What Is a Conflict of Interest? (2024)

What Is a Conflict of Interest?

A conflict of interest occurs when an entity or individual becomes unreliable because of a clash between personal interests and professional duties or responsibilities. When such a situation arises, the party with the conflict of interest is usually asked to remove themselves or can be legally required to recuse themselves.

Understanding Conflict of Interest

A conflict of interest in business normally refers to a situation in which an individual's personal interests conflict with the professional interests owed to their employer or the company in which they are invested. A conflict of interest arises when a person chooses personal gain over the duties to an organization in which they are a stakeholder or exploits their position for personal gain in some way.

All corporate board members have fiduciary duties and a duty of loyalty to the corporations they oversee. If one of the directors chooses to take action that benefits them at the detriment of the firm, they are harming the company with a conflict of interest.

One example might be the board member of a property insurance company who votes on the induction of lower premiums for companies with fleet vehicles—when they, in fact, own a truck company. Even if the institution of lower premiums isn't a bad business move for the insurer, it could still be considered a conflict of interest because the board member has a special interest in the outcome.

In legal circles, representation by a lawyer or party with a vested interest in the outcome of the trial would be considered a conflict of interest, and the representation would not be allowed. Additionally, judges who have a relationship with one of the parties involved in a case or lawsuit will recuse themselves from presiding over the case.

A conflict of interest may lead to legal ramifications as well as job loss. However, if there is a perceived conflict of interest and the person has not yet acted maliciously, it's possible to remove that person from the situation or decision in which a possible conflict of interest can arise. Using the prior example of a board member who owns a truck company, they could simply remove themselves from all decisions that could positively or negatively affect their personal business.

Types of Conflict of Interest

The following list of types of conflicts of interest is not meant to be exhaustive; here are some different types you may come across:

Financial Conflicts of Interest

Financial conflicts of interest occur when an individual or organization stands to benefit financially from decisions or actions taken in their professional capacity. This type of conflict can arise when a financial advisor receives kickbacks from institutions for recommending or selling certain financial products.

Relational Conflicts of Interest

Relational conflicts of interest arise when personal relationships influence professional decisions. These can include familial ties, friendships, or romantic relationships. For instance, a manager might favor a friend or relative for a promotion, or a board member might advocate for a contract with a company owned by a family member.

Professional Conflicts of Interest

Professional conflicts of interest occur when competing professional duties or allegiances interfere with impartiality. For example, a lawyer representing two clients with opposing interests faces a professional conflict. Similarly, a consultant working for competing firms might struggle to maintain objectivity and confidentiality when trying to serve both clients at the same time.

Ideological Conflicts of Interest

Ideological conflicts of interest arise when personal beliefs or values clash with professional responsibilities. For instance, a researcher with strong environmental views might struggle to remain objective while conducting a study funded by an oil and gas corporation.

Time-Based Conflicts of Interest

Time-based conflicts of interest occur when an individual's commitments to multiple roles or projects lead to divided attention and compromised effectiveness. For example, an employee working for two companies simultaneously might not be able to fully dedicate themselves to either role.

Organizational Conflicts of Interest

Organizational conflicts of interest occur when an entity’s interests conflict with those of its stakeholders or the public. For example, a non-profit organization that receives funding from a corporation might face pressure to align its activities with the interests of the donor, even if it conflicts with its mission.

Disclosing Conflicts of Interest

Sometimes, instead of having to recuse yourself from a situation, you can simply disclose the conflict of interest. Best practices for disclosing conflicts of interest involve identifying potential conflicts early and communicating them clearly to the right people.

When disclosing conflicts of interest, you'll want to include detailed information about the nature of the conflict, the individuals or entities involved, and the potential impact on decision-making. Companies often have regular training and awareness programs that help individuals recognize and disclose conflicts of interest effectively.

Regulations surrounding the disclosure of conflicts of interest vary across industries and jurisdictions but generally aim to promote transparency and accountability. For instance, in the financial services industry, regulations often require advisors to disclose any financial incentives that may influence their recommendations to clients.

Organizations can establish oversight committees or appoint compliance officers to review disclosures and ensure adherence to policies. This means that a department, perhaps within the risk department of an organization, reviews the disclosures to determine whether or not more severe action should be taken regarding the conflict.

Positive Aspects of Conflicts of Interest

In general, conflicts of interest are bad. However, there are reasons they arise, and these reasons may actually give a company good reason to have the conflict arise. It may simply be a case where the conflict simply needs to be disclosed or monitored, and the company could still be put in the best situation.

In some cases, individuals with conflicts of interest may bring valuable expertise and knowledge to a situation. For example, a board member with financial ties to a relevant industry might offer insights that enhance decision-making processes. If this expert is heavily tied to the community or industry, they are bound to have conflicts that come along with their expertise.

Conflicts of interest often arise from existing relationships and networks. Leveraging these connections can lead to beneficial collaborations and partnerships. For instance, a business executive with personal relationships in the industry might facilitate strategic alliances or joint ventures that enhance organizational growth. For this reason, a company may pursue someone who intentionally would have conflicts of interest because of their large network or relationships.

Last, financial conflicts of interest, when managed correctly, can actually stimulate innovation and investment. For example, a researcher with financial interests in a startup may be more motivated to push the boundaries of innovation because they have more of a personal stake in the success of the company. In this case, financial ties can create a positive incentive (that also comes with some risk).

Conflicts of Interest and the SEC

The SEC has extensive rules regulating conflicts of interest. For example, on November 27, 2023, the SEC adopted Rule 192 to implement Section 27B of the Securities Act of 1933. This rule prohibits "securitization participants," which include underwriters, placement agents, initial purchasers, and sponsors of asset-backed securities from engaging in transactions that could create material conflicts of interest with investors for a specified period.

The rule defines "securitization participants" broadly to include affiliates or subsidiaries acting in coordination with them. Prohibited transactions include short sales, purchasing credit default swaps, and other actions that could financially benefit the participant at the expense of the ABS investor. The rule also prohibits transactions designed to evade its prohibition, even if they technically comply with the exceptions.

Examples of Conflicts of Interest

Self-dealing is the most common type of conflict of interest in the business world. It occurs when a management-level professional accepts a transaction from another organization that benefits the manager and harms the company or the company's clients.

Gift issuance is also a very common conflict of interest. It happens when a corporate manager or officer accepts a gift from a client or a similar type of person. Companies normally circumvent this issue by prohibiting gifts from customers to individual employees.

Troublesome situations may also arise when, in the course of professional duties, an individual collects confidential information. Any information of this type used for personal gain by an employee is a huge conflict of interest, at least in the United States. The financial industry constantly grapples with this type of conflict of interest in the form of insider trading.

Finally, the hiring of, or showing favorable workplace treatment to, a relative or spouse—known as nepotism—can result in a potential conflict of interest.

Real-World Example of Conflict of Interest

In the financial industry, an agency problem refers to a type of conflict of interest where agents don't fully represent the best interests of their principals. The Enron scandal is an extreme example of an agency problem that led to the collapse of what was at the time one of the largest companies in the United States.

In 2001, Enron Corporation declared bankruptcy after it was revealed that the top leaders in the company had used mark-to-market accounting and special purpose vehicles (SPVs) to hide financial losses. This made the company appear more profitable than it really was.

While Enron's executives had a legal responsibility to protect the interests of its shareholders, some executives instead engaged in illegal activities to camouflage the company's massive losses and debts. Several executives were indicted for their actions and eventually sent to prison.

The Bottom Line

A conflict of interest arises when personal interests or relationships may affect professional duties, causing potential bias in decision-making. To preserve transparency, trust, and ethical standards, companies will want to make sure to identify, disclose, and manage these conflicts appropriately.