March 10, 2004
Jonathan G. Katz
RE: File No. S7-04-04
Dear Secretary Katz:
We appreciate this opportunity to comment on the proposed rule for an Investment Advisor Code of Ethics. Our comment is focused on the need to reinforce fiduciary principles and the Commission's questions regarding the business conduct element of the code of ethics.
The Commission seeks comment on a code of ethics and notes "advisers are fiduciaries that owe their clients a duty of undivided loyalty." The proposed rule is "designed to prevent fraud by reinforcing fiduciary principles," and proposes a framework of required "provisions" an advisor must include in its own a code of ethics.
The formulation will not achieve its stated goal of "reinforcing fiduciary principles", because the Commission explicitly allows advisors, within broad parameters, to decide on their own what is "appropriate conduct", and to define their own "standard of business conduct" that reflects their notions of "fiduciary obligations."
Advisors who have been alleged to breach their fiduciary duties typically must abide by corporate codes of ethics and standards for business conduct that specify their duty of loyalty to their employer - not to their client. Many advisors are placed in untenable positions: they must adhere to rules to respect their fiduciary obligations to both their employer and client. This requirement is, of course, not possible to fulfill.
In lieu of calling for more regulations, we offer two recommendations. First, we support the Commission in favoring additional disclosures. We recommend very specific disclosures that clearly distinguish "non-fiduciary" brokers from fiduciary advisors. With meaningful and omnipresent disclosures, investors will more easily be able to choose between brokers who openly acknowledge their occupation is selling products, and advisors who openly acknowledge they are compensated for not selling products, but for providing advice. In choosing a broker, investors will choose a standard of conduct appropriate for facilitating a transaction. In choosing an advisor, investors choose a fiduciary. Our second recommendation is to apply the tenets of the Uniform Prudent Investor Act as the basis of the code of ethics for fiduciary advisors.
The Commission introduces the need for an, `Investment Advisor Code of Ethics' by simply noting that "advisers are fiduciaries that owe their clients a duty of undivided loyalty." Currently, according to the Commission, evidence of a problem is seen by "too many" enforcement actions against advisors "alleging violations of their fiduciary obligations to their clients." The proposed rule is "designed to prevent fraud by reinforcing fiduciary principles," and calls for advisors to adopt standards for business conduct. (a) The Commission seeks comment on this proposed code. (b)
The Commission focuses attention squarely on the fundamental challenge a code of ethics must address. It states clients are owed "undivided loyalty" from fiduciary advisors. As loyalty is the foundation of fiduciary principles (c), the lack of loyalty is apparently central to many alleged violations of this duty.
While the practical reasons for the increasing numbers of violations of loyalty and "conflicts of interest" seem clear enough (brokers putting their interests above their clients), the appropriate solutions seem less clear. Conventional analysis seems to suggest the central problem is mostly a result of uninformed investors and ethically challenged advisors.
This "investor-focused" view describes only part of the picture. Another significant part of the picture is how a frenzied market place driven by technological, product and economic changes have caused confusion and uncertainty. Demand for "advice" and "planning," from all reports, has soared and pressures for brokerages to respond have been great. Today the operational differences between RIAs and many registered reps are often blurred. Even though the Commission correctly acknowledges their different roles (d), the market place often does not distinguish between RIAs who are required by law to meet fiduciary standards, and registered representatives who are required by the market place to sell financial products. The terms "investment advisors" and "brokers" are often either used almost interchangeably, or are replaced by non-descriptive terms like "consultant." Significant segments of the industry so thoroughly accept this blurring of "broker-advisor services", there appears to have been, until recently, little concern with what it means when fiduciaries are not distinguished from sales people.
[The Wall Street Journal and Washington Post stories of this rule and other proposed SEC rules announced at the same time were focused on increased disclosure requirements to address wrong doing in the mutual fund industry. Interestingly, there was not even a mention in either story of the proposed code of ethics to address breaches of "fiduciary duty." (e)]
Blurring roles: doctors -- drug company reps, and advisors -- brokers. The significance of this phenomenon may be more apparent if viewed in comparison to a similar situation in another industry - the health services industry. The core relationship (in terms of their training, credentials and roles) between brokers and investment advisors is not fundamentally different in its nature from the relationship between drug company reps and medical doctors. The comparison is apt. Brokers and drug reps are "product" experts whose job is to sell products; MDs and fiduciaries are investment or medical "experts," and gatekeepers who are entrusted with the highest responsibility for providing their best professional advice to their clients, without regard to commercial interests. To seriously suggest a drug company representative could credibly diagnose a patient would be met with shock; to suggest a broker can evaluate an investor is met with commissions or fees. That these parallel scenarios in two different professions are viewed so differently illustrates how far the financial and regulatory culture of `advisors' has moved from its fiduciary roots.
This blurring of roles in the context of rapidly changing products and technologies has caused confusion and uncertainty. Confusion for investors as to what can be expected from an "advisor"; uncertainty among brokers as to the appropriate standards of required conduct for different types of transactions. This environment is complex and involves a number of forces - not only "unsophisticated investors."
The Corporate Code of Ethics Challenge
The Commission proposes, among other initiatives, a code of ethics to help address this situation. It does not propose or offer for comment a single `code of ethics', per se, but proposes a framework of required "provisions" an advisor must include in its own a code of ethics. (See note (a) below.) Specifically, the Commission explains, "We have drafted the rule broadly so that each advisor will be able to develop a code that takes into consideration the nature of its business." (emphasis added.) The Commission notes as well that "advisors would be free to
Business Conduct Element of the Code. Consistent with the primacy the Commission places in advisors' fiduciary obligations, this comment focuses on rule language regarding appropriate business conduct. Chief among the provisions focused on by the Commission is "a standard of business conduct that .. must reflect the advisor's fiduciary obligations" and "compliance with federal securities law." The Commission also notes, "the new rule is designed to prevent fraud by reinforcing the fiduciary principles."
The Commission asks, "Is our formulation of the business conduct element of the code of ethics appropriate? Should we specify a particular standard of conduct that all codes of ethics must incorporate? What standard should we adopt? Should the code of ethics require supervised persons to comply with all applicable laws and regulations, rather than federal securities laws?"
Formulation is not likely to attain its' goal. The formulation will not achieve its stated goal of "reinforcing fiduciary principles"; it is not likely to address the current confusion in the market. This is because the Commission explicitly allows advisors, within broad parameters, to decide their own "appropriate conduct", and to define their own "standard of business conduct" that reflects their notions of "fiduciary obligations." Advisors will make these determinations, it appears, without significant guidance from the Commission as to acceptable historical or legal parameters or notions of fiduciary conduct. With no further guidance, and with the Commissions own extensive experiences with advisors' difficulty adhering to fiduciary principles, there is reason to believe advisors will continue to "define" appropriate conduct under this formulation much as they do today.
Corporate Standards of Business Conduct
Current understandings of `conflict of interest' codes. A review of some of the current investment advisors' and brokerages' statements of corporate governance code of ethics policies is informative in this regard. (see attachment 1.) The overriding factor that stands out from a brief review of some of these formulations is how the principles of "loyalty" and "duty" and "conflict of interest" are discussed in the context of the relationship of the employee to the corporation. These topics stand out in company statements; it is clear executive management is concerned about these issues. What is not clear, however, is whether these management concerns reflect the same concerns expressed by the Commission about an advisor's fiduciary duty.
Management's concerns' are focused on its employees responsibility to management - or the company - not its employees responsibilities to clients. American Express speaks of employees' responsibility to "enhance the reputation" of the company; Schwab defines `conflicts of interest' as between employees and company; Franklin Templeton also defines conflicts as between a "covered person" and "the company". A.G. Edwards and Legg Mason do not even have sections on a code of ethics on their webs. Interestingly, AIMR alone acknowledges the possibility of a potential fiduciary obligation between a financial analyst and a client. It notes a financial analyst "shall use particular care in determining applicable fiduciary duty."
Corporate `Commitment' to Investors. Instead of describing the fiduciary responsibility of brokers to clients, firms speak strongly of their company "commitment" to investors. Schwab emphasizes its focus on "the individual investor" and claims "this (focus) allows us to minimize the conflicts of interest that many in our industry are struggling with now." Legg Mason touts its consumer ranking "highest in investor satisfaction" from consumer satisfaction specialist, J.D Powers. AG Edwards mimics Schawb (or visa versa): "In 1887, in the city of St. Louis, an idea was born. A big, very simple idea. An idea that said putting the interests of your customer first is just plain smart business. That's when we decided that each client should have his or her own financial consultant and customized plan, and we would support that plan and make it our primary goal."
Corporate Brands. This strategy of focusing attention on and talking about their corporate commitment to the investor appears to be effective in some respects. This effectiveness is evident in terms of how consumers and investors seem to view brokerage firms. A review of Fortune Magazines annual rankings of the country's most admired corporations is illustrative.
American Express is in the top ranks in the Fortune list - at 8.82 in the 2003 rankings. As a comparison, Microsoft is ranked 7.73 and P&G 8.31. Critically, Amex is no. 1 in its industry group, consumer credit, and in the category of "product - service quality", it ranks 8th overall (8.53) of all 587 companies, well ahead of world leader Wal-mart (6.17). While the survey rankings for Charles Schwab have declined over the past couple years from its peak among the top ten Schwab still ranks fairly high, and Merrill Lynch actually raised its rankings between 2003 and 2004 - right in the midst of the Wall Street scandals. (f)
Reputation of Stockbrokers. Interestingly, these relatively high confidence rankings in corporate brands contrast starkly with consumer expressions of confidence in either "Wall Street" in general terms or generic "stockbrokers". According to a recent survey, 51% of Americans believe (against 36% who do not) "Wall Street is dominated by greed and selfishness". Also, stockbrokers are ranked lower than all other professions - except for real estate agents. (g)
The Corporation and the Advisor. To the extent these findings are indicative of the industry, it is clear that the corporation is the focal point of the relationship. The credibility of the corporate brand is powerful, and the corporation's promise of "commitment" to the investor is a strong message. The investor's "allegiance" is to the corporation as a client of the corporation, and the advisor owes its employer loyalty to the corporation. In this model, it becomes easier to see how the advisor's relationship with and loyalty to the investor might be subordinated to the corporation. Consumer skepticism (or cynicism) of "Wall Street" and "stockbrokers" is yet an additional reason why executive management may not reasonably be expected to promote broker individual loyalty to clients. Many investors apparently often don't trust brokers.
Current corporate codes of ethics and standards of business conduct do not appear to provide the support that is necessary to reinforce advisors' fiduciary responsibilities to clients. On this basis alone, the Commission should provide advisors a specific standard of conduct that all investment advisors' codes of ethics must adopt.
Require Disclosures that Distinguish Between Fiduciaries and Brokers;
Recommendation 1. The Commission should require disclosures that clearly distinguish, in practice as well as in law, investment advisors from registered representatioves. It should clearly state investment advisers must meet fiduciary standards; while brokers and other financial reps meet less stringent "suitability" standards appropriate to facilitating a transaction. The starting point for better protecting reducing the confusion in the market place is to build on the Commission's leadership and recognition that fiduciary conduct must be the standard required of investment advisors. However, as in other professions, not all financial reps will attain this designation. As in other professions where different training and experiences lead to different designations, registered reps should be distinguished from RIAs.
A single code of ethics and standards of conduct for advisors and brokers as they operate today is neither possible nor desirable. It is not possible to craft one code that can effectively cover both a fiduciary advisor and broker. Fiduciaries, by law and in practice, are held to the highest standard of conduct. Brokers, in contrast, with a duty to their employer and operating on the basis of a commercial contract, can not meet this standard. (h) Further, policies or actions that effectively further blur the different responsibilities and roles of brokers and advisors contributes to investor misunderstandings and confusion, helping create an environment ripe for abuse. (i)
Recommendation 2. Adopt the Uniform Prudent Investor Act as the foundation of a code of Ethics for RIAs. The Uniform Prudent Investor Act (UPIA), developed by the National Conference of Commissioners on Uniform State Laws and adopted in 1994, sets out the guidelines for financial planning as a fiduciary. The UPIA lays out an investment process which include the following:
_ Prepare a written client agreement that specifies the scope of services, compensation, termination, and exclusions. Provide the ADV as an agreement attachment.
In contrast to earlier applied definitions of prudent investing, the UPIA today is based on the central importance of a structured and disciplined investment decision process-- and not any expectations for the performance of the investment or trust. Clearly, the "intellectual underpinning" of the UPIA is modern portfolio theory.
The significance of the UPIA is clear: The UPIA establishes a more-demanding process-directed standard for professional trustees than that of prior law. A standard based on the facts and circumstances when investment decisions are made. A standard based on an unquestioned loyalty to the client. The point for advisors concerned about providing the highest standard of services (as well as their own liability) is that a paper trail will be of little value unless it reflects an understanding and consideration of risk consistent with the tenets of MPT. Demonstrating adherence to the principles of UPIA should protect a trustee and like fiduciaries regardless of the "results" or returns of the portfolio.
Issues of conflicts of interest, loyalty and fiduciary responsibility are corporate issues which - understandably - revolve around enhancing shareholder value by building corporate assets and reputation. Shareholders would expect nothing less. Advisors who have been alleged to breach their fiduciary duties operate within these corporate norms, and codes of ethics and standards for business conduct, that reflect advisors' employer loyalty - not their client loyalty.
Many advisors have been placed in the untenable position of needing to respect their fiduciary obligations to both their employer and client. This is, of course, not possible. Firms have tried to reconcile this conflict by down playing their advisory or planning services, claiming they are incidental, while they advertise their "advisors" advisory capabilities. Sometimes, firms also seek to avoid the issue entirely by emphasizing the corporate brand over the individual broker and offering reassuring corporate communications. In this environment, investors can be excused and allowed some leeway for being confused and uncertain of the capacity of their advisor. So, while it is clear that some investors make inappropriate financial decisions, it is not clear these investors' deserve all the responsibility for the confusion in the market -- particularly when the industry is dominated by blue chip brokerages.
Any recommendation seeking to "reinforce fiduciary principles" between advisors and investors must address allowing fiduciary advisors relief from their corporate fiduciary responsibility to their employer. In lieu of more regulations, we support the Commission in favoring more disclosures that allow investors to choose between fiduciary advisors and "non-fiduciary" brokers. With meaningful disclosures, investors can choose between brokers who sell and advisors who advise, between product specialists and fiduciary specialists, and most critically, between employees with a fiduciary responsibility to their employer and advisors with a fiduciary responsibility to them. In this environment, investors can choose between brokers whose sales capacity requires one standard of conduct, and RIAs whose fiduciary capacity requires their `code of ethics' follow the tenets of the UPIA.
Thank you for this opportunity to offer these recommendations. We would be pleased to answer any questions about this comment.
Donald M. Rembert/kar
Knut A. Rostad
(a) Advisors must "establish, maintain and enforce a written code of ethics that, at a minimum, includes: (1) A standard (or standards) of business conduct that you require of your supervised persons, which standard must reflect your fiduciary obligations and those of your supervised persons; (2) Provisions requiring your supervised persons to comply with applicable federal securities laws; (3) Provisions reasonably designed to prevent access to material nonpublic information about your securities recommendations and your clients' securities holdings and transactions, by persons who do not need such information to perform their duties; (4) Provisions that require all of your access persons to report, and you to review, their personal securities transactions and holdings periodically as provided below; (5) Provisions requiring supervised persons to report any violations of your code of ethics promptly to your chief compliance officer or to another person you designate in your code of ethics; and (6) Provisions requiring you to provide each of your supervised persons with a copy of your code of ethics, and requiring your supervised persons to provide you with a written acknowledgment of their receipt of the code and any amendments.
(b) The Commission notes, (A. Standards of Conduct and Compliance with Laws) "Each code of ethics set forth a standard of business conduct ...This standard must reflect the advisor's fiduciary obligations.... And must require compliance with the federal securities laws. These obligations are imposed by law, and thus would establish a minimum requirement for a code of ethics complying with the rule. Advisors would be free, however, to require higher standards such as those we describe above." The Commission then asks, "Is our formulation of the business conduct element of the code of ethics appropriate? Should we specify a particular standard of conduct that all codes of ethics must incorporate? What standard should we adopt? Should the code of ethics require supervised persons comply with all applicable laws and regulations, rather than only federal securities laws?" Further (J. Amendment to Form ADV), "We are proposing to amend Part II of Form ADV to require advisors to describe their codes of ethics to clients and, upon request, to furnish clients with a copy of the code of ethics.... Is a general disclosure requirement effective? Commenters urging that more specific disclosures be required should provide sample text."
(c) "The duty of loyalty is perhaps the most characteristic rule of trust law, requiring the trustee to act exclusively for the beneficiaries, as opposed to acting for the trustees own interest or the interest of a third parties." Uniform Prudent Investor Act, page 14.
(d) The Commission has noted "An investment adviser is someone who is in the business of -- and receives compensation for -- giving individually tailored advice to clients about securities (such as stocks, bonds, or mutual funds). Some investment advisers also manage portfolios of securities for clients." Section 3(a)(4) of the Act defines "broker" as any person engaged in the business of effecting transactions in securities for the account of others...."
(e) "SEC Unveils Mutual-Fund Rule-More on the Way", WSJ, January 15, 2004,
(f) See Fortune.com, "Most Admired Corporations, 2003, 2004.
(g) Harris Interactive web site.
(h) "Fiduciary obligations arise out of fairly defined relationships in the law, which by their very
(i) Financial, industry and consumer organizations have likewise noted how investors can be
American Express. AMEX offers a lengthy code of conduct that details appropriate and inappropriate conduct in numerous business situations; ie: receiving gifts (it is acceptable to receive a bottle of wine while it is not acceptable to receive a "case of fine champagne"). "Business Ethics and Compliance with the Law" and "Conflicts of Interest and Business Opportunities" are of greatest interest.
The "Business Ethics" section opens with the statement: "You are expected to protect and enhance the assets and reputation of American Express Company." It continues "You should never use your position with the Company, or information acquired during your employment, in a manner that may create a conflict - or the appearance of a conflict - between your personal interests and the interests of the Company or its customers and clients."
You also should be aware that actual or potential conflicts of interest can arise not just from dealings with external parties, such as customers or suppliers, but also from relationships or transactions with leaders, subordinates or other employees. ... Rather than a set of specific rules, this Code emphasizes a standard of ethical conduct that must permeate all of our business dealings and relationships."
Charles Schwab. Schwab offers sections on a corporate governance code of ethics, and "Business Practices." Within the `governance' section a subsection on "Conflicts of Interest" sets the tone and establishes the central issue in stating: "A `conflict of interest' occurs when your private interest interferes in any way - or even appears to interfere - with the interests of the company." In a discussion of "loyalty", the issue is introduced with "Your employment with the company must be your primary business association"
Legg Mason Wood Walker, Inc. Legg Mason has no mention of a `code of ethics on its web. A call to its corporate communication department resulted in ....... Legg Mason claims it is "a global financial services company with one product: Advice. Through this product, we serve many types of clients: individual and institutional investors, corporations, high net worth individuals, government entities, endowments and foundations, pension plans, associations, and insurance companies. The firms also points out, "In January 2004, Legg Mason Wood Walker was ranked 'Highest in Investor Satisfaction with Full Service Brokerage Firms' by J.D. Power and Associates (1). Another recent achievement was received in January 2004 when Legg Mason, Inc. was included among Forbes Magazine's 'Best Managed Companies in America' based on growth and return on investment (2). In 2003, Legg Mason, Inc. was also ranked among Forbes Magazine's '400 Best Big Companies' alongside other industry leaders for the second year in a row (3)."
"The highest standard of ethical conduct is expected of all A.G. Edwards personnel. When faced with possible conflicts of interest we should give preference to the client and the firm over our personal interests. We must not use the firm or our positions in it for personal gain, other than our direct compensation."
(In the course of an informal conversation with a broker [who represented himself as a CFP with 20 years experience], we were told that he is compensated by the company by either commissions or a fee that ranged from 1% to 21/2% of assets under management. Then the broker said "I cannot charge (a customer) because I work for a Fortune 500 company" and "Of course I am a fiduciary.")
Franklin Templeton Investments. Franklin Templeton offers a section on conflicts of interest.
AIMR. (Association for Investment Management and Research) AIMR has both a Code of
The Code of Ethics. "A financial analyst should conduct himself* with integrity and dignity and