Incentive Dictates Behavior: The Fiduciary Failure at Its Core

J.P. Morgan, the too-big-to-fail bank, has admitted the violation of its fiduciary duties to clients as so required when offering investment advice in the capacity of a registered investment adviser.  The general objective of the Investment Advisers Act of 1940 is “to protect the public and investors against malpractices by persons paid for advising others about securities.”¹

According to the J.P Morgan website², one of the four core business principles is “A Commitment to Integrity, Fairness and Responsibility”.  The website states (with comments added):

“In business, as in every other arena, ethical behavior does not just happen. It has to be cultivated and repeatedly affirmed throughout the organization. At JPMorgan Chase, acting with integrity is paramount– and it applies to every aspect of our company. Maintaining the highest standards of integrity involves faithfully meeting our commitments to all our constituents – customers, employees, the Board, shareholders, regulators – and to ourselves.” (The interests of these stakeholders can be conflicted.)

Further, under the Governance section of the J.P. Morgan website, it publishes the Code of Ethics for Finance Professionals³:

• “Engage in and promote ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships and disclose to the Office of the Secretary any material transaction or relationship that reasonably could be expected to give rise to such a conflict.
• Carry out your responsibilities honestly, in good faith and with integrity, due care and diligence, exercising at all times the best independent judgment (understandably this is a lower standard than in the client’s best interest.)
• Assist in the production of full, fair, accurate, timely and understandable disclosure in reports and documents that the firm and its subsidiaries file with, or submit to, the Securities and Exchange Commission and other regulators and in other public communications made by the firm.
• Comply with applicable government laws, rules and regulations of federal, state and local governments and other appropriate regulatory agencies.
• Promptly report (anonymously, if you wish to do so) to the Audit Committee of the Board of Directors any violation of this Code of Ethics or any other matters that would compromise the integrity of the firm’s financial statements. You may contact the Audit Committee by mail, by phone, or by e-mail; contact information is set forth below.
• Never to take, directly or indirectly, any action to coerce, manipulate, mislead or fraudulently influence the firm’s independent auditors in the performance of their audit or review of the firm’s financial statements.”

J.P. Morgan Admits Fiduciary Violations

After two years of investigation, on December 18, 2015, the Securities and Exchange Commission (SEC) announced in its Press Release 2015-283⁴ that two J.P. Morgan wealth management subsidiaries have agreed to pay $267 million and admit wrongdoing to settle charges that they failed to disclose conflicts of interest to clients.  Contemporaneously, the U.S. Commodity Futures Trading Commission (CFTC) issued Press Release 7297-15⁵ summarizing the requirement for J.P. Morgan to pay a $40 million civil monetary penalty, to pay disgorgement in the amount of $60 million, and to cease and desist from further violations for its failure to disclose certain conflicts of interest to clients of its U.S.-based wealth management business.

The SEC found that J.P. Morgan willfully violated the Prohibitive Transaction Sections 206(2), 206(4)ⁱ and Fraudulent Interstate Transactions Section 207ⁱⁱ of the Investment Advisers Act of 1940 and Rule 206(4)-7 and Sections 17(a)(2) and 17(a)(3)ⁱⁱⁱ of the Securities Act of 1933.  At the same time, CFTC found that J.P. Morgan failed to fully disclose its preference for investing its client funds in certain hedge funds and mutual funds managed and operated by an affiliate and subsidiary of JP Morgan. Also, J.P. Morgan failed to disclose its preference for investing its clients’ funds in third-party-managed hedge funds, each a commodity pool or exempt pool, that shared management and/or performance fees with an affiliate.  Neil Weinberg at Bloomberg⁶ reported with details regarding these violations.

Through J.P. Morgan’s admission to SEC and CFTC charges, it is clear that the bank has failed to meet its published Business Principal and the Code of Ethics.  Was this a failure of oversight, a few bad actors, a momentary lapse in judgement, or is it something else more permanent, systemic and pervasive?

RIA Fiduciary Standard

The violations can be summarized by one word – CONFLICT.  J.P. Morgan, when offering investment advice to retail clients as a registered investment adviser, must act in the best interest of its clients.  On its website⁷, the SEC states that as a registered investment adviser (with emphasis added):

1. You are a “fiduciary” to your advisory clients – you have a fundamental obligation to act in the best interests of your clients and to provide investment advice in your clients’ best interests.
2. You owe your clients a duty of undivided loyalty and utmost good faith – you should not engage in any activity in conflict with the interest of any client, and you should take steps reasonably necessary to fulfill your obligations.
3. You must employ reasonable care to avoid misleading clients and you must provide full and fair disclosure of all material facts to your clients and prospective clients. Generally, facts are “material” if a reasonable investor would consider them to be important. You must eliminate, or at least disclose, all conflicts of interest that might incline you — consciously or unconsciously — to render advice that is not disinterested.
4. If you do not avoid a conflict of interest that could impact the impartiality of your advice, you must make full and frank disclosure of the conflict.
5. You cannot use your clients’ assets for your own benefit or the benefit of other clients, at least without client consent.

Why Leave Change On the Table

Let’s use an analogy to illustrate what has transpired.  A licensed dietitian (e.g. JP Morgan) is in the profession of designing individualized healthy, nutritious, client specific therapeutic meal plans in meeting their specific health objectives for a fee.  Clients rely on the dietitian’s reasoned analysis, informed judgement, experience, education and objectivity in delivering advice and formulating solutions.  The same dietitian happens to own a group of restaurants (e.g. JP Morgan private bank, asset management, and wealth management services) that cater to clients who are looking to implement the dietary and nutritional guidance for healthy living.  Client dietary needs can be satisfied in a number of ways and via different venues but almost all clients are referred to the dietitian-owned restaurants to purchase their meals and implement their meal plan.  Further, the dietitian has entered into favorable financial reciprocity arrangements (e.g. investment revenue sharing) with other restaurants and food packagers (e.g. non J.P. Morgan proprietary investments) in locations where the dietitian does not own restaurants or provides certain food that are not available through or produced by the dietitian.  On a percentage basis, these non-proprietary locations compensate the dietitian for every unit of food sold to referred clients.  This means that the dietitian is compensated by 1) the fee charged for advice, 2) profit from the food sold in proprietary restaurants, 3) the increasing value of the restaurant chain and 4) the referral fee paid by other restaurants.

The dietitian and staff defend their preferences for recommending proprietary restaurants and restaurant locations where favorable financial arrangement is in place.  The reason cited is that the dietitian knows how each proverbial “sausage” is made in these establishments and they strictly adhere to the dietitian’s standards and methodology consistently.  The dietitian’s staff is naturally comfortable with the arrangement since they are trained and provided ongoing information regarding proprietary food sourcing, preparation, cooking process and message consistency throughout all establishments (e.g. JP Morgan advisers know a lot more about their proprietary asset management process than investments from other asset managers or banks such as Vanguard and Wells Fargo).  The staff is taught to value this consistency, transparency, ready access to information, accessibility to chefs and food preparers, and the consistent standard.  However, they often neglect or purposefully fail to disclose the self-serving financial incentives, and conflicts.

The staff is seldom exposed to the same level of training and communication regarding non-proprietary products, methodologies and standards.  Is the staff made up of professional advisers or sales people blurring the line between advice and promotion?  More recently, the dietitian is looking to expand into fitness to complete his vision of promoting holistic health.  With a steady pipeline of clients and revenue, he is rebranding his company into a global health enterprise to include vitamin supplements, exercise equipment, sportswear, sports drinks and whole health resorts.  Now that there is a “distribution system” with a steady stream of new and repeating clients, there is no end to his expansion and cross-selling.  The old sales management adage comes into mind here: never leave any change on the table.

J.P. Morgan charges a portfolio management fee or wrap fee on an asset basis for delivering wealth and investment management advice and services⁸.  The adviser employee and all those associated in managing, constructing, administrating and reporting the client portfolio are all indoctrinated by the J.P. Morgan way or message.  These are full-time professionals employed by J.P. Morgan to attract and retain clients for asset and wealth management.  They are loyal to and believe in J.P. Morgan and are inundated to all things J.P. Morgan. What should we, the public, expect from this monolithic, albeit well intentioned, lot when implementation of advice is required?  They cannot see beyond their own walled garden. How should the regulators expect the best interest standard from these firms when they are brainwashed to believe they are the only and the best?  It is human nature to use and advocate the familiar.

This conflict is present even before any financial incentives are put in place to reward those same employees for putting their clients into proprietary wrap accounts using proprietary investments (sounds like brokers).  Even if there is no direct incentive or reward for promoting this double dipping arrangement, it is without question that J.P. Morgan is enriched by this conflict.  Not unlike other financial institutions that have developed or acquired complementing businesses and services to feed off the same client base, when there is one revenue source it is good but a second revenue from the same source is that much better.  To meaningfully restore and support the fiduciary standard, multiple financial incentives on every level must be removed.  Department of Labor’s (DOL) current proposed fiduciary rule includes the disclosure of all compensation paid to affiliate and parent companies to bring such multiple incentives out into the open.  The front line advisers may think that they are serving in the best interest of the client all the while their companies truncated their objectivity and best interest through limiting and conflicting solutions that are financially favorable to the companies.

How does J.P. Morgan meet the SEC fiduciary standard of undivided loyalty and utmost good faith to its advisory clients and not be in conflict when J.P. Morgan must at the same time fulfill its corporate fiduciary duty of maximizing shareholder value to its owners?  When an organization is so vast and complicated with tentacles in many business and many sides of a transaction, conflict is the norm.  However, in the fiduciary business, there is only one truth – undivided loyalty.

More Rules

The Securities and Exchange Commission under Mary Jo White announced in late November this year⁹ that the Commission intends to propose a new rule for a uniform fiduciary standard of conduct for broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers.  After five long years of wait-and-see, it is not clear if the SEC’s decision to put this matter on its priority list for late 2016 is a reaction to the proposed DOL Conflict of Interest Rule for Retirement Investment Advice.  I suspect that the final rule would either weaken or dilute the current fiduciary standard (to some this is the same as an abolishment) or make patches that do not absolutely remove the culprit – financial incentives.

What Have We Learned

J.P. Morgan has failed to disclose its conflicts to clients when offering investment advice and management services as an RIA.  Under the SEC fiduciary standard, an RIA must place the interest of clients above all else at all times.  When a conflict is present or arises, the RIA has a duty to fully disclose if it cannot be eliminated.  Based on this standard, J.P. Morgan should be able to continue the current double dipping arrangement through disclosure and to continue its defense for the elegance of favoring its proprietary products all in the best interest of clients.

A “full and frank disclosure of material conflict” is required by the SEC, and to engage in and “promote ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships” is part of J.P. Morgan’s ethics code.  J.P. Morgan’s blatant failure to disclose suggests that the organization recognizes that disclosure of the double dipping arrangement could be harmful to its business.  I suggest that J.P. Morgan has nothing to worry about.  Trust is a curious thing; once granted it is seldom questioned.  Once clients place their trust and confidence in J.P. Morgan, the disclosure of conflict, such as the double dipping approach to wealth management, would be nothing more than another paragraph in a document that the client receives.  J.P. Morgan can just carry on with its conflict; except this time it is legal.  I prefer the current DOL standard of requiring advisers to act SOLELY in the best interest of the client.  ERISA uses exemptions to deal with conflict of interest instead of relying on disclosures.  I hope that the sole interest standard will not be diluted by the new proposed rule.

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1. S. Rep. No. 1760, 86th Cong., 2d Sess. 1 (1960)
2. https://www.jpmorganchase.com/corporate/About-JPMC/ab-business-principles-integrity.htm
3. https://www.jpmorganchase.com/corporate/About-JPMC/ab-code-of-ethics.htm
4. http://www.sec.gov/news/pressrelease/2015-283.html
5. http://www.cftc.gov/PressRoom/PressReleases/pr7297-15
6. http://www.bloomberg.com/news/articles/2015-12-18/jpmorgan-pays-267-million-to-settle-conflict-of-interest-claims
7. https://www.sec.gov/divisions/investment/advoverview.htm
8. http://www.adviserinfo.sec.gov/iapd/content/viewform/adv/Sections/iapd_Adv2Brochures.aspx?ORG_PK=79&RGLTR_PK=50000&STATE_CD=&FLNG_PK=0461273C0008018103FB227005B4EF0D056C8CC0
9. http://www.reginfo.gov/ublic/do/eAgendaViewRule?pubId=201510&RIN=3235-AL27

1. Prohibitive Transaction – (https://www.sec.gov/about/laws/iaa40.pdf)
   SEC. 206. It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly –
   (2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client; and
   (4) to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative.
2. Material Misstatement – (https://www.sec.gov/about/laws/iaa40.pdf)
   SEC. 207. It shall be unlawful for any person willfully to make any untrue statement of a material fact in any registration application or report filed with the Commission under section 203 or 204, or willfully to omit to state in any such application or report any material fact which is required to be stated therein.
3. (https://www.sec.gov/about/laws/sa33.pdf)SEC. 17. (a) It shall be unlawful for any person in the offer or sale of any securities (including security-based swaps) or any security-based swap agreement (as defined in section 3(a)(78) of the Securities
   Exchange Act) by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly—
   (2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading;  and
   (3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.