Does conflicted advice inevitably result in harm to investors? This question is central to the form and substance of how investment advice is regulated.
Based on the Department of Labor's April 2015 edition of the “conflicts of interest rule,” the regulator's thinking has evolved since the proposal was first introduced in 2010. Historically, DOL rule making has provided few departures from a “sole interest” standard that requires conflicts to be avoided altogether.
But now, with the introduction of some new prohibited-transaction exemptions and changes to some old ones, the regulator has overtly accepted the idea it may be better for investors if some conflicts are tolerated rather than banned, so long as they are managed within the confines of specific fiduciary obligations.
'SOLE' OR 'BEST'?
The idea that not all conflicts result in bad outcomes for investors gives rise to the argument that a “best interest” standard can be more cost-beneficial to investors than a strict “sole interest” mandate.
Recently, after reading one of my commentaries about the DOL's proposed rule, Eugene Maloney, executive vice president and corporate counsel of Federated Investors, brought to my attention a brilliant 2005 article published in the Yale Law Journal titled “Questioning the Trust Law Duty of Loyalty: Sole Interest or Best Interest.” The article is by John Langbein, who was the principal drafter of the Uniform Prudent Investor Act.
The “sole interest” rule in trust law (which is the basis for ERISA) applies the fiduciary duty of loyalty stringently. It generally prohibits fiduciaries from having conflicts that pit self-interest against the fiduciary's obligation to serve the exclusive best interests of beneficiaries. The rationale for rigid interpretation of the duty of loyalty is that beneficiaries rely upon fiduciaries for objective advice or have ceded control over assets to fiduciaries and are therefore highly vulnerable to misdeeds by the people they must trust. Allowing fiduciaries to have divided loyalties by permitting conflicts of interest makes fulfillment of the duty of loyalty unreliable. Advocates of the “sole interest” approach note that history is replete with evidence that in the face of a temptation to serve one's self-interest, people in positions of trust frequently sacrifice the interests of those they are sworn to serve.
'NOT INEVITABLY HARMFUL'
Those who propose broader acceptance of a “best interest” approach argue that inflexibility can be counterproductive. Quoting Mr. Langbein: “The stringent view of conflicts of interest that motivates the sole interest rule misunderstands a central truth: Conflicts of interest are endemic in human affairs, and they are not inevitably harmful. Accordingly, indiscriminate efforts to prohibit conflicts can work more harm than good.”
Mr. Langbein notes that as a matter of practical necessity, trust law has accepted certain conflicted situations that, if prohibited, would clearly be detrimental to beneficiaries. For example, compensating trustees represents a conflict of interest because the charge to the beneficiary represents a gain to the trustee; but in the absence of remuneration, skilled professional trustees would not be available.
Exemptions such as this are governed by fiduciary principles that require fairness and impartiality. Thus, as Mr. Langbein asserts, “fiduciary law has two regimes for dealing with conflicts of interest, prohibition and regulation.” The “sole interest” approach relies on prohibition; “best interest” focuses upon regulation.
To be clear, a “best interest” standard does not embrace conflicts. It seeks to avoid them, but accepts the notion that some conflicts should be accepted if they can withstand the high burden of proof that they actually serve to help, rather than hurt the people fiduciaries are obligated to serve.
The DOL has clearly been persuaded by this logic, as evidenced by inclusion of the Best Interest Contract Exemption in the proposed Conflicts of Interest Rule. It would allow variable compensation, which was heretofore prohibited under the “sole interest” obligations of ERISA, in circumstances where fundamental fiduciary principles such as fairness, prudence and impartiality are observed and clients' best interest are demonstrably served.
Assuming the proposed rule goes into effect, the DOL has left it to financial service firms to determine under what circumstances variable compensation can meet the more flexible, but quite rigorous, “best interest” standard. In turn, it will be up to the DOL to ensure that the rule can be effectively enforced.
Blaine F. Aikin is president and chief executive of fi360 Inc.