data analytics financeA major trend in the investment advisory world has been the flight of brokers or advisors from the large wirehouse firms (e.g., Morgan Stanley, UBS, Merrill Lynch) to small SEC or state Registered Investment Advisory firms. This article describes some of the forces driving this trend, and the legal implications for investors who may in future have claims against such brokers and their new firms relating to the handling of their investments.

This trend can be primarily explained by the fact that brokers keep more of their production (earnings from their investing activities) at small independent RIAs than they do at the wirehouses.  They also have more control of their own businesses. These factors benefit brokers. However, in general, the quality of supervision at such firms – a key factor in investor protection—is lower than at the wirehouses. Further, collecting against them for wrongdoing can be expensive and sometimes fruitless.

Over the last 15-20 years the wirehouses have become sophisticated and proficient at monitoring client accounts, curtailing a substantial portion of practices that generated customer complaints in the past, such as unsuitable investment recommendations. This is due to the increased sophistication of computerized compliance systems that better identify improper activity, combined with in person supervision by branch office managers and compliance personnel physically located in the same office as the broker. This level of supervision helps identify and remedy improper conduct early, and, in the event such conduct is not remedied, the supervisory system leaves an electronic trail that documents any supervisory failures which can help the investor recover resulting losses in an arbitration.

The migration of advisors away from the wirehouse firms to small advisory firms will almost certainly result in some loss of protection for investors who follow such advisors to their new firms. Supervision and compliance at such firms tends not to be as elaborate and/or rigorous as at the wirehouses, due to lack of equivalent investment in compliance and supervision.

The wirehouses are governed by a detailed and comprehensive set of supervisory rules and guidance, supplemented by decades of industry practice, enforced by extensive regulatory oversight by FINRA and the SEC.  RIAs, on the other hand, assuming they are federally registered, are governed by regulations promulgated by the SEC pursuant to the Investment Advisors Act of 1940. Investment advisors, unlike registered brokers, do not need to have specified investment experience. There are no licensing or examination requirements as in the broker dealer world.  Nor is there a self regulatory organization, such as FINRA, which acts as the front line regulator for advisory firms. Sole regulatory responsibility falls on the SEC, which in turn must prioritize its focus based on limited resources.  Although RIAs must have written supervisory procedures that adequately address statutory and regulatory requirements, the quality of internal supervision at RIAs differs widely, especially amongst smaller RIAs, and is generally speaking not comparable to wirehouse supervision.

While the RIA has a fiduciary duty to its investors, a higher duty than an ordinary wirehouse broker has to his customer, a small RIA may or may not have an adequate supervisory or compliance structure and may not have insurance or means to satisfy a judgment. Even if the RIA is solvent, a case against it must be brought in court, unless the RIA agreed to submit to arbitration. Unlike a FINRA registered broker dealer, RIA’s are not required by regulation to submit to arbitration. Court litigation can be prohibitively expensive for smaller investors even on a contingency arrangement, primarily because of costs related to deposition discovery, which is typically not a part of the arbitration process at FINRA.

In addition, investors with small RIAs are more vulnerable to theft and other fraudulent schemes because RIAs typically have full investment authority and may even control disbursement of client funds from the clearing broker.

Faced with an insolvent RIA or a prohibitively expensive court case, an investor’s only recourse may be in FINRA arbitration against the clearing broker dealer on whose platform the RIA conducts business. However, the clearing broker has narrower duties to the underlying investor than either the RIA or the wirehouse. It’s responsibility to the RIA’s customer is primarily to execute and clear trades initiated by the RIA, custody investments, and provide margin lending to the customer. It ordinarily does not have a responsibility to monitor the actions of the RIA in making investment recommendations.  There are, however, some legal theories that have been successful against clearing firms.

Aiding and Abetting Common Law Fraud

This theory requires a showing that the clearing firm both had knowledge of a fraud and substantially assisted the RIA or introducing broker in perpetrating it. E.g., McDaniel v. Bear Stearns & Co., Inc., 196 F. Supp. 2d 343, 353 (S.D.N.Y. 2002); Koruga v. Fiserv Correspondent Servs., 183 F. Supp. 2d 1245 (D. Or. 2001); In re Wichler, No. 99655G/2011 (Surr. Ct. Duchess Co. Oct. 27, 2016) (Upholding a $10 million FINRA award based on claims of, inter alia, aiding and abetting advisory firm fraud)  At a minimum, as stated in the McDaniel case, it must be shown that the clearing firm “moved beyond the mere ministerial and routine functions of a clearing firm and became involved in the actions of the investment advisor.”  196 F. Supp. 2d at 353.

A theory of aiding and abetting an RIA’s breach of fiduciary duty is easier to prove because it need not involve proof of fraud. There is authority for this theory but it has not been as fully addressed or firmly established by the courts. “[I]f a broker dealer aids in a breach of fiduciary duty by the investment advisor, it would appear that the broker could be liable for breach of his own fiduciary duties, as well as that of the independent advisor.” Bear Stearns & Co. v. Buehler, 432 F. Supp. 2d 1024, 1027 (C.D. Cal. 2000) See Bestoflife Corp. v. Am. Amicable Life, 5 A.D.3d 211, 216-17 (3d Dep’t 2004); In re Wichler, No. 99655G/2011 (Surr. Ct. Duchess Co. Oct. 27, 2016)

Excessive Margin or Breach of Margin Agreement

Another avenue for recovery against the clearing firm is available when the case involves improper or excessive margin lending by the clearing firm at the behest of the RIA, where in doing do the clearing firm “moved beyond the mere ministerial and routine functions of a clearing firm and became involved in the actions of the investment advisor,” particularly when it can be reasonably argued that such lending at least impliedly violated the margin agreement. In re Wichler, No. 99655G/2011 (Surr. Ct. Duchess Co. Oct. 27, 2016)  Margin agreements typically incorporate the customs and usages of the industry. Expert proof that the provision of margin was excessive in relation to recognized industry practice could help establish such a claim. In addition, if the clearing firm uses a standard margin agreement with its customer but sends margin calls to the RIA and not the customer, that could be the basis for claim. Still, losses must typically be tied to failure to receive margin calls.

Fraudulent Conveyance

This theory could be applicable where customer funds have been transferred by an RIA to a clearing broker account in furtherance of a ponzi scheme or for some other fraudulent purpose.  A FINRA arbitration award on this basis was confirmed in Goldman Sachs Execution and Clearing, LP, (f/k/a Spear Leeds & Kellogg, LP), 758 F Supp 2d 222 (S.D.N.Y. 2010) aff’d 491 Fed. Appx. 201 (2d Cir. 2012).  This is a somewhat complicated claim, premised upon bankruptcy law concerning “transferee” liability and New York state creditor debtor law. The elements are (a) a transfer with intent to defraud, (b) that the transferee recipient of the funds, in this case the clearing firm, had a degree of control over such funds, (c) the transferee recipient was on inquiry notice of a fraud, and (d) failed to conduct a reasonable investigation. The key to applying such a theory against a clearing firm is proof that the firm had requisite control over the funds in the account. A previous New York federal district court case established a precedent for this theory in Bear, Stearns Securities Corp. v. Gredd (In re Manhattan Inv. Fund, Ltd), 397 B.R. 1 (S.D.N.Y. 2007). The court in that case held that because of the extensive rights Bear Stearns was granted by its margin agreement to use the funds in the account to protect itself, the existence of such rights was enough “control” to meet the control standard.


It is important for investors to know that there may be a legal price tag to hitching a ride with their investment advisor to a small RIA firm.

John G. Rich is a founding partner of Rich, Intelisano & Katz.