Public Policy Considerations Which Underlie the Imposition of Fiduciary Status

The key to understanding fiduciary principles, and why, when and how they are applied, rests in first discerning the various public policy objectives the fiduciary standard of conduct is designed to meet. This blog posts sets forth several of these public policy objectives, in hope of further contributing to the discussion on current regulatory initiatives.

Fiduciary Status Addresses “Overreaching” When Person-To-Person Advice is Provided

The Investment Advisers Act of 1940 ("Advisers Act") embodied state common law's existing application of the fiduciary standard of conduct to those providing personalized investment advice. State common law continues to apply this standard to those who provide personalized investment advice and whom are in relatinoships of trust and confidence with their clients. In other words, the Advisers Act never stated that brokers were not fiduciaries - it just ensured that a certain type of advisor - those receiving special compensation - would always be considered fiduciaries.

The U.S. Supreme Court stated that the Advisers Act “recognizes that, with respect to a certain class of investment advisers, a type of personalized relationship may exist with their clients … The essential purpose of [the Advisers Act] is to protect the public from the frauds and misrepresentations of unscrupulous tipsters and touts and to safeguard the honest investment adviser against the stigma of the activities of these individuals by making fraudulent practices by investment advisers unlawful.”[1]  “The Act was designed to apply to those persons engaged in the investment-advisory profession -- those who provide personalized advice attuned to a client's concerns, whether by written or verbal communication[2] … The dangers of fraud, deception, or overreaching that motivated the enactment of the statute are present in personalized communications ….”[3]

Consumers’ Lack of Desire to Expend Time and Resources on Monitoring

The inability of clients to protect themselves while receiving guidance from a fiduciary does not arise solely due to a significant knowledge gap or due to the inability to expend funds for monitoring of the fiduciary.  

Even highly knowledgeable and sophisticated clients (including many financial institutions) rely upon fiduciaries.  While they may possess the financial resources to engage in stringent monitoring, and may even possess the requisite knowledge and skill to undertake monitoring themselves, the expenditure of time and money to undertake monitoring would deprive the investors of time to engage in other activities.  Indeed, since sophisticated and wealthy investors have the ability to protect themselves, one might argue they might as well manage their investments themselves and save the fees. Yet, reliance upon fiduciaries is undertaken by wealthy and highly knowledgeable investors and without expenditures of time and money for monitoring of the fiduciary.  In this manner, “fiduciary duties are linked to a social structure that values specialization of talents and functions.” Tamar Frankel, Ch. 12, United States Mutual Fund Investors, Their Managers and Distributors, in Conflicts Of Interest: Corporate Governance And Financial Markets (Kluwer Law International, The Netherlands, 2007), edited by Luc Thévenoz and Rashid Barhar.

The Shifting of Monitoring Costs to Government 

In service provider relationships which arise to the level of fiduciary relations, it is highly costly for the client to monitor, verify and ensure that the fiduciary will abide by the fiduciary’s promise and deal with the entrusted power only for the benefit of the client.  Indeed, if a client could easily protect himself or herself from an abuse of the fiduciary advisor’s power, authority, or delegation of trust, then there would be no need for imposition of fiduciary duties.  Hence, fiduciary status is imposed as a means of aiding consumers in navigating the complex financial world, by enabling trust to be placed in the advisor by the client.

Fiduciary relationships are relationships in which the fiduciary provides to the client a service that public policy encourages.  When such services are provided, the law recognizes that the client does not possess the ability, except at great cost, to monitor the exercise of the fiduciary’s powers.  Usually the client cannot afford the expense of engaging separate counsel or experts to monitor the conflicts of interest the person in the superior position will possess, as such costs might outweigh the benefits the client receives from the relationship with the fiduciary.  Enforcement of the protections thereby afforded to the client by the presence of fiduciary duties is shifted to the courts and/or to regulatory bodies. Accordingly, a significant portion of the cost of enforcement of fiduciary duties is shifted from individual clients to the taxpayers, although licensing and related fees, as well as fines, may shift monitoring costs back to all of the fiduciaries which are regulated.

Consumers’ Difficulty in Tying Performance To Results

The results of the services provided by a fiduciary advisor are not always related to the honesty of the fiduciary or the quality of the services.  For example, an investment adviser may be both honest and diligent, but the value of the client’s portfolio may fall as the result of market events.  Indeed, rare is the instance in which an investment adviser provides substantial positive returns for each incremental period over long periods of time – and in such instances the honesty of the investment adviser should be suspect (as was the situation with Madoff).

Consumers’ Difficulty in Identifying and Understanding Conflicts Of Interest

Most individual consumers of financial services in America today are unable to identify and understand the many conflicts of interest which can exist in financial services.  For example, a customer of a broker-dealer firm might be aware of the existence of a commission for the sale of a mutual fund, but possess no understanding that there are many mutual funds available which are available without commissions (i.e., sales loads).  Moreover, brokerage firms have evolved into successful disguisers of conflicts of interest arising from third-party payments, including payments through such mechanisms as contingent deferred sales charges, 12b-1 fees, payment for order flow, payment for shelf space, and soft dollar compensation.

Survey after survey (including the Rand Report) has concluded that consumers place a very high degree of trust and confidence in their investment adviser, stockbroker, or financial planner.  These consumers deal with their advisors on unequal terms, and often are unable to identify the conflicts of interest their “financial consultants” possess.  As evidence of the lack of knowledge possessed by consumers, the Rand Report noted that 30% of investors believed that they did not pay their financial consultant any fees!  This calls into substantial question the conclusion derived from the Rand Report’s survey that most customers of brokers are happy with their financial consultant.

Transparency is important, but even when compensation is fully disclosed, few individual investors realize the impact high fees and costs can possess on their long-term investment returns; often individual investors believe that a more expensive product will possess higher returns.[4]

For Fiduciaries the Cost of Proving Trustworthiness Is Quite High

How does one prove one to be “honest” and “loyal”?  The cost to a fiduciary in proving that the advisor is trustworthy could be extremely high – so high as to exceed the compensation gained from the relationships with the advisors’ clients. 

In his influential article discussing the creation of the federal securities acts, and in particular their moral purpose, John Walsh (of the SEC’s OCIE) reviewed the legislative history underlying the creation of the Investment Advisers Act:

• As part of a congressionally mandated review of investment trusts the agency also studied investment advisers.  The Advisers Act was based on that study.  By the time it passed, it was a consensus measure having the support of virtually all advisers.

• Investment advisers’ professionalism, and particularly their professional ethics, dominated the SEC study and the legislative history of the Act. Industry spokespersons emphasized their professionalism.  The “function of the profession of investment counsel,” they said, “was to render to clients on a personal basis competent, unbiased and continuous advice regarding the sound management of their investments.”  In terms of their professionalism they compared themselves to physicians and lawyers.  However, industry spokespersons indicated that their efforts to maintain professional standards had encountered a serious problem.  The industry, they said, covered “the entire range from the fellow without competence and without conscience at one end of the scale, to the capable, well-trained, utterly unbiased man or firm, trying to render a purely professional service, at the other end.”  Recognizing this range, “a group of people in the forefront of the profession realized that if professional standards were to be maintained, there must be some kind of public formulation of a standard or a code of ethics.”  As a result, the Investment Counsel Association of America was organized and issued a Code of Ethics.  Nonetheless, the problem remained that the Association could not police the conduct of those who were not members nor did it have any punitive power.

• The SEC Study noted that it had been the unanimous opinion of all who had testified at its public examination, both members and nonmembers of the Association, that the industry’s voluntary efforts could not cope with the “most elemental and fundamental problem of the investment counsel industry—the investment counsel ‘fringe’ which includes those incompetent and unethical individuals or organizations who represent themselves as bona fide investment counselors.”  Advisers of that type would not voluntarily submit to supervision or policing.  Yet, all counselors suffered from the stigma placed on the activities of the individuals on the fringe.  Thus, an agency was needed with compulsory and national power that could compel the fringe to conform to ethical standards.

• As a result of the Commission’s report to Congress, the Senate Committee on Banking and Currency determined that a solution to the problems of investment advisory services could not be affected without federal legislation.  In addition, both the Senate and House Committees considering the legislation determined that it was needed not only to protect the public, but also to protect bona fide investment counselors from the stigma attached to the activities of unscrupulous tipsters and touts.  During the debate in Congress, the special professional relationship between advisers and their clients was recognized. It is, said one representative, “somewhat [like that] of a physician to his patient.”  The same Congressman continued that members of the profession were “to be complimented for their desire to improve the status of their profession and to improve its quality.”[5]

This is why it is important to fiduciary advisors to be able to distinguish themselves from non-fiduciaries.  A recent example of the problems faced by investment advisers was the “fee-based brokerage accounts” final rule adopted by the SEC in 2005, which would have permitted brokers to provide the same functional investment advisory services as investment advisers but without application of fiduciary standards of conduct.  This would have negated to a large degree economic incentives[6] for persons to become investment advisers and be subject to the higher standard of conduct.  The SEC’s fee-based accounts rule was overturned in Financial Planning Ass'n v. S.E.C., 482 F.3d 481 (D.C. Cir., 2007).

Monitoring and Reputational Threats are Largely Ineffective

The ability of “the market” to monitor and enforce a fiduciary’s obligations, such as through the compulsion to preserve a firm’s reputation, is often ineffective in fiduciary relationships. This is because revelations about abuses of trust by fiduciaries can be well hidden (such as through mandatory arbitration clauses and secrecy agreements regarding settlements), or because marketing efforts by fiduciary firms are so strong and pervasive that they overwhelm the reported instances of breaches of fiduciary duties.

Public Policy Encourages Specialization, Which Necessitates Fiduciary Duties

As Professor Tamar Frankel, long the leading scholar in the area of fiduciary law as applied to securities regulation, once noted: “[A] prosperous economy develops specialization. Specialization requires interdependence. And interdependence cannot exist without a measure of trusting. In an entirely non-trusting relationship interaction would be too expensive and too risky to maintain. Studies have shown a correlation between the level of trusting relationships on which members of a society operate and the level of that society’s trade and economic prosperity.”[7]  Fiduciary duties are imposed by law when public policy encourages specialization in particular services, such as investment management or law, in recognition of the value such services provide to our society.  For example, the provision of investment consulting services under fiduciary duties of loyalty and due care encourages participation by investors in our capital markets system.  Hence, in order to promote public policy goals, the law requires the imposition of fiduciary status upon the party in the dominant position.  Through the imposition of such fiduciary status the client is thereby afforded various protections.  These protections serve to reduce the risks to the client which relate to the service, and encourage the client to utilize the service.  Fiduciary status thereby furthers the public interest.

Public Policy Encourages Participation in our Capital Markets

Investment advisory services encourage participation by investors in our capital markets system, which in turn promotes economic growth.  The first and overriding responsibility any financial professional has is to all of the participants of the market. This primary obligation is required in order to maintain the perception[8] and reality that the market is a fair game and thus encourage the widest possible participation in the capital allocation process. The premise of the U.S. capital market is that the widest possible participation in the market will result in the most efficient allocation of financial resources and, therefore, will lead to the best operation of the U.S. and world-wide economy.  Indeed, academic research has revealed that individual investors who are unable to trust their financial advisors are less likely to participate in the capital markets.[9]

Public Policy Encourages Saving and Proper Investing

As stated in a 2002 white paper authored by Professor Macy: “If people do not make careful, rational decisions about how to self-regulate the patterns of consumption and savings and investment over their life cycles, government will have to step in to save people from the consequences of their poor planning. Indeed the entire concept of government-sponsored, forced withholding for retirement (Social Security) is based on the assumption that people lack the foresight or the discipline, or the expertise to plan for themselves. The weaknesses in government-sponsored social security and retirement systems places increased importance on the ability of people to secure for themselves adequate financial planning.”[10]

More blog posts to come, which will examine the fiduciary duties of those who provide personalized investment advice and comment on current regulatory and professional developments. To be apprised of blog postings, please subscribe to this blog, or follow me on Twitter (@140ltd) or connect with me on LinkedIn. Thank you. - Ron Rhoades, JD, CFP(r)

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[1] Lowe v. SEC, 472 U.S. 181, 200, 201 (1985). 

[2] Id. at 208. 

[3] Id. at 210.

[4] In a recent study, Professors “Madrian, Choi and Laibson recruited two groups of students in the summer of 2005 -- MBA students about to begin their first semester at Wharton, and undergraduates (freshmen through seniors) at Harvard.  All participants were asked to make hypothetical investments of $10,000, choosing from among four S&P 500 index funds. They could put all their money into one fund or divide it among two or more. ‘We chose the index funds because they are all tracking the same index, and there is no variation in the objective of the funds,’ Madrian says … ‘Participants received the prospectuses that fund companies provide real investors … the students ‘overwhelmingly fail to minimize index fund fees,’ the researchers write. ‘When we make fund fees salient and transparent, subjects' portfolios shift towards lower-fee index funds, but over 80% still do not invest everything in the lowest-fee fund’ … [Said Professor Madrian,] ‘What our study suggests is that people do not know how to use information well.... My guess is it has to do with the general level of financial literacy, but also because the prospectus is so long."  Knowledge@Wharton, “Today's Research Question: Why Do Investors Choose High-fee Mutual Funds Despite the Lower Returns?” citing Choi, James J., Laibson, David I. and Madrian, Brigitte C., “Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds” (March 6, 2008). Yale ICF Working Paper No. 08-14. Available at SSRN: http://ssrn.com/abstract=1125023.

[5]   John H. Walsh, “A Simple Code Of Ethics: A History of the Moral Purpose Inspiring Federal Regulation of the Securities Industry,” 29 Hofstra L.Rev. 1015, 1066-8 (2001),  citing SEC, REPORT ON INVESTMENT COUNSEL, INVESTMENT MANAGEMENT, INVESTMENT SUPERVISORY, AND INVESTMENT ADVISORY SERVICES (1939).

[6] One might reasonably ask why “honest investment advisers” (to use the language of the U.S. Supreme Court in SEC vs. Capital Gains) had to be protected by the Advisers Act.  Was it not enough to just protect consumers?  The answer can be found in economic principles, as set forth in the classic thesis for which George Akerlof won a Nobel Prize:

There are many markets in which buyers use some market statistic to judge the quality of prospective purchases. In this case there is incentive for sellers to market poor quality merchandise, since the returns for good quality accrue mainly to the entire group whose statistic is affected rather than to the individual seller. As a result there tends to be a reduction in the average quality of goods and also in the size of the market. 

George A. Akerloff, The Market for "Lemons": Quality Uncertainty and the Market Mechanism, The Quarterly Journal of Economics, Vol. 84, No. 3. (Aug., 1970), p.488.  George Akerloff demonstrated “how in situations of asymmetric information (where the seller has information about product quality unavailable to the buyer), ‘dishonest dealings tend to drive honest dealings out of the market.’ Beyond the unfairness of the dishonesty that can occur, this process results in less overall dealing and less efficient market transactions.”  Frank B. Cross and Robert A. Prentice, The Economic Value of Securities Regulation, 28 Cardoza L.Rev. 334, 366 (2006).  As George Akerloff explained: “[T]he presence of people who wish to pawn bad wares as good wares tends to drive out the legitimate business. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.”  Akerloff at p. 495.

[7] Tamar Frankel, Trusting And Non-Trusting: Comparing Benefits, Cost And Risk, Working Paper 99-12, Boston University School of Law.

[8]  “Applying the Advisers Act and its fiduciary protections is essential to preserve the participation of individual investors in our capital markets.  NAPFA members have personally observed individual investors who have withdrawn from investing in stocks and mutual funds due to bad experiences with registered representatives and insurance agents in which the customer inadvertently placed his or her trust into the arms-length relationship.”  Letter of National Association of Investment advisers (NAPFA) dated March 12, 2008 to David Blass, Assistant Director, Division of Investment Management, SEC re: Rand Study.

[9] “We find that trusting individuals are significantly more likely to buy stocks and risky assets and, conditional on investing in stock, they invest a larger share of their wealth in it. This effect is economically very important: trusting others increases the probability of buying stock by 50% of the average sample probability and raises the share invested in stock by 3.4 percentage points … lack of trust can explain why individuals do not participate in the stock market even in the absence of any other friction … [W]e also show that, in practice, differences in trust across individuals and countries help explain why some invest in stocks, while others do not. Our simulations also suggest that this problem can be sufficiently severe to explain the percentage of wealthy people who do not invest in the stock market in the United States and the wide variation in this percentage across countries.” Guiso, Luigi, Sapienza, Paola and Zingales, Luigi. “Trusting the Stock Market” (May 2007); ECGI - Finance Working Paper No. 170/2007; CFS Working Paper No. 2005/27; CRSP Working Paper No. 602. Available at SSRN: http://ssrn.com/abstract=811545.

[10] Macy, Jonathan R., “Regulation of Financial Planners” (April 2002), a White Paper prepared for the Financial Planning Association; http://fpanet.org/docs/assets/ExecutiveSummaryregulationoffps.pdf provides an Executive Summary of the paper.

Don't Let Misleading Statements Go Unchallenged ... Slice Through Wall Street's Dense Fog

Something smells. The stench is foul. It has been fermenting for nearly a century ... or much longer. Wafting over the media and regulators and consumers alike, it is akin to a fog, seeking to disorient and obscure.

It is Wall Street. And this choking fog grows even denser each time Wall Street opens its mouth to bemoan the fiduciary standard.

Wall Street's Hollow Warnings.

One need not look far to catch this foul odor. Here's one example from a recent InvestmentNews article, quoting a lawyer who "cautioned that applying a fiduciary duty to brokers who sell IRAs could force them out of the market and leave investors without guidance" and who stated:

“We’re not trying to tilt the playing field,” said Kent Mason, a partner at Davis & Harman LLP. “The objective is to provide the best information possible so that participants can make the best decision. But if there is fiduciary liability associated with the provision of information to participants, that information will dry up, which is exactly the opposite of what the GAO is recommending.”

Mark Schoeff, Jr., "GAO: Workers hurt when rolling over 401(k) plans to IRAs" (InvestmentNews, April 3, 2013).

Hmmm ... Wall Street, through its hired gun, states that its objective is to "provide the best information possible." Yet, that can't be done if one is required to act in the best interests of the client, as the fiduciary standard requires? What in the fiduciary standard prevents providing the "best information possible"? - Nothing. In fact, the fiduciary standard ensures that the client receives the best information possible!

Perhaps what Wall Street really wants to continue to provide is "the best information" to plan participants, in the sense of "the best information for Wall Street's interests."

The foregoing threat is similar to Wall Street's repeated warnings that applying the fiduciary standard would leave small investors without the ability to access advice. Yet, similar to the foregoing statement, there is no credible evidence to back up such a position. In fact, as is observed below, the reverse is true - more and better advice will result.

At times I say to myself, "Self - if Wall Street were to carry out its threat, and not adapt its business practices to the fiduciary standard, but rather flee the scene, such would be a good thing ... certainly better than the harm Wall Street causes now in its fleecing of the small investor."

But, I suspect the answer is not that Wall Street will abandon individual investors. If forced to adhere to the fiduciary standard, its business practices will adapt.

What is Wall Street really stating? Wall Street whining really comes down to this: "We can't fleece small investors if a fiduciary standard is applied." Stated differently, "Our business model is only highly profitable for us if we can push proprietary, expensive products and other wares under the weak 'suitability' standard, which permits us to recommend the highest-cost products for our client, even if our clients are substantially disadvantaged by same. We love the financial services sector extracting 35% or more of the profits of this country. We love our bonuses. Don't disturb our greedy practices!"

Fundamental Economic Principles Demonstrate the Positive Effects of the Application of the Fiduciary Standard.  

Wall Street's whining and attempts at obfuscation also ignore fundamental economic principles. In 1970, Nobel-Prize winning economist George A. Akerloff, in his classic thesis, The Market for "Lemons": Quality Uncertainty and the Market Mechanism, The Quarterly Journal of Economics, Vol. 84, No. 3 (Aug., 1970) demonstrated how in situations of asymmetric information (where the seller has information about product quality unavailable to the buyer, such as is nearly always the case in the complex world of investments), "dishonest dealings tend to drive honest dealings out of the market." As George Akerloff explained: “[T]he presence of people who wish to pawn bad wares as good wares tends to drive out the legitimate business. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.”  Akerloff at p. 495.

In other words, as long as Wall Street is able to siphon excessive rents from investors, through conflict-ridden sales practices resulting in higher costs for individual investors (and lower returns), the business model Wall Street seeks to preserve will continue to attract bad actors. It's only human nature ... "join our firm and your compensation potential is virtually unlimited" is Wall Street's "promise" - ignoring of course the requirement that the new employee is required to sell - not only expensive and often proprietary investment products, but indeed his or her very soul.

Enhanced Standards of Conduct Will Fuel Demand, Supply and Quality.  

At a conference I am currently attending (RISE 2013, an investment conference at the University of Dayton), speakers noted yesterday that the reputation of financial advisors is almost as low as that of members of Congress - and both of these reputations fall below that of used car salesmen. This needs to change.

I am surrounded by nearly a thousand students as I write this, all looking to enter the arena of financial services. And not one I have heard speak, in session after session, and in the halls during informal conversations, wants a job selling expensive financial products. Rather, they want to work in a professional environment, where they can help (rather than hurt) their fellow Americans. These students want to be the stewards of their clients' wealth, and of their clients' dreams.

So - what will happen if the fiduciary standard is applied to the delivery of advice to all plan sponsors, plan participants, and individual investors, through potential DOL (EBSA) and SEC rule-making? Economic principles and common-sense logic indicate that three dramatic developments will occur.

First, once individual investors know that they can trust the words coming out of the mouths of their financial advisors, the demand for financial advice will soar. Currently far too many individuals distrust Wall Street, and - given their inability to discern between high-quality, fiduciary advisors and low-quality, non-fiduciary advisors, they simply choose to stay away from both. Additionally, the adverse smell of the non-fiduciary advisors infects the entire landscape of financial advisors.

Second, we will see a surge in the availability (supply) of fiduciary-bound financial and investment advice. More and more actors will be attracted to become such fiduciary advisors. As many, many already have, they will be attracted to a true profession in which they sit on the same side of the table as the client and assist the client in achieving their hopes and dreams. They receive not just professional compensation from providing expert, trusted advice, but they also receive the immense joy from assisting their fellow man.

Third, the quality and quantity of advice will also soar. Currently Wall Street's legions are primarily "asset gatherers" and product salesperson. Much of the training provided is on how to sell - i.e., to close the deal. Fiduciary financial advisors, on the other hand, bound by  fiduciary standards, are required to exercise due care in all aspects of the advice they provide. Clients will receive better budgeting advice, increased levels of savings, and better investment advice.

I can hear those on Wall Street bemoan such logic ... "Surely, you jest," they would say. "No advisor can afford to serve small clients, without selling expensive products to them!"

Yet I ask, what is the compensation paid on a Class A mutual fund, for a client who has $20,000 to invest? 5.75%, plus a small (0.25% or less, typically) trailing 12b-1 fee (in theory, in perpetuity) - in addition to fund management and administrative fees and transaction costs. So a Wall Street firm (and its representative) would receive a $1,150 sales load, plus more over time?

The fact is, there are many financial advisors out there right now who will provide advice for $1,150 - or far less. This advice will be provided under hourly-based compensation or for a flat fee or under some other form of professional-level compensation arrangement. And the advice provided won't be just relating to the sale of an expensive product; rather for the same or lower fees paid by the client the professional fiduciary advisors will provide the clients with better financial advice and investment advice, and far more comprehensive advice at that.

Let fiduciary advisors be paid at professional-level compensation, for truly expert advice in the client's best interest. Wall Street may be unable to extract enough rents to survive, under the fiduciary standard, but there are plenty of independent, objective, trusted professionals who will take Wall Street's place, and do a far better job for the individual investor in the process.

We Need the Fiduciary Standard.

We need the fiduciary standard to be applied to all investment advisory activities. Why?

• To create a new era of demand for financial services, from a public which, for the first time, can place trust in financial and investment advisers who are united in their observance of the fiduciary principle.
• To meet the demand for financial planners over time via both existing advisors who transition to a new profession, as well as tens of thousands of new financial planners who will desire to become members of this true profession.
• To enable more extensive and better financial and investment advice to be provided, thereby enabling the financial and retirement security of our fellow Americans.
• To create a true profession, bound together by the fiduciary principle that our client's best interests are, and always shall be, paramount to those of our own (and that of our firms).

Don't Permit Wall Street's Stench to Spread. Speak Up!

Let us not permit these misleading statements by Wall Street and its proxies to go unchallenged. Each and every time Wall Street touts some new fallacy in stating how small investors won't be able to receive "the best information" or receive any advice at all, just stand up and say: "You speak out of self-interest, to preserve your archaic business model. Your unsupported statements are but mere attempts to mislead. You are adept at influencing others through the emotions of greed and fear - but not this time!"

The time for Wall Street's dinosaurs is over; their extinction event has arrived. For the good of advisors, the clients, and our country, we need to move on to a new, more client-centric era of professional investment advice delivered under a bona fide fiduciary standard.

Do not permit Wall Street to continue to pollute the air. Do not permit Wall Street to continue to stink things up. Speak up and clear away the dense fog Wall Street seeks to perpetuate.

IMPORTANT NOTICE: Surprise SEC Temporary Rule Redefines "Fiduciary"

Author's Note:  This April Fool's Day blog post was, surprisingly, viewed as true by several readers, including a journalist working for a major industry publication, a law professor, and several others. The fact that this was viewed as even possibly true, by some, is itself a sad commentary on the possible direction that the SEC may take as it considers applying the fiduciary standard to the delivery of personalized investment advice by broker-dealers.

In subsequent blogs, later this month, I will explore the fact that the delivery of personalized investment advice - by whomever - is already subject to fiduciary standard of conduct under a robust body of state common law.

Following is the original April Fool's Day blog post. Enjoy ...

In a surprise U.S. Securities and Exchange Commission Temporary Rule issued today, the SEC announced the following:

"To end ongoing consumer confusion, the Commission has unanimously voted to issue an emergency Temporary Rule, effective with the publication date, providing for the adoption of the following Temporary Rule 275-204.1T:

1. All registered representatives of broker-dealer firms will be immediately permitted to provide personalized investment advice, including financial plans, strategic asset allocation, tactical asset allocation, portfolio rebalancing, individual stock selection, to their customers.
2. All registered representatives of broker-dealer firms will be immediately permitted to receive ongoing fees for such personalized investment advice, through asset-based percentage fees, albeit paid indirectly through deduction from the investment products which are sold. These fees will be immediately renamed as "relationship fees" rather than 12b-1 fees.
3. All registered representatives of broker-dealer firms will be immediately permitted to use titles which denote relationships of trust and confidence, such as "financial consultant" and "financial advisor" and "wealth manager."
4. All registered representatives of broker-dealer firms will be immediately permitted to tout, both directly and through "house on the beach" and "attend their clients' childrens' soccer games" advertisements, their "objective advice" and that they act "in the best interests of the client" (in accord with their firms' advertisements and representations and, as well, their firms' codes of ethics).
5. All registered representatives of broker-dealer firms shall, accordingly, be immediately required to adhere to the fiduciary duty of loyalty. However, this adherence will only require, when a conflict of interest is present, that casual disclosure of that conflict of interest occur to the client. Only the disclosure "Our interests may not be aligned with yours" shall be required. There shall be no requirement that the registered representative ensure that the client achieve an understanding of the conflict of interest, given that behavioral biases (which registered representatives have been trained to take advantage of) exist which negate such understanding, anyway. There shall, henceforth, be no requirement that informed consent of the client be obtained; in other words uninformed consent shall be permitted instead. Additionally, the proposed transaction need not, with such uninformed consent, be in the best interest of the client and substantatively fair to the client. In other words, under the Commission's new definition of fiduciary, clients may accordingly consent to harm.
6. When acting as a "fiduciary," even then registered representatives of broker-dealer firms will be permitted to remove their fiduciary hats, at will, with only casual notice to the client, in order to be permitted to more blatantly sell their customers highly costly, toxic and inappropriate securities products. Furthermore, continual "hat-switching" is permitted, for it is known that investment recommendations will need to be undertaken by reference back to the investment strategy and the financial plan provided to the client. Furthermore, two hats - one fiduciary and one non-fiduciary, may be worn at the same time, with respect to the same client as long as two different accounts are maintained, even though it is acknowledged that clients / customers will possess even greater confusion as to the standards to which their "advisors" are held.

This Tempoary Rule is designed to preserve the business practices of broker-dealer firms, by adapting the "fiduciary standard" to fit those business practices. Justice Cardoza's warning of granting "particular exceptions" to fiduciary principles shall be deemed inapplicable, given our broad "redefinition" of the term "fiduciary" itself.

It is recognized that this rule largely codifies already-existing business practices which have been permitted to occur by SEC and FINRA inattention and lack of enforcement over the past several decades. Hence, the economic impact of this rule is deemed to be minimal.

The Commission is ever mindful of the necessity of preserving the high profits of the investment banks and broker-dealer firms, in order to ensure that never again shall the percentage of profits generated by U.S. firms and absorbed by Wall Street fall below 35%. The Commission desires to ensure that, when Commissioners and SEC staff depart the SEC, that its retired commissioners as well as SEC departing staff find excellent-paying jobs with Wall Street firms and the law firms which provide services to them, and receive the huge year-end bonuses they so richly deserve.

The Commission likewise does not desire to see that a true profession of investment advisers and financial planners come into being, it being instead the Commission's desire to preserve, at all costs, the merchandizing aspects of the securities business. It is acknowledged that professional regulation, under a bona fide fiduciary standard, would greater ensure the financial and retirement security of all Americans, but the Commission is under the view that the financial security of Wall Street's firms takes precedence.

This rule shall be effective immediately upon its publication.

Dated this 1st day of April, 2013.  Sadly, one can only speculate if this is an April Fools' joke.

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

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

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

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


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

If the transaction is in reality an arm's-length transaction between the securities house and its

customer, then the securities house is not subject' to 'fiduciary duty. However, the necessity for

a transaction to be really at arm's-length in order to escape fiduciary obligations, has been

well stated by the United States. Court of Appeals for the District of Columbia in a recently

decided case: ‘[T]he old line should be held fast which marks off the obligation of confidence

and conscience from the temptation induced by self-interest.  He who would deal at arm's length

must stand at arm's length.  And he must do so openly as an adversary, not disguised as confidant

and protector.  He cannot commingle his trusteeship with merchandizing on his own account…’

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

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

has held that where a relationship of trust and confidence has been developed between a broker-dealer

and his customer so that the customer relies on his advice, a fiduciary relationship exists, imposing a particular duty to act in the customer’s best interests and to disclose any interest the broker-dealer may

 have in transactions he effects for his customer … [BD advertising] may create an atmosphere of trust

and confidence, encouraging full reliance on broker-dealers and their registered representatives as professional advisers in situations where such reliance is not merited, and obscuring the merchandising aspects of the retail securities business … Where the relationship between the customer and broker is

such that the former relies in whole or in part on the advice and recommendations of the latter, the

salesman is, in effect, an investment adviser, and some of the aspects of a fiduciary relationship arise

between the parties.

1963 SEC Special Study.

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

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

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

    “1. Do you know what you are talking about? – competence; expertise

     2. Will you recommend what is best for me? – customer orientation

     3. Are you truthful? – honesty; candor

     4. Can you and your company back up your promises? – dependability

     5. Will you safeguard confidential information that I share with you? – customer orientation; dependability.”

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

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

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

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

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

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

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

In recent years massive marketing campaigns by Wall Street firms have touted their “objective advice” from “financial consultants” who attended their client’s soccer games and made so many believe that the “advice” received would result in the ability to afford that second home on the beach.  Even long-respected firms like Goldman Sachs have been perceived, at least at times and by some, to “throw clients under the bus” [see http://theweekinethics.wordpress.com/2012/03/22/the-week-in-ethics-goldman-sachs-2012-problem-with-culture/], apparently in violation of their adopted Code of Business Conduct and Ethics in which the firm commits “to conduct our business in accordance with … the highest ethical standards.”

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

There exists a fundamental truth that “to provide biased advice, with the aura of advice in the customer’s best interest, is fraud.” [Angel, James J. and McCabe, Douglas M., Ethical Standards for Stockbrokers: Fiduciary or Suitability? (September 30, 2010), at p.23.  Available at SSRN: http://ssrn.com/abstract=1686756.]

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

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

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

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

Who should speak up?

• Those advisors who desire that consumers not be misled, and instead receive trusted advice - when trusted advice is provided and/or (through use of titles or designations) represented as being provided.

• Consumers themselves, tired of having their trust betrayed by those who do not subscribe and adhere to their fiduciary obligations.

• Those federal and state securities and insurance regulators, as well as advisors and consumers, who desire that truth be spoken, and who desire to combat the pervasive misrepresentations and frauds that have crept into the financial services industry in recent decades.

We should not live in a society in which pervasive fraud - i.e., holding out as trusted advisors, and then failing to adhere to the duties imposed from the resulting fiduciary rleationship - is continued to be permitted to occur.

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

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

To receive notifications of Ron's blog posts, follow him on Twitter (@140ltd), or connect with him via LinkedIn or Facebook. To contact Ron directly, please e-mail him at: RhoadeRA@alfredstate.edu.  Thank you.

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

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

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

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

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

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

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

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

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

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

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

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

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

How important is it to provide this opportunity? Consider how it impacts each student's ability to acquire knowledge and their perspectives on engagement with other advisors:

• “Everyone has a different perspective on a topic – which surprised me,” added Nick McMichael, a senior from Alfred, NY.  “The speaker would make a lot of sense, but then you’d talk to someone after the session who has other ideas.  That’s the difference between being a professional with experience and still learning as a student.”
• For fellow senior Joshua Wing (Hornell, NY), the conference added layers of knowledge to what he has learned in class.  “We do a lot of projects in school to get into the thought process of being an advisor. Part of that is how to get information if you don’t know the answer,” he said. “And that’s why advisors go to conferences and help each other out."

While any donation is appreciated, here are some suggested levels of giving:

• $ 495 Emerald Sponsor- to sponsor one student
• $ 248 Platinum Sponsor - to co-sponsor one student
• $ 124 Gold Sponsor - to co-sponsor a student one student 
• $   62 Silver Sponsor - to help out
• $   36 Bronze Sponsor - to help out
• $   18 Titanium Sponsor - to help out

PLEASE VISIT THE FOLLOWING SITE TO MAKE YOUR DONATION, BY CREDIT CARD, NOW, TO THIS QUALIFIED CHARITY.  http://www.gofundme.com/FinancialPlanningStudents

Thank you in advance for your consideration of this request.

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

Thank you again.

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

E-mail: RhoadeRA@AlfredState.edu

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

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

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.

INTRODUCTORY NOTE: THE TERM "FIDUCIARY ADVISER"

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:

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

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

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.)

And, of course, consider following my blog. When I post updates to my blog, I announce them on Twitter (@140ltd), and on LinkedIn and Facebook (please feel free to connect with me).

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

12b-1 Fees: RIAs and Registered Representatives Beware

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

BACKGROUND: 12B-1 FEES AND CLASS C SHARES.

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

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

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

12b-1 FEES: ADVISORY FEES IN DRAG; APPLICATION OF THE ADVISERS ACT

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

Interestingly, the SEC Staff did not comment the fact that brokers also receive compensation which is in the form of asset-based compensation, similar to the “assets under management” fee structure of most investment advisers, such as 12b-1 fees and payment for shelf space. 12b-1 fees have been criticized by this author as possible “special compensation” and “investment advisory fees in drag.” See Ron Rhoades, “7 reasons why wirehouses shouldn’t milk the old business model,” RIABiz, Jan. 28, 2010 (available at http://www.riabiz.com/a/114009/7-reasons-why-wirehouses-shouldn39t-milk-the-old-business-model).

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

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

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

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

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

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

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

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

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

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

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

THE ANTI-COMPETITIVE NATURE OF 12B-1 FEES

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

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

CLASS C SHARES: A NEW SCANDAL, LIKE CLASS B SHARES?

Another issue is whether Class C shares constitute unreasonable compensation. If Class C shares, with a 1% fee assessed, are continuous in nature, and continue to compensate the broker-dealer even after the transaction is complete, they would appear to constitute “unreasonable compensation.” As stated in a comment letter by the Consumer Federation of America, “12b‐1 fees can be collected in perpetuity, which means that they can result in investors’ paying much higher sales compensation than would have been permissible under other classes of shares.” Comment letter of Mercer Bullard, Fund Democracy, and Barb Roper, Consumer Federation of America, to U.S. Securities and Exchange Commission, dated November 5, 2010, at p.2., located at http://www.consumerfed.org/pdfs/12b1_cmt_ltr.pdf.

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

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

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

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

INDEPENDENT INVESTMENT ADVISERS: AVOID 12B-1 FEES WITH A PASSION

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

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

REGISTERED REPRESENTATIVES: BE A DUAL REGISTRANT IF YOU RECEIVE 12B-1 FEES FOR ADVISORY SERVICES, AND ASSUME YOU ARE A FIDUCIARY

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

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

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

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

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

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

ERISA: PROHIBITED TRANSACTION RULES

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