Has Schwab Opened Pandora’s Box for RIAs? – Part Two

In a recent post, I suggested that the recent court decision upholding Schwab’s class action waiver in customer’s contracts could have potential liability implications for RIAs and other fiduciaries that recommend or use Schwab, or for that matter any other broker-dealer who adopts such a provision, as a custodian for their clients’ accounts.

Ron Rhoades, someone for whom I have the utmost respect, was kind enough to respond with an excellent analysis discussing points and counter-points to some of my comments. Full disclosure requires me to admit that I had personally notified Mr. Rhoades of my post in hopes that he would respond with his usual expertise. He did not disappoint. Mr Rhoades response can be seen at http://scholarfp.blogspot.com/2013/03/schwabs-forced-customer-waiver-of-right.html

First, a few housekeeping details. As expected, I received quite a few nastygrams.  Despite allegations to the contrary, my post was not meant as an attack on Schwab. Quite the opposite. Schwab is doing what any good business would do, enacting risk management programs to protect their business.

RIAs and other fiduciaries would do well to heed Schwab’s message. In my opinion, the number one mistake that RIAs and other fiduciaries make is failing to implement an effective risk management program for their own businesses. RIAs can have all the manuals and other compliance materials required by the ’40 Act or their state’s applicable regulations.  But unless they have implemented and followed an effective risk management program for their RIA, all it takes is one legal action to effectively dismantle their business, especially since a private legal action is often followed by a regulatory audit.

Schwab is taking a prudent action to try to protect their business.  However, unless a customer signs Schwab’s agreement, Schwab owes them no duty, fiduciary or otherwise.  Given current laws and legal decisions, Schwab, as a broker-dealer, would generally not be deemed a fiduciary to a client that signs their agreement with the class action waiver provision.

On the other hand, RIAs and other fiduciaries who might recommend or use Schwab, or any other broker-dealer who adopts a similar class action waiver requirement, would already be in a fiduciary relationship with their client, and thus would have concerns that Schwab would not. While I am not advocating that RIAs and other fiduciaries not do business with Schwab or other broker-dealers that may adopt the class action waiver policy, the fact that Schwab and RIAs and other fiduciaries are in significantly different positions as far as potential liability exposure simply cannot, and should not, be ignored by RIAs and other fiduciaries.

As I mentioned in my earlier post, I think the likelihood of a finding of a fiduciary would increase in large part on the benefits that an RIA or other fiduciary received from the broker-dealer. As a former compliance director, both RIA compliance and general compliance, broker-dealers generally provide registered representatives and RIA affiliates with various forms of benefits.

In terms of the class action waiver issue, it could be argued that the receipt of such benefits could constitute a breach of the fiduciary duty of loyalty and an impermissible conflict of interest. A fiduciary’s duties impose an even higher duty on the fiduciary and allegations of breaches of such duties are closely scrutinized, with little, or no, margin of error.  Famed jurist Benjamin Cardozo clearly explained the high standard for fiduciaries in his landmark decision in Meinhard v. Salmon, when he stated that

A [fiduciary] is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctillo of an honor the most sensitive, is then the standard of behavior….

Mr. Rhoades has suggested that RIAs should provide greater disclosure if they should choose to do business with a broker-dealer that requires customers to agree to the class action waiver. While I am certainly an advocate for greater transparency in the financial services industry, I am not sure that greater disclosure would prevent a finding of a breach of fiduciary duty.

My opinion is based primarily on the unyielding attitude that the courts take towards protecting the public and enforcing the well-established duties of a fiduciary.  A breach of fiduciary duty claim can be upheld even if the alleged breach did not result in any actual harm to a client, as court will often base their decision on not allowing an otherwise offending fiduciary to avoid liability due to fortuitous circumstances.

The courts are even more vigilant when an alleged breach of fiduciary duties involves a conflict of interests involving a fiduciary’s financial self interests.  As noted by the court in Hughes v. Securities and Exchange Commission, when one both provides financial advice and sells investments products, there is an inherent conflict of interests. Given this conflict, the court stated that the courts will review such cases in order to ensure that the public is not taken advantage of or otherwise harmed.

In light of these judicial positions, I am not sure that any extent of disclosure will save an act that otherwise constitutes a breach of one’s fiduciary duties. Fiduciary duties are essentially absolute, a message reinforced by the “pure hearts, empty head” quote.

From a risk management perspective, the best course of action would be simply to avoid engaging in any actions which could be interpreted as a breach of one’s fiduciary duty, any actions in which a question could arise as to whether the fiduciary’s actions were in the client’s best interest. One of my client asked me if it would permissible to have a client sign a waiver to protect against such potential liability. The simple answer…no. After all, that’s the whole issue here, asking a client to waive a significant legal right. Furthermore, any RIA that asks a client to waive a legal right could be prosecuted for fraud under Section 206 of the ‘Act.

If you compare my original post and Mr. Rhoades response, I think you will find that our opinions are not that different.  We both support the idea that the class action waiver provision could have potentially significant liability implications for RIAs and other fiduciaries given the different standards of legal liability review for the parties.  I think we both agree that RIAs and other fiduciaries need to be more conscious of the importance of designing effective risk management programs for the RIA and other fiduciary practices.

When I joined LinkedIn, it was with the hope that the site would provide interesting posts and conversations that would benefit both myself and fellow professionals in managing their practices and better serving their clients. I know that I have enjoyed this discussion with Mr. Rhoades. As I mentioned earlier, I have always respected him and his expertise, and continue to do so.


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.
This entry was posted in compliance, fiduciary compliance, fiduciary law, RIA, RIA Compliance, securities, securities compliance and tagged , , , , , , , . Bookmark the permalink.

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