Investment management is in vogue, and many high-profile investment bankers are shifting from the sell side to the buy side. Some of them may not realize that they are now in a different legal environment, which can have a direct effect on their bottom lines.
Investment managers are fiduciaries-a legal status that imposes rules much stricter than the rules of commerce.
What does it mean to be a fiduciary? The general rule is that fiduciaries must act solely in the interest of the client, rather than in their own interest. However, that truism has limited value. For example, majority shareholders have a fiduciary duty to minority shareholders that is very different from the duty of an investment manager to a pension plan.
The extent and nature of fiduciary duty varies according to the relationship between the parties. Parents, agents, partners, employees, and trustees are all fiduciaries, but in Justice Frankfurter's famous words, "to say that a man is a fiduciary merely initiates our inquiry into the precise nature of that person's obligations."
Fiduciary duty has its origins in trust law, which developed in a very different context than professional investment management. Trusts began as land transfer devices for English property-owning families. Later, as wealth became more intangible, trusts were used to transfer it to descendants. The trustee's main responsibility was preserving, not increasing, wealth, and the trustee was often uncompensated.
A manager may be subject to multiple fiduciary duties under federal and state law. Congress included trust law concepts in the Investment Company Act, the Investment Advisers Act, and the Employee Retirement Income Security Act, and imposed federal fiduciary standards on certain investment managers.
This is an old problem, since investment management is an old business. However, performance pressures have changed the business, because society has become increasingly litigious and regulators more adept at using publicity to accomplish their goals. Problems that go undiscovered in a bull market may become manifest in a downturn.
Investment managers are especially sensitive to litigation. Bad publicity chases clients out the door. Judges follow Justice Cardozo's charge to attack fiduciary violations with "uncompromising rigidity" to keep fiduciary standards above "those trodden by the crowd." The purpose of this harsh application is to eliminate any possibility that fiduciaries will overreach.
A fiduciary owes a duty of loyalty and a duty of care. The latter is basically an enhanced version of the duty of care present in many commercial relationships. The new "prudent investor rule" and ERISA have sought to reconcile that duty with the realities of modern investment management practices by shifting the focus to the portfolio as a whole, rather than its components.
The duty of care does not per se restrict investments in instruments thought to be high risk, such as certain derivatives, initial public offerings, or venture capital. In fact, a fiduciary may incur liability for pursuing an investment strategy that is too conservative. The duty of care requires a high level of competence and procedural thoroughness. It is, however, a predictable standard that largely coexists with the standards for excellence set by the market.
The duty of loyalty restricts activities that may conflict with the interests of the beneficiary or tempt a fiduciary to take advantage of the relationship. However, this is not a market standard, and is often contrary to commercial expectations. For example, a fiduciary generally cannot purchase investment products from itself or an affiliate, even if the prices are at or better than the market. Since an account can void self- dealing transactions, the investment manager may become a guarantor. The mantra of cross-selling can easily and innocently become impermissible self-dealing (or in ERISA terms, a "prohibited transaction.")
The duty of loyalty can present problems to any large organization. Personal trading, proprietary trading, soft dollars, inside information, and compensation can all create potential conflicts between the client and the manager. Crossing orders between customers, different recommendations to different customers about the same security, hot issues, allocation of block orders, and investments for different clients in obligations of an issuer with different rights all present potential conflicts.
The rules vary by activity, regulator, and client. Issues can be dealt with by disclosure, by disclosure and consent, or by a complete prohibition of the activity that presents the conflict. Payment for order flow may be permissible under some circumstances, but not for ERISA clients.
Regardless of the client, some areas are very unsettled, such as the specifics of the duty of impartiality among accounts. The strictness of ERISA and its numerous unresolved issues are constant problems. To compound matters, investment managers can incur liability for the activities of affiliates and co-fiduciaries.
Traditional solutions, such as the so-called Chinese wall restrictions on information flow within an organization, may offer less- than-certain protection. For example, if the head of investment management sits on the integrated firm's management committee, the investment management affiliate may be charged with knowledge of information possessed by other affiliates despite the Chinese wall.
The liabilities and constantly changing circumstances are such that policies and procedures are just a starting point. Firms need a culture of sensitivity to these issues that starts at the top, so they are spotted and analyzed. Also, business realities require that managers act in situations that present issues without clear answers. This assumption of legal risk should not be undertaken in ignorance.