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Raising the Bar

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It is a challenge for a firm to grow, hire new employees, and assume greater responsibilities while offering a wider range of client services. We believe, however, that a serious effort at training and educating our workforce in professional ethical standards is a key to our total success. As our firm–Bingham, Osborn & Scarborough LLC (BOS)–has grown, we have broadened our expectations and requirements for all employees to comply both with the law and appropriate ethical standards of conduct, whether in dealing with our clients or with other associated professionals. We picture our legal and ethical responsibilities in layers, with each layer representing a higher or stricter standard of conduct to which we hold ourselves (see It’s All About Layers sidebar).

Are we really trying to “teach” ethics, then? In a strict sense, the answer is no. We believe that we have hired employees who are honest and ethical. But we think it is possible for a basically honest employee, intending to do the right thing, to make legal or ethical mistakes for any number of reasons:

  1. The employee is new to our industry and is unfamiliar with the requirements of the law.
  2. The employee does not have enough experience with the subject to apply his judgment correctly.
  3. The employee is working on just one part of a project, and cannot see how her individual actions in the broader context of the overall project could create an ethical lapse.

We began annual, mandatory ethics and compliance meetings in 1998. Every member of our firm must attend, from the founding principals to the temporary administrative staff. We expect all our employees to know the requirements of the law, the CFA and CFP code of standards, and the content of our compliance manual. However, we think it is necessary to go beyond these basics. Using case studies, we put our standards and expectations in the context of our firm’s business and the types of situations that can and have developed at the firm.

The case studies we use are updated each year and are developed by talking with employees about ethical quandaries they believe they have faced or that they have seen others face in the course of their jobs. We have a tolerant policy that says that it is OK to make a mistake–once–assuming the employee identifies and corrects the mistake, under guidance from the firm. At BOS it is never acceptable to hide mistakes.

In advance of our annual ethics and compliance meeting, eight to 10 case studies are circulated to the entire staff for thoughtful consideration. Most case studies are not black and white, and while there are no “correct” answers in every case, there are almost always some answers that are better than others. During our group meeting, we engage in lively discussion that can lead to a debate about the best solution.

We do not believe we can train all employees to always know, on their own, the best thing to do. We do believe we can train them to identify issues that will arise in the course of their work, sometimes in very subtle or surprising ways. Our goal is to raise awareness and to encourage consultation with their supervisor, peers, or our compliance officer in order to craft the best solution to a situation. These case studies, drawn from our own experience, achieve what no code of standards or off-the-shelf ethics course can provide.

The following case studies, based on how our firm serves clients, fall into categories that will probably be familiar to both clients and investment professionals alike. We discuss confidentiality, acting only in the client’s best interest when faced with conflicts of interest, full disclosure about investment transactions, acceptance of gifts, and using independence of judgment.

Case A: Confidentiality

During the second week of April, a caller to the firm identifies himself as the accountant for a BOS client. He asks for a critical tax report to be faxed, as had been promised by the portfolio manager. The client’s portfolio manager, portfolio administrator, and principal are all out of the office. You offer the accountant the opportunity to leave a voicemail. He says no, he needs the realized gains report from the previous year right away. You do not have personal knowledge of the client’s account or accountant, but you are able to print a realized gain report. The accountant is very insistent, and becoming agitated.

What should you do?

Comment: You need to get off the phone, but may promise a call back. Try to verify from company records that the accountant, in fact, works with this client and is authorized to receive financial reports. The data the accountant is asking for is confidential information and must not be released without express permission of the client. This should be documented in the client’s file. If not, you may enlist the assistance of any manager in the firm to verify the accountant’s bona fides with other records, or by calling the client to make certain the information may be released to the accountant who called.

Case B: Conflicts of Interest

You have just met with a prospective new client who owns a consulting firm that performs land use planning for several local town governments. You serve as an unpaid volunteer on the finance committee of your town. One responsibility of your committee is to review the annual budget prepared by the town administrator before it is sent to the town council for discussion and a vote. You are aware that the proposed fiscal budget your committee will review in a few weeks includes a planned expenditure for the services of your prospective client’s consulting firm.

Do you have a conflict of interest in performing your duties for the committee? What should you do?

Comment: You do have a conflict of interest, even though the client is still just a prospect. Your favorable action on his behalf could be seen as an attempt to win his business. You must disclose the conflict to the town finance committee and remove yourself from any recommendations or decisions regarding the budget as it might affect the services from this consultant. This disclosure, with written documentation, is even more important when it comes up in the context of public or governmental action.

Case C: Insider Trading?

A personal friend calls you to ask for advice about whether it is legal to make a trade. He tells you that he was briefly in a meeting room where company executives may have been euphoric about particularly good earnings, but it is just before the end of the calendar quarter, and there has been no public statement yet about quarterly earnings from the company. Your friend is interested in buying calls on the stock, with the expectation that the stock could rise significantly if improved earnings are announced.

Regardless of your advice, if your friend executed the purchase of calls, would he be in violation under insider trading rules? Would your answer be different to any of the above if the financial impact for your friend would be a gain of $20,000?

Comment: Insider trading involves the reliance on material, non-public information in making trades. It is illegal under most circumstances. The facts of each particular case are important in the determination of legality. How the individual came into possession of the information, and whether they breached a duty of confidentiality in obtaining it, can also be a factor. You must exercise extreme caution in all such cases, and make additional inquiries into the manner in which the information was obtained, the relationship of the individual to the company involved, and the materiality and dissemination of the information. If in doubt, do not exercise the trade, and caution the client to seek legal counsel. Notify your compliance officer.

Case D: Portfolio Trading Issues:

You are implementing an investment portfolio for a new client. Due to a misunderstanding between you and the client, you do not implement one of the trades the client expected you to make. The investment in question has risen in value approximately $1,000 between the time the client expected you to make the trade and when you actually execute it.

Are you responsible for reimbursing the client?

Comment: Depending on the nature of the misunderstanding, the answer is probably yes. You would be responsible for notifying the client of the error, executing the trade they would have expected you to make, and reimbursing the client’s account for the extra cost or lost earnings. The burden of clarity in setting expectations normally falls on the investment advisor and, ideally, all expectations, including the amounts and timing of expected trades, should be documented. In the case of a discretionary relationship, where a client is not required to approve trades in advance, there is a potential for abuse or cover-up by the advisor. An advisor might argue to the client that he did not intend to make the trade earlier. Procedures must be in place internally to treat the client fairly and reimburse the client, even if it is possible that the client might never be aware of the error.

Case E: Competing for New Business

You are competing for a new client against another firm that you know well. After multiple favorable meetings and good outcomes from references you supply, the prospect nevertheless tells you that she plans to work with the other firm. The other firm is headed by a former employee at your firm, who left about eight years ago while a candidate for the CFA designation. The employee had violated several ethical standards at the time he left, and was sanctioned by the CFA Institute with a one-year suspension of his CFA designation.

Should you tell the prospective client?

Comment: We would never disparage another firm when competing with them for a client, and if asked by a prospective client about another firm, would only share facts about their approach and differences from our firm if there was a factual and verifiable basis for the differentiation. Telling the prospect about the ethical sanction against the competitor could be considered disparagement. This type of sanction would be required to be reported in the competitor’s ADV form, required by the SEC to be delivered to all prospective clients. The most you could do would be to urge the client to carefully read the competitor’s ADV form while stating you would ask the client to do the same if they were considering hiring you.

Case F: Additional Compensation, Disclosure of Conflicts

In each of the four cases listed below, identify whether there is a possible conflict or if there is a need to disclose additional compensation, and then determine the specific action you should take in response.

  1. You mention in a meeting with your client that you will be getting married shortly. After the wedding, you receive a wedding gift from the client with an estimated market value of $100.
  2. You have met several times with a prospective client as a free consultation offered for auction at a local charity fundraiser. The prospect offered to pay you an hourly fee for the time spent beyond the free consultation, but you decide not to take it because the client has become a prospect and your work can be categorized as business development. As a thank you, the client offers you a ticket to Game 4 of the World Series, to attend as the client’s guest. The face value of the ticket is $145. You estimate the market value of the ticket to be $2,000-$2,500.
  3. The firm that holds the majority of your client assets calls to invite you to a Lake Tahoe weekend seminar. Over the two days there will be seminars related to investment management and your business relationship with the firm, but plenty of time for recreation. The sponsoring firm is covering the cost of two nights of lodging, meals, and two days of ski lift tickets. You estimate the market value of all this as about $1,000.
  4. You have helped a new client settle an estate and determine the value of certain securities before you have started to implement a new investment proposal for the client. You have elected not to start collecting an asset management fee on the new account, because you have not yet started to implement the new proposal. The client offers to pay you your normal hourly fee for the work you have done up until the time that implementation starts. You decline, stating that the work you have already done would need to have been done anyway before implementation. The client then states that she would like to send you some wine from her extensive collection.

Comment: The primary issue with accepting gifts is that they have the potential of, or the perception of, compromising the independence of the recipient. Receiving gifts from clients could lead to an expectation, or at least the belief by others, that the client will get better service or better advice relative to other clients. When gifts are offered by another firm, as in case 3) above, the appearance could be left that you are recommending a firm to custody assets because of the gifts, not because the firm is the best choice for the client. Gifts from clients of modest value are not inappropriate. Gifts that do not exceed $250 in value per year from any client are permissible at our firm, as long as they are reported internally. We do not encourage gifts from our clients, and under no circumstances can they ever be solicited. The gifts in cases 1), 2), and 4) referred to above are all consistent with this policy. Example 2) is consistent because business was discussed with the prospective client during the World Series game. We would not accept the ski weekend in example 3) because the value of the non-business component (the gift amount) of the trip exceeded the $250 limit.

Case G: Client Conduct

A prospective client who is serving as a co-trustee on his elderly mother’s two trust accounts seeks your advice on how to invest those assets in two income-producing trusts to provide income both for his mother and for payouts to himself. You advise the client that payouts from a trust account set up for the benefit of his mother during her lifetime must only make distributions for the benefit of the mother, unless she authorizes additional payouts to be made from the trust to others as gifts. In ressponse the prospective client tells you that he will set up a new account, in the name of the mother’s trust, but not visible to you or under your control, into which he will direct you to make regular distributions of cash. You will have no visibility or knowledge of where that cash goes after it is transferred out of the trust accounts you manage.

May you accept the new client?

Comment: No, do not accept this client unless the management and distributions are done with the full understanding and agreement of the mother. As a co-trustee, her authorization of you, as investment advisor, will be needed in any event. It is essential that the mother fully agree with the amounts and purposes of any distributions, so that any distributions to others are properly accounted for as gifts, which may affect her estate taxation. Setting up a separate account you do not see to make cash contributions to her son or to third parties does not absolve you from responsibility for how those funds are being spent, and whether it is in concert with the trust provisions.

Case H: romance

One of your firm’s investment advisors has been providing investment advice to a new client for just over a year. The client is an unmarried woman with a moderate-sized account, but she also serves as the sole trustee for her elderly mother’s much larger living trust account that is also under management. The client and investment advisor decide that they would like to start dating each other.

What issues with respect to professional conduct does this situation raise for the investment advisor and for the client with respect to her fiduciary responsibilities?

Comment: There are two potential issues for the investment advisor, and one for the client. If other clients learn that their advisor is dating a client, they might reasonably expect that that client will get more attention and better investment and financial planning advice. An untrue perception that you are not treating all clients fairly could develop. If the relationship does not work out, it is possible that the client might fire you and the firm, thereby depriving your firm of revenue because of your personal conduct (remember, the client came to the firm before the personal relationship).

The client-trustee also may be in a position to violate her fiduciary duty to manage the accounts in her mother’s best interests. If the trustee is in a personal relationship with the investment advisor, she may be less likely to exercise impartial oversight and diligence because she is protecting the personal relationship.

It may be possible for the relationship to go forward if there is a way to substantially avoid all these problems–perhaps by transferring responsibility for the account to another professional in the firm, if agreed to by the client.

There are few easy answers when it comes to the ethical issues faced by financial advisors and their staffs. Annual meetings to remind everyone at your firm about just how overt or subtle the issues can be is an important step in making sure that the client’s best interest comes first.

William R. Urban is a principal of Bingham, Osborn & Scarborough LLC (BOS), a San Francisco and Menlo Park, California-based fee-only RIA with $1.3 billion in assets under management. BOS has provided investment management and comprehensive financial planning for individuals and endowments since 1985. BOS has eight principals and seven portfolio managers working directly with clients, plus an administration, finance, and systems staff with direct client contact and responsibilities related to client accounts.