With a portion of the DOL’s new fiduciary rule scheduled to go into effect at midnight tonight, there are still some unanswered questions with regard to how some key terms will be interpreted. The key terms in question are primarily located in the rule’s impartial conduct standards.
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.
While the “misleading statements” standard is self-explanatory, it has been suggested that it will be left to the courts and attorneys to define the meaning of “best interest” and “reasonable compensation.” As an ERISA and securities attorney, I would suggest that just as the courts look to the Restatement (Third) of Trusts to interpret fiduciary law, advisers and other investment fiduciaries can, and should, look to the Restatement for guidance as the interpretation of both terms.
“Best Interest” Standard
The fiduciary duty of prudence essentially adopts the Restatement (Third) Trusts’ Prudent Investor Rule. The Prudent Investor Rule requires a fiduciary to execute their fiduciary duties with the same care, skill and caution that a prudent investor would use in managing their own affairs.
The fiduciary duty of loyalty requires that an adviser always put the customer’s financial interests ahead of those of the adviser or the advisory firm. While the duty of loyalty does not absolutely prohibit an adviser from also benefiting from the advice or services provided to a customer, the primary reason for and resulting benefit from an adviser’s advice or actions must be to further the customer’s financial interests.
In satisfying both of these fiduciary duties, Section 88 of the Restatement states that a fiduciary has a duty to be cost conscious, i.e., limit investment selections and recommendations to investment that are cost efficient. Comments h(2) and m of Section 90 state that in choosing between similar mutual funds, actively managed funds should only be chosen if it is reasonable to assume that the fiduciary’s customer will be properly compensated for the higher fees and risks generally associated with actively managed funds. Given the poor relative historical performance of most actively managed mutual funds, the requirements set out in Section 88 and Section 90 create significant hurdles for fiduciaries in trying to meet the new fiduciary rules “best interest” standard.
“Reasonable Compensation” Standard
Most of the media commentary to date on the “reasonable compensation” requirement has centered on the absolute level of monetary compensation an adviser receives from their investment advice and related services. The suggestion has been made that the market will determine whether a certain level of monetary compensation is “reasonable.”
I would suggest that such a definition of “reasonable compensation” is too narrow, as it ignores the “reasonableness” of the adviser’s advice and services relative to the inherent value of such advice and services. Under the law of equity, the concept of quantum meruit arises when one party to a contract refuse to honor and agreement made with another party due to a disagreement over the quality of the services rendered under the agreement, the courts usually reference quantum meruit for the proposition that one is entitled to compensation relative to the inherent value of the services they provided.
I think that some attorneys may incorporate such an argument in actions filed pursuant to the new rule’s “reasonable compensation” standard, as a strong argument can be made that a determination of “reasonable compensation” properly involves both quantitative and qualitative questions. A customer dealing with an adviser obviously seeks useful and valuable advice, and has every right to expect same. Any suggestion that an adviser is entitled to compensation just for giving any advice is inconsistent with both common sense and the law.
Quantifying the Impartial Conduct Standards
One of the common complaints heard from opponents of the new fiduciary rule is that the rule does not adequately define terms such as “best interests” and “reasonable compensation,” Opponents argue that such terms are purely subjective and therefore unfairly expose financial advisers and financial institutions covered under the rule to unnecessary liability exposure.
Advocates of the rule argue that such complaints are without merit, as violations of such standards are often blatant and obvious enough that pure common sense indicate a violation of such standards. Advocates of the rule also point out that since the quality of an adviser’s advice is evaluated as of the time such advice is provided, not upon the ultimate results of such advice, there is no reason that both a qualitative and a quantitative evaluation of the adviser’s advice cannot be done to evaluate an adviser’s compliance with the rule’s “best interests” and “reasonable compensation” standards.
Various metrics currently exist that can assist advisers, customers, and plan sponsors in evaluating the quality of an adviser’s financial advice both in terms of cost efficiency and risk management. Ross Miller’s excellent Active Expense Ratio metric analyzes the cost efficiency issues inherent with “closet index” funds. The Sharpe Ratio and the Modigliani–Modigliani metric (M-squared) are two popular risk management metrics.
In my practices, I also use a proprietary metric, the Active Management Value Ratio™ 3.0 (AMVR). The AMVR is based on the studies of investment icons Charles D. Ellis and Burton Malkiel and analyzes the cost efficiency of an actively managed mutual fund in terms of a fund’s incremental costs and incremental returns.
The simplicity in both the calculation and interpretation of the AMVR are part of its appeal. Calculating the AMVR requires nothing more than the simple ‘My Dear Aunt Sally” (multiplication, division, addition, subtraction) skills everyone learned in elementary school. In interpreting the AMVR, the optimum score is greater than zero (indicating a positive incremental return) and less than one (indicating that the fund’s incremental returns are greater than it incremental costs).
AMVR scores less than zero or greater than one indicates that an investor in the fund would have incurred a financial loss, clearly inconsistent with the fundamental concepts of “best interest” and “reasonable compensation.” Anyone attempting to make a good faith argument that any compensation is reasonable for recommending investment products with excessive fees and/or a historically consistent record of under-performance relative to a comparable benchmark faces a difficult challenge before an objective and impartial arbiter.
As mentioned earlier, the DOL has stated that the purpose of the new fiduciary rule is to ensure consumer protection and fair dealing with pension plans and plan participants. In interpreting the concepts of “best interest” and “reasonable compensation,” simple common sense mandates that one uses the same resources relied on by the courts in interpreting fiduciary law-applicable common law and the Restatement (Third) Trusts. Adopting this approach not only guarantees consistency in enforcement, but provides a set of guidelines that financial adviser and firms subject to the DOL’s new fiduciary can use to proactively ensure compliance with the rule’s impartial conduct standards.
© 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.