A Blunt Refusal to be Compromised

The power of a bona fide fiduciary lies in her or his blunt refusal to be compromised.

Steadfast Integrity. Complete Objectivity. Expert Advice. Complete Candor and Honesty.

The Power of Trust.

Should We Rally Around the CFP Board's Rules of Conduct?

It is time to look for an appropriate marketplace solution to the problem that consumers do not know who they can trust. The essential problem is that Wall Street has captured the SEC, and that the SEC has over the past three decades essentially gutted the fiduciary standard under the Investment Advisers Act - by not applying it and by permitting investment advisers (especially dual registrants) to disclaim away their core fiduciary duty of loyalty. Of course, we know consumers don't understand these disclaimers ("disclosures"), nor the impact of the conflict-ridden practices which the SEC permits dual registrants to engage in.

[See my prior post for a detailed set of subordinate rules, underlying the five core fiduciary principles, which collectively set forth what amounts to a bona fide fiduciary standard. http://scholarfp.blogspot.com/2014/11/less-use-of-financial-advisors-due-to.html]

Given its size and resources, since my prior post some financial advisors have suggested to me that the Certified Financial Planner Board of Standards, Inc. is the best-positioned organization to effect a marketplace solution with a bona fide fiduciary standard. Yet, are the CFP Board's Rules of Conduct a true, bona fide fiduciary standard? And are the CFP Board's conduct standards applied at all times when personalized investment or financial planning advice is delivered?

By way of background, the CFP Board's rules state, in part: "1.4 A certificant shall at all times place the interest of the client ahead of his or her own. When the certificant provides financial planning or material elements of financial planning, the certificant owes to the client the duty of care of a fiduciary as defined by CFP Board."

Not All CFPs are Fiduciaries: The Puzzle as to When "Financial Planning" Takes Place.

The CFP Board also goes on to describe when a "financial plan" is being undertaken in its Rules of Conduct. While, to its credit, the CFP Board takes the position that once fiduciary status is assumed the certificant remains a fiduciary throughout the financial planning relationship, there still appear to be instances in which the definition of "financial planning" is construed quite narrowly.

Many, including me, have expressed dismay at the CFP Board's interpretation of when "financial planning" exists. In essence, it appears to be a vague, multi-factor test which in my view has little basis in common law. Even worse, the CFP Board's application of the test is confusing to both certificants and advisors. I've listened several times to the CFP Board's webinars which directly address when "financial planning" takes place, and I come away each time befuddled (but not amused). I'm trained as a lawyer, a compliance officer, and I'm an academic - yet I cannot understand the fine lines which the CFP Board attempts to draw (or, perhaps, not draw) nor can I discern how they are founded in established principles of law, including the duty to avoid fraudulent representations found in all commercial transactions.

Should not, as well, the mere holding out as an expert advisor evoke fiduciary status? Should not the use of the term "Certified Financial Planner" automatically result in fiduciary status, at all times when providing any financial advice (including any investment advice)? (See my prior blog post for detail as to when "advice" is provided - I encourage the adoption of Harold Evensky's "you" test.) Otherwise, as others have written, does not the use of a term or title which denotes a relationship of trust and confidence, when none exists, result in a "bait-and-switch" and become tantamount to fraud?

Does the CFP Board Believe That Disclosure of a Conflict of Interest is All That is Required?

I firmly believe that the core fiduciary duty of loyalty cannot be waived. Even the "contractualists" (of fiduciary law theory) seem to agree with this general proposition. This is why the fiduciary duty of loyalty requires, even after disclosure occurs, that informed consent of the client occur, and even then that the transaction be fundamentally fair to the client.

In other words, courts refuse to believe that clients would consent to be harmed. At least that is not "informed" consent. (Unless, of course, you believe that clients are gratuitous, and like to gift extra fees to their fiduciary advisors to their own detriment.) Also, courts require that even with disclosure and informed consent, the transaction be and remain substantively fair to the client. If the client does not receive advice which is in the client's best interest, by reason of subordination of the client's interest to the desire of the advisor for more compensation, then such advice is not substantively fair.

In other words, disclosure of a conflict of interest does not negate the ongoing duty of the advisor to keep the client's best interests paramount, and to not subordinate the client's interests to those of the advisor or his or her firm.

But is this the way the CFP Board actually enforces its Rules of Conduct? I note the following excerpt from Bob Veres' Sept. 9, 2014 article, appearing in AdvisorPerspectives, entitled: "What is 'Fee-Only?' Is the CFP Board Taking the Right Approach to Defining It?"

"[U]nder the trees at [the FPA] Retreat, [Rick] Kahler says he posed this fiduciary enforcement question to [Michael] Shaw [General Counsel of the CFP Board], who happens to be a former Northwestern Mutual life agent and NASD (now FINRA) staff attorney in an organization whose primary mission was (and is) to regulate sales activities.  'His answer,' says Kahler, 'was: Rick, if I enforced the fiduciary standard on life insurance agents, I would put insurance companies out of business. I found myself wondering:  who are they supposed to be protecting, the insurance companies or the public? Later he told me: I just can’t get into hair-splitting on what fiduciary is or isn’t. In some cases, those high-fee commission products may have been appropriate. My basic concern is that they disclose compensation.  If they have disclosed compensation, they have fulfilled their fiduciary obligation.' (Another participant in this under-the-trees conversation confirmed to me the accuracy of Kahler’s portrayal of it.  Shaw categorically denies that he said this, though he does say that the general subject of 'fiduciary' was raised.)" [Emphasis added.]

I hope that this position - that mere disclosure of compensation equates to proper management of the conflicts of interest that compensation arrangements often create - is NOT the position of the CFP Board.

Yet, the CFP Board's Rules of Conduct, though progressive at the time they were re-proposed in 2006 and adopted in 2007, appear strikingly bare in describing the parameters of the fiduciary duties of the certificant. This leaves the door wide open for various misinterpretations.

I served as Reporter for the Financial Planning Association's Fiduciary Task Force in 2006-7, which issued a lengthy report. Since the time of that report, in large part due to the ongoing legislative and regulatory debates about whether to apply the fiduciary standard (by rule) to brokers who provide personalized investment advice, we now possess a much greater understanding of what the fiduciary standard is all about, and what it requires. In essence, the CFP Board's 2007 Rules of Conduct are now outdated, and require revision.

Should We "Rally Around" the CFP Certification? Should the FPA?

Michael Kitces alludes to the "rallying" cry around the CFP Board's marks, in a fairly recent blog post (Could The FPA’s Waning Power Given Its Declining Market Share Of CFP Certificants Lead To Its Untimely Demise? - Kitces.com http://www.kitces.com/blog/could-the-fpas-waning-power-given-its-declining-market-share-of-cfp-certificants-lead-to-its-untimely-demise/). A response from the FPA occurred, followed by a response from Michael (both found at http://www.kitces.com/blog/why-im-so-critical-of-the-fpa-that-i-support-and-the-fpa-leadership-responds-in-writing/).

Further commentary thereon has been provided by Bob Clark (Should the FPA Get Behind the CFP Board, or Go It Alone? ThinkAdvisor www.thinkadvisor.com/2014/10/29/should-the-fpa-get-behind-the-cfp-board-or-go-it-a). Also see Bob's more recent post: http://www.thinkadvisor.com/2014/11/05/why-the-fpa-cant-win-in-the-broker-market.

While the discussion involves many aspects of the history of the Financial Planning Association and its relationship with the CFP Board, I believe the focus of any discussion by other industry organizations (FPA, NAPFA, and perhaps others) should be simply this: Are the CFP Board's Rules of Professional Conduct, as written and as applied and as enforced, sufficient to constitute a bona fide fiduciary standard, thereby entitling consumers to look toward all CFP Board's certificants as THE source of trusted, objective, expert (and fiduciary) advice?

In Search of the Marketplace Solution.

As I related in my prior blog post, a recent survey demonstrated that many consumers do not use financial advisors, of any kind, because they don't know if they can trust any of them.

I would prefer that the SEC reverse its policies of the last few decades and draw a meaningful and sensical line between sales and advice, and prohibit the use of titles which denote relationships of trust and confidence by "pretend advisors" who do not abide by, or disclaim away, the fiduciary duty of loyalty. Yet, given the substantial influence by Wall Street over the SEC, I doubt this is possible, in the current political climate. Especially given the influence by Wall Street over Congress, which in turn exerts its own influence on the SEC.

Hence, we must come up with a marketplace solution. I ask again - is the CFP Board the solution, around which we should all rally? I cannot at this time bring myself to that conclusion, as the CFP Board's application of its fiduciary standard seems to be hole-ridden and weak. Without a substantial revision of its standards, these discrepancies will continue to exist.

As a profession, we must ask - WHO DO WE SERVE? Many a jurist has opined that a fiduciary cannot serve two masters. If we truly serve clients, as their trusted advisors, we must embrace fiduciary standards under which that trust cannot be betrayed by particular exceptions or by the non-application of the standards to the delivery of professional advice.

The Financial Planning Association long ago embraced the CFP mark as the mark of the "profession." Yet, as the Financial Planning Association has apparently moved over the past 15 years or so toward greater service to the public and the embrace of fiduciary standards, over the past several years the CFP Board has seemingly moved in the opposite direction. The CFP Board has possessed significant targets for expansion of its number of certificants. Many have suggested that this broader base of certificants includes many who are primarily engaged in insurance and security sales, not the delivery of advice. And commentators have opined that many large broker-dealer firms and insurance companies have embraced the CFP Board, yet have also pressured the CFP Board to not apply or enforce its fiduciary standards.

This has placed the Financial Planning Association in a difficult position. Even though the FPA split off its brokers into a different organization many years ago, and then the FPA put its resources into defeating the SEC's ill-advised "fee-based accounts" rule, the FPA's past embrace of the CFP mark may not now be appropriate, given the CFP Board's evolution over the past several years.

I can hear the rebuttals already. Organizations might be inclined to reply that they continue to support the fiduciary standard as found in the Advisers Act. Yet, as I've stated previously, that Advisers Act's fiduciary standard has itself been eviscerated by the SEC, either expressly (through particular exceptions) or through de facto rule making via non-enforcement. As a profession we should not calibrate our standards to the weak standards of a regulator, but rather we should adopt a standard which justifies the placement of trust and confidence by consumers in the members of our profession.

Hence, I would ask the following of any organization which seeks to reply ... Would you agree that your members (or certificants, or designees) should all sign the "Fiduciary Oath" (as promulgated by The Committee for the Fiduciary Standard, and as re-printed in my previously blog post)? And, just as importantly, would you also agree that the 18 specific principles (or rules) I set forth in my previous blog post are firmly entrenched in your own standards? Would you be willing to adopt, in writing, those specific standards - for the benefit of both advisors (to ensure their understanding of the bona fide fiduciary standard) and for the benefit of the consumers they serve?

(In essence, I request that your organization does not reply with mere talking points and flowery general statements. If you choose to reply, be very clear and state whether your organization believes in, applies, and enforces the bona fide fiduciary standard I previously set forth.)

In a larger view, this is an old question that has haunted the "profession" since its inception (with sales roots) - are we, today, "advisors" or are we "salespersons"?

Only if we become bona fide fiduciaries will we be deserving of the trust and confidence of the public, and all of our clients. Until then, consumers won't trust us. Our profession will not achieve status as a "true profession" serving the public interest if we possess members who eschew bona fide fiduciary standards. Nor will we deserve legislative recognition as a profession. In short, the distrust which so many consumers possess of all "financial advisors" and "financial planners" may continue to occur, and be justified, at least at the professional organization level. Of course, this affects all of us.

I ask again ... what organization (non-profit or profit), or set of standards, deserves to be rallied around as a foundation for a true profession?

A related question arises, as we seek to move forward in the development of a true profession in which each of member of the profession is deserving of the trust and confidence of consumers (through adherence to bona fide fiduciary standards) ... What organizations, due to the weakness of their standards or inappropriate non-application of their standards, risk becoming irrelevant?

UPDATE: 12/4/2014: Bob Clark opines on one of my recent blog posts: Why Aren’t CFPs Always Subject to a Fiduciary Standard?  www.thinkadvisor.com/2014/12/03/why-arent-cfps-always-subject-to-a-fiduciary-stand?t=the-client http://fw.to/0AzoNBS

Less Use of Financial Advisors Due to Distrust: Exploring Potential Solutions

If American consumers believed that they could trust their financial advisors, demand for the services of financial advisors would soar. 

As long as American consumers cannot discern between ethical actors (who adhere to a bona fide fiduciary standard at all times, without disclaimers of core fiduciary duties, and keeping the clients' best interests first even when unavoided conflicts of interest are present and disclosed) and actors bound only by the weak suitability standard, the demand for financial planning and investment advice will stagnate. Consumers will often choose to "go it alone" - as many have.

We have a problem in America.

The world is far more complex for individual investors today than it was just a generation ago. There exist a broader variety of investment products, including many types of pooled and/or hybrid products, employing a broad range of strategies.

This explosion of financial products has hampered the ability of plan sponsors and individual investors to sort through the many thousands of investment products to find those very few which best fit within the retirement plan or individual investor’s portfolios. Furthermore, as such investment vehicles have proliferated, plan sponsors and individual investors are challenged to discern an investment product’s true “total fees and costs,” investment characteristics, tax consequences, and risks. Simply put, retirement plan sponsors and their participants are at a vast disadvantage.

Information Asymmetry is Vast and will Never Disappear.

Disparities in the availability of information, or its quality, or its understanding, lead to advantages by those endowed with the ability to decipher, discern and apply the information correctly. It must be recognized that efforts to enhance financial literacy, while always worthwhile and important, will never transform the ordinary American into a wholly knowledgeable consumer of financial products and services, just as we cannot expect the average American to perform brain surgery.

Given the sophisticated nature of modern financial markets and complex array of investment products, it is not just the uneducated that are placed at a substantial disadvantage – it is nearly all Americans. Hence, other means are necessary to negate advantages brought on by information asymmetry.

If Disclosures Alone were Sufficient, There Would be no Need for the Fiduciary Standard of Conduct.

Substantial academic research has revealed that disclosure is not effective as a means of dealing with the vast information asymmetry present in the world of financial services. Indeed, as the sophistication of our capital markets had increased, so has the knowledge gap between individual consumers and financial advisors.

Additionally, academic research now reveals that disclosures, while important, can lead to perverse results – i.e., worse advice is provided if the advisor, following disclosure, feels unconstrained by the application of the fiduciary standard of conduct.

The Need to Embrace Fiduciary Principles for Certain Actors.

Because of the vast information asymmetry, and due to the many behavioral biases consumers possess which deter them from effectively spending the time and effort to read and understand mandated disclosures, there exists a great need for financial and investment advice. In such situations, our fellow citizens place trust and confidence in their personal financial advisor. It is right and just in such circumstances that broad fiduciary duties be applied to these financial intermediaries.

The absence of appropriate high ethical standards for all providers of personal financial advice, whether to plan sponsors, plan participants, IRA account owners, or others, is a glaring current gap in the financial services regulatory structure.

The Need to Ensure Distinctions between the Types of Financial Intermediaries.

Individual consumers should be empowered to more easily identify the difference between the financial advice role (to which fiduciary status should attach) and the product marketing role (an arms-length relationship, to which only far lesser obligations, such as ensuring suitability, apply). Currently these roles are closely intertwined, and it is exceedingly difficult for consumers to distinguish between them (in part because the product marketer type of intermediary possesses no incentive to make that distinction clear).

Our regulators possess the authority and the ability to ensure that consumers are not misled by the use of titles and designations, and they should ensure that all those who hold themselves out as trusted advisors – or who actually provide advisory services – are bound to act in the interests of their clients under the fiduciary standard of conduct. But, our regulators do not appear to have the backbone to prevent ongoing fraud from occurring. As a result, most consumers who possess "financial consultants" (or advisors with similar titles) believe that their advisor is bound to act in their best interests; sadly, in most instances the advisor is not bound by a fiduciary standard, but is only governed by the suitability standard (designed to protect the advisor, not the consumer).

Investor Distrust = Less Capital Formation & Less U.S. Economic Growth.

The siphoning of profits by Wall Street, away from the hands of individual investors, has led to a high level of individual investor distrust in our system of financial services and in our capital markets. In fact, many individual investors, upset after finally discovering the high intermediation costs present, flee the capital markets altogether. (Many more would flee if they discovered all of the fees and costs they were paying, and realized the substantial effect such had on the growth or preservations of their nest eggs.) 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 a result of the growth of investor distrust in financial intermediaries, the capital markets are further deprived of the capital that fuels American business and economic expansion, and the cost of capital rises yet again. Indeed, as high levels of distrust of financial services continue, the long-term viability of adequate capital formation within the United States is threatened, leading to greater reliance on infusions of capital from abroad. In essence, by not investing ourselves in our own economy, we are selling our bonds, corporate and other assets to investors abroad.

It is well documented that public trust is positively correlated with economic growth. Moreover, public trust is also correlated with participation by individual investors in the stock market. This is especially true for individual investors with low financial capabilities – those who in our society are in most need of financial advice; policies that affect trust in financial advice seem to be particularly effective for these investors.

The lack of trust in our financial system has potential long-range and severe adverse consequences for our capital markets and our economy. As stated by Prof. Ronald J. Columbo in a recent law review article: “Trust is a critical, if not the critical, ingredient to the success of the capital markets (and of the free market economy in general). As Alan Greenspan once remarked: ‘[O]ur market system depends critically on trust - trust in the word of our colleagues and trust in the word of those with whom we do business.’ From the inception of federal securities legislation in the 1930s, to the Sarbanes-Oxley Act of 2002, to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, it has long been understood that in the face of economic calamity, the restoration and/or preservation of trust – especially investor trust – is paramount in our financial institutions and markets.”

There is no doubt that “[t]rust is a critically important ingredient in the recipes for a successful economy and a well-functioning financial services industry. Due to scandals ranging in nature from massive incompetence to massive irresponsibility to massive fraud; investor trust is in shorter supply today than just a couple of years ago. This is troubling, and commentators, policymakers, and industry leaders have all recognized the need for trust's restoration …."

Less Trust = Less Use of Financial Advisors

The issue of investor trust in financial intermediaries does not just concern asset managers and Wall Street’s broker-dealer firms; it affects all investment advisers and financial advisors to individual clients. As Tamar Frankel, a leading scholar on U.S. fiduciary law, once 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.”

In an Oct. 30, 2014 article by Donald Liebenson, "Why Don't Self-Directed Investors Use a Financial Advisor?" - appearing in Spectrum's Millionaire's Corner online publication, "[t]he primary reason for 36 percent of non-Millionaires who elect to go solo regarding their wealth management and financial planning is that they do not believe that a financial advisor would be looking out for their best interests."

Personally, I have seen this time and again. Once burned (or, in some instances, burned several times) by non-fiduciary "financial consultants" and "wealth managers," the consumer turns to self-directed advice. And, too often, consumers who are burned by their "financial advisors" often turn instead to bank depository accounts, thereby avoiding investments in the capital markets (which, by limiting supply of capital, increases the cost of capital to companies).

What Now? Regulatory Solutions?

We can hope that the White House will permit the U.S. Department of Labor (specifically, the Assistant Secretary of EBSA, Phyllis Borzi, and her team) proceed to re-issue the "definition of fiduciary" rule, which would logically apply fiduciary rules to advisors to plan sponsors (who are themselves fiduciaries, and hence should rarely if ever rely upon non-fiduciaries for advice). Given the importance of retirement security for our fellow Americans, the extension of ERISA's sole interests standard to IRA accounts is part of the proposal. Yet, tens of millions of dollars (if not more) are being spent each and every year and hundreds of lobbyists (working on behalf of large Wall Street firms and insurance companies) seek to prevent this rule from seeing the light of day, or alternatively to delay the issuance of the proposed rule. I've been waiting since early 2013 for the DOL's proposal to be released; let's hope an early 2015 release will occur.

We can also hope that the SEC will act, using its authority, to extend the Investment Adviser Act's fiduciary standard (as modified to a degree by Dodd-Frank) to all providers of personalized investment advice, however registered. Yet, the SEC has delayed the process of engaging in rule-making by ordering up another economic analysis. And, given the intense pressure exerted by Congress on the SEC, Chair Mary Jo White may desire to focus on other issues the SEC is required to act upon, pursuant to Dodd Frank. Additionally, as a result of actions taken over the past three decades, the SEC has already gutted the fiduciary standard - by permitting waivers of core fiduciary obligations (and hence permitting double-dipping and similar abuses), and by permitting an easy removal of the fiduciary hat (and, in essence, hat-switching back and forth). Even if the SEC acts, it is unlikely that the SEC's fiduciary standard will be a strong one; the SEC's fiduciary standard will likely continue to be weakened by "particular exceptions" (as the late Justice Benjamin Cardoza warned against).

We can hope that the various state securities administrators step up to the table and adopt new model statutues and/or rules setting forth a bona fide fiduciary standard. But, given the continued preemption of state authority by Congress, they may be fearful of the backlast which would likely ensue from Congress (which is substantially influenced by Wall Street's lobbyists).

The Private Marketplace Solution ... Who Has It?

While continuing to advocate before federal and state policymakers on the fiduciary standard remains important, I believe it is time to also search out and embrace a marketplace solution.

It is important, however, for this marketplace solution to embrace a bona fide fiduciary standard - with principles that are broad and all-encompassing, yet with subsidiary principles (or rules) which illuminate upon the broad principles and leave little or no avenues for those who seek to circumvent the rules by creative "interpretations" of the broad principles.

What is a bona fide fiduciary standard? As stated above - it is not just disclosure of a conflict of interest, when a conflict of interest exists. Rather, it proper management of that conflict of interest. Of course, fiduciary duties also involve a strong professional duty of care.

Where can we find a bona fide fiduciary standard? We can start with The Committee for the Fiduciary Standard (or "CFS," of which this author serves as Chair of its Steering Committee), a group of volunteers. The CFS posits that the fiduciary standard as currently applied under the Advisers Act can be summarily articulated as a set of five core principles:

• Put the client’s best interests first;
• Act with prudence, that is, with the skill, care, diligence and good judgment of a professional;
• Do not mislead clients--provide conspicuous, full and fair disclosure of all important facts;
• Avoid conflicts of interest;
• Fully disclose and fairly manage, in the client’s favor, unavoidable conflicts.

These five core principles form the basis of The Committee for the Fiduciary Standard's "Fiduciary Oath," which all consumers should insist on be signed by their financial advisor or investment adviser:

PUTTING YOUR INTERESTS FIRST 

I believe in placing your best interests first. Therefore, I am proud to commit to the following five fiduciary principles: 

• I will always put your best interests first. 
• I will act with prudence; that is, with the skill, care, diligence, and good judgment of a professional. 
• I will not mislead you, and I will provide conspicuous, full and fair disclosure of all important facts. 
• I will avoid conflicts of interest. 
• I will fully disclose and fairly manage, in your favor, any unavoidable conflicts. 

Advisor ____________________________ 
Firm Affiliation ____________________________ 
Date ____________________________ 

Yet, today we see terms such as "best interests" are being co-opted by non-fiduciary. (Witness, for example, FINRA's embrace of the term in recent communications.) Hence, further definition of the principles appears to be required.

While the world "fiduciary" is not utilized in the CFS' Fidicuary Oath, the five principles flow from the broad fiduciary standard of conduct applied to investment advisers, which is commonly set forth in the United States as a triad of broad fiduciary duties – due care, loyalty, and utmost good faith. As a result, from the CFS' five core principles we can discern additional specific principles in applying the fiduciary standard which can serve to guide both fiduciaries and their clients.

To this end, I propose "Professional Standards of Conduct" which, together with the Five Core Principles and the "Fiduciary Oath," all bona fide fiduciaries can voluntarily subscribe to. Set forth below, these Financial Advisor and Investment Adviser Professional Standards of Conduct are patterned, in part, after the Model Rules of Professional Conduct of the American Bar Association (as attorneys also possess fairly strict fiduciary obligations toward their client). The included footnotes, below, further explore each specific standard.

Which Organization(s) Will Step Forward?

There are many organizations which possess some form of voluntary adherence to a "Code of Ethics" or "Fiduciary Oath" or "Standards of Conduct." At times interpretations of these standards permit actors to not be required to be a fiduciary at all times, when providing financial advice. At other times these voluntary codes are ill-prescribed and/or possess giant loopholes.

Which organization(s) will step forward to adopt clear and unequivocal fiduciary standards for its members, at all times when fiduciary standards are applied?

Which organization(s) exist now, if any, around which we - as an emerging profession - can voluntarily embrace as our professional standard of conduct?

• CFP Board?
• FPA?
• NAPFA?
• Alliance of Comprehensive Planners?
• Garrett Planning Network?
• IAA?
• CFA Institute?
• AICPA/PFP Section?
• ChFC?
• fi360 (AIF)?
• CEFEX?
• Institute for the Fiduciary Standard?
• Others?

In each instance, exploration is needed as to whether the organization embraces bona fide fiduciary standards of conduct (as set forth in detail, below) to the delivery of all personalized financial and investment advice.

Moreover, even with the adoption of the proper oath and standards, the organization must be committed to providing media exposure to its "Fiduciary Oath" and "Standards of Professional Conduct," through concerted promotion, in order to ensure an increased awareness by consumers of where consumers can go for trusted advice. Only in that manner will consumers avail themselves of the trusted financial advice which they need in order to better secure the attainment of their financial goals. Only in that manner will the vast majority of Americans eventually secure trusted advice, leading to increased capital formation and U.S. economic growth. As well as more secure personal financial futures.

Of course, if none of the above organizations is willing to embrace professional standards of conduct, of the form set forth below, should a new organization be formed? If so, should it be private and for-profit, or private and not-for-profit?

These are difficult questions. Let us hope we can explore these questions, and find potential solutions, in the months and years ahead. For the sake of a true profession. For the sake of all Americans.

Ron A. Rhoades, JD, CFP(r)
Asst. Professor, Business Department
Program Director, Financial Planning Program
Alfred State College
Alfred, NY

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For more information about Prof. Ron A. Rhoades, JD, CFP® please visit:

http://www.alfredstate.edu/users/rhoadera 

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The foregoing article represents the individual views of Ron Rhoades, and should not be attributed to any organization with which Ron is affliated in any manner. To contact Ron Rhoades, please e-mail: RhoadeRA@AlfredState.edu. Thank you.
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(NOTE: THESE PROPOSED STANDARDS CAN BE MODIFIED TO ALSO APPLY TO THE DELIVERY OF OTHER ASPECTS OF FINANCIAL ADVICE.)

INVESTMENT ADVISER PROFESSIONAL STANDARDS OF CONDUCT

Any statement which merely describes a security, without more,[i] shall not be construed as personalized investment advice. However, any statement by an investment adviser or broker or their representatives which expresses whether a security is appropriate for a retail client or which constitutes a recommendation[ii] for the purchase or sale of a security by a specific retail client shall be considered the delivery of personalized investment advice.

Investment advisers and brokers, and their representatives, are professionals[iii] providing personalized investment advice are given the highest degree of trust and confidence[iv] by their clients. They are fiduciaries in the broadest sense, and accordingly possess broad fiduciary duties of undivided loyalty, due care, and utmost good faith to the client.  Accordingly, but not by way of limitation,[v] investment advisers and brokers providing personalized investment advice and their representatives shall:

1)         act in the best interests[vi] of the client;

2)         be obedient to the client’s instructions;

3)         act with the utmost good faith,[vii] honestly, and without intimidation;

4)         use reasonable care[viii] to avoid making any misrepresentations to their clients;[ix]

5)         use reasonable care and judgment to achieve and maintain independence[x] and to provide independent,[xi] objective advice;

6)         reasonably act to avoid[xii] conflicts of interest;

7)         not offer, solicit, or accept any gift, benefit, compensation, or consideration[xiii] that reasonably could be expected to compromise their independence and objectivity;

8)         fully disclose[xiv] all material[xv] facts to their clients[xvi] affirmatively[xvii] and in a timely[xviii] manner, including but not limited to conflicts of interest which are not reasonably avoided, in a manner in which client understanding[xix] is assured;

9)         properly manage any remaining conflicts of interest in order to secure the client’s informed consent[xx] to a transaction which remains substantively fair to the client, in order that that the client’s best interests remain paramount[xxi] above the interests of the broker or adviser[xxii];

10)     reasonably seek to not favor the interests of any one client over the interest of another client;

11)     act with the due care,[xxiii] applying the requisite knowledge, experience and attention to the engagement expected of a professional providing personalized investment advice;[xxiv]

12)     ensure that the total fees and costs paid by the client in connection with personalized investment advice and the investments selected are reasonable under the circumstances;

13)     reasonably consider and recommend to the client such strategies and investment products which may reduce the tax burdens imposed upon the client over time;

14)     keep all information about clients (including prospective clients and former clients) in strict confidence, including the client’s identity, the client’s financial circumstances, the client’s security holdings, and advice furnished to the client by the firm, unless the client consents otherwise;

15)     shall be subject to the foregoing fiduciary standards with respect to all of the investment and financial advisory activities provided to the client;

16)     shall not seek to have any client waive[xxv] the adviser’s core duties of loyalty, due care, and utmost good faith, including but not limited to the duties to ensure all fees and costs incurred by the client are reasonable and that tax reduction strategies are properly employed; however, within reasonable boundaries the scope of the client’s engagement of the investment adviser may be limited in writing;

17)     shall not seek to change[xxvi] the fiduciary-client relationship to an arms-length relationship,[xxvii] unless:

a.       the client seeks only trade execution services with no further personalized investment advice (including no references back to any prior investment advice provided); and

b.       the broker or adviser provides the client, in a single writing wholly separate and apart from any other contract or disclosure, of the following statement in bold all-caps print of a minimum 12-point font:

YOU HAVE REQUESTED A CHANGE IN OUR RELATIONSHIP FROM AN ADVISORY RELATIONSHIP TO ONE OF TRADE EXECUTION SERVICES ONLY.

AS SUCH, WE WILL NO LONGER BE PROVIDING PERSONALIZED INVESTMENT ADVICE TO YOU.

YOU ARE NO LONGER ENTITLED RELY UPON ANY STATEMENTS MADE BY THIS FIRM OR ITS REPRESENTATIVES AS “ADVICE.” NO STATEMENT MADE BY THIS FIRM OR ITS REPRESENTATIVES, IN FURNISHING INFORMATION REGARDING A SECURITY OR INVESTMENT PRODUCT, SHOULD BE CONSTRUED BY YOU AS ADVICE.

YOU NOW BEAR SOLE RESPONSIBILITY TO EVALUATE ANY INVESTMENT PRODUCT OR SECURITY.

WE ARE NO LONGER REQUIRED TO ACT IN YOUR BEST INTEREST. ACCORDINGLY, WE MAY CHOOSE TO FAVOR OUR INTERESTS OVER YOUR INTERESTS.

YOU ARE NOW SOLELY RESPONSIBLE FOR YOUR OWN PROTECTION.

and

c.       the client provides informed consent thereto, in writing.

18)     shall not utilize the title which combines the words “investment,” “financial,” “wealth,” or similar terms with “adviser,” “advisor,” “counsel,” “counselor,” “manager,” or similar terms, unless the firm and/or its representatives accept that, as to any and all clients (including prospective clients) who may have received a communication of such title(s), the firm and/or its representatives act as fiduciaries at all time with respect to such client(s), and without exception.[xxviii]

---

[i] See comment letter of Harold Evensky, Evensky & Katz Wealth Management, dated March 8, 2013, available at http://www.sec.gov/comments/4-606/4606-2984.pdf, stating in part:

I would suggest that the Commission consider, in conjunction with any other criteria and guidelines it may develop, requiring anyone providing personalized investment advice to commit to a simple “mom-and-pop” statement describing the adviser’s responsibility. The criterion for determining when this statement would be required is also simple; it is the “you” standard.

The ‘You’ Standard

If a prospective client calls an adviser and says “I would like to buy xx shares of YYY”. No problem, the adviser would be subject to a suitability standard.

If a prospective client calls an adviser and says “I’m thinking of buying YYY, what does your firm think of the stock?” Again, no problem, the adviser would be subject to a suitability standard.

However, if the prospect then says “That sounds good, do you think I should buy YYY?” and the adviser responds “yes, I think YYY would be a good investment for YOU,” he or she would then be held to a fiduciary standard and required to provide the client with the Mom-and-Pop commitment.

The obvious point is, as soon as an adviser uses the term “you” in a recommendation, he or she is no longer acting under a suitability standard. Trust is absolute; therefore, once a relationship of trust has been established and personalized advice has been provided; all subsequent business would be under a fiduciary standard.

At all times the relationship between the describer of the investment security and the customer should remain an impersonal one and no formation of a relationship of trust and confidence, and no overreaching, should occur. See, e.g., Lowe v. SEC, 472 U.S. 181 (1985) (“The dangers of fraud, deception, or overreaching that motivated the enactment of the [Advisers Act] are present in personalized communications … As long as the communications between petitioners and their subscribers remain entirely impersonal and do not develop into the kind of fiduciary, person-to-person relationships that were discussed at length in the legislative history of the Act and that are characteristic of investment adviser-client relationships, we believe the publications are, at least presumptively, within the exclusion and thus not subject to registration under the Act.”) Id. at 210.

[ii] In the SEC Staff’s January 2011 study, the SEC staff noted that “Minimum baseline professionalism standards could include, for example, specifying what basis a broker-dealer or investment adviser should have in making a recommendation to an investor.” SEC Staff Study at p.vii.

We do not suggest that providing stock analyst research reports or a list of all buy and sell recommendations made by a firm to a broad group of clients would constitute personalized investment advice. However, if a broker or its registered representative undertakes a personal, one-on-one communication to a client with a purchase or sale recommendation, such would constitute personalized investment advice.

[iii] Generally, the investment adviser is a professional, and as such accepts restraint on his, her or its conduct as a result of acceding to fiduciary status.  As stated early on by Adam Smith, the founder of modern capitalism: “Our continual observations upon the conduct of others insensibly lead us to form to ourselves certain general rules concerning what is fit and proper either to be done or to be avoided.” Adam Smith, of Moral Sentiments 229 (E.G. West ed. 1969). The domain of the investment counselor has previously been described as the “investment advisory profession. Lowe v. SEC, 472 U.S. 181, 229 (1985) (White, J., dissenting opinion). Clients trust in investment advisers, if not for the protection of life and liberty, at least for the safekeeping and accumulation of property. Bad investment advice may be a cover for stock-market manipulations designed to bilk the client for the benefit of the adviser; worse, it may lead to ruinous losses for the client. To protect investors, the [SEC] insists, it may require that investment advisers, like lawyers, evince the qualities of truth-speaking, honor, discretion, and fiduciary responsibility. Id. Early on, Douglas T. Johnston, Vice President of the Investment Counsel Association of America, stated in part: ‘The definition of 'investment adviser' … include[s] those firms which operate on a professional basis and which have come to be recognized as investment counsel.” Lowe v. SEC, 472 U.S. 181 (1985), fn. 38.  [Emphasis added.]  Moreover, the U.S. Securities and Commission’s report which led to the adoption of the Advisers Act “stressed the need to improve the professionalism of the industry, both by eliminating tipsters and other scam artists and by emphasizing the importance of unbiased advice, which spokespersons for investment counsel saw as distinguishing their profession from investment bankers and brokers.”  SEC Staff, “Study on Investment Advisers and Broker Dealers” (Jan. 21, 2011), citing Investment Trusts and Investment Companies: Investment Counsel, Investment Management, Investment Supervisory, and Investment Advisory Services, H.R. Doc. No. 477 at 27-30 (1939). [Emphasis added.]

[iv] The U.S. Securities and Exchange Commission’s early comments regarding the necessity for imposition of fiduciary duties on those who provide investment advice upon learning the details of a client’s financial affairs should not go unnoticed:  “The record discloses that registrant’s clients have implicit trust and confidence in her. They rely on her for investment advice and consistently follow her recommendations as to the purchase and sale of securities. Registrant herself testified that her clients follow her advice ‘in almost every instance.’ This reliance and repose of trust and confidence, of course, stem from the relationship created by registrant’s position as an investment adviser. The very function of furnishing investment counsel on a fee basis – learning the personal and intimate details of the financial affairs of clients and making recommendations as to purchases and sales of securities – cultivates a confidential and intimate relationship and imposes a duty upon the registrant to act in the best interests of her clients and to make only recommendations as will best serve such interests. In brief, it is her duty to act in behalf of her clients. Under these circumstances, as registrant concedes, she is a fiduciary; she has asked for and received the highest degree of trust and confidence on the representation that she will act in the best interests of her clients.”  In re: Arleen W. Hughes, Exchange Act Release No. 4048 (Feb. 18, 1948).

[v] The SEC has acknowledged that the Advisers Act is a “principles-based” regulatory regime, rather than one based upon rules. In 2008, the Director of the SEC’s Division of Investment Management, who is responsible for implementation of the provisions of the Investment Advisers Act, noted, for example: “When enacting the Investment Advisers Act of 1940, Congress recognized the diversity of advisory relationships and through a principles-based statute provided them great flexibility, with the overriding obligation of fiduciary responsibility.” Andrew J. Donohue, Dir., Div. of Inv. Mgmt., U.S. Sec. & Exch. Comm’n, Keynote Address at the 9th Annual International Conference on Private Investment Funds (Mar. 10, 2008), available at http://www.sec.gov/news/speech/2008/spch031008adj.htm. Hence, while certain aspects of these proposed rules seek to elicit the parameters of the fiduciary obligation, for the guidance and benefit of both fiduciaries and their clients, the setting forth of specific principles should not be interpreted to limit, in any way, the broad fiduciary principles which continue to apply to those investment advisers and brokers, and their representatives, who provide personalized investment advice.

[vi] “The duty of loyalty requires an adviser to serve the best interests of its clients, which includes an obligation not to subordinate the clients’ interests to its own.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.22 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.), citing Transamerica Mortgage Advisors, Inc., 444 U.S. 11, 17 (1979).

See also Amendments to Form ADV, Release No. IA-3060 (July 28, 2010) (ADV Release) at 3: “Under the Advisers Act, an adviser is a fiduciary whose duty is to serve the best interests of its clients….” See also Commission Guidance Regarding the Duties and Responsibilities of Investment Company Boards of Directors with Respect to Investment Adviser Portfolio Trading Practices, Release Nos. 34-58264; IC-28345 (July 30, 2008) (2008 Proposed Director Guidance on Soft Dollars), at n. 64: “Under sections 206(1) and (2), in particular, an adviser must discharge its duties in the best interest of its clients….”

“An essential feature and consequence of a fiduciary relationship is that the fiduciary becomes bound to act in the interests of her beneficiary and not of herself.”  In re Prudential Ins. Co. of America Sales Prac., 975 F.Supp. 584, 616 (D.N.J., 1996).

[vii] See SEC vs. Capital Gains Research Bureau, 375 U.S. 180, 84 S.Ct. 275, 11 L.Ed.2d 237 (1963) (“Courts have imposed on a fiduciary an affirmative duty of 'utmost good faith, and full and fair disclosure of all material facts,' as well as an affirmative obligation 'to employ reasonable care to avoid misleading' his clients.” Id. at 194.)

“Duty to Act in Good Faith: An adviser must –

Act honestly toward clients with candor and utmost good faith.

        Examples of this might include –

-          being truthful and accurate in all communications and disclosures

-          being forthright about issues, mistakes and conflicts of interest

-          providing fund directors with all information in the adviser’s possession that reasonably bears on a board decision, particularly where the adviser has a personal interest in the outcome or similar conflict of interest

Treat clients fairly.

      Examples of this might include –

-          avoiding favoritism of one client or group of clients over another in handling investment opportunities and trade allocations

-          adopting investment opportunity and trade allocation procedures and applying them consistently over time so that no client or group of clients is systematically disadvantaged

-          allocating shared costs across accounts using a rational methodology applied consistently over time

-          seeking a fair and prompt resolution of all legitimate client complaints”

Lorna A. Schnase, An Investment Adviser’s Fiduciary Duty (Aug. 1, 2010), at p.5, available at http://www.40actlawyer.com/Articles/Link3-Adviser-Fiduciary-Duty-Paper.pdf. 

In the corporate context, one court explained: “A failure to act in good faith may be shown, for instance, where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties. There may be other examples of bad faith yet to be proven or alleged, but these three are the most salient.” Stone ex rel. AmSouth Bancorporation v. Ritter, 911 A.2d 362 (Del. 2006) at text surrounding footnote 26 (footnote omitted). This same court concluded that the duty of good faith is essentially a subset of the duty of loyalty.

[viii] See SEC vs. Capital Gains Research Bureau, 375 U.S. 180, 84 S.Ct. 275, 11 L.Ed.2d 237 (1963) (“Courts have imposed on a fiduciary an affirmative duty of 'utmost good faith, and full and fair disclosure of all material facts,' as well as an affirmative obligation 'to employ reasonable care to avoid misleading' his clients.” Id. at 194.)

[ix] “[I]nvestment advisers are prohibited under Advisers Act Sections 206(1) and (2) from making any communications to clients that are misleading.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.30 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

See also SEC vs. Capital Gains Research Bureau, 375 U.S. 180, 84 S.Ct. 275, 11 L.Ed.2d 237 (1963) (“Courts have imposed on a fiduciary an affirmative duty of 'utmost good faith, and full and fair disclosure of all material facts,' as well as an affirmative obligation 'to employ reasonable care to avoid misleading' his clients.” Id. at 194.)

[x] In Bayer v. Beran, 49 N.Y.S.2d 2, Mr. Justice Shientag said: "The fiduciary has two paramount obligations: responsibility and loyalty. * * * They lie at the very foundation of our whole system of free private enterprise and are as fresh and significant today as when they were formulated decades ago. * * * While there is a high moral purpose implicit in this transcendent fiduciary principle of undivided loyalty, it has back of it a profound understanding of human nature and of its frailties. It actually accomplishes a practical, beneficent purpose. It tends to prevent a clouded conception of fidelity that blurs the vision. It preserves the free exercise of judgment uncontaminated by the dross of divided allegiance or self-interest. It prevents the operation of an influence that may be indirect but that is all the more potent for that reason."

[xi]  “[T]he Committee Reports indicate a desire to ... eliminate conflicts of interest between the investment adviser and the clients as safeguards both to 'unsophisticated investors' and to 'bona fide investment counsel.' The [IAA] thus reflects a ... congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to render advice which was not disinterested.”  SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-2 (1963). 

[xii]  See In the Matter of Dawson-Samberg Capital Management, Inc., Now Known as Dawson-Giammalva Capital Management, Inc. and Judith A. Mack, Advisers Act Release No. 1889 (August 3, 2000), citing SEC vs. Capital Gains Research Bureau, 375 U.S. at 191-92.

“The IAA arose from a consensus between industry and the SEC that ‘investment advisers could not 'completely perform their basic function — furnishing to clients on a personal basis competent, unbiased, and continuous advice regarding the sound management of their investments — unless all conflicts of interest between the investment counsel and the client were removed.'” Financial Planning Association v. Securities and Exchange Commission, No. 04-1242 (D.C. Cir. 3/30/2007) (D.C. Cir., 2007), citing SEC vs. Capital Gains Research Bureau at 187.

In its recent Study, the SEC Staff recommended that the “Commission should consider whether rulemaking would be appropriate to prohibit certain conflicts, to require firms to mitigate conflicts through specific action, or to impose specific disclosure and consent requirements.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.118 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

“Conflicts of interest can lead experts to give biased and corrupt advice.  Although disclosure is often proposed as a potential solution to these problems, we show that it can have perverse effects.  First, people generally do not discount advice from biased advisors as much as they should, even when advisors’ conflicts of interest are honestly disclosed.  Second, disclosure can increase the bias in advice because it leads advisors to feel morally licensed and strategically encouraged to exaggerate their advice even further. As a result, disclosure may fail to solve the problems created by conflicts of interest and may sometimes even make matters worse.”  Cain, Daylian M., Loewenstein, George, and Moore, Don A., “The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest”(2003). As Professor Cain has more recently stated in a public appearance, “It does not appear that sunlight is the best disinfectant, after all.” (Fiduciary Forum, Washington, D.C., Sept. 2010).

“Disclosure forms the central focus of most of the federal securities laws … From a behavioral perspective, however, disclosure risks confusing investors already suffering from bounded rationality, availability and hindsight.”  Stephen J. Choi & A.C. Pritchard, Behavioral Economics and the SEC (2003), at pp. 69-70.

In recognition of the extreme conflicts of interest present, and the potential for abuse, the SEC generally prohibits “performance fees” being charged by registered investment advisers. “Generally, investment advisers that are registered or required to be registered with the Commission are prohibited by Advisers Act Section 205(a)(1) from entering into a contract with any client that provides for compensation based on a share of the capital gains or appreciation of a client’s funds, i.e., a performance fee.  Section 205(a)(1) is designed, among other things, to eliminate ‘profit sharing contracts [that] are nothing more than ‘heads I win, tails you lose’ arrangements,’ and that ‘encourage advisers to take undue risks with the funds of clients,’ to speculate, or to overtrade.  There are several exceptions to the prohibition, mostly applicable to advisory contracts with institutions and high net worth clients.” 

SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), pp.41-2 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

“The federal securities laws and FINRA rules restrict broker-dealers from participating in certain transactions that may present particularly acute potential conflicts of interest.  For example, FINRA rules generally prohibit a member with certain ‘conflicts of interest’ from participating in a public offering, unless certain requirements are met.  FINRA members also may not provide gifts or gratuities to an employee of another person to influence the award of the employer’s securities business.  FINRA rules also generally prohibit a member’s registered representatives from borrowing money from or lending money to any customer, unless the firm has written procedures allowing such borrowing or lending arrangements and certain other conditions are met.  Moreover, the Commission’s Regulation M generally precludes persons having an interest in an offering (such as an underwriter or broker-dealer and other distribution participants) from engaging in specified market activities during a securities distribution.  These rules are intended to prevent such persons from artificially influencing or manipulating the market price for the offered security in order to facilitate a distribution.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), pp.58-9 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.) (Citations omitted.)  “FINRA rules also establish restrictions on the use of non-cash compensation in connection with the sale and distribution of mutual funds, variable annuities, direct participation program securities, public offerings of debt and equity securities, and real estate investment trust programs. These rules generally limit the manner in which members can pay for or accept non-cash compensation and detail the types of non-cash compensation that are permissible.”  Id. at p.68.

See also Thorp v. McCullum, 1 Gilman (6 Ill.) 614, 626 (1844) (“The temptation of self interest is too powerful and insinuating to be trusted. Man cannot serve two masters; he will foresake the one and cleave to the other. Between two conflicting interests, it is easy to foresee, and all experience has shown, whose interests will be neglected and sacrificed. The temptation to neglect the interest of those thus confided must be removed by taking away the right to hold, however fair the purchase, or full the consideration paid; for it would be impossible, in many cases, to ferret out the secret knowledge of facts and advantages of the purchaser, known to the trustee or others acting in the like character. The best and only safe antidote is in the extraction of the sting; by denying the right to hold, the temptation and power to do wrong is destroyed.”)

[xiii] “FINRA rules also establish restrictions on the use of non-cash compensation in connection with the sale and distribution of mutual funds, variable annuities, direct participation program securities, public offerings of debt and equity securities, and real estate investment trust programs. These rules generally limit the manner in which members can pay for or accept non-cash compensation and detail the types of non-cash compensation that are permissible.” SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p. 68 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.) (Citations omitted.)

[xiv] “[T]he duty of full disclosure was imposed as a matter of general common law long before the passage of the Securities Exchange Act.”  In the Matter of Arleen W. Hughes, SEC Release No. 4048 (February 18, 1948) (a case involving a conflict of interest arising out of principal trading). See also, e.g., General Instructions for Part 2 of Form ADV: “Under federal and state law, you are a fiduciary and must make full disclosure to your clients of all material facts relating to the advisory relationship.” Id., at #3. In fact, the SEC requires registered investment advisers to undertake a broad variety of affirmative disclosures, well beyond disclosures of conflicts of interest, and many of these disclosures are required to be found in Form ADV, Parts 1 and 2A and 2B.  Part 2A requires information about the adviser’s range of fees, methods of analysis, investment strategies and risk of loss, brokerage (including trade aggregation policies and directed brokerage practices, as well as use of soft dollars), review of accounts, client referrals and other compensation, disciplinary history, and financial information, among other matters.

SEC Staff recently noted that under the “antifraud provisions of the Advisers Act, an investment adviser must disclose material facts to its clients and prospective clients whenever the failure to do so would defraud or operate as a fraud or deceit upon any such person.  The adviser’s fiduciary duty of disclosure is a broad one, and delivery of the adviser’s brochure alone may not fully satisfy the adviser’s disclosure obligations.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.23 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

Disclosure must be full and frank: “If dual interests are to be served, the disclosure to be effective must lay bare the truth, without ambiguity or reservation, in all its start significance.” See “Will the Investment Company and Investment Advisory Industry Win an Academy Award?” remarks of Kathryn B. McGrath, Director of the SEC Division of Investment Management, at the 1987 Mutual Funds and Investment Management Conference, citing Scott, The Fiduciary Principle, 37 Calif. L. Rev. 539, 544 (1949).

[xv] “When a stock broker or financial advisor is providing financial or investment advice, he or she … is required to disclose facts that are material to the client's decision-making.”  Johnson v. John Hancock Funds, No. M2005-00356-COA-R3-CV (Tenn. App. 6/30/2006) (Tenn. App., 2006).

A material fact is “anything which might affect the (client’s) decision whether or how to act.” Allen Realty Corp. v. Holbert, 318 S.E.2d 592, 227 Va. 441 (Va., 1984).  A fact is considered material if there is a substantial likelihood that a reasonable investor would consider the information to be important in making an investment decision. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976); Basic, Inc. v. Levinson, 485 U.S. 224, 233 (1988).

The existence of a conflict of interest is a material fact that an investment adviser must disclose to its clients because it "might incline an investment adviser -- consciously or unconsciously -- to render advice that was not disinterested." SEC v. Capital Gains Research Bureau, Inc., 375 U.S. at 191-192.

The standard of materiality is whether a reasonable client or prospective client would have considered the information important in deciding whether to invest with the adviser. See SEC v. Steadman, 967 F.2d 636, 643 (D.C. Cir. 1992).

All facts which might bear upon the desirability of the transaction must be disclosed. “[W]hen a firm has a fiduciary relationship with a customer, it may not execute principal trades with that customer absent full disclosure of its principal capacity, as well as all other information that bears on the desirability of the transaction from the customer's perspective … Other authorities are in agreement. For example, the general rule is that an agent charged by his principal with buying or selling an asset may not effect the transaction on his own account without full disclosure which ‘must include not only the fact that the agent is acting on his own account, but also all other facts which he should realize have or are likely to have a bearing upon the desirability of the transaction, from the viewpoint of the principal.’”  Geman v. S.E.C., 334 F.3d 1183, 1189 (10th Cir., 2003), quoting Arst v. Stifel, Nicolaus & Co., 86 F.3d 973, 979 (10th Cir.1996) (applying Kansas law) (quoting RESTATEMENT (SECOND) OF AGENCY § 390 cmt. a (1958)).

See also RESTATEMENT (THIRD) OF AGENCY, §8.06(1):

(1)     Conduct by an agent that would otherwise constitute a breach of duty … does not constitute a breach of duty if the principal consents to the conduct, provided that

(a)      In obtaining the principal’s consent, the agent

(i)                   acts in good faith;

(ii)                 discloses all material facts that the agent knows, has reason to know, or should know would reasonabley affect the principal’s judgment …

(iii)                otherwise deals fairly with the principal; and

(b)     the principal’s consent concerns either a specific act or transaction, or acts or transactions of a specified type that could reasonably be expected to occur in the ordinary course of the agency relationship.

[xvi] See SEC vs. Capital Gains Research Bureau, 375 U.S. 180, 84 S.Ct. 275, 11 L.Ed.2d 237 (1963) (“Courts have imposed on a fiduciary an affirmative duty of 'utmost good faith, and full and fair disclosure of all material facts,' as well as an affirmative obligation 'to employ reasonable care to avoid misleading' his clients.” Id. at 194.)

[xvii] The duty to disclose is an affirmative one and rests with the advisor alone.  Clients do not generally possess a duty of inquiry. See, e.g., SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.117 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.) “The [SEC} Staff believes that it is the firm’s responsibility—not the customers’—to reasonably ensure that any material conflicts of interest are fully, fairly and clearly disclosed so that investors may fully understand them.”

As stated in an early case applying the Advisers Act: “It is not enough that one who acts as an admitted fiduciary proclaim that he or she stands ever ready to divulge material facts to the ones whose interests she is being paid to protect. Some knowledge is prerequisite to intelligent questioning. This is particularly true in the securities field. Readiness and willingness to disclose are not equivalent to disclosure. The statutes and rules discussed above make it unlawful to omit to state material facts irrespective of alleged (or proven) willingness or readiness to supply that which has been omitted.” Hughes v. SEC, 174 F.2d 969 (D.C. Cir., 1949).

[xviii] “[D]isclosure, if it is to be meaningful and effective, must be timely. It must be provided before the completion of the transaction so that the client will know all the facts at the time that he is asked to give his consent.” In the Matter of Arleeen W. Hughes, SEC Release No. 4048 (February 17, 1948), affirmed 174 F.2d 969 (D.C. Cir. 1949).

“The adviser’s fiduciary duty of disclosure is a broad one, and delivery of the adviser’s brochure alone may not fully satisfy the adviser’s disclosure obligations.” SEC Staff Study (Jan. 2011), p.23, citing see Instruction 3 of General Instructions for Part 2 of Form ADV; Advisers Act Rule 204-3(f); also citing see also Release IA-3060.

Disclosures of fees, costs, risks and other material facts, far in advance of specific investment recommendations, such as those found upon the initial delivery of Form ADV, Part 2A, would not meet the requirement of undertaking affirmative disclosure in a manner designed to ensure client understanding. We suggest that the Commission re-explore the delivery of point-of-recommendation disclosures, for recommendations of pooled investment vehicles of any form, in order to provide all fiduciary advisors with the benefit of a provisional safe harbor for disclosures. However, to be meaningful and operable as a full disclosure of all material facts, such a disclosure form, if adopted, should incorporate an estimate of all of the fees and costs attendant to pooled investment vehicles, such as brokerage commissions and other transactional costs within the fund which are not included in the fund’s annual expense ratio.

We also recommend that the SEC’s Division of Investment Management replace the currently misleading computational method of “portfolio turnover” within a fund, in which funds are permitted to report the lesser of purchases or sales of securities in relation to the fund’s net assets, to a more accurate method in which purchases and sales of securities within a fund are averaged; it is currently conceivable that a fund with significant inflows or outflows report a “zero” portfolio turnover in its filings, when in fact substantial purchases and sales within a fund exist.

[xix] As stated in an early decision by the U.S. Securities and Exchange Commission: “[We] may point out that no hard and fast rule can be set down as to an appropriate method for registrant to disclose the fact that she proposes to deal on her own account. The method and extent of disclosure depends upon the particular client involved. The investor who is not familiar with the practices of the securities business requires a more extensive explanation than the informed investor. The explanation must be such, however, that the particular client is clearly advised and understands before the completion of each transaction that registrant proposes to sell her own securities.”  [Emphasis added.]   In re the Matter of Arleen Hughes, SEC Release No. 4048 (1948).

The extent of the disclosure required is made clear by cases applying the fiduciary standard of conduct in related professional advisory contexts, such as the duties imposed upon an attorney with respect to his or her client: “The fact that the client knows of a conflict is not enough to satisfy the attorney's duty of full disclosure.” In re Src Holding Corp., 364 B.R. 1 (D. Minn., 2007).  "Consent can only come after consultation — which the rule contemplates as full disclosure.... [I]t is not sufficient that both parties be informed of the fact that the lawyer is undertaking to represent both of them, but he must explain to them the nature of the conflict of interest in such detail so that they can understand the reasons why it may be desirable for each to [withhold consent].") Florida Ins. Guar. Ass'n Inc. v. Carey Canada, Inc., 749 F.Supp. 255, 259 (S.D.Fla.1990) [emphasis added], quoting Unified Sewerage Agency, Etc. v. Jeko, Inc., 646 F.2d 1339, 1345-46 (9th Cir.1981)); “[t]he lawyer bears the duty to recognize the legal significance of his or her actions in entering a conflicted situation and fully share that legal significance with clients.” In re Src Holding Corp., 364 B.R. 1, 48 (D. Minn., 2007) [emphasis added].

The burden of affirmative disclosure rests with the professional advisor; constructive notice is insufficient. See also British Airways, PLC v. Port Authority of N.Y. and N.J., 862 F.Supp. 889, 900 (E.D.N.Y.1994) (stating that the burden is on the client's attorney to fully inform and obtain consent from the client); Kabi Pharmacia AB v. Alcon Surgical, Inc., 803 F.Supp. 957, 963 (D.Del.1992) (stating that evidence of the client's constructive knowledge of a conflict would not be sufficient to satisfy the attorney's consultation duty); Manoir-Electroalloys Corp. v. Amalloy Corp., 711 F.Supp. 188, 195 (D.N.J.1989) ("Constructive notice of the pertinent facts is not sufficient.").  A client of a fiduciary is not responsible for recognizing the conflict and stating his or her lack of consent in order to avoid waiver.  Manoir-Electroalloys, 711 F.Supp. at 195.

[xx] The consent of the client must be “intelligent, independent and informed.”  Generally, “fiduciary law protects the [client] by obligating the fiduciary to disclose all material facts, requiring an intelligent, independent consent from the [client], a substantively fair arrangement, or both.”  Frankel, Tamar, Fiduciary Law, 71 Calif. L. Rev. 795 (1983). [Emphasis added.].

[xxi] “The duty of loyalty requires an adviser to serve the best interests of its clients, which includes an obligation not to subordinate the clients’ interests to its own.” SEC Staff Study, January 2011, at p.22, citing see, e.g., Proxy Voting by Investment Advisers, Investment Advisers Act Release No. 2106 (Jan. 31, 2003 (“Release 2106”); also citing Amendments to Form ADV, Investment Advisers Act Release No. 3060 (July 28, 2010) (“Release 3060”).

[xxii] The Commission recently characterized this as an adviser’s obligation “not to subrogate clients’ interests to its own.” ADV Release, at 3. See also “Without Fiduciary Protections, It’s ‘Buyer Beware’ for Investors,” Press Release issued by the Investment Adviser Association, et al., June 15, 2010, available at: http://www.financialplanningcoalition.com/docs/assets/3C7AB96C-1D09-67A1-7A3E526346D7A128/JointFOFPressRelease-ConferenceCommitteeFINAL6-15-10.pdf.

[xxiii] While a broader elicitation of the duty of due care could be undertaken, the focus of this comment letter is on a fiduciary’s duties of loyalty and utmost good faith, given that these are the distinguishing characteristics of the fiduciary relationship. Nevertheless, we relate some general guidance as to the duty of due care, hereafter.

Under the Advisers Act, the SEC Staff recently interpreted the fiduciary duty of care to require the investment adviser to “make a reasonable investigation to determine that it is not basing its recommendations on materially inaccurate or incomplete information.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.22 and p.27 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.), citing, see, Concept Release on the U.S. Proxy System, Investment Advisers Act Release No. 3052 (July 14, 2010) (“Release 3052”) at 119.

However, we note that SEC Staff has recommended that more guidance be provided in this area:

“The [SEC] Staff believes that the Commission, through rulemaking, guidance, or both, should specify the minimum professional obligations of investment advisers and broker-dealers under the duty of care. In evaluating the regulation of investment advisers and broker-dealers, the Staff believes that it could be useful to develop rules or guidance on the minimum requirements that are fundamental to a duty of care under the uniform fiduciary standard.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.122 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

“Professional standards under the duty of care could be developed regarding the nature and level of review and analysis that broker-dealers and investment advisers should undertake when making recommendations or otherwise providing advice to retail customers. The Commission could articulate and harmonize any such standards, by referring to and expanding upon, as appropriate, the explicit minimum standards of conduct relating to the duty of care currently applicable to broker-dealers (e.g., suitability (including product-specific suitability), best execution, and fair pricing and compensation requirements) under Commission and SRO rules.” Id.  “Any such rules or guidance could take into account long-held Advisers Act fiduciary principles, such as the duty to provide suitable investment advice (e.g., with respect to specific recommendations and the client’s portfolio as a whole) and to seek best execution.  Detailed guidance in this area has not been a traditional focus of the investment adviser regulatory regime.”  Id. at 123.

We suggest that the duty of due care has been articulated in similar fiduciary contexts, such as those arising under ERISA and under the Prudent Investor Rule applicable to trustees.

While the articulation of the duty of due care under the Advisers Act has not been elicited to a large degree by the courts or through administrative decisions or rules, we suggest that the SEC could look to the duty of due care as it is similarly applied under ERISA. While the duty of loyalty under ERISA is a “sole interests” standard (rather than the “best interests” standard applicable under the Advisers Act), it is possible to maintain consistency between the DOL and SEC regulatory regimes by adopting a common duty of due care. We refer the SEC to the following summary of the duty of due care found under ERISA:

The duty of prudence mandated by § 1104(a)(1)(B) "is measured according to the objective prudent person standard developed in the common law of trusts." LaScala v. Scrufari, 479 F.3d 213, 219 (2d Cir. 2007) (quotation marks omitted). Under that common-law standard, and consistent with ERISA's instruction that fiduciaries act in a prudent manner "under the circumstances then prevailing," 29 U.S.C. § 1104(a)(1)(B), "[w]e judge a fiduciary's actions based upon information available to the fiduciary at the time of each investment decision and not from the vantage point of hindsight," In re Citigroup, 662 F.3d at 140 (internal quotation marks omitted). Accordingly, "[w]e cannot rely, after the fact, on the magnitude of the decrease in the [relevant investment's] price; rather, we must consider the extent to which plan fiduciaries at a given point in time reasonably could have predicted the outcome that followed." Id. In other words, as the Court of Appeals for the Third Circuit has nicely summarized, this standard "focus[es] on a fiduciary's conduct in arriving at an investment decision, not on its results, and ask[s] whether a fiduciary employed the appropriate methods to investigate and determine the merits of a particular investment." In re Unisys Sav. Plan Litig., 74 F.3d 420, 434 (3d Cir. 1996). In short, ERISA's "fiduciary duty of care . . . requires prudence, not prescience." DeBruyne v. Equitable Life Assurance Soc'y of the U.S., 920 F.2d 457, 465 (7th Cir. 1990) (internal quotation marks omitted).

Pursuant to ERISA implementing regulations, promulgated by the Secretary of Labor, a fiduciary's compliance with the prudent-man standard requires that the fiduciary give "appropriate consideration" to whether an investment "is reasonably designed, as part of the portfolio . . . to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain (or other return) associated with the investment." 29 C.F.R. § 2550.404a-1(b)(2)(i).14 Accordingly, the prudence of each investment  is not assessed in isolation but, rather, as the investment relates to the portfolio as a whole. See Cal. Ironworkers Field Pension Trust v. Loomis Sayles & Co., 259 F.3d 1036, 1043 (9th Cir. 2001); Laborers Nat'l Pension Fund v. N. Trust Quantitative Advisors, Inc., 173 F.3d 313, 322 (5th Cir. 1999). An ERISA fiduciary's investment decisions also must account for changed circumstances, and "[a] trustee who simply ignores changed circumstances that have increased the risk of loss to the trust's beneficiaries is imprudent." Armstrong v. LaSalle Bank Nat'l Assoc., 446 F.3d 728, 734 (7th Cir. 2006).

Pension Benefit Guar. Corp. v. Morgan Stanley Inv. Mgmt., 712 F.3d 705; 2013 U.S. App. LEXIS 6710 (2013).

The duty of due care has been considered to involve both process and substance.  That is, in reviewing the conduct of an investment adviser in adherence to the investment adviser’s fiduciary duty of due care, a court would likely review whether the decision made by the investment adviser was informed (procedural due care) as well as the substance of the transaction or advice given (substantive due care).  Procedural due care is often met through the application of an appropriate decision-making process, and judged under the standard, not (necessarily) by the end result.  Substantive due care pertains to the standard of care and the standard of culpability for the imposition of liability for a breach of the duty of care. 

Under the Investment Advisers Act of 1940, the duty of due care is measured by the ordinary negligence standard, and it is anticipated that the duty of due care imposed by this rule would likewise be measured by the same ordinary negligence standard.  However, the standard of prudence is relational, and it follows that the standard of care for investment advisers is the standard of a prudent investment adviser.  By way of explanation, the standard of care for professionals is that of prudent professionals; for amateurs, it is the standard of prudent amateurs. For example, Restatement of Trusts 2d § 174 (1959) provides: "The trustee is under a duty to the beneficiary in administering the trust to exercise such care and skill as a man of ordinary prudence would exercise in dealing with his own property; and if the trustee has or procures his appointment as trustee by representing that he has greater skill than that of a man of ordinary prudence, he is under a duty to exercise such skill." Case law strongly supports the concept of the higher standard of care for the trustee representing itself to be expert or professional.  See Annot., “Standard of Care Required of Trustee Representing Itself to Have Expert Knowledge or Skill”, 91 A.L.R. 3d 904 (1979) & 1992 Supp. at 48-49.

Note, however, that the courts recognize that it is simply not possible for a fiduciary to be aware of every piece of relevant information before making a decision on behalf of the principal, and a fiduciary cannot guarantee that a correct judgment will be made in all cases.  Due to the difficulty of evaluating the behavior of fiduciaries, most often courts turn to an analysis not of the advice that was given but rather to the process by which the advice was derived.  Nevertheless, while adherence to a proper process is also necessary, at each step along the process the investment adviser is required to act prudently with the care of the prudent investment adviser.  In other words, the investment adviser must at all times exercise good judgment, applying his or her education, skills, and expertise to the financial planning issue before the investment adviser.  Simply following a prudent process is not enough if prudent good judgment (and the investment adviser’s requisite knowledge, expertise and experience) is not applied as well.

One must evaluate the duty of care, unlike the duty of loyalty, by the process the fiduciary undertakes in performing his functions and not the outcome achieved. The very word “care” connotes a process. One associates caring with a condition, state of mind, manner of mental attention, a feeling, regard, or liking for something.  How else may one determine whether an investment adviser who regularly achieves below average returns, or an attorney who loses most cases, has performed his duty of care? It is only through evaluating the steps the fiduciary took while doing his job, and not whether they resulted in success, that one may judge whether the fiduciary has breached his duty.

Additionally, the suitability standard applicable to broker-dealers has been implied to apply to investment advisers, although by no means is suitability the standard by which an investment adviser’s due care should be judged; suitability remains only a small part of an investment adviser’s fiduciary obligation of due care. Certainly investment advisers owe their clients the duty to provide suitable investment advice. See SEC's "Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act" (Jan. 21, 2011), pp.27-8 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.), quoting Suitability of Investment Advice Provided by Investment Advisers, Investment Advisers Act Release No. 1406 (Mar. 16, 1994) (proposing a rule under the Advisers Act Section 206(4)'s antifraud provisions that would expressly require advisers to give clients only suitable advice; the rule would have codified existing suitability obligations of advisers). However, the due diligence burdens on an investment adviser can extend much further.

[xxiv] There are a variety of organizations which already promulgate professional standards of conduct for those who provide personalized investment advice. See, e.g., Certified Financial Planner Board of Standards, Inc.’s Standards of Professional Conduct,” available at http://www.cfp.net/for-cfp-professionals/professional-standards-enforcement; AICPA Exposure Draft, “Proposed Statement on Standards in Personal Financial Planning Services” (June 11, 2013); CFA Institute’s “Code of Ethics and Standards of Professional Conduct,” available at http://www.cfainstitute.org/ethics/codes/Pages/index.aspx. Other standards of conduct for financial planning and/or investment advisory services are promulgated by other organizations. International standards have also been promulgated for adoption in various countries. See ISO 22222 (2005).

[xxv] Estoppel and waiver possess a place in anti-fraud law, generally.  However, in a fiduciary legal environment estoppel and waiver operate differently than that found in purely commercial relationships.  Core fiduciary duties cannot be waived.  Nor can clients be expected to contract away their core fiduciary rights.  Estoppel has a different role in the context of “actual fraud,” as opposed to its limited role when dealing with “constructive fraud.” For example, for estoppel to make unactionable a breach of a fiduciary obligation due to the presence of a conflict, it is required that the fiduciary undertake a series of measures, far beyond undertaking mere disclosure of the conflict of interest.

By way of further explanation, in the context of arms-length relationships, disclosure and consent creates estoppel, as customers generally possess responsibility for their own actions.  This is fundamental to anti-fraud law, as applicable to arms-length relationships (“actual fraud”) .  Prosser and Keeton wrote that it is a “fundamental principle of the common law that volenti non fit injuria—to one who is willing, no wrong is done.”

Yet, the doctrine of estoppel springs from equitable principles, and it is designed to aid in the administration of justice where, without its aid, injustice might result.  Levin v. Levin, 645 N.E.2d 601, 604 (Ind. 1994). And a breach of the fiduciary standard is “constructive fraud,” not actual fraud.  To prove a breach of fiduciary duty, a plaintiff must only show that he or she and the defendant had a fiduciary relationship, that the defendant breached its fiduciary duty to the plaintiff, and that this resulted in an injury to the plaintiff or a benefit to the defendant. It is not necessary for the plaintiff to prove causation to prevail on claims of certain breaches of fiduciary duty.  It is the agent’s disloyalty, not any resulting harm, which violates the fiduciary relationship.  Comment b to section 874 of the RESTATEMENT (SECOND) OF TORTS recognizes that a plaintiff may be entitled to “restitutionary recovery,” to capture “profits that result to the fiduciary from his breach of duty and to be the beneficiary of a constructive trust in the profits.” In some circumstances, the plaintiff may recover “what the fiduciary should have made in the prosecution of his duties.” RESTATEMENT (SECOND) OF TORTS § 874 cmt. b (1979); see also 2 DAN B. DOBBS, THE LAW OF REMEDIES 670 (2d ed. 1993) (noting that a fiduciary who wrongfully takes an opportunity, if “treated as a fiduciary for the profits as well as for the initial opportunity,” would “owe a duty to maximize their productiveness within the limits of prudent management and might be liable for failing to do so”).

Hence, the role of estoppel in fiduciary law is different in fiduciary relationships than in its application to arms-length relationships in in which caveat emptor (even when aided by disclosure obligations under the ’33 Act and ’34 Act) plays a role.  Mere consent by a client in writing to a breach of the fiduciary obligation is not, in itself, sufficient to create estoppel.  If this were the case, fiduciary obligations – even core obligations of the fiduciary – would be easily subject to waiver.  Instead, to create an estoppel situation, the fiduciary is required to undertake a series of steps :

(1) Disclosure of all material facts to the client must occur. [Even in arms-length relationships, a ratification or waiver defense may fail if the customer proves that he did not have all the material facts relating to the trade at issue. E.g., Davis v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 906 F.2d 1206, 1213 (8th Cir. 1990); Huppman v. Tighe, 100 Md. App. 655, 642 A.2d 309, 314-315 (1994). In contrast, in fiduciary relationships the failure to disclose material facts while seeking a release has been held to be actionable, as fraudulent concealment. See, e.g., Pacelli Bros. Transp. v. Pacelli, 456 A.2d 325, 328 (Conn. 1982) (‘the intentional withholding of information for the purpose of inducing action has been regarded ... as equivalent to a fraudulent misrepresentation.’); Rosebud Sioux Tribe v. Strain, 432 N.W. 2d 259, 263 (S.D. 1988) (‘The mere silence by one under such a [fiduciary] duty to disclose is fraudulent concealment.’)” (Id.)]

(2) The disclosure must be affirmatively made (the “duty of inquiry” and the “duty to read” are limited in fiduciary relationships)  and must be timely made – i.e., in advance of the contemplated transaction. [“Where a fiduciary relationship exists, facts which ordinarily require investigation may not incite suspicion (see, e.g., Bennett v. Hibernia Bank, 164 Cal.App.3d 202, 47 Cal.2d 540, 560, 305 P.2d 20 (1956), and do not give rise to a duty of inquiry (id., at p. 563, 305 P.2d 20). Where there is a fiduciary relationship, the usual duty of diligence to discover facts does not exist. United States Liab. Ins. Co. v. Haidinger-Hayes, Inc., 1 Cal.3d 586, 598, 83 Cal.Rptr. 418, 463 P.2d 770 (1970), Hobbs v. Bateman Eichler, Hill Richards, Inc., 210 Cal.Rptr. 387, 164 Cal.App.3d 174 (Cal. App. 2 Dist., 1974).)

(3) The disclosure must lead to the client’s understanding – and the fiduciary must be aware of the client’s capacity to understand, and match the extent and form of the disclosure to the client’s knowledge base and cognitive abilities.

(4) The informed consent (which is not coerced by the fiduciary in any manner)  of the client must be affirmatively secured (and silence is not consent). [There must be no coercion for the informed consent to be effective. The “voluntariness of an apparent consent to an unfair transaction could be a lingering suspicion that generally, when entrustors consent to waive fiduciary duties (especially if they do not receive value in return) the transformation to a contract mode from a fiduciary mode was not fully achieved. Entrustors, like all people, are not always quick to recognize role changes, and they may continue to rely on their fiduciaries, even if warned not to do so.” Tamar Frankel, Fiduciary Duties as Default Rules, 74 Or. L. Rev. 1209.]

and

(5) At all times, the transaction must be substantively fair to the client – if an alternative exists which would result in a more favorable outcome to the client, this would be a material fact which would be required to be disclosed, and a client who truly understands the situation would likely never gratuitously make a gift to the advisor where the client would be, in essence, harmed. [In the absence of integrity and fairness in a transaction between a fiduciary and the client or beneficiary, it will be set aside or held invalid. Matter of Gordon v. Bialystoker Center and Bikur Cholim, 45 N.Y. 2d 692, 698 (1978) (2006 WL 3016952 at *29).  As stated by Professor Frankel, “if the bargain is highly unfair and unreasonable, the consent of the disadvantaged party is highly suspect. Experience demonstrates that people rarely agree to terms that are unfair and unreasonable with respect to their interests.” Frankel, Tamar, Fiduciary Duties as Default Rules, 74 Or. L. Rev. 1209.]

It should also be noted that attempts to waive core fiduciary duties of an advisor may violate Section 215(a) of the Advisers Act. As stated by SEC Staff in its Jan. 2011 Study: “Advisers Act Section 215(a) voids any provision of a contract that purports to waive compliance with any provision of the Advisers Act. The Commission staff has taken the position that an adviser that includes any such provision (such as a provision disclaiming liability for ordinary negligence or a “hedge clause”) in a contract that makes the client believe that he or she has given up legal rights and is foreclosed from a remedy that he or she might otherwise either have at common law or under Commission statutes is void under Advisers Act Section 215(a) and violates Advisers Act Sections 206(1) and (2). The Commission staff has stated that the issue of whether an adviser that uses a hedge clause would violate the Advisers Act turns on ‘the form and content of the particular hedge clause (e.g., its accuracy), any oral or written communications between the investment adviser and the client about the hedge clause, and the particular circumstances of the client.’ The Commission has brought enforcement actions against advisers alleging that the advisers included hedge clauses that violated Advisers Act Sections 206(1) and (2) in client contracts.” SEC Staff Study (Jan. 2011), p.43. [Citations omitted.]

[xxvi] Within the legal community there has existed a long discussion relating to whether fiduciary duties are “default rules” and contractual in nature, or whether certain core fiduciary duties are non-waivable. We suggest that the answer lies in the disparity of knowledge and ability of the fiduciary vis-à-vis the other party. For example, in the law of partnerships and limited liability companies, the partners or members are usually on relatively equal footing and hence can alter many (but not all) of the fiduciary obligations they possess toward one another. In contrast, stricter rules are imposed in attorney-client relationships, in which attorneys are prohibited from entering into transactions with clients unless the client is clearly advised to seek independent legal counsel, and even then the business transaction must be substantively fair to the client. See ABA Model Rules of Professional Conduct 1.8(a), stating: Rule 1.8 Conflict Of Interest: Current Clients: Specific Rules. (a) A lawyer shall not enter into a business transaction with a client or knowingly acquire an ownership, possessory, security or other pecuniary interest adverse to a client unless: (1) the transaction and terms on which the lawyer acquires the interest are fair and reasonable to the client and are fully disclosed and transmitted in writing in a manner that can be reasonably understood by the client; (2) the client is advised in writing of the desirability of seeking and is given a reasonable opportunity to seek the advice of independent legal counsel on the transaction; and (3) the client gives informed consent, in a writing signed by the client, to the essential terms of the transaction and the lawyer's role in the transaction, including whether the lawyer is representing the client in the transaction.

We suggest to the SEC that the “contractual nature” of fiduciary obligations is not yet accepted by many parts of the legal community, and even if accepted in limited circumstances the theory is wholly inapplicable to a fiduciary-client relationship in which such a great disparity of knowledge exists, as exists in the complex world of securities. Individual investors are simply unable to effectively “bargain” for protection from fraud.

Academic research exploring the nature of individual investors’ behavioral biases, as a limitation on the efficacy of disclosure and consent, also strongly suggests that client waivers of fiduciary duties are not effectively made. In a paper exploring the limitations of disclosure on clients of stockbrokers, Professor Robert Prentice explained several behavioral biases which combine to render disclosures ineffective: (1) Bounded Rationality and Rational Ignorance; (2) Overoptimism and Overconfidence; (3) The False Consensus Effect; (4) Insensitivity to the Source of Information; (5) Oral Versus Written Communications; (6) Anchoring; and (7) Other Heuristics and Biases.  Moreover, as Professor Prentice observed: “Securities professionals are well aware of this tendency of investors, even sophisticated investors, and take advantage of it.” Robert Prentice, Whither Securities Regulation? Some Behavioral Observations Regarding Proposals For Its Future, 51 Duke L.J. 1397 (available at http://www.law.duke.edu/shell/cite.pl?51+Duke+L.+J.+1397#H2N5).  Much other academic research into the behavioral biases faced by individual investors has been undertaken, in demonstrating the substantial challenges faced by individual investors in dealing with those providing financial advice in a conflict of interest situation.

Financial advisors also utilize clients’ behavioral biases to their own advantage, if not restricted by appropriate rules of conduct. As stated by Professor Prentice, “instead of leading investors away from their behavioral biases, financial professionals may prey upon investors’ behavioral quirks … Having placed their trust in their brokers, investors may give them substantial leeway, opening the door to opportunistic behavior by brokers, who may steer investors toward poor or inappropriate investments.”Id. See also Stephen J. Choi and A.C. Pritchard, “Behavioral Economics and the SEC” (2003), at p.18. Practice management consultants train financial and investment advisors to take advantage of the behavioral biases of consumers. The instruction involves actions to build a relationship of trust and confidence with the client first, far before any discussion of the service to be provided or the fees for such services. It is well known among marketing consultants that once a relationship of trust and confidence is established, clients and customers will agree to most anything in reliance upon the bond of trust which has been formed.

In essence, disclosure – while important - has limited efficacy in the delivery of financial services to clients. As stated by Professor Ripken:  “[E]ven if we could purge disclosure documents of legaleze and make them easier to read, we are still faced with the problem of cognitive and behavioral biases and constraints that prevent the accurate processing of information and risk. As discussed previously, information overload, excessive confidence in one’s own judgment, overoptimism, and confirmation biases can undermine the effectiveness of disclosure in communicating relevant information to investors. Disclosure may not protect investors if these cognitive biases inhibit them from rationally incorporating the disclosed information into their investment decisions.  No matter how much we do to make disclosure more meaningful and accessible to investors, it will still be difficult for people to overcome their bounded rationality. The disclosure of more information alone cannot cure investors of the psychological constraints that may lead them to ignore or misuse the information. If investors are overloaded, more information may simply make matters worse by causing investors to be distracted and miss the most important aspects of the disclosure … The bottom line is that there is ‘doubt that disclosure is the optimal regulatory strategy if most investors suffer from cognitive biases’ … While disclosure has its place in a well-functioning securities market, the direct, substantive regulation of conduct may be a more effective method of deterring fraudulent and unethical practices.” Ripken, Susanna Kim, The Dangers and Drawbacks of the Disclosure Antidote: Toward a More Substantive Approach to Securities Regulation. Baylor Law Review, Vol. 58, No. 1, 2006; Chapman University Law Research Paper No. 2007-08.  Available at SSRN: http://ssrn.com/abstract=936528.

Lastly, we must ask, what individual investor would ever permit a fiduciary to contract away its fiduciary obligations? Any truly knowledgeable individual investor would recognize the immense protections provided by the fiduciary standard of conduct, and would not permit the financial or investment adviser to contract out of fiduciary obligations.

See also discussion in the prior endnote regarding waiver and estoppel and its limited application to fiduciaries.

[xxvii] We note that it is suspect whether the rendering of any information regarding investment securities should be considered given in an arms-length relationship, but rather should be given only in a fiduciary relationship. The U.S. Supreme Court stated that there is a “growing recognition by common-law courts that the doctrines of fraud and deceit which developed around transactions involving land and other tangible items of wealth are ill-suited to the sale of such intangibles as advice and securities, and that, accordingly, the doctrines must be adapted to the merchandise in issue.” Capital Gains, 375 U.S. at 194.

However, we do not suggest that the SEC proceed so far. Rather, the SEC should permit direct sales of securities, and sales of securities through intermediaries, provided that the seller not hold out in any fashion as an advisor, and provided further that only a description of the product is provided; any suggestion by a seller that the security is right “for you” (i.e., for the client) crosses the threshold of advice, and hence would be subject to the fiduciary standard of conduct, for – as the Supreme Court has stated – standards covering arms-length transactions are ill-suited to the delivery of advice regarding securities. It should be noted that, in adopting the Advisers Act, “Congress codified the common law 'remedially' as the courts had adapted it to the prevention of fraudulent securities transactions by fiduciaries, not 'technically' as it has traditionally been applied in damage suits between parties to arm's-length transactions involving land and ordinary chattels.” Capital Gains, 375 U.S. at 195.

[xxviii] Common among insurance agents and brokers are two disturbing practices. First, they hold themselves out as "advisors." Second, they all talk of the importance of gaining the trust and confidence of the clients.

In its 1940 Annual Report, the U.S. Securities and Exchange Commission noted: “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 (1940) 113 F. 2d 150.

In 1963, in its Special Report on the securities industry, the SEC also noted that it “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.

There exists a fundamental truth that “to provide biased advice, with the aura of advice in the customer’s best interest, is fraud.” [Angel, James J. and McCabe, Douglas M., Ethical Standards for Stockbrokers: Fiduciary or Suitability? (September 30, 2010), at p.23. Available at SSRN: http://ssrn.com/abstract=1686756.]  Those who use titles and designations, such as "financial advisor" or "CFP" or "ChFC" or "financial consultant" - and who then don't adhere to the fiduciary obligations attendant to such representations - in essence commit intentional misrepresentation. Let's call it for what it is - "fraud" - plain and simple. We should not live in a society in which pervasive fraud - i.e., holding out as trusted advisors, and then failing to adhere to the duties imposed from the resulting fiduciary relationship - is continued to be permitted to occur. There is a simple maxim expressed by a state securities commissioner nearly a decade ago at a conference, and repeated many times since: "Do not lie, cheat or steal. Say what you do. And do what you say."