Woodrow Wilson may have been right when he said, "Loyalty means nothing unless it has at its heart the absolute principle of self-sacrifice."
Fiduciaries owe a duty of loyalty to the beneficiaries they serve. But frequently, they find their commitment to the principle of self-sacrifice tested by conflicts of interest.
By definition, a conflict of interest is a situation that makes fulfillment of a duty of loyalty less reliable. Financial temptation undermines confidence in a fiduciary's willingness or ability to live up to the high standard of trust placed in them.
Two recent studies strongly suggest that fiduciaries are at greater risk of failing to uphold their duty of loyalty when conflicts of interest come into play.
One study, "Estimating Operational Risk for Hedge Funds: The v-Score," was presented in the January/February edition of the Financial Analysts Journal.
The sophisticated analysis by four prominent professors of finance explored the sources of operational risk that account for more than half of all hedge fund failures. Those included the risks of failure in internal operational control and accounting systems, and employee fraud and misconduct.
Among their findings was "a strong relationship between legal/ regulatory problems and various measures of internal and external conflicts of interest," according to the study.
It is worth noting that this study was made possible by the imposition in 2005 of a Securities and Exchange Commission requirement for certain hedge funds to register as advisers and file adviser disclosure forms (Form ADV). While the requirement was overturned by U.S. Circuit Court of Appeals for the District of Columbia Circuit, legislation to require registration of hedge funds is a near certainty given the role unregulated financial entities played in today's financial crisis.
The second study, released on March 24 by the Government Accountability Office, is unambiguously titled "Conflicts of Interest Can Affect Defined Benefit and Defined Contribution Plans."
The study examined disclosed and undisclosed conflicts of interests detected in a 2005 SEC examination of 24 registered pension plan consultants. During the examination, the SEC found that 13 of the pension consultants failed to disclose significant conflicts of interest on their Form ADV filings adequately.
The GAO report zeroed in on the undisclosed conflicts in an effort to quantify the likely effect of those conflicts on investment performance. The analysis found statistically significant underperformance by plans associated with those consultants who failed to disclose their conflicts of interest adequately.
In fact, during the study period, 2000 to 2004, the average return of those plans was 1.2 to 1.3 percentage points less than the returns of plans using consultants who provided full disclosure.
Fiduciaries are expected to select and monitor service providers prudently so as not to incur unnecessary expenses, squander returns or assume unnecessary risks.
While the findings of these two studies are specific to disclosed and undisclosed conflicts of hedge funds and pension consultants, logic suggests that we can generalize the results to draw at least four conclusions regarding how responsible fiduciaries should handle conflicts of interest.
• It is preferable to avoid conflicts of interest rather than simply to disclose and manage them. As the academic study of disclosed hedge funds conflicts demonstrated, the existence of conflicts creates operational risks, which raise the probability of losses.
• When conflicts are permitted to exist, anything less than full disclosure is unacceptable. The GAO analysis of pension consultant conflicts revealed significant underperformance associated with inadequate disclosure.
• Verification of conflict disclosures, either by regulators or independent auditors, is essential to assure the veracity and thoroughness of the information provided.
• Finally, a self-regulatory organization should not be charged with the regulation of advisers. That's because self-regulation is by definition conflicted. In effect, self-regulation of fiduciaries is an oxymoron. Instead, there should be an independent regulator focused on investor protection and equipped with the resources necessary to oversee and enforce adherence to the fiduciary standard of care.
Blaine F. Aikin is president and chief executive of Fiduciary360 LP in Sewickley, Pa.
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