More On Legal & Compliancefrom The Advisor's Professional Library
- Risk-Based Oversight of Investment Advisors Even if the SEC had a larger budget and more resources, it is doubtful that the Commission would have the resources to regularly examine all RIAs. Therefore, the SEC is likely to continue relying on risk-based oversight to fulfill its mission of protecting investors.
- Code of Ethics Rule The Code of Ethics Rule, found in Rule 204A-1, uses severe consequences for violation to help ensure investment advisors will do the right thing.
Conflicts of interest are inherent and at times inescapable in the financial services industry. The entire brokerage and commission-based industry was arguably built on one: a broker getting paid per transaction to sell certain products to clients (i.e., the broker is arguably incentivized to trade an account and recommend securities that generate a higher-commission payout). On the flip side, fee-based advisors may be incentivized to recommend a fee-based account even though the account trades very infrequently and/or invests in cash equivalents (i.e., “reverse churning,” as SEC OCIE Director Andrew Bowden noted recently here). The point is that conflicts of interest are hiding everywhere, and it is an advisor’s fiduciary responsibility to identify such conflicts for clients and mitigate them to the extent possible.
My trusty Black’s Law Dictionary defines a conflict of interest as “A real or seeming incompatibility between one’s private interests and one’s public or fiduciary duties.” Said another way, a conflict of interest exists if an advisor directly or indirectly benefits from a client’s particular course of action. A “seeming” conflict of interest may exist even if a client’s particular course of action is in fact in the client’s best interests. This is why conflicts needn’t always be avoided outright, but simply need to be disclosed to clients (typically in Form ADV Parts 1 and 2, ERISA’s 408(b)(2) disclosure document and/or advisory contracts). Perhaps the best way to illustrate potential conflicts of interest is by way of example:
It is not uncommon for larger advisors to control, be controlled by, or be under common control with another financial institution such as a broker-dealer, custodian, bank or insurance company. If an advisor recommends that a client’s securities transactions clear through an affiliated broker-dealer or be held by an affiliated custodian, e.g., the advisor will likely receive some sort of indirect compensation by virtue of the affiliation. The same can be said if an advisor recommends that clients purchase the products of an affiliated bank or insurance company.
Revenue sharing within the financial services industry goes by many different names: administration, marketing, shareholder servicing, conference support, shelf-space… the list goes on. The bottom line is that clients should know what types of vendors or investment providers an advisor is either paying or receiving payments from to understand where an advisor’s interests lie. An argument can be made that an advisor that receives payments from a fund company, for example, may be more likely to recommend that fund company’s products to the advisor’s clients. (I’m purposely avoiding the entire 12b-1 or “distribution in guise” discussion, as that is an entirely different can of worms.)
If advisors are compensated in such a way that incentivizes them to recommend certain products or services to clients instead of other similar products or services, a seeming conflict of interest exists. Such conflicts are more overt in the commission space, but fee-based advisors may also be compensated by their employers in such a manner that encourages the use of proprietary products, which is discussed below. Compensation that also encourages unnecessary risk-taking to chase performance, e.g., may also not be in the client’s best interests.
Perhaps the most common—or at least the simplest—example of a proprietary product conflict exists in the mutual fund space. Advisors to mutual funds face particular conflicts if the advisor (or an affiliate) recommends that mutual fund to clients. Because the advisor receives investment advisory and other fees from the mutual fund itself, the advisor receives more revenue as the assets of the mutual fund grow. The more clients invest in the mutual fund, the more revenue the advisor receives from the mutual fund. The same conflict exists in any scenario where an advisor earns fees from a product separate and apart from the investment advisory fee or commission charged to a client.
What Advisors Can and Should Do
Advisors should consider a review of their policies and procedures related to gifts and entertainment, allocation of investment opportunities, outside business activities, political contributions, soft dollars and personal trading, as such areas are often ripe with seeming conflicts of interest as well. The examples above are far from exhaustive, and each conflict of interest assessment should be tailored specifically to each advisory practice. Certain conflicts (especially those involving personal trading and advisor conduct) are also appropriate to address in the advisor’s code of ethics.
The SEC takes conflicts of interest very seriously… so much so that it mentions conflicts of interest no less than twenty-one times in its ADV Part 2A Instructions (here). These same instructions highlight an advisor’s fiduciary responsibility with respect to disclosure of conflicts to clients:
“As a fiduciary, you also must seek to avoid conflicts of interest with your clients, and, at a minimum, make full disclosure of all material conflicts of interest between you and your clients that could affect the advisory relationship. This obligation requires that you provide the client with sufficiently specific facts so that the client is able to understand the conflicts of interest you have and the business practices in which you engage, and can give informed consent to such conflicts or practices or reject them.”
Keep it simple when it comes to conflicts: assess no less frequently than annually, avoid or mitigate to the extent possible, and disclose thoroughly to clients.