If a fiduciary investment adviser or financial planner will possess a conflict of interest with a client, must the investment adviser seek to avoid the conflict of interest? When it comes to the receipt of compensation from investment and insurance product manufacturers, the answer is often (if not nearly always) “Yes!”
While Not All Conflicts of Interest Can Be Avoided, Most Conflicts of Interest Related to Product Recommendations Can and Should Be Avoided.
A financial advisor can agree with the client to reasonable compensation of a set amount, or rate, in advance of making any recommendations. The financial advisor should then eschew the receipt of material third-party compensation (such as commissions, 12b-1 fees, and other revenue sharing provided by product producers).
The fact of the matter is that academic research has long confirmed that the higher the fees and costs associated with an investment product, on average the lower returns, vis-à-vis similar investment products.
It is abundantly clear that the receipt of differential material compensation, by a fiduciary, resulting from the recommendation of a security or insurance product, becomes a breach of the fiduciary duties of loyalty and due care. Such a breach cannot be cured by the process of full disclosure, achievement of understanding by the client, and obtaining the client’s informed consent. For no client would ever presumed to be harmed. In addition, the transaction would not be substantively fair to the client (an additional test imposed by the courts, when dealing with a fiduciary’s conflicted recommendations).
A Fundamental Truth: No Fiduciary Can Serve Two Masters.
The fiduciary duty to avoid conflicts of interest, and the necessity to obtain the informed consent of the client as to conflicts of interest not avoided, were well known in the early history of the Advisers Act. In an address entitled “The SEC and the Broker-Dealer” by Louis Loss, Chief Counsel, Trading and Exchange Division, U.S. Securities and Exchange Commission on March 16, 1948, before the Stock Brokers’ Associates of Chicago, the fiduciary duties arising under the Advisers Act, as applied in the Arleen Hughes release, were elaborated upon:
As the Supreme Court said a hundred years ago, the law ‘acts not on the possibility, that, in some cases the sense of duty may prevail over the motive of self-interest, but it provides against the probability in many cases, and the danger in all cases, that the dictates of self-interest will exercise a predominant influence, and supersede that of duty.’ Or, as an eloquent Tennessee jurist put it before the Civil War, the doctrine ‘has its foundation, not so much in the commission of actual fraud, but in that profound knowledge of the human heart which dictated that hallowed petition, ‘Lead us not into temptation, but deliver us from evil,’ and that caused the announcement of the infallible truth, that ‘a man cannot serve two masters.’’
This time-honored dogma applies equally to any person who is in a fiduciary relation toward another, whether he be a trustee, an executor or administrator of an estate, a lawyer acting on behalf of a client, an employee acting on behalf of an employer, an officer or director acting on behalf of a corporation, an investment adviser or any sort of business adviser for that matter, or a broker. [Emphasis added.]
The U.S. Supreme Court Informs Us to Avoid Conflicts of Interest Where Possible
The seminal 1963 U.S. Supreme Court decision applying the Investment Advisers Act of 1940, SEC vs. Capital Gains Research Bureau, has often been summarized incorrectly. Various writers have opined that, with disclosure of a conflict of interest, all that is required is that the client of the adviser be given the option of proceeding with the advisor’s counsel. However, at a footnote to this section of the opinion, the U.S. Supreme Court went further, explaining the “no conflict” rule and providing alternative rationales behind the prohibition on serving two masters:
This Court, in discussing conflicts of interest, has said: ‘The reason of the rule inhibiting a party who occupies confidential and fiduciary relations toward another from assuming antagonistic positions to his principal in matters involving the subject matter of the trust is sometimes said to rest in a sound public policy, but it also is justified in a recognition of the authoritative declaration that no man can serve two masters; and considering that human nature must be dealt with, the rule does not stop with actual violations of such trust relations, but includes within its purpose the removal of any temptation to violate them …. In Hazelton v. Sheckells, 202 U.S. 71, 79, we said: ‘The objection . . . rests in their tendency, not in what was done in the particular case … The court will not inquire what was done. If that should be improper it probably would be hidden and would not appear.’ [Emphasis added.] SEC v. Capital Gains Research Bureau, at p.___, fn. 50, citing United States v. Mississippi Valley Co., 364 U.S. 520, 550, n. 14.
The Fiduciary Standard is Tough.
Possessing a conflict of interest is a breach of the fiduciary duty of loyalty.
The receipt of differential compensation can easily lead to a claim of violation of the “no profit” and “no conflict” rules embedded as part of the fiduciary duty of loyalty.
The ability to cure a conflict of interest, relating to the receipt of compensation from an investment or insurance product manufacturer, is quite limited. To pay such compensation, the product must, by necessity, possess higher fees and costs. And, as so much academic research has concluded, additional fees and costs drive down returns.
A process of curing a breach of fiduciary duty arising from a conflict of interest exists: full and fair disclosure of all material facts, ensuring client understanding, and obtaining the client’s informed consent. Yet, higher product fees and costs harm the client. And no client would ever provide informed consent to be harmed. Nor would such a transaction be deemed substantively fair to the client.
The truth of the matter is this … many conflicts of interest in financial services, especially those related to the receipt of additional compensation from third parties, should be avoided.
This page represents the personal views of Ron A. Rhoades, JD, CFP(r), and do not necessarily reflect the views of any institution, firm, organization, motley crew of characters, cult, gang or other nefarious gathering which Ron has ever belonged to or ever been kicked out of.