Fiduciary capacity

Most commercial relationships are at arm's length. Each side looks after itself, and the law asks only that neither lies.

A fiduciary relationship is not like that. One party is trusted to act on another's behalf, using knowledge the other does not have, over money the other cannot easily supervise. The law responds by raising the standard: the fiduciary must act in the best interest of the client, not merely honestly.

The SEBI (Investment Advisers) Regulations, 2013 state it directly in the general obligations: an investment adviser shall act in a fiduciary capacity towards its clients and shall disclose all conflicts of interests as and when they arise. Two duties in one sentence — the standard, and the disclosure that keeps it honest.

The adviser's version. Under the general obligations, an investment adviser shall:

• act in a fiduciary capacity towards its clients and disclose all conflicts of interest as and when they arise;
• receive no consideration by way of remuneration or compensation or in any other form from any person other than the client being advised, in respect of the underlying products or securities advised on;
• maintain an arm's-length relationship between its activities as an investment adviser and its other activities, and where it carries on other activities, ensure that the advisory services are clearly segregated from them.

The portfolio manager's version is narrower in its wording. The SEBI (Portfolio Managers) Regulations say the portfolio manager shall act in a fiduciary capacity with regard to the client's funds — and back it with operational duties: segregate each client's holding of securities in separate accounts, keep the funds of all clients in a separate account maintained with a scheduled commercial bank, and accept no less than fifty lakh rupees of funds or securities from a client.

Note the difference in scope and be ready to quote it. The adviser owes the duty towards its clients; the portfolio manager owes it with regard to the client's funds.

What the duty requires in practice. Chapter 19 unpacks it: full disclosure of all facts with no omission, and disclosure even where there is only a perception of conflict; suitable advice matched to the specific client's circumstances; and a reasonable or objective basis for every recommendation. The governing principle is utmost good faith — no profit may be made at the cost of the client, and the adviser must not take unfair advantage of the client's trust.

An adviser is asked by a client with Rs 60,00,000 to invest for a ten-year goal. Two schemes are on the shortlist.

Cost to the client over ten years, on Rs 60,00,000 growing at assume 11% before costs:

Scheme A:  60,00,000 x (1.1080)^10  = Rs 1,68,50,000 approx
Scheme B:  60,00,000 x (1.0925)^10  = Rs 1,45,80,000 approx

Difference to the client over 10 years  = about Rs 22,70,000

In an arm's-length sale, recommending Scheme B and disclosing nothing would be lawful. Under a fiduciary standard it is not, and three separate rules bite at once:

1. the adviser may receive no consideration from anyone other than the client in respect of the products advised on, so the trail commission is not available to it at all;
2. any conflict, and even the perception of one, must be disclosed as it arises; and
3. client-level segregation means the same client cannot be both an advisory client and a distribution client within the group.

The fiduciary standard is not an instruction to pick the cheaper fund. Scheme B may genuinely be the better recommendation. It is an instruction that the Rs 22.7 lakh question must be decided on the client's facts and nothing else, and that the adviser's own economics must be on the table when it is.

Chapter 18 (Key Regulations), section 18.6.7 on the general obligations of an investment adviser, is the source of the operative words; Chapter 19 (Ethical Issues), section 19.5 on the fiduciary responsibility of investment advisers, supplies the content of the duty; and Chapter 12 (Portfolio Manager) carries the portfolio manager's formulation. Questions quote one of the two formulations and ask whom it binds, or describe a conflict and ask what the adviser must do.

• Disclosure is not a cure for a conflict, but it is compulsory. The obligation is to act in the client's best interest and disclose — not to choose between them.
• Disclose perceived conflicts too. Chapter 19 is explicit that disclosure should be made where there can be a perception of conflict, so that trust is maintained.
• The adviser may take payment only from the client. No remuneration or compensation in any form from anyone else, in respect of the products advised on — this is what makes the standard enforceable rather than aspirational.
• The two wordings differ. An investment adviser acts in a fiduciary capacity towards its clients; a portfolio manager acts in one with regard to the client's funds. Questions quote the exact phrase.
• A portfolio manager's fiduciary duty comes with plumbing — separate accounts per client for securities, one separate scheduled-commercial-bank account for client funds, and the Rs 50 lakh minimum.
• Fiduciary capacity and arm's-length relationship are not opposites here. The adviser owes a fiduciary duty to the client and must maintain an arm's-length relationship between its own activities.
• Utmost good faith is the underlying principle, expressed in the workbook as uberrimae fidei — no profit at the cost of the client, and no unfair advantage taken of the client's trust.