Social Media and the Investment Adviser

Posted on May 17, 2014 by jwatkins

I could write a new blog entry, but why do so when Financial Planning just wrote an excellent article on the subject. http://www.financial-planning.com/news/practice_management/social-media-and-regulatory-compliance-5-rules-2689208-1.html

Without question, the continued use of Facebook “likes” and LinkedIn “recommendations are the most common violations. The regulators, both the SEC and state agencies, are well aware of the problem and have made enforcement of social media violations one of their “hot spots.”

Some investment advisors have attempted to argue that since they are dually registered and registered representatives are allowed to use testimonials, such “likes” and “recommendations” are allowed. Sorry, that old “two hats” argument does not work given the ruling in the Arlene Hughes decision, where the court said dually registered reps/advisors will be held to the higher standards of advisers.

Once again, as with the fiduciary standard, advisers are held to a different standard than registered representatives. Just as with the fiduciary standard, makes no sense to have such different standards. But I’m just the messenger. Common sense would say hold all financial advisers to a fiduciary standard, which is consistent with the expressed purpose of the securities laws, and hold all financial advisers to the same social media rules. But as Voltaire said, “common sense is not so common.”

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The Investment Adviser’s Achilles’ Heel v. 2.0

Posted on April 17, 2014 by jwatkins

The Securities and Exchange Commission (SEC) recently released a notice regarding the use of testimonials and social media. Investment advisers are generally prohibited from using client testimonials. While the SEC has allowed the use of third-party ratings as long as certain requirements are met, as set out in the Dalbar decision, the whole area of testimonials is fraught with traps and, in my opinion, should be avoided, as it is an accident waiting to happen.

The testimonials and social media issue is just an example of a bigger issue for investment advisers. In my office, I have a framed copy of the famous “Pogo” cartoon where Pogo says “we have met the enemy and he is us.” As I have stated before, I think that the Achilles’ heel for most investment advisers is the lack of an effective risk management program for the firm. As I visit various investment adviser web sites and perform compliance audits for advisory firms, I am always surprised to see how advisory firms leave themselves exposed to unnecessary risk exposure.

I like to tell the story of a client who once called me from a national conference. The conference was being presented by one of the major custodians for advisory firms. The client had just attended a presentation on improved marketing for advisory firms. The client told me that the speaker had recommended giving customers magazine subscriptions and/or tickets to sporting events or plays in exchange for referrals. The client had run this idea by me before and I had explained to  him that such a promotion would require compliance with the ’40 Act’s solicitation rules.

Unfortunately, I see this type of situation all too frequently. Unless one if familiar with investment adviser laws and stays updated on same, it is easy to mislead investment advisers. Although such misinformation is usually unintentional, an investment adviser relying on same is still liable for any violation.

What the conference speaker failed to disclose is that providing anything in return for referrals and/or testimonials can be seen as an actual or potential conflict of interest since the gift could influence a client’s opinion. In fact, the SEC had dealt with this issue several years ago and raised the same non-disclosure of conflict of interest issue.

One of the biggest audit/liability issues for advisers is the use of “canned” or cookie cutter materials, including required manuals and other documents. Advisers need to understand that the first thing the SEC or a plaintiff’s attorney is going to ask for is a copy of the adviser’s manuals, disclosure document, contracts, etc. This is the proverbial “low hanging fruit” for liability and audit purposed, as it often points to violations.

Advisers need to understand that they need to be in compliance with their Form ADV, disclosure brochure, contract or other material. Technically, the advisory contract is the determining factor. However, it can, and usually is, argued that false representations in other advisory material constitute misrepresentations, if not fraud, in violation of Section 206(4) of the ’40 Act. Therefore “canned” or cookie cutter materials should always be amended to ensure that they accurately reflect an advisory firm’s actual practices.

Another issue with regard to advisory compliance is proof of enforcement of the firm’s policies and procedures, both in terms of timeliness and substantive enforcement. At the very least, an advisory firm should keep a separate files for P&P issues and the file should have quarterly reports indicating personal quarterly trades by the firm’s personnel, including any trades that required pre-approval under the firm’s P&P.

Perhaps the most important thing for advisory firms to realize is that their advisory firm is just that, theirs. The fact that the firm’s members may be affiliated with a broker-dealer does not require a broker-dealer to provide compliance and/or other legal services to the independent advisory firm. Under NASD 94-44, a broker-dealer is only responsible for reviewing the trades of the firm’s representatives who are affiliated with an independent advisory firm.

Advisory firms often indicate that they engaged in certain activity based upon their compliance consultants advice. There are some excellent RIA consultants. Unfortunately, there are some RIA consultants that are not excellent. Based upon my experience, while it is easy to go through the ‘4o Act and its related regulations as to an investment adviser’s required infrastructure, many consultants do not properly address the various liability issues that advisory firms need to address. Unfortunately, if an investment advisor is found to have engaged in improper conduct, the violation is going to be enforced, regardless of the quality of the consultant’s advice.

The key is for advisory firms to be proactive in creating and managing their firms. As the commission-based investment services platform is being replaced by the advisory-based platform, there are an increasing number of legal and regulatory decisions that are shaping the investment advisory business. Advisory firms that fail to monitor such development and adapt accordingly simply increase the likelihood of unnecessary liability and/or regulatory woes.

 

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THE Key Factor in Liability Risk Management

Posted on March 6, 2014 by jwatkins

I was at a conference recently to serve on a panel to discuss various fiduciary issues, including FINRA Regulatory Notice 12-25 and the universal fiduciary standard. When I am at a conference, I rarely attend other presentations for the very reasons that occurred when I attended one of the conference’s other sessions.

I stood in the back of the room during the presentation. The presentation was fine until the speaker stated that the most important factor in choosing asset allocation recommendations is a client’s time horizon. As soon as he said that, a number of people in the audience immediately turned around and looked at me, as apparently they had heard one of my presentations on the subject.

Investment advisers and other financial advisers who create asset allocation recommendations based solely upon the belief that a client’s time horizon is the most important investment factor should go ahead and call their E&O carriers and put them on notice. The argument commonly advance in favor of time horizon being the most important factor in asset allocation claim that time reduces risk. Various studies have shown that that simply is not true.

When I review a case, I always focus on what I call the “liability factor.” This is the proverbial “line in the sand,” the threshold for professional liability. From a liability standpoint, a client’s risk tolerance level is always an important factor. And in assessing a client’s risk tolerance level, an adviser must remember the two-part, or I argue the three-part analysis required of investment professionals.

In the key case in this area, the James B. Chase decision, the Securities and Exchange panel stated that in determining a client’s risk tolerance level, a financial adviser must determine both a client’s willingness and ability to bear investment risk. While a new account form may indicate a client’s willingness to assume investment risk, other information may indicate that the client’s financial condition is such that they do not have the ability to bear investment risk at all, or only to a limited extent.

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

Attempting to designate one factor as the most important factor in evaluating a client simply makes no sense. For example, if a client indicates that their investment objective is “preservation of capital,” then the client’s time horizon is irrelevant. Likewise, if a client indicates that they have a short time horizon with an investment objective of “growth” or “aggressive growth,” then the issue of speculation, as opposed to investing, becomes an issue.

When we made our panel presentation, I used the opportunity to recount the earlier seminar. I suggested to the audience that the factor that most financial advisers should focus on going forward is the comprehensive fiduciary standard of “best interests” of a client. While the SEC and Congress continue to drag their feet on the issue, I have been told that many of the major wirehouses on Wall Street are already conducting in-house seminars on the fiduciary standard.

I realize that brokers and other financial advisers probably do not read regulatory notices. After all, that’s what attorneys and compliance consultants are supposed to do. However, FINRA released a total of three separate regulatory notices during 2011 and 2012 advising brokers as to the agency’s position regarding a broker’s obligations in dealing with clients. As set out in FINRA Regulatory Notice 12-25,

“a broker’s recommendations must be consistent with his customers’ best interests,” meaning that “a broker [is prohibited] from placing his or her interests ahead of the customer’s interests”

The Notice provided numerous regulatory decisions in support of their position. While neither the Notice nor the supporting decisions cited in the Notice used the “f” word specifically, all clearly referenced the “f” word’s “best interests” standard.

The Notice does not distinguish between discretionary and non-discretionary accounts. While many financial advisers falsely believe that the fiduciary standard never applies to non-discretionary accounts, courts are increasingly holding financial advisers to a fiduciary standards where it is determined that the adviser had de facto control over an account.

In determining the issue of de facto control, courts and regulatory bodies look at the extent to which a client routinely followed an adviser’s recommendations.  The courts have consistently said that the issue is

“whether or not the customer, based on the information available to him and his ability to interpret it, can independently evaluate his broker’s suggestions” 

There is a clear trend by the courts and regulatory bodies overseeing the investment industry. So, in creating recommendations for a client, prudent financial advisers should always ask whether their recommendations will pass the comprehensive “best interests” test.

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Four Faces of Fiduciary Prudence

Posted on February 6, 2014 by jwatkins

In defining prudence, ERISA’s rules and regulations state that

[A] fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries…with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims;…

Two of the primary duties enumerated within the duty of prudence are the duty to avoid unnecessary costs and the duty to avoid significant losses by diversification. In addressing these prudence issues, it is important for a fiduciary to recognize that the courts have further defined the duty of prudence as requiring both procedural and substantive prudence.

Fiduciaries need to remember that prudence is evaluated in terms of the process used by a fiduciary in carrying out their fiduciary duties, not in terms of the eventual performance of the actual investments recommended, “a test of conduct and procedure, not results.” The applicable regulations define the prudent process for fiduciary, both in terms of procedural and substantive prudence, as:

1. Determine what information is material and relevant to their task.
2. Examine and understand that information.
3. Make an informed and reasoned decision based on that information.

In evaluating a fiduciary’s compliance with their duty of prudence, procedurally speaking courts will focus on whether the fiduciary used appropriate methods to diligently evaluate investment options. Costs are an important factor that fiduciaries must consider, as costs directly reduce an investor’s return. Fiduciaries must factor in the fact that each 1 percent of investment costs and expenses reduces an investor’s end return by approximately 17 percent over a twenty year period.

The fiduciary’s investigation and evaluation must be intensive and objectively. Fiduciaries will be evaluated based on “the facts and circumstances that … the fiduciary knows or should have known (emphasis added). While fiduciaries can use the services and advice of third parties, a fiduciary must perform their own independent investigation and evaluation. A failure by a fiduciary to perform the required independent investigation constitutes a breach of their fiducairy duty.

Issues of substantive prudence focus primarily on whether the decisions/ recommendations resulted in providing the potential for reducing the risk of significant investment losses. Diversification is an important aspect of investment prudence for fiduciaries. As comment f of the Prudent Investor Act states, “diversification is fundamental to the management of risk and is therefore a pervasive consideration in prudent investment management.”

The Department of Labor has published a fiduciary education article on it website www.dol.gov/ebsa/fiduciaryeducation.html. While the article focuses on ERISA fiduciaries, the points regarding fiduciary duties are generally applicable to all investment fiduciaries.

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Quantum Meruit and “Other” Compliance Challenges

Posted on February 2, 2014 by jwatkins

When I was a compliance director, my biggest frustration was not being able to share certain legal information with the broker-dealer’s registered representatives and those who maintained independent RIAs. I understood the BD’s position, namely that volunteering such information potentially increased the BD’s liability exposure. At the same, I knew we could truly help the reps and RIAs.

One thing that I do not think enough independent RIAs understand is that even if the members of the RIA are affiliated with a broker-dealer, the broker-dealer has no legal obligation to help the RIA with compliance matters vis-a-vis the RIA or any other legal matter of the RIA. As a result, I often encounter RIAs that are not compliant with key legal issues, resulting in liability exposure for the RIA.

When I speak to RIAs, I explain that there are two levels of compliance. One level of compliance deals with the various RIA rules pertaining to record keeping and internal procedural matters such as required manuals. Violations of these rules usually only result in fines unless serious and/or repeated violations are involved.

The second type of violations involve actions by an RIA that cause harm to the public and/or an RIAs clients. These violations involve potential liability for an RIA and, if serious enough, can result in the closure of the RIA and both civil and criminal sanctions.

As a securities attorney and RIA compliance consultant, I deal with potential RIA liability issues on a regular basis. As I tell my clients, they may not like what I tell them, but my goal is protect you and the RIA from liability problems. As a former compliance director and a securities attorney, that is the value added service that I can provide that non-legal compliance consultants cannot provide.

When I represent a client against an RIA, the first thing I do is review the case to see if I can have the adviser held to liability under the fiduciary standards, namely the duties of prudence and loyalty. I usually see the same attempted pattern of excuses/defenses by the RIA:

“We’re not subject to the fiduciary standard.” Sorry, strike one. If you are an RIA or an investment advisory representative (IA) of an RIA, you are held to a fiduciary standard. (the Capital Gains decision). Many financial advisers incorrectly believe that a financial adviser cannot be held to a fiduciary standard on non-discretionary accounts. Both the Lieb and the Mihara decisions clearly establish that financial advisers can he held to  a fiduciary standard when it can be shown that the adviser had de facto control over the customer’s account. As the Mihara court stated,

The account need not be a discretionary account whereby the broker executes each trade without the consent of the client. …the requisite degree of control is met when the client routinely follows the recommendations of the broker. 

The applicable standard for both registered representatives and RIAs was set out even more clearly by the court in Carras v. Burns, where the court stated that

In the absence of an express agreement, control may be inferred from the broker-dealer relationship when the customer lacks the ability to manage the account and must take the broker’s word for what is happening….The issue is whether or not the customer, based on the information available to him and his ability to interpret it, can independently evaluate his broker’s suggestions. 

Hint: Some securities attorneys have been known to successfully argue that not many investors understand Modern Portfolio Theory and/or those pretty little pie charts based on same, therefore the adviser had de facto control over the account and all fiduciary standards apply. Checkmate.

“But we do not provide advice through the RIA, only as registered representatives of the BD” This is the old two-hat argument. The most common argument against this defense is that set out in the Arlene W. Hughes decision. The court noted that when one serves in the dual capacity of investment adviser and registered representative, “conflicting interests must necessarily arise.” When they arise, the court noted that the law step in to protect the public since

The business of trading is one in which opportunities for dishonesty are of constant recurrence an ever-present. It engages acute, active minds, trained to quick apprehension, decision and action. The Congress has seen foot to regulate this business. [Such regulations are] to be enforced notwithstanding the frauds to be suppressed may take on more subtle and involved forms than those in which dishonesty manifests itself in cruder and less specialized activities. 

I believe that many financial advisers are honest and truly aim to help the public. On the other hand, my files are filled with cases indicating that not all financial advisers maintain such high standards. The two-hats ruse can be effectively dismissed. Strike two.

And finally, the “I did not know and I did not mean to hurt them” defense. The courts have often cited the standard establish by the Donovan v Cunningham decision, namely that “a pure heart and an empty head are no defense” to a charge of breach of fiduciary duties.” Strike three.

Which brings us to the issue of “quantum meruit,” a Latin term meaning “as much as he deserved.” At some point in the case the financial adviser will usually argue that he/she is entitled to compensation for his/her advice. Nope, simply not true.

Quantum meruit is closely related to the concept of unjust enrichment. Both are equitable principles that seek to prevent one party from taking advantage of another party. The issue usually arise where there is no formal agreement between the parties, but can also be raised as an equitable claim where there are questions as to what amount of payment is properly due for work done.

One of the basic principles behind both quantum meruit and unjust enrichment is that the party seeking compensation actually provided valuable services or advice to the other party. If no valuable services or advice were provided, no compensation is deserved. Furthermore, valuation of the services or advice in question is determined objectively, without regard to subjective opinions. 

Once it is established that a financial adviser will be held to the fiduciary standards, the value of their services or advice will be judged according the duty of prudence (avoidance of unnecessary fees and the avoidance of significant losses) and the duty of loyalty (requirement to always put a client’s interests first), with settlement usually following, as there are three common breach of fiduciary duty screens that often ensnare investment fiduciaries.

I offer this information simply to alert investment advisers that they need to properly  establish and maintain an effective risk management program for their advisory services. A failure to properly maintain the required files and operating manuals may result in fines. A failure to properly establish and maintain an effective risk management program can result in the loss of an adviser’s business, as well as civil liability and unlimited monetary damages.

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2014 – Brave New Fiduciary World

Posted on December 27, 2013 by jwatkins

2014 promises to be a important year for fiduciary liability issues. ERISA advisers, sponsors and attorneys await the Court of Appeals’ decision in Tussey v. ABB,Inc. and its impact on fiduciary issues such as prudence, loyalty and due diligence. If the lower court’s decision is upheld, the pension industry, service providers and plan sponsors alike may be forced to undergo significant changes in its practices.

Both the Department of Labor (DOL) and the Securities and Exchange Commission (SEC) will hopefully enact a much-needed universal fiduciary standard that requires that anyone providing investment advice to the public must always put the customer’s/ client’s best interests ahead of the adviser’s interests.

Even without a DOL/SEC universal standard, it will be interesting to see how the pro-fiduciary positions announce by both FINRA and the courts progress. In several announcements, e.g. Regulatory Announcement 12-25, FINRA has stated that a registered representative always has a duty to put a customer’s interests first. At the same time, there are decisions stating that the decision to impose a fiduciary duty on a financial adviser will be based upon whether a customer had the experience and knowledge/understanding to independently evaluate the adviser’s recommendations. (For further discussion, see our post “Upon Further Review: Do We Already Have a Universal Fiduciary Standard?”)

Another fiduciary issue involves the use of binding arbitrary clauses in fiduciary related contracts. There has already been talk of the SEC considering prohibiting the use of such clauses.

The Financial Industry Regulatory Authority (FINRA) took a significant step in recognizing investors’ rights when it allowed investors to opt for arbitration panels composed entirely of public citizens. FINRA, and its predecessor the National Association of Security Dealers (NASD), had previously required that three member arbitration panels hearing customer grievances had to be made up of one industry representative, one public representative, and one impartial arbitrator. The NASD/FINRA arbitration process was criticized as often being nothing more than a “kangaroo” court, with the “impartial” arbitrator often having ties to the securities industry in one form or another and therefore ruling in favor of the securities industry.

Even with the new all-public arbitration option, the use of binding arbitration clauses by fiduciairies raise serious legal questions. One of a fiduciaries main duties is to be loyal to their client, to always put their client’s best interest first. Requiring a client to waive important legal rights is not only clearly not in a client’s best interests, but it acts to protect the fiduciary at the client’s expense, a clear vioaltion of a fiduciary’s duty of loyalty. For that reason, I advise my RIA clients not to use a binding arbitration clause. Besides, if a fiduciary does their job right, there is no reason to worry about litigation.

There simply is no good faith justification for a fiduciary to require that a client give up their right to seek redress in the courts for tortuous conduct by the fiduciary. The arbitration process is promoted as being less expensive and producing quicker results. Often ignored is the fact that the arbitration process too often produces inequitable results, does not guarantee quick adjudications, and seriously restricts an investor’s right to make effective discovery that might reveal evidence that proves his/her case.

The simple fact is that binding arbitration clauses are put into contracts to protect the broker-dealer and stockbrokers from having to confront the public and face serious financial retribution for their wrongdoing. The limited discovery rights provided to investors in the arbitration process also protect fiduciaries from clients uncovering and exposing other potential abusive practices.

A recent study concluded that only 22 percent of the public trusts the financial services. Both Congress and the regulatory bodies that oversee the financial services industry can do a lot to improve the image of themselves and the financial services industry by passing meaningful rules and regulations that protect the public and demonstrate a true commitment to investors’ rights to a fair and equitable investment system.

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“Hidden” Assets – Potential Liability Implications of the LaRue Decision for Attorneys and Fiduciaries

Posted on November 26, 2013 by jwatkins

During a recent deposition of an executor, I asked the executor, a bank trust officer, whether the bank had evaluated the defined contribution plan in which the deceased had participated. The trust officer replied that the funds in deceased’s account had been distributed pursuant to the beneficiary form for the account. When I repeated my original request, the trust officer became upset and his attorney objected to my question, the old “ask and answered’ objection, saying the trust officer had answered my question.

I explained that my question had nothing to do with the distribution of the deceased’s pension account, but rather with whether the executor had evaluated the defined contribution plan in terms of compliance with ERISA’s requirements. The attorney quickly responded that the bank had no duty to perform such an evaluation.

But does an executor and other fiduciaries have such a duty? I would suggest that in certain circumstances the LaRue decision does create a duty upon certain attorneys and other fiduciaries to evaluate a pension plan’s compliance with ERISA. LaRue recognized the right of an individual participant in a plan to sue the plan for losses sustained in an account due to imprudent acts or other wrongdoing.

Legally, the right to sue constitutes a “chose in action, ” a property right and an asset of the individual involved. An executor has a legal duty to collect all of the deceased’s property/assets and properly distribute them in accordance with the law. Given the fact that various ERISA experts have opined that most 404(c) pension plans are not in compliance with the applicable ERISA requirements, the question of whether an executor or other fiduciaries have a duty to evaluate a pension plan with regard to LaRue rights is a legitimate question, not only in terms of losses suffered, but also in terms of possible breaches of the plan’s fiduciary duties due to non-compliance with ERISA, e.g, excessive fees, conflicts of interest.

In discussing this theory with other attorneys, some have claimed that exploring such an action would unnecessarily delay the administration of the estate. That simply is not true. An executor could quickly administer the estate’s assets on hand and simply leave the estate open pending the resolution of the potential LaRue claims. The executor or other fiduciary would simply need to conduct a cost-benefit analysis to evaluate the merits of pursuing a LaRue claim. Given the potential recovery in a LaRue claim it can be argued that the prudent course of action would be for the executor or other fiduciary, at a minimum, to conduct the cost-benefit analysis and meet with the heirs to discuss the situation.

This situation came up shortly after the LaRue decision was handed down. One of the services that I perform is a forensic prudence analysis of investment portfolios and pension plans. A fellow attorney, noting the wide-spread belief that most 404(c) pension plans are not compliant with ERISA, asked me to perform a forensic analysis of a plan for an estate for which he was serving as executor. As a result of my analysis, the attorney and the heirs decided to file a LaRue claim. The case survived a summary judgement, based largely on the “chose in action”/property right issues previously discussed, and is waiting to be tried or settled.

As a wealth preservation attorney, I focus on both proactive strategies to preserve and protect asset and reactive strategies to recover wealth loss due to improper activity, fraud and similar misconduct. Issues such as potential LaRue claims are what I refer to as “hidden” assets, assets that may only be recognized by thinking “outside the box.” They are valid assets which may not be recognized by attorneys and other fiduciaries due to a lack of understanding of or experience with a particular type of assets. LaRue is a perfect example of this, as many simply the decision as an ERISA decision without recognizing the “chose in action”/ property right issues created by the decision.

Forensic analysis of portfolios and/or pension plans can also be useful in connection with other types of litigation. While divorce cases are usually more time sensitive than probate cases, attorneys involved in cases involving high net worth clients may want to consider performing a forensic analysis to determine the potential recovery that may result from pursuing such an asset. Divorce attorneys that I have worked with have reported that a forensic analysis helped them negotiate a better settlement for their clients, both in terms of the potential asset and the leverage provided by the analysis with respect to a possible LaRue claim.

Many professionals that I have spoken with on this issue have stated that they do not know how to evaluate the value of a “chose in action.” My response is that the first issue should be to determine whether there are improprieties justifying liability to support the “chose in action.” If so, then the process of evaluating the potential value of the “chose in action” should be undertaken.

There are numerous factors which may come into play with regard to evaluating the value of a “chose in action.” While the process necessarily involves consideration of both objective and subjective analysis, the goal should always be to avoid “throwing good money after bad.” Each case necessarily depends on its individual set of facts.

The purpose of this post has been to alert attorneys and other fiduciaries, as well as their clients, of the potential “chose in action”/property right issues that LaRue has created and the need to consider same in order to properly gather and administer all of a deceased’s property in order to ensure that the estate is properly administered, that the heirs receive all of the assets due to them,  and that professionals involved in administering the estate avoid unnecessary liability exposure.

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Creative Chaos – Creating a Win-Win Situation for Investors and Investment Advisers

Posted on November 7, 2013 by jwatkins

Having been involved in the quality of investment advice arena for twenty-five years in some capacity (e.g., securities attorney, RIA consultant, B/D compliance director), I have seen numerous changes in both the industry and the surrounding legal/regulatory environment.

There is an increasing recognition of the power and potential benefits of “chaos” and “deliberate disruption” in producing helpful innovation and beneficial change. “The Chaos Imperative: How Chance and Disruption Increase Innovation , Effectiveness and Success” and “The Innovator’s Manifesto: Deliberate Disruption for Transformational Growth” both provide an excellent discussion of the concepts.

As I have told my consulting clients, I think the current debate over a universal fiduciary standard presents significant opportunities for investment advisers. The recent decision by the House of Representatives to delay consideration and implementation of a much needed universal fiduciary standard, denying investors the protection they desperately need, further demonstrates that the timing is right for proactive investment advisers to engage in “creative chaos” and “deliberate disruption” in order to inform the public of their services and the “value added” factor that their services provide.

Truly independent investment advisers have a distinct advantage over investment advisers that are dually registered, as they are not limited in their marketing approaches. Independent investment advisers can, and should, take advantage of their independence to stress the fiduciary issues inherent in the broker/non-fiduciary standard and the investment adviser/fiduciary and the implications of both for investors.

In order to drive the difference home to clients and potential clients, I have suggested to my clients that they concentrate on a simple question – “what is so objectionable and onerous about requiring that anyone providing investment advice and investment recommendation be required to put their client’s interests ahead of their own?”

The financial service industry and the investment industry continue to argue that a fiduciary standard would deny investment advice to the public. True investment advisers should point out that this argument is disingenuous at best, as a fiduciary standard would not prevent stockbrokers and other financial advisers from selling investment products and earning commissions on such sales. A fiduciary standard only requires that any sales of such products be in a client’s best interests.

Investment advisers should point out to clients and others that the ongoing efforts of the financial services industry and the investment industry to block a universal fiduciary standard amount to what is known legally as an admission against interests, an admission that their business model cannot perform efficiently if they are required to put the public’s interest of their own, as they know full well that a number of their products are not in a client’s best interests. And yet the House of Representatives effectively sanctioned this on-going abuse of investors by blocking a universal fiduciary standard.

Proactive investment advisers can take advantage of the current fiducairy situation and create “chaos” and “deliberate disruption” to demonstrate their worth to clients and prospective clients by pointing out the on-going attempts to deny the public the protection they need and the fact that investment advisers are already legally required to always put a client’s interests first. Investment advisers should then take the opportunity to demonstrate the “value added” aspects  of their services by analyzing a client’s or prospective client’s investment portfolio and pointing out problems.

I offer quality of advice services to pension plans, trust and investors. One of my primary tools is a proprietary metric I created a couple of years ago, the “Active Management Value Ratio™ (“AMVR™”). The AMVR™ is a simple cost-benefit metric that allow investors, advisors and investment fiduciaries to evaluate the cost efficiency of an actively managed investment through the use of simple subtraction and division. The AMVR™, in essence, allows both the public and investment professionals to quantify the prudence of an investment.

Once one is acquainted with the AMVR™ calculation, in most cases it takes less than a minute to calculate an investment’s AMVR™ score. The relatively small investment of time required to calculate AMVR™ and the potential impact of the findings can provide advisers with a powerful marketing tool, as the AMVR™ usually shows a prospective client that the incremental cost of their current investment are significantly greater than the incremental benefit, if any, provided by such investment, thereby creating a win-win opportunity for both the investment adviser and the client.

The opportunity has already been created for investment advisers. The next step is for the proactive investment adviser to seize the opportunity to be creative by creating “chaos” and “deliberate disruption” to demonstrate their value added proposition to prospective clients, and in so doing build their practices and help clients and prospective clients protect their financial security.

For additional information about the Active Management Value Ratio™, please visit my blog, “CommonSense InvestSense (investsense.com). My article on the new “back of the envelope” version of the AMVR™ will be released on Monday, November 11, 2013 on the Paladin Registry blog (paladinregistry.com).

Posted in 401k, 401k compliance, 401k investments, compliance, fiduciary compliance, fiduciary law, investments, retirement plans, RIA, RIA Compliance, securities compliance | Tagged , , , , , , , , , , , , , , , , | Leave a comment

Market Timing and Legal Liability: What Really Matters

Posted on August 23, 2013 by jwatkins

People always ask me how I can be a securities attorney and sue stockbrokers and other financial advisers and also be an RIA compliance consultant. My answer is that by combining the two, ultimate goal is promote a win-win situation. I help advisers by showing them how to protect their practices and achieve good results for their clients. Those that refuse to promote such goals learn the hard way.

In an earlier post, “The RIA’s Achilles’ Heel, I mentioned that I felt that one of the most common errors I see among investment advisors is a failure to develop an effective risk management program to protect their practices. In some cases this is due to a failure to separate investment theory from legal reality.

A perfect example of this is the concept of market timing. Mention the term and people usually react strongly one way or the other. Opponents of market timing claim that it does not work and simply increases risk, has adverse tax consequences and increases overall costs. Proponent of market timing claim that it helps reduce overall risk and can reduce unnecessary and significant financial loss.

One of the main problems with the concept of market timing is that there are various beliefs as to what market timing actual entails. The classic definition of market timing is shifting 100 percent of one’s investment either into the stock market or 100 percent out of the stock market, no middle ground.

The there are those, like investment legend Benjamin Graham, that view market timing as a more flexible and defensive concept, allowing for gradual reallocating of assets in response to changes in the stock market or the economy. Graham’s model called for an initial 50/50 split between stocks and bonds. Graham then suggested that an investor could make changes in the allocation, with the proviso that the allocation to either stocks or bonds never drop below 25 percent or exceed 75 percent. Interestingly enough, Henry Markowitz, Nobel Laureate and the father of Modern Portfolio Theory, admitted that this was the model he used to manage his own investment portfolio.

Then there is yet another camp that believes that any reallocation or rebalancing of asset constitutes market timing. This camp chooses to completely ignore the proven cyclical nature of  the stock market.

Then there is a faction that support the notion of periodic re-balancing to restore a pre-set allocation model. Re-balancing is OK because it is not deemed to be market timing, simply re-balancing.  The first thing I do when I depose an investment adviser is to ask him to describe his approach to investment management. If he/she indicates that they use re-balancing, I ask them why they do so. The I ask them their definition and opinion on market timing.

Come into my parlor said the spider to the fly. I’m leading you into what I call the “Market Timing Gotcha.” Why would you shift assets from a profitable investment and reallocate it to a poorer performing investment? That would seem to be contra to the duty of prudence, would it not? Are you shifting assets to the poorer performing asset in anticipation of a change in performance? Would that not constitute market timing?

To me, from a legal liability perspective, the argument over market timing is a waste of time. Investment advisers are going to be evaluated from a standpoint of the prudence of their management of a client’s portfolio. The key is the effective management of a client’s portfolio so as to prevent significant losses and unnecessary costs.

History has shown that the market is cyclical in terms or performance. Argue all you want, you lose.  Therefore, a simplistic static, or buy-and-hold, portfolio makes no sense from a liability perspective. Simply no way to justify allowing a client to absorb such losses. Want to throw in periodic re-balancing? Fine, but be prepared to explain why you chose to re-balance, as opposed to possibly re-allocating some of the assets (a la Graham), if the re-balancing does not properly protect the client.

There are those predicting a bond bubble based upon the Federal Reserve’s suggestion of increasing interest rates. While long-term bonds are generally considered a better investment when interest rates are low, long-terms take a greater hits when interest rates are rising, when short-term bonds are the preferred bond investment. Would it be prudent for an investment adviser not to re-allocate any assets invested in long-term bonds to avoid the risk of loss due to rising interest rates?

Again, from a liability perspective, an investment adviser is going to be evaluated in terms of the prudence of their investment decisions. Arguing over semantics is a waste of time. The key questions are going to be whether an advisor took steps to minimize a client’s investment risks.

My focus is always on what steps the advisor took to provide a client with upside potential while minimizing downside risks. I’ll reverse engineer the client’s portfolio and analyze the efficiency of the advisor’s actions, both in terms of costs and risk management, including my proprietary metric, the Active Management Value Ratio™. Regardless of whether you call it re-balancing, market timing or whatever, did an advisor manage the client’s portfolio in such a way to preserve the client’s wealth by avoiding significant financial loss. If not, the claim will be breach of fiduciary duty of prudence.

I often have stockbrokers tell me they are not worried since they are not held to a fiduciary duty to their customers. As ESPN analyst Lee Corso would say, “not so fast my friend. In FINRA notices 11-02, 11-25 and 12-25, FINRA warned registered representatives that they do have an obligation to always act in a client’s best interests, which is the exactly required under the fiduciary duty of loyalty, as well as the fiduciary duty of prudence.

Case law also supports the imposition of a fiduciary duty upon stockbrokers and other financial advisors when it is determined that the stockbroker or financial advisor had “de facto” control over a customer’s account.

The courts look at various factors in determining whether an adviser had de facto control over an account. As the courts have stated,

[t]he touchstone is whether or not the customer the intelligence and understanding to evaluate the broker’s recommendations and to reject one when he thinks it unsuitable.(1)

the issue is whether or not the customer, based on the information available to him and his ability to interpret it, can independently evaluate his broker’s suggestions.(2)

If the answer to these questions is in the negative, then the likelihood is that the adviser will be deemed to have had de facto over the customer’s account and they will be held to a fiduciary standard in their dealings with the customer and the account. For more information on the issue of fiduciary duty based on de facto control, see my post, “Upon Further Review: Do We Already Have a Universal Fiduciary Standard.”

My advice to my RIA clients and others has, and always will be, forget the semantic of whether something is or isn’t “market timing.” Instead, focus on doing the right thing for the client. If there are potential tax implications, discuss possible strategies with the client if possible. Just because a client provides a financial adviser with discretion does not mean an advisor should be proactive and consult with a client on certain issues. And remember, document the discussion to better yourself.

One of the biggest, most common mistakes I see are situations where an investment adviser allows the tax “tail” to wag the investment “dog.” I have yet to talk to one investor who has said that they were more comfortable taking the investment losses they suffered in the 2000-2002 and 2008 bear markets rather than pay some taxes and preserve more of their wealth. Advisors who blindly ignored the multiple signs and failed to act prudently and proactively to protect their clients are paying the price now.

Another area ripe for discussions with clients involves wealth preservation, including the use of effective hedging strategies. Fiduciary law states that a fiduciary is required to diversify a client’s portfolio unless there is good cause not to do so. In some cases, hedging strategies such as the use of alternative investments, protective puts and inverse index funds/ETFs may be prudent. At least one case has suggested that, at the least, a financial advisor has an obligation to disclose and discuss such strategies with client’s as necessary to avoid potential losses.(3)

There are plenty of consultants who can advise investment advisers on how to set up an RIA and prepare all the required manuals required by the regulators. However, having all the required RIA manuals is not going to save an RIA’s practice if the RIA breaches its fiduciary duties to their clients.

The typical response of an RIA to a breach of fiduciary duty claim is that they did not know what the law required or that they did not intend to break the law or hurt the client. Neither excuse is an acceptable, for as one court stated, “a pure heart and an empty head is no defense.”

The sad truth is that it is relatively easy to win or settle a breach of duty case. Be proactive and learn, and stay updated on, the applicable law or consult with an attorney experienced and knowledgable in investment/RIA law. And finally, focus on being proactive and doing whatever is necessary to truly protect client’s against significant losses without regard to semantics or other irrelevant concerns.

Notes

1. Follansbee v. Davis, Skaggs & Co., Inc., 681 F.2d 673, 677 (9th Cir. 1982)

2. Carras v. Burns, 516 F.2d 251, 258-59 (4th Cir. 1975)

3. Levy v. Bessemer Trust, 1997 U.S. District LEXIS 11056 (S.D.N.Y. 1997)

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Beware the “We’re #1” Trap

Posted on August 14, 2013 by jwatkins

Michael Kitces recently posted an article about a proposed publication that would provide client reviews of their financial advisors. For those of you who do not follow Michael, you should do so. Michael is recognized as an industry leader. I have turned to Michael on occasion for information, as I know I can trust him to be honest and objective.

Michael and I exchanged some emails regarding the post, as I was concerned that such a publication could result in some investment advisors inadvertently violating the Investment Advisers Act’s (“Act”) prohibition against the use of testimonials.  As a former RIA compliance director and present consultant to RIAs, I hate to see them get mired in unnecessary regulatory hassles due to a lack of information.

All advisers want favorable publicity, but these so-called “best of the best” lists raise a number of potential problems. “Barron’s” publishes a number of these lists. “Barron’s” disclosure that only those advisors who pay a fee are eligible for inclusion on their lists raises a number of issues for advisors named to such lists.  The omission of industry leaders such as Harold Evensky, Ross Levin and Louis Stanasolovich speaks volumes to investment and financial planning professionals, but not so to the readers of “Barron’s” who might rely on such lists in choosing a financial adviser.
The SEC has addressed the issue of third-party rating and has stated that the term “testimonial” includes

a statement of  a client’s experience with, or endorsement of, an investment adviser.   A third-party rating would be a testimonial if it is an implicit statement of a client’s or client’s experience with an investment adviser of investment advisory representative… A third-party rating that relies primarily on client evaluations of an investment adviser would be a testimonial.(1)

Advisors considering using a third-party rating in their marketing program should carefully review the SEC’s so-called Dalbar no-action letter.(2) The no-action letter discusses several factors that advisers must consider in order to avoid having an advertisement referencing a third-party rating deemed to be false and misleading, and therefore a violation of Section 206(4) of the Act and Rule 206(4)-1(a)(5) thereunder.

The Act and the rules created thereunder all stress one point – full disclosure of all material facts to clients. An advisor simply cannot say that they are a “Barron’s Advisor” of that they are a “Top 100 Advisor” without making the disclosures required by the Dalbar no-action letter.

Advisors who decide to ignore the Dalbar no-action letter and claim ignorance if caught are reminded that ignorance of the law is no defense and intent is not a requirement for violation of the Act (or similar state securities laws). The Act’s expressed intent is to protect the public…period. And CFP(r) professionals should remember that violation of securities laws, federal or state can be grounds for a disciplinary action by the CFP Board of Standards.

And yes, one of the requirements set forth in the Dalbar no-action letter is whether an adviser’s advertisement discloses that investment advisers paid a fee to participate in the survey. And yes, I have already seen adviser advertisement referencing third-party rating that are not Dalbar compliant, but none of them is one of my clients.

Notes

1. Investment Adviser Association No-Action Letter (12-2-2005). http://www.sec.gov/divisions/investment/noaction/iaa20205.htm2. Dalbar, Inc. No-Action Letter 3-24-1998), http://www.sec.gov/divisions/investment/noaction/1998/dalbar032498.pdf

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