By Bernadette Sadeek
If firms want to recruit high-producing brokers, they may soon be required to disclose their bonus incentive packages to customers. On September 19, 2013, the Financial Industry Regulatory Authority (FINRA) Board of Directors approved a proposal to require disclosures of conflicts of interest relating to recruitment compensation packages incentivizing brokers to move to a new firm. The proposal is now being considered by the Securities and Exchange Commission (SEC) for final review and approval. The SEC staff may request changes or amendments to the rule proposal.
There are two main components of the proposed rule. The first is a disclosure requirement, obligating “recruiting firm[s] to make important disclosures to a registered representative’s former customer who is contacted about following the representative to the recruiting firm or who decides to transfer assets to the new firm.” Firms would have to disclose any upfront payments (e.g. guaranteed bonuses and loans) and potential future payments (e.g. compensation contingent upon satisfying performance criteria or special payments not ordinarily provided to similarly situated representatives) and the basis for receiving the potential future payments. The disclosure would be required if the broker’s compensation package exceeds $100,001. However, the amount of compensation would only be required to be divulged in ranges, i.e. $100,000–$500,000, not the precise dollar amount. Lastly, because switching firms could be costly to investors, firms would also have to disclose the costs that would “accrue if a customer decides to transfer assets to a new firm” as well as the fact that “certain assets may not be transferrable.”
FINRA states that the purpose for requiring these disclosures is to allow the customer to make an informed decision about the implications of following the broker to the new firm. Many firms offer significant financial incentives to recruit brokers to join their firms and to transfer their book of business to the new firm. A typical compensation package is paid upfront to the broker in the form of a 10-year forgivable loan. The compensation package is usually based on the broker’s 12-month gross production or revenue produced in fees and commissions during the past year at the broker’s old firm. Other factors that may influence a broker’s bonus package include the firm from which the broker is transferring, the broker’s book of business, and the broker’s years of service and experience. The offer is typically an irresistible financial package, sometimes reaching up to several million dollars and exceeding three times a broker’s annual production. At some firms, the compensation package will include a combination of a forgivable loan and an annual bonus that equals the annual installment due on the loan at the time the loan payment is due. As part of this package, each year, the broker is expected to meet or exceed a sales goal in order to be “forgiven” for a portion of the loan. If the broker fails to meet the sales goal, the broker is obligated to pay installments on the loan, plus interest. Consequently, brokers may feel pressured to sell securities as high levels, or worse, engage in conduct that may violate obligations to investors (i.e. recommending unsuitable investment products or churning customer accounts), in order to generate enough fees and commissions to meet the firm’s expectations.
Meanwhile, an unassuming customer would be completely oblivious that this arrangement creates a significant conflict of interest. While the broker is bound by the duty to recommend and operate in the customers’ best interest, the bonus packages incentivize brokers to generate more costs to the customer. Therefore, the disclosures are intended to provide transparency and to protect customers from the conflict that arises when the customer follows the broker to a new firm. Customers would be able to make a fully informed decision to follow the broker to a new firm and understand the costs and other implications associated with transferring his or her account.
The second component of the proposed rule is a reporting obligation—requiring a “recruiting firm to report to FINRA when a representative is expected to receive [either] an increase in total compensation over the prior year of 25 percent or $100,000, whichever is greater, in connection with the transfer to that firm.” FINRA would use this information to compile an industry-wide risk-based examination of compensation packages as it relates to sales abuses.
Some firms who oppose the rule warn the proposed rule is anti-competitive in nature because it would limit compensation and discourage brokers from seeking new employment at another firm. However, the problem of broker sales abuse due to pressures associated with the recruiting practices of the industry has persisted for many years. This proposed rule is a step towards preventing such abuses relating to conflicts of interests between firms, brokers, and their customers.
To view a short video detailing this report, please see the FINRA Regulation Guidance Video