It wouldn’t be an overstatement to say that independent broker-dealers spent the first two weeks of March in a state of paralysis, awaiting the final outcome of the Department of Labor’s fiduciary rule, which was expected to come out around press time in April. All other concerns afflicting broker-dealers are taking a backseat right now as they anticipate what could be a fundamental transformation of the brokerage industry.

Smaller firms that rely on commission revenue, especially from non-traded REITs and variable annuities, will be affected the most. The DOL has proposed a ban on non-traded products in IRA accounts and recommended the use of a controversial “best-interests contract exemption” (BICE) for other commissioned products, including existing holdings.

The DOL earthquake comes amid other tremors shaking up two of the industry’s biggest operators—AIG’s Advisor Group, which is in the process of changing owners, and Cetera Financial, which is restructuring.

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Throw in a volatile equity market, plus fading hopes for a rate hike and a looming advisor succession crisis, and you end up with a semi-toxic environment for broker-dealers. “I’ve never seen a more disruptive period,” says Bill Morrissey, managing director in charge of recruiting for LPL Financial.

The DOL rule by itself is huge. Morningstar estimates that about $19 billion in revenue from commissioned IRA assets could be affected, and that operating margins on those assets could contract up to 30%, the research firm said in an October report.

The added compliance burden is expected to push more commissioned IRA assets into fee-based accounts, which typically have higher minimums. That’s a problem for independent B-Ds, which are more likely to have smaller IRAs than wirehouse firms, says Morningstar analyst Michael Wong.

“If these independent broker-dealers, which are mainly commission-based, [are] to have a chance of preserving their business model, they have to get that BICE to work,” Wong says. “Smaller B-Ds probably won’t have the wherewithal to bear some of those costs.”

The DOL is expected to set an implementation date that will become effective near year’s end. However, a legal challenge seems likely, and the outcome of the presidential election will also be critical. A Republican administration probably won’t support the DOL’s efforts.

Many independent B-Ds have been holding off putting in place final plans to deal with the rule until they see the final version. Quite a few are hoping the whole thing is killed. Many are adamant that the BICE simply isn’t feasible.
“Some firms are just clueless” about how to respond, says industry recruiter Jon Henschen.

Nevertheless, “all the smart firms out there are carefully considering the last [DOL] proposal, and how to restructure their business and move in a direction” to comply with any new DOL regulations, says David Bellaire, general counsel at the Financial Services Institute, which has been critical of the proposal.

Executives at the larger broker-dealers actually see an opportunity. They say they’ve been hearing from potential recruits at smaller firms who are concerned about the lack of preparation at their firms for the coming rule change. “Our phones are absolutely ringing across the board [because of] the uncertainty caused by the DOL,” says Amy Webber, president of Cambridge Investment Research.

Set aside the DOL’s actions, and there exists a bit of good news on the regulatory front. “We anticipate that 2016 will be a relatively light regulatory year,” Bellaire says. But that viewpoint recalls the old line, “Other than that, Mrs. Lincoln, how was the play?”

The SEC is short two commissioners and has a host of additional Dodd-Frank rule-making to finish, he says. Add to that the planned departure of Finra chief executive Richard Ketchum at midyear, and significant regulatory initiatives will likely have to wait.

Strategic Rethink
That’s a good thing because broker-dealers will have their hands full if the DOL rule goes into effect. In fact, “the post-DOL world has sparked a bigger sense of urgency” for firms to consider new strategic directions, Webber says.
For one thing, the shift to fee-based business will accelerate, observers say. At the same time, traditional commissioned products are being revamped into level-load and liquid structures that will meet the DOL’s requirements for level pay.

One case in point: Sales of traditional non-liquid REITs and business development companies have been drying up, partly because of the blowup of real estate investor Nicholas Schorsch’s non-traded REIT empire, but also because of a Finra rule set to take effect in April 2016 that will require transparent pricing of REITs and other illiquid programs.
Overall compensation might be similar in level-load products, “but up front there’s much less cash flow for the B-D and for advisors,” says John Rooney, managing principal at Commonwealth Financial Network. “It could be material.”

The importance of alternatives for some firms was evident in February when LPL Financial reported a 12% drop in commission revenue in the fourth quarter and a 7% decline for the full year, after an industrywide slowdown in alternative sales.

“The DOL [rule] by itself will not be the death of marginal firms,” says Jim Crowley, chief relationship officer at Pershing LLC. “Their death will be the aggregate result of the lack of business transformation” to a more planning-based approach. “The DOL could be the last straw.”

Firms focused primarily on investment management as their core value will be challenged, Crowley says. Investment management as a “stand-alone proposition is [worth] no more than 25 basis points, and it’s on the way down,” he says. As a result, independent B-Ds will have to change compensation plans to include more fixed pay, and be more planning-driven than product-driven.

“A lot of firms are stepping back, looking at planning, and at what sort of training and retooling they have to do,” says Joe Kelly, head of the broker-dealer segment for Fidelity Clearing & Custody Solutions. “Most don’t do planning in its pure state.”

Additionally, hopes of a higher interest rate environment, which would help B-Ds earn something on cash balances, has faded as global economies still struggle and central banks hesitate to pull back on stimulus. Broker-dealer executives say they’re not counting on further increases by the Federal Reserve to boost interest income.

The margin deterioration in B-Ds and the challenging regulatory environment continue to drive the companies toward consolidation. B-Ds say they’re hearing from owners at smaller firms who want to throw in the towel.

Finra reported 3,957 firms at year’s end 2015, down almost 3% from 4,068 in 2014. Cost and regulatory pressures are causing “reflection moments” in the management ranks at broker-dealers, Kelly says. “This market is definitely forcing firms, [to question] who they are—a buyer, seller or a focus player?”

Consolidation is happening at the advisor level as well, Morrissey says, as advisors retire or join larger practices.
“Offices are becoming more and more professionalized,” says Wayne Bloom, the chief executive of Commonwealth Financial Network. “We’re seeing advisors … delegate more and more to the [specialized] professional staff they’re building.”

“The survival rate for solo practitioners will continue to go down,” Crowley says, squeezed by higher costs and the demands of running a business. “There’s a real lack of scalability with that business model.”

Among larger ensemble teams that can deliver holistic advice, “we’re not seeing the same type of fee compression,” Crowley adds. He predicts more large hybrids will use the corporate RIAs of their broker-dealers to access professional money management and better technology and surveillance tools.

Given the need for scale and specialization, combined with the aging advisor force, firms desperately need to figure out how to help the multitudes of solo practitioners prepare for succession. “If you look at the age 55-plus block in the average B-D, [those advisors] account for about 75% of total revenues,” says David Goad, a transition consultant who works with independent broker-dealers.  “It’s scary. Firms are on a time clock” to act before losing the assets, he says.
He advises B-D clients to find out when individual reps plan to retire, identify those with a time frame of five years or less, and then recruit mid-career advisors who can take over for the pre-retirees. “Not only is it a way to handle retention, but it’s a way to gather assets” from the new recruits, Goad says.

Big News At Some Big Firms
The new year began with the attention-grabbing news at two of the biggest independent networks. In January, RCS Capital Corp., parent to the Cetera Financial Group and its 9,500 reps, announced plans to file for bankruptcy and emerge as a pure retail firm.

Later that month, insurer AIG unveiled a deal to sell its four Advisor Group broker-dealers to private equity firm Lightyear Capital, with former Cetera chief Valerie Brown coming on board as executive chairman of the group to join existing chief executive Erica McGinnis, who retained operational control. The new owners promised the Advisor Group’s 5,200 reps that there would be no disruption to their businesses.

As always, competitors and headhunters hope to pick off some producers from the two large B-D networks. But so far, there’s been no major rush to the exits. Advisors at the firms have made inquiries and visits to competitors, sources say, but most of the activity seems to be part of a backup plan—just in case.

“I’d have to say, [Cetera has] done a good job of keeping their reps intact,” says recruiter Henschen. He adds that the Advisor Group didn’t have the extended period of bad press Cetera did.

“Now that both of those organizations have brought about some level of certainty … the advisors’ [interest in leaving their firms] has somewhat slowed,” says Webber at Cambridge. Many of those advisors are used to having an outside owner, she says, and “are apt to sit tight and see what leadership at those companies are going to do.”

The Advisor Group’s McGinnis says the firm has no major concerns about retention.

Advisors will join “for the same reasons they’ll stay,” she says. “Our value proposition is even stronger … because there are no major changes.”

The ownership change means management “can focus 100% on the Advisor Group, instead of working within the broader AIG construct,” she adds.

At Cetera Financial, “there’s no question, the last 12 months have been particularly challenging,” says Larry Roth, the firm’s chief executive. “Fortunately, our advisors have been patient and loyal.”

The good news is, “we have clarity on our future,” Roth says. The firm remains profitable and will emerge even better capitalized than in years past, he claims.
Roth acknowledges Cetera will this year focus more on retaining advisors than on adding bodies. He notes that Cetera has a lot of big OSJs and financial institution clients that continue to recruit into their own operations.
At LPL, recruiting hit a bump last year. The firm had a net gain for the year of just 18 advisors even though it usually has 300 or more.

Recruiters and competitors blame it on the firm’s sheer size and some negative headlines.

But LPL chief executive Mark Casady told analysts in February that the firm purged lower producers and now had a pipeline “probably better than we’ve seen in a couple of years.”

LPL’s Morrissey, who was given expanded recruiting responsibility in January, thinks the DOL rule’s impact and changes in control at other broker-dealers will cause reps to look around. “We see a general flight to quality,” he says, with advisors attracted to B-Ds with larger scale and stability.

Other firms expect 2016 to be a decent recruiting year. Raymond James Financial Services added 215 advisors in fiscal 2015 (ended September), and “this year, we’re ahead of that pace,” Scott Curtis, its president, says. The firm traditionally attracts wirehouse people, but in recent years has been increasing its take from other independents, which Curtis expects to continue.

Commonwealth gained just over $50 million in recruited revenue last year, and Bloom expects to do a bit better this year. Like some other executives, he thinks reps at insurance-affiliated firms that rely on proprietary products will be ripe prospects for recruiting.

Cambridge could get $60 million or so of recruited production, up from around $55 million last year, Webber says. “Our pipeline is really full right now,” driven by turmoil at other firms and the inability of smaller dealers to respond to the DOL.

Even big firms could be challenged in keeping up, however.

Curtis, at Raymond James, points out that all firms have a tough task ahead. “How do you continue to afford investments in technology for efficiency, for client experience and access [and] at the same time invest in improving risk-management capabilities and in meeting regulatory expectations … when the market environment is not very favorable?” Curtis asks.

Crowley hopes those challenges will be counteracted by what he calls a “a bull market for the advice marketplace.” That is the silver lining: it’s the shrinking number of advisors colliding with the booming demand for retirement advice.
There are about 1,000 fewer broker-dealers and 30,000 fewer registered reps since before the financial crisis, Crowley says. So “we know there’s shrinking supply and increasing demand for this service, and we’re starting to see it now.”