B/D Advisor Valuations To Compress As The Broker Protocol Unravels

Correction Note: Because recruiting firms receiving a breakaway broker can only avail themselves of the Broker Protocol if they are signatories of the protocol, Morgan Stanley's withdrawal means that they cannot rely on the Broker Protocol favorably when hiring away from other wirehouses. As a result, a withdrawal from the Protocol likely means that Morgan Stanley will both focus on retention of existing brokers - who can no longer break away under the Protocol - and further reduce focus on recruiting (as Morgan Stanley can no longer rely on the Protocol when seeking to attract brokers from competing wirehouses).

Hat tip to breakaway broker expert Brian Hamburger at MarketCounsel for pointing out this correction.

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#OfficeHours with @MichaelKitces Video Transcript

Welcome, everyone! Welcome to Office Hours with Michael Kitces.

For this week's Office Hours, I want to talk about the big bombshell news that broke on AdvisorHub on Monday, which is that Morgan Stanley, the largest wirehouse by advisor headcount, is leaving the Broker Protocol effective, basically immediately, this Friday, November 3rd. And this is a really big deal.

History Of The Broker Protocol Agreement [Time - 0:36]

So for those of you who aren't familiar, the Broker Protocol is the agreement that most broker-dealers have signed that stipulates exactly what client information you as a broker are allowed to take with you when you leave your broker-dealer without violating the firm's non-solicit agreements, client privacy agreements, confidentiality obligations under Reg S-P.

And it specifically states that you can take five, and only five, pieces of information when you leave: client names, addresses, phone numbers, email addresses, and the account titles of the clients that you serviced at your now-former firm, but nothing else. No client files, no notes, nothing from your CRM, no account number details. You could take those five pieces of information and not need to worry about getting sued by your former broker-dealer for breaching client privacy laws and confidentiality obligations. But that was it.

Now, the Broker Protocol was originally established back in 2004 by Smith Barney, now Morgan Stanley, along with Merrill Lynch and UBS. And the major wirehouses agreed to it because, at the time, they were all really aggressively recruiting against each other, and then they were all aggressively suing each other over the client information that their departing brokers took when they switched wirehouses.

So the Broker Protocol, when it was first formed, was basically a wirehouse ceasefire. The three major wirehouses at the time said, "Look, rather than all of us recruiting from each other and then suing each other, let's uniformly agree to what a departing broker can take without a lawsuit, without violating Reg S-P, and then we'll stop suing each other all the time and let the best recruiter win as long as everyone follows the Protocol." And the number of lawsuits associated with brokers leaving wirehouses really did drop like a rock in the years after the Broker Protocol was established.

Now, since then, the Protocol has expanded rather dramatically. There are now basically four primary wirehouses today, Morgan Stanley, Merrill Lynch, UBS, and Wells Fargo, but there are a whopping 1,680 firms that are part of the Broker Protocol now, which means quite literally, more than 97% of the broker-dealers in the Protocol are not wirehouse broker-dealers. They are independent broker-dealers or even RIAs that are hiring brokers away from wirehouses, which is part of that whole phenomenon that's been dubbed the "breakaway broker trend" of wirehouse brokers breaking away, leaving wirehouses to go to more independent channels.

And that's why over the past five years, Morgan Stanley is the case in point example. Their broker headcount has declined from almost 16,500 to 15,800 today, which means they're not only not growing, they're shrinking in the aggregate facilitated by the Broker Protocol as firms pick off Morgan Stanley brokers. And so, in a world where more and more brokers who leave aren't just leaving a wirehouse to go to another wirehouse but they're leaving the wirehouse channel entirely, it's perhaps not that surprising that Morgan Stanley has decided to just say, "Enough. We're not the winners in the Broker Protocol anymore, so we're not staying in it anymore, we're out."

Why Morgan Stanley’s Exit Will Unravel The Broker Protocol Entirely [Time - 3:37]

Now, the reason why it's such a big deal that Morgan Stanley is leaving the Broker Protocol isn't just about what happens to brokers at Morgan Stanley who want to leave in the future, although I'll come back to that in a few minutes, it's that Morgan Stanley's decision to leave the Broker Protocol is going to unravel the entire Broker Protocol.

I mean, think about it for a moment, if you're at a competing wirehouse like Merrill Lynch, say you're Merrill Lynch leadership and you look at this and say, "So as it stands now, if Morgan Stanley recruits our Merrill broker, the broker can leave under the Protocol, take the five pieces of information with them and then try to pull all their clients with them from Merrill to Morgan." However, if you're at Merrill and you try to recruit a Morgan Stanley broker to you, then Morgan Stanley is going to sue the broker and likely Merrill Lynch for violating non-solicit agreements, breaching client confidentiality, and using every other legal tool available for them to stop the broker's clients from leaving Morgan Stanley.

It feels kind of unfair from the Merrill side. Morgan can recruit Merrill brokers with impunity, but if Merrill recruits Morgan brokers they're going to get sued, which means it's probably short order before Merrill leaves the Protocol as well, along with UBS, along with Wells Fargo. In fact, the whole list of Broker Protocol firms is updated by the law firm Bressler, Amery, and Ross every Monday. They're kind of the keepers of the list. And I wouldn't be surprised to find out that another wirehouse is out as soon as this coming Monday or the next when the newest list gets posted because it really doesn't make sense for wirehouses to stay when Morgan Stanley, the largest wirehouse, leaves.

As long as they were all in and they all shared the potential pain and benefits together, it made sense to stick around, but once someone breaks ranks, once Morgan Stanley leaves, there's really very little reason for the others to stay when they're already reining in recruiting and focusing more on retention in the first place.

And I suspect the effect will just unravel further from there because once the Broker Protocol is no longer an industry standard, then every firm has to take a hard look at their recruiting efforts and their retention efforts, and basically you do the math. If you can recruit more brokers away from competitors than you will likely lose to them, it's worth staying in the Protocol. If you lose more than you gain, you may as well leave the Protocol and then fight harder to retain the clients from every broker who departs. And because the whole broker-dealer industry is net decline right now, I suspect that most broker-dealers are going to decide to leave in the next year.

You know, we've been calling it the breakaway broker trend for a reason because, since the financial crisis, it hasn't just been about brokers switching from one wirehouse to another or from one IBD to another, they've been breaking away to the RIA channel, which continues to grow and gain market share, especially since the financial crisis.

And I don't think it's a coincidence that Morgan Stanley is now winding down participation in the Protocol at this point nine years after the financial crisis. Because most of the wirehouses put seven to nine-year retention deals in place in the immediate aftermath of the crisis to keep their brokers, and so it's now in 2017 that all those retention deals are finally winding down, and so right on cue, the Broker Protocol is beginning to unravel.

And once the Broker Protocol list is shot full of holes like Swiss cheese, it really fails to serve much purpose at all, right? Because the only firms that are likely to stay in it at this point, are the firms that most brokers are joining anyways. The firms that they want to leave, where the Broker Protocol actually mattered, are the firm's most likely to ditch the Broker Protocol now that Morgan Stanley has set the precedent. And I wouldn't be surprised if you see a new round of employment agreements following shortly thereafter, ones with more restrictive non-compete and non-solicit terms for the brokers as I think the whole broker-dealer community is basically now about to circle the wagons around its clients.

The End Of The Broker Protocol Is A Return To The Dark Days Of Breakaway Lawsuits [Time - 7:19]

So why does all of this matter? The reason it's such a big deal is the loss of the Broker Protocol is going to take us back to the dark days of breaking away from broker-dealers that we saw in the early 2000s and the 1990s. And they were dark days. Back then the standard process was that you went to your manager's office at about 4:50 p.m. on Friday afternoon and handed in your letter of resignation. And you had to do it during office hours to keep it legit.

They had to accept your resignation, but you did it so late in the day because you were trying to do it after most other people in the office had left, which was important because the moment you handed your letter of resignation in, the clock was running. The firm would immediately begin reassigning your clients to other brokers who would all place outbound calls to those clients to try to retain them. And as you walk out of your manager's office, you'd call your lawyer to finalize your registration with your new firm last thing on Friday afternoon, and then immediately you have to start calling all of your clients to let them know you were making a change, ask them to sign paperwork and start moving accounts on Saturday and Sunday. You couldn't do it before you left or you would breach your current firm's employment agreement, but you had to do it right away.

Granted that's actually what a lot of breakaway brokers still do today, but here's the difference: In the old dark days, the real action wasn't what happened when you made the phone calls over the weekend. The real action was Monday morning. Because Monday morning is when the broker-dealer's corporate counsel would come in, find out who left on Friday, and start sending out cease and desist letters directing you to stop contacting all of their clients or they would sue you. Then that was really just a delay tactic because once they could establish you were contacting their clients, they'd go to a judge and request a temporary restraining order on you, which would hit a day or two later. So if you didn't already have all the clients switched over, you had to stop or you'd risk going to jail for contempt of court, for violating the judge's orders.

Then the broker-dealer would hit you with a follow-up lawsuit. This is the one that would say that you were stealing trade secrets, the broker-dealer's client list that you took with you, and then they might throw in some other charges along with it, violation of non-solicit terms and your employment agreement, a suit for breaching client privacy and confidentiality for any information you took along the way, then on and on.

Now, the reality is that even with all these lawsuits flying, brokers did leave broker-dealers and break away from wirehouses, but it was ugly, it was risky, and it was expensive because of all those legal costs that you had to navigate and defend the lawsuits that the broker-dealers would throw at you. And they would do it even if they knew they probably weren't going to win, even if you did the breakaway clean, because they wanted to do as often as they could and make it painful because it was meant to raise the cost of breaking away, to make it less appealing for everyone else. In essence, the broker-dealers would make examples of departing brokers to scare everyone else from even thinking about taking the risk of the lawsuits and the cost and all the stress that would go with breaking away.

Why B/D Advisor Valuations Will Compress With The End Of The Broker Protocol [Time - 10:20]

So what are the implications of this for advisors who're currently at broker-dealers? The obvious effect is that literally, it's going to get much more difficult, much more risky and much more expensive to try to leave your broker-dealer and change to another one or go out and become an independent RIA. But the secondary effect that I think is going to come from this is a very adverse impact on the valuation of advisory firms that were built under broker-dealers.

Because when it gets so much harder to leave and take clients with you, brokers will increasingly be compelled to sell to other brokers on the same platform because it just won't be worth the risk of trying to switch firms to sell to someone on another platform or in another channel, and it'll be virtually impossible to sell your client book away to someone on another platform while you stay and retire out from your current broker-dealer.

Granted internal deals of broker-dealers aren't always a bad thing. They can be easier to transition because you don't have to transfer dollars and re-paper all the client accounts, the broker-dealer usually just changes to make a new broker of record, but you can't sell the value of the business you spent a lifetime building to the top buyer willing to pay the best price when you're captive to only the buyers on your existing broker-dealer platform. And even worse, when you're selling to a buyer who knows you're captive. How good of a deal do you think they're likely to offer?

As advisory firm valuation experts like David Grau have been warning for years that internal broker-dealers deals are often the worst ones with the worst terms because they're commonly structured as just revenue-sharing earn-outs with split rep codes. I sell my business to you, I get 50% of it for the next couple of years, you take the other 50%, then you take over all the clients, which leaves the seller with all the risk, because the buyers don't have to take every client, they can cherry-pick your good clients and blow up the rest. And just walk away from lots of small clients with small revenue. The seller loses the revenue and the payout, but the buyer doesn't care because they only pay for the ones that they choose to take.

And it's even bad tax treatment for the seller because all those split rep code revenue shares are all ordinary income. There's no capital gains treatment for the sale of goodwill the way that you can get for the bulk of a valuation when you sell an RIA. And because the broker-dealer wants to retain its clients, it usually doesn't caution the selling broker about this or let them know that they might get more dollars with better tax treatment by switching channels or selling to an RIA instead.

In reality, valuations for advisor broker-dealers have already been coming down. Three years ago, the recruiting deal switched to another wirehouse was frankly as good as or sometimes even better than the going rate for selling an RIA, at least if you were willing to stick around and retain your clients on the transition. But the DoL fiduciary rule shattered those recruiting deals last year, particularly for the valuation of all your retirement accounts, recognizing the way that RIAs recruiting deals were structured with the forgivable loans based on revenue targets, which is rife with bad conflicts of interest. But when DoL's rule shattered the recruiting deals, it brought down the valuation of brokers trying to monetize the value of their client base.

And now with broker-dealer Protocol unraveling, making it even harder and more expensive than ever to leave and making sales more limited to a more captive audience of internal buyers, I fear valuations for brokers or broker-dealers trying to retire and exit are just going to get worse. Even as the RIA community continues to enjoy top dollar and the volume of acquisitions is accelerating now with better terms as more private equity buyers come in and just stoke more interest in buying RIAs, I wouldn't be surprised if it even extends further from there. I expect that within another few years, payouts at wirehouses and other broker-dealers may start to take a hit and get squeezed a little as well, because once the broker-dealers know it's harder to leave because they can sue you if they're not in Broker Protocol, they have a lot more control than leverage to cut payouts too. I mean, what are you going to try to do? Leave?

What Brokers Should Do If They’re Thinking About Selling In The Coming Decade [Time - 14:18]

I don't want to be melodramatic when it's unnecessary. I've been the one saying that the robo disruption trend was overstated and that the industry's succession crisis with a wave of retiring boomer advisors was overstated, but the end of the Broker Protocol is a really big deal. It's a big deal if you're thinking of changing broker-dealers even if you're not at Morgan Stanley because again, this is just the beginning of firms dropping out of the Protocol, especially amongst the wirehouses, I think.

And it's a big deal if you're thinking of retiring in the coming decade and hoping to sell your advisory firm because you're now going to be far more limited to just the buyers internal to your broker-dealer, who are not likely to offer you the best deal and the best tax terms. And if you want to leave, well, you still can, but we're going to go back to the dark days of stressful breakaways, resign on Friday, scramble over the weekend, wait for the cease and desist letter on Monday, the temporary restraining order on Tuesday or Wednesday, and then pray you don't actually lose the follow-up lawsuits that are going to likely be coming after that.

Because the key point to remember here with all of this is that when you work in a broker-dealer they're not your clients. It's not your business. I know that's hard to say, but that's the legal reality. You are a registered representative of their firm working with their clients, that's why you have to add that disclosure on your business card, on your website and every other marketing material.

And now you're going to see the broker-dealers prove it to you by suing you for trying to take their clients when you leave the firm, which is exactly what Morgan Stanley is preparing to do by dropping out the Broker Protocol. I mean, frankly, the only reason for them to leave the Protocol is because they're getting ready to sue brokers who leave over the information that they used to defend themselves with by saying it was allowed under the Protocol. And that's why almost any broker-dealer that's been losing brokers is likely to follow and drop out of the Protocol as well.

Ultimately, I actually expect that FINRA is going to have to intervene in this. There was a rumor even back in 2004 that the Broker Protocol was convened in part because FINRA, then NASD, was already considering an intervention, and there were questions about whether it was basically an antitrust violation to prevent brokers from changing firms. Because all this action of suing brokers who leave is not good. It's not good for the industry, it raises costs, it's not good for brokers, and more importantly, it's bad for clients when the broker doesn't have the ability to change platforms for the benefit of their clients.

And there may even be a countersuit off of the departure from the Broker Protocol for brokers that were hired under the Protocol expecting that they had the option to leave and now find out that it's gone. But there's no telling whether that kind of lawsuit is going to be sustained on behalf of brokers, because, again, it's their clients, you are their employee, you are their registered representative of their firm serving their clients, which means they have the rights to set the terms of their reps serving their clients because it's not actually your client as the broker, it's the broker-dealer's. So we may have to have that fight again about whose client is it really and who should have control. But any resolution realistically is going to take a couple of years. And in the meantime, it's going to be a dark time for breakaways.

Ironically, for a lot of people, this just makes it all the more appealing to break away and avoid this mess. Which is why I think a lot of the broker-dealers that are likely to drop out of the Protocol are going to do it relatively quickly, because otherwise, they risk seeing a mass exodus of brokers who decide to leave just to beat the firm's exit, right? Like, the race is on now about whether brokers can leave faster than broker-dealers to drop out of the protocol. But in the meantime, I'd encourage all of you, take a hard look at your employment agreement and what it actually says because the legal stakes are higher. What are the non-compete and non-solicit terms? And even if your firm doesn't have non-compete and non-solicit terms, you still need to watch out for potential privacy breach lawsuits under Reg S-P if you take any client information with you when you leave.

So if you're mid-transition from Morgan now, call your lawyer. You probably already have, but call your lawyer. If you don't have one, get one, now, seriously. MarketCounsel, Matasar Jacobs, Stark & Stark. There are a bunch out there, but someone with real experience. If you're in mid-transition from another wirehouse, watch out. The next shoe could drop literally any day now. Well, any Monday because that's when the Protocol list is updated. Morgan Stanley dropped on a Monday and by Friday they're out, and everyone can pursue cases. So even if you're underway, you're not safe until you're gone. Other departures from the Protocol might take a while or they could come as soon as the next week or two. And if you're considering a transition from some other wirehouse, you know, Merrill, UBS, Wells, you really need to consider the timing whether you're going to accelerate it because your days may be numbered.

Now, Wells has been the most aggressive on continuing to recruit both to Wells and FiNet, which means they may be a little bit less likely to drop out of the Protocol, but given that the latest headline was FiNet only reported 11 new brokers all year, even they may drop out of the Protocol. And Merrill and UBS have already said they're reining in recruiting, which is the prelude to exiting from the Protocol.

And, again, I have to emphasize this may not be constrained to just wirehouses. It started there and the Protocol went to the independent broker-dealers, but now the departure of wirehouses may become the departure of independent broker-dealers. Because again, they may call it an independent broker-dealer but it's still the firm's clients, not yours. And be especially wary if you're an employee channel at an independent broker-dealer. Firms like Ameriprise or Raymond James, and even if you're on the independent side because they're the firm's clients. It's been 13 years of the Broker Protocol, I think we've gotten so used to how relatively easy it is to change firms and not realizing that's about to end.

So for those of you who're on the hiring side of the breakaway trend, I'd encourage you to watch out as well because if you're an RIA or an IBD that's recruiting aggressively from wirehouses after they leave the Protocol, you and your firm may well be named as a party in that lawsuit as well. So I suspect companies like HighTower and Dynasty Financial are going to have to buff up their own legal teams as well, along with the aggressive wirehouse breakaway recruiters like Raymond James and RBC and Janney.

But in the meantime, as we wrap up, give a hard look at how you really want your firm to be structured. And again, this is why the RIA movement was already underway because you can own your own RIA and actually control your destiny. And ironically, I think again, the shift of winding down the Protocol will likely accelerate the desire to switch from a broker-dealer to an independent RIA, but I think it will inhibit a lot of brokers from actually doing so if and when broker-dealers start aggressively blocking their brokers from leaving and the cease and desist letters and the temporary restraining orders and the lawsuits start winding. So this is a sad time, unfortunately, for advisors or broker-dealers.

If you're at a good firm that you're happy with, great. If you don't have any need or intention of leaving anyways, this is all a moot point, but for everyone else who's already had maybe a tenuous relationship with their broker-dealer and was thinking about possibly leaving or hoping to retire soon and get top dollar for their firm, watch out. There are trends underway and it's not going to end here with Morgan Stanley leaving the Broker Protocol. I think this is a really sad week for financial advisors, and tread lightly if you're looking to changing broker-dealers from here.

In any event, I hope this helps a little as food for thought and why Morgan Stanley leaving the Protocol is such a big deal. This is Office Hours with Michael Kitces, normally 1 p.m. East Coast time on Tuesdays. Thanks so much for joining us, and have a great day, everyone.

So what do you think? Is the Broker Protocol going to unravel? Are other wirehouses going to follow the lead of  Morgan Stanley? Will advisor valuations at broker-dealers compress as a result? Please share your thoughts in the comments below!