Financial Plans v. Investment Policy Statements: One, None or Both?

Posted on August 25, 2014 by jwatkins

As an investment adviser consultant, one of the first things I ask new adviser clients is whether they prepare financial plans for clients. If so, I advise them not to do so going forward. Simply put, a financial plan in the hands of a knowledgeable securities attorney is an accident waiting to happen.

Dually registered advisers often counter by saying that their advisory activity is separate from their brokerage activity under the “dual hats” theory. Having been a compliance executive in the brokerage industry, I am aware of such arguments. However, I do not believe that argument is valid.

The “two hats” theory is derived from legal decisions involving ERISA and the separation of purely administrative duties from fiduciary duties under ERISA.  While a clear division can be established under ERISA, the courts have generally held that the functions of advisers and brokers are so intertwined that they cannot be clearly separated. As the court stated in the 1949 decision in Hughes v. Securities and Exchange Commission,

The record shows clearly that, except for a few isolated instances, petitioner acted simultaneously in the dual capacity of investment adviser and of broker and dealer. In such capacity, conflicting interests must necessarily arise. When they arise, the law has consistently stepped in to provide safeguards in the form of prescribed and stringent standards of conduct on the part of the fiduciary. More than 100 years ago the Supreme Court set forth this principle as follows:

“In this conflict of interest, the law wisely interposes. It acts not on the possibility, that, in some cases, the sense of that duty may prevail over the motives of self-interest, but it provides against the probability in many cases, and the danger in all cases, that the dictates of self-interest will exercise a predominant influence, and supersede that of duty.” (Michoud et al. v. Girod et al., 1846, 4 How. 503, 554-555, 45 U.S. 503, 554-555, 11 L.Ed. 1076.

The cornerstone of most financial plans is some sort of asset allocation or portfolio optimization recommendations generated by a commercial software program. Such programs usually rely on past performance data, even though advisers and investment product ads are required to disclose that past performance does not guarantee future performance. Some plans use projections of future performance, or “guesstimates,” which pose obvious potential liability problems.

Financial plans generally make use of various spreadsheets to make projections regarding financial goals and future financial needs. The software typically used in generating such projections is often highly unstable, often resulting in dubious projections. A careful review of such spreadsheet calculations will generally point out calculation errors, errors which invalidate all or a significant portion of such calculations.

A well-known saying  is that “trees don’t grow to the sky.” History shows that the performance of the stock market is cyclical, alternating between secular bull and bear markets. And yet, financial plans calculations are usually based on assumptions of constant growth , with no allowance for downturns in the market. From a liability standpoint, this flawed premise can result in serious miscalculations regarding a client’s future needs.

Financial plans and their components also pose potential issues under  with regard to the anti-fraud provisions of Rule 10b-5 under the ’34 Exchange Act and/or Section 206 of the ’40 Adviser Act. These issues often arise when an adviser’s implementation recommendations differ significantly from the scenarios and assumptions used within a financial plan.

Some advisers use disclaimers in an attempt to protect against potential liability for plan/implementation variances. However, the extent and language of such disclaimers may create liability issues under the legal concept of quantum meruit. Quantum meruit stands for the proposition that clients who pay for a financial plan have a legal right to receive something of equal value in return. Financial plans with disclaimers may effectively diminishes or totally destroys any inherent value of the financial plan.

The various quality-of-advice issues presented by most financial plans provided by financial advisers has led Nobel laureate Dr. William F. Sharpe to refer to such practices as “Financial Planning in Fantasyland. http://web.stanford.edu/~wfsharpe/art/fantasy/fantasy.htm. Those who do offer financial plans to clients would be well advised to consider Dr. Sharpe’s analysis, especially in terms of potential liability issues.

Based on my experience, many financial advisers prepare financial plans, yet few take advantage of the benefits available from investment policy statements. (IPS) From a risk management perspective, an IPS avoids all the subjective elements of a financial plan and allows a financial adviser to clearly define the terms of the adviser-client relationship. In the event that a dispute should arise, the value of such an agreement cannot be overstated.

Another advantage of an IPS is that it demonstrates to a client that the financial adviser is interested in truly understanding a client and the client’s goal and need, not just using a client as a means to an end, selling product. In this regard, an IPS serves to address the old saying that “people do not care how much you know until they know how much you care.” Prudent financial advisers will take the time to sit down with a client and create a mutually agreeable IPS.

 

 

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Death, Divorce and LaRue: 401(k) Breach of Fiduciary Duty Claims as Assets In Divorce and Probate Cases

Posted on July 22, 2014 by jwatkins

In 2008, the Supreme Court of the United States handed down their landmark decision in LaRue v. DeWolff, Boberg and Associates, Inc.(1) In LaRue, the Court finally recognized the fundamental difference between defined benefit pension plans and defined contribution pension plans. Recognizing that plan participants bear the risk of investment losses in defined contribution plans, the Court ruled that individual participants in defined contribution plans could recover for losses in their accounts that were due to breaches of fiduciary duties by plans and/or plan fiduciaries.

While ERISA lawyers and others involved in the ERISA arena recognized the significance of the LaRue decision, attorneys practicing in other areas of the law have failed to recognize LaRue’s potential impact on their practices, particularly potential malpractice issues. This white paper will discuss the potential implications of LaRue for divorce attorneys, probate attorneys, other ERISA practitioners, and their clients.

Causes of Action As Property
From a legal perspective, “property includes all rights which are of value, including claims against third parties.”(2) A cause of action is a “chose in action,” or claim of one party against another for the rendering of something of value.(3) The Supreme Court and other courts have ruled that causes of action are rights of property.(4)

The Supreme Court’s LaRue decision recognizing the right of individual participants in defined contribution plans to bring an action for individual losses creates a potential cause of action for such plan participants and their beneficiaries. The creation of a cause of action also creates a property right, an asset, for participants and beneficiaries in defined contribution plans.

Compliance Issues in Defined Contribution Plans
ERISA Section 404(a) and the accompanying regulations set out a number of fiduciary duties for plan fiduciaries, including the duty of prudence-the duty to act with the care, skill, prudence and diligence that a prudent man would in a like capacity and familiar with such matters. In meeting the prudent man standard of care, Section 404 states that

a fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and-
(A) for the exclusive purpose of:
(i) providing benefits to participants and their beneficiaries; and
(ii) defraying reasonable expenses of administering the plan;
(B) with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims;
(C) by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so;(5)

Recent ERISA settlements and legal decisions since LaRue suggest that defined contribution plans and fiduciaries are not complying with said 404(a) requirements. (6) Most of the ERISA-based breach of fiduciary duty claims to date have focused on the fees of the investment options available within a plan.

A future basis for ERISA-based breach of fiduciary may be the failure to meet the fiduciary duty to effectively diversify a plan’s investment options. Effective diversification is a two-step process requiring both vertical and horizontal diversification.

Most plans perform vertical diversification, i.e., diversifying among various asset classes. Few plans properly perform horizontal diversification, i.e., diversifying within asset classes. As a result, the plan’s participants are not provided with the ERISA’s required ability to minimize the risk of significant investment losses within their plan accounts.

Some plans believe that they are immune from fiduciary liability under Section 404(a) by virtue of a “safe harbor” known as ERISA Section 404(c). However, experience suggests that few plan and plan fiduciaries actually qualify for the various requirements for Section 404(c) protection.(7) Consequently, the potential for successful ERISA-based breach of fiduciary duty claims may be much higher than many plans and plan fiduciaries believe.

The potential number of successful ERISA-based breach of fiduciary duty claims may also be higher than believed by plans and plan fiduciaries. ERISA does not require small defined contribution plans, defined as plans with less than 100 participants, to conduct annual audits of the plan. As a result, such small plans may not be aware of potential fiduciary liability exposure.

The Department of Labor compiles statistics on defined contribution plans and active participants. The most current statistics, covering plan years ending in 2011, show that

• out of a total of 638,390 plans, 536,069 (88%) had less than 100 participants;
• out of a total of 638,390 plans, 487,795 (76%) had less than 100 participants;
• out of a total of 487,795 plans in which participants direct all investments, 422,072 (86%) had less than 100 participants.(8)

Small plans are less likely to spend the money for expert ERISA advice. Small plans often choose to rely solely on the representations and advice of plan service providers and others parties, who may have no fiduciary duty or other legal obligation to provide a plan or its fiduciaries with complete and accurate ERISA compliance advice.

ERISA-based Breach of Fiduciary Claims and Divorce Actions
The division of marital property is usually a significant issue in divorce actions. In some case, pension plan accounts may be a couple’s major marital asset.

The division of pension plan accounts is usually accomplished by a document known as a qualified domestic relations order (QDRO). The QDRO usually addresses the manner in which a pension plan account will be divided. In most cases, the preferred option is to let the non-owner of the account transfer the money to a separate retirement account, such an individual retirement account (IRA), in order to provide greater flexibility in the management of the funds. However, in some cases the pension plan may impose restrictions on the timing and/or the manner of the non-owner’s payout from the plan.

Under ERISA, the non-owner of the plan account is designated as an “alternate payee” and has the same rights as a plan beneficiary would have. Under ERISA Section 502(b), a beneficiary has standing to sue a plan and plan fiduciaries for breaches of their fiduciary duties. Therefore, the non-owner spouse should be informed of the potential for such ERISA-based breach of fiduciary claims and the possible value of same, in order to calculate the value of marital property and the potential value of individual claims.

Divorce attorneys should determine whether there are possible ERISA-based breach of fiduciary duty claims before finalizing property settlements. The evaluation of such potential claims should be considered not only in determining the total value of the marital property to ensure a fair and appropriate property settlement for their clients, but also to avoid potential malpractice claims

ERISA-based Breach of Fiduciary Claims and Probate Proceedings
The proceeds in a defined contribution plan are usually distributed in accordance with the decedent’s beneficiary form. The Supreme Court has ruled that the beneficiary form, not a decedent’s will, controls the distribution of pension plan accounts.(9)

An executor or administrator has a legal duty to gather all of the decedent’s assets. As mentioned previously, LaRue established a defined contribution plan participant’s legal right to file ERISA-based breach of fiduciary claims, and thus established such claims as property rights and assets.

Consequently, it can be argued that executors and administrators have a fiduciary duty to determine whether the participant’s estate has a potential ERISA-based breach of fiduciary duty claim. Given the high rate of suspected non-compliance by defined contribution plans, this duty to evaluate becomes even more important to protect against a possible breach of fiduciary duty action against the executor or administrator themselves.

Practical Considerations Going Forward
While the ERISA world immediately realized the implications of the LaRue decision, attorneys practicing in other areas of the law, as well as non-attorneys in the ERISA arena, may not have considered the full implications of LaRue for their practices.

Evidence from recent cases support the widely-held belief that many plans are not ERISA compliant in terms of both ERISA Section 404(a) and 404(c). Therefore, it is important for both divorce attorneys and probate attorneys to evaluate their cases for the possibility of an ERISA-based breach of fiduciary claim and the potential value of same. The most likely bases for ERISA-based breaches of fiduciary duty claims include excessive fees issues and issues regarding the improper selection, monitoring and/or diversification of a plan’s investment options.

At a minimum, it is suggested that an attorney involved in divorce or probate proceedings should discuss the possibility of such claims with their clients, leaving the ultimate decision to pursue any such action to the client. While such claims should not be cost prohibitive in most cases, the size of the potential recovery and/or the time element may be an important factor for a client.

401(k) plans are receiving an increasing amount of attention the issue of fees and other fundamental issues. With the number of multi-million dollars settlements and high profile ERISA-based breach of fiduciary actions pending, e.g., Tussey v. ABB, Inc.,(10), with the expectation of more to follow, it is important for attorneys and other ERISA experts to understand the impact of the LaRue decision and its progeny. While employees may be reluctant to file breach of fiduciary duty claims against their employers, ex-spouses and heirs may not be so reluctant, especially when potentially significant amounts of money involved.

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.

Notes
1. Larue v. DeWolff, Boberg and Associates, 552 U.S. 248 (2008)
2. Ray Andrews and Walter B. Raushenbush, “The Law of Personal Property,” 3d ed., (Callaghan & Co., Chicago. IL 1975)
3. Logan v. Zimmerman Brush Co., 455 U.S. 422, 428 (1982)
4. Logan
5. 29 U.S.C. § 1104(a)
6. Recent notable settlements include Bechtel ($18.5 million), Caterpillar ($16.5 million), General Dynamics ($15 million), Wal-mart ($13.5 million) and Kraft ($9.5 million). The Braden-Tibble-Trilogy provide a good overview of the LaRue progeny of cases – Braden v. Wal-Mart Stores, Inc., 588 F.3d 585 (8th Cir. 2009); Tibble v. Edison Int’l, 711 F.3d 1061 (9th Cir. 2013); and Tussey v. ABB, Inc., (8th Cir. 2014)(not reported)(available online at http://scholar.google.com/scholar_case?case= 201457323903537409&hl=en&as_sdt=6&as_vis=1&oi=scholarr.
7. Fred Reish, “The New Take on 404(c): Confusion in the Federal Courts,” available online at http://www.drinkerbiddle.com/resources/publications/2009/the-new-take-on-404c-confusion-in-the-federal-courts?Page=8&Section=SpeakingEngagements& Year=&Practice=0&Attorney=0
7. Department of Labor, “Private Pension Plan Bulletin:Abstract 8f 2011 Form 5500 Annual Reports,” Table 6, available online at http://www.dol.gov/ebsa/pdf/ 2011pension planbulletin.pdf
9. Kennedy v. Plan Adm. For DuPont Sav. And Inv. Plan, 129 S.Ct. 865 (2009)
10. Tussey

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

The Art of Fiduciary Investing: Controlling the Controllable

Posted on July 9, 2014 by jwatkins

“[I]nvesting intelligently is about controlling the controllable.”
Ben Graham, “The Intelligent Investor”

The world of fiduciary investing is going through a significant stage, as more attention is being focused on various issues such as advisory fees, annual fees charged by investments, disclosure of material information, and effective risk management. While many consider the rules of fiduciary investing complex and confusing, fiduciary investing can be relatively simple if one follows Ben Graham’s advice.

I am often asked to name the best books on investing. In my opinion, Graham’s “The Intelligent Investor,” and Charles Ellis’, “Winning the Loser’s Game,” should be required reading for all fiduciaries. Ellis’ discussions on risk management as the proper focus of wealth management and the use of incremental costs and returns as the proper basis for evaluating investments are invaluable in assessing compliance with the fiduciary duty of prudence.

Graham’s concept of controlling the controllable is equally sound. No fiduciary can control the performance of the markets. The law does not impose liability on fiduciaries based solely on an investment’s performance. The law does impose liability on fiduciaries for failing to meet their fiduciary duties of prudence and loyalty, particularly with regard to unnecessary/excessive costs and the failure to provide proper portfolio risk management through effective diversification, two of the controllable elements referenced by Graham

Graham actually references four controllable elements: costs (specifically funds with excessive annual fees); risk management (through effective diversification); taxes (through focusing on capital gain treatment), and the investor’s own behavior. With regard to costs, fiduciaries often mistakenly focus on fees on a relative basis. Even the judicial system makes this mistake.

Fiduciary law, ERISA included, requires a fiduciary to always act in the best interest of the client. Consequently, investment costs should be evaluated in terms of the incremental costs and incremental benefits to the client, the idea advanced by Ellis. I have written about my own metric, the Active Management Value Ratio™, which is a simple calculation requiring only subtraction and division. Another useful metric for evaluating investment costs is Ross Miller’s Active Expense Ratio, which is available online.

While excessive costs have been the focus of recent ERISA actions, I believe that the next wave of ERISA litigation will focus on the failure of plan sponsors to provide the “broad range” of investment options required under ERISA Section 404(c) in order to allow plan participants to effectively diversify their pension accounts so as to minimize the risk of significant investment losses. Based on my experience, the investment options offered by most defined contribution plans consist of mainly of unnecessarily expensive and highly correlated equity-based mutual funds.

Many defined contribution plans are electing 404(c) status, as it potentially allows them to shift investment risk to the plan participants. However, it is has been suggested by at least one prominent ERISA attorney that very few plan sponsors are actually in compliance with all of Section 404(c)’s requirements. Consequently, many plan sponsors and plan fiduciaries face unlimited personal liability for the performance of the plan participants’ investment accounts.

Graham’s inclusion of the need to control one’s behavior has special relevance to fiduciary investing. The issue of conflicts of interest is a key issue in today’s investment industry. Fiduciaries who fail to “control the controllable” can expect to see litigation alleging breach of their fiduciary duties due to conflicts of interest, particularly financial conflicts of interest. Fiduciaries in the ERISA arena should note the post-LaRue trend of courts to recognize and protect the rights and interests of plan participants, as evidenced by the decisions in the recent Braden-Tibble-Tussey trilogy.

Leonardo da Vinci once said that “simplicity is the ultimate sophistication.” Steve Jobs, Apple’s legendary leader also adopted this belief. Whether conducting a fiduciary audit or trying a breach of fiduciary action, I simplify the process by focusing on whether the fiduciary has controlled the controllable – costs, risk and their own behavior. Investment fiduciaries who adopt a similar focus and properly control these elements-while at the same time putting the client’s best interests first-greatly reduce the chance of being successfully being sued for a breach of fiduciary duty. claim.

 

Posted in 401k compliance, 401k investments, 404c, 404c compliance, compliance, fiduciary compliance, fiduciary law, investments, pension plans, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , | 1 Comment

Fiduciary Standard and Selective Amnesia at the SEC

Posted on June 1, 2014 by jwatkins

I just finished reading Knut Rostad’s insightful post on ThinkAdvisor.com regarding the ongoing debate over a uniform fiduciary standard for both stockbrokers and investment advisers. For those unfamiliar with Knut, he is the President of The Institute for the Fiduciary Standard. He has been championing the need for a uniform fiduciary standard that would require that both stockbrokers and investment advisers would be required to always put a customer’s interests first. Currently, stockbrokers are allowed to put their own financial interests ahead of those of their customers.

Knut’s post discussed the financial services industry’s ongoing campaign of misinformation regarding both the need and impact of a uniform fiduciary standard. The industry claims there is no need for such a standard, that everything is fine. The industry claims that such a standard would cause harmful cost increases for the industry and would reduce the number of stockbrokers who would provide advice to the public.

The annual number of court actions and arbitration cases clearly shows that things are not fine. The SEC has reported that their request for information regarding the increased costs that would be associated with such a standard produced little response. This should not be surprising, as the claim has no merit. Most broker-dealers have proprietary investment adviser firms or they allow their brokers to maintain independent advisory firms. Therefore, they are already required to review trades by brokers under the fiduciary standard’s “best interests” criteria pursuant to either the Investment Advisers Act of 1940 or NASD Notice to Member 94-44. Consequently, there should be little or no additional costs to broker-dealers under a uniform fiduciary standard.

The industry’s claim of reduced financial advisers to serve the public is pure speculation. As a trial attorney, courts do not allow purely speculative to be considered. As a former compliance director, I seriously doubt that brokers are going to walk away from any sort of compensation, at least honest brokers. As for those brokers who would not be willing to provide investment advice to the public under a “customer’s best interests first” standard, they should not be providing advice in the first place. If the SEC stays true to its stated mission statement of protecting the public, then the emphasis should be on quality of advice, not quantity.

Another article regarding the debate over a uniform fiduciary standard involved comments attributed to SEC Commissioner Daniel Gallagher. Commissioner Gallagher reportedly stated that he was unconvinced of the need for such a standard. Commissioner Gallagher reportedly based his statements on a lack of evidence regarding abusive practices by the brokerage industry. Commissioner Gallagher reportedly stated his opinion that the brokerage industry was being unfairly targeted, that “advisors are always seen as pure and brokers are seen as miscreants.”

I’m not sure where Commissioner Gallagher is getting his information, but again, as both a former RIA Compliance Director at one of the nation’s largest indie broker-dealers and a securities attorney, the simple truth is as with most industries, there are honest and dishonest in both the financial service and investment advisory industries. Furthermore, Commissioner  Gallagher’s call for additional information is troubling, as he need do nothing more than visit the SEC’s enforcement division and Finra’s enforcement division to uncover whatever evidence he needs.

However, I do not believe Commissioner Gallagher or, for that matter, Chairwoman White or any of the other SEC commissioners, need any additional information of the history of abusive practices within the financial services industry. I do, however, believe that they should take a refresher course in the stated mission and purpose of the SEC.

While the SEC’s home page proudly proclaims to be “The Investor’s Advocate,” recent history would seem to indicate that the SEC has become more “The Investment Industry’s Advocate,” at least with regard to protecting investors. In 2004, the SEC enacted a controversial exemption allowing broker-dealers to effectively act as investment advisors without registering as required by law. The exemption would have allowed broker-dealers to act as investment advisers without requiring them to comply with the “best interests of the customer,” or fiduciary, standard. Fortunately, the Financial Planning Association successfully sued the SEC, with the federal courts revoking the exemption and ordering the SEC to enforce the law as written.

With the current debate over a uniform “best interests” fiduciary standard, perhaps Madame Chairwoman and the commissioners should review the commission’s home page.

The main purpose of the Securities Act of 1933 and the Securities and Exchange Act of 1934 can be reduced to two common-sense notions, [one of which is that] people who sell and trade securities-brokers, dealers, and exchanges must treat investors fairly and honestly, putting investors’ interests first.” (emphasis added.)

Commissioner Gallagher’s statements notwithstanding, the obvious disregard for both the commission’s stated purpose and mission is even more puzzling given the fact that Finra, the entity primarily responsible for overseeing broker-dealers, clearly stated in Notice 12-25 that broker-dealers and their representatives must always act in the “best interests” of their customers. Consequently, a uniform fiduciary standard would simply reinforce Finra’s position. Finra’s position also either weakens the industry’s ‘increased costs” and “reduced advisors” claims or indicates that such claims are an admission that broker-dealers and their representatives have not been in compliance with Finra’s regulations.

Commissioner Gallagher is correct when he references the problem with dishonest brokers and investment advisers. Enacting a uniform fiduciary standard is not going to stop such activity. However, a uniform fiduciary standard will avoid the confusion investors face over what duty, if any, is owed them. A universal fiduciary standard will make it easier for regulators and investors to successfully address the unethical and dishonest brokers and advisers. As Dr. Martin Luther King, Jr. pointed out,

[m]orality cannot be legislated but behavior can be regulated. Judicial decrees may not change the heart, but they can restrain the heartless.

Despite Commissioner Gallagher’s selective amnesia, the financial service’s abusive practices and the resulting need for a uniform fiduciary standard to better protect investors are well-documented. Commissioner Gallagher’s position is inconsistent with the common-sense positions set out on the commission’s home page. Common-sense says that having two standards for groups providing the same services is ludicrous. Common-sense indicates that adopting a uniform fiduciary standard is both fundamentally fair for investors and, in truth, imposes no hardship on broker-dealers and their representatives other than having to treat investors fairly, as guaranteed by securities laws.

In Knut’s post, he references a statement by Scott Curtis, Raymond James’ President, to the effect that a uniform fiduciary standard would not be healthy for the brokerage industry. However Chairwoman White and the other commissioners should remember the mandate announced in 1949 in the decision in Norris v. Hirshberg v. SEC, namely that the federal securities laws were meant to protect the public, not broker-dealers.

Common-sense dictates that the SEC adopt a uniform fiduciary standard in furtherance of its purpose, protecting the public. Here’s hoping the SEC listens to the wise words of former Supreme Court Justice William O. Douglas-“common-sense often makes good law.”

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Incredible Marketing Opportunity for RIAs

Posted on May 22, 2014 by jwatkins

I recently read an article in which SEC Commission Gallagher stated that he is not convinced that a universal fiduciary standard is needed. He also stated that he needed to see more evidence of the need for such a standard.

Commissioner Gallagher, perhaps you should read all the studied that the SEC has conducted and contact both the SEC’s and FINRA’s enforcement divisions. Everyone knows why the SEC is dragging its feet on this issue despite the clear need for same and your own agency’s recommendation for a universal fiduciary standard to protect investors. (See Financial Planning Association v. Securities Exchange Commission, where court ordered SEC to enforce the related RIA law against broker-dealers)

The Department of Labor’s pending fiduciary revisions and the SEC’s stall tactics provide an incredible opportunity for investment advisers, who are already subject to a fiduciary standard. Prudent investment advisers will focus their marketing on the inequitable dual standard that currently exists and the dangers that result from same.

As both a former securities compliance director and an RIA compliance director for major broker-dealers, I believe that most advisors, both brokers and investment advisers, are honest and truly want to help their customers. For these advisers, a universal fiduciary standard is a non-issue, as they already conduct their practices under the fiduciary “best interests” standard.

The financial services industry continues to put up disingenuous arguments, most notably the “increased costs” and the “lack of access to advisers” arguments. Yet, according to the SEC, the industry did not produce much evidence when the SEC requested information to support the “costs” claim.

They did not produce such evidence because the claim is a ruse. Since the NASD release Notice to Member 94-44 and the emergence of the RIA sector, most broker-dealers have created their own proprietary RIA. Consequently, they should already be reviewing such trades under the fiduciary “best interests” standard, especially since FINRA has stated unequivocally that all brokers and  are required to always act in a customer’s best interests. So, the industry’s “increased cost” is either a complete ruse, or the industry’s “cost” claim is an admission against interest, an admission that they are not, and have not been, acting in compliance with FINRA’s compliance rules.

The financial service industry claims that a universal fiduciary standard will result in fewer advisers willing to work with investors, including pension plan participants. In a court of law, this argument would be tossed as purely speculative. The industry has introduced no evidence to support their contentions.

Advisers who are not willing to put a customer’s best interests first may well reduce their activity. However, that would simply provide more opportunities for the majority of brokers and investment advisers who do operate honest and ethical practices and would be glad to provide investors with valuable and objective advice. To be honest, the public would be better served by the loss of the ne’er-do-well, dishonest advisers.

In my opinion, it is highly unlikely that the SEC will adopt a universal fiduciary standard soon, if ever. This present a unique  marketing opportunity for independent RIA firms. Proprietary broker-dealer RIA firms and RIA firms with dually registered members are  not going to be allowed to seize this opportunity, for obvious reasons. This simply increases the opportunity for independent RIA firms.

I liken the current opportunity to the well-known quote attributed (falsely) to Nathan Bedford Forrest, a lieutenant general in the Confederate Army, “get there firstest with the mostest.” (According to the New York Times, he actually said “Ma’am, I got there first with the most men.”) The current situation presents an obvious opportunity for RIAs to create a personal “WOW” value factor by educating the public about the fiduciary/non-fiduciary situation and the implications for their personal financial well-being.

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Social Media and the Investment Adviser

Posted on May 17, 2014 by jwatkins

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

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

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

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

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The Investment Adviser’s Achilles’ Heel v. 2.0

Posted on April 17, 2014 by jwatkins

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

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

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

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

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

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

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

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

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

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

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

 

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THE Key Factor in Liability Risk Management

Posted on March 6, 2014 by jwatkins

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Four Faces of Fiduciary Prudence

Posted on February 6, 2014 by jwatkins

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

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

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

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

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

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

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

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

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

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Quantum Meruit and “Other” Compliance Challenges

Posted on February 2, 2014 by jwatkins

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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