RIAs often have mock audits performed. These audits generally focus on the various regulatory requirements for RIA, including the various documents and internal procedures of an RIA.
More often than not, these mock audits do not include a forensic fiduciary liability analysis. Even when they are performed, I generally find such reviews lacking in quality. Unless an auditor has experience as an actual compliance director, someone who has had the responsibility to review trades on a daily basis, I do not think the auditor can understand all the issues that must be considered.
Based on my experience, I find that RIAs are surprised when they are informed about the amount of unnecessary and unwanted fiduciary liability exposure they actually have. Many RIAs respond by saying that their broker-dealer did not give them sufficient advice on the issues. However, unless a broker is registered through the broker-dealer’s RIA, the broker has no duty to advise an independent RIA on matters involving their RIA. NASD 94-44 only requires that a broker-dealer monitor and supervise trades of brokers affiliated with independent RIAs.
RIAs and investment advisory representatives (IAs) are held to a fiduciary standard. Some IAs argue that under the “two hats” theory, any trading activity they engage in on help of RIA clients is subject to a “suitability” standard, not the fiduciary “best interests” standard.
In my opinion, that argument fails under the Arlene Hughes decision, which held that one who is dually registered will be held to the higher fiduciary standard in their dealings with the public. Recent FINRA Regulatory Notices are clearly in agreement with the Hughes’ decision, stating that a broker-dealer and a broker must always act in a customer’s best interests. For reasons I will explain later herein, I do not think it really matters.
Two of the primary duties of a fiduciary are the duty of loyalty (duty to always act in the best interests of a client) and the duty of prudence (duty to manage a client’s affairs as would a prudent man managing his own affairs). A fiduciary’s duties are absolute and unforgiving. As courts have consistently pointed out, “a pure heart and an empty head” are no defense to a breach of fiduciary claim.
For broker-dealers and brokers who claim that they are governed by FINRA’s less stringent suitability rule, I would suggest that they re-read FINRA’s new Rule 2111, especially 2111.05, and Rule 2010. As strong argument can be, and has been, made that a broker faces just as stringent rules under both of said Rules, especially Rule 2010, often referred to as FINRA long-arm rule, allowing FINRA to sanction any conduct on an “as needed” basis.
Rule 2111.05 sets out the three components of suitability under Rule 2111-reasonable-basis suitability (suitable for at least some investors; customer-specific suitability (suitable for a particular customer); and quantitative suitability (suitability of a series of recommended transaction when a broker has actual or de facto control over a customer’s account.
It should also be noted that FINRA stated in Regulatory Notice 12-25 that “the suitability rule and the concept that a broker’s recommendation must be consistent with the customer’s best interests are inextricably intertwined.” Various enforcement actions, by both NASD/FINRA and the SEC, have also held that
A study commissioned by the SEC in connection with a proposed uniform fiduciary standard stated that
[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.
FINRA Rule 2010 is a potentially strong regulatory tool due to its vague ruling, which results in flexibility in its usage. Rule 2010 states that
A member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade.
The Rule does not define any of the terms contained in the Rule, allowing greater flexibility in its enforcement. The Rule is consistent with the overall stated concept of fair treatment of the public.
The Active Management Value Ratio 2.0™
Which brings us to the role of the Active Management Value Ratio 2.0™ (AMVR) in protecting RIAs and other financial advisers, regardless of whether they are titled as fiduciaries or not. I believe that the AMVR provides objective data that identifies potential liability issues under both a fiduciary standard and FINRA’s rules and regulations, and allows financial advisers an opportunity to address such issues and avoid unwanted liability exposure.
AMVR calculations will result in one of three scenarios:
- the actively managed fund will fail to produce any incremental return for an investor, therefore providing no benefit to an investor;
- the actively managed fund will produce an incremental return for an investor, however the incremental costs incurred by the fund in producing the incremental return will exceed the incremental return, therefore providing no benefit to an investor; or
- the actively managed fund will produce an incremental return greater than the fund’s incremental cost, therefore producing a benefit for an investor.
Scenarios 1 and 2 create obvious liability concerns for a financial advisor, as both scenarios result in increased costs for an investor without providing any benefit in return for an investor. Both scenarios would obviously not be neither suitable, prudent nor in the best interests of any investor, resulting in liability exposure for their provider who provided such recommendations.
Scenario 3 does result in a financial benefit for an investor, justifying further evaluation on qualitative issues such as risk, stress testing and consistency of performance.
Financial advisers often complain about the amount of attention given to a mutual fund’s fees. Higher fees that result in a scenario 3 situation are probably not an issue. The AMVR focuses on a fund’s annual expense ratio and turnover/trading costs, studies have consistently shown that
The two variables that do the best job in predicting future [of mutual funds] are expense ratios and turnover. High expenses and high turnover depress returns….– Burton Malkiel “A Random Walk Down Wall Street”
Furthermore, studies consistently show that most actively managed mutual funds underperform comparable passive/index mutual funds. The latest SPIVA (Standard & Poor’s Index Versus Active) report indicated that as of December 31, 2014, actively managed mutual funds underperformed index funds by 80.82 percent over the most recent five years and by 76.54 percent over the most recent ten-year period. In many cases, a fund’s underperformance can be directly attributed to its incremental costs.
My purpose in creating the AMVR was to provide a means of quantifying suitability and best interests not only for my practice, but also for investors, fiduciaries, attorneys and the courts. The concept of evaluating actively managed mutual funds based on the fund’s incremental costs and returns recently received support from the court hearing the Citigroup 401k excessive fees case.
The decision has received little attention from the media, but the legal community, especially the ERISA community, is definitely aware of the court’s decision, as it upheld the viability of using Vanguard’s mutual funds in assessing the reasonableness of a fund’s expenses. While the decision is technically only binding on that court, you can be sure that the logic of the court will be argued in courts everywhere. It should be noted that the Citigroup case is being heard in the federal court for the Southern District of New York, where most federal securities cases are heard, providing even more legitimacy for the widespread application of the court’s logic and decision.
The AMVR provides fiduciaries and financial advisers with a simple and effective method to evaluate actively managed mutual funds and avoid unnecessary and unwanted liability exposure. Given the interest in the AMVR shown thus far by securities and ERISA attorneys, fiduciaries and financial advisers who include the AMVR as part of their process in providing investment recommendations to their customers may provide greater protection for their practices.