Growth Can Mean Toxic Clients: Can the clearing firm solve the ultimate contradiction? Can the fir

Clearer, know thyself.

Know exactly the kind of client that is a good match. Know when growing your business can hurt your firm. Know when and why to jettison clients. Know a client as you would know your spouse. Know when to marry. Know when to divorce.

These are the warnings of veteran clearing executives as well as introducing brokerage officials who work with them.

"We all get introducing brokerage firms that turn out not to be what we thought they were going to be," says W. Dennis Ferguson, president of Sterne Agee Clearing.

Know that even the best client due diligence in the world can still leave you with the wrong client, clearing officials say. And know one other thing: The regulators will do little to help you with your client selection and how it affects your business (see sidebar). That is until things go wrong.

The pressure for growth is the ultimate contradiction for clearers looking for new business. And how one looks at this contradiction may be the most important factor in determining if firms will prosper or survive, clearing executives say.

"It's a very tough issue for the clearer. There is a lot of desperation and hunger to bring in clients," says Bob Mumby, whose Baltimore-based RM Associates provides consulting services for both clearers and introducing broker-dealers.

Fewer Clients

On the one hand, Mumby says, mergers and consolidation have resulted in fewer potential clients for clearers. But, on the other hand, today clearers are more fearful that they will be sued or will be hurt in some way because of their customers' problems.

But the fault in a bad clearer/broker relationship more often is not legal. It is more likely something more mundane; such as a clearer and an introducing broker are not a good match. And the fault frequently is with the clearer, brokerage officials say.

Brokers often complain that clearers hungry for business promise them the sun, moon and stars. Other times both parties simply misunderstand what the clearer can or will do. Either way it's trouble, says a brokerage executive.

"The most common mistake an introducing broker makes in looking for a clearer is believing everything that a clearer tells them without independent investigation," says Melinda Schramm, chairwoman of the Chicago-based National Introducing Brokers Association (NIBA).

Sterne Agee's Ferguson says clearers must understand exactly the kind of business they want and avoid the temptation to venture outside of their niche.

"You should know the profile of the introducing broker-dealer that you're trying to attract that best fits your capabilities," Ferguson says.

Sterne Agee, he says, must keep a narrow focus, concentrating on its some 90 introducing broker-dealers that typically are "ma-and-pop retailed-oriented firms."

The clearer must also know precisely how it can and can't help these firms. His firm must succeed in its niche, Ferguson says, avoiding the temptation to obtain more business in areas other than its specialty; business that competitors can do better, he says.

For example, Ferguson says Penson Financial is better prepared than he is to service the day-trading/black box business.

Hungry Man

"I'm as hungry as the next guy for new business, but I won't touch that business. I also won't touch the Euroclear securities business because we're not equipped to handle that. The Pershings and the Bear Stearns are the kind of big firms that can clear foreign transactions," Ferguson adds.

Ferguson, in a comment frequently heard from those interviewed for this story, says that despite the best due diligence and risk controls there is one constant for every longtime clearer. Everyone will have at least a few bad experiences with clients.

Ferguson says his problem started with an official who "was a great guy." The client had run an introducing broker-dealer that had been Ferguson's client for many years.

"He had a death in the family. And all of a sudden he started converting customer funds for his own use," he says. But Ferguson didn't immediately discover the problem.

Ferguson says that it can be easy for a clearer to be fooled by introducing brokers engaging in fraud because they can hide transactions. He warns that regulators will only inform the clearer after the problem has become extensive. In the case of Ferguson's longtime client, nine months and $800,000 later the fraud was discovered, Ferguson says. That could be viewed as a warning for all clearers.

Based on a few recent arbitrations, Mumby says clearing officials are fearful that they are more likely to be held legally accountable for almost any kind of client problem. However, Henry Minnerop, a New York-based securities attorney, believes that clearers will not be held liable for their clients' violations. That's provided they follow the appropriate NASD and NYSE rules and have had no prior knowledge of any illegal activities taken by an introducing broker.


Nevertheless, some decisions continue to spook clearing officials. But Minnerop calls a handful of recent arbitrations holding clearers accountable for client actions "aberrations."

What else goes wrong with the clearer's customer?

"Clearing firms often oversell their technology platforms," says the NIBA's Schramm.

A brokerage official, who has changed clearers several times and didn't want to be quoted by name, concedes that technology is usually the biggest factor in a client disappointed with a clearer.

What goes wrong?

Clearers' platforms often aren't technologically advanced. They don't have aggregation capabilities or they lack risk monitoring or access to a long menu of investment products. Their information is not real-time. It lacks sorting and exporting capabilities. The clearer's technology sometimes intimidates the client, the brokerage official complains.

His advice for introducing broker officials is to compare a new clearer with others: "Before going to another firm, compare its technology platform to its competitors because no two platforms are alike and no platform is perfect."

And, say other clearing customers, clearers also oversell their support systems as well as their sales and research capabilities. So clearers, to obtain and hold new business, must be able to favorably compare their technology platforms with likely competitors.

Schramm's gripe about clearers is an echo of what some clearers say about clients: They believed everything they heard about the client when they were in the courting stage. So the clearer and the client in a failed relationship were possibly both fooled. Or possibly they both misunderstood each other. Both need to be more serious. They need to listen to each other, according to a clearing executive.

"It's like getting married. You want it to last. You don't want it to end up in divorce," adds Anne Steer, executive vice president for relationship management for National Financial, Fidelity Investments' clearing arm.

National Financial has some 350 correspondents. So both parties should critically examine each other, she says, before they make a commitment. And clearers should be their own harshest critics, she says.


The self-knowledge that the clearer must have, a persistent, critical self-evaluation, is the only way it can survive in a business that both demands growth and careful client selection, clearing officials say.

Part of the problem of this contradiction comes from the division within the clearing industry since the 1970s. Today, says Craig Gordon, president of the 170-client RBC Dain Correspondent Services, there are two models.

One model is a giant business that sees clearing as a part of an attempt to leverage other core businesses, Gordon says. Here clearing is a niche within the firm. The second is the processing model that views clearing as a scale business. It has a constant need for new clients.

"This one faces a conflict of interest. They need to trade more volume, yet they need to watch the business very closely," Gordon says.

Nevertheless, Gordon concedes that the giant firm faces its own growth pressures that can lead to the wrong clients. For example, the biggest firms have economies of scale, but they also have large overhead.

Never Enough

And that means that the biggest firms can also end up with the same growth pressures as the smaller competitors. "I've never been with an organization, large or small, that said, We've got enough,' " according to Gordon.

So whatever the clearing model, it can be a variant of the same problem. Grow too fast, or grow the wrong way, and

toxic clients may kill or hurt the firm along with the regulators. For example, veteran clearing officials note that Bear Stearns, which paid millions of dollars in fines because of the A.R. Baron & Co. case in the 1990s, has generally shied from the low end of the clearing market.

So what's a clearing firm using either model to do if it hopes to escape the contradiction? Make sure everyone at the firm knows and understands a new client.

Veteran executives say the clearer should ensure that a prospective client has done more than just spoken with sales representatives. He should insist that operations officials for both have gone over exactly how the two firms will work together, clearing officials say. This includes extensive sessions on various technology platforms, the risk group and products.

"Operations people often speak their own special kind of language. So we must understand them. And they must understand us," Steer says. She says National Financial goes through "a pre-new business process" in which all new clients are reviewed. Sometimes they find that a prospective client would be the wrong fit for National Financial.

RBC Dain's Gordon says all prospective clients should be put through a process that never varies. This process should include the background and history of the firms and its principals. But the checks can still leave a clearer with the wrong client. That's because "a front-end review only goes so far," he adds.

"Make sure you understand the business they propose to do through you. Not doing this is how firms get in trouble," Gordon says.

"The clearer sees a revenue opportunity, but he can't explain what the client does. In that case, you will not see the red flags," Gordon says.

Usually, red flags are any significant regulatory problems or certain kinds of business that appear inherently risky. National Financial says this is generally the easiest part of the review. The more tricky part is sometimes passing on a new correspondent that has no problems with the regulators, but whose business isn't a good match.

Here, Steer says, the problem is usually that the clearer doesn't view the correspondent as understanding what it can and can't do for it or what it will need to do to become a National Financial client.

"Sometimes the client is looking for a cheaper price, but they don't understand the costs to their business of going through a conversion to become a customer with us," she says. The costs can include the upgrade of a client's systems so they can keep up with those of its new clearer.

A True Convert?

The clearer also needs to determine if there is unanimous or at least overwhelming support within a brokerage for going to another clearer and subjecting the firm to a conversion process, she notes.

"Sometimes, after talking to a CEO of a firm, one has to ask if the CEO really has the support within the brokerage to make a change," Steer says. A way to ensure that you have the right client is to "include as many people as possible in the process," she adds.

Other problems come during the conversion process, a process that can sometimes take months. New clients often don't take it seriously, she says. They don't put enough resources into it, she notes.

"That's another bad signal," Steer says. She adds that the size of the client isn't the main reason a new client shouldn't be accepted or an old one should be dropped. Instead, patterns of trading-such as rapid buying and selling as well as penny trading-are closely watched and may result in an account being terminated.

Clearing officials stress that firms must act proactively in reviewing clients. For example, First Clearing Correspondent Services jettisoned dozens of clients after a purchase because many of them were not a good fit.

Atul Kamra, president of First Clearing, says his firms feels pressure to grow but the wrong kind of growth can "actually hurt" a clearer in the long run. A financially disadvantageous relationship happens when a clearer, trying to sell a new a client, offers a rate that is too cheap or makes a promise that he can't deliver on.

"You get overzealous about growth," Kamra says. "And when you have a client that doesn't fit, that is unhappy about unfulfilled promises, the clearer's bad reputation "spreads like wildfire," he says.

Indeed, Ferguson, with some 30 years in the securities industry, asserts that almost every clearer in the business for more than a few years has run into problems with fit. Usually the problem has come from clearers changing their rules for a line of business or a new firm they don't understand, he says.

You're Stuck

"What happens to firms is that they may get stuck and be a victim of a scam," he says.

How does that happen? The clearer examines the U-4 forms of the principals of the firm, but doesn't thoroughly examine the U-4s of all the producers, according to Mumby, the Baltimore consultant.

"Know their history of doing business, including all of the producers," he says.

The clearer, Ferguson notes, is at fault because, in his zeal to obtain new business, he made many exceptions to his own risk standards. Ferguson refuses to give small brokerages extensions in settlement procedures. He closely watches that smaller clients always meet net capital requirements.

And Ferguson cautions colleagues at other firms that, if they feel uncomfortable about any aspect of a client's business, they shouldn't shrug it off as the broker's problem and wait until the regulator starts to do something.

Too Late

Regulators usually won't disclose problems at an introducing broker until sanctions have been imposed, he notes. By then, it will likely disrupt the clearer's business. Clearers should be careful, Ferguson says, if they expect to be able to head off trouble before it happens.

"If one of my small brokers calls up, and has a customer who wants to deposit $20 million, it sounds great. But one has to remember that young brokers are the most likely to be scammed," according to Ferguson.

He always views these kinds of proposed transactions skeptically.

"I look at those kinds of things," he says, "and always ask, Why do they want to deposit a big amount with me?''' Another red flag is if the money is only going to be parked at his firm for a short time, he says.

Sometimes Ferguson turns down a client even though he believes his firm is a good match and could do an effective job. He says the "style" of a broker's business will sometimes bother him. For example, he doesn't like brokerages that cold-call because many of their clients will renege on transactions.

"And when you see a pattern of reneging, you anticipate that there are problems to follow," Ferguson says. Reneging can also mean losses for the clearer when transactions go bad.

Clearers must know themselves very well, industry analysts say. However, they should know their clients even better.