Ethics Case Study of the Week: Disclosing Subadviser Fees to Clients

By Gary Sarkissian posted 29 days ago


CFA Institute’s Code of Ethics and Standards of Professional Conduct codify the ethical guidelines for the investment profession that are critical to maintaining the integrity of capital markets and investor trust.  Members, candidates, and even firms make a commitment to uphold these standards as they help elevate ethical decision-making universally around the globe.

As investment professionals, we are certain to face important ethical decisions in our day-to-day activities.  Some scenarios we encounter will be straightforward, while others may be more complex.  No matter what circumstances we face, continuous learning remains imperative in an investment industry that continues to evolve with products undergoing innovation and a regulatory environment continuing to adapt. 

For that reason, each week we will feature a sample case from CFA Institute’s Ethics in Practice Casebook.  Each case is built upon a real-life example that may involve a regulatory matter or even a CFA Institute Professional Conduct investigation.  At the end of the case is a multiple-choice question that addresses the ethical nature of the actions taken in that case.  

This week’s case involves Standard VI(A) Disclosure of Conflicts.

Disclosing Subadviser Fees to Clients
Reeves is the CEO and founding partner of Luxor Asset Management. Reeves provides asset management and allocation services for high-net-worth individuals and a number of small institutional clients. His services include investing client funds with third-party subadvisers who have a specialty in a particular asset class. Reeves’ clients are aware of and approve Luxor’s allocation of their assets to subadvisers. The third-party subadvisers make payments to Luxor based on the total amount of a client’s assets placed or invested in certain subadviser funds. Reeves initially sought to negotiate a direct economic benefit for clients, but the subadvisers would not agree and payments were made directly to Luxor. Reeves’ actions are

A. appropriate because Reeves has disclosed the use of subadvisers.
B. inappropriate unless Reeves discloses the financial arrangement with the subadvisers to his clients.
C. appropriate if the clients receive the ultimate benefit of the subadviser payments in the form of discounted Luxor fees.
D. inappropriate because the payments are an improper referral fee.
E. none of the above.

What do you think is the correct choice?  Click the “Analysis” button below to see the analysis, and feel free to discuss in the comments below.  The completion of this case qualifies for 0.25 hour of Standards, Ethics, and Regulation (SER) credit

This case relates to conflicts of interest between an advisor and clients. CFA Institute Standard VI(A): Disclosure of Conflicts requires CFA Institute members to make full and fair disclosure of all matters that could reasonably be expected to impair their independence and objectivity or interfere with their duties to their clients. The payments by subadvisers to Luxor based on the amount of client assets that Luxor places with the subadvisers create a potential conflict of interest because it incentivizes Reeves to hire those subadvisers that pay the fee to Luxor, but who may not necessarily be the best subadvisers for his clients. Reeves could mitigate the conflict by passing on any economic benefit received from the subadvisers to his clients.

Reeves initially attempted to negotiate a direct benefit for his clients, but his proposal was rejected by the subadvisers. And it is not clear from the facts that Reeves is ultimately passing the benefit on to his clients. Even if that were the case, Reeves should disclose the source and nature of the discount to clients. Reeves has disclosed Luxor’s use of subadvisers, but it seems the financial incentive for Luxor has not been disclosed. Although referral arrangements may be acceptable with full disclosure to clients, Reeves is not referring clients to the subadvisers but hiring them directly on his clients’ behalf. Choice B is the best answer.

This case is based on a US SEC enforcement action from June 2018.

Image by Michael Gaida from Pixabay

© 2019 CFA Institute. All rights reserved. You may copy and distribute this content, without modification and for non-commercial purposes, provided you attribute the content to CFA Institute and retain this copyright notice.  This case was written as a basis for discussion and is not prescriptive of how a business situation or professional conduct matter should or should not be handled or addressed. Certain characters mentioned are fictional to facilitate discussion, and any resemblance to actual persons is coincidental.