“Fair Dealing”-The Key to Navigating the Suitability, Best Interest and Fiduciary Standards

Any intelligent fool can make things bigger and more complex… It takes a touch of genius-and a lot of courage to move in the opposite direction. – Albert Einstein

With FINRA’s recent announcement that it will keep its suitability rule and the Department of Labor (DOL) announcing that it will release a new version of their fiduciary standard, investment fiduciaries and non-fiduciary investment advisers will have three separate standards to navigate in addressing their compliance and risk management concerns. The future of the Securities and Exchange Commission’s (SEC) Regulation Best Interest (Reg BI) remains uncertain, as two separate actions, since consolidated, have been filed asking the courts to vacate the regulation.

While navigating the three standards may appear to be a daunting task, I have suggested to my consulting clients that there is a common thread in the three standards that might reduce compliance and risk management concerns to two words-“fair dealing.” A quick review of the two existing standards, suitability and best interest,” and a projected fiduciary rule, given existing industry standards, will help understand my “fair dealing” theory.

Current Standards
FINRA’s current suitability standard is found in Rule 2111(Rule). The Rule essentially sets up a three-part suitability analysis that broker-dealers and registered representatives must conduct before recommending investment products and/or strategies to the public. The two key standards contained in the Rule require that any products and/or strategies must be suitable for both the general public and the specific customer involved.

While the Rule is important, equally important from both a compliance and professional liability standpoint is the Rule’s Supplemental Material, SM-.01, which states:

Implicit in all member and associated person relationships with customers and others is the fundamental responsibility for fair dealing. Sales efforts must therefore be undertaken only on a basis that can be judged as being within the ethical standards of FINRA rules, with particular emphasis on the requirement to deal fairly with the public. The suitability rule is fundamental to fair dealing and is intended to promote ethical sales practices and high standards of professional conduct.

The requirement of fair dealing is important to FINRA’s overall mission and purpose. The importance of the requirement of fair dealing, as well as the applicable standards in determining when the standard has been violated, have been consistently set out in numerous FINRA and SEC enforcement decisions.

NASD Rule [SM-2111-.01] imposes on members a “fundamental responsibility for fair dealing,” which is ‘implicit in all [their] relationships’ with customers. As relevant here NASD Rule [SM-2111-.01] provides that “sales efforts must be judged on the basis of whether they can be reasonably said to represent fair treatment for the persons to whom the sales efforts are directed….

The record shows that Epstein’s mutual fund recommendations served his own interests by generating substantial production credits, but did not serve the interests of his customers. Epstein abdicated his responsibility for fair dealing when he put his own self-interest ahead of the interests of his customers.1

In short, Belden put his own interest before that of his customer. We thus conclude that the securities that Belden recommended to [the customer] were unsuitable in the circumstances of this case. Belden’s conduct also was inconsistent with Conduct Rule 2110, which requires observance of ‘high standards of commercial honor and just and equitable principles of trade.’ 2

This commitment to “fair dealing” and “just and equitable principles of trade” were reinforced in FINRA Regulatory Notice 12-25, when FINRA stated that

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…These are all important considerations in analyzing the suitability of a particular recommendation, which is why the suitability rule and the concept that a broker’s recommendation must be consistent with the customer’s best interests are inextricably intertwined.3

FINRA’s statement that suitability and a customer’s best interests are “inextricably intertwined” is a perfect lead-in to an analysis of my “fair dealing” theory and compliance with Reg BI. Reg BI tracked FINRA’s suitability Rule so closely that some labeled Reg BI as a watered down version of the Rule. That is one of the major allegations in the current legal actions seeking the revocation of Reg BI.

The pertinent sections of Reg BI state that

240.15l-1 Regulation Best Interest

(a) Best interest obligation-(1) A broker, dealer, or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.

(2) The best interest obligation in paragraph (a)(1) of this section shall be satisfied if:
(ii) Care obligation. The broker, dealer, or natural person who is an associated person of a broker or dealer, in making the recommendation, exercises reasonable diligence, care, and skill to:
(B) Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation and does not place the financial or other interest of the broker,   dealer, or such natural person ahead of the interest of the retail customer;…4

Once again, we see “best interest” defined in terms of “fair dealing,” in terms of a broker-dealer or stockbroker not putting their own interests ahead of the interest of the customer.

While no one knows exactly what the DOL’s proposed new fiduciary standard will provide, it is reasonable to assume that the standard will the closely track the fiduciary standards set out in the Restatement (Third) of Trusts (Restatement). After all, the Supreme Court has endorsed the value of the Restatement in determining fiduciary law questions.5

Two key fiduciary duties identified by the Restatement are the duties of loyalty (always acting solely in the best interest of a trust’s beneficiaries) and prudence. In defining the duty of care required under Reg BI, the SEC basically adopted the same language used by the Restatement, citing a duty to exercise “reasonable diligence, care and skill.” The only major difference between the Restatement’s “duty of care” language and Reg BI’s language was the SEC’s decision not to include an express duty to be prudent.

Two additional duties regard the “fair dealing” theory. Section 205 of the Restatement of Contracts states that implicit in every contract is a duty on both parties to deal fairly in performing the contract. Another consideration is the fact that a number of states have already passed state fiduciary standards requiring fair dealing/fair treatment for public investors, with additional states considering similar laws.

Analyzing and Applying the “Fair Dealing” Requirement
Regardless of the exact term that is used-“fair dealing,” “fair treatment,” ”best interest,” and/or “high standards of commercial honor and just and equitable principles of trade,’- the essential question that must be asked and answered is simple-was the customer treated fairly? Based upon my legal and securities/RIA compliance backgrounds, three obvious issues come to mind in analyzing and applying the fair dealing requirement:

  1. the recommendation of cost-inefficient mutual funds;
  2. the recommendation of “closet index” mutual funds; and
  3. broker-dealer “preferred provider”/revenue sharing programs.

“Fair Dealing” and Cost-Efficiency
One of the key factors in answering the “fair dealing” question has to be whether the recommended investment is cost-efficient. In analyzing an investment option, Nobel laureate William F. Sharpe has noted that

‘[t]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.’ 6

Building on Sharpe’s theory, investment icon Charles D. Ellis has provided further advice on the process used in evaluating the cost-efficiency of an actively managed mutual fund.

So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns! 7

Building upon these pieces of advice, I created a simple metric, the Active Management Value Ratio™ (AMVR). Now in its third iteration, the AMVR allows investors, investment fiduciaries and ERISA/securities attorneys to easily calculate the cost-efficiency of an actively managed mutual fund using information that is freely available online. Bottom line, the AMVR allows anyone to identify actively managed mutual funds that are cost-inefficient, thereby avoiding  unnecessary investment underperformance and unnecessary costs and expenses.

In this example, the expense ratio is expressed in terms of basis points (bps). A basis point is equal to .01 percent. So 100 bps equals 1 percent.

The active fund has incremental costs of 90 basis points and an incremental return of 50 basis points. Since the active fund’s incremental cost exceed its incremental return, the fund is not cost-efficient and would not be a prudent investment.

The active fund’s “% Fee/% Return” numbers provide another indicator that the active fund is not cost-efficient. In this case, 90 percent of the fund’s total expense ratio is only producing approximately 5 percent of the fund’s total return.

The actively managed fund’s AMVR would be 1.8 (.90/.50). This indicates that an investor in the fund would be paying a cost premium of 80 percent relative to the fund’s incremental return. An investment whose costs exceed its returns is never “fair dealing” or in a customer’s “best interest.”

Ideally, investors should look for an AMVR score greater than zero, but less than 1.00. An AMVR less than zero indicates that the actively managed fund failed to provide a positive incremental return relative an index/benchmark fund. An AMVR greater than 1.0 indicates that the fund did provide a positive incremental return. However, the fund’s incremental costs exceeded the fund’s incremental returns, effectively resulting in a loss for an investor.

Furthermore, if we assume that the person who recommended the cost-inefficient actively managed fund received some sort of compensation for their advice, commissions, and/or a fee, while the investor received no relative benefit from the recommendation, then it can be legitimately argued that the adviser in this example put their own interest ahead of the investor’s interests, thereby violating the adviser’s “fair dealing” and “best interest” duties. This would be consistent with the Epstein and Belden decisions and other related decisions.

The “fair dealing” question may prove troublesome for the investment industry and investment fiduciaries with regard to cost-efficiency, as most studies have concluded that the overwhelming majority of actively managed mutual funds are not cost-efficient, with findings such as

  • 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.8
  • Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.9
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.10
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.11

At the end of each calendar quarter, InvestSense prepares a forensic analysis of the top ten actively managed mutual funds used by U.S. defined contribution plans, based on the annual survey by “Pensions & Investments” of the top 100 mutual funds used by such plans.

The “cheat sheet” provides incremental cost and incremental return data in various forms so that the user can see the impact of the data format chosen. Generally speaking, the investment and pension industries prefer to analyze funds on the basis of the funds’ nominal, or stated, data. Plaintiff ERISA/securities attorneys prefer to use data that factors in a fund’s risk-adjusted returns and a fund’s AER-adjusted incremental costs.

Ross Miller, the creator of the Active Expense Ratio (AER) metric, has stated that by factoring in a fund’s R-squared correlation number, the AER-adjusted incremental cost metric provides an implicit cost of the fund’s active management component.13  In many cases, once a fund’s R-squared correlation number is factored in, the fund’s AER is significantly higher than the fund’s stated expense, often as much as 400-500 percent higher.

In this example, only three of the top ten non-index funds managed to provide a positive incremental return at all, whether using the fund’s nominal or risk-adjusted return numbers. This adds credence to the findings of the previously mentioned studies.

An analysis of the same funds using our proprietary InvestSense Quotient (IQ) metric is shown below. If a fund fails to provide a positive incremental return, it does not qualify for an IQ score, thus the numerous “NA” entries.

With the IQ metric, the goal is a high score, which is then used on a relative basis to rate the funds. In this example, while three funds qualified for an IQ score when a fund’s nominal returns were used, none of three funds qualified for an IQ score using the funds’ risk-adjusted returns. These results clearly indicate why the plaintiff’s ERISA/ securities bar prefers to use the risk-adjusted/EAR-adjusted combination in litigation when arguing causation and damages, the argument being that the data provides a more realistic analysis.

“Fair Dealing”  and “Closet Indexing”
“Closet indexing” is a problem that is gaining increased attention worldwide due to the harmful impact that the practice has on investors. Canada and Australia are the latest countries to acknowledge and address the problem.

Closet indexing refers to the practice whereby an actively managed fund creates a mutual fund designed to closely track, or “mirror,” the performance of a market index or index fund, yet charge investors significantly higher fees than those of a comparable index fund. The practice is presumably based on an actively managed fund’s fear of losing investors if their fund significantly underperforms a comparable, less expensive index fund.

Closet indexing clearly violates a stockbroker’s duties of fair dealing and always acting in a customer’s best interest based on the cost-efficiency issue. Furthermore, questions are increasingly being raised as to whether the practice violates securities laws by misleading investors as to the services that the fund will provide, such representations being made to justify the actively managed fund’s higher fees. Violations of any applicable securities laws would constitute violations of the regulatory “fair dealing” requirement.

“Fair Dealing” and Preferred Provider/Revenue Sharing Programs
Many broker-dealers have adopted “preferred provider” or revenue sharing programs. Under such programs, a mutual fund company will either pay a broker-dealer a fee or agree to share revenue from the broker-dealer’s sale of the fund company’s  products in exchange for the broker-dealer granting them access to the broker-dealer’s stockbrokers. The broker-dealer also agrees to limit the number of companies that it will allow to participate in the preferred provider program, thereby limiting the number of investment options that the firm’s stockbrokers can recommend to its customers.

Consumer advocates have been quick to note the obvious conflict-of-interest issues inherent in such programs and the potential inconsistency of such programs with the regulatory bodies’ fair dealing and best interest requirements. For what its worth, SEC Chairman Clayton is on record as saying that firms adopting or maintaining preferred provider and/or revenue sharing program will still be subject to Reg BI’s best interest requirements, with no exemptions.

“Fair Dealing” Compliance and Risk Management Going Forward
There is a saying that says that if you stick your head in the sand, you just provide a larger target for the enemy. While the results of both the AMVR and the IQ metrics usually do not provide beneficial evidence for advocates of active management, to ignore the data would be a mistake.

This is especially true given the fact that the AMVR and IQ metrics and the resulting data are derived not from algorithms and other complex mathematical formulas, but rather from what the late John Bogle referred to as “humble arithmetic,” the same “My Dear Aunt Sally” math we all learned in first grade.

“Fair dealing” is a constant theme in both FINRA and SEC regulations and their regulatory enforcement actions. “Fair dealing” is often used in enforcement actions in connection with defining “best interest.” Whatever the DOL eventually adopts in terms of its new fiduciary standard, “fair dealing” will be a necessary aspect of the standard if the DOL adopts the fiduciary standards followed in the courts, the fiduciary standards established by the Restatement (Third) of Trusts.

Given the fact that the “fair dealing” requirement is a already a common thread in FINRA’s suitability and fair dealing requirements,as well as the SEC’s Reg BI, and is a common element of the fiduciary standards established by the Restatement, it is suggested that the investment industry should objectively review its current business practices in terms of fair dealing in order to reduce any potential liability exposure. Given the overwhelming evidence regarding the general cost-inefficiency of actively managed mutual funds, and the dominance of such funds in U.S pension plans, perhaps that is a good starting for both pension plan and their advisers as well.

Stockbrokers and other financial advisers often recommend actively managed mutual funds. Equally troubling is the fact that financial advisers are often limited to recommending only certain types of investments, i.e., actively managed mutual funds, by virtue of their broker-dealer’s adoption of preferred provider programs.

Given the evidence from both numerous academic studies and the findings of metrics such as the Active Management Value Ratio and the Active Expense Ratio, such funds are often cost-inefficient. If a financial adviser receives compensation for recommending a cost-inefficient mutual fund to a customer or pension fund, does that constitute a situation, where the adviser has put his/her own financial interests ahead of their customer’s best interests? Given the decisions in FINRA and SEC enforcement actions, do such recommendations constitute a clear violation the “fair dealing” and “best interest” requirement of FINRA, the SEC, and the DOL’s eventual fiduciary standard?

Fair dealing, will play a critical role in the future of both the investment and pension industries, in terms of both “best practices” and litigation trends. As a result, investors, investment fiduciaries, investment professionals and ERISA/securities attorneys should begin every investment evaluation with a simple question-would the recommendation to purchase this investment constitute “fair dealing,” would the recommendation be in the “best interest” of the customer?”

To borrow a frequent admonition of Fred Reish, one of the nation’s leading ERISA attorneys “forewarned is forearmed.”

1. Scott Epstein, Exchange Act Rel. No. 59328, 2009 SEC LEXIS 217, at *40 n.24 (Jan.30, 2009).
2. Wendell D. Belden, 56 S.E.C. 496, 503, 2003 SEC LEXIS 1154, at *11 (2003).
3. FINRA Regulatory Notice 12-25.
4. 17 CFR Sections 240.15l-1(a)(1), (2)(ii)(B).
5. Tibble v. Edison International, 135 S. Ct 1823 (2015)
6. Willam F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
7. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,”               available online athttps://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c
8. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
9. Charles D. Ellis, The Death of Active Investing, Financial Times,January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e.
10. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
11. Mark Carhart, On Persistence in Mutual Fund Performance,  Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
12. Ross M. Miller, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol. 5, No. 1, First Quarter 2007. Available at SSRN: https://ssrn.com/abstract=972173

© Copyright 2019 The Watkins Law Firm. All rights reserved.

This article is for informational purposes only, and 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™ 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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