“Piddle, Twiddle and Resolve”

Posted on June 29, 2013 by jwatkins

I just finished Bob Clark’s excellent article, “Dear SEC Chairwoman: About That Pesky Fiduciary Issue…” (http://www.advisorone.com/2013/06/28/dear-sec-chairwoman-about-that-pesky-fiduciary-iss). In the article, Mr. Clark suggests that the SEC be reminded of various statements listed on its web page, including its mission statement to help protect investors.

While I totally agree with Mr. Clark’s suggestions and sentiments, whenever I think of the ongoing attempts by Congress and the SEC to block a meaningful fiduciary standard to protect the public against the proven abuses in the financial services industry, I cannot help but think of John Adams’ lament in the play “1776” – “piddle, twiddle and resolve, not a damned thing do we solve.” What makes all of the stonewalling by the SEC and Congress even more amusing is that FINRA, the SRO for the financial services industry, has already clearly stated that brokers already have a legal duty to always put a customer’s best interests first, especially with regard to financial interests.

  • “As we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests.” (1)
  • “the suitability rule and the concept that a broker’s recommendations must be consistent with the customer’s best interests are inextricable intertwined.” (2)
  • “The suitability requirement that a broker make those recommendations that are consistent with the customer’s best interests prohibit a broker from placing his or her interests ahead of the customer’s interests.” (3)
  • “A broker’s recommendations must serve his client’s best interests…” (4)
  • A broker violates the suitability rule “when he put[s] how own self-interest ahead of the interests of his customer.” (5)

Sound familiar? In fact, when FINRA released Regulatory Notice 11-02, the similarity of the “best interests” language for ERISA fiduciaries was immediately noticed by the legal community. FINRA subsequently released Regulatory Notices 11-25 and 12-25 to address the questions and concerns over the “best interests.” FINRA responded by saying that “best interests” language had always been the applicable standard for brokers, citing several enforcement decisions in support of their position.

So despite cries by Congress and the SEC of the need for harmony, by blocking a universal fiduciary standard that requires brokers to always act in a customer’s “best interests,” Congress and the SEC are actually preventing such harmony. Furthermore, since brokers and broker-dealers are already operating under such a standard and seem to be doing so without  extreme financial hardship, the arguments for a need for cost-benefit analyses are clearly disingenuous, but we already knew that.

Bottom line, the stonewalling by the SEC and Congress is not going to prevent investors from successfully litigating their actions against such brokers and their broker-dealers since FINRA rules are admissible to show the requisite industry standard of conduct. The stonewalling simply shows that the SEC has no desire or intent to protect the public and that author P.J. O’Rourke was right about Congress in his epic, “Parliament of Whores.”

I realize that few brokers, and even some compliance officers,  take the time to review the notices put out by FINRA and/or the SEC. I review these for my RIA compliance clients to make sure they are up-to-date with the current issues and standards. The reviews can prove to be very valuable.

One of the emerging issues in connection with the prudence and suitability of investment advice centers on the issue of mutual fund fees and expenses. Industry leaders Charles Ellis and Burton Malkiel have recently authored articles arguing that fund fees are, in fact, extremely high when evaluated on the basis of incremental return.

I created a proprietary metric, the Active Management Value Ratio (AMVR), which allows investors and fiduciaries to quantify the prudence of a mutual fund’s fee by performing a simple cost-benefit analysis. A number of brokers have responded to my posts regarding fees and the AMVR, saying performance is the only consideration that matters.

Brokers should remember that the regulators regularly review online sites for signs that brokers may be acting in violation of the law. A review of NASD Notice to Members 95-80 reminds members that a fund’s expense ratio and sales charge are factors in determining whether a fund is suitable for an investor. Using the AMVR, my experience has been that the incremental fees for many actively managed greatly exceed the incremental benefit provided by the fund, often by as much as 300-400 percent.  Hard to justify an investment in such as fund as either prudent or as one in the “best interests” of a customer.

“Living is easy with eyes closed, Misunderstanding all you see.” As I have argued herein, those lines from the Beatles classic, “Strawberry Fields Forever ,” are applicable to the current fiduciary debate. Others have argued that the current situation is more a case of financially induced conscious indifference.

I am an advocate of a universal fiduciary standard, as it simply codifies what the rules are and will help prevent the confusion over legal obligations that was revealed in the Rand Corporation study that the SEC’s sponsored. Legally, I know that can usually have a fiduciary standard imposed on a broker by using FINRA’s rules and enforcement decisions, as well as precedent established by legal decisions such as Follansbee or Carras.

When I try a case, opposing counsel and the court know that 99 percent of the time I am going to use the quote by the late General Norman Schwarzkopf to challenge the jury. General Schwarzkopf said “[t]he truth of the matter is that you always know the right thing to do. The hard part is doing it.” The SEC and Congress can make all the disingenuous statements and throw up all the smokescreens that they want, but they know the truth and what the right thing to do is. The question is whether they have the courage and integrity to do the right thing?

Notes

(1) In the Matter of Wendell D. Belden, Exchange Act Release No. 34-47859 (May 14, 2003); In the Matter of Dane S. Faber, Exchange Act Release No. 34-49216 (February 10, 2004)
(2) FINRA Regulatory Notice 12-25, Question No. 1
(3) Ibid.
(4) Dept. of Enforcement v. Bendetsen, 2004 NASD Discip. LEXIS, 13, at *12 (NAC August 9, 2004)
(5) In the Matter of Scott Epstein, Exchange Act Release No. 34-54722 (November 8, 2006)

© Copyright 2013 InvestSense, LLC. All rights reserved.

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

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New “Barron’s Advisor” List-Potential Compliance and Fiduciary Issues

Posted on May 29, 2013 by jwatkins

Barron’s recently released a new list, the “Barron’s Advisor” list. While advisors obviously enjoy being placed on such “top” or “best” lists, Barron’s list raises various issues that can serve as a lesson in addressing potential compliance and fiduciary issues due to the questionable criteria used in the evaluation process and the requirement that advisers pay to be placed on the list.

As a securities attorney, an RIA consultant and a former RIA compliance director, I always view such “best” lists with skepticism. The people on Barron’s new list may be the best financial advisors in the country. However, the criteria that Barron’s claims is not client-centric and therefore is highly questionable in evaluating the skills or performance of the advisors on the list.

Barron’s justifies its list “based on hard numbers: an advisor’s assets under management and annual revenue generated, as well as the length of time in the business, client retention,  and philanthropic work.  None of these criteria translate into truly reliable indicators of a financial advisors skill as a financial advisor.

  • Assets under management and annual revenues may indicate marketing skill, but simply does not necessarily reflect the skills or abilities of a financial advisor. Furthermore, has Barron;’s actually verified an advisor’s representations regarding assets under management and annual revenue.  Recent FINRA notices have addressed the problem of misrepresentation of assets under management;
  • Length of time in the business addresses longevity, but longevity does not necessarily reflect the skills or abilities of a financial advisor, as evidenced by the recent conviction of industry leader Matthew Hutcheson for securities violations;
  • Client retention could be based on client satisfaction, or based on my legal experience, it could also be based on a client not really understanding or being aware of a financial advisor’s actual activity. I use a proprietary metric, the Active Management Value Ratio, to assess the cost effectiveness of an investment and a financial advisor’ recommendations.  Approximately 75 percent of my analyses indicate investments and/or advice that is not cost effective for the investor. In many cases I find situations where the relative cost of the investment or recommendation greatly exceeds the relative benefit by as much as 300-400 percent;
  • Philanthropic work simply makes no sense as a criteria for the skills and abilities of a financial advisor.

The new Barron’s list does include a new disclosure – that advisors must pay a fee to be included on the list. Barron’s assures the public “that the fee has no effect on [an advisor’s] in ranking or continued placement on the list.” Right. Hopefully Barron’s will understand those who view such statement with skepticism, as it sounds like something we have heard repeatedly coming out of Washington.

I have been reading Barron’s for almost forty years and consider it a valuable resource. At the same, as an attorney and RIA compliance consultant, these lists are extremely troubling, as they are arguably based more on marketing skills rather than client-centric criteria, as well a new “pay-for-play” requirement that, despite Barron’s claim to the contrary, raises valid questions as to the legitimacy and value of the list.

Advisors on Barron’s new list and advisors in general should review a no-action letter that the SEC issued in connection with third-party ratings lists. The no-action letter lists various criteria that an advisor should consider before using such rating lists in marketing their practice.  The letter can be found at http://www.sec.gov/divisions/investment/noaction/ iaa120205.htm.

Despute Barron’s claim that the required payment by an advisor doesnot influene the evaluation process, I have advised my RIA consulting clients that any rating program tht requires such payments to be included on a list raise compliance and fiduciary concerns. The no-action letter lists various issues that must be addressed and conditions that must be satisfied. Any use of such ratings in marketing or otherwise would always need to include a full disclosure of such “pay-to-play”requirement be disclosed, as such payments would arguably constitute material information that a client should be aware of.

Given the fact that the criteria used by Barron’s is more marketing oriented than client oriented, the no-action letter would suggest that this information would also need to be disclosed in connection with an advisor’s use of such rating in order to avoid possible claims of misleading a client.

Financial advisors, investment advisers, and other investment professionals should always consult with their compliance departments and/or legal counsel to ensure compliance with all applicable laws and regulations.

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Upon Further Review: Do We Already Have a Universal Fiduciary Standard?

Posted on May 12, 2013 by jwatkins

The debate over a universal fiduciary standard for the financial services industry continues.  To date, as John Adams lamented in “1776,” “piddle. twiddle and resolve, not a damned thing do we solve.”

Several studies have conclusively shown that the American public is confused over what duties various financial professionals owe the public. Both the Department of Labor and the Securities and Exchange Commission have stated that they are studying the issue. The Department of Labor actually released one version of a universal fiduciary standard, but withdrew the proposal.

The Department is reportedly set to release a new proposed fiduciary sometime around the middle of the year.  Given the tendency of the Securities and Exchange Commission to engage in partisan politics and protect the securities industry rather than protect the public, the best bet for any type of meaningful fiduciary standards is probably the Department of Labor.

Through all the debate and posturing over a universal fiduciary standard, one simple question remains – What is so onerous, so unfair, about requiring that anyone that provides financial or investment advice to the public must always put the public’s interest ahead of their own financial interests?

Opponents of such a requirement have argued that the requirement would prohibit sales of investment products, which would thereby increase the cost of financial advice to the public. A Congressional caucus actually came out and made this argument.

This argument is disingenuous at best. A universal fiduciary standard could still allow the sale of investment products as long as such products were fair and such sales were always in the customers best interests. The Department of Labor has already indicated that their new fiduciary proposal will allow such activity. But is that really the sticking point, or is it the fact that the fiduciary standard would require every financial adviser to always act in a  customer’s best interests instead of acting first and foremost to promote the adviser’s financial interests?

Is this whole debate over a universal fiduciary standard actually a moot point? While I am a staunch advocate for a clear, unmistakable universal fiduciary standard so that there is no question about the duties every financial adviser owes a customer, I would suggest that anyone who provides financial and investment advice to the public is subject to the fiduciary standards.

There are basically four ways that an adviser acquires fiduciary status: by contract or express agreement; by state common laws and/or federal regulations; by control over a discretionary account; and by having de facto control over a non-discretionary account.  While the first three methods are fairly obvious, the fourth method is a method that many financial advisors may not be familiar with.

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 has 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.

Registered investment advisers and their representatives are fiduciaries.  Those holding themselves out as financial planners and/or offering to provide financial planning services to the public are fiduciaries. Stockbrokers who manage customer accounts on a discretionary basis are fiduciaries.  The argument has always centered on the applicable standard for stockbrokers involved with non-discretionary customer accounts.

And yet, an argument can be made that the new suitability rule, FINRA Rule 2111, all stockbrokers must adhere to the fiduciary standards and always put their customers’ best interests first ahead of their own financial interests. Rule 2111 was introduced in FINRA Regulatory Notice 11-02, with subsequent notices of guidance in FINRA Regulatory Notice 11-25 and FINRA Regulatory Notice 12-25.

While Rule 2111 was designated as a rule on suitability, many readers took particular notice of footnote 11. Footnote 11 is significant in that it referenced previous enforcement and disciplinary proceedings which addressed a stockbroker’s duties in terms of a customer’s “best interests,” more specifically that “a broker’s recommendations must be consistent with the customer’s best interests” and “a broker’s recommendations must serve his client’s best interests.”(3)

The references to a customer’s “best interests” raised immediate questions among many given its similarity to the fiduciary duty of loyalty set out in both the Restatement of Trusts and the Employees’ Retirement Income Security Act (ERISA).  The current debate over a universal fiduciary standard is due in large part over the fact that the “suitability” so often referred to as the applicable standard for stockbroker does not require that recommendations provided to customers necessarily be in their “best interests.”

To its credit, FINRA did not backtrack from its position that broker’s recommendation have to be in a customer’s best interests.  FINRA responded by noting that the position had been clearly stated in numerous cases and that the “best interests” requirement  “prohibits a broker from placing his or her interests ahead of the broker’s interests.”(4)

You make your own decision, but the prohibition against the broker putting his or her interests before those of a customer sound very familiar to language requiring that a ERISA fiduciary always put a client’s interests first, with “an eye single to the interests of the participants and the beneficiaries,”(5) with ERISA’s requirement that a fiduciary act “solely and exclusively” for the benefit of the plan’s participants and beneficiaries(6) , and the Restatement of Trusts’ requirement, in compliance with the fiduciary duty of loyalty, that a fiduciary act solely in the interests of the beneficiaries.(7)

The Department of Labor has indicated that they modify the fiduciary duties to allow for sales of investment products, which would not otherwise be allowed under common fiduciary guidelines. I personally have no problem with allowing such an exception as long as any such sales could be proven to be consistent with the requirements that such sales are primarily in the customer’s best interests both in terms of risk management and cost efficiency.  There should be no valid argument such a requirement, as FINRA, by virtue of Rule 2111 has indicated that such a requirement already exists for brokers.

So the common argument against a universal fiduciary standard, namely that it would result in higher costs for customer’s, makes no sense since requiring all stockbrokers to put a customer’s interests first is already the applicable standard. Enacting a universal fiduciary standard would simply be a codification of the applicable standard for both registered investment advisers, brokers and anyone else purporting to provide investment advice to the public.

From the public’s perspective, a universal fiduciary standard would eliminate the confusion which obviously exists regarding what duties are owed by one’s financial/investment adviser and better protect the public in their dealings with investment professionals, both of which are consistent with the mission statements of both the Department of Labor and the Securities and Exchange Commission.

So, in response to my original question, there is nothing onerous or unfair about requiring that anyone that provides financial or investment advice to the public must always put the public’s interest ahead of their own financial interests? In fact, that is actually the current standard for both registered investment advisers and stockbrokers.

So if either the Department of Labor and/or the Securities and Exchange Commission refuse to adopt a universal fiduciary standard in order to better protect the public, the public has a right to know the true reason for not doing so. Americans are getting tired of the continuous cover-ups and misinformation, the partisan politics that deny the public the protection they need.

As the court recognized in Archer v. Securities and Exchange Commission,

[t]he business of trading in securities is one in which opportunities for dishonesty are of constant recurrence and ever present. It engages acute, active minds trained to quick apprehension, decision and action. The Congress has seen  fit to regulate this business.(8)

The mission statements of both the Department of Labor and the Securities and Exchange Commission recognize a similar duty to protect the public with regard to investment related activities that impact investors and employees.  Therefore, the failure of either agency to pass a universal fiduciary standard in order to provide the public with a simple, yet meaningful, expression of their rights and protections in their dealings with financial/investment advisers will be yet another in a growing list of government breaches of the public’s trust.

© Copyright 2013 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. 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. http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p122778.pdf

4. http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p126431.pdf

5. DiFelice v. U.S. Airways, 497 F.3d 410 (4th Cir. 2007)

6. 29 U.S.C.A. Sections 1104(a)(1), (a)(1)(A)(i), and (a)(1)(A)(ii)

7. Restatement (Third) Trusts, Section 78 (Duty of Loyalty)

8. Archer v. Securities and Exchange Commission, 133 F.2d 795, 803 (8th Cir. 1943)

Posted in 401k, 401k compliance, 404c, 404c compliance, compliance, fiduciary compliance, fiduciary law, investments, retirement plans, securities compliance | Tagged , , , , , , , , , , , | 2 Comments

How “Safe” Are ERISA 401(k)/404(c) Safe-Harbors?

Posted on April 17, 2013 by jwatkins

Like so many others, I provide consulting services to pension plans. Unlike others, I focus on the risk management aspect of pension plans instead of the fundamental, or administrative, aspects of a plan.  I chose to focus on the risk management aspects of pension plans due to my securities background.

Bottom line, pension plans generally do a terrible job with regard to the risk management aspect of their plans.  In most cases, pensions plans would have a hard time successfully defending a claim by plan participants.

In my opinion, this liability exposure is due in large part to a misunderstanding regarding the protections offered by ERISA’s 401(k)/404(c) so-called safe-harbors. It has been my experience that plan sponsors confronted with potential liability claims immediately claim that they are absolutely immune from any liability due to said safe-harbors. The mood quickly changes when the truth about 401(k)/404(c) safe harbors is explained.

Over the past decade we have seen more pension plans opt to designate their plans as 404(c) plans in an effort to reduce the plan’s risk exposure and shift more liability to plan participants. However, in order to obtain the desired risk protection, plans must comply with all of the various requirements set our in Section 404(c) of ERISA.

I consider Fred Reish to be the foremost authority on ERISA plans. Mr. Reish has been quoted as saying that while “[t]he vast majority of plans believe that they are 404(c) compliant,…,very few of them satisfy all of the 404(c) requirements.”(1) Consequently, plan sponsors and other plan fiduciaries face potential liability to plan participants in connection with the plan’s investment options.

Even if a plan were able to comply with all of the 404(c) requirements, the courts and the Department of Labor have made it very clear that 404(c) does not protect plan sponsors from breach of fiduciary claims by participants based on allegations of imprudent selection of investments:

“The DOL has taken a clear position that Section 404(c) does not shield plan sponsors      from liability for claims of imprudent selection of plan investment options. The DOL has emphasized that a fiduciary has a continuing duty to monitor the prudence of investment options in a plan regardless of the scope of a participant’s control.”(2)

In my last post, I discussed some of the implications of the recent Tibble decision, some of which involve safe-harbor issues. The Tibble decision stated that plan sponsors cannot blindly rely on third-party advice and that the duty of a plan sponsor to conduct a thorough, independent and unbiased investigation and evaluation of investment options goes to the heart of the plan sponsor’s fiduciary duty of prudence.

I have always found it interesting that plan sponsors often hire experts to evaluate potential plan investment options because the plan sponsor properly realizes that they do not have the training or experience to evaluate the investment options themselves. Yet, in order to fulfill, their duty of prudence, they must continue to monitor and evaluate the ongoing prudence of the investments. In too many cases this is simply an accident waiting to happen.

One of the 404(c) requirements is that plan participants be provided with sufficient investment options to allow them to minimize the risk of large losses. On more than one occasion I have had plan sponsors attempt to justify their plan’s mix of investment options on the basis of Modern Portfolio Theory (MPT). In many cases they are quick to let me know they worked with their plan provider in using MPT and then suggest that I should study MPT.

Trust me, I understand MPT, including Markowitz’s little known warning to fiduciaries and advisers at the bottom of page vi and the top of page vii.  I am fully aware “that modern portfolio theory has been adopted in the investment community and, for the purposes of ERISA, by the Department of Labor.”(3)

Plan sponsors and other fiduciaries who intend to rely on MPT in justifying their plan’s mix of investment alternatives should review the DiFelice decision, which dealt directly with the implications of MPT and fiduciary duties. The Court rejected the notion that based on MPT, there were sufficient funds that a participant “may or may not” choose to create a prudent portfolio, stating that

“Standing alone, [MPT] cannot provide a defense to the claimed breach of the “prudent man” duties here. ‘Under ERISA, the prudence of investments or classes of investment offered by a plan must be judged individually….That is, a fiduciary must initially determine, and continue to monitor, the prudence of each investment option available to plan participants. Here the relevant “portfolio” that must be prudent is each available Fund considered on its own,…,not the full menu of Plan Funds. This is so because a fiduciary cannot free himself from his duty to act as a prudent man simply by arguing that other funds, which individuals may or may not elect to combine with [other investment options], could theoretically, in combination, create  a prudent portfolio…. This result would be perverse in light of the Department of Labor’s direction that selection of prudent plan options falls within the fiduciary duties of a plan administrator.”(4)

It should be noted that the Court went on to distinguish between a plan creating one ready-made portfolio for participants, where reliance on MPT could be proper, to the more common situation where the plan offers various investment options which possibly could theoretically be combined to create a properly diversified investment portfolio.

There are three consistent themes that run through ERISA – sufficient disclosure of information to plan participants and their beneficiaries, a proper number of investment options so as to allow participants to minimize potential investment risk, and proper control of investment costs and other expenses. Any hope of qualifying for the protection of a “safe-harbor” must properly address these key themes.

With regard to both the disclosure and the diversification requirements, I have previously posted an article addressing what I consider to be a common deficiency in 401(k)/404(c) disclosures, the lack of information being provided to participants regarding the correlation of returns between a plan’s investment options.  In my article, “A Curious Paradox,” I address the fact that while the  courts and the DOL have adopted MPT, the cornerstone of which is the consideration of the correlation of returns among investments, there is no requirement that plan participants be provided with such information. As a result, plan participants may inadvertently put together a portfolio consisting largely, or entirely, of highly correlated investment, thereby failing to provide the participants with the level of downside protection needed to achieve ERISA’s goal of protection from significant losses.

With regard to the cost control issues, my firm, InvestSense, has introduced a proprietary metric, the Active Management Value Ratio (AMVR), and made it freely available to both plan sponsors and plan participants to raise awareness of the cost-inefficiency of many actively managed funds.  While cases have argued against the absolute level of the high expenses ratios of funds within a plan, the true issue that needs to be addressed is the relative cost-benefit of such funds.

Various studies such as Standard & Poor’s Indices Versus Active annual reports show that many actively managed mutual funds fail to outperform similar index funds.  AMVR analyses only strengthen the argument against such actively managed fund by often showing that even on active funds that do manage to outperform similar index funds, the cost of such active management far exceeds the benefit gained, with the relative cost often exceeding the relative benefit by 300-400 percent.

The bottom line for plan sponsors and other plan fiduciaries is that it is difficult to qualify for many of the so-called 401(k)/403(b) safe-harbors and that many who believe that they are 404(c) compliant are not. Furthermore, there is no safe-harbor protection for plan sponsors with regard to their fiduciary duty to select prudent investment options for plan participants and to provide ongoing monitoring of the plan’s investment options to ensure the continued prudence of same.

Plan sponsors can use the AMVR to evaluate the cost-benefit aspect of actively managed mutual funds in their plans, with no cost to the plan. An AMVR analysis on actively managed mutual funds offered within a plan will generally show that the costs associated with such funds far exceed any benefit derived from such funds, raising valid beach of fiduciary claims against a plan and its sponsors. As a Moody Blues fan, I am reminded of the lyric, “there are none so blind, as they who will not see.”

1. Diane Cadrain, “Are you sure you’re 404 compliant? Meeting safe-harbor provisions to minimize liability for  401 losses may be harder than you think,” HR Magazine (September 2004)
2. Kanawi v. Bechtel Corp., 590 F. Supp.2d 1213, 1232 (2008)
3. DiFelice v. U.S. Airways, Inc., 497 F.3d 410, 423-24 (4th Cir. 2007)
4. DiFelice, 423

Posted in 401k, 401k compliance, 401k investments, 404c, 404c compliance, fiduciary compliance, fiduciary law, investments, retirement plans, securities | Tagged , , , , , , , , , , , | 1 Comment

The Tibble Decision – 3 Valuable Lessons for Plan Sponsors and Other Plan Fiduciaries

Posted on March 26, 2013 by jwatkins

Reading the Ninth Circuit’s recent decision in Tibble v. Edison International, I could not help but notice three issues that I believe will significantly impact ERISA plan sponsors and other plan fiduciaries going forward.

First, the Court correctly pointed out that “HFS is [the plan’s] consultant, not the fiduciary.” (page 48) Too many plans make this same mistake and are therefore unknowingly exposed to unnecessary liability. Too many plan sponsors do not take the time to educate themselves on the difference between the various types of ERISA “fiduciaries” and the potential liability implications of each type, both for plans and plan sponsors.

I have written before about the ERISA 3(21) “fiduciary” ruse. Plan sponsors should have all plan documents reviewed by counsel experienced in such matters to avoid becoming yet another victim to this ruse, which involves holding oneself out as a “fiduciary,” then drafting the fiduciary agreement in such a way to basically avoid any fiduciary obligations or liability. By adopting a proactive approach to risk management and properly utilizing available legal resources, plans and plan sponsors can properly protect themselves and avoid costly “lessons.”

Second, the Court stated that “a firm in Edison’s [fiduciary] position cannot reflexively and uncritically adopt investment recommendations.” (page 49) The Court also pointed out that when a retirement plan relies on consultants and experts to help them administer a plan, the plan has an obligation to ensure that such reliance is “reasonably justified under the circumstances.”

In construing whether a plan’s reliance on an expert’s advice is reasonably justified, the courts have stated various requirements, such as “independent,” “impartial,” “unbiased,” “objective,” and “thorough.” As an attorney, I can state that in far too many cases plans and plan sponsors blindly rely on whatever information and advice the service providers provide.

The Court goes on to properly point out that “ERISA’s duty to investigate requires fiduciaries to review the data a consultant gathers, to assess its significance and to supplement it where necessary.” (page 49).  My experience has been that plan sponsors are totally unaware that plans and plan sponsors have a fiduciary duty to conduct an independent and thorough investigation of each investment option being considered by a plan, and that such independent investigation is “at the very heart of [ERISA’s] prudent person standard.”

The courts have consistently held that a fiduciary’s “failure to do [such an] independent investigation and evaluation is a breach of [their] fiduciary standard.” Again, based on my experience as both an ERISA attorney and plan consultant, many plan sponsors either do not conduct the required independent investigation and evaluation at all, or do so improperly.

The final point in the decision that struck me was the ongoing failure of the courts to recognize the true issue with regard to mutual fund fees. Since the primary investment options offered in most retirement plans are mutual funds, the issue of excessive fund fees is, and will continue to be, a hotly contested issue.

In Tibble, the Court stated that “[nor] is the particular expense ratio out of ordinary enough to make the funds imprudent,” with the Court noting that fees ranged from .03 to 2 percent. (pages 42-43) Given the DOL study that stated that each 1 percent in fees reduces a participant’s end return by approximately 17 percent over a twenty year period, a 2 percent fee would cost a participant over 33 percent, or two-thirds, of their end return!

Rather than focus on mutual fund fees in terms of absolute numbers, courts should focus on fees in terms of the costs to plan participants and their beneficiaries relative to the benefit received for said fees.  The Tibble court intimated as much by refusing to require that plans only use institutional funds, stating that “[t]here are simply too many relevant considerations for a fiduciary, for that type of bright-line approach to prudence to be tenable.”

The Tibble court’s statement works the other way as well. The relevant, and proper, considerations should include some form of a cost-benefit analysis to determine how cost-effective, how prudent,  the plan’s investment options really are.  Most courts and regulators use ERISA’s “prudent person” standard in assessing a fiduciary’s compliance with their duty of loyalty.

I was introduced to the idea of evaluating mutual fund fees by using a cost-benefit analysis in Charles Ellis’ seminal work, “Winning the Loser’s Game.” By evaluating mutual fund fees in terms of the cost-benefit to plan participants, plan sponsors and the courts would actually be furthering the expressed purpose of ERISA, to protect the interests of plan participants and their beneficiaries.  Viewing mutual fund fees only in terms of absolute numbers does not provide the same level of protection for plan participants.

I have previously written about the proprietary metrics that I use in auditing and analyzing pension plans. I even disclosed the method of calculating one such metric, the Active Management Value Ratio (AMVR), which allows investors and fiduciaries to evaluate the cost effectiveness of actively managed mutual funds.  Anyone who can perform basic subtraction and division can calculate a fund’s AMVR.

My experience has been that very few plan sponsors or other fiduciaries perform any type of cost-benefit analysis in choosing investment options for their retirement plans.  Perhaps the reason for not performing some sort of cost-benefit analysis is due to the information such an analysis would reveal.

However, as Aldous Huxley pointed out, “facts do not cease to exist just because they are ignored.” Experience with the AMVR has shown that many actively managed mutual funds fail to provide plan participants with any benefit at all, based upon their failure to outperform less expensive low-load or no-load mutual funds.  Even when an actively managed fund does provide a benefit to an investor by outperforming a comparable low-load or no-load mutual fund, the fund’s fees often exceed the benefit received by 300-400 percent or more.

One would be hard-pressed to justify such an investment as “prudent” or with an “eye single” to the interests of the plan participants and their beneficiaries. Plan sponsors and other fiduciaries who choose to ignore such issues do so at their own risk, as the law clearly imposes personal liability on them for imprudent decisions and actions in connection with the administration of their plan.

It took years before an enlightened court in LaRue finally recognized the different issues involved in defined benefit and defined contribution plans, and the need to protect participants by recognizing different rights in connection with defined contribution pension plans.  Hopefully, an enlightened court will soon realize that defining prudence in terms of absolute mutual fund fees does not properly protect plan participants or further ERISA’s stated goals or purposes.

The Tibble and the Hecker v. Deere decisions provides valuable advice for plan sponsors. Both courts have established that ERISA Section 404(c) does not provide a “safe harbor” from potential liability for plan sponsors in selecting a plan’s investment options.  Plan sponsors must conduct an independent and impartial of each investment options considered by and chosen for their plan.  And in conducting such investigations, prudent plan sponsors will act proactively to protect themselves by evaluating a plan’s investment options in terms of the cost effectiveness of such investments  rather than in terms of absolute fees in order the promote the best interests of plan participants and the expressed purpose of ERISA.

The courts, regulators and plan fiduciaries need to understand that with regard to a plan’s investment options, it is the quality of the investment options, in terms of the benefits provided to plan participants, not the quantity of the plan’s investment options or their absolute fees, that truly matter under ERISA.

Posted in 401k, 401k compliance, 401k investments, 404c, 404c compliance, fiduciary compliance, fiduciary law, investments, retirement plans | Tagged , , , , , , , , , , , , | 2 Comments

Has Schwab Opened Pandora’s Box for RIAs? – Part Two

Posted on March 13, 2013 by jwatkins

In a recent post, I suggested that the recent court decision upholding Schwab’s class action waiver in customer’s contracts could have potential liability implications for RIAs and other fiduciaries that recommend or use Schwab, or for that matter any other broker-dealer who adopts such a provision, as a custodian for their clients’ accounts.

Ron Rhoades, someone for whom I have the utmost respect, was kind enough to respond with an excellent analysis discussing points and counter-points to some of my comments. Full disclosure requires me to admit that I had personally notified Mr. Rhoades of my post in hopes that he would respond with his usual expertise. He did not disappoint. Mr Rhoades response can be seen at http://scholarfp.blogspot.com/2013/03/schwabs-forced-customer-waiver-of-right.html

First, a few housekeeping details. As expected, I received quite a few nastygrams.  Despite allegations to the contrary, my post was not meant as an attack on Schwab. Quite the opposite. Schwab is doing what any good business would do, enacting risk management programs to protect their business.

RIAs and other fiduciaries would do well to heed Schwab’s message. In my opinion, the number one mistake that RIAs and other fiduciaries make is failing to implement an effective risk management program for their own businesses. RIAs can have all the manuals and other compliance materials required by the ’40 Act or their state’s applicable regulations.  But unless they have implemented and followed an effective risk management program for their RIA, all it takes is one legal action to effectively dismantle their business, especially since a private legal action is often followed by a regulatory audit.

Schwab is taking a prudent action to try to protect their business.  However, unless a customer signs Schwab’s agreement, Schwab owes them no duty, fiduciary or otherwise.  Given current laws and legal decisions, Schwab, as a broker-dealer, would generally not be deemed a fiduciary to a client that signs their agreement with the class action waiver provision.

On the other hand, RIAs and other fiduciaries who might recommend or use Schwab, or any other broker-dealer who adopts a similar class action waiver requirement, would already be in a fiduciary relationship with their client, and thus would have concerns that Schwab would not. While I am not advocating that RIAs and other fiduciaries not do business with Schwab or other broker-dealers that may adopt the class action waiver policy, the fact that Schwab and RIAs and other fiduciaries are in significantly different positions as far as potential liability exposure simply cannot, and should not, be ignored by RIAs and other fiduciaries.

As I mentioned in my earlier post, I think the likelihood of a finding of a fiduciary would increase in large part on the benefits that an RIA or other fiduciary received from the broker-dealer. As a former compliance director, both RIA compliance and general compliance, broker-dealers generally provide registered representatives and RIA affiliates with various forms of benefits.

In terms of the class action waiver issue, it could be argued that the receipt of such benefits could constitute a breach of the fiduciary duty of loyalty and an impermissible conflict of interest. A fiduciary’s duties impose an even higher duty on the fiduciary and allegations of breaches of such duties are closely scrutinized, with little, or no, margin of error.  Famed jurist Benjamin Cardozo clearly explained the high standard for fiduciaries in his landmark decision in Meinhard v. Salmon, when he stated that

A [fiduciary] is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctillo of an honor the most sensitive, is then the standard of behavior….

Mr. Rhoades has suggested that RIAs should provide greater disclosure if they should choose to do business with a broker-dealer that requires customers to agree to the class action waiver. While I am certainly an advocate for greater transparency in the financial services industry, I am not sure that greater disclosure would prevent a finding of a breach of fiduciary duty.

My opinion is based primarily on the unyielding attitude that the courts take towards protecting the public and enforcing the well-established duties of a fiduciary.  A breach of fiduciary duty claim can be upheld even if the alleged breach did not result in any actual harm to a client, as court will often base their decision on not allowing an otherwise offending fiduciary to avoid liability due to fortuitous circumstances.

The courts are even more vigilant when an alleged breach of fiduciary duties involves a conflict of interests involving a fiduciary’s financial self interests.  As noted by the court in Hughes v. Securities and Exchange Commission, when one both provides financial advice and sells investments products, there is an inherent conflict of interests. Given this conflict, the court stated that the courts will review such cases in order to ensure that the public is not taken advantage of or otherwise harmed.

In light of these judicial positions, I am not sure that any extent of disclosure will save an act that otherwise constitutes a breach of one’s fiduciary duties. Fiduciary duties are essentially absolute, a message reinforced by the “pure hearts, empty head” quote.

From a risk management perspective, the best course of action would be simply to avoid engaging in any actions which could be interpreted as a breach of one’s fiduciary duty, any actions in which a question could arise as to whether the fiduciary’s actions were in the client’s best interest. One of my client asked me if it would permissible to have a client sign a waiver to protect against such potential liability. The simple answer…no. After all, that’s the whole issue here, asking a client to waive a significant legal right. Furthermore, any RIA that asks a client to waive a legal right could be prosecuted for fraud under Section 206 of the ‘Act.

If you compare my original post and Mr. Rhoades response, I think you will find that our opinions are not that different.  We both support the idea that the class action waiver provision could have potentially significant liability implications for RIAs and other fiduciaries given the different standards of legal liability review for the parties.  I think we both agree that RIAs and other fiduciaries need to be more conscious of the importance of designing effective risk management programs for the RIA and other fiduciary practices.

When I joined LinkedIn, it was with the hope that the site would provide interesting posts and conversations that would benefit both myself and fellow professionals in managing their practices and better serving their clients. I know that I have enjoyed this discussion with Mr. Rhoades. As I mentioned earlier, I have always respected him and his expertise, and continue to do so.

Selah.

Posted in compliance, fiduciary compliance, fiduciary law, RIA, RIA Compliance, securities, securities compliance | Tagged , , , , , , , | Leave a comment

Has Schwab Opened Pandora’ Box for RIAs?

Posted on March 11, 2013 by jwatkins

Schwab’s recent victory upholding its class action waiver provision in its customer contracts raises a number of potential issues for fiduciaries, especially since most B/D’s can be expected to follow suit with similar provisions if Schwab’s waiver provision withstands the anticipated appellate review.  In most cases, broker-dealers (B/D’s) are not held to a fiduciary standard, so actions that they take may not raise the same fiduciary concerns that such actions may raise for RIAs.

After the Schwab decision was announced, I had a number of clients call me and ask me what, if any, ramifications would it have on them. Many of the callers suggested that anything Schwab did should not have any ramifications on them since they could not control Schwab’s actions. While this is certainly true, it does not follow that RIAs and other fiduciaries can ignore potential implications of the class action waiver.

Fiduciary law is based primarily on trust law and agency law.  The fact that RIAs are fiduciaries is clearly established by law. As fiduciaries, RIAs owe their clients a duty of loyalty, a duty to always put the clients interests first and to disclose any actual or potential conflicts of interest.

RIAs routinely maintain relationships with B/D’s. In some cases, RIAs receive soft dollar benefits from B/D’s in exchange for the RIA’s recommending that the client open or maintain a custodial account with the B/D. These soft dollar arrangements often involve the B/D providing an RIA with research and/or money for office provisions.

The right to participate in a class action is a potentially important legal right for many investors.  Class actions have long been criticized on many fronts, including the potential to bring frivolous lawsuits and using leverage to force defendants to settle actions rather than bear the financial burden such actions often create.

As a trial attorney, I feel compelled to point out that in many cases, class actions are the only realistic opportunity that those whose rights have truly been violated have to seek redress for such wrongs.  The costs of litigation can effectively prevent some victims from pursuing claims unless they can pursue a class action.

Like it or not, the law says that there shall be a right for every wrong, whether in law or equity. As is often the case, people do not care about inequitable treatment  or unjust laws until and unless it involves them or their family. Professional prejudices aside, denying the public access to the legal system flies in the face of fundamental rights guaranteed by the Constitution.

OK, I’m off the soap box.  Back to the issue at hand, the potential implications of a class action waiver provision in B/D customer contracts.  In my opinion, an RIA that knowingly recommends that clients open or maintain an account with a B/D that requires that customers waive their legal rights, including an important legal right such as the right to participate in class actions, may very have violated their fiduciary duties. The situation should definitely concern RIAs.

I can already hear the argument that “I’m not an attorney, so I cannot give legal advice.” With all due respect, that is not the point.  Giving up a legal right is an important issue. Both federal and state RIA laws prohibit any advisory contract that requires a client to give up any legal right. RIAs can put in certain clauses that address a client’s legal rights. However, any RIA that chooses to do so must include “clear and conspicuous” language stating that such language is not meant as a waiver of a client’s legal rights.

Supporters of the waiver provision will argue that a client can simply choose not to open an account with a B/D that requires a class action waiver provision or, if their RIA only works with B/D’s that use such a provision, the client can find another RIA. Is that really what RIAs want?  RIAs work so hard to find clients and develop strong client relationships as it is.

If the Schwab provision is upheld on appeal, it is reasonable to assume that other B/D’s will adopt similar provisions in order to protect themselves.  If so, would clients really have a choice? Common sense would suggest that a few B/D’s would not follow suit for marketing purposes and to grow their own business, but due diligence review may raise other fiduciary issues for RIAs and/or clients. Would it be in an RIA’s best interests to work with more than one B/D, one of whom would be a B/D that does not require clients to waive their legal rights?

To me, the strongest case against RIAs who recommend B/D’s that adopt the class action waiver provision would be situations where the RIAs receives some sort of benefit from the B/D, such as common soft dollar benefits like research and money for office needs.  Schwab has their popular annual IMPACT conference.  an argument can be made that any RIA that recommends that their clients agree to the class action waiver and also receive any sort of discount on travel, lodging, etc. in connection with such a conference has violated their fiduciary duty to their clients, both in terms of the “exclusive interests” rule and the conflict of interests rule.

I obviously do not know how the Schwab case will be resolved.  My point is that RIAs and other fiduciaries need to monitor such cases and re-examine what, if any impact, such cases could have for them with regard to their obligations as a fiduciary.  As I always remind my clients, ignorance of the law is no excuse and, to quote my favorite fiduciary quote from the courts, “a pure heart and an empty head are no defense” to a breach of fiduciary claim.

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Gifts and Conflicts of Interest

Posted on February 26, 2013 by jwatkins

I received a call yesterday from an RIA firm that had been providing magazine subscriptions and other gifts to clients that referred new clients to the firm.  The managing member of the RIA firm said that he had attended a seminar at one of the industry’s bigger conventions and the speaker had suggested such an incentive program and had assured them that it was OK as long as no actual money involved.

OK, short answer, don’t go there.  This is an issue that has been debated, as the Advisor’s Act talk in terms of prohibitions of gifts of money.  In an early decision, the SEC implied that the prohibition extended to both money and non-money gifts where same was clearly in exchange for the referral.

Occasional gifts of sports or theater tickets should be fine as long as there is no demonstrable pattern of such gifts that could be construed as compensation for referrals. RIAs often send a gift card or a similar gift to clients on their birthday.  As long as the gift is not excessive ( in excess of $100), such gestures are arguably valid business expenses to thank clients.

The real issue with regard to any form of compensation to clients in exchange for referrals has to do with actual or potential conflicts of interest and disclosure of same.  This is a slippery slope and could possibly depend on the actual facts of the case.  In cases where this practice is involved, I have always argued that the failure to disclose is a violation of the Advisor’s Act if the practice is not disclosed at all in both the RIA’s Form ADV and specifically in writing to the potential client. RIAs should remember that full disclosure is one  of the primary duties under the Act.

One of my ongoing concerns is that many consultants do not take the time to research legal decisions and enforcement actions to fully inform themselves of applicable legal and regulatory standards.  Knowledge of the Advisor’s Act and the relevant regulations is absolutely necessary. However, failing to research all sources of relevant compliance information can result in serious consequences for both the RIA and the consultant.

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“The 401(k)/403(b) Investment Manual”

Posted on February 26, 2013 by jwatkins

My new book, “The 410(k)/403(b) Investment Manual” is now available from both Amazon and CreatSpace. The manual is intended to provide both plan participants and plan sponsors with valuable information to allow them to properly evaluate the investment options within their retirement plans, information which should be provided to participants and sponsors, but often is not due to conflict of interests issues.

Posted in 401k, 401k compliance, 401k investments, 404c, 404c compliance, compliance, fiduciary compliance, fiduciary law, investments, retirement plans, RIA | Tagged , , , , , , , , , , , , | Leave a comment

Your RIA, Their Money!

Posted on February 8, 2013 by jwatkins

As an RIA consultant, I continue to be amazed at those firms who do not take the time to properly inform themselves about the regulatory and liability aspects of engaging in RIA activity. Ignorance and/or good intentions are simply not enough.

First, it’s your RIA. You are responsible for ensuring that your RIA is in compliance with all regulatory and legal requirements. Far to often RIA firms tell me that their broker-dealer will tell them whatever they need to know.

Under NTM 95-44, the only responsibility that a broker-dealer has to RIAs owned by their registered representatives is to monitor and supervise their representatives training activity.  Broker-dealers are not going to engage in activity that could create unnecessary liability exposure when they are legally required to do so.

Another common mistake I see RIAs make is not understanding their legal obligations to their clients.  As a securities attorney I repeatedly see the multi-color pie charts with recommendations to invest in numerous asset categories.  When questioned about the quality of their advice, they attempt to defend their asset allocation  recommendations based upon the popularity of their software program. I, in turn, open Dr. Markowitz’s seminal work, “Portfolio Selection,” to page six and ask them to read the section at the bottom of the page.

RIAs cannot guarantee the performance of their recommendations and are not legally required to do so. But their recommendations must be prudent and in the client’s best interests.  If a client wants to pursue an ultra-conservative strategy, it’s their right to do so.

Yes, they may be exposing themselves to risks such as purchasing power risk, and you should advise them of such risks, but unless what they are proposing to do is illegal, it’s their right to do so. Just be sure to document what your recommendations were and that you advised the client of such risks. And if what they are proposing to do is illegal and/or clearly exceeds the suitability guidelines for the client,  the RIA clearly cannot participate in such conduct. Yes, you may lose the account, but better to keep your licenses.

And finally, on the topic of suitability, every RIA should read and re-read the James B. Chase decision. The Chase decision discusses the two-prong test used in assessing suitability – the client’s willingness to accept risk and the client’s ability to bear investment risk. And be forewarned, a new prong to the suitability test is gradually appearing, that being the client’s need to accept investment risk at all.

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