Monday, November 23, 2015

I Believe In A Bona Fide Fiduciary Standard

I believe in a bona fide Fiduciary Standard.

I believe when you say, "I act in my client's best interests," it means never placing your interests above that of the client. No caveats. No disclaimers.

(I reject the "Best Interests" standard proposed by SIFMA, endorsed by FINRA, and now finding its way in legislation in the U.S. House of Representatives. This "best interests" standard does not require loyalty by the financial or investment adviser. It does not require the continued duty to keep the client's best interest paramount at all times. It permits waivers of fiduciary standards, via mere disclosure. As I've explained before, it is nothing more than "suitability." Worse - it's fraud by rule-making or legislation.)

I believe that core fiduciary duties cannot be waived by clients, nor can disclaimers of fiduciary duties be upheld as legitimate.

I believe that when a person or firm states: "I/We provide objective advice" - It should mean that conflicts of interest are avoided, and that the firm should be held to a nonwaivable fiduciary standard of conduct.

I believe conflicts of interest cannot just be "disclosed away," and that if a conflict of interest is unavoidable then full and complete disclosure of all material facts (including the ramification of the disclosure) must be affirmatively undertaken in a manner to ensure client understanding and to secure the client's informed consent, and even then that the suggested course of action remain substantively fair to the client. For no client would ever consent to be harmed.

I believe when you say, "I am a fiduciary," it means that you cannot push proprietary products, engage in principal trading, receive additional compensation for recommending one product over another, receive revenue sharing payments (including payments for shelf space or 12b-1 fees), or even receive soft dollar compensation.

I believe when you hold out as an advisor (as opposed to a salesperson), whether by use of the terms "financial consultant" or "financial advisor" or "financial planner" or "wealth manager" or any other similar terms, or by using designations such as CFP(r) or ChFC, you represent yourself as a trusted advisor, and should accordingly act as such at all times.

I believe that holding yourself out as a trusted advisor, and not accepting fiduciary status and its burdens and restraints upon conduct, is tantamount to fraud.

I believe that each person should honestly, and forthrightly, say what he or she does, and then should do what he or she says.

I believe that once you accept fiduciary status toward a client, it extends to all aspects of your professional relationship of the client, and that the fiduciary hat cannot be removed.

I believe it is not possible to wear two hats at one time. (And a lot of jurists agree with me.)

I believe that, by either holding out as a trusted financial advisor, or acting as same, you are bound to exercise a professional level of due care, requiring expertise and experience and sound judgment.

I believe, to paraphrase the late Justice Benjamin Cardoza, that the fiduciary standard should not be diminished by "particularized exceptions" which are developed over time.

I believe that I am a steward of my clients' wealth. It is not there for me to play with. I must deal with it prudently, and wisely, applying my vast knowledge of the workings of the capital markets to seek to achieve my client's lifetime financial goals.

I believe that as a financial and investment adviser, I am a professional.

I believe that we, as professionals, should always place the interests of the public ahead of our own.

I believe as a trusted, expert advisor I am entitled to professional-level compensation - not more, and not less.

I believe that promotion of the fiduciary standard will continue, as advocates (such as those in The Committee for the Fiduciary Standard) continue to seek to aid our fellow Americans to receive the honest, trusted advice they all so richly deserve.

I believe that, following the imposition of a bona fide fiduciary standard for all providers of financial and investment advice, the demand for financial planning and investment advice will soar, Americans will become more trusting of the capital markets, the cost of capital will decline, and fuel will be provided to propel America's economy forward.

I believe in The Fiduciary Oath. I believe every single consumer of financial and investment advice should absolutely insist upon the signature of his or her financial or investment advisor to such Oath.

I believe that the best financial planners and investment advisers will migrate to professional associations that seek to minimize all conflicts of interest, by not engaging in third-party compensation schemes. These associations include NAPFA (of which I am a member), Garrett Planning Network (of which I am a member), the Alliance of Comprehensive Planners, and XY Planning Network.

I believe that, over time, consumers will migrate to professional financial and investment advisers that eschew conflicts of interest, whenever possible, and that the media will continue to play an important role in directing consumers to the organizations listed above.

I believe that the time has come to shed the "product sales" roots of the financial planning profession, for once and all.

I believe that we should regulate ourselves. For regulators will usually not understand how to properly evaluate our adherence to our fiduciary duty of due care, nor to our fiduciary duties of loyalty and good faith.

I believe in peer review.

I believe that many of the regulations imposed upon investment advisers over the past 15 years result in time-consuming dotting of the "i's" and crossing of the "t's" - with little impact on deferring fraud or assisting consumers.

I believe that the application of a bona fide fiduciary standard to personalized investment advice, in this ever-more complex financial world, is inevitable. Perhaps not this year, or even this decade. Perhaps not even in my lifetime. But some day.

I believe that government has a role, in setting professional standards, but that government resources are and should be limited, and that government oversight should be reserved for necessary interventions that detect and punish actual fraud and other severe violations.

I believe professional standards of conduct can, and should be, promulgated in such a manner as to provide the professionals with adequate guidance on their activities.

I believe that most advisors would prefer to practice under a bona fide fiduciary standard of conduct, if their firms would let them.

I believe that nearly all consumers would prefer to work with trusted, professional advisers, rather than with product salespersons.

I believe the demise of Wall Street and insurance firms, dedicated to the formulation and distribution of expensive products, is inevitable.

I believe that, even if the huge lobbying efforts by Wall Street and the insurance companies prevent the DOL and the SEC from applying fiduciary standards, that professionals who desire the bona fide fiduciary standard will, nevertheless, prevail in the marketplace over time.

I believe that fees and costs matter, as so much academic research has confirmed.

I believe that, as stewards of our clients' wealth, professional financial and investment advisers possess the duty to ensure that only such fees and costs as are reasonable and necessary are incurred by the client.

I believe that, on average, 90% of the returns offered by the capital markets should flow to individual investors, rather than intermediation consuming 30% to 50% (on average) of those returns.

I believe that capital accumulation is thwarted by our current conflict-ridden financial services system, in which there exist a huge extraction of rents by Wall Street firms, insurance companies, and some others.

I believe that the application of the fiduciary standard will result in a new era of capital accumulation and capital formation, lower costs of capital for firms, and an expanding U.S. economy.

I believe that trust will prevail over betrayals of trust.

I believe that fairness will prevail over greed.

I believe that right will prevail over wrong.I believe.

And - I will continue to believe.

Ron A. Rhoades, JD, CFP(r) serves as Director of the Financial Planning Program at Western Kentucky University. The views expressed herein are his own, and are not necessarily representative of those institutions, organizations and firms of which he is a member.

Wednesday, November 18, 2015

Third-Party Exams for RIAs Proposed; Is It Time to Embrace a True Profession?

As the SEC moves toward proposing a rule for third-party exams of registered investment adviser (RIAs), it seems appropriate to ask - "As professionals, what would we like to be?"

The answer is clear, in the minds of many - a true profession. In which we are proud to call ourselves by the titles that denote those within the profession. In which we practice with high degrees of skill, with singular devotion and determination to assisting our clients to attain their lifetime financial goals.

A true profession - in which the leaders of the profession maintain the highest levels of professional conduct for its members. For these leaders will know, that in so doing, the public will trust the members of the profession, and demand for the professional services of its members will soar, and then remain high.

How do we lead the profession? Through a professional organization.

A professional organization, composed of individual members, that is committed to serving the public interest.

Of course, this organization would not be FINRA (formerly known as NASD). As Tamar Frankel, America’s leading scholar on fiduciary law as applied to the securities industry, wrote in 1965:  “NASD … [does] not, as do the professions, consider the public interest as one of [its] goals … Let us consider the attitude of the professions toward the public interest. The goal of public service is embedded in the definition of a profession. (Pound, The Lawyer from antiquity to modern times 5 1963). A profession performs a unique service; it requires a long period of academic training. Service to the community rather than economic gain is the dominant motive. We may measure the broker-dealer’s activities against these criteria … Although at least part of his trade is to give service, profit is his goal. The public interest is stated in negative terms: he should refrain from wrongdoing because it does not pay. This attitude is the crux of the matter, the heart of the difference between a profession and the broker-dealer’s activity … The industry emphasizes its merchandising aspect, and argues that the broker-dealer is subject to the duties of a merchandiser even when he is also acting is his advisory capacity … the NASD [has] proved incapable of establishing accepted standards of behavior for the activities of the trade … Past experience has proved that it is unrealistic to expect the NASD to regulate in the public interest ….” (Tamar Frankel, f/k/a Tamar Hed-Hoffman, “The Maloney Act Experiment,” 6 Boston College L.R. 186, 217 1965).

Sadly, fifty years later, the words of Tamar Frankel are still true, with respect to FINRA.

But another professional organization, other than FINRA, can reach the lofty heights resulting from a true profession. And, by maintaining and enhancing the professional standards of its members over time, the services of its members become more attractive to the public, fueling demand for the services of its members.  The key ingredient, in this regard, is that the needs of the client always come first – i.e., a bona fide fiduciary standard is maintained.

In other words, conflicts of interest are avoided, wherever possible. And, where not possible to avoid a conflict of interest, a multi-step process is followed to strictly and properly manage the conflict of interest to insure that the client is not harmed.

And, the organization must have as it members individuals (who are more likely to keep professional standards at high levels), not firms (who tend to promote their commercial interests).

Where to begin?

First, we must look to our current organizations.

Are any of them willing to step up to the table and adopt high Standards of Professional Conduct to which there members must adhere? These Standards of Professional Conduct should carefully, and deliberately, spell out the fiduciary duties to which the members should adhere. Commentary should follow each enunciated principle, providing insights into how the principle is to be properly applied.

The fiduciary standard should be applied at all times, to members of this organization, when providing any information, education or advice regarding financial or investment matters to clients or prospective clients. No "fine lines" should be drawn (such as when "material elements of financial planning" are taking place).

All members should be required to abide by the Rules of Professional Conduct. A "Fiduciary Oath" (perhaps of the type promoted by The Committee for the Fiduciary Standard) might be undertaken.

If third-party exams are required, the non-profit organization should be positioned to offer such exams, both to satisfy regulatory requirements for exams as well as ensuring that its members adhere to the organization's Standards of Professional Conduct.

If one of the current organizations is not willing to step up to accept this challenge, then (as Bob Veres has recently opined may be necessary) a new non-profit professional organization might be formed.

This new professional organization could start small, and slowly build. It would offer a meaningful designation, enabling members to clearly differentiate themselves from those who won't subscribe to the organization's Standards of Professional Conduct. Members should possess a high degree of expertise, evidenced by passing one of 3 or 4 certification exams - and perhaps more.

Then, if the SEC moves forward with third-party exams, this professional organization can step in to serve - perhaps as one of several competing organizations in the third-party exam space. The existence of this organization might, over time, result in a "rush to the top" as to standards of conduct, as other organizations seek to emulate it.

And, as a non-profit organization, the fees for third-party exams would be driven down to be as low as possible.

Additionally, the organization might work with the SEC and state securities administrators to foster the promulgation of education surrounding compliance with laws, regulations and standards. The organization could seek to reduce the (costly) compliance burdens of its members by providing up-to-date compliance policies and procedures. And the organization may well advocate to reduce some of the "dot the 'i', cross the 't'" burdens that investment advisers are subject to (unlike CPAs and attorneys), and to reduce the frequency of exams for low-risk firms (always, however, undertaking limited-scope and frequent exams regarding asset verification - custody - of client assets, as a means to deter and detect actual fraud).

Additionally, the organization could promote, through education, higher levels of due diligence as to investment and insurance product and investment manager selection. Academic research regarding MPT, asset allocation, asset class selection, portfolio design and construction, portfolio management, retirement rates of withdrawal, and behavioral finance could be much more heavily emphasized in educational sessions - which could be produced and made available at lower costs to its members.

The organization could provide real-life examples of how to comply with the Standards of Professional Conduct so adopted, by maintaining an online, searchable library of actual cases, commentary, and advisory opinions.

The organization might issue advisory opinions, when called upon. So that members who confront situations can find out the proper course of action, rather than guess.

The organization might work with the SEC and state securities administrators to foster peer review. The first form of peer review would be of a voluntary manner, designed to examine and improve the processes of a firm. This peer review process would be informative, and proactive, and helpful - and not requiring any report to a securities regulator (unless theft of client funds was discovered, or some other similarly egregious violation).

The second form of peer review should be of a mandatory nature, so that whenever a member's conduct is called into question by the filing of a complaint, a panel of his or her peers determines whether there is probable cause to proceed with a hearing, and then, later, determines whether a violation has occurred. Because, except in cases involving actual fraud (and certain other clear violations), only expert professionals can opine on whether another professional's conduct adheres to the duties that exist. It is far better for professionals to judge the conduct of other professionals.

Is it time?

As an emerging profession, is it time to shed the "sales" roots of financial planning?

Is it time to become trusted advisers to our clients through non-waivable core fiduciary duties?

Is it time for each and every financial and investment adviser to train to become a true expert, and then to maintain that high degree of expertise through ongoing education?

Is it time for every financial and investment adviser to be, at all times, completely candid and honest with their clients. Even at the risk of termination of the adviser-client relationship?

Is it time for every "financial consultant" or "financial advisor" or "wealth manager" or "investment advisor" or "estate planner" or "financial planner" or "Certified Financial Planner(tm)" or "Chartered Financial Consultant" or "Personal Financial Specialist" (or whatever other term is utilized that, by its very nature, denotes a relationship of trust and confidence) to use those terms only if they agree to act as fiduciaries at all time?

Is it time for financial planners and all who provide investment advice to act, at all times, not as representatives of some investment product manufacturer, or product distribution company, but rather as a representative of the client?

Is it time for us to treat each and every client as if that client were our parent, sibling, child, or aunt, uncle, niece of nephew? To keep the best interests of our clients paramount at all times.

Is it time for our profession to move to fully embrace business models which avoid conflicts of interest wherever possible. Because mere disclosure of a conflict of interest does not fulfill the fiduciary duties of due care, loyalty, and utmost good faith?

Is it time for us to embrace the call for a true profession?

What do you think?

Monday, November 16, 2015

Fiduciary Duties Conform to the Level of Protection Required

It is time for financial planners and investment advisers to become part of a true profession.

There are many different types of fiduciary relationships. The duty of loyalty itself, and the ability to waive the fiduciary standard, is adjusted to fit the varied types of relationships. In some fiduciary relationships, less protection is required; in others, a much stronger degree of protection required. Generally, the greater the disparity in knowledge and skill between the fiduciary and the entrusted (agent, or business partner, or client), the more strictly the fiduciary standard of loyalty is applied.

Employer-employee relationships. For example, suppose you are an employer, and your employee acts as your agent to purchase some goods for you. The employee has a fiduciary duty to you. Under the best interests fiduciary standard applicable to principal-agent relationships, any conflicts of interest which exist or which may arise must be disclosed by the employee, and the employer must provide consent. For example, if the employee earns a commission upon the purchase of goods, the employer may consent to the employee’s receipt of that commission. In essence, the employer may waive this non-adherence to the fiduciary duty of loyalty that the employee possesses. Of course, in this type of relationship the employer nearly always has greater power and greater knowledge of the subject matter, than the employee. Hence, we don’t feel a great need to protect the employer, as long as there is affirmative disclosure of the conflict of interest and informed consent.

Business Partners. Then there are fiduciary relationships applicable to partners, or members of a limited liability company, with respect to each other. Most state laws permit the parties, at least to some degree, to contract out of fiduciary duties that might otherwise apply. In these situations the law recognizes that the partners likely possess equivalent knowledge and fairly equal bargaining positions, at least when the partnership or limited liability company relationship is entered into.

Attorney-Client Relationships. In contrast, look at the fiduciary relationship between an attorney and her or his client. The law recognizes that, in such a relationship, the attorney has vastly superior knowledge than the client possesses of the law and how the law might be applied. Hence, the lawyer cannot ask a client to waive compliance with a lawyer’s duty of care, nor can the lawyer ask a client to simply waive a conflict of interest where the lawyer is likely to secure a monetary benefit.

For example, under Rule 1.8(a) of the American Bar Association’s Model Rules of Professional Conduct, a “lawyer shall not enter into a business transaction with a client or knowingly acquire an ownership, possessory, security or other pecuniary interest adverse to a client unless: (1) the transaction and terms on which the lawyer acquires the interest are fair and reasonable to the client and are fully disclosed and transmitted in writing in a manner that can be reasonably understood by the client; (2) the client is advised in writing of the desirability of seeking and is given a reasonable opportunity to seek the advice of independent legal counsel on the transaction; and (3) the client gives informed consent, in a writing signed by the client, to the essential terms of the transaction and the lawyer's role in the transaction, including whether the lawyer is representing the client in the transaction.”

Hence, the ethics rules governing attorneys require multiple steps when a lawyer might acquire a pecuniary interest that is adverse to that of the client. The transaction must remain fair and reasonable. The lawyer must advise the client that the client should seek out independent legal counsel. And the client must provide informed consent to the transaction.

But, it is self-evident, that consent is not “informed” – nor is the transaction “fair and reasonable” – if the client might be harmed. The ABA’s comment to Rule 1.8 provides this example: “[I]f a lawyer learns that a client intends to purchase and develop several parcels of land, the lawyer may not use that information to purchase one of the parcels in competition with the client or to recommend that another client make such a purchase. The Rule does not prohibit uses that do not disadvantage the client. For example, a lawyer who learns a government agency's interpretation of trade legislation during the representation of one client may properly use that information to benefit other clients.

Investment Adviser - Client Relationships. So now we turn to investment advisers. Are investment advisers more like employers, or more like partners, or more like lawyers, in terms of the stature and abilities and knowledge of the entrustor - employer, other partners, or client? One can only conclude that clients of financial and investment advisers are much more like clients of attorneys, and not at all like partners entering into a partnership agreement (who presumably have fairly equal knowledge and expertise). Clients of investment advisers certainly don't possess the superior knowledge and skill that most employers possess with respect to their employees.

Clients of investment advisers simply lack the knowledge of the financial markets that financial advisors do. And clients are not likely to gain such knowledge without a very substantial investment of time and effort, and even then many clients won’t possess the aptitude for matters of finance.

Hence, between investment advisers and their clients there exists this huge gap of information. This gap is what allows the clients of a fiduciary to be taken advantage of. The academic research in support of this is absolutely clear. We are no more likely to turn the average consumer into a skilled consumer of investment advice, armed with all the knowledge required to protect himself or herself, than we are to turn the patient of a doctor into a brain surgeon.

Many Clients of "Financial Advisors" Believe Their Advisor Doesn't Get Paid - Anything! The SEC knows this. The 2008 Rand Report, commissioned by the SEC, revealed that 35% (75 of 214) clients of professionals who were able to answer a question on fees thought that were paying no fees to their financial advisor. Many more clients couldn’t answer the question posed by Rand, in their survey.

I have personally seen this lack of knowledge over and over again. I have talked to many potential clients who, upon inquiry, thought that their broker was a "good guy" who "was not charging us, because he is a friend."

Second Opinions Reveal the Harm Often Caused.  A couple of years ago I did a portfolio review for a highly educated retired engineer and executive. This person, despite spending time reading much of the information that was provided, had no idea that she was paying total fees and costs which approached 2.5% on a portfolio which was well over $1.5 million. For another couple, for whom I did a portfolio review about a year ago, the couple had no idea that the dual registrant who was serving them was, in addition to receipt of investment advisory fees, also getting 12b-1 fees and payments for shelf space.

I often provide second opinions on portfolios. When I do my analysis, and reveal these fees and costs to the clients of these “financial advisors,” these individual investors often get very angry. Not just at brokers, but at the entire financial services system.

Disclosures Are Ineffective. It is just absolutely clear that investment disclosures are not read. Even if read, these disclosures are not understood. No amount of simplification of disclosures is going to fix this. For even if high fees are revealed, many clients believe that high-cost products are better investments. Of course, the academic research is clear that higher-cost products, on average, directly correlate with lower returns to investors.

In Conclusion.

There currently exists a "battle for the soul of the profession." On one side are those who desire to adhere to the old ways - trust-based selling leading to product sales. On the other side are those who recognize that the fiduciary standard is needed - both to protect our fellow Americans but also to bring the delivery of financial planning and investment advice to the level of a true profession.

Which side are you on?

Saturday, November 7, 2015

Congress: The DOL’s “Conflict of Interest” Rule is Good for American Business


  • American corporations, large and small, including business owners, would receive substantial protection from potential liability, as a result of the DOL's proposed Conflicts of Interest Rule. 
  • Rather than being hung "out to dry" by their "retirement plan consultants" who largely escape liability for recommendations made to plan sponsors, corporations would be able to hold retirement plan consultants accountable for their recommendations.
  • Several recent cases illustrate that American business often suffers, while Wall Street firms and insurance companies escape liability.
  • The DOL's rule to remove conflicts of interest, when providing advice to business owners on establishing and maintaining retirement plans, provides important protection for American business. American business, including the U.S. Chamber of Commerce, should support the interests of plan sponsors by supporting the DOL's Conflict of Interest rule.

Congress primarily intended ERISA to be a consumer protection bill. Frank Cummings, ERISA: The Reasonable Expec-tation Bill, 65 Tax Notes 880, 881 (1994). Congress desired employees to have "enhanced protection for their benefits." Metro Life Ins. Co. v. Glenn, 554 U.S. 105, 114, 128 S. Ct. 2343, 171 L. Ed. 2d 299 (2008) (citing Varity Corp. v. Howe, 516 U.S. 489, 497, 116 S. Ct. 1065, 134 L. Ed. 2d 130 (1996)).
To accomplish these goals Congress makes an ERISA fiduciary liable for failing to comply with the strict trust standards codified by ERISA. However, due to a regulation adopted by the U.S. Department of Labor shortly after the enactment of ERISA, and before the beginning of 401(k) plans, many of the insurance companies and broker-dealer firms who currently provide advice to companies (employers, or plan sponsors) escape liability for their recommendations, as they are not found to be “fiduciaries” under the overly permissive language of the 1975 regulation, as interpreted by the courts.
Disputes over defined contribution plan fees and expenses are a common form of recent litigation and raise both duty of disclosure and duty of prudence issues. Fiduciaries have an obligation to administer plan duties with reasonable fees and must attempt to defray unnecessary fees as a part of their prudence obligation. The essence of fee litigation cases is that "the [plan] fiduciaries had an obligation to avoid higher than necessary fees in the mutual fund options offered in a plan menu, and failed to do so." See Stephen D. Rosenberg, Retreat from the High Water Mark: Breach of Fiduciary Duty Claims Involving Excessive Fees After Tibble v. Edison International, J. Pension Benefits, Spring 2011, at 12, 13.
Higher fees and costs associated with investment products result, on average, and pervasively, lower returns for investors in those products. It's that simple. And the academic evidence on this is clear. (For a review of recent academic research on this issue, see my comment letter to the DOL, July 2015.)
In excessive fee litigation, employers are often “on the hook” for claims arising for breach of fiduciary obligations, such as choosing mutual funds and other investment options that possess excessive fees. Yet, the insurance companies and broker-dealer firms, even when they provide “fiduciary warranties” to the employers, largely escape liability in such instances. In essence, employers (plan sponsors) are held liable for following the advice provided to them by insurance companies and broker-dealer firms, yet these firms are not held accountable for such advice. Employers suffer the consequences for the advice provided to them by insurance companies and broker-dealer firms, while these insurance and brokerage firms are “off the hook” through their use of clever disclaimers and other techniques in which they ensure that the courts will not find them to act as "fiduciaries."
To correct this unfair treatment, in which plan participants are harmed, employers (plan sponsors) are often liable, but the real experts (financial services firms) escape liability, the U.S. Department of Labor has proposed to greatly expand the definition of “fiduciary” with its new “Conflict of Interest” proposed regulation. However, Wall Street and the insurance companies are currently spending tens (if not hundreds) of millions of dollars to attempt to stop the U.S. Department of Labor’s proposal to revise its outdated rules. In essence, these financial services firms do not want to be held to account for the advice they provide.
Instead, Wall Street and the insurance companies now propose a new “best interests” standard that, upon closer examination, imposes no new significant duties upon them. While casual disclosure of conflicts of interest (such as “our interests may not be the same as yours”) might be required under this new “best interests” standard, the amount and quality of the disclosures are highly suspect. Even if the disclosures were of sufficient detail, disclosures pose significant problems in their application and effectiveness. While requiring increased disclosures may be a politically expedient solution, they do not provide significant protections for either U.S. business owners nor participants in employer-provided defined contribution plans, such as 401(k) plans.
This memorandum discusses three recent cases in which financial services companies have escaped liability for their advice to plan sponsors. As a result of these and many other cases, the U.S. Department of Labor’s “Conflict of Interest” rule is sorely needed. Otherwise, employers will continue to be misled by many financial services firms into reliance upon their recommendations, and will incur liability, even as those insurance companies and broker-dealer firms usually escape liability for the advice they have provided.
Santomenno v. John Hancock, 768 F.3d 284; 2014 U.S. App. LEXIS 18437; 58 Employee Benefits Cas. (BNA) 2845 (September 26, 2014).
This recent case illustrates how investment providers, such as insurance companies and broker-dealers, who provide advice on investment options to plan sponsors and plan trustees, can escape fiduciary status under current the DOL regulation by inserting provisions in contracts in which they disclaim fiduciary status. Despite the insurance company’s “Fiduciary Standards Warranty” in which the insurance company “warrants and covenants that the investment options” the employer/plan sponsor offers to employees “[w]ill satisfy the prudence requirement of … ERISA,” the courts continue to refuse to hold the insurance companies and broker-dealer firms to account for such representations.
J&H Berge, Inc. (“Berge”), the employer and “plan sponsor” of a 401(k) plan, entered into a group annuity contract with John Hancock under which John Hancock, assembled for the 401(k) a variety of investment options. From these investment options, the trustees of the 401(k) plan chose which investment options to offer to plan participants. The plan participants (employees) could then select from the more limited menu of options where to invest their funds.
As part of its agreement with the Plans, John Hancock offered a product feature called the Fiduciary Standards Warranty ("FSW"). Plan trustees received this feature if they selected for their Small Menus at least nineteen funds offered by John Hancock, rather than independent funds. Under the FSW, John Hancock "warrants and covenants that the investment options Plan fiduciaries select to offer to Plan participants: Will satisfy the prudence requirement of . . . ERISA." However, In the FSW, John Hancock stated that it was "not a fiduciary," and that the FSW "does not guarantee that any particular Investment option is suited to the needs of any individual plan participant and, thus, does not cover any claims by any Individual participant based on the needs of, or suitability for, such participant."
When the plan participants (employees) sued John Hancock alleging that John Hancock rendered investment advice to the plans for a fee, and that it charged excessive fees by selecting its own funds and funds of other companies that had high fees, John Hancock’s moved to dismiss the complaint on the basis that it was not a fiduciary under ERISA, and hence owed no duties of care, loyalty and utmost good faith to the plan participants (employees).
ERISA provides that a person is a fiduciary to a plan if the plan identifies them as such. See 29 U.S.C. ß 1102(a). It also provides that:
[A] person is a fiduciary with respect to a plan to the extent
(i) he exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets,
(ii) he renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so, or
(iii) he has any discretionary authority or discretionary responsibility in the administration of such plan. Such term includes any person designated under section 1105(c)(1)(B) of this title.
29 U.S.C. ß 1002(21)(A).
On appeal from the trial court’s grant of John Hancock’s Motion to Dismiss, the appellate court held that John Hancock’s fund selections – including funds with high expense ratios – were mere "product design" features do not give rise to a fiduciary duty, in and of themselves. Additionally, the appellate court, while acknowledging that the U.S. Department of Labor (DOL) had re-proposed a new definition of “fiduciary,” held that the current DOL regulation remained binding. Under the existing regulation, adopted in 1975 and even before 401(k) plans came into existence, a five-factor test exists for determining whether an entity has rendered "investment advice" for purposes of ERISA fiduciary status. An entity is an investment advice fiduciary if it: [1] [R]ender[ed] advice to the plan as to the value of securities or other property, or makes recommendation as to the advisability of investing in, purchasing, or selling securities or other property . . . [2] on a regular basis . . . [3] pursuant to a mutual agreement, arrangement or understanding, written or otherwise, between such person and the plan or a fiduciary with respect to the plan, [4] that such services will serve as a primary basis for investment decisions with respect to plan assets, and [5] that such person will render individualized investment advice to the plan based on the particular needs of the plan. 29 C.F.R. ò 2510.3-21(c)(1). "All five factors are necessary to support a finding of fiduciary status." Thomas, Head & Griesen Emps. Trust v. Buster, 24 F.3d 1114, 1117 (9th Cir. 1994).
While noting the arguments of the employees that the existing DOL regulation “engrafts additional requirements for establishing fiduciary status under 29 U.S.C. ß 1002(21)(A)(ii) that narrow the plain language of this subsection,” the appellate court held that John Hancock was not an investment adviser to the plan, as any advice rendered as to the selection of mutual funds was not “pursuant to a mutual agreement, arrangement or understanding.” Because John Hancock expressly disclaimed taking on any fiduciary relationship, there was no “mutual assent” by John Hancock.
ERISA precludes fiduciaries from contracting away their responsibilities. See 29 U.S.C. ß 1110(a) ("[A]ny provision in an agreement or instrument which purports to relieve a fiduciary from responsibility or liability for any responsibility, obligation, or duty under this part shall be void as against public policy.") But the appellate court that this provision of ERISA did not prevent John Hancock from disclaiming, in the contract, the existence of fiduciary status.
McCaffree Financial Corp. v. Principal Life Ins. Company, 65 F. Supp. 3d 653; 2014 U.S. Dist. LEXIS 172626; 59 Employee Benefits Cas. (BNA) 2233 (December 10, 2014).
This recent court decision illustrates how employers acting as plan sponsors, who are fiduciaries under ERISA, cannot hold to account many of the insurance companies and broker-dealer firms. Despite the fact that employers are lured into such reliance by representations that the insurance companies and broker-dealer firms “undertake a rigorous due diligence process” in selecting investments and that the investment options offered are “designed to be appropriate for” 401(k) plans, these providers of investment advice continue to escape liability for their recommendations.
McCaffree Financial Corp. (McCaffree) sponsored a 401(k) plan for its employees. McCaffree entered into a group annuity contract with Principal Life Insurance Company (“Principal”) under which Principal offered investment options for the participants of the 401(k) plan and provided other services for the plan. The life insurance company offered a number of “separate accounts” – against which are charged “management fees” and “operating expenses.” For participants in McCaffree’s 401(k) plan, Principal selected and offered 29 separate account options. Each of these separate accounts corresponds with a Principal mutual fund that was otherwise available to retail and institutional investors. For the for the separate accounts fees were layered on top of the fees charged by the Principal mutual funds in which the separate accounts exclusively invest, thereby enabling Principal to reap substantial fees on top of the fees charged by its own mutual funds.
In particular, the Separate Investment Account Rider which formed part of the group annuity contract disclosed that each separate account could be subject to a Management Fee of up to 3% plus another fee on the underlying mutual fund. And Rider disclosed that, on top of the other two fees, each separate account is assessed an Operating Expense charge "which must be paid in order to operate a Separate Account."
Principal’s website stated in part: “The Principal understands the fiduciary responsibilities plan sponsors face in developing and monitoring an investment lineup appropriate to help meet the diverse needs of retirement plan participants. We undertake a rigorous due diligence process as a direct response to this challenge, resulting in a key differentiator -- our Sub-Advised Investment Options.”
Principal also stated in its materials that its Sub-Advised Investment Options are "designed to be appropriate for retirement savings under employer-sponsored plans" and that it has "fiduciary oversight and the ability to oversee the investment manager selection and ongoing monitoring process."
McCaffree filed a class action lawsuit against Principal, alleging that Principal violated ERISA by charging grossly excessive investment management and other fees to the participants in the McCaffree 401(k) plan and to participants in other defined-contribution retirement plans subject to ERISA. McCaffree contended that this conduct violated ERISA's duties of loyalty and prudence and involves self-dealing transactions prohibited by ERISA. In response, Principal contended that “a service provider neither acts as a fiduciary nor breaches any duty when it charges fees that are approved by a plan fiduciary--here, [McCaffree].”
The trial court rejected McCaffree’s arguments that Principal was a fiduciary under ERISA, even though Principal selected the separate accounts that will be available to plan participants. The trial court held that there was no nexus between the selection of the accounts and/or the ability to change the investment options and the excessive fees. Even though the selection of the accounts affected the fees charged to plan participants. The trial court also held that Principal was not a fiduciary as an “investment advisor” under ERISA, for if excessive fees were charged they bore no relation to the investment advice provided.
Tussey vs. ABB, Inc., Case No. 2:06-CV-04305-NKL, United States District Court for the Western District Of Missouri, Central Division, 2012 U.S. Dist. LEXIS 45240; 52 Employee Benefits Cas. (BNA) 2826 (March 31, 2012)
This case illustrates that, even when a financial services provider provides investment recommendations that result in greater income to it, and even when the new investments underperform the replaced investments, the financial services provider can still be “off the hook” – as it is not a fiduciary with respect to the investment decisions undertaken.
This case is relatively famous as a result of a later appellate decision, in which the U.S. Eighth Circuit Court of Appeals addressed the intersection between “float” income and plan assets and held that Fidelity did not breach any fiduciary duties by retaining float income. Additionally, the Eighth Circuit upheld a $13.4 million judgment against ABB (the employer), holding that “ABB used revenue sharing to benefit ABB and Fidelity at the Plan’s expense.”
Subsequently, in July 2015, the trial court, in spite of concluding that ABB was acting in breach of ERISA’s self-dealing prohibitions, held that the employees “failed to satisfy their burden of proof on the issue of damages” with respect to the choice of investments claim. This is despite the trial court’s conclusion that, “as a result of the mapping of the assets of the Wellington Fund into the [Fidelity] Freedom Funds, the [401(k) plan] sustained a loss because the Wellington Fund consistently outperformed the Freedom Funds after the mapping occurred until the six year statute of limitation ran.”
But, prior to the appellate case and the subsequent trial court proceedings, arguments in the original court case were made as to whether Fidelity was liable in connection with the investment advice it provided to ABB (and to ABB’s Pension Review Committee).
ABB, Inc. (“ABB”) offered a 401(k) plan to its employees. The Pension Review Committee of ABB was the named fiduciary of the Plan and is responsible for selecting and monitoring the Plan's investment options. The Plan included mutual funds offered by Fidelity Investments. A Fidelity Investments affiliated company, Fidelity Research, served as the investment adviser to the Fidelity mutual funds which were offered by the 401(k) Plan and invested the balances of bank accounts, which held plan contributions in overnight securities. Another affiliated company, Fidelity Trust, served as the record keeper for the 401(k) plan and, as such, provided educational information, bookkeeping, and other services to the plan participants.
In 2000, Fidelity proposed a substantial reduction in its recordkeeping fees if the assets in the Wellington Fund were mapped, or transferred to Fidelity’s Freedom Funds. At the time, the Wellington Fund, an actively managed balanced mutual fund invested in both stocks and bonds, had a 70-year track record and an annual performance exceeding Morningstar’s benchmark by 4 percent, according to the ruling. In 2000, Fidelity’s three Freedom Funds had been in existence for less than five years. Fees for the Wellington fund were lower than fees for the Freedom Funds, and the Wellington Fund contributed less in revenue sharing fees to Fidelity than the Freedom Funds.
The Amended Complaint noted that the 401(k) plan included approximately sixteen (16) retail mutual funds as investment options in 2005 as well as ABB stock and five (5) custom blended funds charging above average fees. The Amended Complaint also noted that In the financial and investments industry, a large institutional investor with billions of dollars, like the 401(k) plan, routinely can obtain lower prices for investment management and other services than can a retail investor with only thousands, or even a few million, dollars. Yet, the plan participants alleged that the plan sponsor and Fidelity subjected the plan participants “to the high costs of retail/publicly-traded mutual funds and failing to provide investment options with significantly lower costs.”
Fidelity Trust was paid two different ways for its services. Originally, Fidelity Trust was selected by a competitive bid process and was paid a per-participant, hard-dollar fee. But, over time, Fidelity Trust was primarily paid with "revenue sharing." The revenue sharing came from some of the investment companies whose products were selected by ABB to be on the 401(k) platform. Those investment companies gave Fidelity Trust a certain percentage of the income they received from PRISM participants who selected their company's investment option. Fidelity Trust also derived revenue sharing from an internal allocation within the interrelated Fidelity companies. For example, Fidelity's Magellan Fund, was one of the mutual funds placed on the 401(k) platform by ABB. When plan participants invested in Magellan, a set number of basis points (i.e., a percentage) was transferred internally from Fidelity Research, which managed the Magellan Fund, to Fidelity Trust; this was been described by Fidelity and others as internal revenue sharing.
When revenue sharing was used to pay Fidelity Trust, its fee grew as the assets of the Plan that provided revenue sharing grew, even if Fidelity Trust provided no additional services to the Plan. The trial court found that the 401(k) plan overpaid for the recordkeeping services provided by Fidelity Trust, as the revenue sharing generated for Fidelity by the funds in the 401(k) plan assets far exceeded the market value for recordkeeping and other administrative services provided by Fidelity Trust.
In essence, Fidelity (collectively, as to all of its affiliates) was the record keeper of the 401(k) plan and had its investment products in the ABB 401(k) plan. According to the plantiff’s legal counsel, Fidelity was very intimately involved with the plan sponsor, ABB, in making recommendations about investment options. In fact, Fidelity told ABB that any changes had to be “revenue neutral” to Fidelity, even though changes were subsequently made that resulted in greater compensation to Fidelity.
The plan participants alleged that Fidelity Trust and Fidelity Management breached their fiduciary duties to the plan participants by providing investment options whose fees and expenses are excessive and not properly disclosed. The trial court’s order in connection with a Motion to Dismiss noted that “the weighted average expense ratio was high compared to peer plans.”
The plan participants also alleged that Fidelity Trust “plays a central role in the selection of the investment options the Plan makes available to participants,” because Fidelity Trust “does the first-cut screening of investment options, and has veto authority over the inclusion of investment options available in the Plan ” (Am. Compl. ¶¶ 15 -16); (Doc. 110, 4). “The Trust Agreement provides that ABB’s Pension Review Committee may select “only (i) securities issued by the investment companies advised by Fidelity Management & Research Co. . . , (ii) securities issued by the investment companies not advised by Fidelity Management & Research Company” as long as Fidelity Trust approves those elections.” (Fidelity Brief Ex. 1-A, Trust Agreement Between Asea Brown Boveri Inc. and Fidelity Management Trust Company).
However, when sued, Fidelity stated that they were not responsible for any decisions of the company because they (Fidelity) were not a fiduciary. And, after trial and appeal, Fidelity was let off the hook – again.

In Conclusion.
The Committee on Investment of Employee Benefit Assets (CIEBA) has, as its members, the chief investment officers of more than 100 of the Fortune 500 companies who individually manage and administer ERISA-governed corporate retirement  plan assets. In its July 21, 2015 comment letter to the U.S. Department of Labor regarding the DOL's proposed "Conflict of Interest" rule, CIEBA stated: "CIEBA believes that participants deserve thorough, prudent, and unbiased advice from all providers involved in the management of [401(k) plan] assets ... the average 401(k) participant needs safeguards from conflicted advice. Anyone advising participants about their 401(k) assets should be held to the same fiduciary standards as plan sponsors."
I agree. Any firm providing recommendations about which investments to include, or not include, in a 401(k) plans line-up is providing advice. Firms should not escape liability for their recommendations by hiding behind the "suitability doctrine" - which is an inappropriate abrogation of the standard of care to which nearly all other service providers are held.
Since the DOL's regulations were enacted in 1975, defined contribution plans (including 401(k) plans) have arisen and now dominate the retirement plan space. Yet, the regulations failed to keep pace. The result was, over time, the use of these out-dated regulations by insurance companies and broker-dealer firms to escape liability for their investment advice, in most instances.
Employers - American businesses - desire to offer retirement plans for their employees. Not being experts in the complex field of investments, they are often duped by "fiduciary warranties" and "due diligence" recommendations made by insurance companies and broker-dealer firms. Yet, when the s**t hits the fan, only the plan sponsor (employer) is held liable in most instances, and the insurance companies and broker-dealer firms - upon whom they were encouraged to rely - are left off the hook. This is gravely unjust and an inherently unfair result.
It is time to protect American business from these misdeeds. The DOL's proposed Conflict of Interest should be permitted to move forward, toward its final adoption.
Congress, especially the Republicans who have long been advocates for American business interests, should wake up and recognize the substantial harm resulting to both plan sponsors (American corporations) and to retirement plan participants (employees) by the numerous conflicts of interest currently present in much of the financial services industry.

Congress should permit the DOL to proceed with its rules, which will minimize those conflicts of interest. In so doing, American business will be encouraged to offer retirement plans for employees, and American business can hold all providers of investment advice to plan sponsors to account for their recommendations. It is just to do so. It is fair to do so.

Thursday, November 5, 2015

Act Now! In The Battle for the Future of the U.S. Economy & Americans' Retirement Security

We have great needs in this country. Greater investments in infrastructure, education, and renewable energy, to provide the foundations for our great country's economic growth.

But these and other needs require capital - and lots of it.

We are blessed with innovation - driven in large part by our great research universities, but also in independent labs and offices throughout the country.

We are blessed with entrepreneurs - risk-takers who, with perseverance and finely honed business skills, can take innovative ideas and bring them to the marketplace.

What we need, to propel our economy forward, is capital.

While Americans invest, primarily in qualified retirement plans and IRAs, in stock and bond mutual funds, which in turn provide capital to fuel American business forward, much more in needed. More savings. More capital investment. Much more accumulations of capital over time.

Yet, a force has emerged, over the past few decades, that has stalled U.S. economic growth. It is Wall Street, and the insurance companies. Acting together they have effected a dramatic extraction of rents from the retirement savings accounts of tens of millions of our fellow citizens. By some estimates, 20% to 40% of all of the returns of the capital markets flow to Wall Street and the insurance companies, rather than to individual investors.

The result? Less capital accumulation, in the retirement savings accounts of our country.

The DOL's Conflict of Interest proposed rule would correct, to a large degree, this wrong. The DOL is due out, within the next few months, with a final rule. Implementation of the rule is expected about 7-9 months later.

This rule will mean more of the returns of the capital markets will flow to our fellow citizens. They, in turn, will accumulate that capital. This, in turn, will greatly assist to fuel future U.S. economic expansion.

But ... Wall Street and the insurance companies don't want this rule. It would affect their ability to extract huge amounts out of the system, and into their pockets. And they are fighting HARD to stop or delay the rule.

Wall Street and the insurance companies are pouring TENS OF MILLIONS (and some estimate HUNDREDS OF MILLIONS) of dollars into Congressional campaign coffers to influence members of Congress to stop the rule.

Wall Street and the insurance companies have funded a multi-million-dollar media campaign, with misleading ads - reminiscent of the tobacco company ads of a couple of decades ago.

CEOs and paid lobbyists from Wall Street firms and the insurance companies are visiting Washington, DC, each and every day, to do everything in their power to stop this rule.

Some in Washington, DC says this campaign by Wall Street and the insurance companies, to protect their own profits and to continue their greedy practices, is the most coordinated, aggressive intensive lobbying effort they have ever seen.

What's at stake?

The retirement security of our fellow Americans. They will possess far greater in retirement if conflicts of interest are largely removed from the "financial advice" and "investment advice" provided to U.S. employees and savers.

The need to protect business owners, who sponsor retirement plans. Currently many get sued, as plan sponsors (and fiduciaries), for providing inappropriate (i.e., costly) investment options to their employees. If the DOL's rules go forward, business owners will receive "retirement consulting" advice not from highly conflicted Wall Street brokers and insurance agents (who nearly always escape liability due to the shield of "suitability"), but rather from trusted advisors who undertake due diligence to identify the best investment products.

Also at stake - the future of the U.S. economy. The IMF in 2015 estimated that excessive financialization of the U.S. economy is costing U.S. economic growth 2% a year!

Moreover, with less capital accumulating, the effect is cumulative. Instead of retirees having larger retirement plan balances, and more capital to invest in the U.S. economy, far less amounts are accumulated. U.S. business becomes starved of capital.

We need to put an end to the archaic system of product sales by those who claim to be "financial advisors" and "wealth managers" and "financial planners" - while in truth they are but product salespeople with incentives to sell the highest cost (and hence, worst) products. We need, instead, to expand the number of financial advisors who possess fiduciary duties of due care, loyalty, and utmost good faith to their clients.

Contact your Senators and U.S. Representative today. Let them know that the DOL's proposed Conflict of Interest rule should go forward. For the sake of our fellow Americans. For the sake of America's future economic prosperity.

Use this simple tool to contact your member of Congress: found at The organizations supporting this web site, and its tool, and this effort include AARP, Better Markets, NAACP, Certified Financial Planner Board of Standards, Inc., Consumers Union, Consumer Federation of America, and many more. This is a non-partisan issue, of importance to all Americans.

The battle with Wall Street and the insurance companies is in full swing. Protect our fellow individual Americans and enable their retirement nest eggs to expand and grow much larger, for the sake of their own financial security in retirement. Protect U.S. business owners (plan sponsors) from the liabilities which arise when they are told to use high-cost, expensive and inappropriate investments in their 401(k) plans and other qualified retirement plans. Most importantly, empower future U.S. economic growth - for the good of us all. ACT TODAY! 

Tuesday, November 3, 2015

The Exceptional Financial Adviser: An Expert, Trustworthy, Candid Life Coach

Being a professor of finance, and chair of the Financial Planning Program at Western Kentucky University, and also serving on many professional associations over the years, has afforded me the opportunity to visit with practitioners - during conferences, at luncheons, and in their own offices. I have greatly benefitted from the insights gathered from those I meet - they serve to help me improve my own practice, as well as our university's financial planning undergraduate program.

As these conversations over many years have progressed, I have learned that financial planning, at its core, is all about assisting clients with achieving their lifetime goals. Because the accumulation of wealth is not an ends, but a means.

The exceptional financial planners I meet are:
  • First and foremost, experts. The body of knowledge required of a financial planner is both broad and relatively deep. A commitment to lifelong learning is absolutely essential. The best financial planners attend professional association conferences - gaining insights not just from the presenters but also from their fellow practitioners. And - they read, read, and read some more. They have good habits ... eschewing watching t.v. every evening and instead devoting time to family, friends, and their own education.
  • Second, trustworthy. The best financial planners realize that the allure of additional compensation, in whatever form it takes place, can distort the advice given to clients. Conflicts of interest are minimized - and avoided altogether when possible. These financial planners enjoy the expert professional-level compensation they receive, and they enjoy being on the "same side of the table" as their clients.
  • Third, candid with their clients. Never pulling punches. Dedicated to assisting their clients overcome obstacles, with often frank advice, even at the risk of losing the relationship. Clients don't just want to be surrounded by "yes" advisors.
Lastly, and most importantly, the exceptional financial planners focus on assisting clients to identify, further development, and work toward the attainment of lifetime goals. Financial planners are "counselors" in a sense, but from another perspective financial planners are more like "life coaches."

Life only happens once. Our clients deserve our expert guidance to empower them to suck all the marrow out of life, to live their lives with passion, to gain the rewards they themselves can receive from assisting others and expressing gratitude, and to live such a life that - near the end of life - they will have no regrets.

Being a financial planner is a gift, in and of itself. It is and can be the most enjoyable of professions. But it requires the commitment to be an expert, the intellectual honesty to maintain the client's interests as paramount at all times, and courage to be candid, and the focus on helping each and every client lead a highly successful life, in all of its many aspects.

Financial planning. A most rewarding profession.

Let us continue to progress toward that goal - a true profession.

Let us achieve, each and every one of us, the esteemed honor that flows from when a client refers to her or his financial planner as "my trusted financial advisor and life coach."