THE Key Factor in Liability Risk Management

I was at a conference recently to serve on a panel to discuss various fiduciary issues, including FINRA Regulatory Notice 12-25 and the universal fiduciary standard. When I am at a conference, I rarely attend other presentations for the very reasons that occurred when I attended one of the conference’s other sessions.

I stood in the back of the room during the presentation. The presentation was fine until the speaker stated that the most important factor in choosing asset allocation recommendations is a client’s time horizon. As soon as he said that, a number of people in the audience immediately turned around and looked at me, as apparently they had heard one of my presentations on the subject.

Investment advisers and other financial advisers who create asset allocation recommendations based solely upon the belief that a client’s time horizon is the most important investment factor should go ahead and call their E&O carriers and put them on notice. The argument commonly advance in favor of time horizon being the most important factor in asset allocation claim that time reduces risk. Various studies have shown that that simply is not true.

When I review a case, I always focus on what I call the “liability factor.” This is the proverbial “line in the sand,” the threshold for professional liability. From a liability standpoint, a client’s risk tolerance level is always an important factor. And in assessing a client’s risk tolerance level, an adviser must remember the two-part, or I argue the three-part analysis required of investment professionals.

In the key case in this area, the James B. Chase decision, the Securities and Exchange panel stated that in determining a client’s risk tolerance level, a financial adviser must determine both a client’s willingness and ability to bear investment risk. While a new account form may indicate a client’s willingness to assume investment risk, other information may indicate that the client’s financial condition is such that they do not have the ability to bear investment risk at all, or only to a limited extent.

Based on recent trends , I would suggest that advisers also need to determine a client’s need to assume investment risk at all. I continue to see cases where the client’s existing portfolio met their needs before the adviser made any recommendations. This issue seems to come up more in cases where income is a client’s primary consideration.

Attempting to designate one factor as the most important factor in evaluating a client simply makes no sense. For example, if a client indicates that their investment objective is “preservation of capital,” then the client’s time horizon is irrelevant. Likewise, if a client indicates that they have a short time horizon with an investment objective of “growth” or “aggressive growth,” then the issue of speculation, as opposed to investing, becomes an issue.

When we made our panel presentation, I used the opportunity to recount the earlier seminar. I suggested to the audience that the factor that most financial advisers should focus on going forward is the comprehensive fiduciary standard of “best interests” of a client. While the SEC and Congress continue to drag their feet on the issue, I have been told that many of the major wirehouses on Wall Street are already conducting in-house seminars on the fiduciary standard.

I realize that brokers and other financial advisers probably do not read regulatory notices. After all, that’s what attorneys and compliance consultants are supposed to do. However, FINRA released a total of three separate regulatory notices during 2011 and 2012 advising brokers as to the agency’s position regarding a broker’s obligations in dealing with clients. As set out in FINRA Regulatory Notice 12-25,

“a broker’s recommendations must be consistent with his customers’ best interests,” meaning that “a broker [is prohibited] from placing his or her interests ahead of the customer’s interests”

The Notice provided numerous regulatory decisions in support of their position. While neither the Notice nor the supporting decisions cited in the Notice used the “f” word specifically, all clearly referenced the “f” word’s “best interests” standard.

The Notice does not distinguish between discretionary and non-discretionary accounts. While many financial advisers falsely believe that the fiduciary standard never applies to non-discretionary accounts, courts are increasingly holding financial advisers to a fiduciary standards where it is determined that the adviser had de facto control over an account.

In determining the issue of de facto control, courts and regulatory bodies look at the extent to which a client routinely followed an adviser’s recommendations.  The courts have consistently said that 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” 

There is a clear trend by the courts and regulatory bodies overseeing the investment industry. So, in creating recommendations for a client, prudent financial advisers should always ask whether their recommendations will pass the comprehensive “best interests” test.

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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