Don’t Poke the Bear: Nevada Rains on Anti-Fiduciary Rule Parade

It is well established that ERISA comprehensively regulates employee pension and welfare plans, and t hat in the area of its coverage it preempts state laws and regulations. …However, it is also clear that there is a presumption against preemption, and that while ERISA’s preemptive effect is broad, it is not all-encompassing. As the Supreme Court has stated,”[s]ome state actions may affect employee benefit plans in too tenuous, remote, or peripheral a manner to warrant a finding that the law ‘relate to the plan….”
Duffy v. Cavalier, 215 Cal.App.3d 1517, 1527 (1989)

Most people are familiar with Gordon Gekko’s famous line from the movie “Wall Street”-“greed is good.” Right now, I’m guessing that the Department of Labor, Secretary Acosta, the investment industry and its trade groups are seriously questioning the accuracy of that statement.

Ever since Secretary Acosta assumed his position, he has made no secret of his pro-investment industry, anti-DOL’s new fiduciary rule position. The investment industry has made various requests in an effort to kill or seriously limit the impact of the rule. In each case, Acosta has granted their wishes, even thought the DOL was crested to protect the interests of American workers, not the investment industry. Secretary Acosta, the DOL, the investment industry and its trade groups have essentially thumbed their noses at American plan participants and retirees with indignation, sending the clear message that the DOL does not care about them.

However, there is another familiar saying–“be careful what you wish for.” In this case, you can only bully people for so long before they decide to fight back. The bullying efforts of the DOL and investment industry have now been countered by the state of Nevada’s announcement that the intend to exercise their 10th Amendment  police powers to protect their citizens by holding all stockbrokers and financial adviser in their state to a fiduciary standard.

Pandora’s box is officially open and the investment industry has clearly indicated its concern, and rightfully so. Other states have used legislation and/or court decisions to hold stockbrokers and financial advisers to a fiduciary standard for some time. Nevada’s announcement, and their statement that other states have already contacted them about following their lead, has implications far beyond just ERISA. States adopting a fiduciary standard for stockbrokers and financial advisers apply the standard to all activities of these parties, not just ERISA related activities. Greed is not good.

The investment industry’s response to Nevada’s annoouncement thus far has been a feeble allegation that Nevada’s adoption of a fiduciary standard for stockbrokers and financial advises will create confusion. What the investment industry and its trade groups realize is that that there is nothing they can do legally to prevent Nevada or any other state from creating and enforcing such laws under their 10th Amendment police powers. Likewise, there is nothing that the Trump administration, the DOL or Secretary Acosta can do to prevent Nevada from enacting such laws.

Equally troubling for the investment industry and other opponents of the DOL’s fiduciary standard is the fact that Nevada’s right to so act and the implications of such actions in ERISA cases has already been addressed in a well-reasoned decision, the aforementioned case of Duffy v. Cavalier. With regard to the DOL’s fiduciary rule. more specifically the DOL’s threats to essentially emasculate the Best Interest Contract exemption (BICE), Duffy stands for the proposition that states can enact laws to allow their citizens to protect their financial interests and preserve their access to the state’s court to do so.

Again, such fiduciary standards would apply to all activities of stockbrokers and financial advisers, not just ERISA related activity. Again, as long as states follow the guidelines set out in Duffy, there is absolutely nothing that the DOL, the investment industry or their trade groups can do to prevent any state from exercising its constitutionally protected 10th Amendment rights in enacting such fiduciary standards.

Nobody likes a bully. As they like to say here in the South, Secretary Acosta, the investment industry and its trade groups got greedy, “got too big for their britches,” and as a result, Nevada and other states decided that if the DOL was not going to do its job and protect plan participants and retirees, then they will use their police powers to do so. As a result, the investment industry has simply ensured that its members will face more stringent regulations and liability exposure in all of its activities, and there is nothing they can do to prevent same.

Check and checkmate.

P.S. For those wanting to read the Duffy decision, the decision can be accessed via www.leagle.com and searching the site using “Duffy v. Cavalier.”

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Posted in 401k, 404c, 404c compliance, BICE, compliance, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, Fiduciary prudence, fiduciary standard, pension plans, prudence | Tagged , , , , , , , , , , ,

Transparency Is the Best Sunlight: Four Due Diligence Questions Plan Sponsors and Plan Participants Should Ask

Sunlight is the best disinfectant. – Justice Brandeis

The ongoing attempts by the Department of Labor (DOL) and Congress to delay or completely reverse the DOL’s fiduciary rule sends a clear message to pension plan sponsors and plan participants – we care more about Wall Street and the overall investment industry than we do about you.

The arguments put forth by Wall Street and the investment industry thus far have been nothing more than self-serving rhetoric and speculation, totally devoid of any legally admissible evidence. And yet, both the DOL and Congress have gone out of their way to agree to any requests for further delays in full implementation of the DOL’s new fiduciary rule.

The DOL recently agreed to delay the effectiveness of the full DOL rule for eighteen months, even though a private foundation estimated that the delay would result in an $11 billion loss to pension plan participants. The DOL agreed to the additional delay even though CEOs for some of the nation’s leading broker-dealers have publicly stated that no delay is necessary, that they were completely prepared for a full and immediate implementation of the DOL’s rule.

So what does this all mean for plans, plan sponsors and plan participants, the primary beneficiaries of the DOL’s fiduciary rule? It means that they need to become more proactive in order to protect their financial security or, in the case of plan fiduciaries, to protect against any unwanted potential personal liability.

In my legal and fiduciary consulting practices, I use five core questions to establish the failure of a meaningful due diligence process by a financial adviser and resulting unsuitable/imprudent advice, in both ERISA and non-ERISA situations. The five core questions that I use in my practices analyze the true nature of the effective returns that investors receive once certain factors are considered. The four factors that I consider in my forensics analyses are: nominal, or stated, annualized returns;  load-adjusted annualized returns; risk-adjusted annualized returns, and potential “closet index” returns, using both Ross Miller’s Active Expense Ratio metric and my Active Management Value Ratio™ 3.0 metric.

Nominal, or Stated, Returns
These are essentially a fund’s absolute returns, based on the difference between a fund’s beginning and ending value over a certain period of time, with no consideration of any other factors. A fund that started the year with a balance of $10,000 and a balance of $10,000 at the end of the year would have earned a return of 10 percent for the year. [(11,000-10,000)/10,000=1,000/10,000, or 10 percent.

Load-Adjusted Returns
The problem with using nominal returns in analyzing a fund’s performance is that it overstates a fund’s effective annualized returns if an investor paid a front-end fee, or load, when they purchased the fund. Front-end loads are immediately subtracted from a fund at the time they are purchased, putting an investor who pays a front-end load behind investors who do not pay a front-end load when they purchase their mutual fund shares.

All things being equal, a front-end load will always cause an investor paying same to lag behind an investor who did not pay any type of load. And the difference in cumulative returns grows larger over time. As a result, mutual funds often use various marketing techniques in an attempt to conceal the negative impact of front-end loads on returns.

Mutual funds are required by law to disclose a fund’s load-adjusted return in a fund’s prospectus. However, it is common knowledge that most investors do not read a fund’s prospectus. One common marketing technique that fund companies use in advertising to hide the negative impact of front-end loads on returns is to use a fund’s nominal returns rather than its lower load-adjusted returns in their ads.

Then, in an attempt to avoid any potential charges of violations of the Exchange Act or the Advisors Act, the fund will ad a footnote, in much smaller print, at the end of the article stating that they did not use the fund’s load-adjusted returns and that, had they done so, the fund’s return numbers would have been lower. They never say how much lower or provide the actual load-adjusted returns numbers. In my opinion, the use of such tactics by a fund or financial adviser is a clear indication of their business ethics and respect for investors, or their complete lack thereof.

Risk Adjusted Returns
Studies have suggested a direct relationship between the level of investment risk assumed and investment return. As the Restatement (Third) Trusts (Restatement) points out, the natural inclination of investors and the duty of investment fiduciaries is to seek the highest level of return for a given level of risk and cost.

The investment industry often downplays the evaluation of a fund’s risk-related returns, with the familiar quote, “investors cannot eat risk-related returns.” However, mutual funds certainly have no problem referencing the number of Morningstar “stars” one of their funds earned if the rating is favorable, even though Morningstar has publicly acknowledged that it bases a fund’s “star” rating on the fund’s relative risk-related returns.

“Closet Index” Returns
“Closet index” funds, also known as “index huggers,” have become an increasing issue with regard to wealth management. Closet indexing refers to situations where a mutual fund holds itself out as an actively managed mutual fund, and charging higher fees for such active management, but whose actual performance closely tracks that of a comparable, but less expensive, index fund. Therefore, such funds are not cost-efficient and violate a fiduciary’s duty of prudence.

One of the best ways to identify a closet index is by using a statistic called R-squared (or R2), which measures the percentage of a fund’s movements that can be explained by fluctuations in a benchmark index. The higher a fund’s R-squared number, the greater the likelihood that the funds can be designated as a closet index fund. R-squared  ratings for funds are available for free on various public internet sites, such as Morningstar, Yahoo!Finance and MarketWatch.

One commonly method commonly used to evaluate a fund’s potential closet index status is to use a fund’s R-squared number to compute a fund’s Active Expense Ratio (AER). A fund’s AER number provides investors and investment fiduciaries with a fund’s effective annual expense ratio given the fund’s reduced active management component. In my practice, I take a fund’s AER and use it in my proprietary metric the Active Management Value Ratio™ 3.o (AMVR). The AMVR allows investors and investment fiduciaries to quantify the cost-efficiency of an actively managed mutual fund.

The impact of such returns on the performance of a fund can be seen in the following example. Capital Group’s American Funds mutual funds are among the most commonly recommended funds to both ERISA and non-ERISA accounts. Financial advisors like the fact that American Funds pay one of the highest commission rates of any fund group, based largely on the 5.75 percent front-end load that American charges non-ERISA accounts. ERISA accounts typically do not charge investors a front-end load on their purchases.

In our example, we will compare the ten-performance of two of American Fund’s most popular funds, Growth Fund of America (retail AGTHX, retirement RGAGX) and Washington Mutual (retail AWSHX, retirement RWMGX) to their comparable fund at Vanguard. Morningstar classifies AGTHX/RGAGX as a large cap growth fund and AWSHX/RWMGX as a large cap value fund. We will use the Vanguard Growth Index Fund and the Vanguard Value Index Fund as benchmarks to evaluate the AGTHX/RGAGX and AWSHX/ RWMGX, respectively. Unless otherwise indicated, the return numbers reflect the ten-year period ending June 30, 2017

AGTHX VIGRX
Nominal 7.24 8.65
Load-Adj 6.93 8.65
Risk-Adj 7.05 8.65
AER 4.19

*AGTHX 10-year cumulative returns – $197,636
*VIGRX 10-year cumulative returns – $229,243

Here, AGTHX lags VIGRX both in terms of nominal and load-adjusted return. AGTHX has a high R-squared number, 93, which results in a significantly higher effective annual expense ratio of 4.19, versus its stated annual expense ratio of 0.66 percent, as compared to VIGRX’s annual expense ratio of 0.18. Based on these numbers, it would be hard to justify AGTHX as a suitable/ prudent investment choice over VIGRX.

A similar comparison on the retirement shares of both funds produces the following results.

RGAGX VIGAX
Nominal 7.54 8.80
Load-Adj 7.54 8.80
Risk-Adj 7.67 8.80
AER 4.07

*RGAGX 10-year cumulative returns – $209,385
*VIGAX 10-year cumulative returns – $232,428

Once again, RGAGX lags VIGAX both in terms of nominal and load-adjusted return. RGAGX has a high R-squared number, 93, which results in a significantly higher effective annual expense ratio of 4.07, versus its stated annual expense ratio of 0.33 percent, as compared to VIGAX’s annual expense ratio of 0.06. Based on these numbers, it would hard to justify RGAGX as a suitable/ prudent investment choice over VIGAX.

It should be noted that when using the AMVR, a fund that fails to provide any incremental return for an investor, or a fund whose incremental costs exceed a fund’s incremental return, is clearly unsuitable and imprudent since an investment in the fund would provide no positive benefit for an investor.

Turning to AWHSX and VIVAX, we find the following results.

 

AWSHX VIVAX
Nominal 6.42 5.69
Load-Adj 5.79 5.69
Risk-Adj 6.48 5.69
AER 4.24

*AWSHX 10-year cumulative returns – $187,361
*VIVAX 10- years cumulative returns – $173,915

Here, AWSHX has a better performance than VIVAX both in terms of nominal and load-adjusted return. AWSHX has a high R-squared number, 97, which results in a significantly higher effective annual expense ratio of 4.24, versus its stated annual expense ratio of 0.58 percent, as compared to VIVAX’s annual expense ratio of 0.18. Even with AWSHX’s higher incremental return (0.79), the incremental costs (4.06), based on AWSHX’s AER number, greatly exceeds AWSHX’s incremental return. Based on these numbers, it would hard to justify AWSHX as a suitable/ prudent investment choice over VIVAX.

Finally, a comparison of the retirement shares for each fund produces the following results.

RWMGX VVIAX
Nominal 6.68 5.83
Load-Adj 6.68 5.83
Risk-Adj 7.46 5.83
AER 1.76

*RWMGX 10-year cumulative returns – $205,337
*VVIAX 10-year cumulative returns – $176,233

RWMGX clearly has significantly higher returns than VVIAX. WMGX has a high R-squared number, 97, which results in a higher effective annual expense ratio of 1.76, versus its stated annual expense ratio of 0.30 percent, as compared to VVIAX’s annual expense ratio of 0.06. RWMGX’s higher incremental return (1.63) exceeds its  incremental costs (1.48). Based on these numbers, RWMGX could be considered a suitable and prudent investment choice for the period analyzed.

Conclusion
Based upon my experience, far too many investors and investment fiduciaries simply take a quick glance at a fund’s nominal return numbers and a fund’s standard deviation and make their decisions based on those numbers alone. Those numbers, alone, simply do not constitute an acceptable due diligence process or a meaningful analysis of a mutual fund.

Based upon my experience, four definite patterns emerge in analyzing mutual funds:

(1) All things being equal, no-load funds typically outperform funds that charge a front-end load and/or excessively high annual expense ratios, especially over the long-term. A front-end load simply puts an investor in a position that is difficult to overcome over the long-term.

(2) Actively managed mutual funds often have lower standard deviation numbers that index funds, showing one potential benefit of active management. However, the difference in standard deviation numbers is rarely enough to make up for the impact of a front-end load.

(3) Both fiduciary and non-fiduciary investors should look for cost efficient funds, funds whose incremental returns exceed a fund’s incremental costs, in order to maximize the benefit of compound returns. Losses, whether due to poor returns and/or excessive costs, deny an investor the benefits of compounds returns.

(4) Closet index funds are never cost-efficient, and therefore are never suitable or prudent investments. Funds with a high R-squared number and/or high incremental cost relative to a comparable index fund should always be avoided, as they are typically the prime candidates for closet index status.

It really is that simple. Investors and fiduciaries should always ask their financial advisors the four questions discussed herein. If an advisor cannot or will not supply all such information, it should raise a red flag as to the professionalism of your advisor, or lack thereof, and how he determined that the advice he has provided to you is suitable and prudent for you – based on your best interests or on the compensation he could receive.

When it comes to the question of suitability/prudence of actively managed mutual funds, the Restatement (Third) Trusts provides investors and investment fiduciaries with a simple test which incorporates the forensic standards discussed herein. After noting the additional costs and risks generally associated with actively managed funds, the Restatement simply states that

These added costs and risks must be justified by realistically evaluated return expectations. Accordingly, a decision to proceed with such a program involves decisions by the trustee that gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks;…

I would strongly suggest the use of the four questions by both plan fiduciaries and plan participants, in fact investors in general, as the cornerstone of their own due diligence process. .  The questions can provide the transparency needed to properly evaluate a plan’s available investment options

As noted ERISA attorney Fred Reish likes to say, forewarned is forearmed.

Posted in 401k, 401k compliance, 401k investments, 404c, 404c compliance, BICE, closet index funds, compliance, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, ERISA, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, investments, IRA, IRAs, prudence, retirement plans, RIA, RIA Compliance, securities compliance, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

Sleeping With the Enemy: DOL’s Betrayal of Plan Participants and Retirees

Despite promises made during election campaign, the Trump administration has predictably chosen to side with big business over the interests of consumers. The regulators responsible for protecting the public against the abusive practices of the investment industry have increasingly become little more than shills for the very industries they are supposed to be regulating, eagerly adopting and promoting every disingenuous argument put forth by the industry to deny investors much needed protections.

The securities industry has requested that complete implementation of the Department of Labor’s (DOL) fiduciary rule be delayed for an additional eighteen months based on claims that they are not ready for the new rules.  I previously addressed the lack of merit in such claims in a previous post. As expected, the DOL formally submitted a request to the Office of Management and Budget for such extension and the OMB has just approved the request.

While the investment industry publicly claims lack of readiness to incorporate the DOL’s new fiduciary rule into their business, insiders claim that the industry’s real motivation is :to delay or totally eliminate the class action provisions of the DOL’s rule, to deny plan participants access to the court system and full discovery rights. The fact that the DOL has suggested to a court that it will most likely consent to the investment industry’s objection on this matter is very interesting given the express language in ERISA regarding its purpose

It is hereby declared to be the policy of this chapter to protect…the interests of participants in employee benefit plans and their beneficiaries…by establishing standards of conduct, responsibility, and obligation for fiduciaries of employee benefit plans, and by providing for appropriate remedies, sanctions, and ready access to the Federal courts.(emphasis added) 29 U.S.C. § 1001(b)

So the DOL has consciously chosen to ignore the clear mandate of ERISA, choosing instead to promote and protect the interests of the industry it is supposed to regulate instead of honoring the Department’s expressed mission statement or promoting and protecting the best interests of American workers and pension plan participants, including the express right to access to the courts.

As an attorney, I cannot help but remember the wise words of the court in Norris & Hirshberg v. SEC (177 F.2d 228, 233). Facing a similar situation, the court rejected the dingenuous arguments of a broker-dealer seeking protection from the court, the court stating that

To accept it would be to adopt the fallacious theory that Congress enacted existing securities legislation for the protection of the broker-dealer rather than for the protection of the public….On the contrary, it has long been recognized by the federal courts that the investing and usually naive public need special protection in this specialized field.

The same position can, and should, be adopted by the DOL, especially in light of the documented evidence of the abusive practices that the investment industry has engaged in in connection with the pension and retirement industries. ERISA was, and still is, intended to provide for the protection of American workers, not the investment industry.

Congress is also actively engaged in efforts to deny American workers and pension plan participants the much needed protections provided to them under the DOL’s new fiduciary rule, despite the fact that the investment industry has failed to produce any legally admissible evidence to support its ‘doom and gloom” claims against the DOL’s fiduciary rule.

With both the executive and legislative branches deserting them, the public can only look to the judicial branch to uphold the law and protect them against the investment industry’s abusive practices. Most courts have recognized the problem and become the sentinels for enforcing the law.

Sadly, some recent court decisions are troubling, as they reflect either a lack of a basic understanding of ERISA’s goals and purposes, as well as investment industry practices that brought about the DOL’s new fiduciary rule. In recent decisions, the courts have seemingly ignored or overlooked one of the primary goals and purposes of ERISA, to help workers work toward accumulating sufficient assets for retirement, by ignoring the financial impact of overpriced and underperforming mutual fund options within pension plans.

In some recent decisions, the courts have focused entirely on the absolute level of fees of actively managed mutual fund options within a plan, an approach the investment industry has constantly opposed. As the investment has pointed out, the focus should be on a fund’s fees relative to the benefit provided by the fund.

Unfortunately for the investment industry, the history of actively managed mutual funds has consistently shown a pattern of overpricing and underperformance relative to comparable passively managed/index mutual funds. This irrefutable evidence makes the recent court decisions supporting actively managed funds even more troubling.

Section 90, comments h(2) and m, of the Restatement (Third) Trusts states that a choice to due to the added costs and risks generally associated with actively managed mutual funds, such funds should only be chosen when it can reasonably be assumed that actively managed fund will produce sufficient benefits to offset such added costs. As mentioned earlier, the majority of actively managed funds cannot meet this requirement. The courts’ decisions seemingly either ignored or overlooked this crucial fact, a fact that indicates that most actively managed mutual funds do not help to promote a plan participant’s ‘best interests” or retirement readiness.

Conclusion
As the investment industry, the DOL and Congress all work to deny plan participants much needed protections against the proven abusive marketing strategies of the investment industries, one can hope that litigation will eventually result, with an informed court stepping forth to protect pension plan participants, including preserving the right of plan participants to access to the court through class-action suits where appropriate, as set out in ERISA. In stepping forth to protect plan participants, such court need only look to the analogous recognition and admonition of the problem by the court in Archer v. S.E.C (133 F.2d 795, 803), where the court stated that

The business of trading in securities is one in which the opportunities for dishonesty are of constant recurrence and ever present. It engages acute, active minds trained to quick apprehension, decision and action. The Congress has seen fit to regulate this business.

The same conditions that necessitated the enactment of ERISA are still present today and even more insidious as plan participants and retirees are fleeced of their life savings. Based on current indications, an enlightened judiciary may be the last hope for American plan participants and retirees.

Posted in 401k, BICE, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, investment advisers, pension plans, retirement plans | Tagged , , , , , , , , , , ,

The New Mathematics of Successful Investing

Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing had happened. – Winston Churchill

Facts do not cease to exist because they are ignored. – Aldoux Huxley

Ask any investor or plan sponsor what their returns were on the investments in their portfolios or plans and you will get a number provided to them on their account statement or from their plan service provider. Little do they realize that such performance numbers are usually highly misleading.

As a wealth preservation attorney and a quality assurance consultant to pension plans, one of the common issues I see is the inability of investors and plan sponsors to properly evaluate mutual funds. As a result, investors needlessly suffer reduced returns and plan sponsors face increased liability exposure.

Prudent investing is a basic tenet of successful investing. Being cost-conscious is a core element of prudent investing, as each additional 1 percent in investment fees and costs reduces an investor’s end return by approximately 17 percent over a twenty year period.

Prudent Cost-Conscious Investing
Being cost-conscious in investing does not mean that an investor or plan sponsor must always choose the least expensive investment option. What it does mean is that before an investor or plan sponsor chooses to use actively managed mutual funds in their investment programs,  they must be able to justify the higher costs of actively managed funds  by showing that the funds being considered have a reasonable expectation of providing additional benefits commensurate with such added costs.

I created a metric a couple of years ago, the Active Management Value Ratio™ 3.0 (AMVR), which allows investors and plan sponsors to easily evaluate the cost-efficiency of actively managed mutual funds. The AMVR is a simple cost/benefit metric that compares an actively managed mutual fund’s incremental cost to the fund’s incremental return, if any. For illustrative purposes, let’s assume Fund A, an actively managed fund, has the following cost and returns

  • total annual costs of 1.6 percent, with incremental costs of 1.4 percent,
  • 5-year annualized return of 10 percent, with 1 percent of incremental return

Those figures would result in an AMVR of 1.40 (1.40/1.00), meaning that the fund’s incremental costs exceeded the fund’s incremental returns, resulting in a net loss for an investor. Funds whose incremental costs exceed their incremental returns are not cost-efficient. An actively managed fund that fails to provide any positive incremental return is also not cost-efficient since an investor would have paid higher costs without receiving any benefit at all.

Some additional investment math based on the AMVR calculations provides even further insight into the cost-efficiency of Fund A. For instance, 87 percent of the fund’s total fee/cost (1.40/1.60) is only producing 10 percent of the fund’s returns. Hardly cost-efficient.

The benchmark in our example has total annual fees/costs of .20 percent and a 5-year annualized return of 9 percent. So, what would be the more prudent investment choice, paying $20 (.20 fees/costs) for a 5-year annualized return of 9 percent, or $140 (1.40 fees/costs) for an additional 1 percent in annualized return? The answer seems obvious; and yet sales of actively managed mutual funds continue to far surpass those of passive/index funds.

Interpreting Investment Returns
I recently posted a video discussing how some mutual funds use various types of returns to mislead investors and plan sponsors about the performance of their investment products. A little investment math shows why investors and plan sponsors need to have a better understanding of the various types of investment returns.

Fund A (actively managed ) 
annual fees/costs – 1.60 percent
20-year annualized return – 10 percent
front-end load (aka “sales charge) – 5.75 percent
5-year R-squared – 95

Fund B (index fund)
annual fees/costs – .20 percent
20-year annualized return – 10 percent

After 20 years the accumulated value of each fund would be as follows (assuming an initial balance of $10,000).

Nominal return:
Fund A – $56,044
Fund B – $64,870

Load-adjusted return:
Fund A – $52,821
Fund B – $64,870

Active Expense Ratio adjusted return (closet index factor of 7.7 percent here)
Fund A – $14,852
Fund B – $64,870

My experience has been that very few investors, plan sponsors, investment fiduciaries take to calculate the Active Expense Ratio for actively managed funds, even though the closet indexing problem is growing, as actively managers try to avoid losing customers due to large variances from index funds’ returns.

Given some recent questionable decisions by the courts in ERISA excessive fees actions, even some judges are overlooking the issue or are unaware of the problem as it relates to reasonableness of fund fees. Publicly marketing a fund as being actively managed, and charging higher fees based on such representations while actually acting as a “closet index” fund, raises issues regarding the violation of federal securities laws, which the courts have also failed to address

Conclusion
The Restatement (Third) Trusts and court decisions state that cost-consciousness is a key element in successful investing. New investment products and new marketing strategies have resulted in the need for new investment mathematical techniques to accurately evaluate investment strategies and protect investors and investment fiduciaries. Given the potential significance of the numbers involved and potential liability issues for investment fiduciaries under the expanding application of fiduciary standards, an investment in time learning about the new mathematics of investing and calculating same would itself be a prudent investment.

Posted in 401k, 401k investments, 403b, 404c, 404c compliance, closet index funds, clsoet index funds, compliance, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, elderly investment fraud, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, investment advisers, investments, pension plans, prudence, retirement plans, securities compliance, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , , ,

An Open Letter to the OMB: No Further Delays in the DOL Rule and BICE

August 11, 2017

Open Letter to the Office of Management and Budget

Re: Department of Labor’s Request for Additional Delay of Full Fiduciary Rule

The Department of Labor recently filed a request to delay the full effectiveness of the Department’s new fiduciary rule (Rule) for an additional eighteen months. I respectfully submit that said request should be denied, for the reasons set forth herein.

On June 9th, 2017, several portions of the DOL’s Rule went into effect, most noticeably the Rule’s Impartial Conduct Standards (ICS). The DOL has stated that the impartial conduct standards are “consumer protection standards that ensure that advisers adhere to fiduciary norms and basic standards of fair dealing.” The standards can be designated as

  • The “best interest” standard – requires that advisers always act in the best interest of a “retirement investor.” The “best interest” standard actually consists of two separate fiduciary standards: the duty of prudence and the duty of loyalty.
  • The “reasonable compensation” standard – requires that an adviser only receive “reasonable compensation in exchange for the advice and/or services provided to a customer.”
  • The “misleading statements” standard – prohibits any misleading by an adviser regarding investment transactions, compensation, and conflicts of interest.

One of the key aspects of the Rule was the inclusion of the Best Interests Contract exemption (BICE). BICE would allow financial advisors to sell commission-based investment products to plan participants, sales which would otherwise be prohibited due to the inherent conflict of interest involved with such commission-based products.

In order to qualify for BICE, financial advisers would be required to fulfill certain disclosure and documentation requirements in order to provide plan participants with sufficient information to make informed decisions about such products and the potential conflicts of interests involves with such products. In the event of violations of BICE, the exemption would provide plan participants with resource to the courts through class actions.

The Rule and BICE were responses to the alleged questionable sales and marketing practices that the investment and insurance industries were using in connection with pension plan and pension plan participants. At the time the Rule and BICE were proposed, it was estimated that such practices were costing American workers billions of dollars annually.

Delaying the Department of Labor’s (DOL’s) fiduciary rule any further will cost retirement plan savers $7.3 billion over the next 30 years, the Economic Policy Institute maintains. Delays that the Trump administration has already instituted will already cost retirement plan savers $7.6 billion over the next 30 years, according to the Institute.

“Any delay will be enormously expensive to retirement savers—and not just during the period of the delay,” says Economic Policy Institute Policy Director Heidi Shierholz. “The losses that retirement savers experience from being steered toward higher-cost investment products during the delay would not be recovered and would continue to compound.

The projected costs from further delays in implementing the entire Rule, as well as denying plan participants the complete protection they need from the inequitable marketing tactics that the investment has chosen to employ against plan participants, are two reasons that the request for further delays in implementing the Rule should be denied.

The Investment Industry’s Arguments
Opponents of the Rule and BICE have basically advanced three arguments for delaying or killing the Rule altogether.

  1. They are not ready to implement the complete Rule and BICE.
  2. It will be too costly to implement the complete Rule and BICE.
  3. Forcing fiduciary status on brokers and broker-dealers under the Rule and BICE will result in advisers refusing to provide advice and services to smaller accounts.

All of these arguments are completely meritless and unproven.

  1. Most broker-dealers should be in position to easily implement both the Rule and BICE. As a former securities compliance director, both RIA compliance and general securities compliance, I know that most broker-dealers have their own proprietary RIA firms in order to service their existing brokers and as a marketing tool to recruit new brokers. Since RIAs and RIA representatives are fiduciaries by law, broker-dealers should already have supervisory procedures in place to monitor and supervise such fiduciaries. Expanding those procedures to any new fiduciaries under the Rule and BICE should be relatively simple.
  2. Implementing both the Rule and BICE should involve very little cost. Since most broker-dealers should already have the necessary supervisory procedures in place to monitor and supervise any new fiduciaries under the Rule and BICE, there should be little costs involved in transitioning such policies and procedures to cover the new compliance rules under the Rule and BICE.
  3. If broker-dealers and stockbrokers decide to stop servicing smaller accounts, that will be as a result of their own decision, since existing laws, rules and regulations already imposed a fiduciary standard on broker-dealers and stockbrokers before the Rule and BICE were adopted. There are several interesting aspects to this argument. The investment industry has yet to offer any admissible evidence to support this claim since they cannot do so until the complete Rule and BICE are in effect. Furthermore, as Bob Clark, one of the most respected commentators on the investment industry has noted, if stockbrokers are in the business of providing investment advice, then they are already held to a fiduciary standard under the Investment Advisers Act of 1940.

This argument also fails to recognize the fact that broker-dealers and stockbrokers are already held to a fiduciary standard under a number of scenarios, including state common law and the rules and regulations of SROs such as FINRA. Stockbrokers managing customer accounts on a discretionary basis are held to a fiduciary standard. The courts have also stated that they will impose a fiduciary standard on stockbrokers on non-discretionary customer accounts where the customer has reposed trust and confidence in the stockbroker and the customer lacks the knowledge, experience and understanding to personally evaluate the recommendations that their stockbrokers provide.

The reasons that full and immediate implementation the investor protections provided by the Rule and BICE are needed are essentially the same as those set forth in a study conducted by the SEC in 2011 on the need for a fiduciary standard for the securities industry in general. (https://www.sec.gov/news/press/2011/2011-20.htm) The SEC study recommended that the SEC adopt various regulations requiring that

when providing personalized investment advice about securities to retail customers, a fiduciary standard no less stringent than currently applied to investment advisers under Advisers Act Sections 206(1) and (2)…. Specifically, the Staff recommends that the uniform fiduciary standard of conduct established by the Commission should provide that: the standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers (and such other customers as the Commission may by rule provide), shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.

The Staff believes that the uniform fiduciary standard and related disclosure requirements may offer several benefits, including the following:

  • Heightened investor protection;
  • Heightened investor awareness;
  • It is flexible and can accommodate different existing business models and fee st It would preserve investor choice;
  • It should not decrease investors’ access to existing products or services or service providers;
  • Both investment advisers and broker-dealers would continue to be subject to all of their existing duties under applicable law; and
  • Most importantly, it would require that investors receive investment advice that is given in their best interest, under a uniform standard, regardless of the regulatory label (broker-dealer or investment adviser) of the professional providing the advice.

The SEC study went on to note that existing rules and regulations of investment industry SROs also held broker-dealers and stockbrokers to high standards of conduct similar to a fiduciary standard,

Broker-dealers are also required under SRO rules to deal fairly with customers and to “observe high standards of commercial honor and just and equitable principles of trade.” Sales efforts must therefore be undertaken only on a basis that can be judged as being within the ethical standards of [FINRA’s] Rules, with particular emphasis on the requirement to deal fairly with the public. [A] central aspect of a broker-dealer’s duty of fair dealing is the suitability obligation, which generally requires a broker-dealer to make recommendations that are consistent with the best interests of his customer.

These duties have been articulated by the Commission and courts over time through interpretive statements and enforcement actions. As the Commission has pointed out, “a broker has ‘an obligation not to recommend a course of action clearly contrary to the best interests of the customer.’” Just as BICE would require certain disclosures and documentation, the regulators require that actions taken by the broker-dealer that are not fair to the customer must be disclosed in order to make this implied representation of fairness not misleading.

So any arguments by the investment industry that the fiduciary duties imposed on broker-dealers and stockbrokers under the Rule and BICE are onerous and/or unfair are meritless, as those same duties have already been recognized by their own SRO, FINRA and its predecessor, the NASD. In 2012, FINRA released Notice 12-25, in which it reiterated the duty of broker-dealers and stockbrokers to always act in a customer’s “best interest,” including references to numerous enforcement actions upholding such duties.

One last point of contention by the investment industry with the Rule and BICE appears to be BICE provision allowing plan participants to participate in class actions involving violations of the ICS or BICE. As an attorney, my guess is that the investment industry is more concerned about the broad discovery rights that would be granted to plan participants under BICE’s class action provision than BICE’s disclosure and documentation themselves. The solution is simple enough – do not violate the Rule, the ICS and/or BICE and the class action provisions are inconsequential.

The reasons set out in the SEC’s study for the need of a universal fiduciary standard are equally applicable to the Rule and BICE. The investment industry now comes forward with “unclean hands” and requests for a further delay in full implementation of the Rule and BICE without any justifiable reason for same, for the sole purpose of extending the time that they can inflict further harm on plan participants by peddling  products which they know cannot satisfy the “best interest” requirement of a fiduciary standard, products such as variable annuities, equity indexed annuities and the majority of actively managed mutual funds.

Variable annuities and equity indexed annuities routinely show up on the annual list of regulators’ customer complaint leaders. The Standard & Poor’s Indices Versus Active (SPIVA) reports consistently show that the overwhelming majority of actively managed mutual funds fail to outperform comparable and less expensive index funds. So why do stockbrokers and other financial advisers continue to recommend such products. Commissions, and the conflicts of interest they create, the very conflicts of interest that the Rule and BICE were created to address in order to provide plan participants with much needed protection against the investment industry long-standing history of abusive sales practices.

The investment industry has not, and cannot, produce any legitimate and legally admissible evidence to support their claims. Thus far, the investment industry has produced nothing more than self-serving rhetoric and pure speculation with regard to their claims. The significant and irreversible damage that has already been done, and will continue to be done, by further delaying full implementation of the Rule and BICE has been documented by several independent research organizations.

In deciding on the request for further delay in the full implementation of the Rule and BICE, I would ask the OMB to consider the admonition of the court in Norris v. Hirshberg v. SEC, (177 F.2d 228, 233) in rejecting a broker-dealer’s suggestion as to the purpose of securities laws, stating that

To accept it would be to adopt the fallacious theory that Congress enacted existing securities legislation for the protection of the broker-dealer rather than for the protection of the public. On the contrary, it has long been recognized by the federal courts that the investing and usually naive public needs special protection in this specialized field.

This need is equally applicable to plan participants investing in ERISA pension plans and in making rollovers from such plans upon retirement. For these reasons, I respectfully request the OMB provide plans and plan participants with the much needed protection they need by denying any and all requests to further delay the full implementation of the Rule and BICE.

Thank you for your time and consideration.

Sincerely,

James W. Watkins, III, J.D. CFP®

Posted in 401k, 401k compliance, BICE, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, fiduciary standard, Impartial Conduct Standards, investment advisers, pension plans, prudence, retirement plans, RIA, securities compliance, wealth management | Tagged , , , , , , , , , , , , , , , , , | 1 Comment

The Often Overlooked Fiduciary “Gotcha”: The Fiduciary Duty (and Challenge) of Cost-Consciousness

The vast majority of active managers are unable to produce excess returns that cover their costs.1

I recently posted an article discussing a brilliant complaint that was filed in connection with a new 401(k) excessive fees/breach of fiduciary duties action. The beauty of the complaint was that it was the first time that I have seen any attorneys address the alleged breaches in terms of the fiduciary duty of cost-consciousness, as set out in the Restatement.

Comment b of Section 90 of the Restatement (Third) Trusts states that a fiduciary has a duty to be cost-conscious in carrying out their duties.2 I have long wondered why more plaintiffs’ attorneys, plan sponsors and other investment fiduciaries have not fully utilized the cost-consciousness “blueprint” that the Restatement provides in drafting pleading and addressing potential liability exposure based on alleged breaches of a fiduciary’s duties of loyalty and/or prudence. The blueprint is a four-step process:

  1. The fiduciary duties of loyalty and prudence, as set out in both ERISA3 and the Restatement.4
  2. The duty of cost-consciousness as a sub-set of the duty of prudence.5
  3. The fiduciary duty to efficiently managing the cost/return/risk relationship of investments.6
  4. The fiduciary duty of cost-consciousness relative to the selection of actively managed mutual funds.”7

The investment industry and even some courts have been quick to reference that fact that ERISA does not require an ERISA fiduciary to always select the least expensive investment option, which is true. However, neither ERISA nor the Restatement gives an ERISA fiduciary carte blanch power to just select any investment option without consideration of the corresponding benefit derived from any additional costs and/or risks associated with the more expensive investment option. The absurdity of such an argument is obvious, as it would essentially nullify the basic fiduciary duties of loyalty and prudence.

The stated mission of ERISA and the Restatement is to protect the rights and interests of American workers and the public. In addressing the selection of investment options for a pension plan, the Restatement sets out two vital considerations,

[Fiduciaries], like other prudent investors, prefer (and, as fiduciaries, ordinarily have a duty to seek) the lowest level of risk and costs for a particular level of expected return-or, inversely, the highest return for a given level of risk and cost.8  

A decision to [select actively managed mutual funds] involves judgments by the [fiduciary] that a) gains from the course of action in question can be reasonable expected to compensate for its additional costs and risks;…9

And there it is, the potential cost-consciousness “gotcha.”  As the opening quote states, not only do a large percentage of actively managed mutual funds fail to outperform a their appropriate benchmarks, they fail to even covert their own costs! Studies such as the Standard & Poor’s SPIVA reports10 and academic studies11 consistently show that the overwhelming majority of actively managed mutual funds underperform comparable index funds, thus failing to compensate for their often significantly higher fees and expense. As the introduction to Section Seven of the Uniform Prudent Investor states, “wasting beneficiaries’ money is imprudent.” The combination of an imprudent recommendation/ selection of investment options and engaging in conduct that is not in the best interest of clients/ beneficiaries clearly indicates a breach of one’s fiduciary duties.

Bottom line – There is no carte blanch power in plan advisors, plan sponsors or other plan fiduciaries in recommending and/or selecting investment options. Incurring additional costs or risks without a commensurate benefit for such additional costs or risks is a violation of the fiduciary duties of loyalty and prudence.

The Active Management Value Ratio™ 3.0
The fact that the referenced complaint chose to expressly incorporate the fiduciary duty of cost-consciousness, combined with the above-referenced requirements, creates a difficult hurdle for any defense to overcome for one simple reason-most of the investments products currently on the market do not satisfy these requirements.

I have written extensively on a metric that I created, the Active Management Value Ratio™ 3.0 (AMVR). The AMVR is based on the studies of investment icons Charles D. Ellis and Burton G. Malkiel. Ellis advocates that the proper way to evaluate investment costs is in terms of an investment’s incremental costs relative to its incremental return.12 Malkiel studies have concluded that the two best predictor’s of as mutual fund’s performance are its annual expense ratio and its portfolio turnover.13

The AMVR evaluates the cost-efficiency of an actively managed mutual fund in terms of its incremental, or additional, costs relative to its incremental return, if any, over and above a comparable benchmark, usually a comparable index fund. My experience has been that very few funds are able to produce positive incremental returns. Even when an actively managed fund does produce positive incremental returns, they often fail to produce returns that exceed the incremental costs incurred in producing such positive returns. Articles regarding the AMVR can be found here and here. In addition, each year I do a forensic analysis of the top ten non-index funds used within defined contribution plans, as reported by “Pensions and Investments.” Samples of past analyses are available here.

The “Closet Index Fund” Factor
Another issue that makes it difficult for plan sponsors to meet the “commensurate benefit” requirement of the fiduciary duty of cost-consciousness is the increasing use of “closet indexing” by mutual funds. Closet indexing refers to situations where a mutual fund holds itself out as an actively managed mutual fund, and charging higher fees for such active management, but whose actual performance closely tracks that of a comparable, but less expensive, index fund.

Two well-known methods for assessing “closet indexing are Russ Miller’s Active Expense Ratio (AER) metric, and Martijn Cremer and Antti Patejisto’s Active Share metric. For my forensic analyses I prefer to use AER because I find it easier to calculate and interpret. The AER is based on a fund’s R-squared rating, which is widely available online

There is no universally mandated level of R-squared for designating a fund as a closet index fund. However, a fund’s R-squared rating does help to provide a meaningful analysis of the effective expense costs that an investor is paying due to the misrepresentation of the extent of active management that a fund is providing. Miller’s research found that funds with high R-squared ratings, and thus low contributions from active management, often had effective expense rates 300-400 percent higher than their stated expense ratios.

My experience has been that very few plan sponsors and other investment fiduciaries even factor in a fund’s R-squared rating in their required due diligence process. This could result in increased personal liability exposure since the courts and regulators assess compliance with one’s fiduciary duties based upon what a fiduciary knew or should have known as a result of a properly conducted due diligence analysis.14

I recently ran a forensic analysis on the mutual fund universe of retirement shares of domestic equity-based mutual funds. The purposes of the analysis was to study the impact of various levels of a fund’s R-squared rating on fiduciary cost-consciousness/ fiduciary prudence standards. The results of my analysis on the large cap retirement funds sectors is attached as Appendix A.

In my analysis, I used the five-year trailing returns of Admiral shares of three Vanguard funds as my benchmarks: Vanguard S&P 500 Index Fund, Vanguard Growth Index Fund, and Vanguard Value Index Fund. I used data provided on the Morningstar Investment Research Center program. In my “closet index” analysis, I screened for retirement class funds that outperformed the relative benchmark fund with R-squared rating of 95 or below, 95 and above, 90 or below and 90 and above.

The analysis produced good news and potentially bad news for plan advisors, plan sponsors and other plan fiduciaries.  The good news – there were a number of funds that did outperform their relative benchmark’s return performance in all three large cap categories. The bad news – once cost-consciousness factors such as a fund’s annual expense ratio and turnover ratio were factored in, only the benchmark fund, and in some cases other share classes of the benchmark fund, survived the cost-efficiency screen.

Additional analyses could be done increasing the turnover and/or expense ratio numbers. However, anyone making such changes needs to consider two key issues. First, each additional 1 percent in additional fees reduces an investor’s end return by approximately 17 percent over a twenty year period. Second, increasing a fund’s incremental costs with a corresponding increase in the fund’s incremental return increases the odds of a fund failing the AMVR’s fiduciary cost-efficiency screens. Once again, “wasting beneficiaries’ money is imprudent.”

Conclusion
While most people are aware of the fiduciary duty of prudence, my experience has been that most are not aware of the Restatement’s position on the duty of cost-consciousness as a sub-set of the duty of prudence. I believe that the recently filed complaint in the MFS ERISA 401(k) action has alerted some people to the cost-consciousness requirement for fiduciaries.

With increasing awareness of a fiduciary’s duty of cost-consciousness, and the difficulty in complying with such duty give the qualities of many of the investment products currently in the market, I believe that plan sponsors and other plan fiduciaries face a daunting challenge to make their plans ERISA compliant and to reduce their risk of personal liability for a failure to do so.  The selection of truly objective, informed and experienced ERISA experts to help them face such challenges will therefore become more valuable than ever before.

Notes
1. Philipp Meyer-Browns, “Mutual Fund Performance Through a Five Factor Lens,” DFA White Paper (August 2010)
2. Restatement (Third) Trusts, Section 90 cmt. b; Tibble v. Edison Int’l, 843 F.3d 1187, 1197
3. 29 C.F.R. Section 2550.401a-1 et seq.
4. Restatement (Third) Trusts, Sections 77, 78 and 90
5. Restatement (Third) Trusts, cmt b
6. Restatement (Third) Trusts, cmt f
7. Restatement (Third) Trusts, cmt h(2)
8. Restatement (Third) Trusts, cmt f
9. Restatement (Third) Trusts, cmt h(2)
10. http://us.spindices.com/spiva/
11. Mark M. Carhart, “On Persistence in Mutual Fund Performance, ”The Journal of Finance, Vol. 52, Issue No. 1 (March 1997), 57-82.
12. Charles D. Ellis, “Winning the Loser’s Game: Timeless Strategies for Successful Investing.”6th ed. (New York, NY: McGraw/Hill, 2018), 104.
13. Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed. (W.W Norton & Co., 2016) 460;
14. 29 C.F.R. Section 2550.404a-1

© 2017 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

APPENDIX A

Morningstar Cost-Consciousness  R-squared Analysis
Large Cap Blend
Funds Screen Funds Screen
173 Return >= VFIAX 173 Return >= VFIAX
97 R-squared <= 95 76 R-squared >= 95
1 Turnover <=  4% 1 Turnover <= 4%
0 Exp. Ratio <= .04% 1* Exp. Ratio <= .04%
Funds Screen Funds Screen
173 Return >= VFIAX 173 Return >= VFIAX
57 R-squared <= 90 116 R-squared >= 90
0 Turnover <=  4% 2 Turnover <= 4%
0 Exp. Ratio <= .04% 1* Exp. Ratio <= .04%
* Vanguard S&P 500 Index Fund – Admiral Shares
Large Cap Growth Funds
Funds Screen Funds Screen
380 Return >= VIGAX 380 Return >= VIGAX
380 R-squared <= 95 0 R-squared >= 95
19 Turnover <=  11% 0 Turnover <= 11%
2* Exp. Ratio <= .06% 0 Exp. Ratio <= .06%
Funds Screen Funds Screen
380 Return >= VIGAX 380 Return >= VIGAX
308 R-squared <= 90 72 R-squared >= 90
15 Turnover <=  11% 4 Turnover <= 11%
0 Exp. Ratio <= .06% 2* Exp. Ratio <= .06%
*Vanguard Growth Index Fund – Admiral and Institutional shares
Large Cap Value Funds
Funds Screen Funds Screen
89 Return >= VIGAX 89 Return >= VIGAX
85 R-squared <= 95 4 R-squared >= 95
2 Turnover <=  4% 0 Turnover <= 4%
2* Exp. Ratio <= .04% 0 Exp. Ratio <= .04%
Funds Screen Funds Screen
89 Return >= VIGAX 89 Return >= VIGAX
69 R-squared <= 90 20 R-squared >= 90
0 Turnover <=  4% 2 Turnover <= 4%
0 Exp. Ratio <= .04% 2* Exp. Ratio <= .04%

* Vanguard Value Index Fund – Admiral and Institutional shares

Posted in 401k, 401k compliance, 403b, 404c, 404c compliance, closet index funds, compliance, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, ERISA, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, investment advisers, investments, IRA, IRAs, pension plans, prudence, retirement plans, RIA, RIA Compliance, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , ,

“Upon Further Review: Do We Already Have a Universal Fiduciary Standard?” Redux

Back in 2013 I posted an article dealing with the controversy over the DOL’s proposed fiduciary standard. In that article, I suggested that a universal fiduciary standard was already in place that applied to stockbrokers, investment advisers and anyone else providing investment advice to the public. A significant portion of the DOL’s rule has now become effective, with the remainder scheduled to become effect the first part of 2018.

And yet the efforts to repeal the DOL’s fiduciary standard continue. Members of the Trump administration, Congress, new DOL Secretary Acosta and new SEC Chairman Cutler have all expressed opposition to the rule. So again, I sit back and shake my head and re-ask my original question – Is this whole debate over a universal fiduciary standard actually a moot point?

While I am a staunch advocate for a clear, unmistakable universal fiduciary standard so that there is no question about the duties every financial adviser owes a customer, I would suggest that anyone who provides financial and investment advice to the public is subject to the fiduciary standard’s “best interest” requirement.

There are basically four ways that an adviser acquires fiduciary status: by contract or express agreement; by state common laws and/or regulatory rules; by control over a discretionary account; and by having de facto control over a non-discretionary account. Fiduciary status based upon contract is fairly obvious. However, financial advisors may not be as familiar with the other three methods of acquiring fiduciary status.

Registered investment advisers and their representatives are fiduciaries pursuant to the Investment Advisers Act of 1940 (’40 Act). IA-1092 clearly establishes that those holding themselves out as financial planners and/or offering to provide financial planning services to the public are fiduciaries. Stockbrokers who manage customer accounts on a discretionary basis are fiduciaries. The argument has always centered on the applicable standard for stockbrokers involved with non-discretionary customer accounts.

Broker-dealers and stockbrokers are quick to point out that they are not covered under the ‘40 Act and therefore are generally not subject to the fiduciary standard’s “best interest” A closer look at rules, regulations and court decisions suggest that broker-dealers and stockbrokers may be operating under a false sense of security.

An argument definitely can be made that under FINRA’s suitability rule, Rule 2111, all stockbrokers must adhere to the fiduciary standards and always put their customers’ best interests first ahead of their own financial interests. Rule 2111 was introduced in FINRA Regulatory Notice 11-02, with subsequent notices of guidance in FINRA Regulatory Notice 11-25 and FINRA Regulatory Notice 12-25.

While Rule 2111 was designated as a rule on suitability, many readers took particular notice of footnote 11. Footnote 11 is significant in that it referenced previous enforcement and disciplinary proceedings which addressed a stockbroker’s duties in terms of a customer’s “best interests,” more specifically that “a broker’s recommendations must be consistent with the customer’s best interests” and “a broker’s recommendations must serve his client’s best interests.”(1)

The references to a customer’s “best interests” raised immediate questions among many given its similarity to the fiduciary duty of loyalty set out in both the Restatement of Trusts and the Employees’ Retirement Income Security Act (ERISA). The current debate over a universal fiduciary standard is due in large part over the fact that the “suitability” so often referred to as the applicable standard for stockbroker does not require that recommendations provided to customers necessarily be in their “best interests.”

To its credit, FINRA did not backtrack from its position that broker’s recommendations have to be in a customer’s best interests. FINRA responded by noting that the position had been clearly stated in numerous cases and that the “best interests” requirement “prohibits a broker from placing his or her interests ahead of the broker’s interests.”(2)

You make your own decision, but the prohibition against the broker putting his or her interests before those of a customer sound very familiar to language requiring that a ERISA fiduciary always put a client’s interests first, with “an eye single to the interests of the participants and the beneficiaries,”(3) with ERISA’s requirement that a fiduciary act “solely and exclusively” for the benefit of the plan’s participants and beneficiaries(4) , and the Restatement of Trusts’ requirement, in compliance with the fiduciary duty of loyalty, that a fiduciary act solely in the interests of the beneficiaries.(5)

The courts look at various factors in determining whether an adviser had de facto control over an account justifying the imposition of the fiduciary standard on an adviser. As the courts have stated,

[t]he touchstone is whether or not the customer has the intelligence and understanding to evaluate the broker’s recommendations and to reject one when he thinks it unsuitable.(6)

the issue is whether or not the customer, based on the information available to him and his ability to interpret it, can independently evaluate his broker’s suggestions.(7)

If the answer to these questions is in the negative, then the likelihood is that the adviser will be deemed to have had de facto over the customer’s account and they will be held to a fiduciary standard in their dealings with the customer and the account.

So the common argument against a universal fiduciary standard, namely that it would result in higher costs for customer’s, makes no sense since requiring all stockbrokers to put a customer’s interests first is arguably already the applicable standard. Enacting a universal fiduciary standard would simply be a codification of the applicable standard for both registered investment advisers, brokers and anyone else purporting to provide investment advice to the public.

From the public’s perspective, a universal fiduciary standard would eliminate the confusion which obviously exists regarding what duties are owed by one’s financial/investment adviser and better protect the public in their dealings with investment professionals, both of which are consistent with the mission statements of both the Department of Labor and the Securities and Exchange Commission.

So, in response to my original question, there is nothing onerous or unfair about requiring that anyone that provides financial or investment advice to the public must always put the public’s interest ahead of their own financial interests? In fact, that is actually the current standard for both registered investment advisers and stockbrokers.

So if either the Department of Labor and/or the Securities and Exchange Commission refuse to adopt a universal fiduciary standard in order to better protect the public, the public has a right to know the true reason for not doing so. Americans are getting tired of the continuous cover-ups and misinformation, the partisan politics that deny the public the protection they need.

As the court recognized in Archer v. Securities and Exchange Commission,

[t]he business of trading in securities is one in which opportunities for dishonesty are of constant recurrence and ever-present. It engages acute, active minds trained to quick apprehension, decision and action. The Congress has seen fit to regulate this business.(8)

The mission statements of both the Department of Labor and the Securities and Exchange Commission recognize a similar duty to protect the public with regard to investment related activities that impact investors and employees. Therefore, the failure of either agency to pass a universal fiduciary standard in order to provide the public with a simple, yet meaningful, expression of their rights and protections in their dealings with financial/investment advisers will be yet another in a growing list of government breaches of the public’s trust.

Notes
1.http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p122778.pdf
2.http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p126431.pdf
3. DiFelice v. U.S. Airways, 497 F.3d 410 (4th Cir. 2007)
4. 29 U.S.C.A. Sections 1104(a)(1), (a)(1)(A)(i), and (a)(1)(A)(ii)
5. Restatement (Third) Trusts, Section 78 (Duty of Loyalty)
6. Follansbee v. Davis, Skaggs & Co., Inc., 681 F.2d 673, 677 (9th Cir. 1982)
7. Carras v. Burns, 516 F.2d 251, 258-59 (4th Cir. 1975)
8. 8. Archer v. Securities and Exchange Commission, 133 F.2d 795, 803 (8th Cir. 1943)

Copyright © 2017 The Watkins Law Firm. All rights reserved.

This article is for informational purposes only, and is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

 

 

Posted in BICE, compliance, DOL fiduciary rule, DOL fiduciary standard, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, financial planning, Impartial Conduct Standards, investment advisers, investments, RIA, RIA Compliance, securities compliance | Tagged , , , , , , , , , , , , , ,