FINRA Is Looking for Additional Disclosure on Up Front Loans to Reps

January 15, 2013

Depositphotos_2505951_xs.jpgIt is commonplace in the securities industry for reps to transition from one broker-dealer to another. If the rep is a big producer, it is typical for the hiring firm to offer the rep a "forgivable loan" as an inducement to join. Depending upon the size of the producer's book, the forgivable loan can equal 100% to 200% of the producer's trailing 12 month's of production, and is typically forgiven in equal increments annually over a 7 to 9 year period.

FINRA just published Regulatory Notice 13-02, seeking comments on a proposed rule to
require disclosure of "conflicts of interest" relating to recruitment compensation practices. The proposed rule, called "Enhanced Compensation", has the following components:

  • For one year following the rep's start date, the "recruiting" broker-dealer must disclose the "details" of the enhanced compensation "at the time of first individualized contact by the recruiting member or registered person with the former customer after the registered person has terminated his or her association with the previous firm." That should make for an interesting first conversation with the customer.
  • If the disclosure is made orally, "the recruiting member also must provide the disclosure in writing to the former customer with the account transfer approval documentation."
  • If the customer seeks to transfer absent contact by the new firm, disclosure must still be made in writing with the ACAT paperwork.
  • The written disclosure must be "clear and prominent." According to Regulatory Notice 13-02, disclosure "must include information with respect to the timing, amount and nature of the enhanced compensation arrangement."
  • The proposed rule requires no disclosure to institutional accounts that meet the definition of FINRA Rule 4512(c) (unless the rep is a registered investment adviser) or for enhanced compensation less than $50,000.

The premise of the proposed rule is that a "conflict of interest" exists when a broker receives a
recruitment package from a new employer. I, for one, reject that premise and FINRA should
publish its studies - if such studies even exist - which support its premise. Why should a broker
be required to disclose his or her total compensation to a customer? Brokers are not held to a
fiduciary standard, and have no obligation under the law to disclose their compensation beyond
the fees charged to any given customer.

The proposed rule is a follow-on to former SEC Chairman Mary Schapiro's "open letter" to
broker-dealers dated August 31, 2009 (http://www.sec.gov/news/press/2009/2009-189-
letter.pdf). In the letter, Schapiro warned broker-dealers not to incentivize churning by giving
an incoming rep increased compensation for hitting a commission target.

However, what if a broker's book is entirely fee-based, surely that would eliminate the
Commission's concern about "churning?" Nevertheless, FINRA's proposed rule gives no carve-
out for fee-based brokers. And what if the hiring broker-dealer offers no increased commission
targets in its compensation package? Nevertheless, FINRA offers no carve-out for that either.

The bottom line is that FINRA's rule is ill-conceived and unsupported. FINRA should articulate
these "conflicts" and then give carve-outs for all "conflict free" compensation packages.