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FINRA Set to Draw a New Line for Hybrid BDs

by Scott Smith

FINRA’s board took an unusual step at its December 2017 meeting that could have a big impact on alternative investment products.

In this era of regulatory expansion, we often expect FINRA to issue proposals that attempt to expand its reach in the financial services industry, often by establishing new rules or regulations that broker dealers must follow.

However, in December, the board approved the publication of a regulatory notice seeking comments on changes to its rule on outside business activity of registered representatives. Among other things, the rule seeks to streamline broker dealers’ obligations by eliminating supervisory obligations for non-broker dealer outside activities, including investment advisory activities at an unaffiliated third-party advisor (emphasis added). Should FINRA make these proposed changes, broker dealers will no longer have liability for the activities of unaffiliated RIA firms. In exchange, however, BDs will no longer have a basis for charging a percentage on the RIA’s advisory business. ThinkAdvisor recently ran a story covering the proposal, how it might impact the BD business model, and how it would affect BD competition for advisors with their own RIA.

Do BDs win or lose?

The proposal is currently only just a proposal, and the board has yet to announce the release date of the regulatory notice. As it always does, FINRA will seek comments on the proposed changes. We’ll be following those comments with much interest. 

Every new rule creates winners and losers. On its face, BDs look like winners. When advice given by hybrid RIAs goes bad, investors (and their attorneys) will always eye BDs for deep pockets (or maybe for deeper E&O coverage). However, BDs who currently supervise unaffiliated RIA activity probably don’t mind running those risks. Presumably, they’ve already made the determination that revenues from the advisor business adequately compensates the firm for the risk. And most mature BDs aren’t unfamiliar with investor litigation and how to handle it. Most BDs probably see this potential change as a loss rather than a win.

RIAs and their alternative investment platforms

In addition to the change in BD business models, we’re interested in how this impacts the distribution of alternative investment products covered by FactRight. Because of the litigation risks that come with offering any investment products to clients, most hybrid BDs limit their unaffiliated RIAs to whatever products are approved for the BD. If these firms no longer have the duty to supervise products, will an army of hybrid RIAs now be freed to make their own product choices? If so, what kind of support would those advisors need now they’re no longer paying for BD product resources?

Perhaps the biggest question in all of this is: how do BDs continue to create value for independent advisors as the distinctions between the brokerage and advisory models become clearer?

Stay tuned.

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Filed Under: Legal and Regulatory