In this paper Youngdahl outlines the history and development of the concept of fiduciary duty in the United States.
He concludes that the interpretation and implementation of fiduciary duty has and will continue to develop based on a core set of common sense principles. He also cautions that regulation must not constrain trustees’ ability to employ the most appropriate tools, and that trustees must be able to consider long-term criteria that are in the best interests of the beneficiaries, even where those criteria have not traditionally been considered.
The concept of fiduciary duty exists to protect the interests of the beneficiary, but the precise scope and interpretation of this duty varies between situations and jurisdictions, which can lead to practical difficulties in implementation. One problem is the existence of different types of fiduciaries that are not necessarily held to the same responsibilities, such as corporate directors, financial advisors or pension fund trustees. A second issue, particularly relevant for investment fiduciaries, is that the scope of their duty has become entangled within a wider debate about the functioning of investment markets and different interest groups have differing opinions on how fiduciaries should act. Fiduciaries must therefore pay careful attention to the specific legal and regulatory background of the jurisdiction in which they operate.
A brief history of trust law
The concept of a trust, i.e. a legal entity in which assets are managed on behalf of another entity, is believed to be hundreds of years old, with precursors of modern trusts found in medieval law. In the early twentieth century corporate trusts evolved to help businesses raise capital for new ventures, with other key drivers in the US including the need to protect the property rights of Native Americans, and to promote workrelated benefits for employees. In response to concerns over how these trusts were managed, in 1974 the Employment Retirement and Income Security Act (ERISA) codified the general responsibilities of pension fund trustees. This Act remains the most influential legislation relating to fiduciary duty in the US today.
ERISA regulates the administration of pension funds and provides a degree of insurance for beneficiaries. It defines fiduciary duty in terms of acting solely in the interests of beneficiaries, using care, skill, diligence and prudence to provide benefits and minimise losses, while acting in accordance with the stated aims of the pension plan. The definition is one of general principles rather than specific requirements, which has led to criticism and a wide range of interpretations of exactly what is means in practice. Additionally, ERISA only applies to private sector pension plans, so in 2000 the Uniform Trust Code (UTC) was developed to try and bring a common framework of governance to all private and public trusts in the US.
Evolution of the concept of fiduciary duty
Over time, as financial markets and the investment industry have become more complex, the role of the fiduciary has also evolved. Initially trust assets could only be invested in ‘safe’ assets such as government bonds. In 1959 the Prudent Man rule was introduced to allow trustees to invest as if they were managing their own assets, with a focus on capital protection. Following the development of modern portfolio theory in 1992, the Prudent Investor rule was introduced. This rule, which still holds today, requires trustees to take into account the purpose and distribution requirements of the trust and invest in a portfolio of assets with an optimal risk-return trade-off.
However, the financial crisis of 2008 exposed some unanticipated shortcomings of modern portfolio theory when it is applied universally, such as risk control techniques at the portfolio level (e.g. diversification, hedging) leading to increased market risk to the global economy and failing to protect portfolios in times of extreme market stress. Furthermore, the focus of investment practices today have become increasingly short term with share price performance often excessively reliant on quarterly corporate reporting, which many believe runs counter to the principle of trustees’ long term duty to beneficiaries, as well as leading to decreased market efficiency and the destruction of long term value.
Today, the enormous size of the pool of capital managed within pension funds means that institutional investors wield significant influence. The issue of what actions fiduciaries are permitted to take has therefore become highly political, leading to the earlier-described problem of different stakeholders trying to protect their own interests. For example, corporations attempting to limit shareholder activism, ostensibly on the grounds that it breaches a strict definition of fiduciary duty but in reality out of self-interest. The outcome is that pension fund trustees are challenged with managing pension assets in the face of declining confidence in traditional investment theories, a changing political and social environment, and an increasing awareness that their investment decisions can influence the long-term stability of the economy. Added to this is an evolving view of fiduciary duty, not least on the topic of issues such as environmental, social and corporate governance factors, where evidence is growing that these issues must be taken into consideration if one takes a broad long term approach to fiduciary duty.
RI Quarterly Vol. 2: Fiduciary duty
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The basis of fiduciary duty in investment in the United States