Tuesday, May 14, 2013

What Would Adam Smith Say About the Fiduciary Standard?

In 431 days at the Securities and Exchange Commission, Joseph P. Kennedy reformed America’s capital markets. Even though Kennedy had profited handsomely during the tumultuous 1920s and the early 1930s from financial manipulation, from 1934 to 1935 Commissioner Kennedy led the effort to adopt rules, nearly all of which were opposed by the securities industry at the time. These rules restored individual American’s trust in our capital markets, leaving an enduring legacy far beyond his accomplishments as a financier, Ambassador to Great Britain, or father to a future U.S. President.

Gordon Gekko Meets Adam Smith

“The point is, ladies and gentleman, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind.”

So stated Michael Douglas in Wall Street (1987) as the infamous Gordon Gekko, a character that has defined Wall Street for a generation. More recently, in Wall Street 2: Money Never Sleeps (2010), Michael Douglas reminisces: “Someone reminded me I once said ‘greed is good’ ... But here’s the kicker, now it seems it’s legal.”

Some observers might opine that Adam Smith, the early champion of capitalism, would surely agree with some of what the character Gordon Gekko espoused. After all, Adam Smith generally held the capitalistic opinion that most persons are motivated by his or her own interests.

Adam Smith, however, recognized the difference between self-interest and greed, and he wrote that steps ought to be taken to keep the former from turning into the latter.

Actions based on self-interest lead to positive forces

The undeniable truth is that capitalism runs on opportunism, a fact long known in our country. Long before economics became a science of economic models, in the late 18th Century Adam Smith in his landmark work, The Wealth of Nations, posited an economic system based upon self-interest. This system, which later became known as capitalism, is described in this famous passage: “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.”[1]

As Adam Smith pointed out, capitalism has its positive effects. Actions based upon self-interest often lead to positive forces that benefit others or society at large. As capital is formed into an enterprise, jobs are created. Innovation is spurred forward, often leading to greater efficiencies in our society and enhancement of standards of living. Indeed, a person in the pursuit of his own interest “frequently promotes that of the society more effectually than when he really intends to promote it.”[2]

However, even Adam Smith knew that constraints upon greed were required. While Adam Smith saw virtue in competition, he certainly recognized the dangers of the abuse of economic power in his warnings about combinations of merchants and large mercantilist corporations.

Adam Smith also recognized the necessity of professional standards of conduct, for he suggested qualifications “by instituting some sort of probation, even in the higher and more difficult sciences, to be undergone by every person before he was permitted to exercise any liberal profession, or before he could be received as a candidate for any honourable office or profit.”[3] In essence, long before many of the professions became separate, specialized callings, Adam Smith advanced the concepts of high conduct standards for those entrusted with other people’s money.

What would Adam Smith, if he were alive 250 years later, observe regarding the modern forces in our economy? He would likely opine, given the economic forces that led to the recent (or current) Great Recession, that unfettered capitalism can have many ill effects. Indeed, he would observe that for all of its virtues, capitalism has not recently been a very pretty sight.

Consumers flee when trust is betrayed

The effects of greed in the financial services industry can be profound and extremely harmful to America and its citizens. Participation in the capital markets fails when consumers deal with financial intermediaries who cannot be trusted. As Tamar Frankel, a leading scholar on U.S. fiduciary law, observed: “I doubt whether investors will commit their valuable attention and time to judge the difference between honest and dishonest … financial intermediaries. I doubt whether investors will rely on advisors to make the distinction, once investors lose their trust in the market intermediaries. From the investor’s point of view, it is more efficient to withdraw their savings from the market.”[4]

I can personally confirm the foregoing observation. I have seen in my 25 years of practice, as an estate planning attorney and then as an investment adviser, a large number of individual Americans withdraw from the stock and bond markets after discovering the inadequacy of the conflict-ridden “investment advice” they received from many securities firms. These individuals had placed trust in their broker – a trust that was fostered by large marketing campaigns in which the offer of a close relationship with a “financial consultant” or “financial advisor” was promoted. Yet, they found that, in the end, any dream of a beachfront home had disappeared, as much of the returns of the capital markets were diverted into the pockets of the very person who, so often, appeared at their child’s soccer game to cheer. Was the cheer for the child, or for the opportunity to undertake more greedy endeavors with the client?

Many millions of American citizens who left the capital markets not because of disappointing returns – but because the trust which was requested of them by their “financial consultant,” and reasonably placed by the citizen in his or her advisor, was subsequently betrayed. It will be many years, before most of these individuals return to the capital markets. Some will never return, choosing instead to maintain their savings in depository accounts earning little interest, or even worse have their savings “stuffed in the mattress” or “hidden in a can.”

The counter to greed: the fiduciary standard of conduct

The fiduciary standard counters unfettered capitalism, by operating to restrain greed. This necessity to so restrain opportunism was reflected in a U.S. Supreme Court decision describing the fiduciary standard embraced by the Investment Advisers Act of 1940: “The dangers of fraud, deception, or overreaching … motivated the enactment of the [Advisers Act] ....”[5]

The fiduciary standard of conduct operates to restrain greed, where other measures of constraint are generally believed to be ineffective. Stated differently, fiduciary status operates to constrain the otherwise-permitted actions of the financial advisor, in order to not usurp the opportunities presented to the client due to the information asymmetry present. In essence, the fiduciary standard constrains conduct, where trust reasonably placed by the client in the advisor would be subject to betrayal.

The underlying question before the U.S. Securities and Exchange Commission (SEC) is how to bring into effect the Congressional intent that the fiduciary standard of conduct be applied to investment advisory activities. How will the SEC deal with current Congress’s current authorization to the SEC, under the Dodd Frank Act provisions, to extend the fiduciary standard to brokers’ investment advice to retail customers?

Will the “best interests of the client” – a phrase so often used by Goldman Sachs executives, even as they admitted betting against the success of the very investment products they promoted – become once again synonymous with a true fiduciary standard of conduct, in which the client’s ends are adopted as the advisor’s own? Or will “acting in the best interests of the client” become forever intertwined with a far lower standard of conduct, suitability, which permits the sale of “sh***y products” to clients.

It has been just a couple of months since Chair Mary Jo White took over the helm of the SEC. Will Chair White be able to restore to Wall Street, through regulation, high standards of ethical conduct?

[An earlier version of this article was published by RIABiz]

Ron A. Rhoades, JD, CFP® serves as Program Director for the Alfred State College Financial Planning Program. This article represents his views only, and not necessarily the views of any organization to which he may be affiliated.

To follow Ron’s articles, connect with him on LinkedIn or follow his Twitter posts (@140ltd).

[1] Smith, p. 14, Modern Library edition (1937)

[2] Smith, p. 423.
[3] Smith, p. 748, see also pp. 734-35. As seen, “Smith embraces both the great society and the judicious hand of the paternalistic state.” Shearmur, Jeremy and Klein, Daniel B. B., “Good Conduct in a Great Society: Adam Smith and the Role of Reputation.” D.B Klein, Reputation: Studies In The Voluntary Elicitation Of Good Conduct, pp. 29-45, University of Michigan Press, 1997. Available at http://ssrn.com/abstract=464023.
[4] Tamar Frankel, “Regulation and Investors’ Trust In The Securities Markets,” 68 Brook. L. Rev. 439, 448 (2002).
[5] Lowe v. SEC, 472 U.S. 181, 210, 105 S.Ct. 2557, 86 L.Ed.2d 130 (1985)


  1. Very interesting post! I personally think the constraint on greed is better achieved through stronger property rights and not more regulation. In many ways, the ills of capitalism have been the result of crony capitalism and not free market operations. For instance, it is the regulations themselves that allow brokers to get away with non-transparent interactions with their clients. If it weren't for our current regulations, I personally believe that the way many brokers and other transaction oriented advisors operate would constitute fraud. If we protect individuals from fraud through the legal system by giving them recourse against an advisor for anything deemed to be intentional deception, I think the investment advisory industry would quickly see much better disclosure. As we travel down the road of extended regulations, the powerful firms with the most lobbying power will likely have their influence and either constrain the interpretation of the fiduciary standard or allow for further pages of "disclosure" which shield them from recourse.

  2. Derek, Good comments. I agree with your comment about regulations - it just provides an opportunity for those to discern what they can do to "get around" the regulations. Yet, therein lies the beauty of principles-based regulation, and the fiduciary principle in particular.

    The fiduciary standard is not static – it evolves as the business practices of financial planners and investment advisers evolve, to fit the nature of the relationship between the parties.

    In the case of Stonemets v. Head, 248 Mo. 243, 154 SW 108 (1913), Judge Lamb or the Missouri Supreme Court stated: "Fraud is kaleidoscopic, infinite. Fraud being infinite and taking on protean form at will, were courts to cramp themselves by defining it with a hard and fast definition, their jurisdiction would be cunningly circumvented at once by new schemes beyond the definition. Messieurs, the fraud-feasors, would like nothing half so well as for courts to say they would go thus far, and no further in its pursuit."

    Breach of fiduciary duty is "constructive fraud" under the law (as opposed to actual fraud, usually involving deceitful action).

    I fear, as well, that the fiduciary standard will be weakened under the pervasive lobbying of the Wall Street and insurance company lobbies. The SEC's Request for Comments indicates just such a path.

    Yet, the fiduciary standard of conduct is of such great import to all Americans, as they seek to save and invest for their retirement security and other needs, that we should press on, with resolve, and seek to counter the forces which seek to not apply or to diminish the fiduciary standard when applied to those who provide investment and financial advice. To do otherwise would give the opponents to the fiduciary standard just the victory they seek.

    The fiduciary standard has recently been adopted - quite strictly - in the U.K., Australia, and New Zealand. We share a history of the law with these countries. The fiduciary standard is based upon common law, derived in large part from precedents established under English law. With resolve, we can accomplish the fiduciary standard here, in the United States. For the good of our fellow Americans. For the restoration of trust in our financial system, and for the capital formation and economic growth which will follow therefrom. In short, for the good of America.

  3. Excellent article Ron and excellent comments by both of you. If you allow investors to have recourse to the courts, with full discovery rights presently unavailable in arbitration, you would definitely see changes in the industry.

    As the court recognized in Archer v. Securities and Exchange Commission,

    [t]he business of trading in securities is one in which opportunities for dishonesty are of constant recurrence and ever present. It engages acute, active minds trained to quick apprehension, decision and action. The Congress has seen fit to regulate this business.

    Unfortunately, I do no think most of us hold out hope for a meaningful fiduciary standard from the SEC. This is the same SEC, charged with protecting investors,that shunned investors and fought the FPA when the SEC tried to ignore the law and protect the industry. Thankfully, an enlightened court prevented same and ruled in favor of the FPA.


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