Why are small broker-dealers disappearing?

The uncertain economy is compounding a long-term problem in the brokerage business: its shrinkage. Since 2005, when 5,111 broker-dealers were registered with the Financial Industry Regulatory Authority Inc., the number of firms has declined by 8.2% to 4,693. Economic conditions and regulatory pressure from the states, Finra and the Securities and Exchange Commission have been a “tough combination for small firms” and are causing some broker-dealers to buckle, said Lisa Roth, chief executive of Keystone Capital Corp. “I think this kind of contraction is to be expected, if not inevitable, given the market and the economy,” said Dale Brown, chief executive of the Financial Services Institute Inc., a lobbying group for independent broker-dealers. “FSI's view would be: How much of this is unnecessarily driven by the cost of compliance or regulatory burden?” When asked how much compliance costs had increased for firms recently, Mr. Brown said, “I don't think you could quantify that.” He added that the burden is particularly heavy on small firms. Finra defines small broker-dealers as having 150 or fewer registered representatives. Besides the economy, a variety of other forces have factored into recent closures. Great American Advisors, with 500 affiliated representatives, said it is exiting the retail securities business so that its parent company can focus on its core insurance business. Also in May, MICG Investment Management LLC shut down because it failed to meet its net-capital requirement. It was later charged with fraud by Finra over allegations it was ginning up the returns of assets it held in its proprietary hedge fund. Other broker-dealer casualties in 2010 include Nationwide Financial Network, GunnAllen Financial Inc. and AFA Financial Group LLC. Nationwide Financial, which had 200 reps, said in January that it was closing due to a larger effort by Nationwide to focus its distribution efforts on its proprietary sales force. GunnAllen, with 400 reps, faced millions in dollars of liabilities from investor lawsuits and ran out of capital in March. And AFA said in April that it was closing because it couldn't keep up with its errors-and-omissions insurance premiums and was facing an increasing number of investor complaints. Prior to 2010, the 100-rep firm had one arbitration claim filed against it; this year, investors have sued the firm seven times. Not all observers believe that the declining number of broker-dealers is a sign of a shrinking industry. “There has always some level of churn in the number of broker-dealers,” said Brian Shea, president and chief operating officer of Pershing LLC. “And while the trend over the past couple of years has been for fewer numbers of broker-dealers, I'm not sure that the business overall is getting smaller.” He cited consolidation and disruptive change in the broad market as opportunities for some firms to make changes to their business model and to drive advisers' productivity. “The rise in the number of independent advisory firms may be offsetting the decline in the number of broker-dealers,” Mr. Shea said. “The number of investment professionals and the active number of investors is the same. The business is still solid, even though you're seeing fewer broker-dealers in the short term.” E-mail Bruce Kelly at bkelly@investmentnews.com.