Contents
Overview
Introduction
Objectives
1.0 Analysing the Relationship between a Fund Management Company and its Client
2.0 Laws Governing the Fund Management Company/Client Relationship
2.1 Principal and Agent
2.2 Investment Management Agreement
2.3 Fiduciary Duties of a Fund Management Company
2.4 Trust Law
2.5 Capital Markets and Services Act 2007
3.0 Ethical Considerations
3.1 Code of Ethics
3.2 Corporate Governance
4.0 Summary
Suggested Answers to Activities
Overview
Introduction
The relationship between a fund management company and its client is complex and requires careful analysis. Further, the potential for dispute between the parties is significant given the nature of the investment services provided. In the event of a dispute involving loss, the amount may be large.
In this topic we review the various taws that regulate the fund management company/client relationship. We will apply the legal principles we have learned in our examination of contract and negligent misstatement.
We will also examine the ethical considerations that may be applied to the fund management company/client relationship — including a review of a Code of Ethics that a fund management company may wish to apply to the operation of its business.
This topic should be read in conjunction with Topic 7 Conduct of a Fund Management Company’s Business and Topic 8 Compliance.
Objectives
At the end of this topic you should be able to:
• analyse and describe the legal relationship involved in a fund management company/client relationship and list the areas of law that impact that relationship
• appreciate the need for and importance of an Investment Management Agreement between a fund management company and client
• list the key provisions of such an Agreement
• describe the duties owed to a client by a fund management company and its directors and employees
• give examples of potential conflicts of interest likely to be experienced in a fund management company’s daily business dealings involving clients
• list the key requirements under the Capital Markets and Services Act 2007 (CMSA) that impact the fund management company/client relationship
• appreciate the value, and list the important elements, of a Code of Ethics that may be applied to a fund management company’s business in Malaysia.
1.0 Analysing the Relationship between a Fund Management Company and its Client
The relationship between a fund management company and its client is a complex one and a number of areas of law are involved:
• The fund management company acts as the agent of the client. The general Law governing the relationship between principal and agent therefore applies.
• The Investment Management Agreement between the fund management company and a client is a contract. The basic principles of contract law have been covered in topic The Law of Contract.
• The fund management company’s actions in managing a client’s portfolio must not be negligent. We look at the law of negligent misstatement in topic Negligent Misstatement.
• The fund management company owes certain duties to its client in its role as a fiduciary. The fiduciary duties of a fund management company are also relevant to the relationship.
• The fund management company may hold monies or property on behalf of its client. If so, the law of trusts applies to this element of the fund management company/client relationship.
• Statutory laws, such as the Capital Markets and Services Act 2007 (CMSA), also impact upon the relationship between fund management companies and client. The impact of the CMSA on a fund management company’s relationship with its client is described in several topics. Other relevant laws that may affect the relationship are )described in Topic 2.
In addition, the requirements of frontline regulators and professional and industry associations may be relevant to the relationship between fund management companies and client. Finally, each fund management company should apply its own standards of corporate governance and ethical principles to the relationship it has with its client.
The fund management company’s compliance function ensures that these requirements and obligations are properly met.
2.0 Laws Governing the Fund Management Company/Client Relationship
2.1 Principal and Agent
The basic legal relationship enshrined within the Investment Management Agreement made between a fund management company and its client is that of principal (the client) and agent (the fund management company).
When appointed as the fund management company by its client, the fund management company acts as the client’s agent when investing the client’s funds. It is for this reason that the fund management company is not responsible for investment losses made by a client. In discharging its duties as a fund management company, it is obliged to exercise a certain level of care. If it is negligent in its actions, the client may have a claim under the tort of negligence.
In carrying out its function, a fund management company uses stockbrokers and other intermediaries to complete transactions. In doing so a fund management company is acting as agent for the client and the charges made by the intermediaries are payable by or borne by the client.
Care must be taken to ensure that, under the Investment Management Agreement defining the arrangement between the fund management company and client, the fund management company is the agent of the client and that other intermediaries, such as a stockbroker or custodian, are also agents of the client. Ideally, such intermediaries should not be regarded as agents of the fund management company since the fund management company could be liable to the client for any acts or defaults of the intermediary.
Where a fund management company acts outside its authority, the fund management company is in breach of the Investment Management Agreement, and the fund management company may be liable for the consequences of the breach.
Liability of a Fund Management Company
A fund management company will be liable for losses caused by agents if the fund management company has failed to discharge its professional responsibility in relation to the appointment and monitoring of these agents. This is because one of the roles of a fund management company is to select and monitor the agents (such as brokers and custodians) it uses for its client’s business. A fund management company has a duty to act with due care and diligence in selecting and monitoring all agents as part of its duty of care to its client. Consequently, failure to choose agents with care which then results in a loss to a client may cause the fund management company to be liable to the client for that loss.
An example of the duty of a fund management company to act with due care and vigilance in selecting and monitoring an agent is that of the nomination of brokers through whom securities transactions on behalf of a client are made. A fund management company should select the brokers whose services it utilises on the basis of a proper evaluation of their services, for example, the broker’s ability to secure best execution of orders and its research capability. The financial risk to the client of default by a broker may be reduced by using agents with appropriate financial resources or backing. A fund management company is generally in a better
position than its client to monitor market awareness of changes in the financial condition of agents.
Careful selection and monitoring of agents does not guarantee that acts or default of an agent will not cause a loss to a client. The terms of an Investment Management Agreement (see below) may deem a fund management company to be responsible for the negligence, default, fraud or dishonesty of an agent that is under the control and supervision of the fund management company, even if the fund management company has selected and monitored the agent with reasonable care. A client would then be indemnified by the fund management company for losses incurred as a result of the negligence, default, fraud or dishonesty of such an agent.
Mistakes of an Agent
Where an agent makes a mistake or an error in, say, dealing or settlement instructions for a trade in securities and suffers a loss as a result, the fund management company is not legally liable for the loss. The fund management company would generally act quickly to resolve the issue with the broker or custodian to minimise the effect of any loss. Any claim for loss would be at the client’s risk although the leverage over the agent that could be obtained by the fund management company could result in the client obtaining restitution for its losses.
Indemnity from a Client
An- agent, such as a fund management company, is entitled to be indemnified against losses, liabilities and expenses incurred by it in the proper performance of its duties on behalf of a client. A loss incurred by a fund management company acting within the scope of its authority to perform its duties should be indemnified by the client (assuming the agent is not itself at fault). An Investment Management Agreement should generally contain an indemnity ensuring that the fund management company is ‘not responsible for normal investment losses, matters beyond its control and defaults of brokers, agents and intermediaries that are not under its direct control and supervision’.
Similarly, if an agent acts outside its authority, the client would not generally be responsible.
The law of principal and agent is part of contract law and is governed 15y Part X of the Contracts Act 1950 (Revised 1974). A contract of agency is formed by the agreement of the principal and the agent. The agreement can be express (stated orally or in writing) or implied (unsaid or unwritten, but taken for granted). Given the nature of the services provided by a fund management company to a client, it would be highly unusual not to have a written agreement between the parties. This agreement is known as the Investment Management Agreement. The rights and duties of each party to the contract of agency depend upon the agreement reached between them.
2.2 Investment Management Agreement
The Investment Management Agreement typically sets out the terms upon which the client appoints the fund management company as its agent for the purpose of managing an investment portfolio. As a contract it is therefore subject to contract law. We examined contract law in topic The Law of Contract.
As the Investment Management Agreement is the key to many aspects of a fund management company’s business, we will review the contents of a typical Agreement as part of Topic 7.
2.3 Fiduciary Duties of a Fund Management Company
A fiduciary is a person who controls property on behalf of others. Hence a fiduciary relationship exists between a fund management company and its client. The fund management company is in a position of trust in relation to the client in its rote as agent acting for its principal. The fiduciary relationship toward the client extends to the directors and to the employees of the fund management company.
A fund management company (and its directors and employees) therefore owes various duties to its client including:
• a duty of loyalty
• a duty to act in good faith
• a duty to avoid conflicts of interest.
Fund management companies usually act for several investor clients at the same time/Consequently, a particular investment opportunity that is limited in availability (e.g. a new issue or a discrepancy in the market price of a thinly traded security) may need to be handled carefully to avoid an accusation by a client that the fund management company failed to act in utmost good faith toward it. Through the markets a client may be transacting with another client under the advice of the same fund management company. Where such transactions are negotiated off-market between two clients of the same fund management company there is a risk of conflict of interest which may, if unrecognised, give rise to a high risk of breach of fiduciary obligations. The duty to disclose to each client the basis of such a transaction allows transactions subject to a conflict of interest to
proceed.
The duty to avoid a conflict of interest is particularly important in the context of a fund management company. A fund management company who transacts client business through an intermediary such as a stockbroker owned by the fund management company or who will receive a share of commission as a result of that transaction, for example, should declare that transactions may be placed with related parties and ensure that the terms of such transactions are at arms length. Fund management companies and their staff are also frequently offered preferential allocations by stockbrokers in new issues.
Another aspect of the duty to avoid a conflict of interest relates to the receipt of bribes or secret commissions to, for example, place shares in particular client portfolios. A share allocation offered to a fund management company for its clients should not be taken up by the fund management company as principal (or by its staff) since this would also be a conflict of interest. Similarly, a fund management company should not compete with the clients for which it acts.
We examine specific conflicts, and describe how a fund management company should handle them, in topic Conduct of Fund Management Company’s Business.
Question / Activity 1
Johnny Chin, a representative at a leading fund management company, is responsible for the management of the RM150 million investment portfolio of the pension fund of International Traders Bhd., a large trading company with offices and warehouses throughout SE Asia. Johnny has heard informally that the trustees of the fund are considering the appointment of a replacement fund management company following a period of under-performance of the portfolio for which he has sole responsibility.
Johnny has been employed by the fund management company since leaving university and has been advised that he could soon be appointed a director of the company. He is concerned that the loss of International Trader’s account will result in him losing the directorship opportunity.
To boost the performance of International Traders’ pension fund portfolio he decides to place the share transactions of all his clients through one broker in the expectation that he will receive a much greater allocation of share in Dynamic Growth Bhd., a highly sought after IPO. Johnny proposes to nominate all the shares allocated to him (expected to be worth approximately RM 7.5 million on listing) to the International Trader’s pension fund in an effort to boost the fund’s performance. The broker has also agreed to provide Johnny with a new research service to help him in his stock selection. Only International Traders’ pension fund is able to invest in the type of investments covered by the research service.
Comment on Johnny Chin’s proposed action.
Answer:
Johnny has a fiduciary duty to each one of his clients. He cannot favour one client over another and must act in the best interests of each. As a fiduciary he must also avoid a conflict of interest between his (or his employers) own interests and those of his clients.
Johnny’s proposal is clearly intended to favour one client over his other clients by allotting the IPO entitlement ‘derived’ from the securities transactions of several clients. He should devise a logical and transparent means of equitably dividing any IPO allocation among all his clients.
By allocating all the transactions of each client to one broker, Johnny is unlikely to be acting in the best interests of his clients (and may be acting negligently). Not all his clients will benefit from the research service provided by the broker so Johnny is again favouring one client over others.
Johnny has a clear duty to avoid a conflict of interest. The sole purpose of his arrangement with the broker is to boost his chances of a directorship and to retain the International Traders’ account for his employer.
By increasing the risk profile of International Traders pension fund (the investment in Dynamic Growth Bhd. is likely to represent a substantial part of its portfolio following listing), Johnny does not appear to be acting in good faith towards his client (and again may be acting negligently).
2.4 Trust Law
Where a fund management company holds monies and property of a client in trust accounts, it acts as a trustee in relation to those assets.
The Trustee Act 1949 applies to the acts of a trustee. Generally, this will be the case since the authorised investments under the Act are very restrictive.
Under the Trustee Act, trustees are restricted to investing in a range of defined authorised investments. The list of authorised investments (in s.4 and 5) includes:
• securities issued by Federal Government or the Government of the State of Sabah or the State of Sarawak or of the Republic of Singapore
• securities the interest on which is or shall be guaranteed by Parliament or by the Federal Government
• titles to immovable property in Malaysia (within specified limits)
• fixed interest securities issued in Malaysia with the approval of the Treasury by any public authority established under federal or State law
• loans to an approved company
• loans the principal and interest on which is or shall be guaranteed by the Federal Government
• securities issued by a company where:
(a) the paid-up ordinary share capital is RM5 million or more
(b) in each of the three years preceding the investment, the company has paid a dividend on its fully paid-up share (in s.4(2)(b)).
• approved unit trust schemes.
Section 6(1) describes the investment powers of the trustee and requires a trustee to have regard for:
(a) the need for diversification of trust investments. The trustee is required to take into account the trust’s circumstances and the degree of risk attaching to each investment or group of investments
(b) the suitability of proposed investments.
Section 6(2) requires a trustee to obtain proper written advice in relation to the proposed investments to ensure that the requirements of s.6(1) are met. (The Public Trustee and trust companies are exempt from this requirement). Proper advice (to be obtained from a stockbroker or authorised accountant) in relation to the investments is also required on an on-going basis.
2.5 Capital Markets and Services Act 2007
The CMSA regulates the conduct of everyone engaged in the securities and derivatives industry. Fund management companies must therefore comply with various requirements under the CMSA.
summary:
• s.89 – 107 provides for the conduct of business of licensed persons in general as well as specific conduct of licensed persons dealing in securities and dealing in derivatives.
• s.109 – 124 regulates the treatment of clients assets in respect of securities, derivatives and fund management
• s. 174 – 209 relates to various market misconduct and other prohibited conduct such as false trading and market rigging, the making of false and misleading statements, insider trading, bucketing etc
3.0 Ethical Considerations
3.1 Code of Ethics
The Malaysian Association of Asset Managers (MAAM) has undertaken various initiatives to promote the development and standard of business conduct of Malaysia’s asset management industry. One in particular is its revision of a Code of Conduct for its members in 2001.
MAAM’s Code of Conduct outlines the best practices expected to be observed by its members.
Objective
The principal areas covered by MAAM’s Code of Conduct are:
• Compliance with laws and regulations
• Risk management
• Management of conflict of interests
• Safeguarding clients’ interests
• Duty to exercise due care and skill
Compliance with Securities Laws and Regulations
A Code should require that members strictly observe all laws and regulations that relate to the conduct of their business. In this course we examine many of these Laws and regulations ranging from capital market laws to business rules of the exchanges, and to taxation law. Members should be required to be cooperative with regulators, and should not knowingly become involved in the breach of laws and regulations that affect their businesses.
Question / Activity 2
Ahmad, a representative of a fund management company, becomes aware that a colleague’s superior investment performance is in part the result of trading in shares of a particular company through a broker who is related to the chairman of the company. The colleague, who is also a representative, suggests that Ahmad should purchase for clients shares in the company because she has seen the draft announcement of the company’s year end results and they are ‘much better than the market expects’.
What should Ahmad do?
Answer:
Ahmad is aware that a breach of the law relating to insider trading (s.183 CMSA) will take place should shares in the company be purchased. Ahmad should not purchase the shares and should report the position to the regulatory authority.
Professional Misconduct
A Code generally requires that members of a professional body should observe higher standards from those laid down in laws and regulations affecting behaviour in the securities industry. Breaches of laws in areas not relevant to the industry but which could bring disrepute upon the professional body may be penalised by exclusion or suspension from membership of that body.
Question 3 / Activity 3
Richel works for a fund management company but has a half-interest in a pirate CD duplication business which is highly profitable. He gives all the profits to which he is entitled to a charitable foundation (a client of his employer) for which he acts as portfolio manager.
Is Richel’s action appropriate?
Answer:
Richel’s ownership of the pirate CD duplication business is inappropriate for someone in the position of a professional portfolio manager. The fact that all of the profits he makes are donated to chanty is not relevant. He should ensure that his employer is aware of his other business activities in case a conflict of interest should arise.
Competition with a Representative’s Employer
A Code will generally include reference to various situations faced by a fund management company’s representative which relate to competition with the representative’s employer. In general terms, an employee has a duty of loyalty to the employer and therefore a Code provides guidance beyond an employee’s legal position.
An employee should not compete with his or her employer without obtaining the prior written consent of the employer and the employee’s prospective client. In the funds management industry it is quite common for an employee to consider the formation of a rival funds management business while continuing to be employed. The employee should ensure that he or she does not do anything (prior to resignation) that may conflict with the duty owed to the employer. Such activities may include duplication of software, research or client lists; negotiating with the employer’s clients to appoint the employee to manage their funds; causing fellow employees to resign and subsequently join with the employee in the new business; or appropriating the employers business ideas.
Question 4 / Activity 4
Abdul is a representative for KK Fund Managers Bhd., a leading investment management company. KK Fund Managers manages a range of portfolios on behalf of clients, including pension and provident funds, unit trusts and private client portfolios. The unit trust for which Abdul is the portfolio manager is the top performing unit trust in Malaysia over 5 years. A wealthy unitholder in the trust asks Abdul to manage her personal portfolio for her for which she is willing to provide Abdul with use of her country house at Mt. Kinabalu for several weeks each year. Abdul proposes to work on the portfolio only outside office hours so as not to interfere with the management of the unit trust.
Should Abdul accept the offer?
Answer:
Abdul should not, without receiving the written consent of his employer, accept the offer as to do so would compete with his employer’s business which includes the management of private client portfolios. The fact that no cash remuneration is received is not relevant since Abdul will receive a benefit of accommodation.
Neither is the fact that Abdul proposes to manage the portfolio ‘outside offices hours’. Abdul should ensure that the client is aware that he proposes to continue working for KK Fund Managers and should obtain her written consent to this.
Conflicts of Interest with a Representative’s Employer
While conflicts of interest in relation to a representative’s actions are generally considered only in the context of a conflict with clients interests, it is common for a Code to also require disclosure of conflicts of interest (and potential conflicts of interest) between a fund management company’s representative and his or her employer. As the circumstances of a conflict or a potential conflict of interest are sometimes difficult to identify, it is usual for a Code to require sufficient information to be reported to the employer such that the employer is able to identify and assess the impact of the conflict. In this way, the employer cam ensure that the interests of the clients of the fund management company can be put before those of the fund management company.
A Code may therefore require a representative to disclose to his or her employer all matters, including beneficial ownership of investments that could affect the employee’s duty to the employer, or the employee’s liability to make unbiased and objective recommendations to clients.
Question / Activity 5
Fatimah is a representative with Johor Bahru Investment Management Bhd. which specialises in the management of pension and provident portfolios. Fatimah has been asked to accept appointment as a director of her family investment company which has an investment portfolio of RM120 million. The portfolio is currently managed with advice from another fund management company.
What steps should Fatimah take before accepting her appointment?
Answer:
Fatinnah’s appointment is likely to take up considerable time which may affect her existing client responsibilities and her duty to her employer. Her appointment is clearly intended to take advantage of her skills and experience in investment management and to assess the investment advice received from the competitor funds management company.
She is likely to be involved in discussions with the investment adviser and her views, and those of her employer, are likely to be transmitted to her employer’s competitor. Fatimah has the potential for a conflict of interest and she should therefore discuss the proposal with the directors of the funds management company by whom she is employed.
The directors would also consider the problems that may arise should the firm’s clients learn that Fatimah may be working closely with a rival funds management company. Fatimah should also ensure that the family investment company’s adviser is aware of her employment with its competitor.
Disclosure of Benefits from Clients
A Code will normally require that a fund management company’s representative disclose to the employer any direct or indirect benefits that they receive over and above the benefits derived from the employer. Non-disclosure of such benefits could affect the employee’s duty of loyalty, his or her objectivity in client dealings, and create potential conflicts of interest. Disclosure in written form discourages the use of any non-cash benefits (i.e. benefits in kind).
Question 6 / Activity 6
Richard is a representative responsible for the Malaysian-invested investment portfolios of clients of Australian Fund Managers Limited, a Sydney-based fund management company. Australian Fund Managers pays Richard’s employer a fee based on the level of funds under management.
The Managing Director of Australian Fund Managers offers to provide Richard and his family with an all expenses paid trip to Sydney if client portfolios outperform the FBM KLCI over a 12 month period.
What should Richard do?
Answer:
Richard should inform his employer (in writing) of the offer of a trip to Sydney. The offer could affect Richard’s ability to handle other accounts he has responsibility for.
It may cause Richard to give preference to clients of Australian Fund Managers Limited. It may also cause Richard to take undue risks with portfolios in an attempt to earn the ‘all expenses paid’ trip to Sydney. This may not be in the best interests of either his employer or the clients.
Reasonable Basis for Investment Recommendations and Actions
A Code will generally require that a fund management company’s representative will act professionally in relation to a client’s investment portfolio. Hence, a representative should be diligent and thorough when making investment recommendations. This means the representative should have a reasonable basis for an investment recommendation before the decision is put to, or actioned on behalf of, a client. Further, the representative should have proper documentation to record the basis of each recommendation and decision.
Research, upon which recommendations and investment decisions are made, may be internal or external. However, a fund management company’s representative is responsible for reviewing such research to ensure that it is reasonable before acting upon it. If he or she believes the research to be based on inaccurate information, the representative should not follow the recommendation.
Question 7 / Activity 7
Chris is a specialist in the discretionary management of aggressive growth portfolios, on behalf of private clients. Disillusioned with the short term prospects of Malaysian equities, he decides to invest in overseas stockmarkets. Chris believes the prospects of capital growth in such markets are superior to those of the local market.
Is Chris’ decision to invest overseas justified?
Answer:
Chris needs to determine whether his clients are prepared to accept the change in investment strategy to meet their investment objective. He should ensure that his clients are conversant with the additional risks he is taking – in particular, currency.
Chris should inform his clients of the many other factors relevant to a decision to invest overseas such as exchange control, tax considerations, market and regulatory differences, custody issues, etc. He should advise them in writing of these differences (and retain records of his research into those differences) before obtaining the clients’ written approval to vary the investment strategy in this way.
Independence and Objectivity in Investment Recommendations and Actions
A Code will generally require a fund management company’s representative to maintain independence and objectivity in making investment recommendations and actions. A representative’s decisions should be made without conflicts of interest or other factors that may influence the representative’s judgement, and such situations should be avoided wherever possible.
A funds management company’s representative is likely to be subject to pressure from many different directions – brokers and other service providers, clients and the representative’s employer – to influence his or her judgement. A broker may provide cash or perks to encourage a representative to transact through that broker;
a client may provide supplementary compensation to encourage preferential attention to a portfolio; and an employer or an associate, such as an investment bank, may encourage investment in the ‘shares of companies for whom the bank is acting as corporate finance adviser.
Generally, a Code will allow a representative to retain gifts of a minor value. However, beyond a specified limit, a Code will usually require gifts and other benefits to be disclosed to the employer. It is then up to the employer to decide if acceptance of the gift or other benefit is likely to prejudice the representative’s independence and objectivity.
Question 8 / Activity 8
Simi, representative of a fund management company is invited to visit the overseas factories of Malaysia Pacific Manufacturing Bhd. (MPM) which is listed on Bursa Securities. Simi is accompanied on the visit by employees of several other fund management companies. All the expenses of the visit (amounting to approximately RM20,000 per person) are paid by MPM.
At the conclusion of the visit, Simi is given a selection of the company’s products valued at RM1,000. Following his return to work, Simi decides to buy MPM shares for all his client portfolios.
You are required to advise Simi.
Answer:
Simi must be careful that his objectivity has not been jeopardised by the visit. His visit appears to have been a normal MPM procedure and he was accompanied by members of staff of several other fund management companies, i.e. Simi did not receive preferential treatment. The trip did not include excessive ‘free’ time. Simi should have support for his purchases of MPM shares based on the findings from his visits. Clients should therefore perceive that Simi’s objectivity has not been compromised by the visit.
The gift provided by the company is excessive in value and cannot be justified as ‘samples’ of the company’s products to aid Sinni’s research. Simi should consider returning them. He should certainly disclose the receipt of the products to his employer, who may then direct Simi to return them to the company. Retention of the products may give cause for suggestions that the decision to buy MPM shares was not made objectively and was influenced by the receipt of the products.
Fiduciary Responsibility
A representative of a fund management company owes a fiduciary duty to his or her client. It would be normal for a Code to reinforce this aspect of a representative’s activities by requiring a representative to act for the benefit of clients and to place the interests of those clients before their own interests.
‘Know your Client’
In managing a client’s portfolio it is clearly vital for a representative to be familiar with a client’s financial position, investment experience and investment objectives before considering the suitability of a particular investment for inclusion in that client’s portfolio. A requirement that a representative consider the needs and circumstances of the client, the characteristics of the investment to be included in a client portfolio, and the characteristics of the total portfolio would usually be included within a Code.
Question 9 / Activity 9
Siti, a representative of a fund management company, is responsible for the portfolio of two private clients.
Client A, aged 60, has a portfolio of RM1 million and is retired with an income of RM100,000. Client B, aged 28, has inherited a portfolio of RM200,000. She is single and has recently completed her university education although she is currently unemployed.
Client A has advised Siti that his portfolio should be invested to maximise capital
growth whereas Client B requests a more conservative approach that will produce an income from which she can live prior to establishing her career.
Siti’s research department is recommending purchase of shares in a company with a high current dividend yield.
Should Siti purchase shares in the company for Client A, Client B or both clients?
Answer:
Client A’s portfolio, while being capital growth oriented, could nevertheless include investments which produce a high yield. It may be that the price of shares in the company could rise as investors are attracted to the yield, thereby producing capital growth. The effect on the current yield of the total portfolio of introducing the high yielding share may be minimal. Nevertheless, the prior approval of Client A should be obtained since the additional income may have implications for the client’s taxation position.
Client B’s portfolio could include the investment to boost the yield on the total portfolio. However, Siti should ensure that the additional income generated is not at the expense of increased risk of capital loss, for example following a cut to the company’s future dividend payment. Siti should, on a regular basis, monitor the client’s personal circumstances since these are likely to change (as the client obtains employment, changes marital status, etc.) and her investment objectives are varied.
Fair Dealing and Equity between Clients
A Code will often require a fund manager’s representative to treat all clients fairly when, for example, portfolios are varied in response to changes in ‘investment recommendations or allocations of new issues are made. The objective of this element of a Code is to maintain the investing public’s confidence in the funds management industry.
A fund management company’s duty of fairness and loyalty to clients can be evidenced by disclosure to clients as to how, for example, new issues are allocated amongst clients. A fund management company should take care that preferential allotments of new issues are not made to favoured clients, to staff, or to the fund management company itself. Transactions in securities ahead of client transactions – a conflict with the fund management company’s duty to its clients – should not be made.
Question 10 / Activity 10
Employees of a fund management company, Sabah Fund Managers Bhd. are not allowed to hold personal investments but are able to invest in a unit trust established by the company. Only employees are able to purchase units.
The performance of the unit trust is excellent and over all periods to 10 years, the trust’s performance exceeds all publicly available unit trusts by a large margin. Analysis of the trust’s investment performance indicates that the trust buys and sells shares on the basis of the company’s investment recommendations a day before those recommendations are made available to the company’s clients (or acted upon where the client portfolio is managed on a discretionary basis). The unit trust also receives preferential allotments of new issues, especially where the company’s allotment in a new issue is so small as to be uneconomic to allocate across the company’s clients.
Is the in-house unit trust operated in the best interests of the company’s clients?
Answer:
While the fund management company’s decision to restrict the personal share dealings of its employees is in the interests of clients by removing the potential for conflicts of interest, the method of compensating employees is likely to cause a breach of the fair dealing aspect of a Code.
The unit trust is not publicly available and entry is restricted to employees. Further, the unit trust’s portfolio is given preference over all client portfolios in terms of access to the company’s investment recommendations. All clients should be given equal access to the company’s investment recommendations following which the unit trust can invest. A potential conflict of interest exists between the employees of the company and the clients of the company since preference is given to the unit trust when investment recommendations are disseminated.
In relation to the preferential allotment of a new issue where a very small number of shares are available, the company’s solution is fair in that a basis to satisfy all clients with an allotment of an economic quantity of shares cannot be made, but the solution to allocate the allotment to employees (through the unit trust) gives unreasonable preference to employees over clients. Perhaps a fairer solution would be to return the allocation to the issuer or sponsoring broker or to allocate the allotment to a client charity.
Misrepresentation of Capabilities
A Code may incorporate a requirement that fund management companies and their representatives not misrepresent their services, qualifications, experience and capabilities to clients in an attempt to obtain or retain investment mandates.
Misrepresentation could be verbal (i.e. through client presentations) or.written (i.e. in reports to clients, in advertisements, or in performance reporting).
Misrepresentation in the form of ‘guaranteed returns or returns based on past performance would be in breach of this aspect of a Code.
Disclosure of Conflicts
A Code would generally incorporate a requirement that a fund management company and a representative should disclose to clients and prospective clients any matters that could potentially affect their ability to make objective investment recommendations. Full disclosure of all actual and potential conflicts of interest, including personal shareholdings, should allow a client or potential client to assess the objectivity of any investment advice offered to the client.
Conflicts of interest may include personal shareholdings (especially if such holdings are material to the representative), financial relationships with associates of the fund management company (e.g. a broker or investment bank), common directorships, etc.
Question 11/ Activity 11
Josephine is a representative employed by Malaysian Asset Management Bhd. Josephine’s remuneration includes a bonus should the investment performance of clients’ portfolios’ exceed specified levels. The bonus would, if achieved, represent a significant portion of Josephine’s total remuneration and was introduced by her employer in an attempt to elicit recovery from a period of under performance of client portfolios.
In her attempt to improve performance, Josephine uses the services of a broker who encourages a high level of transactions but whose research is well above average. The broker is owned equally by an associate of Malaysian Asset Management Bhd. and by a company owned by Josephine’s father.
One of Josephine’s clients acknowledges the better short term returns but notes the much higher turnover of shares in his portfolio. He asks Josephine why there has been an increase in turnover.
How should Josephine answer the client’s question?
Answer:
Josephine (or her employer) should previously have disclosed to clients the basis of its employees’ remuneration and the recently made change. This would provide a warning to clients of the potential for toss of objectivity in relation to the management of their portfolios. Josephine’s use of the broker whose research is ‘well above average is justified but it may not be in the interests of every client to ‘buy’ this research through excessive levels of trading activity.
The fact that the broker is an associate of Malaysian Asset Management Bhd. should also be disclosed to the clients of the company since this represents a potential conflict of interest. Similarly, Josephine’s clients should be aware of her father’s interest in the broker. All disclosures should be in writing and receipt confirmed by each of Josephine’s clients.
3.2 Corporate Governance
In Topic 9, we examine the influence that fund management companies worldwide are having on the companies in which they invest. The principles of good corporate governance identified by fund management companies as applicable .to the companies in which they invest can be — and should be — applied to the manner in which a fund management company’s own business is managed (albeit adjusted to reflect the smaller scale of most fund management companies businesses).
4.0 Summary
In this topic we have reviewed the important elements of the relationship between a fund management company and its client. These elements incorporate both legal and ethical considerations.
We will examine the practical implications of some of the duties owed to clients of a fund management company, identified in this topic, in Topic Conduct of a Fund Management Company’s Business (7).
In the next topic we will examine the licensing requirements relating to fund management companies and those who are employed by such companies.