Broker-dealer compensation

Broker-dealers primarily facilitate securities transactions for their clients. Need help buying a particular investment? You need a broker-dealer. Of course, they don’t offer their services for free. Broker-dealers are most commonly compensated through these means:

Commissions*
Markups*
Markdowns*

*To best understand what type of transaction relates to each form of compensation, please refresh yourself with agency and principal transactions.

Commissions are payments for connecting a client with another investor during a transaction, known as an agency transaction. Markups and markdowns are payments for acting as the contra party in a principal transaction. A markup is charged when an investor is sold a security out of a broker-dealer’s inventory at a slightly higher price than its market value (similar to buying a new car from a car dealership). A markdown is assessed when a broker-dealer buys a security from an investor at a slightly lower price than its market value (similar to selling a used car to a car dealership).

Definitions

Contra party: The entity on the other side of a transaction

For example: A broker-dealer purchases a security from a client and places it into its inventory. The broker-dealer was the contra party in the client transaction.

Generally speaking, transaction fees must be reasonable and fair. The state administrator can punish broker-dealers that charge exorbitant fees without justification. However, there may be a good reason for a higher-than-normal commission, markup, or markdown to be charged. For example, a broker-dealer could justify a significant commission if a security was thinly traded and took months to locate.

Broker-dealers are not required to disclose typical transaction costs prior to a trade occurring, although this information is provided on trade confirmations sent after execution. However, a larger-than-normal commission, markup, or markdown must be disclosed and accepted by a client prior to a trade occurring.

In a previous chapter, we learned that broker-dealers and agents can provide securities advice while avoiding investment adviser and/or IAR registration if compensation is not collected for the advice. But, what if a broker-dealer was dual-registered as both a broker-dealer and investment adviser? In this scenario, the broker-dealer could charge advisory fees, which would be disclosed in the brochure (remember, they’re dual registered as investment advisers in this example).

Broker-dealers can also make fees from various non-transactional services. These include:

Account maintenance fees
Overnight mailing services
Minimum balance fees
Account closure fees
Cash management fees (ATMs, checking, wire transfers)
Transfer and shipping fees
Safekeeping (of securities) fees

The non-transactional services listed above are typically disclosed in the broker-dealer’s fee schedule. The North American Securities Administrators Association (NASAA) provides a model fee disclosure template that most broker-dealers utilize. Virtually all fees a broker-dealer charges are included in this template, except for the following:

Commissions
Markups
Markdowns
Advisory fees (for dual-registered broker-dealers)

Investment adviser compensation

Investment advisers are generally compensated with advisory fees for the securities advice they provide. As we discussed previously, there are three primary advisory fee structures:

Assets under management (AUM) fees
Fixed fees
Hourly fees

Advisers can earn these other forms of compensation in specific circumstances:

Commissions
Wrap account fees
Soft dollar compensation
Performance fees

Commissions

While commissions are normally transaction fees paid to broker-dealers, it’s possible an investment adviser receives a portion of a commission. This occurs specifically when there’s an affiliated broker-dealer, which usually means a broker-dealer is owned by the same parent company. Many large financial institutions offering brokerage services are structured this way. The parent company owns both an investment adviser and a broker-dealer, putting both businesses under one roof.

In this scenario, an investment adviser may keep a portion of a commission. For example, let’s assume ABC Advisers Company (the investment adviser) makes a recommendation to an investor and charges an advisory fee. The client agrees to the transaction, which is then executed by ABC Brokerage Company (the affiliated broker-dealer). Both ABC Advisers Co. and ABC Brokerage Co. are owned by ABC Financial Services Company. When a commission is charged on the trade, the commission is shared between both ABC Brokerage Co. and ABC Advisers Co.

If an investment adviser is not affiliated with the broker-dealer executing their trades, they cannot earn commissions.

Wrap account fees

Securities regulators define wrap fee programs (or wrap accounts) as:

A wrap fee program generally involves an investment account where you are charged a single, bundled, or “wrap” fee for investment advice, brokerage services, administrative expenses, and other fees and expenses.

Instead of paying separate fees for a random assortment of services, clients with wrap accounts are charged one single fee. Technically, these programs are considered advisory products that may only be offered by investment advisers.

The specifics of an adviser’s wrap fee program are disclosed in Form ADV Part 2A Appendix 1, also known as the wrap fee program brochure. Information provided in this disclosure includes:

Services offered in the program
Cost of the program
Compensation paid to the adviser
Account requirements (e.g. minimum balance)
Types of clients
Portfolio manager selection and evaluation criteria*

*This is especially important when an adviser places client funds into products managed by third parties (e.g. mutual funds).

Additionally, advisers must disclose whether the wrap fee program is less or more expensive than paying for each service separately.

Soft dollar compensation

Most investment advisers, particularly smaller firms, pay broker-dealers to maintain custody of their clients’ assets and execute trades. This can be a very profitable business for brokerage firms, resulting in a very competitive market. Broker-dealers may also offer soft dollar compensation to advisers that send their clients’ business their way. For example, XYZ Broker-Dealer offers additional “compensation” to ABC Investment Adviser if ABC chooses XYZ’s platform to safekeep client assets and perform transactions (kind of like a “you scratch my back, and I’ll scratch yours” type of deal).

Soft dollar is a tricky term; technically, broker-dealers are not giving cash (known as “hard dollars”) to investment advisers. Instead, they’re typically offering intellectual property of some form in return for their business. Most broker-dealers employ analysts that examine the securities markets and create reports for the firm. This research could be valuable to advisers providing securities advice to their clients. Broker-dealers may offer this soft dollar compensation in return for the business an investment adviser sends their way.

Two general requirements must be in place for soft dollar compensation to be considered compliant and legal. First, the adviser directing transactions to a broker-dealer in return for soft dollars must believe the fees paid to the broker-dealer are reasonable. If an adviser sent transactions to a broker-dealer with excessive transaction fees to obtain soft dollars, they would be breaking their fiduciary duty to their clients. Remember - advisers must act in their clients’ best interests.

The second requirement - the “compensation” received by the adviser must fall into ”safe harbor.” Meaning, broker-dealers are limited in what they can offer in return for transaction traffic. Regulations on what is and isn’t considered safe harbor have evolved over time, but securities regulators have identified the following as currently allowable:

Research reports
Access to analysts
Meetings with corporate executives (of issuer companies)
Financial newsletters and trade journals
Analytical and trading software (only if related to investing)
Market data
Economic data
Access to seminars or conferences

Generally speaking, it’s safe harbor if the intellectual property (or access to meetings/conferences) better equips the adviser to make suitable recommendations to clients. The following have been explicitly mentioned by securities regulators as not being considered safe harbor:

Office equipment (e.g. furniture, internet access, business supplies)
Operational overhead (e.g. travel expenses, meals, entertainment)
Computer hardware
Computer software if not related to investing
Marketing expenses

Performance fees

If working with a specific type of client, an adviser may be able to retain some of their portfolio gains. For example, let’s assume an adviser makes a net annual return of $100,000 for a client under a 2% performance fee structure. In this scenario, the adviser would keep $2,000 of the gains made on top of the advisory fees already collected.

Performance fees can also be structured as fulcrum fees, where performance is judged against a benchmark. Stock indexes like the S&P 500 are commonly used as benchmarks. For example, assume an adviser’s performance fee is based on how high a portfolio outperforms the S&P 500. If the S&P 500 had annual returns of 10%, the adviser would be paid escalating fees once a client’s portfolio exceeded a 10% return.

NASAA rules allow performance fees to be collected from qualified clients, defined as any client with:

Net worth of at least $2.2 million (excluding primary residence), or
At least $1.1 million invested with the adviser

Additionally, IARs employed by the investment adviser for at least a year are considered qualified clients. This means an IAR with one year of service may have their personal money managed by their employing firm in a performance-based fee account.

Performance fees force the adviser to have “skin in the game,” which some clients tend to prefer. The more the adviser makes for their client, the more they make for themselves. Of course, this compensation structure comes with some added risk. In particular, it gives the adviser an incentive to take on more risk in hopes of higher pay.

It’s important that clients are aware of the added risks, which is why NASAA rules require the following disclosures when charging performance fees:

The fee structure provides an incentive to the adviser to take more risk
Performance fees may be based on both unrealized and realized gains*
The time period for calculating performance
How the fee is calculated
What index is utilized for fulcrum fees
How security values are assigned

*Unrealized gains are gains on unsold securities. For example, assume an investor purchases stock for $50. If the stock price rises to $70 but the shares are unsold, there’s a $20 unrealized gain. Once the shares are sold, the gain is realized. Investors must be aware if unrealized gains are considered when computing performance fees (they usually are).

Sidenote

Compensation to unregistered parties

You may encounter a test question involving payment of securities-related compensation (e.g., commissions, AUM fees) to unregistered parties. In general, a person may only collect these forms of compensation if they are properly registered.

Key points

Broker-dealer compensation

Primary forms of compensation
- Commissions
- Markups
- Markdowns
Secondary forms of compensation
- Account maintenance fees
- Overnight mailing services
- Minimum balance fees
- Account closure fees
- Cash management fees (ATMs, checking, wire transfers)
- Transfer and shipping fees
- Safekeeping (of securities) fees

Broker-dealer fee template

Includes all fees charged, except:
- Commissions
- Markups
- Markdowns
- Advisory fees (for dual-registered broker-dealers)

Typical forms of investment adviser compensation

Assets under management (AUM) fees
Fixed fees
Hourly fees

Unique forms of investment adviser compensation

Commissions
- Only if sending trades to affiliated broker-dealer
Wrap account fees
Soft dollar compensation
Performance fees

Wrap accounts

Offer advisory, brokerage, and administrative services
All costs “wrapped up” into one fee

Soft dollar compensation

Broker-dealer compensates investment adviser for using their services
Safe harbor
- Research reports
- Access to analysts
- Meetings with corporate executives
- Financial newsletters and trade journals
- Analytical and trading software
- Market data
- Economic data
- Access to seminars or conferences
Not safe harbor
- Office equipment
- Operational overhead
- Computer hardware
- Computer software if not related to investing
- Marketing expenses

Performance fees

Adviser keeps part of gains made
May only charge to qualified clients
- Net worth of at least $2.2 million (excluding primary residence), or
- At least $1.1 million invested with the adviser
Required disclosures
- The fee structure provides an incentive to the adviser to take more risk
- Performance fees may be based on both unrealized and realized gains
- The time period for calculating performance
- How the fee is calculated
- What index is utilized for fulcrum fees
- How security values are assigned