From the July 2011 issue of Research Magazine • Subscribe!

Fiduciary Matters

Fiduciary responsibility is a cutting-edge topic with a long and contentious past.

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The prospect of a uniform fiduciary standard that would apply to all advice givers in the financial field is the subject of much current debate among industry participants and overseers. It will become even more of a hot topic in the coming months as the Securities and Exchange Commission decides whether and how to impose new fiduciary rules.

Fiduciary responsibility involves having a particularly high standard of care and loyalty. In the financial advisory field, it is typically understood to boil down to a strict requirement to put a client’s interests ahead of one’s own. Thus, a fiduciary standard differs from a suitability standard, which obligates the advisor to recommend products suitable for a client but not necessarily the best products regardless of the advisor’s fees.

Headline-grabbing as it may be, fiduciary responsibility is an old concept — indeed an ancient one. The roots of the current issue stretch back not only through the 2010 Dodd-Frank financial reforms to the 1940 Investment Advisers Act but also through many centuries of legal and philosophical contention.

Faith and Trust

The word “fiduciary” derives from the Latin words for “faith” (fides) and “trust” (fiducia). Roman law recognized various fiducia contracts in which a person held property in safekeeping or otherwise acted on another’s behalf. Failure to uphold such trust could result not just in monetary penalties but also a formal “infamy” (infamia), in which you lost such rights as to hold public office or be a witness in a legal case.

However, the fiduciary idea arose well before Rome. The Code of Hammurabi, carved into stone in ancient Babylon, required a merchant’s agent to keep receipts and to pay triple damages for failing to provide promised goods (though it allowed an exemption if the loss was due to enemy attack during a journey).

Biblical passages enshrine the obligations of those in whom trust has been placed. Exodus 22:6-14 states the laws of guardianship, whereby the level of responsibility for any loss varies in relation to whether the custodian is being paid or has use of the item under care. Moreover, Jewish tradition has always interpreted Leviticus 19:14 (“you shall not place a stumbling block before the blind”) to mean that an advisor cannot take advantage of a customer’s (metaphoric) blindness to the advisor’s interest in a transaction.

In the New Testament, Luke 16:1-13 is about a steward who, expecting to be fired, curries favor with his master’s debtors by allowing them to repay less than their full debts. This parable, known for illustrating a precept against serving two masters, was cited by scholar Austin Scott in an influential 1949 paper “The Fiduciary Principle.” Subsequent debate has included such questions as whether the steward might have been meeting his fiduciary responsibility if the debtors were unable to make full payment.

Societies around the world contributed to fiduciary thinking. Confucius is said to have encouraged people to ask this question: “In acting on behalf of others, have I always been loyal to their interests?” Muslim rulers in India developed the waqf, an endowment run by a trustee for designated beneficiaries. Franciscan friars returning from the Crusades in the 13th century may have been influenced by the waqf idea in setting up trusts so they could make use of property without violating their vows of poverty.

Court cases over the centuries elaborated on questions of who is a fiduciary and what a fiduciary is supposed to do. In Keech v. Sandford, a landmark 1726 case in England, a child (Keech) had inherited a lease to a marketplace stall. The property was to be looked after by a trustee (Sandford) until the child was of age, but when the landlord declined to renew the lease, Sandford leased the stall for himself. The court ruled in Keech’s favor, requiring Sandford to hand over his profits and establishing that a fiduciary must keep a strict line against conflicts of interest.

Modern Finance

The concept of fiduciary responsibility filtered from British law into American law, and by the late 19th century was expanding into the realm of financial advice with the formation of trust companies that managed the assets of wealthy individuals and institutions. Such trusts, though, were among the financial players hardest hit in the Panic of 1907, so that crisis likely slowed the spread of the fiduciary model.

Following the Crash of 1929, the federal government engaged in a decade-long flurry of legislation providing for regulation of the securities industry. At the tail end of these Depression-era laws was the Investment Advisers Act of 1940 (“adviser” being the common spelling then, unlike today’s widely used “advisor”).

This law set rules on investment advisors regarding registration, disclosure and not engaging in misstatements and fraud. But it also exempted brokers from its requirements, so long as their advice provision was “solely incidental” to their business of implementing transactions on behalf of customers. Such brokerage activity was left to be regulated under other laws, particularly the 1934 Securities Exchange Act, which did not include a fiduciary standard.

The 1940 Investment Advisers Act, however, did not contain an explicit mandate for a “fiduciary standard” either. It was a 1963 Supreme Court case that established that such a standard applies to those registered as investment advisors under the act.

The case was SEC v. Capital Gains Research Bureau. The latter was a firm that had a newsletter recommending stocks for long-term gains (the 1940 law indicated that offering advice via a publication made you an advisor). It also had employees who bought these stocks before the newsletter came out and sold them once prices rose. This scalping was not disclosed to clients. When the SEC sought an injunction against this practice, a couple of courts ruled for the Capital Gains firm, on the grounds that fraudulent intent and damages had not been established.

The Supreme Court, though, stated that the 1940 law reflected recognition of “the delicate fiduciary nature of an investment advisory relationship,” and ruled that Capital Gains had violated its fiduciary duty of “utmost good faith, and full and fair disclosure of all material facts.” The law’s intent, the justices elaborated, was “to eliminate, or at least expose, all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to render advice which was not disinterested.”

Who’s an Advisor?

Over the next few decades, brokers remained generally subject to a suitability standard, though a fiduciary standard applied in such cases as discretionary accounts. But questions of how widely a fiduciary standard should extend moved gradually to the fore, as the brokerage industry evolved away from the commission-based model that had enabled brokers to be regarded as “incidental” advice givers. Distinctions between “brokers” and “advisors” became blurrier.

Legal and regulatory squabbles followed, as industry segments argued over who could do what. In 2005, the SEC adopted a regulation, known as the “broker-dealer rule” or “Merrill Lynch rule,” allowing brokerages to offer fee-based accounts without taking on fiduciary obligations, provided they made certain disclosures. A lawsuit by the Financial Planning Association overturned this regulation in 2007.

In early 2008, at the SEC’s behest, the RAND Corporation presented a study of the fiduciary issue. The think tank found there was considerable confusion among retail investors about the financial advice field’s varying models and responsibilities, and that disclosure documents had done little to mitigate this. On a brighter note, the investors surveyed were generally happy with their advisors.

The eruption of market turmoil later that year would put comprehensive financial reform high on the national political agenda. The 2010 Dodd-Frank legislation, after much maneuvering and debate, resulted in a provision requiring the SEC to study the matter for six months, and giving the agency authority to make new rules if its research determined these were needed.

The agency’s staff report in early 2011 called for a uniform fiduciary standard. But two SEC commissioners dissented, arguing the need for such a standard had not been established, and this skepticism found backers in Congress. The issue has a partisan divide, with Republicans prominent among the skeptics, and much debate has focused on whether a standard would produce unwarranted compliance costs and a flurry of lawsuits.

The history of the fiduciary standard thus is still being written. It’s an issue with a long past, and about which much more will be heard in the not-distant future.

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Strict Standard

A 1928 case in the New York Court of Appeals, the state’s highest court, provided a much-noted description of the nature of fiduciary responsibility. The case, Meinhard v. Salmon, established that business partners have a fiduciary obligation to each other regarding opportunities arising from their partnership.

The particulars of the case involved one partner (Salmon) not informing the other (Meinhard) of an opportunity for redevelopment of a commercial property they had developed jointly in a 20-year lease that was nearly up. The court found for Meinhard, and Chief Judge Benjamin Cardozo (later a Supreme Court Justice) spelled out the standard the court had applied:

“A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.” Noting that courts have been “unbending” in requiring undivided loyalty in positions of trust, Cardozo added: “Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd.”

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