The RIA Name Game

Posted on July 5, 2015 by jwatkins

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

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

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

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

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

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

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

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

 

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“Best Interests” For Fiduciaries 101

Posted on May 26, 2015 by jwatkins

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

© Copyright 2015 InvestSense, LLC. All rights reserved.

This article is for informational purposes only, and is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Notes

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

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Oil and Water: Fiduciaries and Variable Annuities

Posted on March 31, 2015 by jwatkins

The financial services industry continues to try to convince investment advisers and other financial fiduciaries to sell variable annuities. Smart RIAs and other financial fiduciaries ignore these pleas, as they realize that variable annuities are liability traps for fiduciaries, blatant violations of the fiduciary duties of loyalty and prudence.

A fiduciary must be loyal to their client, acting solely in the best interests of the client. The methodology used by most variable annuity issuers essentially guarantees a windfall for the variable annuity issuer at the client’s expense. Even a leading variable annuity issuer has admitted to the inherent inequities in the current system. In the January 2004 issue of Financial Planning magazine, John D. Johns, Chairman  and CEO of Protective Life Corporation, addressed the illogical and inequitable nature of the inverse pricing methodology, where fees are based on the accumulated value of the variable annuity rather that the potential cost to the variable annuity issuer in the event a death benefit had to be paid to the variable annuity owner’s heirs.

Another fiduciary liability trap for fiduciaries involves the actual value of the death benefit itself. Dr. Moshe Milevsky conducted the groundbreaking study on this issue. In the January 2007 issue of Research magazine, he re-counted his earlier findings, namely that

if the M&E fee was only meant to cover pure risk – the typical VA policyholder was being grossly overcharged for this so-called protection and peace of mind. We found that the basic return-of-premium GMDB was worth no more than 5 to 10 basis points of assets per  annum. By the term “worth” we meant that it would only cost the insurance company backing the guarantee 5 to 10 basis points to reinsure or hedge their exposure to this risk.

When you consider that most VA issuers charge approximately 2 percent, or 200 basis points, annually for the M&E, or death benefit, fee, the breach of fiduciary duties as to both loyalty and prudence are obvious. Add in another 1 percent cumulative annual charge for the various subaccounts within the VA itself, and possibly another 1percent annual advisory fee for “managing” the VA, and the abusive nature becomes even more obvious.

A study by the Department of Labor concluded that each additional 1 percent of fees or expenses reduce an investor’s end return by approximately 17 percent a year over a 20 year period. (For nitpickers, the actual number is 16.97 percent.) Over a twenty-five year period, that number increases to 20.75 percent. Over a thirty year period, that number increases to 24.35%.

The true impact of escalating fees is even more problematic. Over a fifteen year period, a 3 percent fee would reduce an investor’s end return by approximately 34.46 percent, while a 4 percent fee would reduce an investor’s end return by approximately 43.22%. Over a twenty year period, a 3 percent fee would reduce an investor’s end return by approximately 43.07 percent, while a 4 percent fee would reduce an investor’s end return by approximately 53 percent. Throw in a 7 percent commission to the stockbroker or insurance agent selling these products and you understand why “financial advisers” and insurance companies push VAs so hard.

There is a saying in the financial services industry that variable annuities are sold, not bought. That’s because any investor who had the information set out in this post would run away from the VA salesman. But salesmen do not explain this aspect of VAs. They just preach tax deferral and the notion that the VA owner can never run out of money. Well, IRAs provide tax deferral without all the added fees. And in order to get the lifetime money guarantee, the VA owner has to annuitize the VA, meaning the VA owner loses control over the money.

While their are various survivorship options available, usually single or joint lives, once those options are over, the insurance company, not the VA owner’s heirs, receive any balance left in the VA account. It is for that reason that VAs are so detrimental to estate planning.

So if you are a fiduciary and you decide to recommend and/or invest in VAs, be sure to check your E & O policy, because if you ever face a client claim based on the VAs, it is essentially what we in the South like to refer to as “shooting fish in a barrel,” for the reasons discussed in this article. The various methods used to guarantee a windfall to the VA issuer basically ensure that a fiduciary will be found liable for violations of both the fiduciary duties of loyalty and prudence.

It is hard to honestly argue that a product that may reduce an investor’s end return by 40 to 50 percent is in their best interests. If it is a jury trial…forget it, and hope that the jury does not decide to set an example. With today’s all public arbitration panels, making such a ludicrous argument may result in an award designed to truly punish the VA salesman and warn others.

For more information on variable annuities and the fiduciary duties/liabilities involved, see our white paper,”Variable Annuities: Reading Between the Marketing Lines,” at http://investsense.com/variable-annuities/.

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A Closer Look At The “Top” 401(k) Mutual Funds

Posted on March 10, 2015 by jwatkins

Each year various publications put out their lists of “top” or “best” mutual funds. I always enjoy going through such lists and performing a forensic analysis of the funds on such lists to get a better analysis of each fund.

One of my favorite lists is the list published by “Pensions & Investments,” one of the leading publications in the ERISA arena. The list published by “Pensions & Investments” is not based on performance, but rather the fund’s assets under management, the most popular funds used in 401(k) plans.

I decided to do a quick analysis on the top ten funds listed on the most recent list. Since four of the funds offered various levels of fees within their fund, I actually compared fourteen funds, using both the high and low fee for the four funds in question. The funds analyzed were:

Fidelity Contrafund (PCNKX)
American Funds Growth Fund of America (RGAAX and RGAGX)
Fidelity Growth Company (FGCKX)
Dodge and Cox Stock (DODGX)
Fidelity Low Price (FLPKX)
American Funds Fundamental Investors Inc ((RFNAX and RFNGX)
American Funds Washington Mutual Investors Fund (RWMAX and RWMGX)
Price Growth Stock Fund (RRGSX)
Price Equity Income Fund (RRFDX)
MFS Value (MEIGX and MEIKX)

The first test was relatively simple – performance relevant to its benchmark the most recent five year period. If a fund did not outperform its relevant benchmark, in other words did not provide an investor with added return, investing in such a fund would not be prudent. After all, why would an investor be willing to pay money for nothing.

Somewhat surprisingly, of the fourteen funds analyzed, only three funds passed this screen – Fidelity Contrafund, Fidelity Growth Company and Price Growth Stock Fund.
The second test was for prudence in terms of cost efficiency, using a fund’s R-squared rating and subsequent effective annual expense ratio. Over the past ten to fifteen years, we have seen an increase in so-called closet index funds, or “index huggers, as fund managers attempt to reduce the risk of losing investors due to significant differences in returns of their funds and less expensive index funds.

R-squared measures the degree to which a fund track its relevant index. Funds with a high R-squared rating are often referred to a “closet index” funds since their returns generally track the returns of similar index funds, albeit at higher expense levels. While there is no generally accepted R-squared score to signify “closet index” fund status, I use 90. Some use a higher score, some a lower score, but to me a fund that tracks its index by 90 percent is not worth the higher costs.

Of the fourteen funds analyzed, only three had an R-squared rating below 90 – Fidelity Contrafund, Fidelity Growth Company and Price Growth Stock Fund. Interestingly, even their R-squared rating were relatively high – Contrafund (89.73), Price Growth Stock (86.77) and Fidelity Growth Company (84.71).

Funds with a high R-squared rating often have effective annual expense ratios significantly higher than their publicly stated annual expense ratios. This is simply due to the facts that a higher R-squared ratio indicates a lower active management component of the fund. When a fund’s additional costs for active management is adjusted for the lower active management component of the fund, the effective annual expense ratio for a fund can increase significantly.

For example, American Funds offer six levels of its R shares. The most recent prospectus indicates that for the three funds analyzed, R-1 shares charge an annual expense fee of approximately 1.40 percent, including an annual 12b-1 charge of 1 percent, while their R-6 shares have an annual expense ratio of 0.22 percent and no 12b-1 fee. Once R-squared ratings are factored in, the annual expense ratio picture changes significantly:

-American Funds Growth Fund of America R-1 – stated annual expense ratio 1.43 percent, effective annual expense ratio 4.30 percent.
-American Funds Growth Fund of America R-6 – stated annual expense ratio 0.22 percent, effective annual expense ratio 1.29 percent.

-American Funds Fundamental Investors Inc. R-1 – stated annual expense ratio 1.41 percent, effective annual expense ratio 6.40 percent.
-American Funds Fundamental Investors Inc. R-6 – stated annual expense ratio 0.22 percent, effective annual expense ratio 1.76 percent.

-American Funds Washington Mutual Investors R-1 – stated annual expense ratio 1.39 percent, effective annual expense ratio 5.36 percent.
-American Funds Washington Mutual Investors R-6 – stated annual expense ratio 0.22 percent, effective annual expense ratio 5.36 percent.

-MFS Value R-1 – stated annual expense ratio 1.63 percent, effective annual expense ratio 8.52 percent.
-MFS Value R-6 – stated annual expense ratio 0.22 percent, effective annual expense ratio 4.00 percent.

The effective annual expense ratios were calculated using InvestSense’s proprietary metric, the Active Management Fee Factor™. Ross Miller’s Active Expense Ratio also uses a fund’s R-squared rating and be used to calculate a fund’s effective annual expense ratio. Based on my experience, both metrics generally provide similar results.

When I perform a forensic analysis for a client, we finish the analysis with two proprietary metrics, The Active Management Value Ratio™ (AMVR) and the Fiduciary Prudence Score™. Both metrics require that a fund outperform their appropriate benchmark, that they provide an incremental return for an investor. Since only three of the fourteen funds provided an incremental return, we would only do an AMVR and Fiduciary Prudence Score for those funds.

Again, the annual list published by “Pensions & Investments” is not based on qualitative measures. The list simply identifies the top mutual funds used by 401(k) plans based on a fund’s assets under management.

The purpose of this white paper has been to point out that “top” and “best” lists of investments should not be blindly relied on by investment fiduciaries and investors. As the paper shows, fiduciaries and investors can perform a meaningful analysis by simply investing a little time in looking up the relevant numbers through free online sources such as Morningstar and Yahoo. The investment in time may prevent unnecessary financial losses and improve one’s overall financial security.

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Done Deal: The SEC, NASD and FINRA on the Fiduciary Standard

Posted on February 11, 2015 by jwatkins

SEC
– As we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests. (Wendell D. Belden, Exchange Act Rel. No. 34-47859, 2003)

– As we have frequently stated, a broker’s recommendations must be consistent with his customer’s best interests. (Raghavan Sathianathian, Exchange Act Rel. No. 34-54722, 2006)

– A broker violates the suitability rule when he puts his own self-interest ahead of the interests of his customers. (Scott Epstein, Exchange Act Rel No. 34-59328, 2009)

NASD/FINRA
– In determining whether a fund is suitable for an investor, a member should consider the fund’s expense ratio and sales charges as well as its investment objectives. (NASD Notice to Members  95-80, September 1985)

– The suitability requirement that a broker only make those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his or her interests ahead of the customer’s interests. (FINRA Regulatory Notice 12-25, fn. 16)

– A broker’s recommendations must serve his client’s best interests…. (Dept. of Enforcement v. Bendetsen, 2004 NASD LEXIS 13, at *12)

– [A] central aspect of a broker-dealer’s duty of fair dealing is the suitability obligation, which generally requires a broker-dealer to make recommendations that are consistent with the best interests of his customer. (“SEC Staff Study on Investment Advisers and Broker-Dealers as Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010,” at 59 (Jan. 2011)).

The SEC and the NASD/FINRA have clearly endorsed a “best interests” requirement for brokers. And yet, various leaders of the financial services industry continue to predict disastrous results if the DOL adopts a universal fiduciary standard. So is that an admission by the financial services industry that they have not been in compliance with the SEC’s and FINRA’s requirements? Or is that an admission that they cannot operate profitably if they are required to comply with the SEC’s and FINRA’s “best interests” requirement?

Even more perplexing is the SEC’s ongoing refusal to adopt a universal fiduciary standard for brokers, when there are numerous enforcement decisions upholding the “best interests” standard, the cornerstone of fiduciary law. How can the SEC ignore its own enforcement decisions?

The decisions I have cited are but a few of the regulatory decisions holding brokers to a “best interests” standard when dealing with the public. As noted above, some decisions have also upheld the “best interests” standard under the regulatory rules requiring fair dealing with the public.

And yet, in all the stories that I have seen addressing the ongoing battle over a universal fiduciary standard, I have yet to see one writer address the fact that regulatory decisions, such as I have cited herein, have already established the duty to always act in a customer’s “best interests.” I have yet to see one story addressing the failure of the current SEC commissioners to respect and enforce such decisions in order to protect the public in accordance with the SEC’s mission statement.

It’s time to hold the SEC and FINRA accountable for failing to recognize and enforce the “best interests” standard established by its enforcement decisions and provide the public with the protection they deserve.

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Robo-advisors: Much Ado About Nothing?

Posted on January 29, 2015 by jwatkins

I just finished reading an article about a recent debate between noted financial advisor Ric Edelman and Adam Nash, CEO of robo-advisor Wealthfront. Interestingly, Edelman suggested that robo-advisors would put many financial advisors out of business.

My position is simple. If you are truly a wealth manage, providing more than just asset allocation/money management services, you should not have a reason to worry. The high net worth sector needs, and wants, more than just money management services. Studies have consistently shown that the HNW sector wants integrated wealth management, including wealth preservation services such as estate planning, asset protection and retirement distribution planning. That’s one of the main reasons I hold myself out as a wealth preservation attorney, as I offer that package of services.

If you hold yourself as a wealth manager, but only provide portfolio management services, then you may have reason to worry. If robo-advisors can prove that they provide meaningful and consistent money management services at a significantly lower rate, then they may in fact have created a better mousetrap for those who only need such services.

Just as the bear market of 2008 was a true test for many financial advisors, I think the true test of the robo-advisors will be when the market encounters it next significant downturn, or “black swan.” Given the length of the current bull market, the recent volatility in the markets, and the suggestion of a pending increase in interest rates, that test may be sooner than later.

I’m not sure what algorithms and concepts robo-advisors use, but the fact that they are computer driven means the potential for “garbage in, garbage out” issues remains real. The same issues that plague current commercial asset allocation/portfolio optimization software programs may well affect robo-advisors.

One of the services that I provide is a forensic analysis of computer prepared asset allocation/portfolio optimization reports. During one of my former positions, we worked with a well-known company to create a proprietary asset allocation program for the company. Based on what I learned during that time, I realized that such programs will always have an inherent instability and a propensity to often make recommendations that are either counter-intuitive at best, or simply flat out improper.

When I prepare a forensic analysis, I use four proprietary metrics, including the Active Management Value Ratio™, which I have made publicly available through posts on this web site. But in many cases, one does not need metrics to detect errors in asset allocation/portfolio optimization recommendation.

One of the best cases of this was a situation where a widow had a plan prepared. One of the questions on a questionnaire she was asked to complete asked if she had a need for current income. She properly marked “no,” as her current portfolio provided a nice stream of income. However, the computer program misunderstood her answer and essentially recommended that she significantly increase her holdings in growth-oriented equity mutual funds with little or no income. Fortunately, I was able to point out these problems to the widow and her attorney before any changes were made to her portfolio.

So, I am suggesting that financial advisors may take advantage of the robo-advisor buzz and offer to review the robo-advisors recommendations and performance and use it as a marketing opportunity. I know a couple of financial advisors who have already offered such services to former clients for free in hopes of demonstrating the worth of their services in comparison to robo-advisors. Since most robo-advisors are offering their services at significantly reduced rates, e.g. 25 basis points, the financial advisor will still have to deal with that issue.

The point is that robo-advisors have yet to be time tested, so their true worth is still suspect. Just like so many 401(k) plans that offer investment options that are far from prudent, both in terms of fees and performance, robo-advisors who provide imprudent investment management, albeit at a reduced price, are worthless and clearly not in the best interests of their clients. Only time will tell.

 

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The Fiduciary Standard – It’s “Best Interests,” Not “Like Everyone Else”

Posted on January 5, 2015 by jwatkins

During a recent deposition of an investment adviser, the adviser told me that was doing the exact same thing as everyone else in the  industry and asked me why I was “targeting” him. Not the first time I have heard this argument, nor probably the last time I will hear it.

I do sue investment advisers and stockbrokers on behalf of investor. I also serve as a consultant to RIA firms and show them how to “bulletproof” their practices. This blog is part of my educational efforts for RIA firms.

Fiduciary law is derived from both trust and agency law. The core principle is that a fiduciary must always show undivided loyalty, must always act in the customer’s/client’s “best interests.” Just remember this statement and you should be OK:

Fiduciary law defines loyalty in terms of the customer’s/client’s “best interests,” not in terms of what the financial services industry or other investment professionals are doing.

I remember the old saying, “well, would you jump off the Golden Gate bridge just because everyone else did?” Same concept. I’ll let you in on a little secret – the law is not going to change anytime soon. Focus on a customer’s/client’s best interests, not what everyone else is doing.

What securities attorneys now realize is that through the use of forensic analysis and tools such my metric, the Active Management Value Ratio™, it is becoming much easier to document both fiduciary prudence and the lack thereof. Therefo0re, it is incumbent on prudent investment advisers and financial advisers to learn and use the same tools and processes in order to protect their practices and better serve their clients.

Stockbrokers who think they are never fiduciaries and can do whatever they want might be interested in the following quotes:

The suitability requirement that a broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his or her interests ahead of the customer’s interests. (from “FINRA Regulatory Notice 12-25)

As we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests. (Wendell D. Belden enforcement decision)

In interpreting the suitability rule, we have stated that a [broker’s] ‘recommendations must be consistent with his customer’s best interests. (Scott Epstein enforcement decision)

Brokers should also be aware that the courts are showing an increased willingness to impose a fiduciary standard on brokers when customers lack the knowledge and/or experience to independently evaluate their broker’s recommendations. I would suggest that this could potentially cover a third to a half of brokerage accounts. Therefore, both investment advisers and stockbrokers wo0uld do well to remember the following:

Fiduciary law defines loyalty in terms of the customer’s/client’s “best interests,” not in terms of what the financial services industry or other investment professionals are doing.

 

 

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Whoomp, There It is! – The New Prudent Fee Fiduciary Standard

Posted on December 18, 2014 by jwatkins

“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 were more than 200 percent higher than those comparable funds'”.

With those words the United States District Court for Southern District of New York, provided the long-anticipated introduction, or more specifically the judicial verification, of Vanguard’s funds’ fees as a comparative basis for assessing excessive of fund fees was established. While the case is not binding on other courts, the rationale used by the court is persuasive and will undoubtedly be referenced by plaintiffs’ attorneys in both 401(k) and other cases where breach of fiduciary issues involving fee issues are involved.

The case involved is Marya J. Leber, et al. v. The Citigroup 401(k) Plan Investment Committee et. al., otherwise known as the Citigroup 401(k) action. The court’s decision is yet another in the continuing pro-plan participant decision s that have been handed down since the Supreme Court’s LaRue decision, recognizing that plan participant’s bear the risk in defined contribution pension plans.

More importantly, the court’s decision provides further support for the relevance of intrinsic costs and returns in analyzing both investment recommendations made by financial advisors and investment options offered by 401(k) plans and other retirement plans. I introduced a proprietary metric, the Active Management Value Ratio™ (AMVR™), as a means of assessing the prudence of actively managed investment products. The AMVR™ is a simple, straightforward metric that requires nothing more than simple subtraction and division. By using the incremental costs and incremental returns of an investment in the calculation process, the AMVR™ provides a truer evaluation of an investments benefits, or lack thereof.

Investment advisers and investment adviser representatives are fiduciaries by law. Many stockbrokers have told me that they do not have to worry about fiduciary issues since they do not manage customer accounts on a fiduciary basis and the law clearly states that a broker does not have any fiduciary duties with regard to non-discretionary customer accounts.

Those same brokers are surprised when I tell them about the cases of Follansbee v. Davis, Skaggs & Co. Inc. and Carras v. Burns. In both cases, the courts ruled that a broker can be held to owe a fiduciary to their customers, even in cases involving purely non-discretionary accounts. As the Follansbee court stated

The touchstone is whether or not the customer had sufficient intelligence and understanding to evaluate [a broker’s recommendations] and to reject one when he thinks it unsuitable.

The Carras court reiterated the Follansbee standard, stating 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.

As a result, I would suggest that broker’s may face imposition of a fiduciary standard more often than they believe. Therefore, all financial advisers, might find it beneficial to consider the impact of the Citigroup decision and the usefulness of the AMVR™ in both providing valuable services to their clients while reducing unwanted  and unnecessary liability exposure.

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Citigroup Decision’s Warning for 401(k) Fiduciaries

Posted on October 23, 2014 by jwatkins

U.S. District Judge Sidney H. Stein recently ruled that the participants in the Citigroup 401(k) excessive fees case had filed their action within the required time period. Judge Stein’s opinion was based primarily on a finding that absent “actual knowledge” of a fiduciary breach,” the time period for filing is six years after a fiduciary’s breach.

As an attorney, I always want to read the actual decision in a case. Judge Stein’s discussion of what is required for “actual knowledge of a fiduciary’s breach is what 401(k) fiduciaries and plan sponsors should review.

The main issue in the Citigroup case is the decision to replace ten funds in the Citigroup plan with other funds, including three Citigroup affiliated funds. As the court noted, the Citigroup funds all “charged higher fees and performed less well  than comparable unaffiliated funds.”

Citing Caputo v. Pfizer, the court stated that

[A] plaintiff has ‘actual knowledge of the breach or violation’ within the meaning of [the statute] when he has knowledge of all material facts necessary to understand that an ERISA fiduciary has breached his or her duty or otherwise violated the Act…one of ‘facts necessary to constitute [the] claim.

The court rejected Citigroup’s argument that by providing plan participants with documents disclosing both the affiliated funds’ fee and the fact that the funds’ affiliated status, the participants’ had actual notice of any breach of fiduciary duties.  In evaluating “actual knowledge” with regard to excessive fees, the court stated that

to demonstrate plaintiff’s actual knowledge of the breach. defendant must show either that plaintiffs possessed, through Plan communications or otherwise, comparisons of the Affiliated funds to the alternatives or knew in some way that the fees were excessive.

The court noted that Citigroup had not even attempted to offer any evidence that the plan participants had been provided with or possessed the necessary fee data Without such data, the court held that the plan participants “could not have known that the fees were excessive, and thus a basis for an ERISA claim.”

After reviewing the court’s decision, two points came immediately to mind. First, few, if any, 401(k) plans provide the type of fee comparison data mandated by the court’s decision. The court seems to suggest that the required fee comparison data includes comparison data on both the unaffiliated funds with a plan, but also on comparable alternative funds with similar types of assets and equivalent performance available in the marketplace.

Essential to the plausibility of plaintiff’s 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.’

There are going to be very few actively managed retirement funds that can match Vanguard’s low fee structure. Furthermore, my experience with forensic investment analysis has shown that only about fifty percent of actively managed funds provide investors with any incremental benefit at all. Even in cases when a fund provides investors with any incremental benefit, the incremental costs incurred far exceed the incremental benefit provided, raising obvious fiduciary issues.

I am a member of the Paladin Registry. I recently posted an article on the issue of retirement funds having various fee options, including various 12b-1 fee payouts. Now I realize that in some cases the higher fees reflect the costs of various 401(k) services. When people responded to point this out, even they admitted that despite new requirements for greater transparency in fee reporting, most mutual funds and service providers do not provide plan participants and,  in some cases, plan sponsors and fiduciaries with a proper breakdown to allow for an accurate evaluation of plan management fees. The reference to 12b-1 fees is especially troublesome, as ERISA prohibits such payments from third parties to those serving as consultants to pension plans.

The second point that came to mind was the court’s discussion of the requirements for “actual  knowledge,” more specifically the requirement that participants had to know “all facts necessary to constitute a claim.” As many people know, I have long been a proponent of requiring that plans provide plan participants with correlation of return data for each of the investment options within a plan.

ERISA does not currently require disclosure of such information. However, such information is obviously material to the goals of ERISA, providing plan participants with “sufficient information to make informed investment decisions” and to ensure that participants “are afforded a reasonable opportunity to materially affect the potential risk and return on amounts in their accounts…” Without such information, plan participants cannot effectively provide the downside protection that their portfolios need to protect against significant investment losses, a stated goal of ERISA.

The importance of correlation of return data is reinforced by the fat that both the Department of Labor and the courts have clearly and consistently stated that Modern Portfolio (MPT) is the applicable standard in determining whether a fiduciary has acted prudently. The cornerstone of MPT…factoring in the correlation of returns among investments options as part of the portfolio construction process.

If both the Department of Labor and the courts consider correlation of returns data to be material information with regard to an ERISA fiduciary’s duty of prudence, and “actual knowledge” requires “knowledge of all material facts necessary to understand that an ERISA fiduciary has breached his or her duty or otherwise violated the act….[knowledge] of all facts necessary to constitute a claim,” then it can be argued that the failure to provide plan participants with fee comparison data and/or correlation of return data constitutes a continuing breach of fiduciary duty by an ERISA plan sponsor and plan fiduciary, effectively preventing the application of the “actual knowledge” three-year statute of limitations.

The Citigroup decision represents the continuing trend of courts to recognize the need to protect 401(k) participants from the pre-Larue abusive practices that denied plan participants the protection guaranteed by ERISA. The sooner that plan sponsors and other plan fiduciaries realize that “a pure heart and an empty head” are no defense to ERISA breach of fiduciary claims, the better for both plan participants and plan sponsors and fiduciaries.

Note: You can review the entire Citigroup decision at http://www.planadviser.com/uploadedFiles/LebervCitigroup.pdf

 

 

 

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Three Investment Adviser Fiduciary Traps to Avoid

Posted on September 30, 2014 by jwatkins

My last post advising advisers not to prepare and distribute financial plans resulted in several emails, some nice, some not so nice. With over nineteen years of experience in RIA law, both as a director of RIA compliance for FSC Securities and an RIA consultant, I stand by my earlier post.

It seems that nowadays there are RIA consultants everywhere, some good, some not so good. A test I often offer to those who ask how to evaluate an RIA compliance consultant is to ask the prospective consultant to explain what the SEC’s position is with regard to non-cash payments for client referrals and the name of the actual decision addressing same. Here’s a hint, most RIAs are in violation of the SEC’s decision and the ’40 Act.

Most of the people holding themselves as RIA compliance consultants only address the registration aspects of RIAs – the Form ADV and the related books and manuals. I like to address the liability aspects of RIA law, as far too often that is overlooked and/or ignored. As I tell RIA firms, the firm, the firm can have all the required manuals and files, but all that is meaningless if the firm has not set up an effective risk management program for the firm itself.

In my last post I addressed the liability issues that I have seen with regard to financial plans. In short, the commercial software programs are often unstable and often produce advice that is not only counter-intuitive, but flat out wrong.

From a liability standpoint, it’s like shooting fish in a barrel. I had several emails telling me that all an RIA has to do is include disclaimer language in the plan to protect the planner. Really, you’re charging some hundreds or thousands of dollars and you’re going to include disclaimer language saying, essentially, this may be totally worthless and, if so, we are not liable. Here’s some free legal advice – if that’s your defense, bring your checkbook with you to the arbitration hearing.

Along those same lines, I advise my RIA consulting clients not to include any binding arbitration requirement in their client advisory contracts. While these arbitration agreements are standard in most broker-dealer client agreements, there is increasing pressure to prohibit such requirements going forward.

RIA firms and their representatives are held to a fiduciary standard by law. Therefore, the firms and their representatives are required to always act in the best interests of their clients, to always put a client’s interests first. Requiring an advisory client to waive an important legal right, the right to a jury trial, is clearly not in a client’s best interests. The arbitration process mandated by the securities industry has long been the subject of serious criticism, and rightly so.

While the process has improved somewhat by the recent decision to allow clients to opt for an all-public hearing panel, there are still genuine and serious shortcomings with the securities arbitration process. Therefore, requiring an advisory to submit to such a process can be seen as a breach of the fiduciary duty of loyalty by an RIA firm.

Finally, there is the issue of variable and indexed annuities. Two primary duties of a fiduciary are first, to always act in the best interests of a client (the duty of loyalty), to always put their interests first, and second, to avoid excessive and unnecessary fees and costs, (the duty of prudence). Variable annuities and indexed annuities fail on both accounts.

Most variable annuities calculate their annual M&E fee on the accumulated value of the variable annuity rather than the cost of their potential liability. commonly referred to as “inverse pricing.” Since most variable annuities limit their liability exposure to the owner’s actual contributions to the annuity, it is easy to see situations where the accumulated value of the variable annuity far exceed the own actual contributions. Therefore, basing the annual M&E fee on accumulated value rather than the variable annuity issuer’s actual legal liability results in both an unmerited and inequitable windfall for the variable issuer at the annuity owner’s expense, as well as a clear breach of a fiduciary’s duties of loyalty and prudence.

Even insurance executives are admitting the inequitable nature of the inverse pricing system used by variable annuity issuers. John D. Johns, Chairman and CEO of Protective Life Corporation noted the need for change from inverse pricing with regard to variable annuity in his article, “The Case for Change,” in the September 2004 issue of Financial Planning magazine.

What’s more, the price charged is significantly higher than the value of the actual benefit conveyed. A noteworthy study by Moshe Milevsky and Steven Posner, “The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities,” concluded that variable annuity issuers were charging variable annuity owners a fee that was anywhere from 5 to 10 times the actual economic value of the death benefit. actual The study is available at http://www.yorku.ca/faculty/academic/milevsky/.

So variable annuities are charging fees that are inequitable both in terms their legal obligations to annuity owners and in terms of the actual value of the benefit conveyed. Since each additional 1 percent of fees and costs reduce an investor’s end return by approximately 17 percent over twenty years, these practices and the windfall that they provide for variable annuity issuers clearly violate a fiduciary’s duties of loyalty and prudence.

Indexed annuities are actually fixed-income products, not investments. The confusion is often due to the fact that indexed annuities base their interest rates on the return of a stock market index, such as the S&P 500 Index.

That’s the way indexed annuities are marketed, but the rate of interest an investor earns is usually significantly lower than the index’s actual return. Index annuity issuers often limit an investor’s return by applying so-called cap rates and participation rates.

For example, lets assume that the index used by an index annuity issuer earns 20 percent in one year. Let’s also assume that the indexed annuity issuer applies a maximum rate cap of 10 percent and a participation rate of 70 percent. In this scenario, despite the fact that the applicable index earned 20 percent, the indexed annuity issuer would only receive a return based on 7 percent (10 percent times 0.70 percent).

Most investors, especially the elderly, do not understand such marketing shenanigans. The courts have recognized these issues and have increasingly imposed fiduciary duties on brokers and advisers, even for non-discretionary accounts, when the court determines that an investor lacked the knowledge and/or experience to independently evaluate a broker’s recommendations. Legal decisions such as Carras v. Burns and Follansbee v. Merrill Lynch are two cases illustrating this new pro-investor position of the courts. Where courts impose fiduciary obligations to protect investors, they may also impose both compensatory and punitive damages for violations of such fiduciary duties.

I get email asking me why I even write this blog, saying that most people will simply ignore the advice provided. I realize that that is probably true, but I also realize that there are some who do value my advice and realize I am only trying to help them protect their practices. Hopefully prudent investment advisers will consider the advice provided and the spirit in which it is offered.

Selah.

 

 

 

 

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