Proprietary Product

A representative recommends a proprietary bond issued by an affiliate of the firm and charges a markup that is fair based on prevailing market price. A principal reviewing the transaction confirms the markup is fair but takes no further action. What has the principal overlooked?

1. A.A fair markup does not by itself address the separate conflict of interest created by recommending an affiliated, proprietary product; the firm's disclosure obligations regarding that conflict are independent of markup fairness.Correct. Conflict disclosure for the proprietary/affiliated relationship is a separate obligation from markup fairness.
2. B.Nothing was overlooked, since Rule 2121 fairness review is the only supervisory obligation triggered by a principal transaction.Wrong. This ignores the separate conflict disclosure obligation triggered by the affiliated proprietary product.
3. C.The transaction should have been rejected outright, since firms may never sell proprietary products to retail customers on a principal basis.Wrong. There is no such prohibition; this overreacts rather than identifying the actual disclosure gap.
4. D.The markup itself must be reduced below the firm's general guideline percentage specifically for proprietary products.Wrong. There is no separate reduced guideline for proprietary products; this conflates the fairness standard with the conflict disclosure obligation.

Why: A fair markup does not by itself address the separate conflict of interest created by recommending an affiliated, proprietary product; the firm's disclosure obligations regarding that conflict are independent of markup fairness.

A firm's written supervisory procedures allow branch managers to design and approve sales contests for their own branch without any review by anyone above them. A branch manager creates a contest that pays a bonus for volume sold in a single proprietary product line and approves it himself under this authority. What is the structural problem with this approval process?

1. A.There is no problem, since the branch manager is a registered principal and therefore qualified to approve compensation arrangements at his own branch.Wrong. Being qualified to approve arrangements generally does not solve the independence problem created by approving one's own design.
2. B.The problem is limited to whether the specific contest terms themselves were fair to all representatives at the branch.Wrong. Fairness among participants is a separate question from whether any independent party ever reviewed the contest for a product-selection conflict.
3. C.The problem is that sales contests should be run at the firm level rather than the branch level, regardless of who approves them.Wrong. Organizational level is not the defect; the defect is that no one independent of the designer reviewed and approved it.
4. D.Allowing the person who designs an incentive program to also be its final approver removes any independent check on whether that program creates an improper product-selection conflict, regardless of how reasonable that particular manager's judgment might be in any individual case.Correct. Self-approval eliminates the independent check the process is meant to provide, regardless of the outcome in any specific instance.

Why: Allowing the person who designs an incentive program to also be its final approver removes any independent check on whether that program creates an improper product-selection conflict, regardless of how reasonable that particular manager's judgment might be in any individual case.

A principal reviewing a representative's book of business notices that a large proportion of his customers, across a wide range of stated risk tolerances and objectives, hold a concentrated position in the same illiquid, firm-proprietary product. What should this pattern prompt the principal to do?

1. A.Nothing further is needed, since firm-proprietary products have already been vetted and approved by the firm and are therefore appropriate for any customer who holds them.Wrong. Product approval for the firm's shelf does not establish individualized suitability across a wide range of differing customer profiles.
2. B.The concern is limited to the product's liquidity, and the principal need only confirm that customers were told the position is illiquid.Wrong. Disclosure of illiquidity alone does not address the pattern-level concentration concern.
3. C.Review whether the recommendation of this product across such a broad range of customer profiles reflects a genuine, individualized fit for each customer or instead reflects a pattern driven by something other than each customer's actual objectives, such as the product's compensation structure.Correct. A concentration pattern across dissimilar customer profiles warrants reviewing whether something other than individualized fit is driving the recommendations.
4. D.The pattern is not a concern as long as no single customer's position exceeds that customer's own account in size.Wrong. An account-level sizing check does not address why such a broad range of differing risk profiles ended up concentrated in the same illiquid product.

Why: The principal should review whether the recommendation of this product across such a broad range of customer profiles reflects a genuine, individualized fit for each customer or instead reflects a pattern driven by something other than each customer's actual objectives, such as the product's compensation structure.

A firm runs periodic sales contests rewarding representatives for selling specific proprietary products. The firm has no written policies addressing how this incentive structure's conflicts of interest will be identified, disclosed, or mitigated, relying instead on principals to notice and address any problems only if a specific recommendation looks suspicious. What is the concern?

1. A.There is no concern, since case-by-case review by principals of any recommendation that looks suspicious is sufficient to address any conflicts created by a sales contest.Wrong. This treats reactive, case-by-case review as an adequate substitute for firm-level policies addressing the incentive itself.
2. B.The firm should have policies and procedures reasonably designed to identify and address conflicts of interest associated with this kind of compensation incentive at the firm level, rather than relying solely on principals to catch a problem after the fact when an individual recommendation happens to look suspicious.Correct. Firm-level policies addressing the incentive structure's conflicts are expected, not just reactive case-by-case review.
3. C.The concern is that sales contests rewarding representatives for selling specific products are prohibited outright and must be discontinued entirely.Wrong. This overstates a categorical prohibition rather than requiring policies to identify and address the resulting conflicts.
4. D.The concern applies only if a specific customer complaint arises from a recommendation made during the contest period; absent a complaint, no firm-level policy is necessary.Wrong. This makes the need for firm-level policies contingent on a complaint rather than being a proactive requirement.

Why: The firm should have policies and procedures reasonably designed to identify and address conflicts of interest associated with this kind of compensation incentive at the firm level, rather than relying solely on principals to catch a problem after the fact when an individual recommendation happens to look suspicious.