Fiduciary Duties Conform to the Level of Protection Required

It is time for financial planners and investment advisers to become part of a true profession.

There are many different types of fiduciary relationships. The duty of loyalty itself, and the ability to waive the fiduciary standard, is adjusted to fit the varied types of relationships. In some fiduciary relationships, less protection is required; in others, a much stronger degree of protection required. Generally, the greater the disparity in knowledge and skill between the fiduciary and the entrusted (agent, or business partner, or client), the more strictly the fiduciary standard of loyalty is applied.

Employer-employee relationships. For example, suppose you are an employer, and your employee acts as your agent to purchase some goods for you. The employee has a fiduciary duty to you. Under the best interests fiduciary standard applicable to principal-agent relationships, any conflicts of interest which exist or which may arise must be disclosed by the employee, and the employer must provide consent. For example, if the employee earns a commission upon the purchase of goods, the employer may consent to the employee’s receipt of that commission. In essence, the employer may waive this non-adherence to the fiduciary duty of loyalty that the employee possesses. Of course, in this type of relationship the employer nearly always has greater power and greater knowledge of the subject matter, than the employee. Hence, we don’t feel a great need to protect the employer, as long as there is affirmative disclosure of the conflict of interest and informed consent.

Business Partners. Then there are fiduciary relationships applicable to partners, or members of a limited liability company, with respect to each other. Most state laws permit the parties, at least to some degree, to contract out of fiduciary duties that might otherwise apply. In these situations the law recognizes that the partners likely possess equivalent knowledge and fairly equal bargaining positions, at least when the partnership or limited liability company relationship is entered into.

Attorney-Client Relationships. In contrast, look at the fiduciary relationship between an attorney and her or his client. The law recognizes that, in such a relationship, the attorney has vastly superior knowledge than the client possesses of the law and how the law might be applied. Hence, the lawyer cannot ask a client to waive compliance with a lawyer’s duty of care, nor can the lawyer ask a client to simply waive a conflict of interest where the lawyer is likely to secure a monetary benefit.

For example, under Rule 1.8(a) of the American Bar Association’s Model Rules of Professional Conduct, 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.”

Hence, the ethics rules governing attorneys require multiple steps when a lawyer might acquire a pecuniary interest that is adverse to that of the client. The transaction must remain fair and reasonable. The lawyer must advise the client that the client should seek out independent legal counsel. And the client must provide informed consent to the transaction.

But, it is self-evident, that consent is not “informed” – nor is the transaction “fair and reasonable” – if the client might be harmed. The ABA’s comment to Rule 1.8 provides this example: “[I]f a lawyer learns that a client intends to purchase and develop several parcels of land, the lawyer may not use that information to purchase one of the parcels in competition with the client or to recommend that another client make such a purchase. The Rule does not prohibit uses that do not disadvantage the client. For example, a lawyer who learns a government agency's interpretation of trade legislation during the representation of one client may properly use that information to benefit other clients.

Investment Adviser - Client Relationships. So now we turn to investment advisers. Are investment advisers more like employers, or more like partners, or more like lawyers, in terms of the stature and abilities and knowledge of the entrustor - employer, other partners, or client? One can only conclude that clients of financial and investment advisers are much more like clients of attorneys, and not at all like partners entering into a partnership agreement (who presumably have fairly equal knowledge and expertise). Clients of investment advisers certainly don't possess the superior knowledge and skill that most employers possess with respect to their employees.

Clients of investment advisers simply lack the knowledge of the financial markets that financial advisors do. And clients are not likely to gain such knowledge without a very substantial investment of time and effort, and even then many clients won’t possess the aptitude for matters of finance.

Hence, between investment advisers and their clients there exists this huge gap of information. This gap is what allows the clients of a fiduciary to be taken advantage of. The academic research in support of this is absolutely clear. We are no more likely to turn the average consumer into a skilled consumer of investment advice, armed with all the knowledge required to protect himself or herself, than we are to turn the patient of a doctor into a brain surgeon.

Many Clients of "Financial Advisors" Believe Their Advisor Doesn't Get Paid - Anything! The SEC knows this. The 2008 Rand Report, commissioned by the SEC, revealed that 35% (75 of 214) clients of professionals who were able to answer a question on fees thought that were paying no fees to their financial advisor. Many more clients couldn’t answer the question posed by Rand, in their survey.

I have personally seen this lack of knowledge over and over again. I have talked to many potential clients who, upon inquiry, thought that their broker was a "good guy" who "was not charging us, because he is a friend."

Second Opinions Reveal the Harm Often Caused.  A couple of years ago I did a portfolio review for a highly educated retired engineer and executive. This person, despite spending time reading much of the information that was provided, had no idea that she was paying total fees and costs which approached 2.5% on a portfolio which was well over $1.5 million. For another couple, for whom I did a portfolio review about a year ago, the couple had no idea that the dual registrant who was serving them was, in addition to receipt of investment advisory fees, also getting 12b-1 fees and payments for shelf space.

I often provide second opinions on portfolios. When I do my analysis, and reveal these fees and costs to the clients of these “financial advisors,” these individual investors often get very angry. Not just at brokers, but at the entire financial services system.

Disclosures Are Ineffective. It is just absolutely clear that investment disclosures are not read. Even if read, these disclosures are not understood. No amount of simplification of disclosures is going to fix this. For even if high fees are revealed, many clients believe that high-cost products are better investments. Of course, the academic research is clear that higher-cost products, on average, directly correlate with lower returns to investors.

In Conclusion.

There currently exists a "battle for the soul of the profession." On one side are those who desire to adhere to the old ways - trust-based selling leading to product sales. On the other side are those who recognize that the fiduciary standard is needed - both to protect our fellow Americans but also to bring the delivery of financial planning and investment advice to the level of a true profession.

Which side are you on?