The Courts, the Restatement of Trusts, ERISA and Fiduciary Liability

Yesterday, I posted an article written by a fellow attorney, Ary Rosenbaum. The article, “Simple Advice to Retirement Plan Sponsors,” provided sound advice on a number of key topics for pension plan fiduciaries.

As an ERISA and fiduciary attorney, it has always amazed me how many people that serve in a fiduciary capacity, whether in an ERISA or non-ERISA capacity, have never taken the time to actually read the Act and the related regulations, the Restatement (Third) Trusts (“Restatement”), or the key fiduciary legal decisions regarding same.  These materials are key in determining the applicable standards for legal liability for fiduciaries.

Given the fact that fiduciaries may face unlimited personal liability for violations of their fiduciary duties, one would think that they would want to know the applicable rules so that they can avoid unnecessary and unwanted such potentially life-changing liability. Yet, my experience is that very few non-professional fiduciaries understand the applicable fiduciary standards and very few have made any effort to educate themselves on such standards.

As the Supreme Court pointed out in the recent Tibble decision1, the courts often look to the Restatement in determining applicable fiduciary law in ERISA cases, since ERISA is essentially a codification of the Restatement. The same is true for courts in non-ERISA fiduciary cases, as courts in non-ERISA fiduciary actions look to both the Restatement and the Restatement Agency.

In my consulting and litigation practices, I have several “go-to” provisions of the Restatement that describe key duties of a fiduciary. While these key provisions are not, and are not intended to be, a substitute for a complete reading of the previously mentioned materials, they are worth reviewing and remembering.

ERISA Fiduciaries
One of the arguments that I often hear from ERISA fiduciaries is that they are not legally required to choose the least expensive investment option available. While this is absolutely true, to suggest that cost is not a factor that must be seriously considered in selecting a plan’s investment options would be a dangerous misinterpretation of ERISA and it stated purpose.

Section 88 of the Restatement states that one of a fiduciary’ key duties is to be cost conscious.2 Section 90 of the Restatement references Section 7 of the Uniform Prudent Investor Act, which warns that “wasting beneficiaries money is imprudent,” and cites a fiduciary’s duty to minimize costs.

Most pension plans use mutual funds as the primary investment options within their plan. The Restatement states that fiduciaries should carefully compare the cost associated with a fund, especially when considering funds with similar objectives and performance.3 The Restatement advises plan fiduciaries that in deciding between funds that are similar except for their costs, the fiduciary should only choose the fund with the higher costs if

the course of action in question can reasonably be expected to compensate for its additional costs and risk,…4

Given the historical under-performance of many actively managed mutual funds, this can be a significant hurdle that pension plan fiduciaries too often fail to properly consider. A higher priced fund that fails to provide a tangible benefit to a plan participant, namely a higher positive incremental return, has no inherent value to a n investors and is therefore clearly imprudent.

Therefore, to simply say that a fiduciary is not legally bound to select the least expensive investment option can be misleading, as other factors must be considered. TIAA-CREF properly summed up a plan sponsor’s fiduciary obligations with regard to factoring in an investment’s costs, stating that

[p]lan sponsors are required to look beyond fees and determine whether the plan is receiving value for the fees paid. This should include an evaluation of vital plan outcomes, such as retirement readiness, based on their organization’s values and priorities.5

One of the most annoying trends that I see in many ERISA-related court decisions is the concept of an acceptable range of fees for a plan’s investment options. As the TIAA-CREF quote correctly point out, given the stated purpose of ERISA, assessing the prudence of investments within a pension plan based purely on the costs associated with such investment options is itself imprudent.

Apparently some courts have lost sight of ERISA’s stated goal, that being to protect workers and to help them prepare for retirement. A prudent pension plan investment option is one that is cost efficient, one whose benefits are at least commensurate with the extra cost involved. Consequently, a fund with higher costs, but commensurable returns, would be more prudent than a less expensive fund with a consistent history of relative underperformance. The problem for many plan sponsors and other plan fiduciaries is the history of consistent underperformance by many actively managed mutual funds relative to passively managed index funds.

Another challenge for plan sponsors with regard to their fiduciary duty to be cost conscious has to do with so-called “closet index” mutual funds. A closet index fund, or “index hugger,” is an actively managed mutual fund that closely tracks a relevant index or index fund, yet charges significantly higher fees than an index fund. Fiduciaries  who chose to offer or to invest in closet index funds face the challenge of justifying the selection of such funds since they could receive the same or, in some cases, better returns from comparable, less expensive index funds. Remember, wasting beneficiaries’ money is always imprudent.

When plan sponsors and their plans are challenged on the prudence of their investment choices, they often try to justify their choices based on allegations of good faith/ignorance and/or the use of modern portfolio theory (MPT) in selecting the plan’s investment options. Plan sponsors and other plan fiduciaries quickly learn that the courts have consistently rejected such defenses. A well-known quote in ERISA breach of fiduciary duty cases is that “a pure heart and an empty head are no defense.”6 The courts have also stated that MPT alone is not a complete defense in fiduciary breach of duty cases involving a defined contribution plan, as prudence is determined as to each investment option in a plan, not with regard to the plan’s investment options as a whole7

Non-ERISA Fiduciaries
Most of what has already been discussed in the context of ERISA fiduciaries is equally applicable to non-ERISA fiduciaries. With non-ERISA fiduciaries, the threshold question is whether or not the stockbroker or financial adviser is even a fiduciary for liability purposes.

Most stockbrokers and financial advisers are not deemed to be fiduciaries for their customers unless they contractually agree to assume such responsibilities, such as managing an account on a discretionary basis, or they are deemed to have taken control of a customer’s account. The “taken control” requirement is generally met when it can be shown that a customer routinely acted in accordance with whatever their  stockbroker or financial adviser recommended. Investment advisers are held to a fiduciary standard by law, which requires them to always act in a client’s best interests.

One development that stockbrokers and financial advisers are often unaware of is that the courts have shown an increasing willingness to impose a fiduciary standard on such investment professionals, even in connection with non-discretionary accounts, when they feel such is necessary to protect naïve or inexperienced investors. The courts have stated that the applicable standard in deciding whether to impose a fiduciary standard on such investment professionals 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.8

[w]hether or not the customer, based on the information available to him and his ability to interpret it, can independently evaluate his broker’s suggestions and to reject one when he thinks it unsuitable.9

With the pending implementation of the DOL’s new fiduciary rule, stockbrokers and other financial advisers should take notice of these decisions and recognize situations that potentially create  a greater risk of being held to the fiduciary standard’s higher “best interests” standard, as opposed to their normal, less stringent suitability standard. Retirees, older customers, women and those suffering some sort of mental impairment are often mentioned as customers who courts would consider as meriting special fiduciary protection.

The courts are becoming more protective of employees and others involved in investing activities. The recent court decisions rejecting challenges to the Department of Labor’s new fiduciary rule are a perfect example of this fact. Given that fiduciaries may face unlimited personal liability for any breach of their fiduciary duties, the prudent fiduciary, in both ERISA and non-ERISA situations, will take the time to educate themselves on both existing and future applicable fiduciary standards and develop due diligence programs than ensure compliance with same.

1. Tibble v. Edison International, 135 S.Ct. 1823, 1828 (2015).
2. Restatement (Third) Trusts §88.
3. Restatement (Third ) Trusts §90 cmt m.
4. Restatement (Third) Trusts §90 cmt h(2).
5. TIAA-CREF, “Assessing the Reasonableness of 403(b) Fees,” available online at
6. Donovan v. Cunningham, 716 F.2d 1455, 1468 (5th 1983).
7. DiFelice v. U.S. Airways, 497 F.3d 410, 423-24 fn. 8 (4th 2007).
8. Carras v. Burns, 516 F.2d 251, 258-59 (4th 1975).
9. Follansbee v. Davis, Skaggs & Co,, Inc., 681 F.2d 673, 677 (9th Cir. 1982).

© 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 fiduciary compliance

Guest Column-Simple Advice to Retirement Plan Sponsors

I generally do not post or allow other parties to post on any of my blogs due to legal concerns. However, Ary Rosenbaum is a fellow attorney and posts some extremely useful and informative material online with regard to ERISA matters for 401(k) plans and plan sponsors. In an effort to provide my followers with the best information and advice to help them build and protect their practices, Ary has graciously agreed to let me post some of his past and present posts on my blogs. I would strongly recommend following Ary online as well to ensure that you receive his posts and articles. His social media and professional information is provided at the end of this article. Enjoy!

Simple Advice to Retirement Plan Sponsors
By Ary Rosenbaum, Esq.

I don’t know about you, most of the advice I got growing up was usually wrong. Maybe some very unsuccessful people surrounded me when I was younger, but advice can be biased and self-serving at times. The best advice I would ever get was from successful people with great people skills and confidence in their own abilities. The problem with advice given to plan sponsors is that it’s often self-serving by the plan providers who want to maintain or get the business from plan sponsors. So this article is simple advice to retirement plan sponsors that you can take or leave, I won’t be offended. Of course if they don’t take it, it may cost them.

Remember why you put the retirement plan in the first place. 
They say the road to hell is paved with good intentions and whoever coined that phrase must have been a retirement plan sponsor because fiduciary responsibility and potential liability can be a headache. As a plan sponsor, you should always remember why you put it in the first place, to save for retirement for yourself and for your employees. If you never lose sight of that, then it makes it easier to understand your responsibility as a plan sponsor/fiduciary. When you remember that your money is there and you employee’s money there, you become more vigilant. If you forget that and treat the retirement plan like that dirty K-cup machine in the break room, your plan is going to be as disheveled as that coffee machine.

Less is more when it comes to 401(k) fund lineups
We are a country of excess, just look at the national average weight. We usually think that more is more, so food portions at the local national chain restaurant can feed a Bulgarian weightlifter. The problem is that many times, more is not more, less is more. Eye makeup, men’s cologne, and Old Milwaukee beer are examples of when less is more. The same can be said with 401(k) fund lineups where participants direct their own investments. Studies have shown that the more investment options available under the Plan, it has the unintended effect of depressing plan participation in salary deferrals. While it may seem like a good idea to offer 30+ mutual funds in the plan because we think more choice is good, it actually overwhelms plan participants so much that they decide not to defer and actively participate in the Plan. Information overload isn’t something any plan sponsor wants to provide plan participants, but it’s an unintended consequence of giving too many choices. There is no reason that any plan should include more than 12-15 mutual funds (not including target date funds) because that should be enough to be a good cross of diversified investment options.

Blind loyalty to plan providers is bad
I have worked at places where the employer had loyalty to employees and it usually was misplaced. Too often, employers think that employees are loyal and that loyalty deserves reciprocity just because they have been there so long. Longevity should not be confused with loyalty because some employees are too incompetent to go somewhere else. Being loyal to someone or to a provider should be more than longevity. When it comes to plan providers, loyalty can be a reward for competent plan providers and it’s a disaster if you have an incompetent plan provider. There are many reasons to have long-term providers because of cost, familiarity, and competence. Keeping a plan provider just because they have been there for that long reminds me of the actuary who wasn’t good at his job and who we could never bring out for a sales meeting. Too often, I had to fix major errors with retirement plan clients because of the incompetent work of plan providers. After fixing these errors, the plan sponsors state that they can’t believe because they were using that provider for so long. There is nothing wrong with being loyal to plan providers, but you still need to benchmark fees and review their work. Blind loyalty will make you blind to the problems that might be affecting your Plan.

Plan design is more important than you think
If you had two accountants and they both prepared tax returns to the letter of the law and one could get you a $1,000 refund and another could get you a $5,000 refund, who would you pick? Retirement plan design is a pretty hard concept for even retirement plan professionals to understand, so laypeople like plan sponsors don’t understand it and don’t value it. Like the accountant who could produce a better tax return, a good retirement plan design could help a plan sponsor like you maximize retirement savings for the highly compensated employees which means larger tax deductions. The best example is the work I did for a 75-year-old attorney many years ago. He had a self-employed pension plan where the maximum contribution at the time was $49,000. I was able to have an actuary design a defined benefit plan where he could put away $230,000 instead. That’s a lot of shekels. Thanks to concepts such as cash balance plans, safe harbor 401(k), and new comparability/cross tested plans, you could save a lot more for retirement than just using a plain vanilla plan design where everyone gets the same pro-rata contribution. So when it comes to selecting a TPA, one should always consider whether the TPA is proficient in plan design because there are many that are not. Picking a TPA that doesn’t have plan design expertise may require more mandatory contributions to the rank and file employees or not enough contributions to the highly paid.

There isn’t anything out there that is a fit for every retirement plan sponsor
Retirement plan service providers are very creative in crafting retirement plan solutions for their current and potential plan sponsor clients. These solutions may be a sophisticated plan design such as safe harbor or a white glove fiduciary solution like an ERISA §3(38) or ERISA §3(16) service. While these can be great solutions for many or most retirement plans, it’s not a solution for everybody. For example, an ERISA §3(38) fiduciary is a great solution where a financial advisor will exercise discretionary control over the fiduciary process and assuming the liability that goes with it. While delegating control of the fiduciary process maybe a great idea, retirement plan sponsors that have proven that can effectively manage the fiduciary process don’t need to give it up. A safe harbor 401(k) plan design is a great tool when combined with a cash balance plan and/or new comparability plan, but if a plan sponsor can’t afford employer contributions and/or if the plan’s compliance testing isn’t an issue; it’s not necessary. Retirement plan features are not one size fits all, it needs to fit the actual needs of your plan.

Being a plan sponsor is a never-ending marathon
When retirement plan sponsors start their plan, they act like they are running a 100-yard dash. They are so quick to get everything in place and hire the plan provider, but then stop when everything is done just like the finish line at 100 yards. However, being a plan sponsor is a never-ending marathon. The race to keep the plan running and avoiding liability is a never ending marathon because a plan requires constant monitoring and upkeep. You should treat running a plan like a marathon, so that means proper pacing and regular intervals of plan review. So you need to review fees, plan design, and plan provider services on a regular annual basis. Reviewing isn’t enough, you also need to memorialize these reviews to cover your “rear-end” in any potential litigation.

Picking providers just on cost is a big mistake
Plan sponsors have a fiduciary duty to pay only reasonable plan expenses. That doesn’t mean that a plan sponsor has to pay the lowest plan expenses, it just has to be reasonable based on the services provided. A plan sponsor can determine reasonableness by shopping the plan around or by benchmarking fees. One of the biggest fears concerning the fee disclosure regulations that were implemented in 2012 was that there would be a race to zero and plan sponsors would gravitate towards plan providers that charged the lowest fees. Picking a plan provider just based on their low fee is an absolute mistake. While there are many low cost plan providers that do a good job, there are those no frill providers that aren’t good at what they do and will end up being more expensive when the plan sponsor has to pay to fix compliance mistakes caused by incompetent low cost providers. There are many reasons to pick a plan provider, just because they charge the lowest fee shouldn’t be the only reason in selecting a plan provider

The Rosenbaum Law Firm P.C.
Copyright, 2017 The Rosenbaum Law Firm P.C. All rights reserved.
Attorney Advertising. Prior results do not guarantee similar outcome.

The Rosenbaum Law Firm P.C.
734 Franklin Avenue, Suite 302
Garden City, New York 11530
(516) 594-1557
Follow us on Twitter @rosenbaumlaw

Posted in 401k, 401k compliance, 404c, 404c compliance, ERISA, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, pension plans, retirement plans, wealth management | Tagged , , , , , , , , , , , ,

Controlling the Controllable: Factoring Investment Costs Into the Prudence/Suitability Equation

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

In an earlier post, I discussed the benefits of controlling the controllable aspects of investing. Investors cannot control the performance of the markets. Investment fiduciaries are not held liable for the eventual performance of the markets. However, investors and investment fiduciaries can control certain elements of investing that play a significant role in determining an investor’s and/or pension plan participant’s success.

Costs associated with an investment are a key factor in determining whether an investment is a prudent and/or suitable choice. The Securities and Exchange Commission has consistently warned investors about the need to look beyond a mutual fund’s past performance numbers and to factor in a fund’s costs when selecting mutual  funds.1 A mutual fund’s annual expense ratio is an obvious cost that an investor should consider. However other less discussed, or “hidden,” costs are equally important and should always be considered in selecting investments.

American Funds’ Growth Fund of America and Fidelity Investments’ Contrafund are two popular mutual funds, both in terms of retail shares and retirement shares. Both funds are classified by Morningstar as large cap growth funds. Vanguard’s Growth Index Investors (retail)/Institutional (retirement) funds will serve as the benchmark fund in this analysis since it is also classified as a large cap growth fund.

Two cost-related metrics that allow investors and investment fiduciaries, such as 401(k) plan sponsors, to evaluate the cost efficiency of mutual funds are the Active Management Value Ratio (AMVR) and Professor Ross Miller’s Active Ratio (AER).

The AMVR is a metric created by InvestSense, LLC.  The AMVR is essentially the same simple cost/benefit metric that students learn in every Econ 101 class. The AMVR compares an actively managed mutual fund to a comparable passively managed/index fund. The AMVR then uses the actively managed fund’s incremental cost and incremental return, if any, as the variables in the calculation process.

In interpreting a fund’s AMVR score, the Optimum Wealth Zone is between zero and one. An AMVR score less than zero would indicate that the actively managed fund underperformed its relative benchmark, and thus provided no positive incremental return for an investor. An AMVR score greater than one would indicate that while the actively managed fund in question did provide a positive incremental return, the fund’s incremental costs exceeded such return, resulting in a loss for an investor or plan participant.

Retail Share Analysis
Analyzing the retail shares of the three mutual funds, based on the five-year annualized performance and cost data as of 12-31-2016, neither Growth Fund of America (AGTHX) nor Contrafund (FCNTX) provided any positive incremental return. Growth Fund of America’s nominal return would have provided an incremental return of +1.13 over Vanguard Growth Index Investor. However, since Growth Fund of America charges investors a front-end load of 5.75%, which is immediately deducted from an investor’s investment, the proper performance number to use in evaluating the fund is its load-adjusted return. Growth Fund of America’s load adjusted return underperformed the benchmark. Since both funds underperformed the relevant benchmark, neither fund would be considered a prudent or a suitable investment since an investor would have lost money.

Retirement Share Analysis
Analyzing the retirement shares of the three mutual funds, based on the five-year annualized performance and cost data as of 12-31-2016, Growth Fund of America’s R-6 shares (RGAGX, the least expensive of the fund’s six R share classes) produced a positive incremental return of +1.52. However, Contrafund’s K shares (FCNKX) failed to provide any positive incremental return. It should be noted that mutual fund companies do not charge front-end loads on retirement shares, as it would create violations of ERISA’s rules and regulations.

Since Growth Fund of America’s R-6 shares did produce a positive incremental return, the next step in the AMVR analysis is to compare the costs of the fund to the costs of the benchmark fund. Based on the studies of well-respected experts such as Burton Malkiel and Mark Carhart2, the AMVR combines a fund’s annual expense ratio and John Bogle’s trading cost metric3 in calculating a fund’s total costs. The total costs on Growth Fund of America’s R-6 shares was 1.03 basis points (a basis point equals .01 percent), while the benchmarks total costs were only 31 basis points. Since Growth Fund of America’s total costs exceeded those of the benchmark. Growth Fund would not be a prudent or a suitable investment since an investor would have lost money.

“Closet index”, or “index hugger,” funds are mutual funds that hold themselves out as actively managed funds, but are funds, in truth, that provide similar returns as passively managed index funds, albeit at significantly higher annual fees/costs. Using an actively managed fund’s R-squared rating, Professor Ross Miller of SUNY-Albany created a metric that allows investors and investment fiduciaries to calculate the effective annual expense ratio investors pay given the reduced contribution of active management. A fund’s R-squared number estimates the correlation of performance between a fund and a relative market index.

Calculating the AER scores for both the retail and retirement share previously mentioned, again based on the five-year annualized performance and cost data as of 12-31-2016, resulted in an AER fee of 2.98 for the Growth Fund of America shares and an AER fee of 2.90 for Contrafund.

AER Adjusted AMVR Analysis
In performing my forensic analyses, I then go back and recalculate a fund’s AMVR score using the fund’s effective AER fee as an actively managed fund’s incremental costs. I add this extra step to address the ongoing “closet index” issue. Contrafund can be eliminated based solely on its failure to produce any positive incremental return for an investor. However, both funds would be considered imprudent and unsuitable investments using their AER numbers, since the AER numbers for both funds exceeds the incremental returns numbers both funds.

In assessing the prudence of a fiduciary’s investment decisions, the courts often turn to the Restatement (Third) Trusts. The Restatement and the Securities and Exchange commission have both cautioned investors and investment fiduciaries that evaluating investment based solely on the investment’s past performance is not enough, that factors such as an investment’s associated costs should be considered in determining whether the investment is a prudent investment option.4

The AMVR and the AER are two simple, yet effective, metrics that allow investors and investment fiduciaries to determine the cost efficiency of actively managed mutual funds. By identifying and avoiding mutual funds that are not cost efficient, an investor and/or investment fiduciary can better protect their financial security and avoid potential personal liability issues.


1. Securities and Exchange Commission, “Mutual Fund Investing: Look at More Than a Fund’s Past Performance,”(SEC Report), available online at
2. Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed. (W.W Norton & Co., 2016) 460; Mark M. Carhart, “On Persistence in Mutual Fund Performance,” The Journal of Finance, Vol. 52, Issue No. 1 (March 1997), 57-82.
3. John Bogle’s metric for calculating an estimate of a fund’s trading costs is [2 x fund’s stated annual turnover] x 0.60.
4. SEC Report; Restatement (Third) Trusts, Section 90 cmt h(2) and cmt m.

Appendix A
The following performance and cost information was used in performing the calculations referenced herein

Growth Fund Of America:
Five-Year Annualized Return: Retail-13.68 (load-adjusted); Retirement-15.42
Costs: Retail-Expense Ratio-0.66; Turnover-31%
Costs: Retirement-Expense Ratio-.33; Turnover-31%
Five-Year R-squared rating-88 (for both retail and retirement shares)

Five-Year Annualized Return: Retail-13.46; Retirement-13.58
Costs: Retail-Expense Ratio-0.68; Turnover-41%
Costs: Retirement-Expense Ratio-.58; Turnover-41%
Five-Year R-squared rating-85 (for both retail and retirement shares)

Growth Index Investors (retail)/Institutional (retirement) Fund:
Five-Year Annualized Return: Retail-13.90; Retirement-14.06
Costs: Retail-Expense Ratio-0.18; Turnover-11%
Costs: Retirement-Expense Ratio-.07; Turnover-11%

© 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 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, DOL fiduciary standard, elderly investment fraud, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, financial planning, investment advisers, investments, IRAs, pension plans, retirement plans, RIA, robo-advisors, special needs advice, special needs planning | Tagged , , , , , , , , , , , , , , , , , , , , ,

RIA Liability for Use of Third-Party Advertising

Recently I have made some comments on social media in connection with some posts made by American Funds with regard to the performance of some of their funds. As a securities/ERISA attorney, RIA compliance consultant and former compliance manager, the ads raised a number of potential issues for me.

As a former compliance manager, one of my duties was to review all advertising that third parties wanted our registered representatives to use in marketing their products. The first thing that I always did was to ask the mutual fund company to provide me with the NASD’s letter unconditionally approving the marketing piece. More often than not, they could not do so, as the NASD had raised issues that they felt needed to be addressed before they would unconditionally approve the marketing piece. Unless and until I had something indicating the NASD’s unconditional approval of the marketing piece, my reps were prohibited from using that document in any way, shape or form. We had good reps overall, and while we did not always agree on things, they knew that I was always acting in their best interest, even if they admitted to same begrudgingly.

One of the most common compliance mistakes I see with independent RIA firms is the failure to use third-party materials with out properly vetting such material. Third-party materials includes not only marketing/sales material from mutual funds and insurance companies, but also any third-party materials that the firm post on their web sites and/or blogs, such as guest posts and links to third-party web sites and blogs.

From a regulatory standpoint, any use of third-party materials results in the RIA firm’s express or implicit adoption of such material as their own, with the resulting potential liability exposure. When I discuss this compliance and consulting issue with my clients, the most common question is whether the inclusion of a disclosure can effectively limit their potential disclosure in such cases.

In connection with third-party marketing pieces, the mutual funds and insurance companies do not allow for modification of their materials, so a disclosure would be ineffective. In connection with guest articles on RIA company web sites and referral links, I am not personally aware of any enforcement actions or no-action letters that have stated that such disclosures would guarantee complete immunity from liability for such use of or reference to such third-party materials or sites.

I often receive requests from third-parties to allow them to post something on my two blogs. I often get an angry response when I refuse their request and try to explain to them the legal issues involved. As my former reps will tell you, I have a firm policy against making exceptions, as once you do so, everyone immediately points to the first time you do so.

As I tell my clients, if you decide to open up your own RIA firm, you also assume responsibility for knowing and enforcing all applicable compliance rules and regulations. That includes dealing with third-party marketing and compliance departments that will often try to dismiss you with the familiar “it’s OK, they said they were sending the unconditional approval letter” and “don’t worry, it’s just a minor thing and we’re taking care of it, so you can go ahead and use the ad.” Ask them to put those assurances in writing, and the story quickly changes.

The easiest and safest policy is to always request the letter from the applicable regulatory body unconditionally approving a marketing piece that the third-party has provided to you. I rarely allow guest posts on my blogs, and then only by close friends who I know and respect. Even then, I require them to submit the material for approval, complete with supporting cites or copies of supporting material in order to allow me properly vet the material. I generally advise my clients to just politely decline third-party requests to post on or link from the RIA’s sites.


Posted in compliance, RIA, RIA Compliance, securities compliance | Tagged , , , ,

Emerging Asset Allocation “Trap?”

As both a securities/ERISA attorney and a CFP® professional, I realize that I often see things from a different perspective that other in those professions. Some would say that is an advantage, others say it’s a disadvantage. I have definitely given me an opportunity to learn about emerging trends in investment adviser liability issues, which I in turn try to share with others to allow them to decide whether to address such issues and reduce unwanted liability exposure.

Financial advisers and investment advisers often use asset allocation software programs, commonly referred to portfolio optimizers, to produce recommendations for clients. These programs have been the subject of legitimate criticism due to the fact that most of them are based on a concept that has proven to be highly questionable.

However, based on my conversations with fellow securities attorneys, a new potential liability issue is emerging with regard to such asset allocation software programs. Asset allocation programs typically rely on data using generic asset categories in producing recommendations. The financial adviser or investment adviser must then select the actual investments to be used in implementing such recommendations.

This two-stage process can create potential liability exposure for an adviser due to the fact that the risk and return assumptions that the software program relied on are often significantly different from those of the actual investments chosen for implementation. The potential liability issues come from a failure to disclose such information to clients and/or a failure of an adviser to perform a check for consistency between the computerized recommendations and actual implementation.

Based on my 30+ years of experience as an attorney, compliance director/consultant, I would say that less than 25% of advisers disclose the recommendations/implementation to clients. Most advisers try to justify their failure to do so on the fact that their asset allocation program does not allow them to do an analysis using specific investments.

First, the fact that a software program will not allow an adviser to do an analysis using specific investments has nothing to do with making a disclosure regarding such issues. Second, there are now various online sites available to financial advisers and investment advisers that make it possible for advisers to create and analyze asset allocation recommendations using specific investments. So that excuse no longer has any merit.

When I was with AXA Advisors, I was the National Director of Financial Planning Quality Assurance. My department’s job was to review the financial plans and asset allocation recommendations before they were provided to a client. Once the plan and recommendations were delivered, if same were implemented. my department reviewed the implementation to ensure that it was consistent with the original plan and recommendations, or that any modifications were within permissible limits.

Since a client typically pays for a financial plan and/or an asset allocation module, the plan/module should have some inherent value. Consequently, it can be argued any implementation should be consistent with the plan’s/module’s original advice and recommendations.

This is exactly what a good securities attorney is going to argue. The exchange between an adviser and the attorney will typically go like this:

Attorney: You charged Mr. Smith $1,000 for the financial plan and asset allocation module you prepared for him didn’t you?
Adviser: Yes.
Attorney: And before you prepared the plan and module, you checked to see what the risk and return assumptions were that the software program was using in making its recommendations, didn’t you?
Adviser: Yes.
Attorney: You reviewed the financial plan and asset allocation module with Mr. Smith, correct?
Adviser: Yes I did.
Attorney: And after that review, you suggested various specific investments to Mr. Smith that he could use to implement the plan’s/module’s advice and recommendation, didn’t you?
Adviser: Yes.
Attorney: Prior to making such implementation recommendations, you did not compare the risk and return characteristics for the specific investments with the risk and return assumptions that the software program used in making its recommendations, isn’t that correct?
Adviser: My asset allocation does not allow me to do an asset allocation analysis based on actual investments.
Attorney: So you did not compare the risk and return characteristics for the specific investments with the risk and return assumptions that the software program used in making its recommendations, isn’t that correct?
Adviser: No, I did not do so because I did not have the means to do so.

At this point, an attorney will stop with the adviser’s admission of his/her failure to do a consistency of advice analysis, knowing that they have an expert who will testify to the existence of several online sites, that allow an adviser to do asset allocation analysis based on actual investments. Quite often, the combination of the failure to perform a consistency of advice analysis and the difference risk and return characteristics between program’s assumptions and the actual investments significantly strengthen an investor’s case. A good attorney will often throw in a reminder that the client had a paid a rather large fee for a plan and asset allocation analysis that, based on the adviser’s actions, had no inherent value to the client and was just a means to charge the client a needless fee.

I provide these arguments and examples to reinforce the need for honest advisers to recognize the potential liability issues and be proactive to reduce such potential liability exposure. The suggested best practices that I recommend to my clients are:

  1. Review the financial plan and/or asset allocation module to ensure that the advice and recommendations in same are fundamentally sound and appropriate for a client given their personal situation and financial parameters.
  2. Review and compare the risk and return assumptions and characteristics between an asset allocation software program and any actual investments being recommended to a client.
  3. If there are differences between such assumptions and characteristics, review all implementation recommendations to ensure that the implementation recommendations are consistent with the advice and recommendations contained in the plan and asset allocation module.
  4. If there are inconsistencies between the plan/asset allocation module and the implementation recommendations, determine if there equally effective and prudent options are available that are more consistent with those from the original plan/asset allocation module, using available online programs, such as, that allow asset allocation modeling based on actual investments. Document such due diligence and the actual results of such analyses.

Investment advisers are fiduciaries by law. Fiduciary law is very unforgiving. Good faith and honest intentions are irrelevant. There are no mulligans in fiduciary law or the ’40 Act. Know the law and regulations, including standards established by legal decisions.

Just remember the famous quote from Donovan v. Cunningham – “A pure heart and an empty head are no defense [to a breach of fiduciary claim].”



Posted in 401k compliance, 404c compliance, compliance, DOL fiduciary standard, elder law, elderly investment fraud, fiduciary compliance, fiduciary law, fiduciary standard, financial planning, investment advisers, investments, IRAs, pension plans, RIA Compliance, securities, special needs advice, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , ,

Special Needs Trusts and Your Value-Added Proposition

Excellent discussion and analysis on a subject that is gaining increasing attention by both financial planners, financial advisers and attorneys, as the need for such services continues to grow as people realize the significant benefits, and protection, that experienced professionals can provide.

Posted in elder law, elderly investment fraud, financial planning, investment advisers, special needs advice, special needs planning, trust realtionships, wealth management, wealth preservation | Tagged , , , , , , , , ,

Fiduciary Standard vs. Suitability Standard: The “Gotcha” That Won’t Go Away

There is currently a lot of speculation on how and if the new Trump administration will attempt to undo the DOL’s new fiduciary rule. Opinions range from an attempt to delay the effective date of the new rule to a complete repeal of the new rule. From a procedural standpoint, a complete repeal would appear to be unlikely, as pointed out in this article.

While the DOL’s new fiduciary rule arguably helps define the duties owed by financial advisers who provide investment advice to retirement plans and their participants, from a purely legal standpoint, those duties may already be sufficiently defined regardless of the actions the Trump administration may take.

Fiduciary is basically derived from a combination of the common law of trusts and agency, as set forth in the Restatements for both areas of the law. Certain types of financial advisers are already held to the high standards required under fiduciary law, namely that they always put a customer’s best interests first.  Registered investment advisers and ERISA fiduciaries are legally held to a fiduciary standard. In addition, some states impose a fiduciary duty on stockbrokers, who are generally not held to a fiduciary standard unless they have contractually agreed to such status, they are managing a customer’s account on a discretionary basis, or the courts have imposed such a standard on them.

Stockbrokers are generally held to a much lower standard which simply requires that any investment recommendations they provide to a customer be “suitable” for that customer given the customer’s personal investment parameters, including their financial goals and needs. From a regulatory standpoint, “suitability” is evaluated in terms of both the suitability of the investment recommendations vis-a-vis both the specific customer and the investing public in general.

While there are those that try to confuse the issues with regard to fiduciary prudence and/or suitability, I would suggest that two simple questions help to clarify the issues for both financial/investment advisers and securities attorneys.

(1) Is an investment that has consistently failed to produce a positive incremental return for an investor a prudent investment and/or suitable for any investor, given the opportunity costs it produces relative to comparable investment options?

(2) Is an investment whose incremental costs have consistently exceeded the investment’s incremental returns a prudent investment and/or suitable for any investor, given the financial losses it produces relative to comparable investment options?

Common sense tells you that any investment that consistently fails to provide a positive incremental return, or whose positive incremental returns are consistently exceeded by the fund’s incremental costs, is neither prudent nor suitable for any investor, as both situations ensure unnecessary financial losses for an investor. This is an argument that financial advisers and financial fiduciaries can expect to see on a more regular basis in securities and ERISA litigation due to both the simplicity of the argument itself and the simplicity in performing the calculations needed to prove such incremental costs and returns.

Various studies, including Standard & Poor’s well-known SPIVA reports, have shown that most funds fail to outperform their relative benchmark index fund. In some cases, the fund underperformance can be attributed to the fund’s higher incremental costs relative to the benchmark’s fees. In fact, a recent study concluded that a large percentage of actively managed mutual funds are priced to fail, as their fees and other costs sometimes negate their actual outperformance of their benchmarks based purely on returns.

Litigation against 401(k) plans has been a trend for several years now. 2016 saw the first fiduciary cases filed against private 403(b) plans. 2017 may well see the first fiduciary cases files against public 403(b) plans and non-profit plans. In many cases, the fiduciary breaches are so obvious that a simple incremental costs/returns analysis basically ensures that a settlement is the best option for resolving the action.

Stockbrokers and broker-dealers can expect to see an increased use of incremental costs/returns analysis to prove suitability violations as well. Investments that basically ensure a loss for investors, whether due to negative incremental returns or positive incremental returns negated by a fund’s incremental costs, will face an extremely difficult challenge in withstanding legal and/or regulatory challenges under even the suitability standard.

One trend in the investment industry has been the increase in dually registered financial advisers, those that are registered as as both registered representatives of their broker-dealer and as investment advisory representatives of a registered investment adviser. The challenge for dually registered financial advisers may be even more daunting, as the courts have undercut the popular “two hats” theory and clearly warned of the liability standard implications for such advisers:

The record shows clearly that, except for a few isolated instances, petitioner acted simultaneously in the dual capacity of investment adviser and of broker and dealer. In such capacity, conflicting interests must necessarily arise. When they arise, the law has consistently stepped in to provide safeguards in the form of prescribed and stringent standards of conduct on the part of the fiduciary.
(Hughes v. SEC, 174 F.2d 969 (1949)

© 2017 InvestSense, LLC.  All rights reserved.

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

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, fiduciary compliance, fiduciary law, fiduciary standard, investment advisers, investments, pension plans, retirement plans, RIA, RIA Compliance, securities, securities compliance, wealth management | Tagged , , , , , , , , , , , , , , , , , , , , , , ,