This interview originally appeared on Advisor Perspectives.
Tamar Frankel may well be the god mother of fiduciary law in the West. Born in Israel, Professor Frankel earned her first legal certificate in Jerusalem in 1948. An L.L.M. and S.J.D followed from Harvard Law School in 1964 and 1972. For 48 years she taught generations of students and regulators while writing extensively at the Boston University School of Law. Today professor Frankel is professor of law emerita.
I spoke with her on August 28.
Knut Rostad: You have written about the origins of fiduciary law, from Hammurabi to Roman law and in England in the Middle Ages. What should regulators and policymakers take away from this History? Why does it matter?
Tamar Frankel: The most effective way to destroy any healthy and lasting economy and financial system is to relieve intermediaries – whether advisers, brokers, bankers, or others – of a duty to be trustworthy. That means to relieve them of the obligation to do what they promise to do for the benefit of their clients. If they have conflicting interests, they must tell the clients about these conflicts, in understandable language. If a client does not understand the conflict, then the adviser must either eliminate the conflict or resign from advising the client. Here is the importance. The history is revealing. The history of every financial disaster tells the same story. It has at its roots breaches of fiduciary duties.
KR: The Investment Advisers Act of 1940 had its 80th anniversary in August. It was enacted because of abuses in the markets in the 1920s. The Supreme Court affirmed in 1963 that the 40 Act places a fiduciary duty on investment advisers. The main pillar of the rule, as set out by the Court in its Capital Gains Research case, is the vital importance of eliminating conflicts of interest, as much as humanly possible. Put us into the heads of the authors of the law in 1940. Help us understand why they were so adamant about conflicts of interest.
TF: The Investment Advisers Act of 1940 deals with a service that is important not only to investors but to the country’s economy, financial system and public good. The service – investment advice – cannot be performed by most people. Investors must rely on the advice of others, advice they generally cannot understand. Yet, they bear the results of the advice.
The 1940 Act followed a disastrous failure of the securities system – a failure whose results were similar to the COVID-virus disaster that struck the world this year. The main difference is the “virus” that attacked the financial system almost a century ago was self-inflicted, i.e., it was driven by the conflicts of interest of those who advised investors and managed their money.
Many of those advisers, brokers and managers stood out in at least two ways: (i) They did not know what real advice meant; and (ii) how much that their interests conflicted with the interests of their clients whose money they controlled. These two wrongs were fatal to their advice and contributed richly to the disaster of the market crash in 1929. These same wrongs present greater risks to the markets today and greater risks than does the COVID virus. Most people are basically honest. Yet, when advisers, brokers or managers have power over other people’s money and have no guidance and supervision, bad things happen. They’re on their own. Temptation creeps in – first, with a “little” extra benefit and some justification, cutting corners in serving customers becomes habit. Rationales develop. Nuanced explanations become misleading statements that can become fraudulent.
KR: The SEC’s Reg BI, which you have written about in Advisor Perspectives, is very permissive to conflicts. By this I mean the SEC release does not require (or even recommend) avoiding conflicts. It only calls for eliminating certain sales contests and associated conflictual programs. It does not require putting the customer’s interests first; it mirrors the brokers’ suitability standard by balancing the interests of customers, brokers and broker-dealer firms. Most conflictual recommendations a broker may make are presumptively okay – with minimal disclosure. Talk about how different the vision of the 40 Act founders is from the vision of the current SEC on the role and importance of conflicts of interest in what investment advice means.
TF: The 40 Act framers understood the importance of avoiding or prohibiting conflicts, if at all possible. Today’s regulators do not. Conflicts of interests are simple to identify and prohibit. They should be prohibited because, like the COVID virus, they harm investors. Investors cannot protect themselves from conflicted recommendations for various reasons. They are left open to abusive sales practices. The regulators fail in their duties.
KR: You write in Fiduciary Law about what happens when an entrustor (client) consents to a material conflict of interest by a fiduciary in a recommendation. You were very specific about what a fiduciary must do to make a client consent legally valid. You are also very clear that when such a client consent is legally valid, the fiduciary is released from their fiduciary duty for that specific recommendation or transaction. This point is almost never mentioned in today’s policy discussion. Why is this? What are the implications?
TF: A definition of a conflict, which a client may understand and approve or disapprove of intellectually, is more refined. It means: “a conflict exists but will not harm me.” Not all clients may distinguish, nor be given all the information to make, the distinction. For example, if the adviser recommends the sale or purchase of securities that belong to his distant cousin, and discloses the fact to the client, could the client decide? Should he ask when the adviser saw the distant cousin last, and where the cousin lives? Thus, one should add that the disclosure of a conflict should be the kind which the specific client could understand and answer in a way that protects his interests. The rules should then reflect the same rule in contract law to determine whether the contracting party could determine intelligently whether to consent to the terms.
