Unintended Consequences: Financial Advisers and Potential Liability Issues Under State Fiduciary Laws

With the investment industry driving and celebrating the continuous efforts of the DOL and Congress to emasculate the DOL’s fiduciary rule, I have received emails from stockbrokers and RIAs/IARs as to what the practical meaning of these actions, from a both a practice management and potential liability standpoint. I do believe that the actions of Congress and the DOL have important implications for the investment industry, including ERISA activity. I also believe that the industry may not be celebrating quite as loudly if some scenarios come true.

In my opinion, the development that could have the most impact on the investment industry is Nevada’s announcement that it will enact a state fiduciary law pursuant to its police powers under the 10th Amendment. A number of states already hold stockbrokers to a fiduciary standard as a result of state laws and/or state court decisions. RIAs and IARs are already held to a fiduciary standard under federal and state law.

Nevada’s announcement, and their announcement that other states had contacted them about following Nevada’s lead, caused quite a reaction in the investment world. Industry trade groups objected to such a move, claiming that ERISA was exclusively a federal issue and that Nevada’s passage of such a law would cause confusions. That argument has no merit, for as mentioned earlier, numerous states already hold stockbrokers and other financial advisers to a fiduciary standard. Furthermore, as long states approach any stockbroker and financial activity in the proper manner, there is nothing that the DOL, Congress, the administration or the courts can do to prevent any state from passing such state fiduciary laws, as it is within their 10th Amendment powers.

I have long been of the opinion that the real reason that the investment industry and other industry groups are so fervently concerned about the DOL rule is that it would protect an investor’s right to pursue legal recourse for violations in the courts, which in turn would provide investors with the right to full discovery. While an investor has a very limited right to discovery in arbitration, investors would enjoy a much broader right of discovery in the courts, discovery which result in the uncovering of other abusive practices by members of the investment industry and stronger cases by investors.

The current state fiduciary laws apply to any and all activity engaged in by stockbrokers and other financial advisers. As a result, current state fiduciary laws, as well as similar laws enacted by Nevada and other states going forward, could effectively replace a watered down or completely repealed BIC exemption since BICE, as currently proposed, applies to what is otherwise a simple securities situation, not an ERISA plan situation.

Waiver of Access to the Courts and Class Action Participation
As a plaintiff’s attorney myself, I have had already had several discussion with other plaintiff’s attorneys on potential issues resulting from the actions of the DOL and Congress, particularly the attack on the prohibition of forced binding arbitration provisions in BIC exemption agreements. The key issue in this regard would be whether any financial adviser who is subject to a fiduciary standard would violate their fiduciary duty of loyalty by advising, or forcing, an investor to forego an important and valuable legal right by waiving their right to pursue legal resource in the courts.

The securities arbitration process has long been the subject of criticism due to perceived manipulation of the process by the regulators and the investment industry. While things have improved somewhat, there is still the perception that investors would have a better opportunity for a fair and impartial trial in the courts. There is also the issue that recent evidence has shown that many stockbrokers and advisers who lose in arbitration never pay the winning investors the amounts awarded to them, with the regulators never doing anything to require such payments. Investors in court cases would have a number of legal options available to collect such financial awards.

The waiver of an investor’s right to redress in the courts would also have potential ERISA implications for plan sponsors, as they could be held liable for breach of their duty of loyalty by selecting a plan provider that required such a waiver, when other options were available that would not have required such waivers. As discussed earlier, such waivers are clearly not in the best interest of plan participants and investors.

Going Forward
Once I explain the practical implications of the situation, the next question inevitably involves some variation of “so what do I do?” My response is to continue to do what you have hopefully been doing all along. As mentioned earlier, RIAs and their representatives are already held to the “best interests” requirement of the fiduciary standard.

Broker-dealers and stockbrokers are always quick to claim that they are subject to the less stringent suitability standard, which does not require them to act in the best interests of a customer. I would suggest that recent regulatory releases and previous regulatory enforcement decisions suggest otherwise.

In interpreting FINRA’s suitability rule, numerous cases explicitly state that “a broker’s recommendations must be consistent with his customers’ best interests.” The suitability requirement that a broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his or her interests ahead of the customer’s interests…. The requirement that a broker’s recommendation must be consistent with the customer’s best interests does not obligate a broker to recommend the “least expensive” security or investment strategy (however “least expensive” may be quantified), as long as the recommendation is suitable and the broker is not placing his or her interests ahead of the customer’s interests…. the suitability rule and the concept that a broker’s recommendation must be consistent with the customer’s best interests are inextricably intertwined. – FINRA Regulatory Notice 12-25 (emphasis added)

In interpreting the suitability rule, we have stated that a [broker’s] ‘recommendations must be consistent with his customer’s ‘best interests.’ – Scott Epstein, Exchange Act Rel. No. 59328, 2009 SEC LEXIS 217, at *40 n.24 (Jan. 30, 2009)

As we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests.Wendell D.Belden, 56 S.E.C. 496, 503, 2003 SEC LEXIS 1154, at *11 (2003)

[A] broker’s recommendations must serve his client’s best interests. – Dep’t ofEnforcement v. Bendetsen, No. C01020025, 2004 NASD Discip. LEXIS 13, at *12 (NAC Aug. 9, 2004)

In resolving the best interests question, I have always advised my consulting clients to follow the guidelines set out in the Restatement (Third) Trusts’ Prudent Investor Rule, especially the Restatement’s “forgotten” fiduciary duty, the duty of being cost conscious, as set out in Section 88 and Section 90, comment b. Stockbrokers and other financial advisers who recommend actively managed mutual funds to clients show pay particular attention to the fiduciary prudence standard set out in Section 90, comment h(2), which states that due to the additional costs and risks associated with actively managed funds as compared to index funds, actively managed funds should only be recommended if it is reasonable to assume that the gains from such actively managed funds will  compensate an investor for such additional costs and risks.

This is a significant hurdle for most actively managed funds, as studies such as Standard & Poor’s SPIVA reports and academic studies such as those done by Carhart(1) , Edelen, and Kadlec (2) have consistently found that most actively managed funds not only do not outperform comparable index funds, but that many actively managed mutual funds do not even manage to cover the fund’s costs. Underperforming funds and those that actually cost investors due to excessive costs clearly do not satisfy the “best interests” standard of either the common law fiduciary standard or FINRA’s suitability/best interest standard.

For stockbrokers and others who still do not believe they need to comply with a “best interests” standard in making recommendations, I would point to various courts’ rulings where they have agreed to impose a fiduciary duty on brokers advising accounts, even non-discretionary accounts, when justice and sense of fundamental fairness dictate same, with the admonition that

The touchstone is whether or not the customer has sufficient intelligence and understanding to evaluate the broker’s recommendations and to reject one when he thinks it unsuitable.  Follansbee v. Davis, Skaggs & Co., Inc., 681F.2d 673, 677 (9th Cir. 1982)

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 recommendations. Carras v. Burns, 516 F.2d 251, 258-59 (4th Cir 1975)

Gordon Gecko’s “greed is good” speech notwithstanding, the investment industry’s greed in trying to emasculate or completely repeal the DOL’s fiduciary rule has apparently resulted in a number of states proposing to join existing states with fiduciary laws in order to protect their citizens. Such fiduciary laws will govern all of a financial advisers actiities, not just ERISA related activity. Since no one can prevent the states from enacting  such legislation, prudent stockbroker and financial advisers will review the common law prudent/best interest investment standards as set out in the Restatement (Third) Trusts and adjust their business and due processes accordingly to avoid unnecessary liability exposure, whether in arbitration or in the courts.

1. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.
2. Roger M. Edelen, Richard B. Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Tradings Costs,” available at http://www.ssrn.com/ abstract=951367

© Copyright 2017 The Watkins Law Firm. All rights reserved.

This article is neither designed nor 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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