LM03 Guidance for Standards I-VII

Part 9

Standard VI: Conflicts of Interest

Standard VI (A) Disclosure of Conflicts

Members and Candidates must make full and fair disclosure of all matters that could reasonably be expected to impair their independence and objectivity or interfere with respective duties to their clients, prospective clients, or employer. Members and Candidates must ensure that such disclosures are prominent, are delivered in plain language, and communicate the relevant information effectively.

Interpretation:

Conflicts occur often in the investment profession. They occur between the interests of clients, interests of employers, or they could be your own personal interests. Disclose the conflict of interest in plain language to employer, clients, or prospective clients.

Guidance:

• Disclosure of conflicts to employers. Some examples:
  • Assume you are working in an investment management firm. You manage a client’s portfolio that has performed extremely well. The client is happy and wishes to compensate you for this performance. This is a conflict of interest with other clients and you must disclose this to your employer.
  • Assume you volunteer at a charity organization that is in no way related to your work, and you are not paid for it. However, you are passionate about the work you do at this charity which keeps you busy on weekends and mentally occupied during the week, and is depriving your employer of your skills. You must disclose this potential conflict of interest to your employer.
  • Assume you hold stocks in your personal account for which your firm has a buy recommendation and is suitable for many clients. This may create a conflict of interest.
• Firms create policies to prevent actions that may appear as a conflict of interest. Policies include restrictions on personal trading, outside board membership, etc.
• Disclosure to clients: There are numerous instances where a conflict of interest exists; these should be disclosed to clients so that they understand the cost of their investments and the benefits received by the firm. A few instances are highlighted below:
  • Assume you hold stocks of General Electric (GE). You are asking your client to buy shares of GE; it may create a potential conflict of interest as, if your client buys and the stock price increases, you will benefit from the movement.
  • You receive compensation (1% commission) from your employer when you recommend certain mutual funds. You must disclose this to the client as the client may believe this recommendation is keeping the client’s best interests in mind. Following the disclosure, the client may decide whether the mutual fund is suitable or not.
  • Assume you issue a buy recommendation on General Electric and recommend your client to buy the stock. If your firm also has an investment banking relationship, for instance, then it must be disclosed to the client. The client can then decide if it is in his best interest, or the interest of the firm and GE.
• Cross-departmental conflicts: Assume you are a research analyst (sell-side analyst) working at a brokerage firm. Your firm has an investment banking department, and may pressurize you to write favorable reports for companies with whom they have an existing relationship or are trying to forge one. Ideally, existing companies should be on a restricted list. But, if that is not possible, then you must make a disclosure of the investment banking relationship in the recommendation report. Another example where such conflicts may arise is buy-side analyst/ banks with underwriting powers.
• Conflicts with stock ownership: Members and candidates must disclose any material ownership in a stock/investment that they are recommending to clients.
• Conflicts as a director: There are three possible conflicts of interest if you are an investment professional and serving as a director of a company:
  • Duties owed to clients and duties owed to shareholders of the company.
  • As a director, you may receive securities/options to purchase securities of the company as compensation. A conflict may arise if trading in these securities increases the value of the security.
  • As a director, you may be privy to material nonpublic information about the company. There may be a perception that the director communicates this information to his firm and investment recommendations are based on that information.

Recommended procedures for compliance:

• Disclose special compensation arrangements with the employer that might conflict with client interests, such as bonuses based on short-term performance criteria, commissions, incentive fees, performance fees, and referral fees.
• If the firm does not permit such disclosure, you should document the request and consider dissociating from the activity. For example, if you receive a 1% bonus from your firm for selling certain mutual funds and your firm does not permit disclosing this compensation, then you should consider dissociating from the activity.

Standard VI (B) Priority of Transactions

Investment transactions for clients and employers must have priority over investment transactions in which a Member or Candidate is the beneficial owner.

Interpretation:

If you are trading for your own account, then you are the beneficial owner. But, assume the transaction happens in your children’s or spouse’s account. Even though those accounts are not in your name, you benefit from them and you are the beneficial owner. The account here applies to any account with whom you have a direct relationship.

Guidance:

• Avoiding potential conflicts: Conflicts between client’s interest and investment professional’s interest may occur. There is nothing unethical about managers, advisers, or mutual fund employees making money from personal investments as long as they follow these three rules:
  • The client is not disadvantaged by the trade. For example, if you are executing a sell trade, then it should not affect your clients in any way.
  • The investment professional does not benefit personally from trades undertaken for clients.
  • The investment professional complies with applicable regulatory requirements.
• Personal trading secondary to trading for clients: The order of executing trades is: clients, employers, and then your personal account, or one in which you are the beneficial owner. The rationale is to prevent personal transactions from adversely affecting the interests of clients or employers.
• Impact on all accounts with beneficial ownership: Members and Candidates may undertake transactions in accounts for which they are a beneficial owner, only after their clients and employers have had an adequate opportunity to act on a recommendation. For example, assume you are working as an investment manager and your group made a buy recommendation on a stock. The client must get the first opportunity to act on the recommendation, then the employer, and then you.
• How should family accounts be treated? : Assume a close family member is a client. He/she should receive the same level of service as any other client. If you have a beneficial relationship in the fee-paying account, then you may be subject to preclearance or reporting requirements of the employer.

Recommended Procedures for Compliance:

• Limited participation in equity IPOs: Some IPO (initial public offerings) issues are highly sought after and the share price rises in value significantly after the issue is brought to the market. Usually, it is a hot IPO if the supply is limited and the demand is high. Purchase of the IPO by investment professionals creates a conflict of interest in two ways:
  • It may appear as if investment personnel are taking the opportunity away from clients for personal gain. For example, assume both you and your client are allotted 200 shares in an IPO. The client had applied for 400 but only got 200. Allotment to your account will make it seem as if some opportunity was taken away from the client for your gain.
  • The party that is giving the investment professional this opportunity to participate in the IPO is possibly trying to influence him/her in the future investment decisions.
• It is recommended that members and candidates should pre-clear participation in IPOs even where there is no appearance of conflict of interest, and stay away from equity IPOs. From a firm’s perspective, it may not be right to follow a blanket policy that bans employees from IPOs. Instead, it would be appropriate to have reliable and systematic procedures in place to identify any conflict of interest, and dealt with by supervisors.
• Restrictions on private placements: Private placements are transactions where you get shares of a company through a private offering, and not through a public offering. The conflict of interest here is similar to that of IPOs as it may seem that this participation in private placement is a favor for future business deals. Assume you have participated in a private placement. When the investment goes public, it may seem as if you have a vested interest if you recommend the investment to clients regardless of its suitability.
• Establish blackout/restricted periods: To prevent front running (the practice of trading for one’s personal account before client accounts), firms have blackout periods during which investment personnel cannot trade for their personal accounts. This is to safeguard the interests of the clients. The policy on blackout and restricted periods varies from firm to firm depending on their size. It can range from a total ban on trading to preventing the investment manager from front running.
• Supervisors must establish reporting procedures for investment personnel. For example:
  • Disclosure of holdings in which the employee has a beneficial interest: This should be done at the beginning of employment and at least annually thereafter.
  • Providing duplicate confirmations of transactions: Investment personnel must direct their brokers to provide duplicate copies of all the securities transactions done with them. It serves two purposes: a) discourages unethical behavior because there is an independent verification b) a clear transaction history and flow of money is available, and not just the holdings.
  • Preclearance procedures: Obtaining clearance for planned trades helps reduce conflict of interest.
• Members and candidates must disclose to investors their firm’s policies about personal investing/trading. It should be in simple language that investors can understand.

Standard VI (C) Referral Fees

Members and Candidates must disclose to their employer, clients, and prospective clients, as appropriate, any compensation, consideration, or benefit received from or paid to others for the recommendation of products or services.

Interpretation:

• Assume you provide equity investment advisory service to a client. The client is now interested in making fixed income investments as well. So, you refer someone providing this service to the client. You receive a fee for this from the person/firm giving fixed income advice. As per this standard, you must disclose the fee you get for the referral.
• Another example is where you recommend your client to purchase a mutual fund, and the fund pays you a commission. You must disclose this arrangement to the client so that he/she can understand the full cost of the investment and the benefit you are receiving.
• Say you receive a reference from someone/firm, and you pay a referral fee to the party introducing the client. You must disclose to the client the fee paid for this referral.

Guidance:

• Advise the client or prospective client about any referral fees before entering into any formal agreement.
• Disclose the nature of the consideration or benefit. For example, flat fee or percentage basis, one-time fee, or continuing benefit based on performance must be disclosed.

Recommended Procedures for Compliance:

• Encourage your employer to develop procedures related to referral fees. The firm may completely restrict such fees.
• Provide clients notification of approved referral fee programs and provide the employer regular (at least quarterly) updates on the amount and nature of compensation received.

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