fi360 Blog

The latest on social media guidance from federal and state regulators

In an increasingly electronic world social media has become an important communications tool, and many advisors find themselves entering the evolving world of media and communications to connect with current and potential clients.  Regulators have taken note and issued guidance to direct advisors and their firms on how to ensure their social media use complies with existing laws and regulations.    

With guidance available from FINRA in 2010, fi360 presented a webinar in December 2010 on building a strategy for effectively using social media and managing risk associated with social media use.  Now, just a little more than a year later, the SEC and a state regulator have issued guidance for investment advisers.  With greater direction now available for both broker-dealers and investment advisers on social media, it’s more important than ever for all advisors to know the rules of the road.   

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. 

Judicial endorsement of the Moench presumption expands

Last month, the list of federal Circuits endorsing the so-called “Moench presumption” expanded to include the U.S. Court of Appeals for the Second Circuit.  The Second Circuit now joins the Third, Fifth, Sixth, Seventh, and Ninth Circuits in endorsing a presumption of prudence in cases involving fiduciary conduct related to 401(k) plans, and more specifically employee stock ownership plans (ESOPs) and eligible individual account plans (EIAPs). 

Several law firms have provided good summaries of the In re Citigroup ERISA Litigation and Gearren v. McGraw-Hill Cos., Inc. cases, which were argued in tandem and decided separately based on the same line of reasoning.  See e.g., summaries and analysis from Morgan Lewis and Alston & Bird.  The quick re-cap is that both cases involved a drop in the value of the employer’s company stock during the 2008 financial crisis.  And in both cases, the court found that investment committees and other employer fiduciaries were entitled to a presumption of prudence related to decisions to invest in the employer’s stock.  The court found the presumption to be workable because it “provides the best accommodation between the competing ERISA values of protecting retirement assets and encouraging investment in employer stocks.”  This presumption can be rebutted where participants can prove that the fiduciary abused its discretion in continuing to offer employer stock as an investment option.  Thus, if fiduciaries have less discretion under plan documents that require investment in the employer’s stock, they are more likely to prevail in court under the presumption.  In fact, the court found that only circumstances placing the employer (and the value of its stock) in a “dire situation” that was unforeseeable when plan documents were created would require a plan fiduciary to override the requirement to invest in the employer’s stock.  The fiduciaries prevailed in these cases before the Second Circuit because the court found that a mere drop in stock value could not have been viewed at the time as a dire situation requiring the fiduciaries to act.  

While the Second Circuit’s decisions further advances the trend that has been building in this area in favor of protecting employers and providing a roadmap for drafting  plan documents, participants and their attorneys may not be as likely to go away quietly as some commenters have predicted.  The reason being that a dissenting opinion in the cases may leave room open to argue that the Moench presumption is not necessarily justified.  In particular, Judge Straub dissented in the cases and criticized the majority’s ruling that established the “dire situation” standard because it seems to draw an arbitrary line that is not clearly defined or articulated.  This lack of clarity in Judge Straub’s view would leave participants unprotected in any situation that falls “just shy of dire.”  In addition, Judge Straub found flaw with a presumption that would displace the prudent man standard of conduct to which fiduciaries are normally held and would deny participants meaningful judicial review. 

Because so many Circuits have adopted the Moench presumption, Judge Straub’s views may simply be drowned out by a strong majority.  However, there may be room for future plaintiffs and their attorneys to argue for stronger and clearer guidance from the courts on how the Moench  presumption should be applied and to better define situations in which participants can overcome the presumption and prove that fiduciaries failed to fulfill their obligation of prudence.  

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. 

Recent cases place emphasis on diversity of investment options for retirement plans

A body of law appears to be forming across federal Circuit courts giving employers greater guidance on how to build the range of investment options available in employee retirement plans in a way that fulfills the employers' fiduciary duty under ERISA.  The most recent case, Renfro v. Unisys Corp., comes from the Court of Appeals for the Third Circuit.  

In Renfro, plan participants claimed the employer breached its fiduciary duty by choosing investments for its 401(k) plan that had excessive fees.  The trial court and Third Circuit disagreed, however, finding that the employer offered a broad enough range of investment options with different fees. 

In reaching its decision, the Third Circuit looked to the Hecker v. Deere case from the Seventh Circuit and the Braden v. Wal-Mart Stores, Inc. case from the Eighth Circuit.  As the Third Circuit noted, Hecker and Braden “share a similar analytical framework for evaluating an ERISA breach of fiduciary duty claim targeting the selection and maintenance of a mix and range of investment options in a 401(k) defined contribution plan.”  Both cases examined the characteristics of the mix and range of investment options and then evaluated the validity of claims challenging fund selection against the backdrop of the reasonableness of the mix and range of investment options.

Court decision a reminder that plan document procedures are to be followed

As most fiduciaries know, investments should be managed in accordance with governing documents, including the investment policy statement, and, in the case of a retirement plan, plan documents.  In addition, fi360 often promotes the concept of ensuring a fiduciary engages in procedural prudence when managing investments in order to reduce their exposure to fiduciary liability.  "Procedure," in this case typically applies to how investments and services providers are chosen and monitored.  However, a recent case serves as an important reminder to plan sponsors and other investment stewards serving as fiduciaries that they need to ensure the procedures set forth in governing documents for all issues affecting plan and investment management are properly followed.   

In the case of Tatum v. R.J. Reynolds Tobacco Co., the plaintiff representing a class of RJR employees and retirees brought a claim in 2002 of a breach of the duty of prudence related to the removal of Nabisco Stock Funds from RJR Tobacco’s retirement plan.  The breach of duty of prudence is still being decided by the trial court, but the court recently issued an order ruling on an amended complaint by the plaintiff that is equally important to fiduciaries. 

Congress, regulators strike out on fiduciary titles

After the financial crisis of 2008, in addition to their primary focus on fixing gaps in systemic risk, Congress also saw the opportunity to address other hotly debated issues that had been festering for years. The fiduciary standard for brokers is an obvious one. The closely related issue of titles associated with fiduciary standards is another that unfortunately remains almost hidden to the public.

When we look at the history of regulation of financial advice, the 111th Congress that passed Dodd-Frank is only the most recent failure in this regard.

Back in 1940, the 76th Congress was perhaps the first to address advisor titles. At the time, the Investment Advisers Act was under consideration, largely in response to a study of stock "tipsters" who charged fees while ripping off the public. Because they fell below the radar and couldn't be studied, the only organized group of advisors called to testify were investment counselors. While they weren't thrilled about regulation, they testified to fully supporting a fiduciary standard and complained that numerous stockbrokers or "customer’s men," as they were called then, often misrepresented themselves by using the same title.

In response, Congress wrote into the new law a provision under Section 208 restricting the use of the title “investment counsel” to those registered under the new Advisers Act. Unless his principal business was acting as an investment adviser and rendering investment supervisory services, a person could not use the title.

Unfortunately, as we know, Congress does not have a long-term memory. Indeed, even with the housecleaning undertaken by the 111th in Dodd-Frank, it did little except study the matter.  Had it moved aggressively to mandate registration as investment advisers or a fiduciary standard of conduct, there would have been a chorus of howls and protests the like of which would probably have killed the bill.

Fiduciary safe harbor protection and the duty to share

Last month, the Sixth Circuit affirmed the decision of a trial court that a trustee could rely on the ERISA Section 404(c) safe harbor to shield itself from fiduciary liability.  The main issue in the case was whether 401(k) participants seeking to recover damages were prevented from exercising “independent control” over their accounts as a result of a failure of the trustee to disclose material nonpublic information.

Prior to this case, it was clear that the participants’ investment advisor had breached his fiduciary duty.  As the court states in the opening of its opinion, the participants “lost substantial amounts of money from their pension accounts because their investment advisor … was a crook.”  However, because the investment advisor was insolvent, the participants sought to recover their losses from the trustee by claiming that the trustee knew of the investment advisor’s fraudulent conduct and failed to disclose it to the participants. 

The trustee claimed it was shielded from liability by ERISA Section 404(c).  The participants argued, however, that all but one of the prerequisites to the safe harbor were met.  In particular, the participants claimed that the requirement that they exercise independent control with respect to the investment of assets in their individual accounts had not been met due to the trustee’s failure to disclose what it knew about the investment advisor’s misdeeds. 

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. 

DOL takes action to require additional transparency and accountability

Two key releases from the DOL this month have furthered the theme of transparency and accountability in financial regulation.  First, the DOL issued its final rule for disclosure to participants and beneficiaries in participant-directed plans.  The rule essentially rounds out the DOL's disclosure initiatives, which also include its recent adoption of 408(b)(2) regulations.  The new participant disclosures will go into effect for calendar year plans in 2012 and will require (1) plan-related information, including general operational and identification information, administrative expenses, and individual expenses; and (2) investment-related information, including investment options and investment expenses, be disclosed to participants.  With regard to disclosure of investment-related information, the Department also has issued a model comparative chart to facilitate comparison of information as required under the new rule.

The DOL's second initiative released this month is a proposal that would expand the regulatory definition of "fiduciary" under ERISA.  I've already received several questions about this proposal, such as what will be the impact on RIAs and aren't advisors that provide advice to plans already fiduciaries?  What should be understood about the DOL's proposed rule change is that it maintains the status quo for advisors that are providing continuous advice to a plan and its participants and beneficiaries.  These advisors are already deemed to be fiduciaries under the current regulation.  What the expansion of the regulation is meant to address is those advisors and consultants working in a gray area or on the periphery of acting as fiduciaries.  To date, the DOL has operated under a five-part test that has restricted its ability to enforce fiduciary obligations.  For an advisor to be deemed a fiduciary under the current regulation, the advisor must (1) provide advice or recommendations (2) on a regular basis (3) pursuant to a mutual agreement or understanding (4) that advice will serve as the primary basis for investment decisions for the plan and (5) that the advice will be individualized to the needs of the plan; and all five of these elements must be present.  

The DOL is proposing to change its regulation by expanding the scope of advice and recommendations that may result in fiduciary status to include appraisals and fairness opinions concerning the value of securities and other property; and advice and recommendations as to the management of securities and other property, including advice related to voting proxies and selecting persons to manage plan investments.   In addition, the DOL proposes to strike the five-part test and replace it with a more flexible test that removes the requirements that advice be provided on a regular basis and serve as a primary basis for plan investment decisions, and that a mutual agreement or understanding between the advisor and plan or participant be in place.  The DOL also would clarify that any advice provider who represents or acknowledges that they are acting as a fiduciary under ERISA or is an investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 would be deemed to be a fiduciary. 

In addition to these changes, the proposed regulation would exempt from fiduciary status persons providing (1) advice or recommendations in their capacity as purchasers or sellers of securities or other property (so long as the recipient of advice understands that the provider's interests are adverse to the interests of the plan and the provider is not providing impartial advice), (2) investment education and materials, or (3) a "platform" of investments from which the plan fiduciary can choose. 

In essence, the proposed definition appears to attempt to draw a clearer line between fiduciary and non-fiduciary status.  As described by Assistant Labor Secretary Phyllis Borzi, those giving advice on an investment would be considered a fiduciary, while those that are only selling their product would not.