I don’t believe the required disclosures associated with the DOL’s Conflict of Interest Rule will pose the greatest liability for firms. It will be the organizations’ inability to demonstrate their procedural prudence that will put firms at risk.
Many organizations are suffering from target fixation. This is a military term to describe a situation where a pilot becomes so absorbed in hitting their target that they lose track of their heading and altitude and actually crash into their objective.
It’s not surprising that firms are fixated on the rule. It’s long, complex and bears no resemblance to established fiduciary best practices or generally accepted investment management principles. So too, the majority of new “fiduciary” training programs are focused almost exclusively on the intricacies of the rule, and not on a fiduciary standard of care.
What most industry observers have overlooked is that besides the rule’s disclosure requirements, a firm also will have ongoing responsibility to demonstrate that their advisors, brokers and agents are procedurally prudent. Simply defined, procedural prudence is a legal term that requires a fiduciary to demonstrate the details of a prudent decision-making process.
Procedural prudence is the bedrock of an ERISA fiduciary standard of care, and has been for more than 40 years. It has been the wellspring for the development of our industry’s generally accepted investment management practices. For example:
- Procedures for identifying a client’s goals and objectives.
- Protocols for diversifying a client’s portfolio.
- Procedures for preparing a statement of a client’s investment strategy.
- The development of peer groups and due diligence criteria for analyzing money managers.
- Procedures for controlling and accounting for a client’s fees and expenses.
- Protocols for monitoring procedures and for preparing periodic performance reports.
The plaintiffs’ bar is very familiar with the above practices, which often serve as a checklist during discovery and depositions. What contributes most to fiduciary liability is often an omission, as opposed to a commission. It’s not what the fiduciary did, but what the fiduciary forgot to do.
Where there is widespread agreement is that the rule is going to expose the industry to significantly more litigation. Industry executives are concerned that the rule’s paperwork and complex disclosure requirements will be the primary source of liability.
I don’t agree. ERISA attorneys, with the assistance of the Labor Department, are going to figure out the language and paperwork to comply with the rule.
Just the same, there will be a number of plaintiffs’ attorneys who will attempt to argue that their clients were harmed because of a firm’s deficient disclosures or noncompliance with the rule. I suspect, however, the courts are going to apply a reasonableness standard and show leniency if a defending firm can demonstrate substantial compliance with the rule.
On the other hand, a firm may face substantial liability if it cannot demonstrate that its advisors, brokers or agents were procedurally prudent. It will be problematic to defend a firm’s departure from generally accepted fiduciary best practices.
This is one of the reasons why I have been opposed to the rule. It will be extremely difficult for firms to provide a procedurally prudent process to retirement savers with account balances of less than $250,000. And the overwhelming majority of advisors, brokers and agents have not been properly trained on an ERISA procedural prudence standard.
The industry is fixated on the wrong target. Being compliant with the rule is important, but not as important as a firm’s ability to demonstrate their procedural prudence.