Fiduciary Standard vs. Suitability Standard: The “Gotcha” That Won’t Go Away

There is currently a lot of speculation on how and if the new Trump administration will attempt to undo the DOL’s new fiduciary rule. Opinions range from an attempt to delay the effective date of the new rule to a complete repeal of the new rule. From a procedural standpoint, a complete repeal would appear to be unlikely, as pointed out in this article.

While the DOL’s new fiduciary rule arguably helps define the duties owed by financial advisers who provide investment advice to retirement plans and their participants, from a purely legal standpoint, those duties may already be sufficiently defined regardless of the actions the Trump administration may take.

Fiduciary is basically derived from a combination of the common law of trusts and agency, as set forth in the Restatements for both areas of the law. Certain types of financial advisers are already held to the high standards required under fiduciary law, namely that they always put a customer’s best interests first.  Registered investment advisers and ERISA fiduciaries are legally held to a fiduciary standard. In addition, some states impose a fiduciary duty on stockbrokers, who are generally not held to a fiduciary standard unless they have contractually agreed to such status, they are managing a customer’s account on a discretionary basis, or the courts have imposed such a standard on them.

Stockbrokers are generally held to a much lower standard which simply requires that any investment recommendations they provide to a customer be “suitable” for that customer given the customer’s personal investment parameters, including their financial goals and needs. From a regulatory standpoint, “suitability” is evaluated in terms of both the suitability of the investment recommendations vis-a-vis both the specific customer and the investing public in general.

While there are those that try to confuse the issues with regard to fiduciary prudence and/or suitability, I would suggest that two simple questions help to clarify the issues for both financial/investment advisers and securities attorneys.

(1) Is an investment that has consistently failed to produce a positive incremental return for an investor a prudent investment and/or suitable for any investor, given the opportunity costs it produces relative to comparable investment options?

(2) Is an investment whose incremental costs have consistently exceeded the investment’s incremental returns a prudent investment and/or suitable for any investor, given the financial losses it produces relative to comparable investment options?

Common sense tells you that any investment that consistently fails to provide a positive incremental return, or whose positive incremental returns are consistently exceeded by the fund’s incremental costs, is neither prudent nor suitable for any investor, as both situations ensure unnecessary financial losses for an investor. This is an argument that financial advisers and financial fiduciaries can expect to see on a more regular basis in securities and ERISA litigation due to both the simplicity of the argument itself and the simplicity in performing the calculations needed to prove such incremental costs and returns.

Various studies, including Standard & Poor’s well-known SPIVA reports, have shown that most funds fail to outperform their relative benchmark index fund. In some cases, the fund underperformance can be attributed to the fund’s higher incremental costs relative to the benchmark’s fees. In fact, a recent study concluded that a large percentage of actively managed mutual funds are priced to fail, as their fees and other costs sometimes negate their actual outperformance of their benchmarks based purely on returns.

Litigation against 401(k) plans has been a trend for several years now. 2016 saw the first fiduciary cases filed against private 403(b) plans. 2017 may well see the first fiduciary cases files against public 403(b) plans and non-profit plans. In many cases, the fiduciary breaches are so obvious that a simple incremental costs/returns analysis basically ensures that a settlement is the best option for resolving the action.

Stockbrokers and broker-dealers can expect to see an increased use of incremental costs/returns analysis to prove suitability violations as well. Investments that basically ensure a loss for investors, whether due to negative incremental returns or positive incremental returns negated by a fund’s incremental costs, will face an extremely difficult challenge in withstanding legal and/or regulatory challenges under even the suitability standard.

One trend in the investment industry has been the increase in dually registered financial advisers, those that are registered as as both registered representatives of their broker-dealer and as investment advisory representatives of a registered investment adviser. The challenge for dually registered financial advisers may be even more daunting, as the courts have undercut the popular “two hats” theory and clearly warned of the liability standard implications for such advisers:

The record shows clearly that, except for a few isolated instances, petitioner acted simultaneously in the dual capacity of investment adviser and of broker and dealer. In such capacity, conflicting interests must necessarily arise. When they arise, the law has consistently stepped in to provide safeguards in the form of prescribed and stringent standards of conduct on the part of the fiduciary.
(Hughes v. SEC, 174 F.2d 969 (1949)

© 2017 InvestSense, 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 adviser should be sought.

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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