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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
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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.
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* 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
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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.
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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
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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.
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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.
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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
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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.
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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
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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.
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"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.
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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
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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
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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
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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.
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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.
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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
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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
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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.
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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.
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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?
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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