Standard III: Duties to Clients
Standard III consists of five subsections:

• III-A: Loyalty, Prudence, and Care
• III-B: Fair Dealing
• III-C: Suitability
• III-D: Performance Presentation
• III-E: Preservation of Confidentiality

Standard III-A: Loyalty, Prudence and Care
Members and Candidates have a duty of loyalty to their clients and must act with reasonable care and exercise prudent judgment. Members and Candidates must act for the benefit of their clients and place their clients' interests before their employer's or their own interests. In relationships with clients, Members and Candidates must determine applicable fiduciary duty and must comply with such duty to persons and interests to whom it is owed.

Reasoning behind Standard III-A
A fiduciary is an individual or institution that has established a relationship of trust and confidence with an individual or a group (the clients or beneficiaries). The concept of fiduciary duty is a legal one and applies to a number of professions, most notably to lawyers, whose responsibility in providing legal counsel and attending to the personal affairs of clients has led to a number of federal, state and local statutes governing a lawyer's unique responsibility. For investment managers, the trust that clients place in them in managing their retirement accounts, college savings and other financial assets has lent itself to creating standards of fiduciary duty, and has also prompted legislation that specifies the requirements they must meet as fiduciaries in a position of trust.

Standard III-A reminds CFA Members and Candidates of this duty and requires them to comply with these guidelines. In addition to the legal requirements of fiduciaries, it also captures a two-part ethical code that must be followed if behavior is to be consistent with this Standard (e.g. "act for the benefit of their clients", "place clients' interests before their own").

Ethics problems on the CFA exam are usually case-study oriented, and the cases involving fiduciary duty can be exceedingly complex. Keep in mind that the CFA exam is not the bar exam - don't get bogged down memorizing a bunch of laws, as you're not likely to be tested on the details of the laws. For a case study, a good way to determine whether fiduciary duty was breached is to ask the two questions specifically addressed in the Standard:

1. Is this person acting in the best interests of clients?

2. Is this person placing clients' interests before his or her own?

These are simple guidelines to remember and a "no" answer to either question will indicate a potential violation.

Four Important Characteristics of Fiduciary Duty to Remember

1. The duty required exceeds what is expected in other business relationships. For example, in relations with a major supplier or an advertising firm hired to market the company, one is not expected to provide undivided loyalty to the other party, or to place its best interests before those of one's employer (or oneself). But customers trust investment managers, and in return managers owe them this duty.
   
2. In the case of a pension plan or trust, the duty is owed to the beneficiaries. The trustee or entity that hires the manager is not the same as the client.
   
3. The duty is heightened when the manager has custody of the assets.
   
4. The duty is specifically determined and detailed by governing documents - for example, the investment management agreement. Actions must follow all facets and provisions of the signed agreements.

The "Prudent Man" or "Prudent Person" Rule
Most states have enacted legislation that governs the activities of fiduciaries, specifically those responsible for private trusts. All of this legislation is designed to give the lawyers of beneficiaries (should they wish to file a lawsuit against the fiduciary) a legal standard, to which actual conduct can be compared. The standard is known as the "prudent man rule".

When originally enacted decades ago, prudent man statutes were used to require trustees to manage assets primarily to avoid excessive risk and preserve the value of the trust. Various asset classes were specified as acceptable (low-risk choices such as T-bills, certificates of deposit and savings bonds), while stocks, corporate debt and all other securities were automatically "imprudent". While these rules did address some types of risk, such as market risk, the stringent guidelines did not provide for purchasing power risk, i.e. the loss of value due to inflation.

As the rules have evolved, the use of modern portfolio theory (MPT) has helped broaden the guidelines. MPT directs portfolio managers to consider a portfolio's risk and return as a whole, given the fact that risky assets, when combined together, can reduce total risk in a portfolio as a result of the low correlation between the individual assets. To be sure, certain speculative investments - for example, untested IPOs and direct purchases of real estate - tend to be considered improper and to remain on a plan trustee's restricted list. But the courts have been allowing fiduciaries to invest in accordance with an updated set of guidelines known as the "prudent investor rule".

Some of the requirements set out by this rule include the following:

1. A fiduciary should exercise loyalty, prudence and objectivity in making recommendations.
   
2. Risk and return objectives should be reasonable, suitable to the trust and the central concern of the fiduciary. An asset allocation plan must balance competing interests: a) those of current beneficiaries, with their income requirements, and b) those of the remaining or later beneficiaries, who don't draw benefits now but who require preservation of the principal and long-term growth in real terms. A fiduciary is required to remain impartial between these two groups.
   
3. A fiduciary should diversify the portfolio in a manner consistent with MPT. In this view, the manager is not restricted from investing in specific asset classes, provided they offer the risk, return and low correlation characteristics required in the trust.
   
4. A fiduciary should delegate authority in a prudent manner to appropriate experts. For example, if 20% of a trust is to be allocated to foreign investments, a fiduciary is permitted to hire a specialist for this portion of the portfolio. In the past, fiduciaries were rarely permitted to outsource.
   
5. A fiduciary should recognize the impact of transaction and trading costs and only incur costs that are reasonable and appropriate. This last rule requires managers, for example, to compare brokerage commissions and work to reduce expenses that can (in some cases) have a material impact on trusts.
   
6. A fiduciary should recognize the potentially significant impact of taxes on performance returns and consult with an accountant and/or tax attorney to properly plan strategies that reduce the impact of taxes.

Employee Retirement Income Security Act of 1974 (ERISA)
ERISA governs all qualified (tax-exempt) private employee-benefit pension plans in the United States and is thus an important set of specific principles to guide fiduciaries as they carry out their duties. ERISA laws are complex, and as indicated earlier, the CFA exam is not likely to rigorously test the details of laws such as ERISA, as those details are more the domain of legal experts. CFA Members and Candidates need to understand what is specifically expected of them as a result of ERISA if they are to act in a fiduciary capacity. ERISA defines a fiduciary as anyone who has discretionary control over the management of a covered plan, either directly or indirectly (e.g. someone who does research and provides investment recommendations for a pension plan would be considered a fiduciary).

Under ERISA, trustees and plan sponsors cannot delegate their fiduciary duties - i.e. a trustee or sponsor remains liable in a lawsuit that charges a violation. However, a trustee can delegate the investment management responsibilities (in a prudent selection process), provided the manager acknowledges the duties he or she is assuming under the ERISA rules, and the trustee sets appropriate benchmarks and monitors and reviews performance. 

ERISA requirements:

• Fiduciaries must act solely in the best interests of plan participants and beneficiaries.
• Fiduciaries must act in accordance with governing documents (e.g. investment management agreement), as long as these documents are consistent with ERISA.
• Fiduciaries must follow the prudent expert rule: "Act with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims." Under the prudent expert rule, the fiduciary must be as prudent as the average expert, not the average person.
• Fiduciaries must diversify the plan's investments in order to avoid substantial losses that could occur as a result of one company's misfortune. A significant issue with pension plan management today is the excessive use of company stock in the plan - on the one hand, ERISA specifies that diversification techniques be adopted to reduce risk, while on the other hand, companies have long used their company pension plan as a destination for stock shares.
• Fiduciaries must not engage in any prohibited transactions, which include:
  • Self-Dealing - The trade is done in the self-interest of the manager and his or her personal securities.
  • Conflict of Interest - The trade is done on behalf of an outside party whose interests are not consistent with those of the plan's beneficiaries.
  • Kickbacks - The trade is done to earn additional compensation or bonuses for the plan manager.

While not specifically covered under the ERISA umbrella, investment managers (separate accounts, mutual funds) owe a similar fiduciary duty to these clients (and mutual fund holders). Registered investment advisors are obligated to follow the guidelines of the U.S. Investment Advisors Act of 1940, which prohibits the following activities:

• Any device or scheme designed to defraud a client or prospective client
• Any transaction or course of business that may operate in a fraudulent or deceitful manner
• Recommending a transaction, whether as a principal or an agent, without first disclosing and receiving consent

Broker/dealers are held to a higher standard of care than the average person, though this standard is not specifically identified as a fiduciary duty. The shingle theory is a legal precedent being used by U.S. courts to govern the activities of broker/dealers in a position to act as a fiduciary. This theory holds that once a broker/dealer "hangs out a shingle" (i.e. holds himself or herself out as capable of providing brokerage services to clients), this person is implying that he or she has the capabilities to perform the same duties as an investment professional. Since a broker/dealer is assuming a relationship characterized by trust and is in a position to exploit a customer's lack of knowledge or sophistication, he or she must thus be held to a higher standard of care. Inherent in the shingle theory is the notion of treating the customer fairly.

Applying Standard III-A

• Proxy Voting -Shareholders have the ultimate authority, through exercising voting rights, to direct how a publicly-traded organization is to be managed. Since many investment management agreements delegate this authority to the manager, the institutional manager who oversees a large number of accounts may have significant power in the corporate governance process.
  
  • Actively exercising this right can not only promote higher standards for corporations (given that entrenched management teams can no longer take proxy votes for granted), but also ultimately increase portfolio value, as the proxy vote reinforces the fact that companies must be managed in the best interests of shareholders.
    
  • Historically, managers have paid little attention to voting their proxies, mostly because they are primarily interested in factors such as company fundamentals or the price pattern on a stock. Moreover, when disenchanted with management, they would rather cast a vote their own way, by selling the stock (and buying another with better management), rather than go through the proxy voting process.

ERISA
Enacting ERISA into law has helped change the standard by requiring appropriate corporate governance procedures and requiring those acting as fiduciaries to establish working proxy voting guidelines. The U.S. Department of Labor (which decides ERISA-related issues) regards proxy voting as an "integral" part of managing a pension plan covered by ERISA standards.

As these standards have taken hold, there has been a push (particularly by the CFA Institute) to carry over the same guiding principles regarding proxy voting to non-ERISA accounts - in other words, to promote the practice of voting proxies as an established industry standard and ethical practice. For those managers who have had proxy voting denied to them by clients, it is a fiduciary responsibility to follow ERISA guidelines and enact a proxy voting process, which should adhere to minimum standards:

• All votes must be cast (yes, no or abstain).
• Votes must consider the issue and its impact on beneficiaries.
• Blindly voting with management guidance is a violation.
• There must be additional scrutiny for non-routine or unusual proposals.
• Records must be maintained.

Soft Dollars
This refers to an agreement between a broker/dealer's trading function and an investment manager, where brokerages offer to provide certain products and services (pay soft dollars) to the investment manager in exchange for the manager directing trades to the broker.

• Using a broker to purchase research in this manner is a practice susceptible to conflicts of interest - particularly if the broker's trade commissions are costing clients an additional premium (compared to commissions available from competing brokers).
  
• On the one hand, the fiduciary duty owed to the client requires the portfolio manager to reduce trading costs as it is in the client's best interests.
  
• On the other hand, the research provided with soft dollars can enhance the investment decision-making process (which directly benefits the client), and since money is saved by buying research products with soft dollars, client fees can be kept lower.

This debate on soft-dollar standards came before the U.S. Congress in 1975, which created a safe harbor under Section 28(e) of the Securities and Exchange Act of 1934, protecting managers from charges that they were in breach of fiduciary duty when using higher commissions to pay for research. Since that time, the number of products and services providing research has skyrocketed. At this point, precisely what constitutes an acceptable use of soft dollars is a confusing issue.

To comply with Standard III-A, governing fiduciary duty guidelines for soft-dollar standards should include the following:

• The nature of the soft-dollar arrangement must be disclosed to clients. Clients may only see the higher trading commissions, and they need to understand that those commissions are helping to pay for research products and are thus indirectly helping portfolio performance.
  
• Goods and services bought with soft dollars must be research related, directly assisting the decision-making process. Third-party research reports or databases of company accounting data are considered acceptable uses of soft dollars. Paying for office furniture is a violation.
  
• When paying up for higher trading commissions, the additional premium must be reasonable when related to the products and services being acquired.
  
• The manager absolutely must continue to seek best price and executionfor trades under his or her discretion, and must not simply direct all trades to the broker providing the soft dollars.

Social Investing
The practice of social investing, or managing a portfolio with a view toward the social or political statements it is making, gained particular attention in the 1980s, as worldwide pressure built to end the South African apartheid system. Activists involved in the movement highlighted the multinational companies that effectively condoned apartheid by continuing to do business in that country. In response to these activists, socially conscious investors asked their broker or manager to restrict the purchase of companies doing business in South Africa. As the practice of social investing developed, investors could promote their personal views against cigarettes, alcohol, gambling, oil drilling, pornography and dozens of other issues by restricting purchase of those firms engaged in those practices. In the crowded universe of mutual funds, certain managers have been able to distinguish themselves by promoting their social consciousness. Public pension funds often have activist beneficiaries who attempt to pressure managers to use social screening.

If you are interested in how you can avoid unethical investments in your mutual funds, while still profiting, see Socially Responsible Mutual Funds.

Does a fiduciary's duty of prudence carry over to social investing? ERISA guidelines on social investing specifically require the fiduciary to make conclusions based not on social or political considerations, but rather on investment merit. Specific criteria include the assessment of risk/return parameters of the security, the need to diversify a portfolio according to modern portfolio theory and the duty to be conscious of trading costs and other types of costs to the client. Social factors can play a secondary or incidental role, but they should not be a primary reason for buying a particular security.

Another social investing technique is known as "relationship investing", the practice of buying a firm with the intent of influencing management by attending company meetings and placing issues on the proxy ballot. Relationship investing is allowable under ERISA standards, provided that these techniques are primarily seen in the context of enhancing shareholder value by promoting corporate governance.

How to Comply
The preceding discussion of fiduciary duty is intended as a summary of the main issues most likely to appear on a CFA Level I exam, not as a comprehensive view of the complete array of duties owed by a fiduciary bound by ERISA guidelines. A number of books, seminars and other forms of analysis have been dedicated to this topic.

To ensure compliance with Standard III-A and to avoid a violation, CFA Members and Candidates should start by thoroughly knowing and understanding the content of all governing documents to which they are bound in their relationships with clients. Given the duty to loyalty required by this Standard, are there any particular restrictions or unique characteristics that are not fully understood? Legal advice should be sought for unclear guidelines.

When in custodial control of client assets, the following procedures are suggested (per the Standards of Practice Handbook):

• Audit the firm at least once a year.
• Produce a quarterly statement for each client, indicating funds and securities in that account and itemized transactions during the period.
• Make full disclosure as to where the assets are maintained, and where and when they are moved.
• Separate assets so that each client's holdings can be distinguished.

To comply with soft-dollar standards, a fiduciary needs to ask three questions to determine whether soft dollars can be used and what percentage of the cost can be allocated:

1. Does this product provide investment research?

2. Will the information it provides contribute to the research process of this organization?

3. Will any portion of this product go for uses not directly involved in the investment research process?

For investment managers, an internal policies and procedures guide should observe the following rules:

• All applicable laws, rules and regulations must be followed.
• Potential conflict of interest arrangements (additional compensation, outside directorships) are required disclosures.
• Investment objectives for each client must be initially established and reviewed at least annually and as circumstances warrant.
• Asset diversification should be practiced as a risk reduction tool, except in cases where specific guidelines and objectives preclude it.
• Fairness and objectivity should be practiced with all clients, with no explicit favoritism toward one client or group.
• A process for vote proxies should be established with clients' best interests in mind; individual responsibilities for voting should be determined; and records should be maintained.
• Best execution on trades should be practiced. In other words, under the particular circumstances in place (i.e. what is reasonably available), what is the broker that provides the lowest total cost to the client? "Cost" refers not only to trading commissions but also to costs related to poorly executed trades (buying at prices that are higher and selling at prices that are lower than what was available from competitors).
• Duty of loyalty to clients, as a company policy, is top priority.