Conflicts of Interest: Some Things to Consider
By Troy A. Paredes*
Let’s consider conflicts of interest. Concerns about conflicts of interest come up all the time in financial markets. The worry is that investors will be harmed if those who owe investors a duty or obligation are conflicted and end up looking out for themselves instead. Given the SEC’s investor protection mandate, it should come as no surprise that a lot of regulation is aimed at conflicts.
“Often, conflicts of interest are met with calls to prohibit the transaction, structure, relationship, or arrangement creating the conflict.”
In addressing conflicts of interest, balance can be key. What do I mean? There sometimes is an undue reaction to the potential harm that conflicts pose. Here, two observations in particular are noteworthy.
First, just because a party is conflicted, we should not jump to the conclusion that the party will bend to the conflict and put its self-interest ahead of the responsibility it owes investors. Actual harm does not materialize from every conflict. Broker-dealers and investment advisers, for example, routinely do the right thing, even when they may have an incentive not to.
Second, as counterintuitive as it may seem at first blush, investors tolerate certain conflicts. It’s safe to assume that, in the abstract, an investor will prefer to transact or do other business with a financial services firm that is not tempted to veer from faithfully serving the investor’s interests. But the real world is not an abstraction. In the real world, investors face choices that require them to make tradeoffs. An investor’s best option, when compared to all other options, may be to engage with a conflicted party, such as when the conflicted party provides a higher-quality service or better pricing and the conflict is managed effectively.
This is where the undue reaction I mentioned comes up. Often, conflicts of interest are met with calls to prohibit the transaction, structure, relationship, or arrangement creating the conflict. The logic is self-evident. By rooting out and eliminating the source of the conflict, the conflict comes to an end and can’t pose any harm.
However, the earlier two observations suggest why a ban is not always the best answer. By their nature, bans are categorical. They flat-out prohibit whatever they target. As a result, whatever their benefits may be, prohibitions also can be costly for investors. Prohibitions limit investor choice – the ability of investors to decide for themselves what is in their best interests – by taking away certain options. This is not to say that conflicts should be overlooked, let alone encouraged, or that a prohibition is never warranted. Rather, it is to recognize that investors can be better off dealing with a conflicted party when the next best alternative is inferior.
As compared to prohibiting conflicts of interest, it can be better to take a more balanced stance by managing them. Disclosure is one way to do that. If a conflict and its potential consequences are disclosed to investors, investors are then empowered when it comes to monitoring and holding the conflicted party accountable. Investors can be on guard for behavior that looks suspicious and can evaluate the conflicted party’s performance with the conflict in mind. For investors who agree to do business with a conflicted party, they can quickly change their mind if the conflict ends up causing real harm. Moreover, to avoid having to disclose the conflict in the first place, a conflicted party may appeal to investors by proactively rooting out the conflict.
All of this is to say that disclosure can strike the right balance in many cases. Disclosure facilitates the kind of market discipline that can keep a conflicted party on the right track because the conflicted party risks losing business if it acts inappropriately. And as compared to a prohibition, disclosure preserves investor choice.
To get the most out of disclosure, the information investors receive needs to be understandable. Disclosure is most effective when the information is straightforward and the material points are not lost in a thicket of boilerplate and legalese. It also is important not to overload investors with so much information that they can’t figure out what really matters and end up ignoring what’s provided to them.
In case there is any doubt about the power of disclosure, it’s worth keeping in mind Louis Brandeis’s famous words: “Sunlight is said to be the best of disinfectants; electric light the most efficient policeman.”
* Mr. Paredes was an SEC Commissioner from 2008-2013. Currently, he is Senior Strategy & Policy Advisor at PricewaterhouseCoopers (PWC). The views expressed here are his own and not necessarily those of PwC or any of PwC’s clients.