The Risks and Disadvantages of Large Brokerage Firms

Conflict of Interest is Always Present with Brokerage Firms

The root cause of a century’s worth of malfeasance on the part of large financial brokerage firms can be summed up in one phrase, “Conflict of Interest”. Clearly, on the part of many firms, other words can enter the picture, such as “fraud” and “theft”. However, it’s important to remember that conflict of interest is always present with large brokerage firms, even for those that commit no fraud or have stolen nothing from their clients. Conflict of interest is built right into the system.

Let’s First Define Conflict of Interest

The Merriam Webster dictionary defines conflict of interest as: a conflict between the private interests and the official responsibilities of a person in a position of trust.

In our example here, the persons in the position of trust are, a) the sales representative at a large brokerage firm, also called the stock broker, registered representative, or sometimes financial advisor, and, b) the manager or management of the large brokerage firm. The third party in the relationship would be you, the investor.

The Interests of the Three Parties Involved

In order to know if interests are in conflict, we need to know the interests of the parties involved.

Interests of You, the Investor: The interests of the investor, simply put, are to maximize earnings on investments and to minimize expenses associated with these investments.

Interests of the Stock Broker: To maximize personal income from commissions and other incentives that result from selling investment products to you, the investor. Remember that compensation to the stock broker comes, both directly and indirectly, from your pocket, meaning from your investment assets. These are the expenses that you, the investor are trying to minimize. The stock broker further seeks to gain favor from management, filling established quotas, winning internal sales contests, and so on. Their very job depends on it.

Interests of Management and the Brokerage Firm: To maximize corporate income and profitability on behalf of shareholders. Sales managers also have quotas to fill, bonuses to earn, bosses to impress and a job to save. Income and profit to the firm also comes directly and indirectly from the invested assets of their clients, the investors.

The Conflict is in the Forms of Compensation, such as Commissions

There are many sources of income to the broker and the brokerage firm. The most known is that of commissions to the stock broker, but there are many more. Different products carry different commissions, sometimes extraordinarily so. Further, different products result in differences in profitability to the firm. Yet, many of these products carrying widely variant rewards to the broker and firm meet the vague and soft standard of “suitability” to you, the investor. As such, the broker and firm are free to sell to you the products that bring them the most financial reward, even though they don’t meet your interest to maximize earnings on investments and to minimize expenses associated with these investments.

Adding insult to injury is that in many cases the income to the broker and firm are not disclosed to the investor. There is no transparency.

Summary of the Three Most Common Reasons for Conflict of Interest

• Different Commissions and Fees on Different Products: A conflict doesn’t necessarily arise if the stock broker would earn the same commission no matter what product is sold. This isn’t the case. A number of products that meet the “suitability” standard offer different rates of commission to the salesperson.
• Pressure from Management to Produce Revenue: Managements’ compensation, often in the form of bonuses, are tied to many factors; and one of those factors is overall commissions and the growth rate of commissions over time.
• Pressure from Management to Favor Certain Products to All Clients: Stock brokers receive regular emails, sometimes daily or several times per day, encouraging them to promote certain products over others (as long as they meet the “suitability” requirement). They are favored because of the benefit they provide to management and the firm.

What is Churning? Some stock brokers have been known to frequently buy and sell stocks or bonds within the investor account as a way to generate commissions. This practice, known as “churning” is detrimental because of the cumulative costs and the absence of benefit to the investor.

There is a Better Way to Receive Investment Advice

Work only with an Independent Financial Advisor who is a fee-only Registered Investment Advisor (RIA). RIAs are legally bound to operate as a fiduciary to clients, meaning they must at all times act in the best interest of their clients. As such they are unable to receive commissioned compensation from the investment advice they give. Fees are disclosed and transparent.

Simply put, an RIA-licensed Financial Advisor shares your interest, to maximize earnings on investments and to minimize expenses associated with these investments. This is reflected in the form of the compensation. Conflicts of interest simply don’t exist.

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How to Find a Financial Advisor?
What is a Financial Advisor?
The Advantages of a Fee-Only Financial Advisor
Why RIAs Make the Best Financial Advisors

About the Author

Todd E. Frank, CPA/PFS, MBA is the President and CEO of Frank Financial Advisors, a Registered Investment Advisory Firm (RIA) serving clients nationwide from our headquarters in Carlsbad, San Diego, California. As an RIA, Frank Financial Advisors is able to offer truly independent, fee-only financial advisory services.