The mini-tender is a conflict of interest you might face when investing, but it’s perfectly legal.

I’ve pointed out many times that a conflict of interest is one of the biggest risks you’ll come across when investing because they’re incredibly common. But there’s one that’s particularly common and totally legal.

Early in my investment career, I used to run into stock-market enthusiasts who you might think of as “recreational investors”. They participated in the stock market the way horse-race enthusiasts participate in horse racing: that is, pick a horse on a hunch, bet on it, and hope things work out in your favour.

Back then, some recreational investors used a strategy they called “putting in a stink bid”. When a stock they liked was in a sharp falling trend, they would enter a standing or GTC (Good Till Cancelled) bid for the stock at a price substantially below the stock’s lowest recent price.

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With a GTC order, your order only gets “a fill”—that is, you only get to buy the stock—if the stock gets offered in the market at or below your “stink bid” price.

The problem is that the stink-bid strategy is just another way of betting on a hunch. If your price is too low, your bid will never get filled. If the stock does get down to or below your price, you are still buying on a hunch. Nobody can predict when or if a falling stock will quit falling and begin to rise. The stock just might keep falling. After all, there’s a large random element in short-term stock-price changes.

Years later, this “stink-bid” strategy got incorporated into what’s known as a “mini-tender”.

Mini-tenders typically bid for shares at prices below the market price, and the offers are highly conditional.

Generally, these proposals aim to buy less than 5% of a company’s outstanding shares. That way, they avoid certain regulatory requirements.

The U.S. Securities and Exchange Commission (SEC) has issued comments about mini-tender offers. The SEC states: “Some bidders make mini-tender offers at below-market prices, hoping that they will catch investors off guard if the investors do not compare the offer price to the current market price.”

A mini-tender has two advantages over a stink bid. First, the bidder offers a price that’s below the stock’s market price, in hopes that some potential sellers won’t notice that they can make more money by selling in the market; second, if the stock starts to fall, the bidder can cancel the offer.

If shareholders tender their stock, the mini-tender operator can sell and make a near-instant profit. If the stock falls below the bid price, the bid gets cancelled. For the mini-tender operator, the odds are hard to beat: heads you win, tails you break even.

We’ve often pointed out that conflicts of interest are the biggest risk you face in an investing career, simply because they are so common. The typical mini-tender is the most glaring example of a conflict of interest that you’re likely to come across, yet it’s perfectly legal.

Other conflicts of interest when investing

Of course, in every industry, some salespeople routinely settle conflicts-of-interest in their clients’ favour—that is, they buy or sell what’s best for the client. This means they make less money in their early years than they could if they focused on month-to-month earnings. Instead they hope to profit in the long run by building a reputation, a growing clientele, and a high degree of customer loyalty.

However, the investment industry deals in intangibles. Successful investors have to wade through a lot of subtleties and conflicting ideas to spot good investments. Not all brokers are able to make those fine distinctions. Brokers face another series of choices when they decide which investments are best for a particular client. What’s more, sales managers may pressure salespeople to sell products that are most profitable for the firm. (These choices may also be highly profitable for the salesperson, but less desirable for the client.)

Even the best-intentioned sales people may give in to this pressure from time to time. That’s especially so for newcomers. To keep their jobs, junior salespeople need to reach minimum revenue levels set by the firm. Senior investment salespeople may also succumb to the selling pressure if they are in a sales slump, due perhaps to personal issues. That’s because the proportion of revenue that goes to the broker rises and falls with the broker’s sales. The more revenue that brokers bring in, the higher the proportion they get to keep.

To invest successfully, avoid conflicts of interest and follow our three-part philosophy

First, invest mainly in well-established companies. When the market goes into a lengthy downturn, these stocks generally keep paying their dividends, and they are among the first to recover when conditions improve.

Second, avoid or downplay stocks in the broker/media limelight. That limelight tends to raise investor expectations to excessive levels.

Third, spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities). This helps you avoid excess exposure to any one segment of the market that is headed for trouble.

What else would you like to know about conflicts of interest when investing?