Friday, April 24, 2015

When Fiduciaries go bad

From Wikipedia: "A fiduciary is a person who holds a legal or ethical relationship of trust between himself or herself and one or more other parties (person or group of persons).

Typically, a fiduciary prudently takes care of money for another person. One party, for example a corporate trust company or the trust department of a bank, acts in a fiduciary capacity to the other one, who for example has entrusted funds to the fiduciary for safekeeping or investment. Likewise, asset managers—including managers of pension plans, endowments and other tax-exempt assets—are considered fiduciaries under applicable statutes and laws. In a fiduciary relationship, one person, in a position of vulnerability, justifiably vests confidence, good faith, reliance, and trust in another whose aid, advice or protection is sought in some matter. 

In such a relation good conscience requires the fiduciary to act at all times for the sole benefit and interest of the one who trusts."

So the Coles notes version of this suggests that a person who is deemed to be 'vulnerable' vests trust and good faith in another person (the fiduciary) for professional advice, guidance or help. Further, upon acceptance of the responsibility, the fiduciary has a legal and ethical responsibility to exhibit a very high standard of behavior (higher than a simple "duty of care") to ensure the vulnerable party is protected from exploitation from that particular relationship.

Obviously a lot of very bad things can happen to a person who establishes a fiduciary relationship with someone who has questionable ethics and bad motives.

So who in the financial industry is a fiduciary and who isn't?

Well - investopedia has a nice description of the difference between the two here: 

here's an excerpt:

"In the investment field, there are two primary parties who are able to offer investment advice to individuals, as well as institutional clients such as pension funds, non-profit organizations and corporations. These parties are investment advisors and investment brokers who work for brokers-dealers. Many clients may consider the investment advice they receive from each party as similar, but there is a key difference that may not be completely understood by the investing public. The difference pertains to two competing standards that advisors and brokers must adhere to, and the distinction has important implications for individuals who hire outside financial assistance. Below is an overview of both parties, the standards each must follow and how the standards that brokers follow can create conflicts between themselves and their underlying customer base. "

So investment advisors, who are regulated by the Securities & Exchange Commission are considered fiduciaries, and as such are bound by the Investment Advisor's Act of 1940. It means all advisors need to put their client's interests above that of their own and insure that all advice fits the client's needs, objectives and risk tolerances.

Broker-dealers on the other hand are regulated via the Financial Industry Regulatory Authority (FINRA) and therefore only need to fulfill a "suitability obligation". This obligation suggests that the broker-dealer makes recommendations and undertakes actions that are "consistent with" the best interests of the client.

I will leave readers to go through all of the details of who is, and isn't a fiduciary, and what the rules and differences are between suitability & fiduciary obligations for themselves. And start getting more to the point of this post...

It is my humble view that ANYONE who provides investment/financial advice to a client of any nature should be considered a 'fiduciary' - and as such should be held to the accepted and much higher standards of a fiduciary.

I believe Wall Street, or more accurately (since I live in Canada) the "financial industry", has done a masterful job of muddying the waters with regards to who should be held under the lens of the fiduciary standard for selfish, profit seeking reasons. I'm sure that's not a shocking statement given all of the amazing abuses we've seen over the last 8 years - but it needs saying (again and again and again...)

I am also of the believe that the financial industry has changed its approach over the last 2 or 3 decades, and has now taken on what I've described in previous posts as a parasitoidal sort of relationship with clients. You can read more about this in my blog post entitled, "Symbiotic, Parasitic and Parasitoidal Cycles of Finance".

Former Goldman Sachs director Gus Levy was famous for suggesting that Goldman was "long term greedy". The insinuation here was that Goldman was pricing their services in a such a way that they were maximizing profits while still keeping clients happy and well represented. This model worked, and worked well. While you may assume that due to my bearish rants on the industry (via here, and twitter) that I'm very much 'anti-finance', but this is actually a model that I'd happily endorse because in the end - everyone wins - and the 'fees' can be negotiated and agreed upon ahead of time.

But, somewhere along the lines - somewhere in the mid 90s I'd argue, Wall Street's profit model changed. I'm not sure who started it, or how, but somewhere, somehow the tried and true, perfectly harmonious "long term greedy" model morphed into something I'd describe as "predatory finance".

Under this new model, it seemed that clients were no longer to be well represented, but instead exploited or sacrificed in the name of quarter over quarter profits or annual bonuses. Of course the biggest problem with this transition was that no one told the client. Meaning for the most part, clients were left believing that the financial industry was still working tirelessly with their best interests in mind.

Obviously there are a lot of fantastic advisors and firms out there who are 100% honest, and as such are busting their buns to do the right thing for their clients - but I think most of them would agree that they are not in the majority.

In fact, as Bill Black discusses (here and here), thanks to a combination of "Control Fraud" and  Gresham's Dynamic, honest brokers are more than likely getting displaced by other, less ethical brokers who don't mind 'bending the rules' and working against their client's best interests to help increase corporate profitability.

Is that assertion a stretch?

Well look at the comments and career of Christian Bittar, who was allegedly "Trader Number 3" from the Deutsche Bank Libor Scandal -

From the article:

"he was Deutsche Bank’s most profitable derivatives trader, earning a bonus of almost 90 million pounds ($136 million) in 2008 alone"

"Bittar, who joined Deutsche Bank in 2001, took billion-euro positions on the direction of short-term interest rates with the firm’s own money and reaped hundreds of millions of euros in profit for the bank."

Bittar was named global head of money market derivatives trading, moving to Singapore, in the years that followed, according to the CFTC

and most importantly - 

Bittar hasn’t been charged with any offense.

There are a million examples of pre-crisis abuses but the one that I always think of as the ultimate poster child of abuse pre-financial crisis is the Goldman Sachs' "Abacus" deal with Paulson.

Or, if you don't like me picking on Goldman, how about that time Bear Stearns tried to play "hot potato" by bundling up all of their problems into one IPO called "Everquest"? They pooled all of their most toxic assets and tried to pitch it out into the muppetsphere (the term Muppet was coined by the industry and refers to naive investors who act as cannon fodder for crappy, problematic deals)

Of course the industry will try to spin a PR friendly narrative that "we had some bad actors", or that "there were holes in our compliance management" or that it's really "not that big a deal", but the "gee whiz, we don't know what happened there" excuses sort of fall short when you consider that as of December 2014, the largest US banks have paid out a collective $180 BILLLION in fines and settlements.

The problem is an epidemic, and the incentives to exploit fiduciary relationships are alive and well.

Bill Black, who was in charge of investigating the Savings and Loans scandal in the 80s presented a very harsh assessment of the Great financial crisis -

To me - the key statement in this video piece was when Black said this,

"When people cheat, you can not as a regulator continue "business as usual". They go into a different category, and you must act completely differently as a regulator"

Let's do a quick acid test - are firms cheating? Answer: Yes


Second question - are regulators 'acting completely different' in the face of cheating?

Not so much - 'deferred prosecutions' and charging fines continue to be favored plays by the regulators, as we continue to wait for ONE arrest and conviction of an executive who is 'personally' responsible for abuse. 

and Wall Street knows it - 

Elizabeth Warren to JP Morgan CEO (in 2013), "I think you guys are breaking the law...."

So what is the point of this post? 

It's to point out that the financial industry is NOT your buddy. For the most part the incentives are out of whack and need to be corrected. Yes, there are still 'great people' working in the industry who are honest and who do a great job - but I think they would agree that they are being heavily out gunned by the predators and exploiters of the system who are busy making as much money for themselves at any cost. 

Remember - the financial industry attracts a tremendously high number of sociopaths.. 

I'm happy to see more research is being done in this area (it's finally not just me going on and on about this stuff). 

Consider this fantastic paper by Alain Cohn, Ernst Fehr1 & Michel Andre Mare entitled, 

which was mentioned in another great article, by William D. Cohan -

"Can Bankers Behave"

(My answer would be for the most part: No, they can't.. unless things change dramatically)

So, when getting financial advice, use Ronald Reagan's advice: "trust but verify" -

Especially when you are being sold stocks are "cheap", or that we are at the start of a recovery, or that you should take out a 109 month car loan (from 2008 & today), or are told to use the equity in your house to buy stocks or use a 7 year car loan to buy stocks  or (alledgedly) get talked into taking out a loan at a 42% annual interest rate...

This behavior and abuse will continue to build until something blows up - which is a large part of the reason why I continue to be so defensive with regards to the market. It's NOT better, it's just that the people who blew it up the first (and second and third) time are TELLING you it's better. they are telling you that they've learned their lesson, that the risks are far lower than they were in 2007 and that there are backstops and protection measures now in place.


We need a present day Ferdinand Pecora to get us back on track. We need to regain control of our financial industry, we need to demand change, and we need to make sure regulators and politicians start representing the best interests of the voters, and not simply that the of monied interests.

It sounds naive, but it's the truth.

We can change things now, or we can wait for another crisis.. it's entirely up to us.

caveat emptor..