Consultants With Affiliated Broker-Dealers: How "Independent" Is Their Advice?
What happens when a consultant, who offers advice on investment management and brokerage matters, has an affiliated brokerage firm? Here the consultant may simply offer its clients the option of paying for services or recapturing commissions through the brokerage affiliate or may actually advise its clients to use its brokerage affiliate.
First, there is a great deal of confusion regarding what the terms "independent" and "affiliated' mean. Consulting firms represent these relationships differently in their marketing materials. Also, under the securities laws, the definition of "affiliate" is quite broad. Two firms under the common control of a third party are considered affiliated. A firm which indirectly has a five-percent interest in another firm may be considered affiliated under the securities laws. Yet many consulting firms which have affiliates in the money management or brokerage businesses refer to themselves as "independent."
So, in answering the question as to whether a consultant is "independent," either the industry must agree on a definition, or every consultant must define what is meant by the term as used in its marketing materials. Or, firms should disclose their ownership structures and business relationships and leave it up to the client to come to his own conclusions.
When a consultant has an affiliated broker-dealer, it is subject to intense potential conflicts of interest as a result of its advisory role to the pension fund. These conflicts exist regarding of whether the consultant explicitly offers advice on brokerage matters. However, the conflicts are potentially the greatest when the consultant with an affiliated broker-dealer is retained to advise its pension fund client on brokerage issues and is in a position to recommend specific brokerage firms -- including its own. When a consultant is not purporting to give advice on brokerage matters specifically, but is simply offering its clients the ability to soft dollar the consultant's fee and/or recapture commissions through the affiliated broker-dealer, the question arises as to what is the consultant's duty in their situation? Is the consultant offering an opinion on the merits of soft dollaring or recapturing by offering the facility? Is the consultant encouraging its clients to soft dollar or recapture commissions by offering the option? Can the client assume that the rate or price the consultant's broker-dealer is proposing is fair? Does the consultant have an obligation to discuss the pros and cons of commission recapture or soft dollaring or the merits of paying the consultant's bill on a hard dollar versus soft dollar basis? Does the consultant have an obligation to disclose the additional money it will earn from providing brokerage services or that the rate it is proposing may be more than another broker might charge? Does the consultant have an obligation to discuss the merits of doing business with its brokerage affiliate versus other brokerage firms? What about the consultant who says or implies that the client can only soft dollar its bill with its affiliated broker-dealer and no other firm?
In my years of experience marketing brokerage services, virtually the only time I have found a single broker-dealer as a commission recapture or soft dollar broker for a fund is what it is an affiliated broker-dealer of the consultant of the fund. In all other cases, consultants advise their clients that if they are going to recapture commissions or soft dollar, the old rule of three applies: offer at least three alternatives so you meet a "prudent person" standard. Query: should a consultant's broker-dealer or any other broker-dealer ever be the only soft dollar or commission recapture firm for a firm?
When a consultant with an affiliated brokerage firm offers specific brokerage consulting advice, the number of questions involved grows exponentially. Here the consultant obviously has the opportunity to advise its clients to do business with its affiliate or other brokerage firms with which the consultant has a business relationship or reciprocal agreement. A reciprocal agreement is an agreement whereby one brokerage firm will direct orders to another firm, in exchange for having orders directed to them. Reciprocal agreements are quite common in the brokerage business and can be used to obscure or conceal financial relationships
It is important to remember that when a consultant has an affiliated brokerage firm, there are significant conflicts of interest and opportunities for self-dealing. Plan sponsors do not realize that the brokerage affiliates of consultants are some of the largest soft dollar and commission recapture firms out there. In many cases, the revenues of the brokerage affiliate exceed those of the consulting firm. Furthermore, these affiliated brokerage firms also sell services to the very same money managers that the consultants review in client searches.
I am not saying that consultants should not provide brokerage services, or that consultants should not sell products or services to money managers. What I am saying is that plan sponsors need to fully understand the services the consultant offers, itself and through affiliates, the financial relationships and affiliations the consultant has, the consultant's sources of revenues and the percentage of total revenues each source represents, and the self-dealing and conflict of interest safeguards the consultant has in place.
Setting Standards For The Investment Management Industry
