FINRA Warns BDs to Better Manage Conflicts of Interest

New report tells BDs to use fiduciary-like methods to handle conflicts or FINRA may make a new disclosure rule

More On Legal & Compliance

from The Advisor's Professional Library
  • Proxy Voting RIAs are not required to vote proxies on behalf of their clients. However, when an RIA does assume responsibility for voting proxies, the firm’s policies and procedures should help to ensure that votes are cast in the best interest of clients.
  • Do’s and Don’ts of Advisory Contracts In preparation for a compliance exam, securities regulators typically will ask to see copies of an RIAs advisory agreements. An RIA must be able to produce requested contracts and the contracts must comply with applicable SEC or state rules.

The Financial Industry Regulatory Authority is warning broker-dealers in a new report that if they fail to implement fiduciary-like methods to better manage their conflicts of interest, a new disclosure rule may be in the offing.

FINRA developed its conflicts report after a year of gathering firms’ responses as part of the self-regulator’s conflicts initiative, which it launched last July.

The report notes conflicts of interest among BDs have improved, but points to three “critical” areas where BDs still need to make headway: firmwide frameworks, new products and compensation practices.

FINRA notes in its report that while areas of conflict have been addressed via rulemaking, oversight and enforcement action by both FINRA and the Securities and Exchange Commission, the report “carries those efforts forward” but does not create any new legal requirements or change any existing regulations.

However, FINRA noted in releasing the report that “FINRA will continue to review how firms manage conflicts and evaluate the effectiveness of firms’ efforts. If we find that firms have not made adequate progress, we will evaluate rulemaking to require reasonable policies to identify, manage and mitigate conflicts.”

Indeed, industry officials speculated that the report could well serve as the basis for a number of rules or changes or replacements to existing rules. After all, Ketchum warned at FINRA’s annual conference in May that if the SEC failed to “act quickly” to finalize a rule to put brokers under a fiduciary mandate, that FINRA would “look hard” at issuing “an additional disclosure rule with respect to broker-dealer firms.”

Jon Henschen of the BD recruiting firm Henschen & Associates says the recommendations in FINRA’s conflicts of interest report “paint a picture of fiduciary without coming out and saying it.”

Henschen notes that while BDs "have come a long way in transparency, there remain numerous areas that are opaque or hidden from not only clients but representatives as well." 

For instance, he says that "firms with proprietary products can no longer require reps to sell their products, but they can indirectly sway them to proprietary products through restriction of wholesalers of competing products from initiating contact, as well as restricting competing products from having a presence at conferences or on the firm website." He adds that "proprietary advisory platforms, which can be a major profit center for broker-dealers, can also get center light while third-party money managers are marginalized or hidden from view."

The report lays out the steps BDs should take to better manage conflicts in these three critical areas:

Implementing an articulated, firmwide framework

One effective practice is for firms to implement an articulated, firmwide framework to manage conflicts of interest, and FINRA observed a number of firms that implemented many facets of such a framework.

The key to making such a framework effective begins with the tone from the top. To be effective, firm leadership should require not only adherence to the letter of the law, but a commitment to the highest ethical standards and to putting customers’ interests first. Of course, reliance on the tone from the top to address conflicts of interest is insufficient by itself.

As appropriate to the scale and complexity of a firm’s business, elements of an effective practice framework for managing conflicts of interest include:

  • Defining conflicts of interest in a way that is relevant to a firm’s business and which helps staff identify conflict situations.
  • Articulating employees’ roles and responsibilities with respect to identifying and managing conflicts.
  • Establishing mechanisms to identify conflicts in a firm’s business as it evolves.

Managing New Product Conflicts

Firms at the forefront of financial innovation are in the best position, and are uniquely obligated, to identify the conflicts of interest that may exist at a product’s inception or that develop over time.

Effective practices firms can adopt to address such conflicts include:

  • Use a new product review process — typically through new product review committees — that includes a mandate to identify and mitigate conflicts that a product may present.
  • Disclose those conflicts in plain English, with the objective of helping ensure that customers comprehend the conflicts that a firm or registered rep have in recommending a product.
  • Product manufacturing firms can implement effective Know-Your-Distributor (KYD) policies and procedures. These KYD measures help mitigate the incentive to increase revenue from product sales by using distribution channels that may not have adequate controls to protect customers’ interests.
  • Firms can perform post-launch reviews of new products to identify potential problems with a product that may not have been readily apparent during the initial review—or that may have arisen as a result of economic events — and take remedial action.
  • Firms can carefully evaluate and decline to offer products to customers when the conflicts associated with those products are too significant to be mitigated effectively.

Compensation Practices

Although the primary focus is on brokerage compensation (and related supervisory and surveillance systems), the report also addresses the application of tools to mitigate conflicts of interest in compensation for associated persons more generally. Many firms have considered and taken steps to mitigate these conflicts directly through changes to compensation arrangements and through supervision of registered reps’ sales activities.

The report highlights the following ways to mitigate conflicts in reps’ sales activities:

  • Use of “product agnostic” compensation grids (also referred to as “neutral grids”) can be an effective practice to reduce incentives for registered reps to prefer one type of product (e.g., equities, bonds, mutual funds, variable annuities) over another.
  • Enhance supervision and surveillance of a registered rep’s recommendations as that person approaches other significant compensation or recognition milestones is a related effective practice.
  • Firms should link surveillance of registered reps’ recommendations to thresholds in a firm’s compensation structure to detect recommendations, or potential churning practices.
  • Enhance supervision and surveillance of a registered rep’s recommendations as that person approaches other significant compensation or recognition milestones is a related effective practice.
  • Enhance supervision and surveillance of a rep’s recommendations around key liquidity events in an investor’s life cycle, such as the point where an investor rolls over her 401(k).
  • Reduce the incentive for a registered rep to prefer one mutual fund or variable annuity family over another by capping the credit a rep may receive for a comparable product across providers.

---

Check out these related stories on ThinkAdvisor:

 

Page 1 of 3
Single page view Reprints Discuss this story
This is where the comments go.