A new booklet outlines the steps fiduciaries should follow.
You can run, but the chances that you can hide from fiduciary duty are getting slimmer all the time. The advisory profession is focusing attention on the issue by publicly pondering a lawsuit against the Securities and Exchange Commission to ensure that brokers who give advice live by the same rules as advisors themselves.
Now, a group of forward-thinking CPA-advisors has published a first-of-its-kind booklet that covers 27 investment practices they say all fiduciaries should follow. Ignore the book at your own peril: It's already been used decisively in two lawsuits against advisors.
The goal of the booklet, aptly titled Prudent Investment Practices-A Handbook for Investment Fiduciaries, is "to protect investors interests at the same time we promote the delivery of competent and objective investment advice," says Joel Framson, a CPA and advisor. Framson helped to spearhead the project at the American Institute of Certified Public Accountants, which co-published the book with the Foundation for Fiduciary Studies.
The booklet focuses on critical practices including: asset allocation; investor risk/return profiles; investment policies; expected returns; the selection of prudent investment managers; documented due diligence and monitoring of managers; the management of investment expenses; and procedures for avoiding conflicts of interest and prohibited transactions.
Framson, who is a principal of Allied Consulting Group in Los Angeles and currently chairs the AICPA's Financial Planning Executive Committee, says the book was written with input from Fortune 100 companies, their retirement plan committees, the American Bar Association, the Big Four accounting firms and Department of Labor officials. "We really felt strongly that if we could form a solid consensus on what practices define a prudent advisory practice, it would go a long way toward standardizing the approach to fiduciary relations with clients," Framson says.
By identifying these practices for investors, "We thought we could set CPA-planners apart. We felt it was critical to educate our members and raise the bar to adopt fiduciary practices and say to the public, 'We admit and recognize the fact that we are fiduciaries,'" Framson adds.
The booklet, which also cites the legal and regulatory basis for each of the 27 practices it illuminates, is "one-stop shopping for identifying the best practices for advisors," says Anat Kendal, AICPA's director of financial planning. "Some practitioners functioning as fiduciaries don't realize the true nature or responsibilities of their roles," Anat maintains. For instance, some fiduciaries erroneously believe they are responsible for making investment decisions, when in fact their job is to manage them. That role includes managing the overall investment process by setting the portfolio's goals and objectives and monitoring managers and expenses.
The booklet's practices are also handy for advisory firms that work with a variety of clients. The practices it identifies as being prudent are applicable to any fiduciary portfolio, including retirement plans, foundations, endowments and private trusts, Kendal says.
Mounting evidence indicates that advisors increasingly are running afoul of the law and regulations. The Foundation for Fiduciary Studies estimates that lawsuits and arbitration cases citing breach of fiduciary duty are increasing at a compound rate of 22% per year. Already, Framson, who works as an expert witness in securities lawsuits, has successfully used the booklet as evidence in two breach of fiduciary duty cases against advisors.
In the first lawsuit against a CPA-advisor, an investor was asking for more than $1 million in damages for losses in a portfolio created in 2000. "The advisor had done a suitability and risk tolerance study, made recommendations for diversification, created an investment policy and documented everything. Then they implemented based on their plan," says Framson. "We used the booklet to show that the advisor had followed prudent practices and fortunately the judge agreed."
In another case, Framson was a witness for an investor. "I felt the advisor didn't meet their standard of care," he says. "They didn't have an investment policy or do any risk tolerance or suitability analysis, or even create an asset allocation plan." As bad, they didn't know what other investments the client held, but went ahead and put 100% of the client's investment in the firm's own large-cap growth portfolio, which Framson says constituted a conflict of interest.
But the booklet wasn't used without a fight. The advisor's attorneys argued that the handbook was too new to be admitted into evidence. The investor's attorney, however, was able to establish that the practices weren't new, but were well established in regulation and law. The booklet was admitted as evidence and the plaintiff got a "reasonable settlement" on a seven-figure loss, Framson says.
The booklet was important to publish precisely because it hadn't been done before, says Clark M. Blackman, a CPA-advisor, who worked on the AICPA committee that spearheaded the project. Codifying all of the actions that constitute a prudent fiduciary practice should raise the bar in the industry as well as in courtrooms and among regulators, who have admittedly left regulation fairly gray when it comes to defining fiduciary duty.
"The fact of the matter is, it's one thing to ask people to act and behave like fiduciaries but it's another to give them actual guidance on what that means," says Blackman, managing director of Investec Advisory Group LP, in Houston. "The handbook does something that the DOL [Department of Labor] and SEC have shirked doing. Up until now, they have purposely avoided putting too hard a definition on fiduciary duty, preferring to leave it to the facts and circumstances of each case. But that makes it very difficult for advisors to know if they're operating within appropriate boundaries."
Regulatory vagueness, at least at the DOL, soon may be a thing of the past too. "The DOL is speaking to us about creating an educational program around the handbook and the practices it identifies," says Framson. "Until now, it's been frustrating for advisors who would ask for a definition of prudent practices. Now the DOL has a blueprint, and they point to it and say, 'Here is the process. If you follow it, we believe you'll fall into a safe harbor.'" So far, the SEC has been unmoved by both the AICPA and other groups who have met with officials to plead their case for making brokers' fiduciary duties explicit. Currently, the SEC has a pending rule that would permanently exempt brokers who offer investment advice from advisor registration and advisor rules, including fiduciary duties.
The Financial Planning Association is considering a lawsuit against the SEC to force the agency to rescind the proposed rule, so that everyone who calls themselves an advisor will be required to live by the same rules and provide the same level of care to clients. "This is slippery stuff, and many of us are opposed to the SEC carving out that exemption for brokers," Framson says.
"The confusing thing for the public is you have all these broker-dealers pushing to call themselves anything but brokers. But to the extent the SEC carves them out, you'll have brokers calling themselves advisors playing by one set of rules and advisors playing by another set," he adds.
It's also a contradiction for the SEC to allow this exemption to stand for brokers at the same time the agency is penalizing widespread trading and ethics problems in the brokerage industry itself, Framson says. "It's inconsistent. It just doesn't make sense," he adds. "We've been communicating with the SEC to make our viewpoint heard, and we hope there are people there who are listening," he says.
Don Rembert, an attorney and advisor who is a principal with Rembert, D'Orazio & Fox in Falls Church, Va., says the time has come for the SEC to draw the line in the sand for consumers and practitioners. "What does 'my financial advisor' mean if a broker cannot be a fiduciary to his or her client without breaching his duty to his broker-dealer?" Rembert asks. "The public is getting hammered." Although the public is getting more discerning in asking planners about their roles, the time has come to differentiate these issues in a plain fashion for investors, he maintains.
Whether the SEC will rescind the broker exemption remains to be seen. The rule has been pending for more than two years. In the meantime, it's an advantage for advisors to take responsibility for the protection of their clients and themselves into their own hands by creating practices that are proactive and meet the standards of prudence. Advisors without these procedures in place face enormous risks, not only in their day-to-day operations but every time an investor asks the advisor to do due diligence on an investment, money manager or outside broker, Clark says.
Without systematized procedures and documentation in place that are applied uniformly with clients, it becomes difficult if not impossible to defend against client complaints, arbitration cases or even lawsuits.
The handbook provides this kind of framework, helping advisors create a comprehensive approach to the way they view and analyze clients and all pertinent investment information and decisions. The starting point in all of this, of course, is the admission of fiduciary duty, which the booklet defines as "someone acting in a position of trust on behalf of, or for the benefit, of a third party." As such, the person usually has control or influence over investment decisions.
From there, the booklet leads the reader through an informative and concise narrative of practices that range from helping the advisor define a five-step investment management process to an in-depth explanation of uniform standards of care. These include analyzing the client's current position, along with a checklist of what types of documents and information need to be collected.
The booklet also does a good job showing the importance of interconnectivity between crucial steps in the investment process, such as the identification of investor risk, return and time horizon, and then the selection of asset classes that are consistent with each of these factors.