Investment Advisers and Outsourcing

Posted on April 20, 2011 by jwatkins

Outsourcing is definitely one of the hot topics with investment advisers.  Most investment advisers I talk to about outsourcing feel that outsourcing asset management and/or compliance responsibilities will allow them to concentrate more on building up their assets under management and, consequently, their fees.

While outsourcing may allow an  investment adviser to concentrate more on asset gathering, advisers need to realize that outsourcing certain responsibilities does not relieve them of their ongoing fiduciary duties in connection with such duties.  Since fiduciary duties are personal in nature, an investment adviser cannot simply delegate fiduciary responsibilities to another and walk away. 

First of all, a fiduciary has a legal duty to monitor third parties to whom the adviser has delegated responsibilities to protect the client against unauthorized or unsuitable activity.  Furthermore, an investment adviser has a duty to redress any harm caused to a client as a result of such improper activity, including an obligation to sue the offending third-party if necessary. 

What many investment advisers do not understand is that third-party assets managers often include language in their master advisory contracts with investment advisers that states that the investment adviser, not the third-party asset manager, remains liable for the suitability of the third-party asset manager’s programs.  On more than one occasion I’ve had the unfortunate duty to tell investment advisers that such language was hidden in the master contract and that they faced liability for not continuing to monitor the client’s account.  Proactive investment advisers who take the time to review such contracts or have such contracts reviewed by an attorney can often negotiate to have such language removed, as asset managers will rarely walk away from potential accounts.

As a former RIA compliance director at one of the largest  nation’s largest independent broker-dealers, I am often asked about outsourcing compliance responsibilities.  First, I’m not sure that such would be acceptable by the SEC, FINRA or state regulators in light of the Royal Alliance decision several years ago.  The decision basically raised issues regarding the ability of a broker-dealer to provide effective compliance oversight to a large network of branch offices spread out over the entire country.  Two of the issues raised by the regulators were the ability to supervise daily activity without having an actual physical presence in the respective branch offices and the sheer number of representatives being supervised.

Assuming that a compliance outsourcing system can be created that would be acceptable to the regulators, investment advisers need to understand that in the event that the third-party compliance provider makes an error, the investment adviser would most likely still have ultimate responsibility for such a mistake, as the courts and the regulators have consistently held that advisers who choose to outsource advisory responsibilities do so at their own risk, regardless of the terms of their contract with the third-party provider.

The bottom line is that outsourcing is yet another example of caveat adviser, another area of investment adviser law where being proactive is the sound course of action.  Taking the time to consult with someone experienced and knowledgeable in investment adviser law can help an adviser protect both their practice and their clients.

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The Little Known Win-Win Fiduciary “Gotcha”

Posted on January 25, 2011 by jwatkins

It is well-established that investment advisers are fiduciaries.  Fiduciary law is based primarily on principles developed under agency law and trust law.  When you mention fiduciary law, most people immediately think of the duty of loyalty, the requirement that a fiduciary always put a client’s interests first.  What many investment advisers do not understand is the extent of that obligation.

I am often asked by investment advisers and attorneys to perform a fiduciary audit on incoming and/or existing accounts.   The prudent investment adviser realizes that even if the actual management of a client’s investment account is outsourced to a third party, the investment adviser still has a responsibility to monitor the account and take actions to redress any wrongs comiitted by a third party asset manager.  What many investment advisers do not realize is that they have a similar duty when they accept a client’s account.

As part of the duty to always act in the best interests of a client, both agency law and trust law require a fiduciary to disclose information that would be beneficial to a client’s interests and to take action, if necessary, to protect and preserve a client’s property.  With regard to the duty to review new fiduciary accounts, Section 76, comment d, of the Restatement, Third, Trusts states that “the trustee ordinarily has the associated responsibility of taking reasonable steps to uncover and redress any breach of duty committed by a predecessor fiduciary.”

Advisers often counter with the objection that they are not attorneys and do not feel comfortable reviewing and/or commenting on another fiduciary’s action for fear of legal consequences.  Both Sections 76 and 77 of the Restatement advise a fiduciary to seek advice of counsel or the court, if appropriate, in order to meet their fiduciary obligations.  Seeking the advice of a compliance officer or a compliance professional may not protect an investment adviser unless the compliance officer/professional understands fiduciary, trust and agency law ands is aware of the relevant legal and regulatory decisions in these areas.

The fiduciary duty to review new accounts and advise clients of potential fiduciary breaches by previous fiduciaries can actually prove beneficial to investment advisers.  In addition to complying with the legal standards for fiduciaries, performing the required review and advising a client helps demonstrate to a new client that the investment adviser is truly watching out for the client’s best interests, which in turn promotes greater trust between the client and the investment adviser.

Furthermore, in the event that any fiduciary breaches resulted in losses, taking action to recover such losses could result in additional assets under management for the adviser and additional management compensation.  Because of the legal and financial issues involved in redressing potential fiduciary breaches, we always recommend that investment advisers fulfill their duty to disclose such concerns to a client and then let the client make the ultimate decision on whether to pursue such matters.  An investent adviser should always document both the disclosure of such information to a client and the client’s decision regarding the matter.

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The Times They Are A Changin’

Posted on December 21, 2010 by jwatkins

With the pending release by the SEC of the new fiduciary rules, I have received a lot of e-mails and calls regarding the potential implications for currently registered  investment advisers.  Since investment advisers have been held to be fiduciaries under both the Investment Advisers Act of 1940 and various court decisions interpreting the Act, the new fiduciary rules should not have any procedural impact on currently registered investment advisers. 

If, as expected and hoped for, the SEC takes the common sense approach and simply adopts a universal “best interest of the client” fiduciary for anyone providing  investment advice to the public, the business model for broker-dealers, registered representatives and insurance companies offering investment products must make significant changes.  According to various reports, broker-dealers have accepted the inevitability of  a “best interests” fiduciary standard.  

However, not surprisingly, the insurance industry apparently continues to fight a “best interests” fiduciary standard.  Such a standard would have serious implications for some current insurance industry practices and products, most notably alleged overselling of coverages and variable annuities.  Based upon my own experience with the insurance industry, insurance sales based on actual needs sometimes becomes buy as much as possible.  Variable annuities raise a number of fiduciary issues given their typically high fees, inverse pricing structure and potentially disastrous impact on one’s estate plans.

A universal “best interests” fiduciary standard would continue to provide an edge to currently registered investment advisers as broker-dealers, insurance companies and their representatives adjust to the new standards.  It can be expected that some will simply ignore the new fiduciary requirements, continuing to do business the old way unless and until they get caught.   Some have predicted a significant increase in the number of independent investment advisory firms, the rationale being that if they have to meet a fiduciary standard anyway, why not increase their profit potential. 

Existing investment advisory firms will be able to tell both existing and potential clients that it’s business as usual, as their firm has always been required to put  a client’s “best interests” first.  Advisory firms may want to consider gaining an additional competitive advantage by pointing to a 2007 Schwab Institutional study that concluded that 75% of brokerage accounts did not match the client’s goals, following that up with an offer for a free portfolio review.

With the release of the new fiduciary standards, the financial services industry will definitely undergo a change.  Prudent investment advisors will recognize and seize upon the opportunity to gain or maintain an edge on their competitors.

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A Pure Heart and an Empty Head Is No Defense

Posted on November 18, 2010 by jwatkins

Unbeknownst to many investment advisers, it is their responsibility to educate themselves as to applicable legal standards for their advisory practices.  Investment advisers affiliated with a broker-dealer often assume that the broker-dealer will keep them updated as to any compliance and/or legal information they need to know.  However, under NASD Notice to Members 94-44, broker-dealers are only required to review the trading activity of their registered representatives that are members of independent investment advisory firms.  Broker-dealers have absolutely no legal obligation to provide compliance or legal support services to independent advisory firms.

Investment advisory firms that discover that they have violated one of the Prudent Investment Adviser Rules or another applicable legal standard often argue that they meant well and they simply were unaware of the applicable legal standards.  This “pure heart, empty head” defense has been consistently rejected by the courts and the regulatory bodies, based primarily on the fiduciary relationship that exists between an investment adviser and their clients.  Investment advisers must be proactive and assume responsibility for learning the applicable legal standards and continuing to monitor future rulings and decisions that may impact their practices.

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Hello world!

Posted on November 11, 2010 by jwatkins

IA Insight is a blog for investment advisers and those who advise investment advisers, such as attorneys and compliance personnel.  The goal is to provide practical and meaningful information to help investment advisers and their advisers develop and maintain acceptable “best practice” standards to better serve their clients and protect their advisory practices.

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