SEC’s Schapiro warns broker firms on recruitment bonuses, financial incentives

SEC Chairman Mary Schapiro cautioned chief executives at securities firms about offering big upfront bonuses and other inducements to recruit brokers, warning the CEOs that they will be held responsible if these incentives lead brokers to questionable sales practices.

Schapiro’s open letter to CEOs at broker-dealer firms cited recent press reports that some firms are engaged in a “vigorous recruiting program” for registered representatives.

“Certain forms of potential compensation may carry with them enhanced risks to customers,” Schapiro wrote. “For example, if a registered representative is aware that he or she will receive enhanced compensation for hitting increased commission targets, the registered representative could be motivated to churn customer accounts, recommend unsuitable investment products or otherwise engage in activity that generates commission revenue but is not in investors’ interest.”

Schapiro reminded the CEOs of “the significant supervisory responsibilities” they had to oversee broker-dealer activities, particularly with regard to sales practices.

Schapiro didn’t cite specific press articles, but a mid-August report from Investment News, an online service for investment advisors, quoted a Merrill Lynch official as saying in a conference call with external recruiters, “We want brokers, brokers, brokers.”

According to this report, Merrill was offering brokers who generate $800,000 or more in fees and commissions per year an upfront bonus of 140% of the broker’s fees and commissions in the previous year. A broker must bring 65% of his assets to Merrill from the prior firm to qualify, and by year five, the broker needs to increase those assets to a level of 1.5 times.

The number of brokers at Merrill has fallen to some 13,000 over the past year, from more than 16,000 before the securities firm was pushed into a merger with Bank of America. In the meantime, Morgan Stanley and Citigroup’s Smith Barney have formed a joint venture with more than 18,000 brokers, making them the nation’s largest broker-dealer.

Schapiro’s letter comes amid a debate about bonuses at banks that encourage traders to take excessive risk for short-term gains. The SEC’s concern is somewhat different – that the broker-dealer’s customers may fall victim to unscrupulous sales practices because of financial incentives.

“Some types of enhanced compensation practices may lead registered representatives to believe that they must sell securities at a sufficiently high level to justify special arrangements that they have been given,” Schapiro said in her open letter. “Those pressures may in turn create incentives to engage in conduct that may violate obligations to investors.”

Schapiro encourages CEOs to be “particularly vigilant” in monitoring broker sales practices, and reminds them that supervisory capacity must also keep pace with any expansion in a firm’s sales force.