Last month, FINRA issued a Targeted Exam Letter to about a dozen retail broker-dealers seeking detailed information about a broad range of compensation practices, including payout grids, recruiting incentives, mutual fund fees, and income received from product sponsors. The letter requests firms to identify and describe how compensation is determined and governed and to explain the systems used to identify, manage, and supervise compensation-related conflicts of interest. This sweep follows FINRA’s comprehensive Report on Conflicts of Interest published in October 2013 and is intended to “continue [FINRA’s] assessment of the efforts employed by firms to identify, mitigate and manage conflicts of interest, specifically with respect to compensation practices.” As noted by one senior official with the regulator, “We really want to find out if [firms have] taken the original guidance to heart.”
Hopefully, yours is not one of the firms “lucky enough” to have received the request. It is comprised of 19 separate questions, many with subparts. Several of the questions could be challenging for many firms to answer, such as this one: “Identify and describe surveillance efforts … that … assess whether potential compensation-related conflicts of interest are materializing … [and] [i]ndicate how many compensation-related conflict of interest escalations occurred during the period of August 2014 through July 2015.” Or this one: “Describe how current compensation structures balance short-term incentives for registered representatives and clients’ long-term interests.”
In my experience, compensation-related conflicts are among the most difficult for compliance and risk officers to get arms around. Many firms have highly complicated pay-out formulas based on grids that have evolved and been revised over many years. Presumably, most firms conducted some level of conflicts review and assessment after the 2013 Report was issued, but I suspect that many did not perform a comprehensive analysis of broker compensation or map out a set of controls specifically designed to identify and manage those conflicts.
Now may be a very good time to do so. Firm and broker compensation lie at the heart of the inherent conflict embedded in the brokerage model. Although the sweep is focused on gathering information and may not be a prelude to a wave of enforcement cases, firms should take heed and act now to ensure the house is in order. If your firm did not conduct a full and detailed analysis of its compensation system in response to the 2013 Report, this may be your last chance as FINRA examiners are likely to ask at least some of the questions from the sweep letter in your next routine exam. Even if you feel comfortable with your firm’s conflicts control structure, it would be a good idea to use the sweep questions as a guide in conducting a self-assessment to measure the effectiveness of your program.