Standard III(A) Loyalty, Prudence, and Care

Standard III(A) clarifies that client interests are paramount. A member’s or candidate’s responsibility to a client includes a duty of loyalty and a duty to exercise reasonable care. Investment actions must be carried out for the sole benefit of the client and in a manner the member or candidate believes, given the known facts and circumstances, to be in the best interest of the client. Members and candidates must exercise the same level of prudence, judgment, and care that they would apply in the management and disposition of their own interests in similar circumstances.

Prudence requires caution and discretion. The exercise of prudence by investment professionals requires that they act with the care, skill, and diligence that a reasonable person acting in a like capacity and familiar with such matters would use. In the context of managing a client’s portfolio, prudence requires following the investment parameters set forth by the client and balancing risk and return. Acting with care requires members and candidates to act in a prudent and judicious manner in avoiding harm to clients.

Standard III(A) sets minimum expectations for members and candidates when fulfilling their responsibilities to their clients. Regulatory and legal requirements for such duties can vary across the investment industry depending on a variety of factors, including job function of the investment professional, the existence of an adviser/client relationship, and the nature of the recommendations being offered. From the perspective of the end user of financial services, these different standards can be arcane and confusing, leaving investors unsure of what level of service to expect from investment professionals they employ. The single standard of conduct described in Standard III(A) benefits investors by establishing a benchmark for the duties of loyalty, prudence, and care and clarifies that all CFA Institute members and candidates, regardless of job title, local laws, or cultural differences, are required to comply with these fundamental responsibilities. Investors hiring members or candidates who must adhere to the duty of loyalty, prudence, and care set forth in this standard can be confident that these responsibilities are a requirement regardless of any legally imposed fiduciary duties.

Standard III(A), however, is not a substitute for a member’s or candidate’s legal or regulatory obligations. As stated in Standard I(A) Knowledge of the Law, members and candidates must abide by the strictest requirements imposed on them by regulators or the Code and Standards, including any legally imposed fiduciary duty. Members and candidates must also be aware of whether they have “custody” or effective control of client assets. If so, a heightened level of responsibility arises. Members and candidates are considered to have custody if they have any direct or indirect access to client funds. Members and candidates must manage any pool of assets in their control in accordance with the terms of the governing documents (such as trust documents and investment management agreements), which are the primary determinant of the manager’s powers and duties. Whenever their actions are contrary to provisions of those instruments or applicable law, members and candidates are at risk of violating Standard III(A).

Standard III(A) establishes a minimum benchmark for the duties of loyalty, prudence, and care that are required of all members and candidates regardless of whether a legal fiduciary duty applies. Although fiduciary duty often encompasses the principles of loyalty, prudence, and care, Standard III(A) does not render all members and candidates fiduciaries. The responsibilities of members and candidates for fulfilling their obligations under this standard depend greatly on the nature of their professional responsibilities and the relationships they have with clients. The conduct of members and candidates may or may not rise to the level of being a fiduciary, depending on the type of client, whether the member or candidate is giving investment advice, and the many facts and circumstances surrounding a particular transaction or client relationship.

Fiduciary duties are often imposed by law or regulation when an individual or institution is charged with the duty of acting for the benefit of another party, such as managing investment assets. The duty required in fiduciary relationships exceeds what is acceptable in many other business relationships because a fiduciary is in an enhanced position of trust. Although members and candidates must comply with any legally imposed fiduciary duty, the Code and Standards neither impose such a legal responsibility nor require all members or candidates to act as fiduciaries. However, Standard III(A) requires members and candidates to work in the client’s best interest no matter what the job function.

Members and candidates who do not provide advisory services to clients but who act only as trade execution professionals must prudently work in the client’s interest when completing requested trades. Acting in the client’s best interest requires these professionals to use their skills and diligence to execute trades in the most favorable terms that can be achieved. Members and candidates operating in such positions must use care to operate within the parameters set by the client’s trading instructions.

Members and candidates may also operate in a blended environment where they execute client trades and offer advice on a limited set of investment options. The extent of the advisory arrangement and limitations should be outlined in the agreement with the client at the outset of the relationship. For instance, members and candidates should inform clients that the advice provided will be limited to the propriety products of the firm and not include other products available on the market. Clients who want access to a wider range of investment products would then have the information necessary to decide not to engage with members or candidates working under these restrictions.

Members and candidates operating in this blended context comply with their obligations by recommending the allowable products that are consistent with the client’s objectives and risk tolerances. They exercise care through diligently aligning the client’s needs with the attributes of the products being recommended. Members and candidates must place the client’s interests first by disregarding any firm or personal interest in motivating a recommended transaction.

A wide variety of professional relationships exists between members and candidates and their clients. Standard III(A) requires members and candidates to fulfill the obligations outlined explicitly or implicitly in the client agreements to the best of their abilities and with loyalty, prudence, and care. Whether a member or candidate is structuring a new securitization transaction, completing a credit rating analysis, or leading a public company, he or she must work with prudence and care in delivering the agreed-on services.

The first step for members and candidates in fulfilling their duty of loyalty to clients is to determine the identity of the “client” to whom the duty of loyalty is owed. A client is a person or entity for which the member or candidate performs a professional service that is of the type usually provided in return for compensation. A prospective client is a person or entity that has expressed interest in retaining the services of a member, a candidate, or a firm or to whom the member, candidate, or firm actively solicits or plans to solicit and that has the potential to become a client.

Members and candidates must look at their roles and responsibilities when making a determination as to who their clients are. Generally, the client is easily identifiable. Such is the case with an investment adviser who works with individual retail or high-net-worth investors. A client relationship exists between a company executive and the firm’s public shareholders. Members and candidates with positions whose responsibilities do not include direct investment management may also have “clients” that must be identified.

When the manager is responsible for the portfolios of pension plans or trusts, however, the client is not the person or entity that hires the manager but, rather, the beneficiaries of the plan or trust. The duty of loyalty is owed to the ultimate beneficiaries.

In some situations, an actual client or group of beneficiaries may not exist. Members and candidates managing a fund to an index or an expected mandate owe the duty of loyalty, prudence, and care to invest in a manner consistent with the stated mandate. The decisions of a fund’s manager, although benefiting all fund investors, are not based on an individual investor’s requirements and risk profile. Client loyalty and care for those investing in the fund are the responsibility of members and candidates who have an advisory relationship with those individuals.

Situations involving potential conflicts of interest with respect to responsibilities to clients may be extremely complex because they may involve a number of competing interests. The duty of loyalty, prudence, and care applies to a large number of persons in varying capacities, but the exact duties may differ in many respects in accordance with the relationship with each client or each type of account for which assets are managed. Members and candidates must not only put their obligations to clients first in all dealings but also endeavor to avoid all real or potential conflicts of interest.

The duty of loyalty, prudence, and care owed to the individual client is especially important because the professional investment manager typically possesses greater knowledge in the investment arena than the client does. This disparity places the individual client in a vulnerable position; the client must trust the manager. The manager in these situations must ensure that the client’s objectives and expectations for the performance of the account are realistic and suitable to the client’s circumstances and that the risks involved are appropriate. In most circumstances, recommended investment strategies must relate to the long-term objectives and circumstances of the client.

Particular care must be taken to detect whether the goals of the investment manager or the firm in conducting business, selling products, and executing security transactions potentially conflict with the best interests and objectives of the client. When members and candidates cannot avoid potential conflicts between their firms’ and clients’ interests, they must provide clear and factual disclosures of the circumstances to the clients. See Standard VI(A) Disclosure of Conflicts.

Members and candidates must follow any guidelines set by their clients for the management of their assets. Some clients, such as charitable organizations or those seeking to support or invest in companies based on environmental, social, and governance (ESG) goals or criteria, have strict investment policies that limit investment options to certain types or classes of investment or prohibit investment in certain securities. Other organizations have policies that do not prohibit investments by type but, instead, set criteria on the basis of the portfolio’s total risk and return.

Investment decisions must be judged in the context of the total portfolio rather than by individual investment within the portfolio. The member’s or candidate’s duty is satisfied with respect to a particular investment if the individual has thoroughly considered the investment’s place in the overall portfolio, the risk of loss and opportunity for gains, tax implications, and the diversification, liquidity, cash flow, and overall return requirements of the assets or the portion of the assets for which the manager is responsible.

An investment manager often has discretion over the selection of brokers executing transactions. Conflicts may arise when an investment manager uses client brokerage to purchase research services, a practice commonly called “soft dollars” or “soft commissions.” A member or candidate who pays a higher brokerage commission than he or she would normally pay to allow for the purchase of goods or services, without corresponding benefit to the client, violates the duty of loyalty to the client.

Unless directed by the client, a member or candidate is obligated to seek “best price” and “best execution.” “Best execution” refers to a trading process that seeks to maximize the value of the client’s portfolio within the client’s stated investment objectives and constraints. However, from time to time, some clients will direct a manager to use a specific brokerage firm for all or some of the client’s trades, a practice commonly called “directed brokerage.” Because brokerage commission is an asset of the client and is used to benefit that client, not the manager, this practice does not violate the duty of loyalty. The member or candidate should, however, seek confirmation from the client that the goods or services purchased from the brokerage will benefit the account beneficiaries. In addition, the member or candidate should disclose to the client that the client may not be getting best execution from the directed brokerage.

The duty of loyalty, prudence, and care may apply in a number of situations facing the investment professional besides those related directly to investing assets.

Part of a member’s or candidate’s duty of loyalty includes voting proxies in an informed and responsible manner. Proxies have economic value for a client, and members and candidates must ensure that they properly safeguard and maximize this value. An investment manager who fails to vote, casts a vote without considering the impact of the question, or votes blindly with management on nonroutine governance issues (e.g., a change in company capitalization) may violate this standard. Voting of proxies is an integral part of the management of investments.

A cost–benefit analysis may show that voting all proxies may not benefit the client, so voting proxies may not be necessary in all instances. Members and candidates should disclose to clients their proxy voting policies.

Regular account information: Members and candidates with control of client assets should (1) submit to each client, at least quarterly, an itemized statement showing the funds and securities in the custody or possession of the member or candidate plus all debits, credits, and transactions that occurred during the period, (2) disclose to the client where the assets are maintained, as well as where or when they are moved, and (3) separate the client’s assets from any other party’s assets, including the member’s or candidate’s own assets.

Client approval: If a member or candidate is uncertain about the appropriate course of action with respect to a client, the member or candidate should consider what he or she would expect or demand if the member or candidate were the client. If in doubt, a member or candidate should disclose the questionable matter in writing to the client and obtain client approval.

Follow all applicable rules and laws: Members and candidates must follow all legal requirements and applicable provisions of the Code and Standards.

Establish the investment objectives of the client: Members and candidates must make a reasonable inquiry into a client’s investment experience, risk and return objectives, and financial constraints prior to making investment recommendations or taking investment actions.

Consider all the information when taking actions: When taking investment actions, members and candidates must consider the appropriateness and suitability of the investment relative to (1) the client’s needs and circumstances, (2) the investment’s basic characteristics, and (3) the basic characteristics of the total portfolio.

Diversify: Members and candidates should diversify investments to reduce the risk of loss, unless diversification is not consistent with plan guidelines or is contrary to the account objectives.

Carry out regular reviews: Members and candidates should establish regular review schedules to ensure that the investments held in the account adhere to the terms of the governing documents.

Deal fairly with all clients with respect to investment actions: Members and candidates must not favor some clients over others and should establish policies for allocating trades and disseminating investment recommendations.

Avoid or disclose conflicts of interest: Members and candidates must avoid or disclose all actual and potential conflicts of interest so that clients can evaluate those conflicts.

Disclose compensation arrangements: Members and candidates should make their clients aware of all forms of manager compensation.

Vote proxies: Members and candidates should determine who is authorized to vote shares and which proxies should be voted and vote proxies in the best interests of the clients and ultimate beneficiaries.

Maintain confidentiality: Members and candidates must preserve the confidentiality of client information.

Seek best execution: Unless directed by the client, members and candidates must seek best execution for their clients. (Best execution is defined in the preceding text.)

First Country Bank serves as trustee for the Miller Company’s pension plan. Miller is the target of a hostile takeover attempt by Newton, Inc. In attempting to ward off Newton, Miller’s managers persuade Wiley, an investment manager at First Country Bank, to purchase a significant amount of Miller common stock in the open market for the employee pension plan. Miller’s officials indicate that such an action would be favorably received and would probably result in other accounts being placed with the bank. Although Wiley believes the stock is overvalued and would not ordinarily buy it, he purchases the stock to support Miller’s managers, to maintain Miller’s good favor toward the bank, and to realize additional new business. The heavy stock purchases cause Miller’s market price to rise to such a level that Newton retracts its takeover bid.

Jackson is CEO of JNI, a successful investment counseling firm that serves as investment manager for the pension plans of several large regional companies. JNI’s trading activities generate a significant amount of commission-related business. Jackson uses the brokerage and research services of many firms, but most of his company’s trading activity is handled through one large brokerage company, Thompson, Inc., because the executives of the two firms have a close friendship. Thompson’s commission structure is high in comparison with charges for similar brokerage services from other firms. Jackson considers Thompson’s research services and execution capabilities average. In exchange for JNI directing its brokerage to Thompson, Thompson absorbs a number of JNI overhead expenses, including those for rent.

Everett, a struggling independent investment adviser, serves as investment manager for the pension plans of several companies. One of her brokers, Scott Company, is close to finalizing management agreements with prospective new clients whereby Everett would manage the new client accounts and trade the accounts exclusively through Scott. One of Everett’s existing clients, Crayton Corporation, has directed Everett to place security transactions for Crayton’s account exclusively through Scott. To induce Scott to exert effort to send more new accounts to her, Everett also directs transactions to Scott from other clients without their knowledge.

Rome is a trust officer for Paget Trust Company. Rome’s supervisor is responsible for reviewing Rome’s trust account transactions and her monthly reports of personal stock transactions. Rome has been using Gray, a broker, almost exclusively for trust account brokerage transactions. When Gray makes a market in stocks, he has been giving Rome a lower price for personal purchases and a higher price for sales than he gives to Rome’s trust accounts and other investors.

Parker, an analyst with Provo Advisors, covers South American equities for her firm. She likes to travel to the markets for which she is responsible and decides to go on a trip to Chile, Argentina, and Brazil. The trip is sponsored by SouthAM, Inc., a research firm with a small broker/dealer affiliate that uses the clearing facilities of a larger New York brokerage house. SouthAM specializes in arranging South American briefing trips for analysts, during which they can meet with central bank officials, government ministers, local economists, and senior executives of corporations. SouthAM accepts commission dollars at a ratio of 2 to 1 against the hard dollar costs of the research fee for the trip. Parker is not sure that SouthAM’s execution is competitive, but without informing her supervisor, she directs the trading desk at Provo to start giving commission business to SouthAM so she can take the trip. SouthAM has conveniently timed the briefing trip to coincide with the beginning of Carnival season, so Parker also decides to spend five days of vacation in Rio de Janeiro at the end of the trip. Parker uses commission dollars to pay for the five days of hotel expenses.

Knauss manages the portfolios of a number of high-net-worth individuals. A major part of her investment management fee is based on trading commissions. Knauss engages in extensive trading for each of her clients to ensure that she attains the minimum commission level set by her firm. Although the securities purchased and sold for the clients are appropriate and fall within the acceptable asset classes for the clients, the amount of trading for each account exceeds what is necessary to accomplish the client’s investment objectives.

Dill recently joined New Investments Asset Managers. To assist Dill in building a book of clients, both his father and brother opened new fee-paying accounts. Dill followed all the firm’s procedures in noting his relationships with these clients and in developing their investment policy statements. After several years, the number of Dill’s clients has grown, but he still manages the original accounts of his family members. An IPO is coming to market that is a suitable investment for many of his clients, including his brother. Dill does not receive the amount of stock he requested, so to avoid any appearance of a conflict of interest, he does not allocate any shares to his brother’s account.

Hensley has been hired by a law firm to testify as an expert witness. Although the testimony is intended to represent impartial advice, she is concerned that her work may have negative consequences for the law firm. If the law firm is Hensley’s client, how does she ensure that her testimony will not violate the required duty of loyalty, prudence, and care to one’s client?

Miller is a mutual fund portfolio manager. The fund is focused on the global financial services sector. Spears is a private wealth manager in the same city as Miller and is a friend of Miller. At a CFA Institute local society meeting, Spears mentions to Miller that her new client is an investor in Miller’s fund. She states that the two of them now share a responsibility to this client.

After providing client account investment performance to external-facing departments but prior to it being finalized for release to clients, Nguyen, an investment performance analyst, notices the reporting system missed a trade. Correcting the omission resulted in a large loss for a client that had previously placed the firm on “watch” for potential termination owing to underperformance in prior periods. Nguyen knows this news is unpleasant but informs the appropriate individuals that the report needs to be updated before releasing it to the client.

Sulejman recently became a candidate in the CFA Program. He is a broker who executes client-directed trades for several high-net-worth individuals. Sulejman does not provide any investment advice and only executes the trading decisions made by clients. He is concerned that the Code and Standards impose a fiduciary duty on him in his dealing with clients and sends an email to the CFA Institute Ethics Helpdesk ([email protected]) to seek guidance on this issue.