Five Legal Decisions Every RIA and Fiduciary Should Know

In his most recent book, “The New Wealth Management, “ respected industry expert Harold Evensky noted that investment advisers have an obligation to understand both their professional duties and their legal responsibilities.  While compliance violations often result in fines, legal violations can threaten the very existence of an advisory firm.

As a former RIA compliance manager for one of the nation’s largest independent broker-dealers, I was always struck with the RIA members’ lack of knowledge about the legal requirements for investment advisers.  In some cases I found that RIA firms mistakenly believed that their broker-dealers had an obligation to advise them as to such requirements.  In other cases I found that the firms just decided to take a chance and hope that nothing happened.

My experience as a compliance officer led me to write “The Prudent Investment Adviser Rules” (“Rules”) for my compliance clients.  The “Rules” is a living document reflecting various key legal and regulatory decisions impacting the investment advisory business, adding new rules as they develop.  At present, there are forty-two rules.

The purpose of this post is to discuss five decisions that threaten every RIA practice. In the first case, the broker had invested one-hundred percent of a customer’s account in one highly speculative stock and had recommended that the customer open a margin account in order to purchase even more of the stock.  The customer was inexperienced in investing and had indicated a desire for conservative investments.

The broker argued that his primary obligation was simply to make sure that the customer was “fully advised of the all the facts and could make intelligent decisions.”  In ruling against the broker, the panel stated that a broker’s suitability obligations require more that than just risk disclosure.  The panel ruled that suitability involves both a customer’s willingness and ability to assume the risk inherent in a broker’s recommendations.

An interesting aspect of this 2001 decision is that Harry Markowitz, the father of Modern Portfolio Theory (“MPT”), had made the same observation regarding MPT based recommendations back in 1952 when he released his seminal book, “Portfolio Selection.”  Advisers often attempt to justify questionable recommendations by pointing to MPT, only to be hoisted on their own petard due to their lack of knowledge of Markowitz’s entire theories.

A third prong is emerging in investment suitability cases, that being a customer’s need to assume the risk inherent in an adviser’s recommendations.  Advisers need to avoid getting so wrapped up in theory that they overlook practical, real world applications and solutions.

Takeaway #1: Make sure your recommendations are consistent with a client’s willingness to accept the indicated level of investment risk, a client’s ability to bear such investment risk, and a client’s need to bear such risk.

In the second case, a customer had a significant position in restricted stock.  He had asked his broker about possible ways to provide downside price protection for the stock.  The broker failed to advise the customer of various hedging techniques that were available to provide the desired price protection.  After absorbing a significant loss in the stock, the customer learned through another brokerage firm that there were hedging strategies that could have been used, such as collars. 

In ruling on a preliminary motion, the court ruled that the customer’s allegations of fraud, breach of fiduciary duty, and negligence needed to be decided by a jury.  The court ruled that the firm’s failure to properly advise of hedging strategies constituted a “strong inference” of fraud given the firm’s previous representations as to their expertise in providing financial services and investment advice to high-net-worth individuals.

Takeaway #2: Make sure to provide clients with advice regarding various wealth preservation strategies, such as hedging techniques, and let them decide whether to implement same.  Be sure to document that such advice was provided and have the client indicate on the same form as to their decision to use or refuse such advice.

The third case involved a far too common situation.  Two customers had a financial plan prepared by a broker.  During the implementation stage, the broker recommended various investments that were inconsistent with the “optimal/efficient” recommendations contained in the financial plan.  The customers sued on various grounds, including fraud and breach of fiduciary duty.

The case was ultimately decided against the customers on procedural issues.  However, in a preliminary hearing the court did rule that the question of whether the adviser’s failure to implement in a manner consistent with the financial plan he had provided to the customers constituted fraud, which was a question of fact for a jury.

There is a wide-spread belief that the “two hats” theory will protect a broker against being held to the more demanding “best interest” fiduciary standard.  With prices for some plans running into the thousands, all financial advisers need to understand that there are various ways that the courts and regulatory bodies can justify imposing the fiduciary standard on someone providing investment advice to the public.

MPT, Monte Carlo simulations, and other computer-based investment recommendation program all have shortcomings, shortcomings that are well-known throughout the financial service industry.   While such programs can be useful tools in providing investment advice, they are just that, tools.  An adviser’s failure to acknowledge and understand the programs’ weaknesses and limitations, including their use in risk tolerance analyses, can have disastrous results for advisers.

Takeaway #3: If you provide a customer with a financial plan or asset allocation/ portfolio optimization plan, make sure that your implementation recommendations are consistent with the recommendations and assumptions in such plan.  After all, the client paid for a plan whose price is justified on the premise that the plan purportedly represents the best course of action for the client, and the adviser will generally use the plan to induce a client to make changes in their investment portfolio and produce income for the adviser.  

As long as the adviser’s recommendations are consistent with the plan they provided to a client, an adviser will generally not be held liable for an investment’s ultimate performance as long as the process used in making the recommendations was prudent and met all applicable legal and regulatory requirements. However, where an adviser’s implementation recommendations are not consistent with the asset allocation/portfolio optimization plan’s recommendations provided to a customer and the assumptions used in preparing the plan, then a claim for potential fraud and breach of fiduciary duty can, and should, be filed upon the theory of a sophisticated, and illegal, form of “bait and switch.”

The fourth case involves a fiduciary’s ongoing duty to monitor a client’s account when the fiduciary has assigned the responsibility for managing that account to a third-party.  Fiduciary law is based upon a combination of trust law and agency law.  An agent (the fiduciary) has an obligation to protect his principal’s (the client’s) interests and to disclose any and all information which would help the principal protect his interests.  The Prudent Investor Act specifically requires a trustee (or other fiduciary) to monitor all accounts and to take action to protect a beneficiaries’ interests when necessary, the so-called “sue or be sued” rule.  There are numerous cases supporting a fiduciary’s duty to monitor client accounts and to take action when necessary to protect a client’s interests.

Takeaway #4: Monitor all client accounts managed by third-parties on an ongoing basis and take prompt action when questionable activity or performance issues arise, with notification to the client/beneficiary recommended as well.

A case can, and has, been made that this same duty of disclosure applies to accounts transferred to a fiduciary from another fiduciary.   Conceptually, the same trust and agency principles that demand disclosure would apply.  While the fiduciary would not be legally responsible for the acts of the previous fiduciary, there is a question as to whether the new fiduciary could be liable for failing to alert the client or beneficiaries to the questionable activity so that a proper and timely investigation could be made.

The last case involves situations where a fiduciary tries to avoid liability by asserting a claim of good faith and lack of bad intent.  There are numerous cases holding that fiduciary liability is based upon purely objective standards.  Subjective standards are irrelevant in determining a breach of one’s fiduciary duties or, in the words of the courts, “a pure heart and an empty head are no defense.”

Takeaway #5: A fiduciary has an obligation to learn the applicable legal standards governing their duties and obligations to their clients.  Ignorance of the law is not an acceptable defense.    

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors on sound, proven investment strategies that will help them protect their financial security.
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1 Response to Five Legal Decisions Every RIA and Fiduciary Should Know

  1. harvey friedentag says:

    This the least we can all do for our clients. I always have tried to do more.

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