"The dirt on coming clean"

We live in a world full of conflicts of interest.

Whether in our personal or professional lives, there are times when our interests don't align with the interests of other important people we deal with.

In any profession, there are conflicts of interest. I haven't come across a business model in professional services, whether in the law, financial advice, accounting, or even medicine, that doesn't have some sort of inbuilt conflict or set of conflicts. And I've seen a lot of attempts to minimise them - whether fee-for-service, set fee, or otherwise. If you charge hourly rates, there is an incentive to spend longer than you might otherwise have. If you charged set fees, then you have an incentive to spend less time than might be ideal. I've seen financial advisory firms that go as far as not even receiving commission for insurance products, that have been influenced by less apparent conflicts of interest.

I'm not saying that such conflicts always adversely impact the quality of services provided. 

What is really important to stress is that conflicts of interest are with us and always will be. They can't be avoided. To provided good quality professional services, conflicts of interest have to be managed.

A popular way of managing conflicts, especially in the financial services and products space, is disclosure. 

The dirt on coming clean: perverse effects of disclosing conflicts of interest is the name of a provocative 2005 article by Daylian M. Cain, George Loewenstein, and Don A. Moore. 

In this paper, the authors suggest that "Although disclosure is often proposed as a potential solution to [the problems of conflicts of interest]", "it can have perverse effects". 

Specifically:

  • From the perspective of people receiving advice - "people generally do not discount advice from biased advisers as much as they should" (even when they are aware of the bias)
  • From the perspective of people providing advice - "disclosure can increase the bias in advice because it leads advisers to feel morally licensed and strategically encouraged to exaggerate their advice even further."

The article does a compelling job of enumerating psychological factors that support these explanations. The authors go as far as suggesting that "These factors may even cause disclosure to backfire, harming rather than helping the recipients of advice". (I emphasise the word "may" because, again, conflicts of interest don't always result in sub-optimal advice being given. It really depends on the circumstances and the parties involved.) 

There's certainly a strong interest in firms in an industry to support disclosure as the primary method for managing certain conflicts of interest. Even when disclosure is mandated, it generally disrupts the status quo less than almost any other method for managing conflicts. 

However, over time, I suspect that unless industries self-regulate especially effectively, we will see more regulation that goes beyond requiring simple disclosure, and instead prescribes actual ways of managing conflicts.

As an example, we've seen the Future of Financial Advice (FOFA) in Australia reforms reflect a shift away from accepting disclosure to mandating how to manage certain conflicts of interest. For example, the ban on conflicted remuneration on advice relating to many financial products.

I personally haven't yet formed any strong opinions about whether this is the "right" way to go or not. It depends on the circumstances and I haven't thought about this deeply enough in enough contexts to have any general rules that might be appropriate. All I can say is that I think that in some cases, it's almost certainly correct that disclosing conflicts is not going to lead to client welfare, and in fact, might have the opposite effect. And I certainly think that regulation over time will be less accepting of disclosure being the solution where the conflicts actively need to be managed.

Call it the cobra effect, I guess.

Sonnie Bailey

Sonnie is the founder and principal of Fairhaven Wealth.

Before founding Fairhaven Wealth, Sonnie worked in the legal and financial services industries for over a decade.

Sonnie first became involved with financial advice as a specialist financial services lawyer. For many years, he was an “adviser of advisers”, reviewing thousands of advice files prepared by hundreds of financial advisers, and providing feedback in relation to the quality and appropriateness of advice; industry best practice; risk management; and regulatory compliance. He has published work in industry publications and spoken at various financial advice conferences.

Sonnie has also worked with banks, investment management firms, insurers, and derivatives providers.

Sonnie has worked as a private client lawyer, focusing on succession, estate planning and trusts. He ran his own legal firm in Australia before relocating to New Zealand. He has also acted in independent trustee and company director positions.

Sonnie is passionate about helping people achieve their goals and manage the risks to which they are exposed.

He has written extensively on his blog, New Zealand Wealth and Risk, which can be found at www.wealthandrisk.nz.

Sonnie is married to his wonderful wife Chrissy, and has two young children, Ben and Anna.