WASHINGTON — Broker-dealer firms can do more to manage conflicts of interest in their businesses, including by taking steps to deal more transparently with retail investors, according to a report published by the Financial Industry Regulatory Authority on Monday.
The report identifies certain conflicts of interest present in dealer operations and provides examples of actions firms have taken or could take to better manage those conflicts. The report touches on acting in the best interests of customers, disclosure of risk to customers and compensation of registered representatives. Potential conflicts exist in any relationship where a duty of care or trust exists between involved parties, the report states, noting that "the history of finance is replete with examples of situations where financial institutions did not manage conflicts of interest fairly." The report focuses solely on broker-dealers, which FINRA regulates.
"In July 2012, FINRA initiated a dialogue with several large firms to review their conflicts management practices to better understand how the industry identifies and manages conflicts," said FINRA chairman and chief executive officer Richard G. Ketchum. "While many firms have made progress in improving the way they manage conflicts, our review reveals that firms should do more."
The report emphasizes that dealer firms should strive to set a "tone from the top" that "stresses the importance of ethical decision making and fair treatment of customers." Without this "first line of defense," other policies aimed at conflict management will not be effective, FINRA said. The self-regulator also looked specifically at codes of conduct, and how some firms have made effective use of their codes to help reduce potential conflicts with customers.
"One dually registered broker-dealer and investment advisory firm's code states that the firm and covered staff 'have an affirmative duty of care, honesty and good faith to act in the best interest of its clients,'" the report offers as an example. "Covered staff, the code continues, '(s)hould avoid even the appearance of a conflict of interest and should fully disclose all material facts concerning any conflict that does arise with a client.'"
"An effective practice," the report continues, "is to add to a firm's code of conduct, or other appropriate documents, a best-interest-of-the-customer standard that applies to registered representatives' personalized recommendations to retail customers. Under this code standard, a broker should make only those recommendations that are consistent with the customer's best interests."
The report recommends that firms be certain customers understand their risks and that there is no room for misunderstanding. If a customer could reasonably say, "I did not realize that could happen," the firm should reevaluate its disclosures, the report states. It is not enough to merely provide some risk information in a product prospectus, it continues. Another recommendation is that investors be required to affirm that they understand their investments.
The report also recommends that registered representatives be paid on a scale that does not favor one type of financial product over another. A "non-neutral" payment grid offers brokers greater commissions for sales of one type of product, such as bonds, compared with another, such as shares in a mutual fund. Using a "neutral" compensation grid would minimize the risk of a conflict of interest, FINRA's report states.
FINRA warns that if firms fail to make progress with conflict management, the authority will "evaluate whether conflicts-focused rule making" is necessary.