Fiduciary Papers #7: What Steps are Required to Properly Manage a Conflict of Interest Held by An Investment Adviser?

While the SEC has provided an interpretative release [SEC Release IA-5248, Commission Interpretation Regarding Standard of Conduct for Investment Advisers (July 12, 2019)] regarding the fiduciary duties of investment advisers, its explanation of the proper management of unavoided conflicts of interest left much to be desired.

In this article I modify, and add substantially to, the SEC’s prior release. In so doing, I set forth the multi-step process by which conflicts of interest are either avoided or properly managed.

These comments represent my own views and are not necessarily those of any institution, firm, association, or organization with whom I may be affiliated.[1]

Introduction: The Fiduciary Duty of Loyalty, Generally

The duty of loyalty, the most distinctive of the duties imposed upon a fiduciary,[2] requires an investment adviser to put its client’s interests first.

Under the fiduciary duty of loyalty, as developed over centuries of case law, there is a duty to not possess a conflict of interest, and also a duty to not profit off of the client.[3] In other words, 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.[4] This is called the “no-conflict” rule, derived from English law.

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.[5]

Because an investment adviser must serve the best interests of its clients, the adviser possesses an obligation not to subordinate its clients’ interests to its own.

The Duty to Avoid, Where Possible, Conflicts of Interest.

To properly adhere to the fiduciary duty of loyalty, an investment adviser must seek to avoid conflicts of interest with its clients.[6]

The “no-conflict rule” states, in essence, that 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.[7]

The no-conflict rule is firmly embedded in the federal fiduciary standard. In SEC vs. Capital Gains the U.S. Supreme Court explained the no conflict rule and provided the rationale behind the prohibition on serving two masters:

This 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 …. In Hazelton v. Sheckells, 202 U.S. 71, 79, we said: ‘The objection . . . rests in their tendency, not in what was done in the particular case … The court will not inquire what was done. If that should be improper it probably would be hidden and would not appear.’[8]

As I have written before, in Fiduciary Papers #6, conflicts of interest relating to differential compensation, in the field of financial services, must generally be avoided. This is because when an investment adviser derives additional compensation from the recommendation of a particular product, paid by the product provider, nearly always there would be a better alternative for the client. The greater compensation of the investment adviser in such circumstances results from greater fees and costs embedded in the financial product. And, as academic research has so robustly demonstrated, the greater the fees and costs of the investment product (all other things being equal), the lower the returns to the consumer. Since clients cannot be presumed to consent to be harmed, nearly all conflicts of interest relating to differential compensation should be avoided.

This does not mean that investment advisers should not be well-compensated. Investment advisers should possess a high level of knowledge and a high degree of skill, and should receive compensation for such knowledge and skill commensurate with the reasonable compensation afforded to similarly situated professional advisors.

In an ideal world, no conflicts of interest between an adviser and its clients would ever exist. Indeed, the avoidance of conflicts of interest was a principal reason behind the enactment of the Advisers Act:

The Advisers Act 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.’[9]

When Conflicts of Interest Cannot Be Avoided, A Process Should Be Followed

However, while avoidance of a conflict of interest is the best method to adhere to an investment adviser’s fiduciary duty of loyalty,[10] and even other securities laws or regulations require the avoidance of certain conflicts of interest (even in non-fiduciary relationships),[11] it must be acknowledged that not all conflicts of interest can be avoided.

In this regard, the “best interests” fiduciary standard is not as strict as the “sole interests” fiduciary standard applicable under the trust law of many states, in that conflicts of interest may exist at times. However, even when a conflict of interest exists, actions must be taken to ensure that the client is not harmed. In other words, the conflict of interest, even when affirmatively and fully disclosed, must be properly managed through a process that includes obtaining the client’s informed consent[12] and, even then, that the transaction remain substantively fair to the client.

When an investment adviser (or other fiduciary) possesses a material conflict of interest with a client, a breach of the fiduciary duty of loyalty occurs. In such situations, the fiduciary is provided a means to “cure” the breach. This means might be might be summarized as involving a multi-step process, including:

  1. Identify the conflict of interest that creates the breach of fiduciary obligation;
  2. Seek to avoid the conflict of interest;
  3. Where the conflict of interest cannot be avoided:
    • Disclose the conflict of interest to the client in a clear, concise, and complete manner;
    • Ensure the client understands the disclosures made, the conflict of interest that exists, and the ramifications to the client;
    • Obtain the client’s informed consent (realizing, however, that no client would ever be presumed to provide informed consent to be harmed); and
    • Even then, ensure that the proposed transaction is substantively fair to the client.

We can further consolidate the process for handling an unavoided conflict of interest through te following three-step process:

STEP ONE: AFFIRMATIVE DISCLOSURE OF THE CONFLICT OF INTEREST, ALL MATERIAL FACTS RELATING THERETO, INCLUDING THE RAMIFICATIONS TO THE CLIENT.

The disclosure of the conflict of interest, and material facts concerning same, must be specific to that conflict of interest. Communications that generally disclose existing or potential conflicts of interest fail to provide clients with an appreciation of all material facts and are generally ineffective as a basis for a client’s informed consent.[13]

All material facts must be disclosed, when a conflict of interest is present. A material fact is “anything which might affect the (client’s) decision whether or how to act.”[14] 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.[15]

A material conflict of interest is always a material fact requiring disclosure.[16]

The disclosure must be timely given. “[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[17] that he is asked to give his consent.”[18]

Disclosure must be affirmatively undertaken. The duty to disclose is an affirmative one and rests with the advisor alone.[19] As conveyed by a recent statement of SEC Staff, clients do not generally possess a duty of inquiry in such circumstances: “The [Commission] 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.”[20]

The fiduciary is required to ensure that the disclosure is received by the client; the “access equals delivery” approach adopted by the Commission in connection with the delivery of a full prospectus to a consumer[21] would not likely qualify as an appropriate disclosure by a fiduciary investment adviser to her or his client of material facts.

Actual disclosure must occur, rather than readiness to disclose.[22] Constructive knowledge of the conflict of interest by the client is insufficient.[23]

Disclosure must be sufficient to obtain client understanding. 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.[24]

 As stated in an early decision by the 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.][25]

The disclosure must not be combined with attempts to unduly influence or coerce the client. Informed consent cannot be obtained through coercion nor sales pressure.[26]

Any disclosure must be clear and detailed enough for a client to make a reasonably informed decision to provide informed consent to such conflicts and practices or reject them.[27]

An adviser must provide the client with sufficiently specific facts so that the client is able to understand the adviser’s conflicts of interest and business practices well enough to make an informed decision.[28] The ramifications of the conflict of interest must be disclosed, so that the client understands the significance of the conflict of interest as it bears upon the client’s affairs.[29]

The disclosure must be frank. As stated by Justice Benjamin Cardoza: “If dual interests are to be served, the disclosure to be effective must lay bare the truth, without ambiguity of reservation, in all its stark significance ….”[30]

The disclosure must be full[31] and forthright. Even reasonably anticipated conflicts of interest must be disclosed.[32] However, an adviser disclosing that it “may” have a conflict is not adequate disclosure when the conflict actually exists.[33]

STEP TWO: ENSURING UNDERSTANDING BY THE CLIENT, AND OBTAIN THE CLIENT’S GRANT OF INFORMED CONSENT.

Following receipt of the disclosures provided, the client must achieve an understanding of the conflict of interest and its ramifications to the client, as well as an understanding of material facts disclosed. With such understanding, the client must then provide informed consent.[34]

Early on the U.S. Securities and Exchange Commission, and the courts, acknowledged that in applying the fiduciary requirements of the Advisers Act a client must provide informed consent.[35] Informed consent provides the client with the opportunity, should the client so choose, to waive the conflict of interest.[36] If a conflict of interest is not avoided and does exist in a fiduciary relationship,[37] mere disclosure to the client of the conflict, followed by mere consent by a client to the breach of the fiduciary obligation, does not suffice.[38]

Stated differently, disclosure is not sufficient to create a “waiver” by the client. Nor does disclosure “estop” the client from pursuing a claim for breach of fiduciary duty under state securities statutes.[39] Under state common law, “mere” disclosure is insufficient to constitute a waiver or estoppel.[40] Nor is disclosure sufficient to constitute waiver or estoppel under the Advisers Act.[41] If this were the case, fiduciary obligations – even core obligations of the fiduciary[42] – would be easily subject to waiver.[43]

The client must provide informed consent, not mere consent, in order for the consent to cure the conflict of interest and negate the potential for damage caused by such conflict.

Why is the tougher standard of informed consent, rather than mere consent, imposed? “By prohibiting all self-interested transactions and profit taking without a beneficiary’s informed consent – regardless of a fiduciary’s intent and irrespective of whether the beneficiary has suffered actual harm—fiduciary law eliminates a fiduciary’s incentives to abuse her position for her own gain.”[44]

To be informed consent, 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.”[45] [Emphasis added.].

A client’s informed consent can be either explicit or, depending on the facts and circumstances, implicit. The Commission believes, however, that it would not be consistent with an adviser’s fiduciary duty to infer or accept client consent to a conflict where either (i) the facts and circumstances indicate that the client did not understand the nature and import of the conflict, or (ii) the material facts concerning the conflict could not be fully and fairly disclosed.[46]

For example, in some cases, conflicts may be of a nature and extent that it would be difficult to provide disclosure that adequately conveys the material facts or the nature, magnitude and potential effect of the conflict necessary to obtain informed consent and satisfy an adviser’s fiduciary duty. In other cases, disclosure may not be specific enough for clients to understand whether and how the conflict will affect the advice they receive. With some complex or extensive conflicts, it may be difficult to provide disclosure that is sufficiently specific, but also understandable, to the adviser’s clients. In all of these cases where full and fair disclosure and informed consent is insufficient, we expect an adviser to eliminate the conflict or adequately mitigate the conflict so that it can be more readily disclosed.

Assuming full, frank and affirmative disclosure of a conflict of interest and its ramifications for the client, and assuming the client provides full consent, only provides a limited defense for the fiduciary against breach of fiduciary duty if the proposed transaction is also substantively fair to the client, as will be discussed in the next section. In other words, disclosure and informed consent do not terminate the fiduciary character of the relationship. Rather, the fiduciary remains subject to fiduciary duties and remains obligated to act loyally and with due care.[47]

It must be emphasized – disclosure of a conflict of interest is not, itself, a cure for a breach of the fiduciary duty of loyalty. Commentators often opine that the U.S. Supreme Court approved, in its 1963 SEC vs. Capital Gains decision, of “disclosure” as the sole means of satisfying a fiduciary’s duty of loyalty, when a conflict of interest of present. But, such commentators choose to ignore these words in the decision – which cannot be ignored:

It is arguable — indeed it was argued by ‘some investment counsel representatives’ who testified before the Commission — that any ‘trading by investment counselors for their own account in securities in which their clients were interested . . .’ creates a potential conflict of interest which must be eliminated. We need not go that far in this case, since here the Commission seeks only disclosure of a conflict of interests ….”[48]

[Emphasis added.] These words, contained in the SEC vs. Capital Gains decision, are often ignored by commentators, most of whom are employed either by broker-dealer firms, insurance companies, or asset managers, or the law firms representing them. Yet, such commentators’ desired interpretation of the decision – that all that is required when a conflict of interest is present is disclosure of the conflict, followed by “mere” (not “informed”) consent – has no foundation in the law. The words of the U.S. Supreme Court – “in this case” and “we need not go that far … since here the Commission seeks only disclosure of a conflict of interests” – show the Court’s judicial restraint only.

The 1933 Securities Act and the Securities and Exchange Act of 1934 both adopt a “full disclosure” regime as a protection for individual investors. But, as made clear by the U.S. Supreme Court, the Investment Advisers Act of 1940 goes further. It recognizes the long-standing understanding that the fiduciary standard exists because disclosure is inadequate as a means of consumer protection in situations in which there is a great disparity in power or knowledge.

Previous actions involving the application of the Advisers Act’s fiduciary standard of conduct support the proper interpretation that disclosure, in and of itself, does not negate a fiduciary’s duties to his or her client. The Commission long disagreed with the notion that all that is required to satisfy one’s fiduciary obligations, when a conflict of interest is present, is “disclosure” and “consent”:

We do not agree that “an investment adviser may have interests in a transaction and that his fiduciary obligation toward his client is discharged so long as the adviser makes complete disclosure of the nature and extent of his interest.” While section 206(3) of the Investment Advisers Act of 1940 (“Act”) requires disclosure of such interest and the client’s consent to enter into the transaction with knowledge of such interest, the adviser’s fiduciary duties are not discharged merely by such disclosure and consent. The adviser must have a reasonable belief that the entry of the client into the transaction is in the client’s interest.  The facts concerning the adviser’s interest, including its level, may bear upon the reasonableness of any belief that he may have that a transaction is in a client’s interest or his capacity to make such a judgment.

Rocky Mountain Financial Planning, Inc. (pub. avail. Feb. 28, 1983) (Emphasis added.)

The fiduciary standard of conduct exists because disclosure, as a means of protection for a person subject to “disadvantage or vulnerability” [Mothew, 1998 Ch.1 (Eng. C.A.) at 17], cannot be adequately protected through the protective means of disclosure. If disclosure of a conflict of interest, alone, were to be sufficient to protect the interests of the entrustor (in the investment advisory context, the client), then there would have been no reason for the equitable principles of fiduciary law to have arisen.

STEP THREE: THE PROPOSED TRANSACTION MUST BE AND REMAIN SUBSTANTIVELY FAIR TO THE CLIENT

Even if the procedural safeguards of full, complete and affirmative disclosure leading to client understanding and to the client’s grant of informed consent all occur, a remaining mandatory substantive requirement exists – that the fiduciary deal fairly with the client.[49] This is because no client would be presumed to authorize a fiduciary to act in bad faith.[50] As stated by one court:

One of the most stringent precepts in the law is that a fiduciary shall not engage in self-dealing and when he is so charged, his actions will be scrutinized most carefully. When a fiduciary engages in self-dealing, there is inevitably a conflict of interest: as fiduciary he is bound to secure the greatest advantage for the beneficiaries; yet to do so might work to his personal disadvantage. Because of the conflict inherent in such transaction, it is voidable by the beneficiaries unless they have consented. Even then, it is voidable if the fiduciary fails to disclose material facts which he knew or should have known, if he used the influence of his position to induce the consent or if the transaction was not in all respects fair and reasonable.

[Emphasis added.][51]

In other words, at all times, the transaction must be substantively fair to the client. This last requirement looks not at the procedures undertaken, but rather casts view upon the transaction itself. It requires that, even if the previous steps involving disclosure, client understanding, and informed consent are followed, at all times the proposed transaction must be and remain substantively fair to the client. If this is not so, the courts will set aside the transaction between the fiduciary and the client.[52]

For example, 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.[53] As stated by Professor Tamar Frankel, for decades the leading scholar on the application of fiduciary law to investment advisers, “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.”[54]

IN CONCLUSION

The fiduciary standard of conduct is tough. It operates to impose restrictions upon the conduct of investment advisers. It generally prohibits the existence of conflicts of interest. And, when an unavoidable conflict of interest remains, the multi-step process for “curing” the breach of one’s fiduciary duty of loyalty must be closely followed, as the conduct of the investment adviser will be subject to intensive scrutiny.


[1] These comments are submitted on my own behalf and not on behalf of any organization, firm, or institution to which I may belong or with whom I may be affiliated. I currently serve as Director of the Personal Financial Planning program and Associate Professor of Finance in the Gordon Ford College of Business at Western Kentucky University. I am also a state-registered investment adviser (Scholar Financial, LLC), serving a select group of clients with holistic financial and investment advice. I have previously served as Chief Compliance Officer and Chair of the Investment Committee of an SEC-registered investment advisory firm. I am also a member of The Florida Bar and currently serve select clients in estate planning and transfer tax planning matters. I served as Reporter for the Financial Planning Association’s Fiduciary Task Force (2006-7) and Standards of Conduct Task Force (2007), and I have held positions in various committees and boards within several financial planning organizations. I am also a member and former Chair of the Steering Committee of The Committee for the Fiduciary Standard, and serve as an adviser to The Institute for the Fiduciary Standard.

[2] “What generally sets the fiduciary apart from other agents or service providers is a core duty, when acting on the principal’s  behalf, to adopt the objectives or ends of the principal as the fiduciary’s own.” Arthur B. Laby, SEC v. Capital Gains Research Bureau and the Investment Advisers Act of 1940, 91 Boston Univ. L.Rev. 1051, 1055 (2011).]

[3] Under English law, from which American law is derived, the broad fiduciary duty of loyalty includes these three separate rules:

  1. The “No Conflict” Rule: A fiduciary must not place itself in a position where its own interests conflict with those of its client.
  2. The “No Profit” Rule: A fiduciary must not profit from its position at the expense of the client. This aspect of the fiduciary duty of loyalty is often considered a prohibition against self-dealing. 
  3. The “Undivided Loyalty” Rule: A fiduciary owes undivided loyalty to its client and therefore must not place itself in a position where his or her duty toward one client conflicts with a duty that it owes to another client.

These separate rules are alive and well in the United States.

[4] 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 v. Capital Gains Research Bureau, 375 U.S. at 191-92.

[5] See 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), at 23: “Second, investment advisers, as fiduciaries, generally are prohibited from receiving any benefit from the use of fund assets ….”

[6] While this statement may appear harsh to some commentators, it is reflective of the vast disparity of knowledge and expertise between the investment adviser and the client, and also reflects the important public policy reasons that support the imposition of the fiduciary standard upon investment advisers. The investment adviser-client relationship is closely analogous to the attorney-client relationship. See, e.g., Julia Smith, Out with “TCF” and in with “fiduciary”?, Butterworths Journal of International Banking and Financial Law (June 2012), P.344 [U.K.] [“On 23 February 2012, the FSCP proposed an amendment to the Financial Services Bill because: “Customers of banks should be owed the same fiduciary duty as those seeking the advice of a lawyer or an MP, with providers prohibited from profiting from conflicts of interest at the expense of their customers…The new Financial Conduct Authority (FCA) should be given powers to make rules to ensure that the industry would have to take their customers’ interests into account when designing products and providing advice.”]

Similar to the fiduciary duties imposed upon an attorney-at-law, the investment adviser’s fiduciary standard also treats the maintenance of conflicts of interest severely. “Conflicts of interest are broadly condemned throughout the legal profession because of their potential to interfere with the undivided loyalty that a lawyer owes to his or her client. The representation of adverse interests can likewise quickly erode the bond of trust between the attorney and his or her client.” Matthew R. Henderson, Chapter 7, “Breach of Fiduciary Duty,” Attorneys Legal Liability (2012), at p.7-8.

[7] 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 v. Capital Gains Research Bureau, 375 U.S. at 191-92.

[8] SEC vs. Capital Gains. at p.___, fn. 50, citing United States v. Mississippi Valley Co., 364 U.S. 520, 550, n. 14

[9] 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 at 187.

[10] “Avoidance is perhaps the best solution to conflict situations. Persons having a duty to exercise judgment in the interest of another must avoid situations in which their interests pose an actual or potential threat to the reliability of their judgment. Although avoidance of conflict situations is an important duty of decision-makers, a flat prescription to avoid all conflicts of interest is not only mistaken, but also unworkable. On the one hand, not all conflicts of interest are avoidable. Some conflict situations are embedded in the relation, while others occur independently of decision-maker’s will.” Fiduciary Duties and Conflicts of Interest: An Inter-Disciplinary Approach (2005), at p.20, available at http://eale.org/content/uploads/2015/08/fiduciary-duties-and-conflicts-of-interestaugust05.pdf.

[11] “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.

[12] See In the Matter of Arleen W. Hughes, Exchange Act Release No. 4048 (Feb. 18, 1948, at 4 and 8, stating: “Since loyalty to his trust is the first duty which a fiduciary owes to his principal, it is the general rule that a fiduciary must not put himself into a position where his own interests may come in conflict with those of his principal. To prevent any conflict and the possible subordination of this duty to act solely for the benefit of his principal, a fiduciary at common law is forbidden to deal as an adverse party with his principal. An exception is made, however, where the principal gives his informed consent to such dealings ….”

[13] See, e.g., Andrew F. Tuch, Disclaiming Loyalty: M&A Advisors and Their Engagement Letters: In response to William W. Bratton & Michael L. Wachter, Bankers and Chancellors, 93 Texas L.Rev. 211, 220-1 (2015) (“Moreover, provisions that generally disclose existing and potential conflicts of interest may be ineffective in obtaining a client’s informed consent. These generalized disclosure provisions may fail to provide clients with a full appreciation of all material facts—as necessary to constitute effective consent. Confirming these doubts in a related context, the Law Governing Lawyers provides that a “client’s consent will not be effective if it is based on an inadequate understanding of the nature and severity of the lawyer’s conflict ….”)

[14] Allen Realty Corp. v. Holbert, 318 S.E.2d 592, 227 Va. 441 (Va., 1984).

[15] TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976); Basic, Inc. v. Levinson, 485 U.S. 224, 233 (1988). See also SEC v. Steadman, 967 F.2d 636, 643 (D.C. Cir. 1992).

[16] 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.

[17] Delivery of the investment advisers Part 2 of Form ADV may not result in timely disclosure, especially when the transaction occurs days, weeks, or months after the transaction is proposed to the client. “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. Note, as well, that the investment adviser must ensure client understanding; a client should not be presumed to have read and understood the disclosures contained in Part 2 of Form ADV.

[18] In the Matter of Arleeen W. Hughes, SEC Release No. 4048 (February 17, 1948), affirmed 174 F.2d 969 (D.C. Cir. 1949).

[19] 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.

[20] The Commission’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.

[21]  See SEC Release No. 33-8998, “Enhanced Disclosure And New Prospectus Delivery Option For Registered Open-End Management Investment Companies,” (Jan. 13, 2009) (“The Commission is also adopting rule amendments that permit a person to satisfy its mutual fund prospectus delivery obligations under Section 5(b)(2) of the Securities Act by sending or giving the key information directly to investors in the form of a summary prospectus and providing the statutory prospectus on an Internet Web site.”)

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).)

[22] 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).

[23] 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.

[24] See, e.g., Julia Smith, Out with “TCF” and in with “fiduciary”?, Butterworths Journal of International Banking and Financial Law (June 2012), P.344 [U.K.] [“In order to obtain B’s fully informed consent: (1) A must make full and frank disclosure of all material facts which might affect B’s consent (New Zealand Netherlands Society Oranje Inc v Kuys [1973] 1 WLR 1126 at 1132) and the extent of disclosure required depends upon the sophistication and intelligence of B (Farah Construction Pty Ltd v Say-Dee Pty Ltd [2007] HCA 22 at [107] to [108]). (2) A must disclose the nature as well as the existence of the conflict (Wrexham Assoc Football Club Ltd v Crucialmove Ltd [2007] BCC 139 at [39]).] (3) The burden of establishing informedconsent lies on the fiduciary (Cobbetts LLP v Hodge [2009] EWHC 786).

Consent is only informed if the client has the ability to fully understand and evaluate the information. For example, many complex products (such as CMOs, structured products, options, security futures, margin trading strategies, some alternative investments, and the like) may be appropriate only for sophisticated and experienced investors.  It is not sufficient for a firm or an investment professional to make full disclosure of potential conflicts of interest with respect to such products. The investment adviser, therefore, must make a reasonable judgment that the client is fully able to understand and evaluate the product and the potential conflicts of interest that the transaction presents. Fiduciary law reposes this burden to ensure client understanding primarily upon the adviser, not the client.

[25] In re the Matter of Arleen Hughes, SEC Release No. 4048 (1948).

[26] 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.

[27] See Arlene Hughes, supra n.18 (in finding that registrant had not obtained informed consent, citing to testimony indicating that “some clients had no understanding at all of the nature and significance” of the disclosure).

[28] See General Instruction 3 to Part 2 of Form ADV. Cf. Arleen Hughes, supra note 13 (Hughes acted simultaneously in the dual capacity of investment adviser and of broker and dealer and conceded having a fiduciary duty. In describing the fiduciary duty and her potential liability under the antifraud provisions of the Securities Act and the Exchange Act, the Commission stated she had “an affirmative obligation to disclose all material facts to her clients in a manner which is clear enough so that a client is fully apprised of the facts and is in a position to give his informed consent.”).

[29] 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].

[30] Wendt v. Fischer, 243 N.Y. 439, 154 N.E. 303 (1926). See also “Will the Investment Company and Investment Advisory Industry Win an Academy Award?” remarks of Kathryn B. McGrath, then-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). See also Bogert on Trusts, Paul D. Finn, Fiduciary Obligations (1977); J.C. Shepherd, The Law of Fiduciaries (1981). See also Scott, The Fiduciary Principle, 37 Calif. L. Rev. 539, 544 (1949).

[31] 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.)

[32] The Commission has stated that disclosure must occur not only of conflicts of interest, but also of potential conflicts of interest. See Release No. IA-1396, In the Matter of: Kingsley, Jennison, Mcnulty & Morse Inc. (Dec. 23, 1993).

[33] The Commission has brought enforcement actions in such cases. See, e.g., In the Matter of The Robare Group, Ltd., et al., Investment Advisers Act Release No. 4566 (Nov. 7, 2016) (Commission Opinion) (appeal docketed) (finding, among other things, that adviser’s disclosure was inadequate because it stated that the adviser may receive compensation from a broker as a result of the facilitation of transactions on client’s behalf through such broker-dealer and that these arrangements may create a conflict of interest when adviser was, in fact, receiving payments from the broker and had such a conflict of interest).

[34] 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).

[35] Hughes v. SEC, No. 9853, COURT OF APPEALS OF DISTRICT OF COLUMBIA, 174 F.2d 969; 85 U.S. App. D.C. 56; 1949 U.S. App. LEXIS 2138; Fed. Sec. L. Rep. (CCH) P90,449, January 14, 1949, observing in pertinent part: “The acts of petitioner which constitute violations of the antifraud sections of statutes and of regulations thereunder are acts of omission in that petitioner failed to fully disclose the nature and extent of her adverse interest … The best price currently obtainable in the open market and the cost to registrant are both material facts within the meaning of the above-quoted language and they are both factors without which informed consent to a fiduciary’s acting in a dual and conflicting role is impossible.”

See also Leonard I. Rotman, Fiduciary Law 279 (2005) (emphasizing the necessity of obtaining the principal’s express and informed consent before a fiduciary may enter into a self- or other-interested transaction).

See also Evan J. Criddle, Liberty in Loyalty: A Republican Theory of Fiduciary Law, 95 Tex.L.R. 993, 1009 (2017), stating in pertinent part: “[T]he no-conflict rule’s categorical prohibition against unauthorized conflicted transactions forces the investment manager to obtain the investor’s fully informed consent ex ante or face court-ordered rescission or disgorgement ex post.”

See also Robert H. Sitkoff, The Fiduciary Obligations of Financial Advisors Under the Law of Agency (2013): (“The duty of loyalty therefore prohibits A from misappropriating C’s property, and it regulates conflicts of interest in which the interests of A or a third party (such as another client) may be at odds with the interests of C.  A is prohibited from undertaking any conflicted action for which A does not first obtain C’s informed consent.”), and citing Restatement (Third) of Agency, §§8.02-8.04, §8.05(1), and §8.06.

[36] See Maplewood Partners, L.P. v. Indian Harbor Ins. Co., CASE NO. 08-23343-CIV-HOEVELER, UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF FLORIDA, 295 F.R.D. 550; 2013 U.S. Dist. LEXIS 103309, July 15, 2013 (In a case involving representation of multiple clients by an attorney: “A client can waive a conflict of interest upon informed consent ….).”

[37] In contrast, in 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”). Section 525 of the Restatement (Second) of Torts provides the general rule for fraudulent misrepresentation: “One who fraudulently makes a misrepresentation of fact, opinion, intention, or law for the purpose of inducing another to act or to refrain from action in reliance upon it, is subject to liability to the other in deceit for pecuniary loss caused to him by his justifiable reliance upon the misrepresentation.”

To prove common law fraud in most states, the plaintiff must show that:

  • the defendant made a material false representation or failed to communicate a material fact, which had the effect of falsifying statements actually made;
  • the defendant did this intentionally (the defendant knew that the representation or omission constituted a falsehood) or recklessly (the defendant made the representation without regard to whether it was true or false);
  • the defendant intended that the plaintiff act on it; and
  • the plaintiff did, in fact, rely on the representation or omission to his or her detriment.

A representation is material if either a substantial likelihood exists that a reasonable person would attach importance to it in making a decision or the person who made the representation has reason to know that the plaintiff is likely to regard it as important in making a decision, even though a reasonable person would not so regard it.

Fraudulent misrepresentation by omission may be actionable if the defendant has a duty to the plaintiff to disclose material facts and fails to do so, and if this failure results in a false impression being conveyed to the plaintiff. A defendant can also be liable for failing to disclose new information that makes previously disclosed information misleading.

To be actionable, a fraudulent misrepresentation generally must concern fact rather than mere opinion, judgment, expectation, or probability. However, a fraud case can be based on a representation of opinion when one or more of the following occurred:

  • the defendant knew that the facts on which the opinion was based were false;
  • the defendant knew that the opinion was false;
  • the opinion was based on the defendant’s special knowledge of information contained in it; and the defendant knew that the plaintiff was justified in relying on this special knowledge;
  • the defendant claimed to have special knowledge of facts that would occur in the future; or
  • the defendant had special knowledge superior to that of the plaintiff about value.

[38] “[D]isclosure is an effective response if it does not affect the decision-maker’s judgment process and if the beneficiary is able to correct adequately for that biasing influence. Psychological research shows that neither of these conditions may be met. Sometimes both parties may be worse off following disclosure.” Id., citing Daylian M. Cain, George Loewenstein, and Don A. Moore, “The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest” (2005) 34 Journal of Legal Studies 1 at 3.

[39] In dealing with the state securities statutes, state courts often disallow the defense of estoppel in order to preserve the protections afforded to retail consumers. See, e.g., Go2net, Inc. v. Freeyellow.com, Inc., 109 P.3d 875 (Wash. App., 2005), stating in pertinent part: “We are persuaded that the better rule is to bar the defenses of estoppel and waiver in an action alleging violation of a securities regulation. The flexibility of such defenses is inconsistent with our Act’s foremost objective of protecting investors. The statute provides the clean and surgical remedy of rescission as the sole recourse for an investor who proves a violation. It would upset the balance struck by the statute to allow factfinders to evaluate the investor’s conduct on a case-by-case basis to determine whether it excuses the violation. We hold that equitable defenses are not available in an action under the Securities Act of Washington and conclude the trial court properly dismissed Molino’s defenses of estoppel and waiver.” Id. at ____.

See also, e.g., Covert v. Cross, 331 S.W.2d 576, 585 (Mo., 1960), stating:

The theory of estoppel the defendants sought to present ‘would tend to nullify and defeat the very purpose of the statute, which is clearly penal in nature . . .  The Act was passed to protect investors against their own weaknesses and to prevent the happening of such losses as are shown by this record.’

Covert, 331 S.W.2d at 585.

The concerns expressed in Covert were cited and echoed by the dissent in the Illinois appellate court Logan decision, which likewise expressed the view that the adoption of an equitable estoppel defense severely undermines the legislation regulating the sale of securities:

The very person sought to be protected, the investor, is denied recovery while the individual violating the law escapes liability. This result neither serves to compensate the innocent purchaser nor does it deter future violations of the Blue Sky Law. In fact, the majority decision could prompt clever promoters of questionable investments to ignore the Blue Sky regulations and, instead, encourage an investor to participate in the management of the company so that an estoppel defense could later be established. Clearly, use of estoppel as a defense in the instant actions is inconsistent with the express terms of the statute, as well as the policy underlying our Blue Sky Law. This law should be strictly enforced, and legal exceptions kept to a bare minimum.

Logan, dissenting opinion at 293 N.W.2d at 364.

See also Gowdy v. Richter, 314 N.E.2d 549, 557 (Ill. App., 1974) (‘The penal character of the statute negates the utilization of in pari delicto or estoppel defenses.’), cited favorably by Go2net, Inc. v. Freeyellow.com, Inc., 109 P.3d 875 (Wash. App., 2005).

A commentator further opines that the overall effect of allowing estoppel, even in limited circumstances, undermines the deterrent effect of the civil liability provisions:

Courts that allow the defense of estoppel lessen the blue sky laws’ deterrent value and thus decrease compliance with the laws by hampering plaintiffs’ chances of recovery.  Repeated successful use of the defenses will result in decreased compliance with the laws. Courts that disallow estoppel, on the other hand, increase deterrence by allowing for more successful suits and creating a ‘general climate of fear of the statutory civil actions.’  To the extent that such courts increase deterrence, they further the primary goal of the laws.

Charles G. Stinner, Estoppel and In Pari Delicto Defenses to Civil Blue Sky Actions, 73 Cornell L. Rev. 448, 463 (1988)(footnotes omitted).

[40] 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).

However, 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. In other words, “reliance” is not a required element of a claim for constructive fraud (while reliance is required in a claim for actual fraud.)

In fact, 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”).

Estoppel and waiver are not applied freely to operate as a defense to “constructive fraud” (breach of fiduciary duty). A breach of the fiduciary standard is “constructive fraud,”  not actual fraud.  The role of waiver and estoppel in fiduciary law is different in fiduciary relationships than in its application to arms-length relationships. Under state common law, for estoppel to make unactionable a breach of a fiduciary obligation due to the presence of a conflict of interest, it is required that the fiduciary undertake a series of measures, far beyond undertaking mere disclosure of the conflict of interest. This contrasts with the relative ease in which estoppel and waiver apply to arms-length relationships, in which mere disclosure and consent creates estoppel and a defense against “actual fraud” – for customers generally possess responsibility for their own actions. 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.” W. Page Keeton et al., Prosser And Keeton On The Law Of Torts 112 (5th ed. 1992); see also Restatement (Second) Of Torts § 892A cmt. a (1977) (asserting that one does not suffer a legal wrong as the result of an act to which, unaffected by fraud, mistake or duress, he freely or apparently consents).

Traditionally, the fiduciary duty of loyalty has been treated with a high degree of reverence. Because violations of the fiduciary duty of loyalty often involve self-dealing, waivers of the duty of loyalty are permitted under state common law far less often then waivers of the duty of care. See Darren Guttenberg, Waiving Farewell Without Saying Goodbye: The Waiver of Fiduciary Duties in Limited Liability Companies in Delaware, and the Call for Mandatory Disclosure, 86 S.Cal.L.Rev. 869, 877 (2013).

[41] Sections 206(1) and 206(2) of the Advisers Act make it unlawful for any investment adviser to employ any device, scheme, or artifice to defraud, or to engage in any transaction, practice, or course of business that operates as fraud or deceit on clients or prospective clients. Those antifraud provisions may be violated by the use of a hedge clause or other exculpatory provision in an investment advisory agreement which is likely to lead an investment advisory client to believe that he or she has waived non-waivable rights of action against the adviser that are provided by federal or state law. See, e.g., In the Matter of William Lee Parks, Investment Advisers Act Release No. 736 (Oct. 27, 1980) and In the Matter of Olympian Financial Services, Inc., Investment Advisers Act Release No. 659 (Jan. 16, 1979). See also Opinion of General Counsel Roger S. Forster Relating to the Use of Hedge Clauses by Brokers, Dealers, Investment Advisers and Others, Investment Advisers Act Release No. 58 (Apr. 10, 1951).

The Commission has previously taken the position that hedge clauses that purport to limit an investment adviser’s liability to acts involving gross negligence or willful malfeasance are likely to mislead a client who is unsophisticated in the law into believing that he or she has waived non-waivable rights. See Auchinloss & Lawrence Incorporated, SEC Staff No-Action Letter (Feb. 8, 1974). This is true even if the hedge clause explicitly provides that rights under federal or state law cannot be relinquished. See Omni Management Corporation, SEC Staff No-Action Letter (Dec. 13, 1975) and First National Bank of Akron, SEC Staff No-Action Letter (Feb. 27, 1976). Such a hedge clause might read, in the context of an adviser-client contract for advisory services:

Non-Waiver of Rights: Notwithstanding the foregoing, nothing contained in this paragraph or elsewhere in this Agreement shall constitute a waiver by Client of any of its legal rights under applicable U.S. federal securities laws or any other laws whose applicability is not permitted to be contractually waived.

The Commissioned has stated that the use of hedge clauses in investment advisory agreements which purport to remove potential advisor liability for gross negligence or wilful malfeasance is not a per se violation of the anti-fraud provisions of the Advisers Act, but rather depends upon the facts and circumstances. In a case involving institutional investors, where the adviser represented to the Commission that institutional investors often dictated the terms of investment advisory contracts, the Commission opined:

We believe that whether an investment adviser that uses hedge clauses in investment advisory agreements that purport to limit that adviser’s liability to acts of gross negligence or willful malfeasance violates sections 206(1) and 206(2) of the Advisers Act would depend on all of the surrounding facts and circumstances. In making this determination, we would consider 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.7 For instance, when a hedge clause is in an investment advisory agreement with a client who is unsophisticated in the law, we would consider factors including, but not limited to, whether: (i) the hedge clause was written in plain English; (ii) the hedge clause was individually highlighted and explained during an in-person meeting with the client; and(iii) enhanced disclosure was provided to explain the instances in which such client may still have a right of action. In addition, we would consider the presence and sophistication of any intermediary assisting a client in his dealings with the investment adviser and the nature and extent of the intermediary’s assistance to the client.

Release No. IA-________, Heitman Capital Management, LLC (Feb. 12, 2007).

[42] An “irreducible core” of fiduciary duties exist, which are not subject to waiver by disclosure and consent under any circumstances. See A. Trukhtanov, The Irreducible Core of Fiduciary Duties (2007) 123 LQR 342.

[43] Note that the contractuarian view of fiduciary law has no place in fiduciary relationships in which there is a great superiority in knowledge held by the fiduciary. The contractualists’ theory of fiduciary law appears misplaced, at least in the context of advisory relationships. “[C]ontract law concerns itself with transactions while fiduciary law concerns itself with relationships.” Rafael Chodos, Fiduciary Law: Why Now! Amending the Law School Curriculum, 91 Boston U.L.R. 837, 845 (and further noting that “Betraying a relationship is more hurtful than merely abandoning a transaction.” Id. See also Laby, The Fiduciary Obligation as the Adoption of Ends, 56 Buff. L. Rev. 99, 104-29 (2008) (rejecting contractual approach as descriptive theory of fiduciary duties, and at 129-30 (arguing that signature obligation of fiduciary is to adopt ends of his or her principal).

Rafael Chodoes further posits that there may be greater flexibility in contracting around fiduciary duties where the entrustor is an employer of a non-expert employee (i.e., in an employer-employee relationship) and has greater control and, presumably, knowledge than the employee. Even then, the “tendency of courts to construe fiduciary limitations narrowly and to be suspicious of provisions purporting to eliminate all fiduciary duties is understandable given the long tradition of treating business partners and managers as fiduciaries.” Chodos, at p.894 (further noting that: “This approach also is consistent with the general drafting principle that limitations on fiduciary duties are strictly construed. See, e.g., Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160, 171–72 (Del. 2002); Restatement (Third) Of Agency § 8.06 (2006).”) Id.

Hence, greater emphasis on the contractual nature of fiduciary obligations may exist when contracting parties enter into a partnership agreement or a limited liability company operating agreement, given that most state statutes permit these parties, upon entry into the relationship, to negotiate (to a degree) the legal duties owed to one another. Yet, in relationships of an advisory-client nature, where there exists a vast disparity in knowledge between the advisor and the client, and where clients do not normally seek legal advice prior to entry into such relationships, the ability of the advisor to negate fiduciary duties by contract is properly more circumscribed.

Other scholars appear reject the contractualist theory of fiduciary duties more broadly. See, e.g., Tamar Frankel, Fiduciary Duties as Default Rules, 74 Or. L. Rev. 1209 (1995) (“[C]ircumstances exist where fiduciary duties are not waivable for reasons such as doubts about the quality of the entrustors’ consent (especially when given by public entrustors such as shareholders), and the need to preserve institutions in society that are based on trust. Further, non-waivable duties can be viewed as arising from the parties’ agreement ex ante to limit their ability to contract around the fiduciaries’ duties.  Under these circumstances fiduciary rules should generally be mandatory and non-waivable … I conclude that private and public fiduciaries should be subject to a separate body of rules and reject the contractarian view..”) Id. See also Scott FitzGibbon, Fiduciary Relationships Are Not Contracts, 82 MARQ. L. REV. 303, 305 (1999) (“This Article explores the nature of fiduciary relationships, shows that they arise and function in ways alien to contractualist thought, and that they have value and serve purposes unknown to the contractualists.”)

“Many courts deny the contractual approach.” Arthur Laby, Fiduciary Obligations of Broker-Dealers, 55 Villanova L.Rev. 701, 711 (2010).

[44] Evan J. Criddle, Liberty in Loyalty: A Republican Theory of Fiduciary Law, 95 Tex.L.R. 993, 1011 (2017), citing: See In re Primedia Inc. Derivative Litig., 910 A.2d 248, 262 (Del. Ch. 2006) (“[T]he duty of loyalty ‘does not rest upon the narrow ground of injury or damage to the corporation resulting from a betrayal of confidence, but upon a broader foundation of a wise public policy that, for purposes of removing all temptation, extinguishes all possibility of profit flowing from the breach of confidence imposed by the fiduciary relation.’” (quoting Guth v. Loft, Inc., 5 A.2d 503, 510 (Del. 1939))).

[45] Frankel, Tamar, Fiduciary Law, 71 Calif. L. Rev. 795 (1983).

[46] See Arleen Hughes, supra note __ (“Registrant cannot satisfy this duty by executing an agreement with her clients which the record shows some clients do not understand and which, in any event, does not contain the essential facts which she must communicate.”) Some commenters on Commission requests for comment agreed that full and fair disclosure and informed consent are important components of an adviser’s fiduciary duty. See, e.g., Financial Planning Coalition 2013 Letter, supra note 21 (“[C]onsent is only informed if the customer has the ability fully to understand and to evaluate the information. Many complex products … are appropriate only for sophisticated and experienced investors. It is not sufficient for a fiduciary to make disclosure of potential conflicts of interest with respect to such products. The fiduciary must make a reasonable judgment that the customer is fully able to understand and to evaluate the product and the potential conflicts of interest that it presents – and then the fiduciary must make a judgment that the product is in the best interests of the customer.”).

[47] See, e.g., Andrew F. Tuch, Disclaiming Loyalty: M&A Advisors and Their Engagement Letters: In response to William W. Bratton & Michael L. Wachter, Bankers and Chancellors, 93 Texas L.Rev. 211, 217 (2015) (“When a fiduciary obtains its client’s informed consent for conduct that would otherwise breach a fiduciary duty, the consent shelters the fiduciary from liability for that conduct. However, it does not terminate the fiduciary character of the relationship. Rather, the fiduciary remains subject to fiduciary duties and thus generally obliged to act loyally within the scope of and for the duration of the relationship—but sheltered from liability for conduct to which its client consented.”)

[48] SEC vs. Capital Gains, at text accompanying note 48.

[49] See Robert H. Sitkoff, The Fiduciary Obligations of Financial Advisors Under the Law of Agency (2013): (]T]here are mandatory rules within the fiduciary obligation that cannot be overridden by agreement. For example, the principal cannot authorize the fiduciary to act in bad faith. Even if the principal authorizes self-dealing, fiduciary law provides substantive safeguards, requiring the fiduciary to act in good faith and deal fairly with and for the principal …”

[50] See Robert H. Sitkoff, Economic Structure of Fiduciary Law, 91 Boston Univ.L.Rev. 1039, 1046 [“To be sure, there is a mandatory core to the fiduciary obligation that cannot be overridden by agreement. For example, the principal cannot authorize the fiduciary to act in bad faith.” and citing See, e.g., UNIFORM POWER OF ATTORNEY ACT § 114(a) (2006); UNIFORM TRUST CODE § 105(b)(2) (2000); RESTATEMENT (THIRD) OF TRUSTS § 78, cmt. c(2) (2007); RESTATEMENT (THIRD) OF AGENCY § 8.06(1)(a), (2)(a) (2006).j]

[51] Birnbaum v. Birnbaum, 117 A.D.2d 409, 503 N.Y.S.2d 451 (N.Y.A.D. 4 Dept., 1986).

[52] 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).

The relationship between an unfair or unreasonable transaction, and whether informed consent has occurred, is a close one. 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.

[53] See Matter of Gordon v. Bialystoker Center and Bikur Cholim, 45 N.Y. 2d 692, 698 (1978) (2006 WL 3016952 at *29).

Note that in the attorney-client fiduciary relationship, which is similar to the investment-adviser fiduciary relationship in that fiduciary duties are imposed in recognition of the vast disparity of knowledge between the fiduciary and the client, not only are informed consent of the client and substantive fairness of the transaction required, but independent legal counsel must be sought before certain transactions can be entered into with clients. 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.

The Commission could adopt a similar rule – requiring that before any transaction is entered into for the purchase of a proprietary mutual fund, a security underwritten by an affiliate of the investment advisory firm, or certain other transactions, independent investment advice must be received. But this is not part of my recommendation at present.

[54] Frankel, Tamar, Fiduciary Duties as Default Rules, 74 Or. L. Rev. 1209, further stating: “Where the beneficiaries are all sui juris and consent to the sale, it cannot be set aside if the trustee made a full disclosure and did not induce the sale by taking advantage of his relation to the beneficiaries or by other improper conduct, and if the transaction was in all respects fair and reasonable. On the other hand, the sale can be set aside if the trustee did not make a full disclosure, or if he improperly induced the sale, or if the transaction was not fair and reasonable … In order to transform the fiduciary mode into a contract mode, four conditions must be met: (1) entrustors must receive notice of the proposed change in the mode of the relationship; (2) entrustors must receive full information about the proposed bargain; (3) the entrustors’ consent should be clear and the bargain specific; (4) the proposed bargain must be fair and reasonable.” Id.