Investment transactions for clients and employers must have priority over investment transactions in which a Member or Candidate is the beneficial owner.
- Recommended Procedures for Compliance
- Application of the Standard
Standard VI(B) reinforces the responsibility of members and candidates to give the interests of their clients and employers priority over their personal financial interests. This standard is designed to prevent any potential conflict of interest or the appearance of a conflict of interest with respect to personal transactions. Client interests have priority. Client transactions must take precedence over transactions made on behalf of the member’s or candidate’s firm or personal transactions.
Avoiding Potential Conflicts
Conflicts between the client’s interest and an investment professional’s personal interest may occur. Although conflicts of interest exist, nothing is inherently unethical about individual managers, advisers, or mutual fund employees making money from personal investments as long as (1) the client is not disadvantaged by the trade, (2) the investment professional does not benefit personally from trades undertaken for clients, and (3) the investment professional complies with applicable regulatory requirements.
Some situations occur where a member or candidate may need to enter a personal transaction that runs counter to current recommendations or what the portfolio manager is doing for client portfolios. For example, a member or candidate may be required at some point to sell an asset to make a college tuition payment or a down payment on a home, to meet a margin call, or so on. The sale may be contrary to the long-term advice the member or candidate is currently providing to clients.In these situations, the same three criteria given in the preceding paragraph should be applied in the transaction so as to not violate Standard VI(B).
Personal Trading Secondary to Trading for Clients
Standard VI(B) states that transactions for clients and employers must have priority over transactions in securities or other investments for which a member or candidate is the beneficial owner. The objective of the standard is to prevent personal transactions from adversely affecting the interests of clients or employers. A member or candidate having the same investment positions or being co-invested with clients does not always create a conflict. Some clients in certain investment situations require members or candidates to have aligned interests. Personal investment positions or transactions of members or candidates or their firm should never, however, adversely affect client investments.
Standards for Nonpublic Information
Standard VI(B) covers the activities of members and candidates who have knowledge of pending transactions that may be made on behalf of their clients or employers, who have access to nonpublic information during the normal preparation of research recommendations, or who take investment actions. Members and candidates are prohibited from conveying nonpublic information to any person whose relationship to the member or candidate makes the member or candidate a beneficial owner of the person’s securities. Members and candidates must not convey this information to any other person if the nonpublic information can be deemed material.
Impact on All Accounts with Beneficial Ownership
Members or candidates may undertake transactions in accounts for which they are a beneficial owner only after their clients and employers have had adequate opportunity to act on a recommendation. Personal transactions include those made for the member’s or candidate’s own account, for family (including spouse, children, and other immediate family members) accounts, and for accounts in which the member or candidate has a direct or indirect pecuniary interest, such as a trust or retirement account. Family accounts that are client accounts should be treated like any other firm account and should neither be given special treatment nor be disadvantaged because of the family relationship. If a member or candidate has a beneficial ownership in the account, however, the member or candidate may be subject to preclearance or reporting requirements of the employer or applicable law.Back to top
Recommended Procedures for Compliance
Policies and procedures designed to prevent potential conflicts of interest, and even the appearance of a conflict of interest, with respect to personal transactions are critical to establishing investor confidence in the securities industry. Therefore, members and candidates should urge their firms to establish such policies and procedures. Because investment firms vary greatly in assets under management, types of clients, number of employees, and so on, each firm should have policies regarding personal investing that are best suited to the firm. Members and candidates should then prominently disclose these policies to clients and prospective clients.
The specific provisions of each firm’s standards will vary, but all firms should adopt certain basic procedures to address the conflict areas created by personal investing. These procedures include the following:
- Limited participation in equity IPOs: Some eagerly awaited IPOs rise significantly in value shortly after the issue is brought to market. Because the new issue may be highly attractive and sought after, the opportunity to participate in the IPO may be limited. Therefore, purchases of IPOs by investment personnel create conflicts of interest in two principal ways. First, participation in an IPO may have the appearance of taking away an attractive investment opportunity from clients for personal gain—a clear breach of the duty of loyalty to clients. Second, personal purchases in IPOs may have the appearance that the investment opportunity is being bestowed as an incentive to make future investment decisions for the benefit of the party providing the opportunity. Members and candidates can avoid these conflicts or appearances of conflicts of interest by not participating in IPOs.
Reliable and systematic review procedures should be established to ensure that conflicts relating to IPOs are identified and appropriately dealt with by supervisors. Members and candidates should preclear their participation in IPOs, even in situations without any conflict of interest between a member’s or candidate’s participation in an IPO and the client’s interests. Members and candidates should not benefit from the position that their clients occupy in the marketplace—through preferred trading, the allocation of limited offerings, or oversubscription.
- Restrictions on private placements: Strict limits should be placed on investment personnel acquiring securities in private placements, and appropriate supervisory and review procedures should be established to prevent noncompliance.
Firms do not routinely use private placements for clients (e.g., venture capital deals) because of the high risk associated with them. Conflicts related to private placements are more significant to members and candidates who manage large pools of assets or act as plan sponsors because these managers may be offered special opportunities, such as private placements, as a reward or an enticement for continuing to do business with a particular broker.
Participation in private placements raises conflict-of-interest issues that are similar to issues surrounding IPOs. Investment personnel should not be involved in transactions, including (but not limited to) private placements, that could be perceived as favors or gifts that seem designed to influence future judgment or to reward past business deals.
Whether the venture eventually proves to be good or bad, managers have an immediate conflict concerning private placement opportunities. If and when the investments go public, participants in private placements have an incentive to recommend the investments to clients regardless of the suitability of the investments for their clients. Doing so increases the value of the participants’ personal portfolios.
- Establish blackout/restricted periods: Investment personnel involved in the investment decision-making process should establish blackout periods prior to trades for clients so that managers cannot take advantage of their knowledge of client activity by “front-running” client trades (trading for one’s personal account before trading for client accounts).
Individual firms must decide who within the firm should be required to comply with the trading restrictions. At a minimum, all individuals who are involved in the investment decision-making process should be subject to the same restricted period. Each firm must determine specific requirements related to blackout and restricted periods that are most relevant to the firm while ensuring that the procedures are governed by the guiding principles set forth in the Code and Standards. Size of firm and type of securities purchased are relevant factors. For example, in a large firm, a blackout requirement is, in effect, a total trading ban because the firm is continually trading in most securities. In a small firm, the blackout period is more likely to prevent the investment manager from front-running.
- Reporting requirements: Supervisors should establish reporting procedures for investment personnel, including disclosure of personal holdings/beneficial ownerships, confirmations of trades to the firm and the employee, and preclearance procedures. Once trading restrictions are in place, they must be enforced. The best method for monitoring and enforcing procedures to eliminate conflicts of interest in personal trading is through reporting requirements, including the following:
- Disclosure of holdings in which the employee has a beneficial interest. Disclosure by investment personnel to the firm should be made upon commencement of the employment relationship and at least annually thereafter. To address privacy considerations, disclosure of personal holdings should be handled in a confidential manner by the firm.
- Providing duplicate confirmations of transactions. Investment personnel should be required to direct their brokers to supply to firms duplicate copies or confirmations of all their personal securities transactions and copies of periodic statements for all securities accounts. The duplicate confirmation requirement has two purposes: (1) The requirement sends a message that there is independent verification, which reduces the likelihood of unethical behavior, and (2) it enables verification of the accounting of the flow of personal investments that cannot be determined from merely looking at holdings.
- Preclearance procedures. Investment personnel should examine all planned personal trades to identify possible conflicts prior to the execution of the trades. Preclearance procedures are designed to identify possible conflicts before a problem arises.
- Disclosure of policies: Upon request, members and candidates should fully disclose to investors their firm’s policies regarding personal investing. The information about employees’ personal investment activities and policies will foster an atmosphere of full and complete disclosure and calm the public’s legitimate concerns about the conflicts of interest posed by investment personnel’s personal trading. The disclosure must provide helpful information to investors; it should not be simply boilerplate language, such as “investment personnel are subject to policies and procedures regarding their personal trading.”
Application of the Standard
Example 1 (Personal Trading):
Research analyst Marlon Long does not recommend purchase of a common stock for his employer’s account because he wants to purchase the stock personally and does not want to wait until the recommendation is approved and the stock is purchased by his employer.
Comment: Long has violated Standard VI(B) by taking advantage of his knowledge of the stock’s value before allowing his employer to benefit from that information.
Example 2 (Trading for Family Member Account):
Carol Baker, the portfolio manager of an aggressive growth mutual fund, maintains an account in her husband’s name at several brokerage firms with which the fund and a number of Baker’s other individual clients do a substantial amount of business. Whenever a hot issue becomes available, she instructs the brokers to buy it for her husband’s account. Because such issues normally are scarce, Baker often acquires shares in hot issues but her clients are not able to participate in them.
Comment: To avoid violating Standard VI(B), Baker must acquire shares for her mutual fund first and acquire them for her husband’s account only after doing so, even though she might miss out on participating in new issues via her husband’s account. She also must disclose the trading for her husband’s account to her employer because this activity creates a conflict between her personal interests and her employer’s interests.
Example 3 (Family Accounts as Equals):
Erin Toffler, a portfolio manager at Esposito Investments, manages the retirement account established with the firm by her parents. Whenever IPOs become available, she first allocates shares to all her other clients for whom the investment is appropriate; only then does she place any remaining portion in her parents’ account, if the issue is appropriate for them. She has adopted this procedure so that no one can accuse her of favoring her parents.
Comment: Toffler has violated Standard VI(B) by breaching her duty to her parents by treating them differently from her other accounts simply because of the family relationship. As fee-paying clients of Esposito Investments, Toffler’s parents are entitled to the same treatment as any other client of the firm. If Toffler has beneficial ownership in the account, however, and Esposito Investments has preclearance and reporting requirements for personal transactions, she may have to preclear the trades and report the transactions to Esposito.
Example 4 (Personal Trading and Disclosure):
Gary Michaels is an entry-level employee who holds a low-paying job serving both the research department and the investment management department of an active investment management firm. He purchases a sports car and begins to wear expensive clothes after only a year of employment with the firm. The director of the investment management department, who has responsibility for monitoring the personal stock transactions of all employees, investigates and discovers that Michaels has made substantial investment gains by purchasing stocks just before they were put on the firm’s recommended “buy” list. Michaels was regularly given the firm’s quarterly personal transaction form but declined to complete it.
Comment: Michaels violated Standard VI(B) by placing personal transactions ahead of client transactions. In addition, his supervisor violated Standard IV(C)–Responsibilities of Supervisorsby permitting Michaels to continue to perform his assigned tasks without having signed the quarterly personal transaction form. Note also that if Michaels had communicated information about the firm’s recommendations to a person who traded the security, that action would be a misappropriation of the information and a violation of Standard II(A)–Material Nonpublic Information.
Example 5 (Trading Prior to Report Dissemination):
A brokerage’s insurance analyst, Denise Wilson, makes a closed-circuit TV report to her firm’s branches around the country. During the broadcast, she includes negative comments about a major company in the insurance industry. The following day, Wilson’s report is printed and distributed to the sales force and public customers. The report recommends that both short-term traders and intermediate investors take profits by selling that insurance company’s stock. Seven minutes after the broadcast, however, Ellen Riley, head of the firm’s trading department, had closed out a long “call” position in the stock. Shortly thereafter, Riley established a sizable “put” position in the stock. When asked about her activities, Riley claimed she took the actions to facilitate anticipated sales by institutional clients.
Comment: Riley did not give customers an opportunity to buy or sell in the options market before the firm itself did. By taking action before the report was disseminated, Riley’s firm may have depressed the price of the calls and increased the price of the puts. The firm could have avoided a conflict of interest if it had waited to trade for its own account until its clients had an opportunity to receive and assimilate Wilson’s recommendations. As it is, Riley’s actions violated Standard VI(B).