What’s a Fiduciary?
Key Points:
“Fiduciary” is a term used to describe a relationship in which one person or organization (an agent) acts entirely in the best interests of another person or organization (a principal)
Legislation spanning 70+ years has contributed to the desirability of fiduciary status among financial advisors
There are many different types of relationships which impart fiduciary responsibility on one party, including attorney/client, guardian/ward, and board members/shareholders
Because of the trust and responsibility placed in the hands of fiduciaries, the penalties for violating the terms of the relationship are often very harsh
In the broadest possible terms, a fiduciary is a person or organization entrusted with the responsibility to act entirely in the best interests of another person or organization. “Fiduciary” is often used as a noun — e.g.: Many financial advisors act as fiduciaries — but it originated as an adjective to describe this trusting, conflict-of-interest-free relationship: Fiduciary responsibility.
There are many different types of relationships in which one person (the agent) is tapped to act wholly in the best interests of another person (the principal). The most common instance of fiduciary bonds come between trustees and beneficiaries, in which trustees are legally and ethically required to act in the best interests of the beneficiaries. Also, lawyers have fiduciary responsibilities to their clients; corporate boards have fiduciary responsibilities to their shareholders; executors have fiduciary responsibilities to their legatees; among many others.
The fiduciary responsibility encompasses two overarching duties: the duty of loyalty, and the duty of care. The duty of loyalty means that the agent will act entirely in the principal’s best interests, never putting their own interests first. The duty of care means that the fiduciary will follow through on their responsibilities to the greatest extent possible, never leaving a job incomplete or a big decision only half-examined.
As it relates to financial advisors, the Investment Advisers Act of 1940, a Federal law, first established the parameters of financial advisors’ fiduciary responsibilities. This act, designed to shield consumers from improper or fraudulent investment advice, was the genesis of the duty of loyalty and duty of care principles, and set a precedent for the evolving role of fiduciaries in financial advising. Subsequent rules — most notably the 2016 Fiduciary Rule introduced by the U.S. Department of Labor (DOL) — have made the fiduciary designation more prominent and desirable among financial advisors.
Not all who advise on financial matters are fiduciaries. Broker-dealers, whose fees often depend at least in part on commissions from investments and product sales, are held to the less rigorous suitability standard. Unlike the fiduciary standard, which stipulates that financial advisors act wholly in their clients’ best interests, 100% of the time, the suitability standard merely stipulates that financial guidance reasonably be deemed “suitable” for clients. This leaves room for conflicts of interest between broker-dealers and their clients. Many clients don’t recognize this. A study conducted by digital wealth manager Personal Capital found that almost 50% of Americans erroneously believed that all who advise on financial matters are legally required to do so exclusively in clients’ best interests.
Indeed, not all who need financial advice need the services of fiduciaries. For limited transactions, like help with making trades, a fiduciary is not necessary. Those who benefit from the duties of loyalty and care offered by fiduciaries are those with more complex financial situations who need assistance in many areas. This often includes investment advice, but reaches much farther, encompassing areas like estate, planning, tax planning, retirement planning, behavioral coaching, and more.
History of the Fiduciary Designation
Depression-Era Fiduciary Legislation
The aforementioned Investment Advisers Act of 1940 was among the many regulatory laws enacted in the wake of the Great Depression. It followed the Securities Act of 1933, which was designed to increase transparency in the administering of financial statements. In 1935, the Securities and Exchange Commission (SEC) brought a report to Congress which illustrated the danger intrinsic to unregulated, unsupervised investment counselors. Shortly thereafter, Congress passed the Public Utility Holding Act of 1935, which permitted the SEC to oversee and inspect investment trusts.
Following the momentum of these acts and the national torpor out of which they arose, the Investment Advisers Act of 1940 aimed to reduce the incidence of fraudulent or misleading investment advice. Among the act’s provisions were:
What constitutes a financial advisor. This includes criteria like the type of advice an individual offers, their method of compensation, and the portion of their income which derives from investment advice. People whose behavior or advertising causes consumers to believe that they are financial advisors may be treated as such.
When financial advisors must register with the SEC. As soon as their assets under management cross the $25 million threshold, they must register with the SEC. These requirements were later adjusted by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which required previously exempted private equity funds and hedge funds to register with the SEC as well.
21st Century Fiduciary Rule
Following a public statement by President Barack Obama calling on the DOL to step up regulations on retirement advisors, in 2016, the DOL introduced the Fiduciary Rule, aiming to expand the types of advisors who could be held to the fiduciary standard. Where before the fiduciary standard applied only to individuals with ongoing advisory relationships with their clients, the new rule would require anybody making recommendations of a financial nature to avoid and/or disclose any and all potential conflicts of interest.
The DOL initially intended for the rule to go into effect on April 10, 2017, and for it to be phased in between then and January 1, 2018. But the rollout was stymied by an array of lawmakers, asset managers, and private citizens, all of whom sought to delay the compliance deadline. The DOL would receive in excess of 178,000 letters that opposed the delay, but as the Obama administration gave way to the Trump administration, this groundswell of support would hold no sway.
In February 2017, just before the fiduciary rule was scheduled to go into effect, the Trump administration issued a memorandum calling for a six-month delay in which the rule would be reassessed for legal and economic impact. This delay was initially successful in pushing back the full implementation of the rule to July 2019. But later, as the Fifth Circuit Court of Appeals in New Orleans vacated the fiduciary rule, the fiduciary rule was effectively dead.
However, despite the government’s failure to enact legislation holding all financial professionals to the fiduciary standard, the rule still had tremendous impact. The term “fiduciary” assumed a prominent role in many more people’s financial vocabularies. People saw the reduced risk and higher upside in advisors who acted completely in their best interests, and fiduciary status became a highly desirable trait in financial advisors.
Common Types of Fiduciary Relationships
While fiduciary status has become a commonly held and widely desired trait among financial advisors, there are many other types of relationships that are guided by fiduciary responsibility. These include:
Guardian/Ward. Upon the death of a parent, legal guardianship of a minor child or other ward is transferred to a pre-selected adult, or, if no one has been chosen, to a court-appointed adult. The fiduciary relationship requires legal guardians to ensure that their wards have optimal medical care, education, discipline, welfare, and more.
Executor/Legatee. Particularly in cases of property sales, where the seller is unable to execute the sale due to illness or other incapacitation, the sale’s executor has a fiduciary responsibility to the legatee to ensure that the sale is fair, that the information presented is accurate, and cannot receive any financial benefits from the sale.
Board Members/Shareholders. The members of a company’s board have a fiduciary responsibility to ensure that all decisions impacting the company are made entirely in the company’s (and by extension, the shareholders’) best interest. This means all possible options must be exhaustively examined and that the company’s interests always exceed the individual board member’s personal interests.
Attorney/Client. This is considered to be among the strictest examples of the fiduciary responsibility. Clients place an enormous amount of trust in their attorneys, and the attorneys resultantly must act with total fidelity, loyalty, and fairness on their clients’ behalves.
Breach of Fiduciary Responsibility
The consequences of an individual acting in a way that violates the terms of their fiduciary role — benefiting financially from an investment or other sale, neglecting a minor’s medical care, or insufficiently defending a client in a legal battle, to name a few — vary depending on the violation and violator. An onus falls on the principal to demonstrate actual loss that occurred as a result of the agent’s breaching either the duty of loyalty or the duty of care. If they can do so, the penalties can be steep; lawyers can be disbarred, financial advisors can be held financially and civically liable, board members can be dismissed. The fiduciary responsibility is integral to the function of human relationships, and so violating it is treated harshly.