Financial Planning

FINRA Makes a 17-Page New Year’s Resolution

FINRA's 2015 regulatory to-do list might help investors make more informed decisions, but it doesn't guarantee clients come first always.

Last week, the Financial Industry Regulatory Authority (FINRA)-brokers' self-regulatory body-released its 2015 rule-writing wish-list, or Regulatory and Examinations Priorities Letter. The goal? Putting customers first! Uniform fiduciary standard or no, regulators want to improve disclosure and incentives so firms are more transparent and client-focused. In theory, great! But even if FINRA finishes its entire to-do list, rules can go only so far. Weighing whether a firm puts clients first will still take more due-diligence than checking its regulatory checklist.

How so? Here are some highlights from FINRA's "areas of focus":

  • Improve the marketing of interest rate-sensitive fixed income securities by discussing how rate changes impact securities' prices
  • Assess "compensation structures that may improperly incent the sale of variable annuities" and audit whether recommended annuities are suitable for a client
  • Widen background checks to prevent firms from hiring shady characters
  • Look closely at how firms deal with IRA rollovers, the sale of a client's business, inheritances, divorce and other "wealth events" and improve the "objectivity" of related recommendations
  • Abandon "alternative mutual fund" as a descriptor for hedge-fund-like mutual funds, and get firms to refer to them by their actual strategies
  • Make sure alternative funds' marketing materials describe how the products actually work, matching the prospectus
  • Encourage brokers to track non-traded REITs they recommended, stop pushing REITs with obvious problems and report more accurate (net-of-fee) pricing
  • Think really hard about exchange-traded funds tracking non-traditional indexes (e.g., book value-weighted, volatility-weighted), which are marketed as "providing superior risk-adjusted performance" even though their returns are back-tested and have little real performance history
  • Think really hard about floating-rate bank loan funds' illiquidity and credit risk
  • Improve oversight of securities-backed lines of credit
  • Root out "excessive trading"
  • Improve brokers' due diligence on recommended private placements
  • Make sure brokers pass on volume-based discounts to customers
  • Provide more and better senior-focused services, and increase regulatory audits of communication with seniors

In our view, Finra's regulatory heart is in the right place. More disclosure helping investors better assess products are good. Encouraging brokers not to peddle complex investments just because commissions are high is right. Requiring more rigorous employee background checks could decrease fraud.

But there are precious few "this will happen" statements. Most of these are descriptions of problems or things to think about. Take variable annuity sales commissions-"assessments of compensation structures" does not mean "end sky-high commissions." FINRA isn't pledging to cap commissions charged for these high-fee, high payout products-it just wants to keep a closer eye on them. Nor are they capping commissions on nontraded REITs-just encouraging disclosure. Similar logic applies as you go down the list. "Recommending" firms improve disclosure of alternative funds and exchange-traded products is not "ordering" change. (Not that we are suggesting this-more on that in a moment.)

Plus, while regulators can tweak the rules, the retail brokerage and insurance sales models have inherent conflicts of interest. FINRA's noble aims probably won't sway anyone who was swayed before by lofty commissions and sales charges. We suspect it will be tough for some brokers with commission-based compensation to put a client's interest first or tell clients the industry he or she works in has a fundamental conflict of interest.

Complexity is another factor. Returns on illiquid, complicated investments like variable annuities and non-traded REITs aren't something you can punch-up on Bloomberg or Yahoo! Non-traded REITs lack a transparent market value, making it impossible to verify yield. Annuities' advertised guaranteed income usually isn't their actual income. It is TBD whether every broker has the time or experience to understand and explain-without jargon-the ins and outs of everything they recommend. (And TBD whether FINRA's training wish-list helps.)

Now, maybe knowing FINRA is watching closely does inspire more brokers to put clients first. But (sadly) trying to force this is a fruitless endeavor, in our view. Values, not rules, are what make firms put clients first. No matter how noble their intent, no regulation or regulator can make someone believe something they don't. Values come from within, not without. You put clients first or you don't. The brokerage model is so rife with conflicts of interest, we think brokers who do have proper, client-centric values face stiff headwinds. Even if they have those values, are they really in a position to act on them? It takes more than simply values to get the job done. It takes resources, experience and time. We see little chance FINRA so utterly reshapes brokerage to enable this.

To be clear, we aren't arguing they should. Regulators can't create values where they don't exist. Investors should have freedom of choice. The only real path to solving the issues FINRA raises is through good ol' fashioned competition. The basis for that competition should be clear and transparent business practices a potential client can easily understand. This is the single biggest plus in FINRA's letter and why we point it out. Disclosing costs, complexities and wrinkles allow an investor to exercise his or her freedom of choice.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.