Chapter 5: Ethical Practices and Obligations - G. Prudent Investor Standard of Care Flashcards
Uniform Prudent Investor Act
The Uniform Prudent Investor Act sets a standard of care for investment advisers managing funds over which they exercise discretionary control. The Act states that advisers will take into account the character of the account and client, and make decisions regarding trustee assets based on what a prudent investor would do. This paradigm calls for caution, care, and control, as well as skill, strategy, and self-control on the part of the financial adviser.
Prudent Man Rule
The Prudent Man Rule is a guide for fiduciaries to act prudently, that is to exercise the same skill, care, and diligence as a prudent person under similar circumstances. This standard applies to the activities of investment advisers. The rule’s definition is as follows: ”to observe how persons of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.”
Being prudent in investment decisions, as well as always addressing the needs of the beneficiary, is key to maintaining an appropriate portfolio. Prudent man rules are determined by the state in which the fiduciary is operating.
Investment Adviser as Trustee Issues
In the role of trustee, an investment adviser faces a multiplicity of potential issues while acting as the fiduciary to the client. A list of those factors would include
- Prudent allocation of portfolio assets;
- Management of risk versus return;
- Management of tax considerations;
- Controlling trust expenses; and
- Dissolution of trust and distribution of assets.
An adviser must take into account the responsibilities inherent in managing a trustee’s account prior to entering into an investment advisory contract to assure compliance with contract provisions stated in the Investment Advisers Act of 1940. Trustees must also ensure that a system of checks and audits is in place to protect the trust from fraudulent activities and potential conflicts of interest.
Agency cross trades
Agency cross trades and principal trades present a potential conflict of interest for investment advisers. In an agency cross trade, the adviser brokers the trade of a security between two of its customers. In a principal transaction, the adviser sells to a customer from inventory or buys from a customer and places the security into inventory. These trades raise suitability and churning concerns.
Because of these concerns, an investment adviser may not execute principal trades with a customer unless it has prior written consent from that customer. Also, the adviser may not perform an agency cross trade unless it discloses to both customers that it is representing both customers. In addition, each agency cross trade must be disclosed on the trade confirmation and on the customer’s account statement. The adviser may not solicit agency cross transactions, and the customer must be permitted to cancel consent for such trades at any time.
Sales and Purchases
The primary intent of the Uniform Securities Act (USA) is the prevention of fraudulent and misleading practices in the securities industry. The Uniform Securities Act covers potential fraud in the following 2 major areas:
- The sales and purchases of securities; and
- Investment advisory practices.
In accordance with the Uniform Securities Act, it is unlawful for any person, in conjunction with any offer, sale, or purchase of a security, whether directly or indirectly, to do any of the following:
- Employ any device, scheme, or artifice to defraud;
- Make an untrue statement regarding a material fact or omit a statement that is necessary to make the material fact accurate; or
- Engage in any act, practice, or course of business which operates, or would operate, as a fraud or deceit upon any person.
The language of the Uniform Securities Act is very broadly written so that any conceivable act or practice taken by a person may constitute fraud. The act lists a broad range of violations that are considered dishonest or unethical. Any person engaging in these practices is subject to penalties under the Act. As a general rule, common sense should prevail in determining whether an action would be constituted as dishonest or unethical. In addition to the NASAA Model Rules, and the statement concerning Dishonest and Unethical Business Practices of Broker/Dealers and Agents, there is also NASAA Unethical Business Practices of Investment Advisers.
Investment Adviser vs. Broker / Dealer liability
An adviser must be cautious to recommend only investments that are suitable for the client based on the client’s personal circumstances. Since a financial adviser acts in a fiduciary role to the client, the adviser and the broker/dealer can be held liable for losses that occur due to recommending investments that are unsuitable for the investor. Therefore, investment advisers must follow the prudent investor guidelines which are contained in the Uniform Prudent Investor Act (UPIA.)
