The past several years have been a bit of a rollercoaster for potential changes to the regulatory landscape for advisors. In the aftermath of the financial crisis, there was discussion of imposing a fiduciary duty on financial advisors as a part of the Dodd-Frank legislation, though it was ultimately scaled back to just a study on the issue under Section 913. Given that the study confirmed there was widespread confusion on the issue of standards for advisors, the Dodd-Frank legislation also authorized the SEC to promulgate new rules to lift the standard for advisors to one "no less stringent" than the Investment Advisers Act, though at this point it remains to be seen whether such a "uniform fiduciary standard" will ultimately be issued, the terms of its standards, and what organization will be responsible for it, especially given the Registered Investment Adviser industry's opposition to FINRA as a potential regulator.

In this context, the recent release of FINRA's "Report on Conflicts of Interest" is all the more striking, as discussed in today's guest post by regulatory lobbyist and expert Duane Thompson. In its report, FINRA takes a surprisingly candid look at the conflicts of interest rife within the brokerage industry, suggesting many times that brokers may need to adjust their compliance processes and procedures to fit a standard more consistent with the best interests of the customers.

What's notable about this FINRA report is not merely the details of the conflict of interest discussion itself - for which Thompson provides an excellent summary - but the fact that in writing it, we may be witnessing an historic shift in FINRA's positioning on the issue. After all, if the reality is that a fiduciary standard is inevitable, FINRA risks being made irrelevant altogether if it can't demonstrate that it is capable of regulating financial advisors in a future fiduciary world. Accordingly, while the Report on Conflicts of Interest never actually uses the word "fiduciary" even once, it seems clear that FINRA is beginning to take steps to lift the standards for brokers, likely in no small part to help demonstrate that it is capable of regulating a clients'-interests-first fiduciary standard for advice, as FINRA tries once again to position itself as a future regulator of all financial advisors, albeit under what would be a higher uniform standard than what exists today.

Duane Thompson headshot

(Michael’s note: Below is reprinted, with permission from the Investment Management Consultants Association, a legislative update on FINRA’s recently released "Report on Conflicts of Interest" in the brokerage industry. Although it applies only to broker-dealer firms and their reps, it has significant relevance for financial planners and virtually anyone involved in providing financial advice to the public. This guest post was written by Duane Thompson, AIFA® who is president of Potomac Strategies LLC, and a consultant to IMCA. He was previously managing director of the FPA’s Washington office for 14 years.)

Background (Comments From Duane Thompson)

In case you’re wondering why a broker’s payout grid should matter to you, especially if you're not already working for a broker-dealer, some additional background may be in order.

For starters, it’s always good to know what the competition is doing, but it’s also good to know what Washington is doing, too. Despite the current political gridlock, Washington does eventually get around to finishing things. And while studies are a dime a dozen inside the Beltway, the release of this one in particular, given FINRA’s lobbying efforts to expand its jurisdiction to investment advisers, can have great import for you, whether you are a fee-only RIA or a registered rep.

FINRA’s study, then, is more than a review of best practices, and conspiracy theories aside, is part of a grand political design to bolster its credentials for the next political fight over regulation of advisers. Even though the latest fight (about whether FINRA would gain oversight of Registered Investment Advisors from the SEC) may be a fading memory for some, FINRA remains the elephant in the livingroom, and it has a pachyderm’s memory, as we shall see.

It’s true that FINRA dropped its lobbying campaign earlier this year to regulate investment advisers under a special Self-Regulatory Organization, or "SRO" for advisers. However, it has always held the long-term view, beginning with a report it submitted to the SEC in the mid’90s concerning problems with ‘rogue’ investment advisers escaping regulatory detection. (Ironically, Senator Ed Markey of Massachusetts just wrote a letter to FINRA complaining of ‘rogue brokers.’) FINRA’s Conflicts of Interest Report is simply the latest chapter of an effort that began nearly two decades ago.

In other words, as a clearly determined suitor, FINRA hasn’t given up its quest for a reluctant bride that, at last count, had $54.8 trillion in assets. And FINRA’s new bouquet includes a few fiduciary roses.

The traditional fiduciary standard under common law is essentially broken down into duties of "Loyalty" and of "Care" to the client. Under the fiduciary principles applied by the SEC and state regulators to investment advisers, a financial advisor is required to disclose and properly manage conflicts of interest under the duty of loyalty and to follow a prudent investment process under the duty of care. Brokers may be subject to a fiduciary standard when holding discretion over customer accounts, but usually are subject only to a suitability standard -- one that permits them to accept financial incentives contrary to the client’s best interest so long as the recommendation itself is suitable.

Last year FINRA first upgraded its suitability rules for brokers, citing a need to merge old NASD and NYSE rules into its consolidated rules book. Investment advisers would be well-acquainted with the new fiduciary-like factors, including liquidity needs, a customer’s investment time horizon, age, and appetite for risk. Fiduciary duty of care? Check. At the same time, FINRA announced it would review disclosure practices by firms during the coming year. Report released this month. Fiduciary duty of loyalty? Check. Best interest standard? Mentioned in both. Check.

Of course, it’s not as simple as that. Purists may hate using FINRA and ‘fiduciary’ in the same sentence, but the longtime Wall Street regulator has clearly started down the fiduciary path, as the fact pattern makes clear.

Does FINRA support a fiduciary duty for brokers? Yes. Would it like to regulate investment advisers? Yes. Does it have experience in fiduciary regulation? No. Can it learn? Read on.

Duties Of Loyalty And Care

Even though the Advisers Act is principles-based, the SEC has fleshed out rules governing the fiduciary duty of loyalty, most notably under disclosure. Form ADV is tangible evidence of an adviser’s obligation to disclose and manage conflicts under such a duty. FINRA, although it does not have the authority on its own to adopt a fiduciary duty for brokers, is now actively fleshing out the duty of loyalty and a vague ‘best interest’ standard.

Conversely, FINRA has done more work with the duty of care than the SEC, even if the connection to a fiduciary standard was largely by happenstance. Although not widely known, SEC staff made it clear years ago that investment advisers have a duty to make only suitable investment recommendations. Advisers have assumed as much, but the SEC has actually never articulated the concept in rule or guidance. The Department of Labor and state trust laws, in contrast, have gone much further in scoping out the duty of care by embracing portfolio diversification, requiring advisors to benchmark expenses and to closely monitor investment performance. As a result, most advisers view FINRA’s suitability rule in the context of a duty of loyalty, not care, given the host of conflicts associated with the broker model. But in practice, FINRA’s suitability standard, while isolated from other aspects of a traditional duty of care, goes further in articulating a prudent process than the Advisers Act. The most recent conflicts report is a logical sequence, by addressing the duty of loyalty. That said, while brokers may have greater clarity in terms of factors associated with a suitability standard, advisers operating in a fiduciary culture are more accustomed to inquiring more deeply into the client’s financial picture.

In summary, the FINRA conflicts report is really part of a strategic effort to expand its turf. As piecemeal as its approach to a fiduciary standard may be, it wields a tremendous amount of influence in shaping future conduct standards. One day it may even tie in the duties of loyalty and care to its rules in a more concerted fashion. Even if the adviser SRO never gets traction in Congress, or the SEC fails to adopt a fiduciary standard for brokers, the Commission could always take the path of least resistance and ‘harmonize’ the rules governing brokers and advisers. And the more fiduciary-friendly rules that FINRA adopts, the more inclined the SEC may be to incorporate rules from FINRA’s playbook. That is why anyone who reads this blog should be interested in closely monitoring FINRA’s quest, whether in pursuit of a quasi- or real fiduciary standard.

(Michael's Note: Duane Thompson raises some intriguing points here. For all those who have advocated for a fiduciary standard, the fundamental point here is that FINRA may actually be slowly capitulating and acknowledging that the future of financial advice is a fiduciary future. However, in the interests of not seeing itself written out of existence, FINRA is clearly beginning to take additional steps to position itself as the prospective future regulator of a future fiduciary world.

How this plays out in the future will be interesting, and raises some striking questions. Might FINRA actually accept and implement a higher fiduciary standard than the brokerage industry would currently like to see, if it means ensuring that it will be able to continue its existence as the regulator in that fiduciary world? Are we seeing a moment of transition where FINRA is shifting from defending the turf of the brokerage industry to defending its own turf and industry, with the recognition that it either gets a stronger position on its fiduciary enforcement capabilities or risks being made irrelevant? And would fiduciary-oriented advisors be willing to accept FINRA as a regulator if the organization really did live up to enforcing a true fiduciary standard? 

Right now, given the investment adviser distrust of FINRA, this report and strategic shift is likely to be perceived as little more than a gesture, and not a serious willingness of FINRA to alienate some of its current members with a shift to fiduciary (especially given that the actual word "fiduciary" is notably missing from the entire Conflicts of Interest Report). Nonetheless, the fact remains that if FINRA has decided that a fiduciary standard really is inevitable, at some point it will have to either be willing to enforce it or be willing to be replaced altogether, and it seems clear that FINRA would prefer the former to the latter, and may be starting the position itself accordingly.

In the meantime, for those who wish further detail on what the FINRA "Report on Conflicts of Interest" said, read on for further detail below!)

IMCA Legislative Update on the FINRA "Report On Conflicts Of Interest"

(This update was written by Duane Thompson, and does not necessarily represent the views of IMCA, nor should it be relied upon as legal or compliance advice.)

In mid-October 2013, the Financial Industry Regulatory Authority (FINRA) released an extensive 44-page report, capping a year-long review of the various approaches to managing conflicts of interest used by member firms. The report covered three major areas: firms’ coordinated approach to managing conflicts across business units, product development and distribution, and compensation arrangements for registered representatives.

FINRA Chairman and Chief Executive Officer Richard Ketchum, in a statement accompanying the report, said that while member firms “had made progress in improving the way they manage conflicts, our review reveals that firms should do more.”

This update focuses on compensation arrangements, including conflicts for wealth managers associated with product distribution and revenue-sharing payments to their firms.

Proprietary Products and Revenue-Sharing Payments

In singling out the wealth-management business for review, the report highlighted the need for wealth managers to make independent decisions about products developed or distributed by the firm “without pressure to favor proprietary products or products for which the firm has revenue-sharing arrangements.”

Along those same lines, FINRA suggested that firms could maintain effective safeguards through the use of product review committees “against pressure to prefer proprietary products to the detriment of customers’ interests.” This is particularly important when firms seek to leverage their brokerage platforms to cross-sell products and services, the report said.

The report also examined ways to reduce financial incentives to push product through the use of “open product architecture,” meaning reps would not be paid incentives for the sale of proprietary products or when the firm has revenue-sharing arrangements with product providers such as mutual funds. Even if reps do not share directly in revenue-sharing payments, the report noted that because of training on preferred products or the mechanics of order processing reps still may be inclined to use funds on the preferred list.

In such cases where there is a conflict, as a best practice the report suggested that the rep should provide the customer information on the conflict in advance of executing the transaction. Current FINRA rules do not require disclosure of so-called shelf payments by mutual fund companies.

Broker Compensation and Oversight

The FINRA report also called attention to pay grids and suggested careful monitoring of “compensation thresholds,” meaning the point when a broker nears a higher payout level on the compensation grid, qualifies to enter a “President’s Club,” or reaches production goals for “back-end” recruitment bonus payments.

Neutral grids are used by some firms, the report noted, although the payouts vary widely among firms and are often complex. Payouts not tied to specific product transactions, such as individual stocks, bonds, exchange-traded funds, options, futures, and mutual funds, can reduce incentives for reps to recommend one product over another, the report said. However, it also noted a neutral grid’s shortcomings, such as commission credit generally being higher for a variable annuity transaction than a mutual fund sale or stock transaction, even though the percentage payout from the overall transaction is the same. In these instances, FINRA said a so-called neutral product grid is not, and should not, be represented to customers as eliminating potential biases in the rep’s recommendations.

The report also suggested that clawbacks—a contract clause that allows the firm to revoke deferred or vested compensation—can be effective as a tool to address conflicts of interest. Currently, the report noted, clawbacks rarely are exercised except in connection with employee terminations for cause. FINRA suggested, however, that the clause should not be used only in those cases.

Lifecycle and Liquidity Events

The report also cautioned firms to monitor the suitability of a rep’s investment recommendations around key “liquidity events,” such as pension rollovers to individual retirement accounts (IRAs). “Firms have a strong incentive to gather assets,” the report noted, citing a recent Government Accountability Office report on rollovers being the largest source of contributions to IRAs. It isn’t always clear, though, according to the report, that a rollover to an IRA—as opposed to keeping it in the old plan or rolling it over to a new employer’s plan—is the investor’s best option.

Brokerage vs. Advisory Accounts and Overlapping Advisory Activity

While the report did not address the jurisdictional issue of making suitable recommendations under FINRA’s Rule 2111 or as a fiduciary under the Investment Advisers Act of 1940, it did suggest that reps consider the best choice of account for customers. Fee-based accounts may be more desirable for clients with a “fair amount of trading activity … and ongoing advice,” the report said, while commission-based accounts may be more cost-effective for customers with little trading activity.

FINRA also cautioned against double dipping by dually registered reps, noting that a “clear conflict would exist if a [dual registrant] recommends that a customer purchase a mutual fund that is subject to a front-end sales load and, shortly thereafter, recommends that the customer move those mutual fund shares into an investment advisory account that is subject to an asset-based advisory fee.” The report went on to say that “this behavior is an example of an inappropriate means by which a representative seeks to increase his compensation at the expense of his customer.”

FINRA’s report did not address the disclosure requirements or fiduciary obligations of a dually registered broker under the Advisers Act, in which a disclosure brochure covering a broad array of conflicts—called Form ADV Part 2—is delivered to clients and advice provided under a principles-based fiduciary standard. Nor did it discuss how such disclosures and advisory activities interface with recommendations made as a broker. In such cases, the instructions for Form ADV require the advisor rep to disclose whether advisory fees are reduced to offset any commissions or markups. Moreover, the advisor also is required to disclose—if mutual funds are the most-common investment recommendation—whether no-load funds are included in recommendations. If the firm itself receives more than 50 percent of its overall revenue from advisory clients in commission income, Form ADV requires disclosure that commissions are the firm’s primary source of revenue.

Finally, as an investment advisor, Form ADV generally requires disclosure of the broker-dealer affiliation, any limitations on the rep’s ability to sell products approved by the broker–dealer, and the option to execute the broker’s investment recommendations through other firms. Conversely, if the advisor’s registered investment advisor (RIA) is independent of the broker–dealer, she should disclose the fact that her advisory activities are separate. Dual registrants are advised to discuss fact-specific situations with their compliance supervisor given the complexities of dual registration.

“Best Interest” Standard

FINRA also emphasized the need to include a “best interest of the customer” standard in codes of conduct that apply to a broker’s personalized recommendations to retail customers. The report said this is necessary “in order to maintain and increase investor trust.” This new emphasis also tracks the best interest standard that now is required in guidance to its updated suitability rule, Rule 2111. However, the report did not elaborate on differences between its recently announced standard and the traditional fiduciary standard applicable to dual registrants under the Advisers Act.

Some observers following the debate over a prospective fiduciary standard for brokers have suggested FINRA’s new emphasis on a heightened best interest standard reflects an effort to position itself as a potential regulator for RIAs should Congress grant the Securities and Exchange Commission the authority to designate a new self-regulatory organization for advisors.

New Disclosure Rules Coming?

As noted by Mr. Ketchum in his press statement, despite the efforts of some broker–dealers to improve the ways they manage conflicts, the report stated much more needs to be done to strengthen their procedures, including an emphasis in “tone at the top” by senior executives. The securities industry plays an important role in the U.S. markets and economy, the report said, but it “must strengthen the investing public’s trust and confidence.”

If firms do not respond appropriately, the report offers a thinly veiled warning by concluding that FINRA “will evaluate whether conflicts-focused rulemaking is necessary to enhance investor protection.” The closing statement did not offer a timeline or any specifics of what would comprise such a rulemaking.

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  • stephenwinks

    Thought It is taking forever, but the industry finally seems to be getting serious about protecting public trust and the professional standing of the broker.
    This Kitces/Thompson assessment delineates how FINRA’s relevancy coincides with its ability to support fiduciary duty and professional standing. Let’s hope, the investing public wins and full fiduciary duty with no exceptions in support of professional standing prevails. If not, nobody wins and the inability of regulators to regulate and discern expert professional standing in advisory services from product sales is confirmed.

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  • RIA

    If FINRA is really serious about looking out for the investor, why don’t they require disclosure of the educational background, degrees earned, and credentials of registered representatives on their broker/check website? Also why don’t they require the presentation of actual investment performance statistics and comparable benchmarks for wrap accounts under management by brokers?

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Michael E. Kitces

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