The Securities Litigation Expert Blog

Private Equity - Due Diligence

Posted by Jack Duval

Nov 16, 2017 8:30:16 AM

This blog post begins a series examining the risks and returns of private equity investments.

Apollo Group Structure:  Got it?

Apollo Group Structure.jpg

Source: Apollo Group S-1

On July 28, 2017, Apollo Group Management LLC announced the largest ever capital raise for a private equity fund.  While this $23.5B fund will be the largest ever, it may not hold the title for long.  The New York Times reports there are two other private equity funds in raises with higher targets.[1]

While these capital raises are impressive, they also raise questions.  As the private equity space has become increasingly crowded, returns have declined.  Industry statistics are sobering.

The most recent data from Prequin reveals that for the time period ending 2016:[2] 

  • Private equity AUM were at $2.491T, an all-time high;
  • Cash held by private equity funds was at $820M, an increase of $65B from 2015;
  • Median net IRRs have declined from 20+ percent in the early 1990’s to 12.6 percent in 2013 (the most recent vintage with meaningful numbers)
  • Likewise, median net multiples have declined from around two to around one over the same time period.

The reduction in returns has led to a number of abusive practices at private equity funds.  These abuses were highlighted by the SEC in a high-profile campaign in 2015.[3]  However, the continued bull market has helped to keep valuations high and has served to reduce litigation.  This will not always be the case.

When the market turns, successful exits will become harder to realize and this will depress IRRs.  At that point, private equity funds and the advisors who sold them may find themselves in the difficult position of having to justify total fund expenses that can amount to six percent of committed capital, annually.

While private equity remains a legitimate asset class, a tremendous amount of diligence must be conducted in order to insure that abusive practices are not being utilized by funds at the expense of their limited partners.

I will give an overview of some areas that disserve heightened diligence and then explore them in later blog posts.

Private Equity Due Diligence

Diligence into private equity funds is a time-consuming and laborious process.  Most investors are not equipped to undertake this due diligence as the private placement memorandums are written in legalese and encompass concepts from finance, economics, accounting, and law.  This is a form of complexity risk, something I have written about extensively.  Indeed, because of their complexity, many professionals are ill-equipped to properly evaluate private equity investments.

An example of private equity complexity risk can be seen at CalPERS, the massive California Pension manager.  CalPERS endured public embarrassment in 2015 when it had to admit it could not account for the fees being paid to the pension's private equity fund managers.[4]  This fact is even more remarkable in context of CalPERS’ investment staff of nearly 400.[5]

Advisors must have extensive training and experience with private equity investments before they can undertake the rigorous due diligence required to make a suitability determination.

Areas requiring heightened diligence include: 

  • General Partner/Limited Partner Conflicts, which include:
    • Non-performance based compensation;
    • Waivers of fiduciary responsibility;
    • Shifting expenses to funds (i.e. limited partners);
  • Valuation:
    • How are marks set?;
    • Assumptions used in marks?;
  • IRRs:
    • Do they reflect the economic returns to limited partners (even if “accurate” at the fund level)?;
    • Treatment of timing of flows;
    • Timing of allocation of unrealized losses;
    • Omissions of key assumptions;
  • Performance
    • Leverage-adjusted returns;
    • De-smoothed returns and volatility;

I will examine these and other factors of private equity risk and return, as well as their implications for suitability and supervision, in subsequent blog posts.



[1]       Tom Buerkle, “Apollo’s Huge Buyout Fund Provides for a Large Margin of Error”, New York Time’s; June 28,2017.  Available at:; Accessed November 16, 2017.

[2]       Prequin 2017 Global Private Equity and Venture Capital Report.  Available at:; Accessed November 16, 2017.

[3]       SEC Announces Enforcement Results for FY 2015; October 22, 2015.  Available at:; Accessed November 16, 2017.

[4]       Randy Diamond; “CalPERS CIO looking at possible drastic cuts to private equity, citing transparency”; Pensions & Investments; June 19, 2017.  Available at:; Accessed November 16, 2017.

[5]       CalPERS biography of Ted Eliopoulos, Chief Investment Officer.  Available at:; Accessed November 16, 2017.

For information about securities expert Jack Duval, click here.


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Topics: suitability, supervision, Due Diligence, private equity, de-smoothed returns, IRR, leverage-adjusted returns

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.

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

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


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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

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.



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


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: 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

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.

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.

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: 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

DOL - Accelerant Fiduciary Rule Expert.jpeg

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

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

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

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

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

Shifting the Burden of Proof

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

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

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

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

Meeting the Burden of Proof

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

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

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

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

Due Diligence and the Firm

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

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

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

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

Due Diligence and the Registered Representative

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

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

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

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

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



[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.

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: 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

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 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.

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

Jack Duval Publishes Municipal Bond and MSRB Rule E-Book

Posted by Jack Duval

Oct 26, 2016 10:27:08 AM

I am pleased to announce the publishing of a new e-book focused on the municipal bond market and MSRB Rules.  

Detroit_Packard_Plant_-_shutterstock_115828237.jpgAbandoned Packard factory in Detroit.

The book covers many topics, including:

  • The continued deterioration of municipal fundamentals;
  • The municipal bond rating whipsaw since 2007;
  • Background on the MSRB;
  • Anti-fraud and fair dealing rules;
  • Suitability rules;
  • Due diligence requirements;
  • Disclosure obligations;
  • Affirmative discosure requirements;
  • Informed consent, and;
  • Supervision.

The book is available for download on Amazon's Kindle for $9.99, or you can download the PDF by clicking on the link below.

Click to Download E-Book

To learn more about author Jack Duval, click here.


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Topics: disclosure, suitability, supervision, Due Diligence, municipal bonds, msrb, anti-fraud, informed consent, fair dealing

FINRA Issues Regulatory Notice 13-31 Suitability

Posted by Jack Duval

Oct 23, 2013 7:36:07 AM

FINRA has issued RN 13-31 to highlight effective practices for member firms when complying with Suitability Rule 2111.  (RN 13-31)

A number of highlights are worth noting, including:

  •  The manner in which the firm supervises explicit hold recommendations, including the method of documentation the firm uses when documentation occurs, as well as the information the firm considers in conducting the review...

  • Transaction red flags such as: those that appear to deviate from the firm’s internal suitability guidelines for a particular security; a long-term investment for an investor with a short-term horizon; a speculative investment or strategy held in the account of an investor with a conservative investment objective; and the same security held in the account or strategy implemented for...

The RN also emphasized compliance with the reasonable-basis component of Rule 2111:
As referenced above, reasonable-basis suitability requires a firm or associated person to perform reasonable diligence to understand the nature of a recommended security or investment strategy involving a security, as well as its potential risks and rewards, and to determine whether the recommendation is suitable for at least some investors based on that understanding. FINRA observed during examinations that many firms have in place a new product vetting process that assists them in executing reasonable diligence obligations. While many large firms have extensive frameworks for assessing products, even smaller firms established investment committees to vet complex or risky products to determine whether the product met the reasonable-basis suitability standard for retail customers, and if so, the type of customer profile for which the product would be suitable if recommended.

A firm’s vetting of new products does not, standing alone, satisfy the need for associated persons to understand the securities and investment strategies they recommend to customers.  In this regard, some firms post due diligence on products (and accompanying documents) to an internal website that associated persons can access when recommending a product. Such information includes audited financial statements, notes of interviews with key individuals of the product sponsor or issuer, and other information relevant to understanding the product and its features. Some firms use the vetting process to aid in product-focused training of their associated persons, supervisors and compliance staff.

Compliance with the reasonable-basis suitability requirement will be an important issue in the next securities litigation cycle.  Chief Compliance Officers are right to focus on this issue before the next cycle is upon them.
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Topics: reasonable basis suitability, FINRA, RN 13-31, litigation, investments, supervision, Due Diligence, SEC, Compliance, regulation.

Finra Introduces Private Placement Filing Requirement

Posted by Jack Duval

Oct 22, 2012 5:10:57 AM

The SEC recently approved Finra Rule 5123 and will create a private placement filing system under which member firms will be required to file the Private Placement Memorandum, Term Sheet, or other Offering Document for deals they sell.  The new rule will go into effect on December 3, 2012.  See Finra NTM 12-40 for details.  (NTM 12-40)

There are many exemptions to this filing requirement, including an exemption for deals that only allow accredited investors.  This will allow most private placements to avoid the filing requirement.

Rule 5123 does not exempt member firms from conducting due diligence into private placements that they offer.  These duties are covered in NTM 10-22.  (NTM 10-22)

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Topics: FINRA, private placement, investments, Due Diligence, SEC, NTM 10-22, NTM 12-40, regulation.

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