By now, most have heard of the U.S. Department of Labor’s new Fiduciary Rule. Because of all the uncertainty surrounding the Rule, “fiduciary” has become something of a dirty word in the financial services industry. Like a four-letter word, some have even argued the Rule should be discarded entirely. Many financial institutions that will become fiduciaries under the rule are scrambling to determine what their legal obligations will be. Investors also want to know what to expect from their investment adviser, broker-dealer, or other relevant financial institution. So, what does it mean to be a “fiduciary”?
Fiduciary Responsibility in Trust Law
The preamble to the new Fiduciary Rule offers some guidance on a fiduciary’s responsibility. It states that fiduciaries are bound by “trust law standards of care and undivided loyalty.” It makes sense that Congress and the Department of Labor would apply trust law standards to investment advice because of the similarities between trust and investment management relationships. In the case of trusts, one party (trustee) manages the trust assets (any type of property) for the benefit of one or more persons (beneficiaries). In the case of investment management, one party (investment adviser) manages assets (usually cash and securities) for the benefit of one or more persons (investors). Both involve fiduciary relationships: the trustee and (usually) the investment adviser are fiduciaries to the beneficiaries and investors, respectively.
Trust law has generally required fiduciaries to operate according to the “prudent man” standard. In other words, fiduciaries must act in good faith and exercise the same degree of discretion that a prudent man of discretion and intelligence would exercise in his own affairs. This prudent man standard may vary in application depending on the facts and circumstances of any given case. Thus, looking at cases dealing with trust law standards of care can provide examples of what constitutes compliance with the standard in the field of investment advice.
A Conflicted Trustee and Adviser
In In re Lesa R. Dentler Family Trust, 2005 PA Super 146 (PA, 2005), an elderly woman with diminishing physical capacity granted a power of attorney to her son. Using that power of attorney, the son then hired an attorney to draft a trust to hold his mother’s assets, which totaled around $802,000. The trust document named the son and the attorney who drafted the trust as co-trustees. It also named the attorney as the investment advisor for the trust assets. The trust document named the son and the elderly woman’s only other child, a daughter who was mentally disabled, as the beneficiaries. After the daughter’s interest in the trust dwindled from nearly $401,000 to approximately $248,000 over the course of four years, she sued her brother and the attorney-trustee on various grounds.
The court found that both trustees engaged in self-dealing, failed to manage the trust in the interest of the beneficiaries, and breached their trust to the beneficiaries. Its analysis in reaching this conclusion offers insight into the duties that trust law imposes on fiduciaries.
Duty to Avoid Conflicts of Interest
Fiduciaries must avoid situations and transactions where their interests conflict with the interests of those they serve. The attorney in Dentler not only drafted the trust document, he also named himself as co-trustee and investment adviser of the trust assets. In his role as trustee, his interest was in making discretionary distributions for the health, maintenance, and support of the mentally disabled daughter. In his role as investment adviser, his interest was in maximizing trust assets because his fee was a percentage of assets under management. These interests are clearly conflicted, yet the attorney did not disclose the conflict to the elderly woman or ask the beneficiaries to waive the conflict in writing. In holding against the attorney, the court reasoned that this failure to address the conflict violated the standard of care for fiduciaries.
Duty Not to Charge Excessive Fees
Fiduciaries must charge reasonable fees for their services. The attorney in Dentler also drafted the trust document to pay the trust’s investment adviser (himself) 2% of assets under management per year. Based on expert testimony at trial, the court noted that the industry-standard investment advisory fee was 1% of assets under management per year. The attorney argued that his advisory fee was double the industry standard because he did not accept compensation for his role as trustee. However, the court was unconvinced and determined that his advisory fee was excessive for a fiduciary.
Duty to Avoid Inappropriate Risk
Fiduciaries must avoid risks they know or should know based on an analysis of the beneficiary’s circumstances. In Dentler, the court provided a list of factors a fiduciary must consider when making investment and management decisions. That list included the liquidity and distribution requirements of the trust, the expected tax consequences of investment decisions, and the role that each investment plays in the overall strategy. The court also noted the need for high liquidity because of the daughter’s mental disability and the high volatility in the markets at the time of the attorney’s investment management. Ultimately, the court ruled that the attorney-investment adviser failed to consider these factors and consequently engaged in inappropriately risky transactions. Therefore, his conduct fell below fiduciary standards of care.
Summary of Fiduciary Duties
In addition to those mentioned above, there are many other aspects of fiduciary duty in trust law, including the duty to act promptly and with due diligence (Parsons v. Wysor 21 S.E.2d 753 (Va. 1942)), and the duty to maintain proper records (Wesley v. O’Brien (Md. App., 2017)). Trust law varies from state to state, but these cases help define the contours of a fiduciary’s standard of care and duty of undivided loyalty. In essence, trust law requires a fiduciary to put the beneficiaries’ interests first and to avoid transactions where the fiduciary’s personal interests could conflict with those of the beneficiary. Because of the similar fiduciary relationship between trustees and financial advisers, the law of trusts offers insight into what the new Fiduciary Rule will require of financial institutions deemed to be fiduciaries.
Black Cypress’s Role as Investment Adviser
Here at Black Cypress, we are no stranger to fiduciary duty, and “fiduciary” is not a dirty word to us. We already put our clients’ interests first and strive to avoid conflicts of interest. We owe our fiduciary accounts (and their owners) the standard of care and duty of undivided loyalty outlined above. In addition to keeping our clients first, we endeavor to provide advice and planning that is unmatched in the industry. If you have any questions about how the firm serves its clients, please contact us at [email protected] or 843-259-2009.
Article by Jordan M. Roberts, Black Cypress Capital Management