In Part 1 of this series, I summarized the recent developments leading to an acceleration of the change in financial services away from product sales and toward fiduciary relationships.
In Part 2 of this series, I explored the distinctions between arms-length (sales) and fiduciary (advisory) relationships, the fiduciary principle, several of the public policy rationales for the imposition of fiduciary duties, and briefly touched upon the various fiduciary duties that exist.
Part 3 explored the impact of fees and costs upon investment returns, and the relationship of academic insights in this area to the fiduciary's duty of due care to control fees and costs incurred by the client.
In Part 4 I turned to the most distinguishing aspect of the fiduciary standard of conduct - the fiduciary duty of loyalty. The procedural and substantive protections afforded to clients, when a conflict of interest is not avoided by the financial advisor, were reviewed. As were the limitations on the ability to disclaim core fiduciary obligations, and the inability of a client to waive core fiduciary protections.
Introduction: Compensation Arrangements, Conflicts of Interests, and the Fiduciary Duty of Loyalty.
By far the "best practice" is for the financial advisor to establish, at the onset of the client relationship, a fee arrangement in which the compensation is "level" and does not vary with the advice provided. These might include an assets-under-management approach, a fixed fee for a specific project, an annual retainer, a monthly subscription fee, hourly fees, or some combination thereof.
Even applying such a "best practice" fee methodology, conflicts of interest may still arise under several of the compensation structures noted above. For example, should a retired client annuitize a portion of his or her portfolio? Should a client pay off a mortgage debt? Should a client gift significant assets to a charitable cause, or to family members? The advice given may affect the advisor's compensation. Beyond some rules which may be adopted within a firm to govern such conflicts of interest (such as a policy on when a client should be advised to pay certain debt off first, rather than investing available cash), perhaps the best approach to addressing this conflict is simply to ask oneself, "What would I tell my parents, or my brothers/sisters, or my children/nieces/nephews, if they wanted to do the same thing?"
Even then, the answer may not always be clear. Or, you may believe that your own interests might be unconsciously affecting your judgment. (The unconscious motivations that can arise, leading to "self-justification" of poor advice when a conflict of interest, is a problem the fiduciary standard was designed to address, by requiring avoidance of conflicts of interests.) In such instances you might turn to a professional colleague (either within your firm, or outside it), to seek out illumination on the proper course of action.
Some of the current compensation practices in broker-dealer firms, dual registrant firms, and insurance brokerage/agency firms, further challenge the ability of fiduciaries to maintain the clients' best interests as paramount at all times. Modern Portfolio Theory and recent insights into the impact of fees and costs on the net returns of clients (discussed in Part 3) provide real challenges to a fiduciary's ability to maintain variable compensation arrangements. In the scenarios that follow, I offer my observations.
Applying Different Fiduciary Standards: Different Results Can Follow Depending Upon the Law Applicable and the Enforcement Forum.
In the discussion that then follows, the scenarios set forth below (in separate posts, for ease of reference) may be reviewed in the context of four different fiduciary standards:
- the "best interests" fiduciary standard found under state common law;
- the "sole interests" standard found under ERISA (applying various statutory exemptions);
- the "best interests" standard found under the proposed "Best Interests Contract Exemption" (hereafter the "BIC exemption") (as proposed in April 2015 by the U.S. Department of Labor); and
- the "best interests" fiduciary standard as found under the Investment Advisers Act of 1940, as currently applied by the U.S. Securities and Exchange Commission ("SEC").
The Perils of FINRA Arbitration
I would further note that the application of these fiduciary standards of conduct, in the context of arbitration under FINRA rules, can lead to widely varying results. FINRA has long opposed fiduciary standards of conduct being applied to brokers, and the observations of FINRA's leadership in this regard inevitably filter down and affect arbitrator's judgments. Moreover, FINRA has a philosophy of telling arbitrators to do "what is fair." Lacking training in the strict requirements of the fiduciary duty of loyalty, and instructed by a "fairness" standard that - in essence - usurps fiduciary law's duties and even burdens of proof, FINRA arbitration will likely remain a pro-broker, anti-consumer forum as fiduciary duties are increasingly applied to brokers and dual registrants, albeit a wide range of outcomes is possible in individual cases.
Also be aware that only consumers, but also firms and brokers, are restricted in their grounds for appeal (due to the application of federal law) from FINRA's arbitration decisions. This leads to even more risks for financial advisors
Additionally, the lack of a requirement for arbitrators to set forth findings of fact, and conclusions of law, in written arbitration decisions, stymies the review of the effectiveness (or, more likely, the ineffectiveness) of FINRA arbitration to correctly apply fiduciary law. This lack of transparency, in turn, challenges efforts to reform FINRA arbitration.
ERISA or Common Law Fiduciary Claims?
Outside of the realm of enforcement actions by regulators themselves, generally consumers pursue private rights of action for breach of a financial advisor's fiduciary duties.
However, please be aware that under the Investment Advisers Act of 1940 there is no general right of consumers to bring a private action against their adviser. Hence, state common law is applied, in which a threshold determination of whether fiduciary status exists must be addressed (and broker-dealer firms fight such determinations all the time).
This will change, in many cases, as a result of the likely implementation of the U.S. Department of Labor's "Conflict of Interest Rule" (and the exemptions thereto) to nearly all ERISA-governed defined contribution accounts, as well as to all IRAs. The DOL's rule is likely to be finalized in early 2016, with a implementation date for many of its provisions in late 2016.
THE SCENARIOS: (Each is set forth as a separate post for ease of reference.)
#6: THE PERPLEXING WORLD OF 12B-1 FEES.
#7: AVOIDING BREAKPOINT DISCOUNTS BY SELLING VARIABLE ANNUITIES.
#8: VARIABLE COMMISSIONS INVOLVING AN EIA RECOMMENDATION.
#9: PREFERRED PRODUCT PLACEMENTS.
#10: SECURITIES UNDERWRITTEN BY AN AFFILIATE.
#11: PRINCIPAL TRADING (MUNICIPAL BONDS).
#12: PROPRIETARY FUNDS.
#13: THE RETIRING EMPLOYEE AND THE PROPOSED IRA ROLLOVER.
- Feb. 24-25, 2016: FPA of Oregon and S.W. Washington Midwinter Conference 2016, where Ron will discuss: "The DOL's Transformational Conflict of Interest Rule"
- Feb. 26, 2016: FPA of Puget Sound's 2016 Annual Symposium, where Ron will discuss: "Reducing Your Risks in the New Fiduciary Era"
Public comments to this blog are welcome, provided that no advertising occurs and that decorum is maintained. To reach Prof. Rhoades directly, please e-mail him at: Ron.Rhoades@WKU.edu. Thank you.