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The financial advisory industry as we know it may be in jeopardy, due to a proposed Department of Labor (DOL) employment rule pertaining to an employee or independent contractor classification under the Fair Labor Standards Act (FLSA). Scheduled for approval on May 6th, the proposed rule is meant to prevent worker exploitation and employee misclassification and ensure that those who should be classified as direct employees are not wrongly designated as independent contractors.
The DOL has stated that:
“The Department acknowledges that the proposed regulation could lead to some reclassification of workers — from independent contractors to employees. However, the Department does not believe that such reclassification would be significant or widespread.”
While its potential effects may be downplayed, this new regulation could have a significant impact on the future of the industry — especially for independent financial advisors, who make up roughly 64% of all registered representatives, or brokers and advisors who work for broker-dealers.
The Proposed DOL Employment Rule
In October 2022, the DOL issued a notice of its proposed employment rule. The proposal indicates that its aim is to simplify and clarify the classification of workers as either employees or independent contractors and thereby provide greater certainty for employers and workers alike.
According to the DOL proposed employment rule, a contractor is an individual who “pursues a profession or business as an independent contractor and includes individuals who have a principal place of business that is their residence, or who travel to various job sites for their work.” The rule goes on to clarify that “a worker who is classified as an independent contractor is generally considered to be in business for themselves and is not an employee under the FLSA.” However, the rule also establishes new criteria that must be met in order to properly classify a worker as an independent contractor, which could impact the classification of workers in certain industries.
Under the proposed rule, workers would be classified as employees when they are economically dependent on an employer, rather than being in business for themselves. An “economic realities” test would be used to determine whether a worker is an employee or an independent contractor.
The test considers five factors:
- the nature and degree of the worker’s control over the work;
- the worker’s opportunity for profit or loss;
- the amount of skill required for the work;
- the degree of permanence of the working relationship; and
- whether the work is part of an integrated unit of production.
A January 2021 Independent Contractor Status Under the Fair Labor Standards Act rule (2021 IC Rule) was published by the DOL. That rule indicated that the first two factors listed above be designated as “core factors.” It asserts that they are the most probative of the five factors, and they carry greater weight in analyzing the economic reality. In other words, if those two factors are both indicative of the same classification — of either employee or independent contractor — it is very likely that that classification is accurate for the individual in question. It is very unlikely that factors three through five could outweigh factors one and two in such cases.
However, the 2021 rule met with some opposition, and the DOL later determined that it did not fully comport with the FLSA’s text and purpose, as interpreted by courts, and it was inconsistent with decades of case law pertaining to the economic reality test. Specifically, the fact that two factors carry more weight in the analysis, the narrow considerations pertaining to the opportunity for profit or loss, and the criterium of the work being part of an integrated unit of production, rather than it being central or important to the employer’s business narrow the test by limiting the facts that it may consider. The DOL believes that those facts are important, despite the adoption of the 2021 IC Rule, so it is unclear which version of the economic reality test will prove to be adopted by the courts.
Financial Services Institute (FSI) Study (2022)
A recent study by the Financial Services Institute (FSI) detailed several alarming potential repercussions of the October 11th Department of Labor employment rule proposing to curb abuses of independent contractors. The consequences could include a potential mass exodus of advisors leaving larger brokerages, in favor of self-owning or joining existing RIAs, with only 11% opting for direct employment at large brokerage firms. This is troubling, considering that the industry is already facing a shortage of advisors. At the same time, 58% of those who participated said that they would start their own registered investment advisor (RIA) or join an existing RIA, instead of becoming an employee of a broker-dealer.
The Impact On Independent Financial Advisors
The DOL’s preferred version of the economic reality test places greater emphasis on factors, such as the degree of control that the employer has over the worker, the level of skill required for the work, and the permanence of the working relationship. As a result, the proposed DOL employment rule would lead to many independent advisors being reclassified as employees, rather than as independent contractors, and it could significantly impact the way that independent advisors operate — potentially limiting their flexibility and increasing their costs. The proposed DOL employment rule would require companies that employ independent contractors who have been reclassified as employees to provide those now-employees with benefits and other perks that are usually associated with full-time employees — such as health insurance, paid vacation time, and sick leave. Doing so would significantly increase the costs incurred by financial-services firms and make it much more difficult for them to operate in their current form. As independent broker-dealers currently operate on very thin margins, this rule could even put some smaller broker-dealers out of business.
For employers, the rule would necessitate withholding Social Security and Medicare payroll for every direct employee, and the cost of this additional recordkeeping would most likely be passed on to clients.
For advisors, the rule could raise ownership concerns over books of business — arguably advisors’ most prized asset and one that they have spent years constructing and maintaining.
The report detailing the FSI study’s findings highlights the importance of independent status for financial advisors and their clients. Financial advisors benefit from their status as independent contractors in several ways — advisors who are independent contractors are able to manage their own businesses, they can set their own hours, they are able to offer preferred products and services, and can thereby maintain a healthy work-life balance.
Independent contractors often appreciate the amount of control that they have over their work. For many, this means taking ownership of their firm, providing more customized solutions to their clients, creating flexible schedules that fit with their other commitments, and curating a client base according to their own, personal preferences or goals. Further, under the existing model, advisors are able to retain more of the fees they earn.
Pride of ownership often plays a major role in an independent advisor’s career, and a book of business may take years to cultivate. When advisors decide to move on from their affiliated broker-dealers, they should be able to take their books with them. However, advisors may not be able to do so if the proposed DOL employment rule counters that possibility and leaves some without contractual protection over their assets.
The proposed DOL employment rule could also lead to a significant number of retirements in the financial services industry. According to the FSI survey, 19% of independent advisors would prefer retirement over becoming direct employees. Moreover, a report by Cerulli Associates projects that 40% of current financial advisors will retire in the next ten years. With one-fifth of all advisors potentially retiring due to the proposed DOL employment rule, it could mark a huge shift for the financial services industry.
Thus in addition to increasing costs and limiting the ability of advisors to work as independent contractors, this proposed rule could also have an adverse effect on customer service. With fewer advisors on hand due to cost concerns, there would be less personal attention available to clients — meaning that they may not get the same level of service that they have grown accustomed to receiving from their trusted advisor.
Another consequence of the proposed rule is that financial advisors and firms will have to make greater investments when it comes to maintaining compliance. According to the survey, 24% of respondents believe that they would require external legal advice or investment in stronger compliance technology if the rule is adopted. This increased need for compliance is likely to cost firms more money, as they will be required to dedicate more resources toward ensuring that they are following all applicable regulations. This can create additional pressure on already-tight budgets and force firm management to make difficult decisions about where the firm allocates its resources. Among the surveyed firms, almost half of them predicted an expected expenditure on such services, averaging $20K for advisors and up to $100K for larger organizations.
As financial advisors adjust to the new requirements under the proposed DOL employment rule, they may also need additional training on the new regulations and best practices for compliance. This can result in increased costs for firms, as well. The firms would now be required to allocate time and money toward training their existing staff members, in addition to any new hires who may join them, in order to make sure that everyone understands how to comply with the new rules.
Starting An RIA Or Joining An Existing Firm
According to the Investment Advisor Industry Snapshot 2022, independent RIAs are now the wealth management sector’s fastest-growing segment, with assets under management reaching a record high of $128 trillion in 2021. If you’re an advisor, and you’re seeking to maximize your income, increase the value of your practice, and gain greater flexibility, making a strategic leap into an RIA structure may be a wise and prudent move for you. But before you make the leap, it’s important to be aware of the fact that starting an SEC or state-registered RIA firm is a complex process that requires careful planning and attention to detail.
Starting an RIA involves more than just filling out a few forms — it requires understanding regulatory requirements along with all of the associated costs of running a business (e.g., filing fees, software costs, etc.). Beyond filing paperwork with the SEC or a state securities regulator, advisors must understand their fiduciary obligation to their clients and how they can protect themselves from liability.
They must also:
- decide which type of entity they will form (e.g., LLC, LLP, etc.);
- consider licensing requirements in multiple states, as necessary;
- create policies and procedures manuals outlining internal procedures for compliance standards and client-service commitments;
- develop marketing materials, such as brochures and website content, to attract new clients and prospects — and the list goes on.
Additionally, advisors need to be mindful of any upcoming changes in the industry that could affect their practices.
Let AdvisorLaw handle your next move.
AdvisorLaw can offer peace of mind throughout all of the stages of your transition process. If the DOL’s latest rule has left you with no choice other than to ditch your FINRA registration and join the RIA sector, our legal team can provide you with the appropriate counsel to guide you through your exit — whether you’re with a broker-protocol participant or a non-protocol firm. We have a proven track record of successfully transitioning financial advisors out of FINRA’s jurisdiction and into their own businesses or an existing RIA.
If you are interested in starting your own RIA, AdvisorLaw makes it simple. We offer tailored registration packages that are designed for efficient onboarding, as well as ongoing compliance support from legal professionals and Certified Securities Compliance Professionals (CSCPs). Not only do our services include setting up your RIA firm from start to finish, but our experienced attorneys also help to guide you through every step along the way — from business-planning consultation, through post-launch support. The services that we provide allow you to focus on growing your business, instead of worrying about regulatory requirements. We take pride in providing comprehensive legal services tailored specifically to independent RIAs so that they can reach their goals without compromising their compliance or quality-assurance standards.
If retirement is on the horizon, let AdvisorLaw’s M&A team handle your succession. AdvisorLaw provides all of the assistance and services required to assist you in formalizing a strategy that serves both your interests and the interests of your clients. We are a one-stop shop that offers complimentary business valuations, partner and successor sourcing, contract drafting, and more.
If you’re worried about how the Proposed DOL employment rule will affect you and your business, reach out to AdvisorLaw’s team today to discuss your options and how we can help you strategically plan your transition. While the proposed rule is currently in the public comment period, and it remains to be seen how it will ultimately be implemented, taking proactive steps today will help to protect your business in the future.
Contact us today for a complimentary consultation!
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