VI.A: CONFLICT OF INTEREST - Disclosure of Conflict
Example 4 (Conflict of Interest and Personal Stock Ownership): Betty Roberts is speculating in penny stocks for her own account and purchases 100,000 shares of Drew Mining, Inc., for US$0.30 a share. She intends to sell these shares at the sign of any substantial upward price movement of the stock. A week later, her employer asks her to write a report on penny stocks in the mining industry to be published in two weeks. Even without owning the Drew stock, Roberts would recommend it in her report as a "buy." A surge in the price of the stock to the US$2 range is likely to result once the report is issued.
Comment: Although this holding may not be material, Roberts must disclose it in the report and to her employer before writing the report because the gain for her will be substantial if the market responds strongly to her recommendation. The fact that she has only recently purchased the stock adds to the appearance that she is not entirely objective.
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.
Disclosure to Clients:
1. MUST maintain their objectivity when rendering investment advice or taking investment action. 2. The most obvious conflicts of interest, which should always be disclosed, are relationships between: a. An issuer & the member or their firm such as a directorship or consultancy by a member; b. IB, underwriting, and financial relationships; c. Broker/dealer market-making activities; d. Material beneficial ownership of stock 3. Members beneficially own securities or other investments if they have a DIRECT OR INDIRECT interest in the securities; have the POWER TO VOTE OR DIRECT THE VOTING of the shares of the securities or inv.; or have the POWER TO DISPOSE or direct the disposition of the security or inv. 4. MUST take reasonable steps to determine IF a conflict of interest exists & disclose to clients any known conflicts of the member's firm. 5. Disclosures SHOULD be made to clients of FEE arrangements, SUB-ADVISORY agreements, or other situations involving NONSTANDARD fee structures. 6. DISCLOSER arrangements in which the FIRM BENEFITS directly from investment recommendations. 7. An obvious conflict of interest is the rebate of a portion of the service fee some classes of mutual funds charge to investors. SHOULD ensure that their FIRM DISCLOSE such relationships so clients can fully understand the costs of their investments and the benefits received by their investment manager's employer.
Guidance
1. MUST make FULL & FAIR disclosure of all matters that could reasonably be expected to impair their IND. & OBJ. or interfere w/ respective duties to their CLIENTS, PROSPECTIVE clients, & EMPLOYER. 2. MUST ensure that such disclosures are PROMINENT (QUICK), are DELIVERED IN PLAIN LANGUAGE (SIMPLE), & COMMUNICATE the relevant information effectively. 3. Best practice is to AVOID THE ACTUAL CONFLICT or the APPEARANCE of conflicts of interest when possible.
Cross-Departmental Conflicts
1. SELL SIDE ANALYSTS working for a BROKER/DEALER may be encouraged, not only by MEMBERS OF HIS OWN FIRM but by CORP. ISSUERS themselves, to write research reports about particular companies. 2. BUY SIDE ANALYSTS is likely to be faced with similar conflicts as banks exercise their UNDERWRITING & security-dealing powers. The marketing division may ask an analyst to recommend the stock of a certain company in order to obtain business from that company. 3. The potential for conflicts of interest also exists with broker-sponsored limited partnerships formed to invest VENTURE CAPITAL. o Increasingly, members are expected not only to follow issues from these partnerships once they are offered to the public but also to promote the issues in the SECONDARY MARKET after public offerings.
Conflicts with Stock Ownership
1. The most prevalent conflict requiring disclosure under Standard VI(A) is a member's ownership of stock in companies that he or she recommends to clients and/or that clients hold. 2. SELL-SIDE MEMBERS SHOULD disclose any materially beneficial ownership interest in a security or other investment that the member is recommending. 3. BUY-SIDE members SHOULD disclose their procedures for reporting requirements for personal transactions
Disclosure of Conflicts to Employers
1. When reporting conflicts of interest to EMPLOYERS, SHOULD give their employers enough info to assess the impact of the conflict. 2. Reportable situations include conflicts that would interfere w/ RENDERING UNBIASED INV. ADVICE. & conflicts that would cause to act NOT IN THE EMPLOYER BEST INTEREST. 3. ARE TO BE PROMPTLY REPORTED TO THE EMPLOYER: - Ownership of stocks analyzed or recommended - Participation on outside boards - Financial or other pressures that could influence a decision 4. The mere appearance of a conflict of interest may create problems for members & their employers. 5. MUST take reasonable steps to avoid conflicts and, if they occur inadvertently, MUST report them PROMPTLY so that the employer & the member can resolve them as quickly & effectively as possible.
QUESTION 21 Smith is a financial analyst with XYZ Brokerage Firm. She is preparing a purchase recommendation on JNI Corporation. Which of the following situations is most likely to represent a conflict of interest for Smith that would have to be disclosed? A. Smith frequently purchases items produced by JNI. B. XYZ holds for its own account a substantial common stock position in JNI. C. Smith's brother-in-law is a supplier to JNI.
21. The correct answer is B. This question involves Standard VI(A)-Disclosure of Conflicts—specifically, the holdings of an analyst's employer in company stock. Answers A and C do not describe conflicts of interest that Smith would have to disclose. Answer A describes the use of a firm's products, which would not be a required disclosure. In answer C, the relationship between the analyst and the company through a relative is so tangential that it does not create a conflict of interest necessitating disclosure.
QUESTION 3. Jamison is a junior research analyst with Howard & Howard, a brokerage and investment banking firm. Howard & Howard's mergers and acquisitions department has represented the Britland Company in all of its acquisitions for the past 20 years. Two of Howard & Howard's senior officers are directors of various Britland subsidiaries. Jamison has been asked to write a research report on Britland. What is the best course of action for her to follow? A. Jamison may write the report but must refrain from expressing any opinions because of the special relationships between the two companies. B. Jamison should not write the report because the two Howard & Howard officers serve as directors for subsidiaries of Britland. C. Jamison may write the report if she discloses the special relationships with the company in the report.
3. The correct answer is C. This question involves Standard VI(A)-Disclosure of Conflicts. The question establishes a conflict of interest in which an analyst, Jamison, is asked to write a research report on a company that is a client of the analyst's employer. In addition, two directors of the company are senior officers of Jamison's employer. Both facts establish that there are conflicts of interest that must be disclosed by Jamison in her research report. Answer B is incorrect because an analyst is not prevented from writing a report simply because of the special relationship the analyst's employer has with the company as long as that relationship is disclosed. Answer A is incorrect because whether or not Jamison expresses any opinions in the report is irrelevant to her duty to disclose a conflict of interest. Not expressing opinions does not relieve the analyst of the responsibility to disclose the special relationships between the two companies.
4. Which of the following statements clearly conflicts with the recommended procedures for compliance presented in the CFA Institute Standards of Practice Handbook? A. Firms should disclose to clients the personal investing policies and procedures established for their employees. B. Prior approval must be obtained for the personal investment transactions of all employees. C. For confidentiality reasons, personal transactions and holdings should not be reported to employers unless mandated by regulatory organizations.
4. The correct answer is C. This question asks about compliance procedures relating to personal investments of members and candidates. The statement in answer C clearly conflicts with the recommended procedures in the Standards of Practice Handbook. Employers should compare personal transactions of employees with those of clients on a regular basis regardless of the existence of a requirement by any regulatory organization. Such comparisons ensure that employees' personal trades do not conflict with their duty to their clients, and the comparisons can be conducted in a confidential manner. The statement in answer A does not conflict with the procedures in the Handbook. Disclosure of such policies will give full information to clients regarding potential conflicts of interest on the part of those entrusted to manage their money. Answer B is incorrect because firms are encouraged to establish policies whereby employees clear their personal holdings and transactions with their employers.
Guidance
4. When conflicts CANNOT BE AVOIDED, clear & COMPLETE disclosure of their existence IS NECESSARY. 5. Best practices dictate UPDATE DISCLOSURE when the nature of a conflict of interest CHANGES MATERIALLY—for example, if the nature of a conflict of interest DEEPENS through the introduction of bonuses based on each QUARTER's profits as opposed to the previous review based on ANNUAL profits. 6. In MAKING and UPDATING disclosures of conflicts of interest, should err on the SIDE OF CAUTION to ensure that conflicts are effectively communicated.
QUESTION 72
72. C is correct. Riser least likely violates Standard IV(B)—Additional Compensation Arrangements when participating in the road shows. The Standard provides guidance regarding the acceptance and disclosure of compensation that might conflict with an employer's interests. Participating in the road shows and receiving compensation from the subsidiary do not appear to conflict with his employer's interests. When participating in the road shows, Riser may violate Standards I(B)—Independence and Objectivity and VI(A)—Disclosure of Conflicts. The Standard relating to Independence and Objectivity requires that members use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Riser's role as board member could jeopardize his objectivity and create a conflict of interest. Standard VI(A)—Disclosure of Conflicts requires that members make full and fair disclosure of all matters that could reasonably be expected to impair the independence and objectivity or interfere with respective duties to the clients, and prospective clients. Full disclosure allows clients to judge motives and possible biases for themselves. Riser does not appear to make adequate disclosure.
QUESTION 76
76. C is correct. Standard VI(A)—Disclosure of Conflicts requires that members and candidates 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 their employer. Riser's holdings of the Japanese equity product and his position on the board of the subsidiary could impair his objectivity and must be disclosed to clients. He need not disclose his compensation from the subsidiary because it is not a referral fee.
Example 8 (Conflict of Interest and Directorship): Carol Corky, a senior portfolio manager for Universal Management, recently became involved as a trustee with the Chelsea Foundation, a large not-for-profit foundation in her hometown. Universal is a small money manager (with assets under management of approximately US$100 million) that caters to individual investors. Chelsea has assets in excess of US$2 billion. Corky does not believe informing Universal of her involvement with Chelsea is necessary.
Comment: By failing to inform Universal of her involvement with Chelsea, Corky violated Standard VI(A). Given the large size of the endowment at Chelsea, Corky's new role as a trustee can reasonably be expected to be time consuming, to the possible detriment of Corky's portfolio responsibilities with Universal. Also, as a trustee, Corky may become involved in the investment decisions at Chelsea. Therefore, Standard VI(A) obligates Corky to discuss becoming a trustee at Chelsea with her compliance officer or supervisor at Universal before accepting the position, and she should have disclosed the degree to which she would be involved in investment decisions at Chelsea.
Example 7 (Conflict of Interest and Compensation Arrangements): Gary Carter is a representative with Bengal International, a registered broker/dealer. Carter is approached by a stock promoter for Badger Company, who offers to pay Carter additional compensation for sales of Badger Company's stock to Carter's clients. Carter accepts the stock promoter's offer but does not disclose the arrangements to his clients or to his employer. Carter sells shares of the stock to his clients.
Comment: Carter has violated Standard VI(A) by failing to disclose to clients that he is receiving additional compensation for recommending and selling Badger stock. Because he did not disclose the arrangement with Badger to his clients, the clients were unable to evaluate whether Carter's recommendations to buy Badger were affected by this arrangement. Carter's conduct also violated Standard VI(A) by failing to disclose to his employer monetary compensation received in addition to the compensation and benefits conferred by his employer. Carter was required by Standard VI(A) to disclose the arrangement with Badger to his employer so that his employer could evaluate whether the arrangement affected Carter's objectivity and loyalty.
Example 3 (Conflict of Interest and Personal Stock Ownership): Carl Fargmon, a research analyst who follows firms producing office equipment, has been recommending purchase of Kincaid Printing because of its innovative new line of copiers. After his initial report on the company, Fargmon's wife inherits from a distant relative US$3 million of Kincaid stock. He has been asked to write a follow-up report on Kincaid. t.
Comment: Fargmon must disclose his wife's ownership of the Kincaid stock to his employer and in his follow-up report. Best practice would be to avoid the conflict by asking his employer to assign another analyst to draft the follow-up repor
Example 6 (Conflict of Interest, Options, and Compensation Arrangements): Wayland Securities works with small companies doing IPOs or secondary offerings. Typically, these deals are in the US$10 million to US$50 million range, and as a result, the corporate finance fees are quite small. To compensate for the small fees, Wayland Securities usually takes "agent options"—that is, rights (exercisable within a two-year time frame) to acquire up to an additional 10% of the current offering. Following an IPO performed by Wayland for Falk Resources, Ltd., Darcy Hunter, the head of corporate finance at Wayland, is concerned about receiving value for her Falk Resources options. The options are due to expire in one month, and the stock is not doing well. She contacts John Fitzpatrick in the research department of Wayland Securities, reminds him that he is eligible for 30% of these options, and indicates that now would be a good time to give some additional coverage to Falk Resources. Fitzpatrick agrees and immediately issues a favorable report.
Comment: For Fitzpatrick to avoid being in violation of Standard VI(A), he must indicate in the report the volume and expiration date of agent options outstanding. Furthermore, because he is personally eligible for some of the options, Fitzpatrick must disclose the extent of this compensation. He also must be careful to not violate his duty of independence and objectivity under Standard I(B).
Example 2 (Conflict of Interest and Business Stock Ownership): The investment management firm of Dover & Roe sells a 25% interest in its partnership to a multinational bank holding company, First of New York. Immediately after the sale, Margaret Hobbs, president of Dover & Roe, changes her recommendation for First of New York's common stock from "sell" to "buy" and adds First of New York's commercial paper to Dover & Roe's approved list for purchase.
Comment: Hobbs must disclose the new relationship with First of New York to all Dover & Roe clients. This relationship must also be disclosed to clients by the firm's portfolio managers when they make specific investment recommendations or take investment actions with respect to First of New York's securities
Example 10 (Conflict of Interest and Requested Favors): Michael Papis is the chief investment officer of his state's retirement fund. The fund has always used outside advisers for the real estate allocation, and this information is clearly presented in all fund communications. Thomas Nagle, a recognized sell-side research analyst and Papis's business school classmate, recently left the investment bank he worked for to start his own asset management firm, Accessible Real Estate. Nagle is trying to build his assets under management and contacts Papis about gaining some of the retirement fund's allocation. In the previous few years, the performance of the retirement fund's real estate investments was in line with the fund's benchmark but was not extraordinary. Papis decides to help out his old friend and also to seek better returns by moving the real estate allocation to Accessible. The only notice of the change in adviser appears in the next annual report in the listing of associated advisers.
Comment: Papis has violated Standard VI(A) by not disclosing to his employer his personal relationship with Nagle. Disclosure of his past history with Nagle would allow his firm to determine whether the conflict may have impaired Papis's independence in deciding to change managers. See also Standard IV(C)-Responsibilities of Supervisors, Standard V(A)-Diligence and Reasonable Basis, and Standard V(B)-Communication with Clients and Prospective Clients.
Example 9 (Conflict of Interest and Personal Trading): Bruce Smith covers eastern European equities for Marlborough Investments, an investment management firm with a strong presence in emerging markets. While on a business trip to Russia, Smith learns that investing in Russian equities directly is difficult but that equity-linked notes that replicate the performance of underlying Russian equities can be purchased from a New York-based investment bank. Believing that his firm would not be interested in such a security, Smith purchases a note linked to a Russian telecommunications company for his own account without informing Marlborough. A month later, Smith decides that the firm should consider investing in Russian equities by way of the equity-linked notes. He prepares a write-up on the market that concludes with a recommendation to purchase several of the notes. One note he recommends is linked to the same Russian telecom company that Smith holds in his personal account.
Comment: Smith has violated Standard VI(A) by failing to disclose his purchase and ownership of the note linked to the Russian telecom company. Smith is required by the standard to disclose the investment opportunity to his employer and look to his company's policies on personal trading to determine whether it was proper for him to purchase the note for his own account. By purchasing the note, Smith may or may not have impaired his ability to make an unbiased and objective assessment of the appropriateness of the derivative instrument for his firm, but Smith's failure to disclose the purchase to his employer impaired his employer's ability to decide whether his ownership of the security is a conflict of interest that might affect Smith's future recommendations. Then, when he recommended the particular telecom notes to his firm, Smith compounded his problems by not disclosing that he owned the notes in his personal account—a clear conflict of interest.
Example 5 (Conflict of Interest and Compensation Arrangements): Samantha Snead, a portfolio manager for Thomas Investment Counsel, Inc., specializes in managing public retirement funds and defined benefit pension plan accounts, all of which have long-term investment objectives. A year ago, Snead's employer, in an attempt to motivate and retain key investment professionals, introduced a bonus compensation system that rewards portfolio managers on the basis of quarterly performance relative to their peers and to certain benchmark indices. In an attempt to improve the short-term performance of her accounts, Snead changes her investment strategy and purchases several high-beta stocks for client portfolios. These purchases are seemingly contrary to the clients' investment policy statements. Following their purchase, an officer of Griffin Corporation, one of Snead's pension fund clients, asks why Griffin Corporation's portfolio seems to be dominated by high-beta stocks of companies that often appear among the most actively traded issues. No change in objective or strategy has been recommended by Snead during the year.
Comment: Snead has violated Standard VI(A) by failing to inform her clients of the changes in her compensation arrangement with her employer, which created a conflict of interest between her compensation and her clients' IPSs. Firms may pay employees on the basis of performance, but pressure by Thomas Investment Counsel to achieve short-term performance goals is in basic conflict with the objectives of Snead's accounts. See also Standard III(C)-Suitability.
Example 12 (Disclosure of Conflicts to Employers): Yehudit Dagan is a portfolio manager for Risk Management Bank (RMB), whose clients include retirement plans and corporations. RMB provides a defined contribution retirement plan for its employees that offers 20 large diversified mutual fund investment options, including a mutual fund managed by Dagan's RMB colleagues. After being employed for six months, Dagan became eligible to participate in the retirement plan, and she intends to allocate her retirement plan assets in six of the investment options, including the fund managed by her RMB colleagues. Dagan is concerned that joining the plan will lead to a potentially significant amount of paperwork for her (e.g., disclosure of her retirement account holdings and needing preclearance for her transactions), especially with her investing in the in-house fund.
Comment: Standard VI(A) would not require Dagan to disclosure her personal or retirement investments in large diversified mutual funds, unless specifically required by her employer. For practical reasons, the standard does not require Dagan to gain preclearance for ongoing payroll deduction contributions to retirement plan account investment options. Dagan should ensure that her firm does not have a specific policy regarding investment—whether personal or in the retirement account—for funds managed by the company's employees. These mutual funds may be subject to the company's disclosure, preclearance, and trading restriction procedures to identify possible conflicts prior to the execution of trades.
Example 11 (Conflict of Interest and Business Relationships): Bob Wade, trust manager for Central Midas Bank, was approached by Western Funds about promoting its family of funds, with special interest in the service-fee class. To entice Central to promote this class, Western Funds offered to pay the bank a service fee of 0.25%. Without disclosing the fee being offered to the bank, Wade asked one of the investment managers to review the Western Funds family of funds to determine whether they were suitable for clients of Central. The manager completed the normal due diligence review and determined that the funds were fairly valued in the market with fee structures on a par with their competitors. Wade decided to accept Western's offer and instructed the team of portfolio managers to exclusively promote these funds and the service-fee class to clients seeking to invest new funds or transfer from their current investments. So as to not influence the investment managers, Wade did not disclose the fee offer and allowed that income to flow directly to the bank.
Comment: Wade is violating Standard VI(A) by not disclosing the portion of the service fee being paid to Central. Although the investment managers may not be influenced by the fee, neither they nor the client have the proper information about Wade's decision to exclusively market this fund family and class of investments. Central may come to rely on the new fee as a component of the firm's profitability and may be unwilling to offer other products in the future that could affect the fees received. See also Standard I(B)-Independence and Objectivity.
Example 1 (Conflict of Interest and Business Relationships): Hunter Weiss is a research analyst with Farmington Company, a broker and investment banking firm. Farmington's merger and acquisition department has represented Vimco, a conglomerate, in all of Vimco's acquisitions for 20 years. From time to time, Farmington officers sit on the boards of directors of various Vimco subsidiaries. Weiss is writing a research report on Vimco.
Comment: Weiss must disclose in his research report Farmington's special relationship with Vimco. Broker/dealer management of and participation in public offerings must be disclosed in research reports. Because the position of underwriter to a company entails a special past and potential future relationship with a company that is the subject of investment advice, it threatens the independence and objectivity of the report writer and must be disclosed.
Conflicts as a Director
Service as a director poses three basic conflicts of interest: 1. Conflict may exist between the DUTIES OWED TO CLIENTS & the DUTIES OWED TO SHAREHOLDERS of the company. 2. Investment personnel who serve as directors may receive the securities or options to purchase securities of the company as compensation for serving on the board, which could raise questions about trading actions that might increase the value of those securities. 3. Board service creates the opportunity to receive MATERIAL NON PUBLIC involving the company. When members providing investment services also serve as directors, they SHOULD BE ISOLATED from those making inv. decisions by the USE OF FIREWALLS or similar restrictions.
