Proposed Professional Standards of Conduct for the Delivery of Personalized Investment Advice

Who Should Define Fiduciary Standards?  

Who will define the fiduciary duties applicable to the delivery of personalized investment advice?

One would hope that it is not (solely) the SEC's Division of Trading and Markets, given the regulatory capture which is apparent from its March 2013 Request for Information. (Either that, or a complete misunderstanding of the purpose of the fiduciary standard and how it functions occurred when the Division of Trading and Markets wrote the Request for Information.)

I offer this alternative suggestion for the process of "defining" and "applying" fiduciary standards to the delivery of personalized investment advice. Have the SEC, DOL/EBSA (for any adviser subject at times to ERISA's requirements), OCC (for bank/trust company fiduciaries) and NASAA (state securities administrators) appoint a group of knowledgeable financial advisers and other legal experts, aided by a staff representative from each agency, and all of whom are committed to a true fiduciary standard, to propose professional standards of conduct under the fiduciary standard, for both investment advisers and brokers. Why? Because a true profession is created by professionals, who actually practice in the trenches, and who are fully aware of how professional standards of conduct may be applied in the "real world."

We have a new SEC Chair, Mary Jo White. And soon we will have two new Commissioners. Will Mary Jo White lead a majority of the five-member U.S. Securities and Exchange Commission in support of the application of a bona fide, true fiduciary standard to the delivery of personalized investment advice?

I would further ask, will Mary Jo White be known as just another one of Wall Street firm's proxies, in leading the SEC? Or will her name be revered as much as that of Joseph P. Kennedy? In 431 days at the Securities and Exchange Commission, Joseph P. Kennedy reformed America’s capital markets. Even though Kennedy had profited handsomely, during the tumultuous 1920s and the early 1930s, from financial manipulation, from 1934 to 1935 Commissioner Kennedy led the effort to adopt rules, nearly all of which were opposed by the securities industry at the time. These rules restored individual Americans’ trust in our capital markets, leaving an enduring legacy for Joseph P. Kennedy far beyond that reflected in his accomplishments as a financier, Ambassador to Great Britain, or father to a future U.S. President.

In other words, will Mary Jo White first put in the place the proper people and the proper process for consideration of all of the issues relating to the application of the the fiduciary standard to the delivery of personalized investment advice? Or will she continue down the current path, in which a true understanding of the fiduciary standard of conduct (and its importance and proper application) either does not exist, or is ignored? Time will tell.

Getting Down to the Nuts and Bolts: The Key Issue of Avoidance/Proper Management of Conflicts of Interest.

I acknowledge that there exists disagreements, in the securities / investment / financial communities, and within the legal communities, regarding the scope of the fiduciary duties of those providing personalized investment adviser. For example, significant disputes exist regarding the fiduciary duty of loyalty. For example, in the presence of a conflict of interest, applying the Advisers Act as well as state common law, what is required of an investment adviser? Perhaps anyone expressing their view of a fiduciary standard for investment advisers should be asked these questions:

A. Must the conflict of interest be avoided? Are there only certain conflicts of interest that must be avoided?

B. If the conflict of interest is not avoided ...

    1) Must disclosure of the conflict of interest occur?

    2) Must disclosure be complete in every respect - including of the potential ramifications of the existence of the conflict of interest?

    3) Does the adviser possess the duty to ensure the client understands such disclosure? How is this measured - objectively or subjectively?

    4) Must informed consent of the client be secured? In this regard, can a client ever consent to harm?

    5) Must the transaction, regardless of the foregoing, remain substantively fair to the client?

As noted above, there exist disputes in the financial advisory community is the extent of fiduciary duties - i.e., what is required. The existence of divergent opinions is not surprising, for four major reasons:

• Calibration. First, fiduciary duties conform to the degree of protection required. For example, the fiduciary obligations of employees are more limited, since employers possess a great deal of control (and usually superior knowledge and bargaining ability) than their employees. In contrast, in the trustee-beneficiary relation, where the trustee possesses far greater control (and usually far greater knowledge) than the beneficiary, and there are limited avenues by the beneficiary to discharge the trustee, the fiduciary duties are far greater. In essence, fiduciary duties are modified to fit the degree of protection required.

• Lack of Decided Cases. Second, there is a dearth of law in applying the "best interests" fiduciary standard found under state common law and the Investment Advisers Act of 1940. In large part this is due to the presence of mandatory arbitration for broker-dealers (and dual registrants, by extension), which prevents the development of a large body of case law. [Yes, brokers are often fiduciaries. See my previous blog at http://scholarfp.blogspot.com/2013/04/shhh-brokers-are-already-fiduciaries.html.]

• Fiduciary Duties Evolve Over Time. Third, fiduciary duties are not static; rather, they must evolve over time to meet the ever-changing business practices of advisors and fraudulent conduct successfully circumscribed. The need for evolution of the fiduciary standard of conduct has been known for well over a century.  “Fraud is kaleidoscopic, infinite.  Fraud being infinite and taking on protean form at will, were courts to cramp themselves by defining it with a hard and fast definition, their jurisdiction would be cunningly circumvented at once by new schemes beyond the definition.  Messieurs, the fraud-feasors, would like nothing half so well as for courts to say they would go thus far, and no further in its pursuit.” Stonemets v. Head, 248 Mo. 243, 154 SW 108 (1913) (Judge Lamb, writing for the Missouri Supreme Court).  

• Legal Debate: Can Core Fiduciary Duties Be Waived? Fourth, within the legal community there exists a minority view, called the "contractualist view of fiduciary duties," that entrustors (i.e., clients) and fiduciaries should be able to contract for the standard of protection which exists.
• This view has been soundly rebuffed by various legal scholars, who note (among many other things) that waiver and estoppel, as would exist under a contractual waiver, possess limited applicability to the fiduciary relationship. It has been noted that fiduciary duties are imposed by law, not by the parties; even if the parties specify in the documents govering the relationship that the relationship is not a fiduciary one, if the advisor-client relationship in fact exists then fiduciary duties are still applied.
• I do not subscribe to the contractualist view of fiduciary duties. There are many types of layers of consumer protection provided under the law. For example, in all contracts between persons there is the requirement that actual fraud be avoided, and there is the implied standard of good faith in the performance of one's contractual duties. Other consumer protections exist, such as enhanced disclosures (such as those required under the '33 Act and '34 Act and regulations adopted thereunder). Required standardized language or contract forms, the prohibitions of certain disclaimers, and even required standardization of various types of products are all means of consumer protection. The fiduciary standard, however, is the highest means of consumer protection available. Hence, the fiduciary standard is not applied lightly. Rather, it is applied to relationships based upon trust and confidence (either recognized as such by the law, such as attorney-client or RIA-client, or under a facts and circumstances test), when public policy considerations dictate their application. See "Public Policy Considerations Which Underlie Fiduciary Status" - located at http://scholarfp.blogspot.com/2013/04/public-policy-considerations-which.html. 
• Regardless, these opposing views exist, and reflect the greater tension in our society between "personal responsibility" versus "caring for those who cannot care for themselves." See "The Tension Between Personal Responsibility and Paternalism - and the Issue of Fiduciary Standards" - located at http://scholarfp.blogspot.com/2013/02/the-tension-between-personal.html.  

In addition, another reason exists - one that has its roots in the economic interests which oppose the application of fiduciary standards to investment advisory activities. It is the arguments advanced by those who don't desire a true fiduciary standard to be applied, as it would restrict their current business activities (and hence profits). These anti-fiduciary advocates refuse to recognize that, at its core, the fiduciary standard of conduct operates as a restraint on conduct.

These anti-fiduciary advocates would prefer to "adopt" the fiduciary standard to their business models, rather than have their business models constrained by the fiduciary standard. If they are successful, the late Justice Benjamin Cardoza would roll over in his grave (as would many other jurists). ["Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the 'disintegrating erosion of particular exceptions' ... Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. It will not consciously be lowered by any judgment of this court."  (Justice Cardoza, writing eloquently for the majority in Meinhard v. Salmon, 249 N.Y. 458, 463-4, 164 N.E. 545 (1928), citing Wendt v. Fisher, 243 N.Y. 439, 444).

[As stated by Rachel Thompson: "Richard Posner, a judge of the modern era also known for his skillful writing, terms this the most famous of Cardozo’s moralistic opinions, suggesting the objection could be made to the language as 'just words, and florid ones at that. But they are memorable words and they set a tone. They make the difference between an arm’s length relationship and a fiduciary duty relationship vivid, unforgettable.' Indeed this language continues to attract the attention of law students and judges across the decades, primarily for its tone. It has been cited more than 1000 times, almost always when the result is that a duty will be found and the court wants to set a tone; if you see Meinhard quoted, you can expect that plaintiff is going to win." Thompson, Robert B., The Story of Meinhard v. Salmon and Fiduciary Duty's Punctilio (October 16, 2008). Vanderbilt Public Law Research Paper No. 08-44. Available at SSRN: http://ssrn.com/abstract=1285705 or http://dx.doi.org/10.2139/ssrn.1285705.]

Specifically, the lobbyists of Wall Street firms and insurance companies, and the hired law firms of many large broker-dealer firms and insurance companies, are now proactively arguing that, should fiduciary duties be applied to brokers by the SEC under Dodd-Frank, only "disclosure" of a conflict of interest is required. To that I would say ... nonsense. The fiduciary duty of loyalty is not met simply by disclosure of a conflict of interest; much more is required. I would add the standards relating to due diligence requirements of fiduciaries are also much higher than those found under a suitability standard, as well.

A Preview: What Professional Standards of Conduct Might Look Like.

So what are the fiduciary duties of financial advisors, under the Advisers Act and state common law?

It is often said that, in the United States, there are tri-parte fiduciary duties of due care, loyalty, and utmost good faith. (However, there may be other fiduciary duties, such as the fiduciary duty of obedience, if such duties cannot not found within the tri-parte fiduciary duties.) Yet, while useful as a clear and succinct statement of the law, the tri-parte general duties or principles still often fail to provide adequate guidance to investment and financial advisors and those who regulate them.

In the remaining part of this article, I offer a discussion draft for defining the fiduciary standard of conduct for investment advisers, in hopes that this draft will inform and stimulate debate.

“INVESTMENT ADVISER STANDARDS OF PROFESSIONAL CONDUCT” - OVERVIEW

The specific principles present under fiduciary law, as discerned from current statutes, regulations, decisions, and agency staff interpretations, is set forth in the form of “Standards of Professional Conduct” which follow.  A legal duty is defined as an obligation under the law “to conform to a particular standard of conduct towards another.”[1]

While these “Standards of Professional Conduct” have not been adopted by any regulatory authority, nor any industry organization, as SEC Staff recently opined “all investors deserve the same protections regardless of where they choose to obtain investment advice.”  Investment advisers who desire to be proactive might choose to incorporate some or all of these professional standards of conduct within their own Code of Ethics.

Presentation in this format is intended to assist the reader in understanding, and thereafter observing, his or her fiduciary obligations.  These standards are formulated as baseline standards; additional specific rules or obligations may be applicable.  Accordingly, these standards are not intended to provide a “safe harbor.”

The obligations set forth herein are specific to those providing investment advice, and are not intended to address the broader array of issues and situations which investment advisers may face (outside of the provision of investment advice).

The term “investment adviser” is utilized to describe broadly those providing investment advice to whom broad fiduciary duties of due care, loyalty, and utmost good faith may attach, whether arising under ERISA, the federal Investment Advisers Act of 1940, state common law, or any other means (including potential adoption of a “uniform fiduciary standard” for investment advisers and broker-dealers pursuant to SEC rule-making under Section 913 of the Dodd-Frank Act[2]).

In each section a “principle” (“Rule”) is set forth, followed by “Commentary” to assist in understanding the principle.  This is followed by further discussion through “Annotations” – recitations to specific statutes, rules, case decisions, administrative decisions, no-action letters, and other sources which may serve to further illustrate the application of these principles. All of the following remains a work-in-progress. 

SECTION 1. Terminology.
 1.1  "Client" denotes a person, persons, or entity who engages an investment adviser and for whom professional services are rendered for compensation. Where the services of the investment adviser are provided to an entity (corporation, trust, partnership, estate, etc.), the client is the entity, which entity then acts through its legally authorized representative.

1.2  “Investment adviser” refers to any person providing investment advice pursuant to an “investment advisory engagement,” and may refer to an individual, the individual’s firm (i.e., employer), or both, as the context requires. The term is not limited to the definition of “investment adviser” found in the advisers act, but is intended to be construed far more broadly for purposes of these standards of professional conduct.

1.3 "Firm" denotes an individual investment adviser’s employer (whether it is a broker-dealer firm, insurance agency or insurance broker or insurance company, registered investment adviser, bank, trust company, or other form of business or non-profit organization), and also includes situations in which the individual investment adviser (as defined herein) is an independent contractor.

1.4  “Reasonable" or "reasonably" when used in relation to conduct by an investment adviser denotes the conduct of a reasonably prudent and competent investment adviser.

SECTION 2. Professionalism.

Rule 2.1  Required Knowledge of Applicable Laws, Regulations, and Standards of Conduct.  Investment advisers must understand and comply with all applicable laws, regulations, and standards of conduct (including but not limited to these Investment Adviser Standards of Professional Conduct) of any government, government agency, regulatory organization, licensing agency, or professional association governing their professional activities.

In the event of conflict, investment advisers must comply with the more strict law, regulation, or standard of conduct, provided that in all events investment advisers shall not violate any law.  Investment advisers must not knowingly participate or assist in and must dissociate from any violation of such laws, rules, or standards of conduct.

Commentary. 

Investment advisers should understand the entire scope and nature of their broad fiduciary duties of due care, loyalty, and utmost good faith.  In addition, investment advisers should consult, where and as applicable, the laws and regulations falling within the purview of the U.S. Securities and Exchange Commission (SEC), the U.S. Department of Labor (DOL/EBSA) the laws and regulations promulgated by various state or territorial securities administrators, the regulations promulgated by FINRA and other self-regulatory organizations and exchanges, any other governmental agency or organization which may regulate the investment adviser and her or his actions, and the ethical standards of other professional organizations to which the investment adviser may belong.  Additional laws may apply to the activities of investment advisers, such as Regulation S-P (privacy requirements) and anti-money laundering requirements.

Standard of conduct are collectively to the rules the laws, government regulations, professional association ethical rules and internal principles of a firm that guide the structure, systems, procedures, and day-to-day decisions of the Investment adviser. They also include the rights and entitlements of individuals established by contract or the assumption of a certain status under the law.  Hence, these Investment Adviser Rules of Professional Conduct are but one part of a larger puzzle each Investment adviser must apply to his or her conduct.

The provision of investment advice is a profession and should be regulated as such.  The purpose of these Investment Adviser Rules of Professional Conduct is to promote the practice by investment advisers as a profession, and an essential aspect of professionalism is the application of positive duties to those who seek to practice in the profession.  As stated by John G. Bruhn , Gary Zajac , Ali A. Al-Kazemi , Loren D. Prescott Jr., in their paper “Moral positions and academic conduct: Parameters of tolerance for ethics failure” (Journal of Higher Education, Vol. 73, 2002):

A profession is defined as an occupation that regulates itself through systematic, required training and collegial discipline; that has a base in technical, specialized knowledge; and that has a service rather than profit orientation, enshrined in a code of ethics (Reader, 1966). Wilson (1942) has suggested six criteria as the framework for a profession: (1) prolonged and specialized training, (2) rigorous standards of licensure, (3) competency tests cannot be simply deduced, (4) absence of contractual terms of work (5) limitation upon the self-interest of the practitioner and an insulation from extraneous matters, (6) positive obligations to the profession and its clientele.

Annotations. 

1.     The Investment Adviser as a Professional, Generally.  Generally, the investment adviser is a professional, and as such accepts restraint on his, her or its conduct as a result of acceding to fiduciary status.  As stated early on by Adam Smith, the founder of modern capitalism: “Our continual observations upon the conduct of others insensibly lead us to form to ourselves certain general rules concerning what is fit and proper either to be done or to be avoided.”[3]  The domain of the investment counselor has previously been described as the “investment advisory profession[4] … Clients trust in investment advisers, if not for the protection of life and liberty, at least for the safekeeping and accumulation of property. Bad investment advice may be a cover for stock-market manipulations designed to bilk the client for the benefit of the adviser; worse, it may lead to ruinous losses for the client. To protect investors, the [SEC] insists, it may require that investment advisers, like lawyers, evince the qualities of truth-speaking, honor, discretion, and fiduciary responsibility[5]  Early on, Douglas T. Johnston, Vice President of the Investment Counsel Association of America, stated in part: ‘The definition of 'investment adviser' … include[s] those firms which operate on a professional basis and which have come to be recognized as investment counsel.”[6]  [Emphasis added.]  Moreover, the U.S. Securities and Commission’s report which led to the adoption of the Advisers Act “stressed the need to improve the professionalism of the industry, both by eliminating tipsters and other scam artists and by emphasizing the importance of unbiased advice, which spokespersons for investment counsel saw as distinguishing their profession from investment bankers and brokers.”[7]  [Emphasis added.] 

2.     Knowledge of Laws and Regulations: Requirements Imposed Upon SEC-Registered Investment Advisers by the Advisers Act.  Various different laws may apply to the conduct of investment advisers.  Following is an overview of various requirements; however, this listing is not designed to be all-inclusive.   Robert Plaze, Asst. Director of the SEC’s Division of Investment Management, notes that “[t]he law governing SEC-registered advisers imposes five types of requirements on an adviser: (i) a fiduciary duty to clients; (ii) substantive prohibitions and requirements; (iii) contractual requirements; (iv) recordkeeping requirements; and (v) administrative oversight by the SEC, primarily by inspection.”  See Plaze, Robert E., “The Regulation of Investment Advisers by The Securities and Exchange Commission” (2006), at p. 13.  Some of the specific requirements imposed upon registered investment advisers include:

a.      Maintain Books and Records.  Advisers Act Rule 204-2 requires an adviser to maintain business accounting records as well as various specified records that relate to its advisory business. For example, advisers must maintain, among other things, the following:

(1)    General and auxiliary ledgers reflecting asset, liability, reserve, capital, income and expense accounts;

(2)    A memorandum of any order given and instructions received by the adviser from clients for the purchase, sale, delivery or receipt of securities (including terms and conditions of any order, who recommended and placed the order, the account and date of entry and who executed the order);

(3)    Trial balances, financial statements, any internal audit papers relating to adviser’s business;

(4)    Original or copies of certain communications sent to or received by the adviser (including responses to requests for detailed investment advice, placement or execution of securities orders, receipt or delivery of securities or funds);

(5)    A list of and documents relating to the adviser’s discretionary client accounts (including powers of attorney or grants of authority);

(6)    Copies of publications and recommendations the adviser distributed to 10 or more persons and a record of the factual basis and reasons for the recommendation;

(7)    A record of certain securities transactions in which the adviser or advisory representatives have a direct or indirect beneficial ownership interest.

(8)    Additional records if an investment adviser has custody of client assets;

(9)    Additional records if an investment adviser exercises proxy voting authority with respect to client securities; and

(10) Additional records if an investment adviser uses a different method for computing “assets under management” in Form ADV Part 2A than that found in Part 1.

b.     Adopt Safeguards Relating to Custody.  Advisers Act Rule 206(4)-2 regulates the custody practices of investment advisers registered or required to be registered under the Advisers Act. Rule 206(4)-2 requires advisers that have custody of client funds or securities to implement controls designed to protect those client assets from being lost, misused, misappropriated or subject to the advisers’ financial reverses, such as insolvency.  Generally, the adviser must maintain client funds and securities with “qualified custodians,” such as a bank or a broker-dealer, and make due inquiry to ensure that the qualified custodian sends account statements directly to the clients.  The adviser must promptly notify its clients as to where and how the funds or securities will be maintained, when the account is opened and following any changes to this information.  Generally, all advisers with custody of client assets must undergo an annual surprise examination by an independent public accountant to verify client assets.  In addition, if the adviser itself maintains, or if it has custody because a related person maintains, client assets as a qualified custodian, it must obtain, or receive from a related person, a report of the internal controls relating to the custody of those assets from an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board.

c.      Possess a Chief Compliance Officer; Fulfill Supervision Requirements; Conduct Annual Reviews. 

(1)    Advisers Act Rule 206(4)-7 requires each registered investment adviser to designate a chief compliance officer (“CCO”). The CCO should be knowledgeable about the Advisers Act and have the authority to develop and enforce appropriate compliance policies and procedures for the adviser.  See Compliance Programs of Investment Advisers and Investment Companies; Investment Advisers Act Release No. 2204 (Dec. 17, 2003) (“Release 2204”) (adopting Advisers Act Rule 206(4)-7).

(2)    Generally, an investment adviser and its associated persons may be subject to liability for failure reasonably to supervise persons subject to its supervision, with a view to preventing violations of the federal securities laws and their rules and regulations. An adviser will not be deemed to have failed reasonably to supervise if (i) the adviser had established procedures, and a system for applying such procedures, reasonably designed to prevent and detect such violations insofar as practicable, and (ii) the adviser reasonably discharged its supervisory duties and obligations, and had no reasonable cause to believe that the procedures and system were not being complied with.

(3)    The SEC requires each adviser to review the effectiveness of the investment adviser’s policies and procedures at least annually pursuant to Rule 206(4)-7 “to determine their adequacy and the effectiveness of their implementation.   The review should consider any compliance matters that arose during the previous year, any changes in the business activities of the adviser or its affiliates, and any changes in the Advisers Act or applicable regulations that might suggest a need to revise the policies or procedures.”[8]  While the SEC does not specify the activities required as part of the annual review, the process is generally believed to include a comprehensive risk assessment and a conflicts of interest assessment.[9]

d.     IA Policies and Procedures Adoption.  Advisers Act Rule 206(4)-7 requires each registered investment adviser to also adopt and implement written policies and procedures reasonably designed to prevent the adviser and its personnel from violating the Advisers Act.  The Commission has stated that an adviser’s policies and procedures, at a minimum, should address the following issues to the extent relevant to that adviser:

(1)    Portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with clients’ investment objectives, disclosures by the adviser, and applicable regulatory restrictions;

(2)    Trading practices, including procedures by which the adviser satisfies its best execution obligation, uses client brokerage to obtain research and other services (“soft dollar arrangements”), and allocates aggregated trades among clients;

(3)    Proprietary trading of the adviser and personal trading activities of supervised persons;

(4)    The accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements;

(5)    Safeguarding of client assets from conversion or inappropriate use by advisory personnel;

(6)    The accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;

(7)    Marketing advisory services, including the use of solicitors;

(8)    Processes to value client holdings and assess fees based on those valuations;

(9)    Safeguards for the privacy protection of client records and information; and

(10) Business continuity plans.

e.      Code of Ethics Adoption, Content Requirements.  Each investment adviser that is registered with the Commission or required to be registered with the Commission must also adopt a written code of ethics.[10]  At a minimum, the adviser’s code of ethics must address the following areas:

(1)    Standards of Conduct. Set forth a minimum standard of conduct for all supervised persons, which must reflect the adviser’s and its supervised persons’ fiduciary obligations;[11]

(2)    Compliance with Federal Securities Laws. Require supervised persons to comply with federal securities laws;

(3)    Personal Securities Transactions. Require each access person to report his or her securities holdings at the time that the person becomes an access person and at least once annually thereafter and to make a report at least once quarterly of all personal securities transactions in reportable securities to the adviser’s CCO or other designated person;

(4)    Pre-approval of Certain Securities Transactions. Require the CCO or other designated person(s) to pre-approve investments by the access persons in IPOs or limited offerings;

(5)    Reporting Violations. Require all supervised persons to promptly report any violations of the code to the adviser’s CCO or other designated person(s); and

(6)    Distribution and Acknowledgment. Require the adviser to provide each supervised person with a copy of the code, and any amendments, and to obtain a written acknowledgment from each supervised person of his or her receipt of a copy of the code.

f.       Filings and Disclosures under Form ADV, Parts 1 and 2A and 2B, Generally.  Generally, a registered investment adviser is required to undertake certain filings and disclosures, and to deliver Form ADV, Parts 2A and 2B to clients.  See further discussion of this requirement, infra.

g.     General Prohibition on Advisory Contract Assignments without Client Consent.  “Any advisory contract entered into by an adviser that is registered or required to be registered with the Commission must provide in substance that it may not be assigned without consent of the client.  An assignment generally includes any direct or indirect transfer of an advisory contract by an adviser or any transfer of a controlling block of an adviser’s outstanding voting securities.  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), pp.42-4 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf) (citations omitted).

h.     Duties If Voting Proxies.  The Commission adopted Advisers Act Rule 206(4)-6 to address the adviser’s fiduciary duties to its clients when the adviser has authority to vote their proxies. In adopting the rule, the Commission stated: “Under the Advisers Act, an adviser, as a fiduciary, owes each of its clients duties of care and loyalty with respect to all services undertaken on the client’s behalf, including proxy voting. The duty of care requires an adviser with proxy voting authority to monitor corporate events and to vote the proxies.”  SEC Release IA-2106.  To satisfy its duty of loyalty, the adviser must cast the proxy votes in a manner consistent with the best interests of its client and must not subordinate client interests to its own.  Additional specific requirements are set forth in Rule 206(3)-6.

2.     Knowledge of Laws and Regulations: State-Registered Investment Advisers.   While state-registered investment advisers are always subject to the broad anti-fraud requirements found in Section 206 of the (federal) Investment Advisers Act of 1940, some state securities regulators vary the specific requirements imposed on state-registered investment advisers and/or impose additional requirements, such as those (in some states) pertaining to bonding (if discretion exists, or if custody exists), net capital requirements, and additional disclosures in Form ADV Parts 2A and 2B.  In addition, investment adviser representatives are registered at the state level and generally must pass the Series 65 examination, although certain designations may be accepted by some states in lieu of meeting the exam requirement.

3.     Knowledge of Laws and Regulations: Broker-Dealer / Registered Representative Specific Duties and Obligations.  Broker-dealers possess a large number of rules prohibiting certain conduct, requiring certain determinations, or mandating certain disclosures.  In addition to rules pertaining to conflicts of interest, suitability, and others discussed in other sections of these Investment Adviser Rules of Professional Conduct, additional rules exist (this list is not intended to be comprehensive) pertaining to: books and records; financial responsibility (including “net capital” requirements); supervision of registered representatives and the maintenance of a supervisory system including supervisory control policies and procedures; designation of a chief compliance officer; supervision of outside business activities and private securities transactions; employee competency standards (including certain continuing education requirements); and disclosures of disciplinary information.  For a general summary of these requirements, see SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), at pages 72-80 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

4.     Knowledge of Laws: ERISA Fiduciaries, Generally.   The requirements of ERISA apply to investment advisers who deal with certain employee benefit plans.  ERISA is generally shorthand for the fiduciary rules that apply to private employee benefit plans and certain tax-qualified retirement/savings accounts.  In other words, ERISA can refer to either the fiduciary provisions under Title I of ERISA or the prohibited transaction rules under the Code.  Certain standards of conduct may be prescribed by ERISA which are beyond those summarized in these Investment Adviser Rules of Professional Conduct (plan document, bonding, co-fiduciary responsibility, trust requirement, indicia of ownership, prohibited transaction rules, etc.).  The Department of Labor recently proposed a rule under ERISA that would broadly define the circumstances under which a person is considered to be a “fiduciary” for ERISA purposes by reason of giving investment advice to an employee benefit plan or a plan’s participants.  Under this proposed rule, which is anticipated to be acted upon by the end of 2011, IRAs and Keoughs might be treated as employee benefit plans and subject to ERISA requirements, with certain exceptions and/or grandfathering permitted.  As a very general overview of the fiduciary duties arising under ERISA: “[A]n ERISA fiduciary must act with the care, skill, prudence, and diligence under the circumstances then prevailing that a reasonably prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of like character and with like aims.  ERISA requires, among other things, that a fiduciary must diversify a plan’s investments so as minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.  ERISA also prohibits a number of transactions, particular those involving conflicts of interest between the plan and certain parties in interest.” SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.88 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)  See sections following for a discussion of many of the specific obligations of ERISA fiduciaries, although the information contained herein is not designed to be all-inclusive with respect to ERISA’s fiduciary requirements.

5.     Knowledge of Laws: Investment Advisers Found Within Banks and Trust Companies.  Those providing investment advisory services (including but not limited to service by the bank or trust company as trustee) are subject to specific duties and obligations arising from bank regulation and/or state common law.  SEC Staff recently observed that there may be “differences” in the “standards of care” applicable to the investment advisory activities of banks.  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.89 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.).

6.     Knowledge of Laws: Regulation S-P; Privacy Requirements.  On June 22, 2000, the Securities and Exchange Commission (“SEC”) issued its Final Rule regarding the obligation of broker-dealers, investment companies and SEC-registered investment advisers to protect the financial privacy of their consumers. The rule, Regulation S-P, implements the privacy requirements of the Gramm-Leach-Bliley Act. Regulation S-P is identical in virtually all essential respects to the privacy rules adopted by the federal banking regulators and the Federal Trade Commission (“FTC”). The FTC privacy rule also applies to state-registered investment advisers.  All references to the “privacy rule” in this overview apply to both the SEC and FTC rules on privacy. The rule embodies two core principles – notice and the right to opt out. All investment advisers and broker-dealers, among others, must deliver initial and annual privacy notices that describe in general terms the firm’s information sharing and collecting practices. Firms that share nonpublic personal information about consumers with nonaffiliated third parties, unless covered by one of the rule’s exceptions, must also provide consumers with an opt out notice and a reasonable period of time for the consumer to opt out (30 days).  Specific state statutes or regulations (e.g., Massachusetts) may impose additional obligations upon investment advisers with respect to the confidentiality of client information or actions required in the event of breach.

7.     Knowledge of Laws: Patriot Act; Anti-Money Laundering.  The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (“USA PATRIOT ACT”) extended the regulations applying the anti-money laundering provisions of the Bank Secrecy Act (“BSA”) beyond banks and certain other institutions that offer bank-like services or that regularly deal in cash to financial institutions, such as registered and unregistered investment companies.  Money laundering has been defined as a criminal activity that occurs when money from illegal activity is moved through the financial system to make it appear that the funds come from legitimate sources. Money laundering also supports terrorism and terrorist organizations. Money laundering involves three stages: 1. placement – placing funds/cash into the financial system; 2. layering – distancing the illegal funds from their criminal source through complex layers of financial transactions; and 3. integration – illegal funds appear as derived from a legitimate source.  In the US anti-money laundering legislation came into existence in 1970 with the Bank Secrecy Act, strengthened in 1986 with the Money Laundering Control Act and brought center stage with the USA PATRIOT ACT after 9/11/2001.  In the current climate, not making basic anti-money laundering efforts can expose a business to significant risk to reputation regardless of whether anti-money laundering rules are technically applicable.

Rule 2.2 Truthfulness.  Investment advisers must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities.

Commentary. 

All oral and written statements made by investment advisers, including those made to clients, prospective clients, their representatives, other advisors of the client, other third parties, or the media, must be professional, accurate, balanced, and not misleading in any way.

Annotations. 

1.      Advertising Restrictions under Advisers Act Rule 206(4)-1.  “Rule 206(4)-1 generally prohibits any investment adviser that is registered or required to be registered under the Advisers Act from using any advertisement that contains any untrue statement of a material fact or is otherwise false or misleading.  As the Commission stated in adopting Advisers Act Rule 206(4)-1, ‘when considering the provisions of the rule it should be borne in mind that investment advisers are professionals and should adhere to a stricter standard of conduct than that applicable to merchants, securities are “intricate merchandise,’ and clients or prospective clients of investment advisers are frequently unskilled and unsophisticated in investment matters.’ While investment advisers are prohibited under Advisers Act Sections 206(1) and (2) from making any communications to clients that are misleading, the prohibitions in Rule 206(4)-1 apply only to ‘advertisements’ by advisers, which the Commission defines generally as written (including electronic) or broadcast communications to more than one person that offer advisory services.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.30 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

Advisers Act Rule 206(4)-1(b) defines advertisement for purposes of the rule as “[a]ny notice circular, letter or other written communication addressed to more than one person, or any notice or other announcement in any publication or by radio or television, which offers (1) any analysis, report or publication concerning securities, or which is to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (2) any graph, chart, formula or other device to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (3) any other investment advisory service with regard to securities.” A communication covered by the rule may be made to new clients or to existing clients where the purpose is to induce them to renew their advisory contract or subscription. See Spear & Staff, 42 S.E.C. 549 (1965).  Specific restrictions or rules exist as to performance advertising, the use of testimonials in advertising, representations that charts or formulas or other devices can be used to determine which securities to buy or sell without disclosing the limitations thereof, and referrals to any report or service as free unless it is actually free and without condition of obligation.  See SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), pp.30-1 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

2.     Broker Dealer Advertising Restrictions.  “Broker-dealers must ensure that their communications with the public are not misleading under the antifraud provisions of the federal securities laws.  In addition, FINRA has detailed rules that address broker-dealers’ communications with the public and specifically requires broker-dealer communications to be based on principles of fair dealing and good faith and to be fair and balanced. For example, pursuant to FINRA rules, communications with the public must include material facts and qualifications, must not exaggerate or include false or misleading statements, must not predict or project performance, imply that past performance will recur, or make exaggerated or unwarranted claims, opinions or forecasts.  FINRA rules also establish disclosure requirements for advertisements and sales literature.”  See SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), pp.70-1 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)  (Citations omitted.)

“In certain circumstances, FINRA rules require that communications with the public be approved by a registered principal of the broker-dealer before distribution to the public. Generally, a registered principal must approve each advertisement, item of sales literature and independently prepared reprint prior to the earlier of its use or filing with FINRA.  Moreover, FINRA rules require that certain broker-dealer communications with the public must be filed with FINRA for approval.  Broker-dealers are generally required to obtain FINRA pre-approval for advertisements for their first year of advertising. Additionally, FINRA must preapprove certain broker-dealer communications with the public if they relate to: (1) registered investment companies (including mutual funds, variable contracts, continuously offered closed-end funds and unit investment trusts) that include or incorporate performance rankings or performance comparisons; (2) collateralized mortgage obligations; (3) security futures; or (4) bond mutual funds that include bond mutual fund volatility ratings.  Further, if after reviewing a member’s advertising or sales literature FINRA determines that the member has departed from the standards of Rule 2210, FINRA may require the member to file all, or a portion of its, advertising or sales literature with FINRA for a period of time to be determined by FINRA.  Other communications, while not subject to FINRA preapproval, must be filed with FINRA. Specifically, within 10 business days of first use or publication, a broker-dealer generally must file the following with FINRA: (1) advertisements and sales literature concerning registered investment companies (including mutual funds, variable contracts, continuously offered closed-end funds, and unit investment trusts); (2) advertisements and sales literature concerning public direct participation programs; (3) advertisements concerning government securities; and (4) any template for written reports produced by, or advertisements and sales literature concerning, an investment analysis tool.  Furthermore, FINRA may subject a member’s written and electronic communications with the public to a spot-check procedure.”  See SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), pp.71-2 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)  (Citations omitted.)

Rule 2.3  Scrupulous Honesty, Avoidance of Deceit, Integrity.  Investment advisers must not engage in any professional conduct involving dishonesty, fraud, or deceit or commit any act that reflects adversely on their professional reputation, integrity, or competence.  In the course of representing a client an investment adviser shall not knowingly make a false statement of material fact or law to a third person.

Investment advisers should disclose material facts to a third person when disclosure is necessary in order to avoid assisting a criminal or fraudulent act by a client.

Commentary. 

As to clients, investment advisers should not defraud any client in any manner nor at any time.  Investment advisers should not mislead any client, whether by affirmative statement or by making a statement that omits material facts.  Investment advisers should not engage in any act, practice or course of conduct which operates or would operate as a fraud or deceit upon a client.  Investment advisers should not engage in any manipulative practice with respect to a client. 

As to third parties, investment advisers should not assist any client in the undertaking of a criminal or fraudulent act or practice.  Nor should investment advisers mislead third parties, whether by affirmative statement or by making a statement that omits material facts.

To maintain and broaden public confidence, investment advisers should perform all of their professional responsibilities with the highest sense of integrity.   Integrity is an element of character fundamental to professional recognition. It is the quality from which the public trust derives and the benchmark against which a member must ultimately test all decisions.

Integrity requires an investment adviser to be, among other things, honest and candid within the constraints of client confidentiality.  Service and the public trust should not be subordinated to personal gain an advantage. Integrity can accommodate the inadvertent error and the honest difference of opinion; it cannot accommodate deceit or subordination of principle.  Integrity requires an investment adviser to observe the fiduciary duties of loyalty and of due care owed to all clients.

Because of the difficulties often encountered in suppressing motivations when an economic interest adverse to the client’s interest is present, investment advisers should seek, when appropriate, opinions from third parties (such as other investment advisers) to ensure that the decision made by the investment adviser keeps the clients’ best interests paramount at all times.

Ethical codes, including these Investment Adviser Rules of Professional Conduct, are limited in nature.  These Investment Adviser Rules of Professional Conduct greatly oversimplify the hard questions which may confront the investment adviser.  In the mind of the investment adviser, issues of professional responsibility should not be resolved as if they were issues of statutory construction.  Rather, integrity is measured in terms of what is right and just. In the absence of specific rules, standards, or guidance, or in the face of conflicting opinions, an investment adviser should test decisions and deeds by asking: “Am I doing what a person of integrity would do?  Have I retained my integrity?”  Integrity requires a member to observe both the form and the spirit of technical laws, regulations and rules of professional conduct; circumvention of laws, regulations or rules of professional conduct constitutes subordination of judgment.

Annotations

The Requirement of Truthfulness Under ERISA.   

“When an ERISA plan administrator speaks in its fiduciary capacity concerning a material aspect of the plan, it must speak truthfully.”  McCall v. Burlington N./Santa Fe Co., 237 F.3d 506, 510 (5th Cir.2000).

b.     “ERISA requires a "fiduciary" to "discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries." ERISA § 404(a). To participate knowingly and significantly in deceiving a plan's beneficiaries in order to save the employer money at the beneficiaries' expense, is not to act "solely in the interest of the participants and beneficiaries." As other courts have held, "[l]ying is inconsistent with the duty of loyalty owed by all fiduciaries and codified in section 404(a)(1) of ERISA," Peoria Union Stock Yards Co. v. Penn Mut. Life Ins. Co., 698 F.2d 320, 326 (C.A.7 1983). See also Central States, 472 U.S., at 570-571, 105 S.Ct., at 2840-2841 (ERISA fiduciary duty includes common-law duty of loyalty); Bogert & Bogert, Law of Trusts and Trustees § 543, at 218-219 (duty of loyalty requires trustee to deal fairly and honestly with beneficiaries); 2A Scott & Fratcher, Law of Trusts § 170, pp. 311-312 (same); Restatement (Second) of Trusts § 170 (same). Because the breach of this duty is sufficient to uphold the decision below, we need not reach the question of whether ERISA fiduciaries have any fiduciary duty to disclose truthful information on their own initiative, or in response to employee inquiries.”  Varity Corp. v. Howe, 516 U.S. 489, 116 S.Ct. 1065, 134 L.Ed.2d 130 (1996).

Rule 2.4.  No Insider Trading / Prohibitions Designed To Protect Integrity of The Capital Markets.  Investment advisers who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on the information.  Investment advisers must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants.

Commentary. 

Investment advisers should not engage in any manipulative practice with respect to securities, including price manipulation or insider trading.

Annotations.

1.     In 1997 the U.S. Supreme Court adopted the misappropriation theory of insider trading in United States v. O'Hagan, 521 U.S. 642, 655 (1997). O'Hagan was a partner in a law firm representing Grand Metropolitan, while it was considering a tender offer for Pillsbury Co. O'Hagan used this inside information by buying call options on Pillsbury stock, resulting in profits of over $4 million. O'Hagan claimed that neither he nor his firm owed a fiduciary duty to Pillsbury, so that he did not commit fraud by purchasing Pillsbury options. The Court rejected O'Hagan's arguments and upheld his conviction.  The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction, and thereby violates 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. Under this theory, a fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of the information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information.

2.     In 2000, the SEC enacted Rule 10b5-1, which defined trading "on the basis of" inside information as any time a person trades while aware of material nonpublic information – so that it is no defense for one to say that she would have made the trade anyway. This rule also created an affirmative defense for pre-planned trades.

3.     Exchange Act Section 15(f) generally requires broker-dealers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the firm or its associated persons from misusing material non-public information (i.e., insider trading).

4.     Under Section 204A of the Investment Advisers Act of 1940, a registered investment adviser "... shall establish, maintain and enforce written policies and procedures reasonably designed ... to prevent the misuse ... of material, nonpublic information by such investment adviser or any person associated with such investment adviser."

Rule 2.5  Role of Investment Adviser - As An Advisor.  In representing a client an investment adviser shall exercise independent professional judgment and render candid advice.  In rendering such advice an investment adviser may refer not only to core competencies achieved by the Investment adviser but to other considerations such as moral, health, economic, familial,  social and political factors that may be relevant to the client's situation.

An investment adviser frequently provides advice not just on investment strategies and investment products, but on a broad variety of economic, family, and personal issues affecting the goals, hopes and dreams of clients.  Taking into account all of the factors pertinent to a client’s situation is not only permitted, but encouraged.

Section 3.  Fiduciary Duty of Loyalty to Clients.

Rule 3.1.  General Duty of Loyalty To Clients.   An investment adviser, who is given the highest degree of trust and confidence by the Investment adviser’s client, is a fiduciary and possesses the duty of undivided loyalty to the client.  An investment adviser shall at all times act in the best (or sole) interest of his or her clients, obediently, in utmost good faith, honestly and without intimidation.

Commentary. 

Fiduciaries have a duty, created by undertaking certain types of acts, to act primarily for the benefit of another in matters connected with such undertaking.  We utilize the term "fiduciary" to mark certain relationships where a party with superior knowledge and information acts on behalf of one who usually does not possess such knowledge and information.  The provision of investment advice is such a relationship, as learning the personal details of a client’s financial affairs, their hopes, dreams, and aspirations cultivates a confidential and intimate relationship.  In these relationships the person with the dominant position (the "fiduciary") acts as if the interests of the other party (the “entrustor” or “client”) were the fiduciary's own.

The greater the knowledge, experience and required degree of expertise of the fiduciary, relative to the knowledge and experience of the client, the more significant the fiduciary association becomes as a protector of the client's interest.  Clients in receipt of investment advice will nearly always start off, in their discussions with investment advisers, from a position of contractual weakness and, as to the complexities of tax law, financial planning issues, estate planning issues, insurance, risk management issues, and investments, from the position of relative ignorance.  Fiduciary status is thereby imposed by the law upon the party with the greater knowledge and expertise, in this instance the investment adviser, in recognition by the law that the client is in need of protection and care.

Each party to a fiduciary relationship possesses the opportunity to consent to the relationship or to terminate the relationship.  Fiduciary rules therefore reflect a consensual arrangement covering special situations in which fiduciaries promise to perform services for clients and receive substantial power to effectuate the performance of the services in circumstances in which the clients cannot efficiently monitor the fiduciaries' performance.

The duty of loyalty is a duty imposed upon an investment adviser, as the investment adviser possesses a fiduciary relationship to his or her client.  Investment advisers must take only those actions that are within the best interests of the client.  The fiduciary should not act in the fiduciary’s own interest.  Engaging in self-dealing, misappropriating a client’s assets or opportunities, having material conflicts of interest, or otherwise profiting in a transaction that is not substantively or “entirely fair” to the client may give rise breaches of the duty of loyalty.  High standards of conduct are required when advising on other people’s money.

Traditionally, the duty of utmost good faith has been closely related to the concept of loyalty.  However, reckless, irresponsible or irrational conduct – but not necessarily self-dealing conduct – will implicate concepts of good faith and cause an investment adviser to be in breach of this Rule.  Utmost good faith has also been utilized to refer to the requirement of the investment adviser to be completely candid and forthright with his or her client.

Honesty is fundamental to the role of the fiduciary.  It means that the investment adviser must act bona fide in the (sole or best) interests of the client.  In exercising the investment adviser’s discretion, the investment adviser should act only to promote and advance the (sole or best) interests of the client.

Investment advisers shall not engage in heavy-handed sales pressure or intimidation with either clients or prospective clients who seek investment advice.

Annotations.  

1.     The Duty of “Utmost Good Faith.”

a.      An investment adviser possesses a duty of utmost good faith. SEC vs. Capital Gains Research Bureau, 375 U.S. 180, 84 S.Ct. 275, 11 L.Ed.2d 237 (1963) (“Courts have imposed on a fiduciary an affirmative duty of 'utmost good faith, and full and fair disclosure of all material facts,' as well as an affirmative obligation 'to employ reasonable care to avoid misleading' his clients.” Id. at 194.)

b.     “Duty to Act in Good Faith: An adviser must –

Act honestly toward clients with candor and utmost good faith.

        Examples of this might include –

-        being truthful and accurate in all communications and disclosures

-        being forthright about issues, mistakes and conflicts of interest

-        providing fund directors with all information in the adviser’s possession that reasonably bears on a board decision, particularly where the adviser has a personal interest in the outcome or similar conflict of interest

   Treat clients fairly.

      Examples of this might include –

-        avoiding favoritism of one client or group of clients over another in handling investment opportunities and trade allocations

-        adopting investment opportunity and trade allocation procedures and applying them consistently over time so that no client or group of clients is systematically disadvantaged

-        allocating shared costs across accounts using a rational methodology applied consistently over time

-        seeking a fair and prompt resolution of all legitimate client complaints”

Lorna A. Schnase, An Investment Adviser’s Fiduciary Duty (Aug. 1, 2010), at p.5, available at http://www.40actlawyer.com/Articles/Link3-Adviser-Fiduciary-Duty-Paper.pdf. 

2.     The “Duty of Obedience.” 

a.      “Conventional theory holds that the fiduciary relationship comprises two fundamental duties, care and loyalty. This paper argues that a third duty, obedience, is more basic, the foundation on which the duties of care and loyalty ultimately rest. In place of the prevailing dualistic theory of fiduciary duty, it offers a trinitarian alternative.  As the trinitarian metaphor implies, the claim here is that, properly understood, three identifiably different elements are functionally distinct yet essentially one … The duty of obedience is often overlooked or reduced to one of the other two fundamental fiduciary duties, precisely because it is so basic as to be almost invisible.  To see why this is so, we need to examine the very foundation of fiduciary duty.  The irreducible root of the fiduciary relationship is one person’s acting for another. The duty of obedience derives directly from – indeed, is virtually synonymous with – that basic principle.”  Rob Atkinson, Rediscovering the Duty of Obedience: Toward a Trinitarian Theory of Fiduciary Law (2008).

b.     “A comprehensive list of an adviser’s fiduciary duties is not found in either the common law or the Advisers Act.  However, duties of care and loyalty are among the basic fiduciary duties advisers are generally held to owe their clients, at a minimum. Some authorities also list a duty of obedience. Still others refer to a duty to act in good faith, and a duty of disclosure. … See, for example, “Will the Investment Company and Investment Advisory Industry Win an Academy Award?” remarks of Kathryn B. McGrath, Director of the SEC Division of Investment Management, at the 1987 Mutual Funds and Investment Management Conference (“McGrath Remarks”), citing Scott, The Fiduciary Principle, 37 Calif. L. Rev. 539, 544 (1949), at p.7: “The words ‘fiduciary duty’ refer to the duties, of first, obedience to the terms of one's trust, second, diligence and care in the carrying out of one's fiduciary functions, and third, undivided loyalty to the beneficiaries of one's trust.” Other authorities do not list the duty of obedience separately, but rather consider it within the framework of the other basic duties of care and loyalty.”  Lorna A. Schnase, An Investment Adviser’s Fiduciary Duty (Aug. 1, 2010), at p.5, available at http://www.40actlawyer.com/Articles/Link3-Adviser-Fiduciary-Duty-Paper.pdf.  Ms. Schnase illustrates, as an example of adherence to the duty of obedience, that an investment adviser must “Follow any instructions or guidelines provided by the client … Examples of this might include – adhering to instructions from clients concerning impermissible investments (such as socially-screened investments), managing their accounts (such as approved brokers or directed brokerage) and handling transactions in their accounts (such as account transfers, liquidations, added assets, tax lot considerations, etc.).” Id. at p.11.

3.      The “Best Interests” Standard Found under the Advisers Act, Generally. 

a.      The U.S. Securities and Exchange Commission’s early comments regarding the necessity for imposition of fiduciary duties on those who provide investment advice upon learning the details of a client’s financial affairs should not go unnoticed:  “The record discloses that registrant’s clients have implicit trust and confidence in her. They rely on her for investment advice and consistently follow her recommendations as to the purchase and sale of securities. Registrant herself testified that her clients follow her advice ‘in almost every instance.’ This reliance and repose of trust and confidence, of course, stem from the relationship created by registrant’s position as an investment adviser. The very function of furnishing investment counsel on a fee basis – learning the personal and intimate details of the financial affairs of clients and making recommendations as to purchases and sales of securities – cultivates a confidential and intimate relationship and imposes a duty upon the registrant to act in the best interests of her clients and to make only recommendations as will best serve such interests. In brief, it is her duty to act in behalf of her clients. Under these circumstances, as registrant concedes, she is a fiduciary; she has asked for and received the highest degree of trust and confidence on the representation that she will act in the best interests of her clients.”  In re: Arleen W. Hughes, Exchange Act Release No. 4048 (Feb. 18, 1948).  Note that Ms. Hughes was dually registered as both a broker and an investment adviser under the federal securities laws.

b.     “An essential feature and consequence of a fiduciary relationship is that the fiduciary becomes bound to act in the interests of her beneficiary and not of herself.”  In re Prudential Ins. Co. of America Sales Prac., 975 F.Supp. 584, 616 (D.N.J., 1996).

c.      “The duty of loyalty requires an adviser to serve the best interests of its clients, which includes an obligation not to subordinate the clients’ interests to its own.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.22 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.), citing Transamerica Mortgage Advisors, Inc., 444 U.S. 11, 17 (1979).

4.     The (Modified) Sole Interests Standard Applicable under ERISA.  In contrast to the “best interests” standard traditionally imposed upon investment advisers and financial planners under the Investment Advisers Act of 1940 and state common law, ERISA generally imposes a “sole interests” loyalty obligation.

a.      Section 404(a) of ERISA, which sets out the primary duties of fiduciaries, provides, in relevant part: “[A]fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and (A) for the exclusive purpose of: (i) providing benefits to participants and their beneficiaries; and (ii) defraying the reasonable expenses of administering the plan ….”  See also Keach v. U.S. Trust Co. N.A., 313 F.Supp.2d 818 (C.D. Ill., 2004) (“Under the section 404(a) duty of loyalty, ERISA fiduciaries must act ‘solely in the interest of plan participants and beneficiaries’ … for the ‘exclusive purpose’ of providing benefits to them.”). Id. at 863.

b.     However, ERISA recognizes that a plan administrator may wear “two hats,” albeit not at the same time.  See discussion under Rule 3.2, Annotations, #6, infra.

5.     Conflicts of Interest and the Modern Large Financial Services Firm.  “The standard of conduct required of the fiduciary is not diminished by reason of its organizational structure.”  Tuch, Andrew, “The Paradox of Financial Services Regulation: Preserving Client Expectations of Loyalty in an Industry Rife with Conflicts of Interest” (January 2008) (Australia) (noting “When an investment bank performs one of its traditional functions – underwriting securities offerings or providing financial advisory services to clients involved in mergers, acquisitions and other strategic transactions – it may under general law be a fiduciary of its client and thereby be required to avoid positions of conflict without its client’s informed consent. Yet the conglomerate structure of the firm may make conflicts of interest an inescapable feature of its doing business.”

6.     The Problem of Wearing “Two Hats” at the Same Time.  The difficulties of reconciling fiduciary duties when dual interests are to be served has not gone unnoticed by commentators and jurists over the many years in which fiduciary principles have been applied.

a.      "I venture to assert that when the history of the financial era which has just drawn to a close comes to be written, most of its mistakes and its major faults will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that ‘a man cannot serve two masters.’”  Harlan Stone (future Chief Justice of the U.S. Supreme Court),  The Public Influence of the Bar (1934) 48 Harv. L.Rev. 1, 8-9.

b.     In Bayer v. Beran, 49 N.Y.S.2d 2, Mr. Justice Shientag said: "The fiduciary has two paramount obligations: responsibility and loyalty. * * * They lie at the very foundation of our whole system of free private enterprise and are as fresh and significant today as when they were formulated decades ago. * * * While there is a high moral purpose implicit in this transcendent fiduciary principle of undivided loyalty, it has back of it a profound understanding of human nature and of its frailties. It actually accomplishes a practical, beneficent purpose. It tends to prevent a clouded conception of fidelity that blurs the vision. It preserves the free exercise of judgment uncontaminated by the dross of divided allegiance or self-interest. It prevents the operation of an influence that may be indirect but that is all the more potent for that reason."

Rule 3.2.  Reasonable Avoidance of Conflicts of Interest.  Investment advisers  must use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities.

Investment advisers must reasonably act to avoid conflicts of interest; when operating under ERISA investment advisers must avoid certain conflicts of interest.

Investment advisers must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise the Investment adviser’s own or another’s independence and objectivity.

Commentary.   

“A fiduciary cannot serve two masters.”  The fundamental truth of this statement cannot be ignored.  Yet, conflicts of interest can and do exist in financial services.  Where they arise or might arise, conflicts of interest are addressed through one of four means[12]:

1.     First, an express prohibition of the conflict of interest;

In various contexts, certain conflicts of interest are prohibited by application of the “sole interests” standard under ERISA, by ERISA’s “prohibited transaction rules,” by SEC rules or decisions, or judicial precedent.

However, SEC Staff recently noted, in its “Staff Study on Investment Advisers and Broker-Dealers” (Jan. 21, 2011), that in its view there are no particular conflicts of interest which are prohibited.  SEC Staff wrote: “While the duty of loyalty requires a firm to eliminate or disclose material conflicts of interest, it does not mandate the absolute elimination of any particular conflicts, absent another requirement to do so.”  SEC Staff Study, p. 113.  Prohibiting certain conflicts of interest is now restricted, to a degree, by federal statute.  The SEC Staff observes: “Dodd-Frank Act Section 913(g) expressly provides that the receipt of commission-based compensation, or other standard compensation, for the sale of securities does not, in and of itself, violate the uniform fiduciary standard as applied to a broker-dealer.  It also provides that the uniform fiduciary standard shall not require broker-dealers to have a continuing duty of care or loyalty to a retail customer after providing personalized investment advice. Moreover, as discussed below, while the uniform fiduciary standard would affect certain aspects of principal trading, it would not in itself impose the principal trade provisions of Advisers Act Section 206(3) on broker-dealers. In addition, Dodd-Frank Act Section 913 provides that offering only proprietary products by a broker-dealer shall not, in and of itself, violate the uniform fiduciary standard, but may be subject to disclosure and consent requirements.”  Id.

It is difficult to reconcile the SEC Staff’s general statement that no “particular conflicts” must be prohibited, when existing rules or decisions under the Advisers Act effect just such a result, such as the prohibition on performance fees being utilized for most retail clients.  Additionally, the SEC Staff later notes that “the Commission could consider whether rulemaking would be appropriate to prohibit certain conflicts.”  SEC Staff Study, p.117.

2.     By the requirement to mitigate or “properly manage” the conflict of interest, usually coupled with a disclosure requirement.

3.     By undertaking disclosure requirements arising to the level required by general fiduciary principles;

As discussed by SEC Staff in its Jan. 21, 2011 Study: “Dodd-Frank Act Section 913(g) recognizes the importance of such disclosure, and directs the Commission to ‘facilitate the provision of simple and clear disclosures to investors regarding the terms of their relationships with broker-dealers and investment advisers, including any material conflicts of interest … the Staff recommends that the Commission explore the utility and feasibility of a summary disclosure document that would describe in clear, summary form, a firm’s services (including the extent to which its advice is limited in time or is continuous and ongoing), charges, and conflicts of interest.’”  SEC Staff Study, p.116.

The SEC Staff also observes: “Another important issue to consider is the timing of customer disclosure. The Staff believes that retail customers would benefit from receiving certain disclosures, such as information about the firm’s conflicts of interest, fees, scope of services, and disciplinary information, before or at the time of entering into a customer relationship, with annual updating disclosures thereafter (as is the case with Form ADV Part 2A). Other disclosures about a product, risks, compensation or any specific conflicts could be more effective at the point when personalized investment advice is given.”  SEC Staff Study, pp.116-7.

4.     By not imposing any additional obligation – disclosure or otherwise - at all, or by mandating only “casual disclosures” (such as “I may possess a conflict of interest” or “my interests may not be the same as yours”).

While the “best interests” fiduciary standard often permits disclosure of a conflict of interest followed by the informed consent of the client, it should be noted that the existence of conflicts of interest, even when they are fully disclosed, can serve to undermine the fiduciary relationship and the relationship of trust and confidence with the client.  The existence of substantial or numerous conflicts of interest, which otherwise could have been reasonably avoided by the investment adviser, could lead to not only an erosion of the investment adviser’s relationship with the client, but also an erosion of the reputation of the investment advisory profession.  Hence, investment advisers shall reasonably act to avoid conflicts of interest.

Investment advisers should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities.  Objectivity is a state of mind, a quality that lends value to a member's services. It is a distinguishing feature of the profession.  The principle of objectivity imposes the obligation to be impartial, intellectually honest, and free of conflicts of interest.  Independence precludes relationships that may appear to impair a member's objectivity in rendering investment advice.

Many types of compensation are permissible under these Investment Adviser Rules of Professional Conduct, including commissions, a percentage of assets under management, a flat or retainer fee, hourly fees, or some combination thereof.  However, the term “independence” requires that the investment adviser’s decision is based on the best interests of the client rather than upon extraneous considerations or influences that would convert an otherwise valid decision into a faithless act.  An investment adviser would not be independent if the investment adviser is dominated or beholden to or affiliated with an individual or entity interested in the transaction at issue and is so under their influence that the investment adviser’s discretion and judgment would be sterilized.  Compensation arrangements which vary the investment adviser’s compensation depending upon the investment strategy or products recommended by the investment adviser to the client creates such a severe conflict of interest that investment advisers should act to reasonably avoid such arrangements.

A conflict of interest occurs when the personal interests of the investment adviser or the investment adviser’s firm interferes or could potentially interfere with the investment adviser’s responsibilities to his, her or its clients.  Hence, investment advisers should not accept inappropriate gifts, favors, entertainment, special accommodations, or other things of material value that could influence their decision-making or make them feel beholden to a person or firm.  Similarly, investment advisers should not offer gifts, favors, entertainment or other things of value that could be viewed as overly generous or aimed at influencing decision-making, or making a client feel beholden to the firm.  De minimis gifts are excluded, as they would not materially affect the relationship with the client or third parties.

Annotations. 

1.      Investment Advisers’ Inherent Difficulties in Managing Conflicts of Interest.  There is both early authority and very recent academic research indicating that investment advisers should, to truly act in the best interests of their client, avoid conflicts of interest to the extent reasonable to do so.

a.      “The temptation of self interest is too powerful and insinuating to be trusted. Man cannot serve two masters; he will foresake the one and cleave to the other. Between two conflicting interests, it is easy to foresee, and all experience has shown, whose interests will be neglected and sacrificed. The temptation to neglect the interest of those thus confided must be removed by taking away the right to hold, however fair the purchase, or full the consideration paid; for it would be impossible, in many cases, to ferret out the secret knowledge of facts and advantages of the purchaser, known to the trustee or others acting in the like character. The best and only safe antidote is in the extraction of the sting; by denying the right to hold, the temptation and power to do wrong is destroyed.”  Thorp v. McCullum, 1 Gilman (6 Ill.) 614, 626 (1844).

b.     “Conflicts of interest can lead experts to give biased and corrupt advice.  Although disclosure is often proposed as a potential solution to these problems, we show that it can have perverse effects.  First, people generally do not discount advice from biased advisors as much as they should, even when advisors’ conflicts of interest are honestly disclosed.  Second, disclosure can increase the bias in advice because it leads advisors to feel morally licensed and strategically encouraged to exaggerate their advice even further. As a result, disclosure may fail to solve the problems created by conflicts of interest and may sometimes even make matters worse.”  Cain, Daylian M., Loewenstein, George, and Moore, Don A., “The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest”(2003).

2.      The “No Conflict” and “No Profit” Rules under the Common Law; These Rules Also Exist Within The Advisers Act.  The rules applicable to fiduciaries under the common law include the “no conflict rule,” which prevents a fiduciary placing himself or herself in a position where his or her own interests conflict or may conflict with those of the client.  The “sole interests” standard generally requires avoidance of conflicts of interest, while the “best interests” standard permits some conflicts of interest provided they are properly managed.

The common law rules applicable to fiduciaries also include the “no profit rule,” which requires a fiduciary not to profit from his position at the expense of his or her client.  At times the no profit rule has been strictly enforced, even to the point of overturning transactions between fiduciaries and their clients where no extra profit was derived by the fiduciary above that which other market participants would have derived.

a.       “[T]he Committee Reports indicate a desire to ... eliminate conflicts of interest between the investment adviser and the clients as safeguards both to 'unsophisticated investors' and to 'bona fide investment counsel.' The [IAA] thus reflects a ... congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to render advice which was not disinterested.”  SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-2 (1963). 

b.     “The IAA arose from a consensus between industry and the SEC that ‘investment advisers could not 'completely perform their basic function — furnishing to clients on a personal basis competent, unbiased, and continuous advice regarding the sound management of their investments — unless all conflicts of interest between the investment counsel and the client were removed.'” Financial Planning Association v. Securities and Exchange Commission, No. 04-1242 (D.C. Cir. 3/30/2007) (D.C. Cir., 2007), citing SEC vs. Capital Gains at 187.

3.     Securities Laws and FINRA Prohibit Certain Conflicts of Interest.  “The federal securities laws and FINRA rules restrict broker-dealers from participating in certain transactions that may present particularly acute potential conflicts of interest.  For example, FINRA rules generally prohibit a member with certain ‘conflicts of interest’ from participating in a public offering, unless certain requirements are met.  FINRA members also may not provide gifts or gratuities to an employee of another person to influence the award of the employer’s securities business.  FINRA rules also generally prohibit a member’s registered representatives from borrowing money from or lending money to any customer, unless the firm has written procedures allowing such borrowing or lending arrangements and certain other conditions are met.  Moreover, the Commission’s Regulation M generally precludes persons having an interest in an offering (such as an underwriter or broker-dealer and other distribution participants) from engaging in specified market activities during a securities distribution.  These rules are intended to prevent such persons from artificially influencing or manipulating the market price for the offered security in order to facilitate a distribution.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), pp.58-9 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.) (Citations omitted.)  “FINRA rules also establish restrictions on the use of non-cash compensation in connection with the sale and distribution of mutual funds, variable annuities, direct participation program securities, public offerings of debt and equity securities, and real estate investment trust programs. These rules generally limit the manner in which members can pay for or accept non-cash compensation and detail the types of non-cash compensation that are permissible.”  Id. at p.68.

4.     Advisers Act’s Prohibition against Registered Investment Adviser “Performance Fees” and “Contingent Fees.”  In recognition of the extreme conflicts of interest present, and the potential for abuse, the SEC generally prohibits “performance fees” being charged by registered investment advisers. “Generally, investment advisers that are registered or required to be registered with the Commission are prohibited by Advisers Act Section 205(a)(1) from entering into a contract with any client that provides for compensation based on a share of the capital gains or appreciation of a client’s funds, i.e., a performance fee.  Section 205(a)(1) is designed, among other things, to eliminate ‘profit sharing contracts [that] are nothing more than ‘heads I win, tails you lose’ arrangements,’ and that ‘encourage advisers to take undue risks with the funds of clients,’ to speculate, or to overtrade.  There are several exceptions to the prohibition, mostly applicable to advisory contracts with institutions and high net worth clients.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), pp.41-2 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

5.     Duties Arising under ERISA When a Conflict of Interest Exists. 

a.      “When a conflict exists for fiduciaries of a retirement plan that is governed by ERISA, two distinct sets of ERISA requirements are implicated: (1) the rules governing breaches of fiduciary duty found in ERISA §404(a) and (2) the prohibited transaction rules in ERISA §§406(a) and (b) … Fiduciaries are obligated under ERISA’s fiduciary responsibility rules to (1) identify conflicts (or potential conflicts) that may impact the management of a plan; (2) evaluate those conflicts and the impact they may have on the plan and its participants; (3) determine whether the conflicts will adversely impact the plan; (4) consider protections that would protect the plan and participants from any potential adverse affect of the conflict (for instance, appointing an independent fiduciary to evaluate the investment or proposed service provider) and; (5) if the conflict adversely impacts the plan and its participants, change service providers, investments or other circumstances related to the conflict.

    Although a conflict of interest may exist in connection with a proposed transaction, entering into the transaction may or may not be a breach of fiduciary duty – the determining factors are whether the fiduciary prudently evaluates the conflict, and acts solely in the interest of the participants and for the exclusive purpose of providing benefits. If material adverse impact on the participants cannot be avoided or properly mitigated, entering into the transaction would not be prudent and would trigger a fiduciary breach.

   Furthermore, if a conflict of interest is precluded under ERISA's prohibited transaction rules, the fiduciaries cannot, as a matter of law, allow the plan to become a party to the transaction – even if the action were otherwise reasonable or profitable to the plan.”  C. Frederick Reish And Joseph C. Faucher, The Fiduciary Duty to Avoid Conflicts of Interest in Selecting Plan Service Providers (April 2009), available at http://www.reish.com/publications/pdf/whitepprmar09.pdf.

6.     ERISA Permits Certain Conflicts of Interest to Exist.

a.      Certain Adverse Financial Interests Permitted, Generally.  “Comparing a traditional trustee to an ERISA fiduciary, the [U.S. Supreme Court in Pegram v. Herdrich, 530 U.S. 211, 120 S.Ct. 2143, 2151, 147 L.Ed.2d 164 (2000)] explained that while a traditional fiduciary "is not permitted to place himself in a position where it would be for his own benefit to violate his duty to the beneficiaries ... [u]nder ERISA ... a fiduciary may have financial interests adverse to beneficiaries." Pegram, 120 S.Ct. at 2152 (citing 2A A. Scott & W. Fratcher, Trusts § 170, p. 311 (4th ed.1987)).” In re Dynegy, Inc. Erisa Litigation, 309 F.Supp.2d 861 (S.D. Tex., 2004).

b.     ERISA’s Two Hats Doctrine.  “Comparing a traditional trustee to an ERISA fiduciary, the Pegram Court explained that while a traditional fiduciary "is not permitted to place himself in a position where it would be for his own benefit to violate his duty to the beneficiaries ... [u]nder ERISA ... a fiduciary may have financial interests adverse to beneficiaries." Pegram, 120 S.Ct. at 2152 (citing 2A A. Scott & W. Fratcher, Trusts § 170, p. 311 (4th ed.1987)). See also Bussian, 223 F.3d at 294-295; Martinez, 338 F.3d at 412-413. "Employers, for example, can be ERISA fiduciaries and still take actions that disadvantage employee beneficiaries when they act as employers (e.g., firing a beneficiary for reasons unrelated to the ERISA plan), or even as plan sponsors (e.g., modifying the terms of a plan as allowed by ERISA to provide less generous benefits)." Id. See also Curtiss-Wright Corp. v. Schoonejongen, 514 U.S. 73, 115 S.Ct. 1223, 1228, 131 L.Ed.2d 94 (1995) (recognizing that a plan sponsor may function in a dual capacity as a business employer (i.e., settlor or plan sponsor) whose activity is not regulated by ERISA, and as a fiduciary of its own established ERISA plan whose activity is regulated by ERISA). Pegram and other courts recognize that [t]he law does not require employers to establish employee benefit plans. Congress sought to encourage employers to set up plans voluntarily by offering tax incentives, methods to limit fiduciary liability, means to contain administrative costs, and giving employers flexibility and control over matters such as whether or when to establish an employee benefit plan, how to design a plan, how to amend a plan, when to terminate a plan, all of which are generally viewed as business decisions of a settlor, not of a fiduciary, and thus not subject to fiduciary obligations.  In re Enron Corporation Securities, Derivative & "ERISA" Litigation, 284 F.Supp.2d 511, 551 (S.D.Tex.2003) (citing Pegram, 120 S.Ct. at 2153).  In Pegram the Court also recognized that there exists no "apparent reason in the ERISA provisions to conclude ... that this tension is permissible only for the employer or plan sponsor, to the exclusion of persons who provide services to an ERISA plan." 120 S.Ct. at 2152.” In re Dynegy, Inc. Erisa Litigation, 309 F.Supp.2d 861, 873-4 (S.D. Tex., 2004)

c.      But – Wear Only One Hat at a Time.  "ERISA does require, however, that a fiduciary with two hats wear only one at a time, and wear the fiduciary hat when making fiduciary decisions." [Pegram, 120 S.Ct. at 2152] (citing Hughes, 119 S.Ct. at 763, and Varity Corp. v. Howe, 516 U.S. 489, 116 S.Ct. 1065, 1070, 134 L.Ed.2d 130 (1996)).  Thus, ERISA does not define "fiduciaries simply as administrators of the plan, or managers or advisers... [i]nstead, it defines an administrator, for example, as a fiduciary only `to the extent' that he acts in such a capacity in relation to a plan." Id. (citing 29 U.S.C. § 1002(21)(A)).  See also Martinez, 338 F.3d at 412-413.  In every case charging breach of ERISA fiduciary duty, then, the threshold question is not whether the actions of some person employed to provide services under a plan adversely affected a plan beneficiary's interest, but whether that person was acting as a fiduciary (that is, was performing a fiduciary function) when taking the action subject to complaint.  Pegram, 120 S.Ct. at 2152-2153.  In re Dynegy, Inc. Erisa Litigation, 309 F.Supp.2d 861, 874-5 (S.D. Tex., 2004).

Rule 3.3  Disclosure of Material Facts, and Proper Management of Non-Avoided Conflicts of Interest. 

(A) Investment advisers shall disclose all material facts to their clients when required to do so.

(B) Investment advisers shall disclose to clients all material conflicts of interest which remain following the investment adviser’s reasonable efforts undertaken to avoid conflicts of interest.  However, disclosure of conflicts of interest does not defeat the continuing duty to act in the best interests of the client.

(C) Accordingly, Investment advisers shall adopt and adhere to reasonable policies and procedures for the management of remaining conflicts of interest in order that the Investment adviser continues to act in the best interests of the client.  These include, but is not limited to, the adoption and periodic revision of a Code of Ethics, appropriate compliance policies and procedures, and sound client engagement practices.

Commentary.   

Does there exist, under the common law applying fiduciary principles, a general duty “to disclose” material facts?  Generally, no.  Rather, the disclosure of material facts is seen as an element of the defense of the fiduciary when a conflict of interest exists.  In other words, where a conflict of interest exists, a duty of disclosure of that conflict of interest arises, along with other duties – including the need to undertake such disclosure thoroughly and affirmatively, and the necessity of obtaining the client’s informed consent.

However, as set forth in the annotations, the SEC has implemented a wide variety of specific disclosure obligations, even in situations where no conflict of interest exists.

Despite the best efforts of an investment adviser to eliminate material conflicts of interest, all investment advisers will still likely possess one or more material conflicts of interest in relation to the recommendations which may be made to their clients.  Investment advisers must address these remaining conflicts of interest by:

First, undertaking full and complete written disclosure of material conflicts of interest to the client; and

Second, continuing to act in the best interests of the client by properly managing the conflict of interest and by not permitting the client’s best interests to become subservient to the interests of the Investment advisers.  (It is emphasized that disclosure of a conflict of interest does not defeat the continuing duty of the investment adviser to act in the best interests of the client.)

In the presence of a conflict of interest, fiduciary law protects the client by obligating the fiduciary to: (1) affirmatively disclose all material facts to the client; (2) ensure client understanding of the transaction, the conflict of interest which exists, and their ramifications; (3) obtain an intelligent, independent and informed consent from the client; and (4) ensure that the proposed transaction, even with client consent, remains a substantively fair arrangement for the client.

Annotations. 

1.     Does a Duty to Disclose Exist Under the Common Law?

An Interesting Take: No Fiduciary Duty of Disclosure Exists, Per Se (Australia).  “In Australian law, there is no distinct and freestanding fiduciary obligation requiring a fiduciary to disclose information to their principal … Despite the fact that fiduciaries, qua fiduciaries, owe no obligation of disclosure, questions of disclosure are often central in cases entailing fiduciary relationships … Given the significance of questions of disclosure in fiduciary cases, it is important to be clear about the role that disclosure plays in fiduciary law. The editors of Meagher, Gummow and Lehane’s Equity Doctrines and Remedies describe that role in the following terms: "If a person occupying a fiduciary position wishes to enter into a transaction which would otherwise amount to a breach of duty, he must, if he is to avoid liability, make full disclosure to the person to whom the duty is owed of all relevant facts known to the fiduciary, and that person must consent to the fiduciary’s proposal. In other words, a breach of fiduciary obligation — either the obligation not to be in a position of conflict of interest and duty or the obligation not to make unauthorised profits—may be averted or cured by the consent of the principal to whom the obligation is owed, and the principal’s consent will be effective only if the fiduciary has first disclosed to the principal any relevant material information. Rather than constituting the discharge of a fiduciary obligation, disclosure which leads to informed consent confers on a fiduciary immunity from liability for the consequences of actions that would ordinarily amount to breaches of fiduciary obligation. And the immunity-conferring function of disclosure and informed consent provides a complete explanation of the role of disclosure in fiduciary law.” Matthew Harding, Two Fiduciary Fallacies (2007).

2.     Advisers Act: Disclosure is Required of Material Facts, Generally.  When a material conflict of interest exist, the investment adviser possesses a duty to disclose the conflict of interest and all material facts pertaining thereto.  But when a conflict of interest is not present, to what extent must material facts be disclosed?

a.      “[T]he duty of full disclosure was imposed as a matter of general common law long before the passage of the Securities Exchange Act.”  In the Matter of Arleen W. Hughes, SEC Release No. 4048 (February 18, 1948) (a case involving a conflict of interest arising out of principal trading).

b.     Disclosures of many material facts are required under SEC regulations, even when a conflict of interest is not present.

                    (1)     “Under federal and state law, you are a fiduciary and must make full disclosure to your clients of all material facts relating to the advisory relationship.”  General Instructions for Part 2 of Form ADV, #3.  In fact, the SEC requires registered investment advisers to undertake a broad variety of affirmative disclosures, well beyond disclosures of conflicts of interest, and many of these disclosures are required to be found in Form ADV, Parts 1 and 2A and 2B.  Part 2A requires information about the adviser’s range of fees, methods of analysis, investment strategies and risk of loss, brokerage (including trade aggregation policies and directed brokerage practices, as well as use of soft dollars), review of accounts, client referrals and other compensation, disciplinary history, and financial information, among other matters.  A full listing and discussion of the extent of these disclosures is beyond the scope of these materials.

                    (2)     SEC Staff recently noted that under the “antifraud provisions of the Advisers Act, an investment adviser must disclose material facts to its clients and prospective clients whenever the failure to do so would defraud or operate as a fraud or deceit upon any such person.  The adviser’s fiduciary duty of disclosure is a broad one, and delivery of the adviser’s brochure alone may not fully satisfy the adviser’s disclosure obligations.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.23 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

3.     What is a “Material Fact”?

a.      “When a stock broker or financial advisor is providing financial or investment advice, he or she … is required to disclose facts that are material to the client's decision-making.”  Johnson v. John Hancock Funds, No. M2005-00356-COA-R3-CV (Tenn. App. 6/30/2006) (Tenn. App., 2006).

b.     A material fact is “anything which might affect the (client’s) decision whether or how to act.”  Allen Realty Corp. v. Holbert, 318 S.E.2d 592, 227 Va. 441 (Va., 1984).  A fact is considered material if there is a substantial likelihood that a reasonable investor would consider the information to be important in making an investment decision. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976); Basic, Inc. v. Levinson, 485 U.S. 224, 233 (1988).

c.      A material conflict of interest is always a material fact requiring disclosure.   The existence of a conflict of interest is a material fact that an investment adviser must disclose to its clients because it "might incline an investment adviser -- consciously or unconsciously -- to render advice that was not disinterested." SEC v. Capital Gains Research Bureau, Inc., 375 U.S. at 191-192.

d.     An example of the type of disclosure, when a conflict of interest is present, is revealed in a recent decision arising under the Advisers Act:   “[W]hen a firm has a fiduciary relationship with a customer, it may not execute principal trades with that customer absent full disclosure of its principal capacity, as well as all other information that bears on the desirability of the transaction from the customer's perspective … Other authorities are in agreement. For example, the general rule is that an agent charged by his principal with buying or selling an asset may not effect the transaction on his own account without full disclosure which ‘must include not only the fact that the agent is acting on his own account, but also all other facts which he should realize have or are likely to have abearing upon the desirability of the transaction, from the viewpoint of the principal.’”  Geman v. S.E.C., 334 F.3d 1183, 1189 (10th Cir., 2003), quoting Arst v. Stifel, Nicolaus & Co., 86 F.3d 973, 979 (10th Cir.1996) (applying Kansas law) (quoting RESTATEMENT (SECOND) OF AGENCY § 390 cmt. a (1958)).

4.     Advisers Act: Disclosures of Material Facts Must Be Timely Given.  “[D]isclosure, if it is to be meaningful and effective, must be timely. It must be provided before the completion of the transaction so that the client will know all the facts at the time that he is asked to give his consent.” In the Matter of Arleeen W. Hughes, SEC Release No. 4048 (February 17, 1948), affirmed 174 F.2d 969 (D.C. Cir. 1949).

5.     Advisers Act:  Disclosure Must Be Affirmatively Undertaken.  The duty to disclose is an affirmative one and rests with the advisor alone.  Clients do not generally possess a duty of inquiry.

a.      “The [SEC} Staff believes that it is the firm’s responsibility—not the customers’—to reasonably ensure that any material conflicts of interest are fully, fairly and clearly disclosed so that investors may fully understand them.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.117 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

b.     The fiduciary is required to ensure that the disclosure is received by the client; the “access equals delivery” approach adopted by the SEC in connection with the delivery of a full prospectus to a consumer[13] would not likely qualify as an appropriate disclosure by a fiduciary investment adviser to her or his client of material facts.

c.      As stated in an early case applying the Advisers Act:  “It is not enough that one who acts as an admitted fiduciary proclaim that he or she stands ever ready to divulge material facts to the ones whose interests she is being paid to protect. Some knowledge is prerequisite to intelligent questioning. This is particularly true in the securities field. Readiness and willingness to disclose are not equivalent to disclosure. The statutes and rules discussed above make it unlawful to omit to state material facts irrespective of alleged (or proven) willingness or readiness to supply that which has been omitted.” Hughes v. SEC, 174 F.2d 969 (D.C. Cir., 1949).

6.     Advisers Act: Disclosure Must Be Sufficient to Obtain Client “Understanding.”  As stated in an early decision by the U.S. Securities and Exchange Commission: “[We] may point out that no hard and fast rule can be set down as to an appropriate method for registrant to disclose the fact that she proposes to deal on her own account. The method and extent of disclosure depends upon the particular client involved. The investor who is not familiar with the practices of the securities business requires a more extensive explanation than the informed investor. The explanation must be such, however, that the particular client is clearly advised and understands before the completion of each transaction that registrant proposes to sell her own securities.”  [Emphasis added.]   In re the Matter of Arleen Hughes, SEC Release No. 4048 (1948).

7.     Conflicts of Interest Are Common with Respect to the Delivery of Investment Advice.  “Compensation is inherent in any commercial transaction; it is simultaneously a source of conflicts of interests and a possible means of reducing these conflicts by creating the proper incentives.”[14]

a.      A conflict of interest is inherent in the relationship between the client and the investment adviser when the investment adviser is compensated by commissions on the sale of financial products. In such circumstances, the investment advisers must affirmatively disclose to the client, in writing and prior to the purchase of the product by the client, the amount of all compensation paid in association with the sale of the product and the placement of the product to the investment advisers or the investment adviser’s firm, including but not limited to commissions, payment for shelf space, commissions paid upon securities transactions within a mutual fund by the investment adviser of that fund to the firm, expense allowances, and bonuses.

b.     However, just because an investment adviser works on a fee-only basis (as opposed to commission-based compensation) does not mean that he or she has no potential conflicts of interest.  Nearly every fiduciary has one conflict of interest - negotiating with the client the amount to be paid to the fiduciary for the fiduciary's services.  Normally negotiations as to the investment adviser’s compensation should occur prior to the client’s engagement of the adviser; this is because once a relationship of trust and confidence is formed, the investment adviser could seek to abuse that trust by seeking to convince the client to pay higher compensation than that originally agreed.  Investment advisers should seek to ensure that each new and existing client will receive significant value from the services and advice provided by the investment advisers, commensurate with the amount of fees and costs paid or incurred by the client.  Investment advisers who charge fees based upon a percentage of the assets upon which advice is provided may possess a conflict of interest when a client seeks advice on gifts (to charity or family), major expenditures, paying down debt, etc.

c.      Where conflicts of interest are permitted to exist, the conflict of interest must be properly managed to keep the best interests of the client paramount.  In other words, the client’s interests must not be harmed, for clients rarely (if ever) undertake gratuitous transfers to their investment advisers.

8.     Disclosures of Conflicts of Interest Must “Lay Bare the Truth … in All Its Stark Significance.”  As stated by Justice Cardoza: “If dual interests are to be served, the disclosure to be effective must lay bare the truth, without ambiguity of reservation, in all its stark significance ….”  Wendt v. Fischer, 243 N.Y. 439, 154 N.E. 303 (1926).

a.      The extent of the disclosure required is made clear by cases applying the fiduciary standard of conduct in related advisory contexts. “The fact that the client knows of a conflict is not enough to satisfy the attorney's duty of full disclosure.” In re Src Holding Corp., 364 B.R. 1 (D. Minn., 2007).  "Consent can only come after consultation — which the rule contemplates as full disclosure.... [I]t is not sufficient that both parties be informed of the fact that the lawyer is undertaking to represent both of them, but he must explain to them the nature of the conflict of interest in such detail so that they can understand the reasons why it may be desirable for each to [withhold consent].") Florida Ins. Guar. Ass'n Inc. v. Carey Canada, Inc., 749 F.Supp. 255, 259 (S.D.Fla.1990) (quoting Unified Sewerage Agency, Etc. v. Jeko, Inc., 646 F.2d 1339, 1345-46 (9th Cir.1981)); see also British Airways, PLC v. Port Authority of N.Y. and N.J., 862 F.Supp. 889, 900 (E.D.N.Y.1994) (stating that the burden is on the client's attorney to fully inform and obtain consent from the client); Kabi Pharmacia AB v. Alcon Surgical, Inc., 803 F.Supp. 957, 963 (D.Del.1992) (stating that evidence of the client's constructive knowledge of a conflict would not be sufficient to satisfy the attorney's consultation duty); Manoir-Electroalloys Corp. v. Amalloy Corp., 711 F.Supp. 188, 195 (D.N.J.1989) ("Constructive notice of the pertinent facts is not sufficient.").  A client of a fiduciary is not responsible for recognizing the conflict and stating his or her lack of consent in order to avoid waiver.  Manoir-Electroalloys, 711 F.Supp. at 195.  Rather, “[t]he lawyer bears the duty to recognize the legal significance of his or her actions in entering a conflicted situation and fully share that legal significance with clients.”  In re Src Holding Corp., 364 B.R. 1, 48 (D. Minn., 2007).

9.     Disclosure Alone Is Insufficient to Meet One’s Fiduciary Obligations; Disclosure’s Inherent Limitations as a Means of Consumer Protection.  It is important to emphasize that while a critical and important aspect of compliance with the fiduciary duty of loyalty is adequate disclosure of a conflict of interest, disclosure remains but one of the elements of compliance with the investment adviser’s fiduciary duty.

a.      Disclosure, in and of itself, does not negate a fiduciary’s duties to his or her client.  As stated in an SEC No-Action Letter:  “We do not agree that an investment adviser may have interests in a transaction and that his fiduciary obligation toward his client is discharged so long as the adviser makes complete disclosure of the nature and extent of his interest. While section 206(3) of the [Advisers Act] requires disclosure of such interest and the client's consent to enter into the transaction with knowledge of such interest, the adviser's fiduciary duties are not discharged merely by such disclosure and consent.”  Rocky Mountain Financial Planning, Inc. (pub. avail. March 28,1983). [Emphasis added.]

b.     Various regulators, including the SEC, have relied upon disclosure extensively.  However, the ineffectiveness of disclosure as a means of providing consumer protection has long been known, and has recently been confirmed by academic research.  “Disclosure forms the central focus of most of the federal securities laws … From a behavioral perspective, however, disclosure risks confusing investors already suffering from bounded rationality, availability and hindsight.”  Stephen J. Choi & A.C. Pritchard, Behavioral Economics and the SEC (2003), at pp.69-70.  See also Daylian M. Cain, George Loewenstein, and Dona A. Moore, The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest (1993) (“Conflicts of interest can lead experts to give biased and corrupt advice. Although disclosure is often proposed as a potential solution to these problems, we show that it can have perverse effects. First, people generally do not discount advice from biased advisors as much as they should, even when advisors’ conflicts of interest are honestly disclosed. Second, disclosure can increase the bias in advice because it leads advisors to feel morally licensed and strategically encouraged to exaggerate their advice even further. As a result, disclosure may fail to solve the problems created by conflicts of interest and may sometimes even make matters worse.”)  As Professor Cain has more recently stated in a public appearance, “It does not appear that sunlight is the best disinfectant, after all.” (Fiduciary Forum, Washington, D.C., Sept. 2010).

c.      More generally, it is submitted that while the presence of a conflict of interest requires the fiduciary to disclose the conflict of interest, disclosure is only a precondition to the gaining of the informed consent of the client.  Only with such informed consent, in a transaction which remains substantively fair to the client, is the investment adviser’s fiduciary obligation met.

10.   The Doctrine of Informed Consent.   The consent of the client must be “intelligent, independent and informed.”  Generally, “fiduciary law protects the [client] by obligating the fiduciary to disclose all material facts, requiring an intelligent, independent consent from the [client], a substantively fair arrangement, or both.”  Frankel, Tamar, Fiduciary Law, 71 Calif. L. Rev. 795 (1983). [Emphasis added.].

11.   Even with Informed Consent, the Proposed Transaction Must Be Fair and Reasonable to the Client.  “One of the most stringent precepts in the law is that a fiduciary shall not engage in self-dealing and when he is so charged, his actions will be scrutinized most carefully. When a fiduciary engages in self-dealing, there is inevitably a conflict of interest: as fiduciary he is bound to secure the greatest advantage for the beneficiaries; yet to do so might work to his personal disadvantage. Because of the conflict inherent in such transaction, it is voidable by the beneficiaries unless they have consented. Even then, it is voidable if the fiduciary fails to disclose material facts which he knew or should have known, if he used the influence of his position to induce the consent or if the transaction was not in all respects fair and reasonable.”  [Emphasis added.]  Birnbaum v. Birnbaum, 117 A.D.2d 409, 503 N.Y.S.2d 451 (N.Y.A.D. 4 Dept., 1986).

12.   General Requirements of the Advisers Act.  Section 206(2) of the Advisers Act makes it unlawful for an adviser to engage in any transaction, practice or course of business that operates as a fraud or deceit upon any client or prospective client.

a.      An adviser violates Section 206(2) if it makes material misstatements or omissions to clients. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 200 (1963).   If the misstatement or omission of a material fact is negligent, then Section 206(2) is violated; if the misstatement or omission is made with scienter, then Section 206(1) is violated. Steadman v. SEC, 603 F.2d 1126, 1134-1135 (5th Cir. 1979).

b.     “[We] think the better reading of section 206 is that it prohibits failures to disclose material information, not just affirmative frauds. This reading is consistent with the fiduciary status of investment advisers in relation to their clients ... and it is also more likely to fulfill Congress's general policy of promoting ‘full disclosure’ in the securities industry.”  S.E.C. v. Washington Inv. Network, 475 F.3d 392 (D.C. Cir., 2007), citing SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 at 191-2, and at 186, 84 S.Ct. 275, 11 L.Ed.2d 237 (1963).

c.      The fiduciary duty to avoid conflicts of interest, and the necessity to obtain the informed consent of the client as to conflicts of interest not avoided, were well known in the early history of the Advisers Act.  In an address entitled “The SEC and the Broker-Dealer” by Louis Loss, Chief Counsel, Trading and Exchange Division, U.S. Securities and Exchange Commission on March 16, 1948, before the Stock Brokers’ Associates of Chicago, the fiduciary duties arising under the Advisers Act, as applied in the Arleen Hughes release, were elaborated upon:

The doctrine of that case, in a nutshell, is that a firm which is acting as agent or fiduciary for a customer, rather than as a principal in an ordinary dealer transaction, is under a much stricter obligation than merely to refrain from taking excessive mark-ups over the current market. Its duty as an agent or fiduciary selling its own property to its principal is to make a scrupulously full disclosure of every element of its adverse interest in the transaction.

In other words, when one is engaged as agent to act on behalf of another, the law requires him to do just that. He must not bring his own interests into conflict with his client's.  If he does, he must explain in detail what his own self-interest in the transaction is in order to give his client an opportunity to make up his own mind whether to employ an agent who is riding two horses. This requirement has nothing to do with good or bad motive. In this kind of situation the law does not require proof of actual abuse. The law guards against the potentiality of abuse which is inherent in a situation presenting conflicts between self-interest and loyalty to principal or client. As the Supreme Court said a hundred years ago, the law ‘acts not on the possibility, that, in some cases the sense of duty may prevail over the motive of self-interest, but it provides against the probability in many cases, and the danger in all cases, that the dictates of self-interest will exercise a predominant influence, and supersede that of duty.’  Or, as an eloquent Tennessee jurist put it before the Civil War, the doctrine ‘has its foundation, not so much in the commission of actual fraud, but in that profound knowledge of the human heart which dictated that hallowed petition, 'Lead us not into temptation, but deliver us from evil,’ and that caused the announcement of the infallible truth, that 'a man cannot serve two masters.' This time-honored dogma applies equally to any person who is in a fiduciary relation toward another, whether he be a trustee, an executor or administrator of an estate, a lawyer acting on behalf of a client, an employee acting on behalf of an employer, an officer or director acting on behalf of a corporation, an investment adviser or any sort of business adviser for that matter, or a broker. The law has always looked with such suspicion upon a fiduciary's dealing for his own account with his client or beneficiary that it permits the client or beneficiary at any time to set aside the transaction without proving any actual abuse or damage. What the recent Hughes case does is to say that such conduct, in addition ‘to laying the basis for a private lawsuit, amounts to a violation of the fraud provisions under the securities laws: This proposition, as a matter of fact, is found in a number of earlier Commission opinions. The significance of the recent Hughes opinion in this respect is that it elaborates the doctrine and spells, out in detail exactly what disclosure is required when a dealer who has put himself in a fiduciary position chooses to sell his own securities to a client or buys the client's securities in his own name …The nature and extent of disclosure with respect to capacity will vary with the particular client involved. In some cases use of the term ‘principal’ itself may suffice. In others, a more detailed explanation will be required. In all cases, however, the burden is on the firm which acts as fiduciary to make certain that the client understands …. [Emphasis added.]

d.     SEC Staff has placed a great deal of emphasis in recent years on full and complete disclosure of conflicts of interest.

             (1)         “The duty to disclose material facts applies to conflicts of interest—or potential conflicts of interest—that arise during an adviser’s relationship with a client. Therefore, the type of required disclosure will depend on the facts and circumstances. As a general matter, an adviser must disclose all material facts regarding the conflict so that the client can make an informed decision whether to enter into or continue an advisory relationship with the adviser. For example, if an adviser selects or recommends other advisers for clients, it must disclose any compensation arrangements or other business relationships between the advisory firms, along with the conflicts created, and explain how it addresses these conflicts.” SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.23 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

             (2)         SEC Staff also stated: “Fundamental to the Advisers Act is an adviser's fiduciary obligation to act in the best interests of its clients and to place its clients' interests before its own. As part of its fiduciary duty to clients, an adviser has an affirmative obligation of utmost good faith and full and fair disclosure of all material facts to clients. Advisers are required to disclose any facts that might cause the adviser to render advice that is not disinterested.  When an adviser fails to disclose information regarding potential conflicts of interest, clients are unable to make informed decisions about entering into or continuing the advisory relationship.”  [“Letter From the Office of Compliance Inspections and Examinations: To Registered Investment Advisers, on Areas Reviewed and Violations Found During Inspections,” dated May 1, 2000.]

             (3)         See also General Instruction 3 to Part 2 of Form ADV: “Under federal and state law, you are a fiduciary and must make full disclosure to your clients of all material facts relating to the advisory relationship. As a fiduciary, you also must seek to avoid conflicts of interest with your clients, and, at a minimum, make full disclosure of all material conflicts of interest between you and your clients that could affect the advisory relationship. This obligation requires that you provide the client with sufficiently specific facts so that the client is able to understand the conflicts of interest you have and the business practices in which you engage, and can give informed consent to such conflicts or practices or reject them. To satisfy this obligation, you therefore may have to disclose to clients information not specifically required by Part 2 of Form ADV or in more detail than the brochure items might otherwise require. You may disclose this additional information to clients in your brochure or by some other means.”

e.      “‘[W]hen a firm has a fiduciary relationship with a customer, it may not execute principal trades with that customer absent full disclosure of its principal capacity, as well as all other information that bears on the desirability of the transaction from the customer's perspective.’… Other authorities are in agreement. For example, the general rule is that an agent charged by his principal with buying or selling an asset may not effect the transaction on his own account without full disclosure which ‘must include not only the fact that the agent is acting on his own account, but also all other facts which he should realize have or are likely to have a bearing upon the desirability of the transaction, from the viewpoint of the principal.’” Geman v. S.E.C., 334 F.3d 1183, 1189 (10th Cir., 2003), quoting Arst v. Stifel, Nicolaus & Co., 86 F.3d 973, 979 (10th Cir.1996) (applying Kansas law) (quoting RESTATEMENT (SECOND) OF AGENCY § 390 cmt. a (1958)).

f.       Investment advisers should not rely upon disclosure documents fashioned pursuant to issuer or broker-dealer obligations arising under the ’33 or ’34 Securities Acts to fulfill their obligation of disclosure.   For example, providing a Summary Prospectus or Prospectus does not necessarily mean that all material facts have been effectively and affirmatively communicated to the client. “[W]e decline to find that providing a client with a prospectus is a complete defense, as a matter of law, to state claims that the stock broker or investment advisor misrepresented facts or failed to disclose facts material to his or her client's investment decisions.” Johnson v. John Hancock Funds, No. M2005-00356-COA-R3-CV (Tenn. App. 6/30/2006) (Tenn. App., 2006).

13.   Principal Trading by Dual Registrants.  “Advisers are restricted by Advisers Act Section 206(3) when entering into principal and agency-cross trades with their clients. Advisers Act Section 206(3) is intended to address the potential for self-dealing that could arise when an investment adviser acts as principal in transactions with clients, such as through price manipulation or the dumping of unwanted securities into client accounts.  Section 206(3) makes it unlawful for an adviser, acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to the transaction.  The Commission staff has taken the position that the adviser must disclose not only the capacity in which the adviser is acting, but also any compensation that the adviser receives for its role in such transaction … While the disclosure must be in writing, Section 206(3) does not require that the client’s consent be in writing. Written disclosure must be provided and consent must be obtained separately for each transaction, i.e., a blanket consent for transactions is not sufficient ... Compliance with the disclosure and consent provisions of Advisers Act Section 206(3) provision alone does not satisfy an adviser’s fiduciary obligations with respect to a principal trade. The Commission has stated that Section 206(3) must be read together with Advisers Act Sections 206(1) and (2) to require that the adviser disclose additional facts necessary to alert the client to the adviser’s potential conflict of interest in the principal trade.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), pp.24-6. (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

14.   Advisers Act: Use by Investment Advisers of Affiliated Brokers.  “The Advisers Act does not prohibit advisers from using an affiliated broker to execute client trades or from directing brokerage to certain brokers. However, the adviser’s use of such an affiliate involves a conflict of interest that must be disclosed to the adviser’s client.  To this end, Item 12 of Part 2A of Form ADV also requires an adviser to describe any relationship with a broker-dealer to which the brokerage may be directed that creates a material conflict of interest.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.28 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

15.   Disclosure Obligations Arising under State Common Law.  “When a stock broker or financial advisor is providing financial or investment advice, he or she … is required to disclose facts that are material to the client's decision-making.”  Johnson v. John Hancock Funds, No. M2005-00356-COA-R3-CV (Tenn. App. 6/30/2006) (Tenn. App., 2006).

16.   Fee Rebates vs. Disclosure:  Bank Trustees and Proprietary Trust Funds.   The FDIC notes the conflict of interest due to the “lucrative array of fees available under a mutual fund arrangement” and suggests that it must be “resolved in the favor of trust beneficiaries.” FDIC Trust Examination Manual, Section 7 “Compliance–Pooled Investment Vehicles,” at Section A.1 (3/21/2009), stating: “One of the incentives for converting a [common investment fund] CIF to a proprietary mutual fund is purely financial.  There is a lucrative array of fees available under a mutual fund arrangement that is not available from bank sponsored CIF's.  However, the desire for increased revenue must not take precedence over the fiduciary responsibility of the bank.  Such a conflict must be resolved in favor of the account beneficiaries.  If the desire for financial reward is dominant, the conflict could become abusive.”

Some of the states, in enacting authority for banks to use proprietary or affiliated mutual funds, have prohibited their use unless the bank or trust company rebates its management fees,  while others just require that certain disclosures be made to trust beneficiaries and/or that total compensation be “reasonable.”  See, e.g., Wisconsin Statutes Sect. 881.01(4) (1989), stating in part: “A bank or trust company may invest in these securities notwithstanding that the bank or trust company, or an affiliate of' the bank or trust company, provides investment services to the investment company or investment trust if the bank or trust company waives its fee as fiduciary for the assets that it invests in these securities or if the bank , trust company or affiliate waives its fees for providing investment services to the investment company or investment trust.”  However, Wisconsin no longer effectively mandates fee waivers of offsets in this situation, and like most other states only requires disclosure in writing of the compensation received for providing services to the mutual fund, etc..  See Wisconsin Statutes Sect. 881.015 (1007-8).  Investment advisers operating in a bank environment should consult the state law applicable to their relationship with the client and/or the account(s).

17.   Disclosure Obligations Under ERISA.

a.      General Duty of Disclosure; Duty to Inform.

             (1)     “[T]rust principles impose a duty of disclosure upon an ERISA fiduciary when there are "`material facts affecting the interest of the beneficiary which [the fiduciary] knows the beneficiary does not know'" but "`needs to know for his protection ….'"” Martinez v. Schlumberger, Ltd., 338 F.3d 407, 412 (5th Cir., 2003), citing Edward E. Bintz, Fiduciary Responsibility Under ERISA: Is There Ever a Fiduciary Duty to Disclose?, 54 U. PITT. L. REV. 979, 985 (1993) (quoting RESTATEMENT (SECOND) OF TRUSTS § 173 cmt. d (1959)).

             (2)     “A fiduciary has an obligation to convey complete and accurate information to its beneficiaries.”  In Re Regions Morgan Keegan Erisa Litigation, 692 F. Supp.2d 944, 955 (W.D. Tenn., 2010).  “"The duty to inform is a constant thread in the relationship between beneficiary and trustee; it entails not only a negative duty not to misinform, but also an affirmative duty to inform when the trustee knows that silence might be harmful."  Id.

b.     Duty to Provide Information with Respect to Participant-Directed Retirement Accounts.  In the past ERISA class action fee litigation resulted in many adverse rulings to participants who alleged a failure to disclose certain fee information, and/or certain fee-sharing information, by a plan sponsor.  Commencing Jan. 1, 2012, plan sponsors can no longer rely upon such decisions, due to a recently adopted interim final rule mandating additional disclosures.   “Paragraph (a) of § 2550.404a–5 sets forth the general principle that, where documents and instruments governing an individual account plan provide for the allocation of investment responsibilities to participants and beneficiaries, a plan fiduciary, consistent with ERISA section 404(a)(1)(A) and (B), must take steps to ensure that such participants and beneficiaries, on a regular and periodic basis, are made aware of their rights and responsibilities with respect to the investment of assets held in, or contributed to, their accounts and are provided sufficient information regarding the plan, including plan fees and expenses, and regarding the designated investment alternatives available under the plan, including fees and expenses attendant thereto, to make informed decisions with regard to the management of their individual accounts … [T]he Department [of Labor] believes, as an interpretive matter, that ERISA section 404(a)(1)(A) and (B) impose on fiduciaries of all participant-directed individual account plans a duty to furnish participants and beneficiaries information necessary to carry out their account management and investment responsibilities in an informed manner ….” DOL, EBSA, Fiduciary Requirements for Disclosure in Participant-Directed Individual Account Plans; Final Rule (Oct. 20, 2010).  The following summarizes just a few of the new major disclosure items required under the new regulation.

                      (1)     Fee and Expense Information Disclosures / Investment Alternatives.  “Paragraph (d)(1)(iv) of the proposal required disclosure of fee and expense information for designated investment alternatives … such as commissions, sales loads, sales charges, deferred sales charges, redemption fees, surrender charges, exchange fees, account fees, and purchase fees … If the fee or expense is charged directly against participant’s or beneficiary’s individual investment or account, as is typically the case with sales loads, account fees, and the other items delineated in the parenthetical, then the fee or expense is to be disclosed as a shareholder-type fee. If, on the other hand, the fee or expense is paid from the operating expenses of a designated investment alternative, then the fee or expense is to be included in the total annual operating expenses of a designated investment alternative ….”  DOL, EBSA, Fiduciary Requirements for Disclosure in Participant-Directed Individual Account Plans; Final Rule (Oct. 20, 2010).

                      (2)     Disclosure of Portfolio Turnover Rates.  The Department of Labor’s recent rule noted the effect of trading costs, by requiring express disclosure of portfolio turnover.  “An investment alternative’s portfolio turnover indicates the frequency with which the investment alternative is buying and selling securities. An investment that is frequently buying and selling securities may be generating higher trading costs. Trading costs are not included in an alternative’s expense ratio, yet the cost of trading on a portfolio level does have an effect, in some cases a large effect, on the alternative’s rate of return. The Department, therefore, believes that such information may be helpful to participants and beneficiaries in assessing the appropriateness of their investment options … must include the investment’s portfolio turnover rate in a manner consistent with Securities and Exchange Commission Form N–1A or N–3, as appropriate.”  DOL, EBSA, Fiduciary Requirements for Disclosure in Participant-Directed Individual Account Plans; Final Rule (Oct. 20, 2010).

                      (3)     Benchmarking of Returns of Investment Options Required.  “Paragraph (d)(1)(iii) of the proposal required, for each designated investment alternative with respect to which the return is not fixed, the disclosure of ‘‘the name and returns of an appropriate broad-based securities market index over the 1-year, 5-year, and 10-year periods * * *’’ for which performance data must be disclosed. [The final rule retains the proposed requirement that a benchmark must be a broad-based securities market index and it may not be administered by an affiliate of the investment issuer, its investment adviser, or a principal underwriter, unless the index is widely recognized and used. The Department, however, notes that paragraph (d)(2)(ii) of the final regulation permits the disclosure of information that is in addition to that which is required by this final regulation, so long as the additional information is not inaccurate or misleading. Thus, in the case of designated investment alternatives that have a mix of equity and fixed income exposure (e.g., balanced funds or target date funds), a plan administrator may, pursuant to paragraph (d)(2)(ii) of the final rule, blend the returns of more than one appropriate broad-based index and present the blended returns along with the returns of the required benchmark, provided that the blended returns proportionally reflect the actual equity and fixed-income holdings of the designated investment alternative.” DOL, EBSA, Fiduciary Requirements for Disclosure in Participant-Directed Individual Account Plans; Final Rule (Oct. 20, 2010).

c.      Reliance upon Plan Service Providers and Issuer Disclosure Information.  “[A] plan administrator will not be liable for the completeness and accuracy of information used to satisfy these disclosure requirements when the plan administrator reasonably and in good faith relies on information received from or provided by a plan service provider or the issuer of a designated investment alternative.”  DOL, EBSA, Fiduciary Requirements for Disclosure in Participant-Directed Individual Account Plans; Final Rule (Oct. 20, 2010).

                      (1)     But – Knowledge of Misleading Information Dictates Greater Disclosures.  “[I]t  should be noted that there may be extraordinary situations when fiduciaries will have a disclosure obligation beyond those addressed by this regulation. For example, if a plan fiduciary knew that, due to a fraud, information contained in a public financial report would mislead investors concerning the value of a designated investment alternative, the fiduciary would have an obligation to take appropriate steps to protect the plan's participants, such as disclosing the information or preventing additional investments in that alternative by plan participants until the relevant information is made public.”  DOL/EBSA, Proposed Rule, Fiduciary Requirements for Disclosure in Participant-Directed Individual Account Plans  (July 23, 2008).

d.     Disclosure of Compensation Arrangements.  Generally, the new 408(b)(2) interim final regulation requires, effective January 1, 2012 (as per 2/11/2011 announcement), certain plan service providers to disclose detailed information to fiduciaries regarding services, including direct and indirect compensation, as a precondition to avoiding liability under 406(a)(1)(C).  Generally, the rule applies to services provided as a fiduciary, including investment advisory services, accounting/auditing services; brokerage services, and recordkeeping services.  Generally the rule requires disclosure regardless of whether the compensation is directly or indirectly received.

e.      No Disclosure Required of Plan Sponsor Considering Amendment to Benefit Plan.  “[W]hether an employer has a fiduciary duty to affirmatively disclose whether it is considering amending its benefit plan, we conclude that no such duty exists. Those circuits which have recognized the existence of such a duty have not presented persuasive reasons, and instead we find that the practicalities of the business world weigh against it.” Martinez v. Schlumberger, Ltd., 338 F.3d 407, 428 (5th Cir., 2003).  “[A]n employer has no affirmative duty to disclose the status of its internal deliberations on future plan changes even if it is seriously considering such changes, but if it chooses in its discretion to speak it must do so truthfully.” Beach v. Commonwealth Edison Co., 382 F.3d 656, 666 (7th Cir., 2004)

f.       No Disclosure Required of Negative Information Regarding Employer Stock.  “The Court cannot glean a broad requirement that ERISA fiduciaries disclose to plan participants any information about an employer that could have a negative effect on the value of the employer's stock when the participants hold said stock under an ERISA plan. Furthermore, such a duty would place too high a burden on employers to continually update plan participants and the public12 about myriad situations within the company which could negatively affect the value of the employer's stock. See Herrington v. Household Int'l, Inc., 2004 WL 719355, at *8 (N.D.Ill. Mar. 31, 2004) (noting that such a disclosure standard "would require defendants to continuously gather and disclose nonpublic information bearing some relation to the plan sponsor's financial condition").” Powell v. Dallas Morning News Lp, 610 F.Supp.2d 569 (N.D. Tex., 2009).

18.   The Disclosure Obligations of Broker-Dealers are Generally Insufficient to Meet the Fiduciary Standard’s Requirements. 

a.      “In practice, with broker-dealers, required disclosures of conflicts have been more limited than with advisers and apply at different points in the customer relationship.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.106 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.).  Often disclosures are not affirmatively made, such as when clients are directed to a web site to view disclosures.  At other times “casual disclosure” is all that is required, such as “we may have conflicts of interest” or “our interests may not be the same as yours.”

b.     However, recently “FINRA requested comment on a concept proposal to require the provision of a disclosure statement for retail investors at or before commencing a business relationship that would include many items of information analogous to what is required in Form ADV Part 2. FINRA, Regulatory Notice 10-54, ‘Disclosure of Services, Conflicts and Duties’ (Oct. 2010).  Specifically, the proposal would require member firms to provide to a retail customer, at or prior to commencing a business relationship, a written statement describing, among other things: the types of accounts and services it provides; the scope of services provided and products offered to retail customers and the fees associated with each brokerage account and service offered; the conflicts associated with such services (e.g., financial or other incentives that the firm or its registered representatives have to recommend certain products, investment strategies or services) and conflicts that may arise and how the firm manages such conflicts; and any limitations on the duties otherwise owed to retail customers (e.g., not assuring the ongoing suitability of an investment or a portfolio of investments nor the propriety of unsolicited orders, and may execute transactions on a principal basis (absent instructions to act only in an agency capacity)).”  SEC Staff Study, p. 114, fn. 518.

Rule 3.4.  Addressing Conflicts of Interest Arising From Duties Owed To Multiple Distinct Clients.   Investment advisers shall reasonably seek to not favor the interests of any one client over the interest of another client.  Since situations may arise in which the Investment adviser’s ability to treat all of the Investment adviser’s clients with equal fairness is compromised, or where it may appear that the interest of one client is favored over the interest of another client, Investment advisers shall inform clients in writing and in advance of the limitations which Investment advisers possesses and how the Investment advisers will address the situation.

Commentary. 

Most fiduciaries (agents) act for more than one client (principal).  Conflicts of interest may arise where the investment adviser has reason to favor the interests of one client over another client (e.g., larger accounts over smaller accounts, accounts compensated by performance fees over accounts not so compensated, accounts in which employees have made material personal investments, accounts of close friends or relatives of supervised persons).

While favoritism of one client over another client should be avoided wherever possible,  as such would constitute a breach of fiduciary duty, situations arise (such as a sudden major stock market value decline) in which the investment adviser may find that the investment adviser is unable to serve all of the investment adviser’s clients equally well due to scarce resources.  Investment advisers should therefore, in advance of such situations, inform clients of investment adviser’s limitations and the policies which the Investment adviser has adopted to treat clients as fairly as possible.

Rule 3.5.  Relationships With Clients Possessing Diminished Capacity. 

         (a)     When a client's capacity to make adequately considered decisions in connection with a representation is diminished, whether because of minority, mental impairment or for some other reason, the Investment adviser shall, as far as reasonably possible, maintain a normal investment adviser - client relationship with the client.  However, under such circumstances nearly all conflicts of interest must be avoided by the investment adviser, given the practical inabiliity of the investment adviser to ensure the client's understanding of the conflict of interest and to secure the client's informed consent.

         (b)     When the Investment adviser reasonably believes that the client has diminished capacity, is at risk of substantial physical, financial or other harm unless action is taken and cannot adequately act in the client's own interest, the Investment adviser may take reasonably necessary protective action, including consulting with individuals or entities that have the ability to take action to protect the client.

         (c)     Information relating to the representation of a client with diminished capacity is protected by the general rule governing client confidentiality.  Notwithstanding this general rule, when taking protective action pursuant to paragraph (b) above, the Investment adviser is impliedly authorized under Rule to reveal information about the client, but only to the extent reasonably necessary to protect the client's best interests or to fulfill the duties owed by the Investment adviser to the client.

SECTION 4.  Fiduciary Duty of Due Care To Clients. 

Rule 4.1 Standard of Due Care.  An investment adviser shall, in the performance of services for a client, act with the due care expected of Investment advisers in like situations, applying the requisite knowledge, experience and attention to the engagement.

Commentary. 

The quest for excellence is the essence of due care.  Due care requires a member to discharge professional responsibilities with competence and diligence.  It imposes the obligation to perform professional services to the best of an investment adviser’s ability with concern for the best interest of those for whom the services are performed and consistent with the profession's responsibility to the public. 

The duty of due care has been considered to involve both process and substance.  That is, in reviewing the conduct of an investment adviser in adherence to the investment adviser’s fiduciary duty of due care, a court would likely review whether the decision made by the investment adviser was informed (procedural due care) as well as the substance of the transaction or advice given (substantive due care).  Procedural due care is often met through the application of an appropriate decision-making process, and judged under the standard, not (necessarily) by the end result.  Substantive due care pertains to the standard of care and the standard of culpability for the imposition of liability for a breach of the duty of care. 

            Substantive Due Care.  Under the Investment Advisers Act of 1940, the duty of due care is measured by the ordinary negligence standard, and it is anticipated that the duty of due care imposed by this Rule would likewise be measured by the same ordinary negligence standard.  However, the standard of prudence is relational, and it follows that the standard of care for investment advisers is the standard of a prudent investment adviser.  By way of explanation, the standard of care for professionals is that of prudent professionals; for amateurs, it is the standard of prudent amateurs. For example, Restatement of Trusts 2d § 174 (1959) provides: "The trustee is under a duty to the beneficiary in administering the trust to exercise such care and skill as a man of ordinary prudence would exercise in dealing with his own property; and if the trustee has or procures his appointment as trustee by representing that he has greater skill than that of a man of ordinary prudence, he is under a duty to exercise such skill." Case law strongly supports the concept of the higher standard of care for the trustee representing itself to be expert or professional.  See Annot., “Standard of Care Required of Trustee Representing Itself to Have Expert Knowledge or Skill”, 91 A.L.R. 3d 904 (1979) & 1992 Supp. at 48-49.

Note, however, that the courts recognize that it is simply not possible for a fiduciary to be aware of every piece of relevant information before making a decision on behalf of the principal, and a fiduciary cannot guarantee that a correct judgment will be made in all cases.  Due to the difficulty of evaluating the behavior of fiduciaries, most often courts turn to an analysis not of the advice that was given but rather to the process by which the advice was derived.  Nevertheless, while adherence to a proper process is also necessary, at each step along the process the Investment adviser is required to act prudently with the care of the prudent investment adviser.  In other words, the investment adviser must at all times exercise good judgment, applying his or her education, skills, and expertise to the financial planning issue before the investment adviser.  Simply following a prudent process is not enough if prudent good judgment (and the investment adviser’s requisite knowledge, expertise and experience) is not applied as well.

            Procedural Due Care.  One must evaluate the duty of care, unlike the duty of loyalty, by the process the fiduciary undertakes in performing his functions and not the outcome achieved. The very word “care” connotes a process. One associates caring with a condition, state of mind, manner of mental attention, a feeling, regard, or liking for something.  How else may one determine whether an investment adviser who regularly achieves below average returns, or an attorney who loses most cases, has performed his duty of care? It is only through evaluating the steps the fiduciary took while doing his job, and not whether they resulted in success, that one may judge whether the fiduciary has breached his duty.

Annotations.

1.     Expert Testimony Is Normally Required to Establish the Investment Adviser’s Standard of Care .  “Persons engaged in the practice of a profession or trade are held to the standard of "'the skill and knowledge normally possessed by members of that profession or trade in good standing in similar communities.’” Mcgraw v. Wachovia Sec., No. C 08-2064-MWB (N.D. Iowa, 2010) (memorandum opinion), citing Kastler v. Iowa Methodist Hosp., 193 N.W.2d 98, 101 (Iowa 1971) (quoting Restatement (Second) of Torts § 283 (1965)).  The burden rests upon the plaintiff to prove the professional's breach of this standard of care.  Mcgraw; also see Devine v. Wilson, 373 N.W.2d 155, 157 (Iowa App. 1985).  “Unless a professional's lack of care is so obvious as to be within the comprehension of a layperson, the standard of care and its breach must ordinarily be established through expert testimony.” Mcgraw, citing Perin v. Hayne, 210 N.W.2d 609, 613 (Iowa 1973); also citing Devine, 373 N.W.2d at 157.

2.     Registered Investment Advisers Must Possess Reasonable Basis for Investment Recommendations.  Under the Advisers Act, the SEC Staff recently interpreted the fiduciary duty of care to require the investment adviser to “make a reasonable investigation to determine that it is not basing its recommendations on materially inaccurate or incomplete information.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.22 and p.27(available at http://sec.gov/news/studies/2011/913studyfinal.pdf.), citing, see, Concept Release on the U.S. Proxy System, Investment Advisers Act Release No. 3052 (July 14, 2010) (“Release 3052”) at 119.

3.     However … Rule-Making is Anticipated Under Dodd-Frank for Registered Investment Advisers and Broker-Dealers.  “The [SEC] Staff believes that the Commission, through rulemaking, guidance, or both, should specify the minimum professional obligations of investment advisers and broker-dealers under the duty of care. In evaluating the regulation of investment advisers and broker-dealers, the Staff believes that it could be useful to develop rules or guidance on the minimum requirements that are fundamental to a duty of care under the uniform fiduciary standard.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.122 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)  “Professional standards under the duty of care could be developed regarding the nature and level of review and analysis that broker-dealers and investment advisers should undertake when making recommendations or otherwise providing advice to retail customers. The Commission could articulate and harmonize any such standards, by referring to and expanding upon, as appropriate, the explicit minimum standards of conduct relating to the duty of care currently applicable to broker-dealers (e.g., suitability (including product-specific suitability), best execution, and fair pricing and compensation requirements) under Commission and SRO rules.” Id.  “Any such rules or guidance could take into account long-held Advisers Act fiduciary principles, such as the duty to provide suitable investment advice (e.g., with respect to specific recommendations and the client’s portfolio as a whole) and to seek best execution.  Detailed guidance in this area has not been a traditional focus of the investment adviser regulatory regime.”  Id. at 123.

4.     ERISA’s “Prudent Man” Due Care Standard.  Section 401(a) of ERISA, which sets out the primary duties of ERISA fiduciaries, in essence adopts the “prudent man rule” as the standard of due care, as it provides in relevant part: “[A] fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries… with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims….”  Unlike the Advisers Act, “under ERISA, the fiduciary standard and the prudent man rule are included in the statute.”  Fred Reish and Bruce Ashton, “Brokers as Fiduciaries: The Reality and the Issues,” Reish & Reicher Bulletin (Dec. 17, 2009).

a.      Prudent Man Standard, Generally.  ERISA requires fiduciaries to discharge their duties "with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims." 29 U.S.C. § 1104(a)(1)(B .  “A fiduciary must discharge his duties with the care, skill, prudence and diligence under the circumstances then prevailing of "the traditional ‘prudent man’."  Donovan v. Bierwirth, 680 F.2d 263, 271 (2d Cir.1982).  "ERISA's fiduciary duty was meant to hold plan administrators to a duty of loyalty akin to that of a common-law trustee." Ameritech Benefit Plan Comm. v. Comm. Workers of America, 220 F.3d 814, 825 (7th Cir.2000).  Accordingly, "[t]he fiduciary must act as though [he] were a reasonably prudent businessperson with the interests of all the beneficiaries at heart." Id.   “The duty of prudence imposes an unwavering duty to act both as a prudent person would act in a similar situation and with single-minded devotion to plan participants and beneficiaries.” In Re Regions Morgan Keegan Erisa Litigation, 692 F. Supp.2d 944 (W.D. Tenn., 2010).

b.     DOL Regulations Assist in Defining Scope of the Obligation of Prudence.  “Regulations under Section 404(a)(1)(B) of ERISA provide that with regard to an investment or investment course of action taken by a fiduciary of a plan pursuant to his investment duties, the requirements of Section 404(a)(1)(B) of ERISA are satisfied if the fiduciary (A) has given appropriate consideration to those facts and circumstances that, given the scope of such fiduciary's investment duties, the fiduciary knows or should know are relevant to the particular investment or investment course of action involved, including the role the investment or investment course of action plays in that portion of the plan's investment portfolio with respect to which the fiduciary has investment duties; and (B) has acted accordingly. 29 C.F.R. § 2550.404(a)-1(b).” Keach v. U.S. Trust Co. N.A., 313 F.Supp.2d 818, 850 (C.D. Ill., 2004).

c.      The Process and/or Methods Followed by Fiduciary Are Examined, Not the Success of Investments. “ERISA requires fiduciaries to discharge their duties "with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims." 29 U.S.C. § 1104(a)(1)(B).  The Fifth Circuit has stated:

In determining compliance with ERISA's prudent man standard, courts objectively assess whether the fiduciary, at the time of the transaction, utilized proper methods to investigate, evaluate and structure the investment; acted in a manner as would others familiar with such matters; and exercised independent judgment when making investment decisions. "[ERISA's] test of prudence ... is one of conduct, and not a test of the result of performance of the investment. The focus of the inquiry is how the fiduciary acted in his selection of the investment, and not whether his investments succeeded or failed." Thus, the appropriate inquiry is whether the individual trustees, at the time they engaged in the challenged transactions, employed the appropriate methods to investigate the merits of the investment and to structure the investment.  Laborers National, 173 F.3d at 317 (citations omitted).

… Because the "prudent man" standard focuses on whether the fiduciary utilized appropriate methods to investigate and evaluate the merits of a particular investment, the appropriate methods in a particular case depend "on the `character' and `aim' of the particular plan and decision at issue and the `circumstances prevailing' at the time a particular course of action must be investigated and undertaken." Bussian, 223 F.3d at 299.” In re Dynegy, Inc. Erisa Litigation, 309 F.Supp.2d 861 (S.D. Tex., 2004).  See also In Re Regions Morgan Keegan Erisa Litigation, 692 F. Supp.2d 944 (W.D. Tenn., 2010) (“The test for the duty of prudence is whether the individual trustees, at the time they engaged in the challenged transactions, employed the appropriate methods to investigate the merits of the investment and to structure the investment.”)

d.     Prudence is Tested under Modern Portfolio Theory, Rather than the (Old) Trust Standard.  “Regulations promulgated by the Department of Labor (DOL) generally reflect that a fiduciary with investment duties must act as a prudent investment manager under the modern portfolio theory rather than under the common law of trusts standard, which examined each investment with an eye toward its individual riskiness. Id. at 317-318 (citing 29 C.F.R. § 2550.404a-1).”  In re Dynegy, Inc. Erisa Litigation, 309 F.Supp.2d 861, 875 (S.D. Tex., 2004).

e.      Prudence is Measured by Objective, Not Subjective, Standards; Hence, The “Good Faith” of the Fiduciary is Not Pertinent. “Prudence is thus measured according to the objective ‘prudent person’ standard developed in the common law of trusts.”  Donovan v. Mazzola, 716 F.2d 1226, 1231 (9th Cir.1983).  Subjective good-faith simply does not come into play.  Leigh v. Engle, 727 F.2d 113, 124 (7th Cir.1984).  “[T]he prudent man standard is an objective standard, and good faith is not a defense to a claim of imprudence.” In re Dynegy, Inc. Erisa Litigation, 309 F.Supp.2d 861, 875 (S.D. Tex., 2004).  See also Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir.1983), cert. denied, 467 U.S. 1251, 104 S.Ct. 3533, 82 L.Ed.2d 839 (1984) ("this is not a search for subjective good faith - a pure heart and an empty head are not enough").”

f.       An Independent Investigation of Merits of the Investment by the Fiduciary is Required.  “The focus of the inquiry under the prudent man rule is on the fiduciaries' independent investigation of the merits of a particular investment rather than an evaluation of the merits alone.  The test of prudence focuses on whether the fiduciaries, at the time they engage in a transaction, have employed the appropriate methods to investigate the merits of the investment and to structure the investment.”  Keach v. U.S. Trust Co. N.A., 313 F.Supp.2d 818, 850 (C.D. Ill., 2004) (Citations omitted.)  See also Harley v. Minnesota Mining & Mfg. Co., 42 F.Supp.2d 898, 906 (D. Minn. 1999) (The "prudent person" standard articulated in § 1104(a)(1)(B) is objective, focusing on the fiduciary's conduct preceding or at the time of the challenged conduct. See [Roth v. Sawyer-Cleator Lumber Co., 16 F.3d 915, 917-18 (8th Cir. 1994)]. Under this standard, a fiduciary is obligated to undertake an independent investigation of the merits of an investment and to use appropriate, prudent methods in conducting the investigation. See, e.g., In re Unisys Sav. Plan Litig., 74 F.3d 420, 435(3d Cir.) ("[T]he most basic of ERISA's investment fiduciary duties [is] the duty to conduct an independent investigation into the merits of a particular investment."), cert. denied, 519 U.S. 810, 117 S.Ct. 56, 136 L.Ed.2d 19 (1996); Liss v. Smith, 991 F.Supp. 278, 297 (S.D.N.Y.1998) (stating that the failure to make an independent investigation and evaluation has "repeatedly been held to constitute a breach of fiduciary obligations") (citing cases); Whitfield v. Cohen, 682 F.Supp. 188, 194 (S.D.N.Y.1988) (stating that the "test of prudence focuses on the trustee's conduct in investigating, evaluating and making the investment," and indicating that the trustee's failure to make an independent investigation is a breach of fiduciary duty) (citing Fink v. National Sav. and Trust Co., 772 F.2d 951, 957 (D.C.Cir.1985)).” Harley at 906-7.

g.     Neither Prescience Nor Omniscence Required.  “ERISA imposes the highest standard of conduct known to law on fiduciaries of employee pension plans … However, this is not equivalent to a standard of absolute liability, as ERISA fiduciaries are only required to exercise prudence, not prescience or omniscience ….” Keach v. U.S. Trust Co. N.A., 313 F.Supp.2d 818, 863 (C.D. Ill., 2004).  “The ultimate outcome of an investment is not proof that a fiduciary acted imprudently.  Marshall v. Glass/Metal Ass'n & Glaziers & Glassworkers Pension Plan, 507 F.Supp. 378, 384 (D.Haw.1980).  “[T]he appropriateness of an investment is to be determined from the perspective of the time the investment was made, not from hindsight.”  Keach v. U.S. Trust Co. N.A., 313 F.Supp.2d 818, 867 (C.D. Ill., 2004).

5.     Best Execution. 

a.      For Broker-Dealers.  “Under the antifraud provisions of the federal securities laws and SRO rules, broker-dealers also have a legal duty to seek to obtain best execution of customer orders.  The duty of best execution requires broker-dealers to seek to execute customers’ trades at the most favorable terms reasonably available under the circumstances.  Traditionally, price has been the predominant factor in determining whether a broker-dealer satisfied its best execution obligations.  The Commission has stated that broker-dealers should also consider at least six additional factors: (1) the size of the order; (2) the speed of execution available on competing markets; (3) the trading characteristics of the security; (4) the availability of accurate information comparing markets and the technology to process the data; (5) the availability of access to competing markets; and (6) the cost of such access.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.69 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf) (Citations omitted).

b.     For Registered Representatives.  “Investment advisers have an obligation to seek best execution of clients’ securities transactions where they have the responsibility to select broker-dealers to execute client trades (typically in the case of discretionary accounts).  In meeting this obligation, an adviser must seek to obtain the execution of transactions for each of its clients in such a manner that the client’s total cost or proceeds in each transaction are the most favorable under the circumstances.  When seeking best execution, an adviser should consider the full range and quality of a broker’s services when selecting broker-dealers to execute client trades including, among other things, the broker’s execution capability, commission rate, financial responsibility, responsiveness to the adviser, and the value of any research provided.  An investment adviser should ‘periodically and systematically’ evaluate the execution it is receiving for clients.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), pp.28-9 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf) (Citations omitted).

Rule 4.2  Achieving and Maintaining Professional Competence.  An investment adviser shall provide services to clients competently.  An investment adviser is competent only when he or she has attained and has maintained an adequate level of knowledge, skill and experience, and is able to apply that knowledge skill and experience effectively in providing services to clients. 

Commentary. 

Competence is derived from a synthesis of knowledge, skill and experience.  Due to ever-changing laws, regulations, and the development of new strategies, services, and products, the maintenance of competence requires a commitment to learning and professional improvement that must continue throughout an investment adviser's professional life.  Maintaining competency is an investment adviser’s individual responsibility. In all engagements and in all responsibilities, each Investment adviser should undertake to achieve a level of competence that will assure that the quality of the Investment adviser's services meets the high level of professionalism required by these principles.

Rule 4.3. When Consultation Required With Other Professionals.  Consultation or referral by the Investment adviser with other professionals shall be required when a professional engagement exceeds the personal competence of the Investment adviser and the competencies of others who might support the Investment adviser from within the Investment adviser’s firm.

Commentary. 

Competence represents the attainment and maintenance of a level of understanding and knowledge that enables an investment adviser to render services with facility and acumen.  It also establishes the limitations of a member's capabilities by dictating that consultation or referral may be required.  Each investment adviser is responsible for assessing his or her own competence – of evaluating whether education, experience, and judgment are adequate for the responsibility to be assumed.

The fiduciary duty of due care requires the investment adviser to possess knowledge, utilize care, and act diligently.  Knowledge requires that the investment adviser possess the necessary education and skills to discharge the Investment adviser’s duties owed to the client.  While investment advisers cannot be experts in all aspects of the complex tax laws, financial, estate and risk management issues, and financial markets that exist, they should not try to represent themselves as such.  However, investment advisers should strive to expand their expertise in areas which will best serve their clients. 

A lack of knowledge or expertise is, in itself, not a violation of the Rule.  However, advising a client in areas where such knowledge is required, or not consulting with others in those areas, would be a violation of the Rule.  The Rule requires investment advisers to provide advice only in areas in which they fully and reasonably understand the technical implications.

Annotations. 

1.     When Client is a Fiduciary – Duty to Delegate.  Where the client is a fiduciary himself, herself, or itself (e.g., acting as a trustee, attorney-in-fact, guardian, etc.), the client may possess a duty to consult with an investment adviser when the client lacks the requisite knowledge to navigate the world of investments. Similarly, under ERISA, in those circumstances where plan sponsors “lack the requisite knowledge, experience and expertise to make the necessary decisions with respect to investments, their fiduciary obligations require them to hire independent professional advisors.”  Liss v. Smith, 991 F.Supp. 278, 387 (S.D.N.Y. 1998).

2.     Reasonable Prudence in Selecting and Monitoring When Delegation Occurs.  “In order to exercise reasonable prudence in seeking expert advice, a fiduciary must (1) investigate the expert's qualifications, (2) provide the expert with complete and accurate information, and (3) make certain that reliance on the expert's advice is reasonably justified under the circumstances.  As such, the fiduciary's duty is to ensure that the expert is qualified and reliable, not to investigate the accuracy of the expert's advice.”  Barboza v. Cal. Ass'n Of Prof'l Firefighters (E.D. Cal., 2011) (applying ERISA to decisions of a plan sponsor).

Rule 4.4.  Diligence in the Delivery of Services.  Investment advisers shall be diligent in discharging responsibilities to clients, employers, and the public. Diligence imposes the responsibility upon Investment advisers to render services reasonably promptly and carefully and with a reasonable level of thoroughness.

Commentary. 

Diligence is the provision of services in a reasonably prompt and thorough manner. Diligence also includes proper planning for, and supervision of, the rendering of professional services.

Diligence requires investment advisers to discharge their duties in a timely manner and to maintain full records of decisions and actions. Timeliness is necessary so that opportunities will not be lost due to inaction. Violations of ethical behavior can be caused by inaction when action would have been required, or by lack of thoroughness in evaluating the investment issue confronting the client.

Various other aspects of “diligence” are discussed in the “suitability” and “due diligence” rules set forth below.

Rule 4.5.  Suitability As To Recommendations of Investment Products.  In recommending securities or investment products to clients the Investment adviser must determine that the security or investment product is suitable for that customer in light of the customer's financial status and investment objectives.

Commentary. 

The duty of suitability in the making of investment product recommendations is a minimal, but important duty.  The fiduciary duty of due care requires greater effort and even more sound judgment to be applied, however, as illustrated by the Investment Adviser Rules of Professional Conduct 4.6, 4.7 and 4.8.

Annotations.

1.     The Three Major Aspects of “Suitability,” Generally.  In general, three approaches to suitability have developed under the case law, including FINRA and Commission enforcement actions – “reasonable basis” suitability, “customer-specific” suitability, and “quantitative” suitability.

2.     Applicability of Suitability Obligations to Registered Investment Advisers.  Investment advisers owe their clients the duty to provide only suitable investment advice. See SEC's "Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act" (Jan. 21, 2011), pp.27-8 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.), quoting Suitability of Investment Advice Provided by Investment Advisers, Investment Advisers Act Release No. 1406 (Mar. 16, 1994) (proposing a rule under the Advisers Act Section 206(4)'s antifraud provisions that would expressly require advisers to give clients only suitable advice; the rule would have codified existing suitability obligations of advisers).

a.      Reasonable Basis Suitability – Investment Strategies and/or Products.  Under reasonable basis suitability, a broker-dealer has an affirmative duty to have an “adequate and reasonable basis” for any security or strategy recommendation that it makes.  See Exchange Act Release No. 27535 (Dec. 13, 1989) (finding that the broker’s recommendations violated suitability requirements because the broker did not have a reasonable basis for the strategy he recommended, wholly apart from any considerations relating to the particular customer’s portfolio). See also Hanly, 415 F.2d at 597, supra note 271; In the Matters of Walston & Co., Exchange Act Release No. 8165 (Sept. 22, 1967) (settled order); Michael F. Siegel, 2007 NASD Discip. LEXIS 20 (2007).  A broker-dealer, therefore, has the obligation to investigate and have adequate information about the security or strategy it is recommending.  “The broker or advisor implicitly represents to the client that he or she has an adequate basis for the opinions or advice being provided.” Johnson v. John Hancock Funds, No. M2005-00356-COA-R3-CV (Tenn. App. 6/30/2006) (Tenn. App., 2006), citing Hanly v. S.E.C., 415 F.2d 589, 596-97 (2d Cir. 1969); Univ. Hill Found. v. Goldman, 422 F. Supp. 879, 893 (S.D.N.Y. 1976).

b.     See also Regulatory Notice 09-25, “Proposed Consolidated FINRA Rules Governing Suitability and Know-Your-Customer Obligations” (and FINRA Rule 2111.05 (effective Oct. 7, 2011) (“The reasonable-basis obligation requires a member or associated person to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. In general, what constitutes reasonable diligence will vary depending on, among other things, the complexity of and risks associated with the security or investment strategy and the member's or associated person's familiarity with the security or investment strategy. A member's or associated person's reasonable diligence must provide the member or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy. The lack of such an understanding when recommending a security or strategy violates the suitability rule.”)

3.     Customer-Specific Suitability.  Under customer-specific suitability, a broker-dealer must make recommendations based on a customer’s financial situation and needs as well as other security holdings, to the extent known.  See In the Matters of Richard N. Cea, et al., Exchange Act Release No. 8662 at 18 (Aug. 6, 1969) (“Release 8662”) (involving excessive trading and recommendations of speculative securities without a reasonable basis); F.J. Kaufman and Co., Exchange Act Release No. 27535 (Dec. 13, 1989); NASD Rule 2310 (requiring that members “have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs”); Regulatory Notice 09-25, “Proposed Consolidated FINRA Rules Governing Suitability and Know-Your-Customer Obligations”; FINRA Rule 2111.05 (effective Oct. 7, 2011) (noting that “the customer-specific obligation requires that a member or associated person have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer's investment profile.”).

a.      This customer-specific suitability requirement is construed to impose a duty of inquiry on broker-dealers and registered investment advisers to obtain relevant information from customers relating to their financial situations.

(1)    “To fulfill the obligation, [a registered investment] adviser must make a reasonable determination that the investment advice provided is suitable for the client based on the client's financial situation and investment objectives.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.22 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

(2)    As to broker-dealers, see NASD Rule 2310: “Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning: (1) the customer's financial status; (2) the customer's tax status; (3) the customer's investment objectives; and (4) such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.”  See also Regulatory Notice 09-25, “Proposed Consolidated FINRA Rules Governing Suitability and Know-Your-Customer Obligations;” FINRA Rule 2111(a) (effective Oct. 7, 2011). (“A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer's investment profile. A customer's investment profile includes, but is not limited to, the customer's age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.”).  See also In the Matter of the Application of Gerald M. Greenberg, et al., Exchange Act Release 6320 (July 21, 1960) (holding that a broker cannot avoid the duty to make suitable recommendations simply by avoiding knowledge of the customer’s financial situation entirely).  However, note that under the FINRA rules, a broker-dealer’s suitability obligations are different for institutional customers than for non-institutional customers. NASD IM-2310-3[FINRA Rule 2111(b)] (effective Oct. 7, 2011) sets out factors that are relevant to the scope of a broker-dealer’s suitability obligations in making recommendations to an institutional customer.

b.     The requirement of customer-specific suitability is also construed to impose a duty of inquiry on broker-dealers and registered investment advisers keep such information current.

(1)    Exchange Act Rule 17a-3(a)(17)(i) requires, subject to certain exceptions, broker-dealers to update customer records, including investment objectives, at least every 36 months from the last recommendation.

4.     Quantitative Suitability (No Excessive Trading, Churning, or Switching).  “Under quantitative suitability, a broker-dealer that has actual or de facto control over a customer account must have a reasonable basis for believing that the number of recommended transactions within a certain period, even if suitable when viewed in isolation, is not excessive and unsuitable for the customer when taken together in light of the customer's investment profile. Activities such as excessive trading, churning, and switching have been found to violate the quantitative suitability obligation under the SRO suitability rules and federal antifraud provisions.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), pp.64-5 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

a.      See In the Matter of the Application of Clyde J. Bruff, Exchange Act Release No. 40583 (Oct. 21, 1998) (excessive trading is itself a form of unsuitability).

b.     “Churning” occurs when a broker-dealer buys and sells securities for a customer’s account, without regard to the customer’s investment interests, for the purpose of generating commissions. See, e.g. In the Matter of the Application of Donald A. Roche, Exchange Act Release No. 38742 (June 17, 1997) ((excessive trading is a type of violation of “broad” suitability rules promulgated by SROs) (quoting Miley v. Oppenheimer & Co., 637 F.2d 318, 324 (5th Cir. 1981).

c.      “Switching” involves transactions in which shares of a particular security are redeemed and all or part of the proceeds are used to purchase shares of another security with the primary effect of benefiting the broker rather than the customer. See, e.g., In the Matter of the Application of Scott Epstein, Exchange Act Release No. 59328 (Jan. 30, 2009), aff’d Epstein v. S.E.C., 2010 WL 4739749 (3rd Cir. 2010) (finding that a registered representative violated NASD Rules 2310(a), 2310(b), IM-2310-2, and 2110 because he did not have reasonable grounds for recommending mutual fund switches and put his own interests ahead of the interests of his customers).

5.     Other SEC/FINRA Rules Pertaining to Suitability.  “Specific disclosure, due diligence, and suitability requirements apply to certain securities products, including penny stocks, options, mutual fund share classes, debt securities and bond funds, municipal securities, hedge funds, direct participation programs, variable insurance products, and non-traditional products, such as structured products and leveraged and inverse exchange-traded funds.  Moreover, considerations related to suitability may be raised with regard to specific types of accounts such as discretionary, day trading, or margin accounts.” SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), pp.65-6 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

Rule 4.6.  Due Diligence In Investment Strategy and investment Product Selection.  In addition to meeting the requirements of the suitability doctrine, the investment adviser must exercise due diligence as to:

- the investment strategy to be employed; and

- the investment products recommended to the client;

seeking to select the investment strategy(ies) and product(s) which best meet the client's needs.

When engaged to do so or required by law, the investment adviser must monitor the investments chosen.

Commentary. 

Consistent with the nature and scope of the engagement, the investment adviser shall undertake a reasonable investigation regarding the investment strategy, as well as the specific investment products, recommended to clients. Such an investigation may be made by the investment adviser or by others provided the investment adviser acts reasonably in relying upon such investigation.

Factors the investment adviser should address in such an investigation include, but are not limited to: (1) the historical and expected returns of the investment product and its asset class; (2) the risks posed by the product as to price volatility,  terminal value, or otherwise; (3) the effect of the addition of the product to the investment portfolio of the client and its expected risks and returns; (4) the fees and costs associated with the acquisition, holding, or potential sale of the product; (5) the tax attributes of the product in light of the client’s situation (both as to tax benefits and tax detriments); and (6) whether any guarantees offered by the product will likely provide a meaningful benefit to the client in light of their costs.

Annotations. 

1.     Investment Strategy Due Diligence, Generally.

a.      Under ERISA.  “We think it is entirely appropriate for a fiduciary to consider the time horizon over which the plan will be required to pay out benefits in evaluating the risk of large loss from an investment strategy.” Metzler v. Graham, 112 F.3d 207, 210 (5th Cir.1997) [Emphasis added.]

2.     Diversification Requirement, Generally.  Unless the fiduciary and the client otherwise agree, it should be assumed by the fiduciary that the prudent man rule applies to the design and implementation of the client’s investment portfolio. 

a.      ERISA’s Diversification Requirement, Generally.  “ERISA requires fiduciaries to diversify "the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so." 29 U.S.C. § 1104(a)(1)(C).  The Fifth Circuit has stated: ‘The degree of investment concentration that would violate this requirement to diversify cannot be stated as a fixed percentage, because a fiduciary must consider the facts and circumstances of each case. The factors to be considered include (1) the purposes of the plan; (2) the amount of the plan assets; (3) financial and industrial conditions; (4) the type of investment, whether mortgages, bonds or shares of stock or otherwise; (5) distribution as to geographical location; (6) distribution as to industries; (7) dates of maturity.’ Metzler v. Graham, 112 F.3d 207, 209 (5th Cir.1997) (citing H.R.Rep. No. 1280, 93d Cong., 2d Sess. (1974), reprinted in 1974 U.S.C.C.A.N. 5038, 5084-85 (Conf. Rpt. at 304)).. Moreover, the court admonished lower courts that "[i]t is clearly imprudent to evaluate diversification solely in hindsight-plan fiduciaries can make honest mistakes that do not detract from a conclusion that their decisions were prudent at the time." Id. at 209.  [Generally, there are four principle fiduciary duties under ERISA §404(a): duty of loyalty; duty of prudence; duty to diversify; and duty to follow plan documents.]

3.     Investment Product Due Diligence, Generally.  

a.      Due Diligence Arising under ERISA, as to Investment Selection and Monitoring.  “An ERISA investment adviser possesses the general duty to prudently select and monitor any service provider or designated investment alternative offered under the plan.”  29 C.F.R. Part 2550 (Oct. 14, 2010), at 132; § 2550.404c-1(d)(2)(iv).  “It is by now black-letter ERISA law that ‘the most basic of ERISA's investment fiduciary duties [is] the duty to conduct an independent investigation into the merits of a particular investment.’ In Re Unisys Savings Plan Litig., 74 F.3d 420, 435 (3d Cir.), cert. denied, ___ U.S. ___, 117 S.Ct. 56, 136 L.Ed.2d 19 (1996).  ‘The failure to make any independent investigation and evaluation of a potential plan investment’ has repeatedly been held to constitute a breach of fiduciary obligations. Whitfield v. Cohen, 682 F.Supp. 188, 195 (S.D.N.Y.1988).”  Liss v. Smith, 991 F.Supp. 278 (S.D.N.Y., 1998).   ERISA regulations defines the “appropriate consideration” which must be given to “those facts and circumstances that ... the fiduciary knows are relevant to the particular investment or investment course of action involved, including the role the investment or investment course of action plays in that portion of the plan's investment portfolio with respect to which the fiduciary has investment duties”: “[A]ppropriate consideration" shall include ... [a] determination by the fiduciary that the particular investment or investment course of action is reasonably designed, as part of the portfolio ... to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain (or other return) associated with the investment or investment course of action, and [c]onsideration of ... (A) [t]he composition of the portfolio ... (B) [t]he liquidity and current return of the portfolio relative to the anticipated cash flow requirements of the plan; and (C) [t]he projected return of the portfolio relative to the funding objectives of the plan.”  29 C.F.R. § 2550.404a-1(b).

4.     Investment Policy Statements- Required?

a.      Under ERISA – As a Practical Matter, “Yes”.  “ERISA does not contain a specific requirement that a written investment policy be maintained by the trustees. I find, at least in this instance, that such a policy is necessary to insure that the plan investments are performing adequately and meeting the actuarial, liquidity and other needs of the Funds. Support for this proposition is found in Department of Labor regulations … The maintenance by an employee benefit plan of a statement of investment policy designed to further the purposes of the plan and its funding policy is consistent with the fiduciary obligations set forth in ERISA § 404(a)(1)(A) and (B).... For purposes of this document, the term `statement of investment policy' means a written statement that provides the fiduciaries who are responsible for plan investments with guidelines or general instructions concerning various types or categories of investment management decisions .... A statement of investment policy is distinguished from directions as to the purchase or sale of a specific investment at a specific time .... 29 C.F.R. § 2509.94-2(2). While this regulation states only that a written investment plan is "consistent" with ERISA's fiduciary duty requirements, in the circumstances here, absence of any plan constitutes a breach of fiduciary duty.”  Liss v. Smith, 991 F.Supp. 278 (S.D.N.Y., 1998).

5.     Duty to Monitor Investments Under ERISA.

a.      “While ERISA does not expressly state a ‘duty to monitor’, courts have recognized a duty to monitor and many of the fiduciary duties outlined above may be fully or partially fulfilled through a regular monitoring process … The duty to monitor investment performance is applicable even with respect to retirement plans that rely on the so-called "404(c) safe harbor" to insulate plan fiduciaries from liability to plan participants for losses sustained in the participants' individual accounts based on investment losses stemming from participant-directed investments.”  Alison Wright, Howard Rice Nemerovski, Caady Falk & Rabkin, P.C., ERISA Fiduciary Duty and the Duty to Monitor (Bloomberg Law Reports / Employee Benefits, 2010), available at http://www.furrandassociates.com/files/13875/Bloomburg%20Law%20Report_ERISA%20Fiduciary%20Duty%20and%20Duty%20to%20Monitor.pdf.

b.     See Lingis v. Motorola, Inc., 649 F.Supp.2d 861 (N.D. Ill., 2009) (“The duty to monitor is thus a natural extension of the duty to appoint and remove plan fiduciaries … The Department of Labor regulation cited above stated that fiduciaries can comply with the duty to monitor by reviewing the fiduciaries' performance "at reasonable intervals." 29 C.F.R. § 2509.75-8 (FR-17).” Id.

c.      See Harley v. Minnesota Mining and Mfg. Co., 42 F.Supp.2d 898 (D. Minn., 1999) [“Once the investment is made, a fiduciary has an ongoing duty to monitor investments with reasonable diligence and remove plan assets from an investment that is improper. See, e.g., Liss, 991 F.Supp. at 299 (noting, in finding a breach of fiduciary duty, that the fiduciaries had failed to monitor the performance of the fund's broker); Hunt v. Magnell, 758 F.Supp. 1292, 1299 (D.Minn.1991) ("ERISA fiduciaries must monitor investments with reasonable diligence and dispose of investments which are improper to keep."); Whitfield, 682 F.Supp. at 196. Typically, whether a fiduciary acted prudently — or in other words, as a reasonably prudent fiduciary — is a question of fact. See, e.g., Roth, 16 F.3d at 919 (finding that whether the fiduciaries acted reasonably in the circumstances presented involved a question of fact precluding summary judgment).”] Harley at 906-7.

6.     Prudence, Not Prescience, is Required.  While the duty of due diligence is a high one, it is not without boundaries.  For example, “ERISA imposes the highest standard of conduct known to law on fiduciaries of employee pension plans.” Reich v. Valley National Bank of Arizona, 837 F.Supp. 1259, 1273 (S.D.N.Y.1993), quoting Donovan v. Bierwirth, 680 F.2d 263 (2nd Cir.1982); Kuper v. Iovenko, 66 F.3d 1447, 1453 (6th Cir.1988).  However, this is not equivalent to a standard of absolute liability, as ERISA fiduciaries are only required to exercise prudence, not prescience or omniscience. Frahm v. Equitable Life Assurance Society of the United States, 137 F.3d 955, 960 (7th Cir.1998); DeBruyne v. Equitable Life Assurance Society of the United States, 920 F.2d 457, 465 (7th Cir.1990).”  Keach v. U.S. Trust Co. N.A., 313 F.Supp.2d 818, 863 (C.D. Ill., 2004).

7.     Investigation of Accuracy of Offering Circulars, Reports Generally Not Required, Unless Facts Give Rise to Suspicions, or Unless Duty Assumed to So Investigate.  Another case “addressed, in the context of determining liability under federal securities laws, whether an investment advisor has a duty to investigate the accuracy of statements made in an offering memorandum not prepared by itself and which its client relies upon in making an investment. The court declined to impose such a duty "when there is nothing that is obviously suspicious about those statements.”  Fraternity Fund v. Beacon Hill Asset, 376 F.Supp.2d 385, 413 (S.D.N.Y., 2005), citing Gabriel Capital, L.P. v. Natwest Finance, Incorporated, 137 F.Supp.2d 251, 262 (S.D.N.Y.2000).  ("An investment advisor is retained to suggest appropriate investments for its clients, but is not required to assume the role of accountant or private investigator and conduct a thorough investigation of the accuracy of the facts contained in the documents that it analyzes for the purpose of recommending an investment.”).  Id. at 263.  However, if a representation is made that the accuracy of documents will be verified, then such a duty of due diligence, voluntarily assumed by the investment adviser, will likely exist.  See Fraternity Fund at p.415 (“Here, however, Asset Alliance allegedly represented to Sanpaolo that it ‘ensure[d] that the portfolios’ marks are consistent with market values.’ By making this representation, Asset Alliance took on a duty to review and check Beacon Hill's prices.”).

8.     ERISA’s Requirements.  Under ERISA, a fiduciary is obligated to undertake an independent investigation of the merits of a particular investment and to use appropriate and prudent methods in conducting that investigation.  Harley v. Minnesota Mining & Mfg. Co., 42 F.Supp.2d 898, 906 (D. Minn. 1999), citing In re Unisys Savings Plan Litigation, 74 F.3d 420, 435 (3rd Cir. 1996).  In determining compliance with ERISA's prudent man standard, courts objectively assess whether the fiduciary, at the time of the transaction, utilized proper methods to investigate, evaluate and structure the investment; acted in a manner as would others familiar with such matters; and exercised independent judgment when making investment decisions.

9.     Hedge Fund Due Diligence.  “Where an investment advisor recommends a hedge fund without conducting sufficient due diligence, an investor's breach of fiduciary duty claim "arises in the securities context" (Bayou Hedge Fund Litigation, 534 F. Supp.2d 405, 422, SDNY 2007, aff'd sub nom., South Cherry St. v Hennessee Group, 573 F.2d 98, 2d Cir., 2009).”  Hecht v. Andover Assoc. Mgt. Corp., 2010 NY Slip Op 50528(U) (N.Y. Sup. Ct. 3/12/2010).

Rule 4.7.  Ensuring the Reasonableness of the Total Fees and Costs Borne By a Client.  An investment adviser shall reasonably ensure that the total fees and costs borne by the client in connection with the Investment adviser’s services and recommendations are reasonable IN light of the services provided.

Commentary. 

The Reasonablenesss of Fees, Generally.  Fees charged or incurred by clients should not be excessive in light of the extent and nature of the services provided, the skill and expertise required of the investment adviser, the risks assumed by the investment adviser in connection with the advice and services provided, and the benefits obtained by the client.

Discussion of Investment Advisor Fee Arrangements, Generally.

AUM Fee Arrangements, Generally.  In the Constellation Financial Management LLC  no-action letter under Investment Advisor Act of 1940 - Section 206, dated January 9, 2003, the SEC Staff discussed charging fees using a percentage of assets under management:

In recent years, the financial services industry has discovered how profitable asset management fees are, and many registered-representatives of broker-dealer firms have transitioned from transaction-generated commissions to asset management fees (i.e., fees based on a percentage of assets under management).  In general, such fees increase as the size of the client's portfolio increases.  While there has been some criticism that fees should not be substantially higher when the time and effort expended are not commensurately higher, there exist at least three major reasons justifying a percentage of assets under management approach. First, there is certainly a greater personal and firm risk (in terms of potential liability) as the amount of managed assets increases.  This often directly translates into increased costs, especially as to E&O insurance premiums for the Investment adviser or his or her firm.  Second, in terms of benefit to the client, an investment adviser benefits more greatly the client who has a greater level of assets under management.  The time that is spent by an investment advisers undertaking investment research and due diligence, and reviewing the academic research promulgated by others, benefits all clients, but perhaps benefits the wealthier client the most.  Third, investment advisers may choose to provide services to those who possess lower amounts of managed assets than would otherwise be accepted by the investment advisers, as a means of benefitting the public good.  While this justification may be controversial, the higher fees paid by some clients enable Investment advisers to serve those of limited resources but who nevertheless possess financial planning needs.  Investment advisers thereby are better equipped to serve the public good, while still permitting the investment advisers to maintain a reasonable level of professional practice income.

Varying AUM Fees, Observations.  Percentage fees can be set substantially lower for clients, as a percentage of the investment portfolio, as the size of the client's portfolio grows.  This is one way of adjusting the compensation to fit the effort required, while still compensating for the added risk of greater managed assets or the greater benefit to the client.  In addition, an investment adviser may choose to voluntarily lower fees for an investor in primarily fixed income investments, in adherence to his or her fiduciary duty, although this, in turn, might create a conflict of interest as to determining the asset allocation to be recommended to the client.

Flat Fee or “Retainer Fee” Arrangements.  Charging a "flat fee" to all clients, regardless of the level of managed assets or the client’s overall wealth, would remove virtually all remaining potential conflicts of interest.  In the fee-only investment community, it is sometimes known as being "pure."  It better ensures that the investment advisers does not have a financial incentive to take an inordinate amount of risk with the client's investment portfolio in pursuit of unnecessarily high returns, fails to recommend that the client convert managed financial assets to non-managed or non-financial assets, or pay off debt, even when such is better for the client, and does not advise against spending the clients' money or giving it away as part of the clients' estate planning.  However, a pure “flat fee” or retainer does not compensate the advisor for the added risk associated with the management of larger accounts, nor for the added benefits to the client related to larger accounts.  Moreover, flat fees may meet resistance from clients, just as any other fee structure would.

Hourly Fee Arrangements, Generally.  There are investment advisers and financial planners who firmly believe in hourly fee arrangements.   Investment advisers should be encouraged to enter into hourly-based financial planning arrangements when appropriate.  However, criticism by hourly-only investment advisers of other compensation structures should be resisted, as an hourly fee only model for the financial planning profession may not be appropriate in all cases, as this commonly repeated story reveals: A woman was strolling along a street in Paris when she spotted Picasso sketching at a sidewalk café. The woman asked Picasso if he might sketch her, and charge accordingly. Picasso obliged. In just minutes, there she was: an original Picasso.  “And what do I owe you?” she asked.  “Five thousand francs,” he answered.  “But it only took you three minutes,” she politely reminded him. “No,” Picasso said. “It took me all my life.”

Commissions; Variable Compensation.  Commissions, since they are paid by third parties to the investment adviser, pose a serious conflict of interest to the investment adviser.  However, the payment of commissions, or other forms of third-party compensation (e.g., principal trading mark-ups and mark-downs) do not constitute a per se violation of an investment adviser’s fiduciary duties.  More problematic is the situation where the investment adviser’s compensation is variable.  Variable compensation, in which the investment adviser may be paid more for recommending one product over another, such as a higher commission (or other forms of third-party compensation, such as payment for shelf space, 12b-1 fees, soft dollar compensation, etc., paid to the investment adviser or an affiliate thereof), presents the investment adviser with the difficult burden to justify the higher compensation – especially when the review of the arrangement is likely to be undertaken by an arbitrator, judge or jury who may be less than inclined to accept the explanation provided.  A better practice for an investment adviser utilizing commission-based compensation (or any other form of third-party compensation) would be to agree with the client, in advance, as to the parameters of the investment adviser’s compensation, and then to select products within such compensation parameters.  A best practice would be the avoidance of third-party material compensation, altogether.

Even with Clients Only Paying Compensation, Conflicts of Interest Relating to Compensation of the Investment Adviser are Likely to Still Exist.  Despite the efforts to avoid conflicts of interest, and regardless of the form of compensation, some conflicts of interest will continue to exist.  Proper management of remaining conflicts of interest is essential to preserving the investment adviser’s ability to act in the best interests of the client.

Close Attention to Fees and Costs is Required.  Fiduciary status requires investment advisers to pay close attention to the total fees and costs which a client will bear in connection with the advisory services, including the total fees and costs of recommended investment products.  Since an investment adviser has the objective of putting the client’s interests first, and since fees and costs borne by the client’s will affect the results obtained by the client, it is obvious that any costs passed on to clients must be spent wisely. This does not mean that the least expensive alternative must always be used, but it does mean that a cost-benefit analysis must be considered for each expense.

Annotations.

1.     Prudent Investor Rule: Duty to Reduce Costs.  As stated previously, at least one court has found the Prudent Investor Rule to be the standard applicable to an investment adviser’s duty of due care under the state common law (while other courts have declined to follow that holding); in any event, most retail clients believe that the investment adviser will, following his or her duty of due care, recommend to the client a “prudent” investment portfolio.  However, even then, an investment adviser and the client may, by mutual agreement, waive the Prudent Investor Rule’s application, provided sufficient information regarding the ramifications of such waiver are disclosed and understood by the client.

If the Prudent Investor Rule is applicable to the investment adviser’s relationship with the client, then the Rule goes a large step is discussing the duties of a fiduciary with regard to costs.  For example, as adopted in Florida, and as set forth in Section 518.11(1)(f), Florida Statutes (2010): “The circumstances that the fiduciary may consider in making investment decisions include, without limitation ... the general economic conditions, the possible effect of inflation, the expected tax consequences of investment decisions or strategies, the role each investment or course of action plays within the overall portfolio, the expected total return, including both income yield and appreciation of capital, and the duty to incur only reasonable and appropriate costs.” [Emphasis added.]  As stated in the commentary to the UPIA, “[I]t is important for trustees to make cost comparisons, particularly among similar products of a specific type being considered for a trust portfolio.”  In other words, to act prudently a fiduciary must act to reduce costs.  Like any investor, a fiduciary should be informed of the total costs of the investment, and should consider alternatives.  Higher costs should be incurred only when there is a legitimate reason to do so - such as higher expected returns or the need to engage an investment advisor to assist the fiduciary.” [Comment to Section 7, UPIA.]

2.     Investment Advisers’s Duty to Understand – and Evaluate - All of the “Total Fees and Costs” of Pooled Investment Vehicles.  The “annual expense ratio” of a mutual fund, unit investment trust, or ETF does not represent all of the fees and costs associated with same.  Knowing this, as part of the investment adviser’s due diligence efforts in mutual fund selection, investment advisers should undertake a reasonable review of the total costs of the investment product recommended.  For a reference article as to how investment advisers might discern, or at least estimate, the "total fees and costs" of U.S. stock mutual funds, see Rhoades, Estimating the Total Fees and Costs of Stock Mutual Funds and ETFs (April 22, 2009), available at http://www.josephcapital.com/EstimatingtheTotalCostsofStockMutualFunds200904.pdf.

3.     Broker-Dealer Rules Which Limit Compensation.  While not meeting the greater obligation of a fiduciary to ensure that all fees and costs are reasonable, “SRO rules generally require broker-dealer prices for securities and compensation for services to be fair and reasonable taking into consideration all relevant circumstances.  Generally, this requirement prohibits a member from entering into any transaction with a customer in any security at any price not reasonably related to the current market price of the security or to charge a commission that is not reasonable.  Recognizing that what may be “fair” (or reasonable) in one transaction could be “unfair” (or unreasonable) in another, FINRA has provided guidance on what may constitute a “fair” mark-up.  Moreover, the courts and the Commission have held that under the antifraud provisions of the federal securities laws, broker-dealers must charge prices reasonably related to the prevailing market price.  The Commission has consistently held that undisclosed markups of equities of more than 10% above the prevailing market price are fraudulent. Markups of less than 10% may also be fraudulent in certain circumstances.  For example, appropriate markups on debt securities are generally much lower, with the Commission even finding markups below 4 or 5% to be excessive and fraudulent.  Broker-dealers are also prohibited under FINRA rules from charging unfair or unreasonable underwriting compensation in connection with the distribution of securities, and must disclose all items of underwriting compensation in the prospectus or similar document.  Similarly, under FINRA rules, a broker-dealer’s charges and fees for services performed (including miscellaneous services such as collection of moneys due for principal, dividends, or interest; exchange or transfer of securities; appraisals, safekeeping or custody of securities, and other services) must be “reasonable” and “not unfairly discriminatory between customers” … charging an unfair commission would also violate a broker-dealer’s obligation to observe just and equitable principles of trade pursuant to FINRA rules.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), pp.66-8 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.) (Citations omitted.)

4.     ERISA Requires All Fees Paid Are “Reasonable.” 

a.      The Prohibited Transaction Rule and Exception Thereto Permitting “Reasonable” Fees.  ERISA §406 (prohibited transaction rule) prohibits the provision of goods and services between a plan and a party in interest. A party in interest includes persons providing services to such a plan. For example, a registered investment adviser (RIA) or stockbroker providing services to a retirement plan is a party in interest. The ERISA prohibitions preclude the furnishing of services between a plan and a party in interest and the transfer of plan assets to a party in interest. Thus, absent an exemption, the plan could not employ the RIA or stockbroker or use plan assets to pay their fees.  Hence, ERISA §408(b)(2) provides an exception to the prohibited transaction rule, which permits the provisions of services between and plan and a party in interest provided that the fees paid are reasonable.

b.     The “Facts and Circumstances” Test for Reasonableness.  A plan fiduciary is allowed to receive “any reasonable compensation for services rendered, or for the reimbursement of expenses properly and actually incurred, in the performance of his duties with the plan.” ERISA § 408(c)(2); 29 U.S.C. § 1108(c)(2).

                      i.     Whether compensation paid to a plan fiduciary for services rendered to a plan is “reasonable” depends on the particular facts and circumstances of each case.  29 C.F.R. § 2550.408c-2(b)(1).

                     ii.     However, if the fiduciary is already receiving full-time pay from an employer or association of employers or from an employee organization, whose employees or members participate in the plan, the fiduciary may receive only reimbursement of direct expenses. Id.

c.      “Reasonable” Not Clearly Defined.  “What constitutes ‘reasonable’ compensation is not clearly defined in the ERISA statute or regulations. The disclosure and other requirements associated with such compensation have been a source of confusion and controversy among plan sponsors, service providers and participants in recent years ... The meaning of ‘reasonable’ is not defined by reference to any specific amount or formula. Rather, reasonableness is a concept derived from the process by which a plan fiduciary selects investment options for plans based on disclosures and other information concerning fees and related services.  DOL regulations address the meaning of ‘reasonableness’ and discuss different contexts in which fees may or may not give rise to a violation of ERISA duties. In general, in order to be reasonable, fees must be reasonable in light of the services provided and must not be duplicative or excessive. A fiduciary has an ongoing duty to monitor fees to ensure that they remain reasonable and to provide plan participants with sufficient information concerning fees to enable them to make informed investment decisions.”  Fein, Melanie L. , The Reasonableness of 401(K) Plan Fees (July 2010). Available at SSRN: http://ssrn.com/abstract=1682074

5.     Termination Fees Not Permitted by Registered Investment Advisers.  An investment adviser should not charge a fee for termination of an investment adviser-client financial planning relationship, as such would give rise to a breach of fiduciary duty.  The SEC has stated that an advisory client has a right at any time to terminate the advisory relationship, and has previously brought enforcement actions regarding the right of advisory clients to receive a refund of any prepaid advisory fees that the adviser has not yet earned.  See, e.g., In the Matter of J. Baker Tuttle Corp., Initial Decision Release No. 13 (Jan. 8, 1990) and In the Matter of Monitored Assets Corp., Investment Advisers Act Release No. 1195 (Aug. 28, 1989) (settled order).

a.      Termination fees for the termination of an investment adviser-client relationship should not be charged, other than reasonable fees normally charged by custodians to all customers of the custodian.  See National Deferred Compensation (pub. avail. Aug. 31, 1987) ("an adviser may not fulfill its fiduciary obligations if it imposes a fee structure penalizing a client for deciding to terminate the adviser's service or if it imposes an additional fee on a client for choosing to change his investment").

b.     See also Constellation Financial Management, LLC (pub. avail. Jan. 9, 2003) (“We have taken the position that certain fees that may have the effect of penalizing a client for ending the advisory relationship, or that may make the client reluctant to terminate an adviser, may be inconsistent with the adviser's fiduciary duty, and may violate Section 206 …” (citing National Deferred Compensation).

6.     Must An Investment Adviser Recommend a Lower Cost S&P 500 Index Fund, If Several Choices Exist?   "A fiduciary must always act in the client's best interest (even when it is not in his or her own best interests).  Therefore, it may be a breach of fiduciary duty to recommend a S&P 500 mutual fund with a 5% load when you know of a fund with an equivalent track record that is no-load and has low annual expenses."  Donald Moine, Are You A Fiduciary?, From the August 13, 2000 MorningstarAdvisor.com, available at http://www.prudentinvestoract. com/Are%20You%20a%20Fiduciary.pdf.

Rule 4.8.  Proper Consideration of Tax Reduction Strategies.   Investment advisers shall reasonably consider and recommend to the client such strategies and investment products which may reduce the tax burdens imposed upon the client over time.

Commentary. 

In recommending investments to clients and undertaking financial planning, taxes also play an important role and must be taken into account by the investment adviser.  The investment adviser is required to possess a reasonable knowledge of tax reduction strategies.  Given the complexity and breadth of tax laws, the investment adviser should seek out tax advice from appropriate tax professionals where appropriate to meet the needs of the Investment adviser’s client and as a means of supplementing the Investment adviser’s own expertise in financial and tax planning.

An investment adviser is not permitted to disavow the duty to consider taxes in the furnishing of financial planning services to the client; however, an investment adviser may delegate or assign the necessary provision of tax advice to a qualified tax professional, provided a qualified tax professional is actually engaged by the investment adviser or the client in connection with the financial planning or investment advice which is rendered.  Additionally, an investment adviser is not obligated to opine on tax matters which are not encountered by most clients.

The duty of due care imposed by the broad fiduciary duty applicable to Investment advisers extends to a consideration of the tax effects of financial planning decisions.  Given the importance of tax reduction in financial planning activities, no investment adviser may state that he, she or their firm does not provide tax advice, unless the investment adviser places the investment recommendations provided to the client placed in writing and has them reviewed by a competent tax professional.

Annotations. 

How important is this attentiveness to taxation? According to an SEC study, investors in actively managed mutual funds lose an estimated 2.5% a year in annual returns to taxes. Another study by accounting firm KPMG Peat Marwick for the Congressional Joint Economic Committee found that the annual impact of taxes ranged from zero for the most tax-efficient funds to 5.6 percentage points for the least. Combined with actively managed stock mutual fund costs (both "disclosed" and "hidden") that average 2.8% or more per year, taxes and costs can combine to eliminate 50% or more of an investor's expected annual return. On a compounded basis, that 50% loss can equate to an erosion of the vast majority of the returns the capital markets have to offer to individual investors.

SECTION 5.  Duty of Confidentiality.

Rule 5.1.  Fiduciary Duty of Confidentiality.  Investment advisers shall keep all information about clients (including prospective clients and former clients) in strict confidence, including the client’s identity, the client’s financial circumstances, the client’s security holdings, and advice furnished to the client by the firm, unless the client consents otherwise.

Commentary. 

The fiduciary duty of confidentiality prohibits the investment adviser from using information obtained in confidence from his client or beneficiary other than for the benefit of that client or beneficiary.  Other laws and regulations, including Regulation S-P (privacy requirements), and other professional standards of conduct, may impose upon an investment adviser the duty to safeguard each client’s confidential and personal information.

An investment adviser shall not disclose any confidential client information without the specific consent of the client.  However, this rule shall not be construed to affect in any way an investment adviser’s obligation to comply with a validly issued and enforceable subpoena or summons, or to prohibit an investment adviser's compliance with applicable laws and government regulations, or prohibit review of an investment adviser’s professional practice, or to preclude an investment adviser from initiating a complaint with, or responding to any inquiry made by any regulatory agency.

Investment adviser’s employees and third-party-vendors who are provided with access to confidential client information should sign a statement agreeing to adhere to the Investment adviser’s privacy policy or otherwise protecting any confidential client information which is received.

In the event of the sale of an investment adviser’s practice or portion thereof, an investment adviser must take appropriate precautions (for example, through a written confidentiality agreement) so that the prospective purchaser does not disclose any information obtained in the course of the review, since such information is deemed to be confidential client information.  Likewise, investment advisers reviewing a practice in connection with a prospective purchase or merger shall not use to their advantage nor disclose the other investment adviser’s confidential client information that comes to their attention.

Best Practices Suggestions.

1.     Privacy Policy.  An investment adviser may desire to consider the following language in its published Privacy Policy:

We are committed to maintaining the confidentiality, integrity and security of the personal information that is entrusted to us.  Federal law requires that we notify you annually of our Privacy Policy, in writing.  The categories of nonpublic information that we collect from you may include information about your personal finances, personal taxes, personal estate planning, information about your health to the extent that it is needed for the financial, tax, estate, and asset protection planning process, and information about transactions between you and third parties (such as financial product providers, etc.).

     We may disclose limited information to attorneys, accountants, trust officers, mortgage lenders and other advisors or firms with whom you have established a relationship.  You may opt out from our sharing information with these non-affiliated third parties by notifying us at any time by telephone, mail, fax, email, or in person.  We may also share a limited amount of information about you with your brokerage firm or other custodian in order to assist you in establishing accounts, transferring accounts, facilitating cash or other transfers, executing securities transactions, and voting proxies.

      We may also share a limited amount of information about you with our portfolio reporting firm (to be selected) and our account aggregation firm and portfolio reporting firm.

     We maintain a secure office to ensure that your information is not placed at unreasonable risk.  We employ a firewall barrier and authentication procedures in our computer environment.  We do not provide your personal information to mailing list vendors or to solicitors.  We require strict confidentiality in our agreements with unaffiliated third parties that require access to your personal information, including auditors, consultants, and other financial services companies.  Federal and state regulators (such as the U.S. Securities and Exchange Commission and/or and the State of Florida Department of Financial Services) and professional organizations with whom we affiliate (such as the Certified Financial Planner Board of Standards, Inc.)  may review our company records and your personal records as permitted by law; this is for your protection.  While we possess a policy of strict confidentiality as to our clients' matters, under certain circumstances we may be required by law to make disclosures to government agencies and to third parties, such as upon receipt of a subpoena.

     Personally identifiable information about you will be maintained while you are a client, and for the required period thereafter that records are required to be maintained by federal and state securities laws and regulations.  After that time, information may be destroyed.  We will notify you in advance if our privacy policy is expected to change.

2.     Obtain Client Signature.  An investment adviser should request that the investment adviser’s clients and prospective clients, prior to the initial receipt of substantial confidential information or upon any material change to the investment adviser’s disclosure policies, sign a written statement accepting the disclosures which are authorized in the investment adviser’s privacy policy, and authorizing disclosures to be undertaken to such third parties as appropriate.

3.     When Investment Adviser is an Attorney.  An investment adviser who is also an attorney admitted to practice before the Bar of any state, or who holds himself or herself out as an attorney, may likewise consider the following addition to the investment adviser’s privacy policy: “(Name of investment advisory firm) does not provide legal services and its files are not afforded such protection under the attorney-client privilege.”

SECTION 6. EXTENT OF DUTIES; NON-WAIVER OF DUTIES; AND DEFINING THE SCOPE OF THE RELATIONSHIP.

Rule 6.1. The duty of an investment adviser to act in the best interests of a client extends to the entirety of the relationship with the client.

The broad duties of due care, loyalty, and utmost good faith are not waivable by the client.

However, within reasonable boundaries the scope of the client's engagement of the investment adviser can be limited by clearly expressed terms.

Commentary. 

Fiduciary status does not result from the negotiations of parties to a proposed contract.  While entry into a relationship by the parties is voluntary, these Investment Adviser Rules of Professional Conduct and public policy play a crucial role in the imposition of fiduciary status and the relationships which follow from it. Fiduciary status is imposed by the Rules of Professional Conduct upon the investment adviser-client relationship due to the parties’ different knowledge and expertise.  Fiduciary status is imposed, in part, because the client is not capable of negotiating, contractually, the protections which the client should be afforded.

Annotations. 

1.     Fiduciary Duties of RIAs Extend to the Entirety of the Relationship.  The fiduciary standard arising under the Advisers Act “applies to the investment adviser’s entire relationship with its clients and prospective clients ….”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.22 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)  But see Dodd-Frank Act Section 913(g), providing that “[n]othing in this section shall require a broker or dealer or registered representative to have a continuing duty of care or loyalty to the customer after providing personalized investment advice about securities.”

2.     Hedge and Indemnification Clauses under the Advisers Act.  “Advisers Act Section 215(a) voids any provision of a contract that purports to waive compliance with any provision of the Advisers Act. The Commission staff has taken the position that an adviser that includes any such provision (such as a provision disclaiming liability for ordinary negligence or a ‘hedge clause’) in a contract that makes the client believe that he or she has given up legal rights and is foreclosed from a remedy that he or she might otherwise either have at common law or under Commission statutes is void under Advisers Act Section 215(a) and violates Advisers Act Sections 206(1) and (2).  The Commission staff has stated that the issue of whether an adviser that uses a hedge clause would violate the Advisers Act turns on ‘the form and content of the particular hedge clause (e.g., its accuracy), any oral or written communications between the investment adviser and the client about the hedge clause, and the particular circumstances of the client.’ The Commission has brought enforcement actions against advisers alleging that the advisers included hedge clauses that violated Advisers Act Sections 206(1) and (2) in client contracts.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.22 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

3.     Registered Investment Advisers and Arbitration Clauses.  Some state securities regulators prohibit clauses in registered investment adviser – client agreements which mandate arbitration.  For SEC-registered investment advisers, however, it appears that pre-dispute arbitration clauses are permitted.  Bakas v. Ameriprise Financial Services, Inc., 651 F. Supp. 997 (D. Minn. 2009).  However, Advisers Act Section 205(f), added by the Dodd-Frank Act, authorizes the Commission to prohibit or restrict mandatory pre-dispute arbitration provisions in client agreements; the Commission has not proposed or adopted such a rule at the time of this writing (April 10, 2011).

4.     Waivers of the Fiduciary Duty to Make Only Suitable Recommendations Are Not Permitted.  “Obtaining a customer’s consent to an unsuitable transaction does not relieve a broker-dealer of his obligation to make only suitable recommendations under the SRO rules.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.62 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf), citing , see, e.g., In the Matter of the Application of Clinton Hugh Holland, Jr., Exchange Act Release No. 36621 at 10 (Dec. 21, 1995) (“Even if we conclude that Bradley understood Holland's recommendations and decided to follow them, that does not relieve Holland of his obligation to make reasonable recommendations.”), aff'd, 105 F.3d 665 (9th Cir. 1997) (table format); Release 30036, supra note 279 (regardless of whether customer wanted to engage in aggressive and speculative trading, representative was obligated to abstain from making recommendations that were inconsistent with the customer's financial condition); In the Matter of the Application of Eugene J. Erdos, Exchange Act Release No. 20376 at 10 (Nov. 16, 1983) (citing In the Matter of Philips & Company, Exchange Act Release 5294 at 8 (Apr. 9, 1956) (“[W]hether or not [the customer] considered the transactions in her account suitable is not the test for determining the propriety of [the registered representative's] conduct. The proper test is whether [the representative] ‘fulfilled the obligation he assumed when he undertook to counsel [the customer], of making only such recommendations as would be consistent with [the customer’s] financial situation and needs.’”).

a.      Why Waivers Not Permitted.  In order to waive the application of the fiduciary standard, a client must be able to undertake, autonomously, an informed waiver.  Given the complexity of the financial planning and securities industries and the complexity of the fiduciary concept in general, it is highly unlikely that the typical client will possess the knowledge to make such an informed, intelligent decision.

b.     Why Waivers Not Permitted.  As evidence of the tremendous difficulty consumers of financial services possess in understanding financial planning concepts, and the difficulty in making good decisions even when handed knowledge of investment products, see James J. Choi, David Laibson, Brigitte C. Madrian,  Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds.  The abstract for this article states:  "We report experimental results that shed light on the demand for high-fee mutual funds. Wharton MBA and Harvard College students allocate $10,000 across four S&P 500 index funds. Subjects are randomized among three information conditions: prospectuses only (control), summary statement of fees and prospectuses, or summary statement of returns since inception and prospectuses. Subjects are randomly selected to be paid for their subsequent portfolio performance. Because payments are made by the experimenters, services like financial advice are unbundled from portfolio returns. Despite this unbundling, subjects overwhelmingly fail to minimize index fund fees. In the control group, over 95% of subjects do not minimize fees. When fees are made salient, fees fall, but 85% of subjects still do not minimize fees. When returns since inception (an irrelevant statistic) are made salient, subjects chase these returns. Interestingly, subjects who choose high-cost funds recognize that they may be making a mistake."  As this study indicates, every seasoned financial planner knows that the vast majority of consumers of financial planning services lack the knowledge to undertake sound financial and investment decisions.

c.      Characterizing a fiduciary’s duties of due care and loyalty as “default rules” that can be cast aside by contractual choice too easily equates fiduciary law with contract law.  Information asymmetries between an investment adviser and her or his client make it unlikely express waivers incorporated in an engagement contract would reflect the client’s judgment that the provision would be value maximizing.  Labeling fiduciary duties as “default rules” also threatens to strip fiduciary rules of their moral content. Fiduciary duties are most effective when they function both as legal rules and moral norms. A label that equates the duty of loyalty with, say, a UCC provision allocating risk of loss undermines the duty’s normative force. The erosion of the social norm may create significant external costs for all future investment advisers and their clients. [See Melanie B. Leslie, “Trusting Trustees: Fiduciary Duties and the Limits of Default Rules,” Benjamin N. Cardozo School of Law, Jacob Burns Institute for Advanced Legal Studies, Working Paper No. 111 (2005).  While some academics have argued that certain fiduciary duties should be waivable, even the vast majority of these academics stress that fiduciary duties should not be waivable in situations where fiduciaries are advising on other people’s money.

d.     The fiduciary duty of loyalty “is not specifically set forth in the Act, established by SEC rules, nor a result of a contract between the adviser and the client (and thus it cannot be negotiated away). Rather, a fiduciary duty is imposed on an adviser by operation of law because of the nature of the relationship between the two parties.” [Robert E. Plaze, Associate Director, Division of Investment Management, United States Securities and Exchange Commission, “The Regulation of Investment Advisers by The Securities and Exchange Commission,” a white paper presented at the Private Investment Funds Conference, International Bar Association - American Bar Association, February 28, 2005].

5.     Generally, Clients Have No Adequate Means To Monitor The Conduct of Their Fiduciaries.  “[E]ntrustors become dependent on their fiduciaries and may not be able to monitor the quality of their services because: (1) the skills involved are not easily acquired or understood; (2) the cost to entrustors of monitoring and evaluating such services would undermine the utility of the arrangement; and (3) there exists no other effective alternative monitoring mechanism. In sum, fiduciary rules reflect a consensual arrangement covering special situations in which fiduciaries promise to perform services for entrustors and receive substantial power to effectuate the performance of the services, while entrustors cannot efficiently monitor the fiduciaries' performance.” Frankel, “Fiduciary Duties as Default Rules,” 74 Or. L. Rev. 1209, ____ (1995).

6.     When Bargaining On Issues Related To Waiver, Consumers Must Fend For Themselves; Specific Procedures Must Be Followed.  “While bargaining with their fiduciaries on the issue of waiver, entrustors must fend for themselves as independent parties.  Their right to rely on their fiduciaries must be eliminated. In fact, during the bargaining, the entire relationship must be terminated.  Fiduciary law allows such termination of the relationship with respect to specified transactions only if the parties follow a specific procedure. This procedure is designed to ensure an effective transition from the fiduciary mode in which entrustors rely on their fiduciary, to a contract mode in which parties rely on themselves. That is why fiduciaries must put entrustors on notice that, in connection with the specified transaction, entrustors cannot rely on their fiduciaries. That is why entrustors must be capable of bargaining independently with their fiduciaries and have the capacity to enter into bargains. That is also why, to allow entrustors to make informed decisions, fiduciaries must provide them with information regarding the transaction, especially when the fiduciaries acquired this information in connection with the performance of their services to the entrustors. This procedure is, and should remain, mandatory.”  Frankel, “Fiduciary Duties as Default Rules,” 74 Or. L. Rev. 1209, 1210-1 (1995).

a.      “In order to transform the fiduciary mode into a contract mode, four conditions must be met: (1) entrustors must receive notice of the proposed change in the mode of the relationship; (2) entrustors must receive full information about the proposed bargain; (3) the entrustors' consent should be clear and the bargain specific; (4) the proposed bargain must be fair and reasonable.  Thereafter, two other general bargaining conditions apply. One relates to consenting parties: entrustors must be capable of independent will.  The other relates to the subject matter of the bargain: the proposed bargain must not cover non-waivable duties.” Frankel, “Fiduciary Duties as Default Rules,” 74 Or. L. Rev. 1209, 1218 (1995).

b.     “Fiduciaries must provide entrustors material information necessary for the entrustors to make an informed decision regarding the waiver. This is necessary because, in contrast to contract law, there is no assumption in fiduciary law that the parties' information about the proposed waiver or bargain is symmetrical. Asymmetrical information among the parties to a fiduciary relationship results both from the nature and from the purpose of the relationship. Fiduciaries possess far more information about their own activities. Entrustors and fiduciaries are not equally equipped to make a cost-benefit analysis of the contemplated change in their relationship. In reality, entrustors can seldom perform such an analysis because they lack accurate information to make it.  Therefore, when the fiduciaries possess information in connection with the bargain, and especially if the information has come to them by virtue of their position as fiduciaries, the change of the relationship mode must be accompanied by the fiduciaries' disclosure of this information to the entrustors.” Frankel, “Fiduciary Duties as Default Rules,” 74 Or. L. Rev. 1209, 1218 (1995).

7.     Lacking Adequate Consideration, The Validity of Informed Consent Is Highly Suspect, Especially With Respect to Broad Waivers of Rights.  “The entrustors must clearly consent to waive or bargain around the fiduciaries' duties towards them, and their awareness must be sharper than contract parties' awareness when they waive contract obligations owed to them.  That is because, by waiving fiduciary duties, entrustors always give fiduciaries something of value. For example, consent to breach the fiduciary duty of loyalty (misappropriation) can provide a defense for fiduciaries - negating a necessary element of a wrong, and the existence of a wrong.  Whether entrustors receive something in return is less clear and depends on their ability to sever the umbilical cord with their fiduciaries, as well as on their bargaining capabilities. The requirement of clarity relates to the condition that the bargain be fair and reasonable. This condition, in turn, is grounded in a rationale, derived from contract law, suggesting that if the bargain is highly unfair and unreasonable, the consent of the disadvantaged party is highly suspect. Experience demonstrates that people rarely agree to terms that are unfair and unreasonable with respect to their interests. Because the bargain or waiver is more likely to be in the fiduciaries' interests, but less likely to be in the entrustors' interests, the consent, by entrustor's action or inaction, must be clear. To ensure clarity, default rules should be as specific and precise as possible. Fiduciary duties of loyalty and care, however, are broad standard rules. Therefore, the bargain around these duties must carve out explicit and specific situations. A number of reasons can be offered for requiring specificity. First, specific rules are efficient for the parties' planning and for bargaining around the rules. Second, specificity is necessary to avoid misunderstandings among the parties. Third, in many cases, a broad waiver of duties is bound to be uninformed and speculative. Waivers of specific claims or level of losses will be more readily upheld. For example, if the fiduciary relationship is an escrow, waiver of particular conditions in advance would likely be upheld because the conditions of the initial relationship are fairly specific, and the waiver will be specific. Fiduciaries may also have better luck enforcing waivers of specific fiduciary duties after violations have occurred. Their chances are improved because the nature and extent of the violation are easily ascertainable, and because the entrustors' bargaining position is stronger. Similarly, waivers of bonding requirements by executors, especially family members or friends of the testator, are likely to be upheld because the testators presumably knew the executors well, and because the waivers are specific and limited to a particular function. A broad waiver of the underlying duties of the executors, however, might not be enforced.  Similar reasons apply to waivers of the duty of loyalty in other contexts. Overall, the courts are not likely to uphold bargaining around the broad duties of fiduciaries far in advance when the fiduciaries have substantial discretion over the entrustors' power or property.” Frankel, “Fiduciary Duties as Default Rules,” 74 Or. L. Rev. 1209, ____ (1995).  “Even if above requirements are met, courts will generally not enforce an unfair or unreasonable bargain, but will require a showing that the transaction is fair and reasonable …  A second reason for doubting the voluntariness of an apparent consent to an unfair transaction could be a lingering suspicion that generally, when entrustors consent to waive fiduciary duties (especially if they do not receive value in return) the transformation to a contract mode from a fiduciary mode was not fully achieved. Entrustors, like all people, are not always quick to recognize role changes, and they may continue to rely on their fiduciaries, even if warned not to do so.  Lack of fairness may also signal the absence of more or less equal bargaining power by the entrustor ….” Frankel, “Fiduciary Duties as Default Rules,” 74 Or. L. Rev. 1209, 1218 (1995).

8.     The “Sticky” Aspect of Fiduciary Duties When Applied To Duties Which Protect Both The Client And the Public Interest.  The duties arising from a fiduciary relationship are not easily cast aside.  While either party to an investment advisory agreement can terminate the agreement governing the provision of investment advisory services, this does not necessarily terminate the fiduciary duties – which can continue to exist.  In fact, it is clear that fiduciary duties which are mandatory under the law, and which benefit the public (such as by encouraging participation by individual investors in the capital markets, and by ensuring that consumers receive trusted advice), are not able to be waived and the relationship of the parties changed as a result to a non-fiduciary one. See discussion in NAPFA comment letter on this point.  Additionally, as a general rule under the common law (which applies fiduciary duties to investment advisory relationships outside the ambit of federal or state statutes and SEC rules, as mentioned above, except when preempted by ERISA) the fiduciary duty does not terminate merely because the contract for advisory services between the party terminates.   For example, in Western Reserve Life Assurance Company of Ohio v. Graben, No. 2-05-328-CV (Tex. App. 6/28/2007) (Tex. App., 2007), a dual registrant met twice with a customer, discussing the customer’s financial goals and the options for investment of a $2.5m portfolio.  The dual registrant recommended a variable annuity to the customer, which investment was entered into.  The dual registrant also undertook to monitor the investments in the variable annuity, and acted as the customer’s financial advisor.  The Texas appellate court, noting that courts do not lightly find fiduciary relationships to exist, stated: “Obviously, when a person such as Hutton is acting as a financial advisor, that role extends well beyond a simple arms'-length business transaction. An unsophisticated investor is necessarily entrusting his funds to one who is representing that he will place the funds in a suitable investment and manage the funds appropriately for the benefit of his investor/entrustor.” [Emphasis added.]  The court further noted that the dual registrant “was much more than a mere order-taker to the Clients—he acted as a financial advisor whom the Clients trusted to monitor the performance of their investments and recommend appropriate financial plans to them. Accordingly, the duty that Hutton owed the Clients went well beyond the ‘narrow’ duty of executing trade orders.”  As illustrated by this case, a dual registrant cannot seek to “switch on and off” a fiduciary hat, claiming that some actions are fiduciary in nature and others are not.  Once a fiduciary relationship is established, it extends to all of the advice given and transactions recommended to the client.  Trust received cannot be cast off and then easily betrayed.

The fact that broad fiduciary duties which benefit the public (such as those imposed by the Advisers Act) cannot be waived, and that fiduciary duties of an investment adviser continue even though his or her contract with the client has been terminated, flows from general principles of fiduciary law and from logic.  These rules are required in order to protect the client, by prohibiting the fiduciary from undertaking a simply expedient action of casting off fiduciary duties just prior to consummating an act which would otherwise be in breach of a fiduciary duty.

In a similar fiduciary context, as to the fiduciary duties owed by partners to each other, under the law of most states certain fiduciary duties of partners are not waivable.  Moreover, a partner cannot announce his withdrawal from a partnership one day and then commence competing with the partnership the next day.  [See Leff vs. Gunter, 22 Cal.3d 508 (1983) (“The notion of a continuing fiduciary duty between former partners is not new … in Donleavey v. Johnston (1914) 24 Cal.App. 319, 141 P. 229 … [t]he court properly observed: 'The sound rule is, that [a former partner] cannot make any profit to himself from a secret transaction initiated while the relation of trustee and cestui que trust exists, no matter when it springs into actual operation.' … The foregoing principles were echoed in Fouchek v. Janicek (1950) 190 Or. 251, 225 P.2d 783, in which the Oregon Supreme Court found a breach of fiduciary duty by one partner who, without using confidential information, preempted a business opportunity after termination of the partnership, having secretly negotiated for the opportunity on his own behalf while the partnership was also engaged in negotiations therefor … [as]the court graphically noted: ‘When a partner wrongfully snatches a seed of opportunity from the granary of his firm, he cannot, thereafter, excuse himself from sharing with his copartners the fruits of its planting, even though the harvest occurs after they have terminated their association ….”)]  [See also Everest Investors 8 v. McNeil Partners (2003) 114 Cal.App.4th 411, 424 ("The fiduciary obligations of a general partner with respect to matters fundamentally related to the partnership business cannot be waived or contracted away.”)].

SECTION 7.  Relationships Between Investment Adviser And His Or Her Firm.

Rule 7.1.  Informing Employer of Material Events.  An investment adviser must advise his or her current employer of any public censure or certification suspension or revocation he or she receives from any governmental body or industry organization, and of any material complaint received from a client.

Rule 7.2.  Ordering of Duties.  An investment adviser shall reasonably resolve any conflicts between duties owed to clients and duties owed to employers in favor of the client.

Commentary.

The first and overriding responsibility any investment professional possesses is to the participants of the market – the client.  This primary obligation is required in order to maintain the perception and reality that the market is a fair game and thus encourage the widest possible participation in the capital allocation process.  The premise of the U.S. capital market is that the widest possible participation in the market will result in the most efficient allocation of financial resources and, therefore, will lead to the best operation of the world-wide economy.  Putting the client first actually protects and promotes the best interests of the entire financial community, and, therefore, society as a whole.  The concept is operationalized by requiring that financial professionals place the interests of their clients ahead of all other concerns.  Responsibilities to employers, colleagues and selves are all placed in a descending order of importance so that the financial markets can be best served.  All relevant information must be disclosed to clients and all decisions made with their interests first in mind.

An investment adviser is required to assess, in her or his individual judgments, whether an activity of their employer with respect to the investment adviser’s client is consistent with the investment adviser’s role as a professional.  For example, an employer of an investment adviser may promote the sale of a particular security through a sales contest or other means under which additional compensation would be paid to the investment adviser beyond that provided normally in connection with product sales; the fiduciary duty of loyalty owed to the client by the investment adviser would require that the investment adviser not  participate in such a sales contest as it would likely interfere with the independent judgment of the client.

There are circumstances, however, where the client’s interests cannot be promoted by the investment adviser over that of his or her employer or prior employer.  An example would be prohibitions established by contract between the investment adviser and his or her employer prohibiting the investment adviser from soliciting clients of the firm other employees of the firm to depart the firm, prohibiting competition within a reasonable geographical area and for reasonable period of time, and prohibiting the Investment adviser from seizing trade secrets of the firm.

7.3.  Responsibilities of Investment Adviser In Connection With Delivery of investment advisory Services by Employees.  An investment adviser in a firm who individually or together with other investment advisers possesses comparable managerial authority in a firm shall make reasonable efforts to ensure that the firm has in effect measures giving reasonable assurance that all employees assisting the investment adviser in the delivery of financial planning services to the investment adviser’s clients conform to the Rules of Professional Conduct and that the actions of those employees in the delivery of financial planning services are compatible with the other professional obligations of the investment adviser.

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[1] Guin v. Brazos Higher Educ. Serv. Corp., Inc., No. Civ. 05-668 (RHK/JSM), 2006 WL 288483, at *3 (D.Minn. Feb. 7, 2006), available at http://www.steptoe.com/assets/attachments/1942.pdf.

[2] On Jan. 21, 2011, SEC Staff recommended “that the Commission exercise its rulemaking authority under Dodd-Frank Act Section 913(g), which permits the Commission to promulgate rules to provide that … the standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers (and such other customers as the Commission may by rule provide), shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.”  SEC Study, pp.108-9.  This “uniform fiduciary standard” would apply only to registered investment advisers and broker-dealers, and not to ERISA fiduciaries or financial institutions such as banks and trust companies.  “The Staff also contemplates that the uniform fiduciary standard would be an overlay on top of the existing investment adviser and broker-dealer regimes and would supplement them, and not supplant them.  SEC Staff Study, p. 109.  “The Staff interprets the uniform fiduciary standard to include at a minimum, the duties of loyalty and care as interpreted and developed under Sections Advisers Act Section 206(1) and 206(2).” SEC Staff Study, pp.110-111.  “In addition, the Staff believes that rulemaking and/or interpretive guidance regarding the uniform fiduciary standard would be useful to both investment advisers and broker-dealers.”  SEC Staff Study, p.111.

[3] Adam Smith, The Theory of Moral Sentiments 109 (1759).

[4] Lowe v. SEC, 472 U.S. 181, 229 (1985) (White, J., dissenting opinion).

[5] Id.

[6] Lowe v. SEC, 472 U.S. 181 (1985), fn. 38.

[7] SEC Staff, “Study on Investment Advisers and Broker Dealers” (Jan. 21, 2011), citing Investment Trusts and Investment Companies: Investment Counsel, Investment Management, Investment Supervisory, and Investment Advisory Services, H.R. Doc. No. 477 at 27-30 (1939). [Emphasis added.]

[8] SEC Rel. IA-2204 (2003). “Although the rule requires only annual reviews, advisers should consider the need for interim reviews in response to significant compliance events, changes in business arrangements, and regulatory developments.”

[9] “To implement a compliance program reasonably designed to prevent violations of the Advisers Act and rules thereunder, each adviser should identify the risks and conflicts of interest that are relevant to its business.  The identification process should be repeatable and firm-wide … Regardless of the process used by an adviser to identify its risks, the end result of the firm’s risk assessment process should be an inventory of potential risks that reflects the current environment of the firm. Such an inventory of risks should not be static. In addition to gathering and analyzing information about an adviser’s risk assessment process, examiners review the firm’s inventory of risks and determine whether it is current and sufficiently comprehensive.” SEC Staff, The Evolving Compliance Environment: Examination Focus Areas (April 2009), located at http://sec.gov/info/iaiccco/iaiccco-focusareas.pdf.

[10] Advisers Act Section 204A, and Advisers Act Rule 204A-1.  See SEC Release IA-2256 (July 2, 2004), “Investment Adviser Code of Ethics.”

[11] Many investment advisers’ Codes of Ethics contain only general language describing the duties of due care, loyalty, and utmost good faith.  It is hoped that these suggested Investment Adviser Standards of Professional Conduct may provide the impetus for investment advisers to revise and expand their discussion of fiduciary obligations, for the benefit and education of their investment adviser representatives.

[12] In its recent Study, the SEC Staff recommended that the “Commission should consider whether rulemaking would be appropriate to prohibit certain conflicts, to require firms to mitigate conflicts through specific action, or to impose specific disclosure and consent requirements.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.118 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)  Of course, the non-imposition of any requirements effects the “fourth option” described in this commentary.

[13]  See SEC Release No. 33-8998, “Enhanced Disclosure And New Prospectus Delivery Option For Registered Open-End Management Investment Companies,” (Jan. 13, 2009) (“The Commission is also adopting rule amendments that permit a person to satisfy its mutual fund prospectus delivery obligations under Section 5(b)(2) of the Securities Act by sending or giving the key information directly to investors in the form of a summary prospectus and providing the statutory prospectus on an Internet Web site.”)

[14] Bahar, Rashid and Thévenoz, Luc, “Conflicts of Interest: Disclosure, Incentives, and the Market,” Conflicts Of Interest: Corporate Governance & Financial Markets, Luc Thévenoz and Rashid Bahar, eds., Kluwer Law International and Schulthess, 2007, at p.2.