Recent statements by securities regulators emphasize that financial firms need to move beyond a "culture of compliance" to ensure that investors have a better understanding of risk and the investments they are purchasing. During his keynote address at FINRA's Annual Conference, held in Washington, D.C., May 20-22, FINRA Chairman and CEO Richard Ketchum recommended firms focus on the quality of the disclosures they provide to their customers.
Disclosure of Conflicts of Interest
Ketchum stated that FINRA is completing its review of industry
practices regarding identification and disclosure of conflicts of
interest and plans to issue a report that outlines some strong
conflict management practices. The quality of disclosure provided
to customers is likely to be a major focus of the report, which
will be published this summer. "How do we change the dynamic
so investors truly understand what they're buying and,
likewise, that financial advisers understand what they are
selling?" Ketchum asked. He stated firms must provide
comprehensible, plain-English risk disclosure to customers and
suggested that some of the compelling images that appear on the
marketing pages of firm websites might be better employed on the
legal and disclosure pages. Ketchum noted that FINRA is
particularly focused on conflicts pertaining to (1) firms'
controls around the sale of structured products both to their own
private wealth divisions and to other firms; and (2) firms'
controls around compensation, regarding their own efforts to design
more product-agnostic commission grids and with respect to
third-party incentives.
FINRA has already taken action to address compensation disclosure.
In January, FINRA proposed a rule requiring disclosure of
recruitment compensation packages. The rule would require a
broker-dealer that recruits representatives using enhanced
compensation (including signing bonuses, up-front or back-end
bonuses, loans, accelerated payouts, transition assistance, and
similar arrangements) to disclose such compensation to customers
solicited to transfer with the representative. The comment period
expired in March, and Ketchum announced the rule will be discussed
at FINRA's July board meeting.
Disclosure of Risks of Complex Products
Ketchum voiced concern about the sale of complex and speculative
products with low liquidity to unsuitable customers by financial
advisers who often don't fully understand the risks of the
products. He cited the fixed-income market as an example, noting
that in this zero-yield environment, many investors are taking on
more risk by moving to longer-duration or high-yield fixed income
products. Ketchum urged firms to ensure that investors better
understand the risks and possible negative scenarios of
concentrated holdings in these types of securities. Firms that make
illiquid investments available to retail customers would be
well-advised to explain to clients the features of the product, how
the product is expected to perform under different market
conditions and the possible negative scenarios that can impact this
investment. Ketchum noted, "It is a great time to remind
clients that bond funds are not the same as directly owning fixed
securities," and he suggested firms also provide better risk
disclosures relating to investments in funds that invest in
leveraged loans, private REITs, closed-end funds and private
placements.
Ketchum's concerns about investor disclosure were echoed by SEC
Commissioner Elisse Walter during a question-and-answer session at
the FINRA Annual Conference, where she encouraged firms to educate
bond investors about how rising interest rates would negatively
impact their bond portfolios.
Disclosure and the Uniform Fiduciary Standard
During the question-and-answer session, Walter stated she would like the SEC to move forward with shaping a uniform fiduciary standard for broker-dealers and investment advisers, noting that she believes "the cost of brokers becoming fiduciaries is very low." Ketchum also called upon the SEC to finalize a uniform fiduciary standard. Enhanced disclosure obligations for broker-dealers are likely to be part of any rule making. The SEC staff study required by Section 913 of the Dodd-Frank Act recommended the SEC facilitate the provision of uniform, simple and clear disclosures to retail customers about the terms of their relationships with broker-dealers and investment advisers, including any material conflicts of interest. These disclosures could take the form of a general relationship guide similar to Form ADV Part 2A, and firms could provide more specific disclosures when they give their clients personalized relationship advice. Walter expressed hope that the comments submitted in response to the SEC's request for data and economic analysis on the costs and benefits of alternative approaches regarding the standards of conduct will assist the agency. The comment period ends on July 5.
Conclusion
Although the culture of compliance continues to be a buzzword in financial regulatory circles, it appears that disclosure -- in plain English rather than legalese -- is primed to be a new regulatory focus. To stay ahead of the curve, financial firms should take a close look at how they communicate with their investors and consider enhancing their disclosures to make them easier to understand.
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