Fiduciary Duty

Fiduciary Standard vs. Suitability Standard

One of the most fundamental concepts on the Series 65 exam is the distinction between the fiduciary standard that applies to investment advisers and the suitability standard that has traditionally applied to broker-dealers. Understanding this distinction is essential because it defines the legal and ethical obligations of investment adviser representatives (IARs) toward their clients.

The Fiduciary Standard

Investment advisers and their representatives owe a fiduciary duty to their clients. This is the highest standard of care recognized by law. The fiduciary standard was established by the Supreme Court in the landmark case SEC v. Capital Gains Research Bureau (1963), which held that investment advisers have an affirmative duty of "utmost good faith and full and fair disclosure of all material facts" to their clients.

The fiduciary duty encompasses two core obligations:

• Duty of Loyalty: The adviser must place the client's interests ahead of their own. The adviser must not benefit at the client's expense. Every recommendation must be made in the client's best interest, not to generate fees or commissions for the adviser. Conflicts of interest must be disclosed and managed.
• Duty of Care: The adviser must provide advice that is suitable and in the client's best interest, considering the client's financial situation, investment objectives, risk tolerance, time horizon, liquidity needs, and other relevant factors. The adviser must have a reasonable basis for every recommendation and must monitor the client's portfolio on an ongoing basis.

The Suitability Standard

Traditionally, broker-dealers and their registered representatives have been held to a suitability standard under FINRA rules. The suitability standard requires that a recommendation be appropriate for the customer based on the customer's investment profile, but it does not necessarily require that the recommendation be in the customer's best interest. A suitable recommendation could include products that generate higher commissions for the broker if the product is still appropriate for the customer.

However, with the SEC's Regulation Best Interest (Reg BI), adopted in 2019, broker-dealers are now required to act in the "best interest" of their retail customers when making recommendations. Reg BI is higher than the old suitability standard but is generally considered to be less stringent than the full fiduciary standard that applies to investment advisers.

Conflicts of Interest

A conflict of interest exists whenever an adviser's personal interests could potentially diverge from the client's interests. The existence of a conflict does not necessarily mean the adviser has acted improperly, but fiduciary duty requires that all material conflicts be disclosed to the client and managed appropriately. The Series 65 exam tests several specific types of conflicts.

Soft Dollar Arrangements

Soft dollars refer to the practice of investment advisers directing client brokerage transactions to broker-dealers in exchange for research and other services. Instead of paying for research with their own money ("hard dollars"), the adviser pays for it indirectly through higher commission rates on client trades. The client effectively pays for the adviser's research through higher trading costs.

Under Section 28(e) of the Securities Exchange Act, soft dollar arrangements are permissible in a safe harbor if:

• The products or services obtained are eligible (research reports, analytical software, financial data services, advice on portfolio strategy).
• The adviser determines in good faith that the commissions paid are reasonable in relation to the value of the research received.
• The arrangement is disclosed to clients (in Form ADV Part 2A).

Items NOT covered by the safe harbor include office furniture, office rent, employee salaries, travel expenses, and other overhead. These must be paid with the adviser's own money.

Directed Brokerage

Directed brokerage occurs when a client directs the adviser to use a specific broker-dealer for executing trades. The client may do this because they have an existing relationship with the broker or want to receive certain services. However, directed brokerage can create conflicts because the adviser may not be able to obtain best execution when forced to use a particular broker. Clients who direct brokerage should be informed that they may pay higher commissions and may not benefit from aggregated or "batched" orders.

Revenue Sharing

Revenue sharing occurs when mutual fund companies or other product sponsors pay advisory firms for placing client assets in their products. This creates a conflict because the adviser may be incentivized to recommend products from sponsors that pay revenue sharing, rather than products that are in the client's best interest. Revenue sharing arrangements must be disclosed to clients.

Personal Trading and Front-Running

Advisers and their associated persons may have personal investment accounts. Personal trading creates a conflict when the adviser trades in the same securities they recommend to clients. The most egregious form is front-running—trading ahead of a client order to profit from the expected price movement caused by the client's trade. Front-running is illegal and violates the adviser's fiduciary duty.

To manage personal trading conflicts, advisers must adopt a Code of Ethics that includes:

• Reporting of personal securities holdings and transactions by "access persons"
• Pre-clearance requirements for certain trades (especially IPOs and private placements)
• Prohibitions on front-running
• Restrictions on trading against client recommendations

Allocation of IPOs and Hot Issues

When an adviser has the opportunity to purchase shares in an IPO or other limited offering, there is a conflict regarding how to allocate those shares among clients (and whether the adviser's own accounts should participate). Fiduciary duty requires fair allocation—the adviser cannot cherry-pick profitable IPO shares for their own account or for favored clients. Many firms allocate IPO shares pro rata based on account size or through other objective, pre-established methods.

Disclosure Requirements

Full and fair disclosure is the cornerstone of the fiduciary relationship. Investment advisers have extensive disclosure obligations designed to ensure clients have all material information needed to make informed decisions. The primary disclosure document is Form ADV.

Form ADV Part 2 (Brochure)

Form ADV Part 2A (the "brochure") is the adviser's primary disclosure document to clients. It must be written in plain English and must cover:

• Advisory business description: Types of services offered, types of clients served.
• Fees and compensation: Fee schedules, how fees are calculated, whether fees are negotiable, other compensation received (commissions, referral fees).
• Performance-based fees: If applicable, how they are calculated and the risks involved.
• Methods of analysis and investment strategies: The types of securities analyzed and the investment strategies employed.
• Material risks: Risks associated with the types of investments and strategies used.
• Disciplinary information: Any legal or disciplinary events that are material to a client's evaluation of the adviser.
• Conflicts of interest: All material conflicts, including soft dollars, directed brokerage, proprietary products, revenue sharing, and related-party transactions.
• Code of Ethics: Summary of the adviser's code, including provisions for personal trading.
• Brokerage practices: How the adviser selects broker-dealers, factors considered in seeking best execution.
• Custody: Whether the adviser has custody of client assets.
• Voting client securities: Whether and how the adviser votes proxies on behalf of clients.

Form ADV Part 2B (the "brochure supplement") provides information about specific individuals who provide advisory services to the client, including their educational background, business experience, disciplinary information, and outside business activities.

Brochure Delivery Requirements

The adviser must deliver the brochure (Form ADV Part 2A) and the brochure supplement (Part 2B) to the client:

• Before or at the time of entering into an advisory contract (initial delivery).
• Annually: Within 120 days of the end of the adviser's fiscal year, the adviser must either deliver an updated brochure or deliver a summary of material changes along with an offer to provide the full brochure upon request.
• Interim updates: If there are material changes to disciplinary information, clients must be promptly notified.

Privacy Notices (Regulation S-P)

Under Regulation S-P, investment advisers must provide privacy notices to clients that describe the adviser's policies for collecting, sharing, and protecting clients' nonpublic personal information (NPI). The privacy notice must be delivered at the time of establishing the client relationship and annually thereafter.

Key provisions: Clients must be given the opportunity to opt out of having their NPI shared with non-affiliated third parties. Advisers must implement policies and procedures to safeguard customer records and information.

Advisory Contracts

The advisory contract is the legal agreement between the investment adviser and the client that establishes the terms of the advisory relationship. Both federal and state securities laws impose specific requirements on advisory contracts.

Required Provisions

Advisory contracts must include or address several key elements:

• Services to be provided: A clear description of the advisory services the firm will provide.
• Fees and compensation: How fees are calculated, when they are charged (in advance or arrears), and any refund policy for prepaid fees.
• Term and termination: The duration of the contract and how either party can terminate the relationship. Both the client and the adviser must have the right to terminate the contract. A client generally can terminate at any time and receive a pro-rata refund of prepaid fees.
• No assignment without consent: The contract cannot be assigned to another adviser without the client's consent. Under the Investment Advisers Act, "assignment" includes any direct assignment as well as situations where a controlling block of the adviser's equity is transferred (change in control).

Performance-Based Fees

A performance-based fee is compensation based on the portfolio's gains (or gains in excess of a benchmark). Under the Investment Advisers Act, performance-based fees are generally prohibited for most clients because they create an incentive for the adviser to take excessive risk.

However, performance-based fees ARE permitted for "qualified clients":

• Clients with at least $1.1 million in assets under management with the adviser, OR
• Clients with a net worth exceeding $2.2 million (excluding the value of the primary residence)

Performance-based fees must be structured as a "fulcrum fee" (also called a symmetrical fee) for registered investment companies. A fulcrum fee adjusts both up and down relative to a benchmark—the adviser earns more when outperforming and less when underperforming, ensuring symmetry.

Assignment of Advisory Contracts

An advisory contract may not be assigned without the client's consent. Assignment includes both direct transfers and changes in majority ownership or control of the advisory firm. If an adviser merges with or is acquired by another firm, this constitutes an assignment and every client must consent. Without consent, the contract is terminated by operation of law.

Code of Ethics and Compliance

Code of Ethics Requirement

Under Rule 204A-1 of the Investment Advisers Act, every SEC-registered investment adviser must adopt and enforce a written Code of Ethics. The code must include:

• Standard of business conduct: A statement reflecting the fiduciary duty owed to clients.
• Compliance with securities laws: Requirements that supervised persons comply with all applicable federal securities laws.
• Personal securities reporting: Requirements that "access persons" report their personal securities holdings (within 10 days of becoming an access person and annually thereafter) and transactions (quarterly).
• Pre-approval of certain investments: Requirements that access persons obtain pre-approval before investing in IPOs and limited offerings (private placements).
• Reporting of violations: Procedures for supervised persons to report violations of the code promptly to the chief compliance officer.

An access person is any supervised person who has access to nonpublic information regarding client transactions, portfolio holdings, or recommendations, or who has access to such information about affiliated fund holdings. In practice, most advisory personnel are considered access persons.

Custody Rules

An adviser is deemed to have custody of client assets if they hold, directly or indirectly, client funds or securities, or have the authority to obtain possession of them. Having custody triggers additional requirements:

• Qualified custodian: Client assets must be maintained with a "qualified custodian" (typically a bank or broker-dealer).
• Account statements: The qualified custodian must send account statements directly to clients at least quarterly.
• Annual surprise examination: An independent public accountant must conduct a surprise examination of custodied assets at least once per year.
• Notification: The adviser must notify the SEC on Form ADV that it has custody.

Important: An adviser is deemed to have custody if it has the ability to deduct fees directly from client accounts, if associated persons serve as trustees of client trusts, or if the adviser has signatory authority over client bank accounts.

Proxy Voting

If an adviser has authority to vote proxies on behalf of clients, Rule 206(4)-6 requires the adviser to adopt written proxy voting policies and procedures reasonably designed to ensure that proxies are voted in the best interest of clients. The adviser must:

• Describe proxy voting policies to clients and provide copies upon request.
• Disclose how clients may obtain information about how their proxies were actually voted.
• Maintain records of proxy votes for at least five years.

Best Execution

Best execution requires the adviser to seek the most favorable terms reasonably available under the circumstances for client transactions. Best execution does not necessarily mean the lowest commission—it considers the full range of services provided by the broker, including execution quality, research, speed of execution, and the broker's financial stability.

Factors considered in evaluating best execution:

• Commission rates and other transaction costs
• Execution speed and quality
• The broker's ability to handle complex or large orders
• Research and other services provided
• The broker's financial responsibility and responsiveness
• Access to a wide range of markets and securities

Prohibited Practices

Investment advisers are prohibited from engaging in certain practices that are considered fraudulent, deceptive, or manipulative under Section 206 of the Investment Advisers Act:

• Fraud or deceit: It is unlawful for an adviser to employ any device, scheme, or artifice to defraud any client or prospective client.
• Misleading statements: Making untrue statements of material fact or omitting material facts that make statements misleading.
• Fraudulent acts or practices: Engaging in any transaction, practice, or course of business that operates as fraud or deceit upon any client.
• Front-running: Trading personal accounts ahead of client orders to benefit from the anticipated price impact.
• Cherry-picking: Allocating winning trades to favored accounts (including the adviser's own accounts) and losing trades to other client accounts.
• Churning: Excessive trading in a client's account to generate commissions rather than to benefit the client.
• Misrepresentation of credentials: Falsely claiming certifications, designations, or experience.
• Guaranteeing against loss: Promising or guaranteeing that the client will not lose money. (Note: This does not prevent discussing risk management strategies.)
• Sharing in client profits/losses: Generally prohibited unless the adviser has a proportionate ownership interest and the arrangement is disclosed.