“Prudence” seems like an old-fashioned word with a stodgy connotation, but for fiduciaries, it is a timeless concept with significant implications.
Too often, investment advisers view prudence simply as an obligation to be competent and careful in their conduct. But there is much more to the concept than that. Advisers must be prudent not only in their personal conduct but in virtually all of the investment management processes they employ.
In a November 2006 paper, “The Regulation of Investment Advisers by the Securities and Exchange Commission,” Robert E. Plaze, associate director of the SEC's Division of Investment Management, wrote: “The [fiduciary] duty is not specifically set forth in the [Investment Advisers Act of 1940], established by SEC rules or a result of a contract between the adviser and the client (and thus it cannot be negotiated away). Rather, a fiduciary duty is imposed on an adviser by operation of law because of the nature of the relationship between the two parties.”
And what exactly is the nature of the relationship between advisers and clients? I would characterize any fiduciary relationship as principles-based and process-driven. Principles define attributes of trustworthy conduct required of those who, as fiduciaries, occupy positions of extraordinary control or influence over resources for the benefit of others. They include the obligations to place clients' best interests first, act with prudence, provide full and fair disclosure of all material facts, avoid conflicts when possible and manage unavoidable conflicts for the benefit of clients.
PRINCIPLES AND PROCESSES
Processes are sets of management practices that advisers use to do their job. Principles and processes must align. Processes that result in violations of any of the principles that define fiduciary conduct cannot be prudent. In other words, the primary determinant of whether a process is prudent hinges upon whether the process conforms to core fiduciary principles.
For investment advisers, prudent processes generally are required on three levels: management of the adviser's practice, management of clients' investment portfolios and management of securities decisions.
At the practice-management level, the adviser establishes the forms of compensation that will be accepted; sets conflict-of-interest policies; forms service partner relationships and referral arrangements; adopts investment philosophies, strategies and tactics that will be employed; determines what types of products and services will be offered; and puts in place other policies and procedures to guide the way business activities will be conducted.
By critically evaluating an adviser's business practices, a prospective client may gain a strong sense as to whether fiduciary principles are deeply ingrained in the adviser's business model (even if he or she is not able to identify investor-friendly business practices with fiduciary principles). An experienced regulator will recognize business practices that are particularly susceptible to fiduciary breaches, and will target these areas for closer scrutiny.
The portfolio-management-level processes are addressed extensively in legislation governing the management of institutional funds, and these same concepts apply to non-institutional portfolios as well. Fiduciaries are obliged to manage portfolios according to generally accepted investment theories. These obligations include employing objective processes to take into account investor characteristics (expected cash flows, risk tolerance, return requirements, etc.), establish and maintain adequate diversification, control and account for expenses, and monitor portfolio and service provider performance, among other things.
Finally, the securities management processes of advisers must be designed to produce recommendations that are suitable for their clients' specific circumstances and are reasonable based upon the investment merits of the product itself.
In particular, the due diligence of a fiduciary must include comparisons to like alternatives in the marketplace with respect to such factors as risk, return, cost and manager qualities.
Moreover, security management processes must address whether each product recommendation conforms to the fiduciary principles as is true for the processes of portfolio and practice management.
Advisers should periodically review their investment management processes at all three levels to make sure the processes are, in fact, prudent.
Blaine F. Aikin is chief executive of Fiduciary360 LLC.
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