fi360 Blog

Howdy Neighbor! Welcome to the ’40 Act

Recent coverage of SEC enforcement actions by the trade press highlights a crackdown on compliance deficiencies by investment advisers.  One former SEC attorney predicted an ‘enforcement wave’ was coming soon for advisers.  Robert Khuzami, director of the SEC’s Division of Enforcement, in a news release featuring three settlements with advisers, tempered his remarks by saying that while not all technical violations result in fraud, “many frauds take root in compliance deficiencies.”

Overlooked by the press in these particular cases were the affiliations of the parties to the brokerage industry.  Of course, that is nothing new.  In recent years a wave of stockbrokers, coincidentally, has moved into the neighborhood.  Dual registrants now comprise nine out of 10 investment adviser representatives on both the federal and state level.  Thus readers should not jump to conclusions about adviser misconduct when brokers are now likely to be one and the same.  However, missing from the news reports and the SEC is an important context – a client-first culture under the Advisers Act that oftentimes is an awkward fit for brokers working in a sales environment at the same time.

In these particular enforcement cases, all three were associated with broker-dealers, two of the three as broker-dealer executives.  A common deficiency found by SEC examiners was a distinct lack of attention to written compliance policy and ethics codes under investment adviser rules adopted in late 2004 and early 2005.  One would think that, as BD executives, they would have been accustomed to FINRA’s rules-intensive compliance requirements.  But for whatever reason, they did not carry over this over to the new fiduciary space.

Several years after the new SEC rules went into effect, these advisers’ books and records were examined by SEC examiners.  All three showed a purposeful or benign neglect of their ethics and compliance oversight requirements despite repeated requests by Commission examiners to update and customize what were sometimes generic, off-the-shelf compliance manuals.  In one instance, the advisor had no compliance manual, only learning about the SEC rules when examiners called to schedule a visit.  To aggravate matters, after a repeat visit several years later, the same advisor backdated records attesting to supervisory reviews the day before producing those records for the agency.

The details vary, but the results were all the same – technical violations of SEC rules that flow from an adviser’s fiduciary duty of loyalty to manage conflicts of interest, and a fiduciary duty of care to, among other things, implement programs designed to protect client privacy, disclose investment philosophy, and review staff compliance with the firm’s ethics code. 

Coming Soon To a Theatre near You: The Latest Adventures in Fiduciary Advice

Warning: This movie is rated ‘FG’ – Fiduciary Guidance. For Mature Advisers Only.

Plot: The Starship Pension Prize has discovered a strange new plan-et inhabited by the Klingons, a crafty race known for hawking lightly regulated insurance products.  The Starship’s chief officer, Captain James T. Kirk, plans to explore compliance with the Federation’s fiduciary adviser rule.

Voice over by Kirk, with a scene of deep space and scary music in the background:  Fiduciary advice: the final frontier.  These are the voyages of the Starship Pension Prize.  Its mission: to explore strange new eligible investment advice arrangements, to seek out generally accepted investment theories, and to boldly go where no regulator has gone before.

Opening Scene: 2^nd Voice over by Kirk as he writes inside his cabin: Captain’s Star Log: 2275. The Fiduciary Adviser Rule has been in effect for 263 years.  We have received disturbing reports that in far flung galaxies of the Universe, a number of Klingon advisers are blatantly ignoring it.  I am planning to personally investigate a strange new phenomenon picked up by the Starship Pension Prize from the plan-et we now orbit.  The sounds, when amplified, seem to be saying ‘risk-free investment; can’t go wrong.’ 

(Script: Kirk walks to the transporter chamber and motions to Chief Medical Officer Dr. Leonard “Bones” McCoy and First Officer Spock to join him.)  He turns to Chief Engineer “Scotty” Scott: Beam us down, Scotty.  I need to check out the eligible investment advice arrangement on the plan-et.  My sensors indicate it is a computer model advice program.

Scott:  Aye-aye, Cap’tun. 

Spock: Captain, I recommend we set the phasers to stun.  The Klingons are known for their self-dealing.

(Script: The Starship team is seen materializing on the planet below.  They are greeted by a Klingon advisor who is smiling and jabbering as he shoves a thick document at Kirk.)

Kirk:  Crap.  The Klingon is trying to sell me an annuity in my 401(k) even before I can audit his computer program!  My sensors aren’t detecting an annuity anywhere in the computer advice program.  Bones! What do I do?  Doesn’t this Klingon even have a heart beat?  As a fiduciary, shouldn’t he know that I’m in the accumulation phase and that inflation outweighs longevity risk at this point?

McCoy:  Jim, unfortunately, the Klingon can survive quite nicely without a heart and be richly rewarded at the same time.  He can recommend the annuity option within the plan and then shed his fiduciary duty when  cross-selling high-load products to the plan-et’s participants and beneficiaries outside of the eligible investment advice arrangement.

Kirk: Spock, can you detect any signs of intelligent life?

Spock: Unfortunately, no, Captain. I must agree with Bones.  Not only is there no heart, but I can find no conscience – fiduciary or otherwise – in this Klingon.  More importantly, he has apparently researched the rule carefully and complied with the letter of the law.  I’m looking at an obscure section of the Fiduciary Adviser rule, (b)(4)(i)(G)(2)(i), which was written in the year 2011 by an extinct federal agency on Earth known as the Department of Labor.  Incredibly, DoL allowed earthlings in the retirement plant to invest in an annuity option, notwithstanding the fact that the annuity could not be properly analyzed by the computer program.

(Spock pauses, then displays a quizzical look.)  Captain, you would think that our advanced civilization would have computers capable of comparing accumulation rates of annuities versus equities, and other critical factors such as the equity premium and inflation risk.  But apparently our scientists have not been able to succeed yet in mastering this process.  All this Klingon adviser needs to do is furnish the plan-et participant with a general description of the annuity and how it operates.  He then satisfies his disclosure requirements under the rule.  Hence the Klingon’s irritating grin.   

Kirk:  Dammit, Spock, that loophole is big enough to drive a photon torpedo through.  Beam us up, Scotty!  I’m going to see if there are any DB plans left in the Universe to audit.

NASAA Sweep is Wake Up Call for IA Fiduciaries

The results of the state securities regulators’ sweep of registered investment advisers are in, and they aren’t pretty, particularly for sole proprietors.  

Officially called the 2011 Coordinated Investment Adviser Exams, the North American Securities Administrators Association has conducted the biennial sweep in alternate years since 2007.  The current sweep covered 825 state-registered investment advisers – including some in Canadian provinces – between Jan. 1^st and June 30^th of this year. 

The U.S. advisers were state-registered and managed less than $30 million in assets.  The typical U.S. advisory firm examined this year, not including financial planning practitioners and solicitors, averaged $14 million in assets under management, had 57 clients, and two investment adviser representatives.  About one in five (18.8%) were affiliated with a broker-dealer.

The dominant group of advisers examined by the state regulators was the single-advisor firm.  Seventy-two percent, or 594 of the 825 advisers, were sole proprietors.

Keeping in mind that, for the most part, RIAs are usually cited for ‘broken tail light’ violations involving inconsistencies in their Form ADVs and books and records omissions, not fraud, the 2011 results were no different.  Sloppy compliance is no excuse, of course.  Although NASAA did not have available the number of advisors who passed with flying colors, reports by the SEC tend to show about 9 out of 10 RIAs are cited for deficiencies, but only a small percentage referred for enforcement. 

In this instance, there were apparently not many Bernie Madoffs caught up in the state reviews – less than 5 percent of the advisors who were cited for ethical deficiencies were found to be engaged in Ponzi schemes, altering documents and the like.  Nonetheless there were some interesting and even startling findings when viewed from a fiduciary perspective. 

Draft SRO Bill not in best interests of investors or advisers

Yesterday, the House Finacial Services Committee released a discussion draft SRO bill for investment adviser oversight. The bill would authorize the creation of one or more self-regulatory organizations. This was one of three options presented by the SEC staff in January, the others being SEC self-funding and the authorization of a single regulator for dual registrants.

Fi360 opposes the bill and still believes that a fully funded SEC is the most cost effective and least conflicted option. If there is a silver lining, it is that the bill calls for one or more SROs, opening the door for an alternative regulator to FINRA that gives investors the choice of advisors who are being held accountable to a true fiduciary standard.  

For more information, consult the following resources:

• Text of the draft bill
• The House Financial Services Committee's page for Tuesday's hearing on the bill. Expect testimony to be linked to this page in the coming days.
• fi360's official statement on the bill
• fi360's executive summary of the bill
• The Advocacy page of fi360.com.  The most recent section is related to the release of the draft bill. We will be posting more information there soon, including an executive summary of the bill. You can also view materials related to the SEC's study on investment adviser examinations in the fifth section from the top.
• While the bill opens the possibility for multiple SROs, bill sponsor Representative Bachus said in a press conference yesterday that he endorses FINRA as regulator.
• fi360's Blaine Aikin gives his first reaction to the bill in an AdvisorOne article, Draft Bill Calling for SRO for Advisors Introduced in House
• Duane Thompson discusses the House proposed bill that would give SROs oversight of investment advisers with Registered Rep
• The website of SROIIA, the startup self-regulator for advisers that hopes to gain authorization as the higher standard alternative to FINRA
• Financial Planning Coalition press release and statement
• Duane Thompson speaks out about his reaction to the House hearing on SRO, fiduciary standard

The Battle over Principle

"War is the continuation of policy (politics) by other means."
- Karl von Clausewitz, Prussian military strategist

Von Clausewitz, a witness to the titanic struggle between nations in the Napoleonic era, once wrote of war being merely an extension of foreign policy.  So, too, in perhaps less dramatic fashion, should the struggle over investment advice be viewed as shifting over the years from the marketplace to Washington politics. 

Today, the most important distinguishing feature between Wall Street and independent financial advisors is the common law fiduciary standard.  Wall Street, while eagerly adopting the lucrative business model of advisors, over the last decade has pressed Washington to keep the FINRA sales model for regulation in play for its advisory services.

When reviewing the uneven battle between the two, given Wall Street’s deep pockets, the latest salvo from the wirehouses is likely to be fired on Sept. 13, when its supporters in Congress convene a House subcommittee to hear testimony on ways to strengthen the Commission’s investment adviser examination as well as on a uniform fiduciary standard for brokers and advisors. 

While the question of a self-regulatory organization for investment advisers can be expected to dominate the discussion, the subtext that will be hard to ignore is how an SRO will ultimately shape the pending uniform fiduciary standard for brokers and advisers.  Will it be an overlay of advisor conduct largely based on principles that follow the common law standard under the Advisers Act, or a rules-dominated standard administered by FINRA, or a mix of the two?

Lack of Dodd-Frank progress reflects politics being put ahead of duty

Recently during a business meeting I referred to myself as the “doomsday girl” of the office.  As in-house counsel, it’s my job to expect the worst out of any situation, even the most amicable of business relationships.  And so I go down the path of imagining the worst case scenario and put into place any measures that I believe will prevent the worst or at least assist with cleaning up a messy situation as quickly as possible.  In other words, I do what I can to fulfill my fiduciary responsibilities as an attorney and act in the best interests of my client.  It’s something investment advisers who serve as fiduciaries can certainly relate to.  But as I was driving to work today reflecting on where we were a year ago when the Dodd-Frank Act was signed into law and where we are now, I came to the scary realization that although a lot of very smart people work in Washington, there appears to be a fundamental lack of fiduciary conduct and understanding in the lawmaking and regulatory world.  

During my time at the SEC, I can vividly remember senior staff asking “how is this good for investors” anytime we discussed a potential solution to a policy issue or a new rule proposed by an SRO.  We were keenly aware that our work was for a greater good and that we had a duty to fulfill the mission of the agency to protect investors.  Of course, our attempts to do so weren’t always successful once special interests and politics inserted their noses, but at the core, we still tried our best to focus on investor interests.  These days, as I watch Washington from the outside, it’s astounding just how political things have gotten.  Party lines are drawn, lobbyists’ arguments win the day over the opinions of industry experts, and the American people are left without the protections needed to prevent future abuses of their trust.

DOL extension of 408(b)(2) and participant-level disclosures

Today, the  DOL issued the final rule on the extension of the 408(b)(2) and participant-level disclosures applicability dates. The effective date of 408(b)(2) has been extended to April 1, 2012, with the final regulation due by the end of the year. Participant-level disclosures would be due 60 days after the effective date of 408(b)(2), at the latest, in order to give adequate transition time between the disclosures to the plans and subsequent disclosures to the participants.

To learn more about 408(b)(2) disclosure requirements, visit the following resources:

• Our March 3rd webinar with ERISA attorney Fred Reish-The Fiduciary Trend: The Combined Effects of the Proposed Advice Regulation and 408(b)(2)
• The DOL website for final 408(b)(2) rule requirements and fact sheet
• Commentary from the law firm of DrinkerBiddle

FINRA’s Back Door Regulation of Fiduciaries

A country lawyer named Abe Lincoln enjoyed using folksy tales to make a point in court.  Once he witnessed a neighbor’s fancy red rooster back down in a cock fight.  As the story goes, the frenzied rooster ran in circles around the pit till its owner got so disgusted he jumped in, grabbed the bird by the neck, and threw it out of the ring.  There the rooster stood up, stretched its neck, flapped its wings, and let out a long cock-a-doodle-doo.  The disgusted owner yelled, “Yes, you little son of a gun, you’re great on dress parade, but you’re not worth a damn in a fight.”

One wonders how much of the rooster is in FINRA, the newest and most enthusiastic booster of a fiduciary standard for brokers.  Its chairman, Richard Ketchum, probably hasn't been in charge long enough for a fair assessment to be made of his conviction to stand up for a comprehensive and undiluted fiduciary approach.  And while the rhetoric there is supportive of a seeming strong standard, there are things FINRA can do now to demonstrate that commitment instead of waiting for the SEC or Congress to make the next move.

What two Moench presumption cases mean for fiduciary liability

As was widely reported last fall, the Ninth Circuit joined the Third, Fifth, and Sixth Circuits in adopting what is known as the “Moench presumption” in the Quan v. Computer Sciences Corp. case.  Under this presumption, plan fiduciaries are presumed to have acted prudently when investing plan assets in employer stock.  The presumption can be rebutted by plan participants and beneficiaries by showing that a fiduciary abused its discretion by investing in employer stock.  In particular, participants would be required to show publicly known information that should have prompted “careful and impartial investigation by a reasonable fiduciary.”  The Ninth Circuit largely based its decision to adopt the Moench presumption on a finding that it is “consistent with the statutory language of ERISA and the trust principles by which ERISA is interpreted.”  DOL, however, has made clear that it believes the Ninth Circuit’s decision is at odds with ERISA’s objective prudence standard and applies a much more lenient judicially created standard. 

MSRB proposal a potential precursor to future fiduciary rulemaking

Last week, the Municipal Securities Rulemaking Board (MSRB) issued a draft rule and draft interpretative notice that would implement a key provision of the Dodd-Frank Act to create a fiduciary duty for municipal advisors. Although it has not received much public attention to date, the proposal could serve as a significant guidepost to future fiduciary regulation. Most notably, the proposal will first require SEC approval and then, once implemented, be enforced by FINRA. Thus, the MSRB proposal could serve as a preview of how the SEC and FINRA work together in reconciling their view of fiduciary obligations and ultimately implementing and enforcing rules for a "uniform fiduciary standard," as was recommended by SEC staff for investment advisers and broker-dealers in the fiduciary study released last month.

Similar to the SEC staff's fiduciary study, MSRB proposed rule G-36 recognizes that a fiduciary duty includes a duty of loyalty and a duty of care. The draft interpretative notice to accompany the rule spells out more concretely what these duties entail.  What is most telling about the proposal, though, is how it stacks up against the five core fiduciary principles that the Committee for the Fiduciary Standard has advocated for the past two years in an effort to maintain the "authentic fiduciary standard."  As the fiduciary debate has drawn on, the Committee has maintained a focus on these principles in hopes of maintaining integrity among advisors and strengthening investor protections.  While the MSRB does not directly acknowledge any single principle, the fact that examples of the principles can be found within the MSRB's proposed guidance bodes well for the advisory profession and investors alike.

Let's take a look at each of the five principles and how they are addressed in the MSRB proposal: