Journal of Financial Planning: August 2016
Blaine F. Aikin, CFP®, CFA, AIFA®, is executive chairman of fi360 and a recognized thought leader in the field of financial advice and fiduciary responsibility. He is a well-known speaker and author of numerous articles on the subjects of fiduciary responsibility and investment management.
Have you ever felt betrayed? Of course you have, everyone has.
Think of a particularly painful experience of betrayal—when someone you trusted implicitly failed you. Who was it? An acquaintance? A merchant? A friend? A professional adviser? A family member?
If you imagine circumstances under which each of these types of people could betray your trust, how consequential would their actions be?
The more personally invested you are in a relationship, the more you are likely to trust them. The more you trust someone, the more you can be hurt by them—emotionally, physically, financially, etc. We are vulnerable to those we trust.
The most egregious breaches of trust by family members generally stand alone in their emotional impact. But the depth and breadth of damage that can be inflicted from betrayals by professional advisers can be even more devastating.
When we go to a doctor, lawyer, or a financial adviser, we share information that we do not share with anyone else outside of the family—often not even within the family. Out of necessity, we make ourselves vulnerable to advisers so they can help us by applying their special skills on our behalf.
Society has long recognized the importance—even sanctity—of such professional relationships of trust.1 Much like a child is dependent upon parents for their physical safety and nurturing their growth as a person, a client is dependent on the skill and integrity of a professional adviser. Failures by professionals through negligence or exploitation can have disastrous consequences to our health, our freedom, or our financial security.
Consider this Cicero quote from more than 2,000 years ago: “…[I]n cases where we ourselves cannot be present, the vicarious faith of friends is substituted; and he who impairs that confidence, attacks the common bulwark of all men, and as far as depends on him, disturbs the bonds of society. For we cannot do everything ourselves; different people are more capable in different matters.”2
These words capture immortal concepts. Certain skills are beyond the reach of the average individual. We must rely on people who have the time, resources, inclination, and talent to achieve professional competence. Additionally, we occasionally must place our affairs or assets under the control of professionals to manage on our behalf. These “friends” are close confidants uniquely qualified to act as stewards or trustees whom we engage to protect and manage that which we have entrusted to them.
Reliance upon professionals for advice, or ceding discretionary control to them, makes us vulnerable and them accountable. The professionals we engage must act in our best interests. Cicero recognized that the adverse consequences stemming from betrayals of trust not only deal damage to the client but to society as a whole. If we cannot rely upon advisers to uphold and be accountable to high standards of professional conduct, then less qualified, non-professional members of society must fend for themselves. This is not only economically inefficient, it also weakens the fiber of the community.
By the time Cicero spoke those words (roughly 135 BC), philosophers and rulers had been discussing relationships of trust and imposing codes of conduct for more than 1,500 years.3 In Roman times, the fiduciary standard began to crystalize and take a form easily recognized in today’s standard. The term “fiduciary” originated in Roman law and means “a person holding the character of a trustee, or a character analogous to a trustee, in respect to the trust and confidence involved in it and the scrupulous good faith and candor it requires.”4
The centrality and continuity of thinking about codes of conduct for people in special positions of authority since literally the origin of recorded legal history makes the fiduciary standard one of the oldest and most revered concepts in law. It is not an overstatement to say that fiduciary principles represent the natural order of things in professional relationships.5
Financial Conflicts of Interest
The most fundamental duty under the fiduciary standard is loyalty, the obligation to avoid conflicts or, in the case of unavoidable conflicts, mitigate them in a manner that serves the client’s best interests. Courts have linked the fiduciary duty of loyalty to the biblical principle that no person can serve two masters, “a maxim which is especially pertinent if one of the masters happens to be economic self-interest.”6
Consider circumstances in law and medicine that involve betrayals of trust, which is to say fiduciary breaches of the duty of loyalty. What is the driving force that typically causes lawyers and physicians to intentionally place their own interests above those of their clients or patients? The answer is, of course, financial conflicts of interest. For example, a lawyer may improperly divert trust assets to his own pocket or a doctor may prescribe an unnecessary treatment regimen to make more money at her patient’s expense (and at the expense of insurance companies—a felony).
Perversely, financial advisers—the people in the profession with the most direct and ongoing exposure to financial conflicts of interest—have the least consistent and rigorous system of holding practitioners accountable as fiduciaries. The threat of harm to the public from financial conflicts of interest is clearly most acute in the field of financial advice.
The problem isn’t that the legal framework for holding financial professionals accountable as fiduciaries doesn’t exist; it most certainly does. Most notably, a robust body of common law has developed over centuries of Anglo-American jurisprudence that recognizes and upholds high principles of fiduciary conduct for those who serve as trusted professional advisers. This fact is captured exquisitely in the following frequently cited opinion of the Court of Appeals of New York written by Judge Benjamin Cardozo in the case Meinhard v. Salmon in 1928:
Many forms of conduct permissible in a workaday world for those acting at arm’s length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the ‘disintegrating erosion’ of particular exceptions (Wendt v. Fischer, 243 N.Y. 439, 444). Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. It will not consciously be lowered by any judgment of this court.7
Unfortunately, there has been a “disintegrating erosion” to the rule of undivided loyalty from particular exceptions when it comes to the regulation of investment advice under the Investment Advisors Act and ERISA. It is not that the required “high level of conduct for fiduciaries” has been consciously lowered by the regulators (the SEC and DOL, respectively). Rather, you could say that it has been unconsciously lowered due to critical loopholes in these laws that have been progressively exploited over time. In effect, there has been a great forgetting of why manufacturers and distributors of financial products are different than providers of professional advice and must be regulated differently.
With the release of the DOL’s Conflict of Interest Final Rule, the marketplace is being thrown into regulatory turmoil by the DOL’s efforts to close the loophole in ERISA that allows most financial service representatives who provide advice to retirement savers to avoid fiduciary accountability. The current emphasis is on what formerly non-fiduciary advisers must do to conform to fiduciary obligations and how they must transform (or reform) their business practices. The why this action is necessary—to restore the natural order of mandatory adherence to the fiduciary principles that underpin all professional advisory relationships—is woefully under-appreciated.8
Disruption to the product distribution segment of the financial services marketplace is being confused by many as a disruption to the field of professional advice. By law, brokers are in the business of facilitating transactions, not giving advice. By society’s definition, advice is a fiduciary function. A product distributor and a professional adviser are two distinct occupations—not two different business models within one occupation, just as pharmacist and a physician are in the same field but not in the same occupation.
In financial services, fiduciary principles have been compromised by the disintegrating erosion of unmanaged conflicts made possible by the failure of regulators to maintain separation of product distribution from advice. This has been allowed to go on for more than four decades in the realm of retirement advice—a long time when you think of it as the professional lifetime of most current practitioners. But in the context of the multi-millennial history of fiduciary principles, it is a brief interlude of having lost our way.
Unravel and Separate
The broker-dealer exemption under the Investment Advisers Act of 1940 that allows advice that is incidental to a transaction provides a similar loophole for advice without fiduciary accountability to retail investors. Under the Dodd-Frank Act of 2010, the SEC has the authority to close that loophole by extending fiduciary accountability to the retail marketplace. SEC Chair Mary Jo White has indicated a commitment to making a fiduciary rule a priority, but that may take some time. The DOL has paved the path toward making it happen.
Product distributors are held to a fair dealing standard. They are counterparties to a transaction. Their reason for being is to maximize company profitability through sales agents while seeking to assure repeat business by satisfying customers’ buying interests. Incentive compensation arrangements (which present inherent conflicts of interest) are the norm.
Registered investment advisers are held to a fiduciary standard. They are engaged in a relationship that requires the professional to serve the client’s best interest. Their reason for being is to optimize client outcomes while they seek to run a profitable and sustainable practice. Conflicts, including conflicted compensation arrangements, are normally prohibited or require unavoidable conflicts to be mitigated in the best interest of the client.
The physician-pharmacist analogy is apropos. My brother is a doctor and my wife is a pharmacist. They are in highly regulated occupations. They are skilled and ethical people who enjoy their separate lines of work. By law, my pharmacist wife cannot make medical diagnoses and prescribe medicine, and my physician brother cannot write prescriptions and fill them himself. The conflicts that would exist from the absence of legal and regulatory separation of their roles are apparent. The incentives to err on the side of prescribing more, higher-cost drugs would be high with obvious adverse consequences to patients and society at large. We simply cannot rely on all professionals to be immune to the temptations of associated systemic conflicts, regardless of our confidence that particular practitioners are paragons of ethical purity.
With respect to retirement accounts, regardless of compensation method, the DOL will now require fiduciary conduct. Financial firms that have intertwined product distribution with advice must now unravel and separate these functions to manage them as distinguishable businesses. Clients must be able to know whether they are entering into a counterparty transaction or a professional advisory relationship when they engage a financial services practitioner. Regulators must be able to enforce accountability to the proper standard of conduct that aligns to these distinctly different business activities.
The unraveling process will not be easy. Firms that have built a sales culture to fit their heritage of product manufacturing and distribution and have become comfortable with giving advice without fiduciary accountability will now have to follow one of three paths: (1) stop giving advice to focus exclusively on product manufacturing and distribution; (2) exit product manufacturing to operate as an advisory firm; or (3) reconfigure internally to formally segregate the businesses, albeit under one roof in a house divided.
Which path each firm in transition chooses to take will be left to the wisdom and skill of executive leadership based upon the particular circumstances of their enterprise. The success of how and what they do to make the necessary transformation will depend in large part upon how deeply they understand why the fiduciary standard exists and embed fiduciary principles, processes, and practices in the fabric of their professional advisory business.
- See the 2010 article, “Fiduciary: A Historically Significant Standard” by Blaine F. Aikin, CFP®, CFA, AIFA® and Kristina A. Fausti, J.D., AIF®, in Volume 30 of Review of Banking and Financial Law, Boston University School of Law.
- See the Perseus Digital Library at www.perseus.tufts.edu.
- Historians have traced the roots of fiduciary principles back to the Code of Hammurabi in Babylon (ca. 1790 BC). See “The Role of a Fiduciary Is Timeless,” by Blaine F. Aikin in the August 15, 2010 issue of InvestmentNews.
- See the 2008 article, “What Are the Specific Fiduciary Duties of Financial Advisors?” by Ron A. Rhoades (citing Black’s Law Dictionary, 5th Ed. 1979) published on FiduciaryNow.com.
- See “Natural Law and the Fiduciary Duties of Business Managers” by Joseph F. Johnson Jr., in the spring 2005 issue of Journal of Markets & Morality.
- See the opinion of the U.S. Supreme Court delivered by Justice Warren in United States vs. Mississippi Valley Generating Company (1961) at supreme.justia.com/cases/federal/us/364/520/case.html.
- See Meinhard v. Salmon, 164 N.E. 545, at 546 (N.Y. 1928) at www.nycourts.gov/reporter/archives/meinhard_salmon.htm.
- See the 2009 book, Start With Why, by Simon Sinek.