The Changing Concept of Ethics

Ethics is critical to the fair operation of America’s financial system – or so says the Financial Industry Regulatory Authority (“FINRA”). And while what constitutes “ethical” behavior by a financial advisor necessarily has to be painted with a broad brush, given all the possible scenarios FAs face, it seems like the ethical line has been changing.

 
Part of this broadening of ethics may involve the increased focus on compliance over the last decade (after the crash of the markets). All industries have seen a move towards systematizing their compliance efforts, including greater emphasis on enhancing risk management. For most industries, like manufacturing or health care, discussions about ethics are part of compliance, instead of separate from it. This is even more true in the financial industry. FINRA’s 2016 Regulatory and Examination Priorities Letter stressed that it would examine a company’s ethical or corporate culture as part of its regulatory actions. In doing so, FINRA acknowledged that ethics was a broad term that was difficult to specifically examine. This new Priorities Letter followed on the heels of its 2015 Sanctions Guidelines that provided for tougher sanctions, and fines, for failure to comply.  This might indicate a greater scrutiny of ethics going forward.
 

So how do we define ethical behavior? FINRA states that it is: as the set of explicit and implicit norms, practices, and expected behaviors that influence how firm executives, supervisors, and employees make and implement decisions in the course of conducting the firm's business.  Other portions of FINRA’s regulation, like the catch-all provision, call for an advisor to engage in business with “commercial honor and equitable principles of trade.” Which, some argue, isn’t necessarily clear either and, also allows FINRA to creep into the regulatory territory of the Securities Exchange Commission (“SEC”). The duty of confidentiality, for example, has been an area of overlap between FINRA and the SEC regulations, as was the matter in the Heath v. SEC, 586 F.3d 122, 127 (2nd Cir. 2009), case.
 

The SEC relies on its fiduciary standard when regulating advisors and their ethical behavior. Because both the SEC and FINRA may regulate the same financial advisor though with two murky definitions, it’s easy to see where an advisor could get confused. It’s also easy to see that these two broad definitions could continue broaden over time, requiring a FA to monitor ethics on a regular basis.
 

For example, courts like that in Heath, have ruled that FINRA’s catch-all provision and portions of SEC’s regulations don’t require bad faith or bad intentions to show lack of compliance.  Some courts have even broadened whether a financial advisor has to have knowledge of their breach of an ethical requirement.
 

As compliance requirements have moved into more of a firm or company’s routines, it seems as though regulators are digging beyond compliance checklists into risk management and internal controls, again not just with the financial industry, but across many regulated industries. To get ahead of this change in ethics and in investigating ethics, it may be helpful to self assess or audit your practices.  Here are a few areas to assess now:

1.     Management’s internal communications: FINRA notes that it looks for how management and supervisors communicate about ethics to those they manage. They want a top down showing of ethical culture. 

2.     Incentive programs: FINRA, like other regulatory bodies, looks for whether firms encourage reporting and discussion on potential issues. Just as the Joint Commission (which regulates hospitals) looks for a “safety culture,” FINRA may look for incentive programs or other human resource files that show a firm is encouraging employees to engage in ethical behavior. Having an incentive program, or ethics policy, in writing may be beneficial in showing how management communicates to staff about ethics as well. To this end, regulators have fined and sanctioned management who fail to monitor incentive programs, as was the case in In the Matter William F, Weiss, Respondent (AWC 2008015164801, July 2, 2012).

3.     Ease of reporting: FINRA requires that employees can report ethics concerns to a supervisor or compliance officer.  It may be helpful to assess how easily employees can report (e.g., through an anonymous tip-line or email) and any roadblocks employees may have in using those reporting methods.

4.     Training programs: Internal training to employees on ethics should be a yearly requirement. Your firm may want to assess if all employees are meeting this requirement as well as whether your training materials are up to date.

5.     Ethical event risk management: FINRA also states that it will search for how proactive a firm is in looking for and identifying potential risk and compliance events. Having a written audit policy or calendar could be of use in evaluating this element.

6.     Internal controls:  FINRA also searches for internal controls on key corporate areas to determine the level of a firm’s ethical culture. Those areas include: technology management and security, conflict-of-interest management, and data quality among others.

7.     Written reports and follow up when breaches happen: Part of your firm’s ethics policy may involve having an investigative committee that researches, discusses and documents risk or compliance events. Reviewing the minutes of this committee, as well as any findings they may have, for whether they adequately show your firm’s ethical standards may be helpful.

8.     High risk areas to focus on: Specific areas to audit may include whether the firm’s goals or individual incentive programs and compensation structure encourage or could lead to employee’s acting in self-interest; conflict of interest issues that could rise by combined roles or responsibilities in stages of model development; and inappropriate reliance or promises about research.

9.     Monitoring your client load: Some regulatory bodies look to whether an advisor is too overloaded with clients to give thoughtful advice.

10. Succession planning: Aging employees close to retirement need to have a plan in place to transition their clients to other advisors. This may include evaluating how (and where) records are kept.

11. Conflicts of interest beyond client and advisor: FINRA and other regulatory bodies have also charged FAs with violations of ethical standards for obtaining donations for charities and schools from clients improperly. Ensuring that your ethics policy (or training) makes clear that ethics involves the whole relationship between advisor and client, not just the transactional side may be helpful.