Ethics Case Study of the Week: Ownership Stakes and Referral Fees

By Gary Sarkissian posted 04-19-2021 08:00


CFA Institute’s Code of Ethics and Standards of Professional Conduct codify the ethical guidelines for the investment profession that are critical to maintaining the integrity of capital markets and investor trust.  Members, candidates, and even firms make a commitment to uphold these standards as they help elevate ethical decision-making universally around the globe.  

As investment professionals, we are certain to face important ethical decisions in our day-to-day activities.  Some scenarios we encounter will be straightforward, while others may be more complex.  No matter what circumstances we face, continuous learning remains imperative in an investment industry that continues to e volve with products undergoing innovation and a regulatory environment continuing to adapt. 

For that reason, each week we will feature a sample case from CFA Institute’s Ethics in Practice Casebook.  Each case is built upon a real-life example that may involve a regulatory matter or even a CFA Institute Professional Conduct investigation.  At the end of the case is a multiple-choice question that addresses the ethical nature of the actions taken in that case.  

This week’s case involves Standard VI(A) Disclosure of Conflicts. 

Ownership Stakes and Referral Fees
Vincent is a 50% owner and managing partner of Paragon Capital, an investment adviser firm, and VP Capital, a broker/dealer. Paragon’s only active advisory clients are three registered investment companies (mutual funds), which have their own boards, trustees, officers, and compliance staff separate from Paragon. An investment committee at Paragon that includes Vincent and other Paragon staff recommends and approves all investments made by the mutual funds. Over time, the committee approves multiple investments and reinvestments in promissory notes issued by Aquarius Capital Management based on trade receivables. The mutual funds invest approximately 15% of their net assets in the Aquarius securities.

Vincent and Aquarius both hold ownership stakes in Willow Grove Equity Solutions, a holding company established to invest in other investment adviser firms. Aquarius grants Willow Grove a $10 million line of credit, which Willow Grove regularly accesses. Aquarius also pays VP Capital, the broker/dealer, fees for referring investors, other than Paragon clients, to invest in the securities issued by Aquarius. These referral fees amount to approximately $1 million per year. Paragon’s regulatory filings and marketing brochures describe Paragon’s and Vincent’s affiliations with VP Capital and Willow Grove. Paragon provides these documents to the mutual funds’ compliance staff each year when they conduct their annual due diligence visits to Paragon’s offices. Vincent’s actions are   

A. acceptable because the referral fees paid by Aquarius to VP Capital exclude Paragon clients.
B. unacceptable because Vincent violates his duty of loyalty to Paragon by investing in other investment adviser firms through Willow Grove.
C. acceptable because Paragon provides disclosure to the mutual funds’ compliance personnel about the affiliations with VP Capital and Willow Grove when they conduct due diligence.
D. unacceptable because Vincent and Paragon’s disclosures are incomplete.
E. none of the above.

What do you think is the correct choice?  Click the “Analysis” button below to see the analysis for this case, and feel free to discuss in the comments below.  The completion of this case qualifies for 0.25 hour of Standards, Ethics, and Regulation (SER) credit

This case relates to the disclosure of conflicts of interest. CFA Institute Standard VI(A): Disclosure of Conflicts requires CFA Institute members to make full and fair disclosures of all matters that could reasonably be expected to impair their independence and objectivity or interfere with their duties to clients. In this case, Vincent’s financial interests are aligned with those of Aquarius through their common ownership stakes in Willow Grove. Vincent and Paragon advise their mutual fund clients to invest their money in Aquarius while Aquarius is paying fees and providing credit to firms partly owned by Vincent. In addition, Aquarius is paying referral fees to a brokerage firm partly owned by Vincent. These circumstances give Vincent a material financial interest in supporting Aquarius by having Paragon’s mutual fund clients invest in Aquarius. Vincent thus has a conflict of interest related to Paragon’s clients’ investments in Aquarius promissory notes.

Vincent and Paragon did not provide the advisory clients with sufficient information about the financial ties to Aquarius so the clients could understand those conflicts. Although Vincent and Paragon provide disclosures related to the affiliation between VP Capital and Willow Grove, the disclosures do not cover the nature, magnitude, or extent of the financial ties between Aquarius, Willow Grove, VP Capital, Paragon, and Vincent. Failure to disclose the conflicts renders the due diligence by the mutual funds’ compliance staff ineffective. Excluding the mutual funds from the referral fee arrangement does not effectively address the conflicts of interest. The fact that Vincent has ownership interest in multiple investment adviser firms through Paragon and Willow Grove may give rise to loyalty concerns, but there are no facts presented supporting any potential unethical conduct relating to conflicts among the advisory firms. Answer D is the best choice.

This case relates to a question submitted to the CFA Institute Ethics Help Desk.

Image by mohamed Hassan from Pixabay  

© 2019 CFA Institute. All rights reserved. You may copy and distribute this content, without modification and for non-commercial purposes, provided you attribute the content to CFA Institute and retain this copyright notice.  This case was written as a basis for discussion and is not prescriptive of how a business situation or professional conduct matter should or should not be handled or addressed. Certain characters mentioned are fictional to facilitate discussion, and any resemblance to actual persons is coincidental.