Essentially, a fiduciary is a person or organization that owes to another the duties of good faith and trust. The highest legal duty of one party to another, it also involves being bound ethically to act in the other’s best interests. A fiduciary might be responsible for general well-being, but often it involves finances — managing the assets of another person, or of a group of people, for example. Money managers, financial advisers, bankers, accountants, executors, board members, and corporate officers can all be considered fiduciaries.
Financial professionals held to the fiduciary standard are required to educate their clients, to be transparent about how they are being compensated, and to provide full and clear disclosure of the cost of their services.
Types of Fiduciary Relationships
Fiduciary duties appear in a wide variety of common business relationships. The most common types of fiduciary relationships are between a trustee and a beneficiary.
Other types of relationships where fiduciary duties are involved include:
– Corporate board members and shareholders
– Executors and legatees
– Guardians and wards
– Promoters and stock subscribers
– Lawyers and clients
– Investment corporations and investors
– Trustee / Beneficiary
Estate arrangements and implemented trusts involve a trustee and a beneficiary. An individual named as a trust or estate trustee is the fiduciary, and the beneficiary is the principal. Under a trustee / beneficiary duty, the fiduciary has legal ownership of the property or assets and holds the power necessary to handle assets held in the name of the trust. However, the trustee must make decisions that are in the best interest of the beneficiary as the latter holds equitable title to the property. The trustee / beneficiary relationship is an important aspect of comprehensive estate planning, and special care should be taken to determine who is designated as trustee.
Politicians often set up blind trusts in order to avoid conflict of interest scandals. A blind trust is relationship in which a trustee is in charge of the investment of a beneficiary’s corpus without the beneficiary knowing how the corpus is being invested. Even while the beneficiary has no knowledge, the trustee has a fiduciary duty to invest the corpus according to the prudent person standard of conduct.
Board Member / Shareholder
A similar fiduciary duty can be held by corporate directors, seeing as they can be considered trustees for stockholders if on the board of a corporation, or trustees of depositors if service as director of a bank.
Executor / Legatee
Fiduciary activities can also apply to specific or one-time transactions. For example, a fiduciary deed is used to transfer property rights in a sale when a fiduciary must act as an executor of the sale on behalf of the property owner. A fiduciary deed is useful when a property owner wishes to sell but is unable to handle his affairs due to illness, incompetence or other circumstances, and needs someone to act in his stead. A fiduciary is required by law to disclose to the potential buyer the true condition of the property being sold, and he cannot receive any financial benefits from the sale. A fiduciary deed is also useful when the property owner is deceased and his property is part of an estate that needs oversight or management.
Guardian / Ward
Under a guardian / ward relationship, legal guardianship of a minor is transferred to an appointed adult. The guardian, as the fiduciary, is tasked with ensuring the minor child or ward has appropriate care, which can include deciding where the minor attends school, that he has suitable medical care, that he is disciplined in a reasonable manner and that his daily welfare remains intact. A guardian is appointed by the state court when the natural guardian of a minor child is not able to care for the child any longer. In most states, a guardian / ward relationship remains intact until the minor child reaches the age of majority.
Attorney / Client
The attorney / client fiduciary relationship is arguably one of the most stringent. The U.S. Supreme Court states that the highest level of trust and confidence must exist between an attorney and his client and that an attorney, as fiduciary, must act in complete fairness, loyalty and fidelity in each representation of and dealing with clients. Attorneys are held liable for breaches of their fiduciary duties by the client and are accountable to the court in which that client is represented when a breach occurs.
Principal / Agent
A more generic example of fiduciary duty lies in the principal / agent relationship. Any individual person, corporation, partnership or government agency can act as a principal or agent as long as the person or business has the legal capacity to do so. Under a principal / agent duty, an agent is legally appointed to act on behalf of the principal without conflict of interest. A common example of a principal / agent relationship that implies fiduciary duty is a group of shareholders as principals electing management or C-suite individuals to act as agents. Similarly, investors act as principals when selecting investment fund managers as agents to manage assets.
While it may seem as if an investment fiduciary would be a financial professional (money manager, banker, etc.), an investment fiduciary is any person who has the legal responsibility for managing somebody else’s money. That means if you volunteered to sit on investment committee of the board of your local charity or other organization, you have a fiduciary responsibility, too: You have been placed in a position of trust and there may be consequences for betrayal of that trust. Hiring a financial or investment expert does not relieve the committee members of all of their duties. They still have an obligation to prudently select and monitor the activities of the expert.
Investment advisors, who are usually fee-based, are bound to a fiduciary standard that was established as part of the Investment Advisors Act of 1940. They can be regulated by the SEC or state securities regulators. The act is pretty specific in defining what a fiduciary means, and it stipulates a duty of loyalty and care, which simply means that the advisor must put their client’s interests above their own. For example, the advisor cannot buy securities for his or her account prior to buying them for a client, and is prohibited from making trades that may result in higher commissions for the advisor or his or her investment firm.
It also means that the advisor must do his or her best to make sure investment advice is made using accurate and complete information, or basically, that the analysis is thorough and as accurate as possible. Avoiding conflicts of interest is important when acting as a fiduciary, and it means that an advisor must disclose any potential conflicts to placing the client’s interests ahead of the advisor’s. Additionally, the advisor needs to place trades under a best execution standard, meaning he or she must strive to trade securities with the best combination of low cost and efficient execution.
The Suitability Rule
Broker-dealers, who are often compensated by commission, generally only have to fulfill a suitability obligation, which is defined as making recommendations that are consistent with the best interests of the underlying customer. Broker-dealers are regulated by the Financial Industry Regulatory Authority (FINRA) under standards that require them to make suitable recommendations to their clients. Instead of having to place his or her interests below that of the client, the suitability standard only details that the broker-dealer has to reasonably believe that any recommendations made are suitable for clients, in terms of the client’s financial needs, objectives and unique circumstances. A key distinction in terms of loyalty is also important, in that a broker’s duty is to the broker-dealer he or she works for, not necessarily the client served.
Other descriptions of suitability include making sure transaction costs are not excessive or that are recommendation is not unsuitable for a client. Examples that may violate suitability include excessive trading, churning the account simply to generate more commissions or frequently switching account assets to generate transaction income for the broker-dealer. Also, the need to disclose potential conflicts of interest is not as strict a requirement for brokers; an investment only has to be suitable, it doesn’t necessarily have to be consistent with the individual investor’s objectives and profile.
The suitability standard can end up causing conflicts between a broker-dealer and client. The most obvious conflict has to do with compensation. Under a fiduciary standard, an investment advisor would be strictly prohibited from buying a mutual fund or other investment because it would garner him or her a higher fee or commission. Under the suitability requirement, this isn’t necessarily the case, because as long as the investment is suitable for the client, it can be purchased for the client. This can also incentivize brokers to sell their own products ahead of competing products that may be at a lower cost.
While the term suitability was the standard for transactional accounts or brokerage accounts previously, the new Department of Labor Fiduciary Rule has toughened things up for brokers. Now, anyone with retirement money under management, who makes recommendations or solicitations for an IRA or other tax-advantaged retirement account, is a fiduciary and must adhere to that standard. However, the new law does not apply to other sorts of accounts, including after-tax investment accounts that may be earmarked as retirement saving
If you make an appointment with a financial consultant on behalf of yourself, your family or your company, make the following inquiry before the meeting ends:
“Are you held to a suitability standard or a fiduciary standard?”
This distinction is very important. You should be aware of the difference.
What is a suitability standard? Investment brokers are frequently asked to abide by suitability standards: when they recommend a financial product to a client, they are ethically bound to recommend a product which is suitable for that client.
Fiduciary Risks and Insurance
The possibility of a trustee / agent who is not optimally performing in the beneficiary’s best interests is referred to as fiduciary risk. This does not necessarily mean that the trustee is using the beneficiary’s resources for his/her own benefit; this could be the risk that the trustee is not achieving the best value for the beneficiary. For example, a situation where a fund manager (agent) is making more trades than necessary for a client’s portfolio is a source of fiduciary risk, because the fund manager is slowly eroding the client’s gains by incurring higher transaction costs than are needed.
In contrast, a situation in which an individual or entity who is legally appointed to manage another party’s assets uses his or her power to benefit financially, or serve his or her self-interest in some other way, in an unethical or illegal fashion is called fiduciary abuse or fiduciary fraud.
A business can insure the individuals who act as fiduciaries of a qualified retirement plan, such as the company’s directors, officers, employees and other natural person trustees. Meant to fill in the gaps existing in traditional coverage offered through employee benefits liability or directors and officers policies, fiduciary liability insurance provides financial protection when the need for litigation arises — due to scenarios such as purported mismanaging funds or investments, administrative errors or delays in transfers or distributions, a change or reduction in benefits, or erroneous advice surrounding investment allocation within the plan.
Investment Fiduciary Guidelines
In response to the need for guidance for fiduciaries, the nonprofit Foundation for Fiduciary Studies was established to define the following prudent investment practices:
In addition to performance reviews, fiduciaries must review expenses incurred in the implementation of the process. Fiduciaries are not only responsible for how funds are invested, but they are also responsible for how funds are spent. Investment fees have a direct impact on performance and fiduciaries must ensure that fees paid for investment management are fair and reasonable.
Fiduciary Rules and Regulations
The Department of the Treasury’s agency the Office of the Comptroller of the Currency is in charge of regulating federal savings associations and their fiduciary activities. Multiple fiduciary duties may at times be at conflict with one another, a problem that often occurs with real estate agents and lawyers. Two opposing interests can at best be balanced; however, balancing interests is not the same as serving the best interest of a client.
Fiduciary certifications are distributed at the state level and can be revoked by the courts if a person is found to neglect his or her duties. To become certified, a fiduciary is required to pass an examination that tests his or her knowledge of laws, practices, and security related procedures such as background checks and screening.
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