Securities brokerage firms are a critical part of the financial landscape, as they provide a vast array of products and services to the financial services industry, the markets, and investors. And while the number of broker-dealers in the United States has declined over the past several years and now stands at fewer than 3,300, their revenues in 2023 were over $600 billion.[1] The services broker-dealers provide can involve potential conflicts of interest, and where conflicts might exist, it is important to maintain a policy of identifying, evaluating, disclosing, and properly managing opposing interests.

This article will discuss many of the conflicts of interest that broker-dealers may have, the issues they raise, and how they are dealt with within the regulatory framework that applies. Particular attention will be given to the perspective of fund directors, and how they may evaluate a broker-dealer’s conflicts as they relate to investment companies and their shareholders. First, let’s lay out some of the services provided by broker-dealers:

• Advice about, and the execution of, securities transactions for customers
• Research regarding, among other areas, the economy, securities issuers, industries and strategies  
• Market making and the provision of liquidity
• Securities lending
• Underwriting of securities
• Investment banking
• Provision of loans and other financing
• Dealer operations

In researching this article, I dove deep into very technical aspects of broker-dealer operations. While I find much of the minutia interesting, I doubt readers would, so let’s address this issue from a common-sense perspective and by asking a few basic questions: What conflicts does the broker-dealer have that may compromise the advice or services they are providing to a customer? How do those conflicts affect the advice or services a broker-dealer provides to its customers? How does the broker-dealer seek to address those conflicts of interest?

In providing a variety of products and services to their customers, broker-dealers are subject to obligations that include, among others, a responsibility to only recommend suitable transactions[2] and a duty to observe high standards of commercial honor and just and equitable principles of trade.[3] Many broker-dealers are complex organizations with different areas of the firm having interests that are not necessarily aligned with each other or with the customers of the firm.

A well-known example of conflicts among broker-dealers is one that has largely been dealt with, but it’s worth reflecting on how things unfolded. Years ago, it was common for brokerages to produce much relied-upon unbiased investment research for their clients. In fact, research was one of the products that differentiated broker-dealers from one another in the eyes of customers. Potential conflicts arose when other areas of a broker-dealer wanted to provide investment banking or other services to companies that were the subject of the research. The Securities and Exchange Commission and other regulators took up the issue, which led to enforcement cases against brokerage firms[4] and the SEC’s adoption of a rule addressing the need for independent research.[5] Upon reflection, it is quite apparent that this particular conflict, which resulted in significant harm to broker-dealer customers, could have been avoided if it had been recognized and properly addressed by the brokerage industry.

Among broker-dealers’ current-day activities, potential conflicts remain. It’s important for the broker-dealers to stay vigilant and address any issues that may arise, and it’s equally important for those utilizing the broker-dealers’ services to be on the lookout for opposing interests and ask for them to be explained and dealt with.

Underwriting activities: Broker-dealers often act in a variety of capacities in securities transactions and can therefore have conflicts of interest. For example, they can be underwriters or members of the syndicate when securities are being distributed. In those roles, broker-dealers face potentially conflicting responsibilities, as the need to distribute securities on behalf of the issuer may be in conflict with the interest of the customers to whom the securities are being sold. In other cases, broker-dealers may be acting as dealers, in a principal capacity, and therefore not acting as the agent of the customer; essentially, the brokerage firm is sitting across from, not next to, the customer in connection to those securities transactions. In those cases, the broker-dealer’s recommendation to enter into the securities transaction, as well as the terms of the transaction, can be subject to real conflicts. So, whenever a broker-dealer is recommending that its customers purchase or sell a particular security, it is wise to ask questions:

• Is it solely because the transaction is best for its customers?
• Does the broker-dealer have a financial or other interest for inducing its customers to make that purchase or sale?
• Is the broker-dealer acting in a dealer capacity and purchasing or selling the security as principal?
• Is the broker-dealer acting in any capacity with respect to the transaction other than as the agent of the customer? If so, for whom and in what capacity?
• In addition to being “suitable,” is the recommended transaction in the customers’ “best interest”?[6]

When broker-dealers execute securities transactions on behalf of customers, there are a number of choices that the broker-dealer can make, some of which may involve a conflict of interest. Broker-dealers often receive payments for order flow or have other arrangements that can provide benefits to the broker-dealer from selecting a particular venue for the transaction or otherwise can influence the choice that the broker-dealer makes in executing the transaction on the customers’ behalf. The broker-dealer can satisfy its obligation to obtain “best execution” in any number of ways. You might wish to inquire how the broker-dealer executes your securities transactions and what conflicts might be involved. What are those conflicts, what is their effect, and how are they resolved?

Evaluating competing interests: As companies and customers often engage brokerage firms for investment banking or other expertise, it is not surprising for the firms to have customers with competing interests. A few examples:

• One customer might be considering the acquisition of another company that is also a customer of that brokerage firm.
• Different customers of the same brokerage firm may be seeking the acquisition of the same company.
• The brokerage firm might be financing the activities of one customer that is averse to the interests of another customer.
• The firm might be enabling the acquisition, sale, or shorting of securities by one customer that adversely impacts another customer.

When utilizing the services of a broker-dealer, it might be wise to inquire about the types of conflicts that might arise, the potential impact of such conflicts on the services the brokerage firm is providing, and how the brokerage firm handles those conflicts.

Looking after their own interests: Broker-dealers often engage in a variety of activities acting on their own behalf, which can conflict with the interests of their customers. A few examples are:

• When the brokerage firm invests in securities for its own account.
  • Questions arise regarding why the firm got the opportunity to make that investment rather than its customers.
  • If additional securities offerings are available from that issuer, the brokerage firm, because of its ownership interest, is conflicted in the advice it might provide customers regarding their participation in that offering.
  • Positions the firm takes in particular securities may, at times, be contrary to the interests of some of its customers.
• When the firm has other products and services it provides (such as custody, administration, transfer agency, securities lending, and more), which it recommends to customers.
  • Are those products and services necessary and appropriate for the customers?
  • Are there potentially other providers of those products and services that might be better for the customers?
• When other departments within the firm offer comparable products or services at different costs to customers and profitability to the firm.

Distribution activities: Funds employ broker-dealers to act as their distributors and to engage others to act as sellers of their shares. As the distributor, a broker-dealer typically agrees to use its “best efforts” to distribute the shares of the fund, and it is not unusual for a broker-dealer to act as the distributor for a substantial number and variety of funds. The interests of the distributor are not necessarily aligned with the interests of each of the funds, especially as some funds may be performing better or be in more demand than others. The broker-dealer, as the distributor of many funds, likely will consider:

• How do I best spend my time and resources to distribute shares of which funds?
• What channels and firms do I concentrate on to distribute fund shares?
• How do I determine which funds I concentrate my distribution efforts and resources on?
• How do I maximize the benefit to my firm while still meeting my obligation to use my “best efforts” on behalf of each fund?

As you can see, the distributor has a number of potential conflicts it needs to address in determining how it best discharges its responsibilities to fund customers. When there are broker-dealers who sell shares of funds, their obligations to their retail customers will be discussed a bit later in this article.

Retail customers: A final area regarding conflicts of interest for broker-dealers relates to the relationship between a broker-dealer and its representative and the retail customer. There are any number of potential conflicts that relate to this relationship, including, among others, the economic incentive the brokerage firm and representative have to recommend products, services, or account types that generate more revenue or other benefits to them.

The 1995 Report of the Committee on Compensation Practices (the “Tully Report”)[7] looked at industry compensation practices for representatives and managers; actual and perceived conflicts of interest for representatives and managers; and best practices used by the industry to eliminate, reduce, or mitigate those conflicts.

The Tully Report recommended that brokerage firms consider paying a portion of a representative’s compensation based on a customer’s assets, thereby reducing the incentive for the representative to recommend transactions to generate revenue. This practice was adopted by many firms but was ultimately determined many years later to be unavailable to broker-dealers unless they were also registered as investment advisers.[8]

After that, there was a fair amount of debate about the relative benefits of the broker-dealer and investment adviser regulatory regimes and whether broker-dealers should be subject to the same “fiduciary duty” as investment advisers.[9] While broker-dealers are not generally subject to a “fiduciary duty” like investment advisers, they are typically subject to a requirement to only recommend suitable transactions[10] to customers, and they have a duty to observe high standards of commercial honor and just and equitable principles of trade.[11] Ultimately, the SEC determined that with respect to transactions with retail customers, broker-dealers and their representatives would have an enhanced obligation: to act in the retail customers’ “best interest.”

There are four components to the “best interest” obligation:[12] disclosure, care, conflict of interest, and compliance. In a staff bulletin,[13] the SEC provided some guidance to broker-dealers and investment advisers in identifying and addressing conflicts of interest. There is recognition that all broker-dealers have some conflicts of interest with their retail customers, and with regard to those conflicts, Regulation Best Interest requires that broker-dealers have policies and procedures to:

• Mitigate conflicts that create an incentive for the firm’s representatives to place their own interests or the interests of the firm ahead of the retail customer’s interest;
• Prevent material limitations on offerings (such as a limited product menu or offering only proprietary products) from causing the firm or its representative to place his or her interest or the interests of the firm ahead of the retail customer’s interest;
• Eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or types of securities within a limited period of time.

Regulation Best Interest provides an interesting approach to the challenges that conflicts of interest present to broker-dealers and their retail customers.

Conflicts IDed By Firms

FINRA issued a Conflicts of Interest Report in October 2013,[14] which focused on brokerage firm approaches to identifying and managing conflicts in three critical areas: Enterprise-level frameworks to identify and manage conflicts of interest; approaches to handling conflicts of interest in manufacturing and distributing new financial products; and approaches to compensating their associated persons, particularly those acting as brokers for private clients.

The  FINRA report also provided a summary of conflicts that were identified by firms,[15] some of which are provided here:[16]

General conflicts

• Outside business interests that could create conflicts
• Gifts and entertainment that could create a conflict
• Political contributions that could create the perception of quid pro quo
• Charitable contributions that could create the perception of a quid pro quo

Supervision and compliance conflicts

• Producing managers may spend more time generating revenue than performing supervision
• Supervising or compliance staff may be subject to pressure from sales management to protect revenue generating representatives

Research-related conflicts

• Timeliness of dissemination of research; research may be disseminated to customers at different times
• Pressure from investment bankers to issue reports or change existing ratings to benefit clients
• Pressure from issuers for favorable reports in return for business
• Preferential access to research
• Pressure from sales and trading to bias research to support the firm’s sales and trading activities

Banking and capital markets

• Advising one bidder for a company while financing another
• Advising on both sides of the same deal
• Advising a seller while financing a buyer
• Financing multiple bidders
• Advising the buy or sell side where the firm has an interest in one or more involved parties

Retail/private wealth

• Firms offering or preferencing particular products or product providers because of their revenue or profit potential for the firm, such as through revenue sharing
• Representatives offering or preferencing particular products or services because of their income potential for the representative
• Representatives recommending transactions in order to generate revenue without due regard to suitability
• Firms offering sales incentive programs to representatives
• Firms or representatives preferencing proprietary products

How to Think, What to Do About Conflicts

As a preliminary matter, many brokerage firms employ a variety of means to address certain potential conflicts of interest. They often provide for the separation of different areas and functions within the firm, thereby lessening the opportunity for conflicts to arise. They also frequently establish information barriers or other means to restrict the flow of information among different areas of the firm or employ other approaches to mitigate conflicts of interest. You may find that it is worth inquiring about this if you are utilizing the service of a broker-dealer and evaluating the manner in which it handles potential conflicts of interest.

While navigating through this area can seem so complicated, I believe the task can be simplified by focusing on the following few topics:

• What is the broker-dealer being asked to do?
• What specific tasks is the customer relying on the broker-dealer to provide?
• With respect to the tasks that the broker-dealer is undertaking, what are the potential conflicts of interest that might compromise the broker-dealer’s ability to perform those tasks in an unbiased fashion on behalf of the customer?'If there are any such conflicts, what are they? What is their impact on the ability of the broker-dealer to perform the tasks the customer has hired the broker-dealer to undertake? How are those conflicts addressed by the broker-dealer?
• Then, considering the responses to these questions, should the customer proceed with retaining the broker-dealer to perform those tasks or follow its recommendation?

These questions are simple, but remember it is not necessarily easy to evaluate whether all the conflicts of interest have been identified by the broker-dealer or, if identified, properly managed. In that regard, you will likely have to rely on the professionalism and integrity of the brokerage firm that is involved.

*This is the second in a series of five articles examining potential conflicts of interest in specific areas of the financial services industry. Each article will discuss the areas where potential conflicts may exist, some abuses involving conflicts that have arisen, some resolutions that have been employed to resolve those conflicts, and the legal and regulatory standards, if any, that may apply. Access the first article, on investment advisers, here.

Andrew J. Donohue (Buddy), who has almost 50 years of experience in the financial services industry, is currently the chair of the Mutual Fund Directors Forum and an independent director of various BNY Mellon Funds. He previously served as chief of staff, from 2015 to 2017, and director of the Investment Management Division, from 2006 to 2010, at the Securities and Exchange Commission. Donohue also was executive vice president and general counsel at OppenheimerFunds, global general counsel at Merrill Lynch Investment Managers, and managing director and investment company general counsel at Goldman Sachs.