ETH 8 Guidance for Standard VI: Conflicts of Interest
A conflict of interest is any circumstance that could reasonably be expected to bias a professional’s judgment or weaken the independence and objectivity that clients and employers are entitled to expect. Such tensions are common in the investment business, because the interests of a client, the interests of an employer, and a professional’s own financial position can easily pull in different directions. Compensation design is a frequent source, especially bonus and incentive schemes that reward quick results while ignoring whether lasting value was created.
Standard VI gathers the rules for handling these tensions into three lettered parts. The thread running through all of them is simple to state: identify the conflict, then either remove it or make it visible, and never let a personal interest ride ahead of a client. Before working through each part, it helps to see the three side by side.
| Subpart | Core requirement |
|---|---|
| VI(A) Avoid or Disclose Conflicts | Avoid conflicts where you can; where you cannot, disclose them fully, fairly, and plainly |
| VI(B) Priority of Transactions | Put client and employer transactions ahead of your own beneficial-owner transactions |
| VI(C) Referral Fees | Disclose any benefit received or paid for recommending a product or service |
Each part is examined in its own section below, following the reading’s own order: the requirement, the guidance that interprets it, the procedures a firm can adopt, and a set of applied cases. The worked examples are judgement scenarios: read the facts, decide whether the conduct meets the standard, and then check your reasoning against the solution.
Standard VI(A) requires members and candidates either to steer clear of, or to disclose fully and fairly, anything a reasonable observer would expect to weaken their independence and objectivity or to get in the way of the duties owed to clients, prospective clients, and the employer. Where disclosure is used, it must be prominent, written in plain language, and framed so the relevant facts actually reach the reader.
What the standard protects, and the avoid-or-disclose choice
The preferred response to a conflict is to steer clear of it altogether, including the mere appearance of one. When avoidance is not realistic, the professional must disclose the conflict clearly and, where possible, take steps to reduce it and explain how it has been reduced. Full disclosure serves investors and employers by handing them the information they need to weigh how much objectivity stands behind a recommendation or an action taken on their behalf. To do its job, a disclosure has to stand out rather than hide in fine print, use ordinary language, and be timed and worded so the message lands. Members and candidates decide how often and in what form to disclose, and best practice is to refresh a disclosure whenever the conflict changes in a material way, for example if a bonus that once tracked annual profit is switched to a quarterly measure, which sharpens the short-term pressure. When in doubt, err toward more disclosure rather than less.
Disclosure to employers
Reporting a conflict to an employer is often the right first move, and it must carry enough detail for the employer to gauge the impact. Situations that call for reporting include anything that would color unbiased advice or push the professional to act against the employer’s interest: ownership of shares in a company being analyzed or recommended, seats on outside boards, and any financial or personal pressure that could sway a decision. Because even the look of a conflict can embarrass a firm, many employers simply prohibit certain activities in advance, such as personal trading or outside directorships, and members and candidates must follow those restrictions. A professional should try to sidestep conflicts that could cloud judgment about, or full commitment to, the work owed to the employer; where a conflict cannot be avoided, it must be reported promptly.
Disclosure to clients
Objectivity has to be preserved whenever advice is given or action is taken, and it can be perceived as compromised in many ways, for instance when the professional owns stock in the recommended company or is personally close to its managers. Requiring disclosure of every matter that could reasonably impair objectivity lets clients and prospective clients judge the motives and possible biases for themselves. Some relationships are so obviously in tension that they must always be avoided or disclosed: a directorship or consultancy, investment-banking or underwriting ties, broker-dealer market-making in the stock, and material beneficial ownership of the shares. For this standard, a person beneficially owns a security when they carry a direct or indirect pecuniary interest in it, can cast or steer the votes attached to the shares, or can sell the holding or direct its sale.
Members and candidates have to make a reasonable effort to establish whether a conflict is present and must reveal any known conflicts of their firm. Telling clients that the firm makes a market in a stock, for example, warns them that a purchase or sale may run through the firm’s own account and that the firm has a stake in the price. Disclosure is also owed for conflicts embedded in fee arrangements, subadvisory deals, or other nonstandard fee structures, and for any setup where the firm gains directly from a recommendation. A clear case is the rebate of part of the service fee charged by some classes of mutual funds, which must be disclosed so clients grasp the conflict.
Cross-departmental conflicts
Other pressures arise across a firm’s units. Sell-side analysts at broker-dealers may be pushed, by colleagues and by the issuers themselves, to publish research on particular companies, and buy-side analysts face parallel pressures as their banks pursue underwriting and dealing business. A marketing unit might lean on an analyst to recommend a company in order to win that company’s business. Broker-sponsored limited partnerships raised to invest venture capital create similar risks, where professionals may be expected to keep covering the deals and to talk them up in the secondary market after the public offering. All such situations must be resolved or disclosed under the principles of this standard.
Stock ownership and board service
The single most common conflict under this part is a professional owning stock in a company they recommend or that clients hold. Banning all such ownership would prevent the conflict but is usually too heavy-handed, so the rule is that any beneficial interest in a recommended security must be disclosed. Serving as a board member or director carries three built-in conflicts: the duty to clients can collide with the duty to the company’s shareholders; directors are often paid in the company’s shares or options, which can raise questions about actions that lift those securities’ value; and a board seat opens access to material nonpublic information, so that even confidential information can create a perception that it is flowing to the director’s firm. Where members and candidates both advise on investments and sit on a board, they should be kept apart from the firm’s investment decision makers by firewalls or comparable barriers.
Weiss is a research analyst at Williamsburg Company, a broker and investment bank. For the past twenty years Williamsburg’s mergers and acquisitions team has advised Jimco, a conglomerate, on every one of its purchases, and Williamsburg officers have periodically held seats on the boards of Jimco subsidiaries. Weiss is now writing a research report on Jimco.
Snead manages public retirement funds and defined benefit pension accounts at Thomas Investment Counsel, LLC, all with long horizons. A year ago her employer, hoping to keep its top managers, brought in a bonus scheme that pays portfolio managers on quarterly performance measured against peers and benchmark indexes. To lift her short-term numbers, Snead shifts strategy and buys several high-beta stocks for client portfolios, purchases that appear to cut against the clients’ investment policy statements. She recommended no change in objective or strategy during the year.
Papis serves as the chief investment officer for the retirement fund of his state, which has always relied on outside managers for its real estate allocation, something stated plainly in fund communications. Nagle, a well-known sell-side analyst and Papis’s old business school classmate, has just left his investment bank to launch an asset management firm, Accessible Real Estate, and is working to build assets under management. He asks Papis for part of the fund’s real estate allocation. Recent real estate returns had merely matched the benchmark, so Papis decides to help his friend and perhaps improve returns by moving the allocation to Accessible. The only record of the switch is the list of external managers in the next annual report.
Notice how the solutions keep pointing to two acceptable responses. At minimum, a professional discloses the conflict so others can judge it. The stronger response, and often the recommended one, is to remove the conflict entirely, for example by handing a report to an analyst who owns no stock in the subject company. Disclosure never cures a conflict; it only makes it visible.
Standard VI(B) requires that dealing for clients and employers outrank any personal dealing where the member or candidate is the beneficial owner. Its purpose is to keep a professional’s personal dealing from creating a conflict, or even the appearance of one, with the people whose money they manage.
Personal investments and the priority rule
Client transactions come before those made for the firm and before a professional’s own transactions. Holding the same position as a client, or investing alongside one, is not automatically a problem, and some mandates actually call for aligned interests. What is never acceptable is a personal position or trade that harms client investments. There is nothing inherently wrong with a manager, adviser, or fund employee making money from personal investing, provided three conditions hold: no client is left worse off by the trade, the professional does not personally gain from trades done for clients, and all applicable regulatory requirements are met. Occasionally a professional must make a personal trade that runs against current client advice, for instance selling an asset to raise cash for a genuine personal need; acting counter to client advice can be justified in such cases.
The standard reaches anyone who knows about pending client or employer transactions. Members and candidates are forbidden from profiting from that knowledge or passing it along, which rules out trading ahead of clients on the strength of it.
Accounts with beneficial ownership
A professional may trade in an account they beneficially own only after clients and employers have had an adequate chance to act on the relevant recommendation. A person is a beneficial owner when they ultimately own, control, can direct, or hold a material interest in the investment. Personal transactions include those in the professional’s own account, in the accounts of immediate family members, and in any account in which the professional has a direct or indirect financial interest. A family account that is also a fee-paying client account is treated exactly like any other client account: it gets neither special favors nor worse treatment because of the family tie.
Compliance practices
Firms differ widely, so members and candidates must follow whichever personal-investing policies apply to their situation, and those policies should be disclosed prominently to clients. Common measures include the following.
- Limits on equity IPOs. Hot new issues can jump soon after launch and are often scarce. Personal participation creates two conflicts: it can look like a professional is taking an attractive opportunity away from clients for personal gain, breaching the duty of loyalty; and it can look like the allocation is a reward meant to steer future business toward whoever handed out the shares. Not participating avoids both. Where a firm does allow it, professionals should preclear their participation, even absent any obvious conflict, and should never trade on their clients’ standing in the market through preferred trading, getting limited offerings allocated to themselves, or oversubscription.
- Restrictions on private placements. These raise conflict issues much like IPOs. Investment personnel should stay out of deals, private placements included, that could look like favors or gifts designed to sway future judgment or to reward past business.
- Blackout and restricted periods. Personnel involved in investment decisions should observe set blackout windows, so a manager cannot use knowledge of client activity to front-run, meaning to trade for a personal account ahead of client accounts.
- Reporting requirements. Members and candidates have to observe the employer’s reporting rules. These commonly include disclosing personal holdings that the employee has a beneficial interest in, both at hire and from time to time; supplying duplicate confirmations and statements for personal accounts, which signals independent verification and allows the flow of personal investing to be traced rather than merely inferred from holdings; and preclearing planned personal trades so conflicts can be spotted before a trade is executed.
- Disclosure of policies. On request, professionals should fully describe the firm’s personal-investing policies to investors, in helpful detail rather than boilerplate such as a bare line saying that personnel are subject to trading policies.
Baker manages an aggressive growth mutual fund. She maintains a brokerage account registered to her husband at several firms that transact heavily with the fund and with many of her own individual clients. Each time a hot issue surfaces, she instructs those brokers to pick it up for that account. Since such issues are typically scarce, Baker often secures shares while her clients get none.
Toffler manages, at Esposito Investments where she works as a portfolio manager, a retirement account that her parents opened as fee-paying clients of the firm. Whenever an IPO becomes available, she allocates shares first to every other client for whom the issue is suitable, and only afterward puts any remainder into her parents’ account, if it fits them. She built this routine so that no one could accuse her of favoring her parents.
Wilson, an insurance analyst at a brokerage, gives an internal video presentation to branches across the country and makes negative remarks about a major insurer. The next day her written report reaches the sales force and public customers, recommending that both short-term traders and intermediate investors sell the insurer’s stock to take profits. But seven minutes after the video call, Riley, head of the firm’s trading desk, closed a long call position in the stock and soon after built a sizable put position. Asked about it later, Riley said she acted to prepare for anticipated institutional client sales.
Standard VI(C) requires members and candidates to tell their employer, their clients, and prospective clients, where relevant, about any pay, consideration, or benefit that they receive from, or hand to, other parties in exchange for recommending products or services.
What must be disclosed, and when
Professionals must reveal any benefit they receive for referring customers or clients, and equally any fee or compensation they pay to others who send prospective clients their way. These disclosures let clients and employers judge two things: whether a recommendation of a product or service is coloured by partiality, and what the full cost of the services really is. To be appropriate, the disclosure has to come before any formal agreement for services is entered into, so the client or prospective client learns of the benefit up front rather than after committing. The professional must spell out the nature of the consideration, whether it is a flat fee or a percentage, a one-time or a continuing benefit, tied to performance, delivered as research or another noncash form, together with its estimated dollar value. Consideration takes in every fee, whether settled as cash, as soft dollars, or in kind.
Compliance practices
Members and candidates should press their employers to build procedures around referral fees. An employer may bar such fees outright or lay out the steps for seeking approval of a referral arrangement. Professionals taking part in approved referral programs should give their employer regular updates, at least quarterly, on the amount and nature of the compensation received through those arrangements.
Brady Securities, Inc., a broker-dealer, sends every prospective tax-exempt account it finds, whether pension, profit-sharing, or endowment, over to Lewis Brothers, Ltd., a firm that manages investments. In return, Lewis Brothers supplies Brady with its research staff’s recommendations and reports, runs monthly economic and market reviews for Brady personnel, and directs all stock commission business from referral accounts back to Brady. White, a Lewis Brothers partner, works out that acting as Brady’s research department costs the firm about US$200,000 a year. Last year, Brady referrals brought Lewis Brothers fee income of US$1.8 million, and routing all stock trades through Brady added US$100,000 in costs to Lewis Brothers’ clients. When Branch, chief financial officer of Maxwell Inc., contacts White seeking a manager for Maxwell’s profit-sharing plan, she mentions that her friend Hill at Brady recommended Lewis Brothers without qualification. White wins Maxwell as a client but never mentions the referral arrangement with Brady.
A state employee pension plan wants to hire a firm to run its emerging market allocation and engages Arronski as a consultant to gather proposals and represent the plan’s best interest in choosing a manager. The search goes smoothly and Overseas Investments is selected. A year later it emerges that Arronski charges fees to the very investment managers he recommends whenever they win new pension allocations. Although the plan is pleased with Overseas’ performance, it orders an outside review of both the proposals and the way the pick was made. That review finds that, although Arronski drew fees from the plan and from Overseas alike, his recommendation of Overseas still looked objective and appropriate.
Standard VI(C) draws no line between a fee paid by an outside third party and a payment made inside a single firm to move business to a sister department. If a trust officer is paid for steering clients to his bank’s own brokerage or financial-management arm, that arrangement must be disclosed to those clients at the time of referral, including its nature and value, just like any external referral fee.