Friday, March 29, 2013

What's in a Name? - The "Pretend" "Advisor" and Fraud

I had the unique experience of having three guest speakers for my classes over the past two days. All three were from the life insurance / annuity industry and all three held Series 6 licenses, and hence were also registered representatives of a broker-dealer.

The guest speakers spoke of "cold calling" and "warm calling." They spoke of the high payouts available on annuities and permanent life insurance sales (as if that would be attractive for my students). They spoke of how they spend 60-70 hour weeks, most of it prospecting.

But what was really disturbing were two practices. First, they held themselves out as "advisors." Second, they all talked of the importance of gaining the trust and confidence of the clients.

In its 1940 Annual Report, the U.S. Securities and Exchange Commission noted:

If the transaction is in reality an arm's-length transaction between the securities house and its
customer, then the securities house is not subject' to 'fiduciary duty. However, the necessity for
a transaction to be really at arm's-length in order to escape fiduciary obligations, has been
well stated by the United States. Court of Appeals for the District of Columbia in a recently
decided case: ‘[T]he old line should be held fast which marks off the obligation of confidence
and conscience from the temptation induced by self-interest.  He who would deal at arm's length
must stand at arm's length.  And he must do so openly as an adversary, not disguised as confidant
and protector.  He cannot commingle his trusteeship with merchandizing on his own account…’

Seventh Annual Report of the Securities and Exchange Commission, Fiscal Year Ended June 30, 1941, at p. 158, citing Earll v. Picken (1940) 113 F. 2d 150.

In 1963, in its Special Report on the securities industry, the SEC also noted that it:

has held that where a relationship of trust and confidence has been developed between a broker-dealer
and his customer so that the customer relies on his advice, a fiduciary relationship exists, imposing a particular duty to act in the customer’s best interests and to disclose any interest the broker-dealer may
 have in transactions he effects for his customer … [BD advertising] may create an atmosphere of trust
and confidence, encouraging full reliance on broker-dealers and their registered representatives as professional advisers in situations where such reliance is not merited, and obscuring the merchandising aspects of the retail securities business … Where the relationship between the customer and broker is
such that the former relies in whole or in part on the advice and recommendations of the latter, the
salesman is, in effect, an investment adviser, and some of the aspects of a fiduciary relationship arise
between the parties.

1963 SEC Special Study.

In the latter half of the 20th Century new sales techniques evolved, as did salespersons’ view of themselves.  Codes of ethics were developed, high-pressure sales techniques were sometimes disavowed, and needs-based selling became a new paradigm.

Later this evolved into “trust-based selling” – now taught by consultants to practitioners, and by academics to their students.

Where do we stand today?  In the 2nd edition of the textbook, Sell (Cengage Learning, 2012), Professors Ingram, LaForge et. al. state that trust, when used as a sales technique, answers these questions:

    “1. Do you know what you are talking about? – competence; expertise
     2. Will you recommend what is best for me? – customer orientation
     3. Are you truthful? – honesty; candor
     4. Can you and your company back up your promises? – dependability
     5. Will you safeguard confidential information that I share with you? – customer orientation; dependability.”

(Sell, p.27).  In looking closely at the list above, it appears that questions 1, 3 and 5 are closely associated with the fiduciary duty of care.  Question 2 is close to the proposition of “acting in the client’s best interests” – one of the major aspects of the fiduciary duty of loyalty.  And Question 3, acting with honesty and candor, translates into the fiduciary duty of utmost good faith.

Of course, as any experienced financial advisor knows, trust-based selling is not just taught from books.  Many (if not nearly all) practice consultants extoll the virtues of a “consultative approach” as a means to not only secure the sale, but also to generate referrals.  Financial advisors are taught techniques such as the “Discovery Conference,” where exploring the personal details of clients’ lives results in building the foundations of trust for a long-term relationship.  Having experienced one of these workshops myself (which this author found to be extremely valuable in subsequently building his own financial planning practice), the stress is upon getting to know the clients, and their goals and values, extremely well, through a process designed to build trust and confidence – prior to any discussion by the financial advisor of a product or service.

There is nothing inherently wrong with a trust-based sales process.  In fact, one might applaud the depth of relationships between financial advisor and client that results from a trust-based, relationship-cultivation process.

Yet, under the law, there are two types of commercial relationships.  One is the arms-length relationship, in which seller and buyer negotiate with each other over the terms of the transaction at hand.  It is an adverse relationship, and from the customer’s perspective the doctrine of caveat emptor (“buyer beware”) applies.

The other type of relationship is the fiduciary-entrustor relationship.  In this type of relationship the provider of services (either management of assets, or the provision of advice) adopts a wholly different role.  The fiduciary becomes bound by fiduciary duties of due care, loyalty and utmost good faith to the entrustor (the “client” in our context of investment or financial advice).  The fiduciary, in essence, “steps into the shoes” of the client, and makes the decisions (or provides the advice) as if the fiduciary was the client.  In other words, the fiduciary is bound to act in the sole or best interests of the client.  As explained by Professor Laby, “What generally sets the fiduciary apart from other agents or service providers is a core duty, when acting on the principal’s behalf, to adopt the objectives or ends of the principal as the fiduciary’s own.”  [Arthur B. Laby, SEC v. Capital Gains Research Bureau and the Investment Advisers Act Of 1940, 91 Boston Univ. L.Rev. 1051, 1055 (2011).]

Somewhere along the way, the practice consultants omitted to tell the financial advisors that “trust-based selling” - designed to achieve a relationship of trust and confidence - results in consumer confusion, at the minimum.  More importantly, trust-based selling increases the likelihood of fiduciary status for the financial advisor, applying state common law.  This is true regardless of how the financial advisor is licensed or regulated (whether as a registered representative of a broker-dealer firm, investment adviser representative of a registered investment adviser firm, dual registrant, or even just a life insurance agent).

In essence, trust-based selling often transforms arms-length, commercial buyer-seller relationships into fiduciary-client relationships.

In recent years massive marketing campaigns by Wall Street firms have touted their “objective advice” from “financial consultants” who attended their client’s soccer games and made so many believe that the “advice” received would result in the ability to afford that second home on the beach.  Even long-respected firms like Goldman Sachs have been perceived, at least at times and by some, to “throw clients under the bus” [see], apparently in violation of their adopted Code of Business Conduct and Ethics in which the firm commits “to conduct our business in accordance with … the highest ethical standards.”

And, as seen recently in my classroom, the brokers / life insurance agents before me (none of whom possessed Series 65/66 licensure), all stated that they always called themselves "advisors" and "consultants" - and one even stated, "My firm wants me to call myself a salesman, but if I did that I would be unable to secure appointments."

There exists a fundamental truth that “to provide biased advice, with the aura of advice in the customer’s best interest, is fraud.” [Angel, James J. and McCabe, Douglas M., Ethical Standards for Stockbrokers: Fiduciary or Suitability? (September 30, 2010), at p.23.  Available at SSRN:]

It has not always been so. Only lax enforcement by the SEC, FINRA (whose multiple failures to raise standards are well-known), and others in recent decades is to blame.

But I sense a shift in the tide. There are many of us who believe that frauds should not go unchallenged, and that consumer confusion should not be permitted to exist forever.

Those who use titles and designations, such as "financial advisor" or "CFP" or "ChFC" or "financial consultant" - and who then don't adhere to the fiduciary obligations attendant to such representations - in essence commit intentional misrepresentation. Let's call it for what it is - "fraud" - plain and simple.

The time has nearly arrived, as DOL and SEC rulemaking is soon underway, to speak up.  And speaking up will be essential, given the hundreds of millions of dollars of lobbying efforts being spent by those who desire to continue existing fraud-ridden sales practices.

Who should speak up?
  • Those advisors who desire that consumers not be misled, and instead receive trusted advice - when trusted advice is provided and/or (through use of titles or designations) represented as being provided.
  • Consumers themselves, tired of having their trust betrayed by those who do not subscribe and adhere to their fiduciary obligations.
  • Those federal and state securities and insurance regulators, as well as advisors and consumers, who desire that truth be spoken, and who desire to combat the pervasive misrepresentations and frauds that have crept into the financial services industry in recent decades.
We should not live in a society in which pervasive fraud - i.e., holding out as trusted advisors, and then failing to adhere to the duties imposed from the resulting fiduciary rleationship - is continued to be permitted to occur.

There is a simple maxim I heard expressed by a state securities commissioner nearly a decade ago. "Do not lie, cheat or steal. Say what you do. And do what you say.

Enough said. For now. More on this subject, and how to reach out to the SEC and DOL, in the weeks to come. - Ron Rhoades, JD, CFP(r)

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Tuesday, March 26, 2013

Enable a College Student to Attend a Financial Planning/Investment Conference

"Attending this conference was the best three days of my college life," one student informed me, at midnight on a snowy night after returning in our van to Alfred State College with nine other students from the NAPFA East conference in Brooklyn, New York, in October 2011.

Another student, Delaney Dugan, a 21-year-old Alfred State senior from Rochester, N.Y., was working that year on completing her Bachelor’s degree in Financial Planning. Attending NAPFA’s conference in Brooklyn put her among people she understood, Delaney said. “I can’t stop smiling,” she said. “I’m a Type-A personality, and there are 300 people here who are just like me.”

After taking this group of 10 students to this 3-day industry conference, each student, in turn, echoed similar thoughts. Even into the following week, the experience of networking with practitioners was all they wanted to talk about during class discussions. I also quickly found that each and every student, already performing at high levels, became even more motivated in their studies. And the students definitely became more excited about their own futures as financial planners and confident in their choice of careers.

As I related to a journalist at the time, “The key is bringing the students closer to the real world. Students can only learn so much from professors. I have seen our students networking at breakfast, listening to speakers from the financial planning professsion, and soaking up information like sponges. They relate each session to what they've learned already in class, sometimes confirming what they know, and at other times challenging their thinking on a particular subject.  The practitioners they meet freely share their knowledge. The students are so excited to be here, and it's such a great experience.”

Yet, that first trip to an industry conference, in Fall 2011, was substantially funded out of my own pocket and also from a generous grant award from NAPFA's Northeast/Mid-Atlantic Region Board of Directors. Since then, I quickly learned, after transitioning from a financial planning practice to the world of academia, that my own income has shrunk substantially. Not that I'm complaining, mind you. The opportunity to provide instruction to these young college men and women, to expand their minds and put them on the road to successful careers, brings more joy to me than any amount of money ever could. And, of course, our industry organizations have limited resources of their own, especially in this era of competition from numerous conferences.

This past year, while I requested students to fund a greater portion of the trip themselves, I've found that nearly every college student of day has very limited funds to devote to attending a multi-day conference. So, while I've been able to offer shorter day trips to students (at no or very little cost to them) to attend very worthwhile Financial Planning Association chapter luncheons and dinners locally, the students have missed out on the absolutely life-enhancing experience they receive in attending a multi-day conference in a larger city.

Hence, I'm reaching out here. The goal is to raise $3,000. This amount is enough to fund the attendance by 10 of our program's students to industry conferences over the next year, when I combine the amount with support from myself and the College. (And I'll continue to pay all of my own costs, when accompanying the students; every dollar you contribute goes to assist students, with no funds for administration or marketing or any other "overhead".)

You may ask - what events will the students attend over the coming year? Each year we look at the locations of industry conferences to see where we can get the most "bang for the buck." Conferences we are likely to consider over the next year are NAPFA East, FPA conferences, and the RISE 2014 conferences. We are hoping to get discounts to enable us to look at attending custodians' conferences, IMCA events, CFA Institute events, and other similar conferences as well.  We typically choose one 2-3 day conference each term, and we try to take 10-12 students to each conference.

Rest assured, we will stretch every dollar, to get the most "bang for the buck." Students stay 3 or 4 to each room; transportation costs are kept minimal by using college vans, and meals are at Subway or similar venues.

Your donation goes to the "Alfred State College Development Fund, Inc." (a qualified charity), where our college administration ensures that each and every dollar received from your donation is devoted to our Financial Planning Program students and is spent on the costs of attending conferences, and nothing else.

And, be further assured that the experience you provide our students will enable a student to learn a great deal, network with existing practitioners (always a huge learning experience, and often leading to internship and job opportunities), and get really excited about the profession they are about to enter. Students come back more motivated in their studies, eager to expand their horizons even more, and more confident in their own abilities.

What can we offer in return? My gratitude, and that of our students. All donees will receive a report of the students' experiences. You will learn of their joys, their triumphs, their exposure to the "real world," and you will feel the passion they possess.

How important is it to provide this opportunity? Consider how it impacts each student's ability to acquire knowledge and their perspectives on engagement with other advisors:
  • “Everyone has a different perspective on a topic – which surprised me,” added Nick McMichael, a senior from Alfred, NY.  “The speaker would make a lot of sense, but then you’d talk to someone after the session who has other ideas.  That’s the difference between being a professional with experience and still learning as a student.”
  • For fellow senior Joshua Wing (Hornell, NY), the conference added layers of knowledge to what he has learned in class.  “We do a lot of projects in school to get into the thought process of being an advisor. Part of that is how to get information if you don’t know the answer,” he said. “And that’s why advisors go to conferences and help each other out."
While any donation is appreciated, here are some suggested levels of giving:
  • $ 495 Emerald Sponsor- to sponsor one student
  • $ 248 Platinum Sponsor - to co-sponsor one student
  • $ 124 Gold Sponsor - to co-sponsor a student one student 
  • $   62 Silver Sponsor - to help out
  • $   36 Bronze Sponsor - to help out
  • $   18 Titanium Sponsor - to help out

Thank you in advance for your consideration of this request.

And, if you desire further information, please just drop me an e-mail and I'll get back to you quickly.

Thank you again.

Ron A. Rhoades, JD, CFP(r)
Program Coordinator, Financial Planning Program
Alfred State College, E.J. Brown Hall #301
10 Upper College Drive
Alfred, NY 14802


Sunday, March 24, 2013

Exploring Aspects of the Fiduciary Advisor's Duty of Due Care: Tibble v. Edison

A recent case arising out of ERISA provides me with the opportunity to express some comments on the fiduciary adviser's duty of due care.

  • Cases arising under ERISA, while a different body of fiduciary law, can provide insight into fiduciary advisers' duty of due care, including due diligence.
  • Under ERISA, a plan sponsor must exercise good judgment in approving the recommendations made by fiduciary (or non-fiduciary) advisers to the plan.
  • For accounts not governed by ERISA, clients possess a reasonable expectation that the investment strategy you recommend will be "prudent." But proving that your investment strategy is "prudent" can be difficult. 
  • Hence, carefully crafter explanations of your investment strategy may be required, especially where academic evidence and/or back-testing is not available.
  • Mutual fund fees and costs matter, and must be taken into account (along with other factors) in the selection of mutual funds when undertaking the fiduciary's duty of due care (i.e., due diligence).
  • Expect greater judicial scrutiny of 12b-1 fees, especially within the context of ERISA.
  • Future rule-making by the DOL/EBSA may well "toughen up" the duties of plan sponsors and their fiduciary advisers.

I use the term "fiduciary adviser" to refer to all those operating under a fiduciary standard of conduct, and regardless of your licensure. Unknown to most registered representatives of broker-dealer firms, when providing personalized investment advice they are already (likely) fiduciaries applying state common law. (Dodd-Frank Action Sect. 913 permits the SEC to impose fiduciary standards upon brokers and their registered representatives; however in many instances fiduciary standards already exist under state common law for those providing personalized investment advice. I will discuss this issue in a later blog post.

Additionally, many dual registrants seek to "remove the fiduciary hat" following presentation of a financial plan; while such may be permitted under a 2007 SEC proposed rule (never finalized), state common law imposes strict requirements upon attempts to remove the fiduciary hat, in recognition that fiduciary status attaches to relationships, not accounts. Moreover, your designation on an account form or other agreement with the client as to whether fiduciary duties exist is not controlling; state common law applies fiduciary status based on what occurs, not (for the most part) based upon your attempts to have the client waive fiduciary status. I will discuss this issue in future blog posts.

TIBBLE V. EDISON: THE FACTS.  On  March 21, 2013, in the long-watched case of Tibble v. Edison, the 9th U.S. Circuit Court of Appeals affirmed a district court opinion that a plan sponsor was imprudent for including retail mutual funds without investigating the possibility of institutional share classes. Additionally, the Court discussed the limits of a plan sponsor to delegate away the plan sponsor's fiduciary duties. I discuss these aspects of the case, and also discuss how this Court's decision can provide guidance to fiduciary advisors acting outside of ERISA's application. Along the way, I seek to illuminate some principles which may assist fiduciary advisors in their duty of due care.


Where Can We Look for Guidance on Fiduciary Standards?  Too often fiduciary advocates bemoan a lack of reported decisions arising under the Investment Advisers Act of 1940 and state common law. In large part this lack of decisions is due to mandatory arbitration under FINRA. As a result, few decisions applying either the Advisers Act or state common law address various aspects of the duty of due care which investment advisers possess. Yet, another body of law - with a large number of reported decisions - exist - cases applying ERISA to qualified retirement plans.

The Duty of Loyalty: ERISA vs. Advisers Act/Common Law.  ERISA's guidance as to dealing with conflicts of interest and other aspects of the duty of loyalty are not fully applicable to fiduciary advisers who deal with accounts not governed by ERISA. Rather than the "best interests" standard applicable under the Advisers Act and state common law fiduciary standards, ERISA applies the strict "sole interests" standard found in trust law [“common law trust principles animate the fiduciary responsibility provisions of ERISA.” Acosta v. Pac. Enters., 950 F.2d 611, 618 (9th Cir. 1991); see also Cent. States, Se. & Sw. Areas Pension Fund v. Central Transp., Inc., 472 U.S. 559, 570–71 (1985) (identifying the statutorily prescribed duties of loyalty and of prudence as imported from trust law)].

By way of general explanation, the "sole interests" standard prohibits most conflicts of interests, while under the best interests standards most (but not all) conflicts of interest are permitted - provided full disclosure of all material facts is affirmatively made in a manner which ensures client understanding, the client provides informed consent (which would not exist if the client were harmed by the recommendation), and the transaction recommended is otherwise substantively fair to the client.

The Duty of Due Care: ERISA Cases Matter to non-ERISA Situations.  However, most aspects of the fiduciary duty of due care does not tremendously vary as between the law under ERISA, the Advisers Act, and state common law.  Hence, for guidance on how investment advisers should undertake due diligence, and other aspects of the fiduciary duty of due care, we can look to ERISA case law for guidance. However, particular language within ERISA may vest greater discretion in plan sponsors than seen for other types of fiduciaries.


Plan Sponsors Cannot Defer All Decisions to Investment Advisors.  In Tibble v. Edison, the appellate court rejected the plan sponsor's (Edison's) argument that it had relied on the advice of its investment consultant, Hewitt Financial Services LLC, to make its selection, ruling that there was enough evidence to show that an experienced investor would have considered a wider variety of share classes during the mutual fund selection process.  “Just as fiduciaries cannot blindly rely on counsel, or on credit rating agencies, a firm in Edison’s position cannot reflexively and uncritically adopt investment recommendations,” the panel said in its ruling.


Generally, The Fiduciary Duty of Plan Sponsor In Selection of Funds to Include.  The plan sponsor attempted to argue that its duties were fully abrogated by including 50 mutual fund choices, which participants could then select from. The Court rejected this argument, quoting the preamble of a 1992 DOL regulation (later codified in 2010 as part of a regulation): "'the act of limiting or designating investment options which are intended to constitute all or part of the investment universe of an ERISA section 404(c) plan is a fiduciary function which ... is not a direct or necessary result of any participant direction.' 57 Fed. Reg. 46,922, 46,924 n.27 (Oct. 13, 1992) ... See 75 Fed. Reg. 64,910, 64,946 (Oct. 20, 2010) (codified at 29 C.F.R. pt. 2550) (Section 404(c) 'does not serve to relieve a fiduciary from its duty to prudently select and monitor any service provider or designated investment alternative offered under the plan') cogently explained by DOL in its brief, 'the selection of the particular funds to include and retain as investment options in a retirement plan is the responsibility of the plan’s fiduciaries, and logically precedes (and thus cannot ‘result[] from’) a participant’s decision to invest in any particular option.'"

How might these principles apply outside of ERISA? Well, obviously, you possess a fiduciary duty of due care, in the nature of due diligence, in selecting mutual funds to recommend to your clients. If you client is a trustee or other type of fiduciary, then that client may not completely rely upon your advice - the client must still exercise good judgment in evaluating your recommendations.

Also, suppose you, as an investment adviser, present three investment portfolio options to your client to choose from: A, B and C. Your recommendation to the client is Investment Portfolio A. But your client chooses Investment Portfolio C. Later, it is discerned by the client that some aspect of your due diligence for the investment strategy or investment products for Portfolio C failed to meet your duty of due care. Are you insulated from liability because you recommended Portfolio A to the client? No. All three investment portfolio options should be formulated by you with appropriate due diligence. See, e.g., Langbeckerv. Elec. Data Sys. Corp., 476 F.3d at 321 (Reavley, J., dissenting) (“All commentators recognize that § 404(c) does not shift liability for a plan fiduciary’s duty to ensure that each investment option is and continues to be a prudent one.”).

In other words, each and every investment strategy and investment product you recommend you meet your fiduciary obligations under the duty of due care. I explore this further in the next section.

Exploring the General Nature of Investment Strategy and Investment Product Selection: The Fiduciary Duty of Due Care and the Prudent Investor Rule.  Does this mean that you should only recommend investment portfolios which satisfy the "Prudent Investor Rule"? No, if you are operating outside of ERISA. (If you are operating within ERISA, the fiduciary duty of due care cannot be waived by the plan participant; however, certain exceptions exist for self-directed brokerage accounts).

Outside of ERISA, the Prudent Investor Rule is not applicable to all investment portfolios recommended by fiduciary advisors. However, in a few states the Prudent Investor Rule applies to certain situations either by statute or through case law. In any event, it is the reasonable expectation of your client, at the commencement of each relationship, that you will recommend a prudent investment portfolio - until you disclose otherwise and secure the client's informed consent. Hence, it would be prudent for you to let your clients know if the investment strategy you recommend meets, or does not meet, the requirements of the Prudent Investment Rule.

Of course, if your recommendations are challenged, the burden falls to you to prove the prudence of your investment strategies. And to undertake such proof, you need to get it admitted into evidence. Your "expert opinion" is not likely to be admitted. And, surprisingly, the opinions of many other "experts" are also not likely to be admissible. This poses a real challenge in meeting your burden of proof.

Proving Your Investment Strategy / Investment Product Selection is "Prudent" - It's Difficult!  By way of explanation, the admission of expert testimony in federal court is governed by Federal Rule of Evidence Section 702.  Generally, if scientific, technical, or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education, may testify thereto in the form of an opinion or otherwise, if: (1) the testimony is based upon sufficient facts or data; (2) the testimony is the product of reliable principles and methods; and (3) the witness has applied the principles and methods reliably to the facts of the case. In addition, expert testimony must be both relevant and reliable to be admitted. Daubert v. Merrell Dow Pharms., Inc., 509 U.S. 579, 589, 113 S. Ct. 2786 (1993). Similar standards of the admission of expert testimony exist in state courts (applying Frye  or Daubert standards for admission of expert testimony, or some combination of the rationale of these cases).

Under the Daubert standard, a judge or arbitrator makes a threshold determination regarding whether certain scientific knowledge would indeed assist the trier of fact (the jury, judge, or arbitration panel).  This entails a preliminary assessment of whether the reasoning or methodology underlying the testimony is scientifically valid, as well as whether that reasoning or methodology properly can be applied to the facts in issue.  This preliminary assessment can turn on whether something has been tested, whether an idea has been subjected to scientific peer review or published in scientific journals, the rate of error involved in the technique, and even general acceptance, among other things.   It focuses on methodology and principles, not the ultimate conclusions generated.

In essence, if an investment adviser purports to utilize a “prudent” investment strategy, the investment adviser would be well-advised, to manage his or her fiduciary risk, to insure that the evidence developed by the investment adviser supportive of the investment adviser’s adopted investment strategy will clear the same threshold analysis a court would employ as to whether expert testimony on the same point would be permitted.  However, while the admissibility of expert testimony focuses on the methodology and not the results,  the investment adviser would be wise to focus on both methodology and results.  In other words, not only will an investment adviser, if his or her investment strategy is later challenged, desire to ensure that expert testimony is available, but that the results of that expert analysis favor the investment strategy adopted. In other words, both procedural due process (proper due diligence methodology) and substantive due diligence (the exercise of good judgment at each step in the process) are important.

Has your overall investment strategy, utilized for the benefit of your clients, been submitted to analysis involving back-testing over multiple time periods? Or, is your portfolio construction strategy based upon generally accepted academic research from multiple sources? If not, what will you do if called upon later to defend your investment strategy?  Or should you disclose in your Form ADV Part 2A that your investment strategy either is not capable of being tested, or that it lacks academic support?

From this author’s review of the academic literature, it appears that relatively few investment strategies, as to the design of portfolios for individual clients, withstand rigorous academic scrutiny.  Some other investment strategies receive mixed reviews and remain the subject of continued discussion.  The challenge for the investment adviser is to sift through the academic evidence, first by throwing out those studies which appear to possess an insufficient sample size, inappropriate benchmark, which rely upon data which suffers from survivorship bias, or in which the author appears to suffer from bias or potential bias.

Hence, an investment adviser may desire to seek answers to the following questions, when undertaking an analysis on any particular investment strategy:
    A. Can the investment strategy be tested?  In other words, are there one or more reliable scientific processes or techniques which may be utilized to assess the investment strategy?
    B. If so, then either:
         (1) Have published academic articles subjected the investment strategy to peer review, and what are the results of that peer review process?  In other words, as a result of academic discourse, has the investment strategy gained general acceptance in the academic community?
          (2) Have you back-tested the investment strategy yourself?  If so, was the back-testing methodology you utilized accepted in the industry?  What is the rate of error seen in that testing methodology relatively low (and, as a result of achieving a low rate of error, did you ensure that “data mining” was unlikely to be present in your testing process)?

What if you are not using academic evidence in your design and management of client portfolios? For example, what if you are using your own qualitative judgment, such as to predict market movements from your own analysis of the macro-economic environment, then back-testing is inapplicable (although you may present your own performance history, if properly computed and presented with applicable disclosures). Additionally, your own qualitative judgment is highly unlikely to be the subject of academic reserarch. Hence, in such a case, you should likely disclose that the investment strategy you recommend is not in accord with the prudent investor rule (although you may think otherwise, you cannot prove it), and then you should further describe your investment strategy in Form ADV, Part II (and disclose risks attributable to that investment strategy, including "manager risk" - i.e., the risk that your judgment will be wrong).


Higher-Cost Retail Funds vs. Institutional Funds.  In Tibble v. Edison, the Court noted that "in 1999 the Plan grew to contain ten institutional or commingled pools, forty mutual fund-type investments, and an indirect investment in Edison stock known as a unitized fund. The mutual funds were similar to those offered to the general investing public, so-called retail-class mutual funds, which had higher administrative fees than alternatives available only to institutional investors."

The Tribble Court's decision is instructive in its review of basic rquirements of the fiduciary duty of due care under ERISA:

ERISA demands that fiduciaries act with the type of “care, skill, prudence, and diligence under the circumstances” not of a lay person, but of one experienced and knowledgeable with these matters. 29 U.S.C. § 1104(a)(1)(B). Fiduciaries also must act exclusively in the interest of beneficiaries. Id. § 1104(a)(1). These obligations are more exacting than those associated with the business judgment rule so familiar to corporate practitioners, Howard v. Shay, 100 F.3d 1484, 1489 (9th Cir. 1996), a standard under which courts eschew any evaluation of “substantive due care.” Brehm v. Eisner, 746 A.2d 244, 264 (Del. 2000), cited in Pac. Nw. Generating Coop. v. Bonneville Power Admin., 596 F.3d 1065, 1077 (9th Cir. 2010). To enforce this duty of prudence, we consider the merits of the transaction and “the thoroughness of the investigation into the merits of the transaction.” Howard, 100 F.3d at 1488 (emphasis added). Courts are in broad accord that engaging consultants, even well-qualified and impartial ones, will not alone satisfy the duty of prudence. See George v. Kraft Foods Global, Inc., 641 F.3d 786, 799–800 (7th Cir. 2011) (collecting cases from the Second, Fifth, Seventh, and Ninth Circuits).

Under the common law of trusts, which helps inform ERISA, a fiduciary “is duty-bound ‘to make such investments and only such investments as a prudent [person] would make of his own property having in view the preservation of the [Plan] and the amount and regularity of the income to be derived.’” In re Unisys., 74 F.3d at 434 (quoting Restatement (Second) of Trusts § 227 (1959)) (first alternation in original).

As set forth above, the fiduciary duty of due care arising under ERISA is very similar to the fiduciary duty of due care applicable to all fiduciary advisers who provide personalized investment advice. Does this mean that institutional funds, or low-cost mutual funds, must be the only offerings recommended by a fiduciary adviser? No. As the Tibble Court stated: "The Seventh Circuit has repeatedly rejected the argument that a fiduciary “should have offered only ‘wholesale’ or ‘institutional’ funds.” See Loomis, 658 F.3d at 671; Hecker, 556 F.3d at 586 (“[N]othing in ERISA requires [a] fiduciary to scour the market to find and offer the cheapest possible fund (which might, of course, be plagued by other problems).”). We agree. There are simply too many relevant considerations for a fiduciary, for that type of bright-line approach to prudence to be tenable. Cf. Braden v. Wal-Mart Stores, Inc., 588 F.3d 585, 596 (8th Cir. 2009) (acknowledging that a fiduciary might “have chosen funds with higher fees for any number of reasons, including potential for higher return, lower financial risk, more services offered, or greater management flexibility”).

While other factors (other than fees and costs) are indeed a consideration, I would note that a substantial body of academic research suggests that the level of mutual fund fees and costs is a very substantial and often the best indicator, on average, of the long-term returns of the mutual fund relative to funds with the same investment strategy (i.e., same asset class). I suspect that future cases arising under ERISA, especially after the "Definition of Fiduciary" rule is adopted, will explore this academic research in detail, and then apply it.

In the interim, there is no question that a fiduciary adviser bears responsibility to ensure that all of the fees and costs borne by the client are substantively fair and reasonable. Each and every fee and cost expended should be for services (or management) which is believed to result in value to the client. Fees that don't add value to the client are suspect. In this respect, as I opined in an earlier blog post ( that revenue-sharing payments in the nature of 12b-1 fees are highly suspect - and fiduciary advisers (regardless of how registered) would do well to avoid all mutual funds which possess 12b-1 fees. The Tribble court, in dicta, also noted the area of 12b-1 fees as an area for further exploration by the courts, stating:

Mutual funds generate this revenue by charging what is known as a Rule 12b-1 fee to all investors participating in the fund. Edison takes the position that because that fee applies to Plan beneficiaries and all other fund investors alike, the allocation of a portion of that total 12b-1 fee to Hewitt is irrelevant. As it put the matter at oral argument: “the mutual fund advisor can do whatever it wants with the fees; sometimes they share costs with service providers who assist them in providing service and sometimes they don’t.” This benign-effect, of course, assumes that the “cost” of revenue sharing is not driving up the fund’s total 12b-1 fee and, in turn, its overall expense ratio. It also assumes that fiduciaries are not being driven to select funds because they offer them the financial benefit of revenue sharing. The former was not explored in this case and the evidence did not bear out the latter, but we do not wish to be understood as ruling out the possibility that liability might—on a different record—attach on either of these bases.

I repeat my warning - if you are either a registered representative of a broker-dealer firm, or an investment adviser representative of a registered investment adviser firm - be extremely wary of recommending any mutual fund share class that includes 12b-1 fees.


One aspect of the Tribble v. Edision decision I find very troubling. The Plan, by its express terms, provided that the employer pay the costs of the plan. But the Court held that this language did not prevent revenue-sharing payments, which permitted recordkeeping services to be paid by revenue-sharing payments, in essence relieving the employer of the need to pay certain costs.  The Court stated: "Section 19.02 required the company to pay the costs, and Edison did. Although beneficiaries argue that the “costs” are the expenses associated with Hewitt before the offsets, the more natural reading is that 'costs' simply are whatever bills Hewitt presented Edison with. Under this commonsense reading, the Plan merely assigned Edison an affirmative obligation to pay. It did not, as beneficiaries would have it, prohibit 'Hewitt’s recordkeeping services from being paid by a third party such as mutual funds.'"

To me, this seems a distortion of plain English. However, various additional facts exist which may have led the court to such a conclusion. Additionally, the court noted that the "DOL, though, has issued several non binding advisory opinions staking out the position that a fiduciary does not violate section 406(b)(3) so long as 'the decision to invest in such funds is made by a fiduciary who is independent' of the fiduciary receiving the fee. DOL Advisory Op. 2003-09A, 2003 WL 21514170 (June 25, 2003); see also DOL Advisory Op. 97-15A, 1997 WL 277980 (May 22, 1997) (fiduciary that “does not exercise any authority or control” to cause the suspect investment is not liable)."

I can only hope that the new "Definition of Fiduciary" rule, to be promulgated by DOL/EBSA later in 2013, and hopefully adopted in 2014 as a final rule, and the interpretations flowing therefrom, will correct this result. For more on the DOL/EBSA's courageous rule-making effort, please see my earlier blog post at


The Tribble v. Edison decison has provided me, in this blog post, with this initial opportunity to explore a couple of subjects near and dear to me - the fiduciary duty of due care, and, specifically, the issue of mutual fund fees and costs.  There are many aspects of the fiduciary duty of due care, as it affects investment strategy selection, investment products (of which there are many types) selection, financial planning, etc. This blog post just touches on a few aspects of that fiduciary duty. In future blog posts I will seek to elaborate more on various aspects of the fiduciary duty of due care.

As I have previously cautioned those who work in larger firms, don't assume that your firm's due diligence is up-to-snuff. Many a representative of a firm has been implicated in client complaints and lawsuites when the firm's due diligence was blindly relied upon.

What can you do, as a fiduciary adviser, to ensure better adherence to your fiduciary duty of due care with regard to your investment recommendations?
  • Undertake due diligence on the investment strategies you recommend. Ensure that your disclosures regarding the risks of those investment strategies are robust. If your investment strategy is not "provable" by academic evidence (past generally accepted research and/or back-testing), then consider a disclosure that your investment strategy may not be in accord with the prudent investor rule (to dispel any client expectations to the contrary).
  • Learn more about the world of investments, and investment strategies - and maintain your knowledge. A great deal of academic research exists. Textbooks on investing (such as the Bodie, Kane texts) exist. Read articles in financial planning / investment advisory publications (always being mindful if the writer has a hidden, or not-so-hidden, agenda). Go to financial planning and/or investment advisory conferences each year, to keep up-to-date on new strategies and/or new research. Better yet, explore conferences and services directed at the obligations of fiduciary advisers. (For example, the fi360 National Conference, held each Spring. See
And, of course, consider following my blog. When I post updates to my blog, I announce them on Twitter (@140ltd), and on LinkedIn and Facebook (please feel free to connect with me).

All my best. - Ron Rhoades, JD, CFP(r), Program Director, Financial Planning Program, Alfred State College. E-mail:

Thursday, March 21, 2013

12b-1 Fees: RIAs and Registered Representatives Beware

Does the Receipt of 12b-1 Fees Subject Registered Representatives to IAA? Are 12b-1 Fees Anti-Competitive? Are Class C Mutual Funds the Next Scandal? Should Independent RIAs Avoid Funds with 12b-1 Fees?


Some funds charge an annual fee to compensate the distributor of fund shares for providing ongoing services to fund shareholders. This fee is called a 12b-1 fee, after the SEC rule authorizing it. The 12b-1 fee is paid by the fund and reduces net asset value.

It appears that 80% of 12b-1 fees received by a fund are used by mutual funds to compensate broker-dealer firms.

Class C shares, which usually charge the maximum 1% annually in 12b-1 fees, usually do not convert to another class. Class C shares are often called "level load" shares, although the "load" (i.e., "commission") appears to be of an ongoing nature - tied not to the transaction but to the continued holding of the fund.


In its January 2011 report, mandated by Section 913 of the Dodd-Frank Act, the SEC staff noted the ways that brokers receive compensation: “Generally, the compensation in a broker dealer relationship is transaction-based and is earned through commissions, mark-ups, mark-downs, sales loads or similar fees on specific transactions, where advice is provided that is solely incidental to the transaction. A brokerage relationship may involve incidental advice with transaction-based compensation, or no advice and, therefore no charge, for advice.” Staff of the U.S. Securities and Exchange Commission, Study on Investment Advisers and Broker-Dealers As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Jan. 2011) (hereafter “SEC Staff 2011 Study”), available at, at pp. 10-11.

Interestingly, the SEC Staff did not comment the fact that brokers also receive compensation which is in the form of asset-based compensation, similar to the “assets under management” fee structure of most investment advisers, such as 12b-1 fees and payment for shelf space. 12b-1 fees have been criticized by this author as possible “special compensation” and “investment advisory fees in drag.” See Ron Rhoades, “7 reasons why wirehouses shouldn’t milk the old business model,” RIABiz, Jan. 28, 2010 (available at

The U.S. Court of Appeals decision in Financial Planning Association vs. SEC, No. 04-1242  (D.C. Cir., March 30, 2007), possesses potentially far-reaching implications. Three times in that decision the Court emphasized that the term “investment adviser” was “broadly defined” by Congress.  Additionally, in discussing the exclusion for brokers (insofar as their advice is solely incidental to brokerage transactions for which they receive no special compensation), the U.S. Court of Appeals stated:

“The relevant language in the committee reports suggests that Congress deliberately drafted the exemption in subsection (C) to apply as written. Those reports stated that ‘investment adviser’ is so defined as specifically to exclude ... brokers (insofar as their advice is merely incidental to brokerage transactions for which they receive only brokerage commissions) ….” [Emphasis added.]

As a result of this language, all arrangements in which broker-dealer firms and their registered representatives receive compensation other than commission-based compensation should be reviewed to see if the definition of “investment adviser” found in 15 U.S.C. §80b-2.(a)(11) applies: “Investment adviser” means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities ….”

The receipt of 12b-1 fees by broker-dealer firms and their registered representatives are, by the SEC’s own admissions, “asset-based fees” and “relationship compensation.” The written submissions to the SEC by many brokerage industry representatives, in connection with earlier hearings on this issue, expressly admitted that 12b-1 fees are utilized in large part to compensate registered representatives for the fostering of an ongoing relationship between the registered representative and the investor, including the provision of investment advice over time with respect to a customer’s personal circumstances, and including financial planning, estate planning, and investment advice (not specific to any transaction).

The fairly recent U.S. District Court case of Weiner v. Eaton Vance, 2011 U.S. Dist. LEXIS 38375 (U.S.D.C. Mass., 2011) may appear to provide some commentators with ammunition that 12b-1 fees are not “advisory fees in drag,” as I have suggested. In that case, the court found that 12b-1 fees, under the facts as alleged, did not compensate “special compensation.” However, the court discussed the linkage between the delivery of advice and the receipt of special compensation, and the judge specifically stated:

I decline to find that the asset-based 12b-1 fees paid by the Trust automatically disqualify broker-dealers from the use of the exemption. As described above, courts rely on fact-based inquiries into the compensation paid, the services rendered, and evaluation of the connection between the two in determining whether the exemption applies. Plaintiff fails to allege sufficient facts to claim that the broker-dealer exemption does not apply here. In particular, there is no allegation that any advisory services have been rendered with respect to the brokerage accounts or that the 12b-1 fees here are actually "special compensation" for the broker-dealers' advisory services to their customers.

Id. [Emphasis added.].  Hence, where personalized investment advice is being delivered, one might see a future case in which the courts find that 12b-1 fees do, in fact, amount to special compensation and the application of the Advisers Act.

While industry representatives have argued that the 12b-1 fee “compensation” received by the broker-dealer firm is not paid by the customer directly, there is no qualification in the definition of investment adviser which says that compensation must be directly paid by an investor. In fact, the SEC has in the past acknowledged that, to meet the “compensation” test under the Advisers Act: “It is not necessary that an adviser's compensation be paid directly by the person receiving investment advisory services, but only that the investment adviser receives compensation from some source for his services.” SEC Release IA-770 (1981). 

Moreover, there is a common law principle which attorneys were taught when they were in law school:  “You cannot do indirectly what you cannot do directly.”  In other words, “if it walks like a duck….”  

While admittedly Class C shares in particular, and fee-based compensation in general, might at times better align the interests of investors with those of financial intermediaries, such an alignment is not the basis of any exclusion from the application of the Advisers Act.

Given the significance of this issue, all ongoing payments to advice-providers deserve close scrutiny – including ongoing payments for shelf space, variable annuity product provider annual fees to broker-dealers, and – as stated above – 12b-1 fees. All of these might constitute “special compensation” under the Advisers Act.


12b-1 fees also may violate the Sherman Act and its anti-trust prohibitions, inasmuch as they negate the ability of a customer to effectively negotiate, in many instances, the compensation for advisory services. This issue involves the unlawful restraint of trade and the potential application of the Sherman Antitrust Act. In essence, do 12b-1 fees constitute a form of “price-fixing” which is per se illegal. Arguably they do not, as each seller of a mutual fund may establish its own fee, up to maximum limits. Yet many cases arising under the Sherman Act find "maximum fee" requirements to be anti-competitive.

Nevertheless, even if 12b-1 fees do not violate the Sherman Act, the anti-competitive nature of 12b-1 fees should not be overlooked. It makes no sense to charge the same 1% “marketing fee” to a client who invests $5,000,000 with a broker-dealer, as it does the client with $50,000. Some multiple classes (“R” shares, typically) of retirement funds exist for plan sponsors. But individual clients are seldom, if ever, provided the opportunity to negotiate 12b-1 fees (except for plan sponsors who can seek lower 12b-1 fees for funds where multiple retirement-share classes exist).


Another issue is whether Class C shares constitute unreasonable compensation. If Class C shares, with a 1% fee assessed, are continuous in nature, and continue to compensate the broker-dealer even after the transaction is complete, they would appear to constitute “unreasonable compensation.” As stated in a comment letter by the Consumer Federation of America, “12b1 fees can be collected in perpetuity, which means that they can result in investors’ paying much higher sales compensation than would have been permissible under other classes of shares.” Comment letter of Mercer Bullard, Fund Democracy, and Barb Roper, Consumer Federation of America, to U.S. Securities and Exchange Commission, dated November 5, 2010, at p.2., located at

About a decade ago, Class B shares were central to investor abuses — brokers sold large numbers of the shares to investors who would have done better with Class A shares. The scandals led so many to view Class B shares negatively that some financial services firms now limit the sales of the share class.

While Class C shares are not necessarily more expensive that Class A shares (nor were Class B shares necessarily more expenseive than Class A shares), this all depends upon the length of time the fund shares are held they can be much more expensive. This begs the question – in what circumstances are brokers recommending Class C shares, when Class A shares would have been better for the customer? If the client indicated that the fund was likely to be held for a long time (such as more than 7 years), why did the broker not recommend the Class A share, which would have likely been cheaper?

Moreover, more broadly, why do we permit this conflict of interest, in the sale of mutual fund shares, to continue? Conflicts of interest, especially where variable (or differential) compensation exists, are insidious and difficult to reconcile with fiduciary principles, much less monitor.

In addition, we must ask - why don’t all Class C shares convert to a cheaper share class, with no distribution fees, after a period of time? Why has the SEC not imposed such a requirement on mutual fund companies?


If you are not associated with a broker-dealer, I would urge you to avoid any mutual fund share class that includes any 12b-1 fees. Why? You have a duty of due care, which includes a duty of due diligence, to identify the best investments (such as mutual funds) for your clients. You act as a purchaser’s representative. Hence, any 12b-1 “marketing fees” charged by funds only constitute additional, unwarranted fees, from which your clients receive no benefit. As an investment adviser, you should be certain that any fees and costs incurred by your clients are reasonable, and result in a benefit to the client in some fashion.

A possible exception would exist for no-transaction-fee funds, where your client is making systematic purchases of the fund [such as within a 401(k) account). In this instance, as long as the value invested in the fund is small, avoiding transaction fees may be a positive. Of course, this assume that transaction fees cannot otherwise be avoided and achieve the same investment objectives; many custodians offer platforms for 401(k) plans which don’t impose transaction fees for periodic investments made by plan participants.


If you are associated with a broker-dealer, and if you receive 12b-1 fees which in part compensate you for advisory services, you should consider the relationship a fiduciary one. (See Wiener vs. Eaton Vance, discussed above.) This is so even if the account is denoted as a "brokerage account, not an advisory account" - since the name of the account is not controlling as to whether the Advisers Act is applicable, or whether common law fiduciary duties attach.

As such, you should meet all of the fiduciary obligations imposed by the Advisers Act, including due diligence with respect to the mutual fund recommended. You should fully and affirmatively and specifically disclose any and all compensation your firm receives (including sales loads, 12b-1 fees, payment for shelf space, soft dollar or other commissions paid by the fund, etc.). The fees you and your firm receive should in all respects be reasonable.

You should also affirmatively disclose to the client, in a manner which ensures client understanding, that funds exist without 12b-1 fees (and other payments to the broker-dealer firm, if such exists), and that should the client ever choose to terminate the relationship with you, that the 12b-1 fees could be avoided by selling the fund at a future time. You should also disclose any costs that may result from the sale of the fund (such as redemption fees, if they exist), and that if the fund is held in a taxable account that capital gains taxes could result which might deter the client from selling the fund.

Such disclosures should be undertaken as specifically as possible. Reliance upon the fund’s prospectus should not be undertaken, given that you know that clients rarely read such document. (The duty to read is abrogated, to a degree, in a fiduciary relationship). In addition, such disclosures should be undertaken prior to the time that the client purchases the fund shares.

Of course, your broker-dealer's compliance department, or your superviser, may not desire to have you undertake such disclosures. But there are many instances in which registered representatives have been the subject of arbitration proceedings, and a tarnished record, in "reliance" on what their firm has stated. Firms view possible liability as a "cost of doing business" ... for the individual registered representative, a tarnished record affects your personal reputation, and your livelihood, for years to come.

Lastly, since the provision of investment advisory services (especially those of an ongoing nature) in return for 12b-1 fees may trigger the application of the Adviser Act, make certain you possess Series 65/66 licensure.


Finally, any discussion of 12b-1 fees would be incomplete without noting that the receipt of 12b-1 fees by a fiduciary to a client may also result in a prohibited transaction under ERISA, in certain circumstances. In this regard, I defer to Fred Reish’s recent blog post, concerning a recent U.S. Department of Labor settlement, for a further discussion of this issue.

Tuesday, March 19, 2013

Will the CFP Board Move the Ball Forward, or Stall Progress Toward a True Profession?

While the Certified Financial Planner Board of Standards, Inc. ("CFP Board") has come a long way in its embrace of the fiduciary standard of conduct, I am concerned that the CFP Board - by not embracing the fiduciary standard fully - may be harming the emergence of the profession of financial planning.  And it may, as well, be misleading consumers.  Permit me to explain both of these conclusions, and suggest a logical evolution it is now time for the CFP Board to embrace.

Dodd-Frank Misses the Point: Those Who Provide Investment and Financial Advice Have Always Been Fiduciaries

To understand the issues discussed in this brief, it is first necessary to review when fiduciary status is obtained under the law.

While much of the recent public debate has been regarding Section 913 of Dodd Frank's, and the SEC's authority thereunder to apply the fiduciary standard existing under the Advisers Act of 1940 to broker-dealers and their registered representatives when they provide "personalized investment advice," there is another body of law which already applies the fiduciary standard in such circumstances.  It is state common law - the accumulation of centuries of court decisions in the United States (and even to the common law of England, adopted by the U.S. at the time of the formation of our country).

It was always recognized, under state common law, that those who provide advice in relationships of trust and confidence are, if fact, fiduciaries.  This is regardless of how the person providing advice is regulated.  This is fundamentally an outcome that flows from agency law - i.e., the scope of the fiduciary relationship is defined by the scope of the services being provided.

Early on both the SEC and the NASD recognized that brokers, when providing advice, were fiduciaries.

For example, in 1942 the SEC summarized a court decision finding that the furnishing of investment advice by a broker was a “fiduciary function.”  The SEC stated:

“In the Stelmack case the evidence showed that the firm obtained lists of holdings from certain customers and then sent to these customers analyses of their securities with recommendations listing securities to be retained, to be disposed of, and to be acquired … The [U.S. Securities and Exchange] Commission held that the conduct of the customers in soliciting the advice of the firm, their obvious expectation that it would act in their best interests, their reliance on its recommendations, and the conduct of the firm in making its advice and services available to them and in soliciting their confidence, pointed strongly to an agency relationship and that the very function of furnishing investment counsel constitutes a fiduciary function.”

1942 SEC Annual Report, p. 15, referring to  In the Matter of Willlam J. Stelmack Corporation, Securities Exchange Act Releases 2992 and 3254.

Even earlier, and shortly the self-regulatory organization for broker-dealers, NASD, was formed, NASD (now FINRA) pronounced that brokers were fiduciaries: “Essentially, a broker or agent is a fiduciary and he thus standards in a position of trust and confidence with respect to his customer or principal.  He must at all times, therefore, think and act as a fiduciary.  He owest his customer or principal complete obedience, complete loyalty, and the exercise of his unbiased interest.  The law will not permit a broker or agent to put himself in a position where he can be influenced by any considerations other than those to the best interests of his customer or principal … A broker may not in any way, nor in any amount, make a secret profit … his commission, if any, for services rendered … under the Rules of the Association must be a fair commission under all the relevant circumstances.” – from The Bulletin, published by the National Association of Securities Dealers, Volume I, Number 2 (June 22, 1940).

Investment advisers are always fiduciaries.  Even early on, shortly after the enactment of the Investment Advisers Act of 1940, it was well known that all investment advisers were bound by broad fiduciary obligations to their clients.  In other words, if you provided advice, you were a fiduciary with respect to the advice provided.

But the Investment Advisers Act of 1940 did NOT - as many now seem to conclude - state that brokers are NOT fiduciaries.  It only prescribed when brokers must register as investment advisers.  It was long recognized that brokers, even though not investment advisers, are fiduciaries with respect to the investment advice they provide.

The state common law - case after case - opines that brokers, when in a confidential relationship with their customer - are fiduciaries.  And it is through the application of this common law that brokers are so often charged with fiduciary status in court cases and arbitration proceedings.  Indeed, it was recently reported that "breach of fiduciary duty" is the most common allegation in FINRA arbitration proceedings.

What is a "Confidential Relation"?

That is not to say that all registered representatives and broker-dealers are fiduciaries, all that time.  Fiduciary status only attaches when they are in a "relationship of trust and confidence."

What is a "confidential relation," for purposes of determining whether fiduciary status attaches?  There are numerous cases in the state courts which explore when a person becomes a fiduciary.  But perhaps thee Supreme Court of Virginia opined as to this definition way back in 1933:

“Confidential relation is not confined to any specific association of the parties; it is one wherein a party is bound to act for the benefit of another, and can take no advantage to himself. It appears when the circumstances make it certain the parties do not deal on equal terms, but, on the one side, there is an overmastering influence, or, on the other, weakness, dependence, or trust, justifiably reposed; in both an unfair advantage is possible.

Trust alone, however, is not sufficient. We trust most men with whom we deal. There must be something  reciprocal in the relationship before the rule can be invoked. Before liability can be fastened upon one there must have been something in the course of dealings for which he was in part responsible that induced another to lean upon him, and from which it can be inferred that the ordinary right to contract had been surrendered ...."

J.B. Hancock v. Jessie G. Anderson, 160 Va. 225; 168 S.E. 458; 1933 Va. LEXIS 201(Va. 1933).

The SEC also “has held that where a relationship of trust and confidence has been developed between a broker-dealer and his customer so that the customer relies on his advice, a fiduciary relationship exists, imposing a particular duty to act in the customer’s best interests and to disclose any interest the broker-dealer may have in transactions he effects for his customer … [BD advertising] may create an atmosphere of trust and confidence, encouraging full reliance on broker-dealers and their registered representatives as professional advisers in situations where such reliance is not merited, and obscuring the merchandising aspects of the retail securities business … Where the relationship between the customer and broker is such that the former relies in whole or in part on the advice and recommendations of the latter, the salesman is, in effect, an investment adviser, and some of the aspects of a fiduciary relationship arise between the parties.” 1963 SEC Study, citing various SEC Releases.

Of course, it would be nice to get away from determining if a "confidential relation" exists.  In essence, this is the authority provided to the SEC under Dodd-Frank, at least with respect to brokerage firms and their registered representatives.  The SEC can choose to draw a new line, respective of the common law, and declare that the bona fide fiduciary standards found under the Advisers Act apply to brokers as to any customer for whom they provided personalized investment advice.

This is all just applying common sense - if you provide advice regarding this complex financial world in which we live - with its multitude of investment products and strategies and tax and financial planning concerns - you are relied upon to act in the best interests of the person who has hired you.  And that's a highly reasonable expectation by the person.

Be Wary of How You Hold Yourself Out! - Use of "Financial Planner" Is Significant Factor in Finding Fiduciary Status Exists.

Early on the SEC warned that, if you don't want to be a fiduciary, you should not be disguised as a trusted advisor.  In its 1941 Annual Report, the U.S. Securities and Exchange Commission noted: “If the transaction is in reality an arm's-length transaction between the securities house and its customer, then the securities house is not subject' to 'fiduciary duty. However, the necessity for a transaction to be really at arm's-length in order to escape fiduciary obligations, has been well stated by the United States Court of Appeals for the District of Columbia in a recently decided case:

‘[T]he old line should be held fast which marks off the obligation of confidence and conscience from the temptation induced by self-interest.  He who would deal at arm's length must stand at arm's length.  And he must do so openly as an adversary, not disguised as confidant and protector.  He cannot commingle his trusteeship with merchandizing on his own account…’”

Seventh Annual Report of the Securities and Exchange Commission, Fiscal Year Ended June 30, 1941, at p. 158, citing Earll v. Picken (1940) 113 F. 2d 150.

Also, several common law court cases over the past few decades – i.e., those few reported decisions which escape from the restrictions of securities arbitration and then, through appeals, lead to reported decisions – find that the use of titles that denote relationships of trust and confidence – such as “financial advisor” – becomes a significant factor in determining whether fiduciary status exist.

Account and Other Documentation Not Determinative of Fiduciary Status

One might assume, based on the discussion in the foregoing session, that all one must do to avoid being a fiduciary is to clearly disclose that the relationship is not a fiduciary one, and to not use titles or other descriptors which denote oneself as a trusted advisor.  But such an assumption would be incorrect.  You just can't declare yourself "not a fiduciary."  It's what you do, and how you hold yourself out, in all respects, that is conclusive as to whether fiduciary status exists under state common law.

Early on even the SRO for broker-dealers, NASD (now FINRA), in discussing the decisions of two court cases, said it was “worth quoting” statements from the opinions:  “In relation to the question of the capacity in which a broker-dealer acts, the opinion quotes from the Restatement of the law of Agency: ‘The understanding that one is to act primarily for the benefit of another is often the determinative feature in distinguishing the agency relationship from others. *** The name which the parties give the relationship is not determinative.’ And again: ‘An agency may, of course, arise out of correspondence and a course of conduct between the parties, despite a subsequent allegation that the parties acted as principals.’” - from N.A.S.D. News, published by the National Association of Securities Dealers, Volume II, Number 1 (Oct. 1, 1941).

Where is the Line Drawn – Fiduciary vs. Non-Fiduciary?

That's the subject of some debate.  Under state common law, it is always necessary to look at the totality of the facts and circumstances.  Fiduciary status is likely to be imposed where the client of a financial planner or securities investment broker is unsophisticated (i.e., the vast majority of clients).  Fiduciary status is less likely to be imposed upon a highly knowledgeable, sophisticated client.  (Wealth is not the determinant; rather, it is whether the client has vast experience and a very high level of knowledge regarding the transaction at hand - so that reliance by the sophisticated client does not exist.)  Of course, if the sophisticated person were truly that sophisticated, that person would have negotiated that the advisor with which he or she is dealing expressly assumes fiduciary status.  Why otherwise would a sophisticated investor desire, and expect to rely upon, the advisor's advice?

If you want an easy answer on where to draw the line, I would look no further than the comments made by a long-time leader of the profession, Harold Evensky.  As he eloquently puts it, if you just describe a financial product to a client, you are not a fiduciary.  But if you opine as to whether that product is good for the client, you are an advisor and hence a fiduciary.  It's a straightforward, relatively easy to apply line.

Many registered representatives may now be wondering ... "what about our suitability obligations, don't they require fiduciary status as you set forth the test above?"  Yes - suitability obligations still exist.  But "suitability" is an internal determination (and subsequent record) by the firm, and does not require that all of the determinations regarding suitability be conveyed to the client.  (Of course, facts and circumstances of the client must be periodically updated for the broker's internal records and to aid in the suitability analysis; but again a suitability determination does not require the furnishing of advice to the client.)

The CFP Board's Application of Fiduciary Status - Far Different from State Common Law?

This brings me to the CFP Board, and its methodology for applying fiduciary status.

I would first note that when, in 2007, the CFP Board adopted its current Standards of Professional Conduct, many who desire to see financial planners arise to the level of true fiduciaries were most appreciative of the courage the CFP Board undertook at the time.  This is especially so when we look back and realize that, just five years ago, there was little scholarly literature concerning the application of the fiduciary standard upon investment advisers and financial planners.

But with time has come a greater understanding of fiduciary duties, when they are applied under the law.  And hence, it is time to look more closely at the CFP Board's application of fiduciary status.

The CFP Board sets forth that there are several “personal financial planning subject areas” or “financial planning subject areas”, which “denote the basic subject fields covered in the financial planning process” and “which typically include, but are not limited to:”
• Financial statement preparation and analysis (including cash flow analysis/planning and budgeting),
• Insurance planning and risk management,
• Employee benefits planning,
• Investment planning,
• Income tax planning,
• Retirement planning, and
• Estate planning.

The CFP Board’s Standards of Professional Conduct then define “Personal financial planning” or “financial planning” as denoting the “process of determining whether and how an individual can meet life goals through the proper management of financial resources. Financial planning integrates the financial planning process with the financial planning subject areas. In determining whether the certificant is providing financial planning or material elements of financial planning, factors that may be considered include, but are not limited to:
• The client’s understanding and intent in engaging the certificant.
• The degree to which multiple financial planning subject areas are involved.
• The comprehensiveness of data gathering.
• The breadth and depth of recommendations.
Financial planning may occur even if the material elements are not provided to a client simultaneously, are delivered over a period of time, or are delivered as distinct subject areas. It is not necessary to provide a written financial plan to engage in financial planning.”

The CFP Board then proclaims, in its Standards of Professional Conduct, that “When the certificant provides financial planning or material elements of financial planning, the certificant owes to the client the duty of care of a fiduciary as defined by CFP Board.”

The language found in the CFP Board’s Standards of Professional Conduct is not wholly unsatisfactory (as to when fiduciary status attaches), although some ambiguities are created.  More important, however, is how the CFP Board has chosen to apply this language.

The CFP Board places a huge emphasis on whether the financial planning engagement touches on more than one subject area.  For example, the CFP Board’s Q&A regarding its Standards state:

“Question 1-14: How many financial planning subject areas can a CFP® professional address with a client without reaching the level of “material elements of financial planning”?

Applying the financial planning process to a single subject area is not likely to be considered financial planning or material elements of financial planning. CFP® professionals who integrate the financial planning process and two or more subject areas may be providing financial planning or material elements of financial planning.”

Where did this “two or more subject areas” emphasis come from?  Not from the common law!  There are many cases which illustrate that the provision of investment advice, alone, involves a fiduciary relationship.  And other cases illustrate where another subject area – retirement planning – invokes fiduciary status.

(Indeed, as an instructor of retirement planning, there are not many instances within the realm of "retirement planning" in which advice is not provided to a client - whether it be to a plan sponsor or to an individual client.  I've never seen a "retirement plan" that does not provide advice - and a whole lot of it.)

The key again, under state common law, is not whether more than one “financial planning subject area” is touched upon, as the CFP Board appears to now emphasizes. Rather, the key is whether any advice is provided.  Whether the advice be investment advice, retirement planning (accumulation or decumulation planning included), or estate planning, all of these are likely to arise to the level of a fiduciary relationship.

It is this recent emphasis by the CFP Board on “two or more subject areas” that is befuddling.  The CFP Board needs to make it clear that the provision of any advice, even within one subject area, will likely give rise to the application of fiduciary status under state common law.  Otherwise, CFP Certificants may be blindly led down a path – at each Certificant’s peril - in which they assume they are not fiduciaries, but where a court or arbitrator would likely decide otherwise.

Fraudulent Advertising by CFP Board?

When it was announced, I applauded the CFP Board’s advertising campaign.  Designed to promote the CFP® mark, and lead to greater understanding by consumers of the benefits of personal financial planning, I saw it as a means of advancing the profession of financial planning.  I still do.

But I am disturbed by some aspects of this advertising campaign.

Let me preface this by the fact that I constantly remind myself of a quote from a paper written in 2010 by Professors James Angel and Douglas M. McCabe: “To give biased advice with the aura of advice in the customer’s best interest is fraud.”

And I’m reminded of the language of the SEC’s 1941 annual report, that a product salesperson (non-fiduciary) “must do so openly as an adversary, not disguised as confidant and protector.” 

I am also reminder of this excerpt from the SEC’s 1963 Report: “where a relationship of trust and confidence has been developed between a broker-dealer and his customer so that the customer relies on his advice, a fiduciary relationship exists, imposing a particular duty to act in the customer’s best interests and to disclose any interest the broker-dealer may have in transactions he effects for his customer … [BD advertising] may create an atmosphere of trust and confidence, encouraging full reliance on broker-dealers and their registered representatives as professional advisers.”

So why I am disturbed by the actions of the CFP Board?  Here are just two examples:

One CFP Board’s advertisment that states: “Bring all your finances together w/help of the 1 person who can" implies CFPs provide ADVICE, not products.

Another CFP Board advertisement boldly proclaims that CFPs "Put Your Needs First."  It doesn’t take a rocket scientist to know that this implies – to consumers – that CFPs are trusted advisors (and hence fiduciaries).

But, as it stands right now, not all CFPs are fiduciaries.

Moreover, the mere use of the title “financial planner” (and even more so, Certified Financial Planner™” – leads the consumer to believe that advice will be received.

Of course, not just the CFP Board can be singled out on this point.  Many other designations and certifications use terminology such as “financial consultant” or “advisor” within the title.  One must ask … didn’t they know, at the time they created the designation, that holding oneself out as a “consultant” or “planner” or “advisor” (or similar terms) was a significant factor, under state common law, in finding that fiduciary status exists?  And don’t they realize that disguising the certificant or designess as a “confident” – when the certificant or designee is not – amounts to fraud?

Where Do We Go From Here?

I hope the CFP Board “moves the ball forward.”

I hope the CFP Board recognizes that nearly all consumers believe that securities professionals – espcially CFPs – are trusted advisors.  They believe that the CFP Certificant is acting in their best interests.  That trust should not be violated by the CFP Board’s overly permissive policies.

I hope the CFP Board will revise and clarify its Standards of Professional Conduct, and recent interpretations thereof, to recognize that all those who hold themselves out as CFP® Certificants should be held to fiduciary status at all times.  To do otherwise is fraud.

I hope that the CFP Board further takes the necessary step to delineate what fiduciary standards exist – for the education of CFP Certificants.  Currently the CFP describes the “fiduciary duty of care.”  Even a cursory elicitation of fiduciary duties sets forth that there are the often-referred-to triparte fiduciary duties of “due care, loyalty, and utmost good faith.”  And it is possible to come up with much better guidance within the Standards of Professional Conduct – by elaborating on the principles further.  This is illustrated by the American Bar Association’s Model Rules of Professional Conduct for lawyers.

I further hope that the CFP Board will lead the profession – toward a true profession, in which Certified Financial Planners are fiduciaries at all times.  Every profession has the incentive to ensure its members hold themselves to higher standards.  By adopting the fiduciary standard for all CFPs, at all times, consumers will come to recognize that they can trust CFPs.  This will lead to far greater utilization of the services of Certified Financial Planners by consumers.

Indeed, adopting a clear, unequivocal fiduciary standard of conduct, as found in state common law, for CFP Certificants, will do far, far more to advance the CFP® mark and the utilization of financial planning services than any advertising campaign could ever hope to achieve.

Of course, there are powerful economic forces which oppose application of fiduciary standards.  And the adoption of a common-sense all-the-time clear fiducary standard for CFP Certificants may well cause some who hold the CFP© certification to relinquish it.  But, in my mind, that’s ok.  If you don’t want to act in the best interests of your clients, I don’t want you as my professional colleague.

And, those CFP Certificants who remain will be proud to associate with the remaining CFP Certificants,.  With a new, clear understanding of the vital trust placed into our hands by consumers, and that all “planners” are “advice providers” and hence fiduciaries at all times, we will move the profession forward, and rapidly, to even greater interest from the public.  With such greater demand for services will come new entrants into the CFP community, attracted by the high standards of conduct and the new level of respect which CFP Certificants are afforded.

In 2007 a brave group of directors of the Certified Financial Planner Board of Standards, Inc. set aside their individual self-interests and adopted a fiduciary standard of conduct (at least much of the time) for Certified Financial Planners.  Now, more than five years later, it is time for this Board of Directors to complete the task – and in so doing move us toward a true profession of financial planners, all bound together by the highest standards of conduct, mutual admiration, and the respect of the public and public policy makers alike.