FINRA Arbitration: Kangaroo Court or the Model of Fairness

The first of a series of articles outlining my whistleblower experience with Morgan Stanley and FINRA.

See: FINRA Arbitration: Kangaroo Court or Model of Fairness

The Moral Hazard of Too Big to Jail recognized by Jack Waymire and InvestorWatchdog.com

The Moral Hazard of Too Big to Jail was the topic of Jack Waymire’s post on www.InvestorWatchDog.com

 

 

 

Fiduciary Misunderstanding

I recently completed an engagement for the Michigan Funeral Directors Association (MFDA) where I created and executed an RFP (request for proposal). This was a fiduciarily complex task governed by the Michigan Prudent Investor Act as well as other Michigan statutes. Below is a blog post by an attorney criticizing the RFP and suggesting that I should have used FINRA rules in conducting the RFP, and further down is my rebuttal.

If nothing else, these posts ought to serve as an example of how common fiduciary misunderstanding is, even among those perceived as experts.

In Investment Strategy: the Man without a Plan 

Posted on March  3, 2013 by Bill Stalter

If you haven’t noticed, there has been some turnover among the associations’ preneed fund managers. With the threat of additional litigation in Wisconsin, this trend could continue. But not all of the turnover has been as publicized as what we have seen in Illinois and Wisconsin. After 20 years at the helm, Merrill Lynch recently gave notice to the Michigan Funeral Directors Association of its resignation. There are no search protocols for preneed fund managers, and so Michigan borrowed from the retirement fund community by publishing a request for proposal (RFP). While the MFDA should be commended in their effort to bring transparency to their program’s asset management, they missed (or ignored) an opportunity to shift more investment responsibilities to the financial industry. Instead of using FINRA Rule 2111 (“know your client”) to their advantage, the MFDA structured the RFP to perpetuate (and extend) the funeral director’s controlling role in investment decisions.

Hidden investment charges have been ‘part of business’ in the death care industry for decades, and this author has contemplated whether ERISA’s fee disclosure requirements could ever be incorporated into preneed trusts by the Federal Trade Commission. The Michigan RFP focused on the same ERISA fee disclosure requirements, which could lead one to assume that association’s leaders did not want to make the same mistake again. The Michigan RFP also raised another ERISA concept worthy of the preneed industry’s consideration: the 401K approach to investment by individual contract. We too have wondered why larger programs have not looked at data from individual contracts and the sponsoring funeral homes to build an investment options matrix.

But, the Michigan RFP can be faulted for cutting off the diligence requirements of FINRA Rule 2111. To insulate the Association from solicitations, the RFP provided summary information about the program and required all inquiries to go through an ERISA consultant. Prospective fund managers were required to submit investment strategies on limited facts and without direct communications to the Association. It is understandable that the Association would want to narrow the field before initiating an exchange of confidential information with prospective managers, but the screening of candidates should have preceded the request for investment strategies. Subsequent to the screening, the MFDA should then have provided detailed information pursuant to a confidentiality agreement. Under FINRA 2111, this sequence would have expanded the fund manager’s diligence responsibilities regarding investment strategy recommendations. The nature of the questions posed by the candidates would also have helped the MFDA in its assessment of the candidates. Instead, the RFP narrowed the fund manager’s diligence to an old investment strategy with a history of mixed results and challenges.

Within the context of ERISA retirement funds, RFPs may take a formula approach to finding a replacement fund manager. But the preneed industry is fragmented by 50 different state laws, and by program issues such as whether non-guaranteed contracts are sold, the association’s role as a seller versus an agent, investment restrictions, and trusting percentages. Injecting preneed asset management with a dose of ERISA could help to discourage hidden fees and improve the quality of fund managers, but the industry also needs an alternative to the strategy of offering funeral directors three investment options to choose from.

 

Mensack Rebuttal

Regarding your March 3, 2013 post, An Investment Strategy: the Man without a Plan, I would like to offer the following comments:

First, in the spirit of full disclosure for your readers, I am the independent fiduciary consultant who wrote and executed the Request for Proposal (RFP) of the Michigan Funeral Director Association Services Corporation (MFDASC).

Second, again in the spirit of full disclosure, your readers may have been interested in knowing that you had been retained by one of the firms that had responded to the RFP “to assist [it] in the preparation of the proposal and reviewing the MFDA structure.” Some would say that the failure to disclose that fact in your post creates an inherent conflict of interest, thereby weakening your assertions. In fact, though, even apart from this factor is that your assertions are simply incorrect. They are not open to debate but are simply wrong.

I would therefore very much appreciate it if you would retract or correct your post in accordance with the facts as follows:

The purpose of the RFP issued by the MFDASC was to identify qualified firms to provide investment management and accept fiduciary responsibility via delegation as per the MFDASC, Section 1510 of the Michigan Estates and Protected Individuals Code, MCL 700.1510.

Your statement “they [the MFDA] missed (or ignored) an opportunity to shift more investment responsibilities to the financial industry” is false and contradicts the purpose of the RFP. In fact, 100% of the investment responsibilities were delegated to a qualified registered investment advisor as per MCL 700.1510, which states in section 2:

 “A fiduciary [i.e., MFDASC] who complies with the requirements of subsection (1) is not liable to the beneficiaries or to the fiduciary estate for a decision or action of the agent [i.e., the selected registered investment advisor] to whom the function was delegated.”

 

Your following statement is also inaccurate: “Instead of using FINRA Rule 2111 (“know your client”) to their advantage, the MFDA structured the RFP to perpetuate (and extend) the funeral director’s controlling role in investment decisions.” 

It is inaccurate because FINRA Rule 2111 has nothing to do with fiduciary delegation or limiting the control of anyone’s investment decisions. Notice that nowhere in the FINRA Rule 2111 link you provide is there mention of these topics.  The reason why is that Rule 2111 is concerned only with the “suitability” standard which governs the activities of stockbrokers and the broker-dealer firms for which they work. Such entities are regulated by FINRA and are subject to only the “suitability” standard (i.e., non-fiduciary). FINRA Rule 2111 addresses directions for brokers recommending securities. Recommending securities that are merely “suitable” for investors defeats the protection sought via fiduciary delegation.

The much higher fiduciary standard of care is based on the trust standard, the highest known to the law. FINRA Rule 2111, also known as the Suitability Rule, is a much lower standard of care than the fiduciary standard mandated in the RFP. The suitability standard is the very antithesis of the “sole interest” fiduciary standard found in section 1506 of the Michigan Prudent Investor Rule which mandates that “a fiduciary shall invest and manage fiduciary assets solely in the interest of the beneficiaries.”

The RFP states that proposing firms must be registered as an investment advisor (RIA) under the Investment Advisers Act of 1940 (’40 IAA) which by law has a fiduciary duty to their clients. This requirement also intentionally precludes FINRA jurisdiction and Rule 2111 in order to avoid a potential conflict with MCL 700.1510(3) which states:

 “In performing a delegated function, an agent owes a duty to the fiduciary estate to exercise reasonable care to comply with the terms of the delegation. If an agent accepts the delegation of a fiduciary function from a fiduciary that is subject to the laws of this state, the agent submits to the jurisdiction of this state’s court.”

 Given the mandatory FINRA arbitration requirement found in many of the contracts used by FINRA member firms, FINRA jurisdiction could potentially conflict with Michigan’s jurisdiction.

 

The following statement is also inaccurate: “But, the Michigan RFP can be faulted for cutting off the diligence requirements of FINRA Rule 2111.”  As outlined above, FINRA Rule 2111 applies to brokers making securities recommendations, and does not apply to choosing a fiduciary investment manager. The suitability standard is akin to non-malfeasance in that a broker should not make a recommendation that harms a client. The fiduciary standard is akin to beneficence in that an advisor must do what’s in a client’s “best” interest under the ’40 IAA and a client’s “sole” interest under the Michigan Prudent Investor Rule and the Employee Retirement Income Security Act of 1974 (ERISA) – the “sole” interest standard being an even higher fiduciary form of conduct than the “best” interest standard. A properly appointed qualified investment manager that accepts fiduciary delegation conducts due diligence and makes discretionary investment decisions under both the “best” interest and “sole” interest fiduciary standards. Someone acting as a stockbroker under FINRA jurisdiction is not subject to either fiduciary standard but instead to the lower suitability standard.

 

Your implication that the focus of ERISA is hidden fees and the quality of fund managers, and that ERISA doesn’t apply to this RFP is inaccurate.  Both ERISA and the Michigan Prudent Investor Rule contain the higher “sole interest” fiduciary standard and both place great emphasis on process. Indeed, “prudence is process.” Section 404(a) of ERISA contains the “sole” interest standard which was borrowed by the 1994 Uniform Prudent Investor Act, from which the Michigan Prudent Investor Rule is derived, more particularly MCL 700.1506 which states:

 “A fiduciary shall invest and manage fiduciary assets solely in the interest of the beneficiaries.”

 

The following statement is also inaccurate: “Prospective fund managers were required to submit investment strategies…”  As per Section I, 3a, the purpose of the RFP was to identify a qualified investment manager “to whom the MFDASC could delegate fiduciary responsibility;” there was no requirement to submit an investment strategy.  I intentionally drafted the RFP in language that a qualified and experienced fiduciary investment manager would understand. Under ERISA this manager is known as an ERISA 3(38) Investment Manager. The responsibilities of an ERISA 3(38) Investment Manager (subject to the “sole interest” fiduciary standard of section 404(a) of ERISA) correspond to those of a fiduciary investment advisor subject to the “sole interest” fiduciary standard of MCL 700.1505. MCL 700.1505 states:

 “Within a reasonable time after accepting appointment as a fiduciary or receiving fiduciary assets, a fiduciary shall review the assets, and make and implement decisions concerning the retention and disposition of assets, in order to bring the fiduciary portfolio into compliance with the purposes, terms, distribution requirements expressed in the governing instrument, and other circumstances of the fiduciary estate, and with the requirements of the Michigan prudent investor rule.”

 

All your criticisms, as noted, regarding investment strategies and Rule 2111 are moot; however, your statement that “the RFP narrowed the fund manager’s diligence to an old investment strategy with a history of mixed results and challenges” is false.  Section I, 3A of the RFP clearly states that an alternative investment strategy would be acceptable, and that a proposal will receive favorable consideration if it includes some method “whereby Funeral Directors may better manage how the assets of each contract are invested so as to meet future obligations.”

In fact, eleven of the proposers, nearly all of which had ERISA 3(38) experience, using the RFP’s “limited facts and without direct communications to the Association” recognized the limited time horizon of the prepaid contracts, took the initiative to design prudent alternatives to the current investment menu, and addressed your concern for the industry having merely “an alternative to the strategy of offering funeral directors three investment options to choose from.”

 

Your following statement, while accurate, has no bearing upon this RFP: “Within the context of ERISA retirement funds, RFPs may take a formula approach to finding a replacement fund manager. But the preneed industry is fragmented by 50 different state laws, and by program issues…”  This RFP was developed to comply with Michigan statutes, and not those of any other state. However, since both ERISA and the 1994 model Uniform Prudent Investor Act contain the “sole interest” fiduciary standard, and since there is negligible difference between the model Act and the versions of the Act adopted by the states (including Michigan and 44 others, plus the District of Columbia and the U.S. Virgin Islands), I suggest that using the higher codified “sole interest’ fiduciary standard found in ERISA and the Michigan Prudent Investor Rule is the most prudent starting point for any RFP where fiduciary responsibility applies. In any event, it is decidedly not the “suitability” standard found in FINRA Rule 2111.

What does a Prudent Champion do?

Thanks to Erin E. Arvedlund for covering my story in the Philadelphia Inquirer:

  Your Money: A One-man Army

408(b)(2) & 404(a)(5) Fee Disclosure: An opportunity for advisors and a potential predicament for plan sponsors.

While the first two fee disclosure dates have passed, there are many more to come. Please join MDM LLC and Brinker Capital on October 10th to learn about the opportunities and the ongoing challenges of 408(b)(2) fee disclosure.

Details:  WEBINAR: What are your next steps after 408(b)(2)?