From the March 2006 issue of Wealth Manager Web • Subscribe!


The Prudent Man Rule has been deeply grounded in the advisory framework since 1830, and the basic wording of the Investment Advisers Act hasn't changed since it was enacted in 1940. So why all the legal wrangling today over what statute covers which practice, and why should wealth managers be paying attention?

Blame it on the lawyers, says C. Frederick Reish, a lawyer himself and managing director of Reish, Luftman and Cohen in Los Angeles.

"There have been no seismic shifts in the wording of the statutes," he says. "The general concept is that anyone who manages or actively participates in the management of money for individuals is conceptually a fiduciary under the law. But to understand the rules, you have to dig into each body of law."

That is where the underlying concepts of fiduciary responsibility have expanded far beyond the basic precepts that you can't lie, cheat or steal, he says. And those shifts are happening in the courts, driven by public perceptions that are too often shaped by the media. You only have to go as far back as the Enron debacle to understand the nuances--and legal implications--of the debate.

Retirement plans have always been covered under ERISA's Prudent Man Rule, but as recently as the 1990s, most employers thought they could still dump company stock into their employees' 401(k) plans, regardless of whether that specific stock was a suitable investment for each employee's retirement needs. When Enron collapsed, taking its stock down with it, the lawsuits started flying.

"The perception of that practice changed overnight after Enron, but the law under the Prudent Man Rule didn't change at all," Reish says. "Substantial losses occurred in a particular area that people had not been paying attention to up to that point."

They are paying attention now, and to more than just the suitability rules for retirement plans. Plaintiffs' attorneys are becoming much more sophisticated in unraveling the myriad fiduciary regulations governing each aspect of financial advice. And they are becoming increasingly aggressive in pursuing remedies for each perceived sleight in court.

The primary point of attack these days is on regulations restricting conflict of interest--still wide-open territory for lawyers, Reish says.

"The rule says you have to behave in a prudent fashion and you have to avoid conflict," he says. "But the definition of conflict hasn't been fully litigated, and the prudent concept has not been defined by courts."

That's a soft spot in the industry, particularly when it comes to explaining fees. Very few financial services companies are good at producing a full explanation of all the fees, revenue sharing and commissions that they receive. Historically, that hasn't been a problem, but now there is a popular public perception that if you do not fully explain each element of your fees--and not just with a boilerplate form-- you're skirting the borders of fraud. Advisors need to make sure each client understands--and signs off on--every fee.

The result is that regulators, the Department of Labor and growing numbers of plaintiffs' attorneys are aggressively asserting that not fully disclosing fees and commissions amounts to a breach of fiduciary responsibility under the existing rules, Reish says.

In December 2005, the NASD slapped Merrill Lynch, Wells Fargo and LPL with fines totaling $19.4 million for suitability and supervisory violations over sales of B and C mutual fund shares. These share classes have been on the market for years, but now the regulators are coming down hard. In this case, the NASD ruled that the firms and their advisors slipped by not "considering or adequately disclosing on a consistent basis that an equal investment in Class A shares would generally have been more advantageous to those customers in view of all relevant considerations."

"The fact is that if you look at the literal words of the rules, not all of the rules are enforced all of the time," Reish says. "That leads to selective enforcement, so as the public and the attorneys starting paying more attention, the rules will be getting more attention."

Not Just Semantics

What's happening in the courts only fans the flames of the industry's raging debate over which agency regulates each action, and much of that debate centers around the increasingly ubiquitous term "wealth manager." It's a title that advisors and brokers are latching onto, not only because it has cach?, but also because it has some legal ambiguity.

Under current regulatory interpretations of the Investment Advisers Act, a financial planner is per se a fiduciary and is required to be a registered investment advisor working under all of the legal regulations that govern RIA's. The title "wealth manager" has no such clear-cut definition.

"If you can find 10 people who have the same definition of what a wealth manager is, you may get some consensus on whether or not they are fiduciaries," says Dan Moisand, a partner with Spraker, Fitzgerald and Moisand, a fee-only financial planning firm in Orlando, and current president of the Financial Planning Association.

That's just one of the reasons that the FPA has been waging an ongoing legal battle with the SEC to force it to more narrowly define the term "financial advisor" and to close the door on the so-called broker/dealer exemption to SEC oversight--also known as the Merrill Lynch Rule. The exemption covers advisors working under a fee-insteadof-commission arrangement, and allows broker/dealers to cover their bases with a simple disclosure document informing clients that the advisor's interests may not always be the same as the client's.

The argument is that advisors working with broker/dealers don't need to be registered with or regulated by the SEC because they are already working under the guidelines of the NASD, which has its own fiduciary regulations and guidelines.

And therein lies the rub, says Bob Plaze, head of compliance with the SEC. The Investment Advisers Act was created in 1940 to fill a gap in the new banking regulations arising from the 1929 crash. The industry has evolved, but the laws have not.

"The statute has aged greatly," Plaze says. "And the walls started to crumble when commissions were unfixed in 1975."

That rule change launched a spate of mergers and consolidations throughout the financial services industry. Banks bought brokerage firms. Insurance companies bought clearinghouses and their independent brokerage businesses. Advisors who fled the traditional broker/dealer firms to escape the restrictions of pushing product suddenly found themselves under a new corporate banner with brand new pressures to sell the parent's products.

Those pressures don't always come with clear-cut strings attached, such as a higher payout. Instead, transaction fees are waived or reduced when advisors sell from a "preferred fund" list. And what happens to advisors whose firms merge with broker/dealers that they have done business with in the past? Their clients are already in the parent's investment products, so does the advisor suddenly have a conflict of interest that didn't exist before?

"Suddenly, life is more complicated and we have a witch's brew of conflicts of interest," Plaze says.

Multiplying those complications are the expanding roles that wealth managers are taking in their clients' lives. The more you take on in your advisory capacity, the deeper you may become entangled in the convoluted and often overlapping regulations controlling each area of your business. For instance, if you are advising a client about how to invest 401(k) assets as part of their overall asset allocation plan, that advice is subject to ERISA Prudent Man rules. If you are managing a private trust, the Uniform Prudent Investor Act comes into play.

"A number of advisors are going to retainer agreements as opposed to assets under management agreements and broadening the scope of their engagement so it's not so portfolio specific, like life planners," says Eliot M. Weissberg, a principal with The Investors Center, Inc., Raymond James Financial, in Avon, Conn. "Does legal liability expand with the practice? From the SEC standpoint, probably not, but it's very young from a case law standpoint."

This means that advisors should view the broker/dealer exemption as the beginning, not the end, of a long debate that will continue to shape and reshape how their businesses are regulated.

"We understand that this involves particular issues that go far beyond this specific rule," says the SEC's Plaze. "We are just sorting it out for the first time."

Get Ready

In the meantime, the safest bet for a wealth manager is simply to assume you are always going to be held to the strictest interpretation of fiduciary responsibility and start preparing your practice to meet every standard.

"Our members who are dually registered or do not have their own RIA registration will be put at risk by their own employers if clients think they are getting one type of service but are receiving another type," Moisand warns.

The standard rule of thumb here is that what you do defines the regulations you are subject to, not the other way around. Under the SEC's most recent ruling, if you are providing specific investment suggestions within the framework of an overarching financial plan, you are a fiduciary. On the other hand, if your advice is only incidental to the selling of financial products, you are not. The catch to this supposedly cut-and-dried statute, however, is the definition of "incidental."

"That is where we have the least understanding and where the most mistakes are being made," says Donald Trone, chief executive officer of the Center for Fiduciary Duties in Pittsburgh.

If a prospect walks in and just wants a few investment ideas for their IRA rollover and the advisor points out five or six mutual funds to consider, that is not a fiduciary relationship. But if someone walks in and says they just sold their business and have more money than they know what to do with and need help managing it, that's a different story, Trone says. Unfortunately, most cases fall somewhere in between.

"It is absolutely, positively clear that wealth management implies comprehensive and continuous advice," Trone insists. But what rules apply?

If you are working under the fee-instead-of-commission SEC exemption, you are only required to make "suitable" investment recommendations. If you are working under an RIA--either your own or your firm's--you must meet the "prudent" investment standard. Again, this goes far beyond semantics. Consider the client who needs large-cap exposure in their mutual fund. Two products may offer the same diversification benefit, but one may have higher fees. Under the suitability statute, the advisor is free to recommend the product that pays more. Using fiduciary standards, that same recommendation could land you in court.

Clouding the issue even more is that most independent broker/dealers give their advisors a choice of umbrellas to work under: fee-instead-of-ommission, their firm's RIA or the advisor's own RIA.

Raymond James took the first step in clearing up some of the confusion last July when it dropped the fee-instead-of-commission option, forcing all of its advisors to obtain some sort of RIA designation--either their own or the company's. Granted, the voluntary decision resulted from a settlement with the NASD over the firm's supervision of its fee-based program, but it was also because the firm could read the writing on the wall, says Michael Pearson, Raymond James' RIA chief compliance office.

"With the restrictions of the NASD and SEC on fee-based brokerage, we decided to disband that platform and focus on our advisory business," he says.

"Raymond James, in my mind, has always been one of the white-hat firms," Moisand says. "And I doubt they were tremendously enthused to be doing things this way. They would like to be presenting more brokerage choices to customers, but I'm not surprised that they had the foresight and vision to make the leap now."

Other firms are considering making the change, but Moisand wouldn't release any names. No matter what position your broker/dealer takes, though, advisors who are not registered with the SEC should anticipate that they are going to be required to do so in the very near future, Trone says.

"There is no downside to preparing a practice to prove fiduciary care," he says. "If you look at the industry's list of best practices and compare them to the fiduciary standards defined by law, you would find a one-to-one correlation."

It's All on You

The first place to start is with your engagement letter and your advisory agreement, Weissberg says. Make sure everything in the agreement matches the services you are providing and that you are capable of providing. That may seem like a no-brainer, but too many advisors use a boilerplate agreement, and one size usually does not fit all clients.

"If the agreement says you will provide items one through 10 on a list, but you are only providing one through six, some attorney can get hold of that," he says.

Next, you need an internal system in place to properly monitor each portfolio and document every step of your due diligence to show that you are doing the work that you have been hired to do. Weissberg has a staff to back him up. Two assistants monitor each portfolio, and two more manage the operations to make sure nothing falls through the cracks. Sole practitioners can do a lot of this electronically. The key is to maintain a thorough, consistent paper trail for everything you do.

If you are unsure of where you stand on any of the legal issues, you might want to keep a copy of Prudent Investment Practices, a Handbook for Investment Fiduciaries, on hand. Written by the Foundation for Fiduciary Studies and edited by the American Institute of Certified Public Accountants, it tops the list of SEC resources for fiduciary prudence.

Based on the tenets of the Prudent Man Rule, the handbook thoroughly covers the standards of fiduciary care and outlines practical applications of each standard for an advisory practice.

"The Prudent Man Rule is a high standard to live by," attorney Reish says. "It's not overwhelming, but you have to consciously pay attention at a knowledgeable level. If you take that and apply it to almost any situation, you have to be doing a good job."

Rebecca McReynolds ( is a freelance writer based in Tucson and a frequent contributor to Wealth Manager.

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