Tuesday, October 2, 2012

Essay on Fiduciary Duty

Fiduciary Duty: Duty of Care and Duty of Loyalty

The recent financial crisis and the economic turmoil it has brought about unveiled more than a few weaknesses of the current financial services industry. Is has shown, for instance, that some of the latter’s economic predictions and financial investments proven to be utterly wrong. But equally (and sometimes even more) severe were the accumulating evidence that the financial sector’s seemingly strict codes of conduct – which allow them to be as powerful as they are – have been breached too often and for too long.

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The backbone of the whole financial sector is trust. Individuals, institutions and countries allow the financial sector to hold, manage and invest their liquid equity because they neither a plausible alternative to the current structure of the banking system, nor they have a reason to doubt financial firm’s commitment to its clients. This commitment, known as fiduciary duty, is the subject matter of this paper, which calls for a rigorous rethinking about the concept in light of the recent financial crisis.

A discussion about fiduciary duty usually revolves around two kinds of duties, namely duty of loyalty and duty of care. The specific characteristics of each duty (in terms of the behaviors they prescribes) may vary among contexts (e.g. corporate vs. financial affairs) and/or fiduciaries (e.g. directors vs. investment bankers), but the general meanings of these two duties define fiduciaries’ responsibilities to principals in terms of:
  • Duty of loyalty: an obligation on behalf of the fiduciaries to put the principles’ interests ahead of their own and to avoid conflict of interests
  • Duty of care: the fiduciaries’ to serve principles’ best interests and to avoid acts and/or omissions that may lead to inferior results.  

Taking the case of Enron as an example, the company’s executives and clearly violated their duty of loyalty to their shareholders. In contrast, Enron’s auditors Arthur Andersen seem to have failed to meet their requirements under duty of care, as they could discover Enron executives’ fraudulent deeds but did not do so. However, the assumption regarding Arthur Andersen’s failures in the field of duty of care indicates a serious flaw in the definition of this duty.

The problem with duty of care is that except extreme cases in which fiduciaries act in an utterly irrational fashion, there is no legal way to link the disastrous effects of their actions to a breach of duty of care (Black, 2001). This is because of the fact that, simply put, “there is no general principal that will determine the existence and scope of a duty of care in all cases” (Brooks & Dunn, 2010, p. 458). By the same token, it seems that the current definition of fiduciary duties is too weak to prevent the aggressive and irresponsible behavior, which led to the 2008 collapse of Lehman Brothers (“Oh, brother”, 2010).

But even if the duty of care is relatively weaker than the duty of loyalty (Black, 2001), one should not be too confident about the latter duty’s premise to secure invertors’ interests. Even when firms maintain strict policies to prevent conflict of interests there is always a considerable risk of insider trading in the financial firm’s own stock and/or in assets it controls. All it takes to get there is one employee with a big mouth and a poor sense of ethics. This is especially true for workers of struggling firm, and even considering by hardcore capitalists as a natural mechanism to ensure and predict fair market prices (Bandow, 2010). In fact, the digital era allows any employee to post information with devastating implications on an anonymous blog, thereby violating his or her duties without ever being caught (Lee, 2006).

Needless to say that even a stricter set of enforcement for issues of fiduciary duty and corresponding obligations would not able to prevent opportunists from using their clean and decent image to deceive investors. The perfect example for this case is Bernard Madoff, who could not carry out his mega ponsi scheme without his (apparent) high fiduciary duty standards, as demonstrated in his career in Wall Street (Creswell & Thomas, 2009).

The evidences discussed in this paper and others leave a very little room to doubt that fiduciary duty is based too much gentlemen’s codes to be considered as strong grounds for investors. However, it is not so certain that strengthening the legal holdings of fiduciary duties can contribute to solving current weaknesses in financial markets; instead, there are good grounds to the argument that increasing the scope of fiduciary duty will result in greater complexity of management and control without reaching material improvement in stakeholders’ rights (Harman, 2010). Possible remedies should therefore stem from other components of the legal framework that surrounds our bulky financial system.  
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