On the Fiduciary Duty of Loyalty, the Nature of Informed Consent, and the Requirement of Substantive Fairness

Informed Consent

In theory, a client who receives full disclosure about a conflict of interest would not knowingly consent to an action that would clearly harm them. The core premise of "informed consent" is that the client understands both the conflict and its potential impact on them.

However, several factors complicate this in practice:

Information asymmetry

- Clients often lack the expertise to fully evaluate the implications of what they're consenting to, even with disclosure. They rely on the adviser's expertise, which is why they sought professional help in the first place.

Disclosure framing

- How conflicts are disclosed matters tremendously. Research has shown that disclosures can be presented in ways that minimize perceived risks or normalize conflicts.

Trust dynamics

- Many clients have strong trust in their advisers and may consent primarily based on that trust rather than critical evaluation of the disclosed conflict.

Hidden or indirect harms

- Some conflicts lead to suboptimal outcomes rather than direct harm (like slightly higher fees or marginally lower returns), making the harm less obvious during the consent process.

Psychological factors

- Clients may rationalize accepting conflicts due to status quo bias, wishful thinking, or to avoid the hassle of finding a new adviser.

This is why many regulatory approaches recognize that disclosure alone is insufficient protection, and why some conflicts are prohibited outright regardless of disclosure and consent.

The ideal fiduciary framework requires both informed consent AND that the action remains in the client's best interest despite the conflict - not merely that the client agreed to it.

The Substantive Fairness Test

To test the validity of the informed consent, and/or to ensure the client's best interest remain paramount, the courts have traditionally applied the

substantive fairness test. This requires that, even with disclosure and consent, the transaction must be objectively fair to the client. This means:

• The terms of the transaction must be at least as favorable to the client as those the client could obtain in an arm's-length transaction with an unrelated third party.
• The fiduciary cannot take advantage of their position to benefit themselves at the client's expense.
• The transaction must provide a genuine benefit to the client or at minimum, not harm the client's interests.

Substantive fairness is a legal concept that goes beyond procedural fairness, examining the fundamental equity and reasonableness of a transaction or decision itself. It asks whether the substance of an agreement is just, balanced, and protective of the interests of the potentially disadvantaged party.

The Key Aspects of Substantive Fairness include:

Intrinsic Reasonableness

• Evaluates the actual terms and outcomes of an agreement
• Ensures the substance of the deal is fundamentally equitable
• Looks beyond mere technical compliance to assess genuine economic and practical fairness

Economic Equivalence

• Determines whether the transaction provides comparable value to all parties
• Checks if the terms are comparable to what would be achieved in an arm's-length market transaction
• Prevents exploitation through technically legal but economically predatory arrangements\

Protection of Vulnerable Parties

• Provides special scrutiny when power imbalances exist
• Prevents stronger parties from leveraging their position unfairly

Contextual Analysis

• Considers the specific circumstances surrounding the transaction
• Evaluates fairness not through abstract standards, but through the lens of practical, real-world implications

On the Application of the Requirements of "Informed Consent" and "Substantive Fairness" to Investment Advisers

The U.S. Securities and Exchange Commission has long adopted the requirement of

informed consent. This differs from mere consent. While beyond the discussion of this article, mere consent in an arms-length relationship can lead to waiver and/or estoppel. However, in a fiduciary-client relationship the application of waiver and/or estoppel is very limited.

The U.S. Securities and Exchange Commission has not expressly incorporated the "substantive fairness test" into its rulemakings on the fiduciary standard. It has, however, stressed that remaining conflicts of interest must be "properly managed."

In some fiduciary-entrustor relationships, such as attorney-client, or trustee-beneficiary, procedures exist (such as judicial review and approval) that protect the entrustor (the client, or beneficiary). But such protection does not exist in the investment adviser-client context.

The difficulty with managing conflicts of interest in financial services is that most of them arise from compensation structures. For example, the investment adviser (or her/his firm) receives greater compensation when undertaking one recommendation, versus another. This may occur due to receipt of soft dollar compensation, 12b-1 fees, marketing support payments, other forms of revenue sharing, or simply by achieving better economies of scale that support the profitability of a proprietary mutual fund or other investment product.

In essence, when greater compensation is received by an investment adviser, resulting from a specific product recommendation, the client usually incurs greater fees and/or costs. And the academic evidence is robust and clear - the greater the fees and costs, then (on average) the lower the returns to the client, all other things being equal.

The No-Conflict and No-Profit Rules: Why Conflicts of Interest Should Be Avoided

One can conclude that, given the inherent difficulty of "properly managing" conflicts of interest - so that the client is never harmed (relative to an alternative course of action that could have been recommended), and instead the client always receives the benefit of truly expert, objective (trusted) advice - most conflicts of interest must be avoided by investment advisers.

The

"no-conflict rule" and the "no-profit rule" are core components of the fiduciary duty of loyalty. These rules fined their roots in the precept - derived from biblical principles and since uttered by many a jurist - that “no man can serve two masters.”

About the No Conflict Rule (Duty of Loyalty):

• Prohibits a fiduciary from placing themselves in a position where their personal interests conflict with their client's interests
• Requires the fiduciary to avoid situations that might compromise their ability to act solely in the client's best interest
• Applies even to potential or prospective conflicts, not just actual conflicts
• Mandates absolute priority of the client's interests over the fiduciary's own
• Extends to both direct and indirect conflicts of interest

About the No Profit Rule:

• Prevents a fiduciary from profiting personally from their fiduciary position beyond their agreed-upon compensation (and this is best achieved when the compensation is agreed-upon in advance of any specific recommendations, and the recommendation undertaken does not change the amount of the compensation)
• Prohibits the fiduciary from using their position to secure any unauthorized additional benefit
• Requires the fiduciary to account for and disgorge any secret profits obtained through their position
• Applies even if the client suffers no actual loss

This is not to say that investment advisers and financial planners should not be compensated well. Those who have achieved true expertise and apply same for the benefit of their clients should be highly compensated as professional, trusted advisers. But compensation arrangements that result in differential compensation should be avoided, and in all instances the compensation received should not be unreasonable.

In summary.

A fiduciary relationship imposes duties of due care, loyalty and good faith on the fiduciary, who is to act only for the benefit of the client to the exclusion of all others (including the fiduciary and her or his firm).

Let's face it - the fiduciary standard is tough. It is often characterized as the highest standard of conduct under the law.

If, as a profession, we are to move forward, then investment advisers and financial planners who are subject to the fiduciary standard must ... must ... must ... fully understand the depth and breadth of the fiduciary duty of loyalty. And then must take actions to completely adhere to that standard - by avoiding conflicts of interest whenever possible.

Once we do this - and the regulators adopt rules that make it clear to consumers as to who is a true fiduciary, and who is a product salesperson - then an ever-greater number of consumers will trust fiduciary financial advisors, and the demand for financial planning and investment advice will soar.

Be a true, bona fide fiduciary. Take the high road. Structure your own practice to avoid conflicts of interest, wherever possible. Live a life of integrity and enjoy the rewards that come from possessing the trust of others and always acting for their benefit.

The foregoing represents the views of Ron A. Rhoades, JD, CFP(r), and are not necessarily representative of any firm, institution, or organization with whom he is or has been associated with, nor are they the views of any cult, gang, or motley crew that he has ever been kicked out from.