SEC vs. Capital Gains Research Bureau Misconstrued: Much More Than Disclosure of a Conflict of Interest Is Required

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.

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[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.