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News January 14, 2008 Issue

A Closer Look at the RAND Report

Now that IM Insight has slogged through all 191 pages of the RAND IA-BD report, we can say this with some measure of confidence:

You can skip it.

(However, those of you involved in marketing or client services might want to read Chapter 6.)

While the report may provide an "important empirical foundation" for regulatory reform, RANDís findings and conclusions will come as no surprise to those already familiar with the investment management and brokerage industries. From an industry readerís perspective, there is a definite lack of "Oooh, thatís interesting!" moments.

Donít get us wrong: The RAND folks clearly conducted an earnest and diligent effort to learn all they could about advisers and brokers. They read lots of articles (a "literature review"), analyzed lots of numbers (a "quantitative analysis of industry data"), and looked at lots of disclosures (a "business-document collection").

And, of course, they talked to lots and lots of people: Industry pundits, firm representatives, and investors of all stripes. They also conducted a nationwide household survey, collecting 654 responses.

It is additionally worth noting that unlike many other commentators on the advisory and brokerage industry, RAND did not have an axe to grind and approached issues objectively and, to the extent possible, quantitatively.

How much did the report cost?

"About $890,000," according to SEC spokesperson John Heine. That amount, he noted, included the additional cost of accelerating the due date of the study.

In any event, now that the report is out, the SEC staff is working on recommendations for improving IA and BD regulation. Chairman Christopher Cox "has tasked the [Divisions of] Trading and Markets and Investment Management to develop a list of policy options that take into account the RAND study," said SEC spokesperson John Nester. The Divisions were told to formulate those recommendations by the end of April, he said.

What might the SEC staff recommend? The Financial Planning Association, for one, already has urged the Commission to hold a roundtable on the report. The Investment Adviser Association asked the SEC to reinstate links to the "Cutting Through the Confusion" brochure, which outlines differences between advisers and broker-dealers.

"Everything is potentially on the table, such as a roundtable, but no decision has been made," said Nester. He said that the staff is "immersed in analyzing the report right now." That review, he said, "must take place before any plans emerge."

IM Insight

wouldnít be surprised to hear renewed talk of an investment adviser SRO. Weíve been reading press releases long enough to suspect thereís a hidden message buried in the January 3 statement of SIFMA senior managing director and general counsel Ira Hammerman: "The broker-dealer community is already more heavily regulated and scrutinized than any of its peers or competitors, including financial planners," said Hammerman. "This robust regulatory regime, including oversight by FINRA, provides customers with clear disclosure and powerful protections."

Is it us, or is he implying that since financial planners arenít regulated by an SRO, customers dealing with them are less protected? We tried playing the press release backwards, to no avail.

While we wait for the SEC staffís recommendations, hereís a quick overview of the RAND report, highlighting issues of particular interest to advisers.

The report begins with an executive summary and a brief introductory chapter. The real fun begins in Chapter Two, which provides an overview of broker-dealer and investment adviser regulation. Among other things, RAND asserts that advisers owe fiduciary duties to their clients "as a categorical matter." For brokers, however, fiduciary status is a case-by-case determination. Since virtually all disputes between brokers and customers during the past two decades have been resolved in non-public arbitration proceedings, noted RAND, the current judicial thinking on brokersí fiduciary duties is somewhat unclear.

The chapter goes on to provide a brief chronology of the whole fee-based brokerage mess, from its origins in the 1995 Tully report up to the FPA v. SEC suit. It then summarizes a variety of concerns expressed by industry pundits:

  • Investors typically donít understand whether their financial professional is a broker or an adviser, much less what the differences between the two might be;
  • The services provided by broker-dealers and investment advisers are converging, making brokers and advisers less distinguishable from each other;
  • Investors donít read disclosures, disclosures arenít well-written, and investors at all income levels have low financial literacy; and
  • The BD and IA regulatory schemes treat brokers and advisers differently, even when they provide essentially the same services to retail investors.

Chapter Three trots through a list of studies, reports, and academic articles reviewed by RAND. Frankly, we didnít see much of interest here. And we were surprised that there was no reference to the article we thought most pertinent: A December 1997 memo sent over by senior NASD officials to the then-directors of SECís Divisions of Market Regulation and Investment Management.

The topic? IA and BD convergence.

Among other things, the NASD memo suggested that brokers and advisers that provide the same services should be regulated the same. In fact, the NASD implied that there was a "regulatory gap" between brokers and advisers, and that advisers that perform functions similar to broker-dealers "are subject to lower levels of regulatory oversight."

As you can imagine, that memo caused pretty big ripples when it came out.

Turning back to the RAND report: Chapter Four provides an analysis of data from the IARD and CRD databases, as well as from FOCUS reports filed by broker-dealers. Here, the most interesting finding was that advisers arenít filling out their ADVs correctly. Of the 12 percent of advisory firms that listed themselves as "registered representatives" of broker-dealers, RAND noted that the "overwhelming majority" were not sole proprietorships. (RAND acknowledged that that wasnít an entirely new finding: The issue was flagged in the 2006 "Evolution/Revolution" report published by National Regulatory Services and the IAA.)

RAND also noted a number of instances where an advisory firm listed itself as being dually-registered as a broker-dealer, but there was no corollary evidence of that registration in the CRD database. "We suspect that many of these inconsistencies emanate from confusion among individual filers about whether they should be reporting information about themselves or about their firm," said RAND. "Indeed, our data show that a great many of these firms have founders or principals who are employed as registered representatives of a broker-dealer."

Hereís the take-away for all you firms out there with brokerage activities: Just because one of your firmís employees is a registered rep of a broker-dealer, you shouldnít be checking the "registered rep" box in Form ADV Part 1A Item 6(A)(2) unless that employee happens to be you and you are a sole proprietor. By definition, a firm consisting of two or more employees cannot be a registered rep of a brokerage firm, because "registered rep" is a term that applies only to an individual.

And hereís another take away: Just because your firmís head poo-bah happens to be a registered rep of a brokerage firm, that doesnít mean that your advisory firm itself is a dual registrant. Thereís this little thing called Form BD you have to fill out, and a ton more stuff you have to do, before your firm can call itself a registered broker-dealer.

Chapter Five of the report covers RANDís review of information provided by firms themselves, such as adviser and broker disclosures and information obtained from firm representatives in interviews. By and large, the chapter itself provides more of a catalog of RANDís efforts to collect documents than any sort of substantive analysis of the disclosures themselves. We learn that RAND initially had hoped to collect sample documents from 75 firms, and therefore sent a document request to 164 selected firms via Federal Express. It engaged in plenty of follow-up nudging: Over 300 phone calls were made, and multiple e-mail messages were sent to "most" firms, reminding them about the survey. Trade groups were asked to post a message on their websites encouraging members that had received the request to respond. RAND sent a follow-up round of Fed Ex packages, this time containing a pre-paid mailing label and a letter from the office of Chairman Cox "stressing the importance of participating in the study."

Still, three months later, RAND had only 29 eligible responses in hand (18 from advisers, 11 from broker-dealers). And some of those responses only "partially complied" with RANDís document request. At that point, RAND called it quits and began trolling firm websites to obtain additional sample disclosures.

RANDís†conclusion? If an investor was presented with the types of disclosures that it reviewed, the investor "would likely obtain a very uneven understanding about these firms." Some firms provided a "flood of information." Others, merely a "trickle." Either way, concluded RAND, investors "would likely be left to turn to individual professionals to summarize the key aspects of the prospective relationship."

While there wasnít much analysis of the actual disclosures provided, a chart in the back of the report did painstakingly quantify the number of times a particular type of disclosure appeared in a particular type of document (see Appendix E). RAND noted that its analysis in this area was limited by firmsí low response rate and partial compliance by the firms that did respond.

Somewhat more helpfully, RAND obtained information from firms via interviews. Since the selected sample firms were less than cooperative, RAND asked trade groups to post announcements on their websites saying that RAND was looking for firms to voluntarily participate in the interview process.

Turns out, advisers were much more forthcoming than brokers. "The response from the investment advisers was overwhelming, with more than 130 individuals volunteering to participate," said RAND. "The response from broker-dealers was much more subdued, with only eight volunteers."

During the interviews with the firm folks, old industry fault lines were exposed. Advisers complained about brokerage firm advertising, asserting that brokerage firm ads "create confusion and set false expectations." Advisers claimed that brokersí ads make it sound as if the broker-dealer is selling advice. "Many of those ads portray a close relationship (e.g., attending a family wedding, walking on the beach together) that almost no client will receive, which is a setup for disappointment with the client," noted RAND.

Hey ó and donít you just love the one with the broker in the maternity ward?

BD firm interviewees had a few gripes of their own. They expressed frustration about providing "the necessary documentation" while "still being held responsible in arbitration hearings when investors fail to read the disclosures." Investors, said the brokerage folks, need to accept "some amount of responsibility for their decisions." However, at least one brokerage firm interviewee acknowledged that "a client is going to sign something that a trusted adviser asks them to sign." RAND noted that "[c]lients feel that the reason they engage a professional is so they do not have to read all the accompanying literature." Consequently, "for many investors, the fact that they were given disclosures was seen as meaningless."

A few full-service brokerage firm reps expressed a dim view of the courtís decision to vacate the fee-based brokerage rule in the FPA v. SEC ruling. As a result, they said, "clients will pay more but have access to less." Interestingly, however, some reps hailing from smaller firms said they had not been in favor of fee-based brokerage accounts to begin with. These brokers felt that investors end up paying more fees in fee-based brokerage accounts than they would have had they simply opened a traditional brokerage account. These "traditional, commission-based brokers" felt that if "they were not making some adjustment to a clientís account, they should not be able to charge for it." To them, it just "seemed wrong" to be paid "for not doing anything with a clientís account."

One thing that advisers and brokers could agree on: Compliance costs. According to RAND, "every representative interviewed complained about the increasing compliance burden." But folks also agreed on the importance of regulatory oversight, within reason. "Most thought that oversight should be measured and streamlined" and that "over the years, it has ballooned to unrealistic proportions," noted RAND.

Chapter Six provides us with an interesting peek inside investorsí minds. This chapter, we think, is good reading for marketing and client services personnel, since it reveals what investors like and dislike about their financial service professionals.

We learn that investors really donít understand the difference between advisers and brokers, but really donít seem to care, either. Their big concern is whether their personal financial consultant provides them with attentive and accessible service. In other words, the more their financial professional picks up the phone, the better. In fact, investors cited "accessibility or attentiveness" and "relationship or personality" as the top two reasons why they liked their personal financial professional. In comparison, factors such as "acts in my best interest" and "honesty and integrity" were cited only about a third of the time. Coming in last, with only a handful of votes: "cost" and "available products, options, or services." RAND did not test whether investor satisfaction was correlated to investment performance.

Interestingly, investors indicated that they were almost equally likely to turn to an adviser as they would a broker. While they liked the compensation structure, disclosures, and legal duties of advisory firms, they also liked the account minimums, industry certification, and costs of brokerage firms. Some investors interpreted the fact that brokers, but not advisers, had to meet certification requirements "to mean that advisers were not as qualified as the brokers."

Investors also did not seem to grasp the difference between a suitability obligation and a fiduciary duty. Even when they were told that a fiduciary duty "is generally a higher standard of care" than suitability, investors expressed skepticism, telling RAND that they doubted that the two standards were actually different in practice.

On a more quantitative note, RANDís nationwide survey revealed that roughly equal numbers of investors believe that advisers and brokers must act in their clientsí best interest and disclose conflicts of interest. For example, 49 percent of the survey participants thought that advisers are required by law to act in their clientís best interest. But 42 percent of investors thought brokers did, too. And, when asked whether their financial professional acts in their best interest, investors with brokerage representatives were even more likely to "agree" or "strongly agree" (72 percent) than investors with advisory firm representatives (67 percent).

From a practical perspective, perhaps the most interesting finding from the investor interview section was that more investors would consider using advisers, rather than broker-dealers, if advisers did not impose account minimums. After looking at model adviser and broker ads, investors told RAND that they would prefer to have a long-term relationship with the advisory firm, "if only they had enough assets." RAND noted that brokerage firms do not set an account minimum because they have a "long-term view of their client relationship" and want to "grow with their clients." Moreover, brokerage firms "often promoted themselves as providing broad offerings so as to be useful at any stage."

Some of the IA firm interviewees noted this dichotomy, saying that advisers "are not currently serving many investors because these investors cannot meet the account minimums." The interviewees suggested that the advisory industry "should give some thought to reaching these underserved populations that could greatly benefit from professional advice."