CFA Level 1

Ethics and Standards - Standard III-A: Loyalty, Prudence And Care

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
Standard III (A) reminds CFA members and candidates that client interests come first. Because a money manager typically has superior investment knowledge, the client/manager relationship is unequal and presumes a level of client trust. Investment professionals must therefore ensure that a client's portfolio is managed with the same care and good sense that they might apply if their own money were at risk. Identify the Client
It sounds easy enough, but identifying the client who is owed your loyalty is not always so clear-cut. For example, the trustee of an employee pension plan may hire an investment manager to buy common shares of the company's stock to thwart a takeover bid, but that may disadvantage the true clients of the pension fund; that is, its plan participants and beneficiaries. Likewise, in the case of a family trust, the client(s) are probably the beneficiaries of the trust, not the individual who hired the investment manager.

Develop the Client's Portfolio
Money managers must work with the client to establish appropriate goals, expectations, and risk levels. This means developing an investment policy centered on the client's best, long-term objectives. Particular care should be taken to disclose potential conflicts of interests, such as selling your own firm's products. All decisions should consider the client's total portfolio.

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. The manager absolutely must continue to seek best price and execution for trades under his or her discretion, and must not simply direct all trades to the broker providing the soft dollars. The member or candidate must disclose to the client in those instances where directed brokerage may not be providing the best execution at the best price.

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.

Part of a Member's or Candidate's duty of loyalty includes voting proxies when they have an economic benefit to their client.

Being careful and loyal does not, however, exempt a member or candidate from transactions and whether members place client interests ahead of their own. Some examples might be similar to the ones below:

(1) Identifying the Client – The portfolio manager of a global financial services mutual fund runs into a friend at an industry event. His friend mentions that her new client is invested in the portfolio manager's fund and therefore the two of them now share responsibility for her new client. Under standard III(A), this is incorrect. The portfolio manager's duty is to uphold the investment guidelines for his mutual fund with objectivity and independence, while his friend's duty is to be loyal to her new client.

(2) Brokerage Arrangements – A small, independent investment advisor manages the pension funds of several companies. One of her brokers is about to win several new client accounts. The advisor expects to manage and trade these accounts exclusively through that broker. To induce the broker to send more new accounts her way, the investment advisor directs trades for all her current clients to that broker, without their knowledge. The advisor violated standard III(A) by not seeking best practice and best execution on all trades. Additionally, the standard was violated because the advisor did not disclose how trades were directed.

(3) Excessive Trading – A CFA charterholder manages money for several high-net-worth families. A major part of his compensation comes in the form of fees based on trading volume. He trades excessively for his accounts, but all the trades made are appropriate and suitable assets for the clients. The manager has violated standard III(A) because he is using the assets of his clients to benefit himself.

How to Comply
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.
Ethics problems on the CFA exam are usually case-study oriented. Keep in mind that many cases involve violations of more than one standard. A good way to determine whether standard III(A) was breached is to ask yourself the following questions:

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.


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