Ethical and Professional Standards · Reading 100
Conflicts of Interest
CFA Level I · Ethical and Professional Standards · Reading 100: Guidance for Standard VI: Conflicts of Interest · about 33 min
What you'll learn
- LOS 100.a Apply Standard VI (Avoid or Disclose Conflicts, Priority of Transactions, Referral Fees) to situations involving professional integrity.
- LOS 100.b Recommend practices and procedures that prevent violations of Standard VI, such as disclosure policies, blackout periods and pre-clearance.
- LOS 100.c Identify conduct that conforms to Standard VI and conduct that violates it.
Module 100.1
Guidance for Standards VI(A), VI(B), and VI(C)
This reading covers Standard VI, Conflicts of Interest: Avoid or Disclose Conflicts, Priority of Transactions, and Referral Fees. A candidate must be able to apply each part to a fact pattern, recommend procedures that prevent violations, and tell conduct that conforms from conduct that violates.
LOS 100.a — Applying Standard VI to real situations
Standard VI groups three rules about conflicts of interest: situations in which a member's own interests, or the interests of the member's firm, could pull against the duty owed to clients, prospective clients or the employer.
Standard VI(A) Avoid or Disclose Conflicts
Members and candidates must avoid or 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.
Actual and potential conflicts should be avoided where that is reasonably possible; a conflict that cannot reasonably be avoided must be disclosed in full. A single line in fine print buried in a long legal appendix does not meet the Standard.
Disclosure lets clients and prospects judge motives and potential biases for themselves. The most common conflict requiring disclosure is actual ownership of stock in companies the member recommends or that clients hold. Toward the employer, members must give the employer enough information to assess how a conflict affects it, must take reasonable steps to avoid conflicts, and must report any conflict promptly once it arises.
The test is reasonableness: would a client or employer reasonably want to know this fact to judge whether the member's advice might be biased? Typical matters that must be disclosed:
Key concept
| Matter | Why it must be disclosed |
|---|---|
| Ownership of stock in a company the member recommends or that clients hold, including shares held in a trust in which the member has a financial interest and the power to vote (beneficial ownership) | The most common conflict: gains or losses on the position could bias the recommendation |
| Firm's material ownership of the covered issuer's securities | The firm benefits if the price rises |
| Market maker role, investment banking / corporate finance relationship, underwriting, M&A advisory work | The firm has a business interest in the issuer |
| Serving on the issuer's board of directors (member or senior firm officers) | Board members owe duties to the company and its shareholders |
| Paid consulting work for the covered company | Direct financial link to the issuer |
| Compensation arrangements that could create incentives at odds with clients' objectives: special compensation arrangements, bonus programs, commissions and incentives (e.g., a bonus tied to short-term trading profits in a long-term fund) | Clients should know how the professional is paid. Disclose when acting in an advisory capacity, and update the disclosure after a significant change in compensation structure |
The Standard reaches only matters that could reasonably be expected to impair independence and objectivity or interfere with duties. A fact that gives neither the member nor the firm any financial interest in the issuer or any duty to it does not meet that test. Examples are a neighbor's holding in which the member has no interest, a relative's past job unrelated to the analysis, and firm property unrelated to the issuer.
Disclosure rather than refusal. VI(A) does not require an analyst to decline an assignment or to sell a position in the covered stock; full and fair disclosure of the holding meets the Standard. Inherited shares are treated like purchased shares: the analyst must tell the employer and disclose the holding in subsequent research.
Who needs to hear it. Conflicts that affect duties to the employer (e.g., a board seat or an unpaid committee role at an institution whose assets the firm manages) must be disclosed to the employer; conflicts that could bias advice go to clients and prospects as well. The disclosure goes in every communication the conflict could color: a member paid in a company's shares for promotional work discloses the holding in the promotional material as well as in any research report.
Standard VI(B) Priority of Transactions
Investment transactions for clients and employers must have priority over investment transactions in which a Member or Candidate is the beneficial owner.
Client transactions also take priority over transactions made on behalf of the member's firm (e.g., proprietary trading). Personal transactions include any transaction in which the member is a beneficial owner: the member's own account and any account in which he or she has a financial interest, such as shares held in a trust for the member.
- A member may trade for his or her own account only once clients and the employer have been given adequate opportunity to act on a recommendation (e.g., after client orders have been executed).
- Front-running is trading ahead of client orders, or ahead of a recommendation's release, to profit from them. It violates VI(B).
- Family accounts that are client accounts (family members who are fee-paying clients of the firm) are treated exactly like other client accounts: they are neither favored nor disadvantaged, and they may trade as soon as the recommendation has been disseminated to clients. If the member also has a beneficial interest in such an account, the firm's pre-clearance and reporting requirements for personal holdings apply to it as well, and the account still may not be favored over other clients.
- If a security is not suitable for any client (e.g., a speculative stock for a manager whose only responsibility is a high-grade bond fund, or futures that none of the clients may hold), the member may trade it personally without first offering it to clients.
- Members must not act on information about pending trades for personal gain; the overriding test is that personal trades do not disadvantage any client. By that test, a personal trade is not prohibited merely because it runs against the firm's recommendation, such as selling shares the firm rates "buy".
- If investors ask, members must give them full disclosure of the firm's personal trading policies.
- IPO / hot issues: members can avoid IPO conflicts by not participating. Members should not take shares of an oversubscribed new issue for their own accounts when that could reduce client allocations, even if clients are told and do not object.
Standard VI(C) Referral Fees
Members and candidates must disclose to their employer, clients, and prospective clients, as appropriate, any compensation, consideration, or benefit received from or paid to others for the recommendation of products or services.
- Both directions count: fees the member receives for referring clients out and fees the member pays to others who refer clients in. The payer can be the member's own employer: a bonus for sending clients to another unit of the same firm must still be disclosed to those clients.
- All types of consideration must be disclosed; non-cash benefits count (free services, gifts, fee discounts); disclose their nature and estimated value.
- Timing: disclosure must be made before the client or prospect enters into an agreement for services, so the client can judge the full cost of the service and any partiality in the recommendation. A packet delivered only after someone has become a client comes too late.
- The Standard does not require disclosing what share of the member's business comes from referrals.
LOS 100.b — Procedures that prevent Standard VI violations
Firms and members should build controls so that conflicts are identified, avoided where possible, and disclosed when not.
Recommended procedures for VI(B):
- If the firm has not yet adopted the procedures below, members should urge it to do so.
- Limitations on employee participation in equity IPOs.
- Restrictions on participation in private placements: strict limits on employee purchases and proper supervisory procedures, because private placements raise the same kind of conflict as IPOs.
- Blackout periods (restricted periods) before client trades for employees involved in investment decision-making, so that no one front-runs client orders. How strict the blackout should be depends on the size of the firm and the type of security.
- Reporting procedures: pre-clearance procedures, duplicate trade confirmations, and disclosure of beneficial ownership positions and personal holdings.
Recommended procedures for VI(C):
- Members should urge their firms to set clear procedures for compensation received for referrals, and should give their employers updates at least quarterly on referral arrangements.
- Where a firm allows referral fees, it should have clear approval procedures and policies on the nature and value of referral compensation received.
Common exam traps
- Allowing "small" or "limited" front-running is never an acceptable control.
- VI(B) ranks client and employer trades ahead of the member's own; III(B) Fair Dealing requires fair treatment among clients. A manager who allocates profitable block trades to his own account violates VI(B), and pushing the losing trades onto the largest client accounts is likely a III(B) violation as well.
LOS 100.c — Conduct that conforms and conduct that violates
Key concept
| Conduct | Verdict |
|---|---|
| Analyst owns the covered stock and discloses the holding in the report | Conforms to VI(A) |
| Analyst joins an unpaid investment committee of an institution whose assets are managed by her firm and tells no one | Violates VI(A) |
| Analyst buys, for an account she funds and controls for her child, a stock she has just upgraded, before the report reaches clients | Violates VI(B): she is the beneficial owner of the account, so the trade is hers, and it comes ahead of the clients; small size is irrelevant |
| Manager advises clients to sell, lets their orders execute, then sells her own position | Conforms to VI(B) |
| Manager buys for himself just before large client purchases | Violates VI(B) (front-running) |
| Planner mentions referral payments only in a welcome kit sent after the client signs | Violates VI(C): disclosure must come before the agreement |
| Member takes an equal share of a hot IPO alongside clients who agree | May violate VI(B) despite consent |
Example. Anneliese is a fixed income analyst whose only duty is a municipal bond fund. She finds a small biotech stock she likes for herself. Because the stock could never be held by the fund, VI(B) does not require her to offer it to anyone first; she may buy it (subject to firm pre-clearance rules). If she later started covering biotech stocks, a personal holding would then have to be disclosed under VI(A) and client trades would take priority under VI(B).
Four Standards deal with benefits and conflicts that look alike. The trigger decides which one applies:
Key concept
| Trigger | Standard | Required step | Who is told |
|---|---|---|---|
| Client's gift for results already achieved | I(B) Independence and Objectivity | Disclose, before accepting if possible | Employer |
| Benefit tied to future performance, or outside pay that competes or may conflict with the employer's interest | IV(B) Additional Compensation Arrangements | Written consent before accepting | All parties involved, above all the employer |
| Holding, relationship or pay scheme that could reasonably be expected to impair independence and objectivity or interfere with duties | VI(A) Avoid or Disclose Conflicts | Avoid where reasonably possible; otherwise disclose | Clients, prospects and employer, as relevant |
| Compensation received from or paid to others for recommending products or services | VI(C) Referral Fees | Disclose before the client or prospect agrees to the service | Employer, clients and prospects, as appropriate |
Exam shortcuts
- To tell look-alike benefits apart, start from the trigger: a client's gift for results already achieved falls under I(B), a benefit tied to future performance or competing outside pay under IV(B), a holding, relationship or pay scheme that could impair independence and objectivity under VI(A), and pay for recommending products or services under VI(C).
Bottom line
- Standard VI(A) requires members to avoid conflicts where reasonably possible and otherwise to make full and fair disclosure in prominent, plain-language form, so a line of fine print buried in a legal appendix does not meet it.
- The conflict that most often requires disclosure is the member's own stock ownership in a company he or she recommends or that clients hold, including beneficial ownership through a trust, and disclosing the holding meets the Standard without declining the assignment or selling the stock.
- Market making, investment banking relationships, board seats held by the member or senior firm officers, paid consulting work for the issuer, and compensation arrangements that could create incentives at odds with clients' objectives must be disclosed.
- Under Standard VI(B), transactions for clients and employers have priority over those in which the member is the beneficial owner, client transactions also come before the firm's proprietary trading, and front-running violates the Standard.
- Fee-paying client accounts of family members are treated exactly like other client accounts, neither favored nor disadvantaged.
- A member may trade personally in a security that is not suitable for any client without first offering it to clients, the overriding test being that personal trades do not disadvantage any client.
- Standard VI(C) requires disclosure of any compensation, consideration or benefit, cash or non-cash, received from or paid to others for recommending products or services, with its nature and estimated value, before the client or prospect enters into an agreement for services.
- Recommended procedures for Standard VI(B) include limits on employee participation in equity IPOs, restrictions on private placements, blackout periods before client trades, and reporting procedures such as pre-clearance and duplicate trade confirmations.
Quick check
Rosalind Mercer, CFA, is an analyst at the investment bank Carrow & Pike. Her manager asks her to initiate coverage of Summit Ridge Ales. Carrow & Pike's corporate finance group has advised Summit Ridge on every acquisition it has made over the last nine years, and two of Carrow & Pike's senior partners serve as Summit Ridge directors. According to the Standards of Professional Conduct, may Mercer write the report?
Show answer and explanation
Correct answer: C
Standard VI(A) requires members to disclose to clients and prospects matters that could reasonably be expected to impair objectivity. It does not prohibit an analyst with potential conflicts from writing the report; the investment banking relationship and the directorships must be disclosed.
Why the other options are wrong
- A. Independence and objectivity are required, but they do not replace disclosure: clients must be told about the relationships so they can judge the report.
- B. The Standard does not bar the analyst from writing the report; it requires the conflicts to be disclosed.
Key takeaway Conflicts rarely forbid the work. They require disclosure.
Practice Questions
A brokerage firm is adding blackout periods to its personal-trading procedures for employees involved in investment decision-making. Under the recommended procedures for Standard VI(B) Priority of Transactions, how strict the blackout requirement should be depends most on:
Show answer and explanation
Correct answer: A
The recommended procedures call for blackout or restricted periods before client trades for employees involved in investment decision-making, so that no one front-runs client or employer transactions. The size of the firm and the type of security should help decide how severe the blackout requirement is.
Why the other options are wrong
- B. The blackout applies because of an employee's role in investment decisions. Seniority and years of service are not the factors that set its strictness.
- C. The number of clients and the size of their accounts are not the factors the recommended procedures name for setting the blackout's strictness.
Key takeaway Blackout periods apply to employees involved in investment decision-making, and their strictness should reflect the size of the firm and the type of security.
Priya Natarajan is an estate-planning attorney. Colin Ashby, CFA, a wealth manager, regularly sends his clients to her for estate work. In exchange, Natarajan prepares the wills and trust documents for Ashby's own family without charging him. Natarajan has just been awarded the CFA charter and become a member of CFA Institute. Under the Standards, Natarajan must:
Show answer and explanation
Correct answer: A
The free legal work Natarajan performs for Ashby is a benefit paid to another person in return for recommending her services, so it is a referral fee under Standard VI(C). Now that she is a CFA Institute member, she must disclose the arrangement to the prospective clients Ashby refers, including the nature of the benefit and an estimate of its value, so they can judge any partiality in Ashby's recommendation.
Why the other options are wrong
- B. Disclosing that the arrangement exists is not enough: the Standard expects the nature and the estimated value of the benefit to be disclosed so the client can weigh it.
- C. Standard VI(C) does not prohibit referral arrangements; it requires that they be disclosed. Ending the arrangement is not required.
Key takeaway Referral consideration can be non-cash (free services, gifts, discounts). Disclose its nature and estimated value.
This reading has 42 questions in the full bank. Practice all of them.
Key Takeaways
- Conflicts rarely forbid the work. They require disclosure.
- Blackout periods apply to employees involved in investment decision-making, and their strictness should reflect the size of the firm and the type of security.
- Referral consideration can be non-cash (free services, gifts, discounts). Disclose its nature and estimated value.