Fiduciary Responsibility: Liability and Consequences: Part 1
by Stuart Ober, AIFA®
Executive Summary
- The role of fiduciaries is one of the most important, yet least understood, in which investment professionals participate. This article, drawing deeply on the work of the Foundation for Fiduciary Studies, is designed to help financial planners understand the responsibilities of a fiduciary. · A fiduciary is generally defined as someone who manages someone else's assets. Financial planners are considered a fiduciary normally when they are registered with the SEC or when their actions provide comprehensive and continuous advice, though "facts and circumstances" ultimately determine the applicability.
- This definition applies regardless of type of compensation, whether the planner is a registered representative or registered investment adviser, or whether the planner has or does not have client discretion.
- The article outlines the Foundation's seven Uniform Fiduciary Standards of Care, including diversifying assets to the client's specific risk/return profile, preparing an investment policy statement, and controlling and accounting for investment expenses.
- A five-step investment management process is described. This includes analyzing the client's current position, implementing an investment policy, and monitoring the investment performance.
- The article then outlines the 27 "practices" for those five steps as recommended by the Foundation, what practices are generally accepted in the investment industry and what is required by law, and practical applications of those practices.
- A due-diligence process should be developed, and it must be demonstrated that it was followed. Several due-diligence procedures are described.by Stuart Ober, AIFA®
Stuart Ober is president of Securities Investigations Inc. in Woodstock, New York, specializing in due diligence and investment research and analysis, and is an arbitrator with the National Association of Securities Dealers (chairperson trained), NYSE, and NFA, and a Certified Mediator. He is an Accredited Investment Fiduciary Auditorª (AIFA®) with over 24 years of experience as an expert for both claimants and respondents in securities disputes, involving such areas as suitability, due diligence, selling away, supervisory failure, and damages calculations. He has set standards on behalf of the Financial Product Standards Board of the Institute of Certified Financial Planners, in mutual funds, insurance products, and tax shelters. He can be reached at (845) 679-2300 or at ober@stuartober.com.
ERISA's fiduciary obligations are among the "highest known to the law."1
The role played by fiduciaries is one of the most important, yet least understood, in which investment professionals participate. And it is likely, considering the complexity of the role of fiduciaries, that lawsuits alleging misconduct will continue.
The key to fiduciary liability is basic: It's not whether you win or lose, but how you play the game. Liability of the fiduciary is determined by whether prudent investment practices are followed, not by investment performance. Prudence is demonstrated by the process through which investment decisions are made, not by performance. Even conservative and traditional investments may not measure up if a sound process is missing, while aggressive and unconventional investments that are arrived at by a sound process can meet the standard.
To help financial planners and others understand the responsibilities of a fiduciary, the Foundation for Fiduciary Studies, a public nonprofit organization established in 2000, has developed and published practices that define a prudent process for investment fiduciaries: Prudent Investment Practice: A Handbook for Investment Fiduciaries.² This article covers, and quotes extensively from, the basic tenets of the Handbook.
While much has been written about fiduciaries, few fiduciaries actually understand their liability. The Enron case has provided the first real-time, high-profile glimpse of how "deep" fiduciary liability can run. Among other things, Enron reminds us that fiduciaries can be held personally liable for all of the investment options in a retirement plan, as well as individual participant investment decisions. And it is likely that complaints and lawsuits alleging fiduciary misconduct will continue.
The law imposes broad duties of care and loyalty on the fiduciary. Fiduciaries have the most important role in the investment process: to manage investment practices, without which the other components of the investment plan can be neither defined, nor implemented, nor evaluated.
According to the Foundation for Fiduciary Studies, the term fiduciary encompasses "the more than five million people who have the legal responsibility for managing someone else's money, including members of investment committees of retirement plans, foundations, and endowments; trustees of private trusts; and investment advisors." And, according to the Foundation, these five million people have the responsibility for managing about 80 percent of the investable liquid assets in this country.
Definition of a Fiduciary
While fiduciary status is determined by facts and circumstance, the Foundation generally describes a fiduciary as a person who
- Manages property for the benefit of another.
- Exercises discretionary authority or control over assets.
- Acts in a professional capacity of trust and renders comprehensive continuous investment advice.
When Are You an Investment Fiduciary?
Under what circumstances is the financial planner a fiduciary?³ As Trone puts it in his position paper, "At the risk of oversimplifying a complex subject, an investment fiduciary generally is defined as a person who has the responsibility of managing someone else's assets. If one accepts the premise that a large majority of financial planners provide investment advice, then when might a financial planner be considered an investment fiduciary?"
In attempting to answer that question, Trone says, we should first qualify and refine the previously stated general definition of an investment fiduciary to make it industry specific. A financial planner may be considered an investment fiduciary under these circumstances: (1) when the financial planner is registered with the Securities and Exchange Commission or (2) when by actions the financial planner provides comprehensive and continuous advice.
The advantages of this industry-specific definition are that it is applicable whether the financial planner is (1) a registered representative or a registered investment adviser; (2) commission or fee-based, or (3) operating with or without client discretion.
But as simple and as straightforward as this definition might appear, the determination of fiduciary status is still difficult and is ultimately decided by the courts or arbitration boards who review the facts and circumstances of each situation. A financial planner may be deemed an investment fiduciary with one client, but not with another. To illustrate this difficulty, consider these two examples drawn from Trone's paper.
Example 1. A client has several different brokers and money managers, as well as a portfolio of stocks and bonds that the client has managed on her own. The client asks the financial planner to review her existing portfolio of stocks and bonds, and to make recommendations as to which securities are no longer appropriate and should be sold. The financial planner uses several different rating agencies to evaluate the portfolio and make several "sell" recommendations, which the client accepts.
Question: Is it likely the financial planner will be considered an investment fiduciary in this example?
Answer: Probably not. The financial planner did not develop a comprehensive investment strategy that reviewed and included all of the client's investment holdings (the services were not comprehensive). It is also implied that the investment review was a one-time or occasional request, and was not an ongoing service provided by the planner (the investment advice was not continuous).
Example 2. A client sells his business for a sizable fortune and, for the first time, has considerable investable assets to manage. He turns to his financial planner for assistance. The financial planner develops an asset allocation study, prepares an investment policy statement, implements the investment strategy with appropriate money managers and mutual funds, and on a periodic basis provides performance reports showing how the client is progressing toward meeting his goals.
Question: Is it likely that the financial planner will be considered an investment fiduciary in this example?
Answer: Very likely. The investment advice is comprehensive and continuous.
The specific industry challenge is to clearly identify the demarcation between executing a brokered transaction and giving investment advice. The compliance regulations and suitability standards of the National Association of Securities Dealers and various market exchanges adequately address the practices associated with the selling of an investment product and the execution of a brokered transaction. But when the investor is provided comprehensive and continuous investment advice, a higher standard of care is justified and warranted-specifically a fiduciary standard of care.
Where Can You Find a Structured Fiduciary Process?
Where can the financial planner turn to find a structured fiduciary process that will leave the planner confident that the critical components of an investment strategy have been properly implemented?
Prudent Investment Practices: A Handbook for Investment Fiduciaries, provides an important tool for financial planning fiduciaries who want to stay out of the courts. The Handbook outlines 27 practices that define a prudent process for investment fiduciaries. Each practice is substantiated by legislation, case law, or regulatory opinion letters. The practices are intentionally written to be equally applicable to investment committee members, trustees, and investment advisors.
While the determination of fiduciary status is the first challenge in determining liability for financial planners, the second challenge is to identify the practices that define the details of the investment process that meet a financial standard of care. The investment fiduciary has the important duty to manage a prudent investment process.
What Legislative Acts Provide Guidance for the Fiduciary?
Three legislative acts provide the legislative basis for fiduciaries.
The first is the Employee Retirement Income Security Act, or ERISA. This is federal legislation that defines fiduciary conduct for qualified corporate retirement accounts (defined-benefit plans and defined-contribution plans, including 401(k) benefit plans).
The second is the state-enacted Uniform Prudent Investor Act, or UPIA, which defines the fiduciary practices for private trusts, foundations, and endowments. Approximately 40 states have enacted the entire, or a substantial part of, UPIA.
The third act was introduced in 1997 and it is proposed legislation called the Uniform Management of Public Employee Retirement Systems Act, or MPERS. This proposal is state-enacted legislation that defines the fiduciary conduct for state, county, and municipal retirement plans. As of January 2005, South Carolina was the only state that has formally adopted MPERS.
What Are the Uniform Fiduciary Standards of Care?
The three legislative acts (ERISA, UPIA, and MPERS) each cite the requirement for the fiduciary to follow a prudent process in the selection of the person(s) or firm(s) that will have responsibility for investment decisions, and all define what the Foundation for Fiduciary Studies identifies as the seven Uniform Fiduciary Standards of Care:
- Know the standards, laws, and trust provisions.
- Diversify assets to the specific risk/return profile of the client.
- Prepare an investment policy statement.
- Use "prudent experts" (money managers) and document the due diligence.
- Control and account for investment expenses.
- Monitor the activities of prudent experts.
- Avoid conflicts of interest and prohibited transactions.
What Are the Steps of the Investment Management Process?
If we take the seven Uniform Fiduciary Standards of Care and arrange them in a sequential process, the simplest process will be a five-step investment management process:
- Analyze a client's current investment position.
- Diversify the client's portfolio.
- Prepare an investment policy statement.
- Implement an investment strategy.
- Monitor the investment strategy.
Let's look at each of these five steps.
(Continue to Part 2)
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