LPL Financial (LPLA) 10-Q2021 Q2 Quarterly report

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We may use our website as a means of disclosing material information and for complying with our disclosure obligations under Regulation Fair Disclosure promulgated by the SEC. These disclosures are included on our website in the “Investor Relations” or “Press Releases” sections. Accordingly, investors should monitor these portions of our website, in addition to following the Company’s press releases, SEC filings, public conference calls and webcasts.

LPL is a leader in the markets we serve, supporting more than 19,000 financial advisors, and approximately 800 institution-based investment programs and 450 registered investment adviser (“RIA”) firms nationwide. We are steadfast in our commitment to the advisor-centered model and the belief that Americans deserve access to objective guidance from a financial advisor. At LPL, independence means that advisors have the freedom they deserve to choose the business model, services, and technology resources that allow them to run their perfect practice. And they have the freedom to manage their client relationships, because they know their clients best. Our mission is to take care of our advisors, so they can take care of their clients.

Under our self-clearing platform, we custody the majority of client assets invested in these financial products, for which we provide statements, transaction processing and ongoing account management. In return for these services, mutual funds, insurance companies, banks and other financial product sponsors pay us fees based on asset levels or number of accounts managed. We also earn interest from margin loans made to our advisors’ clients.

We regularly review various aspects of our operations and service offerings, including our policies, procedures and platforms, in response to marketplace developments. We seek to continuously improve and enhance aspects of our operations and service offerings in order to position our advisors for long-term growth and to align with competitive and regulatory developments. For example, we regularly review the structure and fees of our products and services, including related disclosures, in the context of the changing regulatory environment and competitive landscape for advisory and brokerage accounts.

As a regulated entity, we are subject to regulatory oversight and inquiries related to, among other items, our compliance and supervisory systems and procedures and other controls, as well as our disclosures, supervision and reporting. We review these items in the ordinary course of business in our effort to adhere to legal and regulatory requirements applicable to our operations. Nevertheless, additional regulation and enhanced regulatory enforcement has resulted, and may result in the future, in additional operational and compliance costs, as well as increased costs in the form of penalties and fines, investigatory and settlement costs, customer restitution and remediation related to regulatory matters. In the ordinary course of business, we periodically identify or become aware of purported inadequacies, deficiencies and other issues. It is our policy to evaluate these matters for potential legal or regulatory violations, and other potential compliance issues. It is also our policy to self-report known violations and issues as required by applicable law and regulation. When deemed probable that matters may result in financial losses, we accrue for those losses based on an estimate of possible fines, customer restitution and losses related to the repurchase of sold securities and other losses, as applicable. Certain regulatory and other legal claims and losses may be covered through our wholly-owned captive insurance subsidiary, which is chartered with the insurance commissioner in the state of Tennessee.

Assessing the probability of a loss occurring and the timing and amount of any loss related to a regulatory matter or legal proceeding, whether or not covered by our captive insurance subsidiary, is inherently difficult and requires judgments based on a variety of factors and assumptions. There are particular uncertainties and complexities involved when assessing the adequacy of loss reserves for potential liabilities that are self-insured by our captive insurance subsidiary, which depends in part on historical claims experience, including the actual timing and costs of resolving matters that begin in one policy period and are resolved in a subsequent period.

Our accruals, including those established through our captive insurance subsidiary at June 30, 2021, include estimated costs for significant regulatory matters or legal proceedings, generally relating to the adequacy of our compliance and supervisory systems and procedures and other controls, for which we believe losses are both probable and reasonably estimable.

In June 2018, the U.S. Court of Appeals for the Fifth Circuit invalidated regulations previously enacted by the U.S. Department of Labor (“DOL”) that expanded the definition of “fiduciary” and would have resulted in significant new prohibited transaction exemption requirements for our servicing of certain retirement plan accounts subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and individual retirement accounts (“IRAs”). In December 2020, the DOL finalized a new investment advice fiduciary prohibited transaction exemption with regard to such accounts that became effective on February 16, 2021 (the “DOL Investment Advice Fiduciary Exemption”). ERISA plans and IRAs comprise a significant portion of our business and we continue to expect that compliance with current and future laws and regulations with respect to retail retirement savings and reliance on prohibited transaction exemptions under such laws and regulations will require increased legal, compliance, information technology and other costs and could lead to a greater risk of class action lawsuits and other litigation.

Future laws and regulations, including the new rule proposed by the DOL and state rules relating to the standards of conduct applicable to both retirement and non-retirement accounts, may affect our business in ways that cannot be anticipated or planned for, and may have negative impacts on our products, services and results of operations.

Our business is directly and indirectly sensitive to several macroeconomic factors and the state of the United States financial markets. According to the most recent estimate of the U.S. Bureau of Economic Analysis, the U.S. economy grew at an annualized pace of 6.4% in the first quarter of 2021. Data received during the second quarter of 2021 suggests that growth has likely accelerated further. The unemployment rate, which had increased to 14.8% in April 2020 according to Federal Reserve economic data, decreased to 5.9% in June 2021 as labor markets continued to improve. Consumer spending has picked up, supported by rising incomes, high savings levels and economic reopening. Business investment has also continued to rebound and readings on service sector activity remained elevated. Manufacturing continued to grow but is facing constraints from supply chain bottlenecks. Financial conditions overall eased over the second quarter of 2021. The Federal Reserve’s (“Fed”) most recent median projection of gross domestic product growth for 2021, released following its June 15-16, 2021 policy meeting, saw the economy expanding 7.0% in 2021, an upgrade from a median projection of 6.5% three months earlier.

Looking at markets, the S&P 500 Index gained 8.5% during the second quarter, its fifth consecutive quarter of gains, with investors rotating back to technology-heavy growth stocks. Non-U.S. stocks trailed their U.S. counterparts during the quarter with international developed market equities returning 5.4% while emerging markets returned 5.1%, based on the MSCI EAFE and MSCI Emerging Market Indexes respectively. Most fixed income sectors saw gains as interest rates fell and credit spreads narrowed. The 10-year Treasury yield declined from 1.74% at the end of the first quarter of 2021 to 1.45% at the end of the second quarter of 2021. Falling yields helped lift the broad Bloomberg Barclays U.S. Aggregate Bond Index to a 1.8% gain over the second quarter following first quarter losses.

Our business is also sensitive to current and expected short-term interest rates, which are largely driven by Fed policy. During the second quarter of 2021, Fed policymakers maintained the target range for the federal funds rate at 0 to 0.25 percent. According to projection materials released following the conclusion of the June 15-16 policy meeting, the median expectation among meeting participants was that the Fed would begin to raise rates in 2023, a shift from the previous projections, which had seen a later increase. The Fed continues to emphasize its belief that any near-term increase in inflation is likely temporary, although upside risks have increased, and that it would allow realized inflation to persist moderately above its 2.0% target for a meaningful period of time before it would raise interest rates.

Advisory revenues primarily represent fees charged to clients of our advisors for the use of our corporate RIA advisory platform, and are based on the value of their advisory assets. Advisory fees are billed to clients in advance, on a quarterly basis, and are recognized as revenue ratably during the quarter. The majority of our client accounts are on a calendar quarter and are billed using values as of the last business day of the preceding quarter. The value of the assets in an advisory account on the billing date determines the amount billed, and accordingly, the revenues earned in the following three-month period. Advisory revenues collected on our corporate advisory platform are proposed by the advisor and agreed to by the client and averaged 1.0% of the underlying assets for the six months ended June 30, 2021.

We also support separate investment adviser firms (“Hybrid RIAs”) through our hybrid advisory platform, which allows advisors to engage us for technology, clearing and custody services, as well as access to the capabilities of our investment platforms. The assets held under a Hybrid RIA’s investment advisory accounts custodied with LPL Financial are included in total advisory assets and net new advisory assets. The advisory revenue generated by a Hybrid RIA is not included in our advisory revenues. We charge separate fees to Hybrid RIAs for technology, clearing, administrative, oversight and custody services, which are included in our transaction and fee revenues in our unaudited condensed consolidated statements of income. The fees collected on our hybrid advisory platform vary and can reach a maximum of 0.2% of the underlying assets as of June 30, 2021.

Net new advisory assets are generated throughout the quarter, therefore, the full impact of net new advisory assets to advisory revenues is not realized in the same period. The following table summarizes activity impacting advisory assets for the periods presented (in billions):

The growth in advisory revenues for the three and six months ended June 30, 2021 compared to 2020 was due to increases in net new advisory assets resulting from acquisitions, recruiting efforts and strong advisor productivity, as well as market gains as represented by higher levels of the S&P 500 Index.

The increase in sales-based commission revenues for the three and six months ended June 30, 2021 compared to 2020 was primarily driven by increases in sales of annuities, mutual funds and fixed income products. The increase in trailing commission revenues for the three and six months ended June 30, 2021 compared to 2020 was primarily due to the increase in value of annuities and mutual funds as a result of market increases.

Asset-based revenues for the three and six months ended June 30, 2021 increased compared to 2020 primarily due to increased revenues from recordkeeping and sponsorship programs, partially offset by a decrease in client cash revenues.

Revenues for our recordkeeping and sponsorship programs for the three and six months ended June 30, 2021, which are largely based on the market value of the underlying assets, increased compared to 2020 due to the impact of market appreciation on the value of the underlying assets.

Client cash revenues for the three and six months ended June 30, 2021 decreased compared to 2020 due to the impact of a lower federal funds effective rate, partially offset by higher average client cash balances. For the three months ended June 30, 2021, our average client cash balances increased to $48.0 billion compared to $46.1 billion in 2020. For the six months ended June 30, 2021, our average client cash balances increased to $48.2 billion compared to $42.3 billion in 2020.

Transaction revenues primarily include fees we charge to our advisors and their clients for executing certain transactions in brokerage and fee-based advisory accounts. Fee revenues primarily include IRA custodian fees, contract and licensing fees and other client account fees. In addition, we host certain advisor conferences that serve as training, education, sales and marketing events, for which we charge a fee for attendance. Transaction and fee revenues for the three and six months ended June 30, 2021 increased compared to 2020 primarily due to an increase in IRA custodian fee and technology fee revenues.

We earn interest income from client margin loans, advisor loans, cash segregated under federal and other regulations and cash equivalents. Period-over-period variances correspond to changes in the average balances of margin loans and cash balances as well as changes in interest rates.

Advisory and commission expenses consist of the following: payout amounts that are earned by and paid out to advisors and institutions based on advisory and commission revenues earned on each client’s account; production based bonuses earned by advisors and institutions based on the levels of advisory and commission revenues they produce; the recognition of share-based compensation expense from equity awards granted to advisors and financial institutions based on the fair value of the awards at grant date; and the deferred advisory and commissions fee expenses associated with mark-to-market gains or losses on the non-qualified deferred compensation plan offered to our advisors.

The following table sets forth our payout rate, which is a statistical or operating measure:

Our payout rate for the three and six months ended June 30, 2021 increased compared to 2020 primarily due to higher production bonus payouts and changes in product mix.

Non-operating interest expense and other includes expenses from our senior secured credit facilities, senior unsecured notes, finance leases and other non-operating expenses. Non-operating interest expense and other for the three and six months ended June 30, 2021 decreased compared to 2020, primarily due to a lower outstanding principal balance on our senior secured term loan and lower interest rates on our senior unsecured notes.

On March 15, 2021, we increased our borrowing capacity under and extended the maturity date of our existing senior revolving credit facility, issued senior unsecured notes due in 2029 and redeemed our existing senior unsecured notes due in 2025. In connection with these transactions, we incurred a $24.4 million loss on extinguishment of debt.

We estimate our full-year effective income tax rate at the end of each reporting period. This estimate is used in providing for income taxes on a year-to-date basis and may change in subsequent interim periods. The tax rate in any quarter can be affected positively or negatively by adjustments that are required to be reported in the quarter in which resolution of a particular item occurs. The effective income tax rates reflect the impact of state taxes, settlement contingencies, tax credits and other permanent differences in tax deductibility of certain expenses.

We have established liquidity and capital policies intended to support the execution of strategic initiatives, while meeting regulatory capital requirements and maintaining ongoing and sufficient liquidity. We believe liquidity is of critical importance to the Company and, in particular, to LPL Financial, our primary broker-dealer subsidiary. The objective of our policies is to ensure that we can meet our strategic, operational and regulatory liquidity and capital requirements under both normal operating conditions and under periods of stress in the financial markets.

Our liquidity needs are primarily driven by capital requirements at LPL Financial, interest due on our corporate debt and other capital returns to shareholders. Our liquidity needs at LPL Financial are driven primarily by the level and volatility of our client activity. Management maintains a set of liquidity sources and monitors certain business trends and market metrics closely in an effort to ensure we have sufficient liquidity. We believe that based on current levels of cash flows from operations and anticipated growth, together with available external liquidity sources, we have adequate liquidity to satisfy our working capital needs, the payment of all of our obligations and the funding of anticipated capital expenditures for the foreseeable future.

LPL Financial relies primarily on customer payables to provide liquidity and to fund margin lending. LPL Financial maintains additional liquidity through external lines of credit totaling approximately $575.0 million. LPL Financial also maintains a line of credit with the Parent.

The following table presents our external lines of credit at June 30, 2021 (in millions):

The Company seeks to manage capital levels in support of our business strategy of generating and effectively deploying capital for the benefit of our shareholders.

Our primary requirement for working capital relates to funds we loan to our advisors’ clients for trading conducted on margin and funds we are required to maintain for regulatory capital and reserves based on the requirements of our regulators and clearing organizations, which also consider client balances and trading activities. We have several sources of funds that enable us to meet increases in working capital requirements that relate to increases in client margin activities and balances. These sources include cash and cash equivalents on hand, cash segregated under federal and other regulations, the committed revolving credit facility of LPL Financial and proceeds from repledging or selling client securities in margin accounts. When an advisor’s client purchases securities on margin or uses securities as collateral to borrow from us on margin, we are permitted, pursuant to the applicable securities industry regulations, to repledge, loan or sell securities, up to 140% of the client’s margin loan balance, that collateralize those margin accounts.

Our other working capital needs are primarily related to loans we are making to advisors and timing associated with receivables and payables, which we have satisfied in the past from internally generated cash flows.

We may sometimes be required to fund timing differences arising from the delayed receipt of client funds associated with the settlement of client transactions in securities markets. These timing differences are funded either with internally generated cash flows or, if needed, with funds drawn on our uncommitted lines of credit at LPL Financial or one of our revolving credit facilities.

LPL Financial’s ability to pay dividends greater than 10% of its excess net capital during any 35-day rolling period requires approval from the Financial Industry Regulatory Authority (“FINRA”). In addition, payment of dividends is restricted if LPL Financial’s net capital would be less than 5% of aggregate customer debit balances.

LPL Financial also acts as an introducing broker for commodities and futures. Accordingly, its trading activities are subject to the National Futures Association’s (“NFA”) financial requirements and it is required to maintain net capital that is in excess of or equal to the greatest of NFA’s minimum financial requirements. The NFA was designated by the Commodity Futures Trading Commission as LPL Financial’s primary regulator for such activities. Currently, the highest NFA requirement is the minimum net capital calculated and required pursuant to the SEC’s Net Capital Rule.

In April 2021, the Company acquired a broker-dealer as part of the Waddell & Reed acquisition (“Waddell & Reed broker-dealer”). The Waddell & Reed broker-dealer is required to maintain net capital of $250,000, which represents

the greater of 2% of its aggregate debits or the minimum net capital requirement of $250,000. At June 30, 2021, the Waddell & Reed broker-dealer had net capital of $21.6 million. The Company expects to dissolve the Waddell & Reed broker-dealer during the fourth quarter of 2021.

Our subsidiary, PTC, is also subject to various regulatory capital requirements. Failure to meet the respective minimum capital requirements can result in certain mandatory and discretionary actions by regulators that, if undertaken, could have substantial monetary and non-monetary impacts on PTC’s operations.

Our Credit Agreement and the Indentures allow us to pay dividends and distributions or repurchase our capital stock only when certain conditions are met. In addition, our revolving credit facility requires us to be in compliance with certain financial covenants as of the last day of each fiscal quarter. The financial covenants require the calculation of Credit Agreement EBITDA, as defined in, and calculated by management in accordance with, the Credit Agreement. The Credit Agreement defines Credit Agreement EBITDA as “Consolidated EBITDA,” which is Consolidated Net Income (as defined in the Credit Agreement) plus interest expense, tax expense, depreciation and amortization, and further adjusted to exclude certain non-cash charges and other adjustments (including unusual or non-recurring charges) and gains, and to include future expected cost savings, operating expense reductions or other synergies from certain transactions.