Broker Dealer Models

Broker Dealer Models

Broker Dealer Types: • General Securities • Introducing/Fully Disclosed • Clearing • Franchise/Independent Contractor • Micro-cap • Mutual Fund • Discount • On-line • Bank Affiliated

General Securities Broker Dealer • Description • Also known as “full service” or “wire house” B/D • Generally, “Wall Street” firms such as Merrill Lynch and Morgan Stanley. • Agents are generally domiciled in large branch offices where business is conducted by phone with “face to face” supervision by branch managers. • Agents are generally considered to be “employees” • Formal employee training program

General Securities Broker Dealer • Normally do not allow or restrict outside business activities • Provide all types of services • Execution • Clearing • Safekeeping • Typically offer “managed accounts” for customers

General Securities Broker Dealer • Advantages: • Nationwide name recognition and advertising campaigns • Complete control of transaction processing • No reliance on third party for clearing activity • Retain all commissions • Do not pay a clearing fee to a third party to perform “back office” functions • Additional revenue generated through margin debits (excess interest charged to customers over B/D borrowing rate) and stocks loaned (practice of lending stock for a fee to other B/Ds)

General Securities Broker Dealer • Capture multiple revenue streams • Able to create, underwrite and distribute products

General Securities Broker Dealer • Disadvantages • Costly initial set-up and continual operating expenses • Requires additional “back office” personnel and procedures. • Considerable regulatory compliance responsibilities imposed • Greater potential monetary and compliance liability • Experienced personnel required • Increased net capital requirements

General Securities Broker Dealer • Regulatory Issues • Proprietary products • Supervision • Electronic records retention

Introducing/Fully Disclosed Broker Dealer • Description • The vast majority of broker dealers are this type • Defined as a broker dealer maintaining a formal written agreement with another broker dealer whereby the introducing dealer does not carry customer accounts (hold customer funds or securities or confirm transactions). • The agreement specifies the terms under which execution and record keeping will be maintained.

Introducing/Fully Disclosed Broker Dealer • Although introducing firms will have “back offices” and record creation and retention requirements, they enter into these agreements to reduce operating expenses. • Required to promptly transmit money and securities. • The phrases “account carried by” or “account courtesy of” will be on firm’s documents.

Introducing/Fully Disclosed Broker Dealer • Advantages • Significantly less initial start-up and operating costs than general and self-clearing broker-dealers • Less administrative and compliance responsibilities • Lower net capital requirement • Reduced back office expenses

Introducing/Fully Disclosed Broker Dealer • Disadvantages • Total reliance upon clearing firm for settling transactions, loss of “back office” control • Sizeable portion of revenues may be paid in clearing costs (i.e., clearing deposit, compliance reports, etc.) • Must share participation in margin debits and stock loans with clearing firm

Clearing Broker Dealer • Description • Enters into agreements with introducing broker dealer to “carry” or “clear” accounts • A substantial number of clearing firms are affiliated with or are divisions of a General Securities Broker Dealer • Handles trade executions and transfers • Provides safekeeping (of customer funds/securities) services • Most states require registration of these types of firms as they hold customer funds and securities for customers of your state.

Clearing Broker Dealer • Advantages: • Complete control of transaction processing • No reliance on third party. • Additional revenue generated through margin debits (excess interest charged to customers over B/D borrowing rate) and stock loaned (practice of lending stock for a fee to other B/Ds) • No retail sales force means less compliance issues. • Able to maximize use of technology to automate processes and reduce expenses.

Clearing Broker Dealer • Disadvantages • Total reliance upon introducing dealers to acquire customers. • Costly initial set-up and continual operating expenses. • Requires additional “back office” personnel and procedures. • Greater potential monetary liability. • Experienced operational personnel required. • Increased net capital requirements.

Franchise/Independent Contractor Broker Dealer • Description • Business model under which the firm operates pursuant to a network of franchise offices and agents that are independent contractors for tax purposes. • The firm may have started out as a small operation but has grown to have a large number of branch offices that are geographically disbursed and operate with one or two persons in each office. • Many outside business activities • Limited or no on-site supervision

Franchise/Independent Contractor Broker Dealer • Each office may operate under a name other than that of the registered broker dealer. • The terms by which the location operates in conjunction with the dealer are defined in the franchise agreement. • The agreement sets forth the terms by which areas such as trading, record keeping, supervision and expenses are handled. • Franchises bear most of their own expenses (rent, insurance, staff salaries). In return, they receive commission payouts of up to 90-95%. • Compliance resources in the dealer’s home office

Franchise/Independent Contractor Broker Dealer Business cards and correspondence used by a franchise, such as Reilly Financial, Inc., must disclose the name of the dealer with whom the franchise is affiliated and that the registered dealer, rather than the franchise company, is a member of the FINRA and SIPC. William F. Reilly, Jr. REILLY FINANCIAL, INC. 123 Main Street Miami, FL 33131 Phone (305) 123-4567 Securities offered through XYZ Securities Member FINRA and SIPC Agent Franchise Registered Dealer

Franchise/Independent Contractor Broker Dealer • Independent contractors • The term is not discussed in any securities rule or regulation but is used for tax purposes. • A Broker Dealer has supervisory responsibility over its independent contractors. • Broker Dealer and agent relationships may be spelled out pursuant to independent contractor agreements. • The agent may enter into this agreement with the broker dealer or the franchise branch office.

Franchise/Independent Contractor Broker Dealer • Advantages • Franchise operator maintains name recognition. • Example: Potential customers may not know the name of the broker dealer but, the name of the franchise may be well known. • Profits of the branch are maintained by the franchise owner rather than the registered firm. • Generally neither the firm nor the franchise owners pay benefits (i.e., medical insurance) to independent contractors. • Broker dealer can expand rapidly with little increase in costs because substantially all operating expenses are paid by the agent.

Franchise/Independent Contractor Broker Dealer • Disadvantages • Occasionally, individuals who are statutorily disqualified or have extensive disciplinary problems associate themselves with or own franchise branch offices. • Franchise branch offices may be operating more like an independent broker dealer than a branch. • Supervision is a problem. Harder to detect serious violations such as theft or selling away.

Franchise/Independent Contractor Broker Dealer • Disadvantages • Franchise branch offices and independent contractors tend to have problems caused by selling away and/or unauthorized outside business activities. • Agents may be geographically dispersed • Lack of close, onsite supervision may result in regulatory issues • Agent may have little or no loyalty to dealer’s image or brand name • Some agents work part-time

Franchise/Independent Contractor Broker Dealer • Regulatory Issues • Agents see themselves as “entrepreneurs.” • Client may not understand which entity is registered. • Advertising and public communication issues • Inadequate branch office audits or follow up to red flags. • Compliance staffing may not be able to keep pace with the expansion of business products and increased numbers of agents and branch offices.

Microcap/“Penny Stock” Broker Dealer • Description • Sometimes referred to as “boiler rooms” dealing in high-risk securities • Characterized by high pressure sales tactics. • May employ agents with extensive disciplinary history. • Stocks they sell: • Have generally little or no operating history. • Are thinly capitalized and traded. • May or may not be SEC reporting companies and therefore lack transparency. • Are often listed on the FINRA Over the Counter Bulletin Board (OTCBB) or in the Pink Sheets.

Microcap/“Penny Stock” Broker Dealer • Agents: • Are often young professionals with little or no securities experience. • Make their living by making “cold calls.” • Generally use scripts containing price guarantees, misleading information, spamming, or unsupported statements about the company. • Generally sell “Blue Chip” stocks to “hook” customers then move them to low-priced/high risk stocks. • May receive undisclosed compensation or higher payout for selling low-priced/high risk stocks.

Microcap/“Penny Stock” Broker Dealer • Advantages • Specialized firm serving a legitimate niche by raising money for small or start up businesses • Required limited start up capital • Agents can make large amounts of money in a short period of time

Microcap/“Penny Stock” Broker Dealer • Disadvantages • Pressure by management to sell a limited product line • Poor customer retention • High rate of employee turnover • Firm may not have widespread name recognition

Microcap/“Penny Stock” Broker Dealer • Regulatory Issues • Fraud • Culture of greed • Self-funding private placements • Boiler–room tactics • Hidden control or ownership

Limited Product Broker Dealer • Description • Generally serves as a “salesperson” offering various limited products (i.e., mutual funds, variable annuities, direct participation programs, etc.). • Orders are transmitted to the mutual fund sponsor on either an “application” basis (customers’ monies and a subscription application are sent to the mutual fund sponsor) or on a “wire order” basis (mutual fund orders are transmitted by phone or wire to the sponsor without an application)

Limited Product Broker Dealer • Advantage • Specialized firm requiring little capital expenditure or operational expenses beyond commissions to its salespersons and general office expenses. • Agents only need to pass Series 6 exam. • Limited products allow for a less sophisticated supervisory system and agent training. • Products are well designed and marketed by the issuers. • Sales support from third-party wholesalers. • Less start-up investment needed.

Limited Product Broker Dealer • Disadvantage • Offers a limited product line to customers • Investor funds are “locked up” for extended period of time • Limited incentive for agents to provide ongoing review of customer accounts • Supervision relies heavily on electronic reports, self-reporting and internal audits

Limited Product Broker Dealer • Regulatory Issues • Variable annuity suitability • Switching or 1035 exchanges • Supervision • Mutual fund breakpoints • Revenue sharing

Discount Broker Dealer • Description • Characterized by minimal customer contact with agents and few services offered. • Customers may pay extra for additional levels of service. • Agents generally receive “unsolicited” calls via “800” numbers rather than solicit customers. • Relies on advertising to draw customers.

Discount Broker Dealer • Advantages • Low transaction costs • Ease of execution • Most investors conduct their own research and choose their own securities • Limited number of employees • Agent’s advice is limited and many trades are unsolicited

Discount Broker Dealer • Disadvantages • Provide minimal, if any, advice to customers • Most investors using the services of discount brokers believe their market knowledge is sufficient to perform their own research and make trade decisions.

Discount Broker Dealer • Regulatory Issues • Customers’ ability to navigate a market crisis without advice • Customer service • Advertising

Online Broker • Description • Trades are placed with the firm via personal computers. • Execution of trades occurs generally without any personal contact. • Online firms offer help desk services. • Custodian for small IA clients. • Highly dependent on technology

Online Broker Dealer • Advantages • Low transaction costs • Ease of execution • Investors perform their own research • Disadvantages • Hackers/Intruded accounts • Requires enhanced anti-money laundering (AML) procedures • Investors perform their own research • Server/Systems Interruption

Online Broker Dealer • Regulatory Issues • Customers’ ability to navigate a market crisis without advice • Customer service • Advertising • Hackers

Bank Affiliated Broker Dealer • Characteristics • 3rd party dealer under contract with bank • Broker dealer may operate using a DBA • Customers tend to be conservative • Face to face contact in the bank • Bank employees may help steer business to the broker dealer • Compliance resources at home office • Agents may be “circuit riders”

Bank Affiliated Broker Dealer • Advantages • Captive audience • Real time ability to know when clients have bank funds to invest (CDs maturing) • Partner with bank – ability to piggyback on customers’ trust of the bank • Bank employees are a referral network • Synergy with bank marketing efforts

Bank Affiliated Broker Dealer • Disadvantages • Clients are generally less sophisticated • Need to spend time educating clients • Line between bank and broker dealer can be blurred • Agents assigned to multiple office locations (circuit riders) • Bank employees may be protective of bank customers and work against the agent

Bank Affiliated Broker Dealer • Regulatory Issues • Compliance with NASD Conduct Rule 2350 • Suitability • Supervision • Networking Arrangements • Incentive Program

Broker Dealer Models