------------------------ TITLE PAGE -------------------------- REPORT OF THE COMMITTEE ON COMPENSATION PRACTICES APRIL 10, 1995 Committee Chairman: Daniel P. Tully Chairman and Chief Executive Officer Merrill Lynch & Co., Inc. Thomas E. O'Hara Chairman of the Board of Trustees National Association of Investors Corporation Warren E. Buffett Chairman and Chief Executive Officer Berkshire Hathaway, Inc. Raymond A. Mason Chairman and Chief Executive Officer Legg Mason, Inc. Samuel L. Hayes, III Jacob H. Schiff Professor of Investment Banking Graduate School of Business Administration Harvard University -------------------- BEGINNING OF PAGE #1 -------------------- Executive Summary Report of the Committee on Compensation Practices In May 1994, in response to concerns about actual and potential conflicts of interest in the retail brokerage industry, a broad-based Committee on Compensation Practices was formed at the request of SEC Chairman Arthur Levitt. The Committee had three mandates: 1. Review industry compensation practices for registered representatives (RRs) and branch managers; 2. Identify actual and perceived conflicts of interest for both RRs and managers; and 3. Identify the "best practices" used in the industry to eliminate, reduce, or mitigate these conflicts. After examining the matter and soliciting input through letters, hearings and focus groups, the Committee prepared this report for presentation to Chairman Arthur Levitt. The Committee found that although the existing commission- based compensation system works remarkably well for the vast majority of investors, conflicts of interest persist, and this has been underscored by some widely publicized incidents in which the actions of certain brokerage firms and their representatives clearly damaged the interests of their clients. The Committee defined "best practices" as activities that are most effective in serving the interest of all principal parties to a retail sale or service transactions. Broadly, the Committee said "best practices" were characterized by: * Compensation policies designed to align the interest of all three parties in the relationship -- the client, the registered representative, and the brokerage firm - - and to encourage long-term relationships among them; * Policies that encourage RRs to understand their client's objectives, and to educate the clients about markets and risks; and * Policies that encourage appropriate education, training and supervision for RRs. More specifically, some of the "best practices" found at some or many firms were: * Paying identical commissions to RRs for proprietary and non-proprietary products within a product category, so that with respect to products in the same category at least, RRs are indifferent to incentives. * Paying a portion of RR compensation based on client assets in an account, regardless of transaction activity, so the RRs receive some compensation even if they advise a client to "do nothing." * Prohibiting sales contests, or permitting contests based only on broad measures, rather than on single products. -------------------- BEGINNING OF PAGE #2 ------------------- * Deferring a portion of RR compensation for several years, and linking payment to a clean compliance record. * Using stock options or stock purchase plans as part of a compensation program, to align the interests of the employee with those of the firm, and to reduce RR turnover. * Eliminating up-front bonuses (or paying them over several years) to encourage longer tenure by RRs. * Establishing proactive compliance departments, staffed by talented people, and using information systems to check the consistency of investor objectives and actual transactions. * Making special efforts, beyond the small print, to educate investors and inform them of their rights. Organizational culture is probably the most effective tool for creating the alignment of interest that this report endorses. Senior management of the firms should set the standards of professionalism through patterns of recruiting, personnel advancement, and policy decisions. Finally, investors have an important role to play in the alignment of the interests described above. Competition has created a buyers' market for brokerage services, and thus, today's investors have more potential power over the behavior of brokers than any regulatory or consumer watchdog. In an appendix, the report provided a list of questions for investors to ask of the individual who handles his or her brokerage account. April 10, 1995 -------------------- BEGINNING OF PAGE #3 ------------------- Report of the Committee on Compensation Practices Why This Report Over the past few years, the Securities and Exchange Commission, the investing public, and the securities industry have raised concerns about actual and potential conflicts of interest in the retail brokerage business. These concerns are related to industry compensation practices involving their registered representatives (RRs).-[1]- Such practices include: * the use of contests to stimulate the sales of particular products; * undisclosed bonuses and higher commission payouts made to RRs who move from one broker-dealer to another; and * incentives to encourage the sale of proprietary investment products If the retail brokerage industry were being created today from the ground up, a majority of the Committee that developed this report would not design a compensation system based only on commissions paid for completed transactions. The most important role of the registered representative is, after all, to provide investment counsel to individual clients, not to generate transaction revenues. The prevailing commission-based compensation system inevitably leads to conflicts of interest among the parties involved. But the current compensation system is too deeply rooted to accommodate radical alteration in the near-term. And by all accounts, it works remarkably well for the vast majority of investors. At the same time, the beginnings of a shift towards other forms of compensation, such as fee-based charges for various investment-related services, is taking shape. In the meantime, however, conflicts of interest persist and have been underscored by some widely publicized incidents in which the actions of certain brokerage firms and their representatives clearly damaged the interests of their clients. Investors, brokerage firms, and their registered representatives are bound together in important ways. Each seeks value through mutual interactions, and each must derive tangible benefits if those interactions are to continue. Investors must feel that they are getting what they pay for: professional advice and service that recognizes their objectives and financial capacity, and rewards commensurate with risks. Firms must operate profitably and build customer franchises in the communities they serve. For them--perhaps more than for firms in any other industry--the customer asset is THE UNIT OF VALUE. Registered representatives seek job satisfaction and compensation for the time they dedicate to their customers and for the gross commissions and fees they generate for their firms. Like their firms, RRs aim to create and expand customer franchises of their own. For this set of relationships to persist over time, there -------- FOOTNOTES -------- -[1]- Note: Registered representative is the official title for brokerage firm employees variously known as stockbrokers, financial consultants, and account executives by different firms. -------------------- BEGINNING OF PAGE #4 ------------------- must be three winners: the investor, the brokerage firm, and the registered representative. For this to happen, the interests of all three must be aligned. Aligning those interests is a challenge facing the managers of securities firms. They are in the best position to find the balance and to create the policies and practices that support alignment. Of the three parties, registered representatives occupy a unique and often problematic position, and few who have not held that job can fully appreciate its challenges. While most firms consider customers to be clients of the firm, the RR generally talks about "my book" and "my clients." Likewise, when customers refer to "my broker" they are often referring not to the brokerage FIRM but to their individual registered representatives. There is an implicit understanding that the RR is there to advance their interests. The RR, however, is not just a representative of the customer, but is also an employee of the firm. This means that the RR and the firm each have three interests to balance: the broker has the customer, the employer, and his or her own well- being; and the firm has the customer, the broker, and the firm's own interest (including its shareholders, if it is publicly held). That so few complaints and arbitration cases arise annually from the hundreds of millions of transactions entered into by people and organizations with these multiple interests testifies to the high ethical standards and professionalism that characterize the industry--a story that goes unreported. Still, abuses of investors do occur, and the perception is strong that compensation practices create conditions that foster that abuse. Industry practices that undermine mutuality and harmony of interest between firms, their representatives, and the investing public are a natural concern of the U.S. Securities and Exchange Commission. For over sixty years this agency has sought, within the limits of its authorization, to maintain an environment in which people can invest without risk of fraud or deception, in which information flows freely among all participants, and in which healthy competition leads to greater service and lower costs for all concerned. This is especially important today, as the number of individual investors--many with the most rudimentary understandings of markets, financial instruments, and risks--has markedly increased. For the first time in U.S. history, investment company assets exceed commercial bank deposits, and the number of American families with investments in mutual funds or in the securities markets has risen from one-in-four to one-in-three. America is becoming a nation of investors. This is good for the users of capital, good for the securities industry, and it should be good--before all else--for American investors. The SEC Response Seeking to assure a fair deal for investors, a broad-based Committee on Compensation Practices was formed at the request of SEC Chairman Arthur Levitt, Jr. The Committee's mandate was three-fold: 1. Review industry compensation practices for registered representatives and branch managers; 2. Identify actual and perceived conflicts of interest for both brokers and managers; and -------------------- BEGINNING OF PAGE #5 ------------------- 3. Identify the "best practices" used in the industry to eliminate, reduce, or mitigate these conflicts. In particular, the Committee was asked to examine those issues at the point of sale. It was Chairman Levitt's hope that such a study would initiate a dialogue within the securities industry leading to an even higher standard of industry performance. Headed by Daniel P. Tully, Chairman of Merrill Lynch, the Committee included representatives of the securities industry, investors, and academia. -------------------- BEGINNING OF PAGE #6 ------------------- The Committee on Compensation Practices-[2]- Daniel P. Tully Chairman and Chief Executive Officer Merrill Lynch & Co., Inc. Committee Chairman Samuel L. Hayes III Jacob H. Schiff Professor of Investment Banking Graduate School of Business Administration, Harvard University. Warren E. Buffett Chairman and Chief Executive Officer Berkshire Hathaway, Inc. Thomas E. O'Hara Chairman of the Board of Trustees National Association of Investors Corporation Raymond A. Mason Chairman and Chief Executive Officer Legg Mason, Inc. Input from Industry and Consumer Groups, Brokerage Firms, and Individuals The Committee sought the viewpoints of parties whose interests come together at the point of sale. This input was gathered in three ways: * BROAD-BASED SOLICITATION. The Committee sent "An Open Letter to Members of the National Association of Securities Dealers" actively soliciting comments and recommendations concerning compensation practices. Notice of this letter was widely covered in the print media. Several hundred responses from investors and stockbrokers were received and reviewed by the Committee. * HEARINGS AND FIELD INTERVIEWS. Hearings were held at which the viewpoints of consumer groups, individual RRs, and brokerage managers from branch and senior levels were represented through panel discussions. In addition, hearings and field interviews with staff executives of the Securities Industry Association, the American Stock Exchange, the New York Stock Exchange, the North American Securities Administrators Association, the National Association of Securities Dealers, and other relevant regulatory and consumer advocate bodies were conducted by members of the Committee, their staffs, and outside consultants. * FOCUS GROUPS. Under the direction of the Committee, an independent consulting firm conducted focus group research and field interviews with investors, RRs of varying -------- FOOTNOTES -------- -[2]- Andrew D. Regan, Research Associate at the Harvard Business School, and Richard A. Luecke, an editorial consultant, Made important contributions to the research and writing of the Committee Report. -------------------- BEGINNING OF PAGE #7 ------------------- experience, and managers. These initiatives identified industry practices viewed as problematic for the alignment of interests described earlier. These practices included: COMMISSION VERSUS FEE-BASED COMPENSATION. The historic dilemma of mixing transaction-driven compensation with client advice was at the heart of many of the concerns brought to the Committee. Opponents of commissions view them as fundamentally incompatible with the delivery of impartial investment advice. They generally favor a fee-based system of compensation as a way to eliminate potential conflicts of interest. Advocates of commission-based compensation, on the other hand, view the current commission system as best for the customer and for the RR. Existing regulatory and industry oversight, they argue, already provides investor protection; further, the RR who abuses clients will ultimately go out of business. They also point to the higher costs that fees pose for small and low-activity accounts. Evidence provided to the Committee indicates that a growing number of firms already offer a choice of commissions or fees for a range of services. SALES CONTESTS. Some firms use single product contests to encourage sales. For example, a firm might devise a four-week contest to encourage its representatives to sell a newly offered stock mutual fund. These contests, often sponsored by third- party vendors, offer resort vacations, VCRs, television sets, and other inducements to RRs who reach specified sales levels of a particular mutual fund, limited partnerships, or other financial products. Other firms sponsor contests that are NON PRODUCT-SPECIFIC. They reward the number of new accounts opened, the total sale of all categories of fixed income securities, new client assets brought into the firm, and so forth. Consumer groups and many industry personnel object to product-specific sales contests as undue temptations for RRs to place their own interests ahead of their customers'. Do contests result in the sale of products that may be inappropriate for some investors? Should the existence of contests and prizes be disclosed to investors? Should non product-specific contests be painted with the same critical brush? DIFFERENTIATED COMPENSATION BY PRODUCT OR SOURCE OF PRODUCT. Some product sales or transactions offer much higher commission payouts to RRs than others. $10,000 invested in the typical front-end "load" stock mutual fund, for instance, produces over twice as much immediate commission revenue to the registered representative as an equal amount invested in exchange-listed stocks. The RR's compensation is often larger for sales from the firm's inventory than for equal-sized sales of securities purchased from others. Of particular concern is the practice of firms offering higher payouts when RRs sell proprietary mutual funds instead of funds of a similar class managed by outside investment companies. (Proprietary funds are those created and/or managed by the firm.) This differentiation of compensation raises the question: Is the -------------------- BEGINNING OF PAGE #8 ------------------- RR rendering objective advice or simply maximizing commission income? UNDISCLOSED BONUSES AND HIGHER COMMISSION PAYOUTS PAID TO TRANSFERRING RRs. Established registered representatives sometimes move from one broker-dealer to another. This happens for any number of reasons. "Big producers"--RRs who generate very large annual gross commissions--often receive large up-front bonuses from the firm to which they are moving. In some cases, these bonuses are the equivalent of one year's pay for the transferring RR. A bonus is paid on the presumption that the "big producer" will bring most of his or her best clients to the new firm. As an alternative to a bonus, the new firm may temporarily increase the percentage of gross commission given as compensation to the RR. This percentage jumps from the normal 33-45 percent to 60 percent or more over the transition period, typically 3-6 months.-[3]- Ostensibly, this higher rate--or "accelerated payout"--is intended to help the RR through the transition period, when a great deal of time is spent on the administrative details of account transfers and client reorientation, leaving less time for income-earning activities. Both of these practices--the payment of up-front bonuses and temporarily accelerated payouts--raise concerns about the RR-client relationship. Is the RR transferring because the new firm has better research or other advantages for serving investors, or is the RR simply aiming to maximize personal income? Do accelerated payouts encourage the RR to increase the level of account activities--i.e., churn the accounts? Should up-front bonuses and accelerated payouts be disclosed to the client? THE ROLE OF BRANCH MANAGERS. The first line of defense against unfair or unethical practices in the retail securities industry is the professionalism of the individual registered representative. The second line is the branch manager. Regulation requires regular oversight by a manager of every location that offers investment services to the public. In most cases, that branch manager plays a dual role--handling both his own accounts and supervising other RRs in the same office. A branch manager's compensation has several sources: commissions from his or her own accounts (if the manager has any); a salary for his or her management role; and, in most cases, added compensation determined by gross production, operating profits, or some other measure of branch office performance. While recognizing that many branch offices are too small to -------- FOOTNOTES -------- -[3]- Note: Gross commissions are those charged to the customer by the firm. In the typical instances, the registered representative who generates the commission receives a payout of 33-45 percent of that gross commission. The remainder is retained by the firm as a contribution to overhead and profits. -------------------- BEGINNING OF PAGE #9 ------------------- support full-time managers, several members of the Committee and other participants voiced concern that the dual role of the branch manager--as producer and supervisor--may compromise this line of defense against unfair practices. This concern is two-fold. First, is the typical branch manager capable of providing both thorough supervision of his or her fellow registered representatives AND quality service to his or her own clients? Is this managerial overload? Second, does the practice of linking branch manager compensation to office financial performance create a potential misalignment of interest--i.e., creating a financial incentive for branch managers to "see no evil" when questionable practices contribute to branch profitability? The items described above do not represent the entire range of compensation issues brought to the Committee's attention. However, they clearly represent the issues of greatest concern to investor groups, registered representatives, and securities industry managers. Others include: * disclosure as the antidote to client/firm conflicts of interest (for instance, itemization of the full costs of a transaction to the investor); * compensation based upon investment performance (and practical problems of implementation); * compensation and continued supervision of new RRs as they develop client bases; * the role of top management in creating and eliminating conflicts of interest. The Search for Best Practices Using the issues just described as guidelines, the Committee conducted an active search within the brokerage community for "best practices" in a selected number of customer-based activities. Compensation consulting specialists from Towers Perrin & Company were engaged to refine that search and to develop a coherent set of insights to be shared through this report. It was hoped that these practices would identify workable approaches for aligning the interests of investors, firms, and their registered representatives. For purposes of this search, "best practices" were defined as "activities that are most effective in serving the interest of all principal parties to a retail sale or service transaction." Best practices were seen as manifested by: A. Compensation policies that align the interests of registered representatives, firms, and investors. B. Compensation policies that encourage long-term relationships between firms, RRs, and their clients. C. RRs who understand client objectives, experience, and financial position, and give advice consistent with that understanding. D. Education and training that enhances the quality of advice to clients. E. Compensation plans that encourage appropriate -------------------- BEGINNING OF PAGE #10 ------------------- supervision and behavior by branch managers. F. Education of clients with respect to markets, risks, and their own responsibilities as investors. Best Practices Found Listed and discussed below are the approaches found through field research that meet our definition of "best practices." Because of differences in the way firms conduct business, and their relationships with their clients, and also in the needs and expectations of those clients, these "best practices" may not be applicable to all situations. A. Compensation policies that align the interests of registered representatives, firms, and investors. In general, the Committee's concerns with compensation policies in this area have to do with practices that create potential conflicts of interest for registered representatives. That some products provide significantly higher payouts than others--even within the same product category--is often pointed to as a practice that jeopardizes the provision of unbiased investment advice. Added compensation through contests is a related issue. Both create circumstances in which the interests of those giving advice and those seeking it can diverge. In both cases, the natural concern is that RRs may make a product recommendation because of its impact on his or her performance in the contest or because of payout differentials. Also of concern is the widespread practice of paying up-front bonuses to RRs who transfer from one firm to another without disclosing this payment to their clients. These same clients are usually asked by their RR to follow him or her to the new firm, receiving nothing in the bargain. Often linked with an up-front bonus arrangement is another practice of concern--providing higher commission payouts for some time period after an RR makes the transfer. Best industry practices in this category include the following: PAYMENT OF IDENTICAL COMMISSIONS TO RRs FOR PROPRIETARY AND NON-PROPRIETARY PRODUCTS WITHIN THE SAME PRODUCT FAMILY AND FOR PRINCIPAL AND AGENCY TRANSACTIONS. This practice aims to ensure that RRs are indifferent to incentives when making recommendations--at least with respect to products in the same category. Most firms interviewed have adopted this practice. PAYMENT FOR CLIENT ASSETS IN AN ACCOUNT, REGARDLESS OF TRANSACTION ACTIVITY. In many cases the best advice an RR can give a client at a point in time is to "do nothing," or to keep assets in the safety of a money market account. The RR's reward for this advice is zero compensation. Some firms' practice of basing a portion of RR compensation on CLIENT ASSETS IN AN ACCOUNT is seen as one way to reduce the temptation for income-seeking RR's to create inappropriate trading activity in an account. Fee-based accounts may also be particularly appropriate for investors who prefer a consistent and explicit monthly or annual charge for services received, and whose level of trading activity is moderate. -------------------- BEGINNING OF PAGE #11 ------------------- "NO CONTEST" POLICIES AND/OR PERMITTING CONTESTS BASED ONLY ON BROAD MEASURES. Some firms have policies against contests of any kind. Others use contests, but base them on broader measures--not on single products. These measures include the following: * overall gross production; * new accounts opened; * sales within a product class; for example, a contest would be based upon total mutual fund sales, with nothing to induce an RR to recommend one fund or type of fund over another; and * assets gathered, regardless of the category of investment. These practices do not in themselves eliminate the potential for conflicts of interest between RR and client. A contest based upon total mutual fund sales, for example, may contain this potential conflict if some funds offer substantially higher payouts than others. PAY ONLY REGULAR (NOT ENHANCED) COMMISSIONS TO TRANSFERRING RRs. Only one firm in the research sample followed this practice. This policy was specifically adopted to avoid the undue trading that enhanced commissions might provoke. Other firms placed a high value on financial incentives to persuade successful RRs to switch firms. B. Compensation policies that encourage long-term relationships between firms, registered representatives, and their clients. Long-term relationships contribute to better customer service. Firms and RRs have the opportunity to learn more about the goals, investment experience, and risk capacities of their clients. Clients learn more about the products and services offered by firms, and about the investment philosophy of the individual RRs assigned to their accounts. Firms have an opportunity to evaluate the competency of the RRs who represent them to the public. Practices that encourage long term relationships through incentives include: DEFER A PORTION OF RR COMPENSATION FOR SEVERAL YEARS, AND LINK PAYMENT TO A CLEAN COMPLIANCE RECORD. Linking a portion of compensation to longevity with the firm and to good standing on compliance issues serves at least a couple of purposes for several firms interviewed. It reduces the movement of RRs from one firm to another, a practice that undermines at least one aspect of the long-term relationships described above. It also prompts RRs to take special care to follow the regulatory provisions that apply to their activities. USE STOCK OPTION OR STOCK PURCHASE PLANS IN OVERALL COMPENSATION PROGRAMS. These plans are used by a number of firms to align the interests of employees with those of the firm. RR turnover is presumably reduced and RR accountability increased through these programs. -------------------- BEGINNING OF PAGE #12 ------------------- ELIMINATE UP-FRONT BONUSES. Up-front bonuses paid to RRs who jump from firm to firm are often seen as an inducement for RRs to switch firms, undermining long-term relationships. Some firms interviewed have eliminated them entirely. Others made a vigorous case for their retention. PAY UP-FRONT BONUSES IN THE FORM OF FORGIVABLE LOANS OVER A PERIOD OF FIVE YEARS. To provide reasonable compensation to joining brokers during a transition period, many firms pay up-front bonuses. The majority interviewed structure them as loans forgivable over several years. In theory, at least, this will encourage longer tenure by RRs, promoting longer-term relations for all concerned. LINK RR COMPENSATION TO CUSTOMER SATISFACTION. One large firm was found to link a portion of variable compensation with customer satisfaction measures (e.g., the RR's product knowledge, empathy, responsiveness, effectiveness, etc.). The practice also aims to encourage a focus on long-term values instead of current transactions. C. Understanding client objectives, experience, and financial position, and rendering advice consistent with that knowledge. The golden rule of the brokerage industry is to "know the customer." The relationship between the investment community and its clients is spelled out by New York Stock Exchange Rule 405, which directs firms and their representatives to "use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account. . . ." While every firm requires its RRs to obtain the essential facts when a new account is opened, the amount of time devoted to this requirement is mixed. Knowing customers is only the first of a two-step process. The second is the recommendation of appropriate investments. Making appropriate recommendations is the RR's duty; but since the RR is its agent, the firm has the ultimate responsibility, making this a supervisory issue. If the RR is simply selling what is readily available or what pays the highest commission instead of recommending what is appropriate, there can be a serious misalignment of interests. Several exemplary practices were found in this area: PROVIDE RRs WITH FINANCIAL PLANNING TOOLS. One firm studied provides training in financial planning tools for all new RRs. A recognition program supports the use of these tools with clients. Another firm subjects large accounts to a high level of financial analysis. One regional firm groups investors by objectives (income, aggressive growth, etc.). Investment products are similarly grouped with the purpose of better matching products to investor objectives. This firm will not serve prospective investors who decline to provide the information needed for this grouping process. CREATE A CULTURE OF HIGH ETHICAL AND PROFESSIONAL STANDARDS. A culture with high standards may be the best assurance that the interests of all parties are aligned. This kind of culture is not created by slogans or mission statements. It is created when senior managers articulate high standards -------------------- BEGINNING OF PAGE #13 ------------------- and communicate them through their own behavior and the administration of firm-wide policies. These include policies that: * recognize RRs who create the highest levels of measured customer satisfaction; * prohibit pressure on RRs to push particular products; * demonstrate a willingness to discipline or fire employees who fail to observe high standards--even when they are "big producers." SEPARATE THE RR FROM THE FIRM'S ECONOMIC INTEREST IN ORDER FLOW, BID/ASK SPREADS, AND THE SALE OF INVENTORY. Firms have an economic interest in selling their inventories, and they can (and many do) provide added incentives for RRs to move it. Some firms have organized their trading floors, where feasible, so that RRs are unaware of products held in inventory. (One obvious exception is municipal bonds; because availability of specific municipal issues may be limited, a firm's inventory is often the best source of municipal bonds.) USE INFORMATION SYSTEMS TO CHECK THE CONSISTENCY OF INVESTOR OBJECTIVES AND ACTUAL TRANSACTIONS. Two national broker-dealers interviewed have developed sophisticated information systems for helping branch managers monitor the consistency of RR transactions with known client objectives. One firm's system produces a daily activity report placing potentially inappropriate transactions into one of 27 buckets--e.g., purchase of bonds valued in excess of $1 million; purchase of stocks priced at under $5; a transaction contrary to the firm's research; short-term mutual fund switching; etc. These buckets are used as signals, prompting managers to examine the accounts and the activities of their RRs. The same information is being made available to RRs to encourage self-regulation. SET UP PROACTIVE COMPLIANCE DEPARTMENTS. When it comes to the problem of conduct that is inconsistent with investor objectives, prevention is the best medicine. At the firm level, this is the job of the compliance department, where the following "best practices' were observed: * One national firm involves its compliance department heavily when recruiting experienced RRs. Prospective hires are checked with respect to the type of accounts maintained, compliance record, and sources of current commission production. * Another firm involves its compliance department in product development, recruitment, and the promotion of current personnel. In both instances, front-end involvement of the compliance department helps to identify marketing, advertising, and recruitment practices likely to lead to future problems. ESTABLISH SPECIAL PROCEDURES FOR THE PURCHASE OF HIGH-RISK PRODUCTS. The greatest potential for problems between client and brokerage firms exists in the realm of high-risk products. Because these products typically provide higher compensation to RRs--and higher potential profits for -------------------- BEGINNING OF PAGE #14 ------------------- investors--they may involve inappropriate recommendations. One national firm has a practice of not allowing purchases of penny stocks, limited partnerships, and most derivatives without special authorization from the investor--even when the purchase is unsolicited by the RR. The authorization takes the form of a "Investor Qualification Affidavit." This practice provides a clear signal to both the investor and the RR's branch manager that a risky and potentially inappropriate investment is being made. D. Education and training that enhance the quality of advice to clients. Traditionally, training of registered representatives begins when individuals are hired and formally ends when they pass the National Association of Securities Dealers' Series 7 examination. Although the NASD has recently instituted a formal continuing education requirement for all brokers with less than ten years' experience -- and for their supervisors -- most continuing education takes place on the job and is oriented toward selling skills, product knowledge, and transactional procedures. Many observers believe that training should be expanded and made more systematic to keep RRs apace of growing product complexity and methods for managing client portfolios. Ongoing training is becoming a fact of life at many firms. A number of programs were observed that point to the following best practices: EXTEND THE PERIOD OF INITIAL TRAINING, WITH LESS EMPHASIS ON THE SERIES 7 EXAMINATION. Training aimed at passage of the Series 7 exam fails to address wider and longer-term professional issues. One smaller regional firm has addressed this problem by extending the length of its initial training. Its prospective RRs agree not to take the Series 7 exam for one year. This helps avoid the problems associated with neophyte RRs making "cold calls" that are ill-informed and apt to mislead potential investors. MAINTAIN RIGOROUS AND BROAD PROGRAMS OF CONTINUING EDUCATION FOR RRs. Several firms provide continuing training to develop the professional skills of RRs. This training takes a number of forms: * Training sessions designed to upgrade RR knowledge in specific products and compliance/ethical issues. * In-house training programs aimed at improving RR understanding of client needs--e.g., "Profiling the Client," "Building Relationships with Prospects and Clients," and "Small Business Workshop." * Encouragement for RRs to take outside courses that lead to advanced certification. * Formal programs of continuing education. PAY INEXPERIENCED RRs A FIXED SALARY THAT GRADUALLY TRANSITIONS TO PERFORMANCE-BASED PAY OVER A 2-3 YEAR TRAINING/MENTORING PERIOD. Newly-licensed RRs usually start with a desk, a telephone, and no customers. Policies that expect these individuals to rapidly produce a monthly income from commissions create an atmosphere in which aggressive selling and unsuitable recommendations are bound to take -------------------- BEGINNING OF PAGE #15 ------------------- place. A number of firms recognize this and have developed compensation policies that qualify as best practice: * One major firm pays a base salary to new RRs for two years. This is supplemented by a quarterly bonus based on gross commissions, asset gathering, new accounts, and examination performance. * Another national firm pays trainees a full salary until they pass the Series 7 exam. Over the next 18 months their compensation has three components: base salary, commission payouts, and a bonus based on new accounts and success in asset gathering. E. Compensation plans that encourage appropriate supervision and behavior by branch managers. As described earlier in this report, branch managers must supervise the adherence of RRs to the rules of fair practice. As managers, they must also represent the interests of their firms. These duties are further complicated by the fact that most branch managers have customer accounts of their own. We have found that financial incentives can be used to encourage proper supervision by branch managers. While no single best model is apparent, the compensation plans of several firms suggest the range of useful approaches to this issue: COMPENSATE BRANCH MANAGERS ON A MIX OF MEASURES. At one leading firm, managers' compensation is based both on branch profitability as well as on subjective measures such as community involvement, the compliance record of the branch, and the manager's contribution to firm-wide activities. BASE 100 PERCENT OF BRANCH MANAGER COMPENSATION ON FULLY-ALLOCATED BRANCH PROFITABILITY. At first blush, this approach would seem to provide no incentive to protect the interests of clients from "commission-maximizing" RRs. The firm in our sample that uses this approach, however, charges the full cost of compliance problems, customer complaints, and up-front bonuses for transferring RRs back to the branch. These charge-backs encourage the branch manager to run a tight ship and to recognize the true profitability of clients and products. F. Educate clients with respect to markets, risks, and their own responsibilities as investors. As a general rule, RRs and their clients are separated by a wide gap of knowledge--knowledge of the technical and financial management aspects of investing. The pace of product innovation in the securities industry has only widened this gap. It is a rare client who truly understands the risks and market behaviors of his or her investments, and the language of prospectuses intended to communicate those understandings is impenetrable to many. This knowledge gap represents a potential source of client abuse, since uninformed investors have no basis for evaluating the merits of the advice they are given. It also makes communication between a registered representative and an investor difficult and puts too much responsibility for decision-making on the shoulders of RRs--a responsibility that belongs with the investor. -------------------- BEGINNING OF PAGE #16 ------------------- Brokerage firms are not--and cannot be--teaching institutions for investors, but practices that narrow the knowledge gap between investors and RRs can only be viewed positively. Only one "best practice" was found in this area: MAKE SPECIAL EFFORTS TO INFORM INVESTORS OF THEIR RIGHTS AND RESPONSIBILITIES. All brokerage firms distribute such materials to their clients, as required by law. Typically, however, these are done in print so small that only the most diligent would wade through them. One firm interviewed provides each new account holder with a clear and thorough document explaining risk, return, and the role of the registered representative. The document provides a summary of services provided by the firm, trade and settlement arrangements, and procedures for resolving complaints. Further, the document spells out the client's responsibilities with respect to communicating objectives, and so forth. Other firms spell out alternative compensation arrangements which are fee-based rather than transaction-driven. Best Practices Not Found The Committee noted areas of potential conflicts where "best practices" were NOT found in the field. Some of these are related to disclosure--a time-tested approach to protecting the interests of investors. We find, for instance, no disclosure of the extra compensation RRs receive for the sale of particular products. In the case of sales contests, there is no disclosure to the client that the person providing advice is receiving special incentives beyond the normal commission to sell a particular product. Similarly, when a firm is distributing a security for which it has been a lead underwriter, there is no disclosure of the premium compensation paid to RRs for selling this security. The practice of providing up-front bonuses and temporarily higher payouts to firm-switching RRs is, likewise, one for which no disclosure to clients was found. Knowledge of these practices may lead to better decision-making by clients. The Committee also believes that there are better ways of informing clients about the estimated risks and actual returns of their current investments. While some argue that reliable risk and return measures are almost impossible to devise, portfolio managers and mutual funds do calculate and disclose such measures to their clients on a regular basis. There ought to be a way to provide the retail brokerage customer with objective measures of risk and actual investment returns over particular periods. The Committee recognizes that not all of the problems that arise in the investor-RR relationship are remediable. In many instances, however, full disclosure of the compensation practices described above, and elsewhere in this report, can reduce the potential for conflict and abuse. The Role of Senior Management This report began with a discussion of how the interests of investors, firms, and the registered representatives must be aligned if each is to benefit. The practices identified here may be instrumental in creating and safeguarding that alignment. -------------------- BEGINNING OF PAGE #17 ------------------- Of all the parties to the investment process, only the senior managers of brokerage firms are in a position to initiate the improvements that "best practices" represent and to make those practices stick. Customers are outside the loop of policy-making. Their role is to pursue their own best interests, wherever that leads them. Nor are registered representatives in a position to create the necessary alignment. As employees, they are "takers" not "makers" of policy. Professional standards may compel them to put customer interests first, but their own interests and their firms' interests must ultimately be served if they are to continue in their work. Senior management must take action to align the three interests because they alone have the power and authority to create change inside the firm. The important levers of change are already in their hands. Their policies determine the caliber of people who represent them to the investing public. They determine how those people are trained, supervised, and compensated. And they set the tone for how the business will operate. The fact that so many of the problem RRs are concentrated in a small number of firms supports the view that sound management plays a key role in the avoidance of conflicts of interest. If up-front bonuses or other practices mentioned in this report need to be disclosed to customers, corporate policies can make it happen. Even the culture of the firm is theirs to mold. Through patterns of recruiting, personnel advancement, and other policy decisions, senior managers set the standards of professionalism by which their firms are known. By assigning top caliber people to compliance positions, for instance, management signals its intention to maintain strict adherence to the rules and regulations of the securities business. Organizational culture is probably the most effective tool for creating the alignment of interests that this report endorses. Here again, senior managers have the opportunity to shape rewards and recognition policies that reduce conflicts of interests. Having generally come up from the RR ranks themselves, these managers can appreciate the extent to which those policies influence behavior. The extent to which they make the most of this opportunity will determine whether the most valued customers and the most productive RRs stay with their firms or follow their interests elsewhere. The Role of Investors Investors have an important role to play in the alignment of interests described above. Intense competition has created a buyers' market for brokerage services, giving investors of the 1990s the power to demand AND RECEIVE high levels of professionalism and quality service. Using their ability to direct business to organizations that serve them well, and to withhold it from those who serve them poorly, today's investors have more potential power over the behavior of brokers than any regulator or consumer watchdog. Investors' insistence on professionalism and quality service is the ultimate safeguard of their own best interests and, indirectly, the ultimate enforcer of high standards within the brokerage industry. The investor should insist on high standards of performance -------------------- BEGINNING OF PAGE #18 ------------------- from any firm or any investment advisor, including: * courteous and timely service; * confidentiality in the treatment of personal information; * advice from competent professionals of good character; * clear and even-handed explanations of all recommendations, to include expected returns and potential risks; * clear presentation of all costs, commissions, and fees associated with a transaction or service; * timely execution of transactions at the best available price; * account statements that are accurate and easy to understand; * prompt consideration of complaints and quick redress of errors; * information regarding an RR's disciplinary record on request. Appendix A expands this discussion with a list of questions that every investor should ask of his or her brokerage representative. THE INVESTOR'S RESPONSIBILITIES. Brokerage firms and their representatives can only serve clients to the extent that they understand the client's financial situation and goals. Clients have a responsibility to be clear and open about these issues; otherwise, suitable advice cannot be rendered. Equally important, clients must assume decision-making responsibility for their accounts. It is their responsibility to evaluate the advice of their brokers and to determine which actions will be taken. In many cases this means that clients must educate themselves in the basics of financial markets, the nature of risk, and other aspects of investing. Good decisions cannot be made in ignorance. Closing Thoughts One of the great strengths of the U.S. retail securities industry is its diversity. Full service firms and discounters. Products and services that address virtually every investment need. Mutual funds numbering well over one thousand. Research from many different sources. This diversity creates customer choice and healthy competition among firms. Individual firms will survive and prosper in this competitive environment to the extent that they deliver tangible value to customers. Individual registered representatives form the interface between these firms and the investing public. In serving the long-term interests of these investors, they serve their own. Proper training and incentives help them in this mission. We are encouraged to learn that the NASD, NYSE, several -------------------- BEGINNING OF PAGE #19 ------------------- other self-regulatory organizations and the SEC, have instituted requirements for training in ethics and in other areas of client service. The industry should think beyond these mandates to its own requirements for ongoing, advanced training for registered representatives. For some firms, intensive training in areas such as asset allocation, financial planning, and portfolio management should be considered. Investors, for their part, can also benefit by learning more about markets and investments, and by thoughtful reflection on their financial objectives. -------------------- BEGINNING OF PAGE #20 ------------------- Appendix A: Questions to Ask Your Broker Relationships between individual investors and brokerage firms typically begin in one of three ways: 1) the investor is referred to a firm or to one of its registered representatives by a friend or associate; 2) the investor calls the firm to open an account or to make a transaction; or 3) the investor is solicited directly by the registered representative. Whichever the case, it is essential that the investor ask the following questions of the individual who will be handling his or her business: * What is your experience and training? * How many brokerage firms have you worked for? * How many clients do you currently serve? * How do you charge for your services? Is there a commission or a flat fee? * If you recently changed firms, are you receiving special or enhanced compensation in connection with your move? * Have you ever been disciplined for a violation of the securities laws? The person handling your account should respond fully to these inquiries, and that person should have a number of questions to ask you in return. Industry rules require your representative to determine your financial circumstances, your investment experience, and your investment goals prior to any transaction. This information must be treated with confidentiality and MUST be the basis for subsequent investment recommendations. If the person handling your account recommends the purchase of stocks, bonds, mutual funds or other financial products, you should obtain satisfactory answers to another set of questions: * How will this recommendation serve my investment goals? * Is the recommendation the best course of action, or merely suitable? * What are the risks of this recommendation in the worst case, the best case, and the most likely case? What would happen if I had to liquidate the investment? * What is the commission and any ongoing cost to me of the product/service being recommended? Is the cost negotiable? Do you receive any compensation from a third party? * Are you recommending a proprietary product (a product of the brokerage firm). If it is, are you paid more? How much more? * Are you participating in a contest or promotion that rewards you for selling this product? Again, as a customer, you have every right to ask these questions and to expect unambiguous answers. -------------------- BEGINNING OF PAGE #21 ------------------- After dealing with the same brokerage firm for a while, you should periodically review your investment goals and discuss the performance of the investments you have purchased on your RR's recommendations. Specifically, you should ask: * If I liquidated these investments today, what would be my rate of return? * How do these returns compare to an index of similar investments? -------------------- BEGINNING OF PAGE #22 ------------------- Appendix B: Participating Organizations A number of organizations provided input to the Committee through panel discussion, interviews, and field research. INDUSTRY PARTICIPANTS Advest Group, Inc. A.G. Edwards American Stock Exchange Crowell Weedon & Co. Edward D. Jones & Co. Fidelity Brokerage Services, Inc. Financial Network Investment Corp. The Goldman Sachs Group, L.P. Gradison Inc. Hunter Associates, Inc. Interstate/Johnson Lane Corporation Legg Mason, Inc. Merrill Lynch & Co., Inc. Montgomery Securities Morgan Keegan National Association of Securities Dealers, Inc. New York Stock Exchange, Inc. PaineWebber Group, Inc. Piper Jaffray Companies, Inc. Prudential Securities Inc. Raymond James Financial, Inc. Securities Industry Association Smith Barney, Inc. Stifel, Nicholaus & Company, Inc. Tucker Anthony Inc. Wheat, First Securities Inc. NON-INDUSTRY PARTICIPANTS American Association of Retired Persons Consumer Federation of America Office of the Public Advocate, New York City The Darden School, University of Virginia North American Securities Administrators Association New York City Department of Consumer Affairs University of Maryland Law School U.S. Securities and Exchange Commission