When broker-dealer registered representatives seek to go independent and become RIAs, they soon learn they cannot receive trails without being registered with a broker-dealer. This article addresses why RIAs cannot receive trails, and the typical industry solutions. In conclusion, I will offer a new solution that allows an RIA to drop their series 7 or series 6 and be paid as pure RIAs to service trails-paying annuities.
FINRA Rule 2040 states that broker-dealers may not pay any compensation, fees, concessions, discounts, or commissions to any person who is not registered. The point of this rule is to prevent “commission sharing” between properly registered and unregistered entities. The registration process provides protections to consumers from unqualified salespeople who may not appreciate or adhere to the standards of FINRA and its population of registered representatives and broker-dealers. Circumventing the rules that were established to protect consumers would undermine the purpose and effectiveness of client protection. These rules are aimed squarely at broker-dealers, so naturally, the most widely practiced solution has been for broker-dealers to employ registered representatives with a series 6 or series 7. That way, those representatives can share in commissions for the products they sell.
Trails are considered commissions, and this is where the problems begin. Try to think of another “commission” that pays the seller indefinitely. I can’t think of any. When a seller receives a payment indefinitely for something, we usually consider that payment a licensing fee, a subscription, a lease, or an advisory fee. Trails evolved in response to the recurring revenues being enjoyed by investment advisors. As the financial industry evolved in the 1990s, mutual fund and annuity companies began to offer ongoing commissions to advisors, through 12b-1 fees, and the unspoken understanding was that they would provide ongoing advice in return for those ongoing fees. At the time, many advisors were becoming Certified Financial Planner practitioners who held themselves to a fiduciary standard and provided continuing client services over a client’s lifetime. Paying registered representatives trails bridged the gap between RIAs and broker-dealers, but the solution created other problems for the industry.
Trail commissions are paid to broker-dealers regardless of the service provided by the broker-dealer or their registered representatives. Broker-dealers are held to a suitability standard that focuses on the inducement and sale, so they may receive ongoing trails commissions in perpetuity with no obligation to provide ongoing services. While the payment of trails may have been thought of as an advisory fee by many well-meaning registered representatives and their broker-dealers, the fact is, the trails payments never obligated anyone to provide services commensurate with trail payments. The trail payments are charged to the client regardless of the service being provided. In fact, many clients are paying 12b-1 trails fees long after their registered representatives are gone. In that situation, the broker-dealer or the annuity or investment company simply pocket that fee without providing any fiduciary services.
Most registered representatives who worked in the 1990s sought to elevate their skills, training, and service standards. Major wire-houses were beginning to offer accounts that charged an advisory fee, and their registered representatives were encouraged over time to provide more consultative services. Packaged products such as mutual funds and annuities didn’t fit comfortably under client contracts at the time, so the trail was viewed as the ongoing advisory fee. RIA fees were roughly 1% to 1.5% at the time, and coincidentally, the trails commissions were roughly the same. But the fact is and was, those trails were not and are not considered advisory fees; they are considered commissions.
All of this worked out just fine while RIAs and BDs stayed in their corners. But over the past two decades, many registered representatives began to provide financial planning services. They recommended C share mutual funds and annuities to their clients with the understanding they would provide services in return for those trails. The problem with trails payments is abruptly unveiled when an RR seeks to break away from a broker-dealer to form an independent RIA. Annuity companies and mutual fund companies cannot make a payment of compensation or fees to an advisor who isn’t registered to sell. Admittedly, RIAs are still “registered” because they are required to hold a series 65 registration, but the series 65 only authorizes an advisor to be paid for advice and analysis, it does not allow for the advisor to be paid a commission to “sell.”
This trails dilemma has left breakaway advisors with only a few bad options to best serve their clients. They can stop providing service to the client. They can sell the client a new investment product that can be placed under an advisory fee. They can leave the investment behind and continue to serve the client without getting paid. Those choices may not be in the client’s best interest and could undermine the guiding principles of FINRA, which seeks to provide investor protection and promote market integrity. Consequently, most breakaway advisors acquiesce to retain their series 6 or series 7 registration and enter a dual-registration arrangement with a “friendly” broker-dealer.
A friendly broker-dealer is a BD that agrees to hold an RIA’s registration while allowing the RIA to otherwise operate independently of the BD. This arrangement is often strained because when an advisor is registered with a BD, that BD is required to monitor the business of the advisor. This standard makes sense, because as a representative of the BD, an advisor’s every word and action could be part of a commissionable inducement. The BD must supervise the advisor and their otherwise unrelated advisory business, and to do so, BDs must enforce regulatory requirements on its representatives for continuing education, filings, and communications. Friendly BDs suggest they will be less invasive in their supervisory responsibilities. But the truth is a BD is not granted a lesser standard of supervisory enforcement for these relationships. In fact, a friendly BD must hold their RRs to the same regulatory standards whether they are dual-registered or not.
“But what about if I just have trails and don’t do any new business?” Unfortunately, if a friendly BD holds your registration, they are required to supervise you in the same manner as all their other representatives because you have the ability to sell, whether or not you actually ever sell anything.
For advisors who are resigned to work 100% as an RIA, providing advice and analysis for a fee, there is another industry solution. AnnuityFix, which is offered by my firm, Johnstone Brokerage Services, pays RIAs pursuant to an advisory fee contract based on assets under management. Johnstone Brokerage is assigned the trails paying accounts and becomes the BD and RR. Then, an RIA is retained to provide ongoing advice and analysis as fiduciaries to the clients. Brad Wales of Transition to RIA calls this arrangement a “park and service model.” The solution is not a circumvention of the regulatory rules but rather an honest assignment of services and responsibilities to the appropriate parties involved. RIAs work as RIAs providing ongoing advice and analysis for a fee, and the BD works as a BD providing back-office administrative and support services. The RIA is held to a fiduciary standard and the BD is held to a suitability standard that only begins at the point of assignment, not back to the point of sale. Advisors are not paid a percentage of the trails, because this would be a violation of Rule 2040, but they can be paid an advisory fee based on assets under management. AnnuityFix evaluates the size, complexity, and revenue stream of the annuities and mutual funds that are assigned to them and then develops an advisory contract with RIAs that target 70% of revenues. A book that averages a 1% trail should merit a .70% advisory fee on those assets, and a .5% trail book should merit a .35% advisory fee. Assigning non-trails paying assets simply reduces the percentage advisory fee pro-rata. To stay well within the boundaries of FINRA rules, AnnuityFix does not permit advisors to make any new sales of any commissionable investment. All new investments must be made exclusively with the RIA using an advisory contract. The broker-dealer checks in once a year to confirm advisory services are being provided to the satisfaction of each client.
With AnnuityFix, clients can avoid surrender charges and enjoy continuity of service from their advisors. Annuity and investment companies can retain assets, and clients can retain living or death benefits, or other special features of annuities. Regulators can appreciate that clients, advisors and markets are better served with transparency and consistency under the rules.