The Securities Litigation Expert Blog

Dear "Prudent": The DOL Proposal

Posted by Jack Duval

Sep 24, 2020 8:56:32 AM

NOTE: Since the DOL Fiduciary Rule has been dead for two years, I have provided a review of events since then, primarily focused on Regulation Best Interests and the new DOL proposed class exemption.

If you are familiar with those, skip to the “Prudence - and the Prudent Expert” section for the good stuff.

Introduction

SEC Regulation Best Interest ("RBI") went into effect on June 29, 2020. I've written extensively about RBI and the implications for broker-dealer obligations to clients and won’t cover that here.

Instead, I want to focus on the Department of Labor (“DOL”) proposed class exemption (“DOL Proposal”) that was also released on June 29, 2020.

While much ink has been spilled on RBI and its implementation, on the same day it went into effect the Department of Labor released a proposed update to the Employee Retirement Income Security Act of 1974 ("ERISA").[1]

The DOL Proposal has received much less focus. It shouldn't have. This potential change to ERISA could make almost anyone advising on IRA rollovers, and their investments, a fiduciary.

Indeed, the release appears to be a Trojan horse for the broker-dealer community. It allows for a host of prohibited transactions (welcomed), but will hold those making the recommendations to the prudent expert standard, the highest fiduciary standard in the land (most unwelcomed).

As will be discussed below, many of those criticizing the DOL release, including the Public Investors Advocate Bar Association (“PIABA”)[2] and the State of California Attorney General,[3] (who is leading a coalition to oppose the DOL proposal), appear to have not understood the entirety of the DOL's proposal, or at least not fully understood its terms.

Background

Before reviewing the DOL Proposal, it is helpful to review a quick timeline of how we got here. Additionally, you can access all my writings on the original DOL Fiduciary Rule here.

In 2010, the DOL began work to clarify that anyone advising on IRA rollovers and their assets was subject to ERISA and thus a fiduciary. Six years later, in 2016, the DOL published its final Fiduciary Rule.

The Fiduciary Rule was vigorously opposed by the broker-dealer community, which sued and won a Fifth Circuit Court of Appeals ruling in 2018. This vacated the Fiduciary Rule.

In the mean time, the SEC undertook to create a heightened standard of care for investment professionals dealing with retail clients, Regulation Best Interest (“RBI”). In 2019 it finalized RBI, which requires a neither-fish-nor-fowl "best interest" standard that lies between the FINRA suitability standard and the Investment Advisor fiduciary standard. (Notably, the SEC could not find the spine to define what "best interest" actually means.)

In June, the DOL quietly proposed changes to ERISA that would provide exemptions from prohibited transactions, and also significantly clarified the "five-part test" for fiduciary status. There was a short one-month comment period that has now come and gone.

The DOL Proposal

The DOL Proposal provides prohibited transaction exemptions for IRA rollover accounts:[4] 

This exemption permits Financial Institutions and Investment Professionals who provide fiduciary investment advice to Retirement Investors to receive otherwise prohibited compensation and engage in riskless principal transactions and certain other principal transactions (Covered Principal Transactions) as described below.

 

This exemption permits Financial Institutions and Investment Professionals, and their affiliates and related entities, to engage in the following transactions, including as part of a rollover for a Plan to an IRA as defined in Code section 4975(e)(1)(B)... (Emphasis added)

IRA accounts are significant because roughly 40 percent of U.S. household assets are held in them. According to IRS data, at year-end 2017, there were $9.4 trillion in IRA assets for 60.3 million taxpayers.[5] Furthermore, rollovers are a significant source of new funds for brokers and investment advisors. In 2017, there were 4.7 million rollovers totaling $478 billion in assets.[6]

These trends will almost certainly accelerate as increasing numbers of Baby Boomers retire and roll over their pensions, which were the dominant saving vehicle at the beginning and middle of their careers, and 401(k) accounts, which became popular in the later part of their careers.

Importantly, the DOL proposal also reverses a key 2005 ruling, and now requires the advising broker to satisfy the Impartial Conduct Standards and other conditions.

Reversing Advisory Opinion 2005-32A the "Deseret Letter”

The DOL has specifically put rollovers into fiduciary play by reversing a 2005 ruling known as the “Deseret Letter”, writing:[7] 

In light of potential conflicts of interest related to rollovers from Plans to IRAs, ERISA and the Code prohibit an investment advice fiduciary from receiving fees resulting from investment advice to Plan participants to roll over assets from a Plan to an IRA, unless an exemption applies. The proposed exemption would provide relief, as needed, for this prohibited transaction, if the Financial Institution and Investment Professional provide investment advice that satisfies the Impartial Conduct Standards and they comply with the other applicable conditions discussed below. (Emphasis added)

 

In particular, the Financial Institution would be required to document the reasons that the advice to roll over was in the Retirement Investor's best interest. In addition, investment advice fiduciaries under Title I of ERISA would remain subject to the fiduciary duties imposed by section 404 of that statute.

 

In determining the fiduciary status of an investment advice provider in this context, the Department does not intend to apply the analysis in Advisory Opinion 2005-23A (the Deseret Letter), which suggested that advice to roll assets out of a Plan did not generally constitute investment advice. The Department believes that the analysis in the Deseret Letter was incorrect and that advice to take a distribution of assets from an ERISA-covered Plan is actually advice to sell, withdraw, or transfer investment assets currently held in the Plan. A recommendation to roll assets out of a Plan is necessarily a recommendation to liquidate or transfer the Plan's property interest in the affected assets, the participant's associated property interest in the Plan investments, and the fiduciary oversight structure that applies to the assets. (Emphasis added)

 

Typically the assets, fees, asset management structure, investment options, and investment service options all change with the decision to roll money out of the Plan. Accordingly, the better view is that a recommendation to roll assets out of a Plan is advice with respect to moneys or other property of the Plan. Moreover, a distribution recommendation commonly involves either advice to change specific investments in the Plan or to change fees and services directly affecting the return on those investments. (Emphasis added)

The last part of this is in agreement with SEC and FINRA guidance, which note that a rollover almost always involves a securities transaction. Under RBI the SEC has written:[8] 

… it is our view that Regulation Best Interest should apply broadly to recommendations of securities transactions and investment strategies involving securities. Accordingly, the Commission is including in the rule text account recommendations as recommendations that will be covered by Regulation Best (sic). “Account recommendations” include recommendations of securities account types generally (e.g., to open an IRA or other brokerage account), as well as recommendation to roll over or transfer assets from one type of account to another (e.g., a workplace retirement plan account to an IRA). (Emphasis added)

Similarly, FINRA has put its members on notice that:[9] 

a broker-dealer’s recommendation that an investor roll over retirement plan assets to an IRA typically involves securities recommendations subject to FINRA rules.

Critically, the IRA rollover recommendations and subsequent investment recommendations would enjoy the exemptions from prohibited transactions only if the broker (and broker-dealer) met the Impartial Conduct Standards.

The importance of this language cannot be overstated.

The Impartial Conduct Standards

The DOL proposal would require broker compliance with the Impartial Conduct Standards, which have three components:[10] 

  • Providing advice that is in Retirement Investors’ best interest;
  • Charging only reasonable compensation, and;
  • Making no materially misleading statements about the investment transaction and other relevant matters.

Furthermore, the DOL proposal would require:[11] 

Financial Institutions, prior to engaging in a transaction pursuant to the exemption, to provide a written disclosure to the Retirement Investor acknowledging that the Financial Institution and its Investment Professionals are fiduciaries under ERISA and the CODE, as applicable.

 

The disclosure also would be required to provide a written description, accurate in all material respects regarding the services to be provided and the Financial Institution’s and Investment Professional’s material conflicts of interest. (Emphasis added)

Critics of the DOL proposal have taken aim at the best interest element of the Impartial Conduct Standards. For instance, PIABA, in its comment letter, wrote:[12] 

The first prong of the Impartial Conduct Standards, the best interest obligation, is to be interpreted and applied consistent with the best interest standard as defined by the Commission’s recently enacted Reg. BI.

While PIABA quote the DOL Proposal accurately, the spirit of the DOL Proposal reflects stronger medicine:[13] 

This proposed best interest standard is based on longstanding concepts derived from ERISA and the high fiduciary standards developed under the common law of trusts, and is intended to comprise objective standards of care and undivided loyalty, consistent with the requirements of ERISA section 404. (Emphasis added)

This DOL Proposal language echoes the language propounded in the Impartial Conduct Standard in the proposed Best Interest Contract Exemption on April 8, 2016. At the time, the DOL wrote: 

(the Impartial Conduct Standards) are fundamental obligations of fair dealing and fiduciary conduct, and include obligations to act in the customer’s best interests, avoid misleading statements, and receive no more than reasonable compensation.[14]

 

The Impartial Conduct Standards represent fundamental obligations of fair dealing and fiduciary conduct. The concepts of prudence, undivided loyalty and reasonable compensation are all deeply rooted in ERISA and the common law of agency and trusts.[15] (Emphasis added) 

Prudence - and the Prudent Expert

 

“Prudence” is a word that appears throughout ERISA and the DOL Proposal. However, it was assiduously removed from the originally proposed RBI and did not make the final rule.[16] It’s appearance in the DOL Proposal provides an important distinction between RBI and ERISA.

Critically, the DOL’s version of fiduciary conduct contained within the Impartial Conduct Standards is the prudent expert standard, the absolute highest fiduciary standard in the land.

ERISA Section 404(a)-1 Investment duties, lays out the prudent expert standard:[17] 

… a fiduciary shall discharge his duties with respect to a plan 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. (Emphasis added)

The DOL Proposal reiterates the prudent expert standard language, essentially verbatim from ERISA Section 404(a)-1:[18] 

Investment advice is, at the time it is provided, in the Best Interest of the Retirement Investor. As defined in Section V(a), 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, and does not place the financial or other interests of the Investment Professional, Financial Institution or any affiliate, related entity, or other party ahead of the interest of the Retirement Investor, or subordinate the Retirement Investor’s interest to their own. (Emphasis added)

After the 2016 DOL Fiduciary Rule was vacated by the Fifth Circuit, the DOL issued Field Assistance Bulletin (“Bulletin”) No. 2018-02 that kept the Impartial Conduct Standards in effect. The current DOL Proposal describes the Bulletin guidance:[19] 

In the FAB, the Department stated it would not pursue prohibited transactions claims against investment advice fiduciaries who worked diligently and in good faith to comply with “Impartial Conduct Standards” for transactions that would have been exempted in the new exemptions, or treat the fiduciaries as violating the applicable prohibited transaction rules. (Emphasis added)

The Impartial Conduct Standards discussed in the Bulletin were originally articulated in the Best Interest Contract Exemption proposal, the language of which will by now be familiar:[20] 

As defined in the (Best Interest Contract) exemption, a Financial Institution and Adviser act in the Best Interest of a Retirement Investor when they provide investment advice that 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 Adviser, Financial Institution or any Affiliate, Related Entity, or other party.” (Emphasis added)

Thus, the Impartial Conduct Standards from the now-vacated Fiduciary Rule/Best Interest Contract Exemption have been in effect under the May 7, 2018 DOL temporary enforcement policy, and would remain in effect under the DOL Proposal.

The point of tracing this language back to the original ERISA text is to show the continuity of the prudent expert standard. It has not changed. From ERISA Section 404(a)-1, to the Fiduciary Rule/Best Interest Contract Exemption, to the Bulletin, to the new DOL Proposal, the prudent expert standard has remained intact.

Shifting the Burden of Proof

PIABA and others were correct to flag the adoption of the RBI version of “best interest” in the DOL Proposal. PIABA summarized it well:[21] 

None of the foregoing obligations actually requires the firm to place the customer’s interests ahead of the adviser’s. Instead, Reg BI states that the advisor cannot “place its own interests ahead of the customers’ interests. Consequently, Reg BI allows the adviser to put its own interests on equal footing with the customers’ interests. In baseball terms, a tie goes to the adviser. This is contrary to the fundamental premise of a fiduciary duty: that the investors’ interests must always come first. Similarly, the Department has said that the Impartial Conduct Standard will only require that the Investment Advice Fiduciary may not place their interests ahead of the retirement investors’ interests. (Emphasis added)

There is no doubt that the RBI “best interest” language is less rigorous than the fundamental fiduciary duty that the client’s interests must always come first, which has always existed under ERISA and the Investment Advisors Act. There are no “ties” of interest with the traditional fiduciary duty, the client’s interests win every time.

However, I believe PIABA (and the other critics) have missed the significance of the prudent expert standard, which imposes an even more rigorous standard by:

  1. Holding the advice to the standard of what a third-party expert fiduciary would do in the same circumstances, and;
  2. Without regard to their own financial interests.

These elements of the prudent expert standard raise the bar exceedingly high, much higher than the suitability standard, higher than RBI (which has a version of the prudent expert standard) and arguably higher than even the fiduciary standard of an investment advisor.

Chart 1: The Shrinking Universe of Investment Options

 accelerant jack duval - dol proposal - prudent expert - investment strategy chart

Chart 1, above, shows how the available investment options shrink under successively more exacting standards, with the prudent expert standard being the most rigorous.

Where PIABA is worried that the DOL Proposal allows for the interests of the advisor and client to be pari passu, that potential fails under the prudent expert standard.

No prudent expert, giving advice without regard to their own financial interests, would recommend an investment or investment strategy that put their own interests equal with their clients. This is simply due to the simple math of compensation: all broker compensation comes at the expense of the client.

The Defense Will Have to Make Its Case

In the typical lawsuit, the plaintiff is required to prove their case against a standard. That will change under the DOL Proposal.

At a hearing, a defendant fiduciary will have to prove they met the prudent expert standard, including:

  • Proving the contemporaneous application of care, skill, prudence, and diligence that a prudent expert would have undertaken in a similar situation for a similar client, and;
  • Proving that the recommendations made were consistent with what a prudent expert would have made without regard to their own remuneration.

This is a completely different context than what has existed for broker-dealer clients under the suitability standard, more rigorous that what exists under RBI, and possibly more rigorous that what exists under the Advisers Act.

Changing the Arbiter

Under FINRA’s Suitability Rule 2111, the standard of care is that the broker must have a reasonable basis to believe the recommendation made was suitable for the client. The rule is from the perspective of the broker. Under this rule, the broker is the arbiter of the reasonableness of the recommendation.

Under the DOL Proposal, the rule is from the perspective of an impartial prudent expert observer. That third-party prudent expert is the arbiter of whether skill, care, prudence, and diligence were applied in the making the recommendation.

This shift is enormous. The arbiter is no longer the broker but an expert fiduciary. The standard is not determined by the broker but by the expert fiduciary. The standard is no longer subjective, but objective.

Even more stark is that “reasonableness” is an opinion. It requires no evidence. In contrast, the application of skill, care, prudence, and diligence is objective and requires contemporaneous evidence. (A broker can claim to have come to an opinion about reasonableness with nothing in her files, however, she cannot credibly claim to have applied skill, care, prudence, and diligence in the manner of a prudent expert with an empty file.)

Additionally, how thorough the work was undertaken is objective and the conclusions drawn from that work can be easily weighed.

In most securities litigations I’ve been involved with, the defense has been something like this: the client wanted growth and the broker gave them growth investments, therefore they were suitable. This argument was made with a straight face no matter how expensive, illiquid, speculative, and tax-inefficient the “growth” investment was.

Under the FINRA Suitability Rule, virtually any vaguely plausible investment and/or investment strategy could be argued to be “suitable”, although those arguments frequently failed in arbitrations and in SRO disciplinary proceedings.[22]

Under the DOL Proposal they will be per se deficient.

The burden of proof will shift from the client having to prove that the investments recommended to her were unsuitable, to the broker having to prove that she undertook the required care, skill, prudence, and diligence, and after that work determined the investments recommended were in the client’s best interest. Even more daunting, the broker will have to prove that a prudent investment expert, acting without concern for her own remuneration, would have made the same recommendation, in the same situation, for the same client.

In my experience, the vast majority of “vaguely plausible” investment defenses will wither in the face of the prudent expert standard. Fiduciary defendants will not be able to demonstrate the contemporaneous “care, skill, prudence, and diligence” required to have met the standard, nor will they be able to show their recommendations would have been the same if they had been advising without regard to their own compensation.

Indeed, in the majority of cases I have participated in, brokers typically have very few notes and no evidence of any care, skill, prudence, and diligence being applied to their investment recommendations. Frequently, there is absolutely nothing in the record except the trade confirmation, sent to the client after the trade.

This fact pattern will epically fail the prudent expert standard.

Additionally, accounts that get loaded with multiple “product of the month” type of investments, including (but not limited to): new issues such as closed-end funds, as well as structured products, high fee and high load mutual funds, and insurance products will also fail to meet the prudent expert standard.

In almost all instances the investment thesis behind any high-fee and/or illiquid products can be expressed in low (or no) fee products and/or by shifting the asset allocation of an account.

While brokers are certainly entitled to reasonable compensation, the prudent expert standard shifts the arbiter from the profit maximizing broker to an impartial prudent expert fiduciary deciding without regard to her own remuneration.

These standards are worlds apart.

Once the rigor of the prudent expert standard is established, I would expect IRA-related securities litigations to settle, and for higher percentages of claimed damages.

I would also expect this to further accelerate the shift away from charging commissions on products to fee-based accounts where no product commissions are charged. The later generally eliminate the conflicts of interest inherent to commission-based broker compensation and greatly reduce the required supervisory effort.

Supervisory Impacts

To meet the prudent expert standard, broker-dealers will need to create policies and procedures to ensure that their brokers are undertaking and documenting the necessary care, skill, prudence, and diligence for each recommendation.

While this will require more oversight, the costs should not be large. In my experience of reviewing the compliance and supervisory systems of broker-dealers of all sizes and geographies, even the smallest firms have the supervisory, CRM, and other systems in place to implement the required policies.

While the capital expenditure required will likely be small, the supervisory effort will be larger.

As always, the real issue with broker-dealer policies and procedures is not their existence (every broker-dealer has them, and all but a few are sufficient), but their implementation.

In my next post, I will examine the DOL’s clarification of the five-part test to determine fiduciary status and how it will make almost all brokers fiduciaries when recommending rollovers and the reinvestment of the proceeds.

__________

Notes:

[1]      29 CFR Part 2550 [Application No. D-12011] ZRIN 1210-ZA29; Improving Investment Advice for Workers & Retirees. Available at :https://www.govinfo.gov/content/pkg/FR-2020-07-07/pdf/2020-14261.pdf; Accessed August 14, 2020.

[2]      Public Investors Advocate Bar Association; Comments Letter RE: Application No. D-12011. Available at: https://www.piaba.org/system/files/2020-08/Press%20Release%2C%20DOL%20Comment%20Letter%20%28August%206%2C%202020%29.pdf; Accessed August 21, 2020.

[3]      Attorney General Becerra Opposes DOL Proposal; August 6, 2020. Available at: https://oag.ca.gov/system/files/attachments/press-docs/FINAL%20Comment%20Ltr%20to%20DOL.pdf; Accessed August 21, 2020.

[4]      29 CFR Part 2550 at 40862.

[5]      IRS; SOI Tax Stats – Accumulation and Distribution of Individual Retirement Arrangements (IRA); Available at: https://www.irs.gov/statistics/soi-tax-stats-accumulation-and-distribution-of-individual-retirement-arrangements; Accessed August 21, 2020.

[6]       Id.

[7]      29 CRF Part 2550 at 40839.

[8]       Federal Register; 17 CFR Part 240; Release No. 34-86031; Regulation Best Interest; 33339. Available at: https://www.govinfo.gov/content/pkg/FR-2019-07-12/pdf/2019-12164.pdf; Accessed August 21, 2020.

[9]       FINRA Regulatory Notice 13-45; Rollovers to Individual Retirement Accounts; December 2013; 2. Available at: https://www.finra.org/sites/default/files/NoticeDocument/p418695.pdf; Accessed August 21, 2020.

[10]     29 CFR Part 2550 at 40842.

[11]     Id.

[12]     PIABA Letter at 6. XXX

[13]     29 CFR Part 2550 at 40842.

[14]      29 CFR Part 2550; [Application No. D-11712]; ZRIN 1210-ZA25; Best Interest Contract Exemption; 21007. Available at: https://www.dolfiduciaryrule.com/portalresource/2016-04-08FedReg-DOLBestInterestContractExemption.pdf; Accessed August 21, 2020.

[15]      Id. at 21026.

[16]      17 CFR Part 240; Release No. 34-86031; Regulation Best Interest: The Broker-Dealer Standard of Conduct; 247. “… in response to comments, we are revising the Care Obligation to remove the term “prudence”.

[17]      29 CFR Section 2550.404a-1 – Investment duties. Available at: https://www.law.cornell.edu/cfr/text/29/2550.404a-1#:~:text=Section%20404(a)(1,like%20capacity%20and%20familiar%20with; Accessed September 9, 2020.

[18]      29 CFR Part 2550 at 40862.

[19]      29 CRF Part 2550 at 40835.

[20]      Id.

[21]      PIABA Letter at 8.

[22]      See, for instance, FINRA RN 12-25 – Suitability; Acting in a Customer’s Best Interest. This Regulatory Notice, gives six examples of fact patterns where FINRA and SEC regulators have found investments and/or investment strategies that might have been “vaguely plausible” to have not met the suitability standard if they were not consistent with the customer’s best interests. Available at: https://www.finra.org/rules-guidance/notices/12-25; Accessed September 24, 2020.

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Topics: Investment Suitability, dol fiduciary rule, prudent expert standard, fiduciary duties, SEC Regulation Best Interest

The Historical Origins of Fiduciary Duties

Posted by Jack Duval

Jun 21, 2018 8:36:41 AM

This post continues my blog post series on fiduciary duties and the changing regulatory landscape around a unified fiduciary standard of care for investors.

Accelerant - Jack Duval - Fiduciary Duties Expert Witness

Statue of Cicero

Given the tremendous amount of ink that has been spilled regarding the DOL Fiduciary Rule and now SEC Regulation Best Interest, I thought it would be useful to review the existence of fiduciary rules throughout history.

The idea of a fiduciary duty has existed from the beginning of humanity’s codification of the rules by which it would live.  Indeed, fiduciary duties have been central to the functioning of societies from ancient to modern times and from East to West.

In the most simple terms, a fiduciary duty arises when one person relies on another to perform a task or service for them.  The duty arises from the dependence of the one on the other.  In more modern language, trust and confidence is being reposed by the principal in the agent to carry out the agreed upon work.

Fiduciary Duties Throughout History

Perhaps the first known fiduciary duties exist in Hammurabi's Code from 1790 BC.[1]

Rules of agency, reflected in Hammurabi’s laws, developed along with commerce in Ancient Mesopotamia.  The laws primarily discuss situations in which a tamkarum, or principal/merchant, gives a samallum, or agent, either money to use for travel and for investments or purchases, or goods for trading or selling.

The Bible also has many fiduciary-related quotes, the most famous of which may be:[2]

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.

Jumping to the East, somewhere between 475 and 220 BC, Confucius wrote in The Analects a heuristic for fiduciaries: “In acting on behalf of others, have I always been loyal to their interest?”[3]

From Ancient Greece, Plato’s Republic could be read as a metaphor for the fiduciary duties of leaders to their constituents, and the whole education process of philosopher-kings as instilling these virtues. 

The Roman’s coined the term “fiduciary” in their laws and defined it to mean:[4]

a person holding the character of a trustee, or a character analogous of a trustee, in respect to the trust and confidence involved in it and the scrupulous good faith and candor which it requires.

Cicero also wrote of fiduciary obligations between agent and principal, known by the expressive terms: “mandatory” and “mandator”, respectively.  “An agent who shows carelessness in his execution of trust behaves very dishonorably and ‘is undermining the entire basis of our social system’.”[5]

Making a great leap across time, we come to Anglo-American law and the English Courts of Equity.  Scholars Aikin and Fausti write:[6]

Courts of Equity granted relief in numerous circumstances involving one person's abuse of confidence and, over time, concrete rules and precise terms related to fiduciary relationships began to form as Equity evolved.

The term "fiduciary" itself was adopted to apply to situations falling short of "trusts" but in which one person was nonetheless obliged to act like a trustee.

The second point makes sense because in non-trust fiduciary situations, the principle still owns the property, whereas in the trust situation, ownership of the asset(s) have been transferred to a trust which the trustee oversees.

Lastly, we get to American Law and Benjamin Cardozo, who, in Meinhard v. Salmon, wrote what are probably the most cited words on fiduciary duties:

Many forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties.  A trustee is held to something stricter than the morals of the market place.  Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.  As to this there has developed a tradition that is unbending and inveterate.  Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the "disintegrating erosion" of particular exceptions. Only thus has the level of conduct for fiduciaries been kept at a level higher that that trodden by the crowd.  It will not consciously be lowered by any judgment of this court.

Interestingly, the undermining of “the rule of undivided loyalty by the ‘disintegrating erosion’ of particular exceptions” is what is now contemplated in SEC Regulation Best Interest.  The SEC seeks to dress up FINRA suitability rules in the raiment of fiduciary language without the “uncompromising rigidity” of fiduciary law.

_______

Notes:

[1]       Keith Loveland, JD, AIFA, CIDA.  Available at: http://solisinvicti.com/books/Law/Fiduciary%20Law.pdf.  Accessed June 19, 2018.

[2]       Matthew 6:24; KJV.  Available at: http://biblehub.com/kjv/matthew/6.htm.  Accessed June 19. 2018.

[3]       Confucius; The Analects; Translated by Arthur Waley; Routledge; London and New York; 1938; 84.

[4]       Blain F. Aikin et al; Fiduciary: A Historically Significant Standard; B.U. Law Review; 158.  Available at: https://www.fi360.com/main/pdf/BULawReview_AikinFausti_Fall2010.pdf; Accessed June 21, 2018.

[5]       Id.

[6]       Id. at 159.

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Topics: FINRA, Investment Suitability, dol fiduciary rule, fiduciary duties, SEC Regulation Best Interest

The DOL Fiduciary Rule - Reasonable Compensation and Index Funds

Posted by Jack Duval

Aug 9, 2017 9:23:09 AM

DOL - Accelerant Fiduciary Rule Expert.jpeg

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

A large part of the motivation for the DOL FR is summarized in the Federal Register as follows:[1]

This final rule and exemptions aim to ensure that advice is in consumers’ best interest, thereby rooting out excessive fees and substandard performance otherwise attributable to advisers’ conflicts, producing gains for retirement investors.  (Emphasis added)

Reasonable Compensation

One of the ways that “excessive fees and substandard performance” will be rooted out is the requirement, under the BICE, that no more than reasonable compensation be charged.  For instance, the BICE states:[2]

In particular, under this standards-based approach, the Adviser and Financial Institution must give prudent advice that is in the customer’s best interest, avoid misleading statements, and receive no more than reasonable compensation.  (Emphasis added)

Perhaps the most impactful part of the reasonable compensation standard is that it is not based on what is customary.  The DOL could not be more clear on this, writing:[3]

The Department is unwilling to condone all “customary” compensation arrangements and declines to adopt a standard that turns on whether the agreement is “customary.”  For example, it may in some instances be “customary” to charge customers fees that are not transparent or that bear little relationship to the value of the services actually rendered, but that does not make the charges reasonable…

An imprudent recommendation for an investor to overpay for an investment transaction would violate that standard, regardless of whether the overpayment was attributable to compensation for services, a charge for benefits or guarantees, or something else.  (Emphasis added)

From “Everyone is doing it” to the Prudent Expert Standard

Industry custom and practice is frequently a topic of expert testimony in securities litigations.  However, under the DOL FR, this will no longer be relevant when it comes to justifying compensation.

The mere fact that “everyone is doing it” will fail to meet the fiduciary standard.  As discussed in a previous blog post, what will be required is diligence that meets the Prudent Expert Standard and all the attendant fiduciary obligations.

This will require substantial, documented, due diligence into the recommended investment and alternatives.  Each investment will have to stand on its own against comparable investments in the same category.

As an example, before a large cap growth mutual fund can be recommended, it will have to be judged against other large cap growth investment options, including: both active and passive mutual funds and ETFs.

Are Index Funds the Only Prudent Investment?

There has been some speculation that the DOL FR would require the use of index funds.  The DOL has spoken to this indirectly, writing:[4]

… the Department confirms that an Adviser and Financial Institution do not have to recommend the transaction that is the lowest cost or that generates the lowest fees without regard to other relevant factors.

However, advisors will be hard pressed to justify not using index funds.[5]  Contrary to popular belief, index funds don’t give average returns, most index funds perform in the 75-80th percentile range compared to other funds in their category, over five- and 10-year periods.

Furthermore, the longer the time horizon of the investor, the more compelling are index funds due to the simple math of compounding returns on the fees avoided.  Since, most IRA and pension fund assets are managed for the long term, this is highly salient.

Over the years, Morningstar has conducted research into what is the most predictive factor of mutual fund performance.  The answer every time is: fees.  Morningstar Director of Manager Research, Russel Kinnnel, writes:[6]

The expense ratio is the most proven predictor of future fund returns…

Using expense ratios to choose funds helped in every asset class and in every quintile from 2010 to 2015.  For example, in U.S. equity funds, the cheapest quintile had a total-return success rate of 62% compared with 48% for the second-cheapest quintile, then 39% for the middle quintile, 30% for the second-priciest quintile, and 20% for the priciest quintile.  So the cheaper the quintile, the better your chances.  All told, the cheapest-quintile funds were 3 times as likely to succeed as the priciest quintile.[7]  (Emphasis added)

Chart 1: Performance Success by Fee Quintile[8]

 Accelerant - DOL Fiduciary Rule - Mutual Fund Fees.png

The dominance of fees in predicting future performance addresses another point raised by the DOL:[9]

No single factor is dispositive in determining whether compensation is reasonable; the essential question is whether the charges are reasonable in relation to what the investor receives.  (Emphasis added)

In my example, the investor is receiving large cap growth stocks.  Is it reasonable to charge more and deliver what is likely to be worse performance?  That is very difficult to justify.

Another factor making active management hard to justify is that many active funds have a significant overlap with their benchmark index.  This “closet indexing” means that the fund manager is buying the same stocks that are in the benchmark.  This would be harmless except for the fact that many benchmark indexes are almost costless while active funds frequently charge one percent or more for their services.[10]

Where closet indexing occurs, the client is paying an active fee for passive management, which is not reasonable and fails the fiduciary standard.  Closet indexing can be measured using the active share and other metrics, which I will discuss in more detail in later posts.

Because of their extremely low fees and generally superior long-term performance, index funds can help advisors accomplish the DOL’s goals of "rooting out excessive fees and substandard performance".

----------

Notes:

[1]       Federal Register; Vol. 81. No. 68; April 8, 2016; Definition of the Term Fiduciary; 20951.  This language also appears, verbatim, in the DOL Regulatory Impact Analysis; April 14, 2015; 7.

[2]       Federal Register; Vol. 81, No. 68; April 8, 2016; Best Interest Contract Exemption; 21003.

[3]       Id. at 21031.

[4]       Federal Register; Vol. 81, No. 68; April 8, 2016; Best Interest Contract Exemption; 21030.

[5]       I am including here capitalization-weighted and non-capitalization weighted indexes (aka “smart beta” indexes), many of which have proven to outperform the relevant capitalization-weighted index on an after-fee basis.

[6]       Russel Kinnel, Predictive Power of Fees: Why Mutual Fund Fees Are So Important; Morningstar; May 2016; 1-2.  Available at: http://news.morningstar.com/articlenet/article.aspx?id=752485;  Accessed May 23, 2017.

[7]       Id. Success is defined as a fund surviving the entire time period and outperforming the relevant category group; 1.

[8]       Id. at 3. The lowest fee funds are in the first Expense Ratio Quintile and the highest fee funds are in the fifth Expense Ratio Quintile, etc.

[9]       Federal Register; Vol. 81, No. 68; April 8, 2016; Best Interest Contract Exemption; 21030.

[10]     For instance, the Vanguard S&P 500 Index ETF has an expense ratio of four basis points, (4/100) of one percent.  Bloomberg; August 9, 2017.  Morningstar reports that the average third quintile expense ratios for U.S. Equity mutual funds was 1.26 percent as of December 31, 2010.  See supra Note 6; at 4.

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Topics: litigation, Due Diligence, securities litigation, fiduciary obligations, erisa fiduciary expert, dol fiduciary rule, prudent expert standard, index funds, reasonable compensation, active share

The DOL Fiduciary Rule - Risk Tolerance Questionnaires

Posted by Jack Duval

Aug 2, 2017 7:31:02 AM

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

In my last blog post, I discussed how the traditional three-choice Investment Objective and Risk Tolerance options would no longer be sufficient under the DOL FR.  In this post, I will expand on topic of Investment Policy Statements (“IPS”) and an often-missed aspect of their drafting – determining both the client’s ability and willingness to take risk.

The Difference Between the Ability and Willingness to Take Risk

Most financial plans focus on the client’s ability to take risk.  This is usually accomplished mathematically, by predicting cash flows and evaluating those against known liabilities.  Generally, the thinking is if the client can sustain losses and still meet her needs, then she has the ability to take risk.  (For instance, if the client needs $20,000 per month to sustain her lifestyle, but her portfolio can generate $40,000 per month, after fees and taxes, then she has a high ability to take risk.) 

The client’s willingness to take risk is a softer metric that requires getting to know the client and their history, going through questionnaires, and scenario planning.  Many of the questionnaires and scenario plans revolve around a series of questions, hypothetical situations, and attempt to determine the client’s probable responses to market events.  For instance: what would you do it your portfolio declined by 10, 20, or 30 percent?

Problems with Risk Tolerance Questionnaires

In my experience, most risk tolerance questionnaires lead to inflated risk tolerances.  The reason is that unless the most conservative answer is given to every question, the client will be scored with a moderate or moderate-aggressive risk tolerance.  Furthermore, if even one question is answered with the most aggressive option, the client will typically end up with a moderate-aggressive or aggressive risk tolerance.

Another flaw in risk tolerance questionnaire design is that they are generic and rely on percentage gains and declines in their examples.  Percentage losses don’t live for clients, but dollar losses do.  For instance, many clients can be philosophical about a 30 percent decline in their portfolio, but most would not be as sanguine about a $3 million decline on a $10 million portfolio.

These flaws can have far-reaching implications.  The skewing towards aggressive Risk Tolerances can lead to misaligned asset allocations, unsuitable investments, and higher than expected volatility.  This frequently leads to clients changing their Risk Tolerance (to what it should have been originally) after a market decline.

Ironically, if litigation should ensue from misaligned asset allocations originating from skewed Risk Tolerances, the questionnaires underlying the improper allocations will be presented as proof of the client’s willingness to take risk, and used to justify aggressive and/or speculative investments.

The Prudent Expert and Risk Tolerance

For background on the Prudent Expert Standard required under the Best Interest Contract Exemption, see my previous posts here and here.

Simplistic, one-dimensional Risk Tolerance Questionnaires will not meet the Prudent Expert Standard.  Instead, the due diligence required to "know the client" is at least a two-dimensional approach to risk tolerance that encompasses both the ability and willingness to take risk.

If only one type of Risk Tolerance is identified, the advisor cannot make a Prudent Expert determination of the client’s true Risk Tolerance.  This will not meet the fiduciary standard, nor even the suitability standard.

One of the few financial writers to address the two dimensions of Risk Tolerance is Michael Kitces.  Some of his writings on risk tolerance can be found here, here, and here.  Kitces has created some very useful charts comparing Risk Tolerances that arise from the one- and two-dimensional Risk Tolerance methodologies.

Chart 1:  One- and Two-Dimensional Risk Tolerance Methodologies[1] 

Accelerant - Risk Tolerance - The Ability and Willingness to Take Risk.png

The central idea illustrated in these charts is that in the one-dimensional methodology (left pane), both the ability and willingness to take risk act as a floor to the resulting Risk Tolerance.  Conversely, in the two-dimensional Risk Tolerance methodology (right pane), both the ability and willingness to take risk act as a ceiling to the resulting Risk Tolerance. 

Unpacking One- and Two-Dimensional Risk Tolerance

In the one-dimensional Risk Tolerance methodology, both the ability and willingness to take risk increase Risk Tolerance.  Thus, if the client has either a high ability or high willingness to take risk, she will end up with an aggressive Risk Tolerance.  However, this is the perverse Risk Tolerance outcome discussed above.

Under the one-dimensional Risk Tolerance methodology, a low ability to take risk is overridden by a high willingness to take risk, at the same time a low willingness to take risk is overridden by a high ability to take risk. 

However, under the two-dimensional Risk Tolerance methodology, this cannot happen because both the ability and willingness to take risk decrease Risk Tolerance.  Thus, if the client has either a low ability or low willingness to take risk, she will end up with a conservative Risk Tolerance.

Under the two-dimensional Risk Tolerance methodology, a high ability to take risk is overridden by a low willingness to take risk, at the same time a high willingness to take risk is overridden by a low ability to take risk.

The two-dimensional Risk Tolerance methodology results in much more accurate Risk Tolerances and helps implement a financial advisor’s version of the Hippocratic Oath: help clients achieve their goals with the least amount of risk possible.

----------

Notes:

[1]       Michael Kitces; Nerd’s Eye View; Adopting a Two-Dimensional Risk Tolerance Assessment Process; January 25, 2017.  Available at: https://www.kitces.com/blog/tolerisk-aligning-risk-tolerance-and-risk-capacity-on-two-dimensions/; Accessed August 1, 2017.

 

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The DOL Fiduciary Rule - Investment Policy Statements

Posted by Jack Duval

Jul 26, 2017 9:07:10 AM

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

One of the implications of a fiduciary standard is that investment recommendations will be judged on an ex ante basis.  Ex ante is a Latin phrase common to law and economics that loosely translates to “before the event”.

This means that fiduciary recommendations must meet the Prudent Expert Standard before the recommendation is made.  While this may seem logical and obvious, it carries important implications should litigation arise from the fiduciary advice.

As discussed in my previous post, there are specific duties of due diligence that arise from the DOL Fiduciary Rule (“DOL FR”) for both the firm and the advisor.  In this post, I will focus on one aspect of diligence that should be made and documented, ex ante, in order for a fiduciary recommendation to be made: the Investment Policy Statement (“IPS”).

Investment Objective and Risk Tolerance

Industry standard broker-dealer (“BD”) new account forms have three choices of Investment Objective:[1] 

  • Income;
  • Total Return, and;
  • Growth;

and three choices of Risk Tolerance: 

  • Conservative;
  • Moderate, and;
  • Aggressive.

These traditional Investment Objective and Risk Tolerance choices are vague and generic.  They are also subject to abuse.  In my experience, most clients end up with a Total Return/Moderate or Growth/Moderate Investment Objective/Risk Tolerance.  If litigation arises, these combinations are used to justify virtually any asset allocation or investment strategy.

Furthermore, I have frequently encountered new account forms where multiple Investment Objectives and/or multiple Risk Tolerances will be selected.  This practice renders the new account form useless and the account non-supervisable.  For instance, if the Risk Tolerances: Conservative, Moderate, and Aggressive are all selected, then any type of investment will comport with them, including all cash and all equities.

Under the DOL FR, these short-hand categories will no longer be sufficient.  While they could still be used to provide a supervisor an at-a-glance summary when doing a first-level review, they are too vague and generic for the advisor to demonstrate knowledge of their client at a fiduciary level or to manage the investments appropriately.  They are insufficient for supervision as well.

The industry standard for fiduciaries is to have an Investment Policy Statement.

Investment Policy Statement

An investment policy statement is described by the CFA Institute as:[2]

A strategic guide to the planning and implementation of an investment program… 

The IPS is a highly customized document that is uniquely tailored to the preferences, attitudes, and situation of each investor.  Templates that purport to offer convenience and ease in development of an IPS almost inevitably sacrifice consideration of factors that are highly relevant to the investor.  The investment professional must thoroughly understand the investor’s objectives, restrictions, tolerances, and preferences to be able to develop a truly useful policy guide.  (Emphasis added)

An IPS is important for the successful planning, implementation, and ongoing management of investments over time.  The CFA Institute’s description of the benefits of an IPS includes:[3]

When implemented successfully, the IPS anticipates issues related to governance of the investment program, planning for appropriate asset allocation, implementing an investment program with internal and/or external managers, monitoring the results, risk management, and appropriate reporting.  The IPS also establishes accountability for the various entities that may work on behalf of an investor.  Perhaps most importantly, the IPS serves as a policy guide that can offer an objective course of action to be followed during periods of market disruption when emotional or instinctive responses might otherwise motivate less prudent actions.  (Emphasis added)

As a “highly customized document”, the IPS goes well beyond the check-the-box Investment Objective/Risk Tolerance that is frequently used today.  As an example, instead of a check-box that would allow “Speculative” investments, an IPS would define the exposure as a percentage of the portfolio, i.e. 3 percent, etc.  This policy could then be used to guide implementation, and if litigation were to arise, the investments could be evaluated for comportment with the IPS.

Although not required by the DOL, an IPS is contemplated under the DOL FR. 

The Department of Labor is well aware of the benefits of IPS’ and speaks directly to their requirement under ERISA:[4]

This interpretive bulletin sets forth the Deportment of Labor’s interpretation of sections 402, 403, and 404 of the Employee Retirement Income Security Act of 1974 (ERISA) as those sections apply to voting of proxies on securities held in employee benefit plan investment portfolios and the maintenance of and compliance with statements of investment policy

The maintenance by an employee benefit plan of a statement of investment policy designed to further the purposes of the plan and its funding policy is consistent with the fiduciary obligations set forth in ERISA § 404(a)(1)(A) and (B)...

For purposes of this document, the term “statement of investment policy” means a written statement that provides the fiduciaries who are responsible for plan investments with guidelines or general instructions concerning various types or categories of investment management decisions…

Statements of investment policy issued by a named fiduciary authorized to appoint investment managers would be part of the “documents and instruments governing the plan” within the meaning of ERISA § 404(a)(1)(D). (Emphasis added)

Without an IPS the client’s investments are untethered from predetermined guidelines, unaccountable for performance, and more subject to emotional management and behavioral biases.

It is very difficult to see how an ERISA fiduciary could meet the prudent expert standard without having an IPS.

No Safe Harbor

Importantly, a fiduciary advisor cannot craft an IPS that is inappropriate for the investor and then use that as a safe harbor from the fiduciary standard.  The DOL writes:[5]

… ERISA § 404(a)(1)(D) does not shield the investment manager from liability for imprudent actions taken in compliance with a statement of investment policy.

As I’ve discussed in previous blog posts, the Prudent Expert Standard is extremely rigorous and applies to the crafting of an IPS as well as investment recommendations and implementation.

If an IPS is defective, abusive, or inconsistent with the client’s particular facts and circumstances, goals and objectives, it will violate the fiduciary standard.

----------

Notes:

[1]       Through my securities litigation consulting work, I have seen new account forms from well over 75 different firms, including small, regional, and global BDs.  Some new account forms will also have a check box to select if “Speculative” investments are allowed.

[2]       Elements of an Investment Policy Statement for Individual Investors; CFA Institute; May 2010; 1.  Available at: http://www.cfapubs.org/doi/pdf/10.2469/ccb.v2010.n12.1; Accessed July 25, 2017.

[3]       Id.

[4]       29 CFR Ch. XXV (7.1.07 Edition); § 2509.94-2; Interpretive bulletin relating to written statement of investment policy, including proxy voting policy or guidelines; 364-6.

[5]       Id. at 366.

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The DOL Fiduciary Rule - Shifting the Burden of Proof

Posted by Jack Duval

Jul 7, 2017 9:13:05 AM

DOL - Accelerant Fiduciary Rule Expert.jpeg

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

The DOL’s Regulatory Impact Analysis, states:[1]

… traditional compensation sources – such as brokerage commissions, revenue shared by mutual funds and funds’ asset managers, and mark-ups on bonds sold from their own inventory – can introduce acute conflicts of interest.

… the Department found that conflicted advice is widespread, causing serious harm to plan and IRA investors, and that disclosing conflicts alone would fail to adequately mitigate the conflicts or remedy the harm.

In order to address these conflicts and the resulting harm to investors, the DOL has introduced the DOL Fiduciary Rule (“DOL FR”) and the Best Interest Contract Exemptions (“BICE”), which I have discussed in my previous posts.

Shifting the Burden of Proof

One remarkable facet of the DOL FR is that under the BICE, if violations are alleged, the burden of proof is on the defendants.  The DOL writes:[2]

Moreover, inclusion of the standards in the exemption’s conditions adds an important additional safeguard for ERISA and IRA investors alike because the party engaging in a prohibited transaction has the burden of showing compliance with an applicable exemption, when violations are alleged.  In the Department’s view, this burden-shifting is appropriate because of the dangers posed by conflicts of interest, as reflected in the Department’s Regulatory Impact Analysis and because of the difficulties Retirement Investors have in effectively policing such violations.  (Emphasis added)

This language is reiterated by the DOL elsewhere in the BICE:[3]

Advisers and Financial Institutions bear the burden of showing compliance with the exemption and face liability for engaging in a non-exempt prohibited transaction if they fail to provide advice that is prudent or otherwise in violation of the standards.  The Department does not view this as a flaw in the exemption, as commenters suggested, but rather as a significant deterrent to violations of important conditions under an exemption that accommodates a wide variety of potentially dangerous compensation practices.  (Emphasis added)

Meeting the Burden of Proof

Shifting the burden of proof from plaintiffs to defendants will introduce a new dynamic in securities litigation and arbitrations.  In my experience, brokerage firms and their registered representatives are not prepared to meet this burden.

I have been involved in many cases where brokers will testify that it is their “business practice” to not take notes during client meetings and calls.  Furthermore, this paucity will frequently extend to their research habits.  For instance, despite making hundreds of recommendations to a client over a multi-year period, a registered representative will not produce one document that evidences any research or due diligence for any recommendation.

These practices will immediately fail under a fiduciary standard.[4]  As discussed in a previous post, under the BICE, there is an explicit requirement to undertake rigorous due diligence, document that due diligence, share the results of the due diligence with the client, and to supervise the process.

With the burden of proof residing with defendants, the documentation and supervision of the due diligence process will have high salience in any litigation.

Due Diligence and the Firm

A number of news articles have highlighted a surge in business for compliance software in the wake of the DOL FR passage.  While technological solutions can be helpful, broker-dealers and their registered representatives should not confuse them with actual due diligence.

For instance, having registered representatives cycle through a check-the-box screen before making a recommendation will be a failure if the actual due diligence has not been done.  Firm supervisors will need to insure that:

  • Rigorous and professional due diligence has been undertaken that meets the Prudent Expert Standard;
  • A fiduciary-quality conclusion has been reached, and;
  • Evidence of the entire process has been archived.

Failure to undertake any of these steps will likely result in liability, should a violation be alleged.

Due Diligence and the Registered Representative

Under the fiduciary standard, the client has reposed trust and confidence in their registered representative to look after their interests.  This means the registered representative is charged with carrying out the fiduciary obligations to the client.  These obligations cannot be outsourced.

One of the primary obligations is that of due diligence into investments before a recommendation is made.  Independent due diligence by registered representatives is required to meet the fiduciary standard.  This does not mean that third party resources cannot be used, however, they cannot be the primary means of due diligence.

Conflicted sources of research should be discounted heavily, if not ignored.  Traditionally, one of the most conflicted sources of research has been the brokerage firms at which registered representatives work.  If a brokerage firm is offering a product and will earn a commission from its sale, then the firm is conflicted and its research should be viewed with great skepticism.

Indeed, the offering itself should be viewed with great skepticism by the firm’s own registered representatives.[5]

As will be discussed in greater detail in subsequent blog posts, independent research requires a great deal of work, including: close reading of offering documents, talking with issuers, modeling assumptions, and comparing offering risk, reward, and pricing, to other similar options.

----------

Notes:

[1]       Department of Labor; Fiduciary Investment Advice: Regulatory Impact Analysis; April 14, 2015; 9.

[2]       Federal Register; Vol. 81, No. 68; April 8, 2016; Best Interest Contract Exemption; 21033.  Also see: Fish v. GreatBanc Trust Company; No. 12-3330; (7th Cir. 2014); at 27.  Under ERISA, the burden of proof is on a defendant to show that a transaction that is otherwise prohibited under § 1106 qualifies for an exemption under § 1108.

[3]       Id. at 21060.

[4]       Indeed, they frequently fail under a suitability standard.

[5]       All offerings that involve commissions should be viewed with great skepticism by both firms and their registered representatives.

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The DOL Fiduciary Rule - Due Diligence

Posted by Jack Duval

Jun 29, 2017 8:38:41 AM

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

In my last blog post, I reviewed the Department of Labor’s (“DOLs”) Prudent Expert Standard and how this extraordinarily high standard of care would change securities litigation.  In this post, I explore the types of due diligence that must be performed, documented, presented to clients, and supervised.

Investment Complexity, Customer Reliance, and “Sophisticated Investors”

As I have written about extensively, investments have become much more complex over the past 40 years.  (See my Complexity Risk white paper.)  Because of this, investors rely on their advisors.  The DOL writes about this fact in the Best Interest Contract Exemption filings, including:[1]

Plan fiduciaries, plan participants and IRA investors must often rely on experts for advice, but are unable to assess the quality of the expert’s advice or effectively guard against the adviser’s conflicts of interest.  This challenge is especially true of retail investors with smaller account balances who typically do not have financial expertise, and can ill-afford lower returns to their retirement savings caused by conflicts.  (Emphasis added)

This fact is self-evident, indeed, if clients truly understood investments, they would invest on their own without paying an advisor.   Furthermore, the DOL has stated unequivocally that there is no carve-out for wealthy individuals deemed “sophisticated investors” by virtue of their net worth.  The DOL writes:[2]

… merely concluding someone may be wealthy enough to be able to afford to lose money by reason of bad advice should not be a reason for treating advice given to that person as non-fiduciary.  Nor is wealth necessarily correlated with financial sophistication.  Individual investors may have considerable savings as a result of numerous factors unrelated to financial sophistication, such as a lifetime of thrift and hard work, inheritance, marriage, business success unrelated to investment management, or simple good fortune.  (Emphasis added)

Thus, an advisor to an individual is a fiduciary under the DOL Fiduciary Rule (“DOL FR”), irrespective of the individual’s net worth.[3]

Due Diligence

Since each client is relying on an advisor to act in their best interest, it is incumbent upon the advisor to perform extensive due diligence before making a recommendation.

The obligation for the advisor to perform due diligence by the Prudent Expert Standard is both stringent and objective, and has been specifically contemplated by the DOL.  For instance:[4]

… 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” …  (Emphasis added)

The focus on the fiduciary’s process has a number of implications: 

  • Extensive due diligence must be performed prior to making a recommendation;
  • The due diligence process must be documented by the advisor;
  • The results of the due diligence must be shared with the client;
  • Firms making fiduciary recommendations must document their supervision of the due diligence process of their advisors.

I unpack these below. 

     a. Extensive due diligence

For each recommendation, a number of questions will have to be answered by the fiduciary, including, does the recommendation meet the Impartial Conduct Standards of:[5] 

  • fair dealing;
  • fiduciary conduct;
  • in the customer’s best interest;
  • avoid misleading statements (and omissions);
  • involve no more than reasonable compensation;

I will explore each of these in later blog posts, however, it is worth remembering that many investments that may have been suitable under the FINRA standard would fail under the Impartial Conduct Standards of a fiduciary.

Furthermore, the larger the recommendation is relative to the client’s investments, the more diligence should be undertaken.

     b. Documentation of the due diligence process

In order to prove there was a process involved to reach a determination, the advisor must document her research and due diligence.  The DOL gives an example of this regarding recommendations for rollovers from an ERISA plan to an IRA:[6]

When Level Fee Fiduciaries recommend rollovers from an ERISA plan, they must document their consideration of the Retirement Investor’s alternatives to a rollover, including leaving the money in his or her current employer’s plan, if permitted.  Specifically, the documentation must take into account the fees and expenses associated with both the plan and the IRA; whether the employer pays for some or all of the plan’s administrative expenses; and the different levels of services and different investments available under each option.

… the Level Fee Fiduciary’s documentation must include the reasons that the arrangement is considered in the Retirement Investor’s Best Interest, including, specifically, the services that will be provided for the fee.  (Emphasis added)

A similar documentation regime will necessarily apply to all recommendations by the fiduciary.

     c. Results of the due diligence process must be shared with the client

The fiduciary duty of full and fair disclosure requires that the results of the due diligence process be shared with the client.  Some obvious elements of such disclosure would include: 

  • Total fees, commissions, and costs from the implementation of the recommended strategy or investment;
  • Comparisons to other similar investments available. (For example, if a large cap mutual fund is recommended, is there a large cap EFT that could be utilized with lower expenses?);
  • Risk and return assumptions;
  • How the recommendation complements existing investments and the client’s other particular facts and circumstances;
  • Tax implications. (For IRA accounts, this could involve required minimum distributions, 72-T elections, and Roth conversions to name a few.);
     d.     Supervision of the due diligence process

In order to insure a thorough due diligence process is being implemented by their advisors, firms must supervise their advisors.  This will require the implementation of policies and procedures reasonably designed to insure the process is undertaken.  Some of these policies and procedures would include:

  • Review of research and due diligence undertaken by advisors in support of their recommendations;
  • Making sure the recommendations comport with the client’s investment objectives, risk tolerance and other relevant factors;
  • Making sure the recommendations meet all the obligations of a fiduciary standard;
  • Archiving of evidence of the due diligence process. (The archiving can be done at the advisor level, but the supervisor should review that the documents have been archived.);
  • Documenting the supervisory review.

Complexity and Due Diligence in the Fiduciary Context

The BICE was designed to allow broker-dealers to continue to sell complex, high-fee, opaque, and ill-liquid products inside IRAs.  Advisors selling these products are still required to meet the fiduciary standard.  Thus, they will face the incredibly difficult task of justifying these products in a rigorous analysis that meets the Prudent Expert Standard.

Furthermore, their analyses will have to pass a second test of supervisory review and approval.

Under the fiduciary standard, the advisor must be an expert, however, many advisors and supervisors do not properly understand the complex products they sell.  Any lack of expertise in products recommend is a de facto violation of the fiduciary duty.

The documentation of an advisor’s due diligence (or lack thereof) will reveal the true depth of their understanding.  It will make level of their expertise objective.

----------

Notes:

[1]       Department of Labor; Best Interest Contract Exemption; Federal Register, Vol. 81, No. 68; April 8, 2016; 21005.

[2]       Department of Labor; Definition of Fiduciary; Federal Register, Vol. 81, No. 68; April 8, 2016; 20982.  Notes omitted. 

[3]       There is a carve-out for advice given to independent plan fiduciaries (i.e. institutional money managers) who manage at least $50 million in aggregate.

[4]       Department of Labor; Best Interest Contract Exemption; Federal Register, Vol. 81, No. 68; April 8, 2016; 21028-9.

[5]       Id. at 21007.

[6]       Id. at 21012.

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The DOL Fiduciary Rule - Prudent Expert Standard

Posted by Jack Duval

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

DOL Fiduciary Rule Expert Jack Duval Interviewed on Podcast

Posted by Jack Duval

Jun 8, 2017 9:29:03 AM

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Jack was a guest on The Investment Advisors Podcast with Kattan Ferretti Financial this week and discussed several topics including the DOL Fiduciary Rule, the securities litigation landscape, complexity risk, and his background.

Episode 15 Description:

In episode 15, you’re going to hear about Duval’s exposure to pioneers such as Dick McCabe.  We talk facts that you might find surprising, like 30,000 ultra high net worth investors in the USA or, there are 3,000 arbitration claims from FINRA every year, and there are somewhere between 400-450 people kicked out of the industry every year.

In this industry, there is motive and there is opportunity, as they say.  It’s unfortunate there are set-ups that are ripe for abuse.  Which we might add has created the service gaps in this industry that motivated us to start Kattan Ferretti Financial.

Take note at how thoughtful and deliberate Jack’s approach is to discussing his life and the topics at hand.  We were thoroughly inspired by his demeanor, especially in an industry that can’t help pounding the table, even when they sit down to a full bowl of soup.

Click here to go to the podcast.

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

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

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Topics: securities litigation, Complex Investments, fiduciary obligations, erisa fiduciary expert, dol fiduciary rule

The DOL Fiduciary Rule and Securities Litigation

Posted by Jack Duval

Jun 6, 2017 10:17:15 AM

DOL - Accelerant Fiduciary Rule Expert.jpeg

The DOL Fiduciary Rule becomes effective tommorow.  In advance of this milestone, we are launching a series of blog posts to analyze the DOL Fiduciary Rule (“DOL FR”) and its implications for securities litigation.

We are also launching a DOL Fiduciary Rule - Securities Litigation Resources webpage with useful links for securities litigators.

The DOL FR is the culmination of a process that officially began on April 20, 2015 with the release of the DOL's proposed rule for the "Definition of the term Fiduciary'; Conflict of Interest Rule - Retirement Investment Advice".  (In reality, the process began with a predecessor rule proposed in 2010 that was not implemented.)

The DOL FR will dramatically alter the landscape of investing in IRA accounts by imposing the same fiduciary standards on brokers that have existed for pension advisors under ERISA.  However, it will also change the way securities litigations are prosecuted for IRA-related claims, and not in favor of investment firms.  This is ironic, because this change is due to the apparent success of fierce securities industry lobbying in opposition to the DOL FR.

Essentially, the original draft of the DOL FR was changed to allow exemptions for many high-commission, low-liquidity, and opaque products such as direct participation programs, non-traded REITs, equity-indexed annuities, and variable annuities.  While this may seem like a victory for the industry, it is running afoul of the highest law in the land, the law of unintended consequences.

The Best Interest Contract Exemption - Be Careful What You Wish For

While the recommendation and sale of high-commission, low-liquidity, and opaque products to IRA clients is, under the DOL FR, conflicted, these products may be sold pursuant to the Best Interest Contract Exemption (“BICE”).  I will discuss the nuances of the BICE in subsequent blog posts, however, I would like to highlight one item in this introduction.  Namely the word "contract".

As the title implies, the BICE will be a contract between the investment firm and its IRA client.  As part of this contract, the firm will have to acknowledge that it is acting as a fiduciary and that the investment is in the client's best interest.  Furthermore, as a contract, it will provide a private right of action to clients who are party to it.  Importantly, this private right of action also includes the right to participate in class action lawsuits.

This is a dramatic change from the mandatory arbitration agreement that is part of almost every IRA (and other) new account form.  Indeed, respondent attorneys frequently argue that alleged violations of FINRA rules do not give rise to a private right of action.[1]

Thus, it appears that when faced with the onslaught of lobbying from industry firms to water down the proposed fiduciary rule and allow conflicted advice and products, the DOL acquiesced.  However, the DOL did so in such a way that effectively shifted the enforcement of those conflicted products to the plaintiff’s bar.

Now, instead of having to arbitrate individual claims for each investor, plaintiff’s attorneys will be able to file class actions for all IRA account investors similarly situated.

There will still be litigation on IRA assets that are not subject to the BICE, however, a new door has opened with the potential for class actions, and the stakes will be higher.

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Notes:

[1]       To my knowledge, this argument has never been successful due to the lack of any formal pleading requirements under the FINRA arbitration rules.  Rules 12302 and 13302 require a FINRA arbitration claimant to supply only a “statement of claim specifying the relevant facts and remedies requested”.

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

Click here to listen to Jack's insight regarding the DOL Fiduciary Rule on the Investment Advisors Podcast.

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

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Topics: securities litigation, class action, fiduciary obligations, erisa fiduciary expert, dol fiduciary rule

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