Back in my compliance days, I was known for running a tight and tough house. But many of the brokers came to realize that that was my job, and in doing my job I was protecting them as well. As many of my former brokers have gone independent to form their own RIA firms, I have found it rewarding that they have sought me out and hired me as their compliance consultant.

As I have mentioned before, my reason for creating this post was to raise investment fiduciaries’ awareness of existing and developing compliance issues, thereby allowing them to keep their practices clean and allowing them to concentrate fully on serving their clients. I constantly remind my clients of the “core,” three key cases that every investment professional should be aware of and remember – Chase, Levy v. Bessemer Trust, and Johnston v. CIGNA Corp.

After a recent presentation on these cases, someone said I should write a post to let others know about the decisions and their application to actual practices. So, I did.

In re James B. Chase
The Chase decision was a 1997 regulatory enforcement decision involving a broker’s duty in determining the suitability of their investment recommendations.¹ The Securities and Exchange panel stated that in determining a client’s risk tolerance level, a broker/adviser (collectively “adviser”) must determine both a client’s willingness and ability to bear investment risk. While a new account form may indicate a client’s willingness to assume investment risk, other information may indicate that the client’s financial condition is such that they do not have the ability to bear investment risk at all, or only to a limited extent.

What many advisers may not be aware that they personally have a duty to determine the suitability of their investment recommendations before they provide them to a customer. Many advisers believe that if their compliance director approves the trades, everything is fine.

Legally, however, this does not satisfy an adviser’s legal duty to only make suitable recommendations. An adviser must be able to personally evaluate their investment recommendations and ensure that they are suitable for a customer, that they are consistent with both a customer’s willingness and ability to bear the level of investment risk inherent in the adviser’s recommendations.

Furthermore, based on recent trends, I would suggest that advisers also need to determine a client’s need to assume investment risk at all. I continue to see cases where the client’s existing portfolio met their needs before the adviser made any recommendations. This issue seems to come up more in cases where income is a client’s primary consideration.

Those who have heard me speak on this issue are familiar with the story about the widow whose husband had created a well-devised portfolio that would provide her with all of the income she would once he was gone. After the husband’s death, a broker had her fill out a risk tolerance questionnaire.

One of the questions on the risk tolerance questionnaire was whether she had any additional income needs. Naturally, she answered “no.” The risk tolerance questionnaire misinterpreted her answer and recommended completely revising her husband’s perfect portfolio, essentially destroying the needed income investments and replacing them with risky equity-based investments.

One would have hoped that the adviser would have quickly questioned the results and prevented any implementation of the computer’s recommended reallocations. Sadly, in a perfect example of the danger of “black box” planning, the adviser blindly followed the computer’s recommendations, causing significant harm and financial loss for the widow. The case settled out of court, as her husband’s handiwork was perfect and she had no need to assume the investment risk created by the redesigned equity-based portfolio.

Levy v. Bessemer Trust Company
Put simply, investment advisers and other investment fiduciaries cannot simply watch investors lose money and say ”it’s the markets, everyone is losing money.” Plaintiff’s securities attorneys love these types of cases because it’s like “shootin’ fish in a barrel.” All they have to do is pull out the Levy v. Bessemer Trust decision and the adviser has to pull out his checkbook.²

Levy involved a client that was worried about the potential of loss in his portfolio due to the fact that his portfolio had a concentrated position in one stock. Levy’s company had merged with Corning. As a result of the merger, Levy had received a significant amount of Corning stock, so much so that his portfolio was heavily overweighted with Corning stock.

Levy was concerned about the risk exposure posed by the lack of diversification in his overall portfolio due to the Corning stock. When he asked his adviser if there were ways to mitigate any potential loss, the adviser did not discuss the possible use of options or other hedging techniques to protect against downside risk. The client subsequently suffered a significant loss due to the concentrated stock position.

The client sought advice from another adviser who informed the client of the possible use of options, especially European collars, that could have provided the client with the downside protection he had sought. Levy sued the initial adviser for his negligence and misrepresentation in not alerting the Levy to the option to use options to protect the client’s portfolio. In denying the adviser’s motion to dismiss the case, the court ruled that the question of whether an adviser had a duty to at least advise a client of viable loss prevention options presented a valid question for a jury to decide.

The takeaway from Levy is that advisers cannot simply stand by and watch investors suffer significant losses and then blame it on the markets. Levy and other similar decisions have established that investment advisers and other investment fiduciaries have, at a minimum, a legal duty to advise a client of such hedging strategies, both the positive and negative aspects of same, and then let the client decide on whether to use same.

Even if an adviser has discretionary authority over an account, I always recommend that an adviser involve a client in such matters, if for no other reasons than the costs involved in implementing such strategies The adviser should also document both the disclosures that the adviser provided and have the client acknowledge their decision in writing.

Johnston v. CIGNA Corp.
Full disclosure. This is one of all-time favorite cases due to the issues involved and the potential fiduciary and financial planning liability implications as a result of just two sentences.

Johnson and others invested in a couple of investments through a broker employed by defendant CIGNA Corp. In trying to persuade Johnston and the others to purchase the recommended investments, the broker allegedly stated that CIGNA would cover any losses Johnston and the others suffered as a result of the investments.

They did suffer significant losses, CIGNA refused to cover such losses, and this lawsuit resulted. CIGNA filed a motion asking the court to dismiss the action on the grounds that (1) CIGNA was simply a broker, not a fiduciary, in connection with the sales of the investments in question, and (2) the risks inherent in the investments had been fully disclosed in the various sales material given to Johnston and the other purchasers.

With regard to the fiduciary issue, the question is important in that the courts have consistently held that a buyer’s duty of care and investigation is reduced in a fiduciary relationship due to the legal nature and duties involved in such relationships.

As the court noted,

A fiduciary relationship can arise when one party occupies a superior position relative to another. [Johnston’s] claim that [CIGNA], acting as investment advisers and financial planners, created a relationship of trust and confidence and, accordingly, [CIGNA] owed [Johnston] a fiduciary duty. These labels are terms of art defined in the federal securities laws….³

When confronted with the fiduciary issue, brokers and broker-dealers will immediately counter with the argument that they are just brokers, just salesmen, and they do not owe their customers any fiduciary duties. We just went through several years of that debate and the debate still rages.

Interestingly, there are states that hold brokers and broker-dealers to either a full or limited fiduciary standard, based upon state laws and/or state judicial decisions. Furthermore, some courts have indicated that they have no problem imposing a fiduciary duty on a broker and/or broker-dealer when justice and equity demand such measures, particularly when, as the Johnston court stated, one party has a distinct advantage over another.

The courts have clearly established the guidelines for when they will consider imposing a fiduciary duty on a broker. One of the most common justifications cited by the courts for imposing fiduciary duties on a broker is when a broker has effectively taken over an account, so much so that he/she has become the “de facto” manager of the account.

In other cases, the courts have stated that

Usually the broker will have much greater access to financial information than the customer and will have the support of investigative and research facilities. Such a customer will be expected usually to accept the recommendations of the broker or to disassociate himself from that broker and find someone else in whom he has more confidence.

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.⁴

And in another case, the court announced the applicable guideline as follows:

Control of trading is an essential element of churning. In the absence of an express agreement, control may be inferred from the broker-customer relationship when the customer lacks the ability to manage the account and must take the broker’s word for what is happening…. However, a customer retains control of his account if he has sufficient financial acumen to determine his own best interests and he acquiesces in the broker’s management…. 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 suggestions.⁵

As a result, in my opinion, brokers and broker-dealers are often too quick to dismiss the possibility that they may be legally held to the duties associated with a fiduciary standard. My experience has been that very few investors have the experience and/or understanding to independently and effectively evaluate most investments.

As a CFP® professional for over thirty years, I am intrigued by the court’s judicial recognition that “[f]inancial planners also owe a fiduciary duty to their customers.” That was effectively answered back in 1987 when the Securities and Exchange Commission issued IA-1092..

Given a financial planner’s fiduciary status, a question that I predict will eventually be posed in the courts involves the preparation of asset allocation recommendations as part of a financial plans and/or asset allocation modules. One of the claims that the plaintiffs in Johnston asserted was that that the investments that the defendant recommended to them “did not conform to the financial plans that the defendants had prepared for them.”

What makes this claim potentially significant is that most financial planners use computer programs to generate a plan’s or a modules’s asset allocation and investment recommendations. Such computer programs usually use generic asset indices in generating their investment recommendations.

Such indices include any costs or expenses. Therefore, those matters are not typically factored into the computer program’s assert allocation recommendations. As a result, there are often significant differences between a plan’s or module’s asset allocation representations and the reality of the portfolio and the investments actually used in implementing a plan or module.

In the real world investments obviously do have costs and expenses such as front-end loads, annual expense ratios and trading costs. Costs and expenses of any kind reduce an investor’s end return. In fact, the General Accounting Office has recognized that each additional one-percent in investment fees and expenses reduces an investor’s end-return by approximately 17 percent over a twenty-year period.⁶ As the late John Bogle was fond of saying, “costs matter” and “you get what you don’t pay for.”

All of these conditions have led Nobel laureate William F. Sharpe  to state that the use of the two stage asset allocation/portfolio optimization system makes no sense, and that “a far more rational approach uses only one stage, dealing directly with the actual investment vehicles…”⁶ The fact that most current asset allocation computer programs do not provide this capability will not be an acceptable excuse for “recommendation-implementation gaps,” as planners and advisers know, or should know, about these inconsistency issues and the harm they can produce for clients.

With the knowledge of the referenced shortcoming in computer generated asset allocation recommendations, the question has been raised as to whether a subsequent implementation based upon such recommendations could possibly violate federal securities laws, a sophisticated form of “bait and switch.” “Bait and switch” schemes violate the anti-fraud provisions of Section 10b of the Securities Act of 1934 and related Rule 10b-5, and/or Section 206 of the Investment Advisors Act of 1940.

Rule 10b-5 provides that

• 240.10b-5 Employment of manipulative and deceptive devices.
  It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

So, the potential question going forward would be something along the lines of:

Could the intentional use of computer generated asset allocation plans/modules, with full knowledge of the data input issues and the likely inconsistency between the computer input data and the risk and return characteristics of the actual investments used to actually implement the computer generated recommendations, as well as the eventual actual risk and return, including any loss, generated by the investments purchased in reliance on such plans/modules,  constitute a “device, scheme, or artifice to defraud,” a “untrue statement of a material fact,” and/or an “act, practice, or course of business which operates or would operate as a fraud or deceit upon any person” in violation of Section 10b and Rule 10b-5 and/or Section 206 of the Investment Advisors Act of 1940?

I do not know the answer. I do know the issue has been discussed increasingly in certain legal circles, including the potential for litigation. I raise the issue simply to alert planners and advisers to the potential liability issues and to suggest possible consideration of same in adopting and maintaining their their firm’s and their personal liability risk management program.

Noted ERISA attorney Fred Reish is fond of saying “forewarned is forearmed.” One of my favorite quotes is from Aldous Huxley-“facts do not cease to exist because they are ignored.”

Notes
1. In re James B. Chase, NASD National Adjudicatory Council Decision, Complaint C8A990081 (August 15, 2001)
2. Levy v. Bessemer Trust Company, 1997 U.S. Dist. LEXIS 11056 (S.D.N.Y. 1997).
3. Johnston v. CIGNA Corp., 916 F.2d 643 (Colo. App. 1996).
4. Follansbee v. Davis, Skaggs & Co., Inc., 681 F.2d 673, 677 (9^th Cir. 1982).
5. Carras v. Burns, 516 F.2d 251, 258-59 (4th Cir. 1975).
6. W. F. Sharpe, Investors and Markets: Portfolio Choices, Asset Prices and Investment Advice (Princeton, NJ: Princeton University Press, 2006), 206-209

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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.