Some Common RIA Mistakes That Regulators Are Focusing On in 2016

Posted on January 11, 2016 by jwatkins

Going to start the new year with a rather brief, but important, post. The regulators have announced their intent to perform more RIA audits in 2016. Some recent cases have highlighted issues that do not regularly receive the amount of attention as some other RIA/fiduciary issues.

There have been several cases recently involving the misrepresentation of an adviser’s AUM. Any type of misrepresentation by an adviser would be a violation of Section 206 of the Advisers Act of 1940. While AUM is always subject to fluctuation due to market pricing, withdrawals, distributions and clients leaving, significant variations in AUM are always going to draw the attention of regulators. Significant increases in AUM also raise a red flag. As long as you can properly document your AUM claims, you should have no problem.

Another area that regulators have been focusing on is variances between an adviser’s advisory contract and an adviser’s Form ADV/Disclosure Document. The information provided within these documents should always be consistent. Since the advisory contract actually defines the relationship between an adviser and their client, it will usually be the controlling document unless enforcement of same would be inequitable to a client. This is consistent with the general rule of law that documents will generally be construed against the party who drafted the document.

Along those same lines, language in a contract that attempts to have a client waive rights owed to them by their adviser are void as against public policy. This would also be construed as a violation of the adviser’s fiduciary duty of loyalty, a duty to always put a client’s interests first. This is one reason why I generally advise my consulting clients not to include an arbitration agreement in their advisory contracts. A good securities attorney will jump on that alleging the issues I just discussed.

Asking a client to waive the important rights and advantages possible in trying a case in court, especially the right to conduct meaningful discovery, as opposed to the questionable arbitration process is clearly not in a client’s best interests. Not all my clients follow my suggestion since their broker insists that they include a binding arbitration clause. That’s their choice, but if they own their own RIA, I remind them of that and that they, not their B-D, will be liable if the decisions go against them.

Finally, be sure that you are not misrepresenting the true identity of the investment advisory firm. Simply put, the registered RIA is the name shown on the certificate a firm receives when it registers, not any assumed or fictitious name, i.e., dba name, the firm is using publicly. Contracts executed using only a fictitious name are generally void since there is actually no entity with that name. In such cases, advisers will be required to return any and all money received pursuant to the fraudulent advisory contract.

The proper identification of the advisory firm often comes up involving dually registered representatives who who are offering advisory services through their B-D’s proprietary RIA firm. For some reason, the reps do not want to use the B-D’s RIA’s registered name, but want to use their own fictitious name, presumable to impress prospective clients.

A good compliance department would catch this and ensure proper identification of registered advisory firm, such as “B-D Advisers dba Greatest Investment Adviser in the World,” on all advisory contracts. And yet every year, I run across advisory contracts that are executed using only the GIAW name, subjecting them to possible revocation and substantial fines and other monetary penalties.

Offenders often try to justify the violation by saying that their business cards indicate that advisory services are offered through their B-D. But a business card is generally not considered part of the advisory contract and the “four corners”rule is usually applied to contracts,  meaning that only that which is within the four corners of a page will be considered as part of the contract.

Since the 2015 year-end performance numbers are out, I will be updating the sample of the ERISA Forensic Fiduciary Prudence Analysis sometime this week. I will post a notice on the blog once I have posted the update on SlideShare.

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Combining the Active Management Value Ratio 2.0™ and the Active Expense Ratio – A More Meaningful Evaluation of Fiduciary Prudence

Posted on December 30, 2015 by jwatkins

“The two variables that do the best job in predicting [a mutual fund’s] performance are expense ratios and turnover.”- Burton Malkiel, “A Random Walk Down Wall Street”

Registered investment advisers and their representatives are fiduciaries. The courts have consistently held that a fiduciary’s duties are “the highest standard of care at law or equity,” requiring that the adviser’s advice be truly disinterested. As legendary Justice Benjamin Cardoza stated, a fiduciary must act not simply with “honesty alone, but the punctillo of an honor the most sensitive….”

Fiduciary law is based primarily on common law trust and agency principles. While there are some differences between fiduciary duties under common law and ERISA, the duties are similar in many ways, especially the focus on cost control and risk management through effective diversification. This post will focus on cost control/efficiency, while the next post will focus on a fiduciary’s duties regarding effective risk management.

A fiduciary has a duty to control costs and avoid unnecessary expenses. As most fiduciaries are well aware, the issue of excessive fees has been, and continues to be, the subject of numerous multi-million dollar ERISA lawsuits and settlements.

InvestSense, LLC introduced its own metric, the Active Management Value Ratio 2.0™ (AMVR), which provides a means for evaluating the cost efficiency of actively managed mutual funds. The AMVR is a simple cost/benefit analysis that compares an actively managed fund’s incremental cost to its incremental return. More information about the AMVR and the calculation methodology, can be found in the white paper, “Management Value Ratio 2.0™ on this site and here.

The AMVR uses an actively managed fund’s stated annual expense ratio in calculating the fund’s incremental costs. However, given the fact that more funds are closement ely tracking their relevant benchmark, the actual contribution attributable to active management is reduced. Therefore, a fund’s stated annual expense ratio can understate the effective/implied cost of the active component of a mutual fund, and thus the overall effective cost of an actively managed fund.

The Active Expense Ratio (AER), a metric created by Professor Ross Miller of the University of New York, addresses this very issue. Like the AMVR, the AER is relatively simple to calculate, requiring very little information, all of which is freely available online at sites such as morningstar.com and yahoo.finance.com.

The first step in calculating an actively managed fund’s AER is to calculate the “active weight” (AWt) of the fund. The calculation simply requires the fund’s R-squared rating. Morningstar defines R-squared as the “measurement of the relationship between a portfolio and its benchmark….An R-squared of 100 indicates that all movements of a portfolio can be explained by movements in the benchmark….Conversely, a low R-squared indicates that very few of the portfolio’s movements can be explained by movements in its benchmark index.”

Using a fund’s R-squared rating, a fund’s AWt is calculated by using the equation

AWt = SQRT(1-R-squared)/[SQRT(R-squared) + SQRT(1-R-squared)]

AER is simply a fund’s incremental costs divided by the fund’s AWt (IC/AWt). The fund’s incremental costs are calculated as part of the AMVR calculation, making the calculation of AER that much easier.

The majority of domestic equity-based mutual funds currently have R-squared ratings above 90, with many domestic large-cap funds having an R-squared rating above 95. InvestSense uses 90 as the minimum R-squared rating for classification as a “closet index” fund. So using that number as a fund’s R-squared rating, 1.00 as the fund’s stated expense ratio, and 0.72 as the fund’s incremental costs, the resulting AER would be

AWt = SQRT(0.10)/(SQRT(0.10) + SQRT(0.90) = 0.3162/0.3162 + 0.9486 = 0.2499

AER = Fund’s stated expense ratio + (Fund’s incremental cost/AWt) = 1.00 + (0.72/ 0.2490) = 3.88

So, the actively managed fund’s effective annual expense ratio would be 3.88, or almost 300% higher that its stated annual expense ratio. The significant difference in expense ratios makes it extremely hard to successfully argue that the actively managed fund is cost efficient and a prudent choice, especially once the fund’s AMVR score is re-calculated using the fund’s AER. Bottom line, the higher a fund’s R-squared rating and/or the higher the fund’s incremental costs, the higher the fund’s AER and resulting effective expense ratio, and thus the less prudent the fund becomes.

A recent study by noted finance professors Eugene Fama, a Nobel laureate, and Kenneth French found that only the top 3 percent of active fund managers provided returns in excess of their fund’s costs. That number will likely be further reduced when a fund’s AER rating is incorporated into the calculation of the fund’s AMVR score.

Given the recent trend of a high correlation of returns between U.S. domestic equity funds and a resulting higher percentage of “closet index” funds, calculating a fund’s AMVR using its AER rating is both valuable and justifiable, as it provides a better perspective of the fiduciary prudence of a fund. Fiduciaries that recommend actively managed mutual funds that fail to provide investors with a commensurate return for the higher costs associated with actively managed funds face the risk of a breach of fiduciary claim.

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ERISA, Fiduciary Duty and the Art of Skinnydipping

Posted on November 19, 2015 by jwatkins

Only when the tide goes out do you discover who’s been swimming naked. – Warren Buffett

As followers of this blog know, I normally post once a month. However, I am making an exception due to the importance of the subject matter.

This morning I met with a prominent law firm and performed a forensic fiduciary liability audit on their firm 401(k) plan. When I reviewed my findings with the firm’s managing partner and the head of their 401(k) investment committee to review my findings, they were clearly shocked by my projections as to their current liability exposure. After I went over the key data, they were mad, very mad, but they realized I was right and are dedicated to correcting the problems.

If you are a registered investment adviser, you are overlooking one of the greatest potential work opportunities if you are not helping 401(k)/404(c) plans. Fred Reish, one of the nation’s top ERISA attorneys, identified the opportunity with his observation that

our experience is that very few plans actually comply with 404(c). It is probable that most (perhaps as high as 90%) 401(k) plans do not comply with 404(c) and, as a result, the fiduciaries of those plans are personally responsible for the prudence of the investment decisions made by participants.

Compare Reish’s 90 percent figure with a recent study that reported that 94.6 percent of the 401(k)/404(c) plan sponsors surveyed believed that they were compliant with applicable 401(k)/404(c) regulations.

And it’s not just plan sponsors who simply do not truly understand the investment obligations of ERISA fiduciaries and the proper way to evaluate investment options. The Supreme Court’s recent decision in Tibble v.Edison International  clearly established an ERISA fiduciary’s ongoing duty to monitor a plan’s investment options and remove any unsuitable investment options within a plan. But before the SCOTUS ruling, the Ninth Circuit clearly indicated its lack of understanding regarding the fiduciary duties under ERISA’s prudent man standard when it denied Tibble’s claims with regard to the plan’s imprudent selection of the plan’s investment option, stating that

Nor is the particular expense ratio range out of the ordinary enough to make the funds imprudent…and there were roughly forty mutual funds to choose from.(1)

To be fair, the Ninth Circuit is not the only court to take such an indefensible position. But you would think that courts would educate themselves on the appropriate method to evaluate the prudence, or lack thereof, of investment options.

Stockbrokers and financial advisers who rely on commissions often object when the issue of fees on actively managed mutual funds is brought up , responding that the relative performance of a fund should also be considered. And they are right. Unfortunately, the well-documented consistent under-performance of actively managed mutual funds completely undercuts their arguments.

ERISA states that plan sponsors and other plan fiduciaries cannot simply accept the advice provided by third-parties such as stockbrokers, as there are obvious potential conflict of interest issues which can, and often do, impact the quality of such advice. As the Ninth Circuit properly pointed out in dismissing Edison’s blind reliance on their investment consultant,

HFS is its consultant, not the fiduciary. [Plans are required to] make certain that reliance on the expert’s advice is reasonably justified under the circumstances….Just as fiduciaries cannot blindly rely on counsel, …a firm in Edison’s position cannot reflexively and uncritically adopt investment recommendations.(2)

In applying ERISA’s fiduciary’s duties, the courts have consistently held that plan sponsors and other plan fiduciaries must conduct their own thorough and objective analysis of potential investment options for a plan. The courts have emphasized the importance of a plan sponsor’s independent investigation, stating that

A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard.(3)

The failure to make an independent investigation and evaluation of a potential plan investment is a breach of fiduciary duty.(4)

And there it is, the opportunity for registered investment advisers. The law imposes a duty on plan sponsors to conduct a thorough, objective and independent investigation of potential plan investment options.  The problem is that, to put it bluntly, most plan sponsors have absolutely no understanding as to how to properly conduct such an investigation and therefore, the evidence suggests that, in many cases, thtey do not do so, hoping that they will not get caught.

My father once told me that putting your head in the sand and trying to ignore a problem simply provides your opponents a bigger target. Once I do a fiduciary liability audit and discuss my findings with the plan’s fiduciaries, I often get a response along the lines that their employees are not going to sue the company because they fear losing their jobs.

What plan sponsors do not seem to understand is that those employees eventually become former employees. Most of the current 401(k) excessive fees and breach of fiduciary duty cases are being filed by former employees. Divorcing spouses and the heirs of former employees are increasingly filing actions against 401(k)/404(c) plans. After all, they have nothing to lose and most plans will either settle or lose the cases since, as Reish points out, the majority of such plans are non-compliant.

I often hear investment advisers complain that they simply cannot get a foot in the door to even talk with 401(k)/404(c) plans. I have never had that problem. I ask for fifteen minutes and then I simply tell them how many funds are imprudent and show them the plan’s, as well as their personal, projected current liability. After that, they are more than willing to talk. After all, “money talks.”

Plan fiduciaries hear adviser after adviser tell them they can provide better advice than the plan’s current adviser, so the fiduciaries dismiss such promotion. My suggestion – show the plan’s sponsor and other plan fiduciaries how the plan’s current configuration might hit them personally in their wallets, (remember, plan fiduciaries face unlimited personal liability, including punitive damages, for a breach of their fiduciary duties) and all of a sudden they have all the time in the world to listen to you since you can back up your numbers. Sometimes they’ll even order lunch for everyone.

No one knows for sure when another correction or bear market is going to occur. However, history has shown that the markets are cyclical and bear markets are going to occur, often when least expected. History has also shown that the markets often react to sudden world events. Given the current state of world affairs, a serious market downturn or even a bear market may occur much sooner than expected. And when such events occur, you can be sure that there will be those who look to their 404(k)/404(c) plan now that more people have heard about the multi-million dollar settlements involving such plans and the fact that so many plans and plan fiduciaries will not be able to successfully defend actions against them.

The opportunities are out there. The large multi-national corporations may not want to listen, but there are plenty of local law firms and medical firms that need your services…they just do not know it yet. Based upon my experience as a compliance director, doctors and lawyers are often bad investors. If you make the proper presentation (fiduciary duty to put their interests first, then the identification of imprudent investments and projected potential liability, then a reminder that a loss is not necessary to find one guilt of a breach of one’s fiduciary duties), you should be on your way to a new client.

Notes

  1. Tibble v. Edison International, 711 F.3d 1061, 1083 (9th Cir. 2013)
  2. Tibble, at 1083
  3. Fink v. Nat’l Savs. & Trust Co., 772 F.2d 951, 957 (D.C. Cir. 1985)
  4. U.S. v. Mason Tenders Dist Council of Greater NY, 909 F. Supp. 882, 887 (S.D.N.Y. 1995)

 

 

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Cross-Examining Financial Planning’s Active vs. Passive Study

Posted on November 16, 2015 by jwatkins

Financial Planning magazine recently ran an article on their online site purportedly to demonstrate that actively managed mutual funds provide better performance than passively managed mutual funds, such as the popular index funds. Whenever I see such claims, the securities attorney in me comes out and I have to perform a forensic analysis of the evidence presented to analyze and verify both the evidence and the argument presented.

I immediately knew that there were serious issues with the study because (1) the analysis was based on the three-year annualized returns of the funds, and (2) the analysis was based purely on such returns and the funds’ expense ratios. A proper analysis of a mutual fund’s performance should be based on a time period that includes at least one down year in the market. This allows an investor to see how well an actively managed fund protected the fund’s investors since one of the touted benefits of active management is the ability of the fund’s management team to respond to such situations and better protect their investors.

Costs are an important issue in mutual funds investing, as they directly reduce a fund’s bottom line and, thus, an investor’s end return. Two critical costs for actively managed mutual funds are a fund’s annual expense ratio and its turnover, or trading, costs. As Burton Malkiel pointed out in his seminal work, “A Random Walk Down Wall Street,”

The two variables that do the best job in predicting future performance are expense ratios and turnover.

Since actively managed funds typically have significantly higher turnover than do passively managed mutual funds, it is not unusual to see an actively managed fund’s trading costs exceed the fund’s annual expense ratio. The failure of the financial planning study to factor in such trading costs essentially invalidates the entire study.

It should be noted that the failure to include such trading costs may be due to the fact that while mutual funds are required to disclose their annual expense ratios, they are not required to disclose their trading costs. Nevertheless, to totally ignore such costs is indefensible given their impact on the true cost and performance of a fund. At the very least, a fund’s reported turnover could be used as a proxy for the actual trading costs.

Another alternative used by many investment professional to calculate a fund’s trading cost is the methodology suggested by investment legend John Bogle. Bogle’s method is to double the fund’s stated turnover ratio and multiply the result by 0.60. As long as you consistently use the same methodology for all fund’s, the results are acceptable.

In addition to the previously mentioned shortcomings, the study suffered from from other issues, including

  • five of the scenarios (#6, #8, #10, #13, and #20) involved funds charging front-end loads in excess of 5 percent. There is simply no reason to accept load funds when comparable, if not better, no-loads funds are available;
  • one of the scenarios (#16) involved a fund using C shares with an annual 12b-1 fee of 1 percent. C shares are a red flag to regulators, as they are usually used by unethical financial advisers trying to collect the same 1 percent annual advisory fees charged by RIAs without registering as an RIA as required by law;
  • four of the scenarios (#2, #8, ##15 and #19) involved funds without a five-year track record, raising questions about the reliability of their performance record;
  • five of the scenarios (#2, #3, #5 #13 and #16) involved “active” funds with turnover ratios less than 25 percent, much lower than the average turnover ratio that indicates active management;
  • four of the scenarios (#9, #12, #13, and #16) involved “passive” funds with turnover ratios in excess of 100 percent, significantly higher than the single digit turnover ratio normally associated with passively managed mutual funds; and
  • one scenario (#19) where the turnover ratio for an “active” fund was essentially the same as the turnover ratio for the accompanying “passive fund, 33 percent to 26 percent, respectively.

Adding the turnover costs for each fund to the equation, using financial planning’s original combinations, active management won 9 of the 20 combinations using a three-year period of comparison. Over a five-year period, passive management won 11 of the sixteen scenarios.

The attorney in me wanted to see what the results would have been had financial planning used a benchmark as the passive element in each scenario. In this case, I used Vanguard’s Growth Index fund as my benchmark, as it is designated by Morningstar as a large cap growth fund.

Over the three-year period chosen by financial planning, the actively managed funds won 16 of the twenty scenarios. Over a five-period, the passively managed funds won 11 of the sixteen scenarios.

My takeaway is that the results clearly show why three-years is simply not a valid period for evaluating a mutual fund’s performance, especially when the three years fails to include a down market period. It should be noted that the five-year period I used included 2014-2012, the three-year period used by financial planning, as well as 2011, a down year of the stock market,  and 2010. The market’s poor performance in 2011 definitely had an impact on the noticeable difference in three and five-year performances.

If you exclude the scenarios that had legitimacy issues, there were only four scenarios that merited consideration (assuming one ignores the three-year analysis issue). Out of those four scenarios, active management and passive management each won two scenarios.

The article as a whole raised an issue that I have raised before regarding 401(k)/404(c) plans. Most 401(k) plans try to qualify as a 404(c) plan in order to shift the plan’s investment risks onto the plan’s participants. For that reason, ERISA Section 404(c) states that a plan must provide plan participants with “sufficient information to make an informed decision.”

Both the DOL and the courts have stated that Modern Portfolio Theory (MPT) is the standard for assessing a fiduciary’s prudence under ERISA. The cornerstone of  MPT is factoring in the correlation of returns among investment options in order to combine investments that behave differently under various economic scenarios, the hope being to avoid significant financial losses.

And yet, ERISA does not expressly require that such information be provided to plan participants, even though the plan’s fiduciaries presumably have such information in order to choose prudent investment options for the plan. Without such information, plan participants are not provided with an opportunity to design an effectively diversified plan account.

My fear is that too many people blindly accept these types of “best of’ their findings because they either do not care or are unwilling, or unable, to do the due diligence necessary to verify the claims made. A significant number of the people who call me tell me that they choose their investments based on either a “best of” list in some publication or Morningstar’s star system, even though Morningstar has publicly stated that their star system is not intended to be used in such a manner.

In considering “best of ” lists. investors would most likely be best served by following the warning of former President Ronald Reagan – “Trust, but verify.”

 

 

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Protecting Your Practice with the Active Management Value Ratio 2.0™

Posted on November 2, 2015 by jwatkins

RIAs often have mock audits performed. These audits generally focus on the various regulatory requirements for RIA, including the various documents and internal procedures of an RIA.

More often than not, these mock audits do not include a forensic fiduciary liability analysis. Even when they are performed, I generally find such reviews lacking in quality. Unless an auditor has experience as an actual compliance director, someone who has had the responsibility to review trades on a daily basis, I do not think the auditor can understand all the issues that must be considered.

Based on my experience, I find that RIAs are surprised when they are informed about the amount of unnecessary and unwanted fiduciary liability exposure they actually have. Many RIAs respond by saying that their broker-dealer did not give them sufficient advice on the issues. However, unless a broker is registered through the broker-dealer’s RIA, the broker has no duty to advise an independent RIA on matters involving their RIA. NASD 94-44 only requires that a broker-dealer monitor and supervise trades of brokers affiliated with independent RIAs.

RIAs and investment advisory representatives (IAs) are held to a fiduciary standard. Some IAs argue that under the “two hats” theory, any trading activity they engage in on help of RIA clients is subject to a “suitability” standard, not the fiduciary “best interests” standard.

In my opinion, that argument fails under the Arlene Hughes decision, which held that one who is dually registered will be held to the higher fiduciary standard in their dealings with the public. Recent FINRA Regulatory Notices are clearly in agreement with the Hughes’ decision, stating that a broker-dealer and a broker must always act in a customer’s best interests. For reasons I will explain later herein, I do not think it really matters.

Two of the primary duties of a fiduciary are the duty of loyalty (duty to always act in the best interests of a client) and the duty of prudence (duty to manage a client’s affairs as would a prudent man managing his own affairs). A fiduciary’s duties are absolute and unforgiving. As courts have consistently pointed out, “a pure heart and an empty head” are no defense to a breach of fiduciary claim.

For broker-dealers and brokers who claim that they are governed by FINRA’s less stringent suitability rule, I would suggest that they re-read FINRA’s new Rule 2111, especially 2111.05, and Rule 2010. As strong argument can be, and has been, made that a broker faces just as stringent rules under both of said Rules, especially Rule 2010, often referred to as FINRA long-arm rule, allowing FINRA to sanction any conduct on an  “as needed” basis.

Rule 2111.05 sets out the three components of suitability under Rule 2111-reasonable-basis suitability (suitable for at least some investors; customer-specific suitability (suitable for a particular customer); and quantitative suitability (suitability of a series of recommended transaction when a broker has actual or de facto control over a customer’s account.

It should also be noted that FINRA stated in Regulatory Notice 12-25 that “the suitability rule and the concept that a broker’s recommendation must be consistent with the customer’s best interests are inextricably intertwined.” Various enforcement actions, by both NASD/FINRA and the SEC, have also held that

A study commissioned by the SEC in connection with a proposed uniform fiduciary standard stated that

[A] central aspect of a broker-dealer’s duty of fair dealing is the suitability obligation, which generally requires a broker-dealer to make recommendations that are consistent with the best interests of his customer.

FINRA Rule 2010 is a potentially strong regulatory tool due to its vague ruling, which results in flexibility in its usage. Rule 2010 states that

A member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade.

The Rule does not define any of the terms contained in the Rule, allowing greater flexibility in its enforcement. The Rule is consistent with the overall stated concept of fair treatment of the public.

The Active Management Value Ratio 2.0™

Which brings us to the role of the Active Management Value Ratio 2.0™ (AMVR) in protecting RIAs and other financial advisers, regardless of whether they are titled as fiduciaries or not. I believe that the AMVR provides objective data that identifies potential liability issues under both a fiduciary standard and FINRA’s rules and regulations, and allows financial advisers an opportunity to address such issues and avoid unwanted liability exposure.

AMVR calculations will result in one of three scenarios:

  1. the actively managed fund will fail to produce any incremental return for an investor, therefore providing no benefit to an investor;
  2. the actively managed fund will produce an incremental return for an investor, however the incremental costs incurred by the fund in producing the incremental return will exceed the incremental return, therefore providing no benefit to an investor; or
  3. the actively managed fund will produce an incremental return greater than the fund’s incremental cost, therefore producing a benefit for an investor.

Scenarios 1 and 2 create obvious liability concerns for a financial advisor, as both scenarios result in increased costs for an investor without providing any benefit in return for an investor. Both scenarios would obviously not be neither suitable, prudent  nor in the best interests of any investor, resulting in liability exposure for their provider who provided such recommendations.

Scenario 3 does result in a financial benefit for an investor, justifying further evaluation on qualitative issues such as risk, stress testing and consistency of performance.

Financial advisers often complain about the amount of attention given to a mutual fund’s fees. Higher fees that result in a scenario 3 situation are probably not an issue. The AMVR focuses on a fund’s annual expense ratio and turnover/trading costs, studies have consistently shown that

The two variables that do the best job in predicting future [of mutual funds] are expense ratios and turnover. High expenses and high turnover depress returns….– Burton Malkiel “A Random Walk Down Wall Street”

Furthermore, studies consistently show that most actively managed mutual funds underperform comparable passive/index mutual funds. The latest SPIVA (Standard & Poor’s Index Versus Active) report indicated that as of December 31, 2014, actively managed mutual funds underperformed index funds by 80.82 percent over the most recent five years and by 76.54 percent over the most recent ten-year period. In many cases, a fund’s underperformance can be directly attributed to its incremental costs.

Conclusion
My purpose in creating the AMVR was to provide a means of quantifying suitability and best interests not only for my practice, but also for investors, fiduciaries, attorneys and the courts. The concept of evaluating actively managed mutual funds based on the fund’s incremental costs and returns recently received support from the court hearing the Citigroup 401k excessive fees case.

The decision has received little attention from the media, but the legal community, especially the ERISA community, is definitely aware of the court’s decision, as it upheld the viability of using Vanguard’s mutual funds in assessing the reasonableness of a fund’s expenses. While the decision is technically only binding on that court, you can be sure that the logic of the court will be argued in courts everywhere. It should be noted that the Citigroup case is being heard in the federal court for the Southern District of New York, where most federal securities cases are heard, providing even more legitimacy for the widespread application of the court’s logic and decision.

The AMVR provides fiduciaries and financial advisers with a simple and effective method to evaluate actively managed mutual funds and avoid unnecessary and unwanted liability exposure.  Given the interest in the AMVR shown thus far by securities and ERISA attorneys, fiduciaries and financial advisers who include the AMVR as part of their process in providing investment recommendations to their customers may provide greater protection for their practices.

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Avoiding ERISA’s #1 Fiduciary Liability “Gotcha”

Posted on October 18, 2015 by jwatkins

Facts do not cease to exist because they are ignored. – Aldous Huxley

Fiduciary law is a combination of trust and agency law. The basic rule of fiduciary law is that a fiduciary must always put their customer’s/client’s best interests first.

There are certain duties that are fundamental to fiduciary law. The two primary duties are the duty of loyalty and the duty of prudence. The duty of loyalty simply relates to a fiduciary’s duty to always put a customer’s/client’s best interests first. In describing the duty of prudence, the Section 90 of the Restatement (Third) Trusts (aka the Prudent Investor Rule) (Rule) states that

“[t]he [fiduciary] is under a duty to the [customers/clients] to invest and manage the funds of the trust as a prudent investor would, in light of the purposes, terms, distribution requirements, and other circumstances of the trust. This standard requires the exercise of reasonable care, skill, and caution,…

ERISA Section 404(a) sets out an ERISA fiduciary’s duties, including the same standards of care set out in the Rule, as well as a duty to act solely in the interests of the plan’s participants and beneficiaries and a duty to control the plan’s costs

Many 401(k) plans attempt to qualify as a 404(c) in order to shift the risk of investment returns to the plan’s participants. However, Fred Reish,  one of the nations’s most respected ERISA attorneys, shares the opinion of many ERISA experts that most 401(k)/404(c) plans are not ERISA compliant, and thus face potentially severe consequences.

[O]ur experience is that very few plans actually comply with 404(c). It is probable that most (perhaps as high as 90%) 401(k) plans do not comply with 404(c) and, as a result the fiduciaries of those plans are personally responsible for the prudence of the investment decisions made by participants.

[E]ven if a plan complies with the 404(c) requirements, the pressure is not taken off the fiduciaries. Fiduciaries have a legal obligation to offer investments that are ‘suitable and prudent.’ (1)

Most of the current litigation involving 401(k) plans involves questions about the appropriateness of the of investment options offered within a plan, particularly the fairness of the fees associated with the plan’s investment options, many of which are actively managed mutual funds. Many critics of 404(k) plans point out that plan participants could receive the same, or in many cases, even better returns through the use of less expensive index funds. Many investment professionals complain about the attention given to the fees associated with the plan’s investment options, claiming that it overlooks the benefits provided to plan participants in exchange for an investment’s higher fees.

They say a good attorney can argue both sides of a case. Therefore, as an attorney, I look for evidence supporting arguments on both sides and then weigh the persuasiveness of all of the evidence. For that reason, each your I perform a forensic analysis of the top ten mutual funds used in American defined contribution, as reported each September by “Pensions & Investments” magazine. “Pensions & Investments” is purely objective, as their list is not a subjective ranking, but rather a list based on the cumulative amounts invested in each fund within the defined contribution industry.

I recently posted the new 2015 ERISA Fiduciary Prudence Analysis (Analysis) online at Slideshare. You can find the analysis here. The cornerstone of the analysis is my proprietary metric, the Active Management Value Ratio™ (AMVR). While the AMVR is simple to calculate, requiring only the ability to add, subtract and divide, it provides a clear picture of the benefits, if any, of the incremental, or additional, costs charged by actively managed mutual funds.

The AMVR metric will provide one of three results: (1) that the actively managed mutual fund provides no incremental, or added, benefit for an investor; (2) that the actively managed mutual fund provides an incremental, or added, benefit for an investor, but the incremental cost exceeds the incremental benefit; or (3) that the actively managed mutual fund provides an incremental, or added, benefit for an investor, and the incremental benefit is greater than the incremental cost. Results (1) and (2) are obviously problematic from a fiduciary liability viewpoint, as both result in an investor actually losing money from the investment.

The rules for fiduciary investing are set out in the Prudent Investor Rule (Rule), Section 90 of the Restatement (Third) Trusts and the Uniform Prudent Investor Act (Act), which simply codifies the Rule. Section 7 of the Act, and the comment thereto, makes the Act’s position on investment costs very clear

In investing and managing [account] assets, a trustee may only incur costs that are appropriate and reasonable and reasonable in relation to the assets, the purposes of the trust, and the skills of the [fiduciary].

Wasting [customers’/clients’] money is imprudent. In devising and implementing strategies for the investment and management of [account] assets, [fiduciaries] are obliged to minimize costs.

The Act cites the Restatement (Second) Trusts in support of its position and states that

[I]t is important for [fiduciaries] to make careful cost comparisons, particularly among similar products of a specific type being considered for a [fiduciary] portfolio. 

Again, since results (1) and (2) from the AMVR require investors to pay an additional amount without receiving a commensurate return, it is clear that they would be imprudent. Remember, fiduciary prudence is determined not on an investment’s eventual performance, but rather on the prudence of process that the fiduciary used in selecting the investments for an account/plan.

If we apply these guidelines to the Analysis, we see some obvious issues with the top 10 list. Actually, we will examine 13 funds, since we analyzed both class R-1 and R-6 shares for the three American funds that were in “Pensions & Investments” top ten list. Of the 13 funds, only four passed the AMVR screen. Seven of the funds failed to provide any positive incremental benefit/return (NA), and two of the funds had AMVR ratings greater than 1.0, indicating that the fund did produce a positive incremental return, but the fund’s incremental cost exceeded its incremental return.

The AMVR allows ERISA fiduciaries a relatively quick and simple means of beginning their required independent vetting of a plan’s investment options. Court decisions clearly establish that a fiduciary’s independent investigation of the merits of a particular investment a key element of the prudent person standard.

Some fiduciaries argue that they do not have a duty to evaluate potential investments for a 401k plan using a fund’s incremental cost and incremental return data, that simple annual return data and standard deviation data is sufficient. My response to that is two-fold. I would strongly suggest that fiduciaries review the recent decision in the Leber v. Citigroup action, where a court for the first time upheld the argument that in analyzing the prudence of a fund’s costs, Vanguard’s low cost funds are a viable benchmark.

Secondly, in evaluating the prudence of a fiduciary due diligence process, the courts do not limit their analysis solely to what the fiduciary actually knew.

[T]he determination of whether an investment was objectively imprudent is made on on the basis of what the [fiduciary] knew or should have known; and the latter necessarily involves consideration of what facts would have come to his attention if he had fully complied with his duty to investigate and evaluate. (emphasis added)(2)

A fiduciary obviously can tell if an actively managed mutual funds charges higher fees than a less expensive index fund with comparable, or even better, performance numbers. In that situation, I would submit that the question comes down to whether a fiduciary has a duty to determine whether the added incremental cost of the actively managed fund is justifiable based on a simple cost/benefit analysis  using a fund’s incremental cost and incremental return data, the same process used by the AMVR.

Based on my experience, the courts have looked favorably on the foregoing argument as by logical and persuasive. Other attorneys who have used the AMVR in their cases have reported  similar success. I believe that the simplicity of the AMVR and its ease of calculation has played a large part in its acceptance.

One question I often receive is why the AMVR does not factor in possible revenue sharing received by a 401(K) plan. Revenue sharing could be added into the calculation process. I choose not to include it in my work due to a number of factors. One of the primary reasons that I do not include revenue sharing in my reviews is due to the inability to independently verify the information and confirm how the money was actually used. There are too many reported instances of revenue sharing money being used inappropriately for me to ignore.

Another reason for my reluctance to include potential revenue sharing money in the AMVR process is the fact that the alleged purpose of revenue sharing is to help defray the plan’s administrative costs, not necessarily the plan participants’ investment costs, such as the annual fees and other costs associated with the plan’s investment options. The impact of said annual fees and other costs associated with the plan’s investment options are exactly what the AMVR evaluates.

A final reason for my decision not to include any revenue sharing in the AMVR calculation is the fact that revenue sharing will generally have little impact on a fund’s AMVR score. If a fund underperforms its benchmark, it will result in the fund providing no incremental benefit for the plan participant and obviously fail to meet the “best interests” requirement of any fiduciary standard.  Since most studies of the performance of actively managed mutual funds indicate that the majority of such funds underperform their appropriate benchmark, especially over the long term, potential revenue sharing money would have no impact on a fund’s eventual AMVR and fiduciary score

I believe that a major factor contributing to the ERISA fiduciary liability “gotcha” is the fact that far too often plan sponsors and other ERISA fiduciaries fail to do their own “careful and impartial independent investigation” as required by ERISA. Based on my experience, far too many ERISA fiduciaries blindly accept whatever their chosen service provider tells them or, if they do conduct their own independent investigation of a plan’s investment options, they fail to use prudent practices and/or fail to properly document their investigation and findings.

The danger in following this practice should be obvious given the obvious conflict of interests issue with someone who is both offering financial advice and selling financial products. As the courts have correctly pointed out,

One extremely important factor is whether the expert advisor truly offers independent and impartial advice. (3)

In many cases the service providers chosen by plan sponsors are affiliated with companies selling financial products, people such as stockbrokers or insurance salesmen. In rejecting such practices, the Bierwirth court issued a clear warnings to plan sponsors and other ERISA fiduciaries who decide to follow this practice. The Bierwirth court pointed out that a broker is not an impartial analyst, as his salary is either paid by the company he works for or his job is to close deals and generate commissions for himself and his company.

In relying upon the advice of another, [a fiduciary] should consider whether the person giving the advice is disinterested. Thus it is has been held that in purchasing securities for the defined contribution] plan, [a fiduciary] is not justified in relying solely on the advice of a broker interested in the sale of the securities. (Bierwirth, at 474)

Liability and Best Practices Implications for Plan Sponsors, ERISA Fiduciaries and Investment Advisers

The potential liability issues for plan sponsors and other ERISA fiduciaries are serious given the fact that the analysis found eight of the top ten mutual funds to present serious questions regarding their prudence under applicable fiduciary standard. As pointed out herein, the fact that a plan sponsor or other ERISA fiduciary meant no harm or was unaware of such questions of prudence will not protect the fiduciary if any of the plan’s investment options are determined to have been imprudent.

I have had plan sponsors, ERISA fiduciaries, and even some ERISA attorneys tell me that there is no real reason to worry about a plan’s investment options since the risk of plan participants losing money is relatively. Their attitude usually changes when I inform them that it is not necessary for a plan participant to lose money in order for a plan sponsor or other ERISA fiduciary to be found guilty of a breach of their fiduciary duties.(4)

Plan sponsors, ERISA fiduciaries and ERISA attorneys also like to try to defend themselves by saying that they are benchmarking their plan with other plans. Therefore, if their plan is doing it wrong, so are the other plans. If they are non-complaint, they are no worse than the other plans used in their benchmarking process.

My response is to tell them that their benchmarking process, if incorrect, simply means that they will all have to write checks if their plan is challenged by the DOL and/or their plan participants. Plan sponsors and ERISA fiduciaries need to understand that the DOL and the courts use an “absolute” scale to assess compliance, not a “relevant” scale.

Plan sponsors and other ERISA fiduciaries face a daunting task in selecting investment options for their plans. Fred Reish has acknowledged this challenge, offering his opinion that “many fiduciaries lack the expertise or access to the information needed to satisfy the prudent process requirement.”(5) In those situations, plan sponsors and other ERISA fiduciaries are urged to seek out professional advisers that can recommend prudent investment options. However, as mentioned earlier, a fiduciary’s reliance on third parties must be found to have been “reasonable” for a fiduciary to attempt liability for imprudent decisions.

No one knows for sure what changes will result in questions involving ERISA fiduciary liability once the DOL issues its new fiduciary standards. However, as both this white paper and the analysis point out, it is relatively easy and inexpensive for plan sponsors and other ERISA fiduciaries to conduct meaningful independent analyses of potential investment options using simple metrics such as the AMVR and a fund’s R-squared rating, and in so doing, protecting both plan participants, their beneficiaries and the plan’s fiduciaries.

Notes

(1) Fred Reish, “Participant Investing: Forewarned is Forearmed,” ERISA Report for Plan Sponsors,” September 2004, No. 7, No.2., available online at http://www.drinkerbiddle.com/resources/publications/2004/participant-investing-forewarned-is-forearmed?Section=FutureEvents ; Fred Reish, “Just out of Reish: A Good Defense,” PLANSPONSOR, September 2205, available online at http://www.plansponsor.com/MagazineArticle.aspx?Id=4294991584 
(2) Fink v. Nat’l Sav. and Trust Co., 772 F.2d 951, 962 (D.C.C. 1985); see also, Donovan v. Bierwirth, 538 F. Supp. 463 (E.D.N.Y. 1981); 29 C.F.R. § 2550.404a-1.
(3) Gregg v. Transportation Workers of America Internat’l, 343 F.3d 833, 841-842 (6th Cir. 2003).
(4) Spitzer v. Bank of New York, 43 A.D. 105, 349 N.Y.S. 2d 747 (1974); Leigh v. Engle, 727 F.2d 113 (7th 1983)
(5) Fred Reish, “Selecting and Monitoring 401(k) Plans,” available online at http://www.drinkerbiddle.com/resources/publications/2004/participant-investing-forewarned-is-forearmed?Section=FutureEvents.

Posted in 401k, 401k compliance, 401k investments, 404c, 404c compliance, fiduciary compliance, fiduciary law, investments, pension plans, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , | Leave a comment

Investment Industry Has Some ‘Splaining to Do

Posted on October 4, 2015 by jwatkins
  • “[B]rokers’ recommendations must be consistent with their customers’ “best interest.(1)
  • “[A] central aspect of a broker-dealer’s duty of fair dealing is the suitability obligation, which generally requires a broker-dealer to make recommendations that are consistent with the best interests of his customer.”(2)
  • “[T]he suitability rule and the concept that a broker’s recommendation must be consistent with the customer’s best interests are inextricably intertwined.” (3)
  • In interpreting FINRA’s suitability rule, numerous cases explicitly state that “a broker’s recommendations must be consistent with his customers’ best interests.”(4)
  • “In interpreting the suitability rule, we have stated that a [broker’s] ‘recommendations must be consistent with his customer’s best interests.’”(5)
  • “[a]broker’s recommendations must be consistent with his customer’s best interests”(6)
  • “As we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests.”(7)

The debate over a possible uniform fiduciary standard for anyone providing investment advice to the public continues. The key issue continues to be whether to allow stockbrokers to continue to operate under a “suitability” standard that allows them to put their own financial interests ahead of their customers’/clients’ best interest, or require them to adhere to the fiduciary standard imposed on registered investment advisers, which requires them to always put their customers’/clients’ best interests first.

The answer would seem to be obvious. After all, what would be so onerous or unfair about making stockbrokers put their customers’/clients’ best interests first. Stockbrokers would still be allowed to earn commissions as long as the product being sold if fair and meets the fiduciary “best interests” standard.

But the investment industry would obviously prefer to be able to put their own financial interests first and continue a system which has, and continues to result in abusive practices and results at the public’s expense. Reports of new regulatory enforcement actions, customer complaints/actions and settlements are happen on an almost daily basis.

In their opposition to a uniform fiduciary standard, the investment industry continues to put forth two primary arguments. The first argument is that many investors will be deprived of valuable investment advice, as stockbrokers will not continue to serve them.

First of all, as a former compliance director, I am not sure about the actual value of the advice currently being delivered by stockbrokers. After all, that’s one of the main reasons for the predicament we are currently facing, as the charge is that such advice is often filled with conflict-of-interest issues, with advice that is more beneficial to the stockbroker than the investor.

The second argument is that forcing stockbrokers and their broker/dealers to create and maintain a compliance system based on the fiduciary standard’s “best interests” requirement would cost billions of dollars. Recent studies commissioned by the investment industry have put the estimated cost at $3.9 billion to $5 billion.

I have two comments about such projected costs. First, given the fact that the studies were paid for by the investment industry, obvious issues arise. These issues become more justified in light of the recent scandal involving the Brookings Institute’s self-serving study for the The Capital Group/American Funds, in which various negative accusations were made regarding the proposed uniform fiduciary standard.

I listed a sample of the various comments that have been made by the key regulatory bodies in the investment industry, the SEC and FINRA, to show that they have both clearly stated that stockbrokers have an obligation to act in the best interests of their customers/clients. Therefore, in order to be in compliance with FINRA’s regulations, broker-dealers should already have compliance programs in place to ensure that their brokers are acting in their customers’/clients’ best interests.

If that is the case, then there should be little, if any, additional compliance costs for broker-dealers to comply with a uniform fiduciary standard. Or are the investment industry’s claims of billions of dollars in additional compliance costs under a uniform fiduciary standard an admission that they are not in compliance with FINRA’s best interests requirement?

Despite this obvious inconsistency, I have yet to hear or read of anyone posing this very question to the investment industry. Hopefully the DOL and the SEC will recognize the inconsistency and not be misled by such empty rhetoric.

The investment industry has put themselves in the current position due to their ongoing abusive practices against investors. While not every broker-dealer and stockbroker is guilty of the offensive and abusive practices, the failure of the industry to properly address the issue has resulted in the current need for a uniform fiduciary standard to protect the public.

In closing, I once again ask the question that I have posed since the debate began – what is so onerous and unfair about requiring anyone providing investment advice to the public to always put the best interests of their customers/clients first?

Notes

1. FINRA Regulatory Notice 11-02, at 7 n.11; SEC Staff Study on Investment Advisers and Broker-Dealers as Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, at 59 (Jan. 2011) (IA/BD Study)
2. IA/BD Study, at 4
3. FINRA Regulatory Notice 12-25, at 3
4. Raghavan Sathianathan, Exchange Act Rel. No. 54722, 2006 SEC LEXIS 2572, at *21 (Nov. 8, 2006); Scott Epstein, Exchange Act Rel. No. 59328, 2009 SEC LEXIS 217, at *40 n.24 (Jan. 30, 2009).
5. Dane S. Faber, 57 S.E.C. 297, 310, 2004 SEC LEXIS 277, at *23-24 (2004)
6. Wendell D.Belden, 56 S.E.C. 496, 503, 2003 SEC LEXIS 1154,at *11 (2003)

 

Posted in 401k, 401k compliance, 404c, 404c compliance, compliance, fiduciary compliance, fiduciary law, investments, pension plans, retirement plans, RIA, RIA Compliance, securities compliance, wealth management | Tagged , , , , , , , , , , , , , , , | Leave a comment

Robo-Advisers: Best Deck Chairs on the Titanic?

Posted on September 14, 2015 by jwatkins

Much has been written recently about robo-advisers, including the perceived threat to traditional investment advisers. Robo-advisers do provide an opportunity for investors to receive asset management services, investors whose assets would not meet the high minimum requirements often charged by many investment advisers.

However, it is important for investors to realize the potential issues with the limited services currently provided by robo-advisers. Robo-advisers currently provide asset management services on a reactive basis, as opposed to a proactive basis. As a result, the risk management protection offered by robo-advisers is very poor.

Many of the current robo-advisers offer automatic rebalancing services, which automatically an investor’s portfolio allocations to their original percentages once certain thresholds are breached. The rebalancing takes place without regard to factors such as overall economic and/or stock market conditions.

And therein lies the potential threat to an investor’s financial well-being, and the opportunity for traditional investment advisers to establish their value proposition to investors. By being proactive and recognizing the potential threats posed by existing economic and/or stock market conditions, an alert investment adviser can use various hedging strategies to protect their clients against significant financial losses.

There are those who will quickly counter that such strategies are nothing more than market timing and that market timing does not work. My first responds to such a response is that even rebalancing is market timing if market timing is defined as any reallocation of an investor’s resources.

My second response is that an investment adviser, as a fiduciary, has a legal obligation to consider appropriate hedging strategies to protect a client’s financial security. Support for that position coms from the famous case of Levy v. Bessemer Trust (Levy v. Bessemer Trust Co., N.A., No. 97 Civ. 1785, 1999 WL 199027 (S.D.N.Y. Apr. 8, 1999).

Levy involved a situation where Levy had a investment portfolio that was heavily concentrated in one stock. When Levy inquired about potential ways to protect against a significant financial loss due to a drop in the stock’s price, he was not informed about potential hedging techniques, in this case the use of protective puts. The court ruled that Bessemer breached its fiduciary duty by failing to inform Levy of such strategies and discuss same.

Even where an investment adviser has discretionary power over an account, I generally urge my advisory clients to meet with a client and discuss potential hedging strategies when appropriate and document the meeting with a follow-up letter. The client meeting allows an adviser to avoid potential he said-she said situations. Since  hedging strategies usually involve financial costs, the meeting, and follow-up letter, help avoid controversies involving such costs.

The robo-adviser contracts I have seen clearly limit their actual wealth management services to rebalancing. Therefore, robo-advisers would not be liable for losses sustained by their investors due to a lack of proactive wealth preservation strategies, such as asset reallocation or protective puts. I’m not sure investors using robo-advisers are aware of this fact and the potential losses that may result. Prudent investment advisers can seize the opportunity and reinforce the value of their services in protecting against unnecessary and significant financial losses.

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The RIA Name Game

Posted on July 5, 2015 by jwatkins

One of my favorite jobs was serving as director of RIA compliance at FSC Securities. I love working with RIAs, as they are clearly the future of the financial services industry. While I loved working with RIAs and helping them build their business, I was also frustrated because I felt there was so much more my department could have done. At the same time, I understood the BD’s position re liability exposure.

What many RIAs do not understand is that if they choose to form their own RIA, instead of affiliating with their BD’s RIA, they are responsible for their own RIA’s legal responsibilities, especially compliance. I see far too many RIAs with unnecessary legal issues and liability. In most cases, they feel their BD will let them know what needs to be done and will keep them updated on legal and compliance issues. No, your RIA, your responsibility.

One of the most common issues I see are RIAs improperly using assumed or fictitious names, aka dba’s (doing business as) names. While it is perfectly acceptable to use assumed names in business, the use of same presents special issues for RIAs.

The primary issue is using assumed names in such a way that an RIA violates the anti-fraud provisions of Section 206 of the Investment Advisers Act of 1940, or a state’s version of same. Since assumed names are not legal entities, they cannot contract with clients. Furthermore, use of a fictitious name without disclosing the actual individual or entity registered as the RIA is considered misleading and fraudulent.

Most people that choose to use an assumed name/dba do so to project a certain image to the public. Again, the law generally allows the use of assumed names/dba’s as long as the use of same is registered with a local regulator. However, when an RIA is involved, it must be sensitive to federal and/or state laws requiring disclosure of the actual name under which the RIA is registered, e.g., John Smith dba Premier Wealth Management.

I recently was contacted by an attorney regarding a case that demonstrates the damage that can result from improper use of a fictitious/dba name. The RIA had hired a RIA consulting firm to help it form an independent RIA. The RIA had been in business for some time, with over 100 clients. The RIA’s contact was between the client and the dba name.

Since the dba name represented a company that did not legally exist, all of the contracts were invalid. As a result, I suggested that the RIA was legally required to contact all its clients, explain the situation, and to return all monies that it had received under the invalid contracts, plus interest, should a client request such a remedy. I’m not sure what eventually happened, but the RIA was obviously facing dire consequences.

Bottom line, if you decide to form an independent RIA, pay the extra couple of hundred dollars and form an LLC or a corporation. Yes, it’s a little more trouble, but it allows the RIA to project a professional image and, if done correctly the first time, allows the RIA to properly focus on providing clients with first-class service.

 

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“Best Interests” For Fiduciaries 101

Posted on May 26, 2015 by jwatkins

Facts do not cease to exist simply because they are ignored. – Aldous Huxley

With the release of the DOL’s proposed fiduciary regulations, there has been a considerable amount of discussion about what “best interests” really means and how to determine whether one’s actions are in compliance with a client’s “best interests.”

I would advise advisers and others held to such a standard not to openly admit that they do not understand the term “best interests” of a client. Legally, that could constitute “an admission against interests,” which could seriously hurt an adviser in a breach of fiduciary duty claim.

Ever since the DOL released its proposed fiduciary standards, I have read numerous quotes and posts complaining about the proposed standards. Most of the quotes and posts have been along the lines of “I’m not an attorney, how am I supposed to determine such things.”

Here in the South, we have a saying – “that dog don’t hunt,” or that argument or excuse is unacceptable. “That dog don’t hunt is applicable to whining about being required to act in a client’s best interests and knowing what that means.

“As we have frequently pointed out, a broker’s recommendations must be consistent with his customers’ best interests.”1 That holding, plus a list of other decisions holding the same opinion, was cited in FINRA Release 12-25. I would strongly recommend that advisers and stockbrokers find the release online and carefully read the release, especially the referenced footnotes.

What many adviser and stockbrokers fail to understand is that they have the ultimate responsibility for acting in compliance with all applicable rules and regulations. This is even truer for those who own an independent RIA firm. Even if the RIA advisers are dually registered with a broker-dealer, the broker-dealer has no legal obligation to advise you on legal requirements with regard to your independent RIA firm.

Every year I have RIA firms call me and say that their RIA is in trouble on some legal issue that their broker-dealer did not warn them about. Unfortunately, in most cases I have to tell them that they, not their broker-dealer, are responsible for running their independent RIA, including compliance issues.

Some reoccurring “tar babies” that I see ensnare RIA forms include the “broker-dealer shelf space” issue and the “somebody’s going to get sued” issue. RIA have a fiduciary duty to always put a client’s interests first. Dually registered RIA representatives also have a duty to follow their broker-dealer’s rules. Many broker-dealers have shelf space, or revenue sharing/preferred provider, agreements with mutual fund companies which limit the broker-dealer’s representatives to only recommend investment products that are part of such agreements. Sometimes this fact is not even disclosed to investors, other times it is done so in such a way that investors do not understand the situation, including burying same in some document.

A common practice in most broker-dealers that have these preferred provider agreements is to require a new client to sell any funds in his/her current portfolio and replace them with investment products from one of the preferred providers, even if the current investment is a good investment. This results in new, and unnecessary, costs for the investor and new commissions for the broker/adviser.

The replacement rule is not a regulatory rule. Furthermore, it clearly involves a broker/adviser putting both his and his broker-dealer’s financial best interests ahead of the client’s best interests, a clear violation of the RIA adviser’s fiduciary duty of loyalty, the duty to always put a client’s best interests first. Some advisers try to justify the situation using the old “two hats” theory, claiming that their actions as investment advisory representatives and stockbrokers are not related, therefore do not violate any rules. The Arlene Hughes decision effectively put an end to that supposed loophole.

The “somebody’s going to get sued” issue also involves a fiduciary’s duty of loyalty to their clients. When an RIA firm takes on a new client, the firm has a duty to review and evaluate the new client’s existing investment portfolio. If the RIA firm knows or suspects that there are unsuitable investments in the portfolio, the RIA firm has a fiduciary duty to let the new client know of such issues or, at the least, to suggest that the new client contact a securities attorney to evaluate the prior adviser’s recommendations. Failure to do either may result in breach of fiduciary claims against the new adviser.

The problem that dually registered brokers/advisers may face is that their broker-dealer may not allow them to alert their clients of possible wrongdoing by another broker-dealer and/or stockbroker. The investment industry is a close community and generally frowns on blowing the whistle on other members of the industry, often referred to as a “conspiracy of silence.”

The problem for independent RIAs is that they are independent, and have a legal duty to their clients, the fiduciary duty of loyalty, that legally supersedes any obligations to a broker-dealer. So, either honor the fiduciary duty of loyalty to the RIA’s clients and help them sue the previous wrongdoer adviser, or remain silent and face a potential breach of fiduciary duty claim by the new client.

In most cases that I have dealt with, the issue of “best interests” is really not confusing at all. Is recommending a fund that has consistently underperformed its applicable benchmark in a client’s best interests? Is recommending a “closet index” fund in a client’s best interests? Is recommending a fund whose annual fee is 300% higher than a fund with a comparable historical performance in a client’s best interests?

Most of my cases settle on either the consistent underperformance, closet index, or my AMVR™ metric analysis. In most cases, it’s just that obvious. For the time being, the DOL’s proposals are in the spotlight. I think most people in the investment industry are resigned to the fact that the SEC is going to enact some sort of fiduciary standards, whether they simply decided to adopt the DOL’s proposals or propose standards of their own.

The bottom line is that RIA firms and their advisers need to educate themselves on their fiduciary duties with regard to always putting their clients’ best interests first. Stockbrokers would be well advised to do so as well, as recent decisions have indicated that the courts are more than willing to impose a fiduciary standard on stockbrokers when such is necessary to protect the investing public.2

© Copyright 2015 InvestSense, LLC. All rights reserved.

This article is for informational purposes only, and is not designed or 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.

Notes

1. Dane S. Faber, 2004 SEC LEXIS 277, at *23-24.
2. Carras v. Burns, 516 F.2d 251, 258-59 (4th Cir. 1975); Follansbee v. Davis, Skaggs & Co., Inc., 681 F.2d 673, 677 (9th Cir. 1982)

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