Risk Management and Compliance Consultants
Will Trustees Set the Bar for the Fiduciary Standard?
A survey of definitions of the word “fiduciary” offered by academics, attorneys and judges in textbooks, legal dictionaries, articles, journals, court decisions and other published material results in recurring terminology that is commonly used to describe a fiduciary and the relationship with the person that is owed a duty. The words trust, candor, honesty, loyalty and power are found frequently. Certain phrases that crop up with regularity, such as “utmost good faith”, “avoid self-dealing”, “avoid conflicts of interest”, “sole interests” (and sometimes,“best interests”1), and “undivided loyalty” are often used to describe the obligations of the fiduciary.
No matter the words used to describe a fiduciary relationship, there does seem to be universal consensus that a fiduciary obligation imposes the highest possible standard of duty that one party can owe another under the law.2
Think about the many fiduciary relationships that occur in life:
There are many other relationships not listed here that could give rise to fiduciary obligations. Basically, a fiduciary relationship exists when an individual or firm has the duty to act for the benefit of another party under an umbrella of trust, confidence and dedicated loyalty.
This article is intended to highlight the basic duties of a trustee, a type of fiduciary that has well-established principles rooted in the common law. The duties ascribed to trustees, especially the duty of loyalty, are often benchmark standards for other types of fiduciaries. The reader may be surprised to learn that banks and thrifts that utilize their trust powers to enter into agency relationships with customers to manage their funds are subject to the same fiduciary principles that apply to trustee relationships, per trust banking law and many state statutes (“investment advice for a fee” is a fiduciary capacity).3
A better understanding of trustee duties may enable the compliance officers of broker-dealers, financial planning firms, investment advisory firms, and insurance firms to conduct a better assessment of the current business practices in their shops with an eye towards what might be expected in the future if a fiduciary standard of behavior ever becomes the controlling principle for certain customer relationships. Or, where fiduciary relationships already exist, a deeper understanding of trustee duties can help the reader better assess the adherence of current practices to true fiduciary principles.
This briefing is not intended to be a scholarly dissertation on all of the legal interpretations of trustee duties as evolved over the ages through court opinions. Although these historical interpretations are very important because ultimate liability is ascribed by a court based on these definitions and precedents and not on bank trust law per se, it would not assist the reader in figuring out what must be analyzed with respect to basic business practices. Whole textbooks and law school classes, and even degrees (for example, Campbell University offers a major in Trust and Wealth Management), are offered in the realm of the fiduciary.
Pending legislation, discussed below, is often the disdain of compliance officers who already have too much on their plates. But the fact remains that there is heightened discussion of a possible fiduciary standard for financial intermediaries. Those compliance officers and firm executives who have not previously been exposed to fiduciary standards may wish to be better prepared for significant changes to current business models that may be required in the future should a fiduciary standard become the norm.
Even more of a driver than possible legislative or regulatory dictates is the fact that discussion of fiduciary standards is no longer limited to trade publications, courtrooms, and the halls of Congress. Popular consumer financial publications, daily newspapers, blogs, and cable news shows have all published stories about the “fiduciary standard” or have used the word “fiduciary” to describe duties between parties, albeit sometimes inaccurately.
Some industry financial writers urge investors to demand a fiduciary level of duty from their brokers and advisors. Such encouragement serves to create new customer expectations. Financial professionals are likely to be asked by some customers, if they have not been already, to whom they owe allegiance when making recommendations on the purchase of a security, fund or insurance product. Thus, firms would be wise to elevate their understanding of what customers expect, how a fiduciary standard may impact their business models, and which marketing approaches, business practices, policies, procedures, and training may require adjustment should changes become necessary.
There are some firms that are better prepared than others for these fiduciary assessments. For example, a number of broker-dealer firms are affiliated with financial service companies or bank holding companies that may own banks or thrifts with trust powers, and these affiliates may have fiduciary expertise on staff as well as fiduciary counsel. Also, some financial firms, where permitted under state law, have organized private trust companies. Others have organized limited or special purpose (non-deposit) banks with trust powers.
There have also been cases where individual advisory employees have agreed to act as trustee or as successor trustee for clients who are trust settlors, hopefully only with the approval of their firms and only after an educated risk assessment of the potential pitfalls and firm liability.
Depending on how the trust firm is organized, regulatory oversight could be under the purview of any one (or more) regulators, such as state banking regulators, the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS), the Federal Reserve or, for state non-Fed member banks, the Federal Deposit Insurance Corporation (FDIC). Each of these regulatory agencies has experienced fiduciary examiners on staff who conduct exams annually or, in the case of large banks, continuously. These regulators take the view that all activities pursuant to the bank’s trust powers, including all services where investment advice is rendered for a fee (whether or not a trust is involved), is fiduciary activity.4
There are commonly accepted duties of trustees, and they are articulated in authoritative publications on trusts5 as well as in the issuances of regulators that oversee financial firms such as banks that act as trustees.6 Here is a partial list of the principle duties of a trustee:
It is important for the non-fiduciary professional to recognize from the above list that the myriad of duties that a trustee must fulfill are not all related to the actual investment management of trust assets. Some investment professionals have been surprised when confronted with these other duties and the level of knowledge and skill it requires to properly execute them. For example, adhering to the language of a trust instrument (Duty of Administration) generally requires an understanding of the accepted legal interpretations of certain terms. Such understanding is usually obtained by years of guided mentoring by experienced trust administrators along with input from fiduciary attorneys.
Below are brief highlights of selected duties.
The Duty of Loyalty is one that applies to all fiduciaries and thus deserves special emphasis. As noted above in the list of trustee duties, loyalty is really the foundation of the trust relationship and is the crucial element of the trustee’s obligations. A fiduciary is in a special position of power and expertise and the other party is relying on the fiduciary to act with prudence and without regard to the fiduciary’s own self-interests.
The Duty of Loyalty is the duty that most frequently gives rise to conflicts of interest. Its application to those who give investment advice creates uncertainty for some as to what is permissible conduct and what is not. Conflict situations frequently are not black and white and do not have clear solutions in all cases.
Internal debates about conflicts can be rather routine in a large fiducial firm, and the application of the Duty of Loyalty can invoke controversial discussion of the fiduciary standard. A trustee is required to avoid conflicts. Certain conflicts can be waived specifically in the governing instrument, by statute or court order7, or by waiver from every beneficiary to the trust. In the case of unborn beneficiaries or minor beneficiaries to the trust, a guardian ad litem may have to be appointed by the court to represent their interests. The commentary to Section 802 of the Uniform Trust Code explains further:
Subsection (b) states the general rule with respect to transactions involving trust property that are affected by a conflict of interest. A transaction affected by a conflict between the trustee’s fiduciary and personal interests is voidable by a beneficiary who is affected by the transaction. Subsection (b) carries out the “no further inquiry” rule by making transactions involving trust property entered into by a trustee for the trustee’s own personal account voidable without further proof. Such transactions are irrebuttably presumed to be affected by a conflict between personal and fiduciary interests. It is immaterial whether the trustee acts in good faith or pays a fair consideration. See Restatement (Second) of Trusts Section 170 cmt. b (1959).
…Under subsection (c), a transaction between a trustee and certain relatives and business associates is presumptively voidable, not void. Also presumptively voidable are transactions with corporations or other enterprises in which the trustee, or a person who owns a significant interest in the trustee, has an interest that might affect the trustee’s best judgment. The presumption is rebutted if the trustee establishes that the transaction was not affected by a conflict between personal and fiduciary interests. Among the factors tending to rebut the presumption are whether the consideration was fair and whether the other terms of the transaction are similar to those that would be transacted with an independent party.
Even where the presumption under subsection (c) does not apply, a transaction may still be voided by a beneficiary if the beneficiary proves that a conflict between personal and fiduciary interests existed and that the transaction was affected by the conflict. The right of a beneficiary to void a transaction affected by a conflict of interest is optional. If the transaction proves profitable to the trust and unprofitable to the trustee, the beneficiary will likely allow the transaction to stand. For a comparable provision regulating fiduciary investments by national banks, see 12 C.F.R. Section 9.12(a).
In the asset management world and for insurance agency sales, potential conflicts arise from not only the related interests of the individual investment professional, but also the related interests of the employing or licensing firm and any subsidiaries and affiliated companies, agencies, employees, officers and directors. Products and services manufactured by the fiduciary or its affiliates, or which yield sales commissions, mark-ups, ongoing revenues, or other favorable benefits, both direct and indirect, to any of these parties are considered conflicts of interest. A bank acting in a fiduciary capacity must meet the same conflict waiver requirements for its agency relationships as for its trustee relationships.8
“Favorable benefits” may include non-financial benefits, such as depletion of an unattractive asset from a firm’s inventory even where all mark-ups are removed, valuation methodologies, common directors, or other situations.9
Non-trustee fiduciary relationships can meet the waiver requirement in some cases through the use of disclosure and consent by the account owner. Such disclosures act, in essence, as amendments to the agency agreement. But the requirements for a conflict waiver disclosure are not to be taken lightly as they are far more nuanced than one might think.
A consent to a waiver of a conflict of interest on the part of a trustee can withstand scrutiny only there is full, fair, honest and conspicuous disclosure of all information that would be material to the customer’s decision to grant consent to the conflict. Furthermore, the information about the conflict must be understood by the customer as the decision to waive the conflict must be done on a fully informed basis.10 Put yourself in the shoes of the customer and ask what you would want to know about the possible benefits to the fiduciary if you were deciding whether or not to grant consent to a conflicted transaction.
It is very important to note that some SEC-accepted methods of handling conflict disclosures by registered investment advisors are not condoned by banking regulators for a bank fiduciary, whether in a trustee capacity or an agency capacity. For example, disclosures without accompanying consent specifying the use of products or services of an affiliated company that are made in a Form ADV would not be adequate for a bank fiduciary. Absent language in the governing trust, court order, or statutory exemption, the disclosure provided by a trustee must meet the “full and fair” hallmarks discussed above, be understood by the party granting the waiver, and the subsequent consent obtained only if these requirements are met. General language is not normally considered adequate to relieve the conflict absent precedent in the courts or statutes of jurisdiction.11
Many conflicts are impermissible regardless of whether or not customer consent is obtained. For example, it is a felony for a bank trustee to loan funds from a trust it administers to any bank officer, director or employee.12 Neither client direction nor court order can override this prohibition.13 To illustrate how restrictive this law is, if the trust grantor is a parent of a bank employee, a loan from the trust cannot be made to the bank employee even if he or she is a beneficiary of the trust or even if the grantor is insistent that the bank trustee make the loan.
Another example is that prohibited transactions under ERISA or the Internal Revenue Code for qualified plans and IRAs cannot be waived by a plan sponsor, participant or IRA owner.14
Some conflicts of interest for fiduciaries can be overridden by statute. For example, nearly all states permit a corporate trustee to invest in affiliated mutual funds where an RIA affiliate may also be the investment advisor to the funds.15 The Uniform Trust Code has provisions to permit these investments, though a majority of states have not adopted the Code and some have amended various parts.16 Some states require an offset against the trustee’s fee in the same amount as the fund advisor receives. Other states do not have this requirement but in certain situations the bank trustee may voluntarily reduce its overall trustee fee. The reason for doing is that the total fees received by the trustee, including any funds received by affiliates and subsidiaries, must be reasonable.17
Some investment advisors and brokers have expressed frustration or questioned why a bank trustee insists on holding the assets of the trust and refuses to permit custody in the hands of a broker custodian when an investment advisor has been hired to manage the assets of the trust. This insistence is more easily understood once the investment professional understands the trustee’s obligation to “Control and Protect Trust Property”.
It is incumbent on the trustee to retain possession and control of all trust assets wherever possible. Certain situations, of course, require the engagement of outside facilities or custodians, but only after prudent due diligence. For example, if the trust property includes art work, precious metals, or other physical assets it may not be feasible for the trustee to store these assets and may require the use of a proper facility in order to properly secure and preserve the asset.
Even where trust property is used as loan collateral or as security for a derivative such as a prepaid variable forward contract, the trustee must generally hold the assets or otherwise retain control to prevent distribution by an unauthorized party that does not have distributive powers. If necessary the trustee can keep assets separate from other property of the trust specifically for the benefit of the counterparty in the event the assets are needed to honor a security obligation. The use of securities depositories are permitted.
In any investment setting (RIA, broker, trustee, bank investment manager, etc.) a portfolio manager who is making investment recommendations for assets held in a trust, especially an irrevocable trust, should be balancing the needs of current beneficiaries against the needs of remainder beneficiaries. Are your brokers and advisors adequately trained to understand these differences if they are managing trust assets where the grantor does not have discretion? For example, if the current income beneficiary is demanding high payouts and presses for investment in low rated, high interest bonds, is that balanced against the desire of remainder beneficiaries to preserve or grow principal?
While this is a simplistic description of the Duty of Impartiality, there are several statutory provisions and industry practices that may temper this duty, such as taking into account non-productive trust assets, the current financial situation of the income beneficiary, permissibility in the jurisdiction for total return trusts, and most importantly, the intent of the grantor as articulated in the governing instrument. It may be of interest to non-trustee investment professionals to learn that trustees are expected to review the financial statements and even tax returns of income beneficiaries who make distribution requests to ascertain their true needs prior to distributing any principal which would decrease the ultimate trust corpus for remainder beneficiaries.
Brokerage and insurance executives as well as compliance officers may have expressed a sigh of relief upon hearing that there was no fiduciary standard mandate in the draft financial reform bill passed by the Senate Banking Committee on March 22, 2010, entitled “Restoring American Financial Stability Act of 2010”.18 However, the House version, “Wall Street Reform and Consumer Protection Act of 2010”19 does contain a requirement that investment advice rendered by a broker be under a fiduciary standard. While there are some other provisions of concern to those who are promoting a fiduciary standard, this provision seems to, for the most part, accomplish the Administration’s goal as set forth in the Obama Administration’s White Paper on financial reform.20 In addition, some SEC Commissioners have been vocal about their view that a fiduciary standard is an important element of investor protection.21
It remains to be seen what final Senate legislation may contain and what results from the reconciliation process.
Instead of requiring a fiduciary standard out of the blocks, the draft Senate committee bill demands 16 studies, two of which are about standards of care.22
First, the bill requires the Comptroller General of the United States to study various aspects of the Commodity Futures Trading Commission and the Securities Exchange Commission regarding 1) jurisdictional disputes; 2) holding futures and securities in the same account for cross-netting; 3) possible “harmonizing” of laws and merging of agencies, and 4) the benefits and feasibility of imposing a uniform fiduciary duty on financial intermediaries who provide similar investment advisory services.23
Of perhaps even greater interest is the draft bill language that calls for a “Study and Rulemaking Regarding Obligations of Brokers, Dealers, and Investment Advisers”.24 This study is to look at regulatory gaps as well as the practices of FINRA and the SEC with respect to enforcing “the standards of care for brokers, dealers, investment advisers, persons associated with brokers or dealers, and persons associated with investment advisers when providing personalized investment advice and recommendations about securities to retail customers.”
This same section of the bill directs the SEC to consider “the specific instances in which—(A) the regulation and oversight of investment advisers provide greater protection to retail customers than the regulation and oversight of brokers and dealers; and (B) the regulation and oversight of brokers and dealers provide greater protection to retail customers than the regulation and oversight of investment advisers…”25
In addition, the study is to cover a number of other elements. The fiduciary standard comes into play due to the provision that states that the study is to assess the potential impact on the access of retail customers “to the range of products and services offered by brokers and dealers, of imposing upon brokers, dealers and persons associated with brokers and dealers—(A) the standard of care applied under the Investment Advisers Act of 1940 for providing personalized investment advice about securities to retail customers of investment advisers; and (B) other requirements of the Investment Advisers Act of 1940.”26
Recall that the Investment Advisers Act of 1940 does not actually mention the word “fiduciary,” but numerous court cases have firmly established that a fiduciary duty is owed by an advisor to a client.27
Even though the imposition of a fiduciary standard on brokers and insurance agents does not, for the moment, appear imminent, it would be prudent for a firm’s regulatory risk and compliance departments, and others with regulatory assessment responsibility, to think about their firm’s business model and what would be the likely impacts on business practices should a fiduciary standard become reality for all employees who render personalized investment advice.
Discussions with firm owners and executives should commence to educate and prepare management for possible changes that will require their long-term planning. Perhaps you could start with this article.
To undergo a “fiduciary standard” assessment, it is necessary to understand what the business practices and governance structure of the firm are in order to identify those behaviors and structures that may create a fiduciary relationship with the customer.28 Those activities then should be reviewed to determine if the firm’s business model requires modification, if certain services will be discontinued to avoid a fiduciary duty, or determine if a fiduciary duty will be embraced. If the latter, substantial effort will have to be put forth to be sure that business practices are revised to comply with a fiduciary principles.
The present challenge for compliance officers at broker-dealers is to take time, before any final legislation is passed or new regulations are introduced, to assess the business model at their firms. Look at all the types of interactions representatives or call centers have with customers, know what the customer expectations are, and figure out where and how changes may need to be made to eventually comply with a fiduciary standard in areas where it currently is not applicable. Most importantly, the compliance officer must be able to articulate the implications of such a standard to the business executives who are responsible for determining the organizational structure of the firm and establishing service delivery.
Here is a list of just some of the issues common to many broker-dealers that should be addressed in a comprehensive assessment.
In reality, in spite of all the versions of rhetoric in proposed legislation, the “fiduciary standard” will not simply be what trade associations or even what regulators say it is. These entities can provide guidance and best practices and try to develop industry standards. The actual fiduciary standard is set by customer expectations and what our jurisprudence system has imposed, using two hundred years of past court decisions. The decisions of the future will rely heavily on the ones from the past. The principles adhered to by the fiduciary-trustee will likely be a frequent measure by which other fiduciaries will be judged in the future.
©2010 Janice J. Sackley