On the Endangered List – the Independent Broker-Dealer

The independent broker-dealer is a vanishing breed, and is under fire from many directions.  Why? They are facing 1) both actual and perceived regulatory pressure, 2) new burdensome capital requirements, 3) increasing litigation, 4) errors and omissions (E&O) claims, and 5) industry trends that require more expensive human resources infrastructure.

What is an “independent broker-dealer?”

Taken directly from the SEC’s “Guide to Broker-Dealer Registration,” a broker is defined as, “any person engaged in the business of effecting transactions in securities for the account of others.” A dealer is defined as, “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.” Essentially all broker-dealers are required to register with the SEC to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security.” Independent broker-dealers are firms with fewer than 150 registered representatives.

Along with SEC registration, broker-dealers must also become members of the Securities Investor Protection Corporation (SIPC) to insure investment clients against capital deficiencies or bankruptcy.

Why the change?

In 2009 SIPC membership changed from a flat fee of $150 to one percent of the broker-dealer’s revenue. This change in the SIPC membership fee has proven to be very burdensome for independent broker-dealers.

Other regulations affecting broker-dealers include federal and state requirements designed to expose the background and character of broker-dealer operators. The overall cost of compliance, particularly the recent changes, is a key driver pushing independent broker-dealers out of business.

The irony in all this is that recent regulatory changes came about because of the problems caused by the big broker-dealers (think Lehman Brothers).  So the market is thinning out for independent broker-dealers in part as a consequence of the mess caused by the larger firms.  In the end, the larger broker-dealers that caused the problems will find themselves with a bigger piece of the market.

Here are just a few examples of independent broker-dealers that were unable to meet the challenges of changes in regulations, coupled with the tough recent economy.

  • Florida-based GunnAllen Financial was forced into Chapter 11 bankruptcy due to capital requirement and private placement pressures.
  • Pyramid Securities, a California firm, was shuttered by litigation and capital requirement issues.
  • Another California company, AFA Financial Group, saw its E&O premiums skyrocket because of lawsuits over a private placement.

The independent broker-dealer that finds itself in trouble has two basic options. The first is to seek a merger with a larger firm to immediately boost capital, and to sift through the private placements to expose potential E&O claims. The alternative is to close the business through a controlled wind down.

End-stage crisis management

When it becomes clear that it’s time to wind down an independent broker-dealer firm, the best solution is to engage the services of an experienced end-stage crisis manager. This objective outsider brings both crisis expertise and operating experience to protect the interests of all parties involved in the wind down, starting with the customers, and ending with the principals.

For the most part, the only salable asset of a broker-dealer is its book of business–its customer base–and the first step a crisis manager takes is to find a new home for the book of business, and to ensure that the customers are not harmed in the process. Once the customer base has been moved, the crisis manager then completes the wind down by tackling the operations of the broker-dealer firm.  This includes the treatment of employees, suppliers and vendors.

If the wind down is done haphazardly, the operators and the principals of the firm face significant personal exposure from creditors, regulatory agencies, and employees.   Among other items, the Financial Industry Regulatory Authority (FINRA) will require final financial and operating reports (FOCUS reports) under SEC Rule 17a-5.  The crisis manager will need be available to provide other requested information to SIPC and to the SEC.  In order to do so, the books and records of the independent broker-dealer need to be secured–and the information must be retrievable.  One of the crisis manager’s first tasks is to ascertain how the records are kept, and how to access them.

An experienced crisis manager provides a buffer between the firm and the nuts and bolts of the wind down, and works to protect the best interests of everyone involved in the process.

It is prudent for all stakeholders to use the services of a crisis manager experienced with:

  • SEC, NASD and FINRA regulations, information requests and reports
  • Securities law and bankruptcy law
  • Fraud examinations (preferable a Certified Fraud Examiner)
  • Relevant state banking commission guidelines
  • The bankruptcy process, including information requests and reports (preferably a former chief restructuring officer for companies operating under the protection of Chapter 11 of the Bankruptcy Code)
  • Employment matters related to the termination of insurance coverage
  • The mitigation of tax claims and subsequent personal liability of directors and principals
  • The mitigation of claims stemming from E&O and D&O policies.
  • The mitigation of damaging disclosures to the Central Registration Depository (“CRD”) for licensed securities professionals.

If you are involved with deciding whether to wind down an independent broker-dealer, this is the time to find the right person, one who is knowledgeable and prepared to do the best job possible to protect you and all involved.

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