Referral or Recommendation? Firms Walk Thin Regulatory Line in Sending Self-Directed Clients to Advisors
As the popularity of online trading platforms has surged during the pandemic, traditional brokerage firms are targeting self-directed investors as a potential source of next gen clients.
Firms can double revenues when clients make that transition, according to Boston-based consulting firm Cerulli Associates. But nudging clients too aggressively could trigger firms’ regulatory obligations and raise questions about if the shift is suitable for the clients or in their best interests, according to lawyers.
In one example, Morgan Stanley, which purchased E*Trade Financial in October 2020, considers its pool of 7.4 million self-directed households a “really critical component of future growth,” according to Jonathan Pruzan, chief operating officer, who spoke at an industry conference mid-September.
E*Trade training materials reviewed by AdvisorHub show that Morgan Stanley launched internal campaign in January to have E*Trade’s so-called financial consultants refer self-directed clients who have more than $1 million in investable assets to the brokerage’s full-service advisors. The E*Trade consultants were expected to engage in a warm introduction and receive two-year trailing commissions if they succeed, according to the training materials and a former consultant who asked to remain anonymous.
But the program, referred to as “Quick Win,” according to the training documents instructed the financial consultants early on to, “delineate between a referral and a recommendation.”
The E*Trade financial consultant “is not making a recommendation regarding Morgan Stanley,” according to the training documents. The training documents instruct the financial consultants to “articulate the value proposition and capabilities of [Morgan Stanley] advisors” and disclose to clients the compensation they stand to receive.
They can then refer E*Trade customers who have “given approval for consultation” to a full-service advisor, according to the same documents.
A Morgan Stanley spokesperson declined to comment on the program or how many customers have shuttled from E*Trade to Morgan Stanley. Pruzan insisted at the Barclays Global Financial Services Conference that Morgan Stanley pursues an “agnostic” approach as to which channel clients choose between self-directed or with one of its roughly 16,000 full service brokers.
But if firms were deemed to be making a recommendation, they might have obligations under the Securities and Exchange Commission Regation Best Interest, or the Financial Industry Regulatory Authority’s “suitability” Rule 1111 or fiduciary requirements, to have determined that the move was in the clients’ best interest and also the shift was suitable for the client, lawyers and former regulators say.
“They don’t want the E*Trade referrals to be recommendations under BI because they don’t want to have to establish that it is in the client’s best interest to go to Morgan Stanley,” Brad Bennett, the former chief of enforcement at Finra, said.
“The lexicon is precise to ensure adherence to governing FINRA rules,” said Jacob Frenkel, former senior counsel in the SEC’s Division of Enforcement, and member of Dickinson Wright, who chairs the Washington, D.C.-based law firm’s government investigations & securities enforcement unit, said regarding Morgan Stanley’s training material.
Spokespersons for the SEC and Finra did not return requests for comment. Neither the Commission, nor the industry’s self regulator have raised the issues of this type of referrals among the wide-ranging list of focus areas, including a focus on online brokers.
Morgan Stanley on October 1 further nudged its self-directed customers toward full service brokers by soft closing a program that would allow them to start working with an E*Trade advisor to develop a wealth management plan and then buy stakes in a portfolio that meets their needs.
Morgan Stanley, however, is following a path blazed or being explored by many of its large bank competitors, including Bank of America, the parent of Merrill Lynch, which launched its own self-directed platform, MerrillEdge, in 2010. Wells Fargo is now looking to expand its own WellsTrade platform as the bank looks to improve coordination across its brokerage and bank units, sources have said.
Charles Schwab Corp. arguably lays claim, however, to being the true pioneer of the strategy. Schwab built its business in mid 70s as among the first discount brokerage services, but it started sending self-directed clients to independent registered investment advisors in the late 80s, even before it launched in mid-90s online brokerage services.
BofA and Schwab each differ in how they guard against the regulatory risks tied to transitioning self-directed clients to full-service advisors–including for how they determine which self-directed clients should be offered full-service advice, compensate registered reps who make the referrals, and distribute the clients among full-service advisors.
But like Morgan Stanley, both seek to ensure that their representatives characterize the transitions as referrals, not recommendations, when they engage in conversations with self-directed clients about moving to full-service advisors, an approach that arguably limits the brokerages’ regulatory obligations.
At Schwab, the self-directed platform’s financial consultants are compensated for their client referrals to RIAs who custody clients assets with the brokerage or to the financial giant’s own roster of full-service advisors.
For the referrals, the self-directed consultants receive 20 basis points on the assets referred as a one-time payment, and trailing commissions that range annually from $7.80 to $50.40 per each $100,000 in client assets, depending on the type of advisory service to which the self-directed client transitions, according to a company spokesperson.
Schwab financial consultants, however, are required to make an effort to learn about self-directed clients’ specific needs before sending them to a full-service advisor, according to a spokesperson. Their referrals are “based on a range of factors including specialized expertise, investment management philosophy, and location considering these clients are often seeing a personalized local relationship,” the spokesperson said.
“For the referral process, as financial consultants have discussions with clients, they assess their situation and needs over time and consider what services might make the most sense for them,” the spokesperson said.
So-called financial solutions advisors working with MerrillEdge self-directed clients are not compensated for referrals made to full-service Merrill Lynch advisors, according to a BofA executive, who asked not to be named.
“We don’t monitor client assets to generate referrals, and we don’t have campaigns to solicit referral databases. It’s really based on the customer’s choice,” he added.
If a client expresses an interest in hiring a full-service advisor, the MerrillEdge advisor submits the client’s name into a system set up to deliver “equitable distributions” among Merrill Lynch advisors, the same executive said. Advisors are eligible for the referrals based on their prior follow up to leads in a timely manner and their disciplinary records staying pristine, he added.
But the distinction between referral and recommendation may be a technicality, and Morgan Stanley’s training material language caught the attention of plaintiff lawyers, who sue brokerages on behalf of investors.
“It is basically a distinction without a legal difference,” Andrew Stoltmann, a Chicago lawyer who represents investors suing brokerages and is a former president of the Public Investors Advocate Bar Association. “Legally it simply doesn’t mean much but in the hyper technical world of Morgan Stanley they happen to believe that referring and recommending imposes different liability. Morgan Stanley is wrong.”