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Six years ago, Hilliard Lyons, a successful small broker/dealer with roots dating back to 1854, shocked many by selling itself to PNC Bank. To many, the Louisville, Ky., b/d was the model small firm, a master of its own destiny and consistently profitable. To risk forfeiting such an enviable position was unfathomable to Hilliard's peers particularly given the example of Fifth Third Bank's culture-clash

Six years ago, Hilliard Lyons, a successful small broker/dealer with roots dating back to 1854, shocked many by selling itself to PNC Bank.

To many, the Louisville, Ky., b/d was the model small firm, a master of its own destiny and consistently profitable. To risk forfeiting such an enviable position was unfathomable to Hilliard's peers — particularly given the example of Fifth Third Bank's culture-clash acquisition of another small b/d, The Ohio Company.

Yet today, Hilliard's decision has been vindicated. The firm is co-existing “fabulously” with its parent, expanding its assets under management by 15 percent since the acquisition to more than $200 million.

Furthermore, when it comes to the rising tide of compliance demands placed on brokerage firms. the sale looks downright prescient. The merger has ensured that Hilliard has the personnel and other resources to cope with its ever-increasing compliance burden. Most firms of Hilliard's size and smaller are absolutely drowning in regulatory busy-work that could force more to seek buyouts or face extinction.

“Every situation is a little different, so you can't make a blanket statement, but if a firm that was in our position — and the situation is even tougher now — came to us and asked us if they should listen to suitors, I'd say yes, they'd have to,” says Jim Allen, president and CEO of Hilliard Lyons. “If you can end up in a relationship in the manner that we had, I think yes, it is definitely worth it. There's a comfort we can derive from being part of a larger organization. It makes a big difference.”

The Rising Tide

For small b/ds — those with 500 or fewer reps — it's an angst-ridden time. Technology costs are increasing as firms try to keep up with their larger competitors, continuing education is becoming more vital and, most significantly, new regulatory requirements are spreading resources paper-thin.

Small b/ds, which once thrived by serving local customers and by offering reps an alternative to the intense environments of the wirehouses, are now struggling for their very lives.

“Anecdotally, many of our small-firm members say that if they had a choice, starting from scratch, they wouldn't even open up a broker/dealer at this point,” says Robert Gannon, vice president and director of management services at the SIA.

Gannon says the No. 1 issue affecting small b/ds is meeting the regulatory requirements set by the SEC and the NASD. This, of course, is a concern to all firms, regardless of size, but smaller ones suffer more because they operate more leanly than the larger firms (hard as that might be for wirehouse employees to fathom).

Massachusetts-based researcher TowerGroup estimates that compliance spending comprises between 7 percent and 10 percent of the average securities firm's budget, but at smaller firms, the percentage is more like 12 percent or 13 percent. A Rydex Investments survey says that legal and compliance spending jumped a whopping 153 percent in the last year industrywide.

At a large wirehouse, such spending can be absorbed relatively painlessly. But for smaller firms, designating a chief compliance officer (as dictated by the SEC) and establishing an independent overseer for every branch (as called for by the NASD's so-called “Gruttadauria Rule”), adds up to a crushing load of compliance-related costs.

“On a relative basis, we have to keep up with a lot more new rules and regulations than larger wirehouses,” says William Pictor, president of Buffalo, N.Y.-based Trubee Collins. “On a cost-per-rep basis, they can spread their costs. But the regulations have made it very difficult to keep up with, monitor and enforce all the new rules.”

Deborah Castiglioni, CEO of Missouri-based Cutter & Company Brokerage, and chair of the SIA's Small Firms committee, says she has one compliance person on staff for every 10 of her reps. The added costs have forced Castiglioni to lay off some of her support staff.

“They do need to slow down,” Castiglioni says of the regulators. “It's really going to impact small firms because they have to take all the risk in a business where they're making it increasingly difficult to make money. And that's what we're in this for, after all.”

Castiglioni says some proposed rules changes — like the NASD proposition to require individualized transaction disclosure on mutual funds — could be so cumbersome that they would require her firm and others like it to “simply drop that part of our platform. The cost would exceed the profit.”

Gannon says the SIA understands small firms' concerns but offers little solace. “Frankly, it's something that they have to learn to live with,” he says.

Another Straw on the Camel

Compliance costs are not the only problem confronting small b/ds. According to Barry Mendelson, managing partner of Wisconsin-based Capital Market Consultants, there are three other major woes affecting small b/ds. All of them have become more difficult to handle in the last two years.

Continuing education

As the brokerage business inclines toward comprehensive financial planning, reps are required to carry more professional designations and certifications. The SIA estimates that the number of reps taking the CFP designation exam has risen 50 percent in the last five years, and the Financial Planning Association now requires its members to garner the designation. Advisors today need expertise in areas some could afford to ignore only a few years ago — insurance, estate planning and taxes, for example. On a tight budget, it can be difficult for a smaller b/d to make sure its reps know everything they need to know. The SIA estimates the industry as a whole will spend more than $200 million in continuing education expenses in 2004, and smaller firms say their share of that figure is daunting. “I can't keep up,” says one president of a Midwestern b/d with 74 reps. “There's always something new they're asking for.”

Program offerings

As platforms expand and proprietary products endure more scrutiny, many small b/ds are finding that their bread-and-butter services could turn into magnets for unwanted regulatory attention.

“Everything has to be cleared and looked over in a way it didn't have to in the past,” says Pictor. “When you have to diversify all your holdings and justify every little aspect, it can change some of these firms' business plans in a split second.”

William Alsover, chairman of Grand Rapids, Mich.-based Centennial Securities Company, adds: “One way to avoid regulatory problems sometimes is just not to sell the products. But that's real easy to say, not so easy to do.”


Technology pricing has remained stable, or even dropped, in the last few years. But spending by brokerage companies is up nearly 64 percent from five years ago, according to the SIA, and is expected to continue to rise. Where is the money going? At smaller firms the answer is to compliance systems and to the vendors that provide them. Smaller firms rarely have the infrastructure to build a whole new system from scratch, so they inevitably rely on outside vendors.

Castiglioni says she knows of one small b/d with just 10 reps that outsources its mutual fund transaction assessment at a cost of $40,000 per year. And “that's just one of their several vendors,” she says.

One project like this on its own is “challenging, but manageable” says Alsover. “But all of these hitting at once, it's caused some real problems. You only have so much time in a day.”

Hands Thrown Up

Convinced that the chips are stacked against them, many small b/ds are looking for the exits. With wirehouses like Morgan Stanley reticent to acquire in the last few years, the banks are the most likely buyers. Bank-broker mergers can be win-wins, with the bank getting a ready-to-wear brokerage work force and the broker acquiring help with its overwhelming costs.

True, brokerage and banking have some natural cultural divides that can complicate mergers, as illustrated by Wachovia's ongoing troubles digesting Prudential. But that acquisition involved two large organizations struggling for power. Smaller b/ds approaching such deals with a “give to get” mentality could well achieve the success that Hilliard did when it sold to PNC.

It appears now that banks are warming to the idea of building their brokerage businesses through acquisition. “We're just in the first couple of innings of the consolidation you'll see in financial institutions,” says Matthew Fisher, financial services analyst at Independent Research Group. Still, independent b/ds shouldn't go thinking they have some magic exit strategy if times get too tough.

“Everything is so streamlined right now, if you're not going to provide a return on investment, both immediate and in the long term, you're not going to be bought by anyone, let alone a big bank,” Mendelson says.

Allen points out that even though Hilliard Lyons had a smooth transition with PNC, this deal is an exception. More often the upheaval accompanying bank-broker combinations alienates large percentages of reps and clients. Allen says a “significant” percentage of Hilliard Lyons' advisors quit directly after the PNC purchase was announced and says that's “pretty typical.”

The average small b/d advisor, according to Mendelson, is conservative and family-oriented, with looser production requirements that let him focus on interpersonal relationships. With a banking culture often come corporate requirements that force reps to change their approach to the business, or to leave the firm. “Each time a merger was made, it dropped off a cut,” says one Wachovia rep, who has seen his business card change constantly while still staying in the same office, at the same desk.

It all adds up to an ominous time for small b/ds, for everyone from the chairman to the local rep.

As always, the best way through the uncertainty is ingenuity. “Smaller firms are going to have to be more clever,” Mendelson says. “They're going to have to appeal to the attribute of consumer intimacy that a large New York wirehouse can't offer by virtue of its size.”

He adds that “the competitive bar is being raised. Those who don't raise their game, they're going to be in some serious trouble.”

Or, as Castiglioni puts it: “It's getting to the point that you have to wonder about the business that you are in,” she says. “When [the regulators] put this many obstacles in our way, you have to wonder, ‘Would I be better off running a restaurant?’ It's a challenge as to whether or not profitability even exists anymore.”

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