Going Forward: Quantifying “Best Interest,” Reasonable Compensation and Suitability for Investment Professionals

Posted on May 28, 2016 by jwatkins

With the DOL’s recent release of their new fiduciary rule (Rule)and the related Best Interest Contract Exemption (BICE), there has been an increased interest in the concepts of “best interest” and prudence, two of the key concepts involved with both the Rule and Bice. Chris Caruso, the fine editor of the FiduciaryNews group on LinkedIn, recently raised the question whether the current fiduciary movement is “the beginning of the end or the end of the beginning.” John Bogle recently opined that the current fiduciary movement is just the beginning of a bigger, industry-wide movement.

Opponents of the Rule, Bice and the overall fiduciary movement argue that both “best interest” and prudent are highly subjective concepts and, thus , open to differing interpretations. However, the DOL has taken a lot of steam out of that argument by choosing to define “best interest” in terms of prudence, a simple, common sense principle. The association of prudence with “best interest” become even more meaningful given the admonition of Section 7 the Uniform Prudent Investor Act – “wasting beneficiaries’ money is never prudent.”

The reasonableness of a financial advisor’s compensation in connection with the provision of Retirement Advice is another key, yet arguably highly subjective, concept under both the Rule and BICE. In discussing this issue with my colleagues from both the legal and financial services professions, an important consideration seems to be whether reasonableness is seen in absolute or relative terms. In “absolute” terms means that reasonableness is determines solely in terms of actual monetary compensation, often in terms of peer/industry standards.

Evaluating reasonableness in “relative” terms means comparing the monetary compensation paid by a client/customer to the inherent quality and value, if any, of the investment advice provided, a legal concept known as “quantum meruit.” Given the abundance of evidence establishing the poor historical performance of actively managed mutual funds and the inequitable nature of the “inverse pricing” method used by many variable annuity issuers in computing a variable annuity annual M&E fee, a strong argument can be made that the fees and other costs charged by many investment professionals are not reasonable at all, as shown by the recent decisions and settlements in the ERISA excessive fees cases.

The renewed interest in the concepts of “best interest” and prudence has also spilled over to the interpretation of suitability, the standard of care that is still applicable to most stockbrokers and broker-dealers providing non-Retirement Advice situations. While suitability is considered a far less demanding standard of care than “best interest,” it should be noted that both FINRA and its predecessor, the NASD, are both on record stating that both stockbrokers and broker-dealers must always act in the best interest of their customers. Enforcement decisions involving both entities have consistently upheld this position.

In assessing suitability of advice, there are two significant aspects of suitability. The reasonable-basis obligation requires a member or associated person to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. The customer-specific suitability standard requires that the advice provided to a customer must be suitable in connection to the customer financial need, objective and personal investment parameters.

As an attorney, I am always interested in relevant evidence and the proof of a case. For that reason, I created a metric, the Active Management Value Ratio™ 2.0 (AMVR), that allows investors, financial advisers and attorneys to quickly and effectively evaluate actively managed mutual funds in terms of “best interest,” reasonableness and suitability.

An example will help demonstrate the value of the AMVR in mutual fund analysis. Assume the following facts: Fund A, an actively managed fund, has an annual expense ratio of 100 basis points (1.00%), a turnover ratio of 30 percent and a 5 year annualized return of 19 percent. A comparable index fund has an annual expense ratio of 16 basis points (0.16%), a turnover ratio of 3 percent and a 5 year annualized return of 20 percent.

The AMVR analyzes a mutual fund  in terms of its incremental costs and the incremental return, if any, that it provides. In this example, the actively managed fund does not provide any incremental return, but still costs an investor a significant amount of incremental costs, 116 basis points (1.16%) Investors should remember that each additional 1 percent in fees and costs reduces an investor’s end return by approximately 17 percent over twenty years. Given the lack of any incremental return and the impact of the incremental costs associated with Fund A, an investment in Fund A would actually costs an investor money, hardly a prudent or suitable investment for anyone.

Assume the scenario, with the exception that Fund A’s 5 year annual return is 21 percent. Fund A would provide an incremental return of 100 basis points (1.00%). However the fund’s incremental costs would exceed fund’s incremental return, once again resulting in a net loss from anyone investing in the fund. Furthermore, 85 percent of the fund’s fee would only be producing 4.7 percent of the fund’s overall return. Again, hardly a prudent or suitable investment for anyone.

A recent study by Eugene Fama and Kenneth French concluded that only the top three percent of active managers manage to produce returns that even manage to cover their costs. The AMVR provides a simple means for investors, investment professionals and attorneys to analyze an actively managed fund to see if the fund qualifies as a prudent and/or suitable investment. Given the historical evidence regarding the under-performance of actively managed mutual funds and the continuing trend of decisions and settlements in the ERISA excessive fees/fiduciary breach cases, prudent financial advisers will take greater care in ensuring the quality of the investment advice they provide to the public.

 

 

 

 

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“Best Interest,” BICE and Class Action Targets, Part II

Posted on May 18, 2016 by jwatkins

Much has been written about the Department of Labor’s (DOL) new fiduciary rule and the accompanying Best Interest Contract Exemption (BICE). Several writers have suggested that the group that will benefit the most from the rule and BICE are class action attorneys.

Unless Financial Institutions and their Advisers understand and successfully adapt to the shift from a culture of “suitability” to the more demanding “fiduciary/’best interest’/prudence” culture required under the DOL’s new fiduciary rule and BICE, the likelihood of successful class actions against them will definitely increase.

In Part I of this article, we discussed the fiduciary issues that exist for Financial Institutions and their Advisers with regard to actively managed mutual fund, including so-called “closet index” funds and the popular “preferred provider” programs that many Financial Institutions have adopted. In Part II, we will address the issue of 401(k) Rollovers and IRAs, variable annuities and equity/fixed index annuities.

401(k) Rollover and IRAs Accounts

The abusive marketing and sales strategies directed toward Retirement Investors in connection with 401(k) rollovers and individual retirement accounts (IRAs) were one of the primary reasons for the DOL’s new fiduciary rule and BICE. In many cases, a 401(k) rollover into an IRA is a prudent move, as it often provides a Retirement Investor with a wider selection of investment options that provide better returns and lower fees.

However, experience has shown that far too often unethical financial advisers were recommending that Retirement Investors execute 401(k) rollovers into actively managed mutual funds with historically poorly performing mutual funds and with excessively higher fees. In other cases, financial advisers were recommending questionable products such as variable annuities and fixed/equity indexed annuities in order to receive the high commissions associated with such products, despite the fact that such products raise obvious “best interest” issues for a Retirement Investor.

Under the new fiduciary rule and BICE, making recommendations with regard to 401(k) rollovers and IRA investments is classified as a fiduciary act. Under the new rule and BICE, a financial adviser must determine whether a rollover would be in the “best interest” and prudent of a Retirement Investor. In making such decisions, Financial Institutions and their advisers are required to consider such factors as

  1. the costs associated with the plan versus the costs associated with the IRA;
  2. the Retirement Investor’s available alternatives to a rollover; and
  3. the different levels of services and investments available under each option.

One question that I have received in connection with a financial adviser’s duty to perform a “best interest” analysis in connection with rollover and IRA advice is whether an adviser will be required to perform an analysis similar to that provided by the AMVR metric. Given the continuing legal actions and settlements involving the quality of current 401(k) plans, is it prudent for a Financial Institution and their Advisers to simply assume that a Retirement Investor’s 401(k) plan is prudent with regard to its investment options, both in the quality of the investment options and their fees.

I do not know the answer to the question, but it would seem to be an area that needs to be addressed to further the goals of the new rule and BICE, namely to ensure that Retirement Investors are protected and receiving investment advice that is prudent and in their “best interest.” The question becomes even more relevant if the financial adviser proving the rollover and IRA advice is the same adviser who advised the 401(k) plan as to its investment options, as there would definitely be, at a minimum, a potential conflict of interest since the adviser would be unlikely to admit to making poor investment recommendation for the 401(k) plan. My guess is that someone will eventually raise these questions, again in furtherance of the goals of the rule and BICE.

Variable Annuities

Variable annuities are among the leading grounds for customer complaints each year. The abusive sales strategies, as well as the issues regarding the excessive fees and quality of investment options offered by such products, makes such products imprudent for most investors. Given the fact that most variable annuities charge cumulative annual fees of 2-3 percent, and that each additional 1 percent in fees and expenses reduces an investor’s end return by approximately 17 percent over a twenty year period, it is easy how a variable annuity could reduce an investor’s end return by over 50 percent. Hardly prudent or in an investor’s “best interest.”

The impact of excessive fees and the poor quality of investment subaccounts within variable annuities is  the reason why smart investment advisers have avoided variable annuities since investment advisers have always been held to a fiduciary standard. Smart investment advisers have also realized that the method used by most variable annuity issuers to calculate the annuity’s annual M&E, commonly known as “inverse pricing,” is inherently inequitable. Using “inverse pricing,” the variable annuity issuer bases the annuity’s annual M&E on the accumulated value of the variable annuity, even though the variable annuity issuer’s legal obligation under the death benefit is usually limited to the amount of the variable annuity owner’s actual contributions, which are usually far les than the annuity’s accumulated value.

Experience has shown that in most cases, the variable annuity issuer does not even have to pay a death benefit, as the accumulated value of the annuity at the owner’s death is greater that the death benefit. This makes the inequitable nature of the choice of “inverse pricing” to calculate annual M&E fees even more inequitable and egregious, as it guarantees a windfall at the variable annuity owner’s expense. This results in a situation that is clearly imprudent and not in the variable annuity owner’s “best interest,” as the law clearly states that “equity abhors a windfall.”

Equity/Fixed Indexed Annuities 

A relatively newcomer to the financial services industry, equity/fixed indexed annuities (EIAs) are marketed in such as way as to entice investors to invest in a product that will allow them to benefit from the returns of the stock market without all of the risk associated with the stock market. However, it is the various restrictions and other limitations on an investor’s returns that may result in class action suits involving these products.

EIAs are not technically securities. They are an insurance product that uses the returns on a stock market index or other benchmark to calculate the interest rate earned by the annuity. Given the popularity of EIAs and the confusion and complaints resulting from the restrictions on interest earned by investors, the DOL obviously chose to take steps to protect investors and ensure that Retirement Investors are treated fairly.

The issue with EIAs has to do with the fact that EIAs usually contain various “caps” and restrictions and limitations that result in an investor receiving a level of interest that is far below the return of the applicable market index. Two of the most common restrictions are the “cap rate” and the “participation rate.”  The “cap rate” is just that, a cap on the amount of interest an investor can receive, regardless of the actual return of the applicable market index. Based upon my experience, most EIAs use a cap rate of approximately 10 percent.

The “participation rate” is then applied to further reduce the rate of return actually received by an investor. Again, based on my experience, 2 percent is a popular “participation rate.” Therefore, for example, assume an EIA based its interest rate payable on the S&P 500, with a “cap rate” of 10 percent and a “participation rate” of 2 percent. If the  S&P 500 had an annual return of 30 percent, the investor would only be credited with an interest rate of 8 percent (10 percent “cap rate”) minus 2 percent “participation rate’).

These various restriction and limitations can be confusing to an investor when combined with the marketing materials that tout an interest rate based on the enticing returns of the stock market. Under BICE’s new Impartial Conduct Standards, Financial Institutions and their Advisers are prohibited from making misleading statements about investment transactions, compensation and conflicts of interest. The combination of marketing discussing interest based on market gains with the restrictions on interest actually earned by an investor can obviously raise issues as to misleading statements. Fortunately for Financial Institutions and their Advisers, this is an issue that should be easily resolved through better disclosure , both in terms of the disclosure language itself and the prominence of same.

Conclusion

The bad news – the DOL’s new fiduciary rule and BICE impose strong requirements on Financial Institutions and their Advisers in connection with the provision of investment advice to Retirement Investors. The good news – the requirements, while demanding, can and must be complied with to avoid the potentially severe legal penalties, both from regulators and class actions. The shift from a culture of “suitability” to a much more demanding “fiduciary/”best interest”/prudence culture definite change, but one that can actually help increase business for Financial Institutions and their Advisers by regaining the trust of Retirement Investors by promoting a system that produces win-win situations for all parties. For those unwilling to comply with the DOL’s new fiduciary rule and BICE to produce such result, the guarantee of successful class actions should come as no surprise.

© Copyright 2016 The Watkins Law Firm, 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.

 

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“Best Interest,” BICE and Class Action Targets

Posted on May 17, 2016 by jwatkins

Much has been written about the Department of Labor’s (DOL) new fiduciary rule and the accompanying Best Interest Contract Exemption (BICE). Several writers have suggested that the group that will benefit the most from the rule and BICE are class action attorneys.

As an ERISA attorney, I have to admit that unless Financial Institutions and their Advisers understand and successfully adapt to the shift from a culture of “suitability” to the more demanding and unforgiving “fiduciary/’best interest’/prudence” culture, the likelihood of successful class actions against them will definitely increase.

BICE expressly preserves and protects the right of Retirement Investors to participate in class action actions involving violations of the new fiduciary rule and/or BICE. BICE provides that the exemption is lost is the contract includes any provision attempting to make a Retirement Investor waive or otherwise forfeit their class action rights.

One common tactic used by the financial services industry has been to argue that the suitability standard commonly used in assessing the conduct of stockbrokers is purely subjective, and therefore open to various interpretations. The DOL’s choice of imposing a fiduciary “best interest” standard on Financial Institutions and their Advisers in advising Retirement Investors, and defining “best interest” in terms of the prudent person standard adopted by ERISA and the Restatement (Third) of Trusts effectively nullifies any such “subjectivity” arguments.

I have had several colleagues and a few institutions ask me about the areas that I believe will be the most vulnerable to potential class actions under the rule and/or BICE. Based upon my prior experience as a compliance director and my experience as a fiduciary/ ERISA attorney and consultant, I believe that there are six areas that will face the most scrutiny and potential class action litigation under the DOL’s new fiduciary rule and BICE:

  1. Actively managed mutual funds
  2. Closet index funds
  3. Brokerage “preferred provider” programs
  4. 401(k) rollovers and IRAs accounts
  5. Variable annuities
  6. Equity indexed annuities

Over the next two days, I will address each of these areas and the fiduciary liability concerns that I see for them. Today, I will address the first three areas – actively managed mutual funds, so-called “closet index” funds, and brokerage “preferred provider” programs.

Actively Managed Mutual Funds
Regular reader of my blog know that I created a metric, the Active Management Value Ratio™ 2.0 (AMVR). The AMVR is a cost/benefit metric that provides investors, attorneys and investment fiduciaries with a simple, yet effective means of quantifying prudence. Consequently, it fits perfectly with the DOL’s new focus on prudent investing. Complete information on the AMVR and the procedure for calculating the metric can be found here.

Assessing prudence using the AMVR involves answering a few simple questions. First, does the actively managed mutual funds provide a positive incremental return, or alpha, above and beyond the benchmark? If not, the fund is obviously not a prudent investment since it provides no benefit, and worse yet, a potential loss for an investor when compared to the benchmark fund. Second, if the actively managed fund does provide a positive incremental return, is the incremental return greater than the incremental cost incurred in producing such incremental return? if not, the fund is not a prudent investment since an investment in the fund would end up costing an investor more than the benefit provided.

The AMVR also provides a means of assessing the cost effectiveness of an actively managed mutual fund. For example, assume an actively managed mutual fund has a stated annual expense ratio of 100 basis points (1.0%) compared to a benchmarks annual expense ratio of 20 basis points (0.20%), resulting in an incremental cost of 80 basis points (0.80%).  Assume that the actively managed fund has an annual return of 10.5 percent as compared to the benchmark’s annual return of 10 percent, resulting in an incremental return of 50 basis points (10.5-10). As a result, the incremental, or additional, cost of the actively managed fund constitutes 80 percent of the fund’s expense ratio, yet is only producing 5 percent of the fund’s total return. This raises obvious questions regarding the prudence of the actively managed fund.

Using the same scenario, which would be the prudent choice – paying 20 basis points for an annual return of 10 percent, or paying 100 basis points, five times more than the cost of the benchmark fund, for an annual return of 10.5 percent, paying 80 basis points for an additional 50 basis points of return? Again, the prudent choice is obvious. And yet, financial advisers continue to recommend, and investors continue to trust such recommendation and purchase, the imprudent investment.

These are the types of questions, and adjustments, that Financial Institutions and their Advisers are going to have to deal with as they convert from the “suitability” culture to the “best interest”/prudence standards under the DOL’s new fiduciary rule and BICE. These decisions will become even more difficult given the recent study by Eugene Fama and Kenneth French which found that only the top three percent of active managers were able to produce returns that even managed to cover their fund’s costs. All of these facts simply serve to increase the likelihood of successful class actions going forward.

Closet Index Funds

“Closet index” funds, aka “index huggers,” are generally defined as mutual funds holding themselves out to the public as actively managed mutual funds with higher fees substantially higher than index funds, often 3-4 times higher, but whose actual performance closely tracks the performance of the less expensive index fund.

Canada has recently announced that it is investigating the extent of “closet index” funds in it country due to the potential misrepresentation of services provided by such funds and the higher fees associated with same. Since the Impartial Conduct Standards under BICE prohibit any misrepresentations in connection with the sale of investment products Retirement Investors, it is reasonable to assume that Retirement Investors may file class actions under the new fiduciary rule and BICE base on the same concerns that Canada is investigating.

While there is no universally accepted R-squared rating that classifies a fund as a “closet index” fund, there is general agreement that a fund with a R-squared rating or 90 or higher suggests “closet index” status. Given the recent trend of high R-squared ratings between equity-based mutual funds, both domestic and international funds, there is an even greater likelihood of class actions based on “closet index” fund issues unless Financial Institutions and their Advisers carefully review mutual funds and their R-squared rating to ensure an appropriate correlation of returns between such funds.

Brokerage “Preferred Provider” Programs

When I first entered the securities industry, I was totally unaware of the so-called “preferred provider” programs that are so popular in the investment industry. The attorney in me made me wonder how many investors were aware of these artificial restriction being placed on the investment advice they were receiving. Given the fact that most “preferred provider” programs involve the advisers recommending funds with a history of poor relative performance and excessively high fees, such programs make Financial Institutions and their Advisers participating in same clear candidates for successful class actions.

The new Impartial Conduct Standards under both the rule and BIC call into question the continued use of such programs, as the standards prohibit Financial Institutions from using any sort of bonus or other incentive programs that could cause their Advisers from adhering to the “best interest”/prudence standards of both the rule and BICE. The artificial restriction on investment products that can be recommended to Retirement Investors under such programs as well as the cash and other compensation generally available to financial advisers as part of such programs, e.g., trips and “educational” seminars at resorts and abroad, would clearly appear to violate both the letter and the spirit of the new fiduciary rule and BICE, namely to ensure that Retirement Investors are receiving investment advice that is prudent and in their “best interests.”

Preferred provider programs are so financially profitable for both the mutual fund companies and the Financial Institutions that it can be assumed that both parties will try to develop some “work-around” if the current preferred provider programs become targets form regulatory scrutiny or class actions. However, anything that artificially limits the quality of investment advice being provided to Retirement Investors or anything that compromises the rule and BICE’s commitment to advice that is prudent and in the “best interests” of Retirement Investors can be expected to face strict scrutiny.

© Copyright 2016 The Watkins Law Firm, 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.

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

“Best Interest,” BICE and Liability Exposure for Plan Sponsors

Posted on May 14, 2016 by jwatkins

I recently posted an article in various LinkedIn groups that addressed the need for various parties to address their duties and potential liability under the DOL’s new fiduciary standard. My comment that accompanied the post was

Based on my personal experience and feedback thus far, very of few of those mentioned in the article truly understand both the “best interests” standard and BICE.

My point is simply this – based on my experience in conducting forensic fiduciary prudence audits and analyses, I believe that most plan sponsors and other plan fiduciaries lack the knowledge and experience to properly evaluate the prudence of mutual funds and/or variable annuity subaccounts (403(b) plans).

This point was addressed in detail in  “The Adequacy of Investment Choices Offered by 401(k) Plans,” an article by three finance professors, Edwin. J Elton, Martin J. Gruber, and Christopher R. Blake. The professors reported that for 62 percent of the 400+ 401(k) plans studied, the types of choices offered were inadequate, with difference in fund expenses playing a pivotal role in reduced performance. The study ultimately found that

If investors are given an inferior set of choices in their plan, the effectiveness of their choice is seriously constrained….

Over a 20-year period, ( a reasonable investment horizon for a plan participant), the cost of not offering sufficient choices makes a difference in terminal wealth of over 300%. Since, for more than one half of plan participants, a 401(k) plan represents the participant’s sole financial asset, the consequences are serious.

The study’s findings regarding the negative impact of a fund’s fees and expenses on a fund’s end return is not only common sense, but has been supported by other studies. Burton Malkiel has found that the two best indicators of a fund’s future performance are the fund’s expense ratio and its trading costs.

The primary investment options in many 401(k), 403(b), 457(b) plans and variable annuities are actively managed mutual funds, this despite studies, such as Standard & Poor’s annual SPIVA reports, that have consistently shown that historically most actively managed mutual funds have underperformed passively managed funds, commonly referred to as “index” funds. And yet, plan sponsors continue to load their plans with the underperforming, excessively priced actively managed mutual funds, and then express surprise when they get sued for such fiduciary breaches and eventually settle the case for millions of dollars.

Sponsors were sent a clear message regarding their fiduciary duty to control the investment costs of their plan when the federal district court for the Southern District of New York, the court for the Wall Street district, denied a plan’s motion to dismiss a case filed by the plan’s participants alleging that the plan chose mutual funds charging the participants excessive fees. In denying the motion to dismiss, the court noted that

Essential to the plausibility of plaintiffs’ claims was the allegation that the Affiliated Funds ‘charged higher fees than those charged by comparable Vanguard funds—in some instances fees that were more than 200 percent higher than those comparable funds.’

The court’s explicit acceptance of Vanguard’s funds as appropriate benchmarks in assessing the prudence of the fees has been duly noted by the plaintiff’s bar, and should be likewise noted by plan sponsors and other investment fiduciaries. While the court’s decision is technically only binding on that court, the fact that the court routinely handles cases involving Wall Street and securities issues, as well as the pure common sense rationale behind the decision, ensures that it will be cited in cases involving excessive fees and fiduciary duties issues. And yet, I have found that plan sponsors, and even some ERISA attorneys, are totally unaware of the court’s ruling. For those who want to review the court’s decision, the case is Citigroup v. Leber.

Simply put, there are going to very few instances where a plan’s actively managed investment options are going to be less expensive than a comparable Vanguard fund, especially when the actively managed fund’s expense ratio and its trading costs are considered. In most cases, the actively managed fund’s combined expense ratio/trading costs expenses will often be three times as expensive as those of the comparable Vanguard fund. Given these facts, it is easy to see why the expectation is that cases alleging a plan sponsor’s breach of their fiduciary duties will continue to be filed and settled for millions of dollars. This is also why there is an expectation that 403(b) and 457(b) plans may soon face similar breach of fiduciary duty claims.

Quantifying Fiduciary Prudence With the Active Management Value Ratio™ 2.0

I developed a metric, the Active Management Value Ratio™ (AMVR), to allow investors, plan sponsors and other investment fiduciaries to properly evaluate the prudence of investments, especially actively managed mutual funds and variable annuity subaccounts. An explanation of the principles behind the AMVR, as well as the calculation process, is available here.

The AMVR is based on the studies of investment icons, Charles D. Ellis and Burton Malkiel. Malkiel’s findings re the importance of a fund’s fees and trading costs have already been noted. Ellis noted that index funds have essentially become like commodities, where an investor knows that they will essentially receive the return of the market at the market’s risk level. As a result, Ellis suggested that in evaluating actively managed mutual funds,

[r]ational investors should consider the true cost of fees charged by active managers not as a percentage of total returns but as the incremental fee as a percentage of the risk-adjusted incremental returns above the market index.

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 the incremental fees for active management are really, really – on an average, over 100% of incremental returns.

That’s right: All the value added-plus some- goes to the manager, and there’s nothing left over for the investors who put up the money and took the risk.

And there’s the foundation for a closing argument against a plan sponsor on a claim of breach of the fiduciary duties of loyalty and prudence. Throw in the simple addition, subtraction and division required to calculate the AMVR to provide the evidence of imprudence and all that’s left to do is enjoy the proverbial “checkmate” over the plan and it’s fiduciaries. A plan sponsor’s pleas of not meaning any harm and/or lack of knowledge of such facts are irrelevant on the issue of fiduciary liability, as the courts have consistently ruled that “a pure heart and an empty head are no defense to breach of fiduciary claims.”

In both my law and fiduciary consulting practices, my friends and foes have come to refer to my use of the AMVR as “running the AMVR gauntlet” since I have developed a systematic procedure for effectively using the AMVR. The “gauntlet” involves the following steps/questions:

(1) Does the actively managed mutual fund produce a positive incremental return, i.e., alpha, for an investor? If not, the fund results in a loss for an investor and is therefore not a prudent investment.

(2) If the actively managed fund does produce a positive incremental return, is the fund’s incremental return  greater than the fund’s incremental cost in producing said incremental return? If not, the fund results in an overall loss for an investor and  is therefore not a prudent investment.

(3) If the actively managed mutual fund provides an incremental return that exceeds the fund’s incremental costs, does the fund’s R-squared rating qualify the fund as a “closet index” fund? By definition, closet index funds, aka “index huggers,” are funds that closely track their underlying market index, meaning most of their returns can be attributed to the performance of the market index rather than the active management of the fund. In my practice, I classify any actively managed mutual funds with an R-squared rating of 90 and above as a closet index fund.

The fiduciary liability aspect of closet index funds comes from the fact that they not provide the same, in some cases less, returns than an index fund at a fee that is often two or three times higher than the index fund’s fee. Therefore, closet index funds are not a prudent investment.

(4) To further evaluate a closet index fund, I use a proprietary metric, the Active Management Fee Factor™ (AMFF), to factor in a fund’s R-squared rating to calculate the effective fee for a fund. In cases where a fund has a high R-squared rating of 90 or above, the effective expense ratio is often 6-7 times higher than the fund’s stated expense ratio. I then re-calculate the fund’s AMVR score using the fund’s AMFF score. In most cases, the R-squared adjusted AMVR is well above 1.0, meaning the fund’s effective incremental costs far exceed the fund’s incremental return, thereby making the fund imprudent.

I advise my fiduciary consulting clients to use the same system. I know attorneys that use “the gauntlet” in their securities and ERISA practices. While relatively simple, going through the steps and getting a plan sponsor or other investment fiduciary to admit the imprudence of a fund after each step makes for an impressive and informative presentation.

“All Hands On Deck”

The article I posted on LinkedIn basically warned that all parties in the ERISA arena need to learn how the DOL’ new fiduciary rule, including the BIC exemption, does or could impact their services and legal duties. My experience has been that most plan sponsors blindly rely on whatever their service providers tell them. This is dangerous for several reasons.

In most cases, plan sponsors mistakenly believe that they have recourse against their service providers if the information provided to the plan sponsor is incorrect. In truth, most service providers use contracts that effectively limit any fiduciary liability for the information they may provide to a plan. Plan sponsors should always have service provider contracts reviewed by experienced counsel in order to determine the existence of any exculpatory provisions.

Secondly, the courts have consistently ruled that any reliance by plan sponsors on information provided to them by third-parties must be justifiable in order to provide any defense to potential liability. Plan sponsors should be aware that the courts have held that reliance on stockbroker, insurance agents and others with a potential financial interest in the advice they provide is never justified.

Plan sponsors and others need to be able to independently evaluate the potential investment options for their plans, both as part of the initial selection and as part of their ongoing fiduciary duty to monitor the plan’s investment options. Evaluating funds based solely on annual returns and standard deviation of returns data is not acceptable, as it ignores other important factors in the fiduciary prudence equation. While the AMVR is obviously not the only means for a plan sponsor or other investment fiduciary to meet their fiduciary duties of loyalty and prudence, it does provide a simple, yet effective, means of doing so.

Conclusion

Under the DOL’s new fiduciary rule, an understanding of the meaning of ‘best interest” will be crucial in avoiding unwanted fiduciary liability exposure, both in terms of the rule’s general fiduciary obligations and the Best Interest Contract (BIC) exemption.  Financial advisers and investment fiduciaries often claim that they do not  understand the meaning of the fiduciary “best interest” duty. While such claims often ring hollow, under the DOL’s new fiduciary rule, plan sponsors and other investment fiduciaries need to be able to document that they used a legally appropriate due diligence process in evaluating and selecting investment options for their plans if they have any hopes of avoiding liability for breach of fiduciary liability claims since, as mentioned earlier, the courts will not accept ” a pure heart and an empty head” defense.

 © Copyright 2016 The Watkins Law Firm. 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.

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Making BICE Meaningful – Reality vs. Illusion

Posted on April 19, 2016 by jwatkins

I have had a lot of people ask me what I thought of the DOL’s new fiduciary standard. While I think there are some good points to the new fiduciary standard, in many ways the new standard reminded me of a basic concept I learned in my first year contracts class in law school – the large print giveth, and the small print taketh away.

In this case, the overall new fiduciary standard guidelines are the large print and the Best Interests Contract Exemption, or BICE, is the small print. While I realize why BICE was added to the new law, as a former compliance director I also understand the potential consequences of the exemption, especially in regards to undermining the entire purpose of the DOL’s new fiduciary standard.

From a compliance perspective, I always had to deal with a certain few that were going to try to do whatever they wanted to do, especially if it was financially profitable for them. In some cases, they knew I was not going to approve a proposed trade or trades, so they decided at some point to just keep the applications in their desks and hope I would not find out.

What they forgot was that the compliance director gets a list of all trades and has a key to every desk in the office. The brokers I supervised also quickly learned that I brought those keys with me on my audits of external offices.

Some of the brokers I supervised hated me because of my thoroughness. Brokers know that the percentage of brokers that get caught for improper or illegal activity is very low, due both to the sheer numbers of brokers and trades. If a compliance director is not diligent in his/her supervision of their brokers, unethical brokers can make a lot more money.

So how does this apply to BICE? BICE requires that brokers and other advisers prepare and execute the contract that provides, among other things, that the broker agrees to act as a fiduciary and to put the “best interests” of customer first. Violations of the contact provides customers with a cause of action against the offending broker.

However, the benefits and protections of the BICE agreement are essentially meaningless unless a customer has the ability to detect violations of the agreement and the “best interests” rule. Needless to say, most people lack the knowledge or experience to detect such violations. So, BICE notwithstanding, unethical brokers can maintain their pre-BICE business practices.

Shifting the responsibility for enforcing the “best interests” provision of the DOL’s new fiduciary standard on to the public simply makes no sense and provides a significant loophole for unethical brokers and other financial advisers. It is clearly foreseeable that investors will simply sign whatever is given to them to sign, with little or no understanding as to the content of the document and the accompanying legal significance of same.

One of the aspects of the new DOL fiduciary standard that I did like was the recognition of the abusive marketing strategies often connected to variable annuities and fixed index annuities. By requiring such products to comply with BICE, the hope was that such abusive marketing strategies would be addressed.

Variable annuities often assess their annual M&E fees (primarily the annuity’s death benefit) on what is known as an inverse pricing platform. What this essentially means is that that the variable annuity’s annual fee is based on the accumulated value within the variable annuity rather than on the actual cost to the annuity issuer should they have to pay a death benefit to the variable annuity owner’s heirs.

Since the annuity issuer’s legal and financial obligation as to the death benefit is often limited to the annuity owner’s actual contributions, allowing the variable annuity issuer to bases fees on the accumulated value within the variable annuity ensures a windfall for the annuity issuer in most cases. Allowing a windfall to the the benefit of the annuity issuers at the expense of the annuity owner clearly is not in the “best interests” of the annuity owner and violated a basic principle of equity law – equity abhors a windfall.

Variable annuities and fixed index annuities pay large commissions. Therefor, some brokers and broker-dealers are not going to give up selling such products, BICE be damned. So given the previously mentioned low detection rate for non-compliance with both FINRA guarantees and the BICE guarantees, unethical brokers will simply say whatever they need to say in the BICE agreement and continue to do business as usual, with a wink and a nod to a weak or complicit compliance department.

This presents a perfect marketing opportunity for the prudent and proactive investment adviser. Since investment advisers are already held to a fiduciary standard, the investment adviser should stress this and help educate customers and potential clients of the chance that the guarantees of the DOL’s new fiduciary standard, especially with regard to the guarantees provided by BICE, may be largely illusory unless the customer or clients is knowledgeable enough to understand and detect violations of the fiduciary standard’s “best interest” requirement. Alerting clients and potential clients to these concerns may help develop the trust that is so crucial to forming a solid long-term adviser-client relationship.

 

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And Now the Fiduciary Radar Shifts to …

Posted on April 11, 2016 by jwatkins

Now that the DOL has released its new fiduciary rule, advisers are wondering what could be “the next big thing” drawing upon the new rule. Canada has recently announced that it would conduct a sweeping investigation of the abusive marketing of “closet index” mutual funds. When one does a quick cost/benefit analysis of such funds, it is easy to see why litigation involving the marketing of such funds could easily be on the radar involving both civil and regulatory litigation. It would hard to envision a product that better meets the definition of “low hanging fruit” from a litigation and liability standpoint.

Professor Ross Miller crated a proprietary metric, the Active Expense Ratio, which calculates the effective annual expense fee for mutual funds with a high correlation of return score to an underlying market index, i.e., a high r-squared score. His findings were that such funds often had an effective annual fee significantly higher than the fund’s stated annual fee, often at least 4-5 times higher.

I created a similar metric, the Active Management Fee Factor (AMFF) , that produces a similar effective annual fee using some extra cost factors. The AMFF is generally very close to Miller’s AER, albeit slightly lower.

With the new DOL fiduciary rules, adviser need to be aware of the fiduciary rule’s emphasis on “best interests” and the challenges all advisers, in both the ERISA and non-ERISA context, will have in successfully defending fiduciary breach claims involving closet index funds.

To review I wrote earlier on the legal liability issues involved with closet index funds, click here.

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The 401(k)/404(c) Plan Sponsor’s Achilles Heels Redux

Posted on March 28, 2016 by jwatkins

With the effective date for the DOL’s new fiduciary standard getting closer, I have been receiving questions and calls from plans and fellow attorneys regarding the various obligations under the new standard. For that reason, I am re-posting an updated version of an article I posted earlier this year.

401(k)/404(c) plan sponsors need to realize that the primary reason that plans are being successfully sued involves a plan sponsor’s fiduciary duty that will not be changed due to the DOL’s announcement, a duty that plan sponsors need to address to “bulletproof” their plans. In far too many cases, liability is based primarily on a plan sponsor’s failure to properly perform the personal investigation and evaluation of a plan’s investment options.

ERISA requires that a plan sponsor make an independent investigation and evaluation of the merits of both the investment (1) and any and all service providers(2) chosen by a plan. In determining whether a plan sponsor properly fulfilled their fiduciary duty to investigate and evaluate,

[T]he determination of whether an investment was objectively imprudent is made 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.(3) (emphasis added)

This fiduciary duty to conduct an independent investigation and evaluation of a plan’s investment options is a plan sponsor’s first “Achilles heel.” In applying the “objectively prudence” standard, the court have held that

a decision is “objectively prudent” if “a hypothetical prudent fiduciary would have made the same decision anyway.” (4) (emphasis added)

Plan sponsors and plan service providers often try to justify questionable investment choices by relying on modern portfolio theory (MPT), the idea that investments in an investment portfolio should be evaluated individually, but in the context of the portfolio as a while. While that argument may be applicable with regard to defined benefit plans, where the employer is essentially selecting one investment portfolio which will applicable to all plan participants, the courts have rejected the MPT argument when defined contribution plans are involved.(5) As the DiFelice court pointed out with regard to defined contribution plans

Here the relevant ‘portfolio’ that must be considered is each available fund considered on its own…not the full menu of Plan funds. This is so because a fiduciary cannot free himself from his duty to act as a prudent man simply by arguing that other funds, which individuals may or may not elect to combine [with another investment option], could have theoretically, in combination, create a prudent portfolio.

The case cited by the district court in support of its heavy reliance on modern portfolio theory involves a plaintiff challenging the prudence of one investment, contained in a monolithic, fiduciary-selected portfolio. [In that case], …the fiduciary himself  consciously coupled risk y securities with safer ones to construct one ready-made portfolio for participants….Here, in contrast, modern portfolio theory alone cannot protect [the plan sponsor]…just because it also offered other investment choices that made a diversified portfolio theoretically possible.(6)

While many plan sponsors are experts at the services their company provides, many lack the knowledge, expertise and experience needed to properly evaluate and select investment options. In such cases, the plan sponsor’s fiduciary obligations require them to hire independent professional advisers.(7)

What many plan sponsors do not realize, their second “Achilles heel,” is that they cannot blindly rely on any advice provided by a third party such as a service provider or any other professional adviser.(8) The plan sponsor still has a fiduciary duty to independently “review, evaluate and understand” the third-party advice.

The plan sponsor’s Achilles heel is made more vulnerable by the fact that a plan sponsor is not legally entitled to rely on the advice of a third-party unless the third-party is “independent and impartial.”(9) As the court pointed out in the Gregg decision, parties who do, or can, receive compensation from or produce compensation for other related third parties, such as stockbrokers and insurance agents, do not meet the impartiality requirements. This simple requirement has ensnared more than one plan sponsor and will undoubtedly ensnare others since very few plan sponsors or service providers are aware of the “independent and impartial requirement.

So, a plan sponsor’s duty to investigate, evaluate and select a plan’s investment options applies whether a plan sponsor attempts to do so independently or on the basis of advice provided by a truly “independent and impartial” third-party. And as the Supreme Court recently pointed out,

[A plan sponsor’s] duties apply not only in making investments but also in monitoring and reviewing investments, which is to be done in a manner that is reasonable and appropriate to the particular investments, courses of action, and strategies involved…. In short, under trust law, a [plan sponsor] has a continuing duty of some kind to monitor investments and remove imprudent ones.(10)

The takeaway from these decisions is that plan sponsors need to be able to properly investigate and evaluate a plan’s investment options. And the numerous successful cases that have been filed, and will be filed, against 401(k) and 404(c) plans strongly suggests that many plan sponsors lack the ability to perform this vital fiduciary duty.

It has been argued that requiring a plan sponsor to perform a service that it is not suited for is inequitable and not in the best interests of the plan participants and beneficiaries. Proponents of that position argue that plan sponsors should be able to retain and completely rely on the advice of third-party experts on such duties.

Yet, experience has clearly shown that competing, and conflicting, best interests of such third-parties does not necessarily ensure that the best interests of a plan’s participants and beneficiaries are not served by reliance on a plan’s third-party advisers. Plan sponsors are often unaware that their contracts with third-party providers include “escape” clauses that effectively negate any fiduciary duties and/or liabilities that the third-party would otherwise have to a plan and its participants, leaving the plan sponsor potentially exposed to complete and personal liability for any issues that arise under the plan.

People often ask me why I publicly released my metric, the Active Management Value Ratio™ 2.0 (AMVR). This is exactly why I did so, to provide a simple means for plan sponsors to perform a simple initial evaluation of actively managed mutual funds, as they are the type of funds commonly found in most plans. While there are other aspects of a plan’s prospective or current investment options that will always need to be investigated and evaluated, the AMVR is a simple cost/benefit analysis that is based on sound, proven principles and is an appropriate due diligence technique with regard to an investment’s cost efficiency relative to a fund’s return.

I believe that most plan sponsors truly want to do the right thing, but simply lack the knowledge, expertise, and experience to do so. History has clearly shown that third-party advisers have actual or potential conflicts of interest that prevent them from providing truly independent impartial advice to a plan or its participants. That is the very reason the DOL is revising ERISA’s current provisions to hopefully better protect plans and plan participants and beneficiaries.

But plan sponsors need to understand that the new DOL fiduciary standards will not relieve them of their personal ongoing fiduciary duty to independently investigate, evaluate and monitor a plan’s investments options, even when a third-party expert, such as a 3(21) or 3(38) fiduciary, is retained. The importance of understanding how to properly evaluate a fund’s prospective and actual investment options cannot be overstated. As one court stated

 [I]f fiduciaries imprudently evaluate, select, and monitor a plan’s investment options, or do so for any purpose other than the best interest of the plan, they breach their fiduciary duties. (11)

The new fiduciary standard that the DOL will introduce provides an opportunity for truly independent and impartial third-party advisers to demonstrate their value-added proposition to plan sponsors. Plan sponsors that retain the services of third-party experts should select only those experts that are willing to assume a fiduciary status and both advise and educate both the plan and the plan’s participants on the appropriate evaluation of investment options, thereby promoting a true win-win situation for both the plan, its participants and the third-party adviser.

Notes

1. U.S. v. Mason Tenders Dist. Council of Greater New York, 909 F.Supp. 882. 887 (S.D.N.Y. 1995); Liss v. Smith, 991 F. Supp. 278, 298 (S.D.N.Y. 1998); Fink v. National Sav. and Trust Co., 772 F.2d 951, 957 (D.C.C. 1984).
2. Liss, at 300.
3. Fink, at 962.
4. Tatum v. RJR Pension Investment Committee, 761 F.3d 346 (4th Cir. 2014)
5. DiFelice v. U.S. Airways, 497 F.3d 410, 423 and fn. 8.
6. DiFelice, at 423
7. Mason Tenders, at 886; Liss, at 296.
8. Howard v. Shay, 100 F.3d 1484, 1488 (9th Cir. 1996); Donovan v. Mazzola, 716 F.2d 1226, 1234 (9th Cir. 1983 ); Donovan v. Bierwirth, 680 F.2d 263, 272-73 (2d Cir. 1982).
9. Gregg v. Transportation Workers of America Intern., 343 F.3d 833, 841 (6th Cir. 2003).
10. Tibble v. Edison International, 135 S.Ct. 1823, 1828-29 (2015).
11. In re Regions Morgan Keegan ERISA Litigation, 692 F.Supp.2d 944, 957 (W.D. Tenn. 2010).

© Copyright 2016 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 adviser should be sought

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What the New DOL Fiduciary Standard Will and Will Not Do

Posted on March 14, 2016 by jwatkins

As many of you may know, I released my new book on fiduciary law last week. I was immediately flooded with emails asking me why I would release the book before the DOL’s announcement.

There is so much misinformation and conflicting information about the potential impact of the DOL’s new fiduciary standard, that it is easy to understand the confusion. But whatever the DOL announces, it is only going to change the applicability of fiduciary law to the parties involved in ERISA and possibly other pension plans. The DOL’s announcement is not going to change the long standing principles of fiduciary law, as set out primarily in the Restatement (Third) of Trust, the Restatement of Agency, and the various legal and regulatory decisions that have helped develop and fine tune basic fiduciary law.

The purpose of my writing and releasing my book on fiduciary law was to provide a means for people to learn and understand basic fiduciary law, especially those who might have to deal with fiduciary law for the first time as a result of the DOL’s announcement. Far too many times I see fiduciaries such as investment advisers and ERISA plan sponsors try to avoid liability by saying that they meant no harm or that they were unaware of the applicable legal standards. And each time the court or the regulators references the famous quote from Donovan v. Cunningham, “a pure heart and an empty head are not defenses to a claim of the breach of one’s fiduciary duties.” I often believe that every fiduciary should have that saying tattooed on their arm.

Fiduciary law, especially under ERISA, is to enforced on a purely objective basis. Subjectivity has no place in determining whether a breach of fiduciary duty occurred. People often ask me what is the best way to get a better understanding of fiduciary law. Aside from the obvious answer, my short book, I tell people that they should take the time to read Section 90 of the Restatement (Third) of Trusts, otherwise known as the Prudent Investor, both the section’s black letter law and all of the comments. Yes, it is dull and boring, but it is the authority. Second, I tell people to read the Enron decision in its entirety, as the court handed down an excellent analysis of fiduciary law under both ERISA and the Restatement (Third) of Trusts. It’s over 100 pages long and you may have to take several breaks. but it is one of the best analyses of fiduciary you will ever read.

 

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“The Prudent Investment Adviser Rule™: Risk and Liability Management for Investment Fiduciaries”

Posted on March 8, 2016 by jwatkins

With the pending release of the Department of Labor’s new fiduciary standard, I am happy to announce that my new book and ebook, “The Prudent Investment Adviser Rule™: Risk and Liability Management for Investment Fiduciaries,: are now available at amazon.com.

I have always given my consulting clients a copy of the book to help them better understand the applicable laws and better protect themselves and their practices against unwanted and unnecessary liability exposure. The book also contains passages from key legal decision to clarify common errors and the steps necessary to avoid same.

Many people have questioned the timing of the release of the books before the DOL announces its new rules. The DOL’s new standards are not expected to change existing substantive fiduciary law, only to expand the applicability of same. Therefore the books are meant to help all investment fiduciaries, e.g., investment advisers, pension plan sponsors, trustees, and stockbrokers, better understand what their true legal obligations are to clients.

If the DOL does make some earth shattering to existing fiduciary law, I will obviously release an appropriate press release updating everyone the change.

 

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Outsourcing: Panacea or Placebo?

Posted on March 8, 2016 by jwatkins

Outsourcing has become a buzzword in the investment advisory industry. I have had many RIA firms tell me that they have outsourced bot their compliance and wealth management functions, allowing them to concentrate solely on marketing and  gathering assets. In the words of noted ESPN football analyst Lee Corso… not so fast my friend.

Outsourcing may be an appropriate and strategy if one lacks the ability to perform the function being outsourced. However, the idea that the entity outsourcing the function has no ongoing responsibility is completely wrong, and leaves the outsourcing to all kinds of serious legal consequences.

With regard to the outsourcing of compliance duties, regulators have made it clear that entities who outsource their compliance duties still have a duty to monitor such third-parties and remain ultimately liable for their firm’s compliance with all applicable rules and regulations. Back in the 90’s, the NASD addressed this issues with regard to the popular OSJ system used by most indie broker-dealers, where one OSJ may have the responsibility of supervising 100 or more registered representatives in various offices. The NASD addressed these issue in Notice to Members 99-45, which essentially required indie broker-dealers to make drastic revisions in their supervisory programs to provide more meaningful field supervision of their brokers.

Two of the primary concerns with regard to the outsourcing of compliance duties has to do with the qualifications and experience of the third-party to whom the compliance duties are being outsourced and the lack of on-site supervision by the third-party. The qualifications and experience issue speaks for itself. The fact that most third-party compliance providers are not actually on-site has always raised concerns as to just how effective their compliance oversight can be, especially if they are providing such services to a large number of firms and brokers.

Outsourcing of wealth management responsibilities raises a number of potential issues, including possible double-dipping and quality control monitoring and supervision. Double-dipping refers to a situation where an investment advisory firm represents and contracts with a client to personally mange their asses, but instead outsources the actual management to a third-party.

Given the fact that the advisory firm is not actually managing the client’s assets, the advisory firm should reduce its fee accordingly to account for the actual management by the third-party. An obvious way for the advisory firm to address this issue is the modify their advisory contract to specify exactly what services they are, and are not, providing. Failure to do so could result in liability based on various grounds, including fraud, breach of fiduciary duty, and breach of contract.

Another issue with regard to outsourcing of wealth management duties has to do with the advisory firm’s fiduciary duty to provide ongoing monitoring of the third-party to whom the wealth management services were outsourced and, if necessary, to replace the third-party and, if necessary, to sue the third-party for damages. These ongoing duties are based primarily on the fact that clients generally select fiduciaries on the trust that they have in the person or entity. As a result, the law, while allowing outsourcing, requires the original fiduciary to keep ultimate responsibility for the management of the client’s account.

So to answer the original question, in many ways outsourcing is nothing more than a placebo since the advisory firm still has ultimate responsibility for proving ongoing services to ensure that the account is properly handled and, if not, the advisory firm can be held liable for violations of their fiduciary duty. If a client contracts directly with a third-party wealth management firm, then the advisory firm may not be liable for mismanagement by the third-party, but could still possibly be held liable for their recommendation of the third-party based on a failure to properly conduct due diligence on the third-party.

Both the NASD and FINRA have both recognized the potential  issues with outsourcing. In NASD Notice to Members 05-48 and FINRA Regulatory Notice 11-48, the regulators addressed such issues. FINRA proposed a new rule, Rule 3190, to set out the requirement for the outsourcing of legal responsibilities. While the Rule has never been enacted and investment advisers and their advisory representatives may not be subject to FINRA, the Notices provide useful guidelines for investment advises of issues to address to avoid unnecessary liability exposure.

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