The Securities Litigation Expert Blog

Robinhood Recommendations - Rise of the Machines

Posted by Jack Duval

Feb 9, 2021 7:42:31 AM

accelerant jack duval robinhood litigation - hal 9000 image

Your broker will see you now.

In my first two posts in this series, here and here, I focused on Robinhood's trading restrictions and the potential litigation from those actions.

In this post, I want to shift focus to examine potential liability that could arise from Robinhood's business model and use of algorithms.

This potential liability revolves around Robinhood’s communications to its clients and if those communications constitute recommendations.


Does Robinhood make recommendations to its clients?

At first blush, the obvious answer is “no”. Robinhood is an online broker-dealer that facilitates its clients making self-directed trades through an app. There is no traditional human broker making recommendations to the client, so how could a recommendation have been made?

Upon deeper inspection, the obvious answer is very likely incorrect.


First, it is important to review how FINRA defines a "recommendation".

FINRA Notice to Members (“NTM”) 01-23 - Online Suitability, gives clear guidance about what constitutes a recommendation. FINRA writes: 

The determination of whether a "recommendation” has been made, moreover, is an objective rather than a subjective inquiry. An important factor in this regard is whether - given its content, context, and manner of presentation - a particular communication from a broker/dealer to a customer reasonably would be viewed as a "call to action", or suggestion that the customer engage in a securities transaction...


Another principle that members should keep in mind is that, in general, the more individually tailored the communication to a specific customer or a targeted group of customers about a security or group of securities, the greater likelihood that the communication may be viewed as a "recommendation".[1]

To simplify, there are two criteria that must be met to satisfy FINRA's definition of a recommendation:

  1. A suggestion to transact, (the “call to action”); and,
  2. Specificity to the customer.

For context, NTM 01-23 arose from the proliferation of online brokerage firms during the technology bubble in the late 1990's. These firms would frequently publish "Top 10" stock lists and other types of equities hyping on their websites.

The “Top 10” lists and similar communications clearly meet the call to action prong of the FINRA criteria - the firm was suggesting its clients invest in the listed securities. However, those lists clearly failed the specificity prong - the lists were posted on the firm’s website and were not specific to any individual client.

In a sense, these communications were like billboards on a highway.   Anyone driving down the highway could see them, not just one person or one group of person that had been targeted because of their specific traits.

Importantly, NTM 01-23 specifically addresses “electronic” recommendations, meaning those made by a computer and not by a human speaking to the customer. FINRA writes: 

… NASD Regulation believes that the suitability rule applies to all “recommendations” made by members to customers – including those made via electronic means – to purchase, sell, or exchange a security. Electronic communications from broker/dealers to their customers clearly can constitute “recommendations.” The suitability rule, therefore, remains fully applicable to online activities in those cases where the member “recommends” securities to its customers.[2] (Emphasis added)

Electronic communications to clients is an integral part of Robinhood’s business model and strategy. As will be discussed below, Robinhood did not use the “billboard” approach to its electronic communications. It targeted specific customers (based on their unique traits) with specific suggestions

Robinhood's Business Model

First and foremost, Robinhood is a technology company. It has applied a number of social media business techniques to a broker-dealer business and the results have been spectacular.

The Massachusetts’ Securities Division, filed a complaint against Robinhood (“MA Complaint”) in December 2020. The MA Complaint describes the firm’s business model and growth: 

Robinhood is a broker-dealer that offers commission-free trading for stocks and options. In lieu of commissions and fees, Robinhood earns revenue through a process known as payment for order flow. Payment for order flow is a process in which market makers or exchanges pay broker-dealers to route trades to the market maker or the exchange for execution. Therefore, the more trades Robinhood customers execute, the more revenue Robinhood receives from market makers or exchanges.[3]


Robinhood's stated mission is to 'democratize finance for all'. In its attempt to 'democratize' investing, Robinhood has targeted younger individuals with its advertising, many of whom have limited or no investment experience. According to Robinhood, the median customer age is 31 years old.[4]


Since its founding in 2013, Robinhood has experienced a rapid growth in its customer base. Between 2016 and October 2018, Robinhood grew its customer accounts from approximately one million to approximately six million, a 500% increase. Between the end of 2019 and May 2020, Robinhood grew its customer accounts from approximately ten million to approximately thirteen million, an increase of 30% in only a few short months. [5]


During this period of exponential growth, Robinhood used advertising and marketing techniques that targeted younger individuals, including Massachusetts residents, which little, if any, investment experience. The median age of a Robinhood customer has been reported as 31 years old and approximately 68% of Massachusetts customers approved for options trading on the Robinhood platform identified as having no or limited investment experience.[6]

Perhaps the social media technique most heavily used by Robinhood is that of gamification.


“Gamification” is the use of elements typical in game playing to encourage engagement with a product or service.[7] The MA Complaint states that Robinhood: 

(Used gamification) to encourage and entice continuous and repetitive use of its trading application.[8]


Once individuals become customers, Robinhood relentlessly bombards them with a number of strategies designed to encourage and incentivize continuous and repeated engagement with its application. The use of these strategies is often referred to as gamification: the application of typical elements of game playing to other activities, typically as a marketing technique to boost engagement with a product or service.[9] (Emphasis added)

Robinhood’s “strategies designed to encourage and incentivize continuous and repeated engagement with its application” includes the following: 

Robinhood sends push notifications to customers to encourage interaction with the application and trading.[10]


A customer that has not yet traded in their account may receive a push notification that states: 'Top Movers: Choosing stocks is hard. [flexing bicep emoji] Get started by checking which stock prices are changing the most'. Upon clicking on the push notification, the customer redirects to the aforementioned Top Movers list.[11] (Emphasis added)


Customers may also receive a push notification that states, 'Popular Stocks: Can't decide which stocks to buy [thinking emoji] Check out the most popular stocks on Robinhood.' Upon clicking on the push notification, the customer redirects to the aforementioned 100 Most Popular list.[12]

Robinhood’s Recommendation Engine

I believe the push notifications were recommendations and the algorithms Robinhood used to communicate with the firm’s clients constitute a recommendation engine.

It is almost certain that all the push notifications sent by Robinhood to its clients are tailored to groups that meet specific criteria, such as having not made a trade after opening an account. This is not “billboard” advertising. This was specific communication sent to specific clients based on specific traits they shared.

By suggesting trades to specific clients based on their specific account traits, the communication meets both prongs of the FINRA definition of a recommendation.

Most troublesome is that a push notification based on the number of times the client has traded is not based on information that would enable one to determine client suitability, such as the client’s risk tolerance and investment objective.

The Best Interest Standard

I have written extensively on SEC Regulation Best Interest (“RBI”) and will only review the basics here. In short, RBI requires a broker-dealer to know both the client and the investment in order to make a best interest recommendation. In the final RBI release, the SEC wrote: 

… when making a recommendation to a particular retail customer, broker-dealers must weigh the potential risks, rewards, and costs of a particular security or investment strategy, in light of the particular retail customer’s investment profile. As discussed above, a broker-dealer ‘s diligence, care, and skill to understand the potential risks, rewards, and costs of a security or investment strategy should generally involve a consideration of factors, depending on the facts and circumstances of the particular recommendation and the particular retail customer’s investment profile…[13]

As discussed in the MA Complaint, Robinhood’s recommendation engine appears to have failed to know the investor or the investment in any meaningful way.

First, if an algorithm bases its trade recommendation to a client off of the client's previous number of trades, the recommendation is based off of factors that have nothing to do with the client's investment objective, risk tolerance, and other relevant facts and circumstances, and thus did not consider the investment profile of the clients it made recommendations to.

Second, if the algo is suggesting trades in stocks that have the biggest daily percent change or are the most heavily traded on the platform, the algo only knows those stocks in the most trivial manner (ultra short-term performance and popularity), and in ways that cannot be used to evaluate their appropriateness for each client.

Any recommendation made in ignorance of the investor and investment completely fails the RBI standard of care.

Conflicts of Interest

Another relevant part of RBI that is violated in this scenario is the conflict of interest obligation, which states, in part: 

The broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to:


(B) Identify and mitigate any conflicts of interest associated with such recommendations that create an incentive… to place the interest of the broker, dealer, or such natural person ahead of the interest of the retail customer.[14]

If Robinhood’s algorithms were making recommendations based on the number of trades (or lack thereof) a client had made, then the recommendations were made purely to generate revenue for the firm. This is a blatant conflict of interest.

Indeed, it’s just a form of high-tech churning with bots making the recommendation instead of brokers.


If Robinhood has been making blatantly conflicted and demonstrably unsuitable recommendations to its clients via push notifications, and those clients have lost money on the recommended trades, it would appear the firm has significant liability under RBI.

Furthermore, unlike traditional cases where the broker and client typically give conflicting testimony about what was said as part of the recommendation, or if there was a recommendation at all, there will be none of that here.

The algorithms are likely very simple: 

  1. Call the number of trades for all accounts;
  2. Filter for accounts that have not traded since opening; and,
  3. Send push notification to the filtered list account holders.

The algorithm will establish the basis of the recommendation to each client. The push notifications will establish what was “said”. The statement records will show if the client traded those securities after the push notification was received and the profit and loss on those recommended transactions.

The algorithms, push notifications, and statements should all be discoverable and would establish a causal chain from Robinhood’s selection of the clients for the push notification to the profit and loss of those recommended transactions.



[1]      FINRA Notice to Members 01-23; Online Suitability; 2. Available at:; Accessed February 4, 2020.

[2]      Id. FINRA use to be known as “NASD”.

[3]      In the Matter of: Robinhood Financial, LLC; Administrative Complaint; Docket No. E-2020-0047; 8. Available at:; Accessed February 4, 2020; In Massachusetts, a broker-dealer is a fiduciary. The MA Complaint was filed on December 16, 2020, before the short squeeze mania.

[4]      Id. at 9.

[5]      Id. at 3.

[6]      Id.

[7]      See Merriam-Webster; s.v. “gamification”. Available at:; Accessed February 5, 2021. I am paraphrasing above.

[8]      Id. at 2.

[9]      Id. at 4.

[10]    Id. at 13.

[11]    Id. at 14.

[12]    Id.

[13]    17 CFR Part 240; Regulation Best Interest: The Broker-Dealer Standard of Conduct; 270. Available at:; Accessed February 8, 2021.

[14]    17 CFR Part 240; Regulation Best Interest: The Broker-Dealer Standard of Conduct a(iii)(B); 765-8. Available at:; Accessed February 8, 2021.


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Topics: FINRA, Conflicts of Interest, suitability, securities litigation, investment recommendation, SEC Regulation Best Interest, Robinhood

GameStop Litigation - Part 2

Posted by Jack Duval

Jan 29, 2021 3:46:12 PM

This is the second post in my series on potential litigation arising from the trading restrictions imposed by Robinhood and other firms on GameStop and other securities involved in the recent short squeezes. The first post can be found here.

Broker-Dealer Risks

Broker-Dealers (“BDs”) can get burned by margin clients blowing up. But that’s not what happened to Robinhood or any other BD yesterday.

As of 10am Thursday morning, every owner of Robinhood stock and call options (what the Redditors were buying) was profitable because the stock was at an all-time high.

The risk to a BD is that their margin customers take large losses in excess of the equity in their accounts. In these instances, the BD has to make up the difference to their clearing firm, if that amount is greater than the firm’s equity, it is bankrupt.

The way BDs manage this risk is to change client margin requirements to increase their client's account equity and/or to sell out client positions if their equity falls below a certain level.

Robinhood did increase the margin requirements on GameStop and the other names that were part of the ongoing short squeeze on Wednesday, January 27th.[1]

Clearing Firm Margin Requirements

BDs, like their clients, are subject to their own margin requirements from their clearing firms. Also just like their clients, BD margin requirements change, typically under a formula that includes volatility as an input. As volatility increases, so does the margin requirement of the BD.

When a BD's margin requirement increases, it must post more collateral with its clearing firm.

Robinhood CEO Vlad Tenev said in a CNBC interview this morning that the firm tapped its bank credit lines proactively, meaning that it did so before it received margin calls from the Robinhood’s clearing firms.[2] Further, Tenev stated that Robinhood had “no liquidity problem, and that: 

By drawing on our credit lines, which we do all the time, as part of normal day-to-day operation, we get more capital that we can deposit with the clearinghouses. And that will allow us to enable ideally more investment with fewer restrictions.[3]

If there was no liquidity problem and Robinhood drew on its credit lines to bolster its capital position with its clearing brokers, there should have been no reason to restrict trading in GameStop and the other short squeeze names.

GameStop Volatility

There is no doubt that GameStop volatility has been rising, but it had already risen significantly by Wednesday, January 27, and trading had not been stopped. Again, if Robinhood had bolstered its capital position on January 27th and 28th, why restrict trading yesterday?

Chart 1: GameStop 10, 30, 90, and 120 Day Historical Volatility

accelerant jack duval GME historical volatility chart

 Furthermore, overall market volatility, measured by the VIX Index fell from 37.21 on Wednesday to 30.21 on Thursday, a decline of 18.8 percent.[4]

This is important, because Robinhood clients hold many more securities that GameStop and the other short squeeze names. Thus on an aggregate basis, it is possible that the volatility on the combined Robinhood securities declined on January 28th.

In short, it would appear that Robinhood's proactive trade restrictions were implemented not because the firm had run out of money, but because the firm was worried about running out of money.

However, Robinhood was fully capitalized Robinhood and acted on these worries by preventing its clients from purchasing GameStop and other short squeeze names and only allowing closing transactions.

While it is certainly prudent for Robinhood to act proactively to protect its business it cannot be reckless or negligent in how it does so.

As can be seen in Chart 1, above, the volatilities of GameStop had been rising starting on January 13th, when the 10 day volatility spiked from 100 to 258.

On January 26th, the 10-day volatility spiked again from 308 to 394. Ultimately, the 10-day volatility peaked out at 688, nearly a 10x increase from the January low of 77.

However, Robinhood had lived through other 10x increases in single stock volatility.

Chart 2: Tesla 10, 30, 90, and 120 Day Historical Volatility

accelerant jack duval tesla historical volatility chart


Chart 2, above, shows the 10-day Tesla stock volatility increasing from 18 to 210 in the three months leading to the climax of the COVID selloff in March 2020. Furthermore, this was a time when all equity volatilities were spiking to extreme levels.

In order to protect the firm, prudent risk management would dictate that Robinhood:

  • Raise the margin requirements on its clients in the short squeeze names;
  • Bolster the firm's capital position by drawing on bank lines; and,
  • Raise additional capital from its backers (which have included some bold-faced venture capital names that surely had cash available on short notice).

Robinhood did all three, but not before it helped manipulate a catastrophic decline in the GameStop stock price.

Impact of Broker-Dealer Trading Restrictions

Robinhood implemented its closing-position only trading restrictions at 10am yesterday, January 28th, 2020.

During the day, the SEC halted trading in GameStop 19 times.

These two factors appear to have panicked investors into selling (which is, of course, the only option they had at many BDs yesterday).

Chart 3: January 28, 2021 GameStop Intraday Price Chart

accelerant jack duval GameStop Intraday Chart

Yesterday from 10am to 11:24am, GameStop stock declined by nearly 77 percent.

What's more instructive is that the price was effectively "limit down" multiple times from 10am after almost every trading halt through 11:24am.

This means it was very difficult to sell the stock. It essentially went like this:[5]

  • 10am, Robinhood told clients they could only close out positions (i.e. sell stock or long call options, or buy back short positions), this caused the stock to decline;
  • 10:03am the SEC implemented the first trading halt in GameStop;
  • 10:08am the trading halt was lifted;
  • 10:16am the stock had declined by over eight percent;
  • 10:17am the SEC implemented the second trading halt in GameStop;
  • 10:22am the trading halt was lifted;
  • 10:39am the stock declined by roughly 11 percent; and,
  • 10:40am the SEC implements the third trading halt.

 This cycle repeated seven more times until 11:24am, when the stock has an intraday peak to trough decline of almost 77 percent.

Client Losses

It is not clear how much money was lost during the one hour and 24 minutes that encompassed the 77 percent decline.

However, it is certain that some investors experienced large losses, especially those that had purchased call options over the past few days.


There have already been two class-action cases filed against Robinhood, including Nelson v. Robinhoood Financial et al in the Southern District of New York.

There are many issues involved. On Thursday, Robinhood management pointed to their own margin calls from clearing firms, but this morning said there was no liquidity crunch. If the firm implemented the trading restrictions when it did not need to, under the perception that it might face a cash crunch at some later date, that is problematic.

Instead of restricting trading due to a potential problem, Robinhood should have bolstered its capital and/or undertaken other measures in advance of those potential needs. The firm had plenty of notice as the short squeezed stock appreciation gathered pace over the past month.

Finally, Robinhood claims to have raised an additional $1 billion from its existing backers (in addition to the reported $200 million in bank line draws). If that’s true, why is the firm only allowing the purchase of one additional GameStop share as of 3:15pm today.[6] Something doesn’t add up there.

For attorneys contemplating bringing a complaint, it is good to keep in mind that Robinhood has plans to IPO this year at a price that would value the firm at around $20 billion. The firm has already had regulatory issues and had to pay an SEC fine of $65 million on December 17, 2020 for violations of FINRA's Best Execution rule.

Robinhood will not want to IPO under a cloud of litigation uncertainty and may be more willing to settle cases because of that.


What would the Redditor/Robinhood story be without a good conspiracy? This one is brought to you by Congressman Paul Gosar, D.D.S.:

Melvin Capital Management is owned by the parent company “Citadel, LLC” which, according to a Bloomberg Report, gave Robinhood roughly 40% of their revenue (through payment for order flow). Knowing the involvement Citadel has with Robinhood, it is clear that the actions taken today were motivated by anti-competitive reasons not for concerns of volatility claimed by Robinhood. Because of this blatant conflict of interest and obvious monopolistic activity, I am calling on an immediate investigation by the U.S. Department of Justice into Robinhood and the hedge fund of Citadel, LLC.[7]

 Let the investigations begin.



[1]      Robinhood ramps up margin requirements on zooming GameStop, AMC; Matt Egan; CNN Business; January 27, 2021. Available at:,initial%20margin%20requirement%20and%20maintenance; Accessed January 29, 2021.

[2]      Robinhood CEO: Tapping Credit lines proactive, not a sign of cash crunch in GameStop frenzy; Kevin Stankiewicz; CNBC; January 29, 2021. Available at:; Accessed January 29, 2021.

[3]      Id.

[4]      Source: Bloomberg.

[5]      Bloomberg News reported the Robinhood trading restrictions at 9:43am on January 28, 2021, however the New York Times reported on after-hours trading restrictions the night before at 6pm. See, Trading platforms are limiting trades of GameStop and other companies; Gillian Friedman and Tara Siegel Bernard; The New York Times; January 27, 2021. Available at:; Accessed January 29, 2021. SEC Trading Halts obtained from Available at:; Accessed January 29,2021.

[6]      Robinhood raises $1bn from investors and taps banks at end of wild week; Michael Mackenzie, Eric Platt, James Fontanella-Khan, and Philip Stafford; Financial Times; January 28, 2021. Available at:; Accessed January 29, 2021.

[7]      Letter of Paul A. Gosar, D.D.S. to Activing Attorney General Monty Wilkinson; January 28, 2021. Available at:; Accessed January 29, 2021.

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


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Topics: FINRA, securities litigation, Bantam Inc., GameStop, Trading Restrictions, Trading Halt, Reddit, Robinhood

GameStop Litigation

Posted by Jack Duval

Jan 28, 2021 11:51:17 AM

Yesterday and this morning, TD Ameritrade, Robinhood, and other firms restricted trading in GameStop, AMC, and other heavily shorted stocks that have been undergoing tremendous short squeezes over the past few weeks.

GameStop Chart

Jack Duval Accelerant GameStop litigation image

Source: Bloomberg

Regulatory Halts v. Trading Restrictions

For clarification there is a difference between a Regulatory Halt, which can be issued by FINRA or the SEC, and a broker-dealer ("BD") restricting trading in a security.  The former is common and happens every day, usually due to a large move (up or down) in a stock.  The regulator typically contacts the issuer to see if there is news that needs be be disclosed and will remove the halt after their questions have been answered.  (Frequently, there is no news from the company.)

A BD-initiated trading restriction is much less common.  When they do happen, they are usually for clients a firm wants to fire.  They ask the client to leave and tell them they will only accept closing orders, i.e. sales of securities held long, or purchases of securities held short.

This morning, Robinhood announced it would accept only closing orders for GameStop, AMC, and other securities.  They had already raised the margin requirements for these securities.

Robinhood Customer Agreement

The Robinhood Customer Agreement explicitly allows for the firm to "prohibit or restrict" trading in securities, without notice.

Robinhood Customer Agreement Extract

robinhood account agreement

Litigation Implications

While Robinhood, and most likely all BDs, have the ability to restrict client trading in securities, doing so raises a host of issues.  Some of those include:

  • Was the implementation of the trading restriction commercially reasonable?
  • If the BD allowed the clients to buy the security and then only allowed sales of the same security, are they engineering a decline in the security?  That is, if owners can only sell a security and no one can buy, there is only one way for the security to trade - down.
  • If all BDs implement closing-only restrictions, they themselves are engaging in market manipulation, guaranteeing a price decline and losses for investors.
  • If a client has an open options position, is the BD preventing the client from hedging their position via an opening transaction in the underlying or another option?
  • It is likely that FINRA has been in consultation with the BDs about these restrictions, which would seemingly raise the same liability issues for the regulator.
  • Are these restrictions being applied to institutional investors as well as retail investors?  For instance, are the options market makers able to trade in these names freely?  What about hedge funds and other institutions?
  • If the restrictions have not been implemented uniformly, it raises serious self-dealing issues.  FINRA's members are BDs and are heavily connected to institutional investors such as hedge funds.  If the regulator coordinated a member-wide closing trade only restriction for retail investors, it would benefit the hedge funds (who have been short) at the expense of the retail investors.

As I was writing this, it would appear that the trading restrictions have negatively affected the GameStop stock price.  It has declined by 67 percent from the peak today (from roughly $450 to about $126).

GameStop Intraday Chart

gamestop intraday chart

Source: Bloomberg

I'll have more on this as developments continue.


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


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Topics: FINRA, securities litigation, Bantam Inc., GameStop, Trading Restrictions, Trading Halt

Coronavirus Cases

Posted by Jack Duval

Mar 24, 2020 9:23:37 AM

This is the first post in a series on the securities litigation likely to arise from the recent market declines.

Since the Global Financial Crisis ("GFC") in 2008-9, the Federal Reserve has keep interest rates at extremely low levels.

Indeed, at the end of 2007, the yield on the 10-year U.S. Treasury note was 4.0232 percent and at the end of 2011 it was 1.8762 percent.[1]  As I write this, it is at 0.69 percent.[2]

This has lead brokers and advisors to “reach for yield" for their investors.  Of course, they were able to grasp it, primarily by reducing high quality equity and fixed income investments and increasing:

  • Equity allocations;
  • Equity “bond proxy” allocations, and;
  • Low-quality fixed income allocations.

Over time, these combined shifts have led to an increasing amount of risk in investor's portfolios, even if the equity allocation did not increase (or even decreased).  Indeed, many investors have seen their portfolios become predominately equity exposed, greatly increasing their risk.  Table 1, below offers a comparison.

Table 1:  Typical Pre- and Post-GFC Portfolio Composition


Typical Pre- and Post-GFC Portfolio Composition

Table 1, above, compares typical investor portfolios from the pre- and post-GFC periods.  The yellow banded rows highlight investments with equity or equity-like exposure (even if they are bonds).

The pre-GFC portfolio has a 55/35/10 (stocks/bonds/cash) asset allocation, and is heavily skewed to quality on both the equity and fixed income sides.  The post-GFC portfolio has a 65/30/5 asset allocation, but has added 15 percent of equity “bond proxies” and lower quality fixed income.  (Equity bond proxies include equity investments such as traditional infrastructure, utilities, REITs, MLPs, and other higher yielding equities.)

Importantly, the direct equity exposure only increased from 55 to 65 percent, however, the total equity and equity-like investments increased from 60 to 85 percent.  From a risk perspective, the post-GFC portfolio is 85 percent in equities.

This is a significant increase.  And a bad trade.

In the 10-year rolling periods from January 2001 through June 2018, a traditional 60/40 portfolio returned an average annual 6.56 percent, whereas an 85/15 portfolio returned an average annual 7.13 percent, or 57 basis points higher.[3]

However, the increase in risk is dramatic.  Over the same period, the 60/40 portfolio had a standard deviation of 9.19 percent compared to 12.84 for an 85/15 portfolio.[4]

In percentage change terms, by shifting the equity (and equity-like) allocation from 60 to 85 percent, an investor gets an approximate nine percent increase in expected return, but a 40 percent increase in expected risk.  This is what made it a bad trade.

Worse still is the max drawdown risk of the two portfolios.  The 85/15 portfolio has significantly more drawdown risk.  Those risks are now being felt as the typical post-GFC portfolio proves to be much more highly correlated (i.e. where almost all the assets decline simultaneously) than most investors thought.

Hidden Fixed Income Risks

The litigations arising from the recent declines will likely have a common theme that was not present in those arising in post-GFC litigations:  hidden risks in investor’s fixed income investments.  All the risky fixed income investments that investors have been put into as part of the reach for yield are declining similar to equities, and in some cases more than equities.

These risky fixed income investments include those investing in the following underlying investments and/or strategies:[5]

  • Corporate bonds (which were typically around 50 percent in BBB rated bonds);
  • High yield “junk” bonds;
  • High yield municipal bonds;
  • Leveraged closed-end funds;
  • Convertible bonds;
  • Preferred stocks (almost all preferred stocks are issued through trusts which buy a note from the issuer and then sell interests in the trust);
  • Commercial mortgages;
  • Asset-backed securities;
  • Leveraged loans;
  • Collateralized loan obligations, and;
  • Emerging market bonds;

Table 2:  Bottom Decile One-Month Fixed-Income Mutual Fund Returns through March 20, 2020[6]

Bottom Decile one-month fixed-income mutual fund returns

The full list can be downloaded here.

Table 2, above, shows that the fixed income funds with the worst one-month performance through March 20, 2020, also generally had high, double-digit total returns in 2019.  These funds have fallen in-line with the S&P 500, which was down about 29 percent over the same period.

When reaching for yield, the handhold is risk.  The 2019 returns were the yield part, the previous months performance is the risk part.

In my experience, when bonds decline like equities, litigation ensues.

In subsequent posts, I will examine other aspects of increased risk-taking over the past 11 years.




[1]      Source: Bloomberg.

[2]      Id.

[3]      Goldman Sachs; Diversified Investment Allocation Tool.  Available at:;  Accessed March 20, 2020.  Dataset is the 91 10-year rolling periods from January 01, 2001 to June 30, 2018.

[4]      Id.

[5]      This list is by no means exhaustive.  All kinds of risky fixed income products have been invented over the past 11 years.

[6]      Source: Bloomberg.  Performance data for U.S. domiciled fixed income mutual funds with $500 million or more in assets, through March 20, 2020.


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Topics: collateralized loan obligations, securities litigation, fixed income, Investment Suitability, commercial mortgages, CLO

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".



[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:;  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.



[1]       Michael Kitces; Nerd’s Eye View; Adopting a Two-Dimensional Risk Tolerance Assessment Process; January 25, 2017.  Available at:; Accessed August 1, 2017.


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

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.



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

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.



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

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.



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

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…


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.



[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:; Accessed June 22, 2017.

[4]       Best Interest Contract Exemption with Amended Applicability Dates; Section II(c)(1) – Impartial Conduct Standards; Available at:; Accessed June 22, 2017.

[5]       Uniform Prudent Investor Act; February 14, 1995; Section 2(f) and related comments; Available at:; 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

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