ANSWERS TO QUESTIONS
1. A fiduciary is a person or institution that manages money and/or business
affairs for another person or institution. A fiduciary has discretion in
management rather than just being an order taker.
2. Harvard College v. Amory is the origin of modern fiduciary standards. This
court case was the first legal statement regarding proper trustee investment
choices.
3. a. The prudent man rule states that a fiduciary should not speculate.
b. The rule does not define speculation.
4. a. The court dismissed the contention that the fact that an investment portfolio
appreciated in value is a defense against imprudent investment management.
b. The court also ruled that each portfolio component must be judged on the
extent to which it contributes to overall portfolio characteristics and the
resulting likelihood that the portfolio will serve the beneficiary well.
5. One the one hand, the Spitzer case requires that each portfolio component be
scrutinized. This raises the possibility that someone could focus on one
particular losing position and argue that it was an imprudent investment choice.
On the other hand, the Spitzer case recognizes that portfolio components are
part of a portfolio and that the prudence of a component ultimately depends on
the portfolio in which it is placed. This implies that portfolio focus is
important.
6. The prudent expert standard states that the standard of performance is not an
ordinary person (who may be unfamiliar with modern portfolio management);
rather, it is a person familiar with such matters and acting in a like capacity for
a similar institution with a similar investment policy. The standard essentially
says that we need to see what the experts are doing before making a judgement
about the prudence of some course of action.
7. See Table 20-1.
8. Reasonable care and undivided loyalty.
9. The documents rule requires the portfolio manager to handle investments in
accordance with the documents that govern the pension plan unless the
documents contain a provision that violates the duties of care or loyalty,
ERISA, or state law fiduciary rules.
The indicia of ownership rule requires that documents relating to asset
ownership must be under the jurisdiction of the U.S. court system. This is to
ensure that legal disputes can be settled in U.S. courts.
10. The manager must obey ERISA and other laws ahead of the plan provisions.
11. Under ERISA a party in interest is a person or organization who has some
relationship to a pension plan.
12. A manager may pay more than the minimum in commissions if the manager
gets value in return. This value might come from better order execution or
from research material.
13. Due diligence is an imprecise standard of “prudent behavior” in a particular
circumstance.
14. The manager should take the fund’s wishes into account when making
investment decisions and honor them when doing so would not reduce the
likelihood that the fund will achieve its objectives.
15. Just voting proxies is not enough; you must vote them in the beneficiary’s best
interest.
16. CERES stands for the Coalition for Environmentally Responsible Economies.
The CERES principles endorse various measures to protect the environment,
including waste disposal standards, energy conservation, protection of the
biosphere, etc.
17. Suppose there are 1 million shares of stock outstanding and that there are four
open board seats. Management re-nominates each of the directors whose term
is expiring for another term. A labor group proposes a fifth candidate; union
members collectively own 20% of the outstanding shares. With noncumulative voting, the labor group candidate would need a positive vote from
25% of the shares to be elected. Getting 5% of the non-union shares to vote
against management’s recommendation is nowhere near a sure thing.
With cumulative voting things would be easier. Owning 200,000 shares and
with 4 directors to be elected, the union will cast 800,000 votes. The other
shares outstanding will cast 800,000 x 4 = 3,200,000 votes. If the outstanding
shares spread their votes equally each of the four nominees would get 800,000
votes; presumably the union candidate would also get 800,000. This means if
any other shareholder voted against management the labor group would be
certain of electing their person.
18. a.
b.
c.
d.
vote in person at the annual meeting
return the paper proxy
vote over the Internet
vote via a touchtone telephone
19. A soft dollar arrangement is one in which products or services other than
execution of securities transactions are obtained by an advisor from or through
a broker-dealer in exchange for the direction of trades to the broker-dealer.
20. a. Research reports
b. News
c. Pricing services
21. Student response
22. Student response
23. CFA Guideline Answer (reprinted with permission from the CFA Study Guide,
Association for Investment Management and Research, Charlottesville, VA.
All Rights Reserved.
A. (i) “A decision in invest in a company entails a responsibility to vote
proxies.”
Validity. This statement is true as far as it goes, but it does not go far
enough.
Plan fiduciaries cannot be passive shareholders. Proxy voting rights are
considered assets of a pension plan, and as such, proxy voting involves the
exercise of fiduciary responsibility under ERISA. Votes must be cast in a
way that the fiduciary believes will maximize the economic value of plan
holdings. The fiduciary has a duty to make investment decisions solely in
the interest of participants and beneficiaries and exclusively to provide
benefits to the participants and beneficiaries.
Primary Fiduciary Duties Concerning Proxy Voting
1. Examine underlying issues. Voting requires a thorough examination
of the underlying issues, and those who do the voting must be qualified
to make informed decisions. The plan document should state who has
the authority and responsibility to vote proxies.
2. Keep adequate records. Adequate record keeping tasks must be
performed, including keeping a record of stock held, reconciling
proxies received with stock held on the record date, tracing missing
proxies, and keeping a record of how and why proxies were voted.
3. Designate an individual or group to recommend and implement
proxy voting policy. The investment firm should designate a policymaking body or an individual from within its ranks to recommend
proxy policy and monitor implementation.
4. Identify proxy issues by accounts. Major proxy issues should be
identified by particular accounts and preferences of beneficiaries,
participants, or individuals for whom the funds are held should be
noted.
5. Establish a review process for controversial or unusual proposals.
The investment firm should set specific guidelines and put in place a
regular review process.
6. Train staff. The firm’s staff should be educated and trained on proxy
voting policies and guidelines.
Secondary Fiduciary Duties Concerning Proxy Voting
1. Initiate and/or cosiqn shareholder proposals. The fiduciary should
discuss the issues with those who do the voting and decide whether
additional action is necessary; that is, to initiate and/or cosign
shareholder proposals.
2. Evaluate corporate performance. The fiduciary should consider
applying to proxy decisions internal financial ratios or other criteria for
evaluating corporate performance. Evaluate proxy proposals against the
history and productivity of current management and the conceptual
reasons for or against the proposal.
3. Provide a process for antimanagement votes. The fiduciary should
provide a process for deciding whether a vote against management
should be preceded (or followed) by a letter, telephone call, in-person
discussion with corporate personnel, and/or action to be taken with other
concerned firms and organizations.
4. Decide exclusions from voting. The fiduciary should decide under
what conditions those who hold a concentration of stock in their names
of have other vested interests in the corporations in which stock is held
should not participate in voting.
5. Report to clients. The fiduciary should decide how and when to report
positions taken during the proxy season to clients and sponsors.
6. Monitor delegation of responsibility. The fiduciary should develop a
system to monitor any delegation of responsibility to others.
7. Monitor custodian. The fiduciary should provide for monitoring
performance of the custodian or its agent to ensure timely receipt of
proxies.
8. Avoid or minimize conflicts of interest. The fiduciary should avoid or
minimize conflicts of interest and, when possible, consider instituting
“Chinese Wall” techniques to proxy voting.
(ii) “You have breached your fiduciary duty as a manager if you have
caused an account under your control to ‘pay up’ (i.e., pay a brokerage
commission larger than that charged for a trade done on a ‘best
execution’ basis) on a transaction for the account.”
Validity. This statement is false.
An investment manager can “pay up” in brokerage commissions if the
commissions are reasonable relative to the value of the brokerage and
research services received. Further, the investment manager can make this
determination, assuming it is done in good faith. An excessive payment,
however, could violate the fiduciary rule of prudence and give rise to the
charge that the services represented by the excess fees were wrongfully
appropriated client assets and diverted to the fiduciary’s own benefit.
Brokerage commissions are considered a plan asset. Fiduciaries are
forbidden from using assets of their clients or a plan’s participants and
beneficiaries for their own benefit based on ERISA’s “exclusive benefit”
requirement.
1. Show that services add value to the decision-making process. The
full range and quality of a broker’s services must be considered in
addition to commission rate. For example, important factors are
execution capability, quality of research, and responsiveness to the
investment manager. The key is that the investment manager must
show that the services received
commensurate with their cost.
had
decision-making
value
The critical element distinguishing legal from illegal behavior is the
nature of research, defined in a 1986 Interpretive Release of the SEC as
“information which provides lawful and appropriate assistance to a
money manager in the performance of his investment decision-making
responsibilities.”
One authority states that the law is ambiguous about the status of the
payment of soft dollars: “Given adequate disclosure and a good faith
effort to allocate payments to research functions, paying for brokerage
and research services with soft dollars is a legitimate prerogative of the
money manager.”
2. Disclose brokerage commission allocation policies and commissions
paid. Full disclosure of brokerage commission allocation policies and
actual commissions paid, plus client consent, would serve to lessen
conflict-of-interest situations.
3. Maintain records. The manager must keep accurate and detailed
records of transactions involving soft dollars.
B. “Social investing is inconsistent with the requirements of ERISA.”
Validity. Although this statement is neither true nor false on its face
value, it is closer to the truth than not. The appropriateness or legitimacy
of social responsibility criteria for a pension fund is questionable in a
fiduciary context. Although ERISA has no definitive statement on social
investment, nothing in ERISA suggests using pension assets for anything
other than financial goals.
Arguments Favoring the Statement
1. ERISA’s exclusive benefit statement. Opponents of social investment
feel it leads to violating ERISA’s fiduciary responsibility and prohibited
transaction rules, and compromises the safety, return, and marketability
of a plan’s portfolio. According, social investing could create problems
under ERISA’s prudence and diversification requirements.
2. ERISA’s diversification requirement. Factors to be considered in
meeting prudence and diversification requirements do not include social
goals. The fiduciary may not deviate from ERISA’s diversification
requirement, which requires diversification of pension assets across
asset classes and across securities within asset classes to minimize the
risk of loss.
3. ERISA’s requirement that pension assets must be used only for financial
goals. Any plan excluding investment possibilities for social purposes
without considering their economic and financial merit may be showing
insufficient care for and disloyalty to individuals covered by the plan.
To concentrate a plan’s assets to serve an “excluded purpose” conveys
some sense of imprudence.
Although not a significant factor, empirical studies show the market
does not price social responsibility characteristics. That is, social
responsibility factors do not affect expected stock returns. If social
investing does not have an economic effect on the Fund, it seems to go
beyond the scope of the fiduciary relationship defined by ERISA and,
therefore, appears to be an improper exercise of fiduciary
responsibilities.
Arguments Against the Statement
1. Favorable effect on earnings. A possible rationale for fiduciaryacceptable social investing is that the public view of a company’s social
commitment (or a company’s labor relations, for example) may
favorably affect a firm’s profitability. This effect may favor investing
in a particular “socially responsible” company compared with
alternative investments available to the plan.
2. Safety in numbers. Another rationale, upheld by some courts, is that
the chief test of prudence is whether other trustees commonly hold an
investment. For example, trust funds and institutional investors may
hold the investment. This is the safety-in-numbers argument.
3. No adverse court rulings. Although some pension plans may engage
in social investing, they may be challenged under ERISA because
social investing may not be solely in the interest of plan participants.
To date, no court has found that an investment manager breached his
fiduciary duty by investing based on social responsibility.
4. Comparable returns. Empirical studies are somewhat ambiguous in
terms of addressing this specific question and are inconclusive about
whether socially responsible investments provide real benefit to the
participants or involve any sacrifice of portfolio returns.
The Standards of Practice Handbook states that social investing might
be permissible assuming “the investment manager ensures that such
investments do not impair the integrity of the funds in question or the
financial security of the participants.”
C. “Adverse investment outcomes may trigger inquiry into a fiduciary’s
conduct and may influence a court’s judgment as to prudence and the
extent of any liability. Nevertheless, ERISA’s ‘Prudent Expert Rule’ is
more properly termed a rule of conduct a rule of investment performance.”
Validity. This statement is true.
1. Courts have based findings of imprudence less on the type of
investment at issue than on the fiduciary’s failure to undertake a
thorough and diligent analysis of an investment’s merits that may
have revealed the unsuitability of that investment or the existence of
alternative investments offering a more favorable risk/return tradeoff. The emphasis is on competence and process, not on the
resulting investment performance. For example, did the investment
manager consistently follow a set of well-reasoned investment
policies?
2. A loss on an investment would not be considered imprudent by
itself, nor would a gain on an investment guarantee a finding of
prudence.
Components of the Rule
ERISA’s prudence standard, known as the Prudent Expert Rule, requires a
pension fiduciary to
 Exercise the care, skill and diligence under circumstances then
prevailing,
 That a man in similar capacity, and
 Familiar with such matters would use
 In the conduct of an enterprise of a like character with similar aims.
D. “An investment manager’s responsibilities with respect to ERISA’s
requirements take precedence over the plan documents and objectives in
case of a conflict between these and the ERISA requirements.”
Validity. This statement is true.
Explanation of the conclusion. A plan must be administered according to
the documents governing the plan. Yet, plan documents are to be followed
only to the extent that they are consistent with ERISA requirements. An
ERISA fiduciary must not comply with investment provisions or a plan
document that contravenes the statutory standards under ERISA. ERISA
places on the fiduciary the additional burden of investigating whether the
plan instrument and investment objects are permissible under ERISA.
The Standards of Practice Handbook states, “When developing investment
objectives for an account, one should include an understanding of fiduciary
duties and identify the individual or body to whom such responsibility is
owed.”
The safest way to avoid liability is to develop reasonable and appropriate
investment policies and objectives according to ERISA followed by the
development of a rational investment approach to achieve these objectives.
If the beneficiaries of a closely held plan request that their investment
manager invest all the plan assets in a single security, the individual
manager could not do so under ERISA. This action violates the
diversification rule and the level of diversification implied by the
requirement for prudence. This requirement is contrary to trust law of
many jurisdictions, primarily state and provincial, which allows the
fiduciary to follow the express directives contained in plan instruments
without fear of liability.