Conflict Of Interest Obligation

Agent Roderick Vance recommends 500 shares of Callenberg Foods to a retail customer. Roderick's firm makes a market in Callenberg Foods and will fill the order out of its own inventory at a marked-up price. Neither the recommendation nor any communication with the customer mentions the firm's role in the security. This is:

1. A.Permitted, because making markets in securities is an ordinary and lawful part of the brokerage business.Incorrect. Market making is lawful; failing to disclose that the firm is acting in that capacity when recommending the same security is not.
2. B.Permitted, provided the price the customer pays is fair relative to the prevailing market.Incorrect. A fair price does not substitute for disclosure of capacity. The customer is entitled to know that the recommending firm is also the seller.
3. C.A prohibited practice, because an agent must disclose that the firm is acting as a principal or market maker in a recommended security, a material conflict the customer is entitled to know about.Correct. The firm profits from moving its own inventory, and concealing that role while recommending the security is a prohibited practice.
4. D.Prohibited only if the firm's inventory position in Callenberg Foods exceeds a stated size threshold.Incorrect. No size threshold triggers the obligation. The duty to disclose the capacity in which the firm acts applies to the recommendation itself.

Why: A broker-dealer that makes a market in a security holds a position in it and profits from moving that inventory, which is a material conflict with a customer who is being told to buy the same security. State securities regulation treats the failure to disclose that the firm is acting as a principal or market maker in a recommended security as a prohibited practice: the customer is entitled to know that the person recommending the purchase is also the party selling, and is earning a markup rather than a disclosed commission.

Marchbank Securities pays its representatives a higher share of the commission on funds sponsored by an affiliate than on unaffiliated funds. Under the Conflict of Interest Obligation of Regulation Best Interest, the firm must:

1. A.Disclose the differential in Form CRS, which discharges the obligation entirely.Disclosure alone is not sufficient for an associated-person incentive; mitigation is required.
2. B.Eliminate all compensation differences between affiliated and unaffiliated products.The rule does not require identical compensation across products. It requires identification and mitigation of the incentive.
3. C.Report the arrangement to FINRA and obtain written approval before paying the higher rate.There is no pre-approval mechanism. The obligation is to have policies that identify, mitigate or eliminate conflicts.
4. D.Maintain written policies that identify the conflict and mitigate the incentive it creates, and eliminate any time-limited sales contest tied to selling specific securities.Correct. Associated-person incentives must be identified and mitigated, and limited-period sales contests on specific securities must be eliminated.

Why: The Conflict of Interest Obligation requires written policies and procedures reasonably designed to identify and, at a minimum, disclose or eliminate conflicts. Where a conflict creates an incentive for the associated person to place the firm's or her own interest ahead of the retail customer's, the firm must identify AND MITIGATE that incentive, not merely disclose it. Sales contests, quotas, bonuses and non-cash compensation tied to selling specific securities within a limited period must be eliminated outright.

Marchgate Advisory sweeps uninvested client cash into a bank deposit program operated by an affiliate. The affiliate credits clients 0.30% on swept balances and pays Marchgate an administrative fee equal to 0.85% of those balances. Comparable money market funds available on the same platform yield about 4.5%. Marchgate's brochure states only that "cash may be swept to a bank deposit program." The most accurate assessment is that:

1. A.There is no meaningful conflict, because clients still receive some yield on cash that would otherwise earn nothing.Incorrect. Receiving some yield does not neutralize a conflict in which the firm collects nearly three times what the client earns and profits from leaving cash where it is.
2. B.The arrangement creates a serious conflict, since the firm earns more the longer cash sits in the lower-yielding option, and the brochure language is inadequate: a fiduciary must fully disclose the compensation and the conflict and have a reasonable basis for concluding the sweep serves the client's best interest.Correct. Both fiduciary duties are engaged - loyalty requires disclosure sufficient for informed consent, and care requires a defensible comparison against the available alternatives.
3. C.The disclosure is adequate, because the brochure does inform clients that cash may be swept into a bank deposit program.Incorrect. The sentence is true but omits the affiliation, the firm's compensation and the existence of materially better-yielding alternatives on the same platform.
4. D.The arrangement is permissible without further analysis, because uninvested cash is not an investment subject to fiduciary duty.Incorrect. Cash held in a client account is a client asset, and the fiduciary duty extends to how the adviser handles it.

Why: The arrangement creates an acute conflict of interest: Marchgate is paid nearly three times what the client earns, and its compensation rises with every dollar it leaves sitting in the lower-yielding option. A fiduciary owes duties of care and loyalty. The duty of loyalty requires full and fair disclosure of all material facts about the conflict - the existence of the affiliate relationship, the amount and basis of the firm's compensation, and the fact that better-yielding alternatives are available on the same platform - sufficient for an informed client to consent. The duty of care requires a reasonable basis for believing that the sweep is in the client's best interest given those alternatives, and periodic review of that conclusion. A single passive sentence in a brochure discloses neither the compensation nor the conflict.

Ardmore Securities permits its representatives to recommend only proprietary mutual funds advised by an Ardmore affiliate. Under Regulation Best Interest, how must the firm handle this material limitation on the products it may recommend?

1. A.The limitation must be eliminated, because Regulation Best Interest requires every firm to offer an open architecture product menu.Wrong. Reg BI does not mandate open architecture. A proprietary-only menu is permissible if properly disclosed and managed.
2. B.Disclosure alone is sufficient; nothing further is required once the limitation is described to customers.Wrong. Disclosure is necessary but not sufficient. The firm must also have procedures preventing the limitation from tainting recommendations.
3. C.It must disclose the limitation and the conflicts it creates, AND maintain policies reasonably designed to prevent the limitation from causing recommendations that are not in customers' best interest.Correct. Reg BI pairs disclosure of a material limitation with an affirmative obligation to keep that limitation from driving bad recommendations.
4. D.The limitation need not be disclosed so long as each individual fund recommended is itself suitable.Wrong. A material limitation on what may be recommended is precisely what must be disclosed, independent of any single fund's merits.

Why: Reg BI's Conflict of Interest Obligation singles out material limitations on the securities or strategies a firm may recommend - a proprietary-only menu being the standard example. The firm must have written policies and procedures reasonably designed to identify and DISCLOSE the limitation and the conflicts it creates, and, separately, to PREVENT the limitation from causing the firm or its representatives to place their own interest ahead of the customer's. Disclosure by itself is not the whole answer.