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Chapter 20

Fiduciary Duties and Responsibilities

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The scientific advances provided by modern portfolio theory, together with the evolving prudent expert standard, virtually

require that fiduciaries base their investment actions on a total portfolio approach. Although the legal establishment has been

regrettably slow to provide leadership in this direction, investment managers and other fiduciaries must recognize and

apply these theoretical advances, particularly in drafting investment policy statements and considering the asset classes to

be included in a potential asset mix. No particular asset or strategy should be per se excluded from consideration.

- William G. Droms

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Outline Introduction History Fiduciary duties Emerging areas

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Introduction A fiduciary is a person or an institution

managing money and/or business affairs for another person or institution• E.g., a bank trust department, a private money

management firm, a stockbroker, a CPA, an attorney

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Introduction (cont’d) If a person has discretion in the

management of someone’s funds, he assumes a fiduciary duty• E.g., a stockbroker who merely executes a trade

is not acting in a fiduciary capacity

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History Introduction Prudent man rule The Spitzer case Prudent expert standard Uniform Management of Institutional

Funds Act Uniform Prudent Investor Act

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Introduction Fiduciary law is a developing field

• Legal precedent often evolves slowly

Portfolio managers may get frustrated when financial practice and legal requirements are inconsistent

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Prudent Man Rule The prudent man rule is the origin of

modern fiduciary duty• Developed in Harvard College v. Amory:

– Fiduciaries need to use good judgment and make long-term decisions for other people in a manner consistent with how reasonable people manage their own money

– Disapproves of “speculation,” but does not define it

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Prudent Man Rule (cont’d) 1889 New York bill limits trust investments

to government bonds and mortgage securities unless the trust documents specifically permit other investments• First instance of a legal list• Legal lists were widely accepted until the

1940s, when more flexibility started to be offered

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Prudent Man Rule (cont’d) Restatement (Second) on Trusts (1959):

• Speculation is the assumption of added risk in hope of higher returns rather than for principal preservation

– Appropriate for a man of intelligence

– Not appropriate for a trust investment

The Restatement complicated life for investment managers

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Prudent Man Rule (cont’d) AMEX standards for speculation:

• Speculation for one account may be sound investment in another, due to:

– Tax considerations

– Age of the beneficiary

– Duration of the trust

– Economic climate

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The Spitzer Case 1973 case Spitzer v. Bank of New York:

• Trust guardian Spitzer alleged imprudence on part of the bank in the administration of the trust

• Spitzer disputed four security trades resulting in a loss of $238,000 over four years

– The aggregate portfolio showed a gain of $1.7 million over the same period

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The Spitzer Case(cont’d) Case outcomes:

• The mere fact that the portfolio showed a reasonable rate of return is not a defense against imprudence

– Would provide manager immunity in an advancing market

– Gambling with a client’s account is fundamentally wrong

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The Spitzer Case(cont’d) Case outcomes (cont’d):

• Each portfolio component must be judged on the extent to which it contributes to the overall portfolio and the resulting likelihood that the portfolio will serve the beneficiary well

– Recognizes that securities are normally part of a portfolio

– Recognizes that the characteristics of the portfolio have some bearing on whether or not a particular asset is a good portfolio component

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The Spitzer Case(cont’d) Case outcomes (cont’d):

• Hindsight is an inappropriate perspective from which to judge to prudence of an investment decision

– It is important to consider whether there has been a proper diversification of investments

The Spitzer case led to a revision of the prudent man rule

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Prudent Expert Standard The prudent expert standard is from

Section 404 of the Employee Retirement Income Security Act (ERISA):• Passed because of concerns about private

pension plans and potential failure of large firms

• Established a national, uniform set of requirement for fiduciary conduct within pension funds

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Prudent Expert Standard (cont’d)

Section 404:• A pension fiduciary shall discharge his duties

with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims

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Uniform Management of Institutional Funds Act

The Uniform Management of Institutional Funds Act:• Was enacted by The National Conference of

Commissioners of Uniform Laws

• Recognizes the need for clarity and definitive guidelines in the management of charitable investment funds

– E.g., public foundations and endowments

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Uniform Management of Institutional Funds Act

The Uniform Management of Institutional Funds Act (cont’d):• Eliminates undue concern with individual

investment performance

• Concentrates on the performance of the aggregate portfolio

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Uniform Prudent Investor Act The Uniform Prudent Investor Act:

• Was enacted by The National Conference of Commissioners of Uniform Laws

• Is subject to state by state adoption• Formally embraces what business schools teach

in the classroom– Portfolio managers may handle fiduciary accounts

in accordance with current financial theory

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Fiduciary Duties ERISA Care Loyalty Prohibited transactions

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ERISA ERISA:

• Deals with the management of pension funds

• Has influence throughout the investment community

• Outlines two primary fiduciary duties:– Reasonable care– Undivided loyalty

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Care Prudent expert Diversification rule Documents rule Indicia of ownership rule

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Prudent Expert The ERISA manager must be familiar with

and practice modern investment methods• It is not enough to manage money the way

ordinary people do

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Diversification Rule The diversification rule requires that

pension plans be diversified:• Assets should be selected to reduce the risk of

the portfolio

There may be circumstances when diversification is not prudent:• Requires documentation and intentional action

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Documents Rule The documents rule:

• Requires that the investment manager handle the fund in accordance with the documents that govern the plan

• Does not apply if it violates the duties of care of loyalty

• May not violate ERISA or state law fiduciary rules

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Indicia of Ownership Rule The indicia of ownership rule requires that

documents relating to asset ownership must be under the jurisdiction of the U.S. court system• Foreign property falls under foreign

jurisprudence

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Loyalty Sole interest of beneficiary rule Exclusive purpose rule

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Sole Interest of Beneficiary Rule

The sole interest of the beneficiary rule:• Means that the customer’s best interest comes

ahead of the best interest of the fiduciary• Requires the fiduciary to defray reasonable

administration expenses of administering the plan

– Does not require the fiduciary to deal with the broker offering the lowest commission

– Does require the fiduciary paying more to obtain some additional value for the higher cost

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Exclusive Purpose Rule The exclusive purpose rule:

• Requires a fiduciary to do her job for the single task of providing benefits to the beneficiary

• Provides that the fund may be used to defray reasonable expenses that the fiduciary incurs in carrying out her duties

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Prohibited Transactions Specific transaction restrictions General transaction restrictions Fiduciary conduct restrictions Property restrictions

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Specific Transaction Restrictions

Specific transaction restrictions:• Preclude a fiduciary from making a trade

between the pension plan and a party of interest

– A party of interest is a person or organization who has some relationship to the pension plan

• Require security transaction to be arms-length trades, free of a conflict of interest

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General Transaction Restrictions

General transaction restrictions prohibit the transfer of any plan assets to a party of interest• E.g., the pension fund could not sell shares to a

beneficiary of the fund

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Fiduciary Conduct Restrictions Fiduciary conduct restrictions preclude a

fiduciary from using the plan assets for his own benefit• E.g., a fiduciary cannot direct trades to a

particular brokerage firm and receive kick-backs

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Property Restrictions ERISA limits pension fund investments to

“qualifying employer real property”• Property that is leased to the plan sponsor who

makes lease payments to the pension fund

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Emerging Areas Due diligence Social investing Proxy voting Soft dollars

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Due Diligence Fiduciaries need to exercise due diligence

in the conduct if their duties• Carefully consider investment decisions• Ensure that the information on which you base

your decisions is accurate• Conduct credit checks on employees handling

clients’ money• Make a reasonable effort to gather facts and

ensure their accuracy

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Social Investing The legal status of social investing

requirements is cloudy

A fiduciary should always listen to the wishes of the client and seek to satisfy them when prudent to do so

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Proxy Voting Definition Proxy voting and the law Establishing a proxy voting policy Mechanics of voting

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Definition Shareholders who are unable to attend the

annual meeting for any reason have the right of proxy voting

A proxy statement is a legal document allowing the shareholder to cast an absentee ballot

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Proxy Voting and the Law A fiduciary does not have the right not to

vote• The right to vote is an asset of the organization

and the investment manager breeches a fiduciary duty if he fails to exercise it

• The fiduciary who fails to vote chooses personal convenience over the interest of the beneficiary

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www.proxyvote.com

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Establishing A Proxy Voting Policy

Many money management firms have no clear policy on proxy voting

Obstacles to proxy voting cited by managers:• Lack of a clear policy and support from the

management of the investment firm• The perception that many proxies are routing

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Establishing A Proxy Voting Policy (cont’d) Obstacles to proxy voting cited by

investment managers (cont’d):• Uncertainty about voting responsibilities for

publicly managed funds• Overzealous management attempts to influence

owners• Increasing international investment• Delegation of voting authority• The proxy distribution system

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Establishing A Proxy Voting Policy (cont’d) Common shareholder proposals include:

• Cumulative voting– Makes it easier for an outsider to elect someone to

the corporate board of directors

• Endorsement of the CERES Principles– Protecting the environment

• Eliminating staggered terms for directors• Compensation limits for officers• Diversity and hiring practices

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Establishing A Proxy Voting Policy (cont’d) Voting proxies in the best interest of the

beneficiary is not the same as voting proxies in the best interest of the company• A committee should look at more complicated

issues and determine what makes the best sense for the beneficiary

• There should be a policy for corresponding with management prior to a decision to vote against their recommendation

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Mechanics of Voting Shares can be voted in four ways at an

annual meeting:• Attend the meeting and vote in person

– Inconvenient

• Fill out the paper proxy– Expensive

• Vote over the Internet• Vote via a touch-tone telephone

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Soft Dollars SEC report Soft dollars and research Soft dollars and nonresearch acquisitions SEC recommendations for soft dollar

arrangements

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SEC Report The SEC defines soft dollars as

• “arrangements under which products or services other than execution of securities transactions are obtained by an adviser from or through a broker-dealer in exchange for the direction by the adviser of client brokerage transactions to the broker-dealer”

The SEC requires investment advisers to disclose soft dollar arrangements to their clients

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Soft Dollars and Research The Securities Exchange Act of 1934

specifically allows an investment fiduciary to use soft dollars to acquire research services

Using soft dollars to pay for acquired research is an established practice in the brokerage industry

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Soft Dollars and Nonresearch Acquisitions

Using soft dollars to acquire assets or services other than research is potentially a violation of a fiduciary’s duties

Nonresearch uses of soft dollars that are abuses:• Paying the salary of an adviser’s research

employee• Paying for an adviser’s nonresearch

information technology purchases

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Soft Dollars & Nonresearch Acquisitions (cont’d)

Nonresearch uses of soft dollars that are abuses (cont’d):• Paying for travel, airfare, hotels, means, and

other expenses of a research consultant• Paying for research services provided by a

“consultant” operating out of the adviser’s office• Paying for an adviser’s office rent and

equipment, cellular phone service, and personal expenses

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SEC Recommendations for Soft Dollar Arrangements

Recommendations by the SEC’s Office of Compliance, Inspections and Examinations clarify acceptable practices

Fiduciaries should:• Be aware of the presence of soft dollars• Make a special effort to disclose their use to

beneficiaries