Conflicts of interest are the single greatest obstacle to fulfilling fiduciary duty. A conflict of interest is a circumstance that tempts the professional judgment of fiduciaries to serve someone other than their charge. Typically, that someone is the fiduciary himself or herself. It would be a wonderful world if people were impervious to temptation. Sadly, they are not. Because temptation exists, so does corruption.
And while it is both noble and worthwhile for the financial services industry and investment advice profession to continue promoting a culture of fiduciary responsibility and ethical conduct from within, moral suasion must be backed by structural protections that favor investors.
The most effective and immediate path to improved investor protection is to uncover and eliminate or mitigate conflicts of interest. New legislation and regulation may move down this path, but there are issues that can be addressed right now.
Carlo V. di Florio, director of the Office of Compliance Inspections and Examinations at the Securities and Exchange Commission, delivered an important speech on this subject Oct. 22 to the National Society of Compliance Professionals. In the talk, “Conflicts of Interest and Risk Governance,” he explained that conflicts of interest are an increasing area of attention for regulators and that this emphasis is playing out in enforcement activities.
“We focus on conflicts of interest as an integral part of our assessment of which firms to examine, what issues to focus on and how closely to scrutinize,” said Mr. di Florio, explaining the SEC's risk-based strategy that guides inspection and enforcement strategy. The Watergate-era admonition to “follow the money” comes to mind as the practical link between corruption, and investigation and enforcement.
SWEEP EXAMS
In addition to placing conflicts of interest at the top of the list of risks to explore in routine examinations, the SEC and the
Financial Industry Regulatory Authority Inc. have initiated special conflict- centric sweep exams to identify and control conflicts. Last year, the SEC also began to issue Risk Alerts, which Mr. di Florio described as “a window through which we want to offer the public and the financial services industry a view on key risks and to share effective risk management practices that we have observed.”
Turning to specific practices for managing conflicts of interest, Mr. di Florio recommended three components of an effective risk governance framework.
The first is to establish a well-defined process to scan the organization for conflicts on a continuing basis, risk-assess and prioritize the identified conflicts for elimination or mitigation, and allocate and apply resources to address the compliance and reputational risks imposed by the conflicts.
Second, implement a strong compliance and ethics program tailored to address conflicts. Mr. di Florio noted that the Investment Advisers Act (Rule 206(4)-7), the Investment Company Act (Rule 38a-1) and Finra (NASD Rules 3010 and 3012, and Finra Rule 3130) set specific requirements for compliance and ethics programs.
Surprisingly, the most detailed description of components of compliance and ethics programs Mr. di Florio cited was drawn from the U.S. Federal Sentencing Guidelines. He reported that under the guidelines, an effective compliance and ethics program is required as a mitigating factor in determining criminal sentences for corporations. Such programs are to include standards and procedures to prevent and detect criminal conduct, oversight by an organization's governing authority, education and training, auditing and monitoring, and incentives and discipline, among other considerations.
The third component of an effective conflict risk governance framework is to establish clear lines of defense against conflicts. This includes setting business practices that avoid conflicts as matters of policy and structure, implementing independent risk management and control functions with adequate resources and authority to confront conflicts, and engaging senior management and the board of directors in the entire process.
The bottom line is that conflicts should be treated like invasive species that are a threat to investors, the profession of financial advice and the companies they represent. The goal is to eliminate them where we can and contain them where we must.
Blaine F. Aikin is president and chief executive of fi360 Inc.
