The Deception Series, Part 6--The Ethics of Disclosure

Part 6--The Ethics of Disclosure
While revenue sharing agreements, 12b-1 fees and even the APF, can have a business role in the sale of mutual funds under some circumstances, their legitimacy all treads on the borderline of ethical disclosure.

While the importance of stressing ethical behaviors in the financial services industry unfortunately varies according to market conditions, there are some anchors which ground this discussion.

For example, in a client-broker relationship, “the act of withholding information from a client even if it is not intentional, still raises the flag of why it is not being disclosed in the first place, “according to Julie Anne Ragatz, a fellow at the American College Center for Ethics in Financial Services in Bryn Mawr, Pennsylvania. When compensation is involved, the burden of proof is on the person (in this case, the adviser) who is not disclosing their relationship with the mutual fund company which is providing monetary compensation, she added.

Ms. Ragatz said the issue of fees is part of the larger issue of conflicts of interest that exists within the financial services industry. Yet while these conflicts are common, Ms. Ragatz said they do not have to be “vicious,” or manifest themselves in ways which are self-serving and ethically wrong.

Compensation arrangements between advisers and their clients raise three key issues:

1. The complexity of most forms of compensation between an adviser, their broker/dealer, and a fund distribution company;

2. The lack of transparency which exists to discover these compensation arrangements;

3. The difficulty of explaining compensation arrangements to clients in an understandable way.

These discussions become complicated when fee arrangements distort the adviser-client relationship. In the case of the APF, a mutual fund company gets what it incentivizes, or rewards, and that opens the sticky issue of why the fund company incentivizes a proprietary product?

The answer is that despite its ethical bias, this practice attracts new assets under management, and reduces redemption rates, while compromising an adviser’s relationships with their clients. All this occurs when the broker puts their financial needs ahead of the client’s investment goals, risk tolerance, or if a better investment opportunity arises which does not pay an extra incentive fee.

The Charter Financial Analyst (CFA) Institute, which was wracked by a large analyst scandal in 2000, has adopted a Code of Ethics and Standards of Professional conduct for its members. The Code states that a member must place the interests of clients ahead of their personal interests. Under their Standard of Professional Conduct, a rules states that “Members and Candidates must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or another’s independence and objectivity.”

Under the section, Duty to Clients, the code says that “members and candidates must act for the benefit of their clients and place their clients’ interests before their employer’s or their own interests.” This would clearly eliminate the APF or other revenue sharing agreements.


Disclosure or Eyes Wide Shut?
Disclosure is the bane of the financial services industry. Too much disclosure erodes the mystique of authority which enhances the role of the investment manager and adviser. Too little opens a door to intentional omission. In practical terms, this means that many investment advisers choose to make the lie of omission, which may be convenient, but it is still a lie.

“True disclosure happens when a client can weigh the facts, evaluate them, and make an intelligent decision which is in their own best interest,” according to Ms. Ragatz. But in many areas of the financial services industry, “smoke and mirrors are used in front of the compensation structure, and this makes it very difficult for good advisers to have a forthright discussion about compensation with their clients,” she said.

This is a mistake, she said, since many clients would gladly pay well for good, objective, forthright investment advice. If advisers did this on a mass basis, it would also force fund companies to explain and justify their fees, so everyone knows what they are paying for.

“While there are many areas in the financial services industry which rely on a culture of obfuscation and mystification, the entire industry would benefit if there was an honest discussion about compensation and what investors can realistically expect from their advisers and their fund company,” Ms. Ragatz said.

Fund companies should also examine their commission and incentive programs to see if they align with the fund company’s core values. If fees, including the APF, and commissions make it harder to interact with clients, those incentive structures should be changed, she said.