Although investment advisors recognize that they owe a fiduciary duty to clients, they might not be cognizant of the ramifications that can arise from that special relationship. Even if they inadvertently breach their fiduciary duty, advisors still face a mountain of legal, financial and regulatory consequences.
As fiduciaries, advisors owe a higher duty to their clients. A breach of his fiduciary duty is the most serious transgression an advisor can commit. According to the Center for Fiduciary Studies, lawsuits and arbitration cases relating to a breach duty are increasing at a compound rate of 22 percent per year. In addition to possible legal action, advisors also need to worry about sanctions from securities regulators.
If an advisor becomes embroiled in disputes arising from their role as fiduciaries, they will find it more difficult and expensive to obtain errors-and-omissions insurance. When clients have bad experiences with advisors, negative publicity spreads quickly. Few people will entrust their assets to someone with a sullied reputation. As a result, the advisor likely will receive fewer referrals.
Section 206 of the Investment Advisors Act of 1940 is the general antifraud provision governing investment advisors. It prohibits investment advisors from engaging in fraudulent, deceptive or manipulative conduct. To avoid violating Section 206, advisors must not engage in direct or indirect transactions that act as a fraud upon any client or prospective client. Section 206 prohibits misstatements, as well as omissions of material facts.
Conflicts of interest also must be avoided, but it's not enough to avoid them. Advisors must avoid situations that might be perceived as creating a conflict of interest, even if none exists. They must make full disclosure of fees and practices. It is imperative they document their commitment to compliance with extensive and thorough policies and procedures.
Fiduciary duty encompasses much more than just being honest and avoiding negligence. Advisors owe an affirmative duty of loyalty, which means an advisor must always put the client's interests first. This loyalty includes the following actions on behalf of the clients:
- Duty to only provide disinterested advice
- Duty to give thorough written disclosures of potential or actual conflicts of interest through the Form ADV and advisory agreement
- Duty to maintain strict confidentiality
- Duty to refrain from fraud and misconduct
The concept of fiduciary duty continues to evolve. It may include the duty to pursue class action lawsuits on behalf of clients. When voting proxies, an advisor must always act in the best interest of its clients.
In the most extreme cases, an investment advisor may face criminal charges. These prosecutions may be brought if an advisor defrauds or deceives his clients. Some common examples are misappropriation of a client's funds, lying to clients about the value of their investments or placing the advisor's interests ahead of the client's. Only the SEC has the authority to seek civil sanctions against an advisor. The most serious violations of securities laws are prosecuted by the Justice Department.
The good news is that an effective and thorough compliance program can help advisors avoid a breach of fiduciary duty. Rule 206(4)-7 under the Investment Advisors Act requires SEC-registered advisors to implement and audit their policies and procedures. Compliance with that rule helps to ensure that advisors satisfy their fiduciary obligations.
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