As both a securities/ERISA attorney and a CFP® professional, I realize that I often see things from a different perspective that other in those professions. Some would say that is an advantage, others say it’s a disadvantage. I have definitely given me an opportunity to learn about emerging trends in investment adviser liability issues, which I in turn try to share with others to allow them to decide whether to address such issues and reduce unwanted liability exposure.

Financial advisers and investment advisers often use asset allocation software programs, commonly referred to portfolio optimizers, to produce recommendations for clients. These programs have been the subject of legitimate criticism due to the fact that most of them are based on a concept that has proven to be highly questionable.

However, based on my conversations with fellow securities attorneys, a new potential liability issue is emerging with regard to such asset allocation software programs. Asset allocation programs typically rely on data using generic asset categories in producing recommendations. The financial adviser or investment adviser must then select the actual investments to be used in implementing such recommendations.

This two-stage process can create potential liability exposure for an adviser due to the fact that the risk and return assumptions that the software program relied on are often significantly different from those of the actual investments chosen for implementation. The potential liability issues come from a failure to disclose such information to clients and/or a failure of an adviser to perform a check for consistency between the computerized recommendations and actual implementation.

Based on my 30+ years of experience as an attorney, compliance director/consultant, I would say that less than 25% of advisers disclose the recommendations/implementation to clients. Most advisers try to justify their failure to do so on the fact that their asset allocation program does not allow them to do an analysis using specific investments.

First, the fact that a software program will not allow an adviser to do an analysis using specific investments has nothing to do with making a disclosure regarding such issues. Second, there are now various online sites available to financial advisers and investment advisers that make it possible for advisers to create and analyze asset allocation recommendations using specific investments. So that excuse no longer has any merit.

When I was with AXA Advisors, I was the National Director of Financial Planning Quality Assurance. My department’s job was to review the financial plans and asset allocation recommendations before they were provided to a client. Once the plan and recommendations were delivered, if same were implemented. my department reviewed the implementation to ensure that it was consistent with the original plan and recommendations, or that any modifications were within permissible limits.

Since a client typically pays for a financial plan and/or an asset allocation module, the plan/module should have some inherent value. Consequently, it can be argued any implementation should be consistent with the plan’s/module’s original advice and recommendations.

This is exactly what a good securities attorney is going to argue. The exchange between an adviser and the attorney will typically go like this:

Attorney: You charged Mr. Smith $1,000 for the financial plan and asset allocation module you prepared for him didn’t you?
Adviser: Yes.
Attorney: And before you prepared the plan and module, you checked to see what the risk and return assumptions were that the software program was using in making its recommendations, didn’t you?
Adviser: Yes.
Attorney: You reviewed the financial plan and asset allocation module with Mr. Smith, correct?
Adviser: Yes I did.
Attorney: And after that review, you suggested various specific investments to Mr. Smith that he could use to implement the plan’s/module’s advice and recommendation, didn’t you?
Adviser: Yes.
Attorney: Prior to making such implementation recommendations, you did not compare the risk and return characteristics for the specific investments with the risk and return assumptions that the software program used in making its recommendations, isn’t that correct?
Adviser: My asset allocation does not allow me to do an asset allocation analysis based on actual investments.
Attorney: So you did not compare the risk and return characteristics for the specific investments with the risk and return assumptions that the software program used in making its recommendations, isn’t that correct?
Adviser: No, I did not do so because I did not have the means to do so.

At this point, an attorney will stop with the adviser’s admission of his/her failure to do a consistency of advice analysis, knowing that they have an expert who will testify to the existence of several online sites, that allow an adviser to do asset allocation analysis based on actual investments. Quite often, the combination of the failure to perform a consistency of advice analysis and the difference risk and return characteristics between program’s assumptions and the actual investments significantly strengthen an investor’s case. A good attorney will often throw in a reminder that the client had a paid a rather large fee for a plan and asset allocation analysis that, based on the adviser’s actions, had no inherent value to the client and was just a means to charge the client a needless fee.

I provide these arguments and examples to reinforce the need for honest advisers to recognize the potential liability issues and be proactive to reduce such potential liability exposure. The suggested best practices that I recommend to my clients are:

1. Review the financial plan and/or asset allocation module to ensure that the advice and recommendations in same are fundamentally sound and appropriate for a client given their personal situation and financial parameters.
2. Review and compare the risk and return assumptions and characteristics between an asset allocation software program and any actual investments being recommended to a client.
3. If there are differences between such assumptions and characteristics, review all implementation recommendations to ensure that the implementation recommendations are consistent with the advice and recommendations contained in the plan and asset allocation module.
4. If there are inconsistencies between the plan/asset allocation module and the implementation recommendations, determine if there equally effective and prudent options are available that are more consistent with those from the original plan/asset allocation module, using available online programs, such as iShares.com, that allow asset allocation modeling based on actual investments. Document such due diligence and the actual results of such analyses.

Investment advisers are fiduciaries by law. Fiduciary law is very unforgiving. Good faith and honest intentions are irrelevant. There are no mulligans in fiduciary law or the ’40 Act. Know the law and regulations, including standards established by legal decisions.

Just remember the famous quote from Donovan v. Cunningham – “A pure heart and an empty head are no defense [to a breach of fiduciary claim].”