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You Are Liable

Broker/Dealer management loves separately managed accounts. Individual financial advisors love separately managed accounts. By using outside asset managers to pick stocks, the theory goes, b/ds and their reps are able to concentrate on gathering assets and let the expert money managers pick the stocks and bonds. What's more, if the outside asset manager blows up, hey, it's not the b/ds or financial

Broker/Dealer management loves separately managed accounts. Individual financial advisors love separately managed accounts. By using outside asset managers to pick stocks, the theory goes, b/ds and their reps are able to concentrate on gathering assets — and let the expert money managers pick the stocks and bonds. What's more, if the outside asset manager blows up, hey, it's not the b/ds or financial advisor's fault — it was the asset manager who had discretion over the account. You can't sue us; we didn't have discretion on the account.

Or so the theory goes. But it's not holding water. As separately managed accounts continue to grow, so do customer complaints to regulators. And b/ds and their registered representatives need to understand that this issue of fiduciary accountability for SMA programs is becoming a particularly hot topic for the SEC, NASD and state regulators, such as the Illinois Securities Department, where I work as an enforcement attorney. To be exact: Firms and their financial advisors can't worm out of their responsibilities to their clients if an outside money manager blows up. Regulators believe that firms and their reps still have a fiduciary responsibility to their clients, even if the client signed an SMA program contract that gives the outside manager discretionary power over the portfolio. State regulators are warning firms that enforcement actions may be on the horizon when it comes to problems with separately managed accounts (SMAs). Illinois is just one of the states investigating SMA practices at various firms.

Ironclad Contract?

Obviously, state regulatory actions are largely driven by customer complaints. If clients are happy, regulators will be happy. But when investigating customer complaints about SMAs, we often find that firms and their advisors point to their SMA program contracts, which provide a limited power of attorney to the outside money manager over the client's portfolio. The outside SMA manager then has discretion over the portfolio's holdings day-to-day. If something should go wrong — usually centered around poor returns — the arrangement allows the firms and their advisors to say, “It's not our fault. They had day-to-day control over the portfolio. We couldn't have known what they were doing.”

The fact is, that's not going to work anymore. Regulators want a universal fiduciary standard for everyone for all products. And the fact that the so-called Merrill Lynch Rule (the “broker/dealer” exemption) was overturned brings us one step closer to that. In the case brought by the Financial Planning Association, the United States Court of Appeals, District of Columbia Circuit, found that the SEC had exceeded its authority when it created a registration exemption for b/ds offering “wrap fee programs.” Because of this decision, b/ds offering wrap fee programs (SMA programs) will have to be dually-registered as investment advisors under the Investment Advisers Act of 1940. In fact, many of the leading brokerage firms are starting to require that their brokers become dually-registered, and this will likely become the industry standard in the near future due to this court decision.

Despite this increase in dual-registration, b/ds maintain in their arguments during NASD arbitration and state administrative hearings that they do not have a fiduciary duty to investors in SMA programs once the outside money manager obtains discretion over the account.

Ron Amato, an attorney at Shaheen, Novoselsky, Staat, Filipowski, & Eccleston, a Chicago-based law firm, has represented investors in NASD arbitration matters involving SMAs over the past three years. Amato says, “Certain b/ds have argued in NASD arbitration hearings that problems with SMA accounts are the customer's fault. The customer knew the risk, and the risk was adequately disclosed. The customer filled out the SMA program questionnaire stating that he was willing to take the risk. The b/d could also argue that the customer selected the outside money manager, and the outside money manager made the investments, so the b/d shouldn't be held liable.”

The real question is: What level of responsibility — if any — does a b/d and its registered representative retain over customer accounts managed by an outside money-manager? In other words, if a b/d's registered rep suggests that a client open an SMA account that is managed by an outside money manager, does that b/d's rep still have an obligation (fiduciary or otherwise) to maintain oversight of that account?

Of course, most advisors worth their fees do follow the managers they choose, often with the help of their firms' research departments. This is often advertised to clients as the “value proposition” the advisor brings to the table. Yet, b/ds still try to avoid fiduciary liability by inserting disclaimer language, such as the following, into SMA program contracts:

Additionally, financial consultants will contact their (SMA program) clients periodically to discuss the status and performance of their portfolios. However, since the investment manager is solely responsible for managing client accounts in accordance with client instructions and restrictions, it is important for clients to understand that they can communicate directly with their selected investment managers. [Emphasis added.]

(The b/d) does not assume responsibility for the client's choice of investment manager, the manager's investment performance, its adherence to client objectives and restrictions, its compliance with applicable laws or regulations, or other matters within the manager's control.

B/ds use these types of disclaimers — and this example is excerpted from the SMA program contract of a national firm — because they want to indemnify themselves from any liability that could arise out of maintaining responsibility for oversight of client accounts once they have been handed over to an outside money manager. And, generally speaking, this is strategically a logical argument for broker/dealers to make. However, this “disclosure” language may not absolve the b/d from liability, particularly in regulatory actions.

Suitability vs. Trust

B/ds and their representatives are typically held to the NASD “suitability” standard — a standard that does not create a fiduciary (or trust) relationship with clients. (This is probably news to their clients!) It only makes sense for b/ds and their reps to try to convince clients and arbitration panels that the clients should not be able to find recourse against the firm for breach of fiduciary duty.

B/ds further claim that although they conduct ongoing account reviews, they do not have a fiduciary duty to inform the client if the outside money manager is straying from the agreed upon account objectives. Consider this fine print:

As part of (the SMA program), [the b/d] provides performance measurement reports through its Asset Information and Measurement (“AIM”) service to help clients monitor and assess the performance of their investment portfolios. Clients can choose between the [the b/d's] AIM report or, at no additional charge, the basic AIM report. In either case, these reports contain information regarding investment return, risk and selected benchmark comparisons for the client's portfolio.

(The b/d's) Advisory Services Group personnel conduct certain periodic reviews of the activities of investment managers participating in (the SMA program). Clients should understand that this process does not substitute for their continued review of their portfolios and the performance of their investments. [The b/d] does not monitor each transaction directed by an investment manager for conformity with client investment objectives or restrictions. As indicated previously, the investment manager is responsible for managing client accounts in accordance with client objectives and restrictions and the responsibility for manager selection and the consequences of that selection belong to the client. [Emphasis added.]

It is these types of disclaimers that blur the lines of the fiduciary picture, and have caused the disagreement between b/d management and regulators. Regulators increasingly believe that a fiduciary duty exists for b/ds and their reps who offer SMA programs, program contracts notwithstanding.

“The retail investing public is frequently confused about who owes them a fiduciary duty when dealing with SMA programs, and they usually do not understand that a conflict of interest may exist for a person who is managing their [money] for a bright and hopeful future,” says Joseph Borg, director of the Alabama Securities Commission and president of the North American Securities Administrators Association (NASAA), the state securities regulators' lobby.

Borg says, “To resolve any confusion that exists with b/ds and investment advisors, there should be one standard — a fiduciary standard. The [Appeals] Court made such a determination in the ‘Merrill Lynch Rule’ case, and hopefully the SEC will follow and make rules along the lines that broker/dealers and investment advisors have the same duties with both: dual registration, and the same fiduciary standards.”

It is the industry standard for b/ds with SMA programs to receive a portion of the 100 to 300 basis points management fee annually charged to an SMA investor's account. The fees are split among the broker offering the account to the client, the asset manager and the wrap account provider. Regardless of the split, the b/d is receiving a portion of the annual fee for suggesting the outside money manager, and for conducting periodic account reviews for the client — even after the outside money manager takes discretionary control over the client's account.

Regulators have argued that because b/ds are collecting a portion of the wrap fees for offering what clearly amounts to investment advice, they should therefore owe a continuing fiduciary duty to their SMA program clients. Ron Amato says, “You have a situation where the b/ds' registered representatives are engaging in financial planning when recommending outside money managers, because they are ascertaining the client's investment needs and objectives, risk tolerance, preparing financial plans and then monitoring the outside money managers. Investment advisor duty attaches, and there is no way for firms to get around it.”

There is also case law that supports the regulators' contention that the b/d and its registered reps should be considered fiduciaries, and continue to supervise the client's account, act in the best interest of the client and inform the client if the outside money manager is straying from the client's agreed upon investment objectives. If the b/d fails to meet these fiduciary standards, it should be held liable in the same manner as an investment advisor.

The views expressed in this article are those of the author and do not necessarily reflect those of the Illinois Securities Department or its staff.

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