Supervision and Compliance of Brokerage Firms: Focus on Conflicts of Interest

Abstract

Each year, FINRA publishes its Regulations and Examination Priorities for brokerage firms. Over the past several years, FINRA has focused on firms’ overall management of various types of conflicts of interest. In 2016, in tandem with this examination priority, FINRA formalized its assessment of firm culture and found that the culture was integral to a firm’s management of conflicts of interest. FINRA found that visible mitigation of conflicts of interest may help ensure the ethical treatment of customers.

Last year, FINRA focused on four main types of conflicts: (1) incentive structures; (2) investment banking and research business lines; (3) information leakage; and (4) position valuation. This article will discuss the first three of these areas of focus. With respect to incentive structures, this paper will examine different types of compensation which may lead to conflicts of interest.

The paper will examine several different challenges to firms’ incentive structures. Differential compensation is compensation which varies based on the product sold. FINRA has regularly provided guidance that compensation which may incentivize the sale of particular products, without consideration for the customers’ investment profile, is inappropriate. Several firms have been fined for failing to ensure their brokers comply with other FINRA rules, such as the suitability rule, due to the differential compensation offered. FINRA is also concerned with conditions attached to recruitment compensation. For example, a broker may engage in inappropriate trading to maximize the compensation offered by the new firm when the broker moves from one firm to another. Finally FINRA is concerned with customer wealth events, such as retirement, which may incentivize a broker to provide advice that is inconsistent with the customer’s needs so that the broker can capture additional investable assets.

Next, this paper will examine potential conflicts connected with firms’ investment banking and research. Firms have struggled with conflicts of interest related to these lines of business for many years. FINRA has adopted rules governing a firm’s ability to engage in equity and debt research, intended to minimize the potential for conflicts of interest.

Last, this paper will examine potential conflicts related to information leakage. FINRA has long been interested in a firm’s ability to identify, minimize and mitigate information leakage within or outside the firm. Information leakage might occur in a variety of different contexts, including inappropriate information leakage between different areas of a firm’s trading activities, between a firm’s trading activities and other parts of a firm, and through the front-running of pending rating changes. This section focuses on several firms that have been disciplined as a result of their inability to prevent or detect information leakage.