EXECUTIVE SUMMARY:
- Cases arising under ERISA, while a different body of fiduciary law, can provide insight into fiduciary advisers' duty of due care, including due diligence.
- Under ERISA, a plan sponsor must exercise good judgment in approving the recommendations made by fiduciary (or non-fiduciary) advisers to the plan.
- For accounts not governed by ERISA, clients possess a reasonable expectation that the investment strategy you recommend will be "prudent." But proving that your investment strategy is "prudent" can be difficult.
- Hence, carefully crafter explanations of your investment strategy may be required, especially where academic evidence and/or back-testing is not available.
- Mutual fund fees and costs matter, and must be taken into account (along with other factors) in the selection of mutual funds when undertaking the fiduciary's duty of due care (i.e., due diligence).
- Expect greater judicial scrutiny of 12b-1 fees, especially within the context of ERISA.
- Future rule-making by the DOL/EBSA may well "toughen up" the duties of plan sponsors and their fiduciary advisers.
I use the term "fiduciary adviser" to refer to all those operating under a fiduciary standard of conduct, and regardless of your licensure. Unknown to most registered representatives of broker-dealer firms, when providing personalized investment advice they are already (likely) fiduciaries applying state common law. (Dodd-Frank Action Sect. 913 permits the SEC to impose fiduciary standards upon brokers and their registered representatives; however in many instances fiduciary standards already exist under state common law for those providing personalized investment advice. I will discuss this issue in a later blog post.
Additionally, many dual registrants seek to "remove the fiduciary hat" following presentation of a financial plan; while such may be permitted under a 2007 SEC proposed rule (never finalized), state common law imposes strict requirements upon attempts to remove the fiduciary hat, in recognition that fiduciary status attaches to relationships, not accounts. Moreover, your designation on an account form or other agreement with the client as to whether fiduciary duties exist is not controlling; state common law applies fiduciary status based on what occurs, not (for the most part) based upon your attempts to have the client waive fiduciary status. I will discuss this issue in future blog posts.
TIBBLE V. EDISON: THE FACTS. On March 21, 2013, in the long-watched case of Tibble v. Edison, the 9th U.S. Circuit Court of Appeals affirmed a district court opinion that a plan sponsor was imprudent for including retail mutual funds without investigating the possibility of institutional share classes. Additionally, the Court discussed the limits of a plan sponsor to delegate away the plan sponsor's fiduciary duties. I discuss these aspects of the case, and also discuss how this Court's decision can provide guidance to fiduciary advisors acting outside of ERISA's application. Along the way, I seek to illuminate some principles which may assist fiduciary advisors in their duty of due care.
THE INTERSECTIONS OF ERISA AND NON-ERISA FIDUCIARY LAW.
Where Can We Look for Guidance on Fiduciary Standards? Too often fiduciary advocates bemoan a lack of reported decisions arising under the Investment Advisers Act of 1940 and state common law. In large part this lack of decisions is due to mandatory arbitration under FINRA. As a result, few decisions applying either the Advisers Act or state common law address various aspects of the duty of due care which investment advisers possess. Yet, another body of law - with a large number of reported decisions - exist - cases applying ERISA to qualified retirement plans.
The Duty of Loyalty: ERISA vs. Advisers Act/Common Law. ERISA's guidance as to dealing with conflicts of interest and other aspects of the duty of loyalty are not fully applicable to fiduciary advisers who deal with accounts not governed by ERISA. Rather than the "best interests" standard applicable under the Advisers Act and state common law fiduciary standards, ERISA applies the strict "sole interests" standard found in trust law [“common law trust principles animate the fiduciary responsibility provisions of ERISA.” Acosta v. Pac. Enters., 950 F.2d 611, 618 (9th Cir. 1991); see also Cent. States, Se. & Sw. Areas Pension Fund v. Central Transp., Inc., 472 U.S. 559, 570–71 (1985) (identifying the statutorily prescribed duties of loyalty and of prudence as imported from trust law)].
By way of general explanation, the "sole interests" standard prohibits most conflicts of interests, while under the best interests standards most (but not all) conflicts of interest are permitted - provided full disclosure of all material facts is affirmatively made in a manner which ensures client understanding, the client provides informed consent (which would not exist if the client were harmed by the recommendation), and the transaction recommended is otherwise substantively fair to the client.
The Duty of Due Care: ERISA Cases Matter to non-ERISA Situations. However, most aspects of the fiduciary duty of due care does not tremendously vary as between the law under ERISA, the Advisers Act, and state common law. Hence, for guidance on how investment advisers should undertake due diligence, and other aspects of the fiduciary duty of due care, we can look to ERISA case law for guidance. However, particular language within ERISA may vest greater discretion in plan sponsors than seen for other types of fiduciaries.
PLAN SPONSORS ALWAYS POSSESS FIDUCIARY DUTIES: THEY CANNOT BE COMPLETELY DELEGATED AWAY.
Plan Sponsors Cannot Defer All Decisions to Investment Advisors. In Tibble v. Edison, the appellate court rejected the plan sponsor's (Edison's) argument that it had relied on the advice of its investment consultant, Hewitt Financial Services LLC, to make its selection, ruling that there was enough evidence to show that an experienced investor would have considered a wider variety of share classes during the mutual fund selection process. “Just as fiduciaries cannot blindly rely on counsel, or on credit rating agencies, a firm in Edison’s position cannot reflexively and uncritically adopt investment recommendations,” the panel said in its ruling.
THE FIDUCIARY DUTY OF DUE CARE - DUE DILIGENCE: INVESTMENT STRATEGY AND INVESTMENT PRODUCT SELECTION.
Generally, The Fiduciary Duty of Plan Sponsor In Selection of Funds to Include. The plan sponsor attempted to argue that its duties were fully abrogated by including 50 mutual fund choices, which participants could then select from. The Court rejected this argument, quoting the preamble of a 1992 DOL regulation (later codified in 2010 as part of a regulation): "'the act of limiting or designating investment options which are intended to constitute all or part of the investment universe of an ERISA section 404(c) plan is a fiduciary function which ... is not a direct or necessary result of any participant direction.' 57 Fed. Reg. 46,922, 46,924 n.27 (Oct. 13, 1992) ... See 75 Fed. Reg. 64,910, 64,946 (Oct. 20, 2010) (codified at 29 C.F.R. pt. 2550) (Section 404(c) 'does not serve to relieve a fiduciary from its duty to prudently select and monitor any service provider or designated investment alternative offered under the plan') ...as cogently explained by DOL in its brief, 'the selection of the particular funds to include and retain as investment options in a retirement plan is the responsibility of the plan’s fiduciaries, and logically precedes (and thus cannot ‘result[] from’) a participant’s decision to invest in any particular option.'"
How might these principles apply outside of ERISA? Well, obviously, you possess a fiduciary duty of due care, in the nature of due diligence, in selecting mutual funds to recommend to your clients. If you client is a trustee or other type of fiduciary, then that client may not completely rely upon your advice - the client must still exercise good judgment in evaluating your recommendations.
Also, suppose you, as an investment adviser, present three investment portfolio options to your client to choose from: A, B and C. Your recommendation to the client is Investment Portfolio A. But your client chooses Investment Portfolio C. Later, it is discerned by the client that some aspect of your due diligence for the investment strategy or investment products for Portfolio C failed to meet your duty of due care. Are you insulated from liability because you recommended Portfolio A to the client? No. All three investment portfolio options should be formulated by you with appropriate due diligence. See, e.g., Langbeckerv. Elec. Data Sys. Corp., 476 F.3d at 321 (Reavley, J., dissenting) (“All commentators recognize that § 404(c) does not shift liability for a plan fiduciary’s duty to ensure that each investment option is and continues to be a prudent one.”).
In other words, each and every investment strategy and investment product you recommend you meet your fiduciary obligations under the duty of due care. I explore this further in the next section.
Exploring the General Nature of Investment Strategy and Investment Product Selection: The Fiduciary Duty of Due Care and the Prudent Investor Rule. Does this mean that you should only recommend investment portfolios which satisfy the "Prudent Investor Rule"? No, if you are operating outside of ERISA. (If you are operating within ERISA, the fiduciary duty of due care cannot be waived by the plan participant; however, certain exceptions exist for self-directed brokerage accounts).
Outside of ERISA, the Prudent Investor Rule is not applicable to all investment portfolios recommended by fiduciary advisors. However, in a few states the Prudent Investor Rule applies to certain situations either by statute or through case law. In any event, it is the reasonable expectation of your client, at the commencement of each relationship, that you will recommend a prudent investment portfolio - until you disclose otherwise and secure the client's informed consent. Hence, it would be prudent for you to let your clients know if the investment strategy you recommend meets, or does not meet, the requirements of the Prudent Investment Rule.
Of course, if your recommendations are challenged, the burden falls to you to prove the prudence of your investment strategies. And to undertake such proof, you need to get it admitted into evidence. Your "expert opinion" is not likely to be admitted. And, surprisingly, the opinions of many other "experts" are also not likely to be admissible. This poses a real challenge in meeting your burden of proof.
Proving Your Investment Strategy / Investment Product Selection is "Prudent" - It's Difficult! By way of explanation, the admission of expert testimony in federal court is governed by Federal Rule of Evidence Section 702. Generally, if scientific, technical, or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education, may testify thereto in the form of an opinion or otherwise, if: (1) the testimony is based upon sufficient facts or data; (2) the testimony is the product of reliable principles and methods; and (3) the witness has applied the principles and methods reliably to the facts of the case. In addition, expert testimony must be both relevant and reliable to be admitted. Daubert v. Merrell Dow Pharms., Inc., 509 U.S. 579, 589, 113 S. Ct. 2786 (1993). Similar standards of the admission of expert testimony exist in state courts (applying Frye or Daubert standards for admission of expert testimony, or some combination of the rationale of these cases).
Under the Daubert standard, a judge or arbitrator makes a threshold determination regarding whether certain scientific knowledge would indeed assist the trier of fact (the jury, judge, or arbitration panel). This entails a preliminary assessment of whether the reasoning or methodology underlying the testimony is scientifically valid, as well as whether that reasoning or methodology properly can be applied to the facts in issue. This preliminary assessment can turn on whether something has been tested, whether an idea has been subjected to scientific peer review or published in scientific journals, the rate of error involved in the technique, and even general acceptance, among other things. It focuses on methodology and principles, not the ultimate conclusions generated.
In essence, if an investment adviser purports to utilize a “prudent” investment strategy, the investment adviser would be well-advised, to manage his or her fiduciary risk, to insure that the evidence developed by the investment adviser supportive of the investment adviser’s adopted investment strategy will clear the same threshold analysis a court would employ as to whether expert testimony on the same point would be permitted. However, while the admissibility of expert testimony focuses on the methodology and not the results, the investment adviser would be wise to focus on both methodology and results. In other words, not only will an investment adviser, if his or her investment strategy is later challenged, desire to ensure that expert testimony is available, but that the results of that expert analysis favor the investment strategy adopted. In other words, both procedural due process (proper due diligence methodology) and substantive due diligence (the exercise of good judgment at each step in the process) are important.
Has your overall investment strategy, utilized for the benefit of your clients, been submitted to analysis involving back-testing over multiple time periods? Or, is your portfolio construction strategy based upon generally accepted academic research from multiple sources? If not, what will you do if called upon later to defend your investment strategy? Or should you disclose in your Form ADV Part 2A that your investment strategy either is not capable of being tested, or that it lacks academic support?
From this author’s review of the academic literature, it appears that relatively few investment strategies, as to the design of portfolios for individual clients, withstand rigorous academic scrutiny. Some other investment strategies receive mixed reviews and remain the subject of continued discussion. The challenge for the investment adviser is to sift through the academic evidence, first by throwing out those studies which appear to possess an insufficient sample size, inappropriate benchmark, which rely upon data which suffers from survivorship bias, or in which the author appears to suffer from bias or potential bias.
Hence, an investment adviser may desire to seek answers to the following questions, when undertaking an analysis on any particular investment strategy:
A. Can the investment strategy be tested? In other words, are there one or more reliable scientific processes or techniques which may be utilized to assess the investment strategy?
B. If so, then either:
(1) Have published academic articles subjected the investment strategy to peer review, and what are the results of that peer review process? In other words, as a result of academic discourse, has the investment strategy gained general acceptance in the academic community?
(2) Have you back-tested the investment strategy yourself? If so, was the back-testing methodology you utilized accepted in the industry? What is the rate of error seen in that testing methodology relatively low (and, as a result of achieving a low rate of error, did you ensure that “data mining” was unlikely to be present in your testing process)?
What if you are not using academic evidence in your design and management of client portfolios? For example, what if you are using your own qualitative judgment, such as to predict market movements from your own analysis of the macro-economic environment, then back-testing is inapplicable (although you may present your own performance history, if properly computed and presented with applicable disclosures). Additionally, your own qualitative judgment is highly unlikely to be the subject of academic reserarch. Hence, in such a case, you should likely disclose that the investment strategy you recommend is not in accord with the prudent investor rule (although you may think otherwise, you cannot prove it), and then you should further describe your investment strategy in Form ADV, Part II (and disclose risks attributable to that investment strategy, including "manager risk" - i.e., the risk that your judgment will be wrong).
MUTUAL FUND FEES AND COSTS MATTER: TIBBLE and DUE DILIGENCE.
Higher-Cost Retail Funds vs. Institutional Funds. In Tibble v. Edison, the Court noted that "in 1999 the Plan grew to contain ten institutional or commingled pools, forty mutual fund-type investments, and an indirect investment in Edison stock known as a unitized fund. The mutual funds were similar to those offered to the general investing public, so-called retail-class mutual funds, which had higher administrative fees than alternatives available only to institutional investors."
The Tribble Court's decision is instructive in its review of basic rquirements of the fiduciary duty of due care under ERISA:
ERISA demands that fiduciaries act with the type of “care, skill, prudence, and diligence under the circumstances” not of a lay person, but of one experienced and knowledgeable with these matters. 29 U.S.C. § 1104(a)(1)(B). Fiduciaries also must act exclusively in the interest of beneficiaries. Id. § 1104(a)(1). These obligations are more exacting than those associated with the business judgment rule so familiar to corporate practitioners, Howard v. Shay, 100 F.3d 1484, 1489 (9th Cir. 1996), a standard under which courts eschew any evaluation of “substantive due care.” Brehm v. Eisner, 746 A.2d 244, 264 (Del. 2000), cited in Pac. Nw. Generating Coop. v. Bonneville Power Admin., 596 F.3d 1065, 1077 (9th Cir. 2010). To enforce this duty of prudence, we consider the merits of the transaction and “the thoroughness of the investigation into the merits of the transaction.” Howard, 100 F.3d at 1488 (emphasis added). Courts are in broad accord that engaging consultants, even well-qualified and impartial ones, will not alone satisfy the duty of prudence. See George v. Kraft Foods Global, Inc., 641 F.3d 786, 799–800 (7th Cir. 2011) (collecting cases from the Second, Fifth, Seventh, and Ninth Circuits).
Under the common law of trusts, which helps inform ERISA, a fiduciary “is duty-bound ‘to make such investments and only such investments as a prudent [person] would make of his own property having in view the preservation of the [Plan] and the amount and regularity of the income to be derived.’” In re Unisys., 74 F.3d at 434 (quoting Restatement (Second) of Trusts § 227 (1959)) (first alternation in original).
As set forth above, the fiduciary duty of due care arising under ERISA is very similar to the fiduciary duty of due care applicable to all fiduciary advisers who provide personalized investment advice. Does this mean that institutional funds, or low-cost mutual funds, must be the only offerings recommended by a fiduciary adviser? No. As the Tibble Court stated: "The Seventh Circuit has repeatedly rejected the argument that a fiduciary “should have offered only ‘wholesale’ or ‘institutional’ funds.” See Loomis, 658 F.3d at 671; Hecker, 556 F.3d at 586 (“[N]othing in ERISA requires [a] fiduciary to scour the market to find and offer the cheapest possible fund (which might, of course, be plagued by other problems).”). We agree. There are simply too many relevant considerations for a fiduciary, for that type of bright-line approach to prudence to be tenable. Cf. Braden v. Wal-Mart Stores, Inc., 588 F.3d 585, 596 (8th Cir. 2009) (acknowledging that a fiduciary might “have chosen funds with higher fees for any number of reasons, including potential for higher return, lower financial risk, more services offered, or greater management flexibility”).
While other factors (other than fees and costs) are indeed a consideration, I would note that a substantial body of academic research suggests that the level of mutual fund fees and costs is a very substantial and often the best indicator, on average, of the long-term returns of the mutual fund relative to funds with the same investment strategy (i.e., same asset class). I suspect that future cases arising under ERISA, especially after the "Definition of Fiduciary" rule is adopted, will explore this academic research in detail, and then apply it.
In the interim, there is no question that a fiduciary adviser bears responsibility to ensure that all of the fees and costs borne by the client are substantively fair and reasonable. Each and every fee and cost expended should be for services (or management) which is believed to result in value to the client. Fees that don't add value to the client are suspect. In this respect, as I opined in an earlier blog post (http://scholarfp.blogspot.com/2013/03/12b-1-fees-rias-and-registered.html) that revenue-sharing payments in the nature of 12b-1 fees are highly suspect - and fiduciary advisers (regardless of how registered) would do well to avoid all mutual funds which possess 12b-1 fees. The Tribble court, in dicta, also noted the area of 12b-1 fees as an area for further exploration by the courts, stating:
I repeat my warning - if you are either a registered representative of a broker-dealer firm, or an investment adviser representative of a registered investment adviser firm - be extremely wary of recommending any mutual fund share class that includes 12b-1 fees.
TIBBLE'S DISTURBING VIEW OF "PAYMENT OF COSTS" PROVISION OF A PLAN.
One aspect of the Tribble v. Edision decision I find very troubling. The Plan, by its express terms, provided that the employer pay the costs of the plan. But the Court held that this language did not prevent revenue-sharing payments, which permitted recordkeeping services to be paid by revenue-sharing payments, in essence relieving the employer of the need to pay certain costs. The Court stated: "Section 19.02 required the company to pay the costs, and Edison did. Although beneficiaries argue that the “costs” are the expenses associated with Hewitt before the offsets, the more natural reading is that 'costs' simply are whatever bills Hewitt presented Edison with. Under this commonsense reading, the Plan merely assigned Edison an affirmative obligation to pay. It did not, as beneficiaries would have it, prohibit 'Hewitt’s recordkeeping services from being paid by a third party such as mutual funds.'"
To me, this seems a distortion of plain English. However, various additional facts exist which may have led the court to such a conclusion. Additionally, the court noted that the "DOL, though, has issued several non binding advisory opinions staking out the position that a fiduciary does not violate section 406(b)(3) so long as 'the decision to invest in such funds is made by a fiduciary who is independent' of the fiduciary receiving the fee. DOL Advisory Op. 2003-09A, 2003 WL 21514170 (June 25, 2003); see also DOL Advisory Op. 97-15A, 1997 WL 277980 (May 22, 1997) (fiduciary that “does not exercise any authority or control” to cause the suspect investment is not liable)."
I can only hope that the new "Definition of Fiduciary" rule, to be promulgated by DOL/EBSA later in 2013, and hopefully adopted in 2014 as a final rule, and the interpretations flowing therefrom, will correct this result. For more on the DOL/EBSA's courageous rule-making effort, please see my earlier blog post at http://scholarfp.blogspot.com/2013/03/most-courageous-phyllis-borzi-and-her.html.
IN CONCLUSION: KEEP YOUR DUE DILIGENCE SKILLS UP-TO-DATE.
The Tribble v. Edison decison has provided me, in this blog post, with this initial opportunity to explore a couple of subjects near and dear to me - the fiduciary duty of due care, and, specifically, the issue of mutual fund fees and costs. There are many aspects of the fiduciary duty of due care, as it affects investment strategy selection, investment products (of which there are many types) selection, financial planning, etc. This blog post just touches on a few aspects of that fiduciary duty. In future blog posts I will seek to elaborate more on various aspects of the fiduciary duty of due care.
As I have previously cautioned those who work in larger firms, don't assume that your firm's due diligence is up-to-snuff. Many a representative of a firm has been implicated in client complaints and lawsuites when the firm's due diligence was blindly relied upon.
What can you do, as a fiduciary adviser, to ensure better adherence to your fiduciary duty of due care with regard to your investment recommendations?
- Undertake due diligence on the investment strategies you recommend. Ensure that your disclosures regarding the risks of those investment strategies are robust. If your investment strategy is not "provable" by academic evidence (past generally accepted research and/or back-testing), then consider a disclosure that your investment strategy may not be in accord with the prudent investor rule (to dispel any client expectations to the contrary).
- Learn more about the world of investments, and investment strategies - and maintain your knowledge. A great deal of academic research exists. Textbooks on investing (such as the Bodie, Kane texts) exist. Read articles in financial planning / investment advisory publications (always being mindful if the writer has a hidden, or not-so-hidden, agenda). Go to financial planning and/or investment advisory conferences each year, to keep up-to-date on new strategies and/or new research. Better yet, explore conferences and services directed at the obligations of fiduciary advisers. (For example, the fi360 National Conference, held each Spring. See http://www.fi360.com/fi360-conference.)
All my best. - Ron Rhoades, JD, CFP(r), Program Director, Financial Planning Program, Alfred State College. E-mail: RhoadeRA@AlfredState.edu
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