A recent enforcement action by FINRA underscores the regulator’s continuing concern regarding how financial advisers are paid to sell investment products. In a case announced on November 28, 2016, a member firm settled charges brought by FINRA and agreed to pay a fine of $1,750,000. The FINRA case includes a wide range of allegations involving failure to supervise, train and monitor the sales process for variable annuities. At the heart of the case, however, are concerns about how the firm compensated its sales force. These types of concerns are likely to be of interest to a wide range of broker-dealers, no matter what types of financial products they offer to investors.
FINRA found that the firm’s financial advisers were incentivized to roll over retirement funds into various proprietary products, including accounts which would pay ongoing fees to the firm. If a financial adviser was also registered as an investment adviser representative, he or she could also receive a share of the ongoing management fees paid by the account. By contrast, the financial advisers would not be compensated if they recommended that the customers invest in non-proprietary products. According to FINRA, the implementation of sales incentives favoring proprietary products was quickly followed by a marked increase in the sale of certain proprietary products, in some cases generating more than 600% growth.
Well after implementing the new sales incentives, the firm required customers to sign a disclosure document which provided general disclosures about the compensation payable to its financial advisers, including the fact that compensation would be “more favorable” for the sale of proprietary products. The specific compensation terms were not disclosed.
The case is notable because of the significant fine levied in the absence of any charges that the firm or its financial advisers committed fraud or sold unsuitable products in substantial amounts. FINRA stated that the firm’s “compensation policy created a conflict of interest between registered representatives and customers…” FINRA also found that the firm failed to identify and reasonably address this conflict of interest, which involved an inherent risk that financial advisers would act imprudently, rather than in the interests of their customers. The stark incentives to sell proprietary products, coupled with the extraordinary growth of these sales after adoption of the incentives, were no doubt seen by FINRA as exactly the kind of conflicted conduct which needed to be deterred, even where there was no demonstrable fraud or violations of the suitability requirements.
The case is consistent with FINRA’s recent focus on conflicts of interest as demonstrated by its sweep examination in 2015, and its 2013 report relating to conflicts of interest. Moreover, the issues raised in the case resonate with the Department of Labor’s new fiduciary standards, which would expressly require brokers dealing with retail retirement investors to avoid compensation systems which misalign the interests of financial advisers and their customers.
The lesson for broker-dealers and other investment firms: think carefully about the structure of your compensation policy. Where sales incentives appear to create a potential for conflicts of interest, take actions to mitigate and disclose the conflict. Continually monitor financial adviser behavior and respond quickly to indications that a particular compensation policy may be improperly affecting the advice that financial advisers provide to clients.
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