A Fiduciary Blueprint: The Restatement of Trusts, the Prudent Investor Rule and the DOL’s New Fiduciary Rule

A [fiduciary] is held to something stricter than the morals of the market place.  Not honesty alone, but the punctilio of an honor the most sensitive, is the standard of behavior….
Meinhard v. Salmon, 249 N.Y. 458, 464 (1928)

Ever since the DOL announced its new fiduciary rule, much has been made of the alleged “ambiguity” of certain aspects of the rule, such as “best interests” and “reasonable compensation,” with suggestions that the meaning of the rule and the full extent of one’s obligations under the rule will not be clear until the courts have interpreted the rule.

I realize that as a fiduciary attorney, I probably follow fiduciary matters and legal decisions more closely than others. However, I think those that adopt such a position may well be exposing themselves to unnecessary potential liability exposure.

Fred Reish, one of the nation’s leading ERISA attorneys, has been publishing an excellent series of articles on various aspects of the rule. Reish has appropriately suggested that those seeking clarification on some of the fiduciary issues associated with the rule can turn to the forty-plus years of DOL guidance and fiduciary legal decisions involving and developing such principles. Reish’s articles are available here.

To that, I would add the suggestion that the Restatement of Torts would be a valuable resource in obtaining better understanding of a fiduciary’s duties under the new rule and a fiduciary’s duties in general. The courts have consistently turned to the Restatement of Trusts in interpreting a fiduciary’s obligations.1 More specifically, the courts have looked to the Restatement’s Prudent Investor Rule (PIR)2 for guidance in determining such matters. There is nothing to suggest that the courts would, or should, do otherwise with regard to a fiduciary’s obligations under the DOL’s new fiduciary rule.

It has always struck me as strange how many people involved in providing fiduciary services have never taken the time to review the Restatement and the PIR, including the associated comments and notes,  given the legal system’s reliance on the PIR in fashioning legal liability for fiduciaries. Granted the PIR is lengthy, but it is the recognized blueprint for compliance with one’s fiduciary duties.

Two of the primary fiduciary duties set out in the PIR are the duty of loyalty and the duty of prudence. The duty of loyalty is pretty straight forward. In the context of ERISA, the duty of loyalty requires that plan fiduciaries act solely in the best interests of the plan, its participants, and their beneficiaries, to always put the best interests of the plan participants and their beneficiaries first.

With regard to a fiduciary’s duty of prudence, the PIR stresses two consistent themes – cost consciousness and risk management through diversification. The Restatement and the PIR make it clear that cost consciousness is fundamental to prudence in the investment function.3 Section 88 of the Restatement cites Section 7 of the Uniform Prudent Investor Act – “[w]asting beneficiaries’ money is not prudent.”4

In addressing cost consciousness, the PIR points out that fiduciaries must perform a thorough and objective cost comparison of viable investment alternatives, especially when the fiduciary’s advice and recommendations involve actively managed investments or strategies.5 Since such investments and strategies usually involve higher costs and/or risks, the Restatement states that a fiduciary must be able to explain why it is reasonable to assume that the returns from such investments and/or advice will compensate for the higher costs and/or risks involved.6

In performing the required cost comparisons, the Restatement and the PIR state that fiduciaries should consider both a fund’s annual expense ratio and the fund’s trading costs.7 Trading costs are often overlooked in evaluating mutual funds, providing securities attorneys with a valuable evidentiary advantage in proving their cases. The SEC stressed the potential impact of trading costs in a December 2000 release, describing trading costs as “anti-performance” factors that reduce investors’ end returns8. Like the Restatement and the PIR, the SEC stated that fiduciaries need to document why they reasonably believe that a fund’s expected returns are justified any additional costs associated with an actively managed mutual fund.

Most financial advisers are quick to point out that the prudence of their advice should be evaluated on factors other than just cost. The Restatement agrees, pointing out that in assessing the prudence of investment advice, any and all costs of the investment products recommended should be evaluated relative to the value received in exchange for such costs.9

The issue with actively managed mutual funds is that the evidence clearly shows that historically, the majority of such funds underperform comparable, less expensive index mutual funds, thus failing to provide the required value to justify the extra expense and risk of such funds. This fact is one of the key foundations for the current trend in 401(k) and 403(b) litigation.

Fiduciaries need to remember that fiduciary liability is based on the prudence of their conduct, the prudence of the analytical process that they utilize in selecting investments and investment strategies, not on the basis of the actual performance of such investments and investment strategies.10 Process instead of results.

In evaluating the prudence of the analytical process used by a financial adviser, the Restatement and ERISA state that the fiduciary’s process must be acceptable from both a procedural and a substantive perspective.11 Procedural prudence examines the prudence of the process that the fiduciary used in gathering the relevant information about a prospective investment alternative. Substantive prudence focuses on how a fiduciary uses such information in deciding on their investment recommendations and investment strategies.

One of the key issues raised by the financial services industry is how the new rule’s “reasonable compensation” requirement will be interpreted.  Reish first notes that the issue of reasonable compensation naturally involves a determination of the value received by a customer in terms of the investment recommendations and/or investment advice received relative to the price paid for same. Reish then points out that Internal Revenue Code Section 4975(d)(2) already imposes a reasonable compensation requirement on adviser compensation in connection with advising IRA accounts. However, Reish also states that the requirement is often overlooked due a lack of overall enforcement.

One basic premise involved with the concept of reasonable compensation naturally has to be that a customer receives something of value in exchange for the fees paid for the adviser’s advice or investment product recommendations. The concept of reasonable compensation is derived from the legal concept of quantum meruit, a concept that basically states that parties involved in a transaction shall both receive appropriate consideration for their services or payments to ensure that neither party is unjustly enriched at the expense of the other.

Several years ago I created a metric that factors in all of the key criteria set out in the Restatement and the PIR. The Active Management Value Ratio™ 2.0 (AMVR) allows investors, fiduciaries, and attorneys to evaluate the cost efficiency, or relative value, of actively managed mutual funds. The AMVR is based on the principles set out in the Restatement and the PIR , as well as the studies of investment  icons Charles D. Ellis and Burton G. Malkiel.

One of the most attractive aspects of the AMVR is its simplicity, both in terms of calculation and interpretation. The AMVR clearly indicates whether an actively managed mutual fund is imprudent due to (1) its failure to provide value in terms of a positive incremental return, or (2) its failure to provide an incremental return greater than the fund’s incremental costs. For additional information about the AMVR and the calculation process itself, click here.

On a related fiduciary cost consciousness issue, the DOL’s new fiduciary rule created a special exemption that allows financial advisers to recommend investments that would otherwise be imprudent under the DOL’s new rule. However, financial advisers who decide to rely on the new Best Interests Contract exemption (BICE) need to remember that BICE still requires that financial advisers always put a customer’s best interests first and that all investment recommendations provided pursuant to a BICE agreement must still satisfy all fiduciary prudence requirements.

From my conversations with fellow securities and ERISA attorneys, there seems to a general consensus that recommendations involved variable annuities are expected to be the leading issue in BICE related litigation. Moshe Milvesky’s famous study established the fact that the method used by most VA issuers in assessing a VA’s annual fees result in excessive fees and result in an inequitable windfall for the VA issuer at the VA owner’s expense.12 Fiduciary law is based largely on the principles of equity law, and it is a well established that equity abhors a windfall.13

Conclusion

In adapting their practices to the DOL’s new fiduciary rule, financial advisers need to focus on the fact that fiduciary liability is generally based on a fiduciary’s imprudent conduct in developing their investment recommendations, not the actual performance of the actual investments and strategies. It is reasonable to assume that the courts will continue to rely on the Restatement of Trusts and the Prudent Investor Rule in interpreting imprudent conduct under the DOL’s new fiduciary rule.

Consequently, with regard to actively managed mutual funds, financial advisers should focus on ensuring that their investment recommendations are cost efficient, that the adviser can provide an acceptable explanation as to why they believed that an actively managed fund would provide a return that would be sufficient to compensate a customer for the additional costs incurred. Financial advisers who fail to adopt and follow a due diligence analytical process that is prudent, both procedurally and substantively, and choose to rely on a “good faith’ defense should remember the oft quoted admonition from the courts – a pure heart and an empty head are no defense to a breach of fiduciary duty claim.14

Notes
1. Tibble v. Edison International, 135 S.Ct. 1823, 1828 (2015); Donovan v. Mazzola, 716 F.2d 1226, 1231 (9th Cir. 1983).
2. Restatement (Third) Torts, § 90.
3. Restatement (Third) Torts, § 90 cmt b.
4. Restatement (Third) Torts, § 88 cmt a.
5. Restatement (Third) Torts, § 90 cmt m.
6. Restatement (Third) Torts, § 90 cmt h(1) and cmt m.
7. Restatement (Third) Torts, § 90 cmt h(1) and cmt m; “Division of Investment Management Report on Mutual Fund Fees and Expenses (December 2000), available online at https://www.sec.gov/news/studies/feestudy.htm
8. “SEC Staff Study On Investment Advisers and Broker-Dealers As Required By Section 913 of the Dodd-Frank Wall Street REFORM AND Consumer Protection Act of 2010, at 59 (January 2011).
9. Restatement (Third) Torts, § 90 cmt h(1) and cmt m.
10. Restatement (Third) Torts, § 77 and § 90 cmt b.
11. ERISA § 404(a)(1)(B), 29 U.S.C. § 1104(a)(1)(B); 29 C.F.R. § 2550.404a1(b)(1).
12. Moshe Milevsky and Steven Posner, “The Titanic Option: Valuation of the Guaranteed Death Benefit in Variable Annuities and Mutual Funds,” Journal of Risk and Insurance, Vol. 68, No. 1, (2001), 91-126.
13. Prudential Ins. Co. of America v. S.S. American Lancer, 870 F.2d 867 (2nd Cir. 1989).

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