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.
Reasoning behind Standard VI-C
The business world is built on relationships. While many of the CFA Institute's Standards address relationships between firms and clients, important business relationships can also sprout up between two or more professional firms that can deliver complementary products and services to the client. In building a client base, many practitioners have found that it is often most worthwhile to specialize in one particular discipline and gain extensive knowledge of that practice, hopefully in an effort to gain a favorable reputation and add new customers based on positive feedback from existing satisfied clients.
For example, an insurance broker is likely to spend a majority of her business day marketing a brand new array of insurance products and services to potential clients, educating herself on industry trends and new methods of developing business, and providing services and answering the ongoing inquiries of clients. Next door, a CPA partnership prepares tax returns and audits financial records for small businesses. Across the street is a small broker/dealer equipped to open accounts and trade an array of securities, including stocks, bonds and mutual fund securities. However, this practitioner is largely sales oriented and enjoys spending afternoons at the golf course with heavy-hitter clients; he acknowledges that he may not have the time or inclination to perform stock market research, make investment recommendations to clients and use economic forecasting to allocate between asset classes in a manner that minimizes risk. But this broker went to college with a more studious classmate, a CFA charterholder who obtained these credentials while still in graduate school. She is a leading portfolio manager at a small community bank about a mile away from the office of the broker. The broker wants to help her get better established and also broaden what he can do for his own clients. Thus, he enters into an agreement with the bank, where he agrees to refer clients requiring portfolio management services to his old college friend, in exchange for a modest fee computed by a percentage of the account at the time it opens. The portfolio manager at the bank, grateful for the inflow of business, enters a similar agreement to refer day traders to her friend at the brokerage, given that his firm offers far lower commissions than the bank. She agrees to accept a modest commission for each client referred in this manner. In time, the neighborhood's CPA firm and the insurance broker gain confidence in the other financial services firms and enter similar mutually beneficial referral arrangements with the bank's portfolio manager and with the broker/dealer. Everyone wins.
The CFA Institute guides its members to state the nature of these types of referral arrangements, given that the practice can make the partners in such arrangements partial to each other for reasons of self-interest. Returning to the case of the bank/broker arrangement, let's suppose a competing full-service broker sets up shop in the same general area. The broker offers a wide array of products and services, with a professional staff available to answer questions between 7am and 7pm every business day. The office has two CFA candidates and three others with industry experience, and the fees to the client are competitive. However, the full-service broker, as a matter of policy, will not engage in a formal referral arrangement with the portfolio manager at the bank, given that the two firms offer some of the same services and are thus competitors. However, the portfolio manager knows that this new broker dealer is a high-quality outfit, particularly when compared to her golfer friend who seems more interested in maintaining his existing client base than in maintaining the level of service the portfolio manager believes clients deserve. At the same time, she does receive that ongoing commission for referrals, which has turned into a nice second income (her bank doesn't pay her what she's worth).
Under Standard VI-C, the portfolio manager, as a CFA member and charterholder, must disclose this referral arrangement, both to the clients she receives from her broker friend and to the clients she is referring to him. If the portfolio manager practices fair representation and full disclosure, the client can make an informed decision as to whether a conflict of interest is present.
Applying Standard VI-C
Here are two other points to keep in mind when applying this Standard:
- Creative Referral Arrangements - The concept of a referral fee extends to any beneficial consideration between two parties, including so-called soft-dollar agreements between broker and advisor, where the advisor receives benefits such as research reports or software and databases that archive financial information in exchange for directing trades to the broker. Such arrangements must be disclosed to clients.
- Oral versus Written - A financial planner informs a prospect, referred to her by a CPA firm, that she pays the CPAs a flat $1,000 (out of her pocket) for the referral. However, she only mentions this information over the phone, preferring not to mention it in the contract. Standard VI-C holds that an ethic of fairness is owed to the clients. Many people don't always recall every detail mentioned to them over the phone. In this case, the planner would be in violation unless written language disclosing the $1,000 was included in the contract.
How to Comply
- Specify All Monetary Consideration, Both Given and Received - This disclosure must be in clear language - for example: "I receive a flat commission equal to 0.75% of your account value." Specify whether fees are deducted from the client's personal account, and explain to the client if a referral fee is included as an additional hidden fee within the trading commissions.
- Provide Written Disclosure - Fee arrangements should be included as a part of the contract that is written and signed by both parties.
- Inform Supervisor and Compliance Officer - Let both parties know about any proposed new referral arrangement, and seek legal counsel if clarification is necessary.
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