OPINION Column: Don Trone on What a 'Harmonized' Fiduciary Standard Should Look Like

By Donald B. Trone

Ordinarily, Washington (including Congress and regulators) tends to allow an industry impacted by new legislation to define the details of any standards which emerge from the enabling legislation. I suspect that will be the case with the Dodd-Frank Financial Reform Bill (Reform Bill) but, to be certain, the Foundation for Fiduciary Studies (Foundation) has released the new “2010 Fiduciary Standard” to serve as an initial rallying point.

There are two operative words in developing a standard, particularly a fiduciary standard: “consensus” and “substantiation.” The public and the industry want to see “consensus,” whereas regulators and the courts are more concerned about “substantiation.” A standards developer, such as the Foundation, needs to be able to demonstrate both; that there is a consensus across the industry for the standard, and that every dimension to the standard is substantiated by either legislation, regulations or case law–or in the absence of such substantiation, industry best practices.

A good illustration is the requirement under existing fiduciary legislation (ERISA, UPIA, UPMIFA and MPERS) that a fiduciary demonstrate their “procedural prudence”–the details of their decision-making process. Such a requirement raises three related questions:

1. What constitutes the scope and breadth of activities that constitute procedural prudence?

2. Where do generally-accepted investment theory and industry best practices converge to define procedural prudence?

3. Are there consistent references in legislation, regulations, regulatory opinion letters and bulletins and case law that substantiate a particular dimension of a procedurally prudent process?

The answers to these questions are best left to industry experts; not to regulators, and certainly not to legislators. It is for these reasons that the Foundation was founded in 2000: To provide a ways and means to bring together objective industry experts to mine the answers to these questions, and then to build industry consensus through speaking, teaching and writing.

The Three Pillars of a Fiduciary Standard

To begin to define the details of a “harmonized” fiduciary standard, we need to start by defining what it means to be a fiduciary. I would suggest the following:

A fiduciary makes a commitment to judge wisely and objectively, and to ensure that all processes and procedures are congruent with the goals and objectives of the client.

I would further define two additional terms, which I believe are the cornerstones to a fiduciary standard: “Stewardship” and “Covenant:”

The rewards for being a fiduciary are not always apparent, and not always commensurate with the level of effort, process, and risk undertaken. This is the very essence of stewardship.

A fiduciary standard is a continuous process that requires an ongoing discipline to do the right thing, at the right time. This is the very essence of a covenant.

A word that consistently appears in the above definitions and existing fiduciary legislation is “process,” and therein rises the first pillar to a “harmonized” fiduciary standard–it’s about the process an advisor must follow to demonstrate that decisions are made in the best interest of the client.

A good illustration of process involves the use of proprietary and commission-based products; the Reform Bill included an exception that would allow advisors to use such products. However, a knowledgeable fiduciary expert could have advised Congressional writers that such a carve-out is

unnecessary. Under existing fiduciary Acts, no product or strategy is considered imprudent; it’s how it is used and the decisions surrounding its implementation and monitoring that will determine whether a particular product or strategy are in the best interests of the client. Hence, a no-load mutual fund from an unaffiliated fund family can just as easily trigger a fiduciary breach as a proprietary product, if it can be demonstrated that neither product underwent sufficient due diligence during the implementation and monitoring phases of the investment process.

One of the many lessons I learned from flying military aircraft is that simple is preferable to complex, particularly when you are operating in a complex environment, or under stress. Therefore a good starting point for defining a process for a “harmonized” fiduciary standard would be a straightforward five-step process, or in the case of financial planners, a six-step process that mirrors the six step financial planning process:

If the first pillar is process, the second is prudence. Here we build upon process to define the Dimensions, or the details, of a procedurally prudent investment process. We examine each Step in further detail to further demonstrate that each decision is being managed in the best interests of the client. For example, the first step of the 5-step process is to “Analyze.” the Dimensions to the first step are:

1.1: State goals and objectives (“objectives”)

1.2: Define roles and responsibilities of decision-makers

1.3: Brief decision-makers on objectives, standards, policies, and regulations

Note that the Dimensions are simple straightforward statements, and that the language is universal–or, “harmonized,” if you will. You do not want to use ambiguous terms or laden the text with regulatory or industry jargon. Furthermore, the statements could just as easily define a governance standard for a board of directors, or a project management standard for staff.

Note that there is significance to the numbering of each dimension: The first number is the Step of the Process, and the second is the sequence of the Dimension in the Step. The remaining Dimensions are as follows: