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- The Need for Thorough and Effective Policies and Procedures Whethere an advisor is SEC or state-registered, RIAs must revise their policies and procedures to address significant compliance problems occurring during the year, changes in business arrangements, and regulatory developments.
By Donald B. Trone
Ordinarily, Washington (including Congress and regulators) tends to allow an industry impacted by new legislation to define the details of any standards which emerge from the enabling legislation. I suspect that will be the case with the Dodd-Frank Financial Reform Bill (Reform Bill) but, to be certain, the Foundation for Fiduciary Studies (Foundation) has released the new "2010 Fiduciary Standard" to serve as an initial rallying point.
There are two operative words in developing a standard, particularly a fiduciary standard: "consensus" and "substantiation." The public and the industry want to see "consensus," whereas regulators and the courts are more concerned about "substantiation." A standards developer, such as the Foundation, needs to be able to demonstrate both; that there is a consensus across the industry for the standard, and that every dimension to the standard is substantiated by either legislation, regulations or case law--or in the absence of such substantiation, industry best practices.
A good illustration is the requirement under existing fiduciary legislation (ERISA, UPIA, UPMIFA and MPERS) that a fiduciary demonstrate their "procedural prudence"--the details of their decision-making process. Such a requirement raises three related questions:
1. What constitutes the scope and breadth of activities that constitute procedural prudence?
2. Where do generally-accepted investment theory and industry best practices converge to define procedural prudence?
3. Are there consistent references in legislation, regulations, regulatory opinion letters and bulletins and case law that substantiate a particular dimension of a procedurally prudent process?
The answers to these questions are best left to industry experts; not to regulators, and certainly not to legislators. It is for these reasons that the Foundation was founded in 2000: To provide a ways and means to bring together objective industry experts to mine the answers to these questions, and then to build industry consensus through speaking, teaching and writing.
The Three Pillars of a Fiduciary Standard
To begin to define the details of a "harmonized" fiduciary standard, we need to start by defining what it means to be a fiduciary. I would suggest the following:
A fiduciary makes a commitment to judge wisely and objectively, and to ensure that all processes and procedures are congruent with the goals and objectives of the client.
I would further define two additional terms, which I believe are the cornerstones to a fiduciary standard: "Stewardship" and "Covenant:"
The rewards for being a fiduciary are not always apparent, and not always commensurate with the level of effort, process, and risk undertaken. This is the very essence of stewardship.
A fiduciary standard is a continuous process that requires an ongoing discipline to do the right thing, at the right time. This is the very essence of a covenant.
A word that consistently appears in the above definitions and existing fiduciary legislation is "process," and therein rises the first pillar to a "harmonized" fiduciary standard--it's about the process an advisor must follow to demonstrate that decisions are made in the best interest of the client.
A good illustration of process involves the use of proprietary and commission-based products; the Reform Bill included an exception that would allow advisors to use such products. However, a knowledgeable fiduciary expert could have advised Congressional writers that such a carve-out is
unnecessary. Under existing fiduciary Acts, no product or strategy is considered imprudent; it's how it is used and the decisions surrounding its implementation and monitoring that will determine whether a particular product or strategy are in the best interests of the client. Hence, a no-load mutual fund from an unaffiliated fund family can just as easily trigger a fiduciary breach as a proprietary product, if it can be demonstrated that neither product underwent sufficient due diligence during the implementation and monitoring phases of the investment process.
One of the many lessons I learned from flying military aircraft is that simple is preferable to complex, particularly when you are operating in a complex environment, or under stress. Therefore a good starting point for defining a process for a "harmonized" fiduciary standard would be a straightforward five-step process, or in the case of financial planners, a six-step process that mirrors the six step financial planning process:
If the first pillar is process, the second is prudence. Here we build upon process to define the Dimensions, or the details, of a procedurally prudent investment process. We examine each Step in further detail to further demonstrate that each decision is being managed in the best interests of the client. For example, the first step of the 5-step process is to "Analyze." the Dimensions to the first step are:
1.1: State goals and objectives ("objectives")
1.2: Define roles and responsibilities of decision-makers
1.3: Brief decision-makers on objectives, standards, policies, and regulations
Note that the Dimensions are simple straightforward statements, and that the language is universal--or, "harmonized," if you will. You do not want to use ambiguous terms or laden the text with regulatory or industry jargon. Furthermore, the statements could just as easily define a governance standard for a board of directors, or a project management standard for staff.
Note that there is significance to the numbering of each dimension: The first number is the Step of the Process, and the second is the sequence of the Dimension in the Step. The remaining Dimensions are as follows:
Step 2: Strategize ("RATE")
2.1: Identify sources and levels of Risk
2.2: Identify Assets
2.3: Identify Time Horizons
2.4: Identify Expected Outcomes ("performance")
Step 3: Formalize
3.1: Define the strategy that is consistent with RATE
3.2: Ensure the strategy is consistent with implementation and monitoring constraints
3.3: Formalize the strategy in detail and communicate
Step 4: Implement
4.1: Define the process for selecting key personnel to implement the strategy
4.2: Define the process for selecting tools, methodologies, and budgets to implement the strategy
4.3: Ensure that service agreements and contracts do not contain provisions that conflict with objectives
Step 5: Monitor
5.1: Prepare periodic reports that compare performance with objectives
5.2: Prepare periodic reports that analyze costs, or ROI, with performance and objectives
5.3: Conduct periodic examinations for conflicts-of-interest and self-dealing, and breaches of a code of conduct
5.4: Prepare periodic qualitative reviews or performance reviews of decision-makers
If the first and second pillars are process and prudence, the third is "consistency:" Can the procedurally prudent process be effectively and efficiently applied across all client situations? Nothing trips up an advisor faster than inadvertently demonstrating through an audit or litigation that certain of the advisor's clients were treated differently than others. Most litigation and arbitration is a result of omission rather than commission; it's not what the advisor did, but what the advisor forgot to do, and having a well-defined process can serve as an effective practice management checklist. Advisors can help insulate their practice from liability by demonstrating that they have a procedurally prudent process that is consistently applied in the best interest of their clients.
A consistent process also should be considered with different types of clients. The "harmonized" fiduciary standard referenced in the Reform Bill is intended to protect retail clients. However, it is strongly recommended that advisors develop a consistent process that also can be used when the advisor is working with retirement plans, foundations, endowments, and personal trusts. The 2010 Fiduciary Standard was specifically designed to serve that purpose--no matter the client, the same fiduciary process can be consistently applied.
There also are economic justifications for consistency--back office efficiency. Define a procedurally prudent process, than focus your technology on the fulfillment of that process. No advisor can afford to deliver effective and efficient services if every other client that walks through the door is provided a different process.
Lastly, we can anticipate that people in Washington will want to write specific rules to hang on the "harmonized" fiduciary standard. You can bet the rules will either be unnecessary (such as the carve out for proprietary and commission-based products), redundant, or will add administrative and regulatory costs that will not appreciatively add to the protection of the public's interests. This is the primary reason why the Foundation felt it was important to publicize the new 2010 Fiduciary Standard--to provide an initial reference point of what a "harmonized" standard should look like. The industry and regulators can now step back and see the big picture, and quickly reach a level of comfort that a fiduciary standard does not need to be a cumbersome and unwieldy set of rules and regulations. A fiduciary standard, when properly crafted, can significantly improve how investment decisions are prudently managed in the best interests of a client.
Don Trone is CEO of Strategic Ethos, www.5ethos.com, and is the founder and Executive Director of the Foundation for Fiduciary Studies. The Foundation was established in 2000 to develop and advance registered standards for investment fiduciaries; which includes trustees, investment committee members, brokers, bankers, investment advisers, and money managers. The registered standards are designed to provide the details of a procedurally prudent process based on existing fiduciary legislation, regulations, regulatory opinion letters and bulletins, and case law.