Standard VI (A) – Disclosure of Conflicts

Members and candidates must avoid or fully disclose 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.

Members and Candidates are required to disclose any potential and actual conflicts of interest to promote and protect the interest of their clients and employers. A frequent source of conflict is compensation structures that incentivize short-term gains for Members and Candidates but limited long-term value for their clients.

Members and Candidates should avoid actual conflicts or the appearance of conflict whenever possible. Whenever a conflict cannot be avoided, transparent and complete disclosure is required. Members and Candidates are responsible for the frequency and manner in which they make their disclosures. Effective disclosure of actual or potential conflicts of interest equips clients with the information required to evaluate the objectivity of investment advice given or investment action taken.

Disclosure of Conflict to Employers

• Members and Candidates should give employers adequate information about any potential or actual conflicts of interest.
• Ownership of stocks that a member analyzes or recommends, external board member participation, and financial or other pressures should be promptly disclosed to assess the scale of the conflict and arrive at solutions.
• Members and Candidates should make reasonable efforts to avoid any potential conflicts. Any inadvertent conflicts of interest should be reported promptly to ensure that the member and employer can conflicts are addressed quickly and effectively.

 Disclosure to Clients

•  Relationships between an issuer and the Member or Candidate, or the firm should always be disclosed. Examples of such relationships include but are not limited to:
  1. Directorship or consultancy involvement by Members or Candidates.
  2. Investment banking activity, broker/dealer market-making activities.
  3. Direct or indirect pecuniary ownership of stock that a Member or Candidate analyzes. 
• Members and Candidates must make reasonable efforts to identify and disclose any conflicts of interest.
• Additional disclosures include fee arrangements, non-standard fee-structures, and sub-advisory relationships within the firm.

 Conflicts with Stock Ownership

This is the most prominent conflict that requires disclosure by a Member or Candidate under Standard VI(A) – Conflicts of Interest. Sell-side analysts must disclose any material beneficial ownership that they recommend, while buy-side analysts must disclose the reporting procedures for their personal trades and holdings.

Conflicts as a Board Member or Director

Actual conflicts and the appearance of conflicts arise due to:

• The duty owed to clients and duties owed to the shareholders of the company that the Member or Candidate serves.
• External board service by a Member or Candidate. The Member or Candidate may be in a position to receive material nonpublic information. This may lead to a perception that the Member or Candidate may be sharing this confidential information with their employer.
• Directors are often compensated in the form of stock options or securities. This may bring questions about trading activity that may potentially increase the value of stock price or stock options.

Recommended Compliance Procedures

Members and Candidates should disclose special compensation arrangements that may conflict with client interests. If such disclosures are not permitted, the Member or Candidate should dissociate from this activity.

Also, Members and Candidates’ employers are encouraged to share information on compensation structures in the firm’s promotional material. Finally, Members and Candidates should avoid any potential and actual conflicts or disclose the conflict in a complete and transparent manner if the conflict cannot be avoided.

Application 1: Personal Stock Ownership

Ryan Hernandez frequently speculates on penny stocks. His most recent purchase is 50,000 shares at 10 cents per share of Horizon Media Group (HPG). He intends to sell these stocks if the price of HPG stock reaches his target price estimate of $1 per share.

Two weeks after his purchase, his employer asks him to write a report on Horizon Media Group. Hernandez’s research and analysis points toward HPG being significantly undervalued and he issues a “Strong Buy” recommendation of the stock.

Hernandez disseminates his research report. The price of Horizon Media Group stock stays neutral at 10 cents after the dissemination of his report. Hernandez does not disclose his ownership in Horizon Media to his employers because he does not consider his ownership to be material.

Has Hernandez violated Standard VI(A) – Conflict of Interest?

     A. No, because his ownership – worth $5,000 – would not be considered material.

     B. Yes, because his gain would be substantial if there was an upward movement in the price.

     C. No, because the stock price was unchanged following the dissemination of his report on Horizon Media.

Solution

The correct answer is B.

Although Hernandez’s holdings would not be considered material, Hernandez must disclose his ownership in Horizon Media to his employers. This is because Hernandez stands to benefit substantially from an upward movement in price. The recent purchase of the stock may bring into question Hernandez’s objectivity and independence.

Application 2: Conflict of Interest and Compensation Agreements

Jeffrey Clark, CFA is the CFO of Alliance Premium Brokers. Clark has been approached by Axion Corporation to promote its publicly traded stock. Axion offers to pay Clark a higher-than-average commission for each stock sold to Alliance Premium Brokers clients. Clark has previously been approached by stock promoters and listed companies to recommend their stocks. Clark ensures that all his clients and the firm’s compliance department are aware of the additional compensation offered by Axion Corporation.

Is Clark compliant with Standard VI(A) – Conflict of Interest?

      A. Yes, because he disclosed the nature of his compensation to his employer and clients.

      B. No, because recommending stocks and receiving additional compensation creates a conflict of interest.

      C. No, because Clark’s promotion of Axion stock compromises his independence and objectivity.

Solution

The correct answer is A.

Clark is compliant with Standard VI(A) – Conflicts of Interest because he fully disclosed his additional compensation arrangements to his clients and compliance department. His clients have the necessary information to evaluate his recommendation of Axion Corporation stock. Clark’s employers have the necessary information to evaluate his objectivity with regard to his additional compensation arrangement with Axion.

Application 3: Conflict of Interest and Compensation Agreements

Fay Gordon is a senior portfolio manager at Lakeshore Investments. Gordon manages the Brion University’s endowment fund. The fund has a long-term investment horizon with the primary objective of capital preservation. Lakeshore has recently implemented a bonus compensation structure that rewards its portfolio managers for outperforming certain broad market indexes on a quarterly basis.

In an attempt to outperform the S&P 500, Gordon makes adjustments to Brion’s portfolio allocation. The fund originally had a 60%-40% split between bonds and stocks. Gordon makes adjustments to the portfolio, such that the new allocation is a 50%-50% split between bonds and stocks. Within the fund’s equity holdings, she includes several high beta stocks. Brion’s portfolio outperforms both the S&P and her peers. No change or update of the IPS was approved by Brion’s board of directors.

What is the most likely reason Gordon violated Standard VI(A) – Conflicts of Interest?

      A. Gordon failed to inform her clients about the change in her compensation agreement with her employer.

      B. Gordon made significant changes to the investment style outlined in the IPS without informing her client.

      C. Gordon refused to decline a compensation agreement with Lakeshore that prioritized short-term performance goals.

Solution

The correct answer is A.

By failing to inform her clients of the change in her compensation agreement with her employer Gordon has violated Standard VI(A) – Conflicts of Interest. Her lack of disclosure creates a conflict of interest between her compensation and Brion’s investment objectives. Additionally, the change in the fund’s allocation may not be suitable for Brion University. Before recommending or changing the investment strategy of a portfolio, Gordon must make sure that the investment style or allocation is suitable for her client.

Refer to Standard III(C) – Suitability.

Reading 46: Guidance for The Standards of Professional Conduct (I-VII)

LOS 46 (a) Demonstrate a thorough knowledge of the CFA Institute Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations.