Is Your Broker-Dealer in a Death Spiral? 4 Steps to Discovery

One broker-dealer that closed in 2016 was geographically close to a FINRA branch office. Several years ago, FINRA conducted an audit that lasted nearly 10 months. The firm had numerous problematic advisors, which is why FINRA spent so much time conducting its audit (which normally takes several weeks.) The broker-dealer was so flustered by how long FINRA spent auditing them that they moved the home office to New York City with the hope that they would be lost in the sea of broker-dealers based there. The strategy didn't work as they fell into a compliance death spiral and closed.

Step 3: Review a Firm's Financials

To review a firms' financials, follow these steps: 

1. Go to www.SEC.gov
2. Click on "Filings" and drop down and click on "Company Filings Search"
3. The result may go straight to your broker-dealer or give you several different broker-dealer names, so click on your broker-dealer name and state of domicile.
4. Click on the most recent – Document (Paper) Focus Report
5. Click on Scanned.pdf (highlighted in red)

Two primary areas that you want to focus on with the Focus Filing are:

• Net Gain/Loss
• Net Capital and Minimum Capital Requirements

Obviously, you want your broker-dealer to be profitable. If it's showing a loss for the reporting period, investigate if prior Focus Reports also reflect losses. Firms sometime have situations (usually FINRA fine-related) that can cause an isolated loss. So as with compliance, look for patterns. We've noticed that some firms will do Focus Filings that don't reflect whether they had a loss or profit, which we view as a potential red flag (possibly hiding that they are operating at a loss). Also of note are major bear markets, which can temporarily cause most broker-dealers to show losses, such as in the 2008-2009 market correction. 

Net Capital — A broker-dealer's net capital is their backup money for worst-case scenarios. Some firms don't like to keep large amounts in net capital because they feel it may make them vulnerable to frivolous litigation or simply because it's looked at as dead money. If a BD has other sources of capital to tap into, then holding below-average amounts is fine. Otherwise, you want to see healthy levels of net capital on hand to weather regulatory storms. 

The amount regulators require a firm to keep on hand is the minimum net capital. You can have a large broker-dealer with a $250,000 minimum net capital requirement but they keep a total of $33 million of net capital on hand while a smaller broker-dealer with the same $250,000 requirement may have only $500,000 of net capital. When a broker-dealer has a legal situation arise that isn't covered by its E&O carrier, the net capital is what they dip into to cover legal liabilities, so the more the better.

The risk level of the business the broker-dealer conducts is another factor to consider, so if you have small or mid-sized firms firm doing concentrations of transactional stock and bond business, REITs, BDCs or alternative investments, you want to make sure they have a least $500,000 of net capital on hand.

Net Capital Ratio — Another indicator of financial health is the firm's "Net Capital Ratio." This ratio is a measure of a firm's aggregate indebtedness to net capital. SEC Rule 15c3-1 imposes a cap of no more than a 15-1 ratio. However, we tend to favor firms that keep the ratio under 5:1, with a firm under 1:1 being a very healthy indicator of very little debt load. 

Step 4: Watch for the Death Spiral 'Tells'

Most poker players have a 'tell,' and so do broker-dealers. Here is a sampling of potential tells to watch for that may indicate your broker-dealer is struggling and may very well be in a death spiral: 

• High frequency of disparaging articles over the last five years in the press with large fines paid out  (Google the broker-dealer name and many of these articles will show up)
• Focus reports that don't show "Net Gain/Loss" or show high net capital ratio above 5:1
• Multiple more recent Focus Reports showing Net Loss
• Number of advisors at the broker-dealer has been consistently decreasing
• No improvements in technology or services over last couple of years (firm appears to be coasting)
• Numerous increases in advisor expenses
• Heavy handed compliance audits or calls from compliance with inappropriate behavior directed toward you for the circumstance
• Lack of communication from management 

The DOL fiduciary rule is going to make life significantly more difficult for broker-dealers, both on a profitability and litigation level, so more than ever, it's important to be proactive and make sure you are operating your business with a broker-dealer that is viable. Don't be caught with your head in the sand because it can very well leave you and your clients in a very difficult situation – one that could have been avoided with a little due diligence.

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