Financial management requires expertise. Many investors, both individuals and organizations, may lack the expertise or the time and resources to manage their investments. Therefore, they engage expert advisers to perform the service. With the advisers’ services came regulations to ensure that the advisers use appropriate expertise and avoid conflicts of interest with those of the clients. Thus, the law imposes on financial advisers the legal duties of (i) honesty (loyalty) and (ii) competence (care) towards their clients because many clients are unable to control, or judge, the advisers’ advice and performance.
An emerging recent issue in this area involved a client’s “investment orders.” Suppose the client begins to give specific investment orders to the adviser. Must an investment adviser unconditionally obey its client’s investment orders? Who can decide whether the client’s orders are reasonable? This question applies to similar relationships. Must a lawyer comply with their client’s orders, for example, to ask a witness certain questions, or write certain words in the proposed contract? (Under the ABA Model Rules, a lawyer must generally “abide by a client’s decisions concerning the objectives of representation. However, “[a] lawyer may limit the scope of the representation if the limitation is reasonable under the circumstances and the client gives informed consent.” A lawyer may generally withdraw from representing a client if “the client insists upon taking action that the lawyer considers repugnant or with which the lawyer has a fundamental disagreement.”) Should a physician comply with all its patients’ demands, for example to give the patient more of certain prescriptions? (The AMA Code of Medical Ethics recognizes the right of a patient “[t]o make decisions about the care the physician recommends and to have those decisions respected” and the right of a patient with capacity to “accept or refuse any recommended medical intervention.” Physicians generally have broad discretion to withdraw from the patient-physician relationship. The Code requires only that the physician (a) “[n]otify the patient (or authorized decision maker) long enough in advance to permit the patient to secure another physician” and (b) “[f]acilitate transfer of care when appropriate.”)
The following story is about an investment adviser that did not follow the client’s orders to cease certain investments, at a cost of $4,978,448 to the client. The Securities and Exchange Commission (SEC) got involved, resulting in the investment adviser’s settlement for a significant payment to the client and other conditions, described below. Here are the details of the case.
KCM, a registered investment adviser, managed CIT corporation’s finances. Kornitzer, KCM’s president, CEO, and majority owner, repeatedly failed to follow CIT’s instructions to reduce the high concentrations of is investments in securities of Company A. As CIT’s financial manager, KCM began buying Company A’s securities in 2011 and, as of December 2015, Company A’s investments rose to 89% of CIT’s assets. From 2016 to 2018 CIT’s board members repeatedly requested KCM to reduce concentration levels in Company A securities to 10%, to cause CIT to follow its new 2016 investment policies, and to prepare a specific plan to do so. After all, “dumping” the entire holding on the market in one or a few sales would cause the securities prices to fall significantly. KCM did not provide a liquidation plan on the specified date but told CIT’s board in February 2016 that it would reduce the concentrations of Company A’s securities investment to 10% of CIT’s portfolio, within 12 to 18 months. Yet, KCM failed to do so until, in August 2018, a plan was finally put in place, to bring the concentration levels into compliance as of December 31, 2018. KCM’s failures to follow CIT’s directions and investment policies caused CIT serious losses after Company A’s stock price dropped significantly in 2018. Consequently, the SEC held that KCM violated the Advisers Act of 1940, and Kornitzer violated Section 206(2) of the Advisers Act and caused KCM’s violation of Section 206(4) of the Advisers Act, and Rule 206(4)-7 hereunder.
The SEC and KCM entered into a very detailed agreement concerning KCM’s’ payments to CIT and left the door open for the SEC supervision of their timely performance. For example, the SEC:
- Accepted KCM’s offers to pay the client—CIT—$4,978,448.
- Required KCM and Kornitzer to pay, joint and severally, a civil money penalty of $2,700,000.
- Ordered KCM and Kornitzer to cease and desist from committing or causing any violations and any future violations of Section 206(2) and Section 206(4) of the Advisers Act and Rule 206(4)-7.
- Censured both KCM and Kornitzer, negatively affecting them in future engagements.
- Required KCM and Kornitzer to pay disgorgement, prejudgment interest, and a civil money penalty as mentioned above. Thus, KCM was required to pay the remaining disgorgement amount of $846,316 and prejudgment interest of $80,679.
- These obligations were assured by the creation of a Fair Fund into which the money specified in these financial obligations was to be deposited by certain specified dates. (“Amounts ordered to be paid as civil money penalties pursuant to this Order shall be treated as penalties paid to the government for all purposes, including all tax purposes.”)
- Within 150 days after KCM and others mentioned in the order fully complete the distribution of all the required sums, they had to submit to the Commission staff a final accounting and certification of the disposition of the Fair Fund (mentioned above) for Commission approval, which final accounting and certification shall be in a format to be provided by the Commission staff. The final accounting and certification included, but was not limited to:
(1) The amount paid to each Distribution Recipient, with reasonable interest amount, if any, reported separately; (2) The date of each payment; (3) The check number or other identifier of money transferred; (4) The amount of any returned payment and the date received; (5) A description of any effort to locate a prospective Distribution Recipient whose payment was returned or to whom payment was not made for any reason; (6) the total amount, if any, to be forwarded to the Commission for transfer to the United States Treasury; and (7) an affirmation that KCM and Kornitzer have made appropriate payments from the Fair Fund to affected investors.
Finally, the SEC required KCM, the adviser, to agree not to make certain arguments of entitlement to offer or reduction of compensatory damages and to notify the Securities and Exchange Commission of any related investors’ actions and imposed or agreed-upon penalties. They self-limited their defenses.
Conclusion
The SEC’s decision in this case seems justifiable. The clients’ losses were significant and continuous. The demand to sell Company A’s securities seems reasonable, and the adviser’s resistance to the sale raises the suspicion of conflict of interest. One wonders whether the adviser had an interest in Company A, which interest conflicted with the interests of its clients. However, a general rule that allows or encourages clients to interfere with an investment adviser’s judgment and services may pose problems, just as the patient’s resistance to the physician’s advice would, or the client’s interference in a witness cross-examination of his or her lawyers could.
After all, we need experts, of expertise we are incapable of acquiring. Experts are regulated and supervised to ensure committed and qualified service. If a client continues to interfere in the expert’s work, the quality of the service and the client’s interests might suffer. This is not a fixed balance and depends on the parties’ personalities and relationships. But the division is clear: If we hire an expert, we have to give the expert an opportunity to perform without much interruption.
When is a client’s interference in the expert’s actions justified? Perhaps the answer is: when the client’s demands are reasonable, as in the reported case, and after yielding to the clients’ demands, the advisers do not keep their promise. Then, a suspicion of the adviser’s conflicting interests. or its lack of care, arises and raising the issue with the SEC may be appropriate.
