Disclosure is Not Enough: Fiduciaries and the No Conflict Rule

When one is engaged as a fiduciary, the fiduciary steps into the shoes of the client, in order to act on the client’s behalf. A transfer of power occurs – if not the actual transfer of assets (as may occur in a trust or custody relationship), then the transfer of power through the taking, by the client, of the fiduciary’s advice and counsel (as may occur in a lawyer-client or investment adviser-client relationship).

The client permits this close, confidential relationship to exist in recognition that the expertise of the fiduciary, brought to bear for the benefit of the client, can lead to much more positive outcomes.

But such expertise, if improperly applied, can be used to take advantage of the client. The fiduciary, as a expert, possess a much greater knowledge of investments, portfolio management, etc. Also, the client’s guard is down; due to a variety of behavioral biases, client consent to action by the fiduciary is easily secured.

Fiduciary law guards against the abuse through its "no conflict" rule.

The No Conflict Rule

In a fiduciary relationship, the law requires that the fiduciary must not bring her or his own interests into conflict with the interests of the client. This requirement is called the “no conflict” rule. It is derived from English law concepts that have flowed into American law from centuries past.

The “no conflict” rule has nothing to do with good or bad motive. The U.S. Supreme Court, in discussing conflicts of interest, has said: ‘The reason of the rule inhibiting a party who occupies confidential and fiduciary relations toward another from assuming antagonistic positions to his principal in matters involving the subject matter of the trust is sometimes said to rest in a sound public policy, but it also is justified in a recognition of the authoritative declaration that no man can serve two masters; and considering that human nature must be dealt with, the rule does not stop with actual violations of such trust relations, but includes within its purpose the removal of any temptation to violate them ....”

And, as the U.S. Supreme Court said a hundred years ago, the law “acts not on the possibility, that, in some cases the sense of duty may prevail over the motive of self-interest, but it provides against the probability in many cases, and the danger in all cases, that the dictates of self-interest will exercise a predominant influence, and supersede that of duty.”

Or, as an eloquent Tennessee jurist put it before the Civil War, the doctrine “has its foundation, not so much in the commission of actual fraud, but in that profound knowledge of the human heart which dictated that hallowed petition, “Lead us not into temptation, but deliver us from evil,” and that caused the announcement of the infallible truth, that “a man cannot serve two masters.”

Can Client Consent Occur? Only After Five Steps

In arms-length relationship consent by a customer to proceed, when a conflict of interest is present, is generally permitted. Caveat emptor (“let the buyer beware”) applies to such merchandiser-customer relationships. The customer is not represented by the merchandiser but is rather in an adverse relationship - that of seller and purchaser.

In such instances, it is a fundamental principle of the common law that volenti non fit injuria – to one who is willing, no wrong is done. Customer consent to the transaction generally gives rise to estoppel – i.e., the customer cannot later state the he or she can escape from the transaction because a conflict of interest was present, or because full awareness of the ramifications of the conflict of interest were absent. The customer, in such instances, bears the duty of negotiating and effecting a fair bargain. The law permits customers, in such instances, to enter into "dumb bargains."

But the fiduciary relationship is altogether different. Trust has been given, by the client, to the fiduciary. In such a relationship of trust and confidence, the law guards against the fiduciary taking advantage of such trust.

Hence, mere consent by a client in writing to a breach of the fiduciary obligation is not, in itself, sufficient to create waiver or 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, preventing the client from later challenging the validity of the transaction which occurred, the fiduciary is required to undertake a series of steps:

First, disclosure of all material facts to the client must occur. For some commentators on the fiduciary obligations of investment advisers, this is all that is required. Often this erroneous conclusion is derived from misinterpretations of the landmark decision of SEC v. Capital Gains Research Bureau.

Second, the disclosure must be affirmatively made and timely undertaken. In a fiduciary relationship, the client’s “duty of inquiry” and the client’s “duty to read” are limited; the burden of ensuring disclosure is received is largely borne by the fiduciary. Disclosure must also occur in advance of the contemplated transaction; receipt of a prospectus following a transaction is insufficient.

Third, 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.

Fourth, the informed consent of the client must be affirmatively secured. Silence must not occur. Consent is not obtained through coercion nor sales pressure.  (and silence is not consent).

Fifth, 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.

These requirements of the common law – derived from judicial decisions over hundreds of years – have found their way into our statutes. For example, ERISA’s exclusive benefit rule unyieldingly commands employee benefit plan fiduciaries to discharge their duties with respect to a plan solely in the interest of the plan’s participants and for the exclusive purpose of providing benefits to them and their beneficiaries. And the Investment Advisers Act of 1940 was widely known to impose fiduciary duties upon investment advisers from its very inception, and it contains an important provision that prevents waiver by the client of the investment adviser’s duties to that client.

Disclosure, Alone, Is Neither a Duty Nor a Cure

It must be understood that there exists no fiduciary duty of disclosure. While disclosure may be imposed by other law or regulation, or by contractual obligations created between the parties, disclosure is not, itself, a core fiduciary obligation.

Rather, fiduciaries owe the obligation to their client to not be in a position where there is a substantial possibility of conflict between self-interest and duty. Fiduciaries also possess the obligation not to derive unauthorized profits from the fiduciary position. This is called the “no profit” rule, also derived from English law.

While there is no fiduciary duty of disclosure, questions of disclosure are often central in the jurisprudence discussing fiduciary law, as many cases involve claims for breach of the fiduciary duty due to the presence of a conflict of interest. In essence, a breach of fiduciary obligation – either the obligation not to be in a position of conflict of interest and the duty to not make unauthorized profits – may be averted or cured by the informed consent of the client (provided all material information is disclosed to the client, the adviser reasonably expects client understanding to result given all of the facts and circumstances, the informed consent of the client is affirmatively secured, and the transaction remains in all circumstances substantially fair to the client).

In essence, asking a client to consent to a conflict of interest by the fiduciary is requesting that the client waive the no conflict rule and/or the no profit rule generally applicable to fiduciaries. Again, clients would only do so in circumstances where the client is not harmed.

Hence, disclosure, alone, is not a cure. And disclosure is only one of the five important requirements, all of which must be met, for a client’s waiver of a fiduciary obligation to be valid.

The Importance of the No Conflict Rule

As the debate over the imposition of fiduciary obligations upon those providing advice to retirement plan sponsors, retirement plan participants, IRA account holders, and more broadly to any American receiving personalized investment advice, let us first understand that the fiduciary's obligation includes, at its core, the obligation to not put herself or himself into a situation which is in conflict with the client. And, since some conflicts of interest are unavoidable, when such conflicts do occur a series of five important requirements must be met to properly manage the conflict.

The core of fiduciary law requires nothing less. Nor should we.