The deadline of July 5, 2013 is fast approaching for submitting comments to the U.S. Securities and Exchange Commission (SEC) with regard to its Request for Information.
Comments to the SEC may be submitted at: http://www.sec.gov/cgi-bin/ruling-comments?ruling=4-606&rule_path=/comments/4-606&file_num=4-606&action=Show_Form&title=Duties%20of%20Brokers,%20Dealers,%20and%20Investment%20Advisers
To aid pro-fiduciary advocates in submitting their comments, I offer these quotes from various cases and administrative rulings and pronouncements. Please note that the bolding and highlighting are mine. As can be seen, there are many, many observations in support of applying the fiduciary standard of conduct to the delivery of personalized investment advice, and which further explain the fiduciary standard itself.
NO MAN CAN SERVE TWO MASTERS; THE CHARACTERS OF BUYER AND SELLER ARE INCOMPATIBLE; HUMAN NATURE DICTATES THE REMOVAL OF TEMPTATION
“It is well settled as a general principle, that trustees, agents, auctioneers, and all persons acting in a confidential character, are disqualified from purchasing. The characters of buyer and seller are incompatible, and cannot safely be exercised by the same person. Emptor emit quam minimo potest; venditor vendit quam maximo potest. The disqualification rests, as was strongly observed in the case of the York Buildings Company v. M'Kenzie, 8 Bro. Parl. Cas. 63, on no other than that principle which dictates that a person cannot be both judge and party. No man can serve two masters. He that it interested with the interests of others, cannot be allowed to make the business an object of interest to himself; for, the frailty of our nature is such, that the power will too readily beget the inclination to serve our own interests at the expense of those who have trusted us.” Carter v. Harris, 25 Va. 199, 204 (1826); 1826 Va. LEXIS 26; 4 Rand. 199 (Va. 1826).
(“[I}f persons having a confidential character were permitted to avail themselves of any knowledge acquired in that capacity, they might be induced to conceal their information, and not to exercise it for the benefit of the persons relying upon their integrity. The characters are inconsistent. Emptor emit quam minimo potest, venditor vendit quam maximo potest.” Michoud v. Girod, 45 U.S. 503; 11 L. Ed. 1076; 1846 U.S. LEXIS 412; 4 HOW 503 (1846).
“Christ said: ‘No man can serve two masters, for either he will hate the one and love the other, or else he will hold to the one and despise the other. Ye cannot serve God and Mammon [money].’") Beasley v. Swinton, 46 S.C. 426; 24 S.E. 313; 1896 S.C. LEXIS 67 (S.C. 1896), quoting Matthew 6:24.
“This Court, in discussing conflicts of interest, has said: ‘The reason of the rule inhibiting a party who occupies confidential and fiduciary relations toward another from assuming antagonistic positions to his principal in matters involving the subject matter of the trust is sometimes said to rest in a sound public policy, but it also is justified in a recognition of the authoritative declaration that no man can serve two masters; and considering that human nature must be dealt with, the rule does not stop with actual violations of such trust relations, but includes within its purpose the removal of any temptation to violate them ….’" SEC v. Capital Gains Research Bureau, 375 U.S. 180; 84 S. Ct. 275; 11 L. Ed. 2d 237; 1963 U.S. LEXIS 2446 (1963).
The principle is undeniable that an agent to sell cannot sell to himself, for the obvious reason that the relations of agent and purchaser are inconsistent, and such a transaction will be set aside without proof of fraud.” Porter v. Wormser , 94 N. Y. 431, 447 (1884).
States Supreme Court Justice Harlan F. Stone spoke at the dedication of the University of Michigan Law School Quadrangle. Some of his remarks, foreshadowing the troubled economic times of the early 21st Century, described abuses in unregulated financial markets as part of the cause of the Great Depression: "I venture to assert that when the history of the financial era which has just drawn to a close comes to be written, most of its mistakes and its major faults will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that “a man cannot serve two masters.” More than a century ago equity gave a hospitable reception to that principle. The separation of ownership from management, the development of the corporate structure so as to vest in small groups control over the resources of great numbers of small and uninformed investors, make imperative a fresh and active devotion to that principle if the modern world of business is to perform its proper function. Yet those who serve nominally as trustees, but relieved, by clever legal devices, from the obligation to protect those whose interests they purport to represent, corporate officers and directors who award themselves huge bonuses from corporate funds without the assent or even knowledge of their stockholders, reorganization committees created to serve interests of others than those whose securities they control, financial institutions which, in the infinite variety of their operations, consider only last, if at all, the interests of those whose funds they command, suggest how far we have ignored the necessary implications of that principle. The loss and suffering inflicted on individuals, the harm done to a social order founded upon business and dependent upon its integrity, are incalculable." Harlan F. Stone, The Public Influence of the Bar, 48 Harv. L. Rev. 1 (1934).
Alexander Hamilton once said: "The best security for the fidelity of men, is to make interest coincide with duty." Cited under the definition of "fidelity." See WEBSTER'S NEW 20TH CENTURY DICTIONARY 681 (2d ed. 1983).
As the Supreme Court said a hundred years ago, the law ‘acts not on the possibility, that, in some cases the sense of duty may prevail over the motive of self-interest, but it provides against the probability in many cases, and the danger in all cases, that the dictates of self-interest will exercise a predominant influence, and supersede that of duty.’
Or, as an eloquent Tennessee jurist put it before the Civil War, the doctrine ‘has its foundation, not so much in the commission of actual fraud, but in that profound knowledge of the human heart which dictated that hallowed petition, 'Lead us not into temptation, but deliver us from evil,’ and that caused the announcement of the infallible truth, that 'a man cannot serve two masters.'’
THE NATURE OF THE FIDUCIARY RELATIONSHIP OF TRUST AND CONFIDENCE
"In equity the court looks to the relationship of the parties -- the reliance, the dependence of one upon the other. Where a relationship of confidence is shown to exist, where trust is justifiably reposed, equity scrutinizes the transaction with a jealous eye; it exacts the utmost good faith in the dealings between the parties, and is ever alert to guard against unfair advantage being taken by the one trusted." Jothann v. Irving Trust Company, 151 Misc. 107; 270 N.Y.S. 721, citing Wendt v. Fischer, 215 A.D. 196; 213 N.Y.S. 351 (1926).
“[C]ontract law concerns itself with transactions while fiduciary law concerns itself with relationships.” Rafael Chodos, Fiduciary Law: Why Now! Amending the Law School Curriculum, 91 Boston U.L.R. 837, 845 (and further noting that “Betraying a relationship is more hurtful than merely abandoning a transaction.”
Professor Arthur B. Laby has noted, “Historically, providing advice has given rise to a fiduciary duty owed to the recipient of the advice. Both the Restatement (First) and Restatement (Second) of Torts state, “[a] fiduciary relation exists between two persons when one of them is under a duty to act for or to give advice for the benefit of another upon matters within the scope of the relation” [citing Restatement (Second) Of Torts § 874 cmt. a (1979) (citation omitted) (emphasis added); Restatement (First) Of Torts § 874 cmt. a (1939) (citation omitted) (emphasis added)].
“What generally sets the fiduciary apart from other agents or service providers is a core duty, when acting on the principal’s behalf, to adopt the objectives or ends of the principal as the fiduciary’s own.” Arthur B. Laby, SEC v. Capital Gains Research Bureau and the Investment Advisers Act Of 1940, 91 Boston Univ. L.Rev. 1051, 1055 (2011).
While there have been many judicial elicitations of the fiduciary standard, including Justice Benjamin Cardozo’s lofty elaboration, a relatively recent and concise recitation of the fiduciary principle can be found in dictum within the 1998 English (U.K.) case of Bristol and West Building Society v. Matthew, in which Lord Millet undertook what has been described as a “masterful survey”: "A fiduciary is someone who has undertaken to act for and on behalf of another in a particular matter in circumstances which give rise to a relationship of trust and confidence. The distinguishing obligation of a fiduciary is the obligation of loyalty. The principle is entitled to the single-minded loyalty of his fiduciary. This core liability has several facets. A fiduciary must act in good faith; he must not place himself in a position where his duty and his interest may conflict; he may not act for his own benefit or the benefit of a third person without the informed consent of his principal. This is not intended to be an exhaustive list, but it is sufficient to indicate the nature of the fiduciary obligations. They are the defining characteristics of a fiduciary."
In an address entitled “The SEC and the Broker-Dealer” by Louis Loss, Chief Counsel, Trading and Exchange Division, U.S. Securities and Exchange Commission on March 16, 1948, before the Stock Brokers’ Associates of Chicago, the fiduciary duties arising under the Advisers Act, as applied in the Arleen Hughes release, were elaborated upon:
The doctrine of that case, in a nutshell, is that a firm which is acting as agent or fiduciary for a customer, rather than as a principal in an ordinary dealer transaction, is under a much stricter obligation than merely to refrain from taking excessive mark-ups over the current market. Its duty as an agent or fiduciary selling its own property to its principal is to make a scrupulously full disclosure of every element of its adverse interest in the transaction.
In other words, when one is engaged as agent to act on behalf of another, the law requires him to do just that. He must not bring his own interests into conflict with his client's. If he does, he must explain in detail what his own self-interest in the transaction is in order to give his client an opportunity to make up his own mind whether to employ an agent who is riding two horses. This requirement has nothing to do with good or bad motive. In this kind of situation the law does not require proof of actual abuse. The law guards against the potentiality of abuse which is inherent in a situation presenting conflicts between self-interest and loyalty to principal or client. As the Supreme Court said a hundred years ago, the law ‘acts not on the possibility, that, in some cases the sense of duty may prevail over the motive of self-interest, but it provides against the probability in many cases, and the danger in all cases, that the dictates of self-interest will exercise a predominant influence, and supersede that of duty.’ Or, as an eloquent Tennessee jurist put it before the Civil War, the doctrine ‘has its foundation, not so much in the commission of actual fraud, but in that profound knowledge of the human heart which dictated that hallowed petition, 'Lead us not into temptation, but deliver us from evil,’ and that caused the announcement of the infallible truth, that 'a man cannot serve two masters.'’
This time-honored dogma applies equally to any person who is in a fiduciary relation toward another, whether he be a trustee, an executor or administrator of an estate, a lawyer acting on behalf of a client, an employee acting on behalf of an employer, an officer or director acting on behalf of a corporation, an investment adviser or any sort of business adviser for that matter, or a broker. The law has always looked with such suspicion upon a fiduciary's dealing for his own account with his client or beneficiary that it permits the client or beneficiary at any time to set aside the transaction without proving any actual abuse or damage. What the recent Hughes case does is to say that such conduct, in addition ‘to laying the basis for a private lawsuit, amounts to a violation of the fraud provisions under the securities laws: This proposition, as a matter of fact, is found in a number of earlier Commission opinions. The significance of the recent Hughes opinion in this respect is that it elaborates the doctrine and spells, out in detail exactly what disclosure is required when a dealer who has put himself in a fiduciary position chooses to sell his own securities to a client or buys the client's securities in his own name …
The nature and extent of disclosure with respect to capacity will vary with the particular client involved. In some cases use of the term ‘principal’ itself may suffice. In others, a more detailed explanation will be required. In all cases, however, the burden is on the firm which acts as fiduciary to make certain that the client understands ….
RE: BROKERS AS FIDUCIARIES
“Essentially, a broker or agent is a fiduciary and he thus stands in a position of trust and confidence with respect to his customer or principal. He must at all times, therefore, think and act as a fiduciary. He owest his customer or principal complete obedience, complete loyalty, and the exercise of his unbiased interest. The law will not permit a broker or agent to put himself in a position where he can be influenced by any considerations other than those to the best interests of his customer or principal … A broker may not in any way, nor in any amount, make a secret profit … his commission, if any, for services rendered … under the Rules of the Association must be a fair commission under all the relevant circumstances.” – from The Bulletin, published by the National Association of Securities Dealers, Volume I, Number 2 (June 22, 1940).
Later, in discussing the decisions of two cases, the NASD wrote that it was “worth quoting” statements from the opinions: “In relation to the question of the capacity in which a broker-dealer acts, the opinion quotes from the Restatement of the law of Agency: ‘The understanding that one is to act primarily for the benefit of another is often the determinative feature in distinguishing the agency relationship from others. *** The name which the parties give the relationship is not determinative.’ And again: ‘An agency may, of course, arise out of correspondence and a course of conduct between the parties, despite a subsequent allegation that the parties acted as principals.’” - from N.A.S.D. News, published by the National Association of Securities Dealers, Volume II, Number 1 (Oct. 1, 1941).
RE: THE DECEPTIVE USE OF TITLES AND DESIGNATIONS
“The relationship between a customer and the financial practitioner should govern the nature of their mutual ethical obligations. Where the fundamental nature of the relationship is one in which customer depends on the practitioner to craft solutions for the customer’s financial problems, the ethical standard should be a fiduciary one that the advice is in the best interest of the customer. To do otherwise – to give biased advice with the aura of advice in the customer’s best interest – is fraud. This standard should apply regardless of whether the advice givers call themselves advisors, advisers, brokers, consultants, managers or planners.” James J. Angel, Ph.D., CFA and Douglas McCabe Ph.D., Ethical Standards for Stockbrokers: Fiduciary or Suitability? (Sept. 30, 2010).
“If the transaction is in reality an arm's-length transaction between the securities house and its customer, then the securities house is not subject' to 'fiduciary duty. However, the necessity for a transaction to be really at arm's-length in order to escape fiduciary obligations, has been well stated by the United States. Court of Appeals for the District of Columbia in a recently decided case: ‘[T]he old line should be held fast which marks off the obligation of confidence and conscience from the temptation induced by self-interest. He who would deal at arm's length must stand at arm's length. And he must do so openly as an adversary, not disguised as confidant and protector. He cannot commingle his trusteeship with merchandizing on his own account…’”Seventh Annual Report of the Securities and Exchange Commission, Fiscal Year Ended June 30, 1941, at p. 158, citing Earll v. Picken, 113 F. 2d 150 (1940).
The SEC “has held that where a relationship of trust and confidence has been developed between a broker-dealer and his customer so that the customer relies on his advice, a fiduciary relationship exists, imposing a particular duty to act in the customer’s best interests and to disclose any interest the broker-dealer may have in transactions he effects for his customer … [BD advertising] may create an atmosphere of trust and confidence, encouraging full reliance on broker-dealers and their registered representatives as professional advisers in situations where such reliance is not merited, and obscuring the merchandising aspects of the retail securities business … Where the relationship between the customer and broker is such that the former relies in whole or in part on the advice and recommendations of the latter, the salesman is, in effect, an investment adviser, and some of the aspects of a fiduciary relationship arise between the parties.” 1963 SEC "Special Study of Securities Markets"
“The blurring of the line between brokers and advisers is by now a familiar story. Until the early 1970’s, fixed commission rates enforced by the stock exchanges limited competition in the brokerage industry, generating lucrative rents. The unfixing of commission rates in 1975 via Congressional and SEC mandate led to a rapid reduction in commission rates for executing trades because of aggressive competition and technological innovation, which in turn caused brokers to seek out alternative sources of income.” Donald C. Langevoort, Brokers as Fiduciaries, 71 U.Pittsburgh L. Rev. 439, 440 (2010).
RE: THE LOW ETHICAL STANDARDS OF BROKERS
“[T]he merchandising emphasis of the securities business in general, and its system of compensation in particular, frequently impose a severe strain on the legal and ethical restraints.” – 1963 SEC "Special Study of Securities Markets"
The Chairman of the NASD early on opined: “[T]he time may come when we can arrive at a more professional status and we can give more of our attention as to who should be in the investment business ... The principal by-product [of formation of the SRO], which I don’t believe the founding fathers of this Association ever thought of, is that for the first time in history the securities dealer begins to see what he looks like and it hasn’t been altogether a pleasing sight.” - statement of NASD Chairman Robert W. Baird in an address before the convention of the National Association of Securities Commissioners, as quoted in N.A.S.D. News, published by the National Association of Securities Dealers, Volume II, Number 1 (Nov. 15, 1941).
RE: THE IMPACT OF INVESTOR DISTRUST OF FINANCIAL INTERMEDIARIES ON CAPITAL FORMATION AND ECONOMIC GROWTH
“[S]pecific trust in advice given by financial institutions represents a prominent factor for stock investing, compared to other tangible features of the banking environment.” [Georgarakos, Dimistris, and Pasini, Giacomo, Trust, Sociability and Stock Market Participation (2009), available at http://www.aueb.gr/conferences/Crete2010/Senior/Georgarakos.pdf.]
See also César Calderón, Alberto Chong, and Arturo Galindo, Structure and Development of Financial Institutions and Links with Trust: Cross-Country Evidence (2001) (“We use a new World Bank data set that provides the most comprehensive coverage of financial development and structure to this date. We find that trust is correlated with financial depth and efficiency as well as with stock market development.”) Available at http://www.iadb.org/res/publications/pubfiles/pubWP-444.pdf.
“It is well documented that public trust is positively correlated with economic growth … and with participation in the stock market … we develop a two-period theoretical model in which investors entrust their wealth to a continuum of heterogeneous agents and rely on the agents to honor their fiduciary duty … Trust that arises from the law evolves because investors can rely on the government to make sure that agents honor their fiduciary duty to clients … we consider the effect that professional fees have on the trust that forms in markets … We show that when the value to social capital is relatively low and/or [when] the growth potential in the economy is low, it is never optimal to institute a Coasian plan (absence of government regulation). We also show that ceteris paribus there should be more government intervention in a low-trust equilibrium than in a high-trust equilibrium.” [Carlin et. al., supra.]
RE: 12b-1 FEES AS ADVISORY FEES IN DRAG
Note: While not directly related to the fiduciary debate currently before the SEC, the fact that brokers receive 85% of the 12b-1 fees charged by mutual fund complexes sure does make them look like investment advisers - and in my view the receipt of such fees constitutes "special compensation" triggering registration as an investment adviser (i.e., the broker-dealer exclusion from registration is no longer available).
“It is not necessary that an adviser's compensation be paid directly by the person receiving investment advisory services, but only that the investment adviser receive compensation from some source for his services.” SEC Release IA-770 (1981).
"If it walks like a duck, talks like a duck, and acts like a duck, it's a duck."