The Prudent Investment Fiduciary Rules

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Notes

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

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

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

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.

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.

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.