In the current age of more stringent ethics codes and increased burdens on compliance officers, the level of compliance awareness in financial advisory firms has ratcheted up to new heights.During 2005, audits revealed that almost 80 percent of firms have some sort of conflict of interest not disclosed fully and fairly, with a majority of those issues centering on compensation streams - how and by whom the financial advisor is compensated.
While advisors registered with the Dallas-based broker/dealer 1st Global aren't involved with any of the items on the list, founder and chief executive Tony Batman ticked off a list of possible conflicts in compensation arrangements.
Advisors who receive research or workstations in exchange for directing commissions to a broker incur possible conflicts. Revenue-sharing paid by product sponsors for any activities that promote their products over another provider could cause a bias and be a conflict of interest. Similarly, receiving education, training, and travel and entertainment from managers with whom advisors do business could be seen as influencing decisions.
"Conflicts of interest are inherent in our beautiful capitalist system," said Batman, who is a CPA/PFS and CFA. "But there's a difference between healthy or fully transparent conflicts, and unhealthy, undisclosed conflicts that create a bias for personal financial benefit."
Many of these potential conflicts affect only advisors who are also captive registered representatives of one broker/dealer. This condition was one of the dozen or so potentials for conflicts listed by Gene Gohlke, CPA, Ph.D, who manages the Securities and Exchange Commission's inspection program for registered investment advisors. "It's best to say that this can create conflict of interests for advisors," Gohlke said. "But this situation is not a conflict of interest per se."
The majority of the 600 firms and 1,200 CPA advisors affiliated with 1st Global are dually registered with the firm's RIA and broker/dealer.
"Dual-registered advisors abide by the rules on the side of the toughest regulations," Batman explained. "Today that's the bright-line standards of the NASD over broker/dealers, but I'm convinced that the regulators are getting more serious about enforcing the fiduciary standards that have more leeway."
Advisors doing business only as RIAs must consider several disclosures relating to compensation. For example, Gohlke pointed out that if the advisor negotiates fees, the basis for negotiation should be consistent among clients. Fees based on performance could create possible conflicts to seek returns above the level of risk desired by the client.
Other compensation issues are equally subtle in their potential for conflict. The industry-wide practice of basing the fee on assets under management seems straightforward. But Tom Kirk, CPA/PFS, president and chief executive at CPA Wealth Management Services, in Melbourne, Fla., told of the potential for bias in this payment structure.
"Let's say a client seeks our advice on taking a half million out of his liquid account to pay off his mortgage," said Kirk. "We still give the advice based on what's best for their overall plan, but if the money leaves the account, we get paid less."
Advisors should also watch the issues relating to directing brokerage. Even though advisors can place trades with any broker, as a practical matter most house client assets at one firm that enjoys all the commission traffic.
Gohlke puts the possibility for conflicts under the question of whether the back-office platform provides services of value to the advisor.
"The potential for conflict is out there," said Kirk. "Even if our custodian weren't doing a great job with everything they do for us, there would be strong corporate momentum to keep using them."
Reviewing the custodial relationship annually is one of several recent SEC requirements that were enacted as part of an update to the 70-year-old Investment Advisors Act.
CPA Wealth Management Services started with Fidelity 10 years ago, and enjoys a close relationship because of the size of client assets at Fidelity. "Every year we run through the analysis of what we give to them and what we get from them, and investigate whether we could get a better deal somewhere else," Kirk explained.
Referral fees pose another area of potential conflict. Gohlke noted that advisors should disclose referrals from securities brokers and insurance agents. Introductions to clients from other professionals like attorneys and CPAs should be noted. Even referrals from within the same firm should be disclosed. "It's interesting - as our firm got larger, we forgot what our colleagues in different departments might be doing," explained Kirk. "The extra compensation keeps us all thinking about what other services the client might need. We state in our ADV that team member compensation includes consideration for referrals within the firm."
Firms should consider naming the in-house general counsel as compliance officer. "If an attorney acts as compliance officer, there's a potential for conflict," Gohlke said. "In this situation, legal advice would no longer be protected under attorney-client privilege, for instance."
Complying with other parts of the new regulations points to activities that may already be in place. The new ethical code requires the advisor to establish a regime to track the personal trading activities of personnel. This doesn't necessary create the potential for conflicts, but does demand closer attention on the part of the firm.
Regulators and organizations continue to focus on refining compliance procedures and finding more ways of doing business that eliminate potential conflicts. The SEC has undertaken a study to consider whether it should seek legislation that would integrate the existing regulatory schemes applicable to broker/dealers and investment advisors that provide services to retail clients. According to Kirk, there is active discussion at the National Association of Personal Financial Advisors to create a fee that would be charged on total net worth, in lieu of assets under management.
There is also hope that time and awareness will decrease the number of conflicts not fully and fairly disclosed. "Last year was the first full year under the new compliance regime," said the SEC's Gohlke. "We're hopeful that the incidence of nondisclosures will be fewer in 2006."
