When a Portand, ORE.-based independent rep. recently took detailed client information with her to her new broker/dealer, she had no idea that she was breaking the law. With her current b/d on the verge of being bought out by a much larger firm, she decided it would be best to jump ship. Before leaving, she downloaded all of her client account information into a template provided by the hiring firm so that the account transfer process could get under way as quickly as possible.
“I didn't notify my clients about my move until I joined [my new firm],” she says. “But I had all their information with me. I have it all in my hard drive, paper files and I have it backed up on hard drives too. It belongs to me.”
While this kind of thing would never happen at a wirehouse, it's standard practice in the independent channel, where clients are thought to belong to the rep instead of to the firm. (Unlike wirehouse firms, most independent b/ds don't have non-compete agreements with their reps.) But now, that way of thinking is being challenged.
In fact, switching b/ds just became near impossible thanks to fallout from a routine audit of Next Financial. Next had been accepting client information from incoming reps, and using it to fill new account and account transfer forms before the reps had officially joined the firm — without client consent. But in February, the SEC told the firm that this violated customer privacy rules under Regulation S-P, which requires the explicit consent of a client before his/her information is offered to a third party — in this case, the new b/d. Now, Next, along with at least half a dozen other independent b/ds that offer similar transition services, is being investigated, and is awaiting an enforcement action. One executive from a b/d involved in the matter says he expects enforcement penalties ranging from $50,000 to $60,000.
To complicate matters further, state rules on sharing client information seem to conflict with Regulation S-P. Some states prohibit a rep from soliciting a client for one firm while he is still employed by another (under a concept called “duty of loyalty”). So how would a rep get client consent?
Ultimately, the solution to the problem might be as simple as having firms revise their privacy policy notices to specify what information reps can — and cannot — take with them upon their departure from a firm. But such revisions could be moot, or at least problematic, if the SEC and other federal agencies go through with recently proposed rules that would standardize privacy policy notices for all financial institutions. In the meantime, the whole mess has the potential to leave a lot of client accounts in limbo, and slow down the transition process. It has also left independent b/ds in a pickle where compliance is concerned.
Waiting Game
Peter Anderson, a lawyer for Sutherland Asbill & Brennan in Atlanta who is defending a handful of independent firms under investigation by the SEC for alleged violation of Regulation S-P, says the SEC's discovery of Next's transition practices was a matter of chance. “That kind of transition assistance has been going on for years among independent firms. When block transfers were prohibited a few years back it became even more important [for b/d firms] to assist new reps with account transfers.”
Regulation S-P was adopted in 2000 to protect the privacy of clients' financial information under the Financial Services Modernization Act of 1999, also known as the Gramm-Leach-Bliley Act. The Act requires financial institutions to provide customers with notices disclosing their privacy policies. It also restricts them from sharing clients' non-public personal information, defined as “personally identifiable financial information” (which includes investment details), about its customers to non-affiliated third parties without clients' explicit consent. (Clients must be given the opportunity to “opt out” of the institution's privacy policy.) Generally, client names, telephone numbers and addresses are not considered private.
The lobbying group for the independent b/ds, the Financial Services Institute (FSI), says it has been in talks with the SEC to resolve the Regulation S-P conflict. “We explained why only taking names, phone numbers and addresses doesn't work in the independent world since independent reps have all client information in their own offices,” says Dave Bellaire, general counsel at the FSI. “They understand, and are concerned about it. We're waiting to set up a follow-up discussion.”
The FSI plans to propose an amendment to Regulation S-P that would require all firms to disclose in their privacy notices whether they do — or do not — allow client information sharing when reps change firms.
The problem is, in March, regulators proposed creating one standard privacy policy for all financial institutions at the request of Congress. So any alterations firms make now might have to be reworked later. Under current rules, financial institutions have flexibility in designing their privacy notices — a practice, the regulators say, has resulted in long and complex policies. The standard form is intended to simplify the notices.
But with the wirehouse and independent channels on such opposite ends of the spectrum — unlike independent firms, wirehouses believe the firm owns the client — a uniform privacy policy rule may cause even more headaches. The SEC says it hopes to have a final proposal ready by the year's end.
Taking Action
As word about Next's run in with the SEC has spread, independent b/ds have been making efforts to adjust their own transition services. Jodie Papike, a vice president of Cross-Search in Jamul, Calif., an independent recruiting firm that helps match advisors with b/ds, says firms are adapting in two ways. On one hand, some firms are filling in ACATs and new account forms with only the names, addresses and phone numbers of clients. The firm then hands those forms back to the rep, and asks him to get the remainder of the information on his own. Other firms are providing their soon-to-be advisors with software that downloads all customer information from the contact management system, and then inserts it into the ACAT and new account forms. “This way the b/d is not having anything to do with getting the client information itself,” Papike says.
But these seemingly simple changes don't come cheap. Next president Barry Knight says the firm's revised process for accepting client information from incoming reps adds an additional two to six weeks to the transition process — and doubles the cost.
“The new process causes delays,” says Paul Tolley, Commonwealth Financial Network's chief compliance officer, whose firm now only accepts names, addresses and phone numbers from reps. “It can take 30 days or more, depending on the size of the book of business, to meet with the clients about the move and complete new account forms. Meanwhile the accounts are sitting at the old firm left unattended, and the client is on his own.”
Eric Schwartz, CEO of Cambridge Investment Research in Fairfield, Iowa, says his firm is taking it one step further and is advising potential reps to hire compliance attorneys before making any moves.
I'm Calling You
Ultimately, independent reps say it would be absurd, time-consuming and even illegal for them to contact every single client about transferring their account information to a new firm. Independent contractor reps work out of their own offices, and like the Portland advisor, usually have their own filing cabinets and hard drives full of client information dating back several years.
Critics of Regulation S-P argue that these reps are being asked to dump that detailed information (with the exception of client names, address and phone numbers) as soon as they leave one b/d, and then ask clients for it again once they're at the new firm, a lengthy — even silly — prospect.
David Thetford, principal securities compliance analyst at compliance consulting firm, Wolters Kluwer Financial Services in Minneapolis, says, “This is an unintended consequence of Regulation S-P. In practice, the customers on the independent side belong to the independent rep, and their b/ds say that's okay. But the problem is the law doesn't recognize it that way.”
What's more, making contact with every last client is not as easy as shooting a mass e-mail to all detailing the rep's plan to switch firms. Under NASD Rule 2211, reps must get approval from the b/d for any correspondence sent to 25 or more clients if that correspondence makes any financial recommendation, or promotes a product or service. And a recommendation to follow the rep to a new firm could be construed as just that, the FSI says.
There's another problem with this strategy: Contacting clients before a rep transitions to his new firm is illegal in some states, because it amounts to soliciting business for one firm when you're working for another. But waiting to contact the clients until after the transition period would leave those accounts in limbo, says the FSI. Unlike at wirehouses, accounts left behind at independent b/ds are typically not distributed to other advisors. Instead, they are “orphaned,” and become house accounts where the client can call to make trades, but doesn't get any financial advice.
Further, the FSI is concerned about how these changes will affect the end user: the investor. If the SEC position sticks, and independent reps are forced to collect client information on a one-off basis before switching firms, then it's possible that small accounts may fall by the wayside. “The biggest impact will be upon smaller accounts, which are likely to be the lowest priority. Some smaller accounts may even be abandoned, in fact or effect, as the result of an unduly costly and cumbersome account transfer process,” the FSI says.
“Everyone is stuck,” says Thetford. “The industry members need to get their heads together to work out a solution so everyone can comply, and get back to business as usual.”
The Wirehouse Advantage
While independents grapple to comply with Regulation S-P, the SEC's position on the rule gives further ammunition to wirehouses who say the firm, not the rep, “owns” the client. In fact, wirehouse reps often find themselves in NASD arbitration with their firms, or getting hit by a temporary restraining order if they're accused of taking too much client information with them when they jump ship.
In the last couple of years, the five major wirehouses and Raymond James & Associates, have signed onto a pact called the “Protocol” that allows departing reps to take a very limited amount of information with them. But they cannot make clients aware of their departure until after they have joined the new firm. According to the pact, those clients who choose to follow the rep will have their accounts transferred within one day by the broker's prior employing firm.
But now the wirehouse firms are using Regulation S-P as a way of going after departing reps, regardless of their participation in the Protocol, says Brian Hamburger, founder and managing member of the Hamburger Law Firm, and founder and managing director of MarketCounsel, an affiliated business, regulatory and compliance consulting firm. “We have dozens of broker transition cases, and a majority involve firms making claims that relate to Regulation S-P and privacy policy,” he says. (For more on this, see our story on page 115.)
