Conflict Disclosure | What would your client want to know?
By: Phil Du Heaume
Motivation drives people to action. It’s a simple yet critical concept, commonly discussed in articles that champion techniques in leadership and sales strategy. Whether an individual’s motivation takes the form of financial incentives, ethical beliefs or pursuit of the simple satisfaction that comes along with doing a good job, there is almost always an underlying reason for why people do things. Finding ways to identify and harness these motivating factors can be an effective way to promote success – particularly in exempt market dealerships. These dealerships also need to be wary of motivation’s evil twin: conflict of interest.
In behavioral psychology, incentive theory describes how people are naturally inclined to make decisions that offer positive reinforcement and to avoid decisions that lead to punishment. Unfortunately, the pursuit of positive reinforcement is also subject to a natural human tendency to choose smaller, immediate gratification at the cost of substantial, but delayed success. Perhaps even more dangerous is the fact that we often do not recognize that we are falling prey to an incentive bias until we get the chance to look back on our decisions with the benefit of hindsight.
This is a commonly identified problem with public market investing, where rash buy/sell decisions based on market fluctuations can cost investors longer-term market gains that are traditionally available through a model of diversify and hold. The short-term incentive to escape what is perceived as a potentially catastrophic loss wins out over the longer-term incentive to stay the course and allow for a market rebound.
Investors are not the only ones who are vulnerable to conflicting incentives and decision-making biases. Investment dealers and their representatives are presented with a similar dilemma when they encounter conflicting incentives of their own; particularly if one option is immediately gratifying while the other feels less certain and longer-term. For the most part, industry participants recognize that investor success begets dealer success, because the act of growing investor wealth creates a larger capital pool for the dealership to draw from. But this can be perceived as ‘hard’ because its a long-term objective that requires the dealership to create a consistent track record of effective due-diligence and responsible advising, all while maintaining strong relationships with clients, advisors and issuers.
Conversely, the immediate, positive reinforcement that is available to dealers and representatives who pursue sales commissions from unsuitable transactions and related-party investments is more gratifying and, according to these psychological theories, more attractive. Short term incentives form the basis of many conflicts of interest that threaten industry integrity. It is imperative that Exempt Market Dealers do everything in their power to protect their clients from these conflicts before they have to look back on their decisions through the hindsight that comes with a regulatory investigation.
An incentive bias is considered to be a conflict of interest by provincial securities regulators if it could reasonably result in circumstances where the interests of the client and the interests of the registrant are inconsistent or divergent. A case of a dealer being incentivized in the short term to advance unsuitable deals or sell related-party products is a perfect example of a conflict of interest. Choosing the ‘quick dollar’ over the mutual benefit of actions that lead to client success means that the investor’s goal of building wealth is no longer the primary focus.
The concept of protecting against conflicts of interest runs deep throughout National Instrument 31-103: Registration Requirements, Exemptions and Ongoing Registrant Obligations and its related Companion Policy (for the sake of brevity, we will refer to both the instrument and the companion policy collectively as the ‘Instrument’). The dual requirements of a dealership to (a) provide clients with relationship disclosure information outlining how the firm makes money, and (b) perform suitability assessments prior to recommending or accepting instructions on the purchase or sale of a security, are legislated solutions to the natural conflict of interest that exists between seller and buyer.
Some conflicts, however, are circumstantial rather than industry-wide and are not directly accounted for in the Instrument. This is why a key obligation of dealerships is to implement effective policies and procedures that mitigate conflicts of interest and ensure that they act fairly, honestly and in good faith when dealing with their clients. The dealer must be able to identify potential conflicts of interest, determine the level of risk that they raise, and then respond appropriately by disclosing, controlling, and/or avoiding the conflict.
Perhaps the most important of these conflict mitigation strategies is the requirement to provide disclosure to clients, because it forces the dealership to see the world through the eyes of an investor. Disclosure is specifically codified in the Instrument at section 13.4(3), where it states that, “If a reasonable investor would expect to be informed of a conflict of interest… the registered firm must disclose, in a timely manner, the nature and extent of the conflict of interest to the client whose interest conflicts with the interest identified.”
The wording is nuanced, and it is important for registrants to recognize that the disclosure requirement is born out of whether or not a reasonable investor would expect to be informed of the conflict rather than whether or not the client will actually be harmed. This creates a very low threshold test for necessitating disclosure and forces the dealership to objectively view the conflict of interest before running it through a ‘but I would never do that’ filter.
To illustrate how the test for disclosure must be conducted, we can use the example of an Exempt Market Dealer that distributes the securities of an indirectly related issuer, such as an issuer controlled by a family member or financial backer of the firm. It’s worth noting that section 13.6 of the Instrument also requires that the client be provided with disclosure anytime a dealership recommends that the client buy, sell or hold a security issued by a related issuer of the dealership, as defined under NI 33-105. Due to the requirement that the firm performs a suitability analysis before allowing an investor to acquire securities of that issuer, the dealership may feel that client risk is minimal. Nonetheless, the dealerships perceived risk does not matter if a reasonable client would still want to be afforded the opportunity to independently evaluate the risk, based on full disclosure. Disclosure of the relationship would, in this case, be required under the Instrument.
With complete information relating to the relationship between the dealer and the issuer, the client is able to contextualize the dealerships recommendation to buy or sell the security and decide whether or not their interests are sufficiently aligned. A further byproduct of this disclosure is that it forces the registrant to articulate the conflict and, through that process, consider whether or not additional controls or avoidance measures should be put in place.
Disclosure is only part of the conflict-prevention process; however it is an important tool for registrants to use in protecting their clients. Without proper controls in place, conflicts of interest are a significant risk to market integrity. The requirement to disclose conflicts of interest based on whether or not a reasonable investor would expect to be informed ensures that registrant firms give due consideration to the interests of their clients. It is a fundamental first step to ensuring that clients are always dealt with fairly, honestly and in good faith.
The above is not to be construed as legal advice but is provided for general interest purposes only. Please consult your legal or compliance advisor for matters related to your particular situation and to determine whether or not you have implemented sufficient policies to protect clients against conflicts of interest.