Standards of Practice Guidance 2014
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.
Test your understanding of Standard VI(C)
- Recommended Procedures for Compliance
- Application of the Standard
- Example 1 (Disclosure of Referral Arrangements and Outside Parties)
- Example 2 (Disclosure of Interdepartmental Referral Arrangements)
- Example 3 (Disclosure of Referral Arrangements and Informing Firm)
- Example 4 (Disclosure of Referral Arrangements and Outside Organizations)
- Example 5 (Disclosure of Referral Arrangements and Outside Parties)
Standard VI(C) states the responsibility of members and candidates to inform their employer, clients, and prospective clients of any benefit received for referrals of customers and clients. Such disclosures allow clients or employers to evaluate (1) any partiality shown in any recommendation of services and (2) the full cost of the services. Members and candidates must disclose when they pay a fee or provide compensation to others who have referred prospective clients to the member or candidate.
Appropriate disclosure means that members and candidates must advise the client or prospective client, before entry into any formal agreement for services, of any benefit given or received for the recommendation of any services provided by the member or candidate. In addition, the member or candidate must disclose the nature of the consideration or benefit—for example, flat fee or percentage basis, one-time or continuing benefit, based on performance, benefit in the form of provision of research or other noncash benefit—together with the estimated dollar value. Consideration includes all fees, whether paid in cash, in soft dollars, or in kind.Back to top
Recommended Procedures for Compliance
Members and candidates should encourage their employers to develop procedures related to referral fees. The firm may completely restrict such fees. If the firm does not adopt a strict prohibition of such fees, the procedures should indicate the appropriate steps for requesting approval.
Employers should have investment professionals provide to the client's notification of approved referral fee programs and provide the employer regular (at least quarterly) updates on the amount and nature of compensation received.Back to top
Application of the Standard
Example 1 (Disclosure of Referral Arrangements and Outside Parties):
Brady Securities, Inc., a broker/dealer, has established a referral arrangement with Lewis Brothers, Ltd., an investment counseling firm. In this arrangement, Brady Securities refers all prospective tax-exempt accounts, including pension, profit-sharing, and endowment accounts, to Lewis Brothers. In return, Lewis Brothers makes available to Brady Securities on a regular basis the security recommendations and reports of its research staff, which registered representatives of Brady Securities use in serving customers. In addition, Lewis Brothers conducts monthly economic and market reviews for Brady Securities personnel and directs all stock commission business generated by referral accounts to Brady Securities.
Willard White, a partner in Lewis Brothers, calculates that the incremental costs involved in functioning as the research department of Brady Securities are US$20,000 annually.
Referrals from Brady Securities last year resulted in fee income of US$200,000 for Lewis Brothers, and directing all stock trades through Brady Securities resulted in additional costs to Lewis Brothers’ clients of US$10,000.
Diane Branch, the chief financial officer of Maxwell Inc., contacts White and says that she is seeking an investment manager for Maxwell’s profit-sharing plan. She adds, “My friend Harold Hill at Brady Securities recommended your firm without qualification, and that’s good enough for me. Do we have a deal?” White accepts the new account but does not disclose his firm’s referral arrangement with Brady Securities.
Comment: White has violated Standard VI(C) by failing to inform the prospective customer of the referral fee payable in services and commissions for an indefinite period to Brady Securities. Such disclosure could have caused Branch to reassess Hill’s recommendation and make a more critical evaluation of Lewis Brothers’ services.
Example 2 (Disclosure of Interdepartmental Referral Arrangements):
James Handley works for the trust department of Central Trust Bank. He receives compensation for each referral he makes to Central Trust’s brokerage department and personal financial management department that results in a sale. He refers several of his clients to the personal financial management department but does not disclose the arrangement within Central Trust to his clients.
Comment: Handley has violated Standard VI(C) by not disclosing the referral arrangement at Central Trust Bank to his clients. Standard VI(C) does not distinguish between referral payments paid by a third party for referring clients to the third party and internal payments paid within the firm to attract new business to a subsidiary. Members and candidates must disclose all such referral fees. Therefore, Handley is required to disclose, at the time of referral, any referral fee agreement in place among Central Trust Bank’s departments. The disclosure should include the nature and the value of the benefit and should be made in writing.
Example 3 (Disclosure of Referral Arrangements and Informing Firm):
Katherine Roberts is a portfolio manager at Katama Investments, an advisory firm specializing in managing assets for high-net-worth individuals. Katama’s trading desk uses a variety of brokerage houses to execute trades on behalf of its clients. Roberts asks the trading desk to direct a large portion of its commissions to Naushon, Inc., a small broker/dealer run by one of Roberts’ business school classmates. Katama’s traders have found that Naushon is not very competitive on pricing, and although Naushon generates some research for its trading clients, Katama’s other analysts have found most of Naushon’s research to be not especially useful. Nevertheless, the traders do as Roberts asks, and in return for receiving a large portion of Katama’s business, Naushon recommends the investment services of Roberts and Katama to its wealthiest clients. This arrangement is not disclosed to either Katama or the clients referred by Naushon.
Comment: Roberts is violating Standard VI(C) by failing to inform her employer of the referral arrangement.
Example 4 (Disclosure of Referral Arrangements and Outside Organizations):
Alex Burl is a portfolio manager at Helpful Investments, a local investment advisory firm. Burl is on the advisory board of his child’s school, which is looking for ways to raise money to purchase new playground equipment for the school. Burl discusses a plan with his supervisor in which he will donate to the school a portion of his service fee from new clients referred by the parents of students at the school. Upon getting the approval from Helpful, Burl presents the idea to the school’s advisory board and directors. The school agrees to announce the program at the next parent event and asks Burl to provide the appropriate written materials to be distributed. A week following the distribution of the flyers, Burl receives the first school-related referral. In establishing the client’s investment policy statement, Burl clearly discusses the school’s referral and outlines the plans for distributing the donation back to the school.
Comment: Burl has not violated Standard VI(C) because he secured the permission of his employer, Helpful Investments, and the school prior to beginning the program and because he discussed the arrangement with the client at the time the investment policy statement was designed.
Example 5 (Disclosure of Referral Arrangements and Outside Parties):
The sponsor of a state employee pension is seeking to hire a firm to manage the pension plan’s emerging market allocation. To assist in the review process, the sponsor has hired Thomas Arrow as a consultant to solicit proposals from various advisers. Arrow is contracted by the sponsor to represent its best interest in selecting the most appropriate new manager. The process runs smoothly, and Overseas Investments is selected as the new manager.
The following year, news breaks that Arrow is under investigation by the local regulator for accepting kickbacks from investment managers after they are awarded new pension allocations. Overseas Investments is included in the list of firms allegedly making these payments. Although the sponsor is happy with the performance of Overseas since it has been managing the pension plan’s emerging market funds, the sponsor still decides to have an independent review of the proposals and the selection process to ensure that Overseas was the appropriate firm for its needs. This review confirms that, even though Arrow was being paid by both parties, the recommendation of Overseas appeared to be objective and appropriate.
Comment: Arrow has violated Standard VI(C) because he did not disclose the fee being paid by Overseas. Withholding this information raises the question of a potential lack of objectivity in the recommendation of Overseas by Arrow; this aspect is in addition to questions about the legality of having firms pay to be considered for an allocation.
Regulators and governmental agencies may adopt requirements concerning allowable consultant activities. Local regulations sometimes include having a consultant register with the regulatory agency’s ethics board. Regulator policies may include a prohibition on acceptance of payments from investment managers receiving allocations and require regular reporting of contributions made to political organizations and candidates. Arrow would have to adhere to these requirements as well as the Code and Standards.
About the Author(s)
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