Any relationship that embraces some duty of care or trust has the potential for a conflict of interest. FINRA pointed out in “Report on Conflicts of Interest” that this naturally gives rise to widespread conflicts in the financial services industry.
“While many firms have made progress in improving the way they manage conflicts, our review reveals that firms should do more,” said Richard Ketchum, chairman and chief executive of FINRA.
The report details examples of how some large broker/dealers address conflicts. Firms can study these examples to analyze their own conflicts, and implement a conflicts management framework that is right for the size and scope of their business.
Effective practices—observed at firms by FINRA or which the regulator believes could help firms improve conflicts management practices—are outlined. The report also contains some general observations and commentary on firm practices.
FINRA said its objective is to focus on firms’ approaches to identifying and managing conflicts in three critical areas:
Enterprise-level frameworks to identify and manage conflicts of interest;
Approaches to handling conflicts of interest in manufacturing and distributing new financial products; and
Approaches to compensating their associated persons, particularly those acting as brokers for private clients.
The enterprise-level framework discussion examines how firms address conflicts across their business lines from a top-down perspective. The new product and new business discussion explores how firms address conflicts related to the introduction of new products and services. Together, these areas play critical “gatekeeper” roles. Specifically, if firms are effective with enterprise-level frameworks and handling conflicts with new products, they can be proactive in identifying and managing conflicts. The focus on compensation provides insight on financial incentive structures that may create, magnify or mitigate conflicts of interest.
Conflict in New Products?
The second focus is the introduction of financial products. 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.
A number of effective practices can address such conflicts. First, firms can use a new product review process that includes a mandate to identify and mitigate conflicts that a product may present.
Firms should disclose conflicts in plain English, to help ensure that customers understand the conflicts that a firm or registered representative may have in recommending a product. These conflicts may be particularly acute where complex financial products are sold to less knowledgeable investors, including retail investors.
Product manufacturing firms can implement effective Know-Your-Distributor (KYD) policies and procedures. These 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.
Compensation is the final focus. 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 representatives’ sales activities.
The use of “product agnostic” compensation grids (also referred to as “neutral grids”) can be effective in reducing incentives for registered representatives to prefer one type of product (e.g., equities, bonds, mutual funds, variable annuities) over another. These grids typically pay a flat percentage of the revenue a registered representative generates, regardless of product recommended. FINRA notes, however, that while this eliminates one variable that may influence recommendations, registered representatives still have an incentive to favor products with higher commissions because these produce larger payouts. Consequently, to reduce conflicts, firms should take measures to mitigate biases that differences in compensation by product may create.
Firms can also link surveillance of registered representatives’ recommendations to thresholds in a firm’s compensation structure to detect recommendations, or potential churning practices, that may be motivated by a desire to move up in the compensation structure and, thereby, receive a higher payout percentage.
Enhancing supervision and surveillance of a registered representative’s recommendations as that person approaches other significant compensation or recognition milestones is a related effective practice. A number of firms perform specialized supervision and surveillance of recommendations as a registered representative approaches the end of the period over which performance is measured for receiving a back-end bonus. In addition, some firms perform additional surveillance to assess the suitability of recommendations as a registered representative approaches the threshold necessary for admission to a firm recognition club (e.g., a President’s Club).
While there is no one-size-fits-all framework, the practices can help firms of all sizes improve their conflicts management practices, FINRA said in its report.
In the report’s summary, FINRA said it would continue to review how firms manage conflicts and evaluate the effectiveness of firms' efforts. The regulator also said that if it finds firms have not made adequate progress, it would “evaluate rulemaking to require reasonable policies to identify, manage and mitigate conflicts.”
FINRA’s “Report on Conflicts of Interest” can be downloaded here.