When I was a compliance director, my biggest frustration was not being able to share certain legal information with the broker-dealer’s registered representatives and those who maintained independent RIAs. I understood the BD’s position, namely that volunteering such information potentially increased the BD’s liability exposure. At the same, I knew we could truly help the reps and RIAs.

One thing that I do not think enough independent RIAs understand is that even if the members of the RIA are affiliated with a broker-dealer, the broker-dealer has no legal obligation to help the RIA with compliance matters vis-a-vis the RIA or any other legal matter of the RIA. As a result, I often encounter RIAs that are not compliant with key legal issues, resulting in liability exposure for the RIA.

When I speak to RIAs, I explain that there are two levels of compliance. One level of compliance deals with the various RIA rules pertaining to record keeping and internal procedural matters such as required manuals. Violations of these rules usually only result in fines unless serious and/or repeated violations are involved.

The second type of violations involve actions by an RIA that cause harm to the public and/or an RIAs clients. These violations involve potential liability for an RIA and, if serious enough, can result in the closure of the RIA and both civil and criminal sanctions.

As a securities attorney and RIA compliance consultant, I deal with potential RIA liability issues on a regular basis. As I tell my clients, they may not like what I tell them, but my goal is protect you and the RIA from liability problems. As a former compliance director and a securities attorney, that is the value added service that I can provide that non-legal compliance consultants cannot provide.

When I represent a client against an RIA, the first thing I do is review the case to see if I can have the adviser held to liability under the fiduciary standards, namely the duties of prudence and loyalty. I usually see the same attempted pattern of excuses/defenses by the RIA:

“We’re not subject to the fiduciary standard.” Sorry, strike one. If you are an RIA or an investment advisory representative (IA) of an RIA, you are held to a fiduciary standard. (the Capital Gains decision). Many financial advisers incorrectly believe that a financial adviser cannot be held to a fiduciary standard on non-discretionary accounts. Both the Lieb and the Mihara decisions clearly establish that financial advisers can he held to  a fiduciary standard when it can be shown that the adviser had de facto control over the customer’s account. As the Mihara court stated,

The account need not be a discretionary account whereby the broker executes each trade without the consent of the client. …the requisite degree of control is met when the client routinely follows the recommendations of the broker. 

The applicable standard for both registered representatives and RIAs was set out even more clearly by the court in Carras v. Burns, where the court stated that

In the absence of an express agreement, control may be inferred from the broker-dealer relationship when the customer lacks the ability to manage the account and must take the broker’s word for what is happening….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. 

Hint: Some securities attorneys have been known to successfully argue that not many investors understand Modern Portfolio Theory and/or those pretty little pie charts based on same, therefore the adviser had de facto control over the account and all fiduciary standards apply. Checkmate.

“But we do not provide advice through the RIA, only as registered representatives of the BD” This is the old two-hat argument. The most common argument against this defense is that set out in the Arlene W. Hughes decision. The court noted that when one serves in the dual capacity of investment adviser and registered representative, “conflicting interests must necessarily arise.” When they arise, the court noted that the law step in to protect the public since

The business of trading is one in which opportunities for dishonesty are of constant recurrence an ever-present. It engages acute, active minds, trained to quick apprehension, decision and action. The Congress has seen foot to regulate this business. [Such regulations are] to be enforced notwithstanding the frauds to be suppressed may take on more subtle and involved forms than those in which dishonesty manifests itself in cruder and less specialized activities. 

I believe that many financial advisers are honest and truly aim to help the public. On the other hand, my files are filled with cases indicating that not all financial advisers maintain such high standards. The two-hats ruse can be effectively dismissed. Strike two.

And finally, the “I did not know and I did not mean to hurt them” defense. The courts have often cited the standard establish by the Donovan v Cunningham decision, namely that “a pure heart and an empty head are no defense” to a charge of breach of fiduciary duties.” Strike three.

Which brings us to the issue of “quantum meruit,” a Latin term meaning “as much as he deserved.” At some point in the case the financial adviser will usually argue that he/she is entitled to compensation for his/her advice. Nope, simply not true.

Quantum meruit is closely related to the concept of unjust enrichment. Both are equitable principles that seek to prevent one party from taking advantage of another party. The issue usually arise where there is no formal agreement between the parties, but can also be raised as an equitable claim where there are questions as to what amount of payment is properly due for work done.

One of the basic principles behind both quantum meruit and unjust enrichment is that the party seeking compensation actually provided valuable services or advice to the other party. If no valuable services or advice were provided, no compensation is deserved. Furthermore, valuation of the services or advice in question is determined objectively, without regard to subjective opinions. 

Once it is established that a financial adviser will be held to the fiduciary standards, the value of their services or advice will be judged according the duty of prudence (avoidance of unnecessary fees and the avoidance of significant losses) and the duty of loyalty (requirement to always put a client’s interests first), with settlement usually following, as there are three common breach of fiduciary duty screens that often ensnare investment fiduciaries.

I offer this information simply to alert investment advisers that they need to properly  establish and maintain an effective risk management program for their advisory services. A failure to properly maintain the required files and operating manuals may result in fines. A failure to properly establish and maintain an effective risk management program can result in the loss of an adviser’s business, as well as civil liability and unlimited monetary damages.