Views on improving the integrity of global capital markets
23 October 2013

Interpreting Client Entertainment as Part of the Pension Trustee Code

The Financial Services Authority (FSA) in Japan is currently investigating a variety of financial institutions, and according to a recent article in Reuters part of the FSA’s interest appears to be client entertainment practices at financial firms. In July, the FSA announced administrative actions against KTOs Capital Partners as it sought to punish the company for excessive entertainment practices with the goal of obtaining investments in its fund. As a result, KTOs (a fund of a hedge-fund advisory firm that invests pension funds’ assets in hedge funds) had to shut down operations for a period of three months. Separately, top managers at KTOs (who pleaded guilty to paying a bribe) and the pension fund executive involved were both legally prosecuted, according to another Reuters article.

Now, Japan is not the only place where clients are entertained in the business world. The magnitude of the entertainment KTOs offered to clients was such that Japanese authorities concluded it represented extraordinary benefits of the type prohibited by a Cabinet Office Ordinance based on the Financial Instruments and Exchange Act.

Apart from the legal implications client entertainment may have in Japan or elsewhere, what deserves special attention are the ethical aspects of this type of activity. It is generally accepted wisdom that law does not necessarily constitute a sufficient ethical framework per se but rather it is seen as providing the framework for a minimum level of ethical conduct. Ethical behavior is often distinguished from legal conduct by describing legal behavior as what is required and ethical behavior as conduct that is morally correct. Ethical conduct therefore meets a higher standard than legality.

From the perspective of CFA Institute, the KTOs case is quite interesting as it points to at least two major ethical failures. On one hand, representatives of pension funds who received excessive entertainment would be violating ethical principles, which CFA Institute clearly deems important. For example, as described in the CFA Institute Pension Trustee Code of Conduct, pension trustees should maintain independence and objectivity by avoiding conflicts of interest, refraining from self-dealing, and refusing any gift that could reasonably be expected to affect their loyalty. The Pension Trustee Code of Conduct incorporates the ethical principles found in the Code of Ethics and Standards of Professional Conduct that all CFA charterholders, and CFA Institute members must follow. Relevant guidance states that members and candidates represent the pension plan beneficiaries’ interests, and they should not receive or accept (directly or indirectly) any gift, service, favor, entertainment, or any other item of value from anyone currently engaged by or seeking business from the pension scheme if it could reasonably be expected to influence a decision or be considered a reward.

On the other hand, KTOs, which manages assets on behalf of clients, engaged in activities that clearly went against the principles CFA charterholders would have to adhere to. According to these principles, members and CFA candidates must use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Members and candidates must not offer any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or another individual’s independence and objectivity. Taking a client to a restaurant may not necessarily be an issue; however, when it comes to excessive entertainment the situation may be different.

The temporary suspension of business operations at KTOs may have a significant economic impact on the hedge-fund advisory firm. Both the individuals on the pension fund side as well as the principals at KTOs probably regret their actions, and it would not be surprising if KTOs top management wished for a more ethical culture at their firm. CFA Institute offers an excellent solution, namely the Asset Manager Code of Professional Conduct. On one hand, it helps asset managers introduce a high-level ethical culture at their firms. It also helps plan sponsors and other investors easily identify which asset managers uphold the ethical foundation that resolves conflicts of interest in favor of investors. By adopting the Asset Manager Code, asset management firms signal their commitment to commonly held ethical principles.

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Photo Credit: © Satake

About the Author(s)
Alexander Flatscher, CFA

Alexander Flatscher, CFA, is a former director of professional standards at CFA Institute. He was responsible for promoting the ethical standards, policies, and positions of CFA Institute in the Asia-Pacific region.

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