Level 1 CFA® Exam Ethics, Standards VI (A) & VI (C)
Standard VI: Conflicts of Interest is very important for you in the context of your work in finance.
As we already said in the previous lessons, working in finance involves different interpersonal relationships – with your clients, with your colleagues, with your employer, with individual investors, and with different companies. As a result of these relationships, conflicts of interest may arise.
In dealing with this kind of problems, Standard VI (A): Disclosure of Conflicts comes in handy.
Standard VI (A): Disclosure of Conflicts explains what a CFA member or candidate should do when he or she encounters a conflict of interest and how this conflict should be disclosed.
To keep your reputation untarnished, Standard VI (A) tells you to disclose any potential and actual conflicts of interest.
Such a disclosure should be made in an appropriate manner. What does "appropriate manner" mean here?
Also, how the disclosure is made is significant – it should be aimed to reach all parties involved.
Note that Standard VI (A) is closely connected with Standard I (B): Independence and Objectivity. A conflict of interest mustn't harm the independence and objectivity of a CFA member or candidate. That is why appropriate disclosure is so significant.
Appearance of a Conflict
Sometimes even a mere appearance of a conflict of interest may be problematic. For this reason, sometimes employers forbid certain types of action, e.g., they limit the possibilities of personal trading.
To comply with the Code and Standards, as well as with the firm’s compliance procedures, as a CFA member or candidate you have to abide by such limitations. This will allow you to avoid any potential conflict of interest.
Existing Conflict of Interest
Now, what happens if a conflict of interest comes into existence?
When a conflict of interest occurs, a prompt disclosure should be made:
- to the employer, and
- to the client.
Disclosure to Employer
Disclosure to Client
Also, your client should be properly informed of any matter that may be considered a conflict of interest.
The reason is to allow the client to make a judgment on whether the service provided by you is – in his or her opinion – free of bias.
Suppose that you have options on stocks of a company that you recommended as an investment to your client. Should you disclose the fact to the client?
Also, referral fees and any fee arrangements established between you and other investment professionals for the services performed for the client should be disclosed. This way the client will be able to judge whether by cooperating with other financial professionals, you act to the benefit of the client’s account or probably your own pocket.
Such issues are covered in Standard VI (C), which is mainly devoted to referral fees and compensations received or paid for the recommendation of services to clients.
Generally, receiving and offering any benefits, such as fees, gifts, or compensations, for the mere fact of being recommended to the client or recommending someone else’s services should be disclosed both to the client and to the employer.
Such disclosure should be complete and effective to allow all the parties involved to understand the whole situation, namely any possible partiality on your part or any potential hidden costs. Appropriate disclosure should inform both about the benefit offered and its nature, e.g., whether the benefit is based on performance or not.
It is also necessary that the employer approves such compensations. Sometimes firms regulate these issues by enforcing relevant procedures. It is also possible that restrictions concerning referral fees are introduced.
If, however, the employer approves of such fee arrangements, you should update your employer regularly on any received benefits.
Suppose that in the firm you work for, referral fees are accepted and appropriate policy is implemented. You and your colleague often recommend clients to use each other’s services. In turn, you pay each other fees in an acceptable amount. What is the right thing to do according to Standard VI (C) when you meet with the client for the first time?
The answer is easy. You should inform your client about the referral fee that you paid to your colleague for having your services recommended to the client.
Also, please have a look at the lesson in which we talk about Standard IV (B) to revise additional compensation practices.
Remember that virtually everything that can be expected to have an impact on the way you perform your professional duties should be disclosed to the relevant persons – whether it’s a real conflict of interest or a situation that may impair your independence and objectivity or any fee arrangements that apply to a given situation.
It’s always better to disclose something (even if it is not required to be disclosed) than to fail to disclose a matter meant for prompt disclosure.
You should also remember to provide your clients and employer with updates of the disclosed information whenever appropriate, i.e. when material changes take place.
As far as the nature of disclosure is concerned, there are things that you will disclose to your employer and things that you will disclose to the client. Generally, everything you disclose to the client needs to be disclosed to the employer, as well.
Needless to say, as long as we act ethically and professionally, there’s no need to be afraid of such disclosures. They will always be of benefit to you, your clients, and your employer.
- Always disclose any potential and actual conflicts of interest in an appropriate manner.
- Sometimes even a mere appearance of a conflict of interest may be problematic.
- When a conflict of interest occurs, a prompt disclosure should be made both to the employer and to the clients.
- Also, referral fees and any fee arrangements established between you and other investment professionals for the services performed for the client should be disclosed.
- Remember to provide your clients and employer with updates of the disclosed information whenever significant changes take place.
CFA Exam: Disclosure of Conflicts
- full and fair disclosure
- of anything that creates or can appear to create a conflict of interest, and
- can possibly impair your independence and objectivity or interfere with the duties to your clients, prospective clients, and employer.
Especially when conflicts cannot be avoided, clear and complete disclosure is crucial.
IDENTIFYING AREAS for POTENTIAL CONFLICTS:
- PERSONAL TRADING, i.e., the purchase and ownership of stocks analyzed for and recommended to clients or held by clients (employers often restrict personal trading to avoid conflicts of interest)
- SELL-SIDE: Analysts should disclose any materially beneficial ownership interest in a security or other investment recommended to the client.
- BUY-SIDE: Analysts should disclose the applicable personal transactions reporting requirements and procedures.
- ADDITIONAL COMPENSATION: Receiving additional compensation for recommending and selling a stock should be disclosed.
- COMPENSATION PACKAGE, e.g., when an employee has outstanding options to buy stock as part of the compensation package (the amount and expiration date of such options should be disclosed)
- NONSTANDARD FEE STRUCTURES. i.e., any situation involving nonstandard fee arrangements, including subadvisory agreements
- PERSONAL RELATIONSHIPS & FAVORS: Both financial and other pressures can negatively influence one’s objectivity and responsibilities.
- PARTICIPATION ON OUTSIDE BOARDS: Such new roles can be time-consuming and thus to a possible detriment of one’s analytical responsibilities towards clients (employers often restrict outside board membership and related activities to prevent conflicts of interest).
- BUSINESS STOCK OWNERSHIP, i.e., when a company has an interest in another company whose stock is sold or recommended to clients (the companies may directly benefit from such investment recommendations)
- CROSS-DEPARTMENTAL PRESSURES, e.g., the marketing division may ask an analyst to recommend the stock of a certain company in order to obtain business from that company
- DIRECTORSHIP: Those in a directorial position in the company should be isolated from those making investment decisions by firewalls. WHY? (i) possibly conflicting duties owed to clients vs shareholders of the company; (ii) possibility of receiving the securities or options to purchase securities of the company as compensation for serving on the board vs possible desire to increase the value of those securities; (iii) access to material nonpublic information involving the company that may create an impression that confidential information not available to the public is accessible to the company’s employees.
CFA Exam: Referral Fees
To avoid conflicts of interest – DISCLOSE:
- benefits you give or receive for the recommendation of services,
- nature of the benefits.
TYPES of REFERRAL FEES and BENEFITS:
- flat fee,
- percentage-based fee,
- one-time benefit,
- continuing benefit,
- performance-based benefit,
- provision of research,
- other noncash benefits, etc.