COMPLIANCE BULLETIN 01-15 NEW PICTURE EFFECTS

COMPLIANCE BULLETIN 01-15 NEW PICTURE EFFECTS

A TALE OF TWO VERTICALS: The Differences Between Broker-Dealers and Investment Advisers I t was the best of times, it was the worst of times Well, that might be a bit strong. But, now that we have your attention, we thought we would take this opportunity to compare and contrast the major differences between Broker-Dealer and Investment Adviser organizational models. While this particular article focuses on these models as standalone operations it s important to note and understand that many firms also employ a hybrid-model, where firms will register as a broker-dealer and investment adviser as the two verticals typically work closely together (i.e., Buy-Side firms / Sell-Side Firms). 2

Where Do We BEGIN? As a result of the financial crisis, it became clear to the regulators that investors didn t clearly understand the differences between Broker-Dealers and Investment Advisers. It was evident that Investors historically were confused about the services being offered by various types of investment professionals, the fees being charged, the variations in titles used within these industries, etc. Even more problematic, most of the investing public could not easily delineate the differences in the support they were receiving from bank officers, insurance agents, registered representatives and investment adviser representatives. With that said, the regulators have / and continue to work toward bringing clarity to the investing public in terms of who they are ultimately entrusting their financial well-being to. Why Are We Providing This INFORMATION? Over the past few years, we have discovered that many of our clients and prospects have taken a genuine interest and are often seeking information, trying to ascertain the benefits / issues that exist within the Broker- Dealer and Investment Adviser models. This includes, but is not limited to, regulatory requirements, commission / fee structures, infrastructure requirements, operational issues, fiduciary versus suitability standards, etc. Another interesting fact to note is the Broker-Dealer industry is shrinking. As this industry continues to consolidate, the Registered Investment Adviser community is growing significantly. The rationale for this is quite simple. Many Registered Representatives have grown tired of the wire house mentality and seek an opportunity to break-away from the traditional Broker-Dealer model. The barriers to entry as a Registered Investment adviser are relatively small. Additionally, the ability to operate as an Independent and truly be autonomous in investment / portfolio decision making is something many industry professionals find extremely attractive. With that said, this is where folks making the decision to embrace an Investment Adviser model will truly need understand the difference and impact of operating under a fiduciary standard versus a suitability standard. Whether you operate within a Broker-Dealer or Investment Adviser the basic operating premise must be the needs of the customer outweigh the needs of the firm / investment professional. Having said that, both models offer viable solutions and approaches to customers. However, as we all know you can t be all things to all people. There are certain activities an organization can only undertake within a broker-dealer entity (i.e., IPO s, Secondary Offerings, M&A Advisory, Private Placements, etc.). Conversely, in order to receive a fee for providing advice to customers, an organization must be registered as an Investment Adviser. Feel Free to Connect with Us! We hope you find this side-by-side analysis helpful and educational. As always, we encourage our followers to reach out to us with any questions, comments, etc. Happy Reading! 3

BROKER-DEALERS Size of Industry: INVESTMENT ADVISERS Size of Industry: Approximately 4,000 Registered Broker-Dealers in the US. This sector is continues to consolidate and shrink. This is primarily due to a low interest rate environment, which has impacted broker-dealer revenues due to decreased revenues from lending on margin and difficult business conditions following the financial crisis. Additionally, the requirements of Dodd-Frank and other new regulations have imposed significant compliance costs on independent broker-dealers. Regulation Broker-Dealers are overseen by the Securities Exchange Commission ( SEC ) and usually a member of the Financial Industry Regulatory Authority ( FINRA ), a self-regulatory organization ( SRO ) for broker-dealers doing business in the United States. Most brokerage activity is regulated under the Securities Exchange Act of 1934. Brokers are typically compensated by charging a commission on the sale of an investment product. Brokers are held to fair dealing standards of commerce and are subject to a suitability standard of care with their clients, meaning that their investment recommendations must be suitable to the needs of the client and be consistent with the interests of the customer. SEC and SRO requirements are designed to promote Business practices that protect customers from abusive practices, including practices that may be unethical but not necessarily fraudulent. Federal Securities Laws and SRO Rules address Broker-Dealer conflicts in one of three ways: express Prohibition, mitigation, or disclosure. At the state level, broker-dealers and their agents must register with or be licensed by the states they conduct their business. Persons associated with a member, including assistant officers and other principals, who are engaged in investment banking or other securities business for the member, including functions of supervision, solicitation, or conduct business in securities or are engaged in training the persons associated with the member for any of these functions, must be designated as registered representatives. Based on roles and responsibilities, there are several securities licensing requirements that individuals may be required to meet. The General Securities Representative Exam (Series 7), the basic qualifying exam for individuals to engage in securities related activities within a FINRA member firm. Broker-dealers offering certain types of accounts and services may also be subject to regulation under the Investment Advisers Act. In general, a broker-dealer whose performance of advisory services is "solely incidental" to the conduct of its business as a broker-dealer and that receives no "special compensation is excepted from the definition of Investment Adviser. Approximately 35,000 Investment Advisers in the US. Roughly 15,000 registered with the SEC / Roughly 20,000 registered at the state level. This sector continues to grow. Regulation Investment Advisers are Registered and Regulated by either the Securities Exchange Commission (SEC) or the appropriate State securities regulator(s), depending on the assets they manage. In general, Investment Advisers managing less than $100 million must register with the state securities agency where they have their principal place of business. In general, Investment Advisers managing more than $100 million must register with the SEC. While this process is not as involved as the registration of a broker-dealer, it can be complex. Most advisory activity is regulated under the Investment Advisers Act of 1940. Regulation under the Advisers Act generally is principlesbased. Investment Advisers charge fees for advice. Investment Advisers are subject to a fiduciary standard of care with their clients. Investment recommendations must be in the best interests of the customer and the customer s interests must come first. This is also equated to the duty of loyalty and care. An adviser that has a material conflict of interest must either eliminate the conflict or fully disclose to its clients all material facts related the conflict. The Advisers Act expressly prohibits an adviser, acting as principal for its own account, from effecting any sale or purchase of any security for the account of a client, without disclosing certain information to the client before the completion of the transaction and obtaining the clients consent. Investment Adviser representatives of state and federallyregistered advisers commonly are subject to state registration, licensing or qualification requirements. Agents of an Investment Adviser who are charged with providing investment advice are called an "Investment Adviser Representative" (IAR). These IARs must generally complete The Uniform Investment Adviser Law Examination known as the Series 65 Exam, or by meeting the exam waiver requirement by holding one or more of the following prequalifying designations; Certified Financial Planner (CFP), Chartered Financial Consultant (ChFC); Personal Financial Specialist (PFS), Chartered Financial Analyst (CFA), or Chartered Investment Counselor (CIC). 4

BROKER-DEALERS Compliance Requirements: Every Broker-Dealer that is a member of FINRA is required to establish, maintain, test and modify written compliance policies and written supervisory procedures (WSPs) reasonably designed to achieve compliance with applicable FINRA rules, Municipal Securities Rulemaking Board (MSRB) rules and federal securities laws and regulations. Broker-Dealers must designate one or more CCOs. The CCO should play a critical role as advisor to the firm regarding the applicability of rules and regulations and the policies and procedures the member adopts. Anti-Fraud Compliance requirements include: Duty of Fair Dealing, Suitability Requirements, Duty of Best Execution, Customer Confirmation Rule (Rule 10b-10 and MSRB rule G-15), Disclosure of Credit Terms (Rule 10b-16), Restrictions on Short Sales (Regulation SHO), Trading During an Offering (Regulation M), Restrictions on Insider Trading, and Restrictions on Private Securities Transactions. Broker-dealers that are members of national securities exchanges are subject to additional regulations regarding transactions they effect on exchanges. Broker-Dealers must comply Regulation NMS which addresses topics that are designed to modernize the regulatory structure of the U.S. equity markets: order protection, intermarket access, sub-penny pricing, and market data. Broker-dealers that are exchange specialists or Nasdaq market makers must comply with particular rules regarding publishing quotes and handling customer orders. Broker-dealers, must comply with Regulation S-P, which generally requires a broker-dealer to provide its customers with initial, annual and revised notices containing specified information about its privacy policies and practices. Anti-Money Laundering: Unlike Investment Advisers, Broker-Dealers are subject to AML program requirements as administered through the Financial Crimes Enforcement Network ( FinCEN ), a bureau of the Treasury Department. Such requirements include, among others: - The development of internal policies, procedures, and controls. - The designation of an AML compliance officer. - An ongoing employee training program. - An independent audit function to test programs. - The establishment and implementation of a customer identification program and special due diligence program for foreign correspondent and private banking accounts. - Detection and reporting of suspicious activity. INVESTMENT ADVISERS Compliance Requirements: Under Rule 206(4)-7 of the Advisers Act, An Investment Adviser must: - Adopt written policies and procedures reasonably - Designed to prevent violations of securities laws; - Annually review the policies and procedures; and - Designate a Chief Compliance Officer (CCO). The SEC has further indicated that Investment Advisers should address the following elements in their compliance programs: - Portfolio Management Practices, including allocation of investment opportunities; - Trading practices including best execution and the use of soft dollars; - Proprietary and Personal Trading; - Accuracy of disclosure to clients and regulators; - Safeguarding of client assets; - Recordkeeping; - Marketing Activities; - Valuation of Client Holdings and Fee Assessment; - Client Privacy; and - Business Continuity Plan Anti-Money Laundering: Technically, there is no requirement imposed on Investment Advisers to maintain an anti-money laundering program pursuant to the Bank Secrecy Act of 1970, The Money Laundering Control Act of 1986, or the US PATRIOT ACT, as Advisers are not considered financial institutions as defined therein. For more than a decade, the Financial Crimes Enforcement Network ( FinCEN ), a bureau of the Treasury Department has struggled with the notion of including Investment Advisers within the definition of financial institutions and thus subjecting them to AML program requirements like those above. To date, it has elected not to do so because Advisers must conduct financial transactions for their clients through other financial institutions that are subject to AML requirements, and their clients assets must be carried at these other financial institutions. It would be duplicative to impose AML program requirements at both the advisory firm and custodial firm level. In reality, most banks, broker-dealers and mutual funds will only do business with Advisers that have established an AML program and are willing to work together to detect and prevent money laundering. Based on this and Industry Best Practice, it is recommended that Investment Advisers implement an AML program. 5

BROKER-DEALERS Examination and Enforcement: FINRA has primary responsibility for examining Broker- Dealers. The SEC also examines Broker-Dealers, particularly when a risk has been identified or when evaluating the work of an SRO, including FINRA, but generally does not examine Broker-Dealers on a routine basis. FINRA exams occur every 1-4 years, based on FINRA s assessment of business risk. The exam will include a Financial Operations (FINOP) exam, unless rare exception is made. New members must have an exam 6 months after membership is approved, unless no business has been conducted. In this case, the initial exam can occur within the first year. FINRA high risk firms are examined every year (this includes self clearing firms.) Municipal Securities Rulemaking Board (MSRB) members are examined every two years. INVESTMENT ADVISERS Examination and Enforcement: The Office of Compliance Inspections and Examinations ( OCIE ) examines SEC Registered Investment Advisers using a risk-based approach. Examinations may be conducted on an announced or unannounced basis. OCIE through its National Exam Program (NEP). Given the growth in the number of Investment Advisers and the decrease in the number of SEC examiners, SEC registered Advisers are examined (on average) only once every eleven (11) year unless an examination is conducted for cause. 6

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