Unraveling Conflicts of Interest | CFA Level I Ethics
Hang on tight as we dive into the second last standard, where we explore conflicts of interest in Standard 6. We’ll cover Standard 6A (Disclosure of Conflicts), Standard 6B (Priority of Transactions), and Standard 6C (Referral Fees).
6A. Disclosure of Conflicts
Under Standard 6A, you must make full and fair disclosure of anything that could impair your independence and objectivity or interfere with your duties to clients, prospects, and employers. Conflicts of interest can arise from personal interests, relationships, and compensation structures. To be on the safe side, disclose everything to clients and employers so they can judge your level of independence and objectivity.
Disclosure in Investment Recommendations
Whether you’re an advisor or an analyst, it’s essential to disclose your personal and your firm’s interests in the subject of your investment recommendations. These interests can include:
- Stock ownership
- Personal relationships
- Commissions or benefits
- Directorship in the subject
Always remember to disclose any investment banking relationships your firm has with the subject of recommendation as well.
Conflicts with Your Employer
Disclose any conflicts of interest with your employer, as they need to monitor your activities and act on behalf of clients if necessary. This may include stock ownership, participation in outside boards, and personal financial difficulties.
Directorship in Other Companies
Being a director of another company can lead to conflicts of interest due to:
- Duties owed to clients vs. shareholders
- Receiving stocks or options from the company
- Access to material nonpublic information
To avoid these conflicts, investment firms may isolate employees from making investment decisions or recommendations about the company they’re directors of.
Application (Conflict of Interest and Personal Relationships):
Emily Johnson, an equity analyst at an investment management firm, is in a long-term relationship with the CFO of TechGiant Corporation. Emily’s firm recently decided to invest in technology stocks, and Emily is assigned to analyze TechGiant.
Comment: Emily should disclose her personal relationship with the CFO of TechGiant to her employer. The relationship may create a conflict of interest and potentially affect her objectivity when analyzing the company. The employer may choose to assign another analyst to cover TechGiant or implement measures to ensure unbiased analysis.
Application (Conflict of Interest and Outside Employment):
Michael Brown, a portfolio manager at a small investment firm, starts working part-time as a financial consultant at a startup company. The startup is looking for funding and plans to go public in the near future. Michael believes the startup is a good investment opportunity for his clients at the investment firm.
Comment: Michael should disclose his outside employment and financial consulting relationship with the startup to his employer before recommending the investment to his clients. This disclosure allows the employer to assess any potential conflicts of interest that might arise from Michael’s dual roles and ensure that his recommendations remain objective.
6B. Priority of Transactions
Standard 6B emphasizes that investment transactions for clients and employers must have priority over transactions where you’re the beneficial owner. To avoid potential conflicts:
- Don’t disadvantage clients or employers with your personal trades
- Don’t personally benefit from trades undertaken for clients
- Comply with applicable firm and regulatory requirements
Firm Recommendations
The CFA Institute recommends firms to establish policies and procedures to help employees comply with Standard 6B. These may include restrictions on employee participation in IPOs, private placements, and establishing blackout periods for personal trades.
Beneficial Ownership
Standard 6B applies not only to personal accounts but also accounts where you’re the beneficial owner, including your immediate family members’ accounts. Treat their accounts fairly, just like any other client account.
Application (Front Running Client Orders):
Peter Smith, a trader at a large investment firm, receives a substantial buy order for a stock from one of the firm’s portfolio managers. Before executing the order for the client, Peter purchases shares of the same stock for his personal account, anticipating that the large buy order will drive up the stock price.
Comment: Peter has violated Standard VI(B) by front running the client’s order. By purchasing the shares for his personal account before executing the client’s order, Peter has prioritized his own interests over the client’s and has taken advantage of the potential price movement resulting from the large order.
Application (Delaying Client Orders for Personal Gain):
Jessica Lee, a portfolio manager at a hedge fund, identifies a stock that she believes is undervalued and plans to purchase a large quantity of shares for her clients’ accounts. Before placing the order, she decides to wait until the end of the trading day to buy shares for her personal account, hoping the stock price will drop even further. She then delays placing the client order until the following day.
Comment: Jessica has violated Standard VI(B) by putting her own interests ahead of her clients’. By delaying the client order to potentially benefit from a lower purchase price for her personal account, she has not fulfilled her duty to act in the best interests of her clients and has compromised her professional responsibility.
6C. Referral Fees
Under Standard 6C, disclose any compensation, consideration, or benefit received from or paid to others for the recommendation of products or services. This allows clients to evaluate the full cost of the service and potential conflicts of interest.
Remember to disclose the nature of the benefit and make sure to do so before the client enters into any formal agreement to accept the service. The disclosure should include:
- Whether the fee is on a flat or percentage basis
- Whether it is a one-time or continuing benefit
- Whether it is based on performance
- Whether it is cash or non-cash (such as research)
- Estimated dollar value of non-cash benefits
The CFA Institute recommends that firms develop procedures related to referral fees. If the firm allows referral fees, the procedures should indicate the appropriate steps for requesting approval.
Application (Disclosure of Influential Gifts):
Samantha Green, a portfolio manager at Bright Investments, receives an expensive luxury watch as a gift from a representative of a startup company seeking investment from her clients’ portfolios. She decides to invest in the startup but does not disclose the gift to her employer or clients.
Comment: Green has violated Standard VI(C) by not disclosing the gift she received from the startup company. The gift could potentially influence her investment decisions and create a conflict of interest. To maintain objectivity and transparency, she should disclose the gift to her employer and clients, allowing them to evaluate the potential impact on her investment decisions.
Example 7 (Disclosure of Outside Business Activities):
David Johnson, a financial analyst at Secure Wealth Management, starts a side business offering financial planning services to individuals. He does not disclose his outside business to his employer, and he starts offering his services to some of Secure Wealth Management’s clients.
Comment: Johnson has violated Standard VI(C) by not disclosing his outside business activity to his employer. This side business creates a potential conflict of interest, as he may prioritize his personal interests over those of his employer and clients. He should disclose his outside business to his employer to ensure transparency and proper management of potential conflicts of interest.
Conclusion
In summary, Standard 6 of the CFA Level I Ethics focuses on managing conflicts of interest. To comply with these standards:
- Disclose any potential conflicts of interest to clients and employers
- Give priority to client and employer transactions over personal transactions
- Disclose referral fees and arrangements to clients, prospects, and employers
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