Arms-Length (Sales) vs. Fiduciary (Advice) Relationships.
There are two forms of commercial relationships under the law:
(1) The Seller-Customer Relationship. The most common relationship is that between sellers and buyers, known as arms-length relationships or sales relationships. Under such relationships the purchaser (customer) possesses the duty to protect himself or herself; reliance upon the product salesperson is not available to the customer. The product salesperson cannot commit actual fraud, such as by misrepresenting the product, concealing patent defects in the product, or failing to disclose known latent defects.
Realizing that consumers in certain situations need additional protections, various laws and regulations exist which impose upon certain sellers additional obligations. Often these laws and regulations impose disclosure obligations. For example, the Securities Act of 1933 imposes substantial disclosure obligations upon issuers. Various aspects of the Securities Exchange Act of 1934, and the regulations adopted thereunder (including FINRA rules) also impose certain disclosure obligations upon broker-dealer firms. State insurance laws mandate certain disclosures for the sale of life and annuity products.
Other "market conduct" restrictions may exist. For example, various rules prohibit front-running in connection with execution of securities transactions, limits upon principal mark-ups and mark-downs in connection with bond sales and purchases, and limits upon commissions and/or 12b-1 fees received by broker-dealer firms for mutual fund sales.
(2) The Fiduciary-Client Relationship. At times our society concludes that the protections of the sales relationship, such as the obligation to avoid actual fraud, or even the imposition of additional disclosure obligations or certain rules restricting certain forms of market conduct, are insufficient. At such times the law imposes fiduciary status upon the advisor to the client.
In a fiduciary relationship, the fiduciary (advisor) steps into the shoes of the entrustor (client) and acts, with all of the knowledge and skill of a professional, on the client's behalf.
In dictum in the 1998 English (U.K.) case of Bristol and West Building Society v. Matthew, Lord Millet undertook what has been described as a “masterful survey” of the fiduciary principle: "A fiduciary is someone who has undertaken to act for and on behalf of another in a particular matter in circumstances which give rise to a relationship of trust and confidence. The distinguishing obligation of a fiduciary is the obligation of loyalty. The principle is entitled to the single-minded loyalty of his fiduciary. This core liability has several facets. A fiduciary must act in good faith; he must not place himself in a position where his duty and his interest may conflict; he may not act for his own benefit or the benefit of a third person without the informed consent of his principal. This is not intended to be an exhaustive list, but it is sufficient to indicate the nature of the fiduciary obligations. They are the defining characteristics of a fiduciary."
A fiduciary is “a person having a duty, created by his undertaking, to act primarily for the benefit of another in matters connected with his undertaking.” RESTATEMENT (2D) AGENCY § 13 comment (a) (1958). “[T]he general fiduciary principle requires that the agent subordinate the agent’s interests to those of the principal and place the principal’s interests first as to matters connected with the agency relationship.” RESTATEMENT (3D) AGENCY § 8.01 cmt. b (2007). See also Laby, Arthur B., “The Fiduciary Obligation as the Adoption of Ends,” Buffalo L. Rev 99, 103 (2008), available at: http://ssrn.com/ abstract=1124722. See also Varity Corp. v. Howe, 516 U.S. 489, 116 S.Ct. 1065, 134 L.Ed.2d 130 (1996), in which the U.S. Supreme Court, applying ERISA, stated that: “There is more to plan (or trust) administration than simply complying with the specific duties imposed by the plan documents or statutory regime; it also includes the activities that are "ordinary and natural means" of achieving the "objective" of the plan. Bogert & Bogert, supra, § 551, at 41-52. Indeed, the primary function of the fiduciary duty is to constrain the exercise of discretionary powers which are controlled by no other specific duty imposed by the trust instrument or the legal regime. If the fiduciary duty applied to nothing more than activities already controlled by other specific legal duties, it would serve no purpose.” Id. (Emphasis added.)
In summary, the fiduciary principle imposes constraints upon the conduct of the adviser. It requires that the adviser subordinate its, his or her own interests to that of the client. It requires that the adviser steps into the shoes of the client, with all of the adviser's required level of knowledge and skill, and use the adviser's abilities to advance the ends of the clients.
To Understand the Application of Fiduciary Duties, You Must Know the Reasons for their Application.
The key to understanding fiduciary principles, and why, when and how they are applied, rests in first discerning the various public policy objectives the fiduciary standard of conduct is designed to meet. The following listing of public policy objectives is not all-inclusive, but rather provides an overview of the reasons for the application of the fiduciary principle to certain relationships.
In his influential article discussing the creation of the federal securities acts, and in particular their moral purpose, John Walsh (formerly of the SEC’s OCIE) reviewed the legislative history underlying the creation of the Investment Advisers Act:
- "As part of a congressionally mandated review of investment trusts the agency also studied investment advisers. The Advisers Act was based on that study. By the time it passed, it was a consensus measure having the support of virtually all advisers."
- "Investment advisers’ professionalism, and particularly their professional ethics, dominated the SEC study and the legislative history of the Act. Industry spokespersons emphasized their professionalism. The 'function of the profession of investment counsel,' they said, 'was to render to clients on a personal basis competent, unbiased and continuous advice regarding the sound management of their investments.' In terms of their professionalism they compared themselves to physicians and lawyers. However, industry spokespersons indicated that their efforts to maintain professional standards had encountered a serious problem. The industry, they said, covered 'the entire range from the fellow without competence and without conscience at one end of the scale, to the capable, well-trained, utterly unbiased man or firm, trying to render a purely professional service, at the other end.' Recognizing this range, 'a group of people in the forefront of the profession realized that if professional standards were to be maintained, there must be some kind of public formulation of a standard or a code of ethics.' As a result, the Investment Counsel Association of America was organized and issued a Code of Ethics. Nonetheless, the problem remained that the Association could not police the conduct of those who were not members nor did it have any punitive power."
- "The SEC Study noted that it had been the unanimous opinion of all who had testified at its public examination, both members and nonmembers of the Association, that the industry’s voluntary efforts could not cope with the 'most elemental and fundamental problem of the investment counsel industry—the investment counsel ‘fringe’ which includes those incompetent and unethical individuals or organizations who represent themselves as bona fide investment counselors.' Advisers of that type would not voluntarily submit to supervision or policing. Yet, all counselors suffered from the stigma placed on the activities of the individuals on the fringe. Thus, an agency was needed with compulsory and national power that could compel the fringe to conform to ethical standards."
- "As a result of the Commission’s report to Congress, the Senate Committee on Banking and Currency determined that a solution to the problems of investment advisory services could not be affected without federal legislation. In addition, both the Senate and House Committees considering the legislation determined that it was needed not only to protect the public, but also to protect bona fide investment counselors from the stigma attached to the activities of unscrupulous tipsters and touts. During the debate in Congress, the special professional relationship between advisers and their clients was recognized. It is, said one representative, 'somewhat [like that] of a physician to his patient.' The same Congressman continued that members of the profession were 'to be complimented for their desire to improve the status of their profession and to improve its quality.'"
One might reasonably ask why “honest investment advisers” (to use the language of the U.S. Supreme Court in SEC vs. Capital Gains) had to be protected by the Advisers Act. Was it not enough to just protect consumers? The answer can be found in economic principles, as set forth in the classic thesis for which George Akerlof won a Nobel Prize:
Fiduciary duties are imposed by law when public policy encourages specialization in particular services, such as investment management or law, in recognition of the value such services provide to our society. For example, the provision of investment consulting services under fiduciary duties of loyalty and due care encourages participation by investors in our capital markets system. Hence, in order to promote public policy goals, the law requires the imposition of fiduciary status upon the party in the dominant position. Through the imposition of such fiduciary status the client is thereby afforded various protections. These protections serve to reduce the risks to the client which relate to the service, and encourage the client to utilize the service. Fiduciary status thereby furthers the public interest.
The impact of the application of the fiduciary standard upon financial/investment adviser - client relationships, and the potential for U.S. economic growth, should not be underestimated. “We find that trusting individuals are significantly more likely to buy stocks and risky assets and, conditional on investing in stock, they invest a larger share of their wealth in it. This effect is economically very important: trusting others increases the probability of buying stock by 50% of the average sample probability and raises the share invested in stock by 3.4 percentage points … lack of trust can explain why individuals do not participate in the stock market even in the absence of any other friction … [W]e also show that, in practice, differences in trust across individuals and countries help explain why some invest in stocks, while others do not. Our simulations also suggest that this problem can be sufficiently severe to explain the percentage of wealthy people who do not invest in the stock market in the United States and the wide variation in this percentage across countries.” Guiso, Luigi, Sapienza, Paola and Zingales, Luigi. “Trusting the Stock Market” (May 2007); ECGI - Finance Working Paper No. 170/2007; CFS Working Paper No. 2005/27; CRSP Working Paper No. 602. Available at SSRN: http://ssrn.com/abstract=811545.
Public Policy Encourages Saving and Proper Investing
Fiduciary obligations are not finite. They cannot be limited by descriptions such as those found in rules. This is because new types of both actual and constructive fraud emerge, and the fiduciary standard must be free to adapt to new practices.
In the fiduciary context, when we refer to "fraud" we mean both "actual fraud" (such as that arising from misrepresentation or fraudulent concealment) and "constructive fraud." See Howell v. Texaco Inc., 112 P.3d 1154, 1161 (Okla.2004); Patel v. OMH Medical Center, Inc., 987 P.2d 1185, 1199 (Okla. 1999). A breach of one's fiduciary obligation constitutes constructive fraud.
In the United States it is common to refer to a “triad of fiduciary duties” - the duties of due care, good faith and loyalty. For example, the Delaware Supreme Court embraced the notion of a “triad” of fiduciary duties: loyalty, care, and good faith. See Emerald Partners v. Berlin, 787 A.2d 85, 90 (Del. 2001) (noting that “directors of Delaware corporations have a triad of primary fiduciary duties: due care, loyalty, and good faith”); Malone v. Brincat, 722 A.2d 5, 10 (Del. 1998) (observing “[t]hat triparte fiduciary duty does not operate intermittently but is the constant compass by which all director actions for the corporation and interactions with its shareholders must be guided”); see also In re Fleming Packaging Corp., 370 B.R. 774 (Bankr. C.D. Ill., 2007) (“Corporate directors and officers owe the corporation a triad of fiduciary duties: due care, loyalty and good faith.”). See also In Re: Innovation Fuels, Inc., 2013 Bankr. Lexis 3041.
These tri-parte fiduciary duties often encompass other fiduciary obligations. For example, the fiduciary obligation of "obedience" may be found as an aspect of the duty of loyalty, or the duty of due care, or some combination of both.
Under English common law, from which the American system of jurisprudence was initially derived, it is reasonably well established that fiduciary status gives rise to five principal duties: (1) the no conflict rule preventing a fiduciary placing himself in a position where his own interests conflict or may conflict with those of his client or beneficiary; (2) the no profit rule which requires a fiduciary not to profit from his position at the expense of his client or beneficiary; (3) the undivided loyalty rule which requires undivided loyalty from a fiduciary to his client or beneficiary; (4) the duty of confidentiality which prohibits the fiduciary from using information obtained in confidence from his client or beneficiary other than for the benefit of that client or beneficiary; and (5) the duty of due care, to act with reasonable diligence and with requisite knowledge, experience and attention. The first three of these duties are often used to describe the three aspects of a fiduciary duty's of loyalty.
In the posts that follow, I focus in on the two core fiduciary obligations - the fiduciary duty of loyalty and the fiduciary duty of due care. However, in so doing, I acknowledge that other fiduciary duties exist, which may or may not flow from these two core fiduciary duties. For example, the fiduciary duties of obedience, confidentiality, and utmost good faith may alternatively be viewed as flowing from the two core fiduciary obligations of due care and loyalty, or they may be regarded as separate fiduciary obligations. Other fiduciary obligations may exist.
- Feb. 24-25, 2016: FPA of Oregon and S.W. Washington Midwinter Conference 2016, where Ron will discuss: "The DOL's Transformational Conflict of Interest Rule"
- Feb. 26, 2016: FPA of Puget Sound's 2016 Annual Symposium, where Ron will discuss: "Reducing Your Risks in the New Fiduciary Era"
Public comments to this blog are welcome, provided that no advertising occurs and that decorum is maintained. To reach Prof. Rhoades directly, please e-mail him at: Ron.Rhoades@WKU.edu. Thank you.