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Ron A. Rhoades, JD, CFP®Chief Compliance Officer, Director of
Research
Joseph Capital Management, LLC
Hernando, Florida Alpharetta,
Georgia
Durham, North Carolina
August 3, 20091
NASAA INVESTMENT ADIVISER CONFERENCE
The views expressed herein are those of the
speaker only, and do not (necessarily)
represent the views of:
1.NASAA;
2.any organization to which the speaker
belongs; or
3.my mother.
2
The 3 Main Fiduciary
Duties:
Where Do They Come
From?
What Are They?
What Do They Require?
How Does An Investment
Adviser
“Add Value”?
Case Study Discussion
Questions (and an occasional
answer)
3
FIDUCIARY
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“To Act In The Best Interests of the
Client”"This is a simple statement to make, but one that is more difficult to apply.”
- Lori Richards, Director, SEC’s OCIE, Feb. 27, 2006
“I believe that it is important that the Commission explain what a fiduciary standard requires.”
- Elisse Walter, SEC Commissioner, May 5, 2009
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1. Due Care
2. Utmost Good
Faith
3. Loyalty
Federal Advisers Act
State Securities Acts
Common Law
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An investment adviser in providing investment and financial advice shall exercise such care and skill as a prudent investment adviser would exercise in dealing with his or her own financial affairs.
Duty of Due CarePRUDENCE
Prudence, one of the four Cardinal Virtues from classical and religious texts, is depicted in Simon Vouet’s Allegory of Prudence
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The investment adviser is under a duty
to utilize the “care, knowledge and
skill ordinarily possessed and
exercised in similar situations by the
average member of the profession”Erlich v. First Nat. Bank of Princeton, 505 A.2d 220 (N.J.Super.L., 1984)
KNOWLEDGE & SKILL
Duty of Due Care
For investment advice, knowledge of ???
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Did the adviser
follow a good
process in providing
investment or
financial advice to
her or his clients?
Duty of Due CarePROCEDURAL DUE CARE
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When called upon to
do so, did the
adviser exercise
good judgment?
Duty of Due CareSUBSTANTIVE DUE CARE
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Duty of Due Care: A HOT BUTTON
DILIGENCEWas the adviser
diligent in …
Understanding the needs of the client; and
In reviewing both the suitability and soundness of the investment products recommended
In the development of the investment strategy
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There exists a duty of due care in handling client’s personal information.
Duty of Due CareCONFIDENTIALITY
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Duty of Utmost Good Faith“most abundant good
faith”
“absolute and perfect candor or openness and honesty”
“the absence of any concealment or deception, however slight”
“NO reckless behavior”
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Did the adviser believe that : (1) any statements or representations made to your
client are completely truthful? (2) your conduct is within the realm of decent and
appropriate behavior of a professional? (3) Your actions are in the best interests of your
client?
YOUR GOOD FAITH WILL BE TESTED BY OTHERS, PUTTING THEMSELVES IN THE ADVISER’S SHOES, NOT MERELY BY THE ADVISER’S OWN PERCEPTION.
Duty of Utmost Good Faith
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Duty of Loyalty … No Conflict Rule
No Profit Rule
Undivided Loyalty Rule
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Duty of Loyalty
The “NO CONFLICT” rule“A fiduciary must not place herself, himself, or itself in a position where its own interests conflict with those of its client.”
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Duty of Loyalty
The “NO PROFIT” rule“A fiduciary must not profit from her, his, or its position at the expense of the client.”
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Reasonable compensation – fully disclosed in advance and agreed to by the client – is permitted
Under GENERAL FIDUCIARY LAW, there is no restriction on the form of compensation (AUM, commissions, fixed fees, hourly fees, combinations thereof, etc.)
Duty of Loyalty
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Duty of LoyaltyThe “UNDIVIDED LOYALTY” rule
A fiduciary owes undivided loyalty to each of her, his, or its clients.
The fiduciary should avoid placing the interests of one client ahead of another client.
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How Did The Adviser Address …
Allocations of IPOs, etc.?
Rebalancing during market downturn?
Taking on more clients?
“Outside activities” (CPA, attorney, real estate, etc.)
Duty of Undivided Loyalty
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“No Conflict” and “No Profit” Rules: Disclosure and Consent
Fiduciary law protects the client by requiring …
Disclosure of all material facts
The client’s intelligent, independent, informed consent
Each transaction be a substantively fair arrangement
The fiduciary to act in good faith
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Your Disclosure Obligation
What is a MATERIAL FACT?
Anything Which Might Affect
the Client’s
Decision Whether
or How to Act22
Duty to Disclose Material FactsNo “half-truths”
No omissions of material facts
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If the adviser does not have the information needed – he or she should obtain it
The Adviser (not the client) have the duty to investigate to determine all material facts
The Adviser must disclose all material facts which might be reasonably discovered
Duty to Disclose Material Facts
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“Readiness and willingness to disclosure are not equivalent to disclosure.”
DISCLOSURE MUST BE AFFIRMATIVELY
MADE The client’s duty to “discover” facts is reduced
when being advised by a fiduciary. See Wolf v. Brungardt, 215 Kan. 272, 524 P.2d 726 (Kan., 1974)
Duty to Disclose Material Facts
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Does Providing “Access”
= “Delivery” of Material Facts? Example: “See our web site for
additional information” Example: “See the prospectus for
additional information”But – delivery by custodian after purchase?
Example: Furnishing ADV, Part II
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Duty to Disclose Material Facts
No “Casual Disclosures” Permitted
Examples of “casual disclosure” …
“There may be other facts which may be of interest to you”
“I may possess a conflict of interest.”
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“My affiliated broker-dealer may receive
12b-1 fees, payment for shelf space, and
soft dollar compensation from mutual
fund companies.”
“Full Disclosure” or“Casual Disclosure” ?
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Disclosures Must Be Clear and Understandable
The less the client’s sophistication,the greater the disclosure
(a more extensive explanation is required)
The Disclosure Obligation
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The Disclosure Obligation
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RELATIVELY SOPHISTICATED
…. NOW
What about clients with diminished capacity?
How do you obtain INFORMED CONSENT?
The Disclosure Obligation
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The duty to ensure understanding rests first and foremost on the investment adviser
But - what about the “duty to read” a customer normally possesses?“The failure to read a contract may be excusable where a fiduciary or confidential relationship exists between the parties” Lin v. John Hancock (2007) (Client trust and reliance upon representations made may excuse a client’s duty to read.)
The Disclosure Obligation
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A client who relies upon expert advice, instead of reading disclosures, is entitled to rely upon that expert advice.
Duty to read excused when client “accustomed to signing documents at the (advisor’s) request without reading the documents” Strotz v. Dean Witter (Calif., 1990)
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The Disclosure Obligation
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Disclosures Must Be Timely Made
The client must know all the material facts before he or she is required to provide consent to the transaction or course of action
The Disclosure Obligation
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What Is Required to Be Disclosed?All fees paid in connection with …
Fees paid for your advisory servicesBy the clientAny MATERIAL third-party compensation
Custodial servicesTermination fees which might be appliedYour receipt of benefits from custodians
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Investment products:
Disclosed Fees and Costs
Hidden Fees and CostsSee “Estimating the Total Costs of Stock Mutual Funds”
What Is Required to Be Disclosed?
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What Is Required to Be Disclosed?What About The Tax RamificationsOf Investment Decisions?
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Is a “Conflict of Interest” Always a “Material Fact”?
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Is a “Conflict of Interest” always a “Material Fact”?
YES. (Nearly) Always.(if the conflict of interest is “material”)
Example of “nonmaterial” conflict:
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Must the adviser disclose conflicts of interest which the adviser cannot avoid?
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YES.
Unavoidable conflicts of interest are still conflicts!
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Examples of Unavoidable Conflicts:
Client asks: “Should I pay down my mortgage or invest my cash with you?”
Client desires advice on whether to purchase a lifetime annuity, instead of investing additional cash with adviser.
“How much money should I give to my kids this year?”
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Conflicts of Interest and CompensationYour Method, Amount of CompensationCertain business affiliations or arrangements
Any receipt of third-party compensation Ex: commissions received on sale of product Ex: custodial platform services (TD Ameritrade, Schwab,
Fidelity, Trust Company of America, etc.) Ex: attending educational events (custodian, fund-
sponsored) Ex: receipt of non-de minimus gifts from custodians and
others Ex: “proprietary products” of your firm or an affiliate
Any commitment made to custodian (min. AUM)Many others …
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Is disclosure of a conflict of interest sufficient to meet the adviser’s fiduciary duty of loyalty?
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What is thePURPOSE of Disclosure?
The Purpose of Disclosure is to …
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The Purpose of Disclosure is to …
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“Disclosure by the adviser and the informed consent of the client, based on full and fair disclosure, is at the heart of the Adviser's Act.”
- Lori Richards, Director, SEC Office of Compliance Inspections and Examinations, March 12, 2009
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Sale of higher-margin separate account management products
And sale of higher-cost insurance products
Instead of lower-cost mutual funds
“Ex-Fidelity brokers claim sales pressure” – InvestmentNews, 4/3/2009
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Not Present if ….
1.Any material fact is not disclosed
2.Lack of understanding by facts by the client
3.Use of fiduciary’s position to induce client consent
4.Transaction was not in all respects fair and reasonable
1. A conflict of interest exists2. Disclosure of all material
facts exists3. BUT - the best interests of the
client are NOT kept paramount?
Will Informed Consent Exist If …
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How to Disclose …Form ADV, Part II
SEC Release IA-2711 (March 2008) www.sec.gov Proposed Rule, new Form ADV, Part 2
Recommendation: Investment advisers may desire to go ahead and implement the new Part 2, and furnish the new Part 2 – with enhanced disclosures - to all existing clients, with a cover letter highlighting the sections which discuss conflicts Even though the rule has not been finalized
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Is Form ADV, Part II, the Only Disclosure Required? “Delivering a [Form ADV Part II] brochure ….
does not relieve you of any other disclosure
obligations you have to your advisory clients or
prospective clients under any federal or state
laws or regulations.”
How to Disclose …
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Client Services (Fee) agreementEx: Your compensationEx: Other fees and costs client may bear
(if known at the time)Ex: Non-exclusive relationshipEx: What the adviser is responsible for;
What the client is responsible for
How to Disclose …
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Fiduciary duties of an investment adviser lead to specific requirements imposed by regulation:IA Code of EthicsIA Compliance Supervisory ProceduresChief Compliance Officer (Trained)Business Succession PlanDisaster Recovery PlanForm ADV, Part II disclosures … and more
Some Closing Thoughts …
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Fiduciary duties of an investment adviser lead to other specific requirements
NOT EXPRESSLY FOUND IN REGULATIONS
Some Closing Thoughts …
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1. Read the case - SEC vs. Capital Gains Research Bureau
2. Read the handout (book excerpts) on fiduciary duties, generally, and the fiduciary duty of loyalty
3. Review carefully SEC Release IA-2711 (Form ADV, Part 2)
(www.sec.gov / Proposed Rules / March 3, 2008)
4. Study SEC and/or State Securities Regulations
5. Attend seminars to keep abreast in developments affecting fiduciary duties
Suggested Action Steps – For Advisers (and Examiners)
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6. Indentify Core Competencies Needed
- Investment Advice
7. Obtain core knowledge and skills (or outsource)
EXAMINERS TOO!!!
8. Maintain and enhance skills (ongoing reading, education)
Suggested Action Steps
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9. Learn more about FIDUCIARY DUTIES
10. EXAMINERS: THINK OUTSIDE THE BOX:
ARE YOU EXAMINING COMPLIANCE BY AN ADVISER WITH ALL OF THEIR FIDUCIARY DUTIES?
HOW CAN YOU GET TRAINING TO INVESTMENT ADVISERS SO THEY MAY BETTER ADHERE TO THEIR FIDUCIARY DUTIES?
Suggested Action Steps
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Ron A. Rhoades, JD, CFP®
He’s aninvestmentadviser.
59
Ron A. Rhoades, JD, CFP®
He’s aninvestmentadviser.
60
Ron A. Rhoades, JD, CFP®
He’s aninvestmentadviser.
61
Discussions: How Do Investment Advisers “Add Value”?
Case Study Q & A
62
