Module 3

Question 1

What are soft dollars?

Answer 1

Soft dollars are like airline frequent flyer miles: when an investment adviser
selects a broker-dealer to effect a securities transaction and pays (with its clients’
assets) a brokerage fee to the broker-dealer, the broker-dealer may agree to
provide research (and, sometimes, other benefits) to the adviser.

The adviser is, in effect, using the clients’ assets to obtain a benefit for itself.
(This is unlike frequent flyer miles, which inure to the benefit of the traveller whose
purchase of the airline ticket generated the frequent flier miles. In effect, the travel
agent is keeping the frequent flyer miles for itself.)

Question 2

What aspects describe Fiduciary Duty?

Answer 2

Fiduciary duty is a standard of care, and is a higher standard of care than is usually the case in business relationship.

As a fiduciary, an adviser must act in the “best interests” of its clients.

Question 3

Identify conflicts of interest that investment advisers face.

Answer 3

Conflicts of interest may take many shapes and forms (most frequently, conflicts of
interest are financial in nature.)

Examples include:
1. Scalping (aka “trading ahead’), as in the Capital Gains case
2. Advising the client to invest in a company controlled by the investment
adviser, or in which the adviser has a significant financial interest.

An investment adviser with two or more clients may have conflicts of interest,
even if the adviser makes no investments on its own behalf, by favoring one
client (or a group of clients) over another client (or a group of clients).
The investment adviser owes a duty of loyalty to each client. The adviser must
act in each client’s best interests.

Question 4

Describe how conflicts of interest can result in breaches of fiduciary duty and antifraud violations.

Answer 4

For a breach of fiduciary duty to violate Section 206, the adviser must defraud the
client or take actions that operate as a fraud on the client.

(1) to employ any device, scheme, or artifice to defraud any client or prospective
client;
(2) to engage in any transaction, practice, or course of business which operates as
a fraud or deceit upon any client or prospective client;

If an adviser has a conflict of interest, and the adviser fully and fairly discloses
that conflict to its client, and obtains the client’s informed consent to the
conflicted transaction, there is no fraud and thus no violation of Section 206 (1) or
(2).

Question 5

Describe how investment advisers may avoid violating the antifraud provisions of the IAA when they face conflict of interest situations.

Answer 5

If an adviser has a conflict of interest, and the adviser fully and fairly discloses
that conflict to its client, and obtains the client’s informed consent to the
conflicted transaction, there is no fraud and thus no violation of Section 206 (1) or
(2).

Make full disclosure to the client(s) of the existence, nature and extent of the
conflict (before entering into the conflicted transaction or arrangement)
AND
Obtain the clients’ consent to the conflicted transaction (again, before entering
into the conflicted transaction or arrangement)

In almost all SEC enforcement actions involving investment advisers with conflicts
of interest, the investment adviser failed to disclose its conflict of interest to its
client(s).

Consent must be “informed” consent (i.e., consent is provided after full
disclosure).
Consent can be express or implied.
Whether consent can be implied depends upon the factual circumstance.

Question 6

Describe the duty of care that investment advisers owe to their clients.

Answer 6

The duty of care includes:

1. Duty to provide investment advice that is in the client’s best interest,
   including a duty to provide suitable advice
2. Duty to seek best execution of a client’s transactions (when the adviser has
   the responsibility to select broker-dealers to execute client trades).

Goal: so that the client’s total cost or proceeds in each transaction are the most
favorable under the circumstances.

3. Duty to provide investment advice and monitoring over the course of the
   relationship.

Question 7

Describe how investment advisers may avoid violating the antifraud provisions of the IAA when duty of care issues arise.

Answer 7

1. Don’t overpromise.
2. Do what you say you will do.
3. Act in the client’s best interests.
4. Give suitable investment advice, after making a reasonable inquiry into the
   client’s objectives, and avoid basing your advice on materially inaccurate or
   incomplete information.
5. Seek best execution of clients’ trades.
6. However, if you will NOT comply with the duty of care in any respect, then
   fully disclose what you will do – and what you won’t do – and obtain your
   clients’ consent (express or implied) to your proposed conduct.

Question 8

Describe to whom the fiduciary duty is owed.

Answer 8

Advisers owe a fiduciary duty to their clients.
But who is an adviser’s client?
The Advisers Act contains no definition of client.
The client is the person or entity with which/whom the adviser has entered into an
advisory relationship, typically by entering into an investment advisory agreement.
There need not be a written agreement. (The IAA contains no requirement that
advisory contracts be reduced to writing.)

Exception: If an investment adviser to a private fund has a separate advisory
relationship with an investor in that fund, the adviser owes that investor a fiduciary
duty. SEC v. Lauer.

Question 9

Describe the duty of loyalty that investment advisers owe to their clients.

Answer 9

“The Investment Advisers Act of 1940 thus reflects … a congressional intent to
eliminate, or at least expose, all conflicts of interest which might incline an
investment adviser –consciously or unconsciously – to render advice which was
not disinterested.” SEC v. Capital Gains.

Question 10

What is the Form ADV for?

Answer 10

Must disclose soft dollar practices to clients. Form ADV includes certain soft dollar
disclosure requirements.

“Does the applicant . . . have any arrangements . . . where it . . . is paid cash by or
receives some economic benefit (including commissions, equipment or
non-research services) from a non-client in connection with giving advice to
clients?”

IAs also must disclose the factors they employ in selecting brokers and
determining the reasonableness of their commissions. If the value of
products, research and services provided by a broker is a factor, then the IA must
describe those products, research and services.

Question 11

The analysis of whether a particular product or service falls within the safe harbor involves what three steps?

Answer 11

1. determine whether the products or services offered by the broker-dealer
   constitute eligible brokerage and research under Section 28(e).
2. determine whether those services provide lawful and appropriate assistance in
   the performance of his or her investment decision-making responsibilities.
   3.make a good faith determination that the amount of commission paid is
   reasonable in light of the value of products and services that are obtained from the
   broker-dealer.