Chapter 20
Fiduciary Duties
and Responsibilities
1
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
2
Outline
 Introduction
 History
 Fiduciary
duties
 Emerging areas
3
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
4
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
6
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
8
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
9
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
10
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
11
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
12
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
13
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
14
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
15
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
16
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
17
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
18
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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21
Fiduciary Duties
 ERISA
 Care
 Loyalty
 Prohibited
transactions
22
ERISA
 ERISA:
• Deals with the management of pension funds
• Has influence throughout the investment
community
• Outlines two primary fiduciary duties:
– Reasonable care
– Undivided loyalty
23
Care
 Prudent
expert
 Diversification rule
 Documents rule
 Indicia of ownership rule
24
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
25
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
26
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
27
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
28
Loyalty
 Sole
interest of beneficiary rule
 Exclusive purpose rule
29
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
30
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
31
Prohibited Transactions
 Specific
transaction restrictions
 General transaction restrictions
 Fiduciary conduct restrictions
 Property restrictions
32
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
33
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
34
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 kickbacks
35
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
36
Emerging Areas
 Due
diligence
 Social investing
 Proxy voting
 Soft dollars
37
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
38
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
39
Proxy Voting
 Definition
 Proxy
voting and the law
 Establishing a proxy voting policy
 Mechanics of voting
40
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
41
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
44
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
45
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
46
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
48
Soft Dollars
 SEC
report
 Soft dollars and research
 Soft dollars and nonresearch acquisitions
 SEC recommendations for soft dollar
arrangements
49
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
50
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
51
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
52
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
53
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
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