2019: The Battle of the “Best Interests” – Part Deux

The Chinese calendar designates each year in terms of an animal. I am not sure what the animal is for 2019. However, for the investment industry, 2019 clearly represents the continuation of the battle of the “best interests” between consumers and the investment industry on both the brokerage and pension plan fronts.

Reg BI
On the brokerage front, both consumers and the investment industry await the final version of the SEC’s proposed Regulation “Best Interest’ (Reg BI). Under Reg BI, a broker-dealer and its registered representative would be required

to act in the best interest of the retail customer at the time[any] recommendation is made without placing the financial or other interest of the broker, dealer, or [registered representatives] ahead of the interest of the retail customer.

Various FINRA/NASD and SEC enforcement actions have held that a broker must always act in the best interests of a customer. Those same actions have stated that a broker violates that duty when they place their own financial interests ahead of a customer’s financial interests.

A key provision of Reg BI is the regulation’s Care Obligation requirements. The Care Obligation would require a broker-dealer, “when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, to exercise reasonable diligence, care, skill, and prudence.”

The Care Obligation essentially tracks the requirements of FINRA Rule 2111, otherwise known as FINRA’s suitability rule. Rule 2111 is composed of three main obligations: reasonable-basis suitability, customer-specific suitability, and quantitative suitability.

This similarity is exactly what has caused concern among consumer protection advocates. Such groups would prefer the stronger protections provided by a classic fiduciary standard, including the duties of loyalty and prudence.

The SEC’s refusal to simply adopt the same fiduciary standard required of RIAs under the ’40 Act is puzzling given the fact that Reg BI expressly includes a duty to exercise prudence in making recommendations. Simple common sense necessarily results in the following question-how can an investment be said to be in a customer’s best interest unless it also deemed prudent?

401(k)/403(b) Litigation
2018 saw a continuation of litigation involving alleged excessive fees and/or breach of fiduciary duties within 401(k) and 403(b) plans. While there was a mixture of both settlements and dismissals of such cases, a number of the dismissals were reversed on appeal or are still involved in the appeal process.

There were two reversals that are still involved in the appeal process that could have a significant impact on the defined contribution industry, as they will finally result in uniform standards for 401(k) and 403(b) plans. In Brotherson v. Putnam, the key issue is who has the burden of proof on causation in defined contribution actions once the plaintiff/plan participants prove that the plan sponsor violated their fiduciary duties and that damages were sustained. The First Circuit Court of Appeals reversed the lower court’s decision and ruled that a plan sponsor has the burden of proof on the issue of causation given the fact that the a plan sponsor has the information required to disprove the plaintiff’s evidence.

Putnam appealed to SCOTUS and they accepted the case, arguably to end the split in opinion within the federal appellate courts. If SCOTUS upholds the First Circuit’s decision, it could create an almost impossible burden on plan sponsors and plan advisers given the strong evidence of excessive fees and the consistent underperformance of actively managed mutual funds relative to index funds.

John Langbein was the Reporter for the committee that wrote the Restatement (Third) of Trusts (Restatement). In 1976, shortly after the Restatement was released, he and fellow law professor Richard Posner wrote an article asking whether fiduciaries had a legal duty to “buy the market,” to buy index funds. They concluded that fiduciaries could no longer ignore the evidence and blindly continue to place money in managed accounts.

When market funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent fro trustees to fail to use such vehicles. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A [fiduciary] who declines to procure such advantages for the beneficiaries of his trust may in the future find his conduct difficult to justify.

That day has come. Not surprisingly, comment h(2) to Section 90 of the Restatement, a section commonly known as the Prudent Investor Rule, also states that actively managed mutual funds that are not cost-efficient are imprudent  SCOTUS will now essentially answer the question posed by Langbein and Posner over forty years ago.

The second key case involves the question of whether a plan participant can even bring an action against their 401(k)/403(b) plan. Under ERISA, a plan participant generally has six years to bring an action against their plan. That time limit is shortened to three years if the plan participant had “actual knowledge” of the plan sponsor’s violations.

While “actual knowledge” seems pretty clear, that is not the case in the courts. The federal appellate courts are split on the issue. In Sulyma v. Intel Corporation, the Ninth Circuit recently reversed a lower court and ruled that “actual knowledge” meant just that, that “constructive knowledge” was not sufficient. The Ninth Circuit remanded the case back to the lower court for further consideration. Given the split in the federal appellate courts on such an important issue, it would not be surprising to see this case go to SCOTUS in order to establish a uniform standard.

While 2018 was a memorable year in terms of the battle of best interests between investors and the investment industry, 2019 could turn out to be even more memorable, with the implementation of Reg BI and establishment of two much-needed uniform standards regarding pension plans duties and plan participants’ corresponding rights.

And lurking in the background is the suggestion that 2019 could be the year that pension plans attempt to recover from plan advisers some, if not all, of the money lost in excessive fees and/or breach of fiduciary cases resulting from their adviser’s poor advice. While plan advisers typically include language to insulate themselves from any fiduciary liability for advice provided to plans, it has been suggested that “there is more than one way to skin a cat.”

Happy New Year!

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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