The fundamental duty of an investment fiduciary is to manage investment decisions for the exclusive benefit of another party. In the second Practice for stewards and advisors, the objective is to identify and document all of the fiduciaries associated with a portfolio. The third Practice is making sure that those fiduciaries are clear of conflicts of interest.
In a December '09 Report to Plan Sponsors, Fred Reish and Joe Faucher wrote that conflicts fall into two broad categories, those where the plan sponsor has a conflict and those involving service providers. An example of the former would be where the fiduciary gains a personal advantage via their position to direct assets, such as by self-dealing. An example of the latter would be if the advisor is in a position to receive greater compensation by choosing one investment over another. While some conflicts are strictly prohibited, many others are not. Nonetheless, conflicts have the potential to negatively impact a portfolio and its investors/beneficiaries. For that reason and to help limit fiduciary liability, every fiduciary should have a stated conflicts policy that focuses on the disclosure and management of all material conflicts.
Let's take a look at Practice 1.3 and the associated criteria:
In forming a policy, you will want to identify the various types of conflicts that may exist and should be disclosed. An FDIC examination manual identifies the following areas of potential conflict: receipt of fees beyond the trustee's fees, securities related activities, own-bank deposits, administration of discretionary purchase, sale or retention, investment in securities underwritten by own-bank or affiliates, relationships with outside service providers, inter-account or multi-account transactions, contravention of the governing agreement, and privacy. These are obviously bank-specific, but it serves as a starting point for the type of conflicts that can be specified in your own policy.
The next part of the policy would be to specify what to do about them. Again, you would first want be aware of what the legal requirements are for the type of portfolio you are working with. If certain transactions are strictly forbidden, that needs to be noted. If other conflicts are allowable if properly managed, that needs specified as well. A memorandum written for the Council on Foundations advises that, in the case of a Foundation Board, some ways to manage a conflict are to require disclosure in plan documents of all conflicts and make that disclosure available to other decision makers and beneficiaries and to forbid the conflicted party from participating in discussions or votes that relate to the conflict.
Finally, to ensure that all parties are aware of this and other policies, you should include it in yearly reviews and require every fiduciary to acknowledge the policy; their acknowledgement should require them to disclose any conflicts.
Of course, the best thing you can do regarding conflicts is to avoid them altogether. If a fiduciary even thinks he or she may have a conflict of interest, then they probably do. An excellent question to ask before deciding or voting on an investment issue is: “Who receives the greatest benefit from this decision?” If the answer is any party other than the client, participant, and/or beneficiary, the likelihood is the fiduciary is about to breach his or her duties.
One of the surest ways to avoid conflicts is to separate the four major roles--money manager, broker, custodian and advisor--to provide for a system of checks and balances. In examining cases involving breach of fiduciary responsibility, you most often find that one party was responsible for multiple functions. In the case of Madoff, he was essentially wearing all hats.
For additional resources on policies and procedures regarding conflicts of interest and self-dealing, consult the following resources:
- Complete text of Practice 1.3 from the Prudent Practices for Investment Stewards handbook
- Legal substantiation of Practice 1.3
- Reish article: The Plan Sponsor’s Ability to Evaluate Conflicts of Interest
- Reish whitepaper: The Fiduciary Duty to Avoid Conflicts of Interest in Selecting Plan Service Providers
- SEC/DOL joint Tips for Fiduciaries: Selecting and Monitoring Pension Consultants
- Office of the Comptroller of the Currency: Conflicts of Interest
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The Spotlight on Practices series highlights one of the Prudent Practices for Investment Fiduciaries in order each month. To learn more about the Practices, click "Spotlight on Practices" link in the categories list or visit the Practices page on fi360.com. If you have any questions or comments, leave them in the comments section below each post, or email us at blog@fi360.com.
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