Last week the Law Commission produced a report on fiduciary duty in financial services. It was a recommendation of my 2012 review on equity markets that they be asked to do so. The obligations a financial intermediary owes to its clients are, as the commission explained, a complex mixture of common law, regulation, contract, and custom and practice.
The world was once simpler. A century ago, after one Mr Jackson, a stockbroker, sold dubious shares from his own portfolio to a Mr Armstrong, his client, he was taken to court. He faced the stern wrath of Sir Henry McCardie, the judge: “The prohibition of the law is absolute. It will not allow an agent to place himself in a situation which, under ordinary circumstances, would tempt a man to do what is not the best for his principal.” Jackson was ordered to make good all Armstrong’s losses.
McCardie would have regarded the concept of a broker-dealer as a contradiction in terms. But from the perspective of Bernard Madoff – who, before he turned to Ponzi schemes, was a pioneer of the new breed of broker-dealers that emerged in the 1960s – paying for order flow was as innocuous as financing a rack of tights at the supermarket till. In due course, market-makers would accept payment to allow high-frequency traders to access their dark pools . That was as innocuous as licensing pickpockets to roam the supermarket aisles.
The management of conflict of interest is a slippery slope, and one that Madoff eventually slid off. Even Goldman Sachs sometimes finds it uncomfortable. Daniel Sparks, the former head of the bank’s mortgage department, struggled to explain the Abacus transaction, in which Goldman was accused of constructing and selling to its clients collateralised debt obligations based on mortgage pools that Paulson & Co, the hedge fund, had selected as likely to fail. After a series of equivocal responses at a Senate hearing, the exasperated Susan Collins, a US senator, asked: “Could you give me a yes or no to whether or not you considered yourself to have a duty to act in the best interests of your clients?” After a long pause, Mr Sparks finally replied: “I believe that we have a duty to serve our clients well.”
In the older, simpler world of McCardie, handling other people’s money involved an onerous responsibility.
The money in the global financial system has always been other people’s money. The Abacus transaction was a link in a chain. At one end were the depositors and policyholders of the banks and insurance companies that held the Abacus bonds. At the other were the beneficiaries of the institutions that had invested in Paulson’s funds. Quite possibly, some people were on both sides of the deal.
The regulatory requirement to “treat customers fairly” is a good deal weaker than a duty to act in the best interests of a client, and even that obligation is weakened as one moves along the chain to the professional investor and the regulatory concept of the “eligible counterparty”. But why should savers lose protection against abuse because they trust intermediaries with their money? Savers – most of them – have not chosen to enter a game in which they choose the players that represent them in the hope that they will outwit the players others have chosen. They have not decided to bet on team BlackRock to beat team Fidelity or vice versa. They are looking for a safe home for their cash and savings.
When you talk to people in the financial world, you encounter many – notably in retail banking and asset management – who have a strong sense of responsibility to their customers and clients. You also encounter others who appear to recognise no obligation other than to make as much money as possible for their employer and – particularly – themselves. The only way to restore trust in the finance industry is to emphasise the former more and the latter less.
Both brokers and dealers have a role to play in making markets. But what is unacceptable is to spout rhetoric that proclaims the primacy of the interests of the client while the reality is quite different. McCardie saw that you could be an agent or a trader; but you could not be both at the same time, and you had to make entirely clear to the customer which role you were playing. That is surely as wise today as it was a century ago.
