As the financial advisory industry continues to evolve, more investment professionals and firms are embracing the hybrid registered investment adviser model.
As the financial advisory industry continues to evolve, more investment professionals and firms are embracing the hybrid registered investment adviser model. The development of the hybrid model was intended to allow investment professionals to act as registered representatives of a member firm while maintaining a level of independence by managing their own investment advisory firms.
In concept, a hybrid model provides the best of both worlds. In practicality, it may present a significant liability.
Hybrid advisers are able to provide fee-based investment solutions to their clients while still being able to access certain alternative-investment solutions that may be available only through a broker-dealer, such as nontraded real estate investment trusts, oil and gas for intangible drilling costs, private equity and variable annuities.
These advisers are driven to develop personal brand recognition.
Owning an investment advisory business allows them to distinguish themselves from others through positioning and branding their business as they wish. It has a personal identity.
Investment advisory businesses also tend to be sticky, and client relationships are often stronger than those with transactional relationships.
Last year, more than 140 broker-dealers failed. Much like certified public accounting firms, broker-dealers tend to operate with small profit margins.
The competitive landscape, combined with increasing costs, has created an environment where many broker-dealers can't afford to lose business.
In response to these pressures, broker-dealers have made the decision to allow representatives to have outside RIAs in the hopes of keeping some of the reps' business.
The basic feeling is that it is better to have a percentage of some business than to have nothing.
As this model has evolved, many firms take little to no override on the outside investment advisory business, and promise not to create compliance burdens for the outside investment adviser. After all, it is outside the broker-dealer.
As these changes evolve, so does the approach to regulatory supervision.
LIABILITIES
During the course of broker-dealer examinations, the Financial Industry Regulatory Authority Inc. appears to be spending more time reviewing the supervision of outside investment advisers. Having recently completed an examination, many of these liabilities are fresh in my mind.
• Written supervisory procedures. Finra expects that these procedures (of the broker-dealers, not the investment advisers) will include specific details as to the supervision of outside investment advisers.
• Product mix. Based on the hybrid model, a rep may place only direct- participation-program transactions through the broker-dealer. Although the investment may be part of an overall portfolio mix, the regulatory bodies may not look favorably at a representative whose entire book of business appears to be direct-participation programs.
• Notice to Members 96-33. This notice represents the proverbial 800-pound gorilla. The term “private securities transaction” is used on eight separate occasions. The notice isn't clear as to what could constitute a private securities transaction for an outside investment adviser.
During the course of the review and exit findings, it was determined that the firm didn't review and approve private securities transactions pertaining to asset-based or performance-based compensation for registered reps with outside investment advisers.
Private securities transactions are required, under Article III, Section 40 to be part of the broker-dealers' books and records.
Supervisory expectations may include a list of registered-rep/investment adviser customers, copies of new account forms to determine suitability, duplicate statements, copy of investment advisory agreements, review of advertising materials and sales literature, exception reports, etc.
• Trade supervision. As part of the firm's procedures, the trading activity of outside investment advisers is supposed to be monitored. Many custodial relationships provide electronic data, which enhances the review process, while others provide only hard-copy statements. During the review process, it was stated that a random review of those statements might not be sufficient.
The practicality of reviewing 1,000 client statements per month and actually finding something inappropriate appears to be nearly impossible.
• State securities oversight. Section 410 of the Dodd-Frank Act recommends a shift in regulatory oversight of investment advisers with assets under management between $25 million and $100 million to state securities authorities.
The Securities and Exchange Commission supervises these investment advisers. Most states are experiencing financial difficulties, and some fear that states lack the resources necessary for oversight.
Based on recent events, it could be argued that this new role will provide a valuable income source to states.
In two cases, we have seen a state assess fees between $13,000 and $15,000 for conducting on-site reviews (two days' worth).
Additionally, the broker-dealer was assessed a fee of $900.
The broker-dealer was charged because it was ultimately responsible for the investment advisory firm, as it was registered with it.
The findings weren't extensive and were administrative-related. Nothing was harmful to investors.
Considering the compensation paid to auditors, it is fair to assume that the review process wasn't a financial burden to the state.
In conclusion, as the financial advisory industry continues to evolve, so does the approach to regulatory supervision.
Most attorneys and chief compliance officers would agree that the examination process is inconsistent and that the Notice to Members 96-33 is less than clear.
What is becoming clear is that broker-dealers may now be expected to consider outside investment advisory business — where the investment adviser is charging an asset management or performance fee — as a private securities transaction.
This requirement could result in the untimely demise of the hybrid adviser model. In the event that broker-dealers incur the same level of liability for an outside investment adviser, it will be difficult to justify a 95% to 100% payout on that business.
There are many benefits to the hybrid concept, but I do agree that more oversight is necessary. Taking the leap to the requirements enforced under private securities transactions is an entirely different level.
Todd J. Pack is president and chief operating officer of Financial Advisers of America LLC.
