Standard III(A) – Loyalty, Prudence, and Care

Members and Candidates have a duty of loyalty to their clients and must act with reasonable care and exercise prudent judgment. Members and Candidates must act for the benefit of their clients and place their clients’ interests before their employer’s or their own interests.

Client interests are the ultimate priority. Investment actions must be taken for the benefit of the client, given the Member or Candidate’s knowledge of the facts and circumstance of their client. Standard III(A) – Loyalty, Prudence, and Care is not a substitute for a member or candidate’s legal obligations. Members and Candidates must always comply with the strictest rule as highlighted in Standard I(A) – Knowledge of the Law. Members and Candidates must manage funds in accordance with the terms set by governing documents (such as investment agreements, investor policy statements), which identify the investment manager’s duties and power.

Guidance

Understanding the Application of Loyalty, Prudence, and Care

Standard III(A) sets a minimum benchmark for the duties of loyalty, prudence, and care required by all Members and Candidates. The standard does not impose a fiduciary duty on Members and Candidates. However, Standard III(A) requires that Members and Candidates work in the best interest of clients at all times.

A Note on Fiduciary Duties

A fiduciary duty is a legal requirement for an individual to act in the best interest of a client or entity. As such, an individual or entity found in breach of their fiduciary duties or responsibilities can face legal recourse.

A fiduciary relationship exists when one party has the discretion and responsibility to act on behalf of another.

Examples of a fiduciary relationship may include:

• The relationship between a financial advisor and his or her clients.
• A trustee and the beneficiaries of the trust.
• Corporate board members and shareholders.

Standard III(A) does not legally require members or candidates to act in the best interest of a client or entity. However, it strongly promotes putting a client’s interests first.

Identifying the Actual Investment Client

Members and Candidates should determine the identity of the “client” that the duty of loyalty extends to. When an investment manager is managing the assets of an individual, the client is easily identified. When the manager is managing a pool of assets of a pension plan or trust, the client would be the beneficiaries of the trust or pension and not the hiring personnel.

Developing the Client’s Portfolio

Typically, an investment manager has greater knowledge about the investment universe. This asymmetry reinforces the importance of the duty of loyalty, care, and prudence owed to clients.

Investment managers should ensure that:  

• Client expectations and objectives are realistic and suitable to their risk profile and circumstance.
• Recommendation of investment strategies that take into account the long-term objectives of the client.
• Any potential conflicts of interest are disclosed explicitly.
• There is strict adherence to guidelines and agreements set by their clients.
• Investment actions are taken in the context of the total portfolio.

Soft Commission Policies 

“Soft Dollars” or “Soft Commissions” can be defined as the exchange of brokerage business (through client commissions) for research services or any other brokerage offerings. Investment managers direct transactions to their choice of broker, and in return, the brokerage may offer research services. Brokerage commissions are an asset of the client and consequently, any soft dollars obtained should directly benefit the client.

Clients are allowed to direct their managers to a particular brokerage, a practice referred to as ‘directed brokerage’ without violating Standard III(A) – Loyalty, Prudence, and Care. Members and Candidates are required to seek the “best price” and “best execution” for any goods and services purchased from a brokerage. “Best execution” is defined as trading practices that aim to maximize the value of a client’s portfolio subject to the client’s objectives and constraints. Additionally, managers should disclose any benefits they receive through client brokerage.

Proxy Voting Policies

Members and Candidates are required to vote on proxies responsibly. A member or candidate’s failure to vote or cast votes with little consideration or in line with management would be a violation of Standard III(A). Voting proxies may not always be beneficial for a client. Members and Candidates must always disclose their proxy voting policies.

Compliance Recommendations

Regular Account Information

Members and Candidates should:

• Share with each client the securities in custody or held by the member or candidate as well as all transactions that occurred over the period at least quarterly.
• Disclose where the assets are maintained or moved.
• Separate the client assets’ from every other party’s assets, including the member or candidates.

Client Approval

If a Member or Candidate is unsure about any investment actions, they should disclose the concern in writing to the client and receive approval.

Firm Policies

Members and candidates should:

Follow all applicable rules and laws: Comply with all legal requirements and applicable parts of the Code and Standards.

Establish the investment objectives of the client: Inquire into a client’s investment experience, risk and return objectives, and constraints before making investment recommendations or taking investment actions.

Consider all the information when taking actions: Consider the appropriateness and suitability of the investment relative to:

• A client’s requirements and circumstances.
• The investment’s characteristics.
• The characteristics of the entire portfolio.

Diversify: Diversify investments to minimize portfolio risk and loss – unless stated otherwise.

Carry out regular reviews: Establish frequent reviews to ensure that investment actions comply with the terms stated in the governing documents.

Deal fairly with all clients concerning investment actions: Avoid any favoritism of clients and create policies on trade allocation and the dissemination of recommendations.

Disclose conflicts of interest: Disclose all potential and actual conflicts of interest.

Disclose compensation arrangements: Disclose all forms of compensation.

Vote proxies: Determine who is permitted to vote shares and always vote proxies in the best interest of clients or ultimate beneficiaries.

Maintain confidentiality: Preserve the confidentiality of client information.

Seek best execution: Unless directed otherwise (by the ultimate beneficiary), always seek best execution.

Place client interests first: Serve in the best interests of clients.

Application 1: Soft Dollars

Grace Morris is the CEO of a financial advisory firm – Morris Advisors. Morris routinely uses the same broker for all her client-account trades. The broker offers average prices and below-average execution and research. In exchange, the broker pays Morris Advisors’ employees’ travel expenses and the firm’s rent. All research obtained is used to inform her investment recommendations and advice for her clients.

Is Morris in conflict with Standard III(A) – Loyalty, Prudence, and Care?

     A. No, because it is to her discretion which broker, she selects.

     B. Yes, because she fails to get the best execution and price for her clients.

     C. No, because the research received is a benefit to all her clients.

Solution

The correct answer is B.

Morris has violated Standard III(A) – Loyalty, Prudence, and Care. She uses her client’s brokerage for services that do not directly benefit her clients. Additionally, she fails to get the best execution and price for her clients.

Application 2: Identifying the Client

Isaac Freeman is a mutual fund portfolio manager. The fund has a strong small-cap value bias. Recently, a large family office expressed interest in allocating a substantial part of their assets in the fund. The only condition put across by the family office was that Freeman needed to include the five best performing growth stocks in the S&P 500. Freeman takes the family office as a client but has yet to include the growth stocks into the fund

Would Freeman’s inclusion of the growth stocks violate Standard III(A) – Loyalty, Prudence, and Care?

      A. Yes, because he is bound to a duty of loyalty to all the beneficiaries of the fund.

      B. No, the family office is a big client; they are allowed to make suggestions about asset allocation.

      C. No, because the inclusion of the best performing growth stocks would benefit all the beneficiaries of the fund.

Solution

The correct answer is A.

Freeman’s duty of loyalty extends to all the beneficiaries of the fund. Freeman is required to take investment actions based on the objectives and rules found in the fund’s investment policy statement. The size of the family office’s investment is irrelevant.

Application 3: Client Approval

Hadassah Zachary, CFA, manages Kate Chege’s investment portfolio. Chege has a heavily concentrated position in SunBeam Technologies. She received the majority of her shares after her father – the ex-CEO of Sunbeam – passed away. Zachary has expressed the need for and benefits of diversifying her portfolio. Chege has refused to diversify her holdings and has prohibited the sale of Sunbeam stock in her investment policy statement. News has just broken about SunBeam Technology filing for bankruptcy. Zachary is quick to act and attempts to get in touch with Chege, with no success. The stock price is falling dramatically, and Zachary proceeds to sell the shares and reinvest the proceeds into safer yielding assets.

Has Zachary violated Standard III(A) – Loyalty, Prudence, and Care?

     A. No, because she acted in Chege’s best interest.

     B. Yes, because she failed to diversify Chege’s portfolio.

     C. Yes, because she did not follow instructions found on the investment policy statement.

Solution

The correct answer is C.

Zachary was trying to act in Chege’s best interest. However, Chege’s investment policy statement prohibits the sale of Sunbeam stock. While it may appear that Zachary did the right thing for Chege’s portfolio, she has violated Standard III(A) – Duties to Client. To comply with Standard III(A), Zachary must disclose any investment action and wait for Chege’s approval.

Application 4: Excessive Trading

Samuel Taylor is a wealth manager at Schuster Partners. A percentage of her management fees is derived from trading commissions. Taylor trades excessively in each of his client trading accounts, but the trades are appropriate and in line with his client’s asset allocations. However, the trading activity exceeds what is required to implement her client’s objectives.

Do Taylor’s actions comply with Standard III(A) – Loyalty, Prudence, and Care?

    A. Yes, because he is using his client’s assets to benefit himself.

    B. No, because the trading activity is within his client’s allocations.

    C. No, because Taylor is allowed to direct trading activity and frequency.

Solution

The correct answer is A.

Taylor has violated Standard III(A) –Loyalty, Prudence, and Care. Her actions are in her interest. Regardless of whether the trades were appropriate, Taylor put his needs before his clients.

Application 5: Client Loyalty

Betty Davis is responsible for performing periodic reviews on her firm’s trading activity and allocation practices. In her analysis, she finds that her firm failed to place a large sell order for one of its major clients, Gratus Asset Managers. Correcting this omission will result in a substantial loss for Gratus. Davis is worried that her disclosure of this omission will lead Gratus to terminate its brokerage business with her firm.

What actions should Davis take to best comply with Standard III(A) – Loyalty, Prudence, and Care?

     A. She should take no action. Her correction would lead to her firm losing Gratus’s business.

     B. She should inform Gratus and her firm of the omission.

     C. She should ask the traders in her firm to follow through with the sell order.

Solution

The correct answer is B.

Even though disclosing the omission may lead to Gratus Asset Managers terminating its business with her firm, withholding this information would not be in the best interest of the client. Davis’ duty of loyalty, prudence, and care is owed to the client before her employer.

Reading 46: Guidance for The Standards of Professional Conduct (I-VII)

LOS 46 (a) Demonstrate a thorough knowledge of the CFA Institute Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations.