Remarks From the 2016 FINRA Annual Conference

Richard G. Ketchum

Chairman and Chief Executive Officer

Washington, DC

May 23, 2016

Note: An audio podcast of this speech is available.

As prepared for delivery.

Commerce and Compliance: It’s Not a Culture War

Good morning and welcome to FINRA’s Annual Conference, this year is notable in several ways, including the quality of the program and roster of speakers and attendees. Each year when we come together for this conference, we discuss and debate top regulatory concerns, as well as a range of issues affecting our industry, with the overarching goal of continuously supporting and refining compliance in financial services. One of the most significant developments this year in our collective mission is the evolving fiduciary landscape and what it means for how firms deliver retirement-savings advice. Wherever you stand on the wisdom of DOL’s rule, the fiduciary evolution in many ways gets to the heart of how firms interact with clients—the delivery of products and services that defines the essential qualities of a firm—its motivations and priorities. In a word: culture.

I have spoken out before on culture, as well as conflicts of interest and professional ethics, and FINRA has done a lot of work that touches on these interrelated areas. When I spoke to you at this conference in 2012, I asked you to assess how you identify and disclose conflicts of interest. And in October 2013, FINRA issued a report on conflicts of interest that highlighted effective conflict management practices that firms can apply across their business. Last year, we followed up that work with a review of one specific aspect of conflicts of interest: compensation practices. That work is ongoing. This year, we began reviewing how firms establish, communicate and implement cultural values, and whether cultural values are guiding business behavior. 
 
Having spent nearly four decades regulating the securities industry, and spending some time with a firm, I can say unequivocally that firm culture has a profound influence on how a securities firm conducts its business. I can’t count the number of times throughout my career where a culture that doesn’t value ethical behavior has led to compliance failures for a firm and significant harm to investors.  

High ethical standards are critical to maintaining investors’ trust in the financial markets and in the professionals and firms with which they work.

I’ll take it one step further. A culture that consistently places ethical considerations and client interests at the center of business decisions helps protect investors and the integrity of the markets. This, in turn, leads to and helps maintain investor confidence in the markets. 

While it isn’t FINRA’s goal to prescribe the culture for the industry or to determine the values a firm and reps should have, we think it’s essential that the securities industry embraces a culture that puts investors first. One, investors depend on it. And, two, they must have confidence that the professionals with whom they work are not putting their own interests ahead of their customers.

Beyond a rules-based approach, how can regulators and the industry work toward ensuring that investors’ interests come first? We can start by looking at the practices and expected behaviors that influence how employees make and carry out decisions in the course of conducting the firm's business. Part of that work involves applying research from behavioral scientists to the financial services industry to understand how and why honest people do dishonest things. This morning, I want to explore three areas: group-think versus individual standards of right or wrong, our winner-takes-all culture, and the importance of tone from the top. I also want to take a minute to talk about the appropriate cultural questions for a regulatory organization like FINRA.

Accepted Behaviors

We know that the pressure to conform is powerful. If a group engages in unethical behavior, individuals are far more likely to participate in or condone that behavior rather than risk standing out. 

A few years ago—July 7, 2012, to be exact—the Economist published an article about the LIBOR rate-fixing scandal that described an appalling example of this group behavior. Indeed, the Barclays’ employees’ collusion to fix the rates is the kind of behavior that makes investors question where our industry’s values lie. Not only were the employees conspiring to fix the rate, they openly joked about the small favors given in return for fixing the rate. One trader posted notes in a diary as a reminder to alter the numbers the following week. And another regularly shouted out to colleagues the particular rate he wanted, so other colleagues could review if they had conflicting requests. The blatant manner in which the employees worked together and with traders from other banks means one thing: the behavior was widespread and tolerated. 

Fortunately, we won’t find that kind of behavior on every trading floor, every business unit and every branch office. But the compliance breakdown here, as well as the continued resurgence of issues that had previously received extensive publicity and coverage, raise questions about whether there is a culture within a firm or the industry that tolerates repeated problematic behavior.

We need to recognize that rules alone cannot address the very real challenges that financial firms have in ensuring that “good people” do not take actions that harm their clients and expose their firms. We know that the pressure to conform is powerful. If a group engages in unethical behavior, individuals are far more likely to participate in or condone that behavior rather than risk standing out. This idea suggests that institutional culture—and not just "a culture of compliance"—is really important at firms.

As a regulator, we also want to understand the behaviors and practices that can influence or permit compliance breakdowns. One of the ways we’re doing that is through a review of culture that we initiated in February. 

Our review covers a number of factors, including how a firm communicates and reinforces values directly, implicitly and through its reward system. We are also interested in how a firm measures compliance with its cultural values; what metrics, if any, it uses; and how it monitors for implementation and consistent application of those values throughout its organization. 

In our reviews, FINRA will assess five indicators of a firm’s culture: whether control functions are valued within the organization; whether the organization proactively seeks to identify risk and compliance events; whether policy or control breaches are tolerated; whether supervisors are effective role models of firm culture; and whether sub-cultures—such as those at a branch office, a trading desk or an investment banking department—that may not conform to overall corporate culture are identified and addressed. We are also looking at the role that compensation practices play in reinforcing—or possibly undermining—cultural values. This second piece—our review of compensation as it relates to culture—is a follow-up to our broader review of conflicts of interest that was captured in our 2013 report.  

We are only at the beginning of our culture review, so it’s premature to draw any broad judgments. While I can tell you that we have observed that many firms are paying more attention to their culture and how they manage conflicts of interest, there is still a lot of work to be done.

Hiring Practices

Research from behavioral scientists also tells us that an individual person’s standard of what’s right or wrong is affected by the persons with whom he or she associates. At FINRA, we’re also taking this into account. We are using more data and advanced analytics to identify registered representatives with potentially problematic regulatory histories. These registered representatives could be “negative culture carriers.” That is, if those reps do indeed engage in problematic behavior, they could adversely influence individual colleagues and possibly become the seeds for the creation of a negative sub-culture at a firm. We are also exploring the use of advanced analytics to assess the level of risk that may arise at a branch and aggregate firm level from individuals with problematic histories.  

I’m encouraged that firms are reviewing potential employees’ ethical, financial and regulatory histories before hiring. Many of the firms involved in our culture review have emphasized the importance of ethics at the individual registered representative level, and have also highlighted their processes for reviewing reps prior to hiring as an important, culture-related control. Equally troubling, however, is the fact that there remain firms that have substantial concentrations of employees with significant past disciplinary records or a number of settled sales practice complaints or arbitrations. To say it bluntly, statistical analyses done by FINRA’s Office of the Chief Economist and independent studies demonstrate that these firms are meaningfully more likely to have repeat sales practice violations that harm clients. Of course, I understand that not all complaints are fair and the right supervision can result in former “problem” reps performing well. But I think it is important to emphasize that a firm that takes these risks does it at a cost. First, that firm faces a far greater challenge in communicating that its culture will not tolerate activity that does not place the customer first. Secondly, no firm that tolerates such a concentration of “high-risk” advisers should do so without expecting searching questions from FINRA as to the special supervisory steps they have taken to ensure no further bad actions. 

C-Suite Examples: Do, Not Just Say

Sticking with the idea that an individual person’s standard of what’s right or wrong is affected by the persons with whom he or she associates, I can’t stress enough the importance of the tone that is established at the top of any organization. The board, the CEO, business leaders and the CCO all play critical roles in setting the tone at the top and establishing an organization’s values and ethical climate. The tone carries through to every aspect of the organization’s structures, policies, processes and training. 

For a good culture to flourish, a firms' management must articulate and practice high standards of ethical behavior that are expected and visible throughout the organization. So it’s essential that a firm’s senior leadership “own the culture.” They must assess whether they are effective role models of the behaviors and values they expect in their staff. A CEO’s behavior tells employees what matters, and what behaviors are rewarded and punished. One strong method of communicating the commitment is for the CEO and other senior managers to participate in companywide forums specifically focused on culture issues, which emphasize that the subject is not just an afterthought. Moreover, when individual conduct deviates from the expected behaviors, quick and decisive action must follow. Similarly, firms should be transparent about rewarding those who live by and promote strong ethical values, and they should empower their staffs to speak out when cultural and ethical breaches are at issue.

Competitive Nature of the Securities Industry

Which leads me to how a firm’s compensation practices reinforce—or possibly undermine—its cultural values. I don’t need to tell you that the financial services industry is built on competition—whether through incentives or the opportunity to earn significant bonuses. 

Research tells us, however, that when it comes to ethical behaviors, our competitive culture, our winner-takes-all-approach, doesn’t always produce the best outcomes. 

So the challenge for any firm is to assess whether its compensation system promotes and rewards unethical behavior. 

Be mindful of the conflicts your firm’s compensation systems may create. And, align your compensation system with customers’ interests. That’s not to suggest that all compensation conflicts can be eliminated. Rather, where they persist, we want to see supervisory mechanisms to identify and address situations where those conflicts could contribute to behavior that may result in customer harm or undermines the integrity of the market. We always want to see disclosures of compensation-related conflicts so that investors can make informed decisions. 

Indeed, our follow-up review of conflicts in compensation practices launched in 2015 suggests that firms can do more to manage and mitigate conflicts related to compensation. We’re nearing the end of that review, and while there’s still more work to do, we have found that the quality of new or amended policy, control and surveillance efforts that firms deploy in response to identified compensation conflicts of interest vary widely.

A subset of the firms we reviewed have not added any additional supervision or surveillance related to compensation conflicts of interest. These firms rely on existing business line supervisory processes, such as centralized transaction review groups and exchange exception reports, to identify compensation conflicts of interest. These processes are not the most effective because the supervisory review process is not specifically designed to identify possible manifestations of compensation conflicts. By contrast, some firms have adopted more tailored approaches, for example through surveillance reports designed to trigger additional reviews of sales activity ahead of production thresholds, while other firms have designed velocity reports that trigger additional supervisory reviews in situations where earnings exceed historic norms for a rep. 

We observed mixed results on firms’ testing of their controls related to compensation conflicts. We found that most firms have not tested the effectiveness of supervisory and surveillance efforts or controls designed to address compensation conflicts of interest. 

I’m encouraged by the steps some firms are taking to test their compensation policies. Some firms have engaged in robust testing to determine if their compensation policies, controls and conflict mitigation practices have achieved the intended behavior changes or prevented certain types of undesirable behavior. We’ve observed efforts at some firms to amend policies and controls that were not achieving intended results. 

What Is Next for FINRA and Firms

Looking ahead, culture issues will remain front and center for FINRA and other regulators. FINRA has supported a “best interests of the customer” standard for a number of years, and I continue to believe that a best interest standard for broker-dealers—under the securities laws—is the direction we must go. And we must get it right. 

Regardless of when we get there, culture will continue to be an important driver in FINRA’s regulatory programs. From an examination perspective, we count culture as a factor that influences a firm’s risk profile. There also can be a direct line between culture and the probability or severity of an enforcement action. For example, if a firm does not produce requested documents and information on time, or fails to address examination exceptions, we view these as indicators of a poor culture. And the response or lack of response certainly increases the likelihood of an enforcement action. Similarly, recidivist behavior can be an indicator of poor culture, and is certainly likely to result in more severe penalties.

As our culture review progresses, we anticipate incorporating learnings from that review in more articulated, formalized review procedures related to culture that examiners can draw on. As with other aspects of our examination program, the examination team will determine the specific areas of a firm that we look at using a risk-based approach. 

Going forward, we expect that data analytics will remain an important tool to help us address poor culture and compliance breakdowns that influence a poor culture. Some firms in their responses to our culture review discuss the role of data and analytics in helping them measure and monitor their cultures. This might include, for example, creation of a “dashboard” or similar type of tool that firms can use to assess culture. As we learn more about the approaches firms are taking, we will share effective practices that we observe.

Regulatory Culture

In fairness, a discussion about culture is equally important for FINRA as a regulator as it is for the industry. And as I look back to the market impact and impact on investors large and small of the credit crisis and resulting Great Recession, as well as the horrifying frauds conducted by Madoff and Stanford, there was much cause for self-examination by the regulators and the industry.

I am terribly proud of the changes that FINRA has made in the way we go about our regulatory responsibilities in the last seven years, but never sanguine enough not to conclude that continuous re-examination is not appropriate.

Those of you who know me well will recognize that I often look to key messages in old movies or rock songs to focus my thinking. In fact, I once fashioned an entire speech discussing “principle-based regulation” on the wisdom I had gained from one of my rock “heroes,” John Lennon. Now I might be tempted to fashion a message of my other most admired rock lyricists, like Bruce Springsteen or the Grateful Dead, but I think in this case, I will defer to my wife’s favorite group of her youth: Crosby, Stills Nash and Young. On their second album, Graham Nash penned a song that was somewhat curious in an age characterized by substantial anger and libertarianism called “Teach Your Children.” The fundamental theme of that song was encapsulated by the message that those of us who are on the road “…need a code we can live by.” So, in that spirit, let me suggest a code that a modern self-regulatory organization should live by and be held accountable to.

First, FINRA must be fundamentally independent in everything we do. I will discuss after what differentiates a strong self-regulatory organization like FINRA, but none of that matters if there is any risk or even perception that any decision that we make is subject to improper influence by the firms that we regulate. I believe we achieve that goal as a result of a strong public-majority board and the continuous oversight that we receive from the SEC, but we must be continually attentive that the independence message is embedded again and again in our culture.

Second, and the flip-side of the first point, is that FINRA must be committed to fully understanding the industry. If we don’t succeed in this goal through our interaction with members of our committees and, more generally, with industry firms of all sizes and business models, then we can never consistently get our rulemaking and oversight properly designed to protect investors but not impose unnecessary burdens on firms.  Moreover, if we are not completely fascinated with what makes the industry tick, we will not effectively be able to see around corners and properly identify and address new regulatory risks before they harm investors.

Third, our fundamental goals of investor protection and market integrity cannot be achieved through “keeping score” with enforcement actions. Now don’t get me wrong, I’m incredibly proud of the professional and aggressive work that FINRA’s Enforcement Department conducts, and I believe that no regulatory system can long survive that does not require accountability and ensure investors who are harmed, wherever possible, receive compensation. My point is that enforcement is just a part, not the whole, of an effective regulatory program. While regulators strive to help the industry be perfect, we know that perfection isn’t realistic. And the regulatory structure is not a failure if some enforcement is required. Each day we should count it an equal triumph when an examination or our market surveillance program identifies issues and provides guidance that allows our firms to do the right thing by their clients without the need for an enforcement action.

This point is why I so strongly believe in the importance of being responsive in providing guidance regarding the correct interpretation of FINRA rules and also expanding the number of areas where FINRA provides firms “report cards” of how they rank with their comparators in meeting their compliance obligations. We have steadily expanded the areas where we provide these report cards on the market side, but look to us to strive to more and more provide this type of information through our examinations of firms as we have recently done in our conflicts and cyber reports. There is no higher goal for a regulator than for it to be a positive force in helping firms build their “compliance culture.”

Finally, the overriding goal for FINRA that must fundamentally define our culture, is that everything we do must be justified because the action helps protect investors. Without our constantly asking the question “how is each action we take justified because it will increase our ability to protect investors” we risk fundamentally losing our compass.

There you have it, my best reflective thinking of how both FINRA and the industry can improve our ability to define our cultural guideposts. None of this is easy and certainly no action can ensure infallibility for either FINRA or the industry. But one thing is certain, we are far more likely to succeed in this quest working and communicating together than operating apart. That is, in the end, the most important message that I want to leave with you today. Thank you.