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SECURITIES BROKER'S DUTIES
AS A FIDUCIARY TO A QUALIFIED TRUST
DUTY
TO DIVERSIFY A QUALIFIED PLAN
GLOSSARY-
CAUSES OF ACTION
A. The relationship between any stockbroker and his
or her customer is fiduciary in
nature, imposing on the former, duty to act in the highest good faith
toward the
customer. ERISA holds fiduciaries to a prudent man standard of care
in the manage-
ment of qualified
plans. A fiduciary shall discharge his duties with respect to a plan
with care, skill,
prudence and diligence.
B. There are three ways one can gain fiduciary
status:
1. Exercising discretionary authority or control over the management
of the plan or
disposition of assets.
2. Rendering investment
advice for a fee or other compensation (direct or indirect).
a. Such person renders
advice to the plan as to the value of securities or other
property, or makes recommendation as to the advisability of investing in,
purchasing, or selling securities or other property.
b. Such person renders any advice.....on a regular basis, to the plan
pursuant
to a mutual agreement, arrangement or understanding, written or otherwise,
between such person & the plan....that such services will serve as a
primary
basis for investment decisions with respect to plan assets, and that such
person will render individualized investment advice to the plan based on
the
particular needs of the plan regarding such matters as, among other things,
investment policies or strategy, overall portfolio composition, or
diversification
of plan investments. [29 U.S.C. S 1002 (21) (A) (ii)] 29 C.F.R. S 2510.
3-21
(C) (I) (1992).
3. Exercising
discretionary authority in the administration of the plan.
C. All of the five following factors are
necessary to support a finding of fiduciary status.
1. Providing
individualized investment advice (even to sophisticated customers).
2. The advice was given pursuant to a mutual
understanding. It is not necessary
for the party being added to the
Trust Agreement as a fiduciary. In writing or
orally, the party
need only agree to provide advice that is the primary basis for
the plan's investment decisions.
3. The advice was
provided on a regular basis.
4. The advice
pertained to the value of the property or consisted of recommen-
dations as to the advisability
of investing in certain property.
5. The advice was
rendered for a fee.
29 U.S.C. S
1002 (21) A
D. Notes
1. Court decisions have
upheld that one who sells his own property to an ERISA
Trust is a financial
advisor. Further, a financial advisor is always a fiduciary.
2. Any agent is also a
fiduciary whose obligation of diligence & faithful service is
the same as that of a
trustee. West's ann. Cal. Civ. code S 2322 (C).
3. There is in all cases
a fiduciary duty owed by a stockbroker to his or her cust-
omers; the scope of this
duty depends on specific facts and circumstances
presented in a given case,
including relative sophistication & experience of cust-
omer, customers ability to
evaluate broker's recommendations and exercise an
independent judgment
thereon, nature of account, whether discretionary or
non discretionary, and
actual financial situation and needs of customer.
Broker, If a Fiduciary, Must Diversify a Qualified Plan
A broker may be a fiduciary if, in the process of executing orders,
he or she is asked for recommendations about investments without receipt of
any compensation other than normal commissions and:
A. There is a mutual
understanding that recommendations are to be on an ongoing basis;
B. There is mutual
understanding that the recommendations will serve as a primary basis for investment decisions
with respect to
plan assets; and
C.
The recommendations are individualized to the full range of
the plan’s particular need.
A broker may or may not be a fiduciary with respect to a plan.
One who merely suggests a stock is not.
See Farm King Supply inc. v. Edward D. Jones, 884 F. 2d 288 (7th
Cir. 1989. To be a fiduciary,
the court held that the broker must provide advice pursuant to an agreement,
be paid for that advice, or have influence over the plan’s investment
decisions.
Id.
at 292. See also, Wolin v.
Smith Barney, 83F.3d
847 (7th Cir. 1996); Olson b. E.F. Hutton & Co., 957
F. 2d 622 (8th Cir. 1992). If
determined to be a fiduciary, the broker will then be held to the standards
of conduct of sections 404(a) including the standard to act with care,
skill, prudence and diligence under the circumstances.
In the Restatement Third of the Law of Trusts, the major revision has
been the change of its investment standard from a “prudent man” rule to
a “prudent investor” rule. This
change seeks to incorporate modern portfolio theories of investing into
trust investment theory. The
prudent investor standard has the following affect on fiduciary duties of
trustees:
(a)
Duty of Loyalty(#170) and Impartiality (#183):
inflation erosion affects a fiduciary’s duty to treat the income
and remainder beneficiaries impartially (i.e. investment of trust funds in
interest-bearing securities may benefit income beneficiary while inflation
erodes the principal remaining for the remainder beneficiary.
Under the Restatement Third, growth investments may be justified in
certain trusts, dependent upon trust purpose, beneficiary circumstances and
family financial objectives;
(b)
Duty to Delegate (#171): the new Restatement expands the
fiduciary’s ability to seek expert assistance regarding investment making
decisions (e.g. a fiduciary without investment experience or skill or
when complicated investment strategies are appropriately pursued by
trustees managing large diverse portfolios);
(c)
Other Duties:
(1)
Duties of skill and prudence: the Restatement now adopts a
“total
Return” (income plus
capital appreciation/depreciation) definition as to what constitutes a
“reasonable return” on trust assets;
(2)
Care and caution: the new Restatement emphasizes that a
Fiduciary’s undue
conservatism, as well as excessive risk taking, in investing trust assets
can disserve trust beneficiary’s.
Prudent Investor Theory
The prudence requirement is
evaluated based upon the fiduciary's conduct or actions at the time a
decision is made, not upon the subsequent success or failure of such
decision. To satisfy the prudent man standard, a fiduciary must give
appropriate consideration of the facts and circumstances which, based upon
the scope of fiduciary's investment duties, are relevant to a particular
investment or investment course of action. The fiduciary should
consider each investment or investment course of action in light of the role
it plays within the entire portfolio; each investment should be designed to
further the purpose of the underlying plan given the risk of loss and
opportunity for gain. The following factors should be considered by
the fiduciary:
(a) composition of plan's investment portfolio;
(b) the diversity or lack thereof of the plan's investment
portfolio;
(c) the liquidity, rate of return and cash flow needs of the plan; and
(d) the projected return from the plan investments relative to the
plan's
funding objectives.
Generally, a failure to diversify a plan's investments is a breach of
fiduciary duty, unless the fiduciary can show that the failure to diversify
was "clearly prudent". Compare Brock v. Citizens Bank of
Clovis, 841 F. 2d 344 (N.M. 1988) (investments of over 65% of pension
plan's assets in commercial real estate first mortgages violated ERISA
diversification requirements where trustees failed to establish that lack of
diversification was prudent) with Reich v.King, 861 F. Supp. 379 (Md.
1994) (investment of over 70% of plan's assets in residential mortgages not
per se violation of ERISA diversification requirement; finding that
non-diversification was not clearly prudent required first). The
diversification requirement is evaluated by the following factors:
(a) the plan's purpose;
(b) the amount of plan assets;
(c) financial and industrial conditions;
(d) the type of investment(s);
(e) distribution of investments as to industries;
(f) distribution of investments as to geographic location; and
(g) maturity dates of investment(s).
Lanka v. O' Higgins, 810
F. Supp. 379 (N.D.N.Y. 1992).
PRUDENT PRACTICES FOR INVESTMENT FIDUCIARIES
Financial advisors, trustees, plan sponsors and anyone else involved in
investment decision-making, face a host of issues as they navigate through
complex and sometimes uncertain areas. But, guidance is
available.
One
source of guidance deserves our focus. it is, "Prudent Investment
Practices", a handbook for investment fiduciaries, written by the
Foundation for Fiduciary Studies. A major benefit of the handbook is
its simple organization. There are 5 so-called "Steps" and
27 so-called "Practices", which expand on this sound starting
proposition: "To manage a prudent investment process, without
which the components of an investment plan cannot be defined, implemented or
evaluates." These Steps and Practices were determined after
review of the major investment fiduciary legislation - ERISA (Employee
Retirement Income Security Act of 1974 (Uniform Prudent Investor Act) and
MPERS (Management of Public Employee Retirement Systems Act).
Lets overview the 5 Steps
and some of the 27 Practices
STEP 1: ANALYZE CURRENT POSITION
The first practice is to
review all of the documents relating to the establishment and management of
the investments. These documents include the Investment Policy
Statement, minutes from investment committee meetings, trust documents,
custodial and brokerage agreements, service agreements such as investment
and advisory contracts, regulatory filings such as Form ADV and mutual fund
prospectuses, as well as performance reports. Another Practice is to
ensure that the investment fiduciary knows his duties. Even if the
fiduciary has delegated certain decisions to, for example, professional
money managers, trustees and consultants, the fiduciary always remains
responsible for matters such as: determining investment objectives, choosing
an appropriate asset allocation strategy, establishing written investment
policies, approving appropriate experts, monitoring activities and avoiding
conflicts of interest and prohibited transactions. Likewise, another
Practice requires the fiduciary to prudently manage investment decisions
and, if he or she is unwilling or unable to act, then he or she is
responsible for obtaining assistance from outside professionals who will do
so.
STEP 2: DIVERSIFY - ALLOCATE PORTFOLIO
An important Practice is to
identify the risk level appropriate for the investments. In this
regard, investment fiduciaries must ensure that they adequately have
communicated the potential negative consequences of an investment strategy
or the fact that investment objectives may not be met. Then, the
fiduciary is required to state the presumptions that are being used to model
the probable outcomes of a given investment strategy. Likewise,
another important Practice is to identify the investment time horizon.
Along those lines, the fiduciary would prepare a schedule of the investment
portfolio's anticipated cash flows. At this point, one can select the
asset classes consistent with the identified risk, return and time
horizon. A Practice suggests that the number of asset classes and
investment options will depend upon such factors as the size of the
investment portfolio, sensitivity to investment expenses, as well as the
decision-makers' investment expertise and ability to monitor the strategies
and options considered.
STEP 3: FORMALIZE INVESTMENT POLICY
One of the more critical
functions of the fiduciary is to prepare and maintain the Investment Policy
Statement (IPS). The IPS is the "business plan" for the
portfolio. As such, it defines the duties of all the parties
involvement and provides guidance for diversification and rebalancing of
investments. Another Practice suggests that the IPS define the due
diligence criteria for selecting investment options. The goal is to
ensure that the fiduciary not chase the latest hot Wall Street manager or
the latest top performing asset class. Additionally, the IPS should
define procedures for controlling and accounting for investment
expenses. Another Practice requires that the IPS define the monitoring
criteria for investment options and service vendors.
STEP 4: IMPLEMENT INVESTMENT POLICY
An important Practice is to
implement investment strategies in compliance with the required level of
Prudence. Critically, while the law does not expressly require a
fiduciary to hire a professional money manager, the fiduciary will be held
to the same expert standard of care and his or her conduct will be measured
against that of the investment professionals. Additionally, in
implementing the investment policy, the fiduciary must choose appropriate
investment vehicles. One example provided relates to the decision of
whether to use mutual funds or separate account managers. Another
important implementation Practice is to follow a due diligence process in
selecting service providers such as the custodian.
STEP 5: MONITOR AND SUPERVISE
The final Step is to monitor
and supervise and there are several Practices worth noting. First, the
fiduciary should prepare periodic reports that compare the investment
performance of the portfolio against an appropriate index, peer group and
IPS objectives. A second Practice suggests examining the qualitative
and/or organizational changes of investment decision-makers. There
also should be control procedures in place to periodically review matters
such as best execution, soft dollars and proxy voting. Finally,
another Practice requires that the fiduciary determine that the fees paid to
investment managers (and others) are consistent with agreements and the
law.
The 5 Steps and 27 Practices
are an excellent and highly needed roadmap for investment fiduciaries and
should be immediately implemented.
GLOSSARY
(Causes of Action)
1. DEFINITION OF A
SECURITY
Under California Law, the term Security includes an investment
contract. An investment contract is a contract or transaction in which
a person entrusts money or other capital to another, with the expectation of
deriving a profit, income or some financial benefit from a business
enterprise, the failure or success of which is dependent upon the managerial
efforts of the other person.
Source: People v. Smith.263 Cal. Rptrk. 684,686 (Cal. Ct. App.
1989)
See also SEC v. W.J. Howey Co. 328 U.S. 293 (1946
2. REQUIREMENT THAT
SECURITIES BE QUALIFIED PRIOR TO SALE
It
is unlawful for any person to offer or sell in CA any security unless such
sale has been qualified or unless such security or transaction is exempted
or not subject to qualification.
Qualification entails meeting requirements set by the CA Department of
Corporations for the sale of securities in the state.
Any
person who sells a security that is not qualified or exempt from
qualification is liable to the person who buys the security from him, and
the purchaser is entitled to recover the money paid for the security with
interest at the legal rate, less the amount of any income
received.
Source: CA Corp. Code #25110 and 25503
3. MISSTATEMENTS AND
OMISSIONS IN THE SALE OF SECURITIES
It
is unlawful for any person to offer or sell a security by means of any
written or oral communication which includes an untrue statement of a
material fact or omits to state a material fact necessary in order to make
the statements made, in the light of the circumstances under which they were
made, not misleading.
Any
person who sells a security via misrepresentations and omissions is liable
to the person who purchases a security from him who may sue either for
rescission or for damages.
Source: CA Corp. Code #25401 and 25501
4. MATERIALITY DEFINED
A
fact is material if its disclosure would change the total mix of facts
available and there is substantial likelihood that a reasonable shareholder
would consider the facts important to his or her investment
decision.
Source: Basic Inc. v. Levinson 485 U.S. 224, 231-232 (1988)
5. LIABILITY FOR
MATERIALLY AIDING
When securities are sold via material misrepresentations and omissions or if
the securities are unqualified for sale and non-exempt, not only is the
primary seller liable, but anyone who materially aids the seller, or is a
control person of the seller is also liable.
Any person who materially assists in the sale of an unqualified or
non-exempt security, or who materially assists in a sale made through
misrepresentations or omissions is jointly and severally liable with any
other person liable.
Source: CA
Corporations Code #25504.1
6. CONTROL PERSON
LIABILITY
When securities are sold via material misrepresentations and omissions, or
if the securities are unqualified for sale and non-exempt, not only is the
primary seller liable, but anyone who materially aids the seller, or is a
control person of the seller is also liable.
Control Person Defined
A
"control person" is defined as someone who possesses, directly or
indirectly, the power to manage, or direct the management and policies of a
person.
Source: Hollinger
v. Titan Capital Corp., 914 F.2d 1564, 1569 (9th Cir. 1990)
Every person who directly or indirectly controls a person liable for selling
unqualified securities or for selling securities through misrepresentations
and omissions, every person occupying a similar status or performing similar
functions, every employee of a person so liable who materially aids in the
act or transaction constituting the violation, are also liable jointly and
severally with and to the same extent as such person, unless the other
person who is so liable had no knowledge of or reasonable grounds to believe
in the existence of the facts by reason of which the liability is alleged to
exist.
Source: CA Corp. Code:
25504
7. LIABILITY FOR
UNLICENSED BROKER DEALER
Under California law, a "Broker-dealer" means any person engaged
in the business of effecting transactions in securities in this state for
the account of others or for his own account.
A person who purchases a
security from a broker-dealer that is required to be licensed but is not may
bring an action for rescission of the sale.
Source: CA Corp. Code
# 25004 and 25501.5
8. CLAIM OF EXEMPTION
The
burden of proving an exemption is upon the person claiming it.
Source: People v.
Feno 201 Cal. Rptr. 513, 518 (Cal. Ct. App. 1984) Modified
See also: Kahn v.
State,493 N.E.2d 790, 798 (IN Ct. App. 1986)
State v. Kershner, 801 P.2d 68m (KA 1990)
State v. Tober, 841 P.2d 206,209 (AZ 1992)
9. BREACH OF FIDUCIARY
DUTY
Under CA law, a broker or securities salesman owes a fiduciary duty to his
or her customer. A fiduciary relationship exists whenever trust and
confidence is reposed by one person in the integrity and fidelity of
another. The relationship between a broker and a client is fiduciary
in nature and imposes on the broker the duty of acting in the highest good
faith toward the client.
Source: Duffy v.
Cavalier, 264 CA Rptr. 740,753 n.11 (CA Ct. App. 1989)
Twomey v. Mitchum, Jones & Templeton, Inc., 262 CA App.2d 690,69 CA
Rptr. 222 (1968)
FEND
- Securities Expert Witness
Telephone:
(310)641-0377
FAX: (310)649-3663
Email: fendmase@ca.rr.com
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