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A BIC Litigation Alternative

Morningstar’s response to the Labor Department’s request for proposal contains an intriguing proposal of its own – one that it says “could promote a best interest standard in lieu of using a private right of action framework.”

In addition to comments largely supportive of the fiduciary regulation and its implications for investors and the industry, Morningstar took advantage of the opportunity to comment on the Labor Department’s proposed delay of the applicability date of the fiduciary ruyle to put forth a notion of a better way to ensure that financial institutions comply with the new standards, “instead of using a private right of action.”

Specifically, Morningstar has pitched the notion of:

  • collecting data on all clients’ portfolios across several objective factors;

  • quantifying whether these portfolios aligned with a best interest standard of advice; and

  • using this large set of data to identify and remediate issues.

For example, Morningstar says that each client’s portfolio could be scored on key factors such as:

  • Investment quality, which could be measured using a quantitative fund rating, and expenses at the security, portfolio, and plan level.

  • Asset allocation and “fit to goal,” which could be evaluated based on portfolio efficiency and distance from a risk-based benchmark.

  • The value of advice, which could be evaluated based on key factors such as whether an advisor considered risk tolerance and capacity, human capital, goals, other income sources, and dynamic withdrawal strategies in designing a client’s investment strategy.

Big Data

The proposal explains that a third party that evaluated the aggregate data from thousands of portfolios could ensure that a financial institution’s advisors consistently acted in clients’ best interests. Moreover, that “prudent process such as the one described, combined with aggregate account-level data, could show that each investment, each portfolio, and each plan is within acceptable bounds for every investor advised by a firm,” and could also validate that any investment, portfolio, or plan that is “out of bounds” has been brought into compliance through corrective action.

Morningstar goes on to explain that systems such as this could “…replace the likely or potentially skewed samples used in lawsuits or standard audits, which sample a subset of accounts” and provide, via a “big-data audit,” a positive affirmation of compliance. “That is, instead of having a financial institution responding to a lawsuit by 1) proving that the class of plaintiffs did not receive conflicted advice and 2) that if so, their experience was an exception, the financial institution would pre-emptively prove full compliance.”

The proposal states that using such data and analytics, every investor’s account would be scored to identify those that are outliers or nonconforming to investor needs in terms of investment quality, portfolio fit and planning value. “Provided there was a standard of prudence and reasonableness, a financial institution could at any time provide that its entire book of business was either compliant or being brought into compliance.”

Litigation Costs

Indeed, whatever benefits may result from the new fiduciary regulation, expanded litigation is a near certainty. Morningstar has estimated that the expenses from class action lawsuits stemming from the Best Interest Contract Exemption could range from approximately $70 million to $150 million annually, “adding an increase in compliance costs of about 5%-10% using the department’s estimates,” while noting that they “could be quite a bit higher in the near term as firms adjust to the rule and set up systems to determine, demonstrate, and document best interest recommendations.”

“The idea of substituting an audit for the potential class action liability is an idea definitely worth exploring,” noted American Retirement Association CEO Brian Graff. “Frankly, any idea that is a substitute for the likely crippling impact of class action liability is worth exploring.”