Standard VI(C) Referral Fees

Members and candidates must inform their employer, clients, and prospective clients of any benefit received for referrals of customers and clients. Such disclosures allow clients and employers to evaluate (1) any partiality shown in any recommendation of products or services and (2) the full cost of the services. Members and candidates must also 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 before entry into any formal agreement for services, members and candidates must inform the client or prospective client of any benefit given or received for the recommendation of any services provided by the member or candidate. 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, 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.

Members and candidates should encourage their employers to develop procedures related to referral fees. Employers may completely restrict such fees or outline the appropriate steps for requesting approval of a referral fee arrangement. Members and candidates who participate in approved referral fee programs should provide to their employer regular (at least quarterly) updates on the amount and nature of compensation received through referral fee arrangements.

Brady Securities, Inc., a broker/dealer, has established a referral arrangement with Lewis Brothers, Ltd., an investment management 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.

White, a partner at Lewis Brothers, calculates that the incremental costs involved in functioning as the research department of Brady Securities are US$200,000 annually. Referrals from Brady Securities last year resulted in fee income of US$1.8 million for Lewis Brothers, and directing all stock trades through Brady Securities resulted in additional costs to Lewis Brothers’ clients of US$100,000.

Branch, the chief financial officer of Maxwell Inc., is seeking an investment manager for Maxwell’s profit-sharing plan and contacts White about Lewis Brothers’ investment management services. She tells White that her friend at Brady Securities, Hill, recommended Lewis Brothers without qualification. White secures Maxwell as a new client but does not disclose his firm’s referral arrangement with Brady Securities.

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 at Central Trust to his clients.

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’s 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.

The state employee pension plan is seeking to hire a firm to manage the pension plan’s emerging market allocation. To assist in the review process, the plan hires Arronski as a consultant to solicit proposals from various advisers. Arronski is contracted by the plan 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, it comes to light that Arronski charges fees to investment managers that he recommends if they are awarded new pension allocations. Although the plan is happy with the performance of Overseas since it has been managing the plan’s emerging market funds, the plan still decides to have an independent review of the proposals and the selection process to ensure that Overseas is the appropriate firm for its needs. This review confirms that, even though Arronski was paid by both the plan and Overseas, the recommendation of Overseas appeared to be objective and appropriate.