You dipped, you took a bite, you dipped again!”
Most of us have seen the Seinfeld episode in which George Costanza receives this reprimand after attacking some party snacks in a most unsanitary manner. The comedy of that moment resided in Costanza's subsequent impassioned defense of the indefensible.
It's an episode I recall vividly when I think about a particular brand of double dipping that some brokers practice in their business lives.
In my role as a wrap program manager of a regional brokerage firm, I found there existed a cadre of brokerage Costanzas who discovered that if they purchased IPOs inside of a wrap account, they could get paid twice for a single transaction. The first payment was the fee tied to the underlying assets (the wrap fee), and the second was the built-in IPO sales charge.
Financially, it's an airtight arrangement. When IPOs are issued, the company cannot break out the sales charge that is associated with the offering. And, since wrap fees are very malleable, it's hardly a stretch to attach some to an IPO.
Ethically, however, such arrangements are obviously suspect. But it comes as no surprise that the discovery of this “opportunity” touched off a rise in interest in IPOs among the brokerage staff. Some of the bigger fans of double dipping made regular calls to the sales desk inquiring about the issue dates of coming IPOs. And, for brokers who didn't know about the practice, the offering syndicate would phone brokers to advertise the beauty of double dipping. These solicitations were obviously meant to create interest in the new offerings…and what better way than tell brokers that they can be paid twice without extra work. Some brokers were advised by the syndicate that such practices were permitted by the firm's compliance department.
The Whip Comes Down
When the upper management of the brokerage firm caught wind of this practice, it reacted decisively — but not in a way you'd expect. Instead of exposing double dipping for the customer-abusing practice it is, the firm decided that the only thing wrong with it was that brokers were getting too big a piece of the fees. It promptly instituted a rule that prohibited brokers from collecting the sales commission on an IPO in a wrap account. But instead of sending that commission where it belonged — with the customer — the firm kept it for itself.
The rule change was good in one regard: It eliminated the incentives to purchase questionable IPOs on behalf of clients in a quest for the double-dip fees. But it ignored the core issue of having customers pay twice — often unwittingly — for a single transaction.
The prohibition infuriated many brokers and touched off an intrafirm row over the ill-gotten gains. Brokers felt, perhaps rightly, that if anyone had a right to the money, it was them. They accused management with cutting their pay.
One broker I knew claimed his commissions would be cut in half because of the new rule. For me, this is a powerful exhibit A in the argument for a completely fee-based business. Given the typical broker's obsession with his compensation, customers will get the best of a broker's efforts when his compensation is tied to the performance of the investments he manages for the client. Of course, with IPOs, there is no way to pay brokers other than a commission. The only way to make this fair for the client is to put the IPO shares in a non-wrap fee account. Why should the client pay a wrap fee and a commission — even if the firm and not the broker is getting the commission?
Of course, the brokers at my firm are angry now that they are not receiving a commission for IPOs in wrap accounts. And their arguments about why they should receive the commission are pretty silly. So specious, that I sometimes wish that clients could hear these brokerage Costanzas try to defend their actions.
Joseph Stiles is the pen name of a former manager of various wrap programs at a major investment house. He is currently pursuing a consulting career.