Investment advisers and broker dealers and other persons in relationships of trust that must keep confidential a client’s contact information and wishes must be able to go outside of that circle of trust from time to time. However, laws such as Regulation S-P prohibit them from doing so. That is why many investment adviser in the industry have developed trusted contact person forms to allow just that. Below is a sample form that investment advisers can consider.
almost all events, it is our preference to deal directly with you. However, given our appreciation of mental
health issues that can afflict clients and the potential for their sudden
onset, we have taken proactive steps designed to protect you and us. First, we have developed policies and
procedures and implemented training that are intended to assist our firm in
identifying instances of diminished capacity and financial exploitation. Second, we have developed this Trusted
Contact Person Form to provide us with a contact person in the event you have
not yet appointed a power of attorney over your affairs or we are unable to
locate them and (i) you show signs of declining mental capacity, (ii) we are
unable to contact you after repeated attempts, or (iii) we suspect that you are
the subject of financial exploitation and are unable to understand the events.
completing this form and signing it below, you authorize us to contact and
share information about your accounts and certain transactions in your accounts
with the following person or people:
will continue to rely on this Trusted Contact Person Form unless and until you
or your authorized legal representative has notified us, in writing, that you
have revoked your authorization or wish to change one or more persons listed on
I agree that unless otherwise specifically prohibited
by state or federal securities laws, I agree to release and hold harmless
[INSERT ADVISER NAME] and each of its officers, directors, members, employees,
and agents with respect to any and all claims that might result from its
reliance on this Trusted Contact Person Form.
 The purpose of this Trusted Contact Person Form is designed to protect both clients and our firm. This form is not a power of attorney and does not provide the trusted contact, us or any of our employees or agents with any legal authority over your account or affairs. You are not obligated to complete and submit this form, however, it could make our performance of our job more difficult if (i) you show signs of declining mental capacity, (ii) we are unable to contact you after repeated attempts, or (iii) we suspect that you are the subject of financial exploitation and are unable to understand the events. We recommend you inform your trusted contact so they’re prepared in the event we need to contact them.
Back in December 2014, the Securities and Exchange Commission (“SEC”) approved a Financial Industry Regulatory Authority (“FINRA”) rule governing transaction-based payments to unregistered persons. The FINRA rule—Rule 2040—became effective on August 24, 2015. I understand that FINRA is currently considering providing members and the industry with written guidance so that their registered representatives can receive more favorable tax treatment of their earned income by either i) forming individual corporate entities to receive commissions, or ii) form selling groups with other registered representatives from the same broker-dealer so that they can engage in succession planning. At least I hope that is the case!
Rule 2040(a) states, “[n]o member or associated person shall, directly or indirectly, pay any compensation, fees, concessions, discounts, commissions or other allowances to: (1) any person that is not registered as a broker-dealer under Section 15(a) of the Exchange Act but, by reason of receipt of any such payments and the activities related thereto, is required to be so registered under applicable federal securities laws and SEA rules and regulations; or (2) any appropriately registered associated person unless such payment complies with all applicable federal securities laws, FINRA rules and SEA rules and regulations.” In short, this paragraph states that broker-dealers cannot i) pay unregistered persons or entities, unless the payment would otherwise be legal, and ii) pay registered representatives unless the payment is legal.
What Does it Mean for Payers and Payees of Transaction-Based Compensation?
This particular method of drafting begs the question of what is legal in terms of paying or assigning transaction-based compensation to unregistered persons or entities. However, this was not a matter of poor drafting. It was a deliberate decision, because FINRA has long deferred to the SEC to determine whether or not a person or entity should be registered as a broker-dealer.[i]
There currently exist ways for broker-dealers and registered representatives to prove to FINRA that they are in compliance with Section 15(a) of the Exchange Act. A supplement to Rule 2040 gives members additional guidance. This paragraph states:
FINRA expects members to determine that their proposed activities would not require the recipient of the payments to register as a broker-dealer and to reasonably support such determination (emphasis added). Members that are uncertain as to whether an unregistered person may be required to be registered under Section 15(a) of the Exchange Act by reason of receiving payments from the member can derive support for their determination by, among other things, (1) reasonably relying on previously published releases, no-action letters or interpretations from the Commission or Commission staff that apply to their facts and circumstances; (2) seeking a no-action letter from the Commission staff; or (3) obtaining a legal opinion from independent, reputable U.S. licensed counsel knowledgeable in the area. The member’s determination must be reasonable under the circumstances and should be reviewed periodically if payments to the unregistered person are ongoing in nature. In addition, a member must maintain books and records that reflect the member’s determination.
This guidance is not particularly helpful for a registered representative hoping to establish a selling group operate a corporate entity for expense paying and marketing purposes.[ii] In a line of SEC Interpretive No-Action Letters, the SEC has suggested that it would reserve the right to bring enforcement proceedings against entities that receive securities-based compensation from registered representatives by assignment or otherwise.[iii]
However, No-Action Letters are not binding legal authority. These letters merely serve as the opinions of the Commission on arguable questions of the law. I have long believed that these No-Action Letters reach the wrong legal conclusion, and I have counseled numerous clients on how to establish selling groups in a way to reduce their overall risk.
I would be doing everyone a disservice if I did not mention the recent case of Carey v. Bumstead in Washington . There, a state appellate court unanimously placed great weight on the SEC No-Action Letters in deciding a dispute among two registered representatives. Interestingly, the court acknowledged that it wasn’t bound by SEC No-Action Letters. [iv]
While I appreciate the SEC’s, FINRA’s and Washington State’s intent of preventing fraud and questionable payment arrangements, they have gone too far interpreting the law. That is why I believe (i) the pending guidance should be released expeditiously, and (ii) in the interim, the SEC and FINRA should cease issuing deficiencies from these alleged commission sharing arrangements.
[i]See NASD Interpretive Letter to Ted. A. Troutman, Esquire, Muir & Troutman (Feb. 4, 2002).
[ii] See Herbruck, Alder & Co. (May 3, 2002)(Firm denied no-action relief where all nine owners were registered representatives of a broker-dealer who would receive commission checks directly from broker-dealer, deposit them in their own personal accounts, and then write a check to the firm. The purpose of combining the revenues was that the firm could deduct “overhead, payroll taxes, and fringe benefit costs” and remit the balance to the employee(s).); Wolff Juall Investments, LLC (May 17, 2005)(No relief granted where registered representatives proposed to deposit their commissions with a limited liability corporation not registered as a broker-dealer to cover expenses with the non-registered entity to distribute the remainder to the registered representatives.); Birchtree Financial Services, Inc. (Sept. 22, 1998)(No Action Relief denied where Birchtree Financial Services requested the payment of commissions to an entity owned and operated solely by two registered representatives. Relief also denied for the assignment of commissions by the two registered representatives to an entity. The entity was created to pay operating expenses and health care benefits for employees.); Century Investment Group Incorporated (Jan. 29, 1996)(SEC Division of Market Regulation would not offer relief where certain registered representatives would create their own, single shareholder corporation to receive the individual representative’s share of securities-based compensation.); Voluntary Benefit Systems Corporation of America (Nov. 14, 1995) (Dually registered insurance agent and registered representative of a broker-dealer requested and was denied no-action request where he requested that his commission compensation be directed to an existing life insurance agency not registered as a broker-dealer.); Lombard Securities Incorporated (July 12, 1994)(SEC denied no-action relief when it requested that it be able to direct securities-based compensation directly to “service corporation” rather than make such payments individually to each registered person. All owners of the “service corporation” were proposed to be registered as associated persons of a broker-dealer.); Vanasco, Wayne & Genelly (Feb. 17, 1999)(No Action request denied where registered representatives would continue to be employed by the broker-dealer, the broker-dealer would route all trading commissions earned by the registered representatives to their respective personal service corporations, rather than directly to the individual representatives.).
[iii] See Herbruck, Alder & Co. (May 3, 2002)(Firm denied no-action relief where all nine owners were registered representatives of a broker-dealer who would receive commission checks directly from broker-dealer, deposit them in their own personal accounts, and then write a check to the firm. The purpose of combining the revenues was that the firm could deduct “overhead, payroll taxes, and fringe benefit costs” and remit the balance to the employee(s).); Wolff Juall Investments, LLC (May 17, 2005)(No relief granted where registered representatives proposed to deposit their commissions with a limited liability corporation not registered as a broker-dealer to cover expenses with the non-registered entity to distribute the remainder to the registered representatives.); Birchtree Financial Services, Inc. (Sept. 22, 1998)(No Action Relief denied where Birchtree Financial Services requested the payment of commissions to an entity owned and operated solely by two registered representatives. Relief also denied for the assignment of commissions by the two registered representatives to an entity. The entity was created to pay operating expenses and health care benefits for employees.); Century Investment Group Incorporated (Jan. 29, 1996)(SEC Division of Market Regulation would not offer relief where certain registered representatives would create their own, single shareholder corporation to receive the individual representative’s share of securities-based compensation.); Voluntary Benefit Systems Corporation of America (Nov. 14, 1995) (Dually registered insurance agent and registered representative of a broker-dealer requested and was denied no-action request where he requested that his commission compensation be directed to an existing life insurance agency not registered as a broker-dealer.); Lombard Securities Incorporated (July 12, 1994)(SEC denied no-action relief when it requested that it be able to direct securities-based compensation directly to “service corporation” rather than make such payments individually to each registered person. All owners of the “service corporation” were proposed to be registered as associated persons of a broker-dealer.); Vanasco, Wayne & Genelly (Feb. 17, 1999)(No Action request denied where registered representatives would continue to be employed by the broker-dealer, and the broker-dealer would route all trading commissions earned by the registered representatives to their respective personal service corporations, rather than directly to the individual representatives.). But see, 1st Global, Inc. (May 7, 2001)(No action request partially denied and partially granted. 1st Global Capital Corp. was a registered broker-dealer. The firm had many registered representatives who were also partners in accounting firms. The SEC granted no-action relief where 1st Global Capital Corp. would pay securities commissions to a CPA registered representative who is not subject to a formal or informal agreement requiring him to turn securities commissions over to an unregistered CPA firm, and no unregistered person would be eligible to receive commissions directly or indirectly. However the SEC denied no-action relief where 1st Global Capital Corp. would pay securities commissions to a CPA registered representative, with the understanding that the registered representative would then “voluntarily” turn those commissions over to an unregistered CPA firm.)
[iv] Carey v. Bumstead (“Courts are not bound by the determinations made in SEC no-action letters, and the letters do not carry any precedential value. Apache Corp. v. Chevedden, 696 F. Supp. 2d 723, 735 (S.D. Tex. 2010). Nevertheless, regulatory interpretations in these letters may “enlighten a court struggling with ambiguous provisions in federal securities statutes or [SEC] rules.” Id. (quoting Donna M. Nagy, Judicial Reliance on Regulatory Interpretations in SEC No-Action Letters: Current Problems and a Proposed Framework, 83 CORNELL L. REV. 921, 996 (1998)). Thus, we consider the SEC no-action letters as persuasive authority. Id.; see also Cryl ex rel. Shire Pharm. Grp. PLC v. Shire Pharm. Grp. PLC, 298 F.3d 136, 145 (2d Cir. 2002). Based on these SEC no-action letters, it is highly likely the legal structure Bumstead and Carey created—assigning commissions to SFI to cover expenses and then having SFI pay any residual funds back to them—violated FINRA Rule 2040.”)
Are you a financial adviser, investment adviser, wealth manager, registered representative or similar financial professional? There are many different names for those who render investment advice. Have you ever wondered how your clients’ situations might improve by changing your employer or business partner? Have you ever considered how your own personal financial well-being might improve if you changed your employer or business partner, joined a new firm, or started your own independent investment adviser (RIA)? This article is designed to illustrate the options that exist as you explore your current situation, and ultimately tries to convey how forming and operating your own RIA may be the best choice of all.
I. Employee of “Wirehouse”
The term “wirehouse” is an antiquated term that generally refers to Merrill Lynch, Morgan Stanley, UBS, and Wells Fargo—that are among some of the largest companies in the country.
For current employees, there are numerous reasons why remaining at a wirehouse might not be the best fit for your business. Below is a discussion of some of those reasons why you might want to consider your current affiliation.
1. Name Recognition – Once upon a time, working for a wirehouse was the best form of advertising. These companies carried great name recognition with Americans of all age groups. However, in light of recent regulatory events, scandals and enforcement actions, the original luster of these companies is beginning to fade. The culture at these companies is being exposed for what they truly are—for profit companies that are most concerned with their shareholders.
I performed a Google search using the following keywords “Merrill Lynch SEC enforcement” and uncovered 5 settled enforcement actions in 2018 and 2019 alone between the U.S. Securities and Exchange Commission and Merrill Lynch. Using the same search methodology, I uncovered 1 for UBS and 2 each for Morgan Stanley and Wells Fargo. This doesn’t contemplate any of the trouble these companies have faced from their other regulators such as FINRA and the Consumer Financial Protection Bureau.
2. Conflicts of Interest – Wirehouses tend to have more conflicts of interests than other firms, especially financially related conflicts of interest. They receive payments from the vendors and products that they recommend, they sell affiliated investment funds and bank sweep products, they direct trades to exchanges where they have ownership interests, and the list goes on. All of these conflicts of interest ultimately lead to higher costs and lower returns for your clients.
3. Overhead Expenses – The wirehouse model has historically, and continues to have, some of the lowest payouts in the industry based on financial adviser revenue. One source has suggested that payouts at wirehouses are anywhere between 32-42% of revenue generated. These payouts are the lowest in the industry, because these firms have such expansive overhead. They have massive real estate complexes in most major cities, they have thousands of employees and need to fund their retirement packages, they have highly compensated executives, and they have a stable of professionals with niches that you might never need—annuity, banking, insurance, marketing, corporate, estate planning, IPOs, microcap, structured products, and the list goes on.
4. Lack of Succession Options – When you are employed by a wirehouse, the dynamic is employer-employee. You likely do not have a meaningful equity stake in your employer and you don’t have much flexibility in monetizing your goodwill that you have created by doing your job over the years. At best, you might be able to locate a more junior adviser who will pay you to introduce you to your clients and eventually take over managing those relationships. With an ownership in an independent investment adviser, you have many more options for potential buyers such as other RIAs, which helps you to recognize the true value of your goodwill.
5. Client Ownership – In a practice that has become more prevalent in recent years, wirehouses are treating employees like the wirehouse owns the client relationship, when we all know that no one can “own” a client relationship. Wirehouses include restrictive covenants in their employment agreements that prevent employees from soliciting and servicing their clients upon their departure. Both Morgan Stanley and UBS left the broker protocol in recent years, which makes it more difficult for advisers seeking to leave these firms and to take their clients to new firms. However, it is definitely not impossible and we have counseled numerous clients through this process.
6. Restrictions on Freedom of Investment Universe. While employed by a wirehouse, you will likely be restricted by investment, operations, and compliance policies. You may be forced to keep client portfolios within certain managed strategies, You might also be required to purchase affiliated mutual funds. Further, you might be prohibited from managing a client’s outside assets such as their 401(k) account. All of these things might be to yours and your client’s detriment.
If you are just starting out, you might think that those posting on LinkedIn or other job sites to take part in a financial adviser training program is a great launching point into a career in the financial industry. If it is with the “wirehouse” model, you are probably wrong. According to one source, the Practice Management Division of Merrill Lynch had over a 90% failure rate for new employees. If you are serious about your future in this industry, you may want to explore other options.
II. Join a Hybrid Model
There are many different types of hybrid models for investment professionals. On one end of the spectrum, an advisor can join an independent RIA that has an affiliation with a friendly broker-dealer (e.g., Purshe Kaplan Sterling Investments, The Investment Center, APW Capital). On the other end of the spectrum, an adviser can join a separate operating division or company of a wirehouse such as Wells Fargo’s Finet. This provides these advisers with higher payouts and access to many products to recommend their clients on a commission basis including variable annuities. Many of the same items addressed above can haunt advisers in hybrid models. For example, hybrid firms might be more likely to face regulatory scrutiny. Also, an adviser in a hybrid model might not be entirely free to determine his or her client’s investment policies and security selection. Depending on the firm, they might also not receive the maximal payouts.
There are benefits to these models, however. Making transitions to a hybrid model can present less risk and less time time in addressing operational issues. For example, a person making the decision to go hybrid won’t have to consider registering an RIA and implementing a compliance program. They won’t need to locate office space and enter a lease or purchase real estate. All of these things should be considered in making a decision on what works best for you.
III. Own and Operate an Independent Investment Adviser
While I might be a bit biased, I truly don’t see why anyone would ignore this option. I represent many clients with as few as $25 million under management who are profitable at operating RIAs. The economics of the decision are very compelling. Below is a chart explaining the total revenues generated from different levels of assets and advisory fees (75, 85 and 100 basis points).
This chart only reflects the annual, recurring revenue that one could generate operating an RIA. It doesn’t contemplate what one could earn as part of the sale of their business. RIAs are legal entities and can be sold just like any other company. They have relatively high values compared to other business. Their value fluctuates based on numerous factors (e.g., asset levels, age of clients, location, and expenses). The multiple that we have witnessed in this industry over the last several years is anywhere between 1.5 and 3.5. So for the business referenced on the bottom of the diagram, that owner could expect to achieve anywhere between a $1.5 million and $3.5mm payout when he or she sells the business. This is a very compelling reason alone to consider forming an RIA.
There are numerous other reasons to consider the RIA path. Below are some of the reasons that our clients take the leap:
1. Independence –As a business owner, you have the freedom to dictate how to operate your business. You get to decide who to hire, what investment philosophy you want to adhere to, where your office will be located, whether to manage outside assets, and even more granular details like website and logo design.
2. Legal Standard – RIAs are held to a fiduciary standard when they render investment advice. Under current rules applicable to broker-dealers, they operate under a different legal standard. While it is technically called a “best interest” standard, it does not live up to the RIA standard.
3. Expense Control – Obviously, there are expenses involved in starting your own business—office space, technology, administrative support, legal, and compliance. However, these costs are all controllable and an RIA has lots of control over these variables.
4. Create Your Own Brand – Many clients that I work with are eager to become true entrepreneurs. They express that they have largely felt that way since they started their careers in wirehouses. One of the common refrains I hear is that they were predominantly responsible for the growth of their business. Given that fact, why not continue that trend outside the purview of your prior employer?
If you are considering making a transition away from a wirehouse or from a wirehouse to another wirehouse, I would be happy to have an introductory discussion with you at no cost. I try and offer prospective clients an honest assessment whether going independent is for them. If it is not the right option for you, I have ample experience assisting advisers with negotiating lift outs, bonus compensation and succession plans.
California Assembly Bill 5 (the “Bill”) was passed in Senate on September 9, 2019 after passing the Assembly back in May. According to reporting by the New York Times, it is expected that California Governor, Gavin Newsom, will sign the bill.
The Bill changes the status quo on the classification of employees and independent contractors. As the preamble to the Bill makes clear, California courts currently follow the common law rules for determining whether an employer-employee relationship exists or whether a person is an independent contractor. That test has numerous parts, but one of the important elements for a person to be considered an independent contractor is that the person must be free to control the performance of their work.
However, the Bill provides a greater likelihood that a person would be classified as an employee instead of an independent contractor, which means that the employer would be required to make payments for “payroll taxes, payment of premiums for workers’ compensation, Social Security, unemployment, and disability insurance”. Ultimately, the Bill would provide greater protections and benefits to persons previously classified as independent contractors and now classified as employees. It would cost employers more to employ these individuals and the employers would be subject to added liability.
Under the Bill, “a person providing labor or services for remuneration shall be considered an employee rather than an independent contractor unless the hiring entity demonstrates that the person is free from the control and direction of the hiring entity in connection with the performance of the work, the person performs work that is outside the usual course of the hiring entity’s business, and the person is customarily engaged in an independently established trade, occupation or business.”
Under this test, most independent contractors in the financial services industry in California would be classified as employees absent an exemption. Section (b)(4) of the Bill exempts both broker-dealers and investment advisers and their agents and representatives that are registered with the U.S. Securities and Exchange Commission or the Financial Industry Regulatory Authority from this new test. Instead, the Bill makes it clear that these employers and individuals will continue to be subject to the framework outlined in S. G. Borello & Sons, Inc. v. Department of Industrial Relations (1989) 48 Cal.3d 341.
The following are the top ten considerations to make for starting an investment adviser:
1. You will want to develop and complete your firm’s business plan. You will need to decide on your resignation date and begin to develop your vision and strategy. It may be helpful to consider your existing clients, your strengths, your desired future, and competitive market demographics.
2. You will want to review your current employment agreements to determine whether you are subject to any non-compete or non-solicit provisions. You may want to consider engaging employment lawyers that are well versed in this area of law and familiar with Broker Protocol compliant transitions and non-Broker Protocol transitions.
3. You will need to decide on your firm’s business entity structure (for example, corporation (Corp.), S-Corporation (S-Corp), limited liability company (LLC), etc.) and domicile. You may want to consider engaging legal counsel and tax experts to advise on the business formation requirements and tax implications of varying business entities across jurisdictions.
4. You may want to engage the assistance of legal counsel or compliance experts to assist with licensing and registration requirements at the state or federal level. As part of this process, you will want to evaluate your firm’s initial regulatory assets under management to determine whether your firm will require registration with the U.S. Securities and Exchange Commission or with similar state regulatory authorities.
5. You will want to develop your firm’s business operations and select your firm’s physical office location and move-in date. In setting up your business, you may want to consider engaging an insurance carrier to ensure you have the appropriate insurance policies in place such as an errors and omission policy (E&O) policy.
6. You may want to hire an external information technology vendor to evaluate, assess, and implement your firm’s technological needs for services and software including, but not limited to, Customer Relationship Management (CRM), reporting, billing, and archiving.
7. In preparing client agreements, you may want to consider enlisting the services of legal counsel.
8. You will need to create and implement your firm’s compliance program. You may want to consider engaging legal counsel or compliance consultants to assist in drafting your firm’s legal and compliance documentation including, but not limited to, your firm’s policies and procedures manual and code of ethics.
9. You will need to enter into a custodial agreement and set-up your firm’s custodial platform. You will need to prepare documentation for the transfer of client accounts with the custodian. You will also need to assess what assets that will be converted onto the custodian platform. Once you have entered into proper arrangement with your custodian, you may want to consider employee training in an effort to bolster your firm’s familiarity with custodial operations and compliance issues.
10. You will need to announce your formal resignation. Once you are officially resigned, you will need to complete your transition in by transferring your clients’ assets and continuing to provide ongoing management of your clients’ assets at your new business.
AdvisorCounsel is a blog discussing issues relevant to the investment adviser community. While the focus is on issues pertinent to investment advisers to separate accounts (more specifically, wealth managers), this blog will address issues that extend to institutional managers, private fund managers, advisers to registered investment companies, and roboadvisers. AdvisorCounsel is a compilation of the thoughts and analysis of Max Schatzow, an attorney with the law firm of Stark & Stark, PC. The content of AdvisorCounsel does not necessarily reflect the expressions of Stark & Stark, PC or any of its clients.
Max advises investment advisers and broker-dealers on a range of financial regulatory matters. Max advises private investment vehicles, financial institutions, and other market participants on structure and operations, regulatory guidance and interpretation, investment adviser compliance and controls, and internal and regulatory investigations. He also advises these same entities through examinations, administrative proceedings, and enforcement actions. Max previously practiced law with one of the largest law firms in the world in its New York City office, where he advised investment advisers and broker-dealers on regulatory compliance.