Reasonable or objective basis

Two advisers can recommend the same fund to the same client. One has studied the client's position and the alternatives. The other gets paid more for that fund.

The advice looks identical. Only one of them has a reasonable basis for it.

The workbook lists this as one of the obligations that comes with being a fiduciary. Alongside full disclosure and giving suitable advice, there has to be a reasonable basis or an objective basis for the recommendation.

What matters is the manner in which the recommendation is formed. Not how it turned out. Not whether the client agreed to it.

And there is a specific thing it must not be based on. Factors that benefit the adviser.

The point is to make the reasoning answerable. An adviser should be able to show why this recommendation, for this client, on the facts known at the time.

That is also why the duty survives a bad outcome. A well-founded recommendation that loses money has still met it. A commission-driven one that happens to make money has not.

The fiduciary version (section 19.5). The workbook lists the obligations an Investment Adviser must fulfil when dealing with clients. After full disclosure and suitable advice it says: in addition, there has to be a reasonable basis or objective basis for the recommendation. It then gives the test and the prohibition in two sentences — the manner in which the recommendation is formed by the investment adviser becomes important, and it should not be based on factors that benefit the adviser. The stated purpose is that the client gets the advice they require for meeting their financial goals.

The obligation sits inside the wider fiduciary relationship. Advisers are fiduciaries, which means acting in the best interest of clients; the adviser acts on behalf of another person to manage their financial assets, so the principle of utmost good faith — uberrimae fidei — and trust must be followed. There cannot be profit made at the cost of the client, and the adviser must not take unfair advantage of the client's trust.

The regulatory version (section 18.6.10, Suitability). The same phrase appears as an operative obligation, and here the workbook spells out what the adviser must have a reasonable basis for believing. A recommendation or transaction entered into must:

1. meet the client's investment objectives;
2. be such that the client is able to bear any related investment risks consistent with its investment objectives and risk tolerance;
3. be such that the client has the necessary experience and knowledge to understand the risks involved in the transaction.

All 3 limbs, not one of three. And the same section requires the adviser to have a documented process for selecting investments based on the client's objectives and financial situation, and to understand the nature and risks of the products or assets selected.

A higher bar for complex products. Where the advice is to purchase a complex financial product, the recommendation must be based on a reasonable assessment that the structure and risk-reward profile of the product is consistent with the client's experience, knowledge, investment objectives, risk appetite and capacity for absorbing loss.

What the two versions do together. Section 18.6.10 tells the adviser what must be believed and documented. Section 19.5 tells the adviser what the belief must not be built on. An adviser can satisfy a documented process and still fail the ethical limb if the reason the product reached the shortlist was the adviser's own benefit.

Neither section attaches a figure to the obligation — no minimum number of alternatives to consider, no record retention period, no fee limit. The only count is the 3 limbs of the belief at 18.6.10.

Mrs Anand, 58, retiring in two years, has Rs 40,00,000 to place. She wants her capital intact and an income.

Two advisers recommend the same thing: a credit risk fund yielding 9.2%, against 7.1% on a comparable short duration fund.

Adviser A's file. A risk profiling questionnaire completed and signed. A note recording that Mrs Anand cannot bear a loss of capital, a comparison of 4 alternatives on yield and credit quality, and the conclusion that the extra 2.1 percentage points — Rs 84,000 a year on Rs 40,00,000 — is not worth a portfolio of AA and below paper for a client two years from retirement. Recommendation: the short duration fund. Income Rs 2,84,000 a year.

Adviser B's file. The same questionnaire, completed and signed. No comparison. Recommendation: the credit risk fund. Income Rs 3,68,000 a year. What the file does not record is that the scheme paid Adviser B a higher trail.

Run both against the 3 limbs of section 18.6.10:

Adviser B fails all three, and separately fails section 19.5 because the basis was a factor that benefited the adviser.

Now the part that matters most. Suppose no issuer defaults and the credit risk fund returns 9.2% for both years. Mrs Anand is Rs 1,68,000 better off with Adviser B.

Adviser B has still breached the obligation. The duty is on the manner in which the recommendation is formed, not on the outcome. And if a single issuer in that portfolio had been downgraded and written down by 15%, the Rs 40,00,000 would have become Rs 34,00,000 — a loss the client had already said she could not bear, recommended by an adviser who had not checked whether she could.

A good outcome does not create a reasonable basis after the fact.

Chapter 19 (Ethical Issues), section 19.5 (Fiduciary responsibility of Investment Advisers), where the obligation is named alongside full disclosure and suitable advice; and Chapter 18 (Key Regulations), section 18.6.10 (Suitability), which sets out the 3 limbs of what the adviser must have a reasonable basis for believing, plus the higher bar for complex financial products. Expect a question listing the fiduciary obligations and asking which is missing, and a scenario question where a recommendation is defensible on paper but driven by the adviser's own benefit.

• The test is on the manner in which the recommendation was formed, not on the outcome. A profitable recommendation with no basis is still a breach; a loss-making one with a sound basis is not.
• It must not be based on factors that benefit the adviser. This is the workbook's explicit prohibition and the usual answer to a conflict-of-interest scenario.
• All 3 limbs at section 18.6.10, not one. Meets objectives; client able to bear the risks consistent with objectives and tolerance; client has the experience and knowledge to understand them.
• Reasonable basis is not the same as suitability. Suitability asks whether the product fits the client. Reasonable basis asks whether the adviser's reasoning was sound and untainted. A recommendation can fit and still fail this test.
• Complex products carry a separate, higher assessment — structure and risk-reward profile against the client's experience, knowledge, objectives, risk appetite and capacity for absorbing loss.
• A documented process is required, so an adviser who cannot produce the comparison has not met the obligation, whatever the recommendation was.
• Client consent does not supply a basis. A signed form records that the client agreed, not that the adviser had grounds.