzling money from clients, which resulted in jail time for the advisor and a large fine for the broker-dealer. Because of this finding, the rep came back to us explaining that due to the social media sophistication of her clients, she could not consider that firm. Take a few minutes to research the names of the broker-dealers you are considering so that their press legacy doesn’t come back to bite you.

4. What is the firm’s arbitration history?

Broker-dealers with numerous compliance marks, especially recent activity, make the likelihood of heavy-handed compliance a greater concern. If a firm has had recent high-profile arbitrations and patterns of mismanagement, that firm will be under greater scrutiny, resulting in longer and more frequent audits. When a firm is under FINRA’s microscope, you will likely see the following:

  • Substantially more paperwork with unusually long forms, such as eight-page new client account forms, filled with legalese that clients find intimidating
  • Overly restrictive reviews on marketing materials and painfully slow compliance approvals
  • A plethora of company policies that make transacting business more difficult (These policies go over and above what FINRA requires and are intended to protect broker-dealers from their own reps.)
  • An increase in costs as reps ultimately pay for the added bureaucracy (One firm we watched as they went through compliance difficulties later doubled their reps’ expenses to cover the added compliance supervision expenses.)

By doing a quick check on FINRA’s website, you can see a broker-dealer’s past and pending customer and regulatory issues. Be sure to take things into context. Firms that have been in business for a long time are more likely to have compliance marks than a newer firm. And firms that have transactional reps are more likely to have customer complaints than firms focused on fee-based business. Repeated patterns of infractions are your best tell to problems that should be taken seriously.


5. Watch for firms with unorthodox methods of raising capital.

Representative-funded equity participation. Our firm has always been a big fan of equity participation if no capital outlay is required from the representative. Numerous firms shave off 10% to 25% of their firm to be owned by the reps, while some are 100% owned by reps and broker-dealer staff. The model we find agreeable is when the broker-dealer gives capital units or options each year based on a rep’s production level, i.e., the higher the level of production, the greater percentage of ownership. If the broker-dealer ever sells or goes public, the rep’s shares will have intrinsic value. If nothing ever comes to fruition, it is not a big deal since the rep never had to make a capital outlay.

A few firms elect to offer stock in their broker-dealer, which the firm’s representatives can purchase. The proceeds of the stock purchase are then used in a slush fund to operate and grow the broker-dealer. Valuation of their stock calculation is often times questionable. One recruiter that left such a firm told us, “I would ask management for the value price of their stock, asking three different people and getting three different prices. You might as well throw a dart at a dart board to come up with the price.”

Securities attorney Jim Eccleston of Eccleston Law, operating out of Chicago, expressed concern for rep-purchased ownership. “While customer protection issues are not directly present because advisors are buying shares for their own account in what is an employee-owned company, advisors need to be wary of valuation accuracy, dilution issues, vesting issues, transferability issues and any restrictions associated with related employment agreements such as duty of loyalty, non-solicitation and confidentiality provisions. The devil is in the details,” according to Eccleston.

Broker-dealer notes. Broker-dealers need capital to recruit and expand, which is typically done by investing profits into their marketing or business development budgets, or through funding from a deep-pocketed parent company. In their search for additional capital, some privately owned firms have chosen to sell notes to their representatives’ clients. These note periods can vary from three to five years, paying interest of 5% to 8%. Commissions paid to the representative for selling such notes to their clients typically run between 3% and 8%. Again, Eccleston expressed caution, stating, “The sale of such notes raises a host of issues that regulators would scrutinize. Apart from suitability, and accurate and complete disclosure, there is the issue of conflict of interest. That is, is the buy recommendation primarily motivated by not just the relatively high commission, but also by the advisor’s interest in raising capital to keep his or her independent firm profitable or merely just in business? Notably, advisors need to appreciate that the possibility exists that a kind of Ponzi scheme could be created in a situation in which the firm issues more than one series of notes, with the later series of notes being issued to pay off the earlier series of notes, but the firm ultimately being unable to pay off the later series of notes.”

6. Is the broker-dealer up for potential sale?

Starting at a new broker-dealer, your intentions are, “I hope this is the last move I ever have to make!” Having your firm sold out from under you can change things dramatically as the new owner’s interests may not mesh with your own. Here are some situations and criteria to explore to better discern if the firm you are courting is likely to be sold:

  • No Growth, High Staff Turnover. If a firm has had negligible growth over the last five years and you see high turnover of back-office personnel (talk to a wholesaler to verify), this is a possible indicator of a firm in a downward spiral in need of a buyer.
  • Technology Coasting. If the firm is not investing in new technology on a regular basis, chances are good that it is looking to sell in the near future.
  • Ownership Structure. If a broker-dealer has one person who is a majority owner and that person is in his or her late 50s or older, there is a strong likelihood that the sale of the broker will be the majority share owner’s retirement nest egg. Check the firm’s ownership structure on FINRA’s website and discuss the broker-dealer’s succession plan with management.
  • Unusually High Forgivable Notes. For firms that pay forgivable notes, offering 10% to 20% of a rep’s trailing 12-months production in the form of a five-year forgivable note equates to that firm not making money off the rep for two to three years. When that percentage goes up to between 25% and 40%, the broker-dealer is looking at around four to six years before it sees profits. You have to ask yourself, “In what scenario would it make sense to pay that much money to join them?” There are nearly always two answers to that question: 1) capitalizing the reps’ value through the sale of the firm, and 2) capitalizing the reps’ value through sale of proprietary products and their use of proprietary platforms such as proprietary advisory and clearing platforms.

With 27 broker-dealers closing their doors since March 2010, representatives must exercise greater due diligence in evaluating potential broker-dealers. Problematic alternative investments and financial duress were the death knell for these firms.

Shutdowns are not over, with yet more litigation and margin squeeze likely to occur as Dodd-Frank continues to raise compliance costs and REITs are re-priced at ever lower valuations. The current environment can be likened to tip-toeing through a minefield as you try to avoid firms that can blow up on you. Making the extra effort in your due diligence can help you get to the other side unscathed.

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Published October 10, 2012, by
Written by Jonathan Henschen
Illustrations by Shaw Nielsen
The original article is available at

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