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.

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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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Secrets to a Successful 401(k) Plan

Posted on January 5, 2013 by jwatkins

Over the holidays I was catching-up on my reading. One of the articles I came across involved a debate over which metric was more effective in assessing the success of a defined contribution plan, a plan’s rate of participation or a plan’s deferral rates.  While I realize that the article was not discussing “success” in terms of legal success, I still found the article’s premise interesting.

Given the recent legal developments involving pension plans and the increase in cases involving plans either being held liable or settling cases, I think any discussion of a plan’s success must include an evaluation of its ability to create a true “win-win” situation for both the plan participants and the plan itself so as to avoid legal liability issues.

The Department of Labor is expected to release new fiduciary standards sometime in 2013, with the general consensus being much more stringent requirements.  Even without the new DOL standards, ERISA already requires plans and plan fiduciaries to meet various duties, including the fiduciary duty of loyalty and the duty of prudence.

The fiduciary duty of prudence requires plans and plan fiduciaries to always out the interests of the plan participants and their beneficiaries first. The duty of prudence consists of various responsibilities, including the duty to avoid unnecessary expenses and the duty to provide participants with a selection of investment options that allows them to minimize the risk of significant losses and “sufficient information to allow plan participants to make an informed decision.”

I recently released a white paper on the Active Management Value Ratio,  proprietary metric that allows investors and fiduciaries to analyze the cost efficiency of actively managed funds.  The white paper clearly shows that a number of the leading mutual funds used by pension plans are not cost efficient, in some cases even reducing a plan participant’s return. It could be argued that such inefficiency could constitute a breach of fiduciary duty, clearly not a sign of a successful plan.

Plans and their fiduciaries are required to provide plan participants with a sufficient selection of investment options to reduce the risk of large losses and sufficient information to evaluate such investment options and make informed investment decisions. In short, in most cases this simply is not happening.

In  most cases plans are primarily an assortment of expensive, highly correlated equity-based mutual funds that unnecessarily expose plans and plan fiduciaries to unlimited personal liability. Furthermore, in many cases plans fail to provide plan participants with all of the information they need to make informed decisions, resulting in liability exposure for both the plan and its fiduciaries.

Many plans and plan fiduciaries mistakenly believe that they do not face any personal liability by virtue of their mistaken belief that they have complied with ERISA Section 404(c). However, Fred Reish, one of the nation’s leading ERISA attorneys, has testified that over his twenty plus years of ERISA practice, he has never seen a plan properly comply with all of Section 404(c)’s requirements. Consequently, there are a lot of plans and plan fiduciaries that do not realize the risk exposure that they actually have.

In determining whether a defined contribution plan is a “success,” I would suggest that a more meaningful analysis would be whether the plan presents a true win-win situation for both the plan participant and the plan and its fiduciaries by complying with all of the fiduciary requirement required under ERISA and applicable legal decisions, which in turn would reduce any potential lioability exposure for both the plan and its fiduciaries.

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Seeing Is Believing: Marketing to Plan Sponsors

Posted on November 5, 2012 by jwatkins

One of the most common questions I get is from advisor is how to convince plan sponsors that they need to review their plan for potential compliance issues.  When I ask plan sponsors what it takes to get their attention, the usual response I receive is credibility and both an offer and an  ability to present evidence to support the need to make changes in the plan.

Turns out that a lot of plan sponsors are just like most of us.  Don’t waste my time with a bunch of abstract gobbledygook or self-serving opinions. Show me the money!

Most advisors approach plan sponsors with various abstract arguments as to why changes need to be made in their plans. The problem with this type of approach is that studies have shown that people are more visually oriented.  That is why most attorneys try to always reinforce testimony at trial with supporting visual aids. Advisors would be wise to adopt a similar approach in dealing with plan sponsors.

When I meet with a plan sponsor, I always provide the plan sponsor with both the Active Management Value Ratio and the InvestSense Ratio calculations for the plan’s investment options.  These are two proprietary formulas that InvestSense has developed.  The formulas are relatively simple, yet very persuasive and have proven to effective in resolving legal actions.  While advisors cannot duplicate the results from our proprietary formulas, advisors need to realize the importance of visual evidence in trying to work with plan sponsors.

I can tell the plan sponsor that there are serious compliance and liability concerns that need to be addressed. However, by providing a plan sponsor with a tangible document with meaningful numbers, it gives the plan sponsor not only something that they can wrap their arms around, but also something that they can use to document their due diligence and support their decision in case questions of liability arise.

Advisors trying to work with plan sponsors also need to understand the importance of cognitive biases.  Remember, plan sponsors believe that they are doing things right. Therefore, they can be expected to view most opinions to the contrary with skepticism. Again, another reason for supporting documentation.

Appearance of authority and “anchoring” are two of the most common cognitive biases that advisors face in dealing with any potential customer. Appearance of authority refers to a situation where a customer believes that someone is knowledgeable on a subject simply because of their title or employer. This appearance of authority usually results in a level of trust that can be hard to reverse, even in the face of overwhelming evidence, as most people tend to want to trust other people. This desire to trust others often leads to anchoring, or the tendency to resist change and hold on to personal perceptions and beliefs, no matter how strong the evidence is to the contrary.

Once again, mere oral presentations are unlikely to overcome a plan sponsor’s cognitive biases.  One of the major problems in overcoming cognitive biases is that most people are unaware that they may have such biases.  In my opinion, the best way to handle such biases is simply to use the “touchy feely’ approach, providing the plan sponsor with a tangible document that they can privately review and then use to question the plan’s current consultant.

The bottom line is that mere rhetoric is unlikely to be enough to convince a plan sponsor to listen to your presentation or make any changes.  Advisors attempting to work with plan sponsors need to develop legitimate presentations that emphasize visual persuasion in the form of supporting documentation and other forms of visual material that plan sponsors can easily understand and use.

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Fiduciaries, We Ain’t No Stinkin’ Fiduciaries: Help for Fiduciaries and Unsuspecting Fiduciaries

Posted on September 4, 2012 by jwatkins


As a securities attorney that represents investors and provides consulting and compliance services to RIA firms, I can honestly say that one of the most common problems I encounter with RIA firms is a failure to develop an effective risk management system for the firm. In some cases this oversight is due to a misperception that a broker-dealer will provide the RIA firm with whatever compliance information the RIA firm needs to know.  In other cases, the oversight is due to a reliance on a non-legally trained compliance consultant and, thus, a failure to monitor applicable court and regulatory decisions.

Yes, I am an attorney, but the previous statement is not meant to be a self-serving statement.  When I represent an investor in a case against a stockbroker, one of the first things I do is analyze the case to determine whether I can make a good faith argument that the broker was acting in a fiduciary capacity and therefore the more stringent fiduciary standard, not the suitability standard, is the applicable liability standard. 

When faced with litigation, brokers and their broker-dealers are usually quick to produce new account forms and argue that the account was marked “non-discretionary,” thereby preventing the broker from being deemed a fiduciary.  In other cases, the old “two-hats” argument is advanced to deny a broker’s fiduciary status.

However, to quote Lee Corso of ESPN, “not so fast my friend.” The U. S. Supreme Court decision in the Capital Gains decision established that all investment advisers are fiduciaries.  As for the “two hats” argument, the courts have stated that when a financial adviser acts simultaneously in the dual capacity of investment adviser and of broker and dealer,

“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…’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 possibility 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.’”1

FINRA recently released Regulatory Notice 12-25 regarding the suitability obligations of brokers and broker-dealers.  One of the questions addressed in the Notice was a broker’s duty to always act in the best interests of the client.  Some argued that this position would force brokers to adhere to the fiduciary standard of care rather than the more common suitability standard for brokers.  FINRA rebuffed the brokers’ arguments and referenced several legal decisions and regulatory decisions that had previously mandated that brokers always act in a client’s best interests, effectively shooting down the “two hats” argument again.

As a former compliance officer, I always enjoyed squaring off with the brokers and advisers over the “non-discretionary” issue.  Short and simple – the “non-discretionary” issue is only one of the issues that the courts and regulators consider in deciding whether the fiduciary standard will be used in determining the issue of liability.  Both the courts and the regulators make their evaluations based on substance, not style. 

The key question is whether or not the broker controlled the account, regardless of how the account was labeled. If the broker is found to have controlled the account, then the applicable standard of care will generally be the fiduciary standard.

If a broker is formally given discretionary authority to buy and sell for the account of his customer, he clearly controls it.  Short of that, the account may be in the broker’s control if his customer is unable to evaluate his recommendations and to exercise an independent judgment. The touchstone is whether or not the customer has sufficient intelligence and understanding to evaluate the broker’s recommendations and to reject one when he thinks it unsuitable.2

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.3

So there are various methods an attorney can use to get the courts or regulators to hold a financial adviser to the higher “best interests of the client” fiduciary standard.  Fortunately for RIA firms, there are several relatively simple steps they can take to reduce any potential liability exposure.

First, develop and follow an established due diligence process and document both the process and enforcement of the process. 

Brokers [and investment advisers] are ‘under a duty to investigate, and their violation of that duty brings them within the term ‘willful’ in the Exchange Act. [A broker or adviser] cannot deliberately ignore that which he has a duty to know and recklessly state facts about matters of which he is ignorant. He must analyze sales literature and must not blindly accept recommendations made therein.4

Second, review and verify any financial plans or asset allocation/return projections.  Most asset allocation/portfolio optimization software programs are relatively unstable and easily susceptible to errors.  When I take a case I reverse engineer any plans or projections that were used in connection with the investor, with special emphasis on those areas that are most vulnerable to errors.

With regard to asset allocation recommendations, the two most areas of concern for advisers should be the quality of any risk tolerance questionnaire and the viability of the input data used in any asset allocation/portfolio optimization software program, particularly the risk and return assumptions used for the various assets or asset categories. Seemingly insignificant errors in the input data can result in significant errors in the recommendations produced.

Third, ensure that any recommendations made meet the applicable standards of care.  Address all three prongs of the risk tolerance equation – willingness to accept investment risk, ability to bear investment risk, and need to accept investment risk. With regard to suitability, assess both the issues of qualitative suitability and quantitative suitability. With regard to cost, perform some form of meaningful cost benefit analysis.  Document both the RIA firm’s process and findings in all of these areas and be prepared to produce them as part of a regulatory audit or a civil litigation.

I have previously written about a cost-benefit analysis process that I use during fiduciary audits and litigation, a formula that I refer to as the Active Management Value Ratio.  Another popular cost-benefit formula is the Active Expense Ratio.  The key is to use some sort of meaningful analysis to show that an investor is getting true value in any investment or investment strategy being recommended.

In summary, when I speak to attorneys or financial advisers about RIA risk management, I tell them to focus on the three C’s – correlation of returns, consistency of advice, and cost-benefit analysis. The three C’s cover the basic fiduciary duties – correlation (duty to diversify to minimize the risk of larger losses), consistency (duty of loyalty), and cost-benefit (duty to control costs and avoid unnecessary costs).  Since an experienced securities attorney is going to focus on those areas in order to win their case, the prudent RIA firm will be proactive and develop  and enforce  an effective risk management program that includes a due diligence process to effectively reduces potential liability exposure in those areas.

                                                               Notes

1. Hughes v. S.E.C., 174 F.2d 969 (D.C.C. 1949)
2. Follansbee v. Davis, Skaggs & Co., Inc., 681 F.2d 673 (9th Cir. 1982)
3. Carras v. Burns, 516 F.2d 251 (4th Cir. 1975)
4. Hanley v. S.E.C., 415 F.2d 589 (2d. Cir. 1969)

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The Active Management Value Ratio™- Revealing the Undisclosed Cost of Actively Managed Mutual Funds

Posted on August 6, 2012 by jwatkins

Despite overwhelming evidence that actively managed mutual funds generally under-perform passively managed index funds, the evidence indicates that most investors continue to purchase and hold actively managed funds.  Even when an actively managed fund does outperform its relevant index, the margin is usually slim, often measuring less than 1 percent.  That 1 percent advantage may disappear entirely when the actively managed fund’s annual fees are factored in.

In analyzing the prudence of actively managed mutual funds, I use a proprietary formula, the Active Management Value Ratio™ (AMVR), to determine the cost effectiveness of an actively managed mutual fund. In short, most actively managed mutual funds simply are not cost efficient.

Most investors only think of mutual fund fees in terms of the annual expense fee quoted in ads and prospectuses.  What most investors do not realize is that in breaking down an actively managed mutual fund’s annual fee into its active and passive components, the active component usually exceeds the passive component by a wide margin.

Most investors expect to see a reasonable relationship between the fees they pay and the returns they receive. However, that is usually not the case when it comes to actively managed mutual funds, where it is not unusual to see the portion of the annual fee allocatable to active management, often 60-70 percent of the fund’s annual return, providing only 25-30 percent of the fund’s annual return.

When we apply the AMVR, we often find that the fund’s active fee component either significantly reduces or totally removes the active management component’s contribution to the fund’s overall return. In some cases, the active management component of the fund may actually end up costing an investor money.

These imbalances are also reflected in measurements such as a fund’s active expense ratio (AER).  The AER was developed by Professor Ross Miller of the State University of New York.  Dr. Miller’s study found that due to the fee issues associated with actively managed mutual funds, the effective annual expense ratio for such funds was often significantly higher, often 5-6 times greater, than the fund’s stated annual expense ratio.

Investors often see a stated fee of 1 percent and just dismiss it as being only 1 percent. What investors fail to see is the cumulative impact of fees.  According to a study done by the General Accounting Office, over a twenty year period, each 1 percent of investment fees reduces an investor’s ending return by approximately 17 percent.  So, if you are paying an investment adviser an annual management fee of 1 percent and paying annual 401(k) fees of 1 percent, goodbye 34 percent of your end-return.

This is why variable annuities are such a bad investment decision. If your investment adviser recommends that you purchase a variable annuity (generally imposing an annual fee of 2 percent) and recommends that you retain him to manage the variable annuity for you for an annual fee of 1 percent, goodbye 51 percent of your end-return. Add to that the fact that variable annuity issuers base their annual fee on the accumulated value of the annuity rather than on their actual legal obligation to you, an investor’s best course of action is to just say “no” to variable annuities.  (Please see our white paper under “Variable Annuities” for a more detailed analysis on variable annuities and the questionable and often misleading marketing tricks used to sell them.)

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

Is ERISA Section 408(b)(2) the New 401(k) Fiduciary’s Achilles’ Heel

Posted on June 25, 2012 by jwatkins

On July 1st, the disclosure requirements of ERISA 408(b)(2) go into effect with regard to plan providers and plan sponsors.  Disclosure requirements between plan sponsors and plan participants are scheduled to go into effect at the end of August.

Plan sponsors are already complaining that 408(b)(2)’s lack of a uniform system of disclosure is resulting in disclosures that are often hard to find and often cryptic, far from 408(b)(2)’s goal.  Such evasive tactics will only make the plan sponsor’s disclosure duties more difficult.

Plan sponsors should also note the special requirements for dealing with plan providers who fail to provide the required disclosure under 408(b)(2).  In such circumstances, the plan sponsor has a duty to request the required disclosure from the plan provider.  If the plan provider fails to make the required disclosure within 90 days, the plan sponsor is required to dismiss the plan provider and retain the services of a new plan provider.

408(b)(2) imposes greater responsibilities on plan fiduciaries to properly evaluate the fees being charged under the plan.  Failure to properly evaluate such fees can result in liability for both the plan and the plan’s fiduciaries. 

This responsibility and potential liability poses special questions with regard to actively managed mutual funds. Despite overwhelming evidence that actively managed mutual funds generally underperform passively managed index funds, most investment options offered by 401(k) plans are actively managed mutual funds. 

What many plan fiduciaries fail to understand is that a properly conducted cost-benefit analysis of such actively managed mutual funds may result in a breach of fiduciary claim, regardless of whether or not the inclusion of such fund resulted in a financial loss to the plan participants.  During a recent fiduciary audit, I analyzed the plan’s twenty mutual fund investment options using the Active Management Value Ratio (AMVR), a proprietary formula that I use to determine the cost effectiveness of an actively managed mutual fund.  My analysis indicated that three of the funds were prudent in terms of cost effectiveness and performance, five of the funds provided marginal benefits from active management, and twelve of the funds provided no benefit at all from active management.

In analyzing the active management component of a fund’s overall fee, I found situations such as 74 percent of a fund’s overall fee producing over 100 percent of the fund’s return, 88 percent of the fee fund’s overall fee producing 22 percent of the fund’s return, and numerous examples where the active component of a fund’s overall fee was producing a negative return.

When I presented the results of my analysis to the plan sponsor’s investment committee, I got the “OMG” response I often get.  The “OMG” response is usually followed with the “why didn’t someone explain this to us” question.  The usual answer is that the plan provider either employed the old 3(21) fiduciary trick, confusing the plan sponsor as to the plan provider’s fiduciary duties, or ignored conflict of interest issues, since alerting the plan sponsor to these active management cost-benefit conflict of interest issues would probably have resulted in the plan provider not getting the account.

With 408(b)(2), plan sponsors must be alert to such issues and perform a full and proper analysis of the cost issues inherent in their plan.  One of a fiduciary’s duties under ERISA is to avoid any unnecessary expenses and costs.  With the new disclosures required under ERISA Section 408(b)(2), plan sponsors and plan fiduciaries have a greater responsibility to properly review and evaluate a mutual fund’s fees.  Simply looking at a  funds stated expense fee does not provide the analysis required under ERISA to protect the plan and its participants, especially with regard to the generally higher fees charged by actively managed funds. 

If actively managed mutual funds are chosen as investment options offered within a retirement plan, the plan fiduciaries should evaluate the potential costs of the funds’ active management upon a participant’s return. The failure to recognize the potential impact of such costs and properly evaluate same should not be overlooked. Plan fiduciaries should heed the courts’ warnings that a fiduciary’s failure to personally perform a proper investigation and analysis of a plan’s investment options constitutes a breach of one’s fiduciary duty.

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Integrated Estate Planning: A Win-Win for Both Clients and Wealth Managers

Posted on March 13, 2012 by jwatkins

The concept of wealth management is an interesting proposition.  A recent study by CEG Worldwide concluded that only 6 percent of those holding themselves out as wealth managers actually provided comprehensive wealth management services, with the remaining 94 percent simply being product salesmen.

True comprehensive wealth management involves various areas of a client’s financial affairs, including investments, risk management and estate planning.  Recent surveys have shown an increasing public interest in asset protection, especially among professionals and high net worth individuals.

The concept of integrated estate planning has grown substantially over the past few years.  Integrated estate planning refers to the integration of estate planning and asset protection strategies. 

For RIAs, estate planners and other fiduciaries, integrated estate planning offers the opportunity to create a true win-win situation, an opportunity to enhance one’s practice while also addressing potential liability issues.  The potential malpractice issues for failing to incorporate asset protection considerations into estate planning are being discussed more and more at conferences and in professional publications.

Non-attorneys who claim to offer comprehensive wealth management offer counter that they do not feel experienced enough to offer advice on asset protection strategies or that they do not feel comfortable doing so for fear of violating the unauthorized practice of law rules.  While both are legitimate concerns, neither prevents a non-attorney from generally discussing the issue with a client and referring a client to an attorney for more details and possible implementation.  Failure to do so may be grounds for a malpractice action against an adviser publicly holding themselves out as comprehensive wealth managers.

One common misconception among both the public and financial advisers is that assert protection is expensive and requires an off-shore trust.  While asset protection can be expensive and the most effective option may be an off-shore trust, there are a number of simple, relatively inexpensive, and effective asset protection strategies available, including various types of trusts and wealth transfer strategies.

One type of trust that has been increasingly popular is the so-called “income only” trust (“IOT”).  Often referred to as the “middle-income asset protection plan,” this type of trust is often used in connection with Medicaid planning since it can effectively remove assets from one’s estate, allowing one to qualify for government benefits, while still providing a source of income for needs not covered by government benefits.

In considering asset protection strategies, RIAs, estate planners and other fiduciaries must always stress two important points to clients.  First, asset protection is neither intended to, nor does, provide protection for fraudulent schemes.  Advisers should always take steps to ensure that a client is not interested in asset protection to engage in fraudulent activity. 

Second, the amount of protection provided by asset protection strategies is inversely proportionate to the amount of control given up by a client over the assets involved.  The more control a client retains over the subject assets, the less protection an asset protection strategy will likely provide.  “Control” includes such powers as ability to switch beneficiaries, ability to use assets for personal use, and ability to terminate an asset protection strategy. 

Integrated estate planning offers yet another benefit to RIAs and other financial fiduciaries.  Since implementation of asset protection strategies will generally require an attorney to draft the documentation required to implement many asset protection strategies, integrated estate planning provided a networking opportunity for both the RIA and the estate planning attorney.  

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Five Legal Decisions Every RIA and Fiduciary Should Know

Posted on February 19, 2012 by jwatkins

In his most recent book, “The New Wealth Management, “ respected industry expert Harold Evensky noted that investment advisers have an obligation to understand both their professional duties and their legal responsibilities.  While compliance violations often result in fines, legal violations can threaten the very existence of an advisory firm.

As a former RIA compliance manager for one of the nation’s largest independent broker-dealers, I was always struck with the RIA members’ lack of knowledge about the legal requirements for investment advisers.  In some cases I found that RIA firms mistakenly believed that their broker-dealers had an obligation to advise them as to such requirements.  In other cases I found that the firms just decided to take a chance and hope that nothing happened.

My experience as a compliance officer led me to write “The Prudent Investment Adviser Rules” (“Rules”) for my compliance clients.  The “Rules” is a living document reflecting various key legal and regulatory decisions impacting the investment advisory business, adding new rules as they develop.  At present, there are forty-two rules.

The purpose of this post is to discuss five decisions that threaten every RIA practice. In the first case, the broker had invested one-hundred percent of a customer’s account in one highly speculative stock and had recommended that the customer open a margin account in order to purchase even more of the stock.  The customer was inexperienced in investing and had indicated a desire for conservative investments.

The broker argued that his primary obligation was simply to make sure that the customer was “fully advised of the all the facts and could make intelligent decisions.”  In ruling against the broker, the panel stated that a broker’s suitability obligations require more that than just risk disclosure.  The panel ruled that suitability involves both a customer’s willingness and ability to assume the risk inherent in a broker’s recommendations.

An interesting aspect of this 2001 decision is that Harry Markowitz, the father of Modern Portfolio Theory (“MPT”), had made the same observation regarding MPT based recommendations back in 1952 when he released his seminal book, “Portfolio Selection.”  Advisers often attempt to justify questionable recommendations by pointing to MPT, only to be hoisted on their own petard due to their lack of knowledge of Markowitz’s entire theories.

A third prong is emerging in investment suitability cases, that being a customer’s need to assume the risk inherent in an adviser’s recommendations.  Advisers need to avoid getting so wrapped up in theory that they overlook practical, real world applications and solutions.

Takeaway #1: Make sure your recommendations are consistent with a client’s willingness to accept the indicated level of investment risk, a client’s ability to bear such investment risk, and a client’s need to bear such risk.

In the second case, a customer had a significant position in restricted stock.  He had asked his broker about possible ways to provide downside price protection for the stock.  The broker failed to advise the customer of various hedging techniques that were available to provide the desired price protection.  After absorbing a significant loss in the stock, the customer learned through another brokerage firm that there were hedging strategies that could have been used, such as collars. 

In ruling on a preliminary motion, the court ruled that the customer’s allegations of fraud, breach of fiduciary duty, and negligence needed to be decided by a jury.  The court ruled that the firm’s failure to properly advise of hedging strategies constituted a “strong inference” of fraud given the firm’s previous representations as to their expertise in providing financial services and investment advice to high-net-worth individuals.

Takeaway #2: Make sure to provide clients with advice regarding various wealth preservation strategies, such as hedging techniques, and let them decide whether to implement same.  Be sure to document that such advice was provided and have the client indicate on the same form as to their decision to use or refuse such advice.

The third case involved a far too common situation.  Two customers had a financial plan prepared by a broker.  During the implementation stage, the broker recommended various investments that were inconsistent with the “optimal/efficient” recommendations contained in the financial plan.  The customers sued on various grounds, including fraud and breach of fiduciary duty.

The case was ultimately decided against the customers on procedural issues.  However, in a preliminary hearing the court did rule that the question of whether the adviser’s failure to implement in a manner consistent with the financial plan he had provided to the customers constituted fraud, which was a question of fact for a jury.

There is a wide-spread belief that the “two hats” theory will protect a broker against being held to the more demanding “best interest” fiduciary standard.  With prices for some plans running into the thousands, all financial advisers need to understand that there are various ways that the courts and regulatory bodies can justify imposing the fiduciary standard on someone providing investment advice to the public.

MPT, Monte Carlo simulations, and other computer-based investment recommendation program all have shortcomings, shortcomings that are well-known throughout the financial service industry.   While such programs can be useful tools in providing investment advice, they are just that, tools.  An adviser’s failure to acknowledge and understand the programs’ weaknesses and limitations, including their use in risk tolerance analyses, can have disastrous results for advisers.

Takeaway #3: If you provide a customer with a financial plan or asset allocation/ portfolio optimization plan, make sure that your implementation recommendations are consistent with the recommendations and assumptions in such plan.  After all, the client paid for a plan whose price is justified on the premise that the plan purportedly represents the best course of action for the client, and the adviser will generally use the plan to induce a client to make changes in their investment portfolio and produce income for the adviser.  

As long as the adviser’s recommendations are consistent with the plan they provided to a client, an adviser will generally not be held liable for an investment’s ultimate performance as long as the process used in making the recommendations was prudent and met all applicable legal and regulatory requirements. However, where an adviser’s implementation recommendations are not consistent with the asset allocation/portfolio optimization plan’s recommendations provided to a customer and the assumptions used in preparing the plan, then a claim for potential fraud and breach of fiduciary duty can, and should, be filed upon the theory of a sophisticated, and illegal, form of “bait and switch.”

The fourth case involves a fiduciary’s ongoing duty to monitor a client’s account when the fiduciary has assigned the responsibility for managing that account to a third-party.  Fiduciary law is based upon a combination of trust law and agency law.  An agent (the fiduciary) has an obligation to protect his principal’s (the client’s) interests and to disclose any and all information which would help the principal protect his interests.  The Prudent Investor Act specifically requires a trustee (or other fiduciary) to monitor all accounts and to take action to protect a beneficiaries’ interests when necessary, the so-called “sue or be sued” rule.  There are numerous cases supporting a fiduciary’s duty to monitor client accounts and to take action when necessary to protect a client’s interests.

Takeaway #4: Monitor all client accounts managed by third-parties on an ongoing basis and take prompt action when questionable activity or performance issues arise, with notification to the client/beneficiary recommended as well.

A case can, and has, been made that this same duty of disclosure applies to accounts transferred to a fiduciary from another fiduciary.   Conceptually, the same trust and agency principles that demand disclosure would apply.  While the fiduciary would not be legally responsible for the acts of the previous fiduciary, there is a question as to whether the new fiduciary could be liable for failing to alert the client or beneficiaries to the questionable activity so that a proper and timely investigation could be made.

The last case involves situations where a fiduciary tries to avoid liability by asserting a claim of good faith and lack of bad intent.  There are numerous cases holding that fiduciary liability is based upon purely objective standards.  Subjective standards are irrelevant in determining a breach of one’s fiduciary duties or, in the words of the courts, “a pure heart and an empty head are no defense.”

Takeaway #5: A fiduciary has an obligation to learn the applicable legal standards governing their duties and obligations to their clients.  Ignorance of the law is not an acceptable defense.    

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