Wednesday, May 29, 2013

Responding to Readers' Questions re: DOL/EBSA's Definition of Fiduciary Rule-Making

I respond to readers’ questions regarding the DOL/EBSA’s re-proposed “Definition of Fiduciary” Rule.

Table Of Contents
(1) “Ron, when will the DOL’s re-proposed rule be available to see? And when would it be finalized?”
(2) Will the DOL’s Rule Only Apply to Individuals (Not BD Firms)?
(3) Will Proprietary Products Be Available Under the DOL’s Re-Proposed Rule? 
(4) Will ERISA’s Standards Now Apply to IRAs and to the IRA Rollover Decision?
(5) Specifically, How Will the EBSA’s Re-Proposed Rule Expand the Definition of “Fiduciary”?
(6) Will There Be Any Exemptions Provided from the Expanded Definition of Fiduciary?
(7) What Should Plan Sponsors Do Now?


As many readers are aware, the U.S. Department of Labor’s (DOL’s) Employee Benefits Security Administration (EBSA) is likely to re-promulgate, later this year, its proposed expansion of the “Definition of Fiduciary.” Under current regulations many of those who provide advice relating to investment selection to plan sponsors are not considered fiduciaries. Under the new regulations two major changes are anticipated:

First, nearly everyone who provides investment advice to ERISA-covered plan sponsors (and to plan participants) would be considered a fiduciary.

Second, those providing investment advice to IRA account holders would also be considered fiduciaries.

As I’ve previously written, these rules – if finalized by DOL/EBSA – are likely to be “game-changers” within the financial services industry. Current ERISA regulations, with their pre-emptive nature, prevents the application of common law fiduciary status to many who provide advice on investments to plan sponsors. As a result, many current advisors to defined contribution plan accounts are not fiduciaries under the law. Also, with the inclusion of IRA accounts, and the IRA distribution decision, many more “financial advisors” will be considered fiduciaries, at least respect to such accounts. According to the Investment Company Institute, at the end of 2012:

The largest components of retirement assets were IRAs and employer-sponsored DC plans, holding $5.4 trillion and $5.1 trillion, respectively, at year-end 2012. Other employer-sponsored pensions include private-sector DB pension funds ($2.6 trillion), state and local government employee retirement plans ($3.2 trillion), and federal government plans—which include both federal employees’ DB plans and the Thrift Savings Plan ($1.6 trillion).

2013 Investment Company Fact Book, Chapter 7, available at

While not all of the foregoing accounts are governed by ERISA’s rules, approximately $15 trillion dollars (or more) of retirement accounts would be subject to the new “Definition of Fiduciary” rules. This is a significant portion of the overall capital markets.

For example, “the sum of the market-cap of the NYSE, NASDAQ and AMEX on Bloomberg today (04-02-2012) is $21.4 Trillion — pretty close numbers for the kind of data gathering these summaries involve. Going with the SIFMA and Bloomberg numbers, the US capital market is about $58.4 Trillion, consisting of 63.4% bonds and 36.6% stocks.” QVM Group, LLC, “World Capital Markets – Size of Global Stock and Bond Markets,” Perspectives, April 2, 2012), available at

I’ve received several questions from readers regarding the EBSA’s re-proposed rule, believed to be re-promulgated by EBSA later this year. Here are my replies thereto.

(1) “Ron, when will the DOL’s re-proposed rule be available to see? And when would it be finalized?”

The re-proposed rule must first be submitted by DOL/EBSA to the Office of Management and Budget. At that point it would go through a 90-day review process. Only with OMB’s approval would the re-proposed rule be released for all to see.

It is not certain that the re-proposed rule will be released to OMB, nor that it survives OMB scrutiny. Why? First, there is tremendous opposition from the wirehouses and insurance companies to the rule, and they are flooding Congress with lobbying in opposition to the rule ever seeing the light of day. They are also extensively lobbying OMB to not permit the rule’s release. In addition, a new U.S. Secretary of Labor needs to be confirmed, and when confirmed that person is likely also likely to be lobbied extensively. While Asst. Secretary Phyllis Borzi remains, by all accounts, committed to re-proposing the rule, I would not be totally surprised if lobbying by Wall Street firm and the insurance lobby stops the rule from ever seeing the light of day.

When the re-proposed rule is released, there is likely to be a long comment period – perhaps 3-4 months (or even longer). Thereafter, the EBSA must consider all of the comments prior to finalizing the rule. During this time lobbying against the rule will again be heavy, in an attempt to get the DOL/EBSA to withdraw the rule or delay the process.

My current guess is that the re-proposed rule would be released by October or November of this year, although that timeline could be delayed. It would then likely take another year before any rule is finalized, given the necessity to review all of the hundreds (if not thousands) of comments likely to be submitted.

Having said that, be aware that delays in agency rule-making occur frequently. And, as stated above, given the tremendous opposition to this rule from some sectors, it is altogether far from certain that a re-proposed “Definition of Fiduciary” rule will ever be released, much less finalized and enacted.

(2) Will the DOL’s Rule Only Apply to Individuals? A reader asks: “Under the DOL’s proposal, will the fiduciary obligation fall only on the individual financial advisor, or does it also apply to their associated broker-dealer as well? More specifically, if a financial advisor works for a large broker-dealer, and the broker-dealer has a fixed compensation model for financial advisors (to comply with the newly proposed fiduciary guidelines), would the broker-dealer be able to maintain revenue-sharing arrangements with the asset manager? If not, why not?”

Yes, a broker-dealer firm is liable, in most instances, for a breach of fiduciary duty by its registered representative. This is because, under general principles of law, employers are vicariously liable, under the respondeat superior doctrine, for the acts or omissions by their employees in the course of employment (sometimes referred to as “scope of employment”). For an act to be considered within the course of employment it must either be authorized or be so connected with an authorized act that it can be considered a mode, though an improper mode, of performing it.

The delivery of “advice” – which leads to the imposition of fiduciary status – results from actions undertaken by the registered representative in furtherance of the objectives of the firm. Hence, under ERISA, it is clear that (in nearly all cases) both the firm and the individual advisor possess the fiduciary duty to the client.

But wait, you say … how can a registered representative owe a fiduciary duty to a client, when the registered representative also owes a fiduciary duty to the broker-dealer firm (as the employee of the broker-dealer firm)? Isn’t this a conflict? No. This is because the fiduciary duties are ordered – i.e., the fiduciary duty to the client comes first, and any fiduciary duty the registered representative owes to the broker-dealer firm is secondary.

For example, an attorney might be an employee of a law firm. The attorney, as an employee of the law firm, represents the law firm and has a fiduciary duty of loyalty to the law firm, under general principles of agency. But the individual lawyer also has a fiduciary duty to the client. If the individual lawyer breaches his or her duty of loyalty to the client, such as engaging in a prohibited commercial transaction with the client to further the law firm’s interest (e.g., a commercial transaction in which the client did not receive independent legal advice before entering into the transaction with the lawyer), the lawyer is individually liable, and the law firm is liable as well vicariously, under the doctrine of respondeat superior.

Hence, if and when the “Definition of Fiduciary” rule is applied by the DOL, it will apply to both the broker-dealer firm and its registered representatives. This means that, absent an exemption to the prohibited transaction rules under ERISA (see discussion, below), revenue-sharing arrangements between the broker-dealer firm and an asset manager recommended to a plan sponsor are not permitted (unless, if an exemption is so granted under the new regulations, the fees charged by the fiduciary broker-dealer are reduced by the amount of the revenue-sharing received from the asset manager).

I believe it is very unlikely that revenue-sharing arrangements, so common in the investment industry today, will continue if the “Definition of Fiduciary” regulation is put into effect.

(3) Will Proprietary Products Be Available Under the DOL’s Re-Proposed Rule?  A reader ask: If the broker-dealer is affiliated with the asset manager (i.e., under common ownership, etc.), will the broker-dealer be able to provide products from that asset manager (i.e., proprietary products)?

Look for an exemption here, but the scope of the exemption and its conditions are uncertain.

The issue of sales of proprietary products is a vexing one under fiduciary law. Many states had to deal with this issue, in their statutes, about 2-3 decades ago, when banks and their trust companies desired to switch fiduciary “common trust funds” into bank-owned, proprietary mutual funds. Most states required that the “management fees” charged by the fund be credited against the separate trustee fees charged on the account. However, it has become obvious that this “solution” to the conflict of interest was not perfect. For example, the “administrative fees” paid to other affiliates of banks (or their holding companies) sometimes far exceed similar amounts of administrative fees paid by similar-sized, similarly-managed funds who engage independent third-party firms for services paid for by such fees.

Even with fee crediting, many states also require that the proprietary fund recommended be in the best interests of the client. In practice, according to many trust officers I have spoken with, this results in recommending only those proprietary funds which outperform the average of their peers over a specified time frame. (Since outperformance over any period of time has been shown to be not indicative of future performance, especially when an adjustment is made for the level of fees incurred by the fund’s shareholder, the use of such a benchmarking technique is questionable, in the author’s view).

Australia’s new fiduciary requirements on its financial services professionals take effect soon. Australia’s approach is more stringent, when proprietary products are involved:

RG 175.267. In determining the scope of the advice, an advice provider will need to use their knowledge about a range of strategies, classes of financial product and specific financial products commonly available and which are relevant considering the subject matter of the advice sought by the client ….

RG 175.367 An advice provider must prioritise the interests of the client if the advice provider knows, or reasonably ought to know, when they give the advice that there is a conflict between the interests of the client and the interests of:
(a) the advice provider;
(b) an associate of the advice provider;
(c) the advice provider’s [firm]….

RG 175.372 An advice provider cannot comply with the conflicts priority rule merely by disclosing a conflict of interest or getting the client to consent to a conflict. [Note: A condition of a contract (or other arrangement) is void if it seeks to waive any of the obligations in s961J: s960A. Additionally, these obligations cannot be avoided by any notice or disclaimer provided to the client: see RG 175.213.] ….

RG 175.379 The conflicts priority rule does not prohibit an advice provider from accepting remuneration from a source other than the client (e.g. a fee from a product issuer). However, Div 4 of Pt 7.7A prohibits advice providers from accepting certain types of remuneration which could reasonably influence the financial product advice they give or the financial products they recommend to clients ….

RG 175.380 If an advice provider gives priority to maximising or receiving the non-client source of remuneration over the interests of the client, the advice provider will be in breach of the conflicts priority rule ….

RG 175.381 The conflicts priority rule means that:
(a) an advice provider must not recommend a product or service of a related party to create extra revenue for themselves, their AFS licensee or the related party, where additional benefits for the client cannot be demonstrated;
(b) where an advice provider uses an approved product list that only has products issued by a related party on it, the advice provider must not recommend a product on the approved product list, unless a reasonable advice provider would be satisfied that it is in the client’s interests to recommend a related party product rather than another product with similar features and costs ….

Australian Securities & Investments Commission (ASIC), “REGULATORY GUIDE 175: Licensing: Financial product advisers—Conduct and disclosure” (December 2012).

As seen, the ASIC requires a “tough test” – the “demonstration” of “additional benefits” for the client. Yet, in a note to RG 175.381(b), the ASCI also endorses the use of “benchmarking,” stating: “One way that an advice provider may be able to do this is by benchmarking the product against the market for similar products to establish its competitiveness on key criteria such as performance history, features, fees and risk. The benchmarking must be reasonably representative of the market for similar products that are offered by a variety of different issuers.”

Hence, I would expect that, under the application of ERISA’s tough sole interests standard, we will likely see a similar result. Three requirements are likely to be imposed by EBSA when proprietary funds are recommended: (1) management fees earned must be credited back against other fees charged by the advisor in some fashion; (2) administrative fees paid to affiliates will receive enhanced scrutiny, to ensure no “double dipping” occurs; and (3) benchmarking to the entire universe of similar funds or to broad indexes (not just an index of “actively managed funds” - as used by Lipper indices, for example) will be required.

I suspect that a trend that began more than a decade ago – the divestment by broker-dealer firms of their asset management divisions – will continue. Otherwise, the recommendation of a proprietary fund will always receive a heightened degree of scrutiny, both by regulators and plantiffs’ attorneys alike. Additionally, a competition disadvantage exists when competitors – who don’t utilize proprietary funds – point out the inherent conflict of interest that exists.

(4) Will ERISA’s Standards Now Apply to IRAs and to the IRA Rollover Decision?  A reader asks: “Based on the proposed DOL regulations, are 401k-to-IRA rollover discussions considered a fiduciary conversation? If so, why? If this is the case, does this make it virtually impossible for any financial advisor to solicit for rollover business? Why or why not?”

Yes, and yes.

As to the Dept. of Labor and IRA accounts, under the Internal Revenue Code issue: First, section 4975(e)(3) of the Internal Revenue Code of 1986, as amended (Code) provides a similar definition of the term "fiduciary" for purposes of Code section 4975 (IRAs).  However, in 1975, shortly after ERISA was enacted, the Department issued a regulation, at 29 CFR 2510.3-21(c), that defines the circumstances under which a person renders ``investment advice'' to an employee benefit plan within the meaning of section 3(21)(A)(ii) of ERISA. The Department of Treasury issued a virtually identical regulation, at 26 CFR 54.4975-9(c), that interprets Code section 4975(e)(3). 40 FR 50840 (Oct. 31, 1975). Under section 102 of Reorganization Plan No. 4 of 1978, 5 U.S.C. App. 1 (1996), the authority of the Secretary of the Treasury to interpret section 4975 of the Code has been transferred, with certain exceptions not here relevant, to the Secretary of Labor.

Hence, when the DOL/EBSA, as is expected later this year, issues a re-proposal of its "definition of fiduciary" regulation, in essence the broad exemptions previously provided disappear, and virtually any provider of personalized investment advice to a plan sponsor or plan participant would be a "fiduciary" and subject to ERISA's strict "sole interests" fiduciary standard and its prohibited transaction rules.

In its 2010 release, the DOL sought comment on whether any distribution decision should be subject to a fiduciary standard. I suspect that the DOL will state, in any re-proposed rule, that the decision to undertake a distribution, when the decision involves a transfer of funds into an investment or insurance product, will be subject to the fiduciary standard of conduct. There is much abuse in this area, already. For example, one “strategy” which is taught to some financial advisors, and subsequently deployed with clients (through seminar-based marketing, mainly), is the withdrawal of funds from IRA and other investment accounts for placement of the funds in a (nonqualified) Equity Indexed Universal Life Policy. A dubious technique, considering the high commissions resulting form the sale of most EIUL policies, and the other limitations and features of such products (which falls outside of the discussion of this article).

(5) Specifically, How Will the EBSA’s Re-Proposed Rule Expand the Definition of “Fiduciary”?

We don’t know for certain what the re-proposed rule will look like, but commentators largely expect that the 2010 Proposed Rule from EBSA, which redefined “fiduciary” broadly, will be largely followed. (As discussed below, certain exemptions will be provided from the definition of “fiduciary,” under the re-proposed rule.)
Statutory Definition. The definition of fiduciary under ERISA can be found at Section 3(21)(A). This definition includes parties rendering investment advice for a direct or indirect fee with respect to plan assets. This statutory definition appeared very broad.
1975 DOL Regulations. In 1975, the DOL issued regulations interpreting when offering advice resulted in fiduciary status. The regulations provided a 5-part test. The 1975 regulations, which remain in effect until any new regulation is finalized, provide that in order to be deemed a fiduciary as a result of providing investment advice, the advisor must:
(1)  Render advice as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing or selling securities or other property;
(2)  Provide the advice on a regular basis;
(3)  Provide the advice pursuant to a mutual agreement, arrangement or understanding, with the plan or a plan fiduciary;
(4)  The advice will serve as a primary basis for investment decisions with respect to plan assets, and
(5)  The advice will be individualized based on the particular needs of the plan.
The DOL believed the five-part test was obsolete and the regulations as a whole needed an overhaul. The retirement plan industry and financial investment community have changed dramatically since then, especially with the rise of the 401(k) plan, the rapid growth of IRAs, and the increased moving of retirement money from plan to plan as employees changed jobs more often. Accordingly, EBSA proposed the new regulations to bring the definition of “fiduciary” in line with the times.
2010 Proposed Regulation (Now Withdrawn).  Reflecting the tremendous growth of defined contribution plans (the tremendous growth of 401(k) plans, and the replacement of most pension plans, was not foreseen when ERISA was adopted), as well as the tremendous growth in the complexity of investment and insurance products over the past 35 years, the DOL’s EBSA proposed in 2010 that the definition of fiduciary, found in the regulation, be significantly expanded.
The 2010 proposed regulation clarified that rendering the advice for a fee included any direct or indirect fees received by the advisor or an affiliate from any source, including transaction-based fees such as brokerage, mutual fund or insurance sales commissions.
Under the 2010 proposed regulation, fiduciary status under ERISA could then result in several different ways, which included:
A) Provides advice or make recommendations pursuant to an agreement, arrangement or understanding, written or otherwise, with the plan, a plan fiduciary or a plan participant or beneficiary, where the advice may be considered in making investment or management decisions with respect to plan assets, and the advice will be individualized to the needs of the plan, a plan fiduciary or a participant or beneficiary.
While this language is similar to some of the language from the old test, there are a couple notable changes. First, the advice no longer needs to be offered on a regular basis—offering advice on a single occasion could result in fiduciary status. Second, the advice no longer need be offered as part of a mutual understanding that the advice will serve as the primary basis for investment decisions— the advice could be part of several factors that the plan sponsor considers and still result in fiduciary status.
This would mean that any investment advice, even provided on a non-continual basis, could lead an advisor to become subject to ERISA fiduciary obligations. While many commentators questioned the “expansion” of fiduciary law to cover the provision of discrete advice, other commentators noted that the test should be whether advice is provided, not how often; even one-time advice might be instrumental in a plan sponsor’s or plan participant’s decision-making.
B) Acknowledgement of fiduciary status for purposes of providing advice.
This provision is significant because under the old test, a party could acknowledge fiduciary status, and yet still fail to be held liable if they did not meet all five parts of the old test.
In the 2010 proposed rule, the EBSA that persons who say they are ERISA fiduciaries are ERISA fiduciaries irrespective of the nature of the advice provided to a plan, plan fiduciaries, participants or beneficiaries. This seems entirely logical; it is possible to contract for an advisor to be a fiduciary (although contracting out of fiduciary status is largely restricted under fiduciary law). In addition, holding oneself out as a fiduciary, but not then acting as same, would likely constitute intentional misrepresentation (i.e., actual fraud). Seems pretty straight-forward, i.e., “say what you do, do what you say.”
C)  Is an investment advisor under Section 202(a)(11) of the Investment Advisors Act of 1940.
D) Provides advice, appraisals or fairness opinions as to the value of investments, recommendations as to buying, selling or holding assets, or recommendations as to the management of securities or other property.
The DOL noted that part of the intent of this portion of the test is to establish fiduciary responsibility on parties who provide valuations of closely held employer securities (such as securities held in ESOP plans) and other hard to value plan assets.
Reaction to the 2010 Proposed Regulations. There was a “passionate” and “robust” response from many segments of the securities and insurance industry to the EBSA’s 2010 proposed rule. Lobbying was successful in getting about 100 members of Congress to write to the DOL to question the need for the rule, the pace of the rule’s enactment, the apparent lack of coordination by DOL with SEC, or all three of the foregoing.
Yet, many consumer groups and pro-fiduciary advocates supported the EBSA’s proposed rule. This author submitted two comments, including one which rebutted many of the arguments made by Wall Street’s proxies. See
For a complete listing of public comments, as well as transcripts of a two-day hearing DOL held on the 2010 proposed rule, visit:
The DOL Re-Tools. The DOL has engaged economists (both within and without EBSA) to beef up the economic case for expanding the current definition of fiduciary. (This economic analysis is to be shared with the SEC, as well). EBSA has reviewed all of the comments submitted, and any new re-proposed rule is likely to try to resolve some of the “ambiguities” which some commentators complained about. In addition, EBSA’s Asst. Sec. of Labor Phyllis Borzi remains firmly committed to coming out with a re-proposed rule. See
(6) Will There Be Any Exemptions Provided from the Expanded Definition of Fiduciary?
Let me preface this by stating that exemptions are often granted to agency rules, and yet sometimes the unintended (or intended) consequence is that the exemptions end up “swallowing” the entire rule.  For example, many commentators believe that the “incidental advice” exemption swallowed the rule for the definition of “investment adviser” under the Investment Advisers Act of 1940, under subsequent SEC rule-making. Hence, exemptions must be carefully worded in order to achieve their intended objective, while still achieving the objective of the main rule itself.
Under the 2010 proposed regulation, three major exemptions were provided by EBSA from the definition of “fiduciary”:
The “Seller’s Exemption.”  This exemption was available if recommendations made in the capacity of a seller or purchaser of a security to a plan or participant whose interests are adverse to the plan or its participants, provided that the recipient of the advice or recommendation knows or should have known that the seller or purchaser was not undertaking to provide impartial investment advice (this exception would not include an advisor who has acknowledged fiduciary status). 
As stated in the issuing release, “[t]his provision reflects the Department’s understanding that, in the context of selling investments to a purchaser, a seller’s communications with the purchaser may involve advice or recommendations, within paragraph (c)(1)(i) of the proposal, concerning the investments offered.  The Department has determined that such communications ordinarily should not result in fiduciary status under the proposal if the purchaser knows of the person’s status as a seller whose interests are adverse to those of the purchaser, and that the person is not undertaking to provide impartial investment advice.”
What is interesting about this exemption is that the DOL was proceeding down a path which the SEC has avoided for decade – i.e., drawing a line between “advice” and “sales.” 
In my opinion, there is certainly a place for “product sales” – i.e., situations where one is involved in merchandizing investment products.  The key is to carefully distinguish “merchandizing” from “advice” in a fashion where: (1) if advice is in fact provided, fiduciary status attaches; (2) if advice is not provided, and only a description of the product occurs (with no “recommendation” as to whether the product would be “good” for the customer), that the customer clearly understand that caveat emptor (“let the buyer beware”) applies and that the customer cannot and should not “rely” upon the product provider, other than for an accurate description of the product itself. In addition, the use of titles and designations which denote an advisory relationship should trigger "advisor" ("fiduciary") status.
The “Education Provider” Exemption.  Providing investment education information and materials. Many commentators to this aspect of the proposed regulation questioned how the line between “education” and “advice” would be drawn.
The “Menu of Products” Exemption.  Marketing or making available a menu of investment alternatives that a plan sponsor may choose from, and providing general financial information to assist in selecting and monitoring those investments, provided this is accompanied by a written disclosure that the party is not providing impartial investment advice.
We do not know how each of the foregoing exemptions will be modified under any re-proposed rule.

NOTE: The Prohibited Transaction Rules, and Exemptions Thereto. Over the past two years Asst. Sec. of Labor Phyllis Borzi has hinted that the re-proposed rule may include some special exemptions from the prohibited transaction rules where it is obvious that the participant would benefit from such exemption.
Under ERISA, the term "prohibited transaction" includes any direct or indirect:
  1. The sale, exchange, or leasing of any property between a plan and a disqualified person;
  2. The lending of money or other extension of credit between a plan and a disqualified person;
  3. The furnishing of goods, services, or facilities between a plan and a disqualified person;
  4. The transfer to, or use by or for the benefit of a disqualified person, of the income or assets of a plan;
  5. An act by a disqualified person who is a fiduciary whereby the fiduciary deals with the income or the assets of a plan in his own interest or for his own account; or
  6. Receipt of any consideration by a disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

These prohibited transaction rules are contained in both the Internal Revenue Code and in Title I of ERISA.  The labor law provisions also prohibit fiduciaries from acquiring certain percentages of employer securities or real property.

Also, under current DOL provisions, a fiduciary may not (1) deal with plan assets in his own interest, (2) act in any transaction involving a plan on behalf of a party whose interests are adverse to the plan's interests or those of the participants or beneficiaries, and (3) receive any consideration for his own personal account from any party dealing with the plan in connection with a transaction involving the plan’s assets.

Unlike the application of the “best interests” fiduciary standard under state common law and/or the Investment Advisers Act of 1940, “ERISA’s prohibited transaction rules are unique in that they are absolute. You can never enter into a non-exempt prohibited transaction under ERISA, even if conflicts have been fully disclosed and the client provides its written consent.”  Marcia S. Wagner, Esq., Wagner Law Group, “BASICS OF ERISA” outline, Oct. 17, 2012, at p. 9, available at

There already exist various exemptions from the prohibited transaction rules. However, these exemptions were granted prior to the EBSA’s 2010 proposed rule. In addition, it should be noted that ERISA provides that “the Secretary may not grant an exemption under this subsection unless he finds that such exemption is — (1) administratively feasible, (2) in the interests of the plan and of its participants and beneficiaries, and (3) protective of the rights of participants and beneficiaries of such plan.” 29 USC § 1108(a).

Class exemptions, which possess broad applicability, have been granted in the past. As explained by Marcia S. Wagner, Esq.:

The DOL may grant administrative exemptions allowing a person to engage in a variety of transactions involving employee benefit plans. DOL administrative exemptions can come in the form of ‘class exemptions’ that are available to all persons that can satisfy the applicable conditions, or ‘individual exemptions’ that may only be utilized by the person who requested the exemption.

Class exemptions are administrative exemptions that permit any person to engage in a covered transaction with a plan so long as it is done in accordance with the terms and conditions of the class exemption. Class exemptions typically cover routine plan transactions that were not foreseen when the statutory exemptions in ERISA were enacted. For example, DOL class exemptions permit:

• Investments in mutual funds by a plan when a plan’s investment fiduciary is also affiliated with the fund’s investment manager (subject to fee-leveling so that plan fiduciary does not receive ‘double’ compensation and other conditions of PTE 77-4); and

• Providing brokerage services for a commission, where the broker-dealer or its affiliate is also acting as the plan’s investment manager or adviser (subject to enhanced disclosure requirements and other conditions of PTE 86-128).

“BASICS OF ERISA” at p.12.

Whether these exemptions would continue under the re-proposed rule is the subject of some discussion. Can current industry practices survive under a re-proposed rule? This author thinks that many industry practices will not survive, given the substantial academic research in support of the proposition that higher fees and costs imposed upon plan participants and investors result, on average, in lower returns. Clearly a focus of the EBSA’s disclosure regulations (already adopted) and its “Definition of Fiduciary” re-proposal is to eliminate the often-hidden fees and costs incurred by investors.

In essence, ERISA-governed accounts, and IRA accounts, would be advised upon by “purchaser’s representatives.” Selling of funds to plan sponsors would still be permitted by non-fiduciaries (“seller’s representatives), provided they clearly disclosed their status as such, that they were not providing unbiased advice, and (hopefully) that they only limit their activities to a description of their products.

(7) What Should Plan Sponsors Do Now?

The fact is that litigation against plan sponsors for offering only high-cost, high-fee funds is growing, even under the current ERISA standards.

It is extraordinarily risky for a plan sponsor, for a plan of any size, to deal with a financial services person (or firm) which does not accept full fiduciary obligations. To assist a plan sponsor (as well as individual investors) in locating a “true fiduciary,” I have provided guidance in a prior blog post. See

Wednesday, May 22, 2013

Why American Business Should Support the Bona Fide Fiduciary Standard of Conduct for Investment Advice

American business is the engine which drives forth the growth of our economy, and delivers prosperity for all. An important component of the fuel for this engine is monetary capital. Yet, this monetary capital is not efficiently delivered to the engine of business … it’s as if the engine is stuck using an outdated, clogged carburetor, in the form of substantial intermediation costs by current investment banking practices.

More importantly, the transmission system of our economic vehicle is failing, leading to far less progress in our path toward personal and U.S. economic growth. The transmission system is large, heavy and unwieldy; its sheer weight slows down our vehicle. It unnecessarily diverts much of the power delivered by the engine to Wall Street, rather than deliver it to the investors (our fellow Americans) who provide the monetary capital.

The ramifications of this inefficient vehicle are many, and they are severe. The cost of capital to business is much higher than it should be, due to the significant intermediation costs of Wall Street in raising capital. And, because Wall Street currently diverts away from investors 35% or more of the profits generated by American publicly traded companies, often through high fees and other hidden fees and costs, investors receive far less a proportion of the returns of the capital markets.

This all leads to a high level of individual investor distrust in our system of financial services and in our capital markets. In fact, many individual investors, upset after discovering the high intermediation costs present, flee the capital markets altogether. As a result, the capital markets are further deprived of the capital which fuels American business and economic expansion, and the cost of capital is again raised. Indeed, as higher levels of distrust of financial services continue, the long-term viability of adequate capital formation is threatened.

Even more severe are the long-term impacts of high intermediation costs imposed by Wall Street firms on investors themselves. Individual investors, now largely charged with saving and investing for their own financial futures through 401(k) and other defined contribution retirement plans and IRA accounts, reap far less a portion of the returns of the capital markets than they should. These substantially lower returns from the capital invested, due to Wall Street’s diversion of profits, result in lower reinvestment of the returns by individual investors; this in tern also leads to even lower levels of capital formation for American business.

As individual Americans’ retirement security is not adequately provided through their own investment portfolios, saddled with such high intermediation costs, burdens will shift to governments – federal, state and local – to provide for the essential needs of our senior citizens in future years. These burdens will likely become extraordinary, resulting in far greater government expenditures on social services than would otherwise be necessary. As a consequence, higher tax rates become inevitable, for both American business and individual citizens alike.

In essence, American business has become Wall Street’s servant, rather than its master. The excessive rents extracted at multiple levels by Wall Street firms fuels excessive bonuses paid, in large part, to young investment bankers. Wall Street also drains some of the best talent away from productive businesses, as well. Consequently, Wall Street has become a huge drain on American business and the U.S. economy, as it derives excessive rents at the expense of corporations and individuals. The financial services sector, rather than providing the grease for American's economic engine, instead has become a very thick sludge.

There is but one solution to this crisis. The compelling answer to the problem presented by Wall Street’s excessive growth and consumption of a 35% or greater share of the profits of American business lies in the application of the bona fide fiduciary standard of conduct to all providers of personalized investment advice. Simply put, this broad-based fiduciary standard requires only that financial advisors act in the best interests of their clients.

Yet, Wall Street strongly opposes efforts by the U.S. Department of Labor (Employee Benefits Security Administration) and the U.S. Securities and Exchange Commission to apply a bona fide fiduciary standard to the delivery of investment advice to retirement plan sponsors (business owners), retirement plan participants (employees), and to all Americans. Worse yet, Wall Street and its proxies – brokerage firms, insurance companies, and securities industry organizations which oppose the fiduciary standard – seek to have a “new federal fiduciary standard” adopted which is not a true fiduciary standard at all, and which would permit Wall Street to continue to extract excessive rents from the U.S. economy.

By way of explanation, Wall Street will “accept” more disclosures – provided, of course, they are as general as possible and, as to details, only provided upon request of the client. Yet, a bona fide fiduciary standard of conduct requires much more. While disclosure is important, under a bona fide fiduciary standard of conduct conflicts of interest must be either avoided or, if not avoided, properly managed. And the proper management of a conflict of interest requires not just disclosure of the conflict, but also affirmative disclosure of all of the ramifications of that conflict of interest in a manner designed to ensure client understanding and to secure client consent. Even then, the client must not be harmed (for no truly informed client would ever consent to harm), and the transaction must be substantively fair to the client. Wall Street resists these requirements with a passion, for it knows it would be unable to extract excessive rents, as it does currently, if a bona fide fiduciary standard is applied.

In summary, the bona fide fiduciary standard of conduct is good for all Americans. More importantly, it is good for, and strongly needed by, American business. The application of a true fiduciary standard will assist to restore the much-needed trust in our capital markets, so necessary to foster capital formation and resulting economic growth. Application of the fiduciary standard will result in a much larger and more appropriate share of the returns of the capital markets flowing – not to Wall Street – but instead to investors.

The fiduciary standard of conduct, if applied correctly, will enhance the retirement security of our fellow Americans, reducing future burdens on governments, leading to lower tax rates in future years and greater prosperity for all.

The proper application of the fiduciary standard to the delivery of investment advice, as is now being considered by the DOL and SEC, provides an historic opportunity for American business to speak up, demand adoption and implementation of the bona fide fiduciary standard. In this manner, American business will foster its own future growth, and greater future prosperity for business, our fellow Americans, and for America itself.

I call upon American business leaders to speak up, and let policymakers in Washington, D.C. and beyond know of their concerns for adequacy of future capital formation and economic growth. Unite to restore faith in our capital markets. Resolve to rid our economy of the sludge which slows it down so much, in favor of a more efficient engine and transmission which will propel American business to greater prosperity.

Ron A. Rhoades, JD, CFP(r) is an Asst. Prof. of Business at Alfred State College. To follow this blog, please follow him on Twitter (@140ltd) or link to him via LinkedIn. Please direct any questions to Thank you.

Sunday, May 19, 2013

Musings: “Custodial Support Services Agreements,” RIAs, and Properly Managing Conflicts of Interest

In recent weeks there have been a few articles discussing the implication of one or more independent RIAs receiving a portion of 12b-1 fees paid by mutual funds to a discount custodian.
Another article critical of the arrangement portrayed was posted by Andy Gluck at

Since these articles came out, the question has been posed by several readers of this blog: “Can Registered Investment Advisers (RIAs) receive compensation which is not paid directly by the client?” The Answer: “Yes, and no.”

And the following specific question has also been posed: “Can RIAs receive revenue-sharing, in the form of a portion of 12b-1 fees, from their custodian?” The Answer? “Yes, and no.” Or, as any good lawyer might opine, “it depends.”

Permit me to first convey some additional facts about the practice and compensation method under scrutiny. I then explore the fiduciary of loyalty and what it requires when a conflict of interest is present. I then return to the fee-sharing arrangement between the discount broker (custodian) and the independent RIA firm, and seek to offer an opinion as to whether it is proper.


In the practice under scrutiny, a discount custodian places certain mutual funds on the custodian’s “no-transaction-fee” platform. The mutual fund company pays the custodian all or part of the 12b-1 fees charged to fund shareholders. This practice in itself is not surprising, as this has become the more-or-less standard methodology by which no-transaction-fee funds are offered by discount brokerage firms.

What is surprising, however, is that the discount broker (custodian) then turned around and shared a portion of those fees with an otherwise independent RIA firm (i.e., not one associated with a broker-dealer), under a “custodial support services.”

What services could an RIA possibly be providing to a large discount brokerage firm (custodian)? Part 2A of Form ADV, the "Firm Brochure" of PHH Investments, Ltd. dba Retirement Advisors of America, dated March 2013, states that under the “custodial support services agreement with Fidelity … the Firm provides Fidelity with certain back office, administrative, custodial support and clerical services with respect to Firm accounts (“Support Services”). In exchange, Fidelity provides certain recordkeeping and operational services to the Firm, which may include execution, clearance and settlement of securities transactions, custody of securities and cash balances, and income collections. Fidelity pays the Firm a fee to defray the Firm’s costs and expenses for providing these Support Services. The amounts of these payments are calculated based on the average daily balance of eligible client assets, which consist primarily of client investments in ‘no transaction fee’ mutual funds. The Firm’s receipt of this fee may create a potential conflict of interest. It is the policy of the Firm to place the interest of its clients first, so the decision to invest or not in a particular mutual fund is not dependent upon either of these agreements.”

Similar arrangements may have existed for some time with other RIA firms. For example, here's one disclosure which sets forth the amount of compensation provided:

"[RIA FIRM] has entered into a custodial support services agreement with National Financial Services,
LLC and Fidelity Brokerage Services, LLC (together with National Financial Services LLC,
“Fidelity”) in connection with [FIRM]’s participation in the Fidelity Registered Investment
Advisor Group (“FRIAG”) platform. [FIRM] provides back-office, administrative, custodial
support and clerical services in connection with Client accounts on the FRIAG platform. For
these services, Fidelity pays [FIRM] the following percentage based upon NFPSI Client assets on
the FRIAG Platform:
    Assets                                       Percentage
    $100,000,001 - $150,000,000    0.10%
    $150,000,001 - $200,000,000    0.11%
    $200,000,001 - $500,000,000    0.12%
    $500,000,001 and over              0.14%"

[From the Form ADV, Part 2A dated 2005, of an RIA firm.]

The foregoing Form ADV Part 2 disclosure results in several questions:
  • Are the Fees Paid Reasonable for the Services Provided? First, what are these “back office, administrative, custodial support and clerical services with respect to Firm accounts” that the RIA firm is providing to Fidelity? What value is the RIA firm providing to Fidelity, that merits Fidelity paying a portion of the 12b-1 fees to the RIA firm?
  • Is the Disclosure of Material Facts Made to Client Adequate, Explicit, and Understandable? Second, is the disclosure to the clients adequate? Given that I cannot pinpoint or evaluate the services provided, nor the amount of fees paid to the RIA firm, does the disclosure meet the requirement to disclosure all “material facts” with complete candor? Are other point-of-recommendation disclosures undertaken by the RIA firm to the clients, which provide the level of specific disclosure of material facts required under the fiduciary standard of conduct, in a manner designed to ensure complete client understanding?
  • Has the Client Been Harmed? Third, even with disclosure, is the investment of client funds in no-transaction-fee funds in the client’s best interests? I have previously written about 12b-1 fees, and cautioned RIA firms (and broker-dealers) to avoid them – it is the possible next big scandal to affect the securities industry.  See
Furthermore, since the time of my article referred to above, on the issue of 12b-1 fees, the U.S. Court of Appeals for the 9TH Circuit, in dicta, issued its own warning (applying ERISA’s strict “sole interests” fiduciary standard), 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.”

In essence, the 9th Circuit recognizes that no client would ever provide informed consent to a conflict of interest where the client would be harmed. Since substantial academic evidence exists that fees and costs matter, if 12b-1 fees are charged and not credited back to client accounts, is not the client harmed? In essence, don’t 12b-1 fees nearly always result in a higher overall expense ratio, with no real benefit to the client of a fiduciary advisor?

One can hypothesize that small periodic contributions to a no-transaction-fee fund might be appropriate, to avoid transaction fees and to deploy cash into the markets cost-effectively. But, even then, a prudent RIA firm would likely require the client to sell the no-transaction-fee fund once a certain level of assets was accumulated in same, and purchase a fund without 12b-1 fees instead, in an effort to keep the client’s fees and costs over time as reasonable as possible.


A conflict of interest cannot be dealt with merely by disclosure. A bona fide fiduciary standard requires much more.

The duty of loyalty is a duty imposed upon an investment adviser, as the investment adviser possesses a fiduciary relationship to his or her client. Investment advisers must take only those actions that are within the best interests of the client. The fiduciary should not act in the fiduciary’s own interest. Engaging in self-dealing, misappropriating a client’s assets or opportunities, having material conflicts of interest, or otherwise profiting in a transaction that is not substantively or “entirely fair” to the client may give rise breaches of the duty of loyalty. High standards of conduct are required when advising on other people’s money.

While the “best interests” fiduciary standard often permits disclosure of a conflict of interest followed by the informed consent of the client, it should be noted that the existence of conflicts of interest, even when they are fully disclosed, can serve to undermine the fiduciary relationship and the relationship of trust and confidence with the client. The existence of substantial or numerous conflicts of interest, which otherwise could have been reasonably avoided by the investment adviser, could lead to not only an erosion of the investment adviser’s relationship with the client, but also an erosion of the reputation of the investment advisory profession. Hence, investment advisers should reasonably act to avoid conflicts of interest.

Investment advisers should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. Objectivity is a state of mind, a quality that lends value to a member's services. It is a distinguishing feature of the profession.  The principle of objectivity imposes the obligation to be impartial, intellectually honest, and free of conflicts of interest. Independence precludes relationships that may appear to impair a member's objectivity in rendering investment advice.

Many types of compensation are permissible under these Investment Adviser Rules of Professional Conduct, including commissions, a percentage of assets under management, a flat or retainer fee, hourly fees, or some combination thereof.  However, the term “independence” requires that the investment adviser’s decision is based on the best interests of the client rather than upon extraneous considerations or influences that would convert an otherwise valid decision into a faithless act.

An investment adviser would not be independent if the investment adviser is dominated or beholden to or affiliated with an individual or entity interested in the transaction at issue and is so under their influence that the investment adviser’s discretion and judgment would be sterilized.  Compensation arrangements which vary the investment adviser’s compensation depending upon the investment strategy or products recommended by the investment adviser to the client creates such a severe conflict of interest that investment advisers should act to reasonably avoid such arrangements.

Let me restate this, to be clear: AVOID DIFFERENTIAL OR VARIABLE COMPENSATION ARRANGEMENTS. It will be most difficult to convince a jury that you, the advisor, were acting in the best interests of your client. And the burden of proof falls upon you, the fiduciary, in an action brought for breach of fiduciary duty.

A conflict of interest occurs when the personal interests of the investment adviser or the investment adviser’s firm interferes or could potentially interfere with the investment adviser’s responsibilities to his, her or its clients.  Hence, investment advisers should not accept inappropriate gifts, favors, entertainment, special accommodations, or other things of material value that could influence their decision-making or make them feel beholden to a particular person or firm.


Under the ERISA “sole interests” fiduciary standard and its prohibited transaction rules, an ERISA fiduciary must nearly always avoid conflicts of interest relating to compensation.

However, under the Investment Advisers Act of 1940 and state common law “best interests” fiduciary standard, certain conflicts of interest are permitted – but provided they are properly managed. (Yet, as we will see, it is difficult to properly manage conflicts of interest.)

Why is, under the Advisers Act and state common law, disclosure of a conflict of interest (alone, and without more) insufficient to meet one’s fiduciary obligations? This is because the legal concepts of estoppel and waiver possess a place in anti-fraud law, generally; however, in the fiduciary legal environment estoppel and waiver operate differently than that found in purely commercial relationships. Core fiduciary duties cannot be waived. Nor can clients be expected to contract away their core fiduciary rights.  Estoppel has a different role in the context of “actual fraud,” as opposed to its limited role when dealing with “constructive fraud.” For estoppel to make unactionable a breach of a fiduciary obligation due to the presence of a conflict, it is required that the fiduciary undertake a series of measures, far beyond undertaking mere disclosure of the conflict of interest.

It should be also noted that the common law rules applicable to fiduciaries also include the “no profit rule” (part of the commonly referred-to duty of loyalty), which requires a fiduciary not to profit from his position at the expense of his or her client. At times the no profit rule has been strictly enforced by courts in different types of fiduciary arrangements, even to the point of overturning transactions between fiduciaries and their clients where no extra profit was derived by the fiduciary above that which other market participants would have derived.  in the jurisprudence involving registered investment advisers, such a strict enforcement has not been undertaken - at least not yet.


The jurisprudence of the Investment Advisers Act of 1940 amply illustrates the true nature of fiduciary obligations.  When a conflict of interest is present, “disclosure” followed by “consent” are, in and of themselves, wholly insufficient to prevent a breach of fiduciary obligations.  Disclosure must occur timely and be of all material facts.  The burden is upon the investment adviser to reasonably ensure client understanding, and the client’s “duty to read” is circumscribed.  Such disclosure and achievement of client understanding is fundamental to securing not just the client’s “consent,” but rather the client’s informed consent.  Even then, the proposed action must remain substantively fair to the client.

Breaking this down into its parts, each part can then be separately examined:

First, disclosure must be affirmatively undertaken of all material facts relating to the conflict of interest and its potential impact on the client.

Second, the informed consent of the client is obtained.

Third, the transaction must remain substantively fair to the client.

Disclosure is Required of All Material Facts. “Under federal and state law, you are a fiduciary and must make full disclosure to your clients of all material facts relating to the advisory relationship.”  General Instructions for Part 2 of Form ADV, #3.  In fact, the SEC requires registered investment advisers to undertake a broad variety of affirmative disclosures, well beyond disclosures of conflicts of interest, and many of these disclosures are required to be found in Form ADV, Parts 1 and 2A and 2B.  For example, Part 2A requires information about the adviser’s range of fees, methods of analysis, investment strategies and risk of loss, brokerage (including trade aggregation policies and directed brokerage practices, as well as use of soft dollars), review of accounts, client referrals and other compensation, disciplinary history, and financial information, among other matters. (A full listing and discussion of the extent of these disclosures is beyond the scope of this article.)

SEC Staff also recently noted that under the “antifraud provisions of the Advisers Act, an investment adviser must disclose material facts to its clients and prospective clients whenever the failure to do so would defraud or operate as a fraud or deceit upon any such person.  The adviser’s fiduciary duty of disclosure is a broad one, and delivery of the adviser’s brochure alone may not fully satisfy the adviser’s disclosure obligations.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.23 (available at

Furthermore, disclosure must be undertaken with absolute candor and clarity. As stated by Justice Cardoza: “If dual interests are to be served, the disclosure to be effective must lay bare the truth, without ambiguity of reservation, in all its stark significance ….”  Wendt v. Fischer, 243 N.Y. 439, 154 N.E. 303 (1926).

The extent of the disclosure required is made clear by cases applying the fiduciary standard of conduct in related advisory contexts. “The fact that the client knows of a conflict is not enough to satisfy the attorney's duty of full disclosure.” In re Src Holding Corp., 364 B.R. 1 (D. Minn., 2007).  "Consent can only come after consultation — which the rule contemplates as full disclosure.... [I]t is not sufficient that both parties be informed of the fact that the lawyer is undertaking to represent both of them, but he must explain to them the nature of the conflict of interest in such detail so that they can understand the reasons why it may be desirable for each to [withhold consent].") Florida Ins. Guar. Ass'n Inc. v. Carey Canada, Inc., 749 F.Supp. 255, 259 (S.D.Fla.1990) (quoting Unified Sewerage Agency, Etc. v. Jeko, Inc., 646 F.2d 1339, 1345-46 (9th Cir.1981)); see also British Airways, PLC v. Port Authority of N.Y. and N.J., 862 F.Supp. 889, 900 (E.D.N.Y.1994) (stating that the burden is on the client's attorney to fully inform and obtain consent from the client); Kabi Pharmacia AB v. Alcon Surgical, Inc., 803 F.Supp. 957, 963 (D.Del.1992) (stating that evidence of the client's constructive knowledge of a conflict would not be sufficient to satisfy the attorney's consultation duty); Manoir-Electroalloys Corp. v. Amalloy Corp., 711 F.Supp. 188, 195 (D.N.J.1989) ("Constructive notice of the pertinent facts is not sufficient.").  A client of a fiduciary is not responsible for recognizing the conflict and stating his or her lack of consent in order to avoid waiver.  Manoir-Electroalloys, 711 F.Supp. at 195.  Rather, “[t]he lawyer bears the duty to recognize the legal significance of his or her actions in entering a conflicted situation and fully share that legal significance with clients.”  In re Src Holding Corp., 364 B.R. 1, 48 (D. Minn., 2007).

But, having said all of the foregoing, what is a “material fact”?  “When a stock broker or financial advisor is providing financial or investment advice, he or she … is required to disclose facts that are material to the client's decision-making.”  Johnson v. John Hancock Funds, No. M2005-00356-COA-R3-CV (Tenn. App. 6/30/2006) (Tenn. App., 2006). A material fact is “anything which might affect the (client’s) decision whether or how to act.”  Allen Realty Corp. v. Holbert, 318 S.E.2d 592, 227 Va. 441 (Va., 1984).  A fact is considered material if there is a substantial likelihood that a reasonable investor would consider the information to be important in making an investment decision. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976); Basic, Inc. v. Levinson, 485 U.S. 224, 233 (1988).

In essence, a material conflict of interest is always a material fact requiring disclosure.  The existence of a conflict of interest is a material fact that an investment adviser must disclose to its clients because it "might incline an investment adviser -- consciously or unconsciously -- to render advice that was not disinterested." SEC v. Capital Gains Research Bureau, Inc., 375 U.S. at 191-192.

Disclosure Must be Adequately Undertaken.

“The [SEC} Staff believes that it is the firm’s responsibility—not the customers’—to reasonably ensure that any material conflicts of interest are fully, fairly and clearly disclosed so that investors may fully understand them.”  SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), p.117 (available at

As stated in an early case applying the Advisers Act:  “It is not enough that one who acts as an admitted fiduciary proclaim that he or she stands ever ready to divulge material facts to the ones whose interests she is being paid to protect. Some knowledge is prerequisite to intelligent questioning. This is particularly true in the securities field. Readiness and willingness to disclose are not equivalent to disclosure. The statutes and rules discussed above make it unlawful to omit to state material facts irrespective of alleged (or proven) willingness or readiness to supply that which has been omitted.” Hughes v. SEC, 174 F.2d 969 (D.C. Cir., 1949).

Disclosure Must Be Sufficient to Obtain Client “Understanding.”  As stated in an early decision by the U.S. Securities and Exchange Commission: “[We] may point out that no hard and fast rule can be set down as to an appropriate method for registrant to disclose the fact that she proposes to deal on her own account. The method and extent of disclosure depends upon the particular client involved. The investor who is not familiar with the practices of the securities business requires a more extensive explanation than the informed investor. The explanation must be such, however, that the particular client is clearly advised and understands before the completion of each transaction that registrant proposes to sell her own securities.”  In re the Matter of Arleen Hughes, SEC Release No. 4048 (1948).

Even with Informed Consent, the Proposed Transaction Must Be Fair and Reasonable to the Client.  “One of the most stringent precepts in the law is that a fiduciary shall not engage in self-dealing and when he is so charged, his actions will be scrutinized most carefully. When a fiduciary engages in self-dealing, there is inevitably a conflict of interest: as fiduciary he is bound to secure the greatest advantage for the beneficiaries; yet to do so might work to his personal disadvantage. Because of the conflict inherent in such transaction, it is voidable by the beneficiaries unless they have consented. Even then, it is voidable if the fiduciary fails to disclose material facts which he knew or should have known, if he used the influence of his position to induce the consent or if the transaction was not in all respects fair and reasonable.”  [Emphasis added.Birnbaum v. Birnbaum, 117 A.D.2d 409, 503 N.Y.S.2d 451 (N.Y.A.D. 4 Dept., 1986).


Regardless of whether conflicts of interest are permitted under federal securities law for RIAs, or under state common law, there is both early authority and recent academic research indicating that investment advisers, to truly act in the best interests of their client, should avoid conflicts of interest to the extent reasonable to do so:
  • “[T]he Committee Reports indicate a desire to ... eliminate conflicts of interest between the investment adviser and the clients as safeguards both to 'unsophisticated investors' and to 'bona fide investment counsel.' The [IAA] thus reflects a ... congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to render advice which was not disinterested.”  SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-2 (1963). 
  • “The IAA arose from a consensus between industry and the SEC that ‘investment advisers could not 'completely perform their basic function — furnishing to clients on a personal basis competent, unbiased, and continuous advice regarding the sound management of their investments — unless all conflicts of interest between the investment counsel and the client were removed.'” Financial Planning Association v. Securities and Exchange Commission, No. 04-1242 (D.C. Cir. 3/30/2007) (D.C. Cir., 2007), citing SEC vs. Capital Gains at 187.
  •  “The temptation of self-interest is too powerful and insinuating to be trusted. Man cannot serve two masters; he will foresake the one and cleave to the other. Between two conflicting interests, it is easy to foresee, and all experience has shown, whose interests will be neglected and sacrificed. The temptation to neglect the interest of those thus confided must be removed by taking away the right to hold, however fair the purchase, or full the consideration paid; for it would be impossible, in many cases, to ferret out the secret knowledge of facts and advantages of the purchaser, known to the trustee or others acting in the like character. The best and only safe antidote is in the extraction of the sting; by denying the right to hold, the temptation and power to do wrong is destroyed.”  Thorp v. McCullum, 1 Gilman (6 Ill.) 614, 626 (1844).
  • “Conflicts of interest can lead experts to give biased and corrupt advice.  Although disclosure is often proposed as a potential solution to these problems, we show that it can have perverse effects.  First, people generally do not discount advice from biased advisors as much as they should, even when advisors’ conflicts of interest are honestly disclosed.  Second, disclosure can increase the bias in advice because it leads advisors to feel morally licensed and strategically encouraged to exaggerate their advice even further. As a result, disclosure may fail to solve the problems created by conflicts of interest and may sometimes even make matters worse.”  Cain, Daylian M., Loewenstein, George, and Moore, Don A., “The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest” (2003).
These cases leave open the possibility that most conflicts of interest are prohibited for RIAs operating under state common law and the Investment Advisers Act of 1940. The purpose of avoiding conflicts of interest is, without a doubt, to maintain the complete objectivity of the investment adviser, and to avoid the conflict of interest even unconsciously affecting his or her judgment.


Without knowledge of all of the facts behind these “custodial support services” arrangements, it is impossible to know if the existence of these “custodial services support agreements” and the sharing of revenues by discount brokers to RIA firm arising from these agreements causes harm to the client.

It is easy to suspect that the practice of paying 12b-1 fees to the RIA firm is not in accord with the RIA firm's fiduciary duty. The services provided by the firm do not appear to be of the type which would result in each client who bears the burden of such fee receiving a benefit in accordance with the payment of such "extra" 12b-1 fees.

However, I cannot rush to judgment. More facts are required.

Unfortunately, Jed Horowitz may have uncovered just the tip of a very dark and ugly iceberg. Many RIA firms possess insurance agency affiliates, and often the investment adviser representatives recommend the purchase of costly life insurance and annuity products.

Moreover, In the world of dual registrants (i.e., where RIAs are jointly licensed as broker-dealer firms, or have an affiliated broker-dealer firm) many more pervasive conflicts of interest exist.  Just look at this disclosure, found in a large dual registrant's Form ADV, Part 2:

  • "Some of our Advisors may participate in incentive trips and receive other forms of non-cash compensation based on the amount of their sales through NFPSI, affiliated marketing groups or nonaffiliated marketing groups or product manufacturers. To the extent your Advisor participates in an incentive trip or receives other forms of non-cash compensation, a conflict of interest exists in connection with the Advisor’s recommendation of products and services for which they receive these additional economic benefits."

(There is no discussion in the Form ADV from which the above paragraph was taken as to how such conflict of interest was properly managed, to keep the best interests of the client paramount. Presumably such discussion is lacking because proper management of such an insidious conflict of interest was not even possible.)

The fact of the matter is, many firms - especially dual registrants - don't believe that the fiduciary duty to avoid conflicts of interest, or to properly manage conflicts of interest, is all that important. Many believe that once a conflict of interest is disclosed, that such disclosure provides a license to the advisor to engage in conduct which harms the client. Of course, nothing could be further from the truth.

We have a long way to go to create a profession. Especially as Wall Street and the insurance companies continue their assault on the SEC and DOL/EBSA, to not proceed with the application of fiduciary duties by regulation. (Alternatively, they desire a "new federal fiduciary standard" that involves disclosure only.)

In the meantime, I hope that a reader of this blog post will forward more information about these "custodial support service" arrangements to me (E-mail:, so that I can then provide an informed opinion on this matter.