Conflicts of interest can arise in any relationship where a duty of care or trust exists between two or more parties, and, as a result, are widespread across the financial services industry. While the existence of a conflict does not, per se, imply that harm to one party’s interests will occur, the history of finance is replete with examples of situations where financial institutions did not manage conflicts of interest fairly. Indeed, many of the foundational pieces of legislation governing financial services in the United States contain provisions crafted precisely to address conflict situations.
This report focuses solely on broker-dealers, the entities the Financial Industry Regulatory Authority (FINRA) regulates. Broker-dealers are subject to comprehensive regulation under the federal securities laws, Securities and Exchange Commission (SEC) rules and FINRA rules. Conflicts of interest are an SEC and FINRA priority and have been addressed through rulemaking, oversight and enforcement action. (See Appendix I for a non-exhaustive list of conflicts-related rules.)
This report carries those efforts forward. It recognizes that many broker-dealer firms have made progress in improving their conflicts management practices, but emphasizes that firms should do more to manage and mitigate conflicts of interest in their businesses. To assist in these efforts, FINRA launched its conflicts initiative in July 2012 to review firms’ approaches to conflicts management and to identify effective practices. We used firms’ responses to FINRA’s conflicts review letter, in-person meetings and a follow-up compensation questionnaire to develop the observations detailed in this report.
The report is not intended as an inventory of conflicts that firms face, nor does it cover many conflicts that federal securities laws and SEC and FINRA rules already address, such as investment banking-research separation, outside business activities, soft dollars, payment for order flow or securities allocations to customers. Instead, FINRA’s objective is to focus on firms’ approaches to identifying and managing conflicts in three critical areas—firms’:
- enterprise-level frameworks to identify and manage conflicts of interest;
- approaches to handling conflicts of interest in manufacturing and distributing new financial products; and
- approaches to compensating their associated persons, particularly those acting as brokers for private clients.
The enterprise-level framework discussion examines how firms address conflicts across their business lines from a top-down perspective. The new product and new business discussion explores how firms address conflicts related to the introduction of new products and services. Together, these areas play critical “gatekeeper” roles. Specifically, if firms are effective with enterprise-level frameworks and handling conflicts with new products, they can be proactive in identifying and managing conflicts. The focus on compensation provides insight on financial incentive structures that may create, magnify or mitigate conflicts of interest.
The report identifies effective practices that FINRA observed at firms or that, based on experience and analysis, FINRA believes could help firms improve their conflicts management practices. It also contains more general observations and commentary on firms’ practices that we share for the industry’s information. FINRA recognizes that the effective practices and observations in this report are drawn from discussions with large firms and, as a result, will not in all cases be directly applicable to small firms.
This report is a point-in-time review of several facets of conflicts of interest. Given conflicts’ pervasiveness and potential to cause customer harm, FINRA will continue to assess firms’ conflicts management practices and the effectiveness of those practices in protecting customers’ interests. FINRA will also monitor the effectiveness of approaches to conflicts regulation used internationally.
FINRA expects firms to consider the practices presented in this report, and to implement a strong conflict management framework. If firms do not make adequate progress on conflicts management, FINRA will evaluate whether rulemaking to require reasonable policies to identify, manage and mitigate conflicts would enhance investor protection.
FINRA stresses that this report is not intended to express any legal position, and does not create any new legal requirements or change any existing regulatory obligations. Throughout the report, we identify conflicts management practices that we believe firms should consider and tailor to their business model as they strengthen their own conflicts frameworks.