Most people do not associate Philadelphia with the birth of the modern American securities industry, instead picturing early traders auctioning stocks under trees on the street corners of downtown Manhattan. But in 1790, the “City of Brotherly Love” spawned the nation’s first market maker.
It was first called the “Board of Brokers” and operated out of the Merchants Coffee House in downtown Philadelphia. The Coffee House later became City Tavern, which is still in business today. The exchange, meanwhile, moved around to several different locations in downtown Philadelphia before settling about a mile west of City Tavern on Walnut Street. It wouldn’t change its name to the Philadelphia Stock Exchange until 1875. By then, the industry it fostered was in full blossom and the New York Stock Exchange had assumed its role as the largest exchange in the country.
The founders of the Philadelphia Exchange could have never appreciated the magnitude of the industry they helped create and the effects (both positive and negative) it would have on the global economy. Without an organized exchange, the brokerage business could not have grown into the multi-trillion-dollar industry it is today. And while Wall Street remains the hub of the U.S. securities industry, as of the summer of 2012, the U.S. Bureau of Labor Statistics estimated the industry employs more than 803,000 individuals across the country.1 Most of those employed in the industry work as stock brokers and financial advisors.
Recruitment in the Modern Securities Industry
According to FINRA, the nation’s largest securities regulator, there are roughly 635,000 licensed registered representatives in the country. Those representatives, in turn, work for approximately 4,300 securities firms. The biggest names left standing on Wall Street—Morgan Stanley, Merrill Lynch and UBS—are undoubtedly most familiar to the public. But there are hundreds of smaller firms, banks and independent broker dealers, such as LPL Financial, Raymond James and Commonwealth, as well as small, single office “mom and pop” firms vying for brokers by offering higher commission payouts and broader product and service offerings.
There have been a number of widely publicized, high-profile defections from the legacy wirehouse firms in recent months, and there is no question the industry is trending toward the independent model. Some brokers, meanwhile, are shucking the broker-dealer model altogether and the heavy yoke of FINRA supervision, joining independent, “fee-only” advisory firms. With so many new options and platforms available, broker attrition and movement among firms is at an all-time high.
Historically, firms used comprehensive training programs to groom young advisors, teach them the industry and train them to build their business. In the late 1980’s, however, firms began to realize that hiring experienced brokers with established books of business was easier—and less expensive—than developing them from within. Instead of spending tens of millions of dollars per year on broker training programs for young brokers with no assets under management and unproven track records, firms discovered they could “buy” existing books of business by paying up-front money to experienced brokers to lure them to the firm. By the mid-2000’s, up-front bonuses, which traditionally were around 25 percent of a broker’s trailing-12 commission production, had snowballed to total up-front deals exceeding 300 percent of the broker’s prior-year gross production. That meant in some cases a broker generating $750,000 in annual gross commissions could cash a check for more than $2 million after joining a new firm and meeting certain revenue or asset thresholds.2
A brokerage firm cannot make money without assets under management. Firms need brokers to generate commissions off those assets. And there is no dispute that a primary focus of every firm is recruiting new advisors and increasing assets under management. But the “up-front money model” has spiraled out of control, and firms now find themselves trapped in a system of their own design. To attract top producers, they have to offer more and more up-front money, bonuses and perks in hopes to entice them to leave their current firm.3 Even independent firms, which historically did not pay large up-front bonuses, have begun offering upfront money and other benefits to compete with larger firms.
The net result is competition in recruiting quality brokers—those with established books of business and steady commission revenues—is higher than ever. In most firms, branch and regional managers are chiefly responsible for recruiting new advisors, though outside recruiters and headhunters sometimes play a part. In either scenario, however, the recruiting manager’s compensation is generally tied directly to the number of recruits they attract and the assets they bring to the firm.
Covering All Bases in the Recruitment Process
The recruitment process can take many months and involves hours of meetings and discussions with recruiters. It can be a stressful and daunting time for the financial advisor, particularly if he or she has never moved firms before. They may be fearful that some of their clients will not move with them or unsure whether the new firm will be a good fit. But the recruitment process is not all lunch meetings and happy hours. Industry standards and regulations require the recruiting firm to conduct due diligence to ensure the firm’s products and services are compatible with the broker’s book of business. The recruiting firm is, of course, in the best position to know the products and services it offers.
Unfortunately, much of the recruitment process is spent not on conducting thorough due diligence, but on trying to win the broker over and discussing the terms of their upfront and backend compensation. Recruiters know if they do not pay top dollar to top advisors, they risk losing them to a competitor. The pressure to recruit new advisors is so high—whether caused by a desire to meet regional recruitment targets, achieve a bonus threshold or impress a new boss—that recruiters often paint a rosier picture than what the reality will be at the new firm. Some will flat out tell the recruit whatever they want to hear to bring them over. After all, once the recruit joins the new firm they will be locked in to a forgivable promissory note and unlikely to put their clients through another move in the near future.
These negligent—and sometimes intentionally fraudulent—misrepresentations are, regrettably, fairly common in the recruitment process. Recruiters will make promises involving anything from the firm’s compensation and commission payout policies to product and service offerings, the advisor’s prospects for advancement within the firm or the availability of management positions. But when a deal is struck, brokers are presented with a litany of prolix, standardized paperwork—including letters of understanding, offer letters, promissory notes, bonus agreements and complicated employment agreements—carefully prepared by the firm’s team of lawyers. Those agreements say, in essence: Forget about everything we discussed during the recruitment process. If they’re not in these documents, our discussions never took place, and you cannot rely on anything we told you during the past several months.
By this time, the advisor has already decided to move to the new firm and selected a move date; held numerous meetings with the recruiting managers; met with product specialists at the new firm; discussed the move with their business partners, family and perhaps some of their clients; and probably even ordered new business cards. And while he or she may ask the recruiting manager for written confirmation of their prior discussions or agreements, the agreements are by and large presented to the recruit on a take-it-or-leave-it basis with no possibility of negotiation. It is not uncommon, however, for the recruiter to further assure the financial advisor that all previously-discussed commitments will be upheld and that the paperwork is more of a formality required by the corporate back-office to initiate the transition process.
An agreement doesn’t always need to be in writing to be enforced. In many instances, oral agreements are just as valid as written agreements. In an industry notorious for deals sealed with a handshake, however, an ounce of prevention is worth a pound of cure. It is best to get all material terms of the deal in writing. If that’s not feasible, as is often the case, recruits should keep detailed, contemporaneous notes of recruitment meetings, indicating who was present, where the meeting took place and what was discussed. They should ask difficult questions of the recruiting manager and, if possible, meet with other new recruits to the firm to discuss their transition experience. Finally, during the recruitment process, recruits should seek the advice of competent counsel with experience in the securities industry to help ensure they are doing everything they can to protect their interests and understand what they are signing up for. Their livelihood, after all, hangs in the balance.
1 This figure does not account for hundreds of thousands of individuals employed in other financial sectors—such as banking, credit, insurance and real estate—that are closely related to the securities industry. http://www.bls.gov/news.release/pdf/empsit.pdf.
2 These “golden handcuff” deals are not without their drawbacks. Generally up-front “bonuses” are tied to promissory notes forgiven over a seven or nine year period, and brokers are responsible for the substantial tax liabilities caused by the forgiveness of the note.
3 In April 1995, at a time when up-front bonuses peaked around 60% of trailing-12, the SEC released a report authored by the Commission on Compensation Practices recommending the elimination of up-front bonuses or, at a minimum, paying them over several years to reduce attrition amongst brokers. See http://www.sec.gov/news/studies/bkrcomp.txt. The commission was chaired by Daniel P. Tully, then Chairman and Chief Executive Officer of Merrill Lynch & Co. Tully is credited with doubling the firm’s assets under management in just four years—assets brought in using up-front notes no doubt helped him achieve that accomplishment.
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A two-decades-old rule by the Securities and Exchange Commission prevents companies from going public if the company attempts to limit the rights of shareholders from filing a class-action lawsuit. The ruling has prompted the Carlyle Group, a multinational asset management firm, to remove a mandatory arbitration clause in its initial public offering.
Seeking to go public after 24 years as a private equity group, the Carlyle Group recently abandoned the provision rather than file a lawsuit against the SEC. It faced opposition from the SEC and various members of Congress.
Senator Richard Bloomenthal, D-Conn., said in an interview with Bloomberg that a mandatory arbitration clause in an IPO would “open the door to arbitration clauses in all IPOs, and thereby eviscerate shareholder rights.”
However, Hal Scott, a professor at Harvard Law School, told Bloomberg that “competitiveness is at stake,” and that if the SEC was going to block Carlyle’s IPO, it was entitled to know why the SEC found class action lawsuits by stockholders helpful, as opposed to arbitration.
From 2001 to 2010, settlements from class action lawsuits by shareholders have totaled $52.7 billion, according to Cornerstone Research.
The U.S. Supreme Court in recent years has held that arbitration is the preferred method of resolving stockholder disputes. In addition, Carlyle is a limited partnership, which would be key to any decision by the Supreme Court. Delaware state law, which governs most U.S. corporations, allows partnerships more leeway regarding fiduciary duties to shareholders. Thus, many legal experts have speculated that if the Carlyle Group had taken the issue to the Supreme Court, it would have allowed the private equity firm to go public with a ban on class action lawsuits.
The Supreme Court has held that brokerages can force arbitration for customer disputes, but has yet to rule on whether public companies can extend the same concept to their shareholders.
For questions regarding the legality of an IPO or securities transaction, consult an experienced business and securities law firm.
Schedule a free initial consultation by calling Shustak Reynolds & Partners, P.C. toll free at 888-748-8748, or contact us online.
The global financial crisis brought unprecedented change to the securities industry. Investment banks and brokerage firms once thought to be insulated from the ebbs and flows of the market failed outright or were brought to the brink of bankruptcy. Thousands of stockbrokers, investment advisers and others employed in the industry found themselves unemployed, sometimes overnight. Public sentiment for Wall Street fell to an all-time low.
At the same time, main street investors still needed investment advice and a place to invest their savings. More than ever, they sought unbiased, conservative advice to help avoid the risky products and investments that contributed to the financial crisis in the first place. Unlike stockbrokers, who sometimes are motivated to “sell” certain products to investors to generate enhanced commissions (usually the riskier or more exotic the product is, the higher the broker’s commission), investment advisers typically are compensated through annual advisory fees, ranging from .5-2% of total account value. As their compensation is not directly tied to the individual products they recommend to clients, there is, in theory, less of a chance their recommendations will be biased.
According to a study recently published by Fidelity Investments,2 most investors turned to investment advisers for advice following the financial crisis. In fact, more than 90% of investors surveyed ranked their adviser as being more helpful during the financial crisis than any other source. As the securities industry continues trending away from the traditional wirehouse model, however, it has become increasingly difficult for the public to differentiate between stockbrokers and investment advisers. This article expounds upon California’s definition of “investment adviser” and highlights some of the key differences between brokers and advisers.
“Investment Adviser” Defined
In California, an investment adviser is defined as “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing or selling securities, or who, for compensation and as a part of a regular business, publishes analyses or reports concerning securities.” Cal. Corp. Code §25009; see also Investment Adviser’s Act of 1940, codified, as amended, at 15 U.S.C. §§80b-1, et seq., at §80b-2(a)(11). Most state “blue sky” securities laws define “investment adviser” similarly. In short, anyone who gives investment advice to another for compensation is considered an investment adviser in California, subject to the licensing and registration requirements discussed below.
Moreover, anyone who engages in any of the following activities also may be deemed an investment adviser under California law: (1) recommending securities; (2) managing accounts or portfolios of clients; (3) soliciting, offering or negotiating for the sale of investment advisory services; and (4) supervising employees who perform any of the foregoing acts. Commissioner’s Opinion, 2010 WL 4222049 (Cal. Dept. Corp. 2010); see also In the Matter of the Desist and Refrain Order Against Robert T. Reese, et al., 2009 WL 6769332 (Cal. Dept. Corp. 2009) (issuing cease and desist order against unlicensed individual who received compensation for providing investment advice to a prospective investor).
A stockbroker, by contrast, is one who is “engaged in the business of effecting transactions in securities for the account of others…”. Cal. Corp. Code §25004. In short, investment advisers give advice for compensation while brokers effect securities transactions for commissions. Dually registered individuals-e.g., investment advisers who also are licensed and registered with a brokerage firm to act as a broker-may give investment advice andprocess securities trades. Unless an exception applies, and there are many, anyone who gives investment advice for compensation must be licensed and registered either with the SEC or the state securities regulator as an investment adviser.
Exceptions to the Registration Requirement
While the definition of “investment adviser” is very broad, there are a number of exceptions to the licensing and registration requirements. Stockbrokers, lawyers, accountants and other professionals whose rendering of advisory services is “merely incidental” to the conduct of their business are exempt. See 15 U.S.C. §80b-2(a)(11)(D). In addition, investment advisers whose only clien ts are insurance companies or who operate as a foreign private adviser, charitable organization or business development company (i.e., a private equity firm) generally need not be registered. See 15 U.S.C. §80b-3(b)(1)-(7). In California, a narrow “de minimis” registration exception also applies to advisers who do not maintain an office within California and have fewer than six clients within the state. See Cal. Corp Code §25230.1. Other states have similar exceptions.
One of the most common exemptions from the regulatory scheme, however, applies to publishers of “bona fide newspaper[s], news magazine[s] or business or financial publication[s] of general and regular circulation.” See 15 U.S.C. §80b-2(a)(11)(D); accord Cal. Corp. Code §25009. As long as the publication does not give rise to a person-to-person relationship formed for the purpose of rendering financial advice, these publications are presumed to be excluded from the licensing and registration requirements. See Lowe v. S.E.C., 472 U.S. 181, 207-210 (1985) (“The dangers of fraud, deception, or overreaching that motivated the enactment of the statute are present in personalized communications but are not replicated in publications that are advertised and sold in an open market.”). This exception is based on First Amendment “commercial speech” protections.
While financial publications and pundits often skirt the line of engaging in conduct that falls within the definition of an “investment adviser”, their “recommendations” generally are carefully worded, expressed as opinions and not targeted toward any specific individuals. They also are not directly compensated for their investment advice, instead earning subscription or appearance fees. As a result, their conduct typically falls within the free speech exception to the regulatory framework.
Investment Adviser Regulation
Assuming no exception or exemption applies, all investment advisers must be licensed and registered with the SEC and/or the state securities regulator for the states in which they do business, depending on their total assets under management. Cal. Corp. Code §25230; N.R.S. 90.330; 15 U.S.C. §80b-3(a). Generally, the SEC regulates investment advisers with more than $100 million in assets under management, while advisers with less than $100 million are regulated by the state securities regulators of the states in which they do business. See SEC Rule 203A-1. All advisers must have passed the Series 65 securities license examination in effect as of January 1, 2000, or hold an older version of the Series 65 (or other combination of securities licenses) through a permissible “grandfathered” exception.3SeeCal. Code Regs. §260.236.
For dual registrants (e.g., individuals acting as both an investment adviser and stockbroker), the Series 65 license typically is registered with both the adviser’s broker-dealer of record and an investment advisory firm. Advisers who no longer wish to handle securities transactions or affiliate with a FINRA member firm may register their Series 65 license (or its equivalent) solely with a registered investment advisory firm. Prospective clients of an investment adviser may view the adviser’s licensing information and disciplinary history through the SEC’s Investment Adviser Public Disclosure (IAPD) website, at www.sec.gov/answers/iapd.htm.
Conclusion
The number of registered investment advisers has grown substantially in recent years.4 This trend is expected to continue as investors seek unbiased advice and clarity in what still is an uncertain economic environment. Investment advisers, and those interested in becoming advisers, should seek the advice of competent counsel to ensure they meet the numerous regulatory requirements governing the profession. And before entrusting their hard-earned savings to someone holding him or herself out as an “investment adviser”, public investors should confirm the individual is properly licensed and registered with the appropriate regulatory authorities.
Schedule a free initial consultation by calling Shustak Reynolds & Partners, P.C. toll free at 888-748-8748, or contact us online.
1 Mr. Miller is an associate attorney based in the firm’s San Diego, California office. His practice focuses on securities arbitrations, including customer and “intra-industry” employment and promissory note disputes, business and corporate litigation, contractual disputes and judgment enforcement proceedings.
2 See http://www.fidelity.com/inside-fidelity/individual-investing/fidelity-study-finds-financial-crisis-was-wake-up-call-for-investors. The study describes the financial crisis as a “wake up call” for investors which caused permanent changes in their approach to handling finances, including expanded reliance on advice from financial professionals.
3 The Series 65 was developed by the North American Securities Administration Association (NASAA) and will qualify an individual to operate as an investment adviser representative in most states. The exam was substantially revised in early 2000 and currently is administered by FINRA. In California, advisers employed or engaged as an investment adviser prior to December 31, 1999, and advisers who have passed an older version of the Series 65 in addition to the Series 7, generally are exempt from re-taking the January 2000 version of the Series 65 examination. See Cal. Code Regs §260.236.
4 According to a research brief published by the RAND Corporation, a non-profit global policy think tank financed by the U.S. government and private endowments, the number of investment advisers has grown considerably in recent years. See http://www.rand.org/content/dam/rand/pubs/research_briefs/2008/RAND_RB9337.pdf.
We are proud to announce that our firm took top honors for cash donated and number of suits collected in the small firm category of LAWSUITS, a cash and professional clothing drive for local law firms organized by Second Chance and Chaired by San Diego District Attorney Bonnie Dumanis. Our firm collected 18 suits and other professional clothing and $500 in cash donations which will be made available to graduates of Second Chance’s job readiness training program. The program helps at-risk youth, the homeless, recovering addicts and former prisoners reenter the community and workforce.
Thank you to everyone who made our first year in the annual LAWSUITS competition a tremendous success. We plan to up the ante next year!
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Investors in UBS Willow Fund, L.L.C. (the “Willow Fund”), which was sponsored and sold by UBS Financial Services, Inc., have begun filing claims to recover significant investment losses allegedly caused by the fund manager’s decision to shift his investment strategy and invest in complex derivative trades. According to public sources, the fund, which historically focused on corporate bonds and other traditional debt interests, held assets approaching the $500 million mark in 2006. But after its long time manager began channeling fund assets into derivative investments including credit default swaps in 2007, the fund began a series of precipitous declines which ultimately led to its total liquidation in October 2012. According to a recent New York Times article, the fund lost 89% of its value in 2012 alone.
An investor who recently filed suit against UBS claims the fund’s disclosures did not sufficiently warn investors of the risks of investing in credit default swaps or the shift in the fund manager’s strategy. UBS denies the claim, calling the Willow Fund a “specialized, speculative investment sold only to sophisticated and experienced investors who represented that they understood the fund’s substantial risks.” The remaining assets of the fund will be distributed to investors this summer.
If you have been the victim of misrepresentations or fraud in connection with the purchase of securities or been sold an unsuitable mutual fund or other investment, you may contact our firm’s managing partner, Erwin Shustak, at (619) 696-9500 or shustak@shufirm.com to discuss your potential claim.
