Do You Know Which Hat You Are Wearing?
It is a constant source of amazement to me, that two of the most important financial institutions in our country are confused by almost all of the people that patronize them, as well as, most of the professionals that work for them. Registered Investment Advisers (“RIA’s”) and Broker/Dealers (“B/D’s”) may look nearly identical to the lay public, but they are worlds apart in the way that they are structured, how they operate and how they are regulated.
I first learned this when I was serving as an industry panelist on an arbitration case that a customer had filed against their broker and the B/D. The co-respondents in the case were a B/D that was owned by a ‘too big to fail’ bank, which also owned and operated a separate RIA, and a broker who was registered as a selling agent, with both the B/D and the RIA.
Although the customer had a claim against the B/D only, my fellow public panelists, who were both highly-educated and seasoned-professionals, did not understand the difference between the two. To them, the B/D was the same as the RIA.
Why was it important to differentiate between the two types of entities? It was important because the claim centered on a very specific rule only a B/D is required to execute, which they did in fact perform correctly. The RIA, on the other hand, had no obligation to follow any such rule, and as a result, did not. The fly in the ointment materialized when my fellow panelists got confused between obligations required of a B/D and the obligations required of an RIA.
Had there been no insight as to the vast operational differences between an RIA and a B/D, the outcome of the case would have resulted in a miscarriage of justice. If experienced professionals do not know the difference between the two entities, how can we reasonably expect an average working person to understand the distinction.
Adding to the confusion are the titles that these financial companies give their employees. Numerous RIA’s and B/D’s give the individuals servicing clients the same all-inclusive titles, such as financial consultant or financial advisor.
Additionally, the products and services offered by both types of entities, on the surface, may appear to be very similar. They both deal in investments, stock and bonds for example. They both help clients invest their assets. They both offer advice to their customers. And, that is where the similarity ends, on the surface.
RIA’s, and the people working with them, render investment advice for a fee. That is they charge their customers an amount, usually an hourly fee, or a percentage fee, for the financial advice that they provide. An RIA’s compensation is not contingent on any of the transactions that they may place for their customers.
B/D’s, on the other hand, get paid based upon the transactions that they place for their clients. They charge a commission (or markup/markdown), and generally, if a B/D does not place a trade, it does not get paid. While investment advice is often rendered in connection with the transactions that are placed for clients, the investment advice rendered by a B/D and its agents, must be ‘incidental’ to the trade.
Virtually every B/D is regulated by the Financial Industry Regulatory Authority, or FINRA, and most employees of B/D’s need to obtain various securities licenses before they can interact with the public. RIA’s, depending on their size, are regulated either by the states they operate in, or by the Securities and Exchange Commission, or SEC. Although there are no formal securities licensing requirements for RIA employees, most advisory associates obtain professional designations, such as a Certified Financial Planner, or CFP.
Now why does any of this matter? If you are a stand-alone operation, either operating as an RIA, and never offering brokerage services, or operating as a B/D, and never offering advisory services, chances are it doesn’t matter a whole lot. But, if you are affiliated with both an RIA and B/D, and offer both advisory and brokerage services to your clients, it matters greatly.
While the rationale to differentiate between the two types of entities is numerous, the major reasons are regulatory and legal. While they may appear on the surface to be twins, RIA’s and B/D’s are certainly not identical twins.
Modern day brokerage operations are the primary result of the ’33 and ’34 Exchange Acts, as well as the Mahoney Act that established the National Association of Security Dealers, or NASD, which was the predecessor to FINRA. RIA’s were spawned from the 1940′s Investment Company Act.
As such, each entity has a vastly different regulatory structure. If you commingle the services of the two operations, by not having a definitive ‘Chinese Wall’ in place between them, then you run the risk of regulatory crossover, and may have exposure were there would otherwise be none. For example, if you make a mistake in communicating with your customers as an RIA, you may likely run afoul of FINRA’s strict and exacting communication requirements with customers.
Overlooking the legal landscape, if your customers are unclear, and do not realize what hat you are wearing when you are providing particular services to them, then you run the risk of an entity, or individual, being wrongly named if legal action is filed. More importantly, your defense against an action may be severely compromised, if there is not a clear distinction between RIA activities and B/D operations.
What can be done about this situation? First off, client education, making certain you clearly explain the differences between RIA’s and B/D’s to your customers. Follow up with disclosure forms that will provide proof of your clients’ understanding of the differences. Second, separate both operations in fact and form, such as office space, if possible, and documentation, for example separate stationary, letterhead and business cards. Titles should be clear and distinct; when your B/D hat is on you should be called a Registered Representative, never a Financial Advisor, and vice versa.
Lastly, if you need help, contact us at www.forestbrokerageadvisers.com. Our work is dedicated exclusively to Broker/Dealers and Registered Investment Advisors, and we are here to help you.