Déjà Vu All Over Again: FINRA to Focus on Conflicts of Interest Regarding the Sale of Complex Financial Products in the Wake of the Financial Crisis

by Pepper Hamilton LLP

[authors: Ivan B. Knauer and Min Choi]

The Financial Industry Regulatory Authority (FINRA) has announced it will be looking closely at potential conflicts of interest and financial incentives tied to the sales of complex financial products by major brokerages. The regulator also is looking at conflicts and incentives at broker-dealers that develop and sell certain complex products. FINRA has already commenced a sweep of firms to review how they identify and manage these conflicts of interest.

As noted in a recent Wall Street Journal column, these initiatives are “the first systematic look at conflicts” by the self-regulatory organization “in years.”1 The steps taken by FINRA are reminiscent of its investigation into conflicts of interest that began in earnest in 2003 tied to research analysts and investment banking practices. Those investigations were preceded by large investor losses attributable to the bursting of the dot-com bubble. Similarly, and as discussed below, FINRA’s current investigation appears to be tied to ongoing investigations into “New and Structured Products,” most notably mortgage-backed securities and related derivative products associated with the financial crisis of 2007-2008. As many will recall, although FINRA’s efforts in 2003 were focused on high-profile investigations into major financial institutions, they resulted in a number of related investigations into smaller firms that acted as partners, intermediaries, and trade counterparties.

The Announcement and Related Sweep

FINRA’s renewed interest in conflicts of interest was first highlighted in a speech given by CEO Richard Ketchum at FINRA’s Annual Conference on May 21, 2012.2 Ketchum described changes in FINRA’s examination process, including greater emphasis on pre-exam screening to identify specific “problem securities” and “problem trading activity,” as well as heightened surveillance of firms trading across multiple markets and financial products. Ketchum also discussed how firms can work with FINRA to make its new exam program more effective and less intrusive. Specifically, Ketchum called on firms “to do a better job” of assessing and disclosing conflicts arising out of broker-dealers getting more heavily involved in the sale of “complex products.”

Although Ketchum was unwilling to offer any bright-line tests as to what constitutes a “complex product,” he cited a January 2012 Regulatory Notice. The Notice provided guidance on financial products designed to perform well in both bull and bear markets, products whose performance is contingent on the performance of other assets or the outcome of certain events, and any security whose value may be tied to the performance of derivative contracts.3 FINRA has since identified specific products and instruments such as mortgage-backed securities, REITs and exchange-traded funds.4

That said, Ketchum suggested that, as a rule of thumb, before an advisor offers a product to a customer, he or she should be able to write on a single page why that investment is good for the client. To reach this point, Ketchum suggested firms work on vetting products more thoroughly; making sure sales supervision policies and procedures are tight enough to ensure this rule of thumb; and training sales staff so that when they go out on to the market, they understand the product and the risks of selling, and explain these features to customers in a clear and concise manner.

Ketchum’s speech was followed in July 2012 by a series of “Targeted Examination Letters” that were sent to a number of firms asking for information by September 14, 2012.5 Echoing Ketchum’s speech, the letters asked for: the “most significant conflicts” each firm was currently managing; the names of persons and departments responsible for conflict reviews; the types of reports prepared as a result of conflict reviews; and, in general, the processes firms have in place to identify and assess whether their business practices put the firm’s or its employees’ interests ahead of those of its customers.

Notably, the letters also requested a follow-up meeting during the fourth quarter of 2012 with the firms’ executive business and compliance staff. How many or which firms were approached by FINRA is not known. Industry professionals speculated that FINRA was likely starting off with larger institutions with diversified business models – particularly those with internal proprietary trading arms – and those with retail operations.6

More recently, at a Securities Industry and Financial Markets Association (SIFMA) conference in New York on September 27, 2012, Ketchum and another FINRA executive, Susan Axelrod, announced that FINRA was beginning to look more closely at sales compensation practices tied to complex financial products. Ketchum suggested that firms should consider whether any special incentives or fee structures were in place that would cause a broker to recommend a complex product over other products.7 Ketchum reminded firms that sales of complex products to discretionary accounts were particularly concerning, and that sales staff should in all instances explain to customers potentially good and bad product features.

Axelrod, of Member Regulation and Sales Practices, noted that in the current market climate, many investors are seeing returns on traditional investments sharply decline.8 According to Axelrod, investors have migrated toward complex products in an effort to benefit from higher yield, even though investors do not understand the associated risks. She then addressed FINRA’s recently announced sweep. She suggested that FINRA was taking a close look at the conflicts arising from products created by one firm and sold by a related firm, and any underlying commission agreements. Axelrod also suggested FINRA was scrutinizing whether investments made by broker-dealers directly conflicted with positions sold to clients of those same broker-dealers. She advised that firms should have written policies to address how these conflicts are managed and disclosed.

What to Make of It All

As mentioned above, FINRA’s renewed interest in conflicts of interest is similar in look and feel to investigations by FINRA into conflicts regarding investment bankers and research analysts in 2003. Both followed major disturbances in the market. Both challenged longstanding practices that were considered by industry to be “business as usual.” In addition, FINRA’s efforts in 2003 were combined with investigations by the Securities and Exchange Commission (SEC) and state regulators. Notably, at the September 27, 2012 SIFMA conference, William Hayden, a senior director at FINRA specializing in emerging regulatory issues, was joined on a panel by senior attorneys from the New York Office of the Attorney General and the SEC’s Structured and New Products Unit.9 The panel noted that a significant number of customer complaints have been related to complex products, and that the New York Attorney General’s Office has created a task force to deal with these complaints.

Similarly, the panel noted that the SEC’s initial foray into complex products, immediately following the financial crisis, involved sales by major firms to institutional investors. But while the risks to these larger investors have declined, the SEC has begun to see sales of these products in the retail sector. According to the panel, given their prior experience with these products, if the SEC has reason to believe that a firm distributing these securities might be engaged in improper sales of complex products to retail customers, it may begin to look at that firm’s peers to determine if they are engaging in similar misconduct. This tactic would be a more comprehensive, risk-based approach to investigations by the agency, which historically limited the scope of its investigations to tips the SEC received about specific problems at individual companies.


1 Jason Zweig, Conflict of Interest? Moi?, The Wall Street J., Oct. 5, 2012, at B1.

2 FINRA CEO & Chairman Richard G. Ketchum, Remarks from the FINRA Annual Conference (May 21, 2012) (“Ketchum Speech at FINRA Annual Conference”).

3 See FINRA Regulatory Notice 12-03 at 3-5.

4 See FINRA CEO & Chairman Richard G. Ketchum, Remarks From the SIFMA Complex Products Forum, (Sept. 27, 2012) (“Ketchum Speech to SIFMA”); FINRA Executive Vice President Susan F. Axelrod, Remarks From the SIFMA Complex Products Forum (Sept. 27, 2012) (“Axelrod Speech to SIFMA”).

5 The letter is posted on FINRA’s Web site at http://www.finra.org/Industry/Regulation/Guidance/TargetedExaminationLetters/P141240.

6 Ben Maiden, FINRA Launches Conflicts-of-Interest Sweep, Compliance Reporter, July 27, 2012.

7 Ketchum Speech to SIFMA, supra.

8 Axelrod Speech to SIFMA, supra.

9 See Suzanne Barlyn, U.S. SEC, in Tactical Shift, Casts Suspicious Eye on Peers, Reuters, Sept. 27, 2012; Lloyd Harmetz & Anna Pinedo, It’s Complicated: A Recap of SIFMA’s Complex Products Conference, Mondaq Blog, Oct. 5, 2012.



DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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