Fiduciary Duty

Fiduciary duty is the legal obligation of a fiduciary — a person or firm entrusted with power over another’s interests — to act solely in that other person’s best interest and to avoid conflicts of interest. Investment advisers, trustees, and some brokers owe fiduciary duties. The duty is the highest standard of care in commercial law. A fiduciary cannot profit from its position except as transparently agreed. Breach of fiduciary duty is the basis for many securities and trust litigation claims.

The three core duties

Fiduciary duty has three components:

1. Duty of loyalty — the fiduciary must put the beneficiary’s interests first, avoiding conflicts of interest and self-dealing. A fiduciary cannot use beneficiary assets for its own benefit or recommend investments that benefit the fiduciary more than the beneficiary.

2. Duty of care — the fiduciary must act competently and prudently. It must investigate investments, monitor performance, and avoid reckless decisions.

3. Duty of disclosure — the fiduciary must fully disclose all material conflicts of interest and all information relevant to the beneficiary’s decisions.

These are flexible standards applied by courts based on the facts and the relationship.

Loyalty and self-dealing

The duty of loyalty is the strictest. A fiduciary cannot engage in self-dealing — using its position for personal profit. If a fiduciary recommends an investment from which it earns a commission, this is a conflict. The fiduciary must disclose the conflict, show it is reasonable, or obtain the beneficiary’s informed consent.

Some fiduciaries structure their business to eliminate conflicts. Fee-only investment advisers (who charge a flat fee rather than commissions) have fewer conflicts than advisers paid by commission.

The care standard: the prudent investor rule

Fiduciaries must meet a “care” standard. Historically, this was the “prudent investor rule” — a fiduciary must invest as a prudent person would, based on the beneficiary’s financial situation, risk tolerance, and objectives.

Modern portfolio theory has shaped the prudent investor rule. A prudent fiduciary diversifies across asset classes rather than concentrating in single stocks. A prudent fiduciary benchmarks performance against appropriate indices.

Disclosure and transparency

A fiduciary must disclose all material information. If an adviser has a relationship with an investment it recommends, it must disclose. If it earns more in some investments than others, it must disclose. Secrecy is the enemy of fiduciary duty.

The scope of disclosure can be contentious. How detailed must a conflict disclosure be? A brief statement “we earn commission from this investment” might not be fully transparent if the fiduciary earns 10x more from that investment than others.

Investment Advisers Act and fiduciary duty

The Investment Advisers Act of 1940 imposes a statutory fiduciary duty on registered investment advisers. Section 206 makes it unlawful for an adviser to:

• Engage in deceptive practices
• Act without disclosure of material conflicts
• Act as principal in a transaction with the client without disclosure

Breach of Section 206 is the basis for SEC enforcement and private lawsuits by defrauded clients.

Brokers and the dual-standard problem

Historically, investment advisers owed fiduciary duties while brokers only owed a “suitability” standard. This created perverse incentives — a broker could recommend higher-fee investments that were merely suitable (appropriate for the customer) rather than best. An adviser had to recommend the best option.

Regulation Best Interest, adopted in 2020, raised broker standards closer to fiduciary. However, brokers still do not owe a full fiduciary duty in all contexts. The distinction matters for litigation — an investor suing a fiduciary for breach has broader remedies than an investor suing a broker for breach of suitability.

Trustee fiduciary duty

Trustees of trusts, estates, and pensions owe fiduciary duty to beneficiaries. A trustee cannot invest trust assets in property the trustee owns, cannot employ itself to manage assets, and cannot profit from the trust except as explicitly stated in the trust deed.

Breach of trustee fiduciary duty is a major source of trust litigation. Beneficiaries sue trustees for self-dealing, conflicts of interest, or poor investment decisions.

Remedies for breach

If a fiduciary breaches its duty, remedies include:

• Damages — compensation to the beneficiary for losses
• Disgorgement — return of any profits the fiduciary earned from the breach
• Removal — removal of the fiduciary from office
• Constructive trust — in equity, sometimes a beneficiary can impose a trust on assets misappropriated by the fiduciary

See also