By Kent Crocker
FINRA recently issued a report on observations made while analyzing brokerage firms that suggests a broker’s accountability and compensation may need to be altered in order to protect the “best interests” of customers. More specifically, FINRA recently modified the suitability rule when it added more duty of care elements, but is now raising the possibility of implementing the duty of loyalty standard. Holding a broker to the duty of loyalty standard may help prevent conflicts of interest, which often arise from how the broker is compensated. For instance, a broker can be compensated more favorably based on what investments he sells to customers. The broker could also be under the direction of the firm to sell only certain investments to customers in cases where the firm is motivated to generate the revenue from investments that more favorably compensate the firm.
Implementing a duty of care standard helps guide brokers in a few respects. The duty of care standard creates the requirement that the broker be well-informed in the investment a customer is being placed in. If the broker breaches the duty of care, then the broker can be found liable for negligence and entitle the customer to damages. Under this rationale, it is quite obvious why FINRA decided to include the duty of care in the suitability standard, as brokers should be aware of the consequences of not finding the correct investment for each customer. However, the duty of care standard draws into question the compensation platforms that some brokerage firms may use and suggests that caps should be placed on the amount of fees a broker or brokerage firm is allowed to receive or charge. The logic behind this rationale is simple: Brokers and firms are motivated and driven to make a profit, which can create a conflict of interest where the customer’s “best interests” are not considered to the extent FINRA would like.
FINRA is now hinting at implementing the duty of loyalty in order to offset the amount of influence profit and compensation can have on both the firm and broker’s decision making process. Again, the manner in which brokers and firms are compensated would have to be altered in order for the amount of claims being brought to decrease. However, if the duty of loyalty were to be enacted, then it would run contrary to how the duty of loyalty is applied in corporate settings. For instance, a board of director for a corporation has the fiduciary duty of loyalty to always make decisions that are in the best interests of the corporation. Here, the brokers and firms would have a duty of loyalty to the client’s best interests and would be prevented from making decisions based on the best interests of the firm.
In order to help firms and brokers evolve towards a greater concern for the “best interests” of the customer, FINRA and the Securities and Exchange Commission (“SEC”) could tighten the standards for brokers and firms by intensifying the fiduciary duties owed to clients. In the view of the regulators, the financial industry is often driven by sales and profits, which suggests the motivation behind the duty of loyalty discussion. FINRA and the SEC are regulating the industry to ensure the rights of investors are protected, but overregulation can be just as devastating in the opposite respect. Unsurprisingly, many in the financial industry do not want brokers to be subject to a duty of loyalty by FINRA, the SEC, or any other regulatory agency. It will be interesting to see how far regulation can go. The duty of loyalty appears reasonable on its face, but its application in the current compensation structure for firms and brokers may prove difficult.