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Based on my anecdotal experience, I’ve come to the reluctant conclusion that many advisors are clueless about what it means to be a fiduciary.
Those advisors embrace the term in their marketing to differentiate themselves from brokers who are held to a lower standard.
Unless you understand the ramifications of your fiduciary status, you’re ignoring legal liability that could have devastating consequences for you and your firm.
If you believe I’m overstating the risks, look no further than the spate of 401(k) lawsuits that interpreted what it means to be a fiduciary in a way no one contemplated. Hundreds of lawsuits have been filed against plan sponsors over excessive fees, inadequate disclosure, inappropriate investment choices, self-dealing and other issues, resulting in substantial settlements.
The principles governing the fiduciary obligation of plan sponsors apply with equal force to any advisor’s fiduciary duty to your clients.
It’s a very high standard, as I discuss below.
You are a fiduciary
Whether you like it or not, as an SEC-registered investment advisor, the law considers you a fiduciary.
This fiduciary obligation is codified in the Investment Advisers Act of 1940. This statute, together with other legislation, has been determined by the U.S. Supreme Court “...to substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry.”
The Supreme Court elaborated on this standard, stating: “The Investment Advisers Act of 1940 thus reflects a congressional recognition ‘of the delicate fiduciary nature of an investment advisory relationship,’ as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to render advice which was not disinterested.”
The fiduciary standard
What does it mean to be a fiduciary?
The SEC rendered an extensive interpretation of the standard of conduct for investment advisors in this Release.
An adviser is obligated to “make full and fair disclosure to its clients of all material facts relating to the advisory relationship.” The disclosure “....must be clear and detailed enough for the client to make an informed decision to consent to the conflict of interest or reject it.”
What constitutes acceptable behavior of a fiduciary is subject to interpretation, which poses additional risks to advisors.
The standard is exceptionally high. As Justice Benjamin Cardozo (then sitting on the Court of Appeals of New York) famously stated: “Not honesty alone but the punctilio of an honor the most sensitive, is then the standard of behavior” (referring to the fiduciary duty of a trustee).
When you are assessing whether your behavior meets this standard, consider analogous situations where a fiduciary obligation is imposed, like the relationship between a trustee and beneficiaries, or a conservator of the assets of a disabled person or a child.
Your conduct will be judged by whether your disclosures were sufficient to realistically inform your clients of the conflict at issue. That standard may differ when you are dealing with an institutional client who is presumably more sophisticated than a retail client.
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Ask yourself these questions:
- Is your fee disclosure sufficient to adequately inform your clients of the impact of your fees on their returns, especially over time?
- Are you required to disclose all fees the client will incur, including custodial fees, 12b-1 fees, expense ratios, trading costs and other fees levied by the mutual funds you recommend?
- Do you have an obligation to disclose the after-tax historical returns of the mutual funds you recommend and to compare those returns to the after-tax returns of comparable index funds?
- For retirement accounts, are you obligated to disclose the actual or projected tax consequences of required minimum distributions and other withdrawals?
- Do you have a fiduciary obligation to disclose that lower fees for comparable services may be available from others? This disclosure is mandatory in California. Have you checked the requirements in your state?
- If you’re recommending actively managed mutual funds, do you have an obligation to disclose the data comparing the performance of actively managed mutual funds to comparable index funds, especially over the long term?
- If you’re recommending many different mutual funds, are you obligated to compare the returns of those funds with a less complex portfolio, consisting of only one to three index funds?
- Are you obligated to disclose how many accounts you handle and how that workload impacts your ability to focus on the needs of your clients?
- Are you obligated to disclose that some of your clients negotiated lower fees?
- Do you customize your disclosures based on the sophistication of your client, or do you use a “one size fits all” approach?
Before you brush these concerns aside, remember the standard: the punctilio of an honor the most sensitive.
Are you meeting it?
Dan trains executives and employees in the lessons based on the research on his latest book, Ask: How to Relate to Anyone. His online course, Ask: Increase Your Sales. Deepen Your Relationships, is currently available.
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
