Is it legal for my stock broker to request a percentage of a non-commissioned trade?
I received a phone call from a stock broker known to me, who has given good advice in the past, allowing me to profit from trades I authorized with individual money wire transfers to fund them. In the phone call, he has offered to waive his BUY and SELL commission on a trade of about $150,000, asking only that, after I SELL, I pay him a percentage of the profit I derived from the trade. This sounds irregular to me. Is this legal? Is this dangerous?
Paying a performance fee is definitely illegal by SEC rule 205-3 which specifies that this is permitted only for qualified clients with a total net worth of at least two million dollars not counting a primary residence, or if the advisor has at least one million dollars of money invested by the client. Such an agreement must be made in advance, and should never be done immediately prior to a trade.
For a sophisticated investor, paying zero management fees and 20% performance fees can be a superior method of compensation so an advisor only gets paid when is client comes out ahead. However, only the wealthiest clients qualify for this kind of fee structure.
This is a bad idea. Even if the stockbroker were a Registered Investment Advisor, he would be prohibited from accepting what amounts to a piece of the action. In addition, there would be a conflict of interest because he would be likely to invest in risker trades to increase the potential for his own gain. Although I can think of an exceptional situation in which the logistics of such of an arrangement would be possible, my sense is that you must turn down this offer. It is irregular, usually prohibited, and yes, dangerous.
Your stockbroker has been working for you on a commissioned basis and has now decided that since his advise has been profitable he wants to participate in your profits. This sounds like a conflict of interest. The paragraph below is an excerpt from the SEC/FINRA on sharing of profits in accounts:
"(c) Sharing in Accounts; Extent Permissible (1)(A) Except as provided in paragraph (c)(2), no member or person associated with a member shall share directly or indirectly in the profits or losses in any account of a customer carried by the member or any other member; provided, however, that a member or person associated with a member may share in the profits or losses in such an account if: (i) such person associated with a member obtains prior written authorization from the member employing the associated person; (ii) such member or person associated with a member obtains prior written authorization from the customer; and (iii) such member or person associated with a member shares in the profits or losses in any account of such customer only in direct proportion to the financial contributions made to such account by either the member or person associated with a member."
There needs to be full disclosure of all fees and commissions prior to hiring a financial advisor. Nevertheless, 70% of firms say their pricing is simple and easily understood by their clients. Yet only 30% of clients agree that they completely understand the fees and commissions they are charged. And 25% of clients think they do not pay any fees at all.
Look for an advisor who is transparent. An advisor who is changing how they bill their clients will work only if they make sure clients understand what they are being billed for and why your billing practice is changing. As an uninformed client you may simply misunderstand what is happening and think you are being taken advantage of.
In each of these cases, there is a good chance your investment philosophies are incompatible. Working with an incompatible financial advisor is not in your best interest. If your financial advisor is not forthright about their compensation and the exact cost of their advice, you may want to start looking for a new advisor. All the compensation an investment advisor receives should come directly from his clients. Any other sources of income should be insignificant and fully disclosed. Brokers can earn commissions on trades, trailer fees for mutual funds and annuities, and bonuses tied to their firm’s proprietary investment products or trading. These other sources of income create lots of conflicts.There is nothing wrong with paying your financial advisor. They work hard to ensure your money works for you. But you deserve to know how your advisor gets paid and which option benefits you in the long run.
This related answer may be of interest:
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If you financial advisor is not giving you full disclosure of all fees you are paying then I would seriously consider another advisor. Whether you have asked him and not received a straight answer or if you do not feel comfortable enough to ask would be reason enough.
The following are differing structures most financial advisor use:
- Percentage of assets that they manage on your behalf, typically anywhere from 1% - 2% per year. The more assets you have, the lower the fee.
- Commissions paid to them from financial products you buy through them.
- Combination of fees and commissions.
- Hourly rate.
- Flat fee to complete a specified project.
There are times that the percentage of assets is appropriate then there are other times that a commission is to your advantage. Personally, I use both. It depends on the client and the client's assets. This is a subject that should be discussed prior to investing or entering into a relationship with an advisor.
It is important to always ask a financial advisor for a clear explanation of how they will be compensated before you hire them. This is one question you would want to ask any potential financial advisor. Look for an honest, straight-forward answer and avoid "advisors" who try to avoid the question.
What you describe certainly deserves a closer look. So, I will refrain from levying a premature judgement not knowing all the facts. Here is what I can tell you.
There are very specific rules for this kind of compensation structure. These rules are addressed in both the Investment Advisers Act of 1940 and the Uniform Securities Act. Generally performance based fees are not allowed. There are exceptions. Advisors are allowed to participate in capital gains if a client:
1) Is a registered investment company. (ETFs, Unit Investment Trusts, REIT, Mutual Funds)
2) Is a private client with an account value in excess of $1 million (Uniform Securities Act).
Is a private client with a minimum net worth of $1.5 million and a minimum account value of $750,000 (Investment Adviser Act)
***Even then the advisor must also agree to participate equally on losses resulting from the investment.
I hope this helps!
It is not illegal for some providers of financial advice to receive a performance fee. Without knowing what licenses or what standard (fiduciary/suitability) the stock broker holds it is difficult to answer your question. However, I don't know of any situation outside of private placements (which are restricted offerings and not registered) where a general partner receives a performance fee - not the broker. In fact, registered investment advisors that receive a performance fee must adhere to certain rules and are scrutinized because of the potential conflict of interest that comes with a performance fee. For example, if there is no risk that a broker can personally lose money on a recommendation but has unlimited upside from a performance fee, there could be an incentive to take undue risk in the hope of hitting a home-run on any one investment, even if 9 out of 10 go bad. My advice to you: Don't take advice from this person. It IS highly irregular to ask for a performance fee in this manner and quite possibly - depending on factors not mentioned here - unethical too. Good luck. Arturo