It's imperative that advisors who say they crave the feel and responsiveness of a smaller BD, perform an extra level of due diligence when choosing  a small firm.

They need to dig into the financials and consider a prospective broker dealer's excess net capital and profitability. (They may be required to sign a non -disclosure agreement to get this information.)

What's to discover? Smaller broker dealers that don't have abundant resources to survive the current regulatory climate, especially in fighting arbitration claims before FINRA.

Unlike the wirehouses, larger regionals and major IBDs, small broker-dealers may not be able to fully cover the cost of engaging attorneys to defend against these claims, and to pay off disgruntled clients to go away.  Add the ever-expanding regulatory burden that FINRA already imposes on its members, and the smaller operators hardly have a fighting chance.

For example, how would one have survived the recent hit taken by LPL?


The largest independent broker-dealer was censured by FINRA, fined $10 million and ordered to pay $1.7 million in restitution. The fines were for widespread supervisory failures and for failure to monitor and report trades and deliver to customers more than 14 million trade confirmations.  LPL did not admit to or deny the charges, but consented to the entry of FINRA's findings.

Read more: LPL Hit With $11.7 Million in FINRA Sanctions

LPL most-likely fared better than its smaller and poorer IBD cousins would in a similar predicament, and there are many reasons.

The IBD world is often referred to as a "skinny" business. Even low producers are often on 90% payouts. In a low interest rate environment, firms can no longer make  money by capturing the spreads on customer money market accounts. Fees that asset managers pay IBDs for inclusion on their platforms are comparatively meager at smaller operations because they have fewer brokers. Ticket charges remain an important source of IBD profitability.


Brian Kovack, newly elected member to FINRA's Board of Governors, says one of his top goals will be to allow arbitrators to throw out frivolous claims from investors. That's good news for the smaller broker-dealers.

Kovack, a securities attorney who defended advisors in arbitration cases, and who also was a FINRA arbitrator, was elected to represent midsize broker-dealers much like his own Kovack Securities. Prior to his election, Kovack was already saying how clients can file complaints at minimal cost, alleging losses ranging from a few thousand dollars to millions.

After winning his board seat last week, Kovack went further to say the defense cost in arbitration cases is minimally from $3,000 to $10,000. Compounded many times over at firms where client complaints are piling up, and that could deliver a serious blow to smaller operations.

Small firms may be so much at a disadvantage trying to cover the escalating compliance costs that some may even find themselves going out of business. That doesn't bode well for the IBD world, which already is shrinking.

According to FINRA, there were 4,031 independent broker-dealers as of May, compared with 4,578 in 2010. FINRA reports that 37 firms were shuttered in the first five months of this year, and that 78 firms closed in 2014.


Under this kind of scenario, it's understandable why Kovack is speaking up. FINRA is very much like a medieval trade guild that exists both to set industry standards and to limit the number of competitors.

FINRA's current approach to policing the industry favors the larger firms with the deepest benches of compliance and legal staff members to ensure conformity with the organization's rules and regulations. Larger broker-dealers are also more likely to have the budget to settle clients' claims.

That's going to be costing the smaller players, who are not FINRA's primary constituents, some big bucks. Smaller broker-dealers without the financial  backing of large corporate parents and with lesser numbers of advisors generating revenue  are clearly at a competitive disadvantage.


Advisors at the wirehouses and large regionals may want to move between those firms, or choose independence with a major IBD. Otherwise, they should stick with broker-dealers that would likely survive consolidation in the industry.

They also may want to go with a firm they know. Employee advisors already are drawn to well-known industry brands and have typically gone the route of independence with Wells Fargo, Raymond James, Ameriprise and LPL, all which have fatter wallets for dealing with regulators.

Further, advisors should be careful not to affiliate with a small firm which has had too many bad apples. These firms are the most likely to have advisors who will be the subject of lawsuits. Anyone can easily check out a firm's compliance history on FINRA'S website, and also look up their advisors' track records using the site's BrokerCheck search engine.

It's noteworthy that some of the industry's top producers have opted to affiliate with super RIA's like Focus Financial, United Capital and Dynasty Financial, instead of hanging their own shingle.

That's because in addition to their multi-custodial platforms, these firms handle an advisor's compliance.

Mark Elzweig is president of Mark Elzweig Co., a New York-based recruiting firm placing financial advisors at wirehouses, regional and independent broker-dealers.

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