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.