Conflicts of Interest: Unthinkable for Trustees
I have drawn the great moral lesson, perhaps the only one of any practical value, to avoid those situations of life which bring our duties into conflict with our interests, and which show us our own advantage in the misfortune of others; for it is certain that, in such situations, however sincere our love of virtue, we must, sooner or later, inevitably grow weak without perceiving it, and become unjust and wicked in act, without having ceased to be just and good in our hearts.
– Jean-Jacques Rousseau, Confessions (Wordsworth: 1996), p. 53.
- What does it mean to be a fiduciary?
- Who is a fiduciary and who is not in the investment industry?
- What are the different levels of fiduciaries in the investment industry?
- How do conflicts of interest factor into the investment industry?
- What should I expect if I do business with a registered broker or insurance agent? A registered investment adviser? A dually-registered adviser? A trust company?
- Benefitting from a fiduciary culture and highest fiduciary laws that protect the client.
If you are confused by the different kinds of investment providers in the industry, you are not alone. Some firms’ claim the top of the fiduciary pyramid in advertising, while others say they work in your “best interest.”
Broker-dealers and registered brokers, insurance companies, registered investment advisers (RIAs), and trust companies all have different business models designed to service different clients and meet different needs. In turn, each type of firm is subject to different laws, regulations and rules. Consequently, the application varies for whether “fiduciary standards” exist, how demanding such standards might be, and how the standards apply. They vary for the types of firms, types of accounts, and different contractual situations. All this variation causes confusion for clients trying to understand the distinctions.
Related to this, the term “fiduciary” has multiple meanings under different laws and rules. This diverse application of “fiduciary” has implications for whether conflicts of interest may exist and, if so, how they affect you as an investor. Among other things, conflicts of interest can affect: the agreement you sign; the fees you pay and your investment costs; the liquidity of securities in which you are invested; whether you give up your rights to seek remedy in the courts; the investments recommended to you; the buy-hold-sell recommendations for any given security; and, how your investments perform.
Conflicts of interest are especially pernicious when driven by compensation structures. Many studies show that people who work under commission schemes are influenced by their compensation arrangements. This is contrary to what investors expect. When investors choose someone to advise them about financial management, they usually expect that person or firm to put the client first above any potential revenues the manager receives.
This article digs deeper into these issues. To make it easier, let’s have common ground for some general definitions first:
- Fiduciary – According to Black’s Law Dictionary, a fiduciary is, “a person having duties involving good faith, trust, special confidence, and candor towards another.” A fiduciary also is described generally as, “one who is granted authority to manage the affairs of the principal and, therefore, is entrusted to further the principal’s best interest in her actions and decisions.” 1
- Fiduciary duties – Someone serving in a fiduciary capacity has a collection of duties that they must fulfill. These may be defined in laws and regulations. A fiduciary duty is the highest standard of care required by law. Case law provides additional interpretation. Many legal experts describe fiduciary duties as largely falling into two broad descriptions: the duty of loyalty and the duty of care. Specifics for fiduciary duties will vary by profession. For example, the duties obligated to a physician are different from those obligated to an attorney, or a trust company.
- Duty of care – This is one of the core duties of someone serving in a fiduciary capacity. According to one legal dictionary: “a requirement that a person act toward others and the public with the watchfulness, attention, caution and prudence that a reasonable person in the circumstances would use. 2 In Arizona and other states that have adopted the Uniform Trust Code, two trust statutes relate closely to the duty of care. First, a trustee “…shall administer the trust in good faith, in accordance with its terms and purposes and the interests of the beneficiaries…” The duty to act in good faith and in accordance with the terms of the trust and the interests of the beneficiaries is not waivable by the trust agreement. Also, “a trustee shall administer the trust as a prudent person would, by considering the purposes, terms, distributional requirements and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill and caution.” 3
- Duty of loyalty – In trust law, this duty requires that the trustee administer a trust solely in the interest of the beneficiaries. The Uniform Trust Code (UTC) considers this to be “the most fundamental duty of the trustee.” 4 The UTC identifies a number of circumstances that presumptively characterize a number of transactions that involve the trustee, the trustee’s officers or employees, or a trustee’s family members as presumptively affected by a conflict of interest.
- Conflict of interest – “A conflict of interest is a set of circumstances that creates a risk that professional judgement or actions regarding a primary interest will be unduly influenced by a secondary interest.” A conflict of interest occurs in situations where “a person or organization is involved in multiple interests, financial or otherwise, and serving one interest could involve working against another. Typically, this relates to situations in which the personal interest of an individual or organization might adversely affect a duty owed to make decisions for the benefit of a third party.” 5
- Conflicted advice – Advice given by a financial representative who has a sales incentive or disincentive, often when it’s not in an investor’s best interest (Wall Street Journal). Conflicted advice is considered a significant problem for retail investors. Many laws and rules exist in an effort to deal with conflicted advice, but have constrained success.
- Rules-based regulation – A rules-based approach attempts to provide prescriptive detail about what is required or prohibited. The approach is narrower and more rigid. It tends to lead to “the letter of the law being followed while the spirit of the law is missed.” 6 Under rules-based approaches, inventive bad actors will seek loopholes and identify blind spots. Regulatory models overseeing non-fiduciary situations are more likely to employ this approach.
- Principles-based regulation – A principles-based approach establishes a set of principles and required outcomes. Governance and management must evaluate the organization and establish what is required to be in compliance with the principles and achieve the outcomes. Regulatory models overseeing fiduciary situations usually employ this approach.
- Dually-registered advisor/financial professional or “hybrid adviser” – A (natural) person who is both a registered representative associated with a broker-dealer and an investment advisor representative of an RIA. Clients who work with dually-registered individuals are more likely to be exposed to compensation-related conflicts of interest (Pershing/ BNY Mellon). To add complexity, an individual may also be a licensed insurance agent.
With recent rule changes for brokerage firms and guidance changes for registered investment advisers, one observer has described the situation for retail investors as playing Where’s Waldo? “Spotting the fiduciary standard—and in particular, the duty of loyalty—indeed has become increasingly difficult.” 7 Below, we cover the range from the weakest to the highest standards of investment and fiduciary advice, and how conflicts of interest are treated.
Broker-Dealers, Registered Brokers, and Most Insurance Entities
Rarely a fiduciary. Best Interest Standard newly applies, but only to retail clients (institutional investors, you are on your own, and still with the Suitability Standard). Conflicts-of-interest permitted. Prescriptive-based rules, not principles-based. Occasional regulatory enforcement for branch offices—greater enforcement for “home office.”
Broker-dealers play an important role in the economy as a financial intermediary. This role in particular, among other contracts and relationships, contributes to significant conflicts of interest as broker-dealers serve clients with competing interests. Furthermore, commission-based compensation structures create a conflict of interest for the registered broker.
Although broker-dealers and their registered brokers serve tens of millions of retail clients, until summer 2020, there was no national standard for broker-dealers to put their clients’ interests first by avoiding conflicted advice. On the contrary, major brokerage firms published misleading advertising implying that they put their clients’ interests first, but then took no such responsibility in arbitration claims. 8
Effective June 30, 2020, Regulation Best Interest (Reg BI) now requires that broker-dealers: “act in the ‘best interest’ of the retail customer at the time the recommendation is made [emphasis added], without placing the financial or other interest of the broker-dealer ahead of the interests of the retail customer; and address conflicts of interest by establishing, maintaining, and enforcing policies and procedures reasonably designed to identify and fully and fairly disclose material facts about conflicts of interest [emphasis added], and in instances where we have determined that disclosure is insufficient to reasonably address the conflict, to mitigate or, in certain instances, eliminate the conflict.”
Reg BI ended up being an intentionally moderate attempt to address conflicts of interest. As a result, the Reg falls materially short and does not approach fiduciary-level standards:
- Alert! Alert! Reg BI specifically rejects a “fiduciary standard” as relevant for broker-dealers and avoids using the term “fiduciary.” Directly from the Reg:
“Finally, although our standard draws from key fiduciary principles, for various reasons, including to emphasize that Regulation Best Interest is tailored to the broker-dealer relationship and distinct from the investment adviser fiduciary duty, we are not referring to Regulation Best Interest as a “fiduciary” standard, and we emphasize that Regulation Best Interest is separate from any common law analysis of whether a broker-dealer has fiduciary duties.” 9
- Reg BI avoids applying the term “duty” throughout except where it explains that duties do not apply, or referencing the duties of investment advisers (as defined by the Investment Advisers Act of 1940). Because fulfilling one’s “fiduciary duties” is a fundamental tenet of fiduciary and trust law, Reg BI only uses the term “duty” within the Reg to apply to a Duty of Care. There are no defined “fiduciary duties” that specifically flow from Reg BI.
- One of the fundamental duties of a fiduciary is the “duty of loyalty.” There is no duty of loyalty in Reg BI. The term “duty of loyalty” never appears in the body of a 770 page “final” document from the SEC. It appears only in footnotes, referring to duties that apply to SEC-registered investment advisers.
- The Reg intentionally chose not to interfere with the brokerage industry’s compensation structures. Notably, Reg BI does not eliminate conflicted advice. Nor does the obligation to provide “full and fair” disclosure eliminate conflicts of interest. Knut Rostad, president of the Institute for the Fiduciary Standard, comments that the REG BI text, “explicitly says it does not require any ‘specific conflict mitigation measure.’”
- Reg BI acknowledges that, “…the provision of recommendations in a broker-dealer relationship is generally transactional and episodic…” As such, the Reg imposes no duty for ongoing advice and monitoring. Investment clients usually expect ongoing monitoring of their portfolios and they presume that ongoing fees warrant ongoing monitoring. However, this is simply not the case.
- While Reg BI was promulgated by the SEC, broker-dealers operate significantly under supervision by FINRA, a self-regulatory body. The conflicts inherent in self-regulation contribute to weak enforcement practices and a history of recidivism by bad actors.
- “In spite of the Regulation [Reg BI], retail investors will nonetheless face significant conflicts of interest, confusion about the protections they are afforded in the market, and less actual protection than the fiduciary standard. To effectively address the conflicted advice problem, therefore, the SEC must decide which it values more: protecting investors protection or maintaining the viability of commission-based compensation.” 10
SEC Registered Investment Advisers (RIAs), Dual-Registered Firms, Dual Registered Advisers
Yes, fiduciary-lite. But, conflicts-of-interest permitted. Huh? Best interest, principles-based standard that accounts for the scope and nature of the client relationship. Occasional regulatory enforcement (averaging regulatory examinations every 6.7 years). Applies to RIAs and to dually-registered firms or persons when they are serving as an RIA.
The Investment Advisers Act of 1940 (IAA) designates any firm or person meeting the definition of investment adviser as a “fiduciary.” Such investment advisers are held to a “fiduciary standard” that is described as a “best interest standard” that incorporates the duty of care and duty of loyalty, to a degree. This particular fiduciary standard still permits conflicts of interest.
Unfortunately, the fiduciary duty to which advisers are subject was not defined in the IAA or in SEC rules. In 2019, the SEC issued the Interpretation 11 of the fiduciary standard for investment advisers that included several clarifying comments and implications:
- Although the Act’s fiduciary standard applies to both retail and institutional clients, there are some distinctions between them that the Interpretation allows.
- Investment advisers may define the relationship by contract and limit responsibilities that the investment advisor, “as agent, has agreed to assume for the client, its principal.”
- Duty of care includes: providing advice in the best interest of, and suitable for the client; seeking best execution of client transactions where an adviser has the responsibility to select executing broker-dealers; and, provide advice and monitoring over the course of the relationship.
- The standard applies to “all investment advice,” from the type of account the client might open to the investment strategy to advice about retirement plan rollovers. The “best interest” standard applies to the “entire relationship” between the adviser and client.
- Extra caution is warranted for clients choosing to conduct business with dually-registered individuals. Key conclusions from 2019 research found that, “Many fiduciaries are dual-registered as brokers (DRs) and have potential conflicts of interest including revenue sharing from mutual funds, receiving asset-based fees and transaction-based commissions on the same security, and preferential treatment of affiliated mutual funds. Regulators frequently discipline DRs for these conflicts. DRs charge their retail RIA clients higher fees than their brokerage clients or clients of independent RIAs. Finally, DRs prefer institutional share classes of the same underperforming mutual funds they offer brokerage clients. Many DRs appear to fall short of the fiduciary standard.” 12 Notwithstanding the presence of these conflicts, dually-registered individuals serve the majority of small retail clients, and they oversee about 81% of RIA assets under management. 13 The researcher concluded that dually-registered persons, “often fall short of the spirit of the fiduciary standard.” 14
- With the Interpretation, “Duty of loyalty” now requires that an investment adviser may not place its own interest ahead of its client’s interest. The Interpretation newly requires investment advisers to “eliminate or at least expose through full and fair disclosure all conflicts of interest which might incline [emphasis added] an investment adviser—consciously or unconsciously—to render advice which was not disinterested.” Neither the Act nor the Interpretation eliminate conflicts of interest nor create an obligation to eliminate or mitigate conflicts of interest. In this dumbed-down duty of loyalty, conflicts of interest are largely dealt with through putting a client in the position of being able to understand the conflict and then provide “informed consent.”
Both Reg BI and the IAA deal with conflicts of interest by requiring disclosure to the client. The problem with this approach is that a large percentage of retail clients are unable to discern the effects of such conflicts of interest. Many will not read the disclosures. Others will not understand them. Even some commissioners of the SEC believed the disclosures would not be effective. One of the key challenges in relying on disclosure is the significant unequal information gap between the broker/adviser and the client. Lastly, for brokers especially, compensation related conflicts are unavoidable.
Trust Companies (and other trust entities)
Always a fiduciary. Often a trustee. Trustee obligations inform operations of the entire business. Principles-based standards with extensive laws and case law to support. No conflicts-of-interest permitted. Best interest standard required. Annual regulatory examination.
When a trust company such as Mission serves as trustee, the trust company is held to the highest standards under any laws that exist—trust laws. These laws have higher standards than the laws and rules that apply to brokers or registered investment advisers. We highlight three key ways trust laws impose higher standards:
- Complete avoidance of conflicts of interest – Unlike “fiduciaries” under standards that permit conflicts of interest, Mission is not permitted to have conflicts of interest. Regulatory oversight enforces avoidance of them. More importantly, Mission’s fiduciary culture permeates our policies, procedures, team member education, client communication and reporting, trading and investing practices, company decision making, and more. The following illustrate just a few policies that block the potential for conflicts of interest:
- Mission may not commingle company assets with your assets.
- Mission may not conduct a transaction with you. Nor may Mission’s directors, officers, employees or affiliates conduct such a transaction. For example, if you needed to sell some securities to buy a vacation property, we are not allowed to purchase those securities, even if the price was verified to be above market value.
- Mission does not have any proprietary funds, meaning we do not receive fees from a fund that we also manage.
- Mission is not compensated for any account activity or trading. We don’t have financial product to move. We don’t sell securities.
- Mission’s fees are completely disclosed and appear separately in your statement.
- Mission may not benefit from client assets in any way. Period.
- Application of the highest investment standard through the Uniform Prudent Investor Act (UPIA) – The UPIA applies when trustees invest and manage the assets of a trust. Notably, it does not apply to fiduciaries who are not trustees. Unless waived by a trust document, the UPIA is the default standard for trusts in Arizona and the vast majority of states.The UPIA imposes “the obligation of prudence in the conduct of investment functions” and specifies the “attributes of prudent conduct.” 15 As part of this, the trustee has the responsibility to assess suitability and invest in a manner that is “suitable” for the purposes of the trust.
- Trust law imposes a fundamental standard of good faith that is non-waivable. – The Uniform Trust Code indicates that “The terms of a trust prevail over any provision of this [Code] except: …the duty of a trustee to act in good faith and in accordance with the terms of and purposes of the trust and the interests of the beneficiaries…” Mission may not require clauses in a trust agreement that waive this standard. A broker or registered investment adviser may insert clauses that put you on notice about conflicts of interest and essentially require you to waive these conflicts.
So, Mission is held to higher standards than those that apply to brokerage firms, insurance entities, or registered investment advisers. Mission also is held to a higher standard than what would apply to licensed private fiduciaries or a private individual serving as a trustee. Even when Mission is serving only as your agent managing your money, and not serving as a trustee, Mission remains a fiduciary.
As a trust company, Mission has chosen to offer investment management and trust services from a business model that puts the interests of our clients and trust beneficiaries first. Our principled, client-centered values and fiduciary culture are embodied in our Trust for a Lifetime creed.
Mission’s fiduciary culture is important, but it is not all that matters. How we fulfill our responsibilities to you also is guided by applicable laws and regulations. Among the different business models in the industry, the laws and regulations that apply to trust companies provide the greatest protections afforded investors. Our fiduciary duties make it unthinkable that Mission would have conflicts of interest.
This means you can have greater confidence and be secure in the knowledge that Mission will place your interests first. If you wish to work with a firm that has eliminated conflicts-of-interest, start with a trust company. Start with Mission.
You can find more information about Mission’s trust services here, and Mission’s investment management services here. Please call us at 520-577-5559 or complete our contact form if you would like to speak with a true fiduciary.
By Susan L. Ernsky, President
- Fletcher, Gina-Gail S.: The Conflicted Advice Problem: A Response to Conflicts & Capital Allocation (June 2019). Ohio State Law Journal, 2019, Indiana Legal Studies Research Paper No. 407, p. 3. Available at SSRN.com.
- Arizona Revised Statutes, §14-10801 and §14-10804, as of January 1, 2020.
- Uniform Law Commission, Final Act, With Comments: Uniform Trust Code (Last Revised or Amended in 2010), p. 127.
- Wikipedia contributors, “Conflict of interest,” Wikipedia, The Free Encyclopedia, (accessed October 15, 2020). Note: The Wikipedia entry for conflicts of interest is a good summary.
- Conradie, Lizelle: Rules-based approach vs Principle-based approach to regulation in the financial industry. Etude Risk Management blog post at Etude.co.za.
- Thompson, Duane: “Where’s Waldo? Finding the Fiduciary in Regulation Best Interest.” Investments & Wealth Monitor, September/October 2018, p. 9.
- Peiffer, Joseph C. and Lazaro, Christine: Major Investor Losses due to Conflicted Advice: Brokerage Industry Advertising Creates the Illusion of a Fiduciary Duty. Public Investors Arbitration Bar Association Report, March 25, 2015. While this report was prepared prior to the new Regulation Best Interest, the fact that brokerage firms and registered brokers still are not fiduciaries after the regulation suggest these issues will persist. The impact is billions of dollars annually.
- Securities and Exchange Commission 17 CFT Part 240: Regulation Best Interest: The Broker-Dealer Standard of Conduct, p. 68.
- Fletcher, Gina-Gail S. “The Conflicted Advice Problem: A Response to Conflicts & Capital Allocation,” p. 24.
- SEC 17 CFT Part 276: Commission Interpretation Regarding Standard of Conduct for Investment Advisers.
- Boyson, Nicole M., The Worst of Both Worlds? Dual-Registered Investment Advisers (December 1, 2019), Abstract. Northeastern U. D’Amore-McKim School of Business Research Paper No. 3360537, Available at SSRN.com.
- Ibid, p. 2.
- Ibid, p. 25
- Uniform Law Commission, Final Act, With Comments: Uniform Prudent Investor Act §1,Comment, p. 4.