On the football field, nowhere is trust more important than at the quarterback position. With every snap, a quarterback puts his own career and health on the line, having faith that his offensive lineman will protect him. There’s an unspoken rule that a lineman will do everything in his power to protect the QB, and both the QB and lineman need to be on the same page in order to execute a successful play. If the lineman misses a block intentionally, trust is broken, and the impact can be devastating for everyone, physically and professionally. The same effects are felt with a breach of fiduciary duty.
Like the relationships on the football field, many individuals and professionals trust others to protect them. Trustees, especially, may delegate investment discretion and rely heavily on an investment advisers’ expertise as part of their duty to act in the beneficiary’s best interest. Likewise, the investment adviser has a fiduciary duty to act in the trustee’s best interest.
Although most will act with integrity, when there is a breach of fiduciary duty by the financial adviser, it is ultimately the trustee who may be held liable. It’s important that the trustee understands what is considered a breach of fiduciary duty by the adviser and the steps that can be taken to prevent such a breach from happening.
What is a Breach of Fiduciary Duty?
According to California’s civil jury instructions, a breach of fiduciary duty is based on three key elements:
- An existence of a fiduciary relationship
- A breach in that relationship
- Damages caused by the breach
Existence of a fiduciary relationship
Case law has shown that there exists a fiduciary relationship between an investment adviser and a client. However not all investment professionals are advisers. Thus, trustees who have delegated investment authority should be aware of the differences in standards within the investment industry.
Trustees who work with a broker might not be in a fiduciary relationship because a broker is held to the suitability standard. This means that a broker only needs to recommend investments suitable to the situation, but not necessarily in the client’s best interest. The SEC began requiring stock brokers to follow a “best interest” standard in 2020, but this standard is not the same as a fiduciary standard. In fact, the new regulation for brokers, known as “Regulation Best Interest”, helps mitigate conflicts of interest around incentives, but it doesn’t require the parent company (i.e., the broker dealer) to alleviate its own conflicts of interest.
In short, trustees who are working with brokers are unable to monitor for a breach of fiduciary standard, because the broker is not an adviser and is not held to that standard. For the trustee, this means potential additional liability.
In contrast, trustees who work with an investment adviser have a fiduciary relationship. This is why many professional trustees end up working with investment advisers.
This relationship may become unclear for successor trustees, who end up inheriting the former trustee’s existing relationship with an adviser. If this is the case, the successor trustee should conduct an assessment of the current adviser. This is because although investment advisers are held to a fiduciary standard, not all advisers are familiar with the trustee’s own requirements of trustee investing, which include standards such as the Uniform Prudent Investor Act (UPIA).
Breach in the Fiduciary Relationship
Generally, a trustee who monitors an investment adviser should be able to spot any egregious or intentional breaches of the fiduciary relationship, such as excessive trading, the purchase of unsuitable investments, or “reverse churning” (charging fees on inactive accounts that aren’t really managed).
It is the unintentional breaches of fiduciary duty, however, that are more difficult to spot. If an investment adviser is unfamiliar or inexperienced with trustee investing, it is possible for an investment adviser to be negligent in their role even when following the fiduciary standard. This can leave the trustee exposed to potential damages, even when the violation was not intentional.
Oftentimes, the breach can come from a lack of review and a lack of oversight. To get on the same page, trustees should be familiar with the terms of the trust and verify that the investment adviser is willing to abide by those terms.
For example, an individual might personally use an investment adviser who favors an investment management style using options. He’s named as successor trustee and brings that account to his adviser. The adviser does not review the trust document closely, which explicitly prohibits option trading. If the adviser ends up managing the account and incurring losses, this would be a breach of fiduciary duty by both parties because the option trades violated the terms of the trust.
Other breaches can come from violations of the rules of trustee investing practices. Most states have adopted the Uniform Prudent Investor Act, which trustees are required to follow unless specifically exempted by the trust. There are many aspects to the UPIA, but key provisions require the trustee to:
- Find an appropriate balance of risk and return
- Diversify, unless it is is imprudent not to
- Understand tax consequences
- Only incur reasonable costs
As not all advisers are familiar enough with the UPIA, it is important that the trustee properly vet their adviser. If the investment adviser doesn’t understand the UPIA, he and the trustee risk being on the same team, while using a different playbook.
Damages Caused by the Breach
Fiduciary breaches normally come to light when there is significant financial injury, as for a breach to occur, there has to be some sort of damage incurred. Most people think of damages in terms of straight economic terms, but they come in various forms.
Investment losses are one possible way to identify whether a breach has caused damages. But, losses are not necessarily evidence enough to show harm caused. This is because losses are an inherent part of the risk/reward nature of investing. In fact, the UPIA asserts that investment compliance should be determined in light of the facts existing at the time, and not by hindsight. It may be easy for a beneficiary to play arm-chair quarterback and second guess a decision after the fact. However, if the decision was made in compliance with the terms of the trust and the standards of the UPIA, it will likely fail the damage test.
Damages can also be in the form of the lost opportunity of profits. For example, if a trust stays in cash and is not invested, this can result in damages. Although the investments avoided losses, the money was not put to use and missed out on the opportunity for growth.
Unlike economic losses, these damages may be harder to quantify. Due to the psychological nature of the loss, they are just as legitimate in determining whether damages have occurred.
Lastly, if the economic or psychological damages are severe enough, exemplary damages may apply in order to punish the offending party. Normally these are imposed only when actual damages are awarded and may require unanimous agreement by the jury.
It’s important that the trustee understands the various ways an investment adviser’s actions can result in a breach of fiduciary duty. Even though both the trustee and the adviser are held to a fiduciary standard, this does not mitigate the adviser from unintentionally shirking their duty.
When it comes to trustee investing, the trustee might need to coach the investment adviser in trustee investing in order to prevent possible breaches of fiduciary duty. In reality, a trustee and investment adviser should be on the same page from the start as that will make the most successful team.
Prudent Investors has decades of experience working with public, private and family fiduciaries and their teams. We’re bound to the same fiduciary standards as the fiduciaries and understand the complexities associated with the trust coordination. To help make your role as fiduciary easier, we’ve organized a helpful guide on How to Choose an Advisor as a Trustee, which is chalk-full of helpful information when considering an advisor for your trust.