Skip to content

Paper Regulator

I may be the only person in the world who reads FINRA regulatory reports for their entertainment value. They unfailingly provide a delightfully clear window into what FINRA knows or believes about the securities industry, giving away all sorts of things that the organization might regret revealing in retrospect.

So when FINRA published its "Report on Conflicts of Interest" (, it was a double treat. The organization that thinks a fiduciary standard means disclosing how you're going to rip off customers before you do it is going to lecture its members on how to tiptoe around the various temptations inherent in recommending in-house products, trading for your own investment account and touting the great investment benefits of whatever you want to get rid of to your customers.

Will it recommend that wirehouses stop doing these things, or just "monitor" them? Will it sternly tell them not to hire sleazeball brokers with long regulatory histories, or just "consider whether this is prudent?"

The report doesn't disappoint. It starts off by noting, in the very first sentence of the executive summary, that "conflicts of interest can arise in any relationship where a duty of care or trust exists between two or more parties." Is this admitting that brokers and BDs owe a fiduciary duty of care to their customers? Will I see the word "fiduciary" anywhere in the report? (Spoiler alert: the word appears nowhere in the report's 44 pages.) We are told that this is a summary of best practices in the FINRA-regulated industry, with recommendations for the best, most effective top-down compliance procedures.

So which conflicts are we talking about? Page three identifies one: "Firms involved in both the manufacture and distribution of products should maintain effective safeguards to alleviate pressure to prefer proprietary products to the detriment of customers' interests. This is particularly important as firms seek to leverage their brokerage and other platforms to cross-sell products and services."

This already gives away the game. FINRA could not possibly acknowledge more clearly that it is aware that brokerage firms are seeking to cross-sell their proprietary products. Instead of sternly forbidding them to tell their brokers to sell the house product rather than a better option for the client, it says the brokerage firms should "alleviate pressure" to prefer those products. Don't stop pressuring the reps, just alleviate the amount of pressure you put on them… (Come on; is that not funny?)

The next sentence is just as revealing. "Equally important, firms with revenue sharing or other partnering arrangements with third parties should exercise the necessary diligence and independent judgment to protect their customers' interests." There's another term for "revenue sharing;" it's called "payment for shelf space." The brokerage firm takes a generous cut of the management fees in return for recommending the outside product. FINRA is acknowledging that it is aware of the practice. Rather than forbidding it, it is telling brokerage firms to "exercise necessary diligence."

Is anybody fooled that these half-measures will prevent BDs and brokerage firms from pressuring their reps to recommend in-house products and separate accounts that share revenues? FINRA knows that customers are in danger. It is recommending that the firms it regulates keep an eye on this and not go too far in putting their own interests ahead of their customers. Remember that the next time some FINRA executive gives a pompous, self-important speech on how the organization is totally behind the fiduciary standard.

Okay, but is FINRA aware of how these brokerage firms are putting pressure on their reps to sell the most profitable products, customers be damned? Indeed it is. On page four of this report, we are told about compensation grids. FINRA says that "'product agnostic' grids are one way to reduce incentives for registered reps to prefer one type of product… over another." (Once again, the goal is interesting: we aren't aiming to "eliminate" incentives; only "reduce" them.) This, the report tells us, can reduce the biases that differences in compensation by product may (may!?) create. The so-called regulatory organization, that tells anyone who will listen that its sole purpose is to protect consumers, reveals that it knows all about compensation grids that pay more whenever a rep sells the in-house or revenue-sharing product. Its recommendation: "firms should take measures to mitigate biases that differences in compensation by product may create." We protect consumers by "mitigating" rather than "eliminating" biases.

Later on the same page, FINRA shows its awareness of another form of pressure on those reps. It identifies an "effective practice:" "surveillance of registered representatives' recommendations… to detect recommendations, or potential churning practices, that may be motivated by a desire to move up in the compensation structure and, thereby, receive a higher payout percentage."

In other words, FINRA knows that the more brokers sell, the higher their payout, and it knows that brokers are motivated to churn accounts or make investment recommendations that will move them up the payout ladder. What would be the best remedy offered by the alleged consumer-protecting regulator? Surveillance.

The report also identifies other strong incentives to give advice against the best interests of a broker's customers: "as a registered representative approaches the end of the period over which performance is measured for receiving a back-end bonus" or "as a registered representative approaches the threshold necessary for admission to a firm recognition club (e.g. a President's Club or similar)."

FINRA is obviously familiar with the way that its sales cultures recognize their top producers, and is not especially troubled by it; it mildly recommends that firms "perform specialized supervision" to watch over those brokers who have been motivated by their compensation and recognition structure to act against their customers' best interests.

But more than that, it is very interesting to see how FINRA uses the word "performance" here. "Performance" is clearly defined here as sales volume. This also gives the game away. You are a top performer, not if you benefit the consumer or get a higher return for the consumer, but if you sell enough stuff to make the President's Club.

This isn't a brokerage firm saying that. It's the brokerage firm's regulatory organization. Is Congress listening?

There's more. The report notes that "virtually every financial firm, including those regulated by FINRA, faces potential conflicts of interest in its business." It recommends that firms identify those conflict situations and "manage them appropriately." You wonder if anybody at FINRA knows that fee-compensated fiduciary advisors eliminate those conflicts by not having in-house products in the first place, not receiving commissions for sales, not recognizing people for their sales activities, not defining performance as how much stuff you sell.

FINRA gives away more of its thinking when it talks about the temptations faced by different types of firms, including "a small firm selling basic products." (This makes it clear that "selling" is the basic business of FINRA-regulated firms, which is a different business model from the fiduciary RIA firm.)

Larger firms, we are told, "may be tempted to hire an associate person in spite of a poor regulatory history, if they believe that the individual can boost firm profitability." In less euphemistic language, FINRA is saying that the firms it regulates think it might be worth hiring a sleazeball if he can sell a lot of those in-house products and products that pay for shelf space.

On page 6, we are told that firms must display "a willingness to avoid severe conflicts, even if that avoidance means foregoing an otherwise attractive business opportunity." Can anyone possibly be confused that these "severe conflicts" leading to "attractive business opportunities" is more accurately called a classic rip-off of the consumer? Like, maybe, selling a terrific investment opportunity that you have deliberately constructed to fail, and then, in your own account, betting heavily against it with other customers, using this inside information? FINRA says that you should "avoid" such things, instead of outright prohibiting them.

Later, on page 10 of the report, FINRA lists specific examples of "firm vs. client conflicts" that may arise, and the list is familiar: recommending products for which the firm receives greater compensation; where the firm plays multiple roles like underwriter, lender or derivative counterparty of products it recommends; where the firm is trading for its own accounts and client accounts at the same time; when the firm is managing client portfolios and also recommending in-house products. But… FINRA says nothing about churning or selling high-commission annuities. In fact, we have heard all we're going to hear about churning already.

I said that this report was entertaining; you can have great fun with the section on hiring practices. For the second time, we are told that "the firm might seek to hire a candidate with a problematic financial or regulatory history because of the book of business she could bring to the firm." Apparently it is not uncommon for firms to hire unethical brokers who bring a lot of sales volume to the table. Brokerage firms, FINRA says, should look at whether their new hire "exhibited poor compliance behavior or engaged in sales practices that posed risks to customers." Apparently, brokerage firms really need to be told to review a broker's regulatory history before they hire him. Boiled down to the simplest terms, FINRA is recommending that its members don't just hire based on production. Wow!

But of course, this never actually happens in the real world, right? The FINRA report makes it explicitly clear that it does–often. "In light of the negative impact individuals with poor ethical standards can have on a firm, FINRA remains concerned about the number of firms willing to hire associated persons with problematic disciplinary histories." (p. 14)

Okay, maybe the brokerage firm reading this doesn't totally understand what is being said here. FINRA apparently needs to be totally, completely explicit about this. It says: "A firm hiring an associated person must affirmatively determine that the associated person satisfies FINRA's qualification requirements and is not subject to a 'statutory disqualification.'" (p. 14) Roughly translated, that means, hey, guys, you're not supposed to hire top producers who have been banned from the securities industry.

But FINRA actually leaves the door open to hiring sleazeballs. Notice the word "and" rather than "or" in this admonitive sentence: "If an individual has an employment history that includes items such as a large number of customer complaints, recent terminations for cause/permitted to resign, arbitration proceedings, disciplinary actions, frequent changes in employer, *and* a disproportionate number of disclosures of liens and judgments, firms should carefully assess the prudence of hiring such a person." (p. 15) And!? Only if a person has all these red flags should the brokerage firm be cautious?

And notice the remedy. Not: don't hire the sleazy broker whose resume is printed on a red flag, who walks in the office dressed in red flags, and waves red flags at you during the interview. "Carefully assess the prudence" of hiring him.

We're getting just what I was hoping for: a clear window into how brokerage firms and broker-dealers really operate. And in light of FINRA's posturing as a strong proponent of the fiduciary standard, and as a would-be regulator of fiduciary RIAs, FINRA is surprisingly weak in its recommendations to "avoid" (not ban) sales practices that pose risks to customers, to "supervise" and "monitor" (not eliminate) sales incentives to churn and burn to enhance their "performance" and move up payout grids, and "carefully assess the prudence" of hiring (rather than just don't) a sleazeball with impressive "performance."

Fast-forward to page 18, where FINRA makes an interesting admission, apparently in regard to tricky and complex derivatives that were sold in the leadup to 2008: "Unfortunately, the financial services industry has frequently shown limited ability to effectively manage conflicts of interest that may arise in the course of product innovation." Later, talking about FINRA's evaluation of how these products are created, the organization tells us: "This product focus reflects FINRA's concerns about the increased sale of complex products to retail investors who may struggle to understand the features, risks and conflicts associated with these products."

Apparently, when brokerage firms created products that were designed to fail, and then bet against them, FINRA noticed. Page 21 of the report notes that "In addition to conflicts related to selling, FINRA is also concerned with how manufacturing firms handle conflicts of interest that may be inherent in a product. These conflicts arise where a manufacturer or its affiliates play multiple roles in determining a product's economic outcome and where firm and investor interests may diverge."

May!? Is there any question that this creates a divergence between the firm's and investor's interests?

In the interest of completeness, let's finish up with three other types of admissions. First, FINRA says that a big problem in the industry is "the sale of products or services to generate revenue or profit without proper regard to suitability standards." (p. 23) (This also, once again, gives away the fundamental business model: the sale of products.) Then FINRA says that payment for shelf space (referred to here euphemistically) adds to the problem at some brokerage firms: "This conflict is magnified when a firm favors proprietary products or engages in revenue-sharing with third parties to the detriment of customer interests." (p. 23) If somebody at FINRA ever says in testimony before Congress that this doesn't happen, wave this regulatory notice in his face.

Later on the same page, FINRA says that firms should create "new product review committees" to guard "against pressure to prefer proprietary products to the detriment of customers' interests." (p. 23) Right after that, it acknowledges again that revenue sharing arrangements threaten the best interests of customers.

The second admission is that reps have incentives to push unsuitable products, which FINRA would like to see &q ot;mitigated" rather than banished altogether. The report talks about reviewing and even blocking "the sale of a product" that a customer might not understand. Then it says: "This broader review may mitigate the incentive for an individual registered representative to push a product that may be unsuitable for a customer." (p. 24)

Your goal is to institute a procedure which "may mitigate" these incentives. Is that the kind of strong, unyielding consumer-focused regulatory structure we want to bring to the RIA world? Where does this fit into an argument that brokerage firms are more heavily-regulated than RIAs?

The third admission is somewhat astonishing. Remember when FINRA was calmly, without any visible signs of embarrassment, talking about those revenue-sharing arrangements? The organization is clearly aware of exactly how this works in the brokerage offices: "The funds for which a firm receives revenue sharing payments often will be placed on a “preferred” list of funds the firm offers." (p. 24) Is this not totally acknowledging that these product companies are paying for shelf space? And that this is resulting in increased sales for the "revenue sharing" product companies? And even HOW this results in increased sales?

There's more. "Although registered representatives do not share in the revenue sharing payments directly, they still may favor funds on preferred lists, because of training the issuer provides or because the mechanics of order processing are, in some cases, easier for funds on the preferred list." (p. 24) Registered reps may favor funds on preferred lists because they are trained to or because order processing is somehow made easier for these preferred products. What about the fact that there IS a "preferred list" in the first place? Does the rep not know what is expected of him? What else could "preferred" mean, exactly, in the office where the broker works?

If FINRA is so clearly aware that these arrangements exist, perhaps there should be an investigation by the SEC into whether this does indeed represent payment for shelf space. The investigation could consist primarily of reading this report.

Toward the end, on page 27, we are shown a sample payout grid, where the higher producers get a higher commission if they achieve higher "performance" and we see that the investment company's own products pay higher commissions than other products the rep might consider recommending. The report compares a "$1 million producer" with a "$500,000 producer" (p. 28) and repeats the earlier admonition that brokerage firms should try to detect potential adverse activities that a rep might resort to in order to move up the grid. (p. 30) We are told that some brokerage firms "collect relatively little data, do not implement performance assessments, and whose registered representatives' compensation structure is mostly or entirely commission-driven with little or no non-formulaic variable compensation, i.e., bonus." (p. 32) Hmmmmm. Is FINRA doing anything about this? Apparently not. Other, of course, than make recommendations.

I'm sure many of my readers will be troubled by FINRA's visible tolerance for all sorts of bad behavior and conflicts, and wince at the obvious and grave harm it does to the consuming public. But I urge you to find the entertainment value here. It's as if we are given a dressing room view of a clown meticulously putting on the face paint, fitting on the squeaky red nose, donning the ridiculous wig, soberly pulling on the enormous floppy shoes, picking up the seltzer bottle and then going out into the Congressional hearing room and, through the painted smile, telling our elected representatives that it is exactly the perfect entity to protect financial consumers from harm. How can you not laugh at that?

I'm sure that you will read articles soberly quoting FINRA and broker-dealer executives telling us how dangerous the "unregulated" fee-compensated advisors are, and the public menace of advisors who voluntarily give up conflicts of interest rather than merely watch them and "try" to "mitigate" them.

In light of this report, that, too, will be pretty darned funny.