“Best Interest,” BICE and Class Action Targets

Much has been written about the Department of Labor’s (DOL) new fiduciary rule and the accompanying Best Interest Contract Exemption (BICE). Several writers have suggested that the group that will benefit the most from the rule and BICE are class action attorneys.

As an ERISA attorney, I have to admit that unless Financial Institutions and their Advisers understand and successfully adapt to the shift from a culture of “suitability” to the more demanding and unforgiving “fiduciary/’best interest’/prudence” culture, the likelihood of successful class actions against them will definitely increase.

BICE expressly preserves and protects the right of Retirement Investors to participate in class action actions involving violations of the new fiduciary rule and/or BICE. BICE provides that the exemption is lost is the contract includes any provision attempting to make a Retirement Investor waive or otherwise forfeit their class action rights.

One common tactic used by the financial services industry has been to argue that the suitability standard commonly used in assessing the conduct of stockbrokers is purely subjective, and therefore open to various interpretations. The DOL’s choice of imposing a fiduciary “best interest” standard on Financial Institutions and their Advisers in advising Retirement Investors, and defining “best interest” in terms of the prudent person standard adopted by ERISA and the Restatement (Third) of Trusts effectively nullifies any such “subjectivity” arguments.

I have had several colleagues and a few institutions ask me about the areas that I believe will be the most vulnerable to potential class actions under the rule and/or BICE. Based upon my prior experience as a compliance director and my experience as a fiduciary/ ERISA attorney and consultant, I believe that there are six areas that will face the most scrutiny and potential class action litigation under the DOL’s new fiduciary rule and BICE:

  1. Actively managed mutual funds
  2. Closet index funds
  3. Brokerage “preferred provider” programs
  4. 401(k) rollovers and IRAs accounts
  5. Variable annuities
  6. Equity indexed annuities

Over the next two days, I will address each of these areas and the fiduciary liability concerns that I see for them. Today, I will address the first three areas – actively managed mutual funds, so-called “closet index” funds, and brokerage “preferred provider” programs.

Actively Managed Mutual Funds
Regular reader of my blog know that I created a metric, the Active Management Value Ratio™ 2.0 (AMVR). The AMVR is a cost/benefit metric that provides investors, attorneys and investment fiduciaries with a simple, yet effective means of quantifying prudence. Consequently, it fits perfectly with the DOL’s new focus on prudent investing. Complete information on the AMVR and the procedure for calculating the metric can be found here.

Assessing prudence using the AMVR involves answering a few simple questions. First, does the actively managed mutual funds provide a positive incremental return, or alpha, above and beyond the benchmark? If not, the fund is obviously not a prudent investment since it provides no benefit, and worse yet, a potential loss for an investor when compared to the benchmark fund. Second, if the actively managed fund does provide a positive incremental return, is the incremental return greater than the incremental cost incurred in producing such incremental return? if not, the fund is not a prudent investment since an investment in the fund would end up costing an investor more than the benefit provided.

The AMVR also provides a means of assessing the cost effectiveness of an actively managed mutual fund. For example, assume an actively managed mutual fund has a stated annual expense ratio of 100 basis points (1.0%) compared to a benchmarks annual expense ratio of 20 basis points (0.20%), resulting in an incremental cost of 80 basis points (0.80%).  Assume that the actively managed fund has an annual return of 10.5 percent as compared to the benchmark’s annual return of 10 percent, resulting in an incremental return of 50 basis points (10.5-10). As a result, the incremental, or additional, cost of the actively managed fund constitutes 80 percent of the fund’s expense ratio, yet is only producing 5 percent of the fund’s total return. This raises obvious questions regarding the prudence of the actively managed fund.

Using the same scenario, which would be the prudent choice – paying 20 basis points for an annual return of 10 percent, or paying 100 basis points, five times more than the cost of the benchmark fund, for an annual return of 10.5 percent, paying 80 basis points for an additional 50 basis points of return? Again, the prudent choice is obvious. And yet, financial advisers continue to recommend, and investors continue to trust such recommendation and purchase, the imprudent investment.

These are the types of questions, and adjustments, that Financial Institutions and their Advisers are going to have to deal with as they convert from the “suitability” culture to the “best interest”/prudence standards under the DOL’s new fiduciary rule and BICE. These decisions will become even more difficult given the recent study by Eugene Fama and Kenneth French which found that only the top three percent of active managers were able to produce returns that even managed to cover their fund’s costs. All of these facts simply serve to increase the likelihood of successful class actions going forward.

Closet Index Funds

“Closet index” funds, aka “index huggers,” are generally defined as mutual funds holding themselves out to the public as actively managed mutual funds with higher fees substantially higher than index funds, often 3-4 times higher, but whose actual performance closely tracks the performance of the less expensive index fund.

Canada has recently announced that it is investigating the extent of “closet index” funds in it country due to the potential misrepresentation of services provided by such funds and the higher fees associated with same. Since the Impartial Conduct Standards under BICE prohibit any misrepresentations in connection with the sale of investment products Retirement Investors, it is reasonable to assume that Retirement Investors may file class actions under the new fiduciary rule and BICE base on the same concerns that Canada is investigating.

While there is no universally accepted R-squared rating that classifies a fund as a “closet index” fund, there is general agreement that a fund with a R-squared rating or 90 or higher suggests “closet index” status. Given the recent trend of high R-squared ratings between equity-based mutual funds, both domestic and international funds, there is an even greater likelihood of class actions based on “closet index” fund issues unless Financial Institutions and their Advisers carefully review mutual funds and their R-squared rating to ensure an appropriate correlation of returns between such funds.

Brokerage “Preferred Provider” Programs

When I first entered the securities industry, I was totally unaware of the so-called “preferred provider” programs that are so popular in the investment industry. The attorney in me made me wonder how many investors were aware of these artificial restriction being placed on the investment advice they were receiving. Given the fact that most “preferred provider” programs involve the advisers recommending funds with a history of poor relative performance and excessively high fees, such programs make Financial Institutions and their Advisers participating in same clear candidates for successful class actions.

The new Impartial Conduct Standards under both the rule and BIC call into question the continued use of such programs, as the standards prohibit Financial Institutions from using any sort of bonus or other incentive programs that could cause their Advisers from adhering to the “best interest”/prudence standards of both the rule and BICE. The artificial restriction on investment products that can be recommended to Retirement Investors under such programs as well as the cash and other compensation generally available to financial advisers as part of such programs, e.g., trips and “educational” seminars at resorts and abroad, would clearly appear to violate both the letter and the spirit of the new fiduciary rule and BICE, namely to ensure that Retirement Investors are receiving investment advice that is prudent and in their “best interests.”

Preferred provider programs are so financially profitable for both the mutual fund companies and the Financial Institutions that it can be assumed that both parties will try to develop some “work-around” if the current preferred provider programs become targets form regulatory scrutiny or class actions. However, anything that artificially limits the quality of investment advice being provided to Retirement Investors or anything that compromises the rule and BICE’s commitment to advice that is prudent and in the “best interests” of Retirement Investors can be expected to face strict scrutiny.

© Copyright 2016 The Watkins Law Firm, LLC. All rights reserved. 

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.

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ 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 and investment fiduciaries on sound, proven investment strategies that will help them protect their financial security and/or avoid unnecessary fiduciary liability exposure.
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