For some time now, there has been a net outflow of advisers from broker-dealers to investment advisory firms. For most of these individuals, the change involves a voluntary transition from a rules-based fair-dealing standard to a principles-based fiduciary standard.
Under regulatory reform, it is likely that many more brokers will face this transition involuntarily. If, as expected, the SEC extends fiduciary accountability to brokers who provide advice, broker-dealers will need to establish compliance structures to accommodate the change.
For many newly minted fiduciaries, it will be a challenge to shift from a system of rules designed to balance their own financial interests and those of their firm with the interests of clients, to a system of principles designed to serve the best interests of clients exclusively. They must recognize that the fiduciary standard requires advisers to consider their actions in the context of conformity to obligations owed to the client rather than compliance to specific rules.
Supreme Court Justice Felix Frankfurter provided a succinct overview of how the actions of a fiduciary should be examined to determine whether they may involve a breach of fiduciary obligations to a client. In SEC v. Chenery in 1943, he said: “To say that a man is a fiduciary only begins analysis; it gives direction to further inquiry. To whom is he a fiduciary? What obligations does he owe as a fiduciary? In what respect has he failed to discharge these obligations? And what are the consequences of his deviation from duty?”
The outcome of a recent lawsuit, St. Vincent Catholic Medical Centers/Queensbrook Insurance Ltd. v. Morgan Stanley Investment Management Inc., provides an excellent case study of how Mr. Frankfurter's four questions can frame an evaluation of fiduciary conduct. In this case, the answers to the first two questions were not contested. Morgan Stanley served as a registered investment adviser and owed fiduciary obligations to St. Vincent as a result of being hired to manage the fixed-income portfolio of the hospital's defined-benefit retirement plan. As a fiduciary, it was obligated to, among other things, perform its services according to a prudent-expert (professional) standard of care.
In the suit, brought in Manhattan federal court, the primary dispute was over whether Morgan Stanley failed to exercise due care at a professional level of prudence when, according to the plaintiff, it “concentrated between 9% and 12% of the plan's fixed-income portfolio in mortgage-backed securities on the eve of a national collapse in the subprime-real-estate lending market.” The consequences of being heavily invested in mortgage-backed securities were easy to determine based on the precipitous decline in these investments. But whether Morgan Stanley could be held responsible hinged on whether the court felt that the manager breached its due-care obligation.
While there is much more to this case than can be addressed adequately, the outcome and selected commentary of the presiding judge are instructive as to the principles-based and process-driven nature of the fiduciary standard. Judge P. Kevin Castel noted: “The fiduciary's investigative process is critical to determining whether the duty of prudence is satisfied.” He concluded: “The complaint sets forth no facts that [are directly pertinent] to a claim that Morgan Stanley breached its duty of prudence to St. Vincent. It contains no allegations of inadequacy of Morgan Stanley's investigation of the merits of its investments. Rather, plaintiffs premise their theory of liability on the poor results of the investments.”
This case study illustrates two important points:
• A determination of conformity to the fiduciary standard generally is a matter of fact and circumstance. As in other advisory professions, such as law and medicine, financial advice is personal and situation-specific. It requires good judgment rendered by competent practitioners able to choose responsibly among multiple methods of addressing an issue.
• Process trumps performance. An adviser may take actions that are prudent and necessary on behalf of the client but fail to produce a desired outcome. What matters is not what outcome is achieved but the rigor of the decision-making process.
For many facing the shift from the fair-dealing to the fiduciary standard, a change in mindset is required. Fiduciaries must apply critical thinking when evaluating their actions against core fiduciary principles of loyalty, due care and utmost good faith, and rely less upon transaction-based rules to guide their actions. Those facing the transition should commence the process of realigning their investment processes and regulatory mindset to accommodate the standard against which they ultimately will be judged.
Blaine F. Aikin is chief executive of Fiduciary360 LLC.
For archived columns, go to
InvestmentNews.com/fiduciarycorner.
