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Saturday, January 23, 2016

How Can Broker-Dealer Firms Adapt to the New Fiduciary Regime?

If the DOL's fiduciary ("Conflicts of Interest") rule is finalized in 2016 (which appears likely), and if it is not repealed by a subsequent administration (possible, if Republican U.S. President is elected), then broker-dealer firms of all kinds face huge challenges. It is likely that 40% to 60%, and possibly more, of BD's asset base would be governed by fiduciary regulation. And SEC rule-making would likely follow in subsequent years, transforming even more to some type of fiduciary standard.

Essentially, this means an era of transformation for most broker-dealer firms. Some have already begun the transformation, via the adoption of nearly conflict-fee programs to serve their clients. Others have publicly stated that they have made changes, but the changes made are mere window-dressing. Still others have their heads in the sand. See "Who Moved My Cheese?" - Part 1.

In this blog post I explore strategies broker-dealer firms can undertake to respond to the upcoming shift from a sales-dominated financial services industry, to an era of fiduciary professionals providing investment advice.

Some changes should occur immediately. Other changes require wholesale changes to the firm's vision, mission, strategies and culture - which requires a concentrated effort at all levels of the organization, commencing with top management.


When the fee-based accounts rule was overturned in 2007, a huge number of brokerage accounts were shifted into investment advisory accounts. And a huge number of registered representatives became dual registrants. Since this takes time, and time is short, begin the process of getting Series 7-licensed reps their Series 66 licensure, immediately.


Let's face it: a few clients will not desire investment advice; they just want products. And some older advisers won't desire to change, and will rather deal with non-fiduciary accounts only than take on fiduciary status. Hence, a sales channel will need to be maintained, perhaps for at least five years (or more), as the "old guard" transitions to retirement, or departs the industry altogether.


Executives of broker-dealer firms first need to "go to school" - in the sense that they must learn about the fiduciary standard of conduct and the reasons for its imposition. Without an understanding of "why" fiduciary status is imposed, the nature of the fiduciary-entrustor (i.e., advisor-client) relationship, and the specific fiduciary duties that flow from fiduciary status, the next steps can't be accomplished effectively.

How? Unfortunately, many broker-dealer firms will turn to their longstanding law firms for guidance. But many of these firms, and the attorneys within them, possess as part of their own culture (after years of service to the industry) a pattern of advising broker-dealers on how to escape fiduciary status, or they have been called upon to issue opinions that suggest fiduciary standards are far weaker than they really are. So, perhaps outside sources should be looked at, instead.

For initial readings in this area, I suggest:


Of course, the decision must be made, at the very top level of the firm, to transition the firm to a fiduciary culture. The firm's Board of Directors must realize that the firm must adapt, and quickly, for its very survival.

Part of this will be the design and embrace of a new vision statement for the firm. And a new mission statement. These are not just minor adjustments, nor should they be taken lightly. Rather, the firm's vision and mission will form the basis for Step 3, below.

I predict that broker-dealer firms that adapt quickly, and correctly, will gain market share over their competitors. Their revenues will decline, on average per client, but market share gains can keep profitability measures high.

Broker-dealer firms that are late to the table will find their revenues falling precipitously, and will lack the resources to make the transition at some later date. These firms will likely be forced into mergers or acquisitions, in order to survive.

I gave a presentation to the "big firms" at a conference a couple of years ago. I suggested to the audience of mid-level executives gathered that the broker-dealer firms embrace a fiduciary culture and fiduciary principles, by altering their business methods. My message was met with incredulity. How, they asked, could they choose their clients interests over the interests of their shareholders? My reply was simple and direct - your market share continues to shrink; what will your shareholders think when your firm is but a footnote in history, 20 years from how, if you don't change?


Broker-dealer firms with exceptional leaders, able to transform the firm from a sales culture to a fiduciary culture, will thrive in the years ahead. Firms whose leaders do not understand the nature of the fiduciary-client relationship and the rationale for the imposition of fiduciary status, who do not understand the firm's new vision and mission, will stumble (and perhaps fail).

The process of instilling a fiduciary culture begins with senior leadership buy-in, followed immediately (i.e., the next day) by communications to, and training of, mid-level management. This is then followed immediately (i.e., the next day) by communications to all levels of the organization.

This communication process must be well-designed, and sustained. It will involve senior leadership visits to the firm's regional offices, for gatherings and discussion with both mid-level managers and rank-and-file, with two-way communications. It will also involve the wide deployment of motivational and training materials, including in larger firms internal webinars, internal conference calls, compliance training sessions, newsletters, and much more. The process will involve repeated communications of the benefits of change (for all stakeholders), the necessity of making the change, the desire to undertake the change "correctly and deliberately," followed by detailed discussions of fiduciary obligations, and repeated learning opportunities involving the presentations of hypotheticals.

I suspect that many individual advisers in the firm, especially younger ones, won't need much convincing. But, even then, they will not fully understand the fiduciary principle, nor how it is to be applied. And, even a few years of working within a sales culture can make it hard to adapt to a new fiduciary culture. So, don't assume that the level of resistance by rank-and-file will be low; be prepared to meet it via leadership and consistently messaged, repeated communications.


Concurrent with the communication of the firm's new fiduciary culture will be the roll-out of new policies, procedures and systems. These, of course, flow from strategic planning and the adoption of tactics.

Decisions will need to be made regarding divesture of certain aspects of the business, and a re-alignment of other parts of the business. For example:

  • Proprietary funds and other proprietary products. The most difficult issue present in applying the fiduciary standard to financial services firms is what occurs when the firm has proprietary products. In my view, given the availability of some many other pooled investment vehicles and separate account management platforms, it is hard to defend the "objectivity" of the firm, and the instillation of a new fiduciary culture, with proprietary product offerings. Divestiture should be considered.
  • Principal trading. Likewise, the fiduciary obligation appears inconsistent with principal trading.
    • The DOL's proposed Conflicts of Interest Rule provides a methodology to retain principal trading. Embrace it.
    • Consider the formation of a specific fixed income desk for fiduciary advisers to turn to, to ensure adherence to principal trading restrictions at all times. Without a dedicated desk, it's too easy to slip up.
    • Contrast the underwriting practices of the firm two decades ago, to the underwriting practices of today. Consider a return to the underwriting culture of the past, in which deals were often refused by the top firms if the security offering was not of high quality.
  • Revenue sharing. Firms face a difficult choice. Revenue received from asset managers should be credited against advisory fees or - better yet - avoided altogether. Discussions with asset managers should occur.
  • Investment committee re-formation. Gone will be an investment committee that considers as its primary mission tactical asset allocation decisions and individual stock selection. While some programs may still do this, the core of the investment committee should consider:
    • First, what investment strategies will the firm offer to its clients. Intensive research into investment strategies, the academic research behind such strategies, the back-testing (over prolonged time period, and if possible using multiple diverse data sets) of such strategies, and the likely future success of such strategies as the world of finance continues to evolve. If you want an investment committee that works effectively, seek out the best minds in finance, and combine them with the best minds from your trading desk.
    • Second, what investment products or other solutions can be identified that will best implement the chosen strategies. Realize that having "good" products is not enough; if you want to be an exceptional firm, in the new fiduciary environment, find the best investment products. Extensive due diligence is required.
    • Third, realize that there is a place for active management. Such as in tax-efficient pooled investment vehicles. And in low-cost active management strategies. But high-cost active management strategies are doomed to underperform. See my discussion of the fiduciary obligation's to control fees and costs.
    • Fourth, as the transition occurs, limit advisers to implementing the investment strategies set forth in your programs with the investment products that have been pre-approved for those strategies. Convey the reasons for these restrictions to your sales force, who may in the past have possessed greater flexibility. (Roll out the academics, from your investment committee.) Welcome feedback from salespersons of suggestions for products, and provide adequate and timely feedback after evaluating their suggestions.
  • Training. Gone are the days when training is centered around "how to close the sale." Rather, training will need to be intensified in all aspects of financial planning, as well as conveying the extensive due diligence undertaken in the selection of investment strategies and products. Extensive training in how to design and manage investment portfolios tax-efficiently should be undertaken.
  • Recruitment and Retention. Recruitment of new advisers to the firm will need to be intensified, as they will bring new skill sets to teams that you may form to better serve the holistic needs of clients. Identify the university programs that are producing top graduates in their financial planning degree programs - not only well versed in all aspects of financial planning, but also programs that push their graduates to work better in teams, to possess exceptional writing skills, and to possess strong verbal communication and presentation skills.
    • Commit to hiring the best talent. The best firms of the future will bring in the best people, today.
    • Partner with programs to provide "career path" presentations (by the younger members of your firm, preferably).
    • Sponsor visits to your firm by groups of students, in which several members of your firm provide 2-4 hours of presentations about everything from the firm's culture to "day in the life of a financial adviser" to "what I wish I knew in college, that I know now" to "your first year as a financial adviser."
    • Seek out interns. The best way to evaluate a prospective hire is to have them work at your firm for a few months. To recruit the top talent, pay interns well.
    • Consider sponsorship of Series 65 licensure for students who intern with you.
    • Ensure you possess a well-defined career path, for all professionals in your firm.
    • Consider whether deferred compensation arrangements really aid in retention, or not. Consider, as an alternative, a sharing of the ownership of client relationships. With 80% of clients typically following advisers, and with advisers often leaving to independent firms not part of the protocol (a trend likely to accelerate in years ahead), a "buy-out" of the firm's investment in a client relationship, paid out of fees received by the departing adviser over a period of years, seems much more likely to avoid loss of the majority of value of the client upon an advisor's departure. A bonus results from less litigation.
  • Compliance Leadership. Obviously, your compliance department has a huge role to play in the transition. Your Chief Compliance Officer plays a huge role in the transformation to come, and must be up to the task.
    • The Compliance Department's job will be huge, at first. But, if you transform to a fiduciary culture correctly, with conflicts of interest avoided, and with correct offerings and training, then over time the size of your compliance department will diminish. Client complaints also diminish, as will legal costs and liability insurance costs.
    • New fee structures should be considered. These include not only assets-under-management fees, but also annual retainers, fixed fees for certain projects, and even hourly-based fee engagements. Level (or "maximum") commission arrangements should also be explored with insurance product providers, where no-load insurance product offerings remain scattered. Fee-offsets might also be considered, where appropriate.

Here's where the market share gains can occur. But only if your firm is ready to implement the new practices, policies, procedures, and systems. And only if the roll-out to current clients is handled correctly.

It is likely that you will need to build a new brand, around a new offering (or an expanded offering, if it already exists).

You don't need to use the term "fiduciary" in your public communications. But consider ways to properly message the elements of fiduciary - experts, acting on behalf of the client as trusted adviser, with complete candor and honesty.

The media can be your friend, as you roll out the programs. If your program offering is truly a bona fide fiduciary engagement for the client.

Current clients must be transitioned properly. For example, where front-load commissions have been paid, credits might be provided for a few years against AUM fees.

Different programs will be needed, to address different market segments. Don't try to fit a $100,000 IRA rollover AUM client into the same program as a $5m client (executive, business owner) with diverse needs.


Of course, any plan of change must include multiple feedback loops, the formulation of new strategies and tactics, and adjustments to existing programs.

Ensure that feedback is sought from all stakeholders - managers, advisers, compliance staff, trading desk personnel, clients, vendors, etc. - proactively, as the transition occurs, and thereafter.


What will your firm look like, a few years from now?

Chances are, operating under a fiduciary standard, it will be streamlined, with far less central office staff. The number of executives will diminish, as will their compensation. Certain operations may have been divested.

For firms that embrace a fiduciary culture promptly, and correctly, gains in market share will follow. Top-line revenue may fall, but so will expenses, especially over time.

For firms that fail to be proactive in the embrace of a fiduciary culture, they are likely to encounter an acceleration of the loss of market share. The firm will not attract nor retain the best talent. The future of such firms is both predictable, and poor.

CHANGE IS COMING. Don't dawdle. "Who Moved My Cheese?"

Ron A. Rhoades, JD, CFP® is the Program Director for the Financial Planning Program and an Asst. Professor of Finance at Western Kentucky University, at its beautiful main campus in Bowling Green, KY. He is a CFP certificant, a regional board member of NAPFA, a consultant to the Garrett Planning Network, and a member of the Steering Group for The Committee for the Fiduciary Standard. Ron previously served as Reporter for the Financial Planning Standards of Conduct Task Force and Fiduciary Task Force, and as member or chair of other various industry organization committees. He also previously served as a consultant to a major financial services firm on a project involving IRA rollovers, 

An estate planning and tax attorney (Florida), and a fee-only investment adviser, Professor Rhoades currently spends the majority of his time providing instruction to highly motivated students at Western Kentucky University in courses such as the Personal Financial Planning Capstone, Applied Investments, Estate Planning, and Retirement Planning. He has previously taught courses in Insurance and Risk Management, Advanced Investments, Employee Benefits Planning, Business Law I and II, and Money & Banking.

This blog represents Professor Ron Rhoades' personal views and is not necessarily indicative of the views of any institution, organization or firm with whom he may be associated.

Ron is scheduled to provide two presentations in early 2016 on the DOL's rules and the general impact of the fiduciary standard on the financial services industry:
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