FINRA Warns BDs to Better Manage Conflicts of Interest

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.

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