More On Legal & Compliancefrom The Advisor's Professional Library
- RIAs and Customer Identification Just as RIAs owe a duty to diligently protect their clients privacy and guard against theft, firms also play a vital role in customer identification. Although RIAs are not subject to an anti-money laundering rule, securities regulators expect advisors to address these issues in their policies and procedures.
- Privacy Policies and Rules Whether an RIA is SEC or state-registered, the firm must have policies and procedures in effect to protect clients privacy. Policies and procedures should explicitly require an RIA to send out its privacy notice each year.
Regarding the AdvisorOne blog entry of Sept. 26, 2012 entitled, “HighTower Advisors: The New Face of Fiduciary?,” I agree with author Knut Rostad’s premise and conclusion. However, I would take issue with the opening statement that avoiding or managing conflicts of interest is, arguably, “[t]he centerpiece of a fiduciary's responsibility and the glue in an advisor/client relationship of trust and confidence.” While one might accept this as true, one cannot “surmise [it] from the investment professionals who advised Congress as it crafted the Advisers Act of 1940, or the Supreme Court 1963 Capital Gains Research decision or, to fast forward, clear guidance that is offered by the SEC today.”
The Capital Gains case continues to have a profound influence on the law governing investment advisors nearly a half-century after the Court’s decision. The case often is cited for the proposition that Congress established a federal fiduciary duty for advisors when it passed the Investment Advisers Act in 1940. A careful reading of the Act and its legislative history, however, demonstrates that although Congress recognized certain advisors to be fiduciaries, Congress did not create or impose a fiduciary duty on advisors. Moreover, the Capital Gains case itself did not state that the Advisers Act created a fiduciary duty. Rather, the federal fiduciary duty was a creation of subsequent Supreme Court decisions, such as Santa Fe Industries v. Green and Transamerica Mortgage Advisers v. Lewis, which stated, in reliance on Capital Gains, that the Advisers Act created a federal fiduciary obligation.
After Santa Fe and Transamerica, the law governing advisers has developed against a backdrop of a federal duty, which has had important implications for advisors. The duty has expanded liability for advisors beyond liability for fraud, which is the prohibition adopted by Congress in the Advisers Act, and the duty has introduced an element of vagueness into the law governing advisors with respect to both the source and the content of the duty imposed.
Having said that, I wholeheartedly agree that there is no such thing as “zero” conflicts of interest. There will always be occasions where conflicts arise, such as the case where the advisor honestly believes that a particular mutual fund is the best choice for his client even though the advisor will be paid more than if another recommendation. In the context of CFP professionals, there is no distinction made between “technical conflicts” (whatever those may be) and outright conflicts.
However, not all conflicts are created equally. Advisors do not have a duty to disclose all current conflicts or future potential conflicts except when the conflicts are material, which may form the basis for Elliot Weisbluth’s characterization of conflicts (see the HighTower Advisors’ CEO’s answer on the issue in this video). The basic definition of a Conflict of Interest for the purposes of CFP Professionals is as follows, “A conflict of interest exists when a CFP Board designee’s financial, business, property and/or personal interests, relationships or circumstances reasonably may impair his/her ability to offer objective advice, recommendations or services.” Section 2 of the Rules of Conduct, “Information Disclosed to Prospective Clients and Clients” goes on to narrow what must be disclosed, to wit:
2.1 A certificant shall not communicate, directly or indirectly, to clients or prospective clients any false or misleading information directly or indirectly related to the certificant’s professional qualifications or services. A certificant shall not mislead any parties about the potential benefits of the certificant’s service. A certificant shall not fail to disclose or otherwise omit facts where that disclosure is necessary to avoid misleading clients.
2.2 A certificant shall disclose to a prospective client or client the following information:
a. An accurate and understandable description of the compensation arrangements being offered. This description must include:
i. Information related to costs and compensation to the certificant and/or the certificant’s employer, and
ii. Terms under which the certificant and/or the certificant’s employer may receive any other sources of compensation, and if so, what the sources of these payments are and on what they are based.
b. A general summary of likely conflicts of interest between the client and the certificant, the certificant’s employer or any affiliates or third parties, including, but not limited to, information about any familial, contractual or agency relationship of the certificant or the certificant’s employer that has a potential to materially affect the relationship.
c. Any information about the certificant or the certificant’s employer that could reasonably be expected to materially affect the client’s decision to engage the certificant that the client might reasonably want to know in establishing the scope and nature of the relationship, including but not limited to information about the certificant’s areas of expertise.
In other words, not just any information, but material information must be disclosed. It would be misleading under our rules for a CFP Professional to state that he/she has “zero” conflicts of interest because non-material conflicts arise frequently enough in an advisor/client relationship such that they must be distinguished from material conflicts.
The Supreme Court has, on numerous occasions, reaffirmed the traditional test of Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988) and TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976), that the materiality requirement under Section 10(b) of the Exchange Act is satisfied when there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as being important to his or her investment decision (including a decision to retain the security or not).” Thus, materiality depends on the facts and is to be determined on a case-by-case basis (pp. 238-241. Basic v Levinson, et al.)
Following the Basic and TSC Industries materiality definition, it seems incredulous that Mr. Weisbluth would have suggested that he had neither material nor non-material conflicts of interest since by definition some non-material or material fact will always exist in every advisory relationship. Although an advisor may have no material conflicts of interest, it does not follow that he has “zero” – a standard that is, for all intents and purposes, unachievable.
Ultimately, every CFP Professional and Investment Advisor has an ongoing obligation under our Practice Standards to disclose material conflicts of interest. In view of the ongoing nature of the obligation to disclose material conflicts and the fact that, as every financial adviser knows, and history has shown, material conflicts can arise at any time during a client-planner relationship, it is simply inappropriate for a CFP® professional to say to a client that he/she has zero conflicts of interest. Here, a question of materiality comes into play.
As mentioned above, CFP Professionals have a duty to disclose material conflicts of interest to clients. The more difficult question is: "How much disclosure is enough?" In a 2010 settled enforcement action, the SEC suggests that disclosure of material facts alone may not be sufficient, and that more explicit disclosure is needed when investment advice may result in additional compensation to the adviser. The case is Matter of Valentine Capital Asset Management.
The SEC's administrative order found that the advisor "fail[ed] to fully and adequately disclose a material conflict of interest" by not informing its clients that the advisor would receive an additional commission if its clients accepted its recommendation to switch from one series of a managed fund to another series in that same fund. The SEC reached this conclusion despite the fact that the advisor fully disclosed all commission costs to its clients.
Despite disclosure of the fees, the SEC found that the advisor was required to make "full and clear disclosure" about any conflict of interest in recommending the exchanges, and that it "failed to disclose to clients that [it] would receive additional commissions" if clients followed the advice. Consequently the SEC found that the advisor breached its fiduciary duty. The SEC charged the advisor with failing to tell clients that he would receive additional commissions if they switched from one series of a fund to another; the case settled with a censure, disgorgement of approximately $395,000 in commissions, and a $60,000 fine for the advisor’s president.
In a release publishing recent amendments to Form ADV, the SEC addressed this type of conflict issue. The SEC noted that Item 5 of the amended form requires that advisers receiving compensation, such as commissions, attributable to the sale of a security or other investment product, disclose the compensation as well as "the conflict of interest it creates, and ... how the adviser addresses this conflict."
Valentine should serve as a cautionary tale for all CFP Professionals. Not only is there no such thing as “zero” conflicts of interest but the nature of “material” is subject to change. Be careful and diligent. Keep abreast of regulatory developments and the latest literature. Many traps lie in wait for the careless or uninformed CFP Professional, including those regarding “material” conflicts during the client-planner relationship.