Transcript Slide 1

An Overview of
Fiduciary Duties
Ron A. Rhoades, JD, CFP®
Chief Compliance Officer, Director of Research
Joseph Capital Management, LLC
 Hernando, Florida  Alpharetta, Georgia
 Durham, North Carolina
August 3, 2009
NASAA INVESTMENT ADIVISER CONFERENCE
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A Necessary Disclosure
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.
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Today …
 The 3 Main Fiduciary Duties:
FIDUCIARY
 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)
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The ATTORNEY … and the ANGEL
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iduciary duties: What Are They?
“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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iduciary duties: What Are They?
Where Do They Come From?
1. Due Care
Federal Advisers Act
2. Utmost Good Faith
State Securities Acts
3. Loyalty
Common Law
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Duty of Due Care
PRUDENCE
 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.
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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Duty of Due Care
KNOWLEDGE & SKILL
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)
For investment advice, knowledge of ???
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Duty of Due Care
PROCEDURAL DUE CARE
Did the adviser follow
a good process in
providing investment
or financial advice to
her or his clients?
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Duty of Due Care
SUBSTANTIVE DUE CARE
When called upon to
do so, did the adviser
exercise good
judgment?
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Duty of Due Care: A HOT BUTTON
DILIGENCE
Was 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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Duty of Due Care
CONFIDENTIALITY
 There exists a duty of due care in handling
client’s personal information.
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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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Duty of Utmost Good Faith
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.
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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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Duty of Loyalty
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.)
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Duty of Loyalty
The “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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Duty of Undivided Loyalty
How Did The Adviser Address …
 Allocations of IPOs, etc.?
 Rebalancing during market downturn?
 Taking on more clients?
 “Outside activities”
(CPA, attorney, real estate, etc.)
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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 Act
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Duty to Disclose Material Facts
 No “half-truths”
 No omissions of material facts
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Duty to Disclose Material Facts
 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
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Duty to Disclose Material Facts
 “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)
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Duty to Disclose Material Facts
 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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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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“Full Disclosure” or
“Casual Disclosure” ?
 “My affiliated broker-dealer may receive
12b-1 fees, payment for shelf space, and
soft dollar compensation from mutual
fund companies.”
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The Disclosure Obligation
Disclosures Must Be
Clear and
Understandable
 The less the client’s
sophistication,
the greater the
disclosure
(a more extensive explanation
is required)
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The Disclosure Obligation
RELATIVELY
SOPHISTICATED
….
NOW
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The Disclosure Obligation
 What about clients with
diminished capacity?
 How do you obtain
INFORMED CONSENT?
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The Disclosure Obligation
 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.)
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The Disclosure Obligation
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
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
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What Is Required to Be Disclosed?
 All fees paid in connection with …
 Fees paid for your advisory services


By the client
Any MATERIAL third-party compensation
 Custodial services


Termination fees which might be applied
Your receipt of benefits from custodians
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What Is Required to Be Disclosed?
 Investment products:
 Disclosed
 Hidden

Fees and Costs
Fees and Costs
See “Estimating the Total Costs of Stock
Mutual Funds”
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What Is Required to Be Disclosed?
What About The Tax Ramifications
Of 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 Compensation
 Your Method, Amount of Compensation
 Certain 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?
What is the
PURPOSE
of Disclosure?
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The Purpose of Disclosure is to …
Obtain a
Client’s
Consent
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The Purpose of Disclosure is to …
Obtain a
Client’s
INFORMED
Consent
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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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“Ex-Fidelity brokers claim sales
pressure” – InvestmentNews, 4/3/2009
Sale of higher-margin
separate account
management products
And sale of higher-cost
insurance products
Instead of lower-cost
mutual funds
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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
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Will Informed Consent Exist If …
1. A conflict of interest exists
2. Disclosure of all material
3.
facts exists
BUT - the best interests of the
client are NOT kept paramount?
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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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How to Disclose …
 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.”
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How to Disclose …
 Client Services (Fee) agreement
 Ex: Your compensation
 Ex: Other fees and costs client may bear

(if known at the time)
 Ex: Non-exclusive relationship
 Ex: What the adviser is responsible for;
 What the client is responsible for
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Some Closing Thoughts …
 Fiduciary duties of an investment adviser lead to
specific requirements imposed by regulation:
 IA Code of Ethics
 IA Compliance Supervisory Procedures
 Chief Compliance Officer (Trained)
 Business Succession Plan
 Disaster Recovery Plan
 Form ADV, Part II disclosures

… and more
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Some Closing Thoughts …
 Fiduciary duties of an investment adviser lead to
other specific requirements
 NOT EXPRESSLY FOUND IN
REGULATIONS
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Suggested Action Steps – For Advisers
(and Examiners)
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
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Suggested Action Steps
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)
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Suggested Action Steps
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?
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He’s an
investment
adviser.
Ron A. Rhoades,
JD, CFP®
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He’s an
investment
adviser.
Ron A. Rhoades,
JD, CFP®
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He’s an
investment
adviser.
Ron A. Rhoades,
JD, CFP®
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Discussions:
How Do Investment
Advisers “Add Value”?
Case Study
Q&A
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