The Perils of a Fiduciary Advisor

By Tim Meehan. Tim is president of Tim Meehan & Associates, which provides counseling to businesses and fiduciaries on strategy, compliance and governance matters. Tim may be contacted at tsmeeh AT aol.com.

A recent case provides a rather chilling example of the potential, and perhaps unanticipated, risks in providing investment advice as defined by ERISA. In Ellis v. Rycenga Homes Inc.¹ , the question of liability had nothing to do with the quality of the advice given. Rather, the provision of the advice was used to establish liability for broader fiduciary duties owed to plan participants. The Ellis case demonstrates how Advisors may be liable for their clients' fiduciary breaches even without the Advisor's direct involvement.

The Setting

In line with a typical industry scenario, Edward Jones acted as broker to a small 401k plan, provided the plan trustee (the firm's CEO) with investment advice on a periodic basis, and was compensated for the advice with commissions, service fees and revenue-sharing. The representative servicing the plan based his advice on the broker's asset allocation models, and used the models to determine the appropriate time to rebalance the plan's portfolio. The advice service was limited to product recommendations. There is no dispute that all decisions to buy or sell securities were made by the plan trustee and not by the broker. Edward Jones did not acknowledge fiduciary status in any document or have discretionary control over the plan's management or its assets.

Unfortunately for the broker and the plan participants, the trustee absconded with a fair amount of the plan's assets through illegal loans to the plan sponsor, and then fell into bankruptcy leaving the plan short-handed. The plan's participants and successor trustee sued Edward Jones claiming that the broker was liable for the wrongdoing of the former trustee. Plaintiffs asserted both the breach of a direct fiduciary duty to the plan and, in the absence of a direct duty, liability as a co-fiduciary. The Court allowed both theories to proceed.

It is important to point out that the Court found Edward Jones to be a fiduciary as a matter of law. That is, the evidence supporting the broker's fiduciary status was "so powerful that no reasonable jury would be free to disbelieve it… [and is not] susceptible of different interpretations or inferences."

The question of whether an individual achieves fiduciary status solely through his or her function (such as providing investment advice) is very fact specific. In reaching its finding in this case the Court focused on the fact that:

Edward Jones (in the Court's view) made no serious attempt to deny that it provided investment advice to the plan.
The record showed a mutual understanding that the broker's services would serve as a primary basis for investment decisions. The Court noted that the regulations do not require the broker to be the sole basis for investments decisions, although in fact it was.
The trustee provided the broker regular access to information on the entire plan portfolio allowing the broker to provided "individualized" advice; i.e., advice tailored to the specific needs of the plan.
The advice rendered involved strategy as well as individual investments, and periodic rebalancing.

Common Defenses Fail

In applying its defense Edward Jones saw several standard lines of argument deftly cast aside by the Court:

First, the Court rejected the notion that fiduciary status requires discretionary control over plan assets; the Court relied on the broker's fiduciary status attained through its provision of investment advice (as defined by ERISA).
An attempt to characterize the relationship as a series of sales pitches, followed by the trustee's decision to accept or reject the recommendation could not, according to the Court, "be accepted by any rational trier of fact."
The Court discarded the broker's argument that the use of model portfolios generated by its investment policy committee could not constitute "individualized" advice, saying such an argument "distorts the term 'individualized' beyond all recognition."
The Court also rejected as "untenable" the argument that the advice was "free," finding that sales commissions are sufficient for meeting the direct or indirect fee standard.

Scope of Potential Liability

Once the Court concluded that Edward Jones was a fiduciary, the next step was to determine the nature of the broker's duties to the plan. As the Court pointed out, being a fiduciary "does not make Jones automatically liable for all loses to the plan, fiduciary status under ERISA is not 'an all or nothing proposition.'"

First, the Court found no evidence that Edward Jones actively participated in the illegal loan scheme. Yet, the potential for fiduciary liability extends beyond actual causation. The Court went on to conclude that in order to fulfill its fiduciary duty to deliver competent advice, it is at least arguable that Edward Jones had some duty to investigate the increasing amount of "Employer Receivables" (i.e., the loan receivables) appearing on the plan's annual reports. The broker's failure to investigate could amount to a breach of its fiduciary duty to act in accordance with the prudent person standard.

In addition, the Court found the potential for co-fiduciary liability for Edward Jones based on its inferred knowledge of the trustee's breach and the broker's failure to investigate or make reasonable attempts to remedy the breach.

The Future of Investment Advice - The Need for Education

The Ellis case sets a disturbing precedent² for firms interested in providing investment advice to their retirement plan clients. Keep in mind that the new fiduciary Advisor safe harbors provided by the Pension Protection Act have as their premise that the Advisor acknowledges its fiduciary status.

Those considering acting as a fiduciary Advisor will need to consider the extent of their responsibilities. What is the scope of their fiduciary obligations? Will the Advisor's duties stop at the "participant's edge," or, spill over to the plan at large? For example, what is the duty of a fiduciary Advisor that knows (or should know) that the existence of a certain plan investment option is per se a prohibited transaction?

What is clear is that investment Advisors of any ilk who turn a blind eye or deaf ear to the actions of other plan fiduciaries do so at the risk of stepping into a morass of liability. There has never been a greater need for educating financial Advisors on the essence of fiduciary practices and responsibilities. Indeed, a rigorous fiduciary training program and established policies and procedures may become an element of the annual auditing guidelines of fiduciary advisors under the PPA

Footnotes

1. 484 F.Supp.2d 694, 40 Emp. Bene. Cas. 1889.
2. The value of the case as precedence is uncertain. The rulings were made by a federal magistrate in trial court in the Western District of Michigan, Southern District.

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