Effective Expense Management is Crucial to Complying with Conflict-of-Interest Regulations

Regulators watching for conflicts of interest

The SEC recently released a staff bulletin in which it reiterated the standards of conduct for broker-dealers and investment advisers in identifying and addressing conflicts of interest — and noted the importance of recording and reporting non-cash compensation in doing so. In part, the SEC reminded firms that Reg BI requires a broker-dealer to disclose “all material facts relating to conflicts of interest” when making a recommendation to a retail customer.

In citing common sources of conflicts of interest, the SEC included “gifts, entertainment, meals, travel, and related benefits, including in connection with the financial professional’s attendance at third-party sponsored trainings and conferences.”

FINRA similarly perceives that third-party relationships could cause conflicts of interest that prevent a financial professional from acting in a client’s best interest. Therefore, the regulator’s Non-Cash Compensation Rules prohibit a member firm or associated person from directly or indirectly accepting or making payments of any non-cash compensation, subject to specified exceptions.

FINRA’s Non-Cash Compensation Rules include:

• 2310 (Direct Participation Programs)
• 2320 (Variable Contracts of an Insurance Company)
• 2341 (Investment Company Securities),
• 5110 (Corporate Financing Rule – Underwriting Terms and Arrangements)

Though FINRA does not prohibit offerors from paying for any training, events, or entertainment on behalf of firms at all, the regulator does impose limitations and conditions. Per FINRA, exceptions to its Non-Compensation Rules include:

• “an occasional meal, a ticket to a sporting event or the theater or comparable entertainment which is neither so frequent nor so extensive as to raise any question of propriety and is not preconditioned on achievement of a sales target;” and
• “payment or reimbursement by ‘offerors’ (product issuers, advisers, underwriters and their affiliates) in connection with training or education meetings, subject to certain conditions, including meeting location restrictions and not preconditioning attendance on achievement of a sales target.”

With strict rules governing permitted payments and requiring disclosures, managing business entertainment expenses effectively and efficiently is essential to firms and offerors maintaining — and demonstrating — compliance with regulations such as the SEC’s Reg BI and FINRA’s Non-Cash Compensation Rules.

However, many firms and offerors rely on systems and processes that are ineffective and inefficient — and regulators have frequently cited failures in managing entertainment expenses or other non-cash compensation in levying fines and penalties against financial services firms. In addition to monetary losses, such sanctions can also damage a firm’s reputation.

Firms struggling with systems and processes

Non-cash compensation is often unrecorded or reported inaccurately because firms estimate values or overlook events entirely. Similarly, at offerors, salespeople may not enter expenses for compliance purposes. So, the offeror’s non-cash compensation records and reports could be inaccurate or incomplete.

Firms also may struggle to maintain compliance with their internal policies and procedures or external regulations due to a lack of effective processes and supporting technology. For example:

• Tracking multiple contributions for the same event often requires repetitive data entry and aggregation is subject to errors.
• Determining and enforcing firm policy and threshold levels requires significant effort to ensure accuracy and efficiency.
• Relying on manual spreadsheets is inefficient and can result in tracking errors and difficulty in reporting and analysis.
• Identifying potential violations is difficult without a system of automated alerts and visual indicators.
• Manually completing processes prevents sales and compliance teams from focusing on their core business functions.

If there is a potential compliance breach, a firm may not spot it right away because its non-cash compensation records and reports are inaccurate or incomplete.