Duty Of Loyalty

A trading error at Coldstream Peak Advisers causes a $9,000 loss in one client's account, while a separate error the same week produced a $9,000 gain in another client's account. The firm proposes to treat the two as offsetting. This approach is:

1. A.Proper, because the firm's clients collectively suffered no net economic harm from the two errorsThere is no collective client to be made whole. Obligations run to each account individually, and the fact that the totals happen to cancel is an accounting coincidence rather than a defense.
2. B.Proper, provided both affected clients are notified of the errors and the offsetting treatmentNotice does not create a right to take one client's gain. The benefited client would have to surrender money that is properly hers, and disclosure cannot authorize that transfer.
3. C.Improper, but only because the two errors occurred in the same week rather than the same trading dayTiming is irrelevant to the analysis. Netting would be equally improper if both errors occurred within the same hour, because the defect is crossing between separate client relationships.
4. D.Improper, because the harmed client must be made whole by the adviser and the other client's gain belongs to that clientThe adviser bears the cost of its own error and must restore the damaged account itself. The gain in the second account is that client's property and cannot be redirected to satisfy the adviser's obligation elsewhere.

Why: Each client account is a separate relationship, and the duty of loyalty runs to each client individually. The client harmed by an error must be made whole by the adviser, which bears the cost of its own operational failure. A windfall in an unrelated account belongs to that client and cannot be seized to fund the adviser's obligation to someone else, so netting across clients is improper regardless of how neatly the amounts match.

A partner in a general partnership secretly diverts a lucrative business opportunity that arose through the partnership's normal operations to a separate company the partner owns personally, without disclosing the opportunity to the other partners. Has this partner violated a duty owed to the partnership?

1. A.No, because partners are free to pursue any personal business opportunities separately from the partnership at any timeWrong. This opportunity arose through the partnership itself, which the duty of loyalty specifically addresses.
2. B.Yes, this is a breach of the fiduciary duty of loyalty partners owe each other, since the partner diverted a partnership opportunity for personal gain without disclosureCorrect. Secretly diverting a partnership opportunity for personal benefit breaches the fiduciary duty of loyalty partners owe each other.
3. C.No, because only a partnership's designated managing partner owes a fiduciary duty to the other partnersWrong. Fiduciary duties among general partners generally run to and from all partners, not only a designated manager.
4. D.Yes, but only because the partner's separate company happens to compete directly with the partnership's businessWrong. Direct competition is not a required element; diverting a partnership opportunity without disclosure is itself the breach.

Why: Yes. Partners in a general partnership owe each other a fiduciary duty, including a duty of loyalty, because each partner acts on behalf of, and can bind, the partnership and its co-partners. Diverting a business opportunity that arose through the partnership to a separate entity the partner personally owns, without disclosure, is a breach of that duty of loyalty, since the partner used the partnership relationship for personal gain at the partnership's expense. This is different from an arm's-length business relationship, where each party is generally free to pursue its own separate opportunities without owing the other side this kind of loyalty.

A plan fiduciary recommends that the plan invest in a DPP sponsored by a company in which he personally holds an undisclosed financial interest. Assume the investment, evaluated purely on its own merits, would otherwise have been a prudent choice for the plan. Does the fiduciary's undisclosed personal interest create a problem independent of the investment's underlying merit?

1. A.Yes -- the undisclosed personal interest breaches the separate duty of loyalty regardless of whether the investment was otherwise prudent.Correct. Loyalty and prudence are distinct duties; an undisclosed personal conflict breaches loyalty even where the investment itself would have been a prudent choice.
2. B.No -- so long as the investment would otherwise have been prudent, the fiduciary's personal financial interest is not a separate concern.Wrong. The duty of loyalty is independent of the duty of prudence; an undisclosed conflict is a problem on its own, regardless of the investment's underlying merit.
3. C.Yes, but only if the plan actually loses money on the investment.Wrong. The duty-of-loyalty breach arises from the undisclosed conflict itself, not from whether the investment ultimately performs poorly.
4. D.No, because duty-of-loyalty concerns apply only to transactions directly between the fiduciary and the plan, not to third-party sponsors he has an interest in.Wrong. A fiduciary's undisclosed financial interest in a third-party sponsor he is recommending the plan invest with is exactly the kind of conflict the duty of loyalty addresses.

Why: ERISA's duty of loyalty requires a fiduciary to act solely in the interest of participants and beneficiaries, and a fiduciary with an undisclosed personal financial stake in the outcome has a conflict that exists regardless of whether the investment, viewed in isolation, would have been prudent. The duty of loyalty and the duty of prudence are separate obligations; satisfying one does not satisfy the other, and an undisclosed conflict of interest is a breach even where the investment itself checks out on the merits.

Thackeray Grove Advisers directs client brokerage to a firm that, in exchange, pays part of Thackeray's office rent. Thackeray discloses the arrangement in detail in its Form ADV. This arrangement is:

1. A.Permissible, because the arrangement is fully and accurately disclosed in the firm's Form ADVDisclosure addresses the client's right to know about a conflict; it does not authorize spending client commission dollars on the adviser's overhead. An arrangement outside the safe harbor is improper whether or not it is described.
2. B.Permissible, because the same broker also supplies Thackeray with genuine investment researchReceiving qualifying research alongside a non-qualifying benefit does not shelter the non-qualifying part. Each item is tested on its own, and the rent portion would have to be paid with the adviser's own funds.
3. C.Outside the Section 28(e) safe harbor, because office rent is not brokerage or research assisting the investment decision-making processThe safe harbor extends only to brokerage and research services that lawfully and appropriately assist the adviser's investment decision-making. Rent is general overhead unrelated to that process, so client commissions cannot fund it regardless of disclosure.
4. D.Permissible, because the commissions Thackeray pays are reasonable in relation to the total value of everything receivedThe reasonableness-of-commissions test applies only after an item qualifies as brokerage or research. It cannot rescue a benefit that never enters the safe harbor in the first place.

Why: The Section 28(e) safe harbor reaches only brokerage and research services that provide lawful and appropriate assistance to the adviser in carrying out investment decision-making. Office rent is ordinary overhead the adviser would bear in any event, so it falls outside the safe harbor entirely. Disclosure is a necessary condition for a soft dollar arrangement but never a sufficient one, because disclosing a breach of the duty of loyalty does not convert client commissions into the adviser's own money.