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The DOL Fiduciary Rule - Prudent Expert Standard

Posted by Jack Duval

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Jun 23, 2017 8:44:48 AM

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This blog post continues a series exploring the DOL Fiduciary Rule (“DOL FR”).  My original blog post can be found here.

No man can serve two masters: for either he will hate the one, and love the other; or else he will hold to the one, and despise the other.  Ye cannot serve God and mammon. [1]

It appears that by negotiating for the Best Interest Contract Exemption (“BICE”), the broker-dealers have positioned themselves to serve two masters: the fiduciary standard and revenue.

In order to understand this conflict, it is necessary to understand the obligations of a fiduciary in general, and the higher obligations due under the DOL’s Prudent Expert Standard.

Fiduciary Obligations

The general fiduciary obligations due to an investor include duties of:[2] 

  • Undivided loyalty;
  • Always putting the client’s interests first;
  • Utmost good faith and fair dealing;
  • Full and fair disclosure of all material facts, and;
  • Full and fair disclosure of all actual or potential conflicts of interest;

These duties are present in all fiduciary relationships (where trust and confidence has been reposed in another).  However, the DOL FR imposes an even higher standard upon advisors.

Prudent Expert Standard

The DOL FR imposes the Prudent Expert Standard, which is the highest standard of care possible.  It encompasses the standard fiduciary obligations outlined above, but in addition requires their application in a manner that an expert in the field would use.

The Prudent Expert Standard has existed in the ERISA law under Section 404, Fiduciary Duties, which states:[3]

… 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; and

(D) In accordance with the documents and instruments governing the plan insofar as such documents and instruments are consistent with the provisions of this title and title IV. (Emphasis added)

The “with the care, skill, prudence, and diligence” language highlighted above is what gives rise to the Prudent Expert Standard.

The language under the BICE, Section II(c)(1) is very similar:[4]

When providing investment advice to the Retirement Investor, the Financial Institution and the Adviser(s) provide investment advice that is, at the time of the recommendation, in the Best Interest of the Retirement Investor.  As further defined in Section VIII(d), such advice reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person 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, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Advisor, Financial Institution or any Affiliate, Related Entity, or other party.  (Emphasis added)

Interestingly, the BICE Prudent Expert Standard also specifically includes elements of the investor’s profile to the application of the fiduciaries advice and explicitly excludes the financial or other interests of the fiduciary from tainting their advice.

The Professional Fiduciary

The idea of higher fiduciary standards for professionals also exists in the trust law.  The Uniform Prudent Investor Act speaks to the idea of a “professional fiduciary”:[5]

Section 2 (f) A trustee who has special skills or expertise, or is named trustee in reliance upon the trustee’s representation that the trustee has special skills or expertise, has a duty to use those special skills or expertise…

Comments

The distinction taken in subsection (f) between amateur and professional trustees is familiar law.  The prudent investor standard applies to a range of fiduciaries, from the most sophisticated professional investment management firms and corporate fiduciaries, to family members of minimal experience.  Because the standard of prudence is relational, it follows that the standard for professional trustees is the standard of prudent professionals; for amateurs, it is the standard of prudent amateurs.  Restatement of Trusts 2d § 174 (1954) provides: “The trustee is under a duty to the beneficiary in administering the trust to exercise such care and skill as a man of ordinary prudence would exercise in dealing with his own property; and if the trustee has or procures his appointment as trustee by representing that he has greater skill than that of a man of ordinary prudence, he is under a duty to exercise such skill”  Case law strongly supports the concept of the higher standard of care for the trustee representing itself to be expert or professional.  (Emphasis added)

The concept of a professional fiduciary lies at the foundation of the BICE:[6]

It is worth repeating that the Impartial Conduct Standards are built on concepts that are longstanding and familiar in ERISA and the common law of trusts and agency.  Far from requiring adherence to novel standards with no antecedents, the exemption primarily requires adherence to basic, well-established obligations of fair dealing and fiduciary conduct.  Moreover, as discussed above, the exemption’s reliance on these familiar fiduciary standards is precisely what enables the Department to apply the exemption to the wide variety of investment and compensation practices that characterize the market for retail retirement advice, rather than to a far narrower category of transactions subject to much more detailed and highly-proscriptive conditions.  (Emphasis added)

Loyalty and Prudence

The Department of Labor’s filings related to the fiduciary rule use a shorthand phrase to summarize the fiduciary duties owed by the advisor to their client: loyalty and prudence.

This shorthand should not be mistaken for a diminution of the fiduciary duties, indeed they are forceful, explicit, and most importantly, objective.  For instance:[7]

the duties of loyalty and prudence embodied in ERISA are objective obligations that do not require proof of fraud or misrepresentation, and full disclosure is not a defense to making an imprudent recommendation or favoring one’s own interests at the Retirement Investor’s expense.  (Emphasis added)

By stating that the duties of loyalty and prudence are “objective obligations”, the DOL is lifting the standards from the vague waters of suitability and into the realm of black and white.  Advisors recommending high-fee, complex, and ill-liquid investments will find it hard to justify their actions under such a standard.

Furthermore, the fact that “proof of fraud or misrepresentation” is not required to violate the duties of loyalty and prudence and that “full disclosure is not a defense to making an imprudent recommendation”, should give real pause to those advising on retirement assets.

Indeed, the DOL makes it clear that what is required of the fiduciary is objective diligence to justify a recommendation, and not good intentions:[8]

… the courts have evaluated the prudence of a fiduciary’s actions under ERISA by focusing on the process the fiduciary used to reach its determination or recommendation – whether the fiduciary, “at the time they engaged in the challenged transactions, employed the proper procedures to investigate the merits of the investment and to structure the investment” …

“This is not a search for subjective good faith – a pure heart and empty head are not enough.”  (Emphasis added)

Shifting Legal Arguments from the Subjective to the Objective

The “process the fiduciary used” (and evidence of that process) is objective.  Fees, complexity, and liquidity are objective.  Comparisons to other investments available at the time are objective.  Risk and return assumptions are objective. Statistical and mathematical analyses are objective.  Diversification is objective.

Under the DOL FR, litigants will be freed from searching for “smoking guns” proving or disproving scienter.  The tedious “he-said, she-said” arguments before the trier of fact will also be eliminated.  Likewise, the “prospectus defense”, whereby the delivery of a prospectus is argued to be a get-out-of-jail-free card for advisors, will also be jettisoned.[9]

What is left is the objective evaluation of the process by which the recommendation was made and if it was in the client’s best interest.

Many investments which may have been suitable under the FINRA rules will abjectly fail under the DOL FR.  Broker-dealers should change their policies and procedures accordingly.

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Notes:

[1]       The Bible; Matthew 6:24; King James Version.

[2]       See Lemke and Lins, Regulation of Investment Advisers; 2006; 167-8, and SEC v. Capital Gains Research Bureau, 375 U.S. 18 1963.

[3]       ERISA Section 404(a); Available at: https://legcounsel.house.gov/Comps/Employee%20Retirement%20Income%20Security%20Act%20Of%201974.pdf; Accessed June 22, 2017.

[4]       Best Interest Contract Exemption with Amended Applicability Dates; Section II(c)(1) – Impartial Conduct Standards; Available at: https://www.dol.gov/sites/default/files/ebsa/laws-and-regulations/rules-and-regulations/completed-rulemaking/1210-AB32-2/best-interest-contract-exemption-with-amended-applicability-dates.pdf; Accessed June 22, 2017.

[5]       Uniform Prudent Investor Act; February 14, 1995; Section 2(f) and related comments; Available at: http://www.uniformlaws.org/shared/docs/prudent%20investor/upia_final_94.pdf; Accessed June 22, 2017.

[6]       Federal Register, Best Interest Contract Exemption, 21032.

[7]       Federal Register, Best Interest Contract Exemption, 21028.

[8]       Id. at 21028-9.

[9]       Although this argument is frequently made, FINRA and the SEC have clearly opined that the delivery of a prospectus is not a defense to an otherwise unsuitable investment, and that it does not cure misrepresentations or omissions made as part of a recommendation.  See FINRA NTM 05-59 – Structured Products, at footnote 3; 8.

Click to view useful links on our DOL Fiduciary Rule - Securities Litigation Resources page.

To learn more about fiduciary expert Jack Duval, click here.

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Topics: dol fiduciary rule, fiduciary obligations, erisa fiduciary expert, securities litigation, prudent expert standard

    

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