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  1. 1. Chapter 20 Fiduciary Duties and Responsibilities Portfolio Construction, Management, & Protection , 5e, Robert A. Strong Copyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.
  2. 2. <ul><li>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. </li></ul><ul><li>William G. Droms </li></ul>
  3. 3. Introduction <ul><li>A fiduciary is a person or an institution managing money and/or business affairs for another person or institution </li></ul><ul><ul><li>e.g., a bank trust department, a private money management firm, a stockbroker, a CPA, an attorney </li></ul></ul><ul><li>If a person has discretion in the management of someone’s funds, he assumes a fiduciary duty </li></ul><ul><ul><li>e.g., a stockbroker who merely executes a trade is not acting in a fiduciary capacity </li></ul></ul>
  4. 4. Fiduciary Law <ul><li>Developing field </li></ul><ul><ul><li>Legal precedent often evolves slowly </li></ul></ul><ul><li>Portfolio managers may get frustrated when financial practice and legal requirements are inconsistent </li></ul>
  5. 5. Prudent Man Rule <ul><li>The prudent man rule is the origin of modern fiduciary duty </li></ul><ul><ul><li>Developed in Harvard College v. Amory : </li></ul></ul><ul><ul><ul><li>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 </li></ul></ul></ul><ul><ul><ul><li>Disapproves of speculation , but does not define it </li></ul></ul></ul>
  6. 6. Prudent Man Rule (cont’d) <ul><li>1889 New York bill limits trust investments to government bonds and mortgage securities unless the trust documents specifically permit other investments </li></ul><ul><ul><li>First instance of a legal list </li></ul></ul><ul><ul><li>Legal lists were widely accepted until the 1940s, when more flexibility started to be offered </li></ul></ul>
  7. 7. Prudent Man Rule (cont’d) <ul><li>Restatement (Second) on Trusts (1959): </li></ul><ul><ul><li>Speculation is the assumption of added risk in hope of higher returns rather than for principal preservation </li></ul></ul><ul><ul><ul><li>Appropriate for a man of intelligence </li></ul></ul></ul><ul><ul><ul><li>Not appropriate for a trust investment </li></ul></ul></ul><ul><li>The Restatement complicated life for investment managers </li></ul>
  8. 8. Prudent Man Rule (cont’d) <ul><li>AMEX standards for speculation: </li></ul><ul><ul><li>Speculation for one account may be sound investment in another, due to: </li></ul></ul><ul><ul><ul><li>Tax considerations </li></ul></ul></ul><ul><ul><ul><li>Age of the beneficiary </li></ul></ul></ul><ul><ul><ul><li>Duration of the trust </li></ul></ul></ul><ul><ul><ul><li>Economic climate </li></ul></ul></ul>
  9. 9. The Spitzer Case <ul><li>1973 case Spitzer v. Bank of New York : </li></ul><ul><ul><li>Trust guardian Spitzer alleged imprudence on part of the bank in the administration of the trust </li></ul></ul><ul><ul><li>Spitzer disputed four security trades resulting in a loss of $238,000 over four years </li></ul></ul><ul><ul><ul><li>The aggregate portfolio showed a gain of $1.7 million over the same period </li></ul></ul></ul>
  10. 10. The Spitzer Case (cont’d) <ul><li>Case outcomes: </li></ul><ul><ul><li>The mere fact that the portfolio showed a reasonable rate of return is not a defense against imprudence </li></ul></ul><ul><ul><ul><li>Would provide manager immunity in an advancing market </li></ul></ul></ul><ul><ul><ul><li>Gambling with a client’s account is fundamentally wrong </li></ul></ul></ul>
  11. 11. The Spitzer Case (cont’d) <ul><li>Case outcomes (cont’d): </li></ul><ul><ul><li>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 </li></ul></ul><ul><ul><ul><li>Recognizes that securities are normally part of a portfolio </li></ul></ul></ul><ul><ul><ul><li>Recognizes that the characteristics of the portfolio have some bearing on whether or not a particular asset is a good portfolio component </li></ul></ul></ul>
  12. 12. The Spitzer Case (cont’d) <ul><li>Case outcomes (cont’d): </li></ul><ul><ul><li>Hindsight is an inappropriate perspective from which to judge the prudence of an investment decision </li></ul></ul><ul><ul><ul><li>It is important to consider whether there has been a proper diversification of investments </li></ul></ul></ul><ul><li>The Spitzer case led to a revision of the prudent man rule </li></ul>
  13. 13. Prudent Expert Standard <ul><li>The prudent expert standard is from Section 404 of the Employee Retirement Income Security Act ( ERISA ): </li></ul><ul><ul><li>Passed because of concerns about private pension plans and potential failure of large firms </li></ul></ul><ul><ul><li>Established a national, uniform set of requirements for fiduciary conduct within pension funds </li></ul></ul>
  14. 14. Prudent Expert Standard (cont’d) <ul><li>Section 404: </li></ul><ul><ul><li>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 </li></ul></ul>
  15. 15. Uniform Management of Institutional Funds Act <ul><li>The Uniform Management of Institutional Funds Act : </li></ul><ul><ul><li>Was enacted by The National Conference of Commissioners of Uniform Laws </li></ul></ul><ul><ul><li>Recognizes the need for clarity and definitive guidelines in the management of charitable investment funds </li></ul></ul><ul><ul><ul><li>e.g., public foundations and endowments </li></ul></ul></ul><ul><ul><li>Eliminates undue concern with individual investment performance </li></ul></ul><ul><ul><li>Concentrates on the performance of the aggregate portfolio </li></ul></ul>
  16. 16. Uniform Prudent Investor Act <ul><li>The Uniform Prudent Investor Act : </li></ul><ul><ul><li>Was enacted by The National Conference of Commissioners of Uniform Laws </li></ul></ul><ul><ul><li>Is subject to state by state adoption </li></ul></ul><ul><ul><li>Formally embraces what business schools teach in the classroom </li></ul></ul><ul><ul><ul><li>Portfolio managers may handle fiduciary accounts in accordance with current financial theory </li></ul></ul></ul>
  17. 17. Five Major Responsibilities of a Fiduciary <ul><li>Presented by Director of the SEC’s Office of Compliance Inspections and Examinations in 2006 </li></ul><ul><li>Put client’s interests first </li></ul><ul><li>Act in utmost good faith </li></ul><ul><li>Provide full and fair disclosure </li></ul><ul><li>Not to mislead clients </li></ul><ul><li>Expose all conflicts of interest </li></ul>
  18. 18. Sarbanes-Oxley Act of 2002 <ul><li>Makes Board of Directors more aware of their fiduciary responsibilities by: </li></ul><ul><ul><li>Requiring a “financial expert” on audit committee </li></ul></ul><ul><ul><li>Requiring CEO and CFO attest to financial statement accuracy </li></ul></ul><ul><ul><li>Tampering with corporate records may result in jail time </li></ul></ul><ul><ul><li>Requires one accounting firm for auditing purposes and another for in-house accounting services (e.g., bookkeeping) </li></ul></ul><ul><ul><li>Established Public Company Accounting Oversight Board to verify accuracy of public statements </li></ul></ul>
  19. 19. Fiduciary Duties <ul><li>Defined by ERISA: </li></ul><ul><ul><li>Deals with the management of pension funds </li></ul></ul><ul><ul><li>Has influence throughout the investment community </li></ul></ul><ul><ul><li>Outlines two primary fiduciary duties: </li></ul></ul><ul><ul><ul><li>Reasonable care </li></ul></ul></ul><ul><ul><ul><li>Undivided loyalty </li></ul></ul></ul><ul><ul><li>Also identifies prohibited transactions </li></ul></ul>
  20. 20. Reasonable Care <ul><li>Prudent Expert </li></ul><ul><ul><li>The ERISA manager must be familiar with and practice modern investment methods </li></ul></ul><ul><ul><ul><li>It is not enough to manage money the way ordinary people do </li></ul></ul></ul><ul><li>Diversification Rule </li></ul><ul><ul><li>Assets should be selected to reduce the risk of the portfolio </li></ul></ul><ul><li>Documents Rule </li></ul><ul><ul><li>handle the fund in accordance with the documents that govern the plan </li></ul></ul><ul><li>Indicia of Ownership Rule </li></ul><ul><ul><li>Documents are under the jurisdiction of the U.S. court system </li></ul></ul>
  21. 21. Loyalty Rules <ul><li>The sole interest of the beneficiary rule : </li></ul><ul><ul><li>Means that the customer’s best interest comes ahead of the best interest of the fiduciary </li></ul></ul><ul><ul><li>Requires the fiduciary to defray reasonable administration expenses of administering the plan </li></ul></ul><ul><ul><ul><li>Does not require the fiduciary to deal with the broker offering the lowest commission schedule </li></ul></ul></ul><ul><ul><ul><li>Does require the fiduciary paying more than the minimum fee available to obtain some additional value commensurate with the higher cost </li></ul></ul></ul>
  22. 22. Loyalty Rules (cont’d) <ul><li>The exclusive purpose rule : </li></ul><ul><ul><li>Requires a fiduciary to do her job for the single task of providing benefits to the beneficiary </li></ul></ul><ul><ul><li>Provides that the fund may be used to defray reasonable expenses that the fiduciary incurs in carrying out these duties </li></ul></ul>
  23. 23. Prohibited Transactions <ul><li>Specific Transaction Restrictions </li></ul><ul><li>General Transaction Restrictions </li></ul><ul><li>Fiduciary Conduct Restrictions </li></ul><ul><li>Property Restrictions </li></ul>
  24. 24. Specific Transaction Restrictions <ul><li>Specific transaction restrictions: </li></ul><ul><ul><li>Preclude a fiduciary from making a trade between the pension plan and a party of interest </li></ul></ul><ul><ul><ul><li>A party of interest is a person or organization who has some relationship to the pension plan </li></ul></ul></ul><ul><ul><li>Require security transactions to be arms-length trades, free of a conflict of interest </li></ul></ul>
  25. 25. General Transaction Restrictions <ul><li>General transaction restrictions prohibit the transfer of any plan assets to a party of interest </li></ul><ul><ul><li>e.g., the pension fund could not sell shares to a beneficiary of the fund </li></ul></ul>
  26. 26. Fiduciary Conduct Restrictions <ul><li>Fiduciary conduct restrictions preclude a fiduciary from using the plan assets for his own benefit </li></ul><ul><ul><li>e.g., a fiduciary cannot direct trades to a particular brokerage firm and receive “kick-backs” </li></ul></ul>
  27. 27. Property Restrictions <ul><li>ERISA limits pension fund investments to </li></ul><ul><ul><li>Marketable debt </li></ul></ul><ul><ul><li>Marketable equity securities </li></ul></ul><ul><ul><li>“Qualifying employer real property” </li></ul></ul><ul><ul><ul><li>Property that is leased to the plan sponsor, who makes lease payments to the pension fund </li></ul></ul></ul>
  28. 28. Emerging Areas <ul><li>Due Diligence </li></ul><ul><li>Social Investing </li></ul><ul><li>Proxy Voting </li></ul><ul><li>Soft Dollars </li></ul>
  29. 29. Due Diligence <ul><li>Fiduciaries need to exercise due diligence in the conduct of their duties </li></ul><ul><ul><li>Carefully consider investment decisions </li></ul></ul><ul><ul><li>Ensure that the information on which you base your decisions is accurate </li></ul></ul><ul><ul><li>Conduct credit checks on employees handling clients’ money </li></ul></ul><ul><ul><li>Make a reasonable effort to gather facts and ensure their accuracy </li></ul></ul>
  30. 30. Social Investing <ul><li>The legal status of social investing requirements is cloudy </li></ul><ul><li>A fiduciary should always listen to the wishes of the beneficiaries and seek to satisfy them when prudent to do so </li></ul>
  31. 31. Proxy Voting <ul><li>Shareholders who are unable to attend the annual meeting for any reason have the right to vote by proxy </li></ul><ul><ul><li>A proxy statement is a legal document allowing the shareholder to cast an absentee ballot </li></ul></ul><ul><li>A fiduciary does not have the right not to vote </li></ul><ul><ul><li>The right to vote is an asset of the organization and the investment manager breeches a fiduciary duty if he fails to exercise it </li></ul></ul>
  32. 32.
  33. 33. Establishing a Proxy Voting Policy <ul><li>Many money management firms have no clear policy on proxy voting </li></ul><ul><li>Obstacles to proxy voting cited by managers: </li></ul><ul><ul><li>Lack of a clear policy and support from the management of the investment firm </li></ul></ul><ul><ul><li>Uncertainty about voting responsibilities for publicly managed funds </li></ul></ul><ul><ul><li>The perception that many proxies are routine </li></ul></ul><ul><ul><li>Increasing international investment </li></ul></ul>
  34. 34. Establishing a Proxy Voting Policy (cont’d) <ul><li>SEC rule 206(4)-6 provides requirements on investment advisors and proxy voting, such as: </li></ul><ul><ul><li>Adopt proxy voting rules in the best interest of the customer </li></ul></ul><ul><ul><li>Disclose these voting rules to clients </li></ul></ul><ul><ul><li>Disclose how clients can find out how the investment advisor has voted proxies </li></ul></ul>
  35. 35. Establishing a Proxy Voting Policy (cont’d) <ul><li>Voting proxies in the best interest of the beneficiary is not the same as voting proxies in the best interest of the company </li></ul><ul><ul><li>A committee should look at more complicated issues and determine what makes the best sense for the beneficiary </li></ul></ul><ul><ul><li>There should be a policy for corresponding with management prior to a decision to vote against their recommendation </li></ul></ul>
  36. 36. Soft Dollars <ul><li>The SEC defines soft dollars as </li></ul><ul><ul><li>“ 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” </li></ul></ul><ul><li>The SEC requires investment advisers to disclose soft dollar arrangements to their clients </li></ul>
  37. 37. Soft Dollars and Research <ul><li>The Securities Exchange Act of 1934 specifically allows an investment fiduciary to use soft dollars to acquire research services </li></ul><ul><li>Using soft dollars to pay for acquired research is an established practice in the brokerage industry </li></ul>
  38. 38. Soft Dollars and Nonresearch Acquisitions <ul><li>Using soft dollars to acquire assets or services other than research is potentially a violation of a fiduciary’s duties </li></ul><ul><li>Nonresearch uses of soft dollars that are abuses: </li></ul><ul><ul><li>Paying the salary of an adviser’s research employee </li></ul></ul><ul><ul><li>Paying for an adviser’s nonresearch information technology purchases </li></ul></ul>
  39. 39. Soft Dollars and Nonresearch Acquisitions (cont’d) <ul><li>Nonresearch uses of soft dollars that are abuses (cont’d): </li></ul><ul><ul><li>Paying for travel, airfare, hotels, meals, and other expenses of a research consultant </li></ul></ul><ul><ul><li>Paying for research services provided by a “consultant” operating out of the adviser’s office </li></ul></ul><ul><ul><li>Paying for an adviser’s office rent and equipment, cellular phone service, and personal expenses </li></ul></ul>
  40. 40. SEC Recommendations for Soft Dollar Arrangements <ul><li>Recommendations by the SEC’s Office of Compliance, Inspections and Examinations clarify acceptable practices </li></ul><ul><li>Fiduciaries should: </li></ul><ul><ul><li>Be much more aware of the presence of soft dollars </li></ul></ul><ul><ul><li>Make a special effort to disclose their use to beneficiaries </li></ul></ul>