The Securities Litigation Expert Blog

SEC Regulation Best Interest - Reasonable Care

Posted by Jack Duval

Sep 14, 2018 8:12:46 AM

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This blog post continues my series on SEC Regulation Best Interest ("RBI") and the DOL Rule.

Knowing the Client and the Investment

As I’ve written previously, a Registered Representative must know both the client and the investment in order to make a Best Interest recommendation under the proposed SEC rules.  (This is also true under the existing FINRA Suitability Rule 2111.)

Under RBI, the SEC addresses this directly, writing: [1]

... we believe acting in the best interest of the retail customer would require a broker-dealer to have a reasonable basis to believe that a specific recommendation is in the best interest of the particular retail customer based on its understanding of the investment or investment strategy under proposed paragraph (a)(2)(ii)(A), and in light of the retail customer's investment objectives, financial situation, and needs.  (Emphasis added)

Additionally, the SEC believes the principals that underlie the RBI requirements are the same as those under the DOL’s Best Interest Standard (which was a fiduciary standard):

We believe that the principles underlying our proposed best interest obligation as discussed above, and the specific Disclosure, Care, and Conflict of Interest Obligations described in more detail below, generally draw from underlying principles similar to the principles underlying the DOL's best interest standard, as described by the DOL in the BIC Exemption.[2]  (Emphasis added)

Although RBI does not impose a fiduciary duty, the SEC refers to the DOL Rule (as well as obligations under RBI) regarding how Registered Representatives will be held to a prudent expert standard:

(The DOL Rule) defines advice to be in the "best interest" if the person providing the advice acts "with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with the such (sic) matter would use... without regard to the financial or other interests" of the person.[3]

Further, the proposed Disclosure Obligation, Care Obligation and Conflict of Interest Obligations described in more detail below, establish standards of professional conduct that, among other things, would require the broker-dealer to employ reasonable care when making a recommendation.[4]  (Emphasis added)

Reasonable Care

An important question, then, is what constitutes “reasonable care”?  (I am here only focusing on the reasonable care obligation concerning investments, not those regarding the obligation to know the client.)

At a minimum, reasonable care requires the Registered Representative to undertake an analysis of the potential recommended investments to express her investment thesis and choose one that is in the best interest of the client.

In short, reasonable care requires that the Registered Representative do her homework.  Additionally, the diligence undertaken will need to be evidenced in writing so that it can be supervised, and for the broker’s own protection, should litigation ensue.

Choosing Between Investments

The SEC has provided guidance on the analysis of investments in RBI, writing: [5]

We reiterate that we recognize that it may be consistent with a retail customer's investment objectives - and in many cases, in a retail customer's best interest - for a retail customer to allocate investments across a variety of investment products, or to invest in riskier or more costly products, such as some actively managed mutual funds, variable annuities, and structured products.

However, in recommending such products, a broker-dealer must satisfy its obligations under proposed Regulation Best Interest.  Such recommendations would continue to be evaluated under a fact specific analysis based on the security or investment strategy recommended in connection with the retail customer's investment profile, consistent with the proposed best interest obligation.  (Emphasis added)

Fact Specific Analysis

The “fact specific analysis” is a new requirement and, as mentioned above, will need to be evidenced for each recommendation and supervised by the broker-dealer (“BD”).

The SEC mentions variable annuities as an example of a “more costly product”.  A fact specific analysis would need to show that a variable annuity was in the client’s best interest after accounting for those costs and compared to other available options.  For most variable annuities, this will be exceedingly difficult.

In a typical variable annuity contract the client is charged two to four percent per year in total fees.  These consist of asset management fees, mortality and expense fees, administrative fees, and riders.  Academic literature has shown a typical death benefit guaranteeing the principal to be worth between one and 10 basis points per year.[6]  However, most variable annuity contracts charge 100 to 125 basis points for the guarantee.

Such a high markup is very difficult to justify (as are all the other fees).

The advantage of tax-deferred growth inside a variable annuity is overwhelmed by these extremely high fees and the net investment returns will likely never overcome them when compared to a similar allocation into index funds, which typically distribute no capital gains.

Furthermore, most variable annuities require the sacrifice of liquidity, a risk that is completely uncompensated.[7]

In order to justify the recommendation of a variable annuity under RBI, a Registered Representative would have to show, in a fact specific analysis, how it is in her client’s best interest to buy the variable annuity versus a similar allocation in index funds.

I have yet to see such an analysis and am highly skeptical that one could pass the prudent expert standard.

The Importance of Costs

The SEC recognizes the importance of costs when undertaking a fact specific analysis, writing:[8]

… we emphasize that the costs and financial incentives associated with a recommendation would generally be one of many important factors...

Furthermore, the SEC states clearly that when choosing among identical securities, RBI requires the less expensive security be recommended:[9]

Thus, where, for example, a broker-dealer is choosing among identical securities available to the broker-dealer, it would be inconsistent with the Care Obligation to recommend the more expensive alternative for the customer…

If a broker-dealer recommends a more expensive security or strategy over another reasonably available alternative offered by the broker-dealer, they must have a reasonable basis to believe the higher cost is justified and that the recommendation is in the customer's best interest.

A key word in the quote above is “identical”.  Very few investments are likely to be identical in the literal sense.  However, many are certain to be highly comparable with differences that are essentially trivial.  For instance, in the variable annuity example, a large cap blend sub-account inside the variable annuity is likely to be highly comparable to an S&P 500 Index fund.

A simple correlation analysis would almost certainly reveal that the differences were small, as would an analysis of the holdings and the sub-accounts active share.  Indeed, most funds (or sub-accounts) in the same size and style category are likely to be close to identical, although none would likely meet the literal meaning of “identical”.

The more comparable two investments are, the more important it will be to choose the less expensive option.  For products that have insurance or other features such as principal protection, an additional analysis of the costs, liquidity, guarantor risk, and other factors will be required.

Importantly, the case of identical investments isn’t the only standard the SEC sets out, indeed, it is only a special case.

Comparable Product Factors

The SEC has provided guidance on what a BD must consider when undertaking their fact specific analysis for comparable products or strategies offered by the firm:[10]

While every inquiry will be specific to the broker-dealer and the investment or investment strategy, broker-dealers may wish to consider questions such as: 

  • Can less costly, complex, or risky products available at the broker-dealer achieve the objective of the product?
  • What assumptions underlie the product, and how sound are they? What market or performance factors determine the investor’s return?
  • What are the risks specific to retail customers? If the product was designed mainly to generate yield, does the yield justify the risk to principal?
  • What costs and fees for the retail customer are associated with this product? Why are they appropriate?  Are all of the costs and fees transparent?  How do they compare with comparable products offered by the firm?[11]
  • What financial incentives are associated with the product, and how will costs, fees and compensation relating to the product impact an investor’s return?
  • Does the product present any novel legal, tax, market, investment, or credit risks?
  • How liquid is the product? Is there a secondary market for the product?

As described above, the broker-dealer's diligence and understanding of the risks and rewards would generally involve consideration of factors, such as the costs; the investment objectives and characteristics associated with a product or strategy (including any special or unusual features, liquidity, risks and potential benefits, volatility and likely performance in a variety of market and economic conditions), as well as the financial and other benefits to the broker-dealer.

Fact Specific Analysis Supervision

Perhaps most important is that Registered Representatives will have to undertake their fact specific analysis before the recommendation is made.  As discussed above, that analysis would need to be in writing and show how the recommendation is in the client’s best interest and comports with all their particular facts and circumstances, including risk tolerance and investment objectives.

If there was no analysis, or the analysis was deficient, then the recommendation would likely fail to meet the RBI standard (or might only meet it by chance) and would certainly have failed to have been supervised.

The requirement of a fact specific analysis will necessitate additional supervisory systems and oversight, and BDs will need to implement policies and procedures to make sure they comply with RBI.

__________

Notes:

[1]           SEC Regulation Best Interest; Release No. 34-83062; File No. S7-07-18; Available at: https://www.sec.gov/rules/proposed/2018/34-83062.pdf; Accessed September 12, 2018.

at 141.

[2]           Id. at 58.

[3]           Id. at 108.

[4]           Id. at 59.

[5]           Id. at 147.

[6]           Mose Arye Milevsky and Steven E. Posner; The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds; The Journal of Risk and Insurance, 2001; Vol. 68; No. 1, 93-128.  Available at: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.178.1519&rep=rep1&type=pdf;  Accessed September 12, 2018.

[7]           Many variable annuities allow the withdrawal of up to 10 percent of the original investment on a penalty-free basis every year.  However, withdrawals above that amount often have eight to 10 percent penalties in the first year and decline each year after that.

            Typically, investors in illiquid investments such as hedge funds and private equity funds demand an illiquidity premium of three percent per year for the loss of liquidity.  Variable annuities provide no such return premium.  Indeed, because of their fee structure, they are likely to return three percent less than the benchmark each year.

[8]           RBI at 147.

[9]           Id. at 148.

[10]         Id. at 139-40 and 143.

[11]         An interesting question arises about firms that only offer one type of product, such as insurance carriers that only sell insurance or variable products.  I will address this in later posts.

 

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Topics: fiduciary obligations, Investment Suitability, Suitability Expert, FINRA Rule 2111 (Suitability), Securities Exchange Commission, Regulation Best Interest, prudent expert standard, Reasonable Care, Fact Specific Analysis

SEC Regulation Best Interest - The Prudent Expert Standard

Posted by Jack Duval

Aug 23, 2018 9:38:27 AM

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As discussed in my previous posts, SEC Regulation Best Interest (“RBI”) will require broker-dealers and their agents to put the best interests of their clients first.  What is less well understood is that RBI will also impose a prudent expert standard on Registered Representatives.

There are three broad obligations to RBI:[1]

  • Disclosure;
  • Care, and;
  • Conflicts of Interest.

The Prudent Expert Standard

I am here focusing on the Care Obligation, which the SEC has described as:

The broker, dealer, or natural person who is an associated person of a broker or dealer, in making the recommendation exercises reasonable diligence, care, skill, and prudence to:[2]

  • Understand the potential risks and rewards associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers;
  • Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks and rewards associated with the recommendation; and
  • Have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile. (Emphasis added)

While RBI does not establish a fiduciary obligation, the SEC is clear that it views the duty to exercise reasonable diligence, care, skill, and prudence as similar to a fiduciary duty, writing:[3]

Under Regulation Best Interest, as proposed, a broker-dealer’s duty to exercise reasonable diligence, care, skill and prudence is designed to be similar to the standard of conduct that has been imposed on broker-dealers found to be acting in a fiduciary capacity.  (Emphasis added)

The “reasonable diligence, care, skill, and prudence” language, as well as the process of understanding “potential risks and rewards”, applying that understanding to the retail customer’s investment profile, and evaluating a series of recommended transactions, all necessitate coming to an expert opinion.

Indeed, coming to an expert opinion will be the only way the Care Obligation can be fulfilled.

The SEC points to the prudent expert standard in RBI, writing:[4]

We believe that the principles underlying our proposed best interest obligation as discussed above, and the specific Disclosure, Care, and Conflict of Interest Obligations described in more detail below, generally draw from underlying principles similar to the principles underlying the DOL’s best interest standard, as described by the DOL in the BIC Exemption

The BIC Exemption’s best interest Impartial Conduct Standard would require (as here relevant) that advice be in a retirement investor’s best interest, and further defines advice to be in the “best interest” if the person providing the advice acts “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with the (sic) such matters would use… without regard to the financial or other interests” of the person..  (Emphasis added)

The SEC believes the principles underlying RBI are consistent with those of the DOL rule.  The DOL language of “a prudent person acting in a like capacity and familiar with such matter” is the prudent expert standard.  Thus, that is the standard that should apply to Registered Representatives making recommendations to retail customers.

Furthermore, the SEC refers to RBI as establishing “standards of professional conduct”:[5]

… the proposed Disclosure Obligation, Care Obligation and Conflict of Interest Obligations described in more detail below, establish standards of professional conduct that, among other things, would require the broker-dealer to employ reasonable care when making a recommendation.  (Emphasis added)

Knowing the Investment and the Client

As with the FINRA Suitability standard, the registered representative must know both the investment and the client in order to meet the Best Interest standard.  The SEC makes this clear in RBI, writing about:

Knowing the investment

Without establishing such a threshold understanding of its particular recommendation, we do not believe that a broker-dealer could, as required by Regulation Best Interest, act in the best interest of a retail customer when making a recommendation…[6]

Knowing the customer

A broker-dealer that makes a recommendation to a retail customer for whom it lacks sufficient information to have a reasonable basis to believe that the recommendation is in the best interest of that retail customer based on the retail customer’s investment profile would not meet its obligations under the proposed rule.[7]

Anyone arguing that the prudent expert standard will not apply under RBI will need to overcome the SEC’s own language, the shingle theory,[8] as well as what will likely be a mountain of advertising and marketing material from the broker-dealer extoling its expertise.[9]  Furthermore, there will be the matter of the CRS Relationship Summary, which will affirm the BDs adherence to the securities law and regulations (including RBI and all the attendant obligations) and will nowhere disavow the firm’s expertise with investments.[10]

Supervisory Implications of the Prudent Expert Standard

Under RBI, broker-dealer supervisors will be tasked with making sure their registered representatives know both their clients and the investments recommended.  In theory, they are doing this already.  However, RBI, by requiring recommendations in the client’s best interest (instead of being merely suitable) will necessitate more work and documentation around knowing the investment.

I will discuss this in more detail in my next post.

__________

Notes:

[1]       SEC Regulation Best Interest; Release No. 34-83062; File No. S7-07-18; Available at: https://www.sec.gov/rules/proposed/2018/34-83062.pdf; Accessed August 23, 2018.

[2]       Id. at 404-5.

[3]       Id. at 134.

[4]       Id. at 58 and footnote 108.  Also see, Accelerant blog post: The DOL Fiduciary Rule – Prudent Expert Standard; Available at: http://blog.accelerant.biz/blog/the-dol-fiduciary-rule-prudent-expert-standard; Accessed August 23, 2018.

[5]       Id. at 59.

[6]       Id. at 137.  This language also exits in FINRA RN 12-25 at Q22.  “Brokers cannot fulfill their suitability responsibilities to customers… when they fail to understand the securities and investment strategies they recommend.”

[7]       Id. at 145.

[8]       The “shingle theory” goes back to a 1943 Second Circuit decision, Charles Hughes & Co., Inc. v. SEC (139 F.2d 434; 2d Cir. 1943).  As Louis Loss wrote: “the theory was that even a dealer at arms’ length implicitly represents when he or she hangs out a shingle that he or she will deal fairly with the public.”  Fundamentals of Securities Regulation, Fourth Edition; Louis Loss and Joel Seligman; Aspen Publishers (New York); 2004; 1063.  Of course, RBI makes the relationship similar that of a fiduciary, which is far higher than one of “arms’ length”.

[9]       See, for instance, Merrill Lynch website of its Private Banking & Investment Group:  “Your private wealth advisor is dedicated to understanding your goals and experienced in the complexities of managing significant wealth.”  Available at: https://www.pbig.ml.com/; Accessed August 23, 2018.

[10]      SEC Form CRS Relationship Summary;  Release No. 34-83063;  IA-4888; File No. S7-08-18.  Available at: https://www.sec.gov/rules/proposed/2018/34-83063.pdf; Accessed August 23, 2018.

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Topics: fiduciary obligations, Investment Suitability, Suitability Expert, FINRA Rule 2111 (Suitability), Securities Exchange Commission, Regulation Best Interest, prudent expert standard

Comparing SEC Regulation Best Interest to Existing FINRA Rules

Posted by Jack Duval

Apr 27, 2018 9:30:35 AM

 

SEC Regulation Best Interest - Commissioner Kara Stein

AGENCE FRANCE-PRESSE/GETTY IMAGES US Securities and Exchange Commissioner Kara Stein.

This blog post continues a series exploring the fiduciary rules proposed by the DOL and now the SEC.  The DOL Rule posts can be found here and the SEC Rule post can be found here.

The SEC's proposed Regulation Best Interest ("RBI") is remarkable in how poorly it is crafted.  Indeed, it is a disaster.

If passed in it's current form, RBI will:

  • Not create a unified fiduciary standard as it was supposed to under the Dodd-Frank Act Section 913;
  • Confuse clients as to the duties of broker-dealers compared to investment advisors, and;
  • Pass off existing FINRA Rules and interpretations as some kind of heightened standard.

Table 1:  Comparing SEC Regulation Best Interest to Existing FINRA Rules

SEC Regulation Best Interest v. Existing FINRA Rules

For a PDF of this table click here.

As can be seen above, the only thing RBI adds are the disclosures relating to the scope and terms of the relationship and material conflicts of interest.  While these are good additions, they fall far short of increasing investor protections.

Everything else in RBI already exists within the FINRA rules.

Kara M. Stein Comments

SEC Commissioner Kara M. Stein has savaged RBI in her public statement:

... does this proposal require financial professionals to put their customers' interest first, and fully and fairly disclose any conflicting interests? No.  Does this proposal require all financial professionals who make investment recommendations related to retail customers to do so as fiduciaries? No.  Does this proposal require financial professionals to provide retail customers with the best available options? No.

Commissioner Stein also points out, as have others, that nowhere in the 1,000+ pages of related documents does RBI define what "best interest" means.  Instead, the RBI states the best interest obligation will be satisfied "if the broker-dealer complies with four component requirements: a Disclosure Obligation, a Care Obligation,and two Conflict of Interest Obligations."  (96)

Thus, broker-dealers will be able to check the boxes to prove that they complied with an undefined "best interest" obligation that already exists under FINRA rules.  This can only weaken investor protection.

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Topics: fiduciary obligations, Investment Suitability, Suitability Expert, FINRA Rule 2111 (Suitability), Securities Exchange Commission, Regulation Best Interest, erisa fiduciary expert, fiduciary expert

SEC Regulation Best Interest

Posted by Jack Duval

Apr 20, 2018 8:18:52 AM

Accelerant SEC Regulation Best Interest - Logo 

 

This blog post continues a series exploring the fiduciary rules proposed by the DOL and now the SEC.  My previous blog posts can be found here.

On Wednesday, April 18, 2018, the SEC issued a number of rule proposals designed, in theory, to "unify" the obligations of registered representatives of broker dealers with those of registered investment advisors.

It does no such thing.

Broker-dealers and their registered representatives will not be fiduciaries under Regulation Best Interest.  Investment advisors will remain fiduciaries.

Essentially, Regulation Best Interest will take many of the obligations that already exist in the FINRA Rules and Regulatory Notices and bring them under the SEC's aegis.  Indeed, the SEC stated:

As discussed herein, some of the enhancements that Regulation Best Interest would make to existing suitability obligations under the federal securities laws, such as the collection of information requirement related to a customer's investment profile, the inability to disclose away a broker-dealer's suitability obligation, and a requirement to make recommendations that are "consistent with his customers' best interest," reflect obligations that already exist under the FINRA suitability rule or have been articulated in related FINRA interpretations and case law.  (Emphasis added.  Regulation Best Interest; 10)

This means the suitability standard will remain for registered representatives with some additional language about the "best interests" of the client.  I will try to define exactly what the additional "best interest" language actually means in subsequent posts.

The SEC has released approximately 1,000 pages relating to this proposal.  You can find the three related releases here:

Release No. 34-83062; Regulation Best Interest;

Release No. IA-4889; Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation;

Release No. 34-83063; form CRS Relationship Summary; Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles.

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Topics: fiduciary obligations, Investment Suitability, Suitability Expert, FINRA Rule 2111 (Suitability), Securities Exchange Commission, 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: dol fiduciary rule, fiduciary obligations, erisa fiduciary expert, securities litigation, prudent expert standard, Due Diligence, litigation, reasonable compensation, active share, index funds

The DOL Fiduciary Rule - Risk Tolerance Questionnaires

Posted by Jack Duval

Aug 2, 2017 7:31:02 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.

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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Topics: dol fiduciary rule, fiduciary obligations, erisa fiduciary expert, securities litigation, prudent expert standard, Due Diligence, litigation, Investment Policy Statement, risk tolerance, suitability

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 must 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.

What is required to meet the fiduciary standard is 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.

A highly customized IPS is required 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.

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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Topics: dol fiduciary rule, fiduciary obligations, erisa fiduciary expert, securities litigation, prudent expert standard, Due Diligence, litigation, Investment Policy Statement

The DOL Fiduciary Rule - Shifting the Burden of Proof

Posted by Jack Duval

Jul 7, 2017 9:13:05 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.

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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Topics: dol fiduciary rule, fiduciary obligations, erisa fiduciary expert, securities litigation, prudent expert standard, Due Diligence, burden of proof, litigation

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.

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

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.

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

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