Are We At a “Tipping Point’ in ERISA Fiduciary Litigation?

As I went through my daily social media review, I noticed a post indicating that DOL Secretary Acosta has indicated that the DOL is ready to enforce the department’s new fiduciary rule (“Rule”). Excuse me if I’m skeptical, given the Secretary’s seeming opposition to the rule before he was even confirmed as Secretary.

Or perhaps Nevada’s announced intention to adopt its own state fiduciary law, as well as other states’ interest in doing the same, has caused Acosta to make his announcement, since state laws would ensure access to the courts for pension plan participants, making the Rule and accompanying best interests contract exemption, known as BICE, potentially irrelevant.

The Rule and BICE have the potential to address the ongoing abusive practices that drove the adoption of the Rule in the first place. However, the ongoing efforts of the DOL and Congress have raised serious questions as to whether the Rule and BICE will ever be totally effective. Hopefully, the states will follow through and adopt state fiduciary laws to ensure that investors, both retail and pension plan participants, are properly protected against the abusive marketing practices by the investment industry.

A number of recent decisions dismissing 401(k) actions involving fees and breach of fiduciary duties has caused some commentators and investment industry leaders to claim that the tide has shifted and such actions will meet with similar summary dismissals going forward. However, a closer analysis of the decisions suggests that such dismissals may result in nothing more than a false sense of optimism.

In reviewing the recent dismissals, the court’s rationale in dismissing the action typically involve three themes: the number of funds offered by a plan; the fact that a plan’s fees have been “approved” in other 401(k) actions, and/or alleged deficiencies in the plaintiff plan participants’ pleadings. With all due respect, the courts’ use of such issues appear to be inconsistent with prior court decisions and the primary resource used by the courts in fiduciary cases, especially actions involving ERISA issues. Pleading issues can always be addressed and prevented.

Dismissals Based on Number of Investment Options
Courts dismissing 401(k) actions involving fee and/or fiduciary breach issues based upon a plan’s number of investment options have frequently cited the decision in Hecker v. Deere(1) as justification for their decision. In that decision, the court appeared to suggest that the mere number of funds offered by a plan could ensure that the plan was insulated from liability for alleged breach of fiduciary duties.

However, the courts seemingly have ignored the fact that the 7th Circuit Court of Appeals subsequently went back and “clarified” their early decision in what is often referred to as Hecker v. Deere II(2). Most legal experts agree that the court’s “clarification” was actually a reversal of their earlier decision. Responding to concerns from the DOL and others that the court’s first decision was contrary to law and denied plan participants with basic  protections guaranteed under ERISA, the 7th Circuit sated that their earlier decision did not, and was not intended to, insulate plan sponsors and other plan fiduciaries, saying

The Secretary also fears that our opinion could be read as a sweeping statement that any Plan fiduciary can insulate itself from liability by the simple expedient of including a very large number of investment alternatives in its portfolio and then shifting to the participants the responsibility for choosing among them. She is right to criticize such a strategy. It could result in the inclusion of many investment alternatives that a responsible fiduciary should exclude. It also would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives. The panel’s opinion, however, was not intended to give a green light to such ‘‘obvious, even reckless, imprudence in the selection of investments’’ (as the Secretary puts it in her brief).(3)

So any decision dismissing a 401(k) fees/breach of fiduciary duties based on the number of investment option within a plan, with no consideration of the prudence of same, would be improper.

Dismissals Based on Investment Fees Being Within an Allowable Range
There is nothing in ERISA mentioned any specific allowable range of fees. The whole “allowable range” of fees theory has been derived by the courts and the investment industry based on cases in which ranges of fees were deemed fair and appropriate.

An interesting aspect of this logic is that for years the investment industry consistently argued that evaluating actively managed funds based purely on fees rather than the value provided by such funds was unfair and inappropriate…and they were, and still are, absolutely correct. And yet, that appears to be exactly what the courts are now doing.

As the Supreme Court has noted,

We have often noted that an ERISA fiduciary’s duty is “derived from the common law of trusts.” In determining the con­tours of an ERISA fiduciary’s duty, courts often must look to the law of trusts.(4)

The Restatement of Trusts sets out the common law of trusts. The Restatement’s position is that fees for actively managed mutual funds should be evaluated relative to the incremental return that such incremental fees and costs provide. Noting the extra costs and risks typically associated with actively managed funds relative to comparable index funds, the Restatement states that

those added costs and risks must be justified by realistically evaluated return expectations. Accordingly, a decision to proceed with such a program involves judgments by the [fiduciary] that: (a) gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks;…(5)

This is a significant hurdle for any plan choosing to offer actively managed funds. Analyses such as Standard & Poor’s Indices Versus Active Management (SPIVA) consistently show that most actively managed funds fail to outperformed their relative indices. Academic studies by well-respected parties such as Carhart(6) and Edelson, Evans and Kadlec(7)  go even further, as their findings show that most actively managed funds do not even manage to cover their costs, resulting in a net loss for investors.

The courts’ reliance on the “allowable range” logic is clearly inappropriate and indefensible as it ignores the importance of the requisite inherent value of a fund in terms of the positive incremental return, if any, provided to an investor. A basic axiom of fiduciary law is that “wasting beneficiaries’ money is imprudent.”(8) Before dismissing a 401(k) fees/fiduciary breach action, courts should compare an actively managed fund’s incremental return to the fund’s incremental costs.

Dismissals Based on Pleading Insufficiencies
Many of the recent dismissals involving   401(k) fees/fiduciary breach actions cited pleading insufficiencies such as failure to properly plead wrongful conduct and/or damages. The courts have every right to demand proper pleading from plaintiffs’ attorneys. Fortunately, such errors are easily corrected. Properly pleaded complaints should survive any motion to dismiss filed by the defendants.

Going Forward-Are We At a “Tipping Point” in ERISA Fiduciary Litigation?
In my humble opinion, the answer is “yes.” The rationale behind m opinion is that the courts will have little “wiggle room” to dismiss a 401(k) fees/fiduciary breach action if the action is properly plead and proper negation of the number of funds or “allowable range” of fees arguments in connection with any motion to dismiss.

Given the legal system’s reliance on the Restatement of Trust, investment fiduciaries, including plan sponsors, should know and understand the Restatement’s position on various fiduciary issues, especially Section 90 of the Restatement, more commonly known as “The Prudent Investor Rule.”

I continue to be amazed at how many investment fiduciaries have never looked at the Restatement. The usual response is that they will simply plead lack of knowledge and innocent mistake. For fiduciaries adopting such a strategy, expect to hear one or both of the following fundamental legal axioms – “ignorance of the law is no excuse” and “ a pure heart and an empty head are no defense in actions involving alleged breaches of one’s fiduciary duties.”

I expect to see more 401(k) fees/fiduciary breach actions focusing on the forgotten fiduciary duty, a fiduciary’s duty to be cost-conscious.(8) Restatement Section 88. Based on the SPIVA reports and my years of forensic analyses of actively managed mutual funds, very few actively managed mutual funds meet the Restatement’s requirement of cost-efficiency.

™Using resources such as the Restatement and previously mentioned SPIVA reports, the academic studies of Carhart and Edelson, and InvestSense’s metric, the Active Management Value Ratio (AMVR™), plaintiff’s attorneys can easily establish the cost-efficiency of a plan, essentially bulletproofing their cases against successful dismissal actions. Elimination or a significant reduction in dismissal of 401(k) fees/fiduciary breach cases would clearly result in a “tipping point,” as pensions plans and investment fiduciaries would be forced to adopt prudent processes to ensure that they meet the applicable fiduciary standards or face the consequences.

Notes
1. Hecker v. Deere (Hecker I), 556 F.3d 575 (7th Cir. 2009)
2. Hecker v. Deere (Hecker II), 569 F.3d 708 (7th Cir. 2009)
3. Hecker II, at 711
4. Tibble v. Edison Int’l, 135 S. Ct. 1823, 1828 (2015)
5. Restatement (Third) Trusts, Section 90 cmt h(2)
6. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.
7. Roger M. Edelen, Richard B. Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Tradings Costs,” available at http://www.ssrn.com/abstract=951367
8. Uniform Prudent Investor Act (UPIA), Section 7, comment

Copyright © 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.

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Unintended Consequences: Financial Advisers and Potential Liability Issues Under State Fiduciary Laws

With the investment industry driving and celebrating the continuous efforts of the DOL and Congress to emasculate the DOL’s fiduciary rule, I have received emails from stockbrokers and RIAs/IARs as to what the practical meaning of these actions, from a both a practice management and potential liability standpoint. I do believe that the actions of Congress and the DOL have important implications for the investment industry, including ERISA activity. I also believe that the industry may not be celebrating quite as loudly if some scenarios come true.

In my opinion, the development that could have the most impact on the investment industry is Nevada’s announcement that it will enact a state fiduciary law pursuant to its police powers under the 10th Amendment. A number of states already hold stockbrokers to a fiduciary standard as a result of state laws and/or state court decisions. RIAs and IARs are already held to a fiduciary standard under federal and state law.

Nevada’s announcement, and their announcement that other states had contacted them about following Nevada’s lead, caused quite a reaction in the investment world. Industry trade groups objected to such a move, claiming that ERISA was exclusively a federal issue and that Nevada’s passage of such a law would cause confusions. That argument has no merit, for as mentioned earlier, numerous states already hold stockbrokers and other financial advisers to a fiduciary standard. Furthermore, as long states approach any stockbroker and financial activity in the proper manner, there is nothing that the DOL, Congress, the administration or the courts can do to prevent any state from passing such state fiduciary laws, as it is within their 10th Amendment powers.

I have long been of the opinion that the real reason that the investment industry and other industry groups are so fervently concerned about the DOL rule is that it would protect an investor’s right to pursue legal recourse for violations in the courts, which in turn would provide investors with the right to full discovery. While an investor has a very limited right to discovery in arbitration, investors would enjoy a much broader right of discovery in the courts, discovery which result in the uncovering of other abusive practices by members of the investment industry and stronger cases by investors.

The current state fiduciary laws apply to any and all activity engaged in by stockbrokers and other financial advisers. As a result, current state fiduciary laws, as well as similar laws enacted by Nevada and other states going forward, could effectively replace a watered down or completely repealed BIC exemption since BICE, as currently proposed, applies to what is otherwise a simple securities situation, not an ERISA plan situation.

Waiver of Access to the Courts and Class Action Participation
As a plaintiff’s attorney myself, I have had already had several discussion with other plaintiff’s attorneys on potential issues resulting from the actions of the DOL and Congress, particularly the attack on the prohibition of forced binding arbitration provisions in BIC exemption agreements. The key issue in this regard would be whether any financial adviser who is subject to a fiduciary standard would violate their fiduciary duty of loyalty by advising, or forcing, an investor to forego an important and valuable legal right by waiving their right to pursue legal resource in the courts.

The securities arbitration process has long been the subject of criticism due to perceived manipulation of the process by the regulators and the investment industry. While things have improved somewhat, there is still the perception that investors would have a better opportunity for a fair and impartial trial in the courts. There is also the issue that recent evidence has shown that many stockbrokers and advisers who lose in arbitration never pay the winning investors the amounts awarded to them, with the regulators never doing anything to require such payments. Investors in court cases would have a number of legal options available to collect such financial awards.

The waiver of an investor’s right to redress in the courts would also have potential ERISA implications for plan sponsors, as they could be held liable for breach of their duty of loyalty by selecting a plan provider that required such a waiver, when other options were available that would not have required such waivers. As discussed earlier, such waivers are clearly not in the best interest of plan participants and investors.

Going Forward
Once I explain the practical implications of the situation, the next question inevitably involves some variation of “so what do I do?” My response is to continue to do what you have hopefully been doing all along. As mentioned earlier, RIAs and their representatives are already held to the “best interests” requirement of the fiduciary standard.

Broker-dealers and stockbrokers are always quick to claim that they are subject to the less stringent suitability standard, which does not require them to act in the best interests of a customer. I would suggest that recent regulatory releases and previous regulatory enforcement decisions suggest otherwise.

In interpreting FINRA’s suitability rule, numerous cases explicitly state that “a broker’s recommendations must be consistent with his customers’ best interests.” The suitability requirement that a broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his or her interests ahead of the customer’s interests…. The requirement that a broker’s recommendation must be consistent with the customer’s best interests does not obligate a broker to recommend the “least expensive” security or investment strategy (however “least expensive” may be quantified), as long as the recommendation is suitable and the broker is not placing his or her interests ahead of the customer’s interests…. the suitability rule and the concept that a broker’s recommendation must be consistent with the customer’s best interests are inextricably intertwined. – FINRA Regulatory Notice 12-25 (emphasis added)

In interpreting the suitability rule, we have stated that a [broker’s] ‘recommendations must be consistent with his customer’s ‘best interests.’ – Scott Epstein, Exchange Act Rel. No. 59328, 2009 SEC LEXIS 217, at *40 n.24 (Jan. 30, 2009)

As we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests.Wendell D.Belden, 56 S.E.C. 496, 503, 2003 SEC LEXIS 1154, at *11 (2003)

[A] broker’s recommendations must serve his client’s best interests. – Dep’t ofEnforcement v. Bendetsen, No. C01020025, 2004 NASD Discip. LEXIS 13, at *12 (NAC Aug. 9, 2004)

In resolving the best interests question, I have always advised my consulting clients to follow the guidelines set out in the Restatement (Third) Trusts’ Prudent Investor Rule, especially the Restatement’s “forgotten” fiduciary duty, the duty of being cost conscious, as set out in Section 88 and Section 90, comment b. Stockbrokers and other financial advisers who recommend actively managed mutual funds to clients show pay particular attention to the fiduciary prudence standard set out in Section 90, comment h(2), which states that due to the additional costs and risks associated with actively managed funds as compared to index funds, actively managed funds should only be recommended if it is reasonable to assume that the gains from such actively managed funds will  compensate an investor for such additional costs and risks.

This is a significant hurdle for most actively managed funds, as studies such as Standard & Poor’s SPIVA reports and academic studies such as those done by Carhart(1) , Edelen, and Kadlec (2) have consistently found that most actively managed funds not only do not outperform comparable index funds, but that many actively managed mutual funds do not even manage to cover the fund’s costs. Underperforming funds and those that actually cost investors due to excessive costs clearly do not satisfy the “best interests” standard of either the common law fiduciary standard or FINRA’s suitability/best interest standard.

For stockbrokers and others who still do not believe they need to comply with a “best interests” standard in making recommendations, I would point to various courts’ rulings where they have agreed to impose a fiduciary duty on brokers advising accounts, even non-discretionary accounts, when justice and sense of fundamental fairness dictate same, with the admonition that

The touchstone is whether or not the customer has sufficient intelligence and understanding to evaluate the broker’s recommendations and to reject one when he thinks it unsuitable.  Follansbee v. Davis, Skaggs & Co., Inc., 681F.2d 673, 677 (9th Cir. 1982)

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 recommendations. Carras v. Burns, 516 F.2d 251, 258-59 (4th Cir 1975)

Conclusion
Gordon Gecko’s “greed is good” speech notwithstanding, the investment industry’s greed in trying to emasculate or completely repeal the DOL’s fiduciary rule has apparently resulted in a number of states proposing to join existing states with fiduciary laws in order to protect their citizens. Such fiduciary laws will govern all of a financial advisers actiities, not just ERISA related activity. Since no one can prevent the states from enacting  such legislation, prudent stockbroker and financial advisers will review the common law prudent/best interest investment standards as set out in the Restatement (Third) Trusts and adjust their business and due processes accordingly to avoid unnecessary liability exposure, whether in arbitration or in the courts.

Notes
1. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.
2. Roger M. Edelen, Richard B. Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Tradings Costs,” available at http://www.ssrn.com/ abstract=951367

© Copyright 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.

Posted in BICE, compliance, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, pension plans, prudence, retirement plans, RIA, RIA Compliance | Tagged , , , , , , , , , , , , , , , ,

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.”

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