The Fiduciary Dilemma in Large-Scale Organizations: A Comparative Analysis

Andrew Tuch is Associate Professor of Law at Washington University School of Law. This post is based on an article authored by Professor Tuch, forthcoming in Research Handbook on Fiduciary Law, edited by Andrew S. Gold & D. Gordon Smith.

In the 1970s and ’80s, as financial conglomerates grew significantly and diversified their operations, they increasingly faced conflicting duties and interests. For instance, thanks to their widening range of activities, firms found themselves obliged under agency law to disclose information to clients even when doing so violated duties of confidence to other clients. Firms also began to participate directly in transactions involving their clients, creating conflict between firms’ financial interests and fiduciary duties to clients. At the time, courts and scholars in the United States and United Kingdom observed the fundamental tension between firms’ organizational practices and the fiduciary duties they owed. Some saw in this “fiduciary dilemma” an existential problem: firms, ultimately, would need to slim down their operations, perhaps even to disaggregate, to avoid fiduciary liability.

These concerns could not be easily dismissed. The primary mechanisms for allaying them—information barriers, then known as Chinese walls, and contractual disclaimers of fiduciary duties—had not been endorsed by courts or regulators, and scholars doubted their effectiveness. In 1992 the UK Law Commission observed that the challenges posed by fiduciary law went “to the core of the structure of the financial markets.” [1] “At bottom,” the Commission reported, “the Chinese wall will not work as a matter of private law” and contractual disclaimers “cannot … safely be relied upon. [2] US law was no different. [3]

In The Fiduciary Dilemma in Large-Scale Organizations: A Comparative Analysis, a contribution to the forthcoming Research Handbook on Fiduciary Law, edited by Andrew S. Gold & D. Gordon Smith, I examine how the fiduciary dilemma has been addressed. I seek to explain how financial firms have managed to continue growing and diversifying despite the imposition of fiduciary constraints generally seen as robust. I consider the erosion of fiduciary duties by contract, regulators’ and courts’ legitimation of information barriers as checks on conflicts, the implicit modification of fiduciary principles by regulation, the shift toward arbitration of client disputes, and clients’ non-enforcement of fiduciary duties.

I argue that contract has been fairly successful in eroding the force of fiduciary doctrine in the United Kingdom, yet contract does not fully resolve the fiduciary dilemma there. While UK courts have become far more willing to permit parties to contractually exclude, modify, or otherwise defeat fiduciary protections, important limits still exist on parties’ ability to avoid the constraints of fiduciary law. And in the United States, fiduciary doctrine has retained its vigor in important areas. Indeed, agency law has arguably grown stricter in prohibiting parties contracting out of fiduciary duties.

Judicial or regulatory acknowledgement of information barriers also does not offer a complete explanation for the apparent weakness of fiduciary constraints on financial conglomerates. Information barriers are self-enforced by firms. They consist of policies and procedures intended to prevent employees in one part of a firm spreading non-public information to employees in other parts of the firm. [4] In the United States, the Securities and Exchange Commission has never formally endorsed information barriers as legally effective means of addressing the fiduciary dilemma, although the regulator acknowledges their usefulness for other purposes, such as avoiding insider-trading liability. Only recently have courts affirmed the legal efficacy of information barriers in satisfying fiduciary duties. But this conclusion is conditioned on barriers’ practical effectiveness in stanching information flows, which cannot be assured. In the United Kingdom, information barriers may serve a similar purpose, especially when used in combination with contractual measures. However, as in the United States, doubt remains as to their legal effectiveness in satisfying fiduciary duties. In 1992 the Law Commission suggested legislation to formally recognize that information barriers satisfy fiduciary duties (or avoid their breach), but its provision was never adopted.

There are indications under US and UK law that courts will take account of coexisting regulatory regimes to mold the scope of fiduciary duties, potentially addressing the fiduciary dilemma. Consider a quandary the District Court for the Southern District of New York faced in 2011. JP Morgan allegedly had breached its fiduciary duty to an asset-management client by lending money to a company in which it had invested the client’s funds. When that company subsequently went bankrupt, the bank’s loan ensured it a higher-priority claim to the company’s assets than the asset-management client enjoyed. [5] (The client lost its investment, while the bank profited, allegedly in the amount of $2 billion.) The court warned that if fiduciary law were given its usual effect, extreme consequences would follow, including “ultimately, … the disaggregation of commercial and investment banking functions from asset management.” [6] The court sought to avoid this result but had no controlling authority on which to base a decision. Instead, the court referred to the intended effect of the Gramm-Leach-Bliley Act of 1999, the purpose of which was to create multifunction financial institutions. The court held that the statutory framework implied relaxation of strict fiduciary duties that would otherwise apply. JPMorgan could breathe easy. The case nicely illustrates the fiduciary dilemma and acknowledges what’s at stake. But it is not clear that future courts will take the same approach. The position in the United Kingdom is clearer: the Law Commission in 2014 asserted that fiduciary duties would conform to inconsistent regulatory rules, in effect allowing firms to perform functions that would otherwise be incompatible under fiduciary law.

In the chapter, I explore two other possible explanations for the continued growth and diversification of firms despite the imposition of fiduciary constraints. One is that financial conglomerates have avoided the consequence of conflicting duties and interests in litigation by requiring many of their disputes to be arbitrated. In the late 1980s, the US Supreme Court upheld the enforceability of contractual provisions which require clients to relinquish their rights to litigate disputes with broker-dealers and instead resolve them by arbitration. Since then, virtually all financial conglomerates have adopted mandatory arbitration provisions in contracts with broker-dealer clients, including retail clients. Investment advisors also commonly use such provisions. In consequence, disputes that would otherwise have been litigated are resolved by arbitration. Breach of fiduciary duty was, and remains, among the claims most commonly advanced by clients in arbitration, but the success of such claims is not evident, as many arbitrators do not disclose the reasoning behind their decisions. Thus, shortly after the fiduciary dilemma was broadly recognized, opportunities for disputes to be publicly ventilated and ruled on by courts largely dried up in the US, suggesting that apparent weaknesses in the force of fiduciary doctrine stemmed in part from the inability of parties to litigate their concerns.

Finally, in some contexts, clients of financial conglomerates rarely sue their fiduciaries. In the case of investment banking, for example, it is most unusual for a client to sue its financial advisor. In the chapter, I briefly consider reasons for clients’ failure to pursue fiduciary remedies. Understanding this client tendency will require further inquiry.

Weighing potential explanations side-by-side, I tentatively conclude that the weak deterrent force of fiduciary duties in the US owes less to changes in the law than to inhibitions on its enforcement. Financial conglomerates there have successfully evaded the fiduciary dilemma, engaging in activities that have amplified the risk of conflict even as legal doctrine supposedly ameliorates it. In the United Kingdom, by contrast, courts have been generally willing to conform fiduciary duties to inconsistent regulatory rules, thus addressing the fiduciary dilemma.

The complete article is available for download here.

Endnotes:

1Law Commission, Fiduciary Duties and Regulatory Rules, 1992, Consultation Paper 124, at 7, 8, 222.(go back)

2Id. at 8.(go back)

3See, e.g., Norman S. Poser, Chinese Wall or Emperor’s New Clothes? Regulating Conflicts of Interest of Securities Firms in the U.S. and the U.K., 9 Mich. Y.B. Int’l Legal Stud. 91, 103–13 (1988).
(go back)

4For more detail, see Andrew F. Tuch, Financial Conglomerates and Information Barriers, 39 J. Corp. L. 563 (2014), available at https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=2363312.(go back)

5Board of Trustees of AFTRA v. JP Morgan Chase Bank, 806 F. Supp. 2d 662 (S.D.N.Y. 2011).(go back)

6Id. at 690.(go back)

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