Reconciling Codes of Ethics in the Handling of Client Funds

Reconciling Codes of Ethics in the Handling of Client FundsBy Kevin Carmichael MS JD LLM CPA

About the AuthorKevin Carmichael MS JD LLM CPA, is a Tax Partner with the Naples office of Salvatori Wood and Buckel, PL and is a frequent lecturer on business tax and estate planning issues. He taught business law as an adjunct professor with Florida Gulf Coast University from 2004 to 2009. He is licensed to practice before the US District Court for the Middle and Southern Districts of Florida, the US Claims Court and the US Tax Court. Mr. Carmichael is a member of the Florida Institute of Certified Public Accountants and serves on the FGCU Accounting and Tax Conference Committee which he Chaired from 2004 to 2008. He is a member of the Florida and Pennsylvania Bars. He recently served on the Board of Governors of the Florida Institute of Certified Public Accountants and Board of Directors of the Association of Graduates of he United States Air Force Academy and continues to serve as founding director and chairman of the Board of Directors of the Center for Great Apes in Wauchula Florida

Prologue Preparing to Learn about EthicsNan-in, a Japanese master during the Meiji era (1868-1912), received a university professor who came to inquire about Zen. Nan-in served tea. He poured his visitor's cup full, and then kept on pouring. The professor watched the overflow until he no longer could restrain himself. "It is overfull. No more will go in!" "Like this cup," Nan-in said, "you are full of your own opinions and speculations. How can I show you Zen unless you first empty your cup?"

The Purpose of this Speech is to provoke deep thought and discussion about Ethics from a very basic starting point with an application to some examples of Ethical Principles and Codes governing a professionals relationship to investor funds

Breaking Everything to Basics-an 18th Century Enlightenment PrincipleA rough summary of this principle is to analyze everything anewTo reduce everything back to Nature and by Reason redefine it.In this presentation we will attempt to reduce Ethics to its fundamental ( the Telos "end", "purpose", or "goal") and through reason redefine it for presentation purposesUnderstand that this is an extremely broad brush discussion

Of Ethics and ZebrasReturning to the Natural LawMale Zebras, it is said, when fighting for territory and mates in the wild will kill the stallion and any living offspring to ensure that it is their genetic line and their territory that is passed on.Are we so different from animals? We are creatures of nature after all. If one of our young is in danger we will attempt to protect it as other animals do. We create families, sacrifice for and feed our young, we acquire and desire to pass on propertyAre our Jobs, our chosen professions really anything more than a specialized form of the protection of property and ensuring its decent along genetic lines?

Can we Distinguish Humanity from other Animals If so How?Is it our ability to communicate? No. Chimpanzees and Bonobos may not be able to speak but they can communicate with humans through sign language and picture boards. Other animals can communicate as well. Is it our ability to reason or choose? No. Some animals make choices if offered them.Is it Conscience?O, Conscience, into what Abyss of fears and horrors hast thou driven me; out of which I find no way, from deep to deeper plunged. Milton, Paradise Lost, X, 842

The Science of Ethics - The Techne or the art or craft of Ethics is - the study of right and wrong; morality; good and evil; justice, virtueIt is Moral Philosophy Normative EthicsEthics consists of analyzing right and wrong and creating rules to modify and enforce socially acceptable behavior in a social grouping

The of Ethics

Normative Ethics involves Religion, Law, Custom and other inputsNone of these principles is dominant or determinative

Ethics and CustomThere is no clear line between social conduct that is indicative of custom or common manners and social conduct that conforms to a set of moral rulesMorals and customs differ between social groupings. When a thing is done again and again, it seems to proceed from a deliberate judgment of reason. Accordingly, Custom has the force of law, abolishes law and is the interpreter of law. Aquinas, Summa Theologica, I-II, 97,3Since no man has a natural authority over his fellow, and force creates no right, we must conclude that conventions (custom) form the basis of all legitimate authority among men. Rousseau, Social Contract I, 4It is important to give the freest scope possible to uncustomary things, in order that it may in time appear which of these are fit to be converted into customs. John Stuart Mill, On Liberty, III

Religion as a source of Law and Ethics Western ConceptsThe goodness of the human will depends on the Eternal Law much more than on Human Reason. And when Human reason fails we must have recourse to the Eternal Reason. Aquinas, Summa Theologica, I-II 19,6

To establish order, codify Custom and provide an explanation of social hierarchy, ancient cultures looked to deities as the unquestionable source of the law. A sort of higher authority form of negotiating good behavior.Cultures developed a deference to the First Mover, Prime Cause, Efficient Cause, First Good, First Nature, Eternal Nature, Unchanging Nature, etc. often referred to as one or more gods.

Religion as a source of Law and Ethics

The natural is always without error, but mental love may choose an evil object or err through too much or too little vigor. As long as it is directed toward the First Good (God) and tends toward secondary goods with measure, it cannot be the cause of evil pleasure . . . From this you see that of necessity love is the seed of all virtue and of all acts deserving punishmentDante Aligheri, Purgatorio, Canto XVII, 94-105

Religion as a source of Law and Ethics Eastern ConceptsEastern Concepts of God and an ethical lifeBook of Tao (the Way)

The tao that can be described is not the eternal Tao. The name that can be spoken is not the eternal Name.

The nameless is the boundary of Heaven and Earth. The named is the mother of creation.

Freed from desire, you can see the hidden mystery. By having desire, you can only see what is visibly real.

Yet mystery and reality emerge from the same source. This source is called darkness.

Darkness born from darkness. The beginning of all understanding.

Religion as a source of Law and EthicsThe Decline of the Tao (the Way) ...The Tao declined among the folkAnd then came kindness and morality.*When wisdom and intelligence appeared,They brought with them a great hypocrisy.The six relations were no more at peace,So codes were made to regulate our homes.The fatherland grew dark, confused by strife:Official loyalty became the style.

* Notice that the morality is a degradation of the eternal truth and that having laws is even a worse state of existence.

Religion as a source of Law and EthicsBuddhism and the Eightfold Path Right action (samyak-karmnta samm-kammanta) can also be translated as "right conduct". As such, the practitioner should train oneself to be morally upright in one's activities, not acting in ways that would be corrupt or bring harm to oneself or to others.Right livelihood (samyag-jva samm-jva). This means that practitioners ought not to engage in trades or occupations which, either directly or indirectly, result in harm for other living beings.

The Importance of the Law

De Bracton, de Legibus 13th Century England

The Needs of a King

To rule well a king requires two things, arms and laws, that by them both times of war and of peace may rightly be ordered. For each stands in need of the other, that the achievement of arms be conserved [by the laws], the laws themselves preserved by the support of arms. If arms fail against hostile and unsubdued enemies, then will the realm be without defence; if laws fail, justice will be extirpated; nor will there be any man to render just judgment.

The Importance of the Law

England alone uses within her boundaries unwritten law and custom

Though in almost all lands use is made of the leges and the jus scriptum, Englandalone uses unwritten law and custom. There law derives from nothing written [but]from what usage has approved. Nevertheless, it will not be absurd to call English laws leges, though they are unwritten, since whatever has been rightly decided and approved with the counsel and consent of the magnates and the general agreement of the res publica, the authority of the king or prince having first been addedthereto, has the force of law. England has as well many local customs, varyingfrom place to place, for the English have many things by custom which they donot have by law, as in the various counties, cities, boroughs and vills, where it will always be necessary to learn what the custom of the place is and how those whoallege it use it.

Much of the basis of the Law in England come from the Code of Justinian as England was ruled by the Romans for Centuries

The Law as a Source or Companion to EthicsBreaking it to its essenceIn the West we 4,000 years of evidence of written law.Earliest Codes Code of Lipit-Ishtar Code of Ur Nammu

Not surprisingly these Codes deal with issues of property, trespass to property (both civil and criminal) and the descent of property

Code of Lipit-IshtarLipit Ishtar, a human was called on by the Mesopotamian god, Enlil to establish order and justice in the land and to banish complaintsWhen Anu and Enlil had called Lipit-Ishtar, Lipit-Ishtar the wise shepherd whose name had been pronounced by Nunamnir, to the princeship of the land in order to establish justice in the land, to banish complaints, to turn back enmity and rebellion by force of arms, and to bring well-being to the Sumerians and Akkadians, then I, Lipit-Ishtar, the humble shepherd of Nippur, the stalwart farmer of Ur, who abandons not Eridu, the suitable lord of Erech, king of Isin, king of Sumer and Akkad, who am fit for the heart of Inanna, established justice in Sumer and Akkad in accordance with the word of Enlil.

Code of Lipit-IshtarMay a Slave Inherit Property? If a man married his wife and she bore him children and those children are living, and a slave also bore children for her master but the father granted freedom to the slave and her children, the children of the slave shall not divide the estate with the children of their former master.Earliest written child support law If a man's wife has not borne him children but a harlot from the public square has borne him children, he shall provide grain, oil and clothing for that harlot. The children which the harlot has borne him shall be his heirs, and as long as his wife lives the harlot shall not live in the house with the wife.

Code of Ur Nammu Protection of the Right of Descent ensuring your offspring are yoursIf a man violates the right of another and deflowers the virgin wife of a young man, they shall kill that male.

If the wife of a man followed after another man and he slept with her, they shall slay that woman, but that male shall be set free.

Code of Hammurabi Descent of Property If a chieftain or a man be caught in the misfortune of a king, if his son is able to enter into possession, then the field and garden shall be given to him, he shall take over the fee of his father. Guardianship If his son is still young, and can not take possession, a third of the field and garden shall be given to his mother, and she shall bring him up.The First Trusts? If any one give another silver, gold, or anything else to keep, he shall show everything to some witness, draw up a contract, and then hand it over for safe keeping.

Code of Hammurabi Constructive Trust? If any one deliver silver, gold, or anything else to another for safe keeping, before a witness, but he deny it, he shall be brought before a judge, and all that he has denied he shall pay in full.

Foundation of social order provided by god to man: When Anu the Sublime, King of the Anunaki, and Bel, the lord of Heaven and earth, who decreed the fate of the land, assigned to Marduk, the over-ruling son of Ea (Enlil?), God of righteousness, dominion over earthly man, and made him great among the Igigi, they called Babylon by his illustrious name, made it great on earth, and founded an everlasting kingdom in it, whose foundations are laid so solidly as those of heaven and earth; then Anu and Bel called by name me, Hammurabi, the exalted prince, who feared God, to bring about the rule of righteousness in the land, to destroy the wicked and the evil-doers; so that the strong should not harm the weak; so that I should rule over the black-headed people like Shamash, and enlighten the land, to further the well-being of mankind.

How are Law and Ethics relatedThere is no real answerthe relation between law and ethics is the source of endless Philosophical debate See e.g. I. Kant, J. Bentham, J.S. MillThe argument dates at least to Plato in the West, see e.g. CritoOnes interpretation of Ethics will necessarily influence ones interpretation of the law and vice versa

How are Law and Ethics relatedAs we previously stated Customs become laws, customs and laws are ever changingIf this is true the foundations of both law and ethics are inherently unstableIt may be our current custom that one has an ethical obligation to protest against laws that are judged to be unethical, but it was always so and may not be so in the future.

The Shaky Underpinnings of Ethics and the LawThere are two primary schools of EthicsThe Duty based ethical principles most often associated with Immanuel KantThe Utilitarian based ethical principles espoused by Jeremy Bentham and John Stuart Mill

The Categorical ImperativeKantDeontology or Duty Based Ethics ,judges actions based on duties and obligationsIt is our motives not the consequences of our actions that is importantWe must act in the interest of the highest good

There is. . .but one categorical imperative, namely, this: Act only on the maxim whereby you can at the same time will that it should be come the universal law.Kant, Fundamental Principles of the Metaphysic of Morals, II

(Do unto other as you would have them do unto you. Confucius, Analects)

Consequentialism or UtilitarianismThe Consequentialist approach to Ethics provides that it is not our actions, but the results of our actions that is important. Our Actions are labeled good or bad as determined by the results producedThe Ends Justify the meansThe best actions are those which benefit the most persons

Comparing Ethical Code and Rules Across DisciplinesWe have looked at the Sources and Schools of EthicsNow lets look at the application of Present Ethical Principles and Concerns in the Investment Industry and how each discipline involved handles ethical and regulatory issuesIdentify the principles as Duty Based versus Greater Good based Ethical approaches and see whether we can arrive at a similar conclusion using the other method. We will look at the least involved discipline first

What Rules Apply to Attorneys Handling Client FundsOPINION 63-14July 11, 1963No attorney is permitted to make a secret commission on placement of his client's funds or to obtain commissions from an outside source without the full knowledge, approval and consent of his client.How does this compare to FINRA and Code of Ethics of Financial Advisors?Is this a rule? Are we following a Deontological approach? Is this now a duty or obligation?

What Rules Apply to Attorneys Handling Client FundsOPINION 70-13November 16, 1970An attorney investing funds for a client may not charge a full fee to his client and at the same time accept a finder's fee for placing the investments in a particular institution.

What Rules Apply to Attorneys Handling Client FundsOPINION 75-24November 30, 1975A lawyer may not participate in an arrangement in which a small loan company agrees to make loans for living expenses to the attorney's clients awaiting settlements on the condition that the attorney and client sign an agreement that the loan will be repaid from the settlement proceeds.

What Rules Apply to Attorneys Handling Client FundsOPINION 02-8(January 16, 2004)

A lawyer may not enter into a referral arrangement with a nonlawyer who is a securities dealer to refer the lawyers clients to the securities dealer, who would then pay the lawyer a portion of the advisory fee for the clients referred. A lawyer may refer a client to the lawyers own ancillary business to provide financial services to the client only if the referral is in the clients best interests and the lawyer follows the rule on business transactions with a client. If the services to be provided by the lawyers ancillary business are nonlegal, the lawyer should advise the client that the protections of the attorney-client relationship will not apply to the nonlegal services. The lawyer should not use the ancillary business as a feeder to the law firm.

Could this arguably be a consequentialist approach to an ethical issue?

Ethics and the Law in Motion The Rise and Fall of the Merrill Lynch Rule (Almost)Taking what we have discussed so far about Ethics, sources, schools and the Law lets look at a specific example of the Ethics and the Law in Motion

The Securities and Exchange Commission possesses the primary regulatory and enforcement powers over securities sales and investor relations. The Investment Advisor, Broker and Financial Manager have some self-regulatory authority though their standards are not the same

Ethics and the Law in Motion The Rise and Fall of the Merrill Lynch Rule (Almost)Under the Investment Advisers Act of 1940, investment advisors must register with the SEC and/or with the states in which they operate Registered Advisors are Subject to Fiduciary Standards under the ActIn addition, Registered Advisors may be subject to certain codes of ethics

Ethics and the Law in Motion The Rise and Fall of the Merrill Lynch Rule (Almost)CFR 275.204A-1Investment adviser codes of ethics.

(a) Adoption of code of ethics. If you are an investment adviser registered or required to be registered under section 203 of the Act (15 U.S.C. 80b3), you must establish, maintain and enforce a written code of ethics that, at a minimum, includes:(1) A standard (or standards) of business conduct that you require of your supervised persons, which standard must reflect your fiduciary obligations and those of your supervised persons;(2) Provisions requiring your supervised persons to comply with applicable Federal securities laws;(3) Provisions that require all of your access persons to report, and you to review, their personal securities transactions and holdings periodically as provided below;(4) Provisions requiring supervised persons to report any violations of your code of ethics promptly to your chief compliance officer or, provided your chief compliance officer also receives reports of all violations, to other persons you designate in your code of ethics; and(5) Provisions requiring you to provide each of your supervised persons with a copy of your code of ethics and any amendments, and requiring your supervised persons to provide you with a written acknowledgment of their receipt of the code and any amendments.

Ethics and the Law in Motion The Rise and Fall of the Merrill Lynch Rule (Almost)Brokers are required to: 1) know their clients financial situations well enough to understand their financial needs, and 2) recommend investments that are suitable for them based on that knowledge. Brokers are not required to provide upfront disclosures of the type provided by investment advisers, including, but not limited to their conflicts of interest.

Ethics and the Law in Motion The Rise and Fall of the Merrill Lynch Rule (Almost)Financial Planner are not separately regulated, but are regulated based on the services they perform (e.g. may be required to register under the 1940 act)Certified Financial Planners have a separate Code of EthicsFinancial planners providing Investment Management services are held to a fiduciary standardInvestment advisers who also buy and sell securities for customers must meet the requirements applicable to both investment advisers and brokers.

Ethics and the Law in Motion The Rise and Fall of the Merrill Lynch Rule (Almost)"Merrill Lynch Rule. proposed 1999 and formally adopted in 2005. Stockbrokers could act as "advisors" and charge percent of assets fees. Prior to this rule, only investment advisors who registered with the SEC or with the states and who were regulated under the Investment Advisers Act of 1940 were permitted to do this. (Registered Advisors are Subject to Fiduciary Standards) Under the Merrill Lynch Rule, brokerscould call themselves advisers, yet remain exempt from regulation under the Investment Advisers Act, as amended.

Ethics and the Law in Motion The Rise and Fall of the Merrill Lynch Rule (Almost)In essence the brokerage industry desiring to enter into the investment advisor market lobbied the Congress and the SEC for an exemption for fee based services in the name of competition and received it.The brokerage industry was allowed to compete and yet be regulated under a lesser standard, even though a long standing fiduciary standard was in place. Under a Consequentialist Approach to Ethics is the Greater Good Served by such an exception to a Rule?Under a Deontological Approach should a broker or the brokerage industry recognize its duty to the marketplace to provide the highest standard of conduct?

Ethics and the Law in Motion The Rise and Fall of the Merrill Lynch Rule (Almost)In March of 2007 the US Court of Appeals stuck down the Merrill Lynch RuleFound no congressional intent to "support the SECs interpretation of its authority." Rule permitted brokers to call themselves "advisors," "counselors," and other similar terms that implied they were helping clients to make financial and investment decisions in their clients' best interests. Brokers, though, had no legal obligation to act in the best interests of their clientsRule required only that they sell "suitable" financial and investment products to the public.

Ethics and the Law in Motion The Rise and Fall of the Merrill Lynch Rule (Almost)Suitability in Practice prior to recent rule makingit merely requires that a broker have a reasonable basis for recommending a security or investment strategy.

Ethics and the Law in Motion The Rise and Fall of the Merrill Lynch Rule (Almost)Market Reaction to the revocation of the Merrill Lynch RuleIn May 2009 FINRA requested comments on its proposal to use the NASD suitability rule as the model for a modified suitability rule for the Consolidated FINRA Rulebook, proposed FINRA Rule 2111, and to eliminate NASD Rule 2310.5 The modified rule would codify various interpretations regarding the scope of the suitability rule, clarify the information to be gathered and used as part of a suitability analysis and create a clear exemption for recommended transactions involving institutional customers, subject to specified conditions.

Proposed FINRA changesThe Scope of the Proposed Suitability RuleFINRA proposed to explicitly apply suitability obligations to a recommended transaction or investment strategy involving a security or securities. In this regard, the proposal would codify longstanding SEC and FINRA decisions and other interpretations stating that NASD Rule 2310 covers both recommended securities and strategies. For instance, NASD IM-2310-3 (the institutional customer interpretive material (IM), discussed below) explicitly states that firms responsibilities under NASD Rule 2310 include having a reasonable basis for recommending a particular security or strategy.As with the current NASD rule, the proposed suitability rule would apply only if the firm or associated person makes a recommendation.

August 2010 Changes to FINRAOn August 13 the SEC indicated that it would issue revisions to FINRA dealing concerning Know your Client and Investment SuitabilityThe changes are intended to strengthen existing rules

Know Your Client ChangesIn opening and maintaining accounts, Broker Dealers must: use due diligence; and know the essential facts concerning every customereliminates the existing requirement to learn the essential facts relative to every order.

Essential Facts1.Effectively service the customers account;2.Act in accordance with special handling instructions for the account3.Understand the authority of each person acting on behalf of the customer4.Comply with applicable laws, regulations and rules.

Changes to Suitability Requirementswould impose a reasonableness standard on broker-dealers in determining whether a transaction or investment strategy is suitable for a customerwould require the broker-dealer to use reasonable diligence to ascertain the customers investment profileThis is not a Fiduciary Standard

Changes to Suitability RequirementsNon-Exclusive relevant Customer Information:age,other investments,financial situation and needs,tax status,investment objectives,investment experience,investment time horizon,liquidity needs, andrisk tolerance

Where are we after the FINRA changesBrokers still not held to a Fiduciary StandardSome Clarification and tightening in the Law

From a Consequentialist approach does this rule serve the greatest good?From a Deontological Approach Does a Broker have a duty to use the highest standards?Will it take additional investor losses for the brokerage industry to acquiesce to the fiduciary standard?

Conclusions and ThoughtsAfter briefly discussing what ethics is, what its sources are and how it relates to the law, we have attempted to apply two diverse schools of ethical principles to recent changes in FINRAUnder Either Approach are we any closer to doing the Right Thing or providing the greatest good with regard to investors?If we compare the law and ethical standards of the investment industry as a whole to standards applied to attorneys do we see uniformity under either ethical school?

Homework Read the Britannica Great Books

Thank you for your attention

Tao is the Empty Vessel that pours forth all knowledge