Many transition managers purport to offer ‘fiduciary transition management services’. But what does this really mean? Clients and prospects might intuit the phrase to mean that the transition manager will at all times act in the best interests of their client — even to their own detriment. But in the modern financial world, is this realistic or merely a false promise with no regulatory enforceability? How should pension plans ensure that transition managers are really providing appropriate levels of protection?
In the UK transition management services are usually delivered by providers acting either as a broker/dealer or as an investment manager (discretionary manager). Clients are generally classified by the UK Financial Services Authority (FSA) as either intermediate clients or market professionals. These classifications – of both service providers and clients — place specific requirements on the transition manager.
At the top level, both broker/dealers and investment managers must comply with overriding FSA principles, including Principle 8, which mandates that conflicts of interest be managed fairly between the provider and the client. But this is where the similarities end.
The specific conflicts rule, requiring firms not to act unless they take steps to ensure fair treatment for their client, only applies to advice and discretionary dealing. Investment managers musts enter into a FSA-compliant contracts that disclose all potential conflicts of interest. Broker dealers providing execution-only services, by contrast, are not required to enter into FSA compliant terms of business.
The US concept of fiduciary
In the US, investment advisory and execution services are governed by the Investment Advisers Act of 1940 (“40 Act”) which regulates conflicts of interest in investment companies and securities exchanges and by the Employment Retirement Income Security Act of 1974 (Erisa), which sets minimum standards for most voluntarily established pension plans. By these regulations an investment advisor acts as a ‘fiduciary’ - a highly-qualified, independent expert with the responsibility for the overall outcome of an event. This fiduciary has both a duty of care (requiring best execution and other best practices) and loyalty (which requires full and fair disclosure of fees and potential conflicts).
Broker/dealers are not obliged to maintain the same exclusive loyalty. As a trader, a broker/dealer can have multiple potential sources of revenue from each event and while it is in the firm’s long-term commercial interest to treat all sides fairly (and regulation imposes some helpful safeguards), when competing interests exist, they cannot all be placed first. Also under their regulatory mandate, transactions are viewed in isolation and negotiated individually. For trading relationships involving large institutional clients, all parties are presumed capable of protecting themselves. While exact duties vary according to the circumstances, the general legal rule is much less restrictive than the fiduciary obligation.
The US regulatory regime fundamentally prohibits a fiduciary from executing transactions as a principal counterparty to the client. However, under particular circumstances an exemption may be granted based on overcoming certain hurdles and meeting certain criteria. These requirements may include some or all of the following:
The transition manager must obtain client authorisation for each individual principal transaction completed by the transition manager or any of its affiliates.
The transition manager must be able to verify that the terms offered are at least as favourable to the plan as those generally available in arms-length transactions between unrelated parties. This requires that the transition manager obtain quotations from at least one of an agreed-list of independent financial institutions based on an agreed time of execution; match the best quote given and maintain records of all quotations received.
Transaction reporting
The transition manager must provide all the details above of the transaction to the client in a timely manner.
These requirements make it virtually impossible for a fiduciary to act as principal counterparty to a client transaction. For investment banking firms that are executing trades as principal counterparty the preferred market practice is to appoint an independent transition fiduciary to oversee any principal transactions.
The term ‘transition management fiduciary’ is often misused in the UK marketplace – this is certainly the case if one defines the term according to stringent US requirements. A UK fund looking for a transition manager to act as a fiduciary, as defined by the US regulatory mandate, should ensure that neither the transition manager nor its affiliates trade as principal unless they meet each of the requirements detailed above. The bottom line: the best way of managing a conflict of interest in not to have one in the first place.
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State Street Global Markets provides specialised investment research and trading in foreign exchange, equities, fixed income and derivatives. Its goal is to enhance and preserve portfolio values for asset managers and asset owners. From its unique position at the crossroads of the global markets, it creates and unlocks value for its clients with original flow-based research, innovative portfolio strategies, trade process optimisation, and global connectivity across multiple asset classes and markets.
