May 5, 2010 10:45 AM, By Kristen French

Squeezed by investor lawsuits, rising compliance and insurance costs, as well as departing advisors and clients, some of the industry’s smallest independent broker/dealers are struggling to stay afloat, say industry observers. Expect more of these firms to fail or merge with other firms this year, they predict, especially those with 100 or fewer reps, which account for almost 90 percent of independent b/ds.

“There are an awful lot of factors out there that could cause these smaller firms to go out of business,” said Larry Papike, president and owner of recruiting firm CrossSearch, in Jamul, Calif. “There are an awful lot of firms that are operating on a shoestring.”

Fraudulent private placements and other failed investments are one potential catalyst. Last week, AFA Financial Group, a small independent broker/dealer with about 100 advisers in Calabasas, Calif., shut itself down. The firm simply couldn’t keep up with its errors and omissions (E&O) insurance payments after it was hit with seven lawsuits related to sale of a private placement called Provident Royalties, which turned out to be a Ponzi scheme, according to SEC charges. Just one month prior, GunnAllen was shut down by FINRA after it failed to meet its net capital requirements due to a series of lawsuits related to investments sold by its brokers, including Provident. Other small b/ds that unwittingly sold Provident, or other allegedly fraudulent private placements like Medical Capital Holdings, could also be vulnerable.

Six broker/dealers received subpoenas from Massachusetts Secretary of State William Galvin in late March over sales of Medical Capital Holdings and Provident Royalties, including: QA3 Financial (500 reps), National Securities (350 reps), CapWest Securities (74 financial advisors), Independent Financial Group (240 advisors), Investors Capital (700 reps) and Centaurus Financial (600 reps).

“When the lawyers get their teeth into it, they’re going to go after the broker/dealer first,” said Papike. “Hopefully they’ve got E&O coverage, hopefully they can cover it. But a small firm probably can’t handle something like that. And you’re going to see more deals going bad, particularly in the alternative space.”

Lon Dolber, president and CEO of American Portoflios, an independent b/d with 700 reps, $12 billion in client assets and $100 million in revenue, said b/ds of all sizes worry about their brokers peddling bad investments. “That’s the biggest fear of every b/d. You get one rogue broker who’s doing something you don’t know about, and he can cause you all kinds of trouble,” said Dolber. “Most firms are allowed to sell private placements. But do their reps really understand them, are they really able to do the due diligence?”

Dolber, too, predicts a number of small firms will close their doors or merge in 2010. “I don’t know that too many more firms the size of Gunn Allen or Brookstreet will fold. But all kinds of small firms will probably fold or merge with other firms.”

Of course, fraud is only one of a number of pressures small firms face. Compliance costs will also rise as the SEC tries to show it has more mettle and as Congress pushes through regulatory reform. “One thing that hasn’t hit yet, but is coming down the pike, is that the SEC is the new sheriff in town,” says Papike. “And states are becoming a lot more tough in registering people. Compliance is going to be more in vogue. Reps are going to have to do more. And small firms have to do the same amount of compliance big firms do, but they don’t have the capital to do it. So small firms are likely to have problems.”

E&O insurance, and FINRA and SIPC fees are also rising. These days, E&O insurance, which covers things like operational errors, is typically in the six figures for most b/ds. “In general our expenses have gone up, while revenue is only now starting to go up,” said Dolber. “There's a lot of challenges in the indie space. To get ahead, you have to recruit or increase margins. If you can’t grow you may have a problem.”

On top of everything else, some small broker/dealers found it tough to hold onto advisors and clients last year, and to keep production and asset levels up, according to Aite Group analyst Doug Dannemiller. Their biggest advisors, with their biggest clients, may have been lured away by larger firms, who were on the recruiting warpath in 2009; their smallest clients were scooped up by do-it-yourself online brokerages, according to Aite research released in April 2010.

“I would say there are a lot of firms out there and it would not be surprising if you saw a few more collapse,” says Dannemiller. “As many as 35 in any year fold. But consolidation would be the approach I would expect to see instead of them just going away. Of course, plenty of them will maintain their position in the marketplace as well ”

Those b/ds that find themselves in a pinch will have to act fast to find an acquirer, before their best brokers get wind of it and start jumping ship to other firms. “Once the reps all start to realize there’s a problem, they take their business and move elsewhere and when the principal realizes, ‘Oh, this isn’t going to work out, I give up,’ everyone but a small handful has gone,” says Dannemiller.

“Any potential acquirer is going to think, “I don’t want to buy that.’ The value that could have been had by giving up earlier is destroyed because the good reps have left.”