As a securities attorney that represents investors and provides consulting and compliance services to RIA firms, I can honestly say that one of the most common problems I encounter with RIA firms is a failure to develop an effective risk management system for the firm. In some cases this oversight is due to a misperception that a broker-dealer will provide the RIA firm with whatever compliance information the RIA firm needs to know.  In other cases, the oversight is due to a reliance on a non-legally trained compliance consultant and, thus, a failure to monitor applicable court and regulatory decisions.

Yes, I am an attorney, but the previous statement is not meant to be a self-serving statement.  When I represent an investor in a case against a stockbroker, one of the first things I do is analyze the case to determine whether I can make a good faith argument that the broker was acting in a fiduciary capacity and therefore the more stringent fiduciary standard, not the suitability standard, is the applicable liability standard. 

When faced with litigation, brokers and their broker-dealers are usually quick to produce new account forms and argue that the account was marked “non-discretionary,” thereby preventing the broker from being deemed a fiduciary.  In other cases, the old “two-hats” argument is advanced to deny a broker’s fiduciary status.

However, to quote Lee Corso of ESPN, “not so fast my friend.” The U. S. Supreme Court decision in the Capital Gains decision established that all investment advisers are fiduciaries.  As for the “two hats” argument, the courts have stated that when a financial adviser acts simultaneously in the dual capacity of investment adviser and of broker and dealer,

“conflicting interests must necessarily arise. When they arise, the law has consistently stepped in to provide safeguards in the form of prescribed and stringent standards of conduct on the part of the fiduciary…’in this conflict of interest, the law wisely interposes. It acts not on the possibility, that, in some cases, the sense of that duty may prevail over the motives of self-interest, but it provides against the possibility in many cases, and the danger in all cases, that the dictates of self-interest will exercise a predominant influence, and supersede that of duty.’”¹

FINRA recently released Regulatory Notice 12-25 regarding the suitability obligations of brokers and broker-dealers.  One of the questions addressed in the Notice was a broker’s duty to always act in the best interests of the client.  Some argued that this position would force brokers to adhere to the fiduciary standard of care rather than the more common suitability standard for brokers.  FINRA rebuffed the brokers’ arguments and referenced several legal decisions and regulatory decisions that had previously mandated that brokers always act in a client’s best interests, effectively shooting down the “two hats” argument again.

As a former compliance officer, I always enjoyed squaring off with the brokers and advisers over the “non-discretionary” issue.  Short and simple – the “non-discretionary” issue is only one of the issues that the courts and regulators consider in deciding whether the fiduciary standard will be used in determining the issue of liability.  Both the courts and the regulators make their evaluations based on substance, not style. 

The key question is whether or not the broker controlled the account, regardless of how the account was labeled. If the broker is found to have controlled the account, then the applicable standard of care will generally be the fiduciary standard.

If a broker is formally given discretionary authority to buy and sell for the account of his customer, he clearly controls it.  Short of that, the account may be in the broker’s control if his customer is unable to evaluate his recommendations and to exercise an independent judgment. The touchstone is whether or not the customer has sufficient intelligence and understanding to evaluate the broker’s recommendations and to reject one when he thinks it unsuitable.²

The issue is whether or not the customer, based on the information available to him and his ability to interpret it, can independently evaluate his broker’s suggestions.³

So there are various methods an attorney can use to get the courts or regulators to hold a financial adviser to the higher “best interests of the client” fiduciary standard.  Fortunately for RIA firms, there are several relatively simple steps they can take to reduce any potential liability exposure.

First, develop and follow an established due diligence process and document both the process and enforcement of the process. 

Brokers [and investment advisers] are ‘under a duty to investigate, and their violation of that duty brings them within the term ‘willful’ in the Exchange Act. [A broker or adviser] cannot deliberately ignore that which he has a duty to know and recklessly state facts about matters of which he is ignorant. He must analyze sales literature and must not blindly accept recommendations made therein.⁴

Second, review and verify any financial plans or asset allocation/return projections.  Most asset allocation/portfolio optimization software programs are relatively unstable and easily susceptible to errors.  When I take a case I reverse engineer any plans or projections that were used in connection with the investor, with special emphasis on those areas that are most vulnerable to errors.

With regard to asset allocation recommendations, the two most areas of concern for advisers should be the quality of any risk tolerance questionnaire and the viability of the input data used in any asset allocation/portfolio optimization software program, particularly the risk and return assumptions used for the various assets or asset categories. Seemingly insignificant errors in the input data can result in significant errors in the recommendations produced.

Third, ensure that any recommendations made meet the applicable standards of care.  Address all three prongs of the risk tolerance equation – willingness to accept investment risk, ability to bear investment risk, and need to accept investment risk. With regard to suitability, assess both the issues of qualitative suitability and quantitative suitability. With regard to cost, perform some form of meaningful cost benefit analysis.  Document both the RIA firm’s process and findings in all of these areas and be prepared to produce them as part of a regulatory audit or a civil litigation.

I have previously written about a cost-benefit analysis process that I use during fiduciary audits and litigation, a formula that I refer to as the Active Management Value Ratio.  Another popular cost-benefit formula is the Active Expense Ratio.  The key is to use some sort of meaningful analysis to show that an investor is getting true value in any investment or investment strategy being recommended.

In summary, when I speak to attorneys or financial advisers about RIA risk management, I tell them to focus on the three C’s – correlation of returns, consistency of advice, and cost-benefit analysis. The three C’s cover the basic fiduciary duties – correlation (duty to diversify to minimize the risk of larger losses), consistency (duty of loyalty), and cost-benefit (duty to control costs and avoid unnecessary costs).  Since an experienced securities attorney is going to focus on those areas in order to win their case, the prudent RIA firm will be proactive and develop  and enforce  an effective risk management program that includes a due diligence process to effectively reduces potential liability exposure in those areas.

                                                               Notes

1. Hughes v. S.E.C., 174 F.2d 969 (D.C.C. 1949)
2. Follansbee v. Davis, Skaggs & Co., Inc., 681 F.2d 673 (9th Cir. 1982)
3. Carras v. Burns, 516 F.2d 251 (4th Cir. 1975)
4. Hanley v. S.E.C., 415 F.2d 589 (2d. Cir. 1969)