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.¹

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.²

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.’³

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.⁴

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.

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;…”⁵

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.

Interestingly enough, Reg BI itself endorses the importance of cost-efficiency, stating that

A rational investor seeks out investment strategies that are efficient in the sense that they provide the investor with the highest possible expected net benefit, in light of the investor’s investment objective that maximizes expected utility. [A]n efficient investment strategy may depend on the investor’s utility from consumption, including …(4) the cost to the investor of implementing the strategy.⁶

Cost-Efficiency and Regulatory Standards
So, how do current investment industry practices stand up against the described regulatory standards?

One of the key factors in answering the fair dealing/best interest question has to be whether the recommended investment is cost-efficient. In analyzing an investment option, Nobel laureate William F. Sharpe has stated 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.’ ⁷

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!⁸

The images below represent three simplified forensic analyses of two well-known mutual funds, two funds that are annually among the top ten mutual fund options in U.S. 401(k) plan. First, an analysis of the retail shares of one of the funds.

This is an example of the forensic analyses we provide to attorneys and investment fiduciaries, such as 401(k) plan sponsors and trustees, using our proprietary metric, the Active Management Value Ratio 3.0^TM (AMVR). The AMVR is based largely on the concepts of Ellis and Sharpe. The AMVR allows investors, investment fiduciaries and attorneys to quickly determine the cost-efficiency of an actively managed mutual fund relative to a comparable, but lee expensive, index fund.

Fortunately, investors can often obtain the cost-efficiency information they need by using a scaled-down version of the AMVR.

The AMVR is simply a version of the familiar cost/benefit methodology. AMVR is simply a fund’s incremental costs (IC) divided by the fund’s incremental return (IR). If a fund’s AMVR is greater than 1.0, it indicates that the fund is not cost-efficient, as its incremental costs are greater than its incremental returns/benefits.

One of the strengths of the AMVR is its simplicity. Once a fund’s AMVR has been calculated the user only has to answer two questions:

1. Did the actively managed fund provide a positive incremental return relative to the benchmark?
   
2. If so, did the actively managed fund’s positive incremental return exceed the fund’s incremental costs?

If the answer to either question is “no,” then the actively managed fund does not meet the standards of cost-efficiency set out in the Restatement (Third) of Trusts’ fiduciary standards.

In this example, the retail shares of this fund do not even produce a positive incremental return. As a result, the fund would not be deemed to be cost-efficient under the Restatement’s prudence standards.

Most actively managed funds impose a front-end “load,” or fee, just to purchase their funds. The front-end load is immediately deducted from an investor’s investment funds upon purchase of the fund, reducing the amount of the investor’s actual investment. As this example illustrates, front-end loads can significantly reduce an investor’s realized return, not only in the initial year, but also in each year thereafter, as the fund tries to make up for the continuing “lag” created in the first year.

The financial media and investment professionals often talk about the “search ” for alpha, the importance of achieving a positive incremental return. However, as the following image illustrates, alpha alone is not enough. I suggest that the goal, properly stated, should be cost-efficient, positive incremental returns.

Here the fund did manage to provide a small positive incremental return. However, the fund’s incremental costs (.80) far exceeded the fund’s positive incremental returns (.04). As a result, this fund would also be deemed not to be cost-efficient under the Restatement’s prudence standards.

For benchmarking purposes, I typically use Vanguard’s and/or Fidelity’s low-cost index funds. The returns and costs for both funds are essentially the same, so the AMVR results are usually similar as well.

The returns shown here are expressed in basis points, a term commonly used in the investment industry. A basis point is equal to .01 percent of one percent. Therefore, 100 basis point equals one percent. An analogy I often use to help investors understand the importance of the AMVR is to “monetize” the results by asking the following question-“Would you pay $80 to receive only $4 in return?”

Cost-Efficiency and ERISA
Plan sponsors are fiduciaries. Therefore, the forgoing discussion regarding prudence and various investment compliance standards would be applicable with regard to compliance with ERISA’s regulatory standards.

A plan sponsor’s two primary fiduciary duties under ERISA are the the duty of loyalty and the duty of prudence. Most of the recent 401(k) and 403(b) litigation has focused on alleged breaches of the fiduciary duty of prudence.

ERISA Section 404a-(1)(a) and (b) set out the applicable duty of prudence for ERISA fiduciaries, defining prudence as follows:

(a) In general. Section 404(a)(1)(A) and 404(a)(1)(B) of the Employee Retirement Income Security Act of 1974, as amended (ERISA or the Act) provide, in part, that a fiduciary shall discharge that person’s duties with respect to the plan solely in the interests of the participants and beneficiaries, for the exclusive purpose of providing benefits to participants and their beneficiaries and defraying reasonable expenses of administering the plan, and with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.

(b) Investment duties.

(1) With regard to the consideration of an investment or investment course of action taken by a fiduciary of an employee benefit plan pursuant to the fiduciary’s investment duties, the requirements of section 404(a)(1)(B) of the Act set forth in paragraph (a) of this section are satisfied if the fiduciary:

(i) Has given appropriate consideration to those facts and circumstances that, given the scope of such fiduciary’s investment duties, the fiduciary knows or should know are relevant to the particular investment or investment course of action involved, including the role the investment or investment course of action plays in that portion of the plan’s investment portfolio with respect to which the fiduciary has investment duties; and

(ii) Has acted accordingly.⁸

Under Section 404(a) of ERISA, the prudence of the investments chosen for a plan will be determined with regard to each investment individually and the investments as a whole. Actively managed funds still dominate most pension plans’ investment options despite their consistent record of underperformance and excessive pricing.

Consequently, both the number of 401(k)/403(b) filed and the number of multi-million settlements continues to increase. There is nothing to suggest that the trend will change anytime soon, especially as more ERISA plaintiff attorneys use the AMVR to analyze potential actions.

Hopefully, plan sponsors will follow suit and use the AMVR in selecting and monitoring investment options for their plans, especially given the ease of using the metric. Simply put, cost-inefficient mutual funds are never prudent, are never in the best interest of plan participants.

Closing Argument
Most stockbrokers and financial advisers do not like to discuss the cost-efficiency of the products they recommend and sell. Now you know why.

Going forward, the “fair dealing/best interest” question may prove troublesome for the investment industry and investment fiduciaries with regard to cost-efficiency, as most studies have consistently 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.⁹
• 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.¹⁰
• [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.¹¹
• [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.¹²

Perhaps the best way to summarize the data and arguments presented herein are to reference a quote made by John Langbein shortly after the Restatement (Third) of Trusts was released. Langbein, the reporter on the Restatement, made the following prediction:

When market index funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such accounts. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.¹³

I would argue that the evidence, and the Brotherston Court’s comments, indicates that that day has arrived.

Notes
1. FINRA Rule 2111, SM-2111-.01
2. Scott Epstein, Exchange Act Rel. No. 59328, 2009 SEC LEXIS 217, at *40 n.24 (Jan.30, 2009).
3. Wendell D. Belden, 56 S.E.C. 496, 503, 2003 SEC LEXIS 1154, at *11 (2003).
4. FINRA Regulatory Notice 12-25.
5. 17 CFR Sections 240.15l-1(a)(1), (2)(ii)(B).
6. 17 CFR 240.15l-1, 377-379
7. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
8. 29 C.F.R Section 2550.404a-1(a), (b)(i) and (b)(ii)
9. 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
9. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
10. 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.
11. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
12. Mark Carhart, On Persistence in Mutual Fund Performance,  Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
13. John H. Langbein and Richard A. Posner, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol 5, No. 1, First Quarter 2007 http://digitalcommons.law.yale.edu/fss_papers/498

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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.