Facing a barrage of customer lawsuits and with capital reserves significantly weakened by market turmoil, many independent broker-dealers are struggling under increased scrutiny from regulatory agencies while facing higher compliance and insurance costs. Some are choosing to throw in the towel.

AFA Financial Group shut its doors in May, amid reports that the small independent had fallen behind on its errors and omissions (E&O) insurance payments. The shortfall was due to claims from a series of investor lawsuits related to the sale of a private placement. In late March, FINRA shut down GunnAllen Financial after it failed to meet net capital requirements and as the number of claims against the firm rose, following a $50 million series of lawsuits related to investments sold by its brokers.

The two failures have many in the industry wondering whether other smaller firms are teetering on the brink. While that remains to be seen, it's clear that as regulations tighten, smaller firms may face increased pressure to police their reps. At the same time, industry consolidation will ensure that hiring and keeping reps becomes more challenging.

TOO BIG, TOO FAST

The winding down of GunnAllen, founded in 1996, is a bleak lesson in the folly of growth by any means. The Tampa, Fla.-based B-D had been expanding quickly for some years, but had a troubled track record. It repeatedly ran afoul of FINRA for a variety of deficiencies-including problems with complaint reporting, recordkeeping, supervision and the failure to implement an adequate anti-money laundering compliance program.

"What appears to have happened to GunnAllen was a function of timing," says Tim Murphy, CEO of Investors Capital. "They had a significant number of customer complaints that happened when the market was declining, and the firm's future became uncertain. So reps were leaving, which further destabilized them. FINRA audited them and concluded that the firm needed additional capital to continue to operate. When that did not happen, they [FINRA]stepped in to wind the firm down in a systematic way, before it fully imploded."

"GunnAllen was a fast-growing firm and when you grow quickly, you have to be in control of your due diligence and your processes," says Lon Dolber, CEO of American Portfolios, an independent broker-dealer in Holbrook, N.Y. He speculates that GunnAllen didn't get its arms around its systems quickly enough, and the market did not help. "And then there was that rogue broker," he says, referring to GunnAllen broker Frank Bluestein, whom the SEC charged with soliciting 800 investors to sink $74 million into a Ponzi scheme in 2007.

ROGUE BROKERS

During its years of fast growth, GunnAllen recruited aggressively and, along the way, it gained a reputation for bringing on advisors with spotty compliance records. The continuous pressure to expand may have contributed to the slackening of standards, allowing the firm to venture into riskier products.

"When you're recruiting reps, maybe three out of 10 will want to do plain-vanilla products, and the other seven will want to do alternative investments that you've never heard of. FINRA always says don't do products that you can't understand and can't properly oversee," says Dolber, adding that other small firms could fall prey to the same pressures. "My biggest fear is that there is some broker in our company doing something I don't know about. You have your systems in place, but how do you really know that money is not going into some nefarious deal?"

Other industry figures are even more blunt. "Some of those small broker-dealers have the reputation of being bucket shops. That's what GunnAllen's reputation was-and now they're out of business," says Danny Sarch, founder of Leitner Sarch Consultants, a recruiting firm in White Plains, N.Y.

Since the firm closed, many of GunnAllen's remaining 400 reps and advisors have been left scrambling to find new homes. The firm's founders are reportedly moving to rival JP Turner, while at least 16 advisors (with $240 million in assets) are joining JHS Capital Partners, the firm founded by former owner John Sykes late last year, following his abrupt resignation. Meanwhile, GunnAllen's company website currently reads, "We are currently working toward an orderly shutdown of the company and expect to cease operations."

In contrast, the most recent B-D casualty, AFA Financial, was a smaller, lesser-known firm. Based in Calabasas, Calif., the firm was founded in 1975 and had 100 advisors. Like GunnAllen, the company was also hit with multiple customer lawsuits after the SEC charged it with selling a private placement that also turned out to be a Ponzi scheme. As a result, it was unable to keep up with its E&O insurance payments. In the end, AFA shut itself down.