SEC Publishes Interpretation of Investment Advisers’ Fiduciary Duty and Adopts Rules and Interpretations for Financial Professionals and their Retail Clients

On June 5, 2019, the Securities and Exchange Commission (“SEC”) released an interpretation to reaffirm and clarify certain aspects of an investment adviser’s fiduciary duty to its clients under the Investment Advisers Act of 1940 (the “Advisers Act”).  The SEC also announced a package of rulemakings and other interpretations addressing investment advisers and broker-dealers, focusing primarily on their relationships with retail investors.

Advisers Act – Fiduciary Duty Interpretation

Under the Advisers Act, investment advisers owe their clients a fiduciary duty comprised of a duty of care and a duty of loyalty.  Under the duty of care, an adviser must provide investment advice that is in its client’s best interests, based on the client’s objectives.  Under the duty of loyalty, an adviser must eliminate or make full and fair disclosure of all conflicts of interest that might cause the adviser (consciously or unconsciously) to render advice that is not disinterested so that a client can provide informed consent to the conflict.

Scope of the Client Relationship.  In the new interpretation, the SEC noted that fiduciary duty under the Advisers Act must be viewed in the context of the agreed-on scope of the adviser’s relationship with its client.  For example, the duty of an adviser providing comprehensive discretionary advice to a retail client will be significantly different than the duty of an adviser to a private fund because the fund’s advisory contract defines the scope of the adviser’s services and limits its authority with substantial specificity.

While fiduciary duty varies with the scope of the relationship, an adviser’s federal fiduciary duty may not be waived.  Examples of unacceptable waivers of fiduciary duty include:  a statement that the adviser will not act as a fiduciary; a blanket waiver of all conflicts of interest; and a waiver of any specific obligation under the Advisers Act.

The SEC reiterated its view that there are few (if any) circumstances in which a “hedge clause”[1] in a retail client agreement would be consistent with the Advisers Act’s antifraud provisions, where the hedge clause purports to relieve the adviser from liability for conduct for which the client has a non-waivable cause of action against the adviser under state or federal law.

Duty of Care.  The duty of care includes, among other things, the duty to provide advice in the client’s best interest, the duty to seek best execution where the adviser is responsible for selecting broker-dealers to execute client trades, and the duty to provide advice and monitoring over the course of the relationship.

To provide advice in the client’s best interest, the adviser must make a reasonable inquiry into the client’s objectives, and have a reasonable belief that its advice is in the client’s best interest.  For a retail client, the adviser should, at a minimum, make a reasonable inquiry into the client’s financial situation, level of financial sophistication, investment experience and financial goals (collectively, the retail client’s “investment profile”).  The adviser would need periodically to update that investment profile to maintain that understanding.  For institutional clients, the nature and extent of the reasonable inquiry into client objectives will be shaped by the specific investment mandates from those clients.  For example, an adviser whose client is a private fund would need to have a reasonable understanding of the fund’s investment guidelines and objectives; the obligation to update the client’s objectives generally would not apply except as may be set forth in the advisory agreement.

An adviser must have a reasonable belief that its advice is in the client’s best interest based on the client’s objectives.  Certain riskier investments may be less appropriate for a retail client than for a sophisticated client with a higher risk tolerance.  When assessing high risk products for a retail client, the adviser should generally apply heightened scrutiny as to whether those investments fit the client’s risk tolerance and objectives.  A reasonable belief also requires a reasonable investigation into the investment sufficient not to base its advice on materially inaccurate or incomplete information.  The SEC notes that it has taken enforcement action where an adviser did not independently or reasonably investigate securities before recommending them to clients.  Cost could be an important factor, but fiduciary duty does not necessarily require an adviser to recommend the lowest cost product or strategy.

Duty to Seek Best Execution.  An adviser fulfills this duty by seeking to obtain execution with the goal of maximizing value for the client under the particular circumstances occurring at the time of the transaction.  This is more than just minimizing costs.  Rather, the determinative factor is whether the transaction represents the best qualitative execution.  An adviser should periodically and systematically evaluate the execution it is receiving for clients.

Duty to Provide Advice and Monitoring over the Course of the Relationship.  The duty of care includes a duty to provide advice and monitoring at a frequency that is in the client’s best interest, taking into account the scope of the agreed relationship.  In the absence of any agreed limitation or expansion, the scope of the duty to monitor will be indicated by the duration and nature of the agreed advisory relationship.

Duty of Loyalty.  Generally, an adviser must not place its own interest ahead of its client’s interest.  To meet its duty of loyalty, an adviser must make full and fair disclosure of all material facts relating to the advisory relationship.  In addition, an adviser must eliminate, or at least fully and fairly disclose, all conflicts of interest that might incline the adviser, consciously or unconsciously, to render advice that is not disinterested.  While an adviser may satisfy its duty of loyalty by making full and fair disclosure of conflicts of interest and obtaining informed client consent, an adviser may not overreach or take unfair advantage of a client’s trust.

For disclosure to be full and fair, it should be sufficiently specific that a client can understand the material fact or conflict of interest and make an informed decision whether to consent.  Whether disclosure is full and fair depends on, among other things, the nature of the client, the scope of services and the material fact or conflict.  Disclosure for an institutional client may differ significantly from disclosure for a retail client.  The SEC provided examples of disclosure that would not be sufficiently specific, for example, saying an adviser “may” have a particular conflict is not adequate when the conflict actually exists.  Advisers are not required to make an affirmative determination that a particular client understood the disclosure and that the client’s consent to the conflict of interest was informed; rather, the disclosure should be “designed” to put a client in a position to be able to understand and provide informed consent.

An adviser may have a conflict of interest in allocating investment opportunities among clients.  The adviser must eliminate or at least fully and fairly disclose the conflicts associated with its allocation policies, including how the adviser will allocate investments, so that a client can provide informed consent.  When allocating, the adviser is permitted to consider the nature and objectives of the client and scope of the relationship. Pro rata or a particular method of allocation is not required but must not prevent advice in the client’s best interest.

Informed consent can be either explicit or, depending on the fact and circumstances, implicit.  If an adviser cannot fully and fairly disclose a conflict of interest such that the client can provide informed consent, the adviser should either eliminate the conflict or adequately mitigate (that is, modify practices to reduce) the conflict such that full and fair disclosure and informed consent are possible.

Advisers Act – Solely Incidental” Interpretation.

Section 202(a)(11)(C) of the Advisers Act provides an exclusion from the definition of “investment adviser” for broker-dealers whose advisory services are “solely incidental” to their businesses as broker-dealers and who receive no special compensation for those services.

The SEC’s interpretation sets forth the practical application of the exclusion in the context where a broker-dealer is exercising investment discretion over customer accounts and performing account monitoring services.  For example, a broker with discretion over a customer account may deem that advice “solely incidental” if it is limited in time, scope, or other manner and is not comprehensive and continuous.  The SEC suggested that broker-dealers and investment advisers may wish to create account monitoring policies and procedures for personnel that are tailored to their proper capacities.

Form CRS – New Form ADV Part 3

Registered investment advisers and broker-dealers will be required to deliver a relationship summary (“Form CRS”) to “retail investors” at the beginning of their relationship, and re-deliver it to existing clients in certain circumstances (for example, if the adviser opens a new account for a retail client different from its existing account).  Form CRS will need to be updated within 30 days of becoming materially inaccurate, and such amended Form CRS would need to be delivered to retail investors within 60 days.  “Retail investor” is defined as “a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family or household purposes.”

An adviser registered with the SEC before June 30, 2020, must file its initial Form CRS, beginning on May 1, 2020, and by no later than June 30, 2020.  An adviser filing a registration application on or after June 30, 2020, must comply with Form CRS by the date on which its application becomes effective.

The 2-page summary (4-pages for dual investment adviser/broker-dealer registrants) will disclose the nature and scope of services provided by the firm, the types of fees customers would incur, the conflicts of interest faced by the firm and the firm’s disciplinary history.  In addition, Form CRS restricts use of the terms “adviser” and “advisor” by a broker-dealer and its associated persons, and requires a firm and its investment professionals to disclose their SEC registration status in communications with retail investors.

A template of Form CRS was included in the SEC’s proposing release in 2018; the final Form CRS has not yet been released.

Regulation Best Interest for Broker-Dealers

Beginning June 30, 2020, under Regulation Best Interest, broker-dealers will be required to act in the best interest of a retail customer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer.  Regulation Best Interest is intended to enhance the broker-dealer standard of conduct beyond existing suitability obligations, and make it clear that a broker-dealer may not put its financial interests ahead of the retail customer when making recommendations.

***

The SEC’s press release and related materials are available at: https://www.sec.gov/news/press-release/2019-89.

If you have any questions, please contact one of the attorneys in the Investment Funds & Advisers Group at Shartsis Friese LLP: John Broadhurst, Geoffrey Haynes, Carolyn Reiser, Neil Koren, Jim Frolik, Christina Hamilton, David Suozzi, Joan Grant or Lyn Roberts.

Previous letters to our investment advisory clients and friends and discussions of other topics relevant to private fund managers, investment advisers and private investment funds can be found at our insights page: www.sflaw.com/blog/investment-funds-advisers-insights.


[1] A “hedge clause” is an exculpation of the adviser from liability and/or indemnification of the adviser by the client except in the case of the adviser’s gross negligence, reckless disregard, willful misconduct or bad faith.  A hedge clause is usually followed by language nothing in the agreement should be construed as a waiver by the client of any rights the client has under applicable law.