By Marion Asnes
(Note: Fiduciary September is a good time to pause and ask the question, why do fiduciary principles matter? Why are they important? In this piece, Institute co-founder Marion Asness gets her arms around this question through a conversation with law professor Tamar Frankel, one of the world’s leading experts in fiduciary law. If you’re confident you know the answer, continue reading and (maybe) you’ll be in for a surprise. Hint: Think jewelry. Knut )
I recently spoke to Tamar Frankel, the Michaels Faculty Research Scholar at the Boston University School of Law, author of several books, and the nation’s leading expert on the fiduciary law. Here is how she explains the fiduciary standard: It is an upright rebuttal to the tendency to dishonesty that is part of human nature. The fiduciary standard promises that when you entrust your affairs to an expert, the expert will not take advantage of you. The expert will not steal, will not lie, will not behave incompetently, and will not self-deal. “Fiduciary offers services Frankel says. “The fiduciary cannot perform the services without acquiring assets, power or both from the user of the services and the performance of the services cannot be easily controlled by the client. That is either because the client is not an expert or because we want the client to do something else rather than supervise the fiduciary.”
The fiduciary standard has a long history, and originally had to do with handling funds for the benefit of children or incompetents. But you don’t have to be incompetent to need a fiduciary. You might just have something else to do.
Say, for example, you are a cardiologist. You are brilliant, capable and well compensated, and want to put that compensation to work. Investing, however, leaves you cold; you’d rather put your time and energy toward resecting your patients’ faulty heart valves. You deserve to put your money in an advisor’s hand with the same confidence your patients need to have in you—that is, you are going make use of an expertise they do not share on their behalf. Patients may have done their diligence in order to find you, but they did not go to med school in order to supervise your work.
This seems obvious but it is not, particularly if you have been in the company of experts for a long time. Work in the financial world long enough and you will come to view the world of money like fish view water—it is natural. It seems astonishing that others do not understand what you do.
According to Dr. Frankel, addressing this inequality of expertise is one of many reasons the fiduciary standard is crucial. Supervision is difficult when you don’t know what to watch for, but trust cannot be blind. “Financial institutions must be fiduciaries by definition. If their duties are left to their judgment, some will follow their duties and some will begin to bend a little,” she says. The temptation of large sums and the impulse to cut corners can be too powerful to resist. “This is a slippery slope–you start and then, slowly, you find full-fledged dishonesty. Look at the LIBOR fraud by large banks. It started in 1991! It flourished until it was uncovered in 2008 or 2009. It takes time for fraud to flourish.”
But the need to uncover basic dishonesty and fraud is not where the real argument about the fiduciary standard lies. The elements that have the financial world and its lobbyists all aflutter are two: the requirement to disclose conflicts of interest and resolve them in favor of the client, and the requirement to charge reasonable fees and fully disclose them, so the client is aware of the total cost of the investment.
This is where you, the cardiologist, are vulnerable. Do you know what you’re really paying for your investments, including all the hidden fees? Do you know if your “financial advisor”—a completely unregulated term—is presenting you with the best investment for you, at a reasonable price, or with the overpriced limited partnership that the entire brokerage team has been told to sell this week? Do you know if the advisor who sells the most people into the partnership will get a week in Bermuda for two as a bonus? Do you know if your advisor continues to get paid out of our investment over time? Of course not. You’re busy sewing up hearts, and many elements of advisor compensation are not discussed. You’re probably paying more for your financial products than you realize—which is perfectly legal, by the way—and may find yourself holding financial products that do more for their issuers than for yourself. Chances are, unless there’s another big financial blowup to focus everyone’s attention, you’ll never know it.
But you’re a cardiologist—you can afford to pay a little bit extra. Why worry?
Here’s why: The nature of American investors—our goals, resources and motivations–has changed and the financial world has not kept up. Today’s investor is more likely to be a middle manager with a 401(k) than a leading cardiologist, or the equivalent, with money to burn. For the middle manager, this 401(k) is most, if not all, of the money he or she will save for retirement. The middle manager, has no pension, most likely, and little succor from the fading promise of Social Security. A small miss on returns, compounded over time, will make a big difference to the middle manager’s future.
This is why the fiduciary standard is so important. Today, the stakes for the individual investor are much higher than making sure every last coin of stock market profit finds its way to Scrooge McDuck’s vault. Weigh this moral imperative against the ability to charge large, often hidden commissions, and the needs of the individual investor predominate.
Okay, now let’s look at a bigger picture. The fiduciary standard fosters a general sense that our financial system is trustworthy. Before you scoff, think about the lack of trust that froze our financial system in late 2008, when concerns about counterparty risk dried up the liquidity in our banks. Or think about 1933, when the new President Roosevelt declared a bank holiday to stop the runs on failing banks. A society in which we do not trust our trading partners to be ethical, competent or even solvent leads individuals to avoid doing business except when necessary. “Some of the poorest places in the world have a non-trusting culture,” Frankel observes. These are places where individuals bury their money in the back yard, or wear their wealth as jewels. They will not invest it in capital growth.
The fight for fiduciary is not about preventing excessive regulation. If you think about a world in which investors cannot trust their advisors or money managers, you will end up with disengaged, avoidant investors. Even if most financial advisors and institutions are on the level, the bad actors will engender paranoia for everyone. And with no reason to trust, those who must invest may, eventually, insist on extra rules—on managing every interaction with very specific regulations so that cheating is limited. If you’ve ever seen parents after a very nasty divorce, that is how they operate. They are tied, but distastefully so, and every forced encounter is as elaborately choreographed as a minuet.
Those who say that competition will force better behavior are deluding themselves. What forces better behavior is a fair playing field with clear rules. “We do not trust people avoid murdering and have a law that prohibits murder, even though most people are not killers,” Professor Frankel says. “We must have laws that prohibit financial intermediaries and advisers from using their clients’ money for anything but the clients’ benefit, even though many are honest and do that.
“Total honesty is what fiduciary duties impose by law and that is all that is required. A fiduciary should not use other people’s money except for their own benefit and in the best way the fiduciary can. The court of public opinion must demand it. The financial intermediaries will comply and cease their push-back. Any investor should ask: Are you a registered adviser? If not, the investor should say: Goodbye.”
Marion Asnes is president of Idea Refinery LLC, a strategic marketing consultancy, and a co-founder of the Institute for the Fiduciary Standard.