The Regulators Do Not Understand Conflicts – ValueWalk Premium
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The Regulators Do Not Understand Conflicts

Click here to listen to a podcast commemorating the 80th anniversary of the 40 Act and the future of the fiduciary standard, featuring Knut Rostad, Ron Rhoades and Jim Allen.

Q2 2020 hedge fund letters, conferences and more

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Tamar Frankel may well be the godmother of fiduciary law in the West. Born in Israel, Professor Frankel earned her first legal certificate in Jerusalem in 1948. An L.L.M. and S.J.D followed from Harvard Law School in 1964 and 1972. For 48 years she taught generations of students and regulators while writing extensively at the Boston University School of Law. Today professor Frankel is professor of law emerita.

I spoke with her on August 28.

You have written about the origins of fiduciary law, from Hammurabi to Roman law and

In England in the Middle Ages. What should regulators and policymakers take away from this History? Why does it matter?

The most effective way to destroy any healthy and lasting economy and financial system is to relieve intermediaries – whether advises, brokers, bankers, or others – of a duty to be trustworthy. That means to relieve them of the obligation to do what they promise to do for the benefit of their clients. If they have conflicting interests, they must tell the clients about these conflicts, in understandable language. If a client does not understand the conflict, then the adviser must either eliminate the conflict or resign from advising the client. Here is the importance. The history is revealing. The history of every financial disaster tells the same story. It has at its roots breaches of fiduciary duties.

The Investment Advisers Act of 1940 had its 80th anniversary in August. It was enacted because of abuses in the markets in the 1920s. The Supreme Court affirmed in 1963 that the 40 Act places a fiduciary duty on investment advisers. The main pillar of the rule, as set out by the Court in its Capital Gains Research case, is the vital importance of eliminating conflicts of interest, as much as humanly possible. Put us into the heads of the authors of the law in 1940. Help us understand why they were so adamant about conflicts of interest.

The Investment Advisers Act of 1940 deals with a service that is important not only to investors but to the country’s economy, financial system and public good. The service – investment advice – cannot be performed by most people. Investors must rely on the advice of others, advice they generally cannot understand. Yet, they bear the results of the advice.

The 1940 Act followed a disastrous failure of the securities system – a failure whose results were similar to the COVID-virus disaster that struck the world this year. The main difference is the “virus” that attacked the financial system almost a century ago was self-inflicted, i.e., it was driven by the conflicts of interest of those who advised investors and managed their money.

Many of those advisers, brokers and managers stood out in at least two ways: (i) They did not know what real advice meant; and (ii) how much that their interests conflicted with the interests of their clients whose money they controlled. These two wrongs were fatal to their advice and contributed richly to the disaster of the market crash in 1929. These same wrongs present greater risks to the markets today and greater risks than does the COVID virus.

Most people are basically honest. Yet, when advisers, brokers or managers have power over other people’s money and have no guidance and supervision, bad things happen. They’re on their own. Temptation creeps in – first, with a “little” extra benefit and some justification, cutting corners in serving customers becomes habit. Rationales develop. Nuanced explanations become misleading statements that can become fraudulent.

Read the full article here by Knut Rostad, Advisor Perspectives


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