Fiduciary Papers #4: Thoughts on the State of Fiduciary Duties for RIAs and Financial Planners

Doubt. It is an essential precondition to the process of critical thinking. Possessing doubt permits the receipt and evaluation of opposing points of view.

We must first acknowledge that there exists doubt as to the proper application of fiduciary duties to registered investment advisers (RIAs), under both the 1940 Investment Advisers Act and under state common law. This should be no surprise, given the many varied forces at work that seek to raise or lower the fiduciary standard.

DIFFERENT FIDUCIARY STANDARDS EXIST

In fact, we cannot say that there is only one fiduciary standard. Fiduciary law, at times, creates exceptions. For example, the business judgment rule serves to ameliorate – to an extent – the fiduciary duties of corporate directors.

And there are even two distinct fiduciary duties of loyalty. The strictest is the “sole interests” standard found in the common law of trusts, requiring avoidance of all conflicts of interest. (Thereby respecting the “no conflict” and “no profit” rules which spring from a fiduciary duty of loyalty.)

The less strict fiduciary duty of loyalty, but only slightly so, involves the “best interest” standard, which permits certain conflicts of interest, but only if a regime is followed to ameliorate the breach of the fiduciary duty of loyalty. These steps include: (1) full, frank and complete disclosure of the conflict of interest; (2) ensuring that the entrustor (i.e., client, for purposes of the delivery of financial planning and investment advice) fully understands the disclosure; (3) obtaining the informed consent of the client; and (4) even with such informed consent, testing the consent to ensure that the proposed transaction (or one that has occurred) is substantively fair to the client.

The nature of informed consent and the requirement of substantive fairness are intertwined. They work together to largely negate the application of the legal doctrines of estoppel and waiver.

THE LIMITS ON THE APPLICATION OF ESTOPPEL AND WAIVER

In arms-length relationships, in many instances a customer’s agreement with a statement or proposition can be used to “estop” a customer later making a statement in which she or he now says otherwise. Or a customer can “waive” certain rights, or the other’s duties, in advance.

But in a fiduciary-client relationship, the requirement of informed consent, and substantive fairness, place severe limits on the applications of both estoppel and waiver.

It is fair to say, in situations where there exists a wide gap in knowledge and skill between the fiduciary and the client, as is the case in for the practice of law, and in the delivery of investment advice, the law requires a stricter level of adherence to the fiduciary duties present. When applying the fiduciary duty of loyalty, it is therefore said that no client would ever be presumed to consent to be harmed.

THE ONGOING MOVEMENT TO NOT APPLY, WEAKEN, OR PROVIDE EXCEPTIONS TO THE FIDUCIARY STANDARD

The fiduciary standard operates as a restraint on conduct. It both prohibits certain actions that a fiduciary may otherwise desire to undertake, and requires a higher duty of due care to which certain actors may not desire to be held.

A close examination of the best interests standard demonstrates that some conflicts are permitted to exist in situations where they cannot be avoided. The classic example involved the sale of municipal bonds in a state where there were few dealers (and perhaps only one) in such bonds. The common law fiduciary standard would have typically required a bank, when acting as a fiduciary, to avoid acting as principal in a sale of bond to the client to whom a fiduciary duty was owed. The problem of limited issuers of such bonds was solved, legislatively, by providing a means of effecting such sale – provided certain conditions were met.

At times the pressure has existed to not apply the fiduciary standard at all (even in situations in which a relationship of trust and confidence existed, and the fiduciary acknowledge her or his role as such – by using certain titles or by other means. At other times there has been immense pressure to expand upon the various “exceptions” to the fiduciary standard – harking back to the days of Justice Benjamin Cardoza, when he so famously announced that he would not lessen the fiduciary principle through “particular exceptions.”

Yet, these pressures exist. Broker-dealer firms, insurance companies, and asset managers – all involved in the production and sale of financial products – don’t desire that their sales activities be limited by any application of the fiduciary standard.

The battle over standards of conduct in financial services is a long one, with battles occurring even in the 1800’s as state common law developed and in the early 1900’s as various state “blue sky” laws were enacted.

A troubling development at the federal level occurred in the 1940’s, when NASD (now known as FINRA) successfully persuaded policy makers to not require brokerage activities (i.e., acting in an agency capacity, with quasi-fiduciary duties imposed) to be separated from dealer activities (i.e., acting as a principal to a customer, for the sale to or purchase from the customer of a security).

RECENT DEVELOPMENTS THAT LIMIT THE APPLICATION OF THE FIDUCIARY STANDARD AND/OR CONFUSE CONSUMERS

Given the 100+ year battles over the application of fiduciary standards to the delivery of investment and financial advice, it should come as no surprise that heavily monied interests continue to seek to not have applied, or weaken, the fiduciary standard of conduct.

• Earlier in 2023, a district court struck down a U.S. Department of Labor rule that effectively required fiduciary standards to be applied to IRA rollovers.
• Relying upon extremely dubious prior interpretations of case law by FINRA, the SEC adapted broker-dealer lobbying group’s proposals into Regulation Best Interest, effectively redefining the phrase “acting in one’s best interest” to mean something other than the fiduciary duty of loyalty – despite over 9,000 judicial decisions in the U.S. that have expressly equated the loyalty to “best interests.” Yet, it appears that the emperor’s effort lacks clothes, as to date the cases brought under Reg BI could have all been brought under the low suitability standard, except for a few cases that have alleged the failure to adopt proper procedures under Reg BI.
• State insurance commissioners have followed suit, by adopting state regulations for insurance agents who sell annuities under a “best interests” standard.
• The SEC staff effectively stated that the term “fiduciary” should not be utilized in Form CRS. Wow. Just when consumers were asking, more and more, when interviewing financial advisors – “Are you a fiduciary?” – the SEC’s main disclosure document on standards of conduct effectively prevented RIAs from answering this question within such document. (There exists a substantial claim that the SEC’s guidance on this matter is an impermissible restraint on commercial speech.)

THE MARKETPLACE CONTINUES TO EVOLVE – TOWARD FIDUCIARY ADVICE

The significant lobbying efforts by broker-dealers, insurance companies and asset managers have slowed, but will not stop, the movement toward a proper application of fiduciary standards.

There is no doubt from various statistics that the market share of RIAs (fiduciaries) continues to grow.

Even with the broker-dealer industry, a large transition has already occurred (and continues to occur) toward fiduciary advice. As reported by McKinsey: “One of the most important trends in the retail brokerage industry over the past decade is shifting away from traditional, commission-based business and moving toward arrangements where clients pay an advisory fee based on the value of the holdings in the account.”

Fiduciary advisors no longer need to reach out to commission-based insurance agents to acquire life insurance and annuities for their clients. Stripping out high distribution costs has led to better products, in a movement spearheaded by DPL Financial Partners, along with some direct-to-consumer sales by insurance companies.

In essence, the marketplace is the weighing mechanism upon which the future of fiduciary duties will rest. There are several reasons for this:

• Clients eschew commission-based compensation, when they are aware of it. (As discerned from the 2008 Rand Report paid for by the SEC, some 30% or greater of customers of broker-dealers were unaware that they paid a fee to their broker-dealer – an indication of the vast gulf of knowledge that exists, and the clever sales techniques which are often taught to registered representatives.)
• New entrants to financial services strongly desire to be “trusted advisors” and not “product salespeople.” They don’t desire to “push product,” but instead act as a purchaser’s representative (fiduciary). As such, they step into the shoes of the client, but remain armed with the expertise required by the fiduciary duty of due care.
• Firms realize that their enterprise value substantially increases when their revenue is derived from fee-based compensation, rather than commission-based compensation. The multiples for fee-based firms are much greater.
• Commission-based salespeople and dual registrants increasingly depart to RIA firms, as a means of moving to “the same side of the table as the client” and in order to unlock, and then grow, their equity-based compensation.

THE FIDUCIARY MODEL VS. PURE CAPITALISM; A VIEW THROUGH THE LENS OF ADAM SMITH

At times I’ve been called a communist, or a socialist, for my advocacy of fiduciary standards of conduct.

As mentioned previously, the imposition of a bona fide fiduciary standard acts as a constraint on conduct. No longer is greed permitted. Duties of care are enhanced. The ability to profit declines.

Yet, professional-level compensation continues. Trained and trusted experts in financial planning and investments deserve to be highly compensated.

Will fiduciary standards of conduct be applied in the U.S. to all providers of investment advice and financial planning? This has been done in a few other countries (to varying degrees, and with certain exceptions). But I suspect that such a move, in the U.S., remains quite distant.

Here in the U.S. our citizens embrace capitalism fervently. Adam Smith’s 1776 treatise, An Inquiry into the Nature and Causes of the Wealth of Nations, generally referred to by its shortened title The Wealth of Nations, continues its influence with a vision of the marketplace guided by an invisible hand. I embrace many of Smith’s economic lessons.

Yet, as if often forgotten, Adam Smith also recommended the adoption of professional standards of conduct in business “by instituting some sort of probation, even in the higher and more difficult sciences, to be undergone by every person before he was permitted to exercise any liberal profession, or before he could be received as a candidate for any honourable office or profit.” [WN, p.748.]

Similarly, in Adam Smith’s The Theory of Moral Sentiments, he writes: “The civil magistrate is entrusted with the power not only of preserving the public peace by restraining injustice, but of promoting the prosperity of the commonwealth, by establishing good discipline, and by discouraging every sort of vice and impropriety; he may prescribe rules, therefore, which not only prohibit injuries among fellow-citizens, but command good offices to a certain degree.”

I would speculate, therefore, that society has accepted, and will continue to accept, a light hand of the state which could occur through the adoption of fiduciary principles (but not via a host of specific rules flowing from such principles, which I regard as counter-productive).

MOVING THE FIDUCIARY DISCOURSE FORWARD

There has been much progress made in the past two decades, both in the marketplace and within various professional organizations.

There exists a much greater understanding of the fiduciary standard, and its requirements – although much more education is warranted.

Despite the efforts of monied lobbyists representing investment product manufacturers and distributors, fiduciary principles have been adopted voluntarily by many organizations. The most lofty adoption of fiduciary principles can be found within the fee-only investment advisory community – including among members of such organizations such as NAPFA, XYPN Network, Garrett Planning Network, and the Alliance of Comprehensive Planners.

Other organizations have embraced fiduciary principles, to varying degrees, including the Certified Financial Planning Board of Standards, Inc., the CFA Institute, the AICPA’s Personal Financial Planning division, Financial Planning Association, and others.

Yet, concerns exist that among some of these organizations, the fiduciary standard is not interpreted correctly. And/or that enforcement is lacking.

I see the glass as half-full, not half-empty. I foresee that the various organizations, particularly those which are not fee-only but which have explicitly endorsed or adopted the fiduciary standard, continue an evolution toward a true fiduciary standard of conduct. As the marketplace continues to move toward fee-based accounts, the resulting momentum will provide the foundation for ever-more-robust application and interpretation of the fiduciary standard of conduct and its requirements.

Yet I am also concerned that federal and state rule-making, around the fiduciary standard, may seek to diminish it, or constrain its application over time. Regulations tend to transform hallowed principles into specific rules; exceptions to such specific rules will then develop.

As the future unfolds, progress toward the adoption of a bona fide fiduciary standard will occur. Not in a linear fashion, but through short periods of advancement of the fiduciary principle, fostered by courageous industry leaders and policy makers.

How can we move the ball forward, specifically? I suggest a number of ways.

• Through more robust education, of those who provide and seek to provide fiduciary investment and financial planning advice.
• By supporting and working from within (and at times from without) our industry organizations to further develop, and correctly interpret, the fiduciary standard.
• By assisting our organizations as they advocate for the greater adoption of fiduciary standards by either Congress, state legislatures, or via agency rulemaking proceedings.
• By seeking to engage more with securities regulators, through practitioner advisory councils (especially for the review of existing regulations, and prior to the adoption of new ones) and peer review structures (for experienced practitioners are likely best at advising on the enforcement of many of the fiduciary duties).
• By resisting efforts to diminish the fiduciary standard through the adoption of various statutes, regulations, interpretations and guidance that fall short of our expectations.
• By continuing to educate consumers on the ways to discern bona fide fiduciaries – who seek to avoid conflicts of interest – from pretenders.
• Through academic research, providing insights into fiduciary principles and their application.
• Through a continuation of the process of establishing a true profession, consisting of an organization consisting of individuals (not firms) who are dedicated to preserving and advancing the fiduciary principle, always.

The task may seem monumental. There are many who oppose the effort, and they possess a strong ability to influence policy makers. The number of fiduciary battlegrounds may well continue to increase.

The fight to advance the fiduciary principle, as it relates to the provision of investment and financial advice, can be part of one’s calling. It is a noble cause.

For if a bona fide fiduciary standard is more widely adopted and correctly interpreted and enforced, the potential benefits are many. More of our fellow citizens will be inclined to seek out the financial advice they so desperately need. Greater savings rates will follow, as consumers make smarter decisions about financial expenditures. The burden placed on governments and charitable organizations to provide for our senior citizens (many of whom possess little personal capital) will likewise diminish over time.

In the face of such increased demand for trusted advice, more and more students will be attracted to the career – and the calling – of serving others and fostering their hopes and dreams.

With greater fiduciary adoption will come a greater restoration of faith in our capital markets. As social trust improves, this may well encourage democratic consensus, economic equality and psychological wellbeing.

Disintermediation will occur, and more of the returns obtainable in the capital markets will flow through to individual investors.

With the effect of compounding, the growth of capital will accelerate, and the cost of capital to corporations will lessen. This in turn will foster a new golden age of U.S. economic growth and prosperity.

The stakes are, indeed, high. Will you join in the effort?

• Reach out to your industry organization(s) with the request to “get involved in advancing the fiduciary standard of conduct.”
• Provide support to organizations that advance the fiduciary principle, such as The Committee for the Fiduciary Standard, as well as The Institute for the Fiduciary Standard.
• Obtain guidance from various organizations on advocacy, and request to meet with your federal and state legislators, as well as policymakers in federal and state agencies.
• Seek to further education the general public, and your own clients, on the importance of fiduciary principles in our modern world.
• Seek to listen to opposing points of view. Permit doubt in your own beliefs. But then, through careful consideration, seek out truths, and advocate for a strong fiduciary principle.

The challenge is great. But the cause is a noble one, with potential bountiful positive outcomes for our fellow Americans, as well as for the prosperity of America itself.