Finding out whether your broker has a conflict of interest can make the difference between a successful investment and a disastrous one

Oct 25, 2013

Pros and Conflicts: Whose Side Is Your Broker On?

JASON ZWEIG

Finding out whether your broker has a conflict of interest can make the difference between a successful investment and a disastrous one. A new report by securities regulators suggests how brokerage firms can mitigate their many conflicts. At the same time, the report’s findings could make one of the most important and difficult tasks for investors—knowing your broker—a little easier. Earlier this month, the Financial Industry Regulatory Authority, which oversees how brokers sell investments, released a 44-page study on conflicts of interest in the securities industry.“Conflicts have existed, they still exist and they will exist in the future in this industry,” says Susan Axelrod, Finra’s executive vice president for regulatory operations. The report doesn’t address all conflicts of interest or call for eradicating them; that would be the Wall Street equivalent of King Canute commanding the tide to stop climbing higher on the beach.

Rather, the report seeks to explain how conflicts arise and to “inspire discussion and self-evaluation by firms to determine whether their current policies are aligned with best practices,” Ms. Axelrod says.

Beginning late in 2012, regulators from Finra spent months studying products, procedures and sales practices at more than a dozen major brokerages. Finra won’t name any of the firms. The final report looks at the governance of firms; how complex financial products are marketed; and how brokers are paid.

There is probably no way to know whether conflicts in the brokerage business are more severe or common than they used to be.

But they aren’t hard to find. An adviser might earn undisclosed fees that could taint his objectivity or recommend mutual funds run by his firm over cheaper third-party choices; he could collect upfront commissions on funds right before moving the client’s assets to a fee-based account.

Often, the code of conduct meant to guide brokers’ behavior doesn’t require them to act in their clients’ best interest. The Finra report urges firms to adopt such a proviso. Some firms don’t give brokers specialized training to sell complex products like “structured notes,” debt securities whose returns depend on factors beyond interest payments alone.

However, other firms review such products after launching them to see whether they perform as promised and to learn whether they have been sold to investors—or by brokers—who don’t understand them.

“That’s a strong process,” Ms. Axelrod says, “and one that I would strongly suggest that firms consider adopting.”

Some brokerages, according to the Finra report, refuse to offer higher payouts for selling in-house mutual funds or other investments; that might help prevent brokers from pushing funds that benefit the firm more than the client.

Others electronically monitor whether brokers are churning their clients’ portfolios with extra transactions at the end of a month in order to earn bonus payments for themselves; that could help reduce excessive trading.

“As Upton Sinclair said, ‘It is difficult to get a man to understand something when his salary depends on his not understanding it,’” says Tom Lin, a securities-law professor at Temple University in Philadelphia. “Finra is saying,

‘Don’t let your employees get into that kind of position.’”

Overall, the Finra document is a reminder that the brokerage industry remains focused not on managing investments and delivering advice for clients, but on generating sales and trading by customers.

While the words “customer” and “customers” appear 126 times in the Finra report, “client” and “clients” turn up only 44 times, according to the search function in Adobe Reader. “Product” and “products” appear 278 times; “investment” and “investments” 45. Variants of “sale” and “sell” are used 78 times; “advice,” only eight. There are 29 uses of the word “trading”; “investing” is used just twice in the 22,000-word report.

Still, by identifying the best techniques that firms are using to lessen conflicts, Finra has given investors a leg up, says Henry Hu, a law professor at the University of Texas and a former director of economic and risk analysis at the Securities and Exchange Commission.

Imagine, suggests Prof. Hu, that your broker didn’t seem to understand that structured note he sold you—which has since collapsed. You can contact your broker’s supervisor and ask whether the broker got special training before he sold it and whether the firm has been monitoring the note’s performance.

By invoking the best practices highlighted in the Finra report, you should be able to get special attention for your complaint, Prof. Hu says.

As always, the best protection against a conflicted adviser is to be a vigilant client.