With the private wealth industry integrating more services under one financial umbrella, the opportunity to profit increases dramatically — but so does the potential for conflicts of interest.

The industry seeks economies of scale and to do more business with more clients by offering a wider range of products, greater access to investment opportunities and perhaps even more talented personnel. Are the inherent conflicts of interest a necessary tradeoff for the benefits wealth owners may receive? How do conflicts of interest affect the working relationship between advisors and their clients? And what can be done to mitigate misunderstandings?

To find some workable answers to these increasingly pressing questions, prominent figures in the private wealth industry were invited by the Family Office Exchange (FOX), a for-profit network of ultra-affluent families, family officers and their advisors, to participate in “FOX Thought Leader Roundtables.” Twenty-five of them met in Chicago on Oct. 20, 2003; eighteen took part in a second session in New York on April 29, 2004. Both events were moderated by First Tuesday Zurich, a Europe-based business think tank and dialogue facilitator. Participants were selected by FOX and its roundtable partner and sponsor, U.S. Trust, for their perceived leadership, contributions to the industry and success in their areas of expertise.

From these two meetings came a working definition of “conflicts of interest,” the identification of four environments in which such conflicts can arise, recommendations on how clients might protect themselves and a list of suggestions for how the industry might police itself.

DEFINING TERMS

“People can become paralyzed by worries about conflicts,” warned roundtable participant Michael Horvitz, of counsel at Jones Day in Cleveland. “Instead of accepting and managing them, they go on a quest for the conflict-free advisor — and they will never find him. Clients have to learn how to manage conflicts, because they will always exist.”

What are these conflicts of interest that have a permanent place on the financial landscape? The participants settled on a description offered in “The Geneva Report on the World Economy 5,”1 published by the International Centre for Monetary and Banking Studies (ICMB) and the Centre for Economic Policy Research (CEPR) in London. The report, released Feb. 4, says, a “conflict of interest is present when a financial service provider has multiple interests that create an incentive to act in such a way as to misuse or conceal information.”

The challenge is to recognize where conflicts of interest reside. As the Geneva Report observes, “It is easier for the market to identify a potential conflict of interest than it is to observe if it is being exploited, because the ability to exploit conflicts depends on the hard-to-monitor internal controls and compensation mechanisms within financial service firms.”

SETTING THE STAGE

So, where do these conflicts flourish? The roundtable participants identified four key environments:

  • Wherever there is a lack of alignment of interests between advisors and clients. Many successful firms have a number of objectives, creating competing interests among professionals in various departments. Many successful financial firms are committed to a number of mandates, which creates competing interests among professionals within a firm's various departments, and a need for one department to protect its clients from inappropriate treatment by another department. The bond department, for example, might dump its least desirable bonds — which an institutional client would readily recognize as a poor investment — on an unsuspecting private investor. An advisor who manages the wealth of seniors also may need to represent the interests of that generation's beneficiaries.

  • Wherever there is a lack of effective disclosure of information. For example, are advisors withholding information needed by an owner to make an informed decision? Clients may be paying for advisory services through costly brokerage commissions while thinking that such advice is complimentary. Advisors also may present biased or incomplete research on an investment to persuade a client to buy an unsuitable product.

  • Wherever advisors give preferential treatment to favored clients while limiting the alternatives made available to others. For example, if some clients were given unfair access to public offerings (now illegal) or if preferences are given in pricing of products and services, applying discounts, recommending an advisor's firm in exchange for referrals or to other providers based on business relationships or affiliations that may not be appropriate for the client.

  • Wherever an advisor receives undisclosed financial incentives to offer specific advice or products to a client. An advisor may receive an undisclosed commission on sales or a rebate — sometimes disguised as a consulting fee — to steer clients toward that product, or an advisor may create an investment package that may include other product components priced dramatically higher than the market rates.

SAVVY CLIENTS

As in public life, sunshine is the best disinfectant in the private wealth industry. Clients must question advisors' rationales in making recommendations. Though the number and type of conflicts may seem daunting to the client — and perhaps disconcerting for the advisor to reveal — it is important to understand that proactive measures can be taken to reduce the effect of (or neutralize) potential conflicts.

As roundtable participant Marianne Young, president of Market Street Trust Company in Corning, N.Y., said: “First, there are so many conflicts of interest in the investment world. Second, they are hard to uncover. There are many things that people won't point out to you, and you won't know about them unless you ask.”

George Feiger, a senior executive at Zions Bancorporation Private Wealth Management Group in Salt Lake City, added: “A client has to [be able to] say, ‘I'm not sure you're acting in my best interest.’”

Of course, it's usually unnecessary to put it quite that way. Instead, ask securities brokers such questions as, for example: “How do you ensure the best execution for client transactions, in terms of price and timing?” “What is the turnaround time to process and clear a transaction, and what return will I receive on my cash in the interim?” “On the fees and commissions your company is paid, what percent do you receive — and what percent goes to your employer?” Or, speaking in more general terms: “What are the limitations of the advice you are able to give me?”

According to roundtable participant Douglas Freeman, national managing partner at the Institute for Family Foundations in Irvine, Calif.: “The way advisors get paid may affect the way they do business. There is nothing unethical about commissions, but if I as a customer know how you get paid (or don't), then I will be an informed decision maker.”

Within the investment consulting field, clients can ask advisors questions such as: “Do you accept any type of compensation from sources other than client fees?” “What percentage of your new business do you receive from investment managers that you recommend to clients, and what is your manager turnover rate?” “How many managers are you actively screening, and how many managers are your current clients using?” “What percentage of your clients' money is held with these managers?”

Corporate trustees might be asked: “Do you have a policy to voluntarily step down when beneficiaries are unhappy with your performance?” “Without disclosing confidential information, what types of fiduciary issues led to lawsuits or settlements against your firm during the past three years?” And, “How do you react to beneficiaries who are unhappy with your investment performance — or with other decisions you make, such as distributions?”

Questioning advisors will not eliminate all conflicts of interest; there are too many interdependencies and complexities in financial services to make that world conflict-free. Also, the advantages of an integrated service approach often outweigh the potential conflicts of interest. As Loraine Tsavaris, managing director of the Family Wealth Group at U.S. Trust in New York noted: “It would be very expensive to have everyone completely independent of each other, because clients would miss some economies of scale that a full-service firm can offer.”

But if clients receive enough disclosure, they can manage conflicts of interest.

And not all advisors are resistant to transparency. Horvitz of Jones Day said: “An informed client is always better for the advisor. In a relationship, the best results come from a strong understanding between the client and advisor.” Added Tsavaris: “If a conflict is acknowledged, discussed and made transparent, it is no longer a conflict. It's just information, and with the right amount of information, conflicts can be managed to the client's advantage.”

INDUSTRY OVERSIGHT

What might a future of actively managed conflicts of interest look like? Participants' suggestions ranged from developing voluntary disclosures to independent auditing of advisors; from establishing a rating service for conflict disclosures to creating disclosure insurance; and from certifying investors by their level of sophistication and pricing services based on a client's expertise to encouraging financial firms to restructure their business models so that their interests would be guaranteed to be aligned with those of the client.

But managing conflicts to the client's advantage will require a careful balancing of opposing forces. While ultra-affluent individuals require access to sophisticated financial products to sustain the buying power of their assets for future generations, they also want to work with advisors who agree to serve as their financial advocates, refusing to push inappropriate products into their portfolios.

Creating a business platform that allows ethical advisors to do what is best for their clients — rather than for the institution — is a fundamental challenge for today's financial services industry.

This goal is idealistic, but achievable, and industry insiders who think otherwise should remember the lessons of the open-architecture trend. When I talked about open architecture in the early 1990s, many financial institutions discarded the idea as unworkable. But clients saw that they could have a choice in selecting investment products, and open architecture gained momentum throughout the past decade. Eventually, even the most reluctant firms were forced to alter their philosophy and, where necessary, accept reduced profit margins — in order to retain clients.

The same dynamic likely will characterize the private wealth industry in the years ahead, spurred in part by the conflict-of-interest issues being publicized in the media. A few innovative firms already have built partnerships with their clients based on transparency of information and client advocacy, and prospective clients have moved instinctively toward these providers. The response has been overwhelmingly favorable, suggesting that clients and advisors are headed for a future of greater transparency — a future that will benefit investors and provide a new model of conduct for the private wealth industry.

Endnote

  1. 1. Andrew Crockett, Trevor Harris, Frederic S. Mishkin and Eugene White, “Conflicts of Interests in the Financial Services Industry: What Should We Do About Them?” Geneva Report on the World Economy 5.

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