Ethics and Standards - Standard VI-A: Disclosure Of Conflicts
Standard VI contains three subsections:
- Standard VI-A: Disclosure of Conflicts
- Standard VI-B: Priority of Transactions
- Standard VI-C: Referral Fees
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 and employer. Members and Candidates must ensure that such disclosures are prominent, are delivered in plain language, and communicate the relevant information effectively.
Reasoning behind Standard VI-A
As with the other Standards under Category IV, the primary intent of this Standard is to protect the employer. Full disclosure is a standard that is met with some resistance by those who wish to protect their privacy, but the principle recognizes the greater good that results from required disclosures.
By extension, disclosing conflicts of interest protects clients and the public - indeed in Standard IV-B this same principle is revisited as it relates to relationships with clients and prospects. Devoting two separate Standards to the guideline shows that conflicts of interest are of vital concern to the investment industry, as they potentially impact the final three words of the Code of Ethics: "independent professional judgment". In the view of the CFA Institute, a beneficial ownership in stock of a company could potentially lead to bias in favor of that security, especially in larger firms where an influential portfolio manager can often move the market in favor of his or her personal holdings simply by recommending their purchase for client accounts or for a mutual fund he or she is managing.
Conflict of interest guidelines crafted by compliance departments often seem excessive from the outside looking in, but these rule are more important than ever in today's environment, where the mere appearance of a conflict can be the basis for a lawsuit. Legal guidance tends to be risk averse and works toward rules and regulations that aren't likely to be challenged by a court of law. There's little to be gained by arguing that "you are ethical and won't be unbiased" - these rules are crafted to provide a legal foundation so that everyone is subject to the same guidelines, and thus, faithful adherence to these rules must be followed.
With regard to personal ownership of securities, note that the first part of this Standard simply requires disclosure to the employer of all securities owned. Based on this disclosure, and based on the activities of the firm, the company may issue additional restrictions that may limit personal trading in certain securities. The second part of the Standard states that for any internal directive that is imposed, the employee is fully obligated to honor what the employer is requiring. In other words, it is not simply breaking a company rule; it is also violating the Code and Standards and an individual would be liable to sanctions from both his or her firm's compliance department and the CFA Institute's Professional Standards and Policy Committee.
If the CFA Level 1 Exam presents a conflict of interest situation, it's usually worthwhile to pick out the choice that seems the most excessive in terms of disclosure and communication. Ignoring or failing to report something is almost certainly the wrong way to go!
Current versus Revised: Standards relating to Conflicts of Interest have been grouped together under their own Roman numeral (VI, Conflicts of Interest) for the first time - an indication of their importance to the profession. Traditionally, Standards have been organized in relation to the affected entity (Employer, Customer, Investing Public), but conflict of interest issues tend to affect all of these relationships.
Applying Standard VI-A
Here are some problematic situations to be aware of when you are tested on this Standard on the exam:
- The fact that a transaction is small and insignificant isn't a valid excuse for violating this Standard. An exam question might describe a situation in which an analyst bought only 10 shares of a stock that was on a company's restricted list, and tell you that he bought it for his 10-year-old daughter's college fund (exam situations often try to mask violations by making them seem innocent), but these details do not matter. Yes, buying 10 shares of a stock for a child's account has no material effect on one's ability to be unbiased. However, one must strictly adhere to the conflict of interest rules as they are established not only to prevent material conflicts, but also to avoid the appearance of a conflict, and to establish the legal foundation that these rules are universally enforced.
- Don't leave a decision on whether to report something to the discretion of the individual. When in doubt, report the relationships or the purchased securities to the compliance officer or other appropriate person, and allow the employer the chance to determine whether a conflict of interest exists in a particular situation.
- Immediate family members are generally subject to the same disclosure rules. If you come across a question dealing with this subject on the exam, don't answer that a person was not required to report a material position in a company simply because the stock was registered in his wife's name. That would be wrong.
- Disclose "quid pro quo" business relationships. For example, the Standards of Practice Handbook (pg. 54) gives the example of an advisor who was using a small broker/dealer for trades, even though that broker/dealer wasn't giving competitive prices - the relationship existed because the advisor was receiving referrals in return (a quid pro quo) and the broker/dealer was an old college friend. This scenario shows a failure to act in the client's best interests and is a violation of the Standard governing conflict of interest.
- An analyst is also a board director. Here's a summary of possible conflicts:
|Duty owed to shareholders||Fiduciary duty to clients|
|Securities or options received as compensation||Recommendation will bid share price higher|
|Privy to material nonpublic information||Using material nonpublic information?|
- A small investment advisory firm is bought by a larger firm. The new relationship must be disclosed on any recommendations of the larger firm's securities.
- There's a change in the bonus incentive. A firm changes the way it compensates its portfolio managers, switching to an incentive plan where more of the emphasis is on short-term (one-year) performance numbers (relative outperformance). Earlier, the primary incentive was trailing five-year numbers. The new incentive represents a material change in how accounts are handled and must be disclosed to clients.
- An analyst puts out some favorable research. An analyst has options that will expire worthless unless the underlying stock price can rally in the next couple of months. The analyst writes up a buy recommendation on the stock to help ignite a rally. Is this action a violation? While the situation presents an obvious conflict of interest, the analyst is free to make such a recommendation, provided that (a) there is a reasonable and adequate basis and (b) there is disclosure of the ownership in the options and the fact that they are expiring.
On exam day, when you're presented with a situation and asked to evaluate whether it is truly a conflict of interest, ask whether that information seems material. Would a reasonable person view it as creating a potential bias? The Standard requires that you err on the side of caution - what seems trivial to one person (e.g. "I once worked at a broker/dealer, and 10 years ago we participated in an underwriting for preferred shares in this firm.") might mean quite a bit to another.
How to Comply
- Report beneficial interest in any security that could reasonably be considered to interfere with the individual responsibility to render unbiased opinions in one's day-to-day work.
- Report all such securities owned by one's immediate family, and any accounts (e.g. family trusts) over which one has investment discretion.
- Report all transactions for self and families.
- Report all outside relationships that might give the appearance of a conflict (e.g. board memberships, trustee positions).
- Obey all internal directives of a firm.
- Discuss conflict of interest questions with the compliance officer and the immediate supervisor (or legal counsel, if appropriate) prior to taking any action.
If a research analyst's wife serves on the board of directors of a company and the analyst writes a research report recommending purchase in those shares, such a relationship might create a particular bias in favor of that company and those shares. A client might read the research report and say, "Well, of course this guy likes the stock - his wife serves on the board of directors. He's probably just recommending it to support her." The client might view the wife's seat on the board as a factor that makes unbiased and objective reporting impossible. Even if the research is thorough, complete and fully supported, it's those material relationships - which create a conflict of interest in the eyes of some - that must be fully represented and fairly disclosed to the client pondering whether to act on the recommendation. To not disclose such information is regarded as unfair to the client and an ethical violation.
Standard VI-A was created to address situations where there are material relationships associated with companies that are also the subject of research reports and investment recommendations. The sole requirement associated with this Standard is disclosure of the relationship - what sort of potential conflict does this person have? The disclosure should be made in plain language, in such a way that the essential information is conveyed to the client, who needs to know.
For the case study above, placing the disclosure "An immediate family member sits on the board of directors" on the first page of the report would put the analyst in compliance with the Standard. Disclosing that it's the analyst's wife might carry even more meaning, but the analyst also has a right to privacy and "immediate family member" is all that is required by the Standard.
The Standard applies most particularly to situations where an analyst recommends the stock and also retains a personal investment position in the shares. Some people might view this type of conflict in a positive light - as "the analyst likes it enough to own it". Important relationships that require disclosure include, but are not limited to, the following:
- Material beneficial ownership of securities (self or immediate family)
- Underwriting relationships between the company and the analyst's firm
- Broker/dealer relationships (e.g. whether this broker makes a market in the stock)
- Board of directors, retained as a consultant, etc.
- Immediate family circumstances (e.g. spouse employed there)