Facts do not cease to exist simply because they are ignored. – Aldous Huxley

With the release of the DOL’s proposed fiduciary regulations, there has been a considerable amount of discussion about what “best interests” really means and how to determine whether one’s actions are in compliance with a client’s “best interests.”

I would advise advisers and others held to such a standard not to openly admit that they do not understand the term “best interests” of a client. Legally, that could constitute “an admission against interests,” which could seriously hurt an adviser in a breach of fiduciary duty claim.

Ever since the DOL released its proposed fiduciary standards, I have read numerous quotes and posts complaining about the proposed standards. Most of the quotes and posts have been along the lines of “I’m not an attorney, how am I supposed to determine such things.”

Here in the South, we have a saying – “that dog don’t hunt,” or that argument or excuse is unacceptable. “That dog don’t hunt is applicable to whining about being required to act in a client’s best interests and knowing what that means.

“As we have frequently pointed out, a broker’s recommendations must be consistent with his customers’ best interests.”1 That holding, plus a list of other decisions holding the same opinion, was cited in FINRA Release 12-25. I would strongly recommend that advisers and stockbrokers find the release online and carefully read the release, especially the referenced footnotes.

What many adviser and stockbrokers fail to understand is that they have the ultimate responsibility for acting in compliance with all applicable rules and regulations. This is even truer for those who own an independent RIA firm. Even if the RIA advisers are dually registered with a broker-dealer, the broker-dealer has no legal obligation to advise you on legal requirements with regard to your independent RIA firm.

Every year I have RIA firms call me and say that their RIA is in trouble on some legal issue that their broker-dealer did not warn them about. Unfortunately, in most cases I have to tell them that they, not their broker-dealer, are responsible for running their independent RIA, including compliance issues.

Some reoccurring “tar babies” that I see ensnare RIA forms include the “broker-dealer shelf space” issue and the “somebody’s going to get sued” issue. RIA have a fiduciary duty to always put a client’s interests first. Dually registered RIA representatives also have a duty to follow their broker-dealer’s rules. Many broker-dealers have shelf space, or revenue sharing/preferred provider, agreements with mutual fund companies which limit the broker-dealer’s representatives to only recommend investment products that are part of such agreements. Sometimes this fact is not even disclosed to investors, other times it is done so in such a way that investors do not understand the situation, including burying same in some document.

A common practice in most broker-dealers that have these preferred provider agreements is to require a new client to sell any funds in his/her current portfolio and replace them with investment products from one of the preferred providers, even if the current investment is a good investment. This results in new, and unnecessary, costs for the investor and new commissions for the broker/adviser.

The replacement rule is not a regulatory rule. Furthermore, it clearly involves a broker/adviser putting both his and his broker-dealer’s financial best interests ahead of the client’s best interests, a clear violation of the RIA adviser’s fiduciary duty of loyalty, the duty to always put a client’s best interests first. Some advisers try to justify the situation using the old “two hats” theory, claiming that their actions as investment advisory representatives and stockbrokers are not related, therefore do not violate any rules. The Arlene Hughes decision effectively put an end to that supposed loophole.

The “somebody’s going to get sued” issue also involves a fiduciary’s duty of loyalty to their clients. When an RIA firm takes on a new client, the firm has a duty to review and evaluate the new client’s existing investment portfolio. If the RIA firm knows or suspects that there are unsuitable investments in the portfolio, the RIA firm has a fiduciary duty to let the new client know of such issues or, at the least, to suggest that the new client contact a securities attorney to evaluate the prior adviser’s recommendations. Failure to do either may result in breach of fiduciary claims against the new adviser.

The problem that dually registered brokers/advisers may face is that their broker-dealer may not allow them to alert their clients of possible wrongdoing by another broker-dealer and/or stockbroker. The investment industry is a close community and generally frowns on blowing the whistle on other members of the industry, often referred to as a “conspiracy of silence.”

The problem for independent RIAs is that they are independent, and have a legal duty to their clients, the fiduciary duty of loyalty, that legally supersedes any obligations to a broker-dealer. So, either honor the fiduciary duty of loyalty to the RIA’s clients and help them sue the previous wrongdoer adviser, or remain silent and face a potential breach of fiduciary duty claim by the new client.

In most cases that I have dealt with, the issue of “best interests” is really not confusing at all. Is recommending a fund that has consistently underperformed its applicable benchmark in a client’s best interests? Is recommending a “closet index” fund in a client’s best interests? Is recommending a fund whose annual fee is 300% higher than a fund with a comparable historical performance in a client’s best interests?

Most of my cases settle on either the consistent underperformance, closet index, or my AMVR™ metric analysis. In most cases, it’s just that obvious. For the time being, the DOL’s proposals are in the spotlight. I think most people in the investment industry are resigned to the fact that the SEC is going to enact some sort of fiduciary standards, whether they simply decided to adopt the DOL’s proposals or propose standards of their own.

The bottom line is that RIA firms and their advisers need to educate themselves on their fiduciary duties with regard to always putting their clients’ best interests first. Stockbrokers would be well advised to do so as well, as recent decisions have indicated that the courts are more than willing to impose a fiduciary standard on stockbrokers when such is necessary to protect the investing public.2

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This article is for informational purposes only, and is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Notes

1. Dane S. Faber, 2004 SEC LEXIS 277, at *23-24.
2. Carras v. Burns, 516 F.2d 251, 258-59 (4th Cir. 1975); Follansbee v. Davis, Skaggs & Co., Inc., 681 F.2d 673, 677 (9th Cir. 1982)