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Fiduciary Links: SEC Should Fix Longstanding ‘Mismatch’ in Broker-Advisor Data to Advance Fiduciary Rule

Posted by Duane Thompson on May 19, 2014

>>>>>For far too long the Securities and Exchange Commission has failed to calibrate examination and enforcement data comparing inspection cycles and resulting enforcement violations between brokers and investment advisors. The mismatch in data collection and analysis can and should be fixed as critics of a fiduciary standard, in search of another trope, continue their calls for delaying or ending the SEC’s consideration of a fiduciary rule.

In recent statements by SEC Commissioner Daniel Gallagher, who has become increasingly outspoken on a variety of topics, the paucity of information on advisors compared to what FINRA and the SEC have on brokers is simply the result of too much enforcement data on brokers.

“We know a lot more about brokers and their practices – we know when they are committing rule violations, and there are so many more rules to violate,” Commissioner Gallagher recently told ThinkAdvisor’s Melanie Waddell. As a result, “advisors are always seen as pure and brokers are seen as miscreants.”

In a May 9^th speech at the annual Rocky Mountain Securities Conference in Denver, Commissioner Gallagher acknowledged that the decades-old problem with aberrant broker behavior continues, noting that “an astonishing” 20 percent of the 600,000-plus brokers have between one and five disciplinary problems on their disclosure forms, ranging from regulatory violations and customer complaints to bankruptcies and liens.

At the same time, he insisted that “in reality, there are plenty of repeat offenders at investment advisory firms…we’re just not finding them as quickly because the SEC allocates a disproportionate amount of resources to policing the activities of broker-dealers.”

Commissioner Gallagher went on to say that there are nearly three times as many advisory firms (11,100) versus 4,300 broker-dealer firms, implying the ratio is an appropriate apples-to-apples comparison. Thanks to the self-regulatory organizations, he observed, broker-dealers are examined in much greater proportion than RIAs. “The Commission,” he added, “should slow down and get all of the facts before adding to the long list of rules resulting from these false narratives.”

Since the issue has been raised, let’s examine some of those statistics, and other relevant facts that were omitted.

First, it is a slight exaggeration to say there are nearly ‘three times as many” advisers as brokerage firms. We’re probably quibbling here, but there are closer to 2½ times the number of advisory firms registered with the SEC (10,804 as of January 2014), as brokerage firms (4,142 as of March 2014), not three times. But the comparison fails to stand up since the only appropriate yardstick would be comparing the sub-unit of the broker-dealer that provides investment advice, such as a private client group or retail broker branch office, not the overall firm. According to the SEC’s Section 913 report, just over one-third of brokerage firms either own directly, or are affiliated with RIAs.

Certainly brokerage firms are far different from advisory firms in terms of overall size. The typical advisory firm in 2012, according to an annual Form ADV review sponsored by the Investment Adviser Association, had eight employees and focused principally on managing assets. Brokerage firms, in contrast, average 146 agents per firm in the same time frame, not including back office and other administrative support. Of course with so many other product distribution activities in the larger firms, it is like comparing apples and oranges.

When we look at the inspection cycle for brokerage firms, there is indeed a stark difference in inspection cycles. FINRA performs member audits once every two years. SEC advisers are at roughly a once in 12-13 year cycle. This statistic has been cited by proponents of an advisor self-regulatory organization for years, but is it an appropriate apples-to-apples comparison?

In 2002, the Commission’s examination department departed from it’s so-called ‘five-year plan,’, which at the time meant each RIA was inspected, on average, once every five years, no matter the size or risk profile. At the time, the Office of Compliance Inspections and Examinations adopted a somewhat different approach. Like FINRA does today, it moved to a complex risk-based approach that is more efficient in identifying problem firms, but also targets the larger ones with the greatest risk to the securities markets. This is just common sense.

What hasn’t been used in the apples comparison, but should, are the 160,000-plus branch offices of broker-dealers. If these were used to make comparisons, the current 12-13 year inspection cycle for RIAS -- few of which have an extensive branch office network like broker-dealers -- seems downright draconian. In its most recent annual reports from 2010 to 2012, FINRA noted that 500 branch office exams were conducted in 2010 and about 800 each in the following two years, leading to a once in every 200-year inspection cycle. Even if the 5,100 for cause examinations made by FINRA in 2012 are added to the branch office inspections, the cycle would still be an anemic once-in-27 years, or more than twice the average cycle for SEC-registered advisor firms.

Finally, it’s not clear how FINRA and the SEC track enforcement data, since nearly 90 percent of investment adviser representatives are dually registered as brokers. We do not always know, when reading the enforcement settlement details, whether the original violation involving a dual registrant started on the advisor or broker side. To be fair to all parties, the SEC and FINRA should go back and look at the source of the enforcement problem in developing accurate documentation.

Commissioner Gallagher is to be commended in his call for more data, since the overlap of broker and adviser retail services continues to generate considerable finger-pointing and debate over the best regulatory approach and deserves to be objectively reviewed. However, the data sets offered as evidence to-date are often provided out of context, and overall are largely unconvincing in making the case to halt adoption of a fiduciary rule.

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