Global Trustee and Fiduciary Services News and Views Issue 50

Prime, Futures and Securities Services | Financial Services Regulation 80 • General conflicts . First, broker-dealers must address general material conflicts of interest that are associated with any recommendation made to retail customers. Regulation BI defines a “material conflict of interest” as “a conflict of interest that a reasonable person would expect might incline a broker-dealer — consciously or unconsciously — to make a recommendation that is not disinterested.” To satisfy this obligation, broker-dealers are required to both identify and disclose such conflicts, or eliminate them entirely. • Conflicts arising from financial incentives . Regulation BI also would require broker- dealers to address material conflicts of interest arising from financial incentives associated with any recommendations made to retail customers. The SEC has provided a non-exhaustive list of material conflicts of interest arising from financial incentives, including: 1) compensation practices established by the broker-dealer; 2) employee compensation or employment incentives; 3) compensation received from third parties (such as revenue sharing); 4) receipt of commissions or sales charges or other fees or financial incentives or differential or variable compensation; 5) sales of proprietary products or services or products of affiliates; and 6) principal transactions. To satisfy this obligation, broker-dealers are required to identify, disclose, and mitigate such conflicts arising from financial incentives, or avoid them entirely. In other words, under Regulation BI, disclosure alone is not sufficient to manage a conflict arising from a financial incentive. • Mitigation of conflicts arising from financial incentives . The Regulation BI Proposal notes that the level of mitigation required may vary based on the conflict of interest. For example, “heightened mitigation measures” such as “enhanced supervision” may be necessary in situations involving a less sophisticated retail customer. Heightened mitigation measures may also be necessary if compensation arrangements are less transparent, e.g. when the broker-dealer or its registered representatives are receiving compensation from a third party, such as the sponsor or issuer of a security. The Regulation BI Proposal states that a broker-dealer could decide to apply the same mitigation measures to similar retail customers, similar products, or similar compensation conflicts. The SEC suggests a list of potential practices that broker-dealers consider incorporating into their supervisory programs: 1) avoiding compensation thresholds that disproportionately increase compensation through incremental increases in sales; 2) minimising compensation incentives for employees to favour one type of product over another, proprietary or preferred provider products, or comparable products sold on a principal basis — for example, establishing differential compensation criteria based on neutral factors (e.g. the time and complexity of the work involved); 3) eliminating compensation incentives within comparable product lines; 4) implementing supervisory procedures to monitor recommendations that are near compensation or recognition thresholds; and 5) limiting the types of retail customers to whom a product, transaction or strategy may be recommended. • Elimination of conflicts . As noted, the SEC expects broker-dealers to, at a minimum, disclose (and mitigate, if necessary) or eliminate material conflicts of interest. While the SEC notes that broker-dealers will not be required to eliminate any particular conflicts of interest, it notes that a firm may choose to do so by removing incentives associated with particular products, by removing products with special incentives or by negating the effects of a conflict. Furthermore, the SEC notes that there may be instances when disclosure of conflicts may be insufficient. Examples may include conflicts for which a disclosure cannot be made in a manner that will allow a retail customer to understand the conflict, or where it is not obvious to a broker-dealer that it is not putting its own interest ahead of the retail customer’s interest. The SEC also notes that certain material conflicts of interest arising from financial incentives “may be more difficult to mitigate, and may be more appropriately avoided in their entirety for retail customers or for certain categories of retail customers (e.g., less sophisticated retail customers).” According to the SEC, these practices may include the payment or receipt of non- cash compensation such as sales contests, trips, prizes, and other similar bonuses that