The following is excerpted from the comment letter recently submitted to the SEC by The Committee for the Fiduciary Standard's Steering Group.
THE
FIDUCIARY ADVISOR AND CONFLICTS OF INTEREST: THE TRUE MEANING OF SEC vs. CAPITAL GAINS RESEACH BUREAU – IT
IS NOT JUST DISCLOSURE
It has been written[i]
by some in the securities bar that the U.S. Supreme Court’s landmark decision
in SEC v. Capital Gains provided a
road map for an investment adviser’s handling of conflicts of interest, in that
disclosure of a conflict of interest would be sufficient to comply with the
fiduciary’s duty of loyalty. Is this
true, or did the U.S. Supreme Court intend something altogether different? In essence, the questions should be asked:
Have some securities law attorneys
misconstrued SEC vs. Capital Gains? -
Yes.
Does there exist, for investment advisers, a duty to avoid
certain insidious conflicts of interest? - Yes.
For permitted conflicts of interest which are disclosed and for
which informed consent is provided, does there exist a continuing duty to properly
manage such conflicts of interest? – Yes.
In the seminal 1963 decision of SEC v. Capital Gains Research Bureau, the U.S. Supreme Court
stated:
An adviser who, like respondents, secretly
trades on the market effect of his own recommendation may be motivated –
consciously or unconsciously – to recommend a given security not because of its
potential for long-run price increase (which would profit the client), but
because of its potential for short-run price increase in response to
anticipated activity from the recommendation (which would profit the adviser).
(Citation omitted.) An investor seeking the advice of a registered investment adviser must,
if the legislative purpose is to be served, be permitted to evaluate such
overlapping motivations, through appropriate disclosure, in deciding
whether an adviser is serving ‘two masters” or only one, ‘especially . . . if
one of the masters happens to be economic self-interest.’[ii]
[Emphasis added.]
This section of the opinion may
appear to suggest that, with disclosure of a conflict of interest, all that is
required is that the client of the adviser be given the option of proceeding
with the advisor’s counsel. However, at
a footnote to this section of the opinion, the U.S. Supreme Court went further,
explaining the “no conflict” rule and providing alternative rationales behind
the prohibition on serving two masters:
This Court, in discussing conflicts of
interest, has said: ‘The reason of the
rule inhibiting a party who occupies confidential and fiduciary relations
toward another from assuming antagonistic positions to his principal in matters
involving the subject matter of the trust is sometimes said to rest in a sound
public policy, but it also is justified in a recognition of the authoritative
declaration that no man can serve two masters; and considering that human
nature must be dealt with, the rule does
not stop with actual violations of such trust relations, but includes within
its purpose the removal of any temptation to violate them .... In Hazelton v. Sheckells, 202 U.S. 71, 79,
we said: ‘The objection . . . rests in their tendency, not in what was done in
the particular case … The court will not inquire what was done. If that should
be improper it probably would be hidden and would not appear.’[iii] [Emphasis
added.]
Moreover, the U.S. Supreme Court
in the Capital Gains decision only
held that the fiduciary investment adviser had an affirmative obligation to “to
make full and frank disclosure of his practice of trading on the effect of his
recommendations.”[iv] Why did the U.S. Supreme Court not go
further, and hold that the Advisers Act prohibited the very existence of such a
conflict of interest? The answer lies in
the decision itself:
It is arguable – indeed it was argued by ‘some
investment counsel representatives’ who testified before the Commission -- that
any ‘trading by investment counselors for their own account in securities in
which their clients were interested ….’ creates a potential conflict of
interest which must be eliminated. We
need not go that far in this case, since here the Commission seeks only disclosure of a conflict of
interests with significantly greater potential for abuse than in the situation
described above.[v] [Emphasis
added.]
In other words, it was not
necessary to the U.S. Supreme Court decision, as it was before the Court, for
the Court to find that the Advisers Act outlawed significant conflicts of
interest between investment advisers and their clients. The SEC in the
underlying action only sought an injunction pertaining to disclosure; given
that this was the only relief requested, the Court did not need to address the
other parameters of the fiduciary duty of loyalty.
Despite this factual limitation, the
U.S. Supreme Court went to great lengths to recite legislative history, especially
portions which discussed prohibitions on conflicts of interest as applied to
investment advisers:
Although certain changes were made in the bill
following the hearings, there is nothing to indicate an intent to alter the
fundamental purposes of the legislation.
The broad proscription against
‘any ... practice … which operates … as a fraud or deceit upon any client or
prospective client’ remained in the bill from beginning to end. And the
Committee Reports indicate a desire to preserve ‘the personalized character of
the services of investment advisers,’ and 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 Investment Advisers Act of 1940 thus
reflects a congressional recognition ‘of the delicate fiduciary nature of an
investment advisory relationship,’ as well as 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. [Emphasis added.]
Hence, while the U.S. Supreme
Court was not called upon to decide if conflicts of interest should be avoided
by investment advisers, this does not lead to the conclusion that that the “no
conflict” and “no profit” rules which form foundations of the fiduciary duty of
loyalty in English common law do not remain imbedded within the Advisers
Act. Nor can it be concluded from the
decision, as some interpreters may have done, that all that is required when a
conflict of interest exists is that disclosure of material facts to the client
occur, followed by the client’s consent to proceed with the recommendation or
transaction despite the presence of the conflicts of interest.
Furthermore, some key aspects of
the legislative history underlying the Advisers Act were summarized by the U.S.
Supreme Court’s landmark 1963 decision, SEC
v. Capital Gains Research Bureau, and this additional legislative history
bolsters the conclusion that the “no-profit” and “no-conflict” rules are firmly
embedded within the Advisers Act. In the
decision, the U.S. Supreme Court stated:
The
Public Utility Holding Company Act of 1935 ‘authorized and directed’ the
Securities and Exchange Commission ‘to make a study of the functions and
activities of investment trusts and investment companies ….’ Pursuant to this mandate, the Commission made
an exhaustive study and report which included consideration of investment
counsel and investment advisory services.
This aspect of the study and report culminated in the Investment
Advisers Act of 1940.
The
report reflects the attitude - shared by investment advisers and the Commission
- 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.’ The report stressed that affiliations by
investment advisers with investment bankers, or corporations might be ‘an
impediment to a disinterested, objective, or critical attitude toward an
investment by clients …’
This concern was not limited to deliberate
or conscious impediments to objectivity. Both the advisers and the Commission were well
aware that whenever advice to a client might result in financial benefit to the
adviser – other than the fee for his advice – ‘that advice to a client might in
some way be tinged with that pecuniary interest [whether consciously or]
subconsciously motivated ….’ The report
quoted one leading investment adviser who said that he ‘would put the emphasis
. . . on subconscious” motivation in such situations. It quoted
a member of the Commission staff who suggested that a significant part of the
problem was not the existence of a ‘deliberate intent’ to obtain a financial
advantage, but rather the existence ‘subconsciously [of] a prejudice’ in favor
of one's own financial interests. The report incorporated the Code of
Ethics and Standards of Practice of one of the leading investment counsel
associations, which contained the following canon:
‘[An
investment adviser] should continuously occupy an impartial and disinterested
position, as free as humanly possible from the subtle influence of prejudice, conscious or unconscious; he should scrupulously avoid any affiliation, or any
act, which subjects his position to challenge in this respect.’ [Emphasis added
in Supreme Court’s own decision.]
Other
canons appended to the report announced the following guiding principles: that compensation for investment advice ‘should
consist exclusively of direct charges to clients for services rendered”;
that the adviser should devote his time ‘exclusively to the performance’ of his
advisory function; that he should not
‘share in profits’ of his clients; and that he should not ‘directly or indirectly engage in any activity which may
jeopardize [his] ability to render unbiased investment advice.’ These canons were adopted ‘to the end that
the quality of services to be rendered by investment counselors may measure up
to the high standards which the public has a right to expect and to demand.’
This
study and report -- authorized and directed by statute – culminated in the
preparation and introduction by Senator Wagner of the bill which, with some
changes, became the Investment Advisers Act of 1940. In its ‘declaration of policy’ the original
bill stated that ‘Upon the basis of facts disclosed by the record and report of
the Securities and Exchange Commission … it is hereby declared that the
national public interest and the interest of investors are adversely affected -
… (4) when the business of investment advisers is so conducted as to defraud or
mislead investors, or to enable such
advisers to relieve themselves of their fiduciary obligations to their clients.
‘It is hereby declared that the policy and purposes of this title, in
accordance with which the provisions of this title shall be interpreted, are to mitigate and, so far as is presently
practicable to eliminate the abuses enumerated in this section.’ S. 3580,
76th Cong., 3d Sess., § 202.
Hearings
were then held before Committees of both Houses of Congress. In describing their profession, leading
investment advisers emphasized their relationship of ‘trust and confidence’
with their clients and the importance of “strict limitation of [their right] to
buy and sell securities in the normal way if there is any chance at all that to
do so might seem to operate against the interests of clients and the public.’
The president of the Investment Counsel Association of America, the leading
investment counsel association, testified that the ‘two fundamental principles
upon which the pioneers in this new profession undertook to meet the growing
need for unbiased investment information and guidance were, first, that they
would limit their efforts and
activities to the study of investment problems from the investor's standpoint, not engaging in any other activity, such as
security selling or brokerage, which might directly or indirectly bias their
investment judgment; and, second, that their remuneration for this work
would consist solely of definite,
professional fees fully disclosed in advance.’[vi]
Although
certain changes were made in the bill following the hearings, there is nothing
to indicate an intent to alter the fundamental purposes of the legislation.
The broad prescription against ‘any … practice … which operates … as a
fraud or deceit upon any client or prospective client’ remained in the bill
from beginning to end. And the Committee
reports indicated a desire to preserve ‘the personalized character of the
services of investment advisers’ and 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 Investment Advisers Act of
1940 thus reflects a congressional recognition ‘of the delicate fiduciary
nature of an investment advisory relationship,’ as well as 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. [Citations omitted.]
[Emphasis added.]
As seen in the text above, the U.S. Supreme
Court’s recitation of the legislative history of the Advisers Act references
aspects of both the “no conflict” and “no profit” rule, and appears to indicate
that the scope of an investment adviser’s activities should be limited in order
to avoid conflicts of interest and the deviation of profits away from the
client (except as to profits derived from compensation paid directly by the
client, which has been previously agreed to by the client).
A philosophy of full disclosure is
not the Advisors Act’s only purpose. While some commentators have advanced the argument that the Advisers
Act’s purpose was “to substitute a philosophy of full disclosure for the philosophy
of caveat emptor,” a closer reading
of the decision reveals that this purpose was set forth as a “common” purpose
of the federal securities acts enacted in the 1930’s and in 1940. This does not lead to the conclusion that the
Advisers Act’s only purpose was to
require disclosure; it was merely one means by which Congress sought to protect
clients of investment advisers.
Moreover, other commentators on
the decision have focused on the language found in the last paragraph quoted
above of the decision, that the “congressional intent” was “at least to expose”
conflicts of interest. And they seize
upon this language of the decision:
An
investor seeking the advice of a registered investment adviser must, if the
legislative purpose is to be served, be permitted to evaluate such overlapping
motivations, through appropriate disclosure, in deciding whether an adviser is
serving “two masters” or only one, “especially . . . if one of the masters
happens to be economic self-interest.” United
States v. Mississippi Valley Co., 364 U.S. 520, 549.
Yet, again, this reading of the
decision is far too narrow. While
certainly disclosure is one means by which the intent of Congress was effected,
the avoidance of conflicts of
interest is another fundamental purpose of the Advisers Act. As the U.S. Supreme Court stated in its own
footnote to the passage set forth above:
This
Court, in discussing conflicts of interest, has said … The reason of the rule
inhibiting a party who occupies confidential and fiduciary relations toward
another from assuming antagonistic positions to his principal in matters
involving the subject matter of the trust is sometimes said to rest in a sound
public policy, but it also is justified in a recognition of the authoritative
declaration that no man can serve two masters; and considering that human
nature must be dealt with, the rule does not stop with actual violations of
such trust relations, but includes within its purpose the removal of any
temptation to violate them....
Furthermore, the Supreme Court
near the end of its majority opinion stated: “The statute, in recognition of
the adviser's fiduciary relationship to his clients, requires that his advice
be disinterested. To insure this it empowers the courts to require disclosure
of material facts.” But, again, this is
but one requirement of the Advisers Act.
The avoidance of investment adviser conflicts of interest, and
profit-taking resulting from actions of investment advisers, are additional
purposes of the Advisers Act.
Why did the Supreme Court not go
further, and hold in the Capital Gains
decision that the investment adviser’s secret purchase of shares of a
particular security shortly before recommending it to clients (and thereby
profiting from the increase in market price which occurred as a result of the
recommendation, by selling the shares ) was prohibited? As mentioned above, the SEC’s request for an
injunction was limited to requiring disclosure, and not more. Hence, it should not be inferred from this
language that investment advisers are only required to undertake disclosures of
conflicts of interest, as opposed to avoiding them.
Think
about it … If disclosure was effective as a means of consumer
protection, there would be no need for the fiduciary standard of conduct!
The Advisers Act imposes, in
situations where a conflict of interest is not avoided, substantial additional
burdens upon the fiduciary adviser, beyond mere disclosure. We have suggested
the boundaries of these additional duties in our suggested rules for adoption,
above.
ADDENDUM: WHAT DOES THE FIDUCIARY STANDARD REQUIRE, WHEN A CONFLICT OF INTEREST IS PRESENT? To properly observe the fiduciary standard of conduct requires the active avoidance of conflicts of interest. However, it is not possible to avoid all conflicts of interest. Under the "best interests" fiduciary standard, a person who is a fiduciary to a financial/investment adviser client possesses the specific duties to:
fully disclose[i]
all material[ii]
facts to their clients[iii]
affirmatively[iv]
and in a timely[v]
manner, including but not limited to conflicts of interest which are not
reasonably avoided, in a manner in which client understanding[vi]
is assured;
properly manage any remaining conflicts of
interest in order to secure the client’s informed consent[vii]
to a transaction which remains substantively fair to the client, in order that
that the client’s best interests remain paramount[viii]
above the interests of the broker or adviser[ix];
All advisors should remember this fundamental truth - a client cannot consent to be harmed.
[i] See Barbash, Barry P., and Massari, Jai, “The Investment Advisers Act of 1940: Regulation by Accretion,” 39 Rutgers L.J. 627, stating: “[T]he Court in Capital Gains … provided investment advisers with clear guidance on fulfilling their obligations under the Act: appropriate disclosure can cure a conflict of interest. As the Court said, an adviser may “make full and frank disclosure” of the conduct in question to address the concerns raised by the Commission under the Advisers Act. The disclosure, the Court went on to say, would serve the purposes of the Act’s anti-fraud provisions by allowing clients to evaluate ‘overlapping motivations’ …. in deciding whether an adviser is serving ‘two masters’ [i.e., the client and its own economic self-interest] or only one … Capital Gains both expanded the scope of the duties owed by an investment adviser to its client as a fiduciary and, consistent with the Advisers Act’s approach, found disclosure an effective tool in curing conflicts of interest faced by an adviser..”) Id. at 631, 633-4. See also Jennifer L. Klass, “Investment Adviser Conflicts of Interest Disclosures” (Outline for IAA Annual Compliance Workshop, Oct. 27, 2008), stating: “[T]he Advisers Act, like the other federal securities laws, is based on the fundamental principal of “full disclosure.’ In this regard, the Advisers Act reflects the “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.”
[ii] 375 U.S. 180, ___, citing United States v. Mississippi Valley Co., 364 U.S. 520, 549.
[iii] Id. at p.___, fn. 50, citing United States v. Mississippi Valley Co., 364 U.S. 520, 550, n. 14.
[iv] Id. at p.___.
[v] Id. at p.___.
[vi] Capital Gains, 375 U.S. 180, ____, citing “Investment Trusts and Investment Companies, Report of the Securities and Exchange Commission, Pursuant to Section 30 of the Public Utility Holding Company Act of 1935, on Investment Counsel, Investment Management, Investment Supervisory, and Investment Advisory Services,” H. R. Doc. No. 477, 76th Cong., 2d Sess., 1.
ADDENDUM NOTES:
[i] “[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). See
also, e.g., General Instructions for 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.” Id., at #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.
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.)
Disclosure must be full and frank: “If dual
interests are to be served, the disclosure to be effective must lay bare the
truth, without ambiguity or reservation, in all its start significance.” See “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, citing Scott, The Fiduciary
Principle, 37 Calif. L. Rev. 539, 544 (1949).
[ii] “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).
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).
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.
The standard of materiality is whether a reasonable
client or prospective client would have considered the information important in
deciding whether to invest with the adviser. See SEC v. Steadman, 967 F.2d 636, 643 (D.C. Cir. 1992).
All facts which might bear upon the desirability of
the transaction must be disclosed. “[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)).
See also RESTATEMENT (THIRD)
OF AGENCY, §8.06(1):
(1)
Conduct by an agent that
would otherwise constitute a breach of duty … does not constitute a breach of
duty if the principal consents to the conduct, provided that
(a)
In obtaining the principal’s
consent, the agent
(i)
acts in good faith;
(ii)
discloses all material facts
that the agent knows, has reason to know, or should know would reasonabley
affect the principal’s judgment …
(iii)
otherwise deals fairly with
the principal; and
(b)
the principal’s consent
concerns either a specific act or transaction, or acts or transactions of a
specified type that could reasonably be expected to occur in the ordinary
course of the agency relationship.
[iii] See 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.)
[iv] The duty to disclose is an
affirmative one and rests with the advisor alone. Clients do not generally possess a duty of
inquiry. See, e.g., 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.) “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.”
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).
[v] “[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).
“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
Staff Study (Jan. 2011), p.23, citing
see Instruction 3 of General
Instructions for Part 2 of Form ADV; Advisers Act Rule 204-3(f); also citing see also Release IA-3060.
Disclosures
of fees, costs, risks and other material facts, far in advance of specific
investment recommendations, such as those found upon the initial delivery of
Form ADV, Part 2A, would not meet the requirement of undertaking affirmative
disclosure in a manner designed to ensure client understanding. We suggest that
the Commission re-explore the delivery of point-of-recommendation disclosures,
for recommendations of pooled investment vehicles of any form, in order to
provide all fiduciary advisors with the benefit of a provisional safe harbor
for disclosures. However, to be meaningful and operable as a full disclosure of
all material facts, such a disclosure form, if adopted, should incorporate an
estimate of all of the fees and costs attendant to pooled investment vehicles,
such as brokerage commissions and other transactional costs within the fund
which are not included in the fund’s annual expense ratio.
We
also recommend that the SEC’s Division of Investment Management replace the
currently misleading computational method of “portfolio turnover” within a
fund, in which funds are permitted to report the lesser of purchases or sales
of securities in relation to the fund’s net assets, to a more accurate method
in which purchases and sales of securities within a fund are averaged; it is
currently conceivable that a fund with significant inflows or outflows report a
“zero” portfolio turnover in its filings, when in fact substantial purchases
and sales within a fund exist.
[vi] 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).
The
extent of the disclosure required is made clear by cases applying the fiduciary
standard of conduct in related professional advisory contexts, such as the
duties imposed upon an attorney with respect to his or her client: “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) [emphasis added], quoting
Unified Sewerage Agency, Etc. v. Jeko, Inc., 646 F.2d 1339, 1345-46 (9th
Cir.1981)); “[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) [emphasis added].
The
burden of affirmative disclosure rests with the professional advisor;
constructive notice is insufficient. 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.
[vii] 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.].
[viii] “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 Staff
Study, January 2011, at p.22, citing see, e.g., Proxy Voting by Investment Advisers,
Investment Advisers Act Release No. 2106 (Jan. 31, 2003 (“Release 2106”); also citing Amendments to Form ADV,
Investment Advisers Act Release No. 3060 (July 28, 2010) (“Release 3060”).
[ix] The Commission recently
characterized this as an adviser’s obligation “not to
subrogate clients’ interests to its own.” ADV Release, at 3. See also “Without Fiduciary
Protections, It’s ‘Buyer Beware’ for Investors,” Press Release issued by the
Investment Adviser Association, et al., June 15, 2010, available at: http://www.financialplanningcoalition.com/docs/assets/3C7AB96C-1D09-67A1-7A3E526346D7A128/JointFOFPressRelease-ConferenceCommitteeFINAL6-15-10.pdf.
