Reconciling Codes Of Ethics In Handling Client Funds

By Kevin Carmichael MS JD LLM CPA

About the Author
 Kevin 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
Ethics
 Nan-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 professional’s relationship to investor funds

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

Of Ethics and Zebras
Returning to the Natural Law
 Male 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 property
 Are 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
 τέχνη - The “Techne” or the art or craft of Ethics is -
the study of right and wrong; morality; good and evil;
justice, virtue
 It is Moral Philosophy – Normative Ethics
 Ethics consists of analyzing right and wrong and creating
rules to modify and enforce socially acceptable behavior in
a social grouping

The τέχνη of Ethics
 Normative Ethics involves Religion, Law, Custom and
other inputs
 None of these principles is dominant or determinative

Ethics and Custom
 There 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 rules
 Morals 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, 97,3
 Since 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, 4
 It 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 Concepts
 The 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.

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 punishment
 Dante Aligheri, Purgatorio, Canto XVII, 94-105

Ethics – Eastern Concepts
 Eastern Concepts of God and an ethical life
 Book 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.

Ethics
The Decline of the Tao (the Way) ...
 The Tao declined among the folk
And 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.

Ethics
 Buddhism and the Eightfold Path
 Right action (samyak-karmānta • sammā-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-ājīva • sammā-ājīva). 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, England
alone 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 added
thereto, has the force of law. England has as well many local customs, varying
from place to place, for the English have many things by custom which they do
not 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 who
allege 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
Ethics
Breaking it to its essence
 In 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-Ishtar
 Lipit Ishtar, a human was called on by the Mesopotamian
god, Enlil to establish order and justice in the land and to
banish complaints
 When 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-Ishtar
 May 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 yours
 If 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 related
 There is no real answer
 the relation between law and ethics is the source of
endless Philosophical debate – See e.g. I. Kant, J.
Bentham, J.S. Mill
 The argument dates at least to Plato in the West, see
e.g. “Crito”
 One’s interpretation of Ethics will necessarily
influence one’s interpretation of the law and vice versa

How are Law and Ethics related
 As we previously stated Customs become laws,
customs and laws are ever changing
 If this is true the foundations of both law and ethics
are inherently unstable
 It 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 Law
 There are two primary schools of Ethics
 The “Duty” based ethical principles most often
associated with Immanuel Kant
 The “Utilitarian” based ethical principles espoused by
Jeremy Bentham and John Stuart Mill

The Categorical Imperative
Kant
 Deontology or Duty Based Ethics ,judges actions based on duties
and obligations
 It is our motives not the consequences of our actions that is
important
 We 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 Utilitarianism
 The 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 produced
 The Ends Justify the means
 The best actions are those which benefit the most
persons

Comparing Ethical Code and Rules
Across Disciplines
 We have looked at the Sources and Schools of Ethics
 Now let’s look at the application of Present Ethical
Principles and Concerns in the Investment Industry
and how each discipline involved handles ethical and
regulatory issues
 Identify 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 Funds
 OPINION 63-14
July 11, 1963
 No 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?

 OPINION 70-13
November 16, 1970
 An 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.

 OPINION 75-24
November 30, 1975
 A 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.

 OPINION 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 lawyer’s 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 lawyer’s own ancillary business to
provide financial services to the client only if the referral is in the client’s
best interests and the lawyer follows the rule on business transactions
with a client. If the services to be provided by the lawyer’s 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 let’s 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

 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 Act
 In addition, Registered Advisors may be subject to
certain codes of ethics

 CFR 275.204A-1 Investment 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. 80b–3), 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.

 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.

 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
Ethics
 Financial planners providing Investment Management
services are held to a fiduciary standard
 Investment advisers who also buy and sell securities
for customers must meet the requirements applicable
to both investment advisers and brokers.

 "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, brokers could call
themselves advisers, yet remain exempt from regulation
under the Investment Advisers Act, as amended.

 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?

 In March of 2007 the US Court of Appeals stuck down the
Merrill Lynch Rule
 Found no congressional intent to "support the SEC’s
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 clients
 Rule required only that they sell "suitable" financial and
investment products to the public.

 Suitability in Practice – prior to recent rule making
 it merely requires that a broker have a reasonable basis
for recommending a security or investment strategy.

 Market Reaction to the revocation of the Merrill Lynch
Rule
 In 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 changes
 The Scope of the Proposed Suitability Rule
FINRA 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 FINRA
 On August 13 the SEC indicated that it would issue
revisions to FINRA dealing concerning “Know your
Client” and “Investment Suitability”
 The changes are intended to strengthen existing rules

Know Your Client Changes
 In opening and maintaining accounts, Broker Dealers
must:
 use “due diligence”; and
 know the “essential facts” concerning every customer
 eliminates the existing requirement to learn the
essential facts relative to “every order.”

Essential Facts
1. Effectively service the customer’s account;
2.Act in accordance with special handling instructions
for the account
3.Understand the authority of each person acting on
behalf of the customer
4.Comply with applicable laws, regulations and rules.

Changes to Suitability
Requirements
 would impose a “reasonableness” standard on broker-
dealers in determining whether a transaction or
investment strategy is suitable for a customer
 would require the broker-dealer to use reasonable
diligence to ascertain the customer’s investment
profile
 This is not a Fiduciary Standard

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

Where are we after the FINRA
changes
 Brokers still not held to a Fiduciary Standard
 Some 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 Thoughts
 After 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 FINRA
 Under 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

Reconciling Codes Of Ethics In Handling Client Funds

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