The salad days of broker-dealers and their registered investment advisors routinely maximizing compensation at investors’ expense will soon be coming to an end as the Securities and Exchange Commission (SEC) ramps up enforcement, two veteran industry experts said yesterday.
The SEC and Finra will be moving from requiring firms to disclose their conflicted compensation, including 12b-1 fees and differential compensation, to actually requiring them to halt such practices or face enforcement consequences, Christine Lazaro, professor and director of the Securities Arbitration Clinic at St. John’s University School of Law, and Ron Rhoades, associate professor and director of the personal financial planning program at Western Kentucky University, said during a press call sponsored by the Institute for the Fiduciary Standard.
“Through enforcement actions, I expect we’ll get a clearer expression of what will be deemed insufficient mitigation with regard to Regulation Best Interest,” the SEC’s retail investment advice rule, Lazaro said. “I think there will be a focus early on in a few areas where brokers may maximize their compensation at the expense of their customers.”
Enforcement will result in fines and restitutition orders for firms and individual sales professionals who fail to eliminate compensation and advice practices that enrich them at the cost of investors, said Lazaro, past president of the Public Investors Arbitration Bar Association (PIABA).
One of the likely enforcement flashpoints will be products that pay higher or “differential” compensation, especially in connection with complex products, Lazaro said.
Firms have long justified paying brokers more for sales of complex products because they require brokers to spend more time understanding and explaining the products. But the practice “raises serious conflicts and places the broker’s interest in direct competition with the investor’s interest,” she said.
Lazaro said she has seen “so many cases” where a broker has justified the recommendation of a complex product because it generates income for the investor, but with no justification or appreciation of the risk of the investment or the illiquidity of the investment. “In many cases, it’s often obvious that the reason for the recommendation is that it generates a substantial amount of income to the broker,” she said.
Regulators will also focus on the conflicts in recommendations by dual registrants regarding account types—"especially those who recommend an investor’s buy-and-hold investments be placed in a managed account where the advisor can receive an ongoing fee, while the complex, high-commission products are placed in a brokerage account where active trading will be most profitable to the advisor,” Lazaro added.
The SEC may want to consider banning dual registrants from being able to offer both brokerage and advisory accounts to the same customer, Rhoades said. “Some countries like the U.K. have severely limited when brokerage accounts can exist. While many advisors left the industry, the demand for financial advice soared,” he added.
“In these situations, the investor doesn’t understand that the investment professional has one duty with regard to advisory account and a different duty with respect to the brokerage account. Nor do they understand how they’re paying the person. But it can be clear in these situations that the investors’ interests are being subordinated to the broker’s interest and I expect the regulators are going to say that’s not OK,” Lazaro said.