• FINRA Requests Comment on a Proposed Rule Requiring Disclosure of Conflicts of Interest in Recruitment Compensation Practices
  • January 16, 2013 | Authors: Margaret R. Blake; W. Hardy Callcott; Amy Natterson Kroll
  • Law Firms: Bingham McCutchen LLP - Washington Office ; Bingham McCutchen LLP - San Francisco Office ; Bingham McCutchen LLP - Washington Office
  • On Jan. 7, 2013, FINRA issued Regulatory Notice 13-02, Recruitment Compensation Practices (“Notice”), which requests comment on a proposed rule requiring disclosures of financial incentives paid to registered representatives when changing brokerage firms (“Proposed Rules”). Comments on the Proposed Rules must be received by FINRA by March 5, 2013.

    Overview

    Many member firms offer “enhanced compensation” to registered representatives as incentive to move from one firm to another. For purposes of the Proposed Rule, FINRA defines “enhanced compensation” as compensation paid in connection with the transfer of securities employment (or association) to the recruiting member other than compensation normally paid by the recruiting member to its established registered persons. The Proposed Rule assumes that most firms have a standard “commission grid” or similar schedule and that it is easy to identify “enhanced compensation” that is above that standard compensation. It is not clear how the Proposed Rule would apply to smaller firms with more individualized compensation arrangements.

    FINRA notes that certain recruitment programs provide enhanced compensation that, if not disclosed, create a conflict of interest about which customers should be advised. In particular, in some instances, these programs are viewed as enticing representatives receiving the enhanced compensation to engage in activity that may not be in the best interest of the underlying clients (such as churning or unsuitable mutual fund or variable annuity “switching”), but rather is geared toward achieving the level of sales required to receive the enhanced compensation rewards.

    According to FINRA, “enhanced compensation” would include such things as signing bonuses, upfront or back-end bonuses, loans, accelerated payouts, or a similar arrangement where an individual is paid in connection with the transfer of securities employment (or association) to the recruiting member. The disclosure requirement also would apply to “transition assistance” payments, although it is not clear how those payments could create the feared potential conflict of interest with customers. The disclosure requirement would not include any payout by the recruiting member that is not related to the transfer of securities employment (or association).

    The Proposed Rule would require disclosure of these enhanced compensation payments to a retail customer of the representative at the representative’s prior firm at the time the representative requests the customer to transfer accounts to the representative’s new firm.

    The Proposed Rule

    The Proposed Rule would require the recruiting firm to make detailed disclosure of the enhanced compensation to be paid to a registered representative who is joining the recruiting firm. The disclosure must be clear and prominent, and must include information regarding the amount and type of enhanced compensation, as well as the timing of the arrangement.

    The disclosure would be made by the recruiting firm to any customer with an account assigned to the registered representative at his/her prior financial services industry firm who (1) is individually contacted by the recruiting member or representative, either orally or in writing, regarding the move of the representative to the recruiting firm; or (2) seeks to transfer an account from the representative’s prior firm to an account with the registered person at the recruiting member firm.1 The disclosure would not apply to new customers with whom the registered representative did not have a relationship at his/her prior firm, although arguably some of the compensation conflicts of interest created by the incentives could apply to those customers as well. FINRA requests comment on this issue.

    The required disclosure would be required for one year following the date on which the representative associates with the recruiting member firm (no matter how long the recruiting incentives might exist). The disclosure would be made either orally or in writing after the representative has associated with the recruiting firm (and has terminated association with the prior firm) and at the first individual contact with the customer by the recruiting firm or the registered person. If the disclosure is made orally or if the customer seeks to move an account to the recruiting member firm and no individualized contact between the recruiting firm or the representative and the customer has occurred, then a required written disclosure must be made by the recruiting member firm to the customer with the account transfer approval documentation.

    Exclusions

    Most institutional accounts would be excluded from the disclosure requirements. Specifically, disclosure need not be given to any “institutional account” as defined under FINRA Rule 4512(c). However, disclosure still must be made to natural persons or to a natural person advised by a registered investment adviser.

    In addition, a de minimis exception provides that the recruiting firm need not disclose enhanced compensation in an amount under $50,000. According to FINRA, this is to allow firms to offset the costs a representative might incur in transitioning to the new firm, since, in FINRA’s view, these costs do not present the same level of conflict as other enhanced compensation arrangements. FINRA requests comment on the appropriateness of the de minimis exclusion, and whether it is set at the right level.

    Request for Comments

    The Notice seeks comment on a number of areas including,

    • When and how should the disclosures be made (e.g., should the Proposed Rule require written disclosure at the first individualized contact in all instances, rather than allowing oral disclosure?); and

    • Should the customer be required to affirm receipt of the required disclosure, and whether such an affirmation would delay the account opening process to a customer’s disadvantage.

    The Proposed Rules also contain a detailed request for information (including data where possible) about the economic impact and potential benefits of the Proposed Rule, such as the direct and indirect costs for the recruiting member that might result, the possible benefits to the investors as a result of the Proposed Rule, and whether the Proposed Rule will indeed reduce conflicts related to recruiting compensation. FINRA has recently committed to provide economic cost-benefit analysis to the SEC in support of major rule change proposals. The recruiting compensation disclosure proposal is one of the first in which FINRA appears to be following through on this commitment. How FINRA conducts its cost-benefit analyses, and how the SEC assesses those analyses when deciding whether to approve FINRA rule changes, are issues that bear careful attention in the coming year.

    In October 2010, in Notice 10-54, FINRA issued a concept proposal which would have required FINRA member firms to have provided customers with a disclosure brochure at the outset of every customer relationship outlining the firms’ services, fees and potential conflicts of interest - similar to the Form ADV brochure required for investment advisers. Many in the securities industry commented that this proposal was premature, and urged FINRA to wait for the SEC to complete its investment adviser/broker-dealer harmonization project before adopting such a comprehensive disclosure requirement. FINRA appears to have broken off a piece of larger proposal, for a situation (recruiting incentives) in which it saw particular opportunities for customer harm.

    Conclusion

    It is unclear whether the disclosures required under the Proposed Rule will achieve what FINRA is seeking. Compensation incentives can be complex and hard for those outside the industry to understand, and it is not clear that all customers view them as material in any event. Moreover, some may view FINRA’s attempt to discourage recruiting compensation incentives as potentially anti-competitive. If FINRA is concerned about churning and mutual fund or variable annuity switching, there may be more direct and effective ways of addressing those problems. Moreover, there will be costs to the member firm of providing yet another disclosure, and requiring the disclosure is likely to slow the process of allowing customers to follow the registered representatives on whose advice they have relied. However, unless these costs can be quantified and are significant, we believe FINRA is not likely to accept an economic argument of this sort. Member firms engaged in the use of enhanced compensation in recruiting efforts should consider the Notice and FINRA’s specific questions in light of these practices.


    Endnotes

    1 For purposes of the proposed rule, FINRA defines “financial services industry” to include industry regulated by the SEC, Commodity Futures Trading Commission, state securities authorities, federal or state banking authorities, state insurance authorities, or substantially equivalent foreign regulatory authorities.