Standard III(B) Fair Dealing

Standard III(B) requires members and candidates to treat all clients fairly when disseminating investment recommendations, making material changes to prior investment recommendations, or taking other investment action for clients. Only through the fair treatment of all parties can the investment management profession maintain the confidence of the investing public.

When an investment adviser has multiple clients, the potential exists for the adviser to favor one client over another. This favoritism may take various forms—from the quality and timing of services provided to the allocation of investment opportunities.

The term “fairly” implies that the member or candidate must take care not to discriminate against any clients when disseminating investment recommendations or taking investment action. Standard III(B) does not state “equally” because members and candidates could not possibly reach all clients at exactly the same time. Each client has unique needs, investment criteria, and investment objectives, so not all investment opportunities are suitable for all clients. In addition, members and candidates may provide more personal, specialized, or in-depth service to clients who are willing to pay for premium services. Members and candidates may differentiate their services to clients, but different levels of service must not disadvantage or negatively affect clients. In addition, the different service levels should be disclosed to clients and prospective clients and should be available to everyone (i.e., different service levels should not be offered selectively).

For many members and candidates, their primary function is the preparation of investment recommendations to be disseminated either to the public or within a firm for the use of others in making investment decisions. This group includes members and candidates employed by investment counseling, advisory, or consulting firms, as well as banks, brokerage firms, and insurance companies. The criterion is that the member’s or candidate’s primary responsibility is the preparation of recommendations to be acted on by others, including those in the member’s or candidate’s organization.

An investment recommendation is any opinion expressed by a member or candidate relating to purchasing, selling, or holding a given security or other investment. There are many ways to disseminate opinions to customers or clients, including through an initial detailed research report, through a brief update report, by addition to or deletion from a list of recommended securities, or simply through verbal communication. A recommendation that is distributed to anyone outside the organization is considered a communication for general distribution under Standard III(B).

Standard III(B) addresses the manner in which investment recommendations or changes in prior recommendations are disseminated to clients. Each member or candidate is obligated to ensure that information is disseminated in such a manner that all clients have a fair opportunity to act on every recommendation. Communicating with all clients on a uniform basis may present practical problems for members and candidates because of differences in timing and methods of communication with various types of customers and clients. Members and candidates should use an equitable system to prevent selective or discriminatory disclosure and inform clients about the types of communications they will receive.

The duty to clients imposed by Standard III(B) also applies when members or candidates change their recommendations. Material changes in a member’s or candidate’s prior investment recommendations must be communicated to all current clients; particular care should be taken that the information reaches those clients who the member or candidate knows have acted on or been affected by the earlier advice. Clients who do not know that the member or candidate has changed a recommendation and who, therefore, place orders contrary to a current recommendation should be advised of the changed recommendation before the order is accepted.

Some members and candidates take investment action (manage portfolios) on the basis of recommendations prepared internally or received from external sources. Investment action, like investment recommendations, can affect market value. Consequently, Standard III(B) requires that members and candidates treat all clients fairly in light of their investment objectives and circumstances. For example, when making investments in new offerings or in secondary financings, members and candidates must distribute the issues to all customers for whom the investments are appropriate in a manner consistent with the policies of the firm for allocating blocks of stock. If the issue is oversubscribed, then the issue should be prorated to all suitable accounts. This action should be taken on a round-lot basis to avoid odd-lot distributions. In addition, if the issue is oversubscribed, members and candidates must forgo any sales to themselves or their immediate families in order to free up additional shares for clients. If the investment professional’s family-member accounts are managed similarly to the accounts of other clients of the firm, however, the family-member accounts must not be excluded from buying such shares.

Members and candidates must make every effort to treat all individual and institutional clients in a fair and impartial manner. A member or candidate may have multiple relationships with an institution; for example, the member or candidate may be a corporate trustee, pension fund manager, manager of funds for individuals employed by the customer, loan originator, or creditor. A member or candidate must exercise care to treat all clients fairly.

Members and candidates should disclose to clients and prospective clients the documented allocation procedures they or their firms have in place and how the procedures would affect the client or prospect. The disclosure should be clear and complete so that the client can make an informed investment decision. Even when complete disclosure is made, however, members and candidates must put client interests ahead of their own. A member’s or candidate’s duty of fairness and loyalty to clients can never be overridden by client consent to patently unfair allocation procedures.

Members and candidates must follow their firm’s compliance procedures for treating clients fairly. The extent of the formality and complexity of such compliance procedures depends on the nature and size of the organization and the services it provides. Members and candidates should recommend appropriate procedures to management if none are in place. Members and candidates should also make management aware of possible violations of fair-dealing practices when they come to the attention of the member or candidate.

Members and candidates who have responsibility and authority to implement compliance procedures for their firm should work to implement formal written procedures to ensure that all clients receive fair investment action.

Members and candidates should consider the following points for fair-dealing compliance practices:

• Disseminate investment recommendations based on indications of interest and suitability: Make initial investment recommendations available to all clients who indicate an interest. Although a member or candidate need not communicate a recommendation to all customers, the selection process by which customers receive information should be based on suitability and known interest, not on any preferred or favored status. A common practice to ensure fair dealing is to communicate recommendations simultaneously within the firm and to customers.
• Limit the number of people involved: Members and candidates should make reasonable efforts to limit the number of people who are aware that a recommendation is going to be disseminated.
• Shorten the time frame between decision and dissemination: Members and candidates should make reasonable efforts to limit the amount of time that elapses between the decision to make an investment recommendation and the time the actual recommendation is disseminated. If a detailed recommendation could take two or three weeks to publish, a short summary report including the conclusion might be published in advance.
• Publish guidelines for predissemination behavior: Members and candidates who have prior knowledge of an investment recommendation should refrain from discussing or taking any action on the pending recommendation and must follow any firm policies regarding conduct prior to dissemination of investment recommendations.
• Simultaneous dissemination: Members and candidates should establish procedures for the timing of dissemination of investment recommendations so that all clients are treated fairly—that is, informed at approximately the same time. For example, if a firm is going to announce a new recommendation, supervisory personnel should time the announcement to avoid placing any client or group of clients at an unfair advantage relative to other clients. Once this distribution has occurred, the member or candidate may follow up separately with individual clients, but members and candidates must not give favored clients advance information when such advance notification may disadvantage other clients.
• Maintain a list of clients and their holdings: Members and candidates should maintain a list of all clients and the securities or other investments each client holds in order to facilitate notification of customers or clients of a change in an investment recommendation. If a particular security or other investment is to be sold, such a list can be used to ensure that all holders are treated fairly in the liquidation of that particular investment.
• Develop and document trade allocation procedures: When formulating procedures for allocating trades, members and candidates should develop a set of guiding principles that ensure,
  • fairness to advisory clients, both in priority of execution of orders and in the allocation of the price obtained in execution of block orders or trades,
  • timeliness and efficiency in the execution of orders, and
  • accuracy of the member’s or candidate’s records as to trade orders and client account positions.
  
  With these principles in mind, members and candidates should follow certain allocation practices, especially with regard to block trades and new issues. Practices to consider include,
  • requiring orders and modifications or cancellations of orders to be documented and time stamped;
  • processing and executing orders on a first-in, first-out basis with consideration of bundling orders for efficiency as appropriate for the asset class or the security;
  • developing a policy to address such issues as calculating execution prices and “partial fills” when trades are grouped, or in a block, for efficiency;
  • giving all client accounts participating in a block trade the same execution price and charging the same commission;
  • when the full amount of the block order is not received, allocating partially executed orders among the participating client accounts pro rata on the basis of order size while not going below an established minimum lot size for some securities (e.g., bonds); and
  • when allocating trades for new issues, obtaining advance indications of interest, allocating securities by client (rather than portfolio manager), and providing a method for calculating allocations.
• Disclose trade allocation procedures: Members and candidates should disclose to clients and prospective clients how they select accounts to participate in an order and how they determine the amount of securities each account will buy or sell. Trade allocation procedures must be fair and equitable, and disclosure of inequitable allocation methods does not relieve the member or candidate of this obligation.
• Establish systematic account review: Members and candidates who are supervisors should review each account on a regular basis to ensure that no client or customer is being given preferential treatment and that the investment actions taken for each account are suitable for each account’s objectives. Because investments must be based on individual needs and circumstances, an investment manager may have good reasons for placing a given security or other investment in one account while selling it from another account and should fully document the reasons behind both sides of the transaction. Members and candidates should encourage firms to establish review procedures, however, to detect whether trading in an account is being used to benefit a favored client.
• Disclose levels of service: Members and candidates must disclose to all clients whether the organization offers different levels of service to clients for the same fee or different fees. Different levels of service should not be offered to clients selectively.

Ames, a well-known and respected analyst, follows the computer industry. In the course of his research, he finds that a small, relatively unknown company whose shares are traded over the counter has just signed significant contracts with some of the companies he follows. After a considerable amount of investigation, Ames decides to write a research report on the small company and recommend purchase of its shares. While the report is being reviewed by the company for factual accuracy, Ames schedules a luncheon with several of his best clients to discuss the company. At the luncheon, he mentions the purchase recommendation scheduled to be sent early the following week to all the firm’s clients.

Rivers, president of XYZ Corporation, moves his company’s growth-oriented pension fund to a particular bank primarily because of the excellent investment performance achieved by the bank’s commingled fund for the prior five-year period. Later, Rivers compares the results of his pension fund with those of the bank’s commingled fund. He is startled to learn that, even though the two accounts have the same investment objectives and similar portfolios, his company’s pension fund has significantly underperformed the bank’s commingled fund. Questioning this result at his next meeting with Jackson, the pension fund’s manager, Rivers is told that, as a matter of policy, when a new security is placed on the recommended list, Jackson first purchases the security for the commingled account and then purchases it on a pro rata basis for all other pension fund accounts. Similarly, when a sale is recommended, the security is sold first from the commingled account and then sold on a pro rata basis from all other accounts. Rivers also learns that if the bank cannot get enough shares (especially of hot issues) to be meaningful to all the accounts, its policy is to place the new issues only in the commingled account.

Seeing that Rivers is neither satisfied nor pleased by the explanation, Jackson quickly adds that nondiscretionary pension accounts and personal trust accounts have an even lower priority on purchase and sale recommendations than discretionary pension fund accounts. Furthermore, Jackson states that the company’s pension fund had the opportunity to invest up to 5% in the commingled fund.

Morris works for a small regional securities firm. His work consists of corporate finance activities and investing for institutional clients. PickleDilly, Ltd., is planning to go public. The partners have secured rights to buy a professional pickleball franchise and plan to use the funds from the issue to complete the purchase. Because pickleball is the current rage, Morris believes he has a hot issue on his hands. He has quietly negotiated some options for himself for helping convince PickleDilly to do the financing through his securities firm. When he seeks expressions of interest, institutional buyers oversubscribe the issue. Morris, assuming that the institutions have the financial clout to drive the stock up, fills all orders (including his own) but decreases the institutional blocks.

Preston, the chief investment officer of Porter Williams Investments (PWI), a medium-size money management firm, has been trying to retain a client, Colby Company. Management at Colby, which accounts for almost half of PWI’s revenues, recently told Preston that if the performance of its account did not improve, it would find a new money manager. Shortly after this threat, Preston purchases mortgage-backed securities (MBSs) for several accounts, including Colby’s. Preston is busy with a number of transactions that day, so she fails to allocate the trades immediately or write up the trade tickets. A few days later, when Preston is allocating trades, she notes that some of the MBSs have significantly increased in price and some have dropped. Preston decides to allocate the profitable trades to Colby and spread the losing trades among several other PWI accounts.

Saunders Industrial Waste Management (SIWM) publicly indicates to analysts that it is comfortable with the somewhat disappointing earnings-per-share projection of US$1.16 for the quarter. Roberts, an analyst at Coffey Investments, is confident that SIWM management understated the forecasted earnings so that the real announcement would cause an “upside surprise” and boost the price of SIWM stock. The “whisper number” (rumored) estimate based on extensive research and discussed among knowledgeable analysts is higher than US$1.16. Roberts repeats the US$1.16 figure in his research report to all Coffey clients but informally tells his large clients that he expects the earnings per share to be higher, making SIWM a good buy.

Weng uses email to issue a new recommendation to all his clients. He then calls his three largest institutional clients to discuss the recommendation in detail, and they compensate him for the personal outreach.

Hampton is a well-respected private wealth manager in her community with a diversified client base. She determines that a new 10-year bond being offered by Healthy Pharmaceuticals is appropriate for five of her clients. Three clients request to purchase US$10,000 each, and the other two request US$50,000 each. The minimum lot size is established at US$5,000, and the issue is oversubscribed at the time of placement. Her firm’s policy is that odd-lot allocations, especially those below the minimum, should be avoided because they may affect the liquidity of the security at the time of sale.

Hampton is informed she will receive only US$55,000 of the offering for all accounts. Hampton distributes the bond investments as follows: The three accounts that requested US$10,000 are allocated US$5,000 each, and the two accounts that requested US$50,000 are allocated US$20,000 each.

Chan manages the accounts for many pension plans, including the plan of his father’s employer. Chan developed similar but not identical investment policies for each client, so the investment portfolios are rarely the same. To minimize the cost to his father’s pension plan, he intentionally trades more frequently in the accounts of other clients to ensure the required brokerage commissions are incurred to continue receiving free research that benefits all the pension plans.

Burdette was recently hired by Fundamental Investment Management (FIM) as a junior auto industry analyst. Burdette is expected to expand the social media presence of the firm, including on Facebook, LinkedIn, and X (formerly known as Twitter). Burdette’s supervisor, Graf, encourages Burdette to explore opportunities to increase FIM’s online presence and ability to share content, communicate, and broadcast information to clients.

As part of her auto industry research for FIM, Burdette is completing a report on the financial impact of Sun Drive Auto Ltd.’s new solar technology for compact automobiles. This research report will be her first for FIM, and she believes Sun Drive’s technology could revolutionize the auto industry. In her excitement, Burdette posts a brief message to FIM LinkedIn followers summarizing her “buy” recommendation for Sun Drive Auto stock.

Rove, a performance analyst for Alpha-Beta Investment Management, is describing to the firm’s chief investment officer (CIO) two new reports he would like to develop to assist the firm in meeting its obligations to treat clients fairly. Because many of the firm’s clients have similar investment objectives and portfolios, Rove suggests a report detailing securities owned across several client accounts and the percentage of the portfolio each security represents. The second report would compare the monthly performance of portfolios with similar strategies. The outliers in each report would be submitted to the CIO for review.