Missouri Legislature Proposes Investment Adviser Disclosure of Social Objectives

On January 8, 2023, Representative O’Donnell introduced a bill to the 102^nd General Assembly that adds to the disclosure obligations of Missouri-registered investment advisers. If enacted, Missouri House Bill No. 824 will amend Chapter 409 (Regulation of Securities) of the Missouri Revised Statutes to require these investment advisers and investment adviser representatives to disclose any socially responsible criteria included in any recommendation to a client or solicitation of a prospective client. Then, before acting on any such social objective, the proposed law would require client written consent, such as:

“I, (NAME OF CLIENT), consent to my adviser or adviser’s representative incorporating a social objective or nonfinancial objective into any discretionary investment decision my adviser or adviser’s representative makes for my account; any recommendation or advice my adviser or adviser’s representative makes to me for the purchase or sale of a security or commodity; or the selection my adviser or my adviser’s representative makes, or recommendation or advice my adviser or my adviser’s representative makes to me regarding the selection, of a third-party manager or subadvisor to manage the investments in my account.  Also, I acknowledge and understand that incorporating a social objective or nonfinancial objective into investment decisions, recommendations, advice, and/or the selection of third-party manager or subadvisor to manage the investments in my account will result in investments and recommendations/advice that are not solely focused on maximizing a financial return on my account.”

This bill’s proposed effective date is August 28, 2023, which is very timely considering the U.S. Securities and Exchange Commission’s similar recently proposed amendments to rules and reporting forms that would establish disclosure requirements for funds and investment advisers that market themselves as having environmental, social, and governance (ESG) strategies.

Since matters such as investment adviser client disclosures are complicated, it can be helpful to hire an attorney that specializes in such areas. Cosgrove Law Group has experience dealing with these questions. If you are a client or a prospective client of a Missouri-registered investment adviser that has questions about these or other investment adviser disclosure obligations and would like to speak with one of our Missouri-licensed attorneys, call 314-563-2490.

Court Strikes Non-Compete and Non-Solicitation Provisions

 In a financial services industry dispute, the Eighth Circuit Court of Appeals recently reversed a district court's enforcement of a non-compete agreement and non-solicitation agreement in employment contracts. The appellants were a financial advisor and her new financial services firm. The appellee that lost on appeal was the financial advisor's former employer.

The financial advisor was Cara Miller. When she worked for Honkamp Krueger Financial Services, she signed an employment agreement that included a non-compete and non-solicitation agreement and then an Agreement Ancillary to Employment that failed to include a non-compete provision. Miller voluntarily terminated her employment when Honkamp Krueger was purchased by another firm. She wisely sent a letter terminating her employment agreement rather than just her employment. She sought a declaratory judgment in the district court. Honkamp Kruger counterclaimed, seeking a preliminary injunction against her, and prevailed.  

The Court of Appeals took different approaches to the non-compete and non-solicitation agreement[1]. The Court concluded that the non-compete agreement ended when Miller provided written notice that the employment contract had ended. The Court found that the District Court's application of the non-solicitation agreement was void against public policy in that it prohibited accepting clients as well as soliciting them. Two quotes from the opinion are worthy of repetition: 1) "…non-compete agreements are 'strictly' constructed against the one seeking to restrain another from pursuing his profession, business, or employment", and 2) "…a contract cannot prevent former employees from accepting clients of their former employers because clients are not parties to the contract and should be allowed to choose with whom they want to do business." Food for thought.

Please follow us on Twitter @CosLawGroup, on LinkedIn at Cosgrove Law Group, LLC, and on Facebook at Cosgrove Law Group, LLC. 

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[1]https://1.next.westlaw.com/Document/Ic18609b004ed11ec8cc1ca5e79b1b862/View/FullText.html?listSource=Foldering&originationContext=clientid&transitionType=MyResearchHistoryItem&contextData=%28oc.Search%29&VR=3.0&RS=cblt1.0

Steps To Take Upon Termination by a Broker Dealer

So the unimaginable happens. You receive a call and are told to report to HR. There you are handed a letter stating you have been terminated for cause and that the broker-dealer has terminated your registrations with the firm.

What steps should you take?

First, and before leaving HR, you should request that they not file the Form U5 until after they have been contacted by your attorney. Pursuant to FINRA rules, the broker-dealer has 30 days from the date of termination to file the Form U5 that sets forth the reasons for the termination. And, what is stated by the firm on the Form U5 will be critical in determining your ability to join another firm, have clients move with you to your new firm, and avoid a FINRA Enforcement investigation.

Experienced securities industry counsel may be successful in framing the wording on the Form U5 such that it is accurate, which would avoid the subsequent time, expense and aggravation of removing inaccurate information from your Form U5. Pursuant to the laws of some states, broker-dealers have actual immunity or qualified immunity from defamation claims for statements made on Form U5s. Therefore, it’s imperative that you have experienced securities counsel on your side to try to prevent defamatory statements from being placed on your Form U5.

Second, you need to consider the host of other legal issues that may need to be resolved. Such as whether you are going to be subject to a FINRA Enforcement investigation, what information regarding your clients you may take from the firm, or what your continuing obligations are under your broker/registered representative agreement. 

Therefore, if you are a broker agent/registered representative and you have been terminated for cause, do not delay in consulting your securities industry attorney. You should consider having counsel engage with your broker-dealer before your Form U5 is filed. If you need assistance, you may wish to consult with experienced securities industry counsel at Cosgrove Law Group.

By: Brian St. James, Cosgrove Law Group, LLC

BROKER TERMINATIONS

Are you a financial adviser who has been terminated unfairly?  Well, if you are, you are not alone.  The attorneys at Cosgrove Law Group, LLC have represented advisers all over the country who have fallen prey to a system very unique to the financial services industry – the internet publication of involuntary termination justifications via the Form U-5.  And while the regulators thought this system would be a good thing for investors, it has proven to be a devastating system for many innocent advisers.  We refer to it as “the weaponization of the U-5.”

You will not obtain a new position with a Broker-Dealer or hybrid until your U-5 is filed.  And you probably will not get hired if it contains a negative narrative or one of the answers to question #7 (a) – (f) is marked in the affirmative.  Nor will your home state or FINRA register you until they are done investigating the purported reasons for termination.  If you are in this horrible situation, call us for help today.

SEC Cracking Down on Share Class Selection: High Standards and High Stakes

Last February the Securities and Exchange Commission ("SEC") announced their Share Class Selection Disclosure Initiative. This initiative is to prevent Investment Advisers from having their clients purchase shares with higher 12b-1 fees when cheaper ones are available. 12b-1 fees are paid by shareholders for the marketing, advertising, mailing of fund literature and prospectuses to clients, and paying the brokers.

Recently, the SEC settled with American Portfolio Advisers to pay $895,353 in disgorgement and prejudgment interest and a civil penalty of $250,000 due to inadequate client disclaimers regarding conflict of interests with 12b-1 fees.

In their Initiative Announcement, the SEC defined Investment Advisers receiving 12b-1 fees to mean (1) directly receiving fees, (2) a supervised person receiving fees, or (3) an affiliated broker dealer receiving fees. The SEC went on to state a proper disclosure does two things: it describes the conflict of interest in (1) making investment decisions in light of receipt of 12b-1 fees, and (2) selecting more expensive 12b-1 fee paying shares when lower cost shares are available for the same fund.

The initiative notes that disclosing that investment advisers “may” receive a 12b-1 fee and that there “may” be a conflict of interest was not enough. If the adviser is in fact receiving a 12b-1 fee they must say so and if the client is eligible for a lower cost share the adviser must inform them.

This duty stems from Section 206(2) of the Investment Advisers Act of 1940 ("Advisers Act"). Interpreted in SEC v. Capital Gains ResearchBureau, Inc., 375 U.S. 180, 194 (1963) to impose a financial duty on Investment Advisers to disclose to its clients all conflicts of interest which might incline an investment adviser consciously or unconsciously to render advice that is not disinterested.

These are high-standards and high-stakes for Registered Investment Advisers and for the Investment Advisers themselves. If you questions related to these standards or other SEC initiatives or regulatory standards, please call us at Cosgrove Law Group, LLC.

Get Your Own Lawyer, Darn It!

Financial advisors facing an arbitration claim or regulatory inquiry often count on their broker-dealer or registered investment advisor for legal counsel. These “employers” will frequently provide them with an ostensibly independent “conflict counsel” after they retain their own counsel. Unfortunately, however, it is arguably little more than a charade when the “independent” attorney either has, or one day hopes to represent the broker-dealer or registered investment advisor.

Consider viewing the situation in the context of an attorney's ethical duty of loyalty, her fiduciary duty to put the client's interests first, and her obligation to avoid even the appearance of failing to do so. If you (the attorney) have been hired and paid by a large client that you covet to represent an individual financial advisor that you will never see again, would you not be hesitant to suggest the financial advisor save herself – even if it injures the interests of the large corporate client? Would you really warn the advisor if you caught wind of the broker-dealer's or registered investment advisor's intention to throw him or her under the bus, or even put their interests before your client's in just a small way? And these are not mere hypotheticals. I have seen these situations, and even been caught up in them.

Loyalty and independent judgment are essential elements in the lawyer's relationship to a client. Concurrent conflicts of interest can arise from the lawyer's responsibilities to another client, a former client, or a third person or from the lawyer's own interests. For specific Rules regarding certain concurrent conflicts of interest, see Rule 4-1.8. For former client conflicts of interest, see Rule 4-1.9. For conflicts of interest involving prospective clients, see Rule 4-1.18¹.

Many years ago, I was in a fairly “steady relationship” with a large broker-dealer. But my firm was more like a second fiddle to a larger law firm they had used for years. Upon the advent of a large regulatory action, the broker-dealer hired me to represent some of their former advisors and executives. I became uncomfortable with this arrangement when it became apparent to me that many of my clients had a strong defense to the allegations, in that the broker-dealer was in large part responsible for my clients' alleged omissions. But before that day of reckoning arrived, something happened. The broker-dealer's primary attorney decided to file what appeared to me to be a frivolous motion that would not be in the best interests of my individual clients. I informed the primary attorney that my clients would not be joining the motion as he had directed. I received a major ass-chewing from him, and an order to get in line. Long story short is that I did not comply with that demand, and the broker-dealer got sanctioned for the motion. My individual clients were relieved, and ultimately dismissed from the case for zero fines or sanctions. But the broker-dealer never hired me again.

In another case, a financial advisor hired me to file a breach of fiduciary duty action against his former broker-dealer's attorney. That attorney initially represented both the broker-dealer and the advisor during a regulatory investigation. That same attorney then proceeded to play an instrumental role in throwing that financial advisor under the bus. When the dust had settled, no pun intended, the broker-dealer and attorney paid almost $4,000,000 to my client for their respective roles in the subsequent U-5 defamation and breach of fiduciary duty.

Finally, in a more recent situation, the attorneys for a broker-dealer's employee never even broached the subject of a resolution between my client and her individual client. Her firm covets their relationship with the broker-dealer far more than I had even dared to imagine. Things went south fast in our previously cordial relationship when I had the audacity to raise the “appearance” issue with her. Nothing changed in terms of proper legal representation, other than the tenor of the relationship.

The moral of these stories is this: if you are in hot water together with your employer, avoid the temptation of having your employer pay your legal bills and pick your lawyer for you. And if you are representing a broker-dealer and they ask you to serve as an unbiased loyal counsel for an employee or independent contractor, “just say no." Food for thought.

1 Comment to: RULE 4-1.7: CONFLICT OF INTEREST: CURRENT CLIENTS (https://www.courts.mo.gov/courts/ClerkHandbooksP2RulesOnly.nsf/c0c6ffa99df4993f86256ba50057dcb8/d06710dff1830d2686256ca600521205?OpenDocument)

A SHOT ACROSS THE BOW OF ROBO-ADVISERS

The Massachusetts Securities Division – one of the most active and sophisticated in the nation – recently issued a Policy Statement “to provide its state-registered investment advisers who establish concurrent or sub-advisory relationships with third-party robo-advisers with guidelines on how to best comply with the Massachusetts Uniform Securities act and meet the fiduciary duties owed to their clients.” That may be the longest sentence I have ever written.

So let’s start with the basics: what is a robo-adviser? Generally speaking, a robo-adviser is an online wealth management service that provides automated algorithm-based portfolio advice. Of course, a traditional adviser may also utilize software based data but they typically employ that data in the context of more personalized advice and wealth management or retirement planning. A few examples of robo-advisers in the marketplace today are Covestor, Market Riders, Asset Builder and Flex Score.

The problem, at least as I see it, is robo-advisers dressed up as fiduciaries. Some, and in particular one ubiquitous SEC registered RIA, actually promotes itself as a premium fiduciary with unparalleled individualized portfolio construction. In my opinion, it is not. Not even close. Unfortunately, the SEC has failed to take action against such cynical charades, but the Massachusetts Securities Division is doing what it can do within its jurisdictional constraints.

According to the new Massachusetts policy, any investment adviser registered pursuant to the Massachusetts Uniform Securities act must:

• Must clearly identify any third-party robo-advisers with which it contracts; must use phraseology that clearly indicates that the third party is a robo-adviser or otherwise utilizes algorithms or equivalent methods in the course of providing automated portfolio management services; and must detail the services provided by each third-party robo-adivser;
• If applicable, must inform clients that investment advisory services could be obtained directly from the third-party robo-adviser;
• Must detail the ways in which it provides value to the client for its fees, in light of the fiduciary duty it owes to the client;
• Must detail the services that it cannot provide to the client, in light of the fiduciary duty it owes to the client;
• If applicable, must clarify that the third-party robo-adviser may limit the investment products available to the client (such as exchange-traded funds, for example); and
• Must use unique, distinguishable, and plain-English language to describe its and the third-party robo-adviser’s services, whether drafted by the state-registered investment adviser or by a compliance consultant.

If you want to review the flesh on these bones, click here. Now, if only the SEC, California, Missouri, Florida and… would follow Lantagne’s lead.

Even General Counsels Get Defamed

What happens when the media re-states bluntly what you tried to say cleverly? A jury might find you liable for defamation, even if your statement was made in a legal document.

This observation is one of many take-aways from the litigation victory achieved by Minnesota attorney Chet Taylor. A jury awarded Chet $600,000 for a defamatory statement his former broker-dealer made in a corrective action plan attached to a FINRA consent order. The defendant added another $250,000 after the initial verdict to end the case.

Would a broker-dealer really throw former employees, including its General Counsel, under the proverbial bus? Perhaps. In this instance, broker-dealer Feltl and Company implied in the corrective action plan with FINRA that the “replacement” of certain employees, including its General Counsel, would “enhance a culture of compliance at the firm.” The Wall Street Journal subsequently published an article about Feltl utilizing a direct summary of the rather ham-handed plan: “The firm also said it replaced its general counsel...to beef up compliance.” The jury obviously did not care that Chet was not identified by name in the corrective action plan or Journal article. But they certainly cared that Chet had voluntarily departed for private practice about 2 years before the execution of the Consent Order and plan. Food for thought.

David Cosgrove has obtained monetary awards and expungements for various members of the financial industry from broker-dealers such as U.S. Bancorp Investments, Raymond James Financial Advisers, and Questar. He has also achieved negotiated confidential resolutions on behalf of other advisers and employees.

Does your Investment Adviser Firm Have a Social Media Policy?

Social media such as Facebook, Twitter, LinkedIn, or blogs have become popular mechanisms for companies to communicate with the public. Social media allows companies to communicate with clients and prospective clients, market their services, educate the public about their products, and recruit employees. Social media converts a static medium, such as a website, where viewers passively receive content, into a medium where users actively create content. However, this type of interaction poses certain risks for investment advisers and this topic has been a hot button for securities regulators. 

The SEC previously issued a National Examination Risk Alert on investment adviser use of social media. As a registered investment adviser, use of social media by a firm and/or related persons of a firm must comply with applicable provisions of the federal securities laws, including the laws and regulations under the Investment Advisers Act of 1940 (“Advisers Act”). The Risk Alert noted that the various laws and regulations most affected by social media are anti-fraud provision, including advertising, compliance provisions, and recordkeeping provisions. Advisers Act Rule 206(4)-7 requires firms to create and implement social media policies, and periodically review the policy’s effectiveness. 

Anti-fraud provisions with respect to advertising are probably most affected by the use of social media. All social media use and communications must comply with Rule 206(4)-1. While advertising policies should already be included in a firm’s compliance manual, such policies may not be sufficient enough to address some of the concerns with advertising in the context of social media. Establishing a specific policy to address social media may be prudent.

The area of advertising that has caused the most confusion is the prohibition on the use of testimonials. The SEC has previously defined testimonial to include a statement of a client’s experience with, or endorsement of, any investment adviser. Firms and IARs must ensure that third-party comments on their social media sites do not constitute a testimonial. Furthermore, the SEC vaguely discussed whether the popular “like” function on many social media sites would be deemed a testimonial:

[T]he staff believes that, depending on the facts and circumstances, the use of “social plug-ins” such as the “like” button could be a testimonial under the Advisers Act. Third-party use of the “like” feature on an investment adviser’s social media site could be deemed to be a testimonial if it is an explicit or implicit statement of a client's or clients' experience with an investment adviser or IAR. If, for example, the public is invited to “like” an IAR’s biography posted on a social media site, that election could be viewed as a type of testimonial prohibited by rule 206(4)-1(a)(1).

The types of policies that firms must create concerning advertising and testimonials depend greatly on the function of a specific website. For instance, approving the firm or IARs use of certain websites may turn on whether that website allows for review and approval of third-party comments before such comments are posted on the site or whether the “like” function can be disabled. A firm’s monitoring capabilities and the latitude it wants to provide employees with respect to personal use of social media cannot be ignored either.

The SEC has outlined various factors that should be considered by an investment adviser when evaluating the effective of their compliance program. These factors are:

• Usage and content guidelines and restrictions on IAR use of social media whether on behalf of the firm or for personal use
• Mechanisms for approval of social media use and content;
• Monitoring of social media use by the firm and IARs and the frequency of monitoring;
• Consideration of the function or risk exposure of specific social media sites;
• Establishing training and requiring IAR certification;
• Whether access to social media poses information security risks; and
• Firm resources that can be dedicated to implementation of social media policies.

There are various considerations firms must take into account when establishing social media policies or evaluating the effectiveness of its existing policies. If your firm needs assistance, the Cosgrove Law Group, LLC can assist with creation or review of such policies.

Calculating Breach of Fiduciary Duty Damages

According to a variety of authorities including the SEC, the much-debated fiduciary duty for registered investment advisers and their representatives includes a subset of responsibilities[1].  Common sense would, or should tell you that the appropriate damage calculation for a breach of fiduciary duty will be directly dependent upon and vary according to the particular unfulfilled responsibility.  For example, a breach of the fiduciary duty regarding conflicts of interest or honesty, as opposed to mere suitability, will call for out-of-pocket damage compensation if these breaches occurred before any market-losses at issue.  Even in a suitability only arbitration, however, expert witnesses may debate the applicability of out-of-pocket loss calculations as opposed to model portfolio based market-adjusted damage calculations.

It is common in breach of fiduciary duty cases involving trustees to award damages in the amount necessary to make the beneficiary whole. Restatement of Trusts, Second, § 2205, (1957), provides that proof of harm from a breach of fiduciary duty entitles an injured party to whom the duty was owed to damages that: (a) place the injured party in the same position it would have been in but for the fiduciary breach;(b) place the non-breaching party in the position the party was in before the breach; and (c) equal any profit the breaching fiduciary made as a result of committing the breach. See also Restatement (Second) of Torts § 874 (1979) (“One standing in a fiduciary relation with another is subject to liability to the other for harm resulting from a breach of duty imposed by the relation.”).

Delaware law is consistent with this principle. In Hogg v. Walker, 622 A.2d 648, 653 (Del. 1993), the court noted that “where it is necessary to make the successful plaintiff whole” for a breach of fiduciary duty, courts have been willing to allow the plaintiff to recover a portion of trust property or its proceeds along with a money judgment for the remainder. The court in Hogg stated that “[i]t is an established principle of law in Delaware that a surcharge is properly imposed to compensate the trust beneficiaries for monetary losses due to a trustee’s lack of care in the performance of his or her fiduciary duties.” Id. at 654.[2]; see also Weinberger v. UOP, Inc., 457 A.2d 701, 714 (Del. 1983) (stating that in measuring damages for breach of fiduciary duty the court has complete power “to fashion any form of equitable and monetary relief as may be appropriate, including rescissory damages.”); Harman v. Masoneilan Intern., Inc., 442 A.2d 487, 500 (Del. 1982) (finding that “the relief available in equity for tortious conduct by one standing in a fiduciary relation with another is necessarily broad and flexible.”) (citing See Restatement (Second) of Torts, § 874 (1979)).

In O'Malley v. Boris, 742 A.2d 845, 849 (Del. 1999), the court stated that the relationship between a customer and stock broker is that of principal and agent. The court stated a broker must act in the customer’s best interests and must refrain from self-dealing, and that these obligations are at times described “as fiduciary duties of good faith, fair dealing, and loyalty.” (emphasis added) Id. The court further found that fiduciary duties of investment advisors “are comparable to the fiduciary duties of corporate directors, and are limited only by the scope of the agency.” Id.   Bear, Stearns & Co. v. Buehler, 432 F.Supp.2d 1024, 1027 (C.D.Cal. 2000) (finding that reasoning from case addressing breach of fiduciary duty by a trustee was persuasive in case involving investment advisor because, “[l]ike a trustee, an investment advisor may be considered a fiduciary.”).

In sum, it is critical to identify the particular duty at issue in order to arrive at a proper damage calculation.  The broker’s duty of suitability is essentially a limited duty of care akin to the one at play in a negligence matter. The fiduciary duty, however, carries within it an entire penumbra of duties of which portfolio/investment suitability is just one.  If an alleged breach of fiduciary duty is limited to the adviser’s responsibility to recommend or make a suitable investment only, the damage calculations may indeed mirror the broker-dealer damage calculation.  An adviser’s breach of its fiduciary duty beyond the mere standard of investment care, however, requires the finder-of-fact to calculate “make-whole” damages.

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[1]Miley v. Openheimer, 637 F.3d 318 (1981) is “the seminal case on damages in a suitability case[.]”

[2] A “surcharge” is relief in the form of monetary compensation for a loss resulting from a trustee’s breach of duty. The Supreme Court in CIGNA Corp. v. Amara, 131 S.Ct. 1866, 1880 (2011), stated that an ERISA fiduciary can be “surcharged” or ordered to pay money damages under the ERISA provision allowing a participant or beneficiary of the plan to obtain “other appropriate equitable relief.” In making this determination, the court stated that “[t]he surcharge remedy extended to a breach of trust committed by a fiduciary encompassing any violation of a duty imposed upon that fiduciary.” The court went on to conclude that “insofar as an award of make-whole relief is concerned, the fact that the defendant in this case, . . . , is analogous to a trustee makes a critical difference.”

Is your RIA's Code of Ethics Adequate?

Being a fiduciary to clients means acting in the client’s best interest and putting their interest before yours and others. Sometimes knowing what is in the client’s best interest can get foggy so establishing certain guidelines can help protect you, your client, and your representatives. 

In accordance with Rule 204A-1 of the Investment Advisors Act of 1940, RIA’s registered with the SEC are required to maintain a written code of ethics that outline the fiduciary duties and standards of conduct of the RIA and its representatives. State registered RIA’s may also be required to develop a code of ethics consistent with state regulations. 

It’s important to keep in mind that in creating a code of ethics, the SEC and various state regulations set minimum requirements.  The following items are required in an RIA’s code of ethics under Rule 204A-1:

• A standard of business conduct which reflects the fiduciary obligations to clients;  
• Provisions requiring all advisers’ and supervised persons’ compliance with applicable federal securities laws;
• Protection of material non-public information of both the adviser’s securities recommendations, and client securities holdings and transactions;
• Periodic reporting and reviewing of access persons’ personal securities transactions and holdings;
• Advisor’s approval before an access person can invest in an IPO or private placement;
• Duty to report violations of the code of ethics;
•  A written acknowledgment that all supervised persons received the code of ethics; and
• Recordkeeping provisions. 

RIAs often set higher standards that work to reinforce the values or business practices of the company.  Rule 204A-1 does not require detailed measures to be included into every code because of the vast differences among advisory firms.  However, the SEC has offered guidance and recommendations on additional best practices that advisors should consider incorporating into its code of ethics.  The following list contains additional safeguards that are commonly implemented by other advisers:

• Prior written approval before access persons can place a personal securities transaction (“pre-clearance”);
• Maintenance of lists of issuers of securities that the advisory firm is analyzing or recommending for client transactions, and prohibitions on personal trading in securities of those issuers;
• Maintenance of “restricted lists” of issuers about which the advisory firm has inside information, and prohibitions on any trading (personal or for clients) in securities of those issuers; 
• “Blackout periods” when client securities trades are being placed or recommendations are being made and access persons are not permitted to place personal securities transactions.
• Reminders that investment opportunities must be offered first to clients before the adviser or its employees may act on them, and procedures to implement this principle.
• Prohibitions or restrictions on “short-swing” trading and market timing.
• Requirements to trade only through certain brokers, or limitations on the number of brokerage accounts permitted;
• Requirements to provide the adviser with duplicate trade confirmations and account statements; and
• Procedures for assigning new securities analyses to employees whose personal holdings do not present apparent conflicts of interest.

Another issue that may be important to include in your code of ethics is provisions concerning gifts and entertainment since giving or receiving gifts between a client and advisor may create the appearance of impropriety.  Gift and entertainment provisions usually contain reporting requirements and a prohibition of accepting gifts over de minimus values, such as $100.

While the above requirements and recommendations generally encompass an advisor’s fiduciary duty as it relates to conflicts of interests, advisors have additional fiduciary duties to clients that should be memorialized in a code of ethics as well.  For example, and what might appear obvious to some, advisors cannot defraud or engage in manipulative practices with a client in any way.  Advisors also have a duty to have a reasonable, independent basis for the investment advice provided to a client and to ensure that investment advice meets the client’s individual objectives, needs, and circumstances.  Advisors are also expected to stay abreast of market conditions.  Clients should be provided with all material information related to their investments or investment strategy and should be adequately informed of the risks associated with those investments.  The depth of the explanation of those risks or strategy depends on the client’s level education and experience.     

The buck doesn’t stop with establishing a written code of ethics, however.  Implementation and enforcement of your code of ethics are just as crucial.  This also includes educating your representatives.  Rule 204A-1 does not mandate specific training procedures but ensuring that your representatives understand their obligations and their fiduciary duties is imperative.  Thus, periodic training with new and existing employees is not only in your best interest, but also the interest of your employees and clients.  Finally, you should annually review your code of ethics to determine if there are any areas of deficiency or whether changes need to be made.

The Syndicate can assist with your firm in the following ways: (1) drafting or establishing a code of ethics; (2) reviewing your current code to assure it complies with applicable state or federal laws; (3) implementing training programs; and (4) analyzing your firm’s implementation procedures to ensure compliance with the codes provisions.

Missouri Securities Division Cancels the Registration of Missing Investment Adviser Rep

In late 2013, Missouri Commissioner of Securities ordered the cancellation of Joseph Jackson and J. Andrew Jackson & Co. LLC’s registration.  The company was a Registered Investment Adviser with Jackson registered as its investment adviser representative.  

According to the Missouri Order, in July 2012, a Missouri Resident (“MR”) opened an account with Interactive Brokers LLC, a Missouri registered broker-dealer, through J. Andrew Jackson & Co., LLC.  Jackson was listed as the representative of record on the account.  By August, 2012, Jackson, acting as the registered representative on the account, had lost over $83,000 in MR’s account due to his purchasing of options in MR’s account.  Jackson never discussed purchasing options with MR and MR had no knowledge about how options work.   Jackson told MR that he was attempting to “hit a home-run” with the purchases.  In September 2012, Jackson repaid MR $10,000 and agreed to pay MR $5,000 every other week until the losses were recouped.  MR has been unable to contact Jackson since September 21, 2012.  Jackson is believed to have other Missouri clients.    

Since June of 2013, investigators of the Missouri Securities Division made several attempts to contact Jackson at his last known addresses and phone numbers to no avail.  Thus, pursuant to Section 409.4-408(e) of the Missouri Securities Act,

(e) If the commissioner determines that a registrant or applicant for registration is no longer in existence or has ceased to act as a broker-dealer, agent, investment adviser, or investment adviser representative, or is the subject of an adjudication of incapacity or is subject to the control of a committee, conservator, or guardian, or cannot reasonably be located, a rule adopted or order issued under this act may require the registration be canceled or terminated or the application denied.

Therefore, in the interest of investors and because all means of contacting Jackson had been exhausted, the Commissioner ordered the cancellation of the registrations of both Jackson and J. Andrew Jackson & Co. LLC. 

It remains to be seen whether Jackson will resurface.  If that happens, we will likely see another Enforcement Action concerning his alleged neglect and mishandling of client accounts. 

While this advice is probably obvious to most of our readers, investment adviser reps should always maintain contact with their clients.  Finally, if you receive an inquiry from a State Securities Department or other related agency, contact the attorneys at Cosgrove Law Group, LLC immediately. 

Investment Adviser Fiduciary Duty Standard Requires Reasonable Basis for Client Recommendation

The Securities and Exchange Commission regulates investment advisers under the Investment Advisers Act of 1940 (the “Act”). Perhaps the most significant provision of the Act is Section 206, which prohibits advisers from defrauding their clients. The Supreme Court has interpreted this provision as imposing on advisers a fiduciary obligation to their clients. See Transamerica Mortgage Advisors, Inc. (TAMA) v. Lewis, 444 U.S. 11, 17 (1979) (“[T]he Act’s legislative history leaves no doubt that Congress intended to impose enforceable fiduciary obligations.”).

The federal fiduciary standard requires that an investment adviser act in the “best interest” of its advisory client. Belmont v. MB Inv. Partners, Inc., 708 F.3d 470, 503 (3d Cir. 2013) (citing SEC v. Tambone, 550 F.3d 106, 146 (1st Cir.2008) (“[15 U.S.C. § 80b–6] imposes a fiduciary duty on investment advisers to act at all times in the best interest of the fund and its investors.”). Under a “best interest” test, an adviser may benefit from a transaction with or by a client, but the details of the transaction must be fully disclosed. See SEC v. Capital Gains Research Bureau, 375 U.S. 180, 191-92 (1963) (stating that Advisers Act was meant to “eliminate, or at least to expose, all conflicts of interest which might incline as investment adviser–consciously or unconsciously–to render advice which was not disinterested”).

A number of obligations to clients flow from the fiduciary duty imposed by the Act, including the duty to fully disclose any material conflicts the adviser has with its clients, to seek best execution for client transactions, to provide only suitable investment advice, and to have a reasonable basis for client recommendations. See Registration Under the Advisers Act of Certain Hedge Fund Advisers, SEC Release No. IA-2333; Status of Investment Advisory Programs under the Investment Company Act of 1940, SEC Release No. IA-1623.

As noted by the Third Circuit in Belmont, even when a private litigant brings a cause of action for common law breach of fiduciary duty “the evolution of duties governing investment advisers as fiduciaries appears to have been shaped exclusively by the Advisers Act and federal common law.” 708 F.3d at 500-01. The Belmont court noted that one might reasonably wonder why the cause of action is presented as springing from state law if one looks to federal law for the statement of the duty and the standard to which investment advisers are to be held. 708 F.3d at 502. However, the court found that the answer was straightforward: no federal cause of action is permitted. Id. The court found that while “[t]hat reality ought to call into serious question whether a limitation in federal law can be circumvented simply by hanging the label ‘state law’ on an otherwise forbidden federal claim, that is the labeling game that has been played in this corner of the securities field, and the confusion it engenders may explain why there has been little development in either state or federal law on the applicable standards.” Id.

Based on the foregoing, a common law breach of fiduciary duty claim can in all likelihood be based on an investment adviser’s failure to have a “reasonable basis” for making a client recommendation. The question then becomes what constitutes a “reasonable basis” in the context of making such recommendations? This is not an issue that has been faced by many courts in the context of private causes of action brought by clients against investment advisers. For example, no Missouri case has addressed the issue.

However, in other situations where a reasonableness standard is employed, Missouri courts utilize an objective standard. See Graham v. McGrath, 243 S.W.3d 459, 463 (Mo. Ct. App. 2007) (noting that when damages are capable of ascertainment for purposes of statutes of limitations, Missouri utilizes an objective reasonable person standard); Robin Farms, Inc. v. Bartholome, 989 S.W.2d 238, 247 (Mo. Ct. App. 1999) (noting that the test for determining disqualification of a judge based on bias is whether a reasonable person would have factual grounds to doubt the impartiality of the court, “which is an objective standard[.].”).

As such, in Missouri and other jurisdictions that utilize the objective standard for reasonableness in other situations, the determination of whether an investment adviser had a “reasonable basis” for making a particular recommendation will likely be measured by an objective standard. This means that the fact finder will have to determine whether a reasonable person in the investment adviser’s circumstances might have made the same recommendation as the investment adviser, and need not consider what the adviser may have honestly -- but perhaps mistakenly -- believed.

Class Arbitration: Are Investment Advisers Representatives Excluded?

Investment Adviser agreements typically contain provisions which require all disputes between the Registered Investment Adviser (“RIA”) and Investment Adviser Representative (“IAR”) to be determined in a final and binding arbitration.  These agreements also preclude class claims from being brought to arbitration.  In effect, RIAs have thereby evaded being the subject of class actions brought by IARs, at least for now. 

At the beginning of the year, the National Labor Relations Board (“NLRB”) decided a case which outlaws contract provisions in which the employer conditions employment upon signing an agreement that precludes employees from filing joint, class, or collective claims in any forum.  However, the claims must address issues such as wages, hours, or other working conditions. 

D.R. Horton v. Michael Cuda involved an employment contract where the employee was required to submit all claims to arbitration.  The agreement also prevented employees from consolidating or bringing class claims.  The NLRB determined that these agreements prohibit the exercise of substantive rights that are protected under Section 7 of the National Labor Relations Act (“NLRA”).  The NLRB’s decision specifically outlines certain limitations to its holding.  In particular, the decision is only applicable to “employees” as defined in the NLRA.  This definition specifically excludes independent contractors.

It should be noted that the US Supreme Court recently ruled in AT&T Mobility LLC v. Conception that the Federal Arbitrations Act (“FAA”) permits companies to require customers to arbitrate their complaints individually, precluding class action claims.  D.R. Horton differs in that it involved employee class actions, which is protected by statute, versus customer or consumer class actions.  However, since D.R. Horton has been appealed to the 5^th Circuit Court of Appeals, it will be interesting to see the outcome, and whether or not the Supreme Court will grant certiorari.  My guess is that it will.   

That being said, the hurdle for IARs is that they are often classified as “independent contractors” rather than employees.  Not only is this usually set forth in their investment advisor agreements, but the type of relationship between the employer and the IAR has some characteristics of an independent contractor.  However, they also have employer-employee characteristics that could be crucial in determining the type of employment relationship. 

There are various factors that determine whether one is considered an employee versus an independent contractor.  These factors include but are not limited to the following: (1) the level of control the employer has over the work performed by the individual; (2) whether the employer or worker furnishes the tools, materials, supplies, or equipment needed to perform the job; (3) whether the worker provides services for more than one firm or company at a time; (4) whether the worker can realize a profit or loss as a result of his services; (5) whether the employer set the work schedule; and (6) whether the employer hires, supervises, or pays assistants of the worker.

Perhaps one of the more determinative factors in defining an employment relationship is the level of control and supervision the employer has over an individual.  By design, RIAs are required to supervise the conduct and activities of any IAR that represents it, whether the IAR is an employee or an individual that provides investment advice on behalf of the RIA.  An RIA’s legal duty to supervise its IARs emanates from a number of sources.  For instance, Section 203(e)(6) of the Investment Advisers Act of 1940 permits the SEC to take action against an RIA for failing to supervise its IARs.  Pursuant to SEC Rule 206(4)-7 under the Advisers Act, RIAs are required to adopt policies and procedures that are reasonably designed to prevent violations of securities laws by the adviser and its supervised persons.   Furthermore, SEC Rule 204A-1 requires RIAs to adopt a code of ethics which sets forth the standard of business conduct to be exhibited by IARs. 

Generally, investment advisory agreements authorize RIAs to monitor and evaluate the IAR and subject the IAR to the supervision of the adviser.  Moreover, the duty to supervise an IAR may also stem from the fiduciary duty the RIA owes to its clients.  This supervisory duty and level of control is often implemented with periodic or annual compliance audits of each IAR.  Despite this level of control, the IAR is often contractually defined as an independent contractor.   

Therefore, as it stands, IARs could face a substantial but perhaps surmountable hurdle in bringing class arbitration claims if the investment advisor agreement defines the representative as an independent contract and precludes class actions.  Since the NLRA definition of employee precludes traditional independent contractors, there may be no statutory protection granted to some IARs.