The Borrowed $50,000 and the Principal Trade
You are the compliance consultant for a state-registered investment adviser with 80 clients. The owner, Priya, asks you to review three actions: (1) she wants to borrow $50,000 from a long-time client to cover a short-term cash-flow gap, promising 6% interest and repayment in six months; (2) she wants to sell the client a bond from her personal account at a 1.5% markup without written disclosure or consent; and (3) she wants to use $12,000 of client brokerage commissions to pay for her trip to a due-diligence conference, arguing that the conference will benefit clients. Priya has discretionary authority over the client's account, and the client has verbally said 'you decide.' The adviser's written policies prohibit borrowing from clients and principal transactions without approval.
1. Analyze each of the three actions under the Advisers Act fiduciary duty and the adviser's policies. Which are prohibited, and which might be permitted with conditions?
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Borrowing from a client is a direct conflict of interest and is prohibited by the adviser's written policy. It may also violate state rules that restrict or ban adviser borrowing from clients. The client's verbal 'you decide' does not cure the conflict or waive the written policy. A principal trade, where Priya sells a bond from her personal account to the client, requires written disclosure of her capacity and the conflict, and the client's informed consent before completion under Advisers Act Section 206(3). The undisclosed 1.5% markup is also a material fact. The policy independently prohibits it. Using $12,000 of client commissions to pay for Priya's conference travel is not a protected soft-dollar research benefit; personal travel and overhead are the adviser's expenses. Discretionary authority does not permit self-dealing, and the verbal instruction does not make the conduct suitable or fair.
2. What should Priya do to remediate, and what records should be kept?
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Priya should stop all three actions before execution. She should decline the loan or, if state law and the policy permit any exception, obtain full written disclosure and informed written consent; here the policy bars it, so the answer is no. For the principal trade, she must not complete the sale without prior written disclosure and consent, and because the policy prohibits it, she should route the trade through an unrelated broker-dealer or abandon it. She should repay the $12,000 of client commissions, disclose the allocation, and review whether any client paid higher commissions as a result. The firm should conduct an independent compliance review, document the corrective action, update training, and consider whether self-reporting is required. Records should include the written disclosures, client consents, trade confirmations, commission allocation records, best-execution review, and compliance committee minutes.
3. How would the analysis change if the client were Priya's mother and the loan were $5,000?
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The conflict is smaller in dollar terms but does not disappear. A loan from an immediate family member may be treated differently under some state rules, but Priya must still check the applicable state prohibition, disclose the loan in writing, and obtain informed consent if permitted. The adviser's written policy still applies unless properly amended, and the firm should document why an exception is appropriate. The principal trade would still require written disclosure and consent before completion, and the family relationship may make the conflict more acute because the client may be less willing to question the adviser. The $5,000 amount and family relationship may affect the remedy and disclosure, but they do not convert self-dealing into ordinary advice.