COMPLY-Wearing two hats triggers compliance headaches for advisers

Thu Jan 30, 2014 8:00am EST

Jan 30 (Reuters) - Brokers who want to set up their own advisory businesses have a lot of compliance issues to consider, especially when they plan to hold licenses through both of the top U.S. securities regulators instead of just one.

The allure of more income and independence drives many brokers to set up their own practices. They often set up an advisory firm that registers with the U.S. Securities and Exchange Commission, and also affiliates with an independent broker-dealer licensed through Wall Street's industry-funded watchdog, the Financial Industry Regulatory Authority (FINRA).

These so-called "dually-registered" firms are one of the fastest-growing sectors in the securities industry. Dually-registered firms managed nearly $1.1 trillion at the end of 2012, a 21.5 percent spike from 2011, according to Cerulli Associates, a financial services industry research firm in Boston. Its 2013 data is not ready.

But that freedom typically triggers a brand-new set of compliance responsibilities. Holding licenses through two regulators means more scrutiny than an adviser may anticipate.

The SEC, for example, is honing in on dually-registered advisers as part of its 2014 program for examining firms, according to a list of "priorities" it published on Jan. 9. Among its concerns: "reverse churning," a practice in which brokerage firms trade very infrequently in accounts they manage for fixed fees.

At issue are two different ethical standards: Advisers who register with the SEC or states are "fiduciaries" and, therefore, must give advice in clients' best interests. But those who also hold licenses through FINRA are bound by other regulations that require recommendations to be "suitable" for investors, based on factors such as risk tolerance or age. There may also be differences in regulations for record-keeping, disclosures and other issues, say compliance professionals.

Advisers with dual-licenses provide advice for a flat fee through the firm's investment advisory arm - typically a percentage of the total assets under management - but may also offer services through the firm's brokerage arm, such as accounts in which clients can stash money for college.

A big challenge for dually-registered advisers is making sure clients know the standards in play and when they apply.

"The fact that the SEC has a separate category called 'dual registrants' speaks volumes,' said Kevin Taylor, chief compliance officer of Pershing Advisor Solutions LLC, a unit of Pershing LLC, a subsidiary of The Bank of New York Mellon Corp .

While the business model itself is not a problem, some advisers jump in without thinking through their new compliance responsibilities, Taylor said.

Here are four compliance issues advisers should consider before taking the leap:

1) Use caution with client details: Brokers risk regulatory violations when they take client information from their old brokerage to their new dually-registered firm. In many situations, the new advisory firm is not a signatory to an industry-wide agreement in which firms agree not to sue one another as long as brokers take only basic information, such as a client's name and email address, said Tom Lewis, a lawyer at Stevens & Lee in Princeton, New Jersey.

In that case, advisers who take just a list of clients' names can trigger SEC and FINRA investigations for violating privacy regulations. It's a "hot-button issue" leading to fines and suspensions for some advisers, Lewis said. Advisers can avoid the problem by having their new firms enter the industry-wide agreement just as the advisers leave their former firms. The agreement is available through the Securities Industry and Financial Markets Association, a Wall Street trade group.

2) Square away disclosures: Clients need to know which type of adviser they are dealing with and when, said Nicholas Olesen, a partner at The Philadelphia Group, a financial advisory firm in King of Prussia, Pennsylvania.

Olesen tells new clients at the onset that he can provide services either through the registered investment advisory arm of his practice, or the brokerage arm. His firm, affiliated with LPL Financial, a unit of LPL Financial Holdings Inc, has separate agreements for the two divisions outlining the different responsibilities, fees, and potential conflicts of interest, Olesen said.

Clients review the fees and disclosures every year and sign new agreements, Olesen said. Some advisers also verbally remind clients of their two hats, depending on the situation.

3) Give clients a fair deal: Flat fees for advice that some clients may pay at an advisor's new business are higher than the total commissions they paid for trades in a brokerage account at the advisor's former firm. That is especially true for clients who do not trade regularly. SEC and FINRA officials have both voiced concerns about the practice, known as "reverse churning."

Advisers whose clients move with them to the new business have to calculate which model costs less and disclose that to the client, said Joel Beck, a lawyer in Lawrenceville, Georgia who advises brokers. "Clients may still be OK with the extra fee when the understand the difference between the two types of accounts. But they can make an informed decision," Beck said.

4) Get help: Brokers who launch an independent firm without help from a compliance professional may run into trouble when regulators uncover problems down the road. They may not realize, for example, that policies they must follow for the brokerage with which they affiliated, such as LPL Financial or Raymond James Financial Inc, do not extend to the advisory arm that the SEC oversees.

Consultants charge anywhere from $3,000 to more than $10,000 to set up a registered investment adviser, depending on factors such as the number of advisers and business model. Services typically include filing a mandatory SEC disclosure form to developing a compliance manual and documents. The bill may be tough to stomach, but cleaning up a regulatory violation could cost even more, say lawyers.

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