A:

Fiduciary duty is one the most important professional obligations. It basically provides a much-needed protection for individuals or businesses that enter into various types of legal and financial contracts with other entities. Without it, there is nothing preventing one party from unfairly benefiting from a business relationship at the expense of the other party.

What Is Fiduciary Duty?

Fiduciary duty refers to the legal obligation of one party to act solely in the interest of another party. In general, fiduciary duty applies to professionals who handle money or property for others, or advise them in legal or financial matters. A common example of fiduciary duty is the obligation of a lawyer to his clients.

The party who owes the duty is the fiduciary, while the party to whom the duty is owed is called the principal. In general, the fiduciary is barred from making any profit from his relationship to the principal, unless the principal grants specific permission for him to do so. In addition, the fiduciary must avoid any conflicts of interest that may impede his ability to fulfill his obligation to the principal. For example, a lawyer cannot represent both spouses in a divorce case because it is a very clear conflict of interest and prevents him from properly representing either party.

Financial advisors who are registered with the Securities and Exchange Commission (SEC) or state securities regulators also have a fiduciary duty to their clients. However, unlike attorneys, financial advisors are not required to be registered, so many are not bound by fiduciary duty. Instead, they are only required to recommend financial products that are "suitable" for their clients but not necessarily in their best interest. Because it is a legally binding obligation, the choice between using an advisor who is governed by fiduciary duty versus one who is not can be of utmost importance.

Illustrating the Importance of Fiduciary Duty

Assume you have $10,000 to invest in a mutual fund and want to enlist the aid of a financial advisor to help you choose the fund that best suits your investment goals. Advisor A and Advisor B both work for comparable firms that offer comparable funds. The only difference is Advisor A is a fiduciary while Advisor B is not.

Further assume there are three mutual funds that meet your specific financial goals and have identical return rates: one offered by Advisor A's firm, one offered by Advisor B's firm and one offered by third firm. These three funds have projected expense ratios of 2%, 3% and 1.5%, respectively. Both advisors receive commissions from any investment you make in products offered by their firms.

If you choose to employ Advisor A, she is bound by fiduciary duty to recommend the fund with the lowest expense ratio, despite the fact that she does not receive any commission on your investment, because it is in your best interest. If you employ Advisor B instead, he is under no such obligation to look out for your interests. With no fiduciary duty, he is well within his rights to steer you toward the fund offered by his firm to receive the commission, regardless of the fact it has the highest expense ratio.

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