Author: LegalEase Solutions

Issue

In dealing with clients’ money, does an investment company / portfolio manager need to exercise diligence in its purchase of different investments?

Short Answer 

Investment companies, portfolio managers, and investment advisers investing client’s money have a fiduciary duty to act with due caution and prudence while making investments on clients’ behalf.

Discussion 

All Advisers Owe a Mandatory Federal Fiduciary Duty to Clients

Courts have imposed on a fiduciary an affirmative duty of “utmost good faith, and full and fair disclosure of all material facts,” as well as an affirmative obligation “to employ reasonable care to avoid misleading” his clients. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (U.S. 1963).  The Investment Adviser’s Act has recognized an investment adviser to be a fiduciary. 15 USCS § 80b et seq.  Investment advisers are bound to occupy an impartial and disinterested position, as free as humanly possible from the subtle influence of prejudice, conscious or unconscious. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 188.  They should scrupulously avoid any affiliation, or any act, which subject their position to challenge in this respect.  Id.

Fiduciary Duty Between an Investment Adviser and a Client Arises From the Relation between them. 

In order to determine whether a fiduciary relationship exists, a court will look to whether a party reposed confidence in another and reasonably relied on the other’s superior expertise or knowledge.  Sergeants Benevolent Ass’n Annuity Fund v. Renck, 19 A.D.3d 107, 110 (N.Y. App. Div. 1st Dep’t 2005).  Liability for breach of a fiduciary duty is not dependent solely upon an agreement or contractual relation between the fiduciary and the beneficiary but results from the relation. Id.

In Sergeants Benevolent Ass’n Annuity Fund v. Renck, 19 A.D.3d 107 (N.Y. App. Div. 1st Dep’t 2005), plaintiff, a trust that managed annuity payments, sued defendant, an investment advisor and fund manager, for breach of contract and of fiduciary obligations, overcharging, retaining refundable commissions, negligent misrepresentation, and unjust enrichment. The Supreme Court, New York County, New York, granted certain defendants’ motion to dismiss all individual claims against them for failure to state a cause of action. The trust appealed. The appeals court reversed the order, denied defendants’ motion to dismiss, and reinstated all of the trust’s claims against defendants.

The court found that although the agreement between the parties did not impose any fiduciary duty, the allegation that defendants provided investment advice regarding asset allocation, portfolio manager selection, investment objectives, investment guidelines and transaction costs, and that plaintiff’s trustees relied on defendants’ proclaimed expertise in field of investment consulting and management were sufficient to raise factual issue regarding existence of fiduciary duty owed by defendants in their individual capacities.

Duty of Disclosure

An investment adviser has a duty to provide full and fair disclosure of material facts. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (U.S. 1963).  They also have a duty to avoid misleading statements to their clients. Id.    The duty to disclose arises when one party has information that the other [party] is entitled to know because of a fiduciary or other similar relation of trust and confidence between them. Chiarella v. United States, 445 U.S. 222, 228 (U.S. 1980).

Under the scheme of the Investment Company Act an investment adviser is “under a duty of full disclosure of information to . . . unaffiliated directors in every area where there was even a possible conflict of interest between their interests and the interests of the  fund” – a situation which occurs much more frequently in the relations between a mutual fund and its investment adviser than in ordinary business corporations .  Galfand v. Chestnutt Corp., 545 F.2d 807, 811-812 (2d Cir. 1976).  Additionally, even where a fiduciary has made full disclosure, it is the duty of a federal court to subject the transaction to rigorous scrutiny for fairness. Id.

NASD Rules of Fair Practice

 Pursuant to Article III, Section 2 of the National Association of Securities Dealers’(NASD) Rules of Fair Practice, in recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs. Krull v. SEC, 248 F.3d 907, 912 (9th Cir. 2001).

Making unsuitable recommendations is a violation of the rules of fair practice. 1989 SEC LEXIS 2376 (SEC 1989).  The Securities Exchange Commission affirmed NASD’s findings of violation and the imposed sanctions in a case where a member firm of registered securities association and its registered principal made unsuitable recommendations to customers. Id. 

Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning:(1) the customer’s financial status; (2) the customer’s tax status; (3) the customer’s investment objectives; (4) such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer. GMS Group, LLC v. Benderson, 191 F. Supp. 2d 318, 323 (D.N.Y. 2001).

Duty to Provide Suitable Investment Advice

Investment advisers are fiduciaries. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191, 194 (1963).  They owe their clients a series of duties.  Id. at 191-92.  The duty to provide only suitable investment advice is one of them.  This duty is enforceable under the antifraud provision of the Advisers Act, section 206. Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979).  The Commission has sanctioned advisers for violating this duty.  In re Shearson, Hammill & Co., 42 SEC 811 (1965).

The Securities Exchange Commission is proposing for comment new rule 206(4)-5 under the Investment Advisers Act of 1940 that would expressly prohibit investment advisers from making unsuitable recommendations to clients.  Proposed rule 206(4)-5 would make explicit advisers’ suitability obligations under the Advisers Act.

Duty to Provide Advice on a Reasonable Basis

In the Matter of Alfred C. Rizzo, Rizzo, was an investment adviser registered with the Commission pursuant to Section 203(c) of the Advisers Act, published the Dynamic Growth Letter (“Letter”), a monthly newsletter containing investment information and advice about various issuers of securities. 1984 SEC LEXIS 2429, 2 (SEC 1984).  The Letter contained a detailed table which showed the “proven” and “probable” estimated reserves for each of Major’s leases in Texas, with total “proven” reserves for all properties estimated at in excess of $232 million and total “probable” reserves estimated at in excess of $2.4 billion. Id at 4 In fact, Major’s leases in Texas had total “proven” oil and gas reserves of less than $3 million.  In the Letter, Rizzo failed to disclose that he was supposed to receive material amounts of revenue from the very issuer about which an article was written.Id 4

Based on this order and the Offer of Settlement, the Commission found that:

Rizzo willfully violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder and Section 206 of the Advisers Act in that (1) he drafted and disseminated to the subscribers to the Letter an article about Major without a reasonable independent basis for the investment advice therein; (2) he authorized Major to reprint and disseminate the article about Major without a reasonable independent basis for the investment advice therein; and (3) failed to disclose that he was supposed to receive contemporaneous revenue from the issuer about which an article was written in the Letter. Id at 7.

As a registered investment adviser, Rizzo was required to have a reasonable basis for his investment advice. This duty follows from the “delicate fiduciary nature of an investment advisory relationship,” a relationship that requires the investment adviser to “furnish to clients on a personal basis competent . . . advice regarding the sound management of their investments.” Securities and Exchange Commission v. Capital Gains Research Bureau, Inc, 375 U.S. 180, 191 and 187 (1963). Id at 8.

Investment Adviser’s Act

15 USCS § 80b-6 of the Investment Adviser’s Act specifies certain transactions that are prohibited by investment advisers.  The Investment Advisers Act of 1940 (IAA) prohibits fraud and deceit in investment adviser dealings with client, however it is not simply an anti-fraud measure like section 10(b).  ‘ Norman v. Salomon Smith Barney, Inc., 350 F. Supp. 2d 382, 391-392 (D.N.Y. 2004). The Investment Advisers Act of 1940 was “directed not only at dishonor, but also at conduct that tempts dishonor.” SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 200 (U.S. 1963).  Unlike claims brought under section 10(b) of the Securities Exchange Act, claims of IAA violations do not require proof of intent or scienter. The IAA’s purpose is much broader, reflecting a “congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser — consciously or subconsciously — to render advice which was not disinterested.  In place of the previous regime of caveat emptor, the IAA “created a fiduciary duty on the part of investment advisers to exercise good faith and fully and fairly disclose all material facts to their clients, and an affirmative obligation ‘to employ reasonable care to avoid misleading clients. Norman v. Salomon Smith Barney, Inc., 350 F. Supp. 2d 382, 391-392.

Pursuant to 15 USCS § 80b-11, the Securities and Exchange Commission may promulgate rules to provide that the standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers.  The rules states that investment advisers should act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice. 15 USCS § 80b-11.  In accordance with such rules, any material conflicts of interest shall be disclosed and may be consented to by the customer. Id.

The Investment Advisers Act Creates a Trust Relationship 

After a careful examination of section 80b-6 of the Investment Advisers Act and certain rules and regulations promulgated thereunder, as enumerated in 17 C.F.R. § 275.204-2, -3, and .206(4)-2, the court in In re Peterson, 96 Bankr. 314, 321 (Bankr. D. Colo. 1988), held that the Act creates an express trust relationship within the meaning of section 523(a)(4).  Jacobs v. Mones (In re Mones), 169 B.R. 246, 255-256 (Bankr. D.D.C. 1994).  First, any funds coming into the investment adviser’s hands directly or indirectly form the res or particular property of the trust. Id.  Second, section 80b-6 of the Act implies the general duty to handle client funds free from any scheme to defraud. Id.  Third, the Act and regulations set forth a prescribed method for management, control and accounting of all client funds. Id.
The court further stated that the reasoning in Peterson is persuasive and it finds no authority to the contrary.  Therefore, the court held that the Investment Advisers Act gives rise to a trust that imposes a fiduciary capacity as contemplated by section 523(a)(4). Id. at 256.

ERISA and Fiduciary Duty Of Investment Advisors

Fiduciaries under ERISA are obligated to discharge their duties “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in his conduct of an enterprise of like manner of a like character and with like aims,” 29 U.S.C. § 1104(a)(1)(B), and, (D) “in accordance with the documents and instruments governing the plan insofar as such documents and instruments are consistent with the provisions of this subchapter and subchapter III of this chapter. § 1104(a)(1)(C), also imposes a duty of diversification whereby the fiduciary should not normally invest all or an unduly large portion of plan funds in a single security, or any one type of security, or even in various securities that depend on the success of one enterprise. Ulico Cas. Co. v. Clover Capital Mgmt., 335 F. Supp. 2d 335, 339 (N.D.N.Y 2004).  The standards set forth in these sections is the objective “prudent person” standard developed in the common law of trusts. Id

Courts have interpreted ERISA’s prudent person standard as an objective standard requiring (1) to employ proper methods to investigate, evaluate and structure the investment; (2) to act in a manner as would others who have a capacity and familiarity with such matters; and (3) to exercise independent judgment when making investment decisions. Ulico Cas. Co. v. Clover Capital Mgmt., 335 F. Supp. 2d 335, 340.

Investment Company Act of 1940 (SEC. 36. (a) Breach of fiduciary duty) 

The investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company, or by the security holders thereof, to such investment adviser or any affiliated person of such investment adviser.

• (1) It shall not be necessary to allege or prove that any defendant engaged in personal misconduct, and the plaintiff shall have the burden of proving a breach of fiduciary duty.
• (2) In any such action approval by the board of directors of such investment company of such compensation or payments, or of contracts or other arrangements providing for such compensation or payments, and ratification or approval of such compensation or payments, or of contracts or other arrangements providing for such compensation or payments, by the shareholders of such investment company, shall be given such consideration by the court as is deemed appropriate under all the circumstances.
• (3) No such action shall be brought or maintained against any person other than the recipient of such compensation or payments, and no damages or other relief shall be granted against any person other than the recipient of such compensation or payments. No award of damages shall be recoverable for any period prior to one year before the action was instituted. Any award of damages against such recipient shall be limited to the actual damages resulting from the breach of fiduciary duty and shall in no event exceed the amount of compensation or payments received from such investment company, or the security holders thereof, by such recipient.

New York Laws 

Where an investment advisor recommends a hedge fund without conducting sufficient due diligence, an investor’s breach of fiduciary duty claim arises in the securities context. Sacher v Beacon Assoc. Mgt. Corp., 2010 NY Slip Op 50826U, 14 (N.Y. Misc. 2010)

Where a claim for breach of fiduciary duty is based upon a “significant component” of the representations that induced plaintiff to invest, the claim arises from the alleged securities fraud and is preempted by the Martin Act.  Claims against a fund for unjust enrichment and conversion, based upon misrepresentations as to the investment’s level of risk, are precluded as merely “recast securities fraud claims”. Sacher v Beacon Assoc. Mgt. Corp., 2010 NY Slip Op 50826U, 14 (N.Y. Misc. 2010).

The State of New York recognizes a duty by a party to a business transaction to speak in three situations: first, where the party has made a partial or ambiguous statement, on the theory that once a party has undertaken to mention a relevant fact to the other party it cannot give only half of the truth; second, when the parties stand in a fiduciary or confidential relationship with each other; and third, ‘where one party possesses superior knowledge, not readily available to the other, and knows that the other is acting on the basis of mistaken knowledge. Copland v. Nathaniel, 164 Misc. 2d 507, 515 (N.Y. Sup. Ct. 1995); Mitsubishi Power Sys. Ams., Inc. v. Babcock & Brown Infrastructure Group US, LLC, 2010 Del. Ch. LEXIS 11, 43 (Del. Ch. Jan. 22, 2010).

In People v. Federated Radio Corp., 244 N.Y. 33 (N.Y. 1926), the court found that promoters are under a duty to make reasonable investigation before issuing a prospectus and to the extent that they fail in the performance of their duty, lack of scienter will not relieve them from liability in actions brought under the act. Nor can they exempt themselves, as matter of law, from that duty by inserting in printed matter, complained of as deceptive and misleading, the words “information contained herein has been obtained from sources which we deem reliable but do not guarantee.” Id.

In Downey v. Finucane, 205 N.Y. 251 (N.Y. 1912), the court held that the promoter of a company, whether he be a director or not, who knowingly issues or sanctions the circulation of a false prospectus containing untrue statements of material facts naturally tending to mislead and to induce the public to purchase its stock or other securities is unquestionably responsible to those who are injured thereby. Where there are a number of such promoters all the co-adventurers are liable in damages for the fraud of an agent employed by them to effect the sale of the corporate securities without reference to their own moral guilt or innocence.

A representation as to the financial condition or credit standing of another is actionable if false and known to be false by the representor.  60A NY Jur Fraud and Deceit § 88.  It is well settled that false and fraudulent representations made to one contemplating a business transaction or negotiations with a third person, concerning the financial status, solvency, or credit standing of such third person, constitute misrepresentations which may furnish the basis of a cause of action for fraud. Id.  This is especially true where the representor states that he or she has investigated the third person and believes him or her to be financially responsible, whereas, in fact, the representor has made an insufficient investigation and possesses inadequate information to assert as a belief that the third person is financially responsible.  Id.

NY CLS Gen Bus § 352-c – Prohibited Acts Constituting Misdemeanor; Felony.

1. It shall be illegal and prohibited for any person, partnership, corporation, company, trust or association, or any agent or employee thereof, to use or employ any of the following acts or practices:

(a) Any fraud, deception, concealment, suppression, false pretense or fictitious or pretended purchase or sale;

(b) Any promise or representation as to the future which is beyond reasonable expectation or unwarranted by existing circumstances;

(c) Any representation or statement which is false, where the person who made such representation or statement: (i) knew the truth; or (ii) with reasonable effort could have known the truth; or (iii) made no reasonable effort to ascertain the truth; or (iv) did not have knowledge concerning the representation or statement made; where engaged in to induce or promote the issuance, distribution, exchange, sale, negotiation or purchase within or from this state of any securities or commodities, as defined in section three hundred fifty-two of this article, regardless of whether issuance, distribution, exchange, sale, negotiation or purchase resulted.

2. It shall be illegal and prohibited for any person, partnership, corporation, company, trust or association, or any agent or employee thereof, to engage in any artifice, agreement, device or scheme to obtain money, profit or property by any of the means prohibited by this section.
3. It shall be illegal and prohibited for any person, partnership, corporation, company, trust or association, or any agent or employee thereof, engaged in the sale of any securities or commodities, as defined in section three hundred fifty-two of this article, within or from the state of New York to represent that they are an “exchange” or use the word “exchange,” or any abbreviation or derivative thereof, in its name or assumed name unless it is registered with the Securities and Exchange Commission as a national securities exchange, pursuant to section six of the Securities and Exchange Act of 1934, or unless it has been designated as a contract market by the Commodity Futures Trading Commission, pursuant to section five of the Commodity Exchange Act.
4. Except as provided in subdivision five or six, a person, partnership, corporation, company, trust or association, or any agent or employee thereof, using or employing any act or practice declared to be illegal and prohibited by this section, shall be guilty of a misdemeanor.
5. Any person, partnership, corporation, company, trust or association, or any agent or employee thereof who intentionally engages in any scheme constituting a systematic ongoing course of conduct with intent to defraud ten or more persons or to obtain property from ten or more persons by false or fraudulent pretenses, representations or promises, and so obtains property from one or more of such persons while engaged in inducing or promoting the issuance, distribution, exchange, sale, negotiation or purchase of any securities or commodities, as defined in this article, shall be guilty of a class E felony.
6. Any person, partnership, corporation, company, trust or association, or any agent or employee thereof who intentionally engages in fraud, deception, concealment, suppression, false pretense or fictitious or pretended purchase or sale, or who makes any material false representation or statement with intent to deceive or defraud, while engaged in inducing or promoting the issuance, distribution, exchange, sale, negotiation or purchase within or from this state of any securities or commodities, as defined in this article, and thereby wrongfully obtains property of a value in excess of two hundred fifty dollars, shall be guilty of a class E felony.

Conclusion

The investment adviser has a duty to exercise due care and caution while investing client’s money.