SEC Issues Interpretation Regarding Standard of Conduct for Investment Advisers
September 10, 2019
On June 5, 2019, the SEC issued an interpretation (Interpretation) of the standard of conduct for investment advisers under the Investment Advisers Act of 1940 (Advisers Act).1 The Interpretation accompanied other interpretations, guidance and proposals from the SEC addressing the standards of conduct for investment advisers and broker-dealers under the federal securities laws. These SEC actions follow years of debate within the financial services industry concerning the standards of conduct for advisers and broker-dealers.
In the Interpretation, the SEC stated that an investment adviser’s fiduciary duty under the Advisers Act comprises a duty of care and a duty of loyalty. The SEC also stated that an investment adviser’s obligation to act in the best interest of its clients is an overarching principle that encompasses both the duty of care and duty of loyalty. In addition, the SEC:
- stressed that the fiduciary duty applies to the entire relationship between the adviser and the client and follows the contours of the relationship;
- confirmed that while the fiduciary duty cannot be waived generally it can be shaped by agreement between the adviser and the client;
- noted that the duty of care includes (i) the duty to provide advice that is in the best interest of the client, (ii) the duty to seek best execution of a client’s transactions where the adviser has the responsibility to select broker to execute client trades, and (iii) the duty to provide advice and monitoring over the course of the relationship; and
- stated that the duty of loyalty dictates that the adviser must (i) not place its own interests ahead of its client’s interests, (ii) make full and fair disclosures to its clients of all material facts relating to the advisory relationship, and (iii) eliminate or at least expose through full and fair disclosure all conflicts of interest which might incline the adviser to render advice which is not disinterested.
The following discussion highlights key guidance provided by the SEC with respect to each of the matters set forth above.
Scope of the Client Relationship – The Sculpted Duty
In the SEC’s view, the fiduciary duty applicable to an investment adviser under the Advisers Act follows the contours of the relationship between the adviser and its client, and the adviser and client may shape (or sculpt) that relationship by agreement, provided that the client is first provided full and fair disclosure, and on that basis, provides its informed consent. This applies irrespective of the services provided by the adviser or the type of client served. Thus, the obligations of the adviser, as agent, depend upon what functions the adviser has agreed to assume for the client, as principal. The Interpretation highlights, for example, that an adviser providing comprehensive, discretionary advice (with an ongoing relationship) to a retail client would have obligations that are significantly different from the obligations of an adviser to a private fund where the contract defines the scope of the adviser’s services and limitations on its authority with substantial specificity.
There remain, however, limitations on an adviser’s ability to sculpt its duties to its clients. The SEC cautioned that contractual provisions purporting to waive the adviser’s federal fiduciary duty generally, such as provisions (i) stating that the adviser will not act as a fiduciary, (ii) seeking to obtain a blanket waiver of all conflicts, or (iii) seeking to obtain a waiver of any specific obligation under the Advisers Act, are inconsistent with the Advisers Act, regardless of the sophistication of the client.
Duty of Care
The duty of care is multifaceted and includes: (i) the duty to provide advice that is in the best interest of the client; (ii) the duty to seek best execution of a client’s transactions where the adviser has the responsibility to select broker to execute client trades; and (iii) the duty to provide advice and monitoring over the course of the relationship.
Best Interest Advice
The SEC views the duty of care as including a duty to provide investment advice that is in the best interest of the client, which further includes a duty to provide advice that is suitable to the client. To provide suitable advice, an adviser must, according to the SEC, have a reasonable understanding of the client’s objectives. Developing a reasonable understanding varies based on the nature of the client, the scope of the advisory relationship and the nature and complexity of the anticipated investment advice.
- For retail clients, 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. This information should be updated with such frequency warranted by the relationship.
- For institutional clients, the nature and extent of the reasonable inquiry into the client’s objectives is shaped by the specific mandates for those clients.
An adviser must, according to the SEC, have a reasonable belief that the advice it provides is in the best interest of the client based on its investment objectives. This best interest analysis must be evaluated in the context of the portfolio that the adviser manages for the client and its objectives and involves considering the type of client to which the advice is provided (e.g., retail vs. institutional), the risk tolerances of the client and the corresponding risk of investments in the portfolio. It also requires the adviser to conduct a reasonable investigation into each investment so as to not base its advice on materially incorrect or incomplete information.2
In the Interpretation, the SEC reiterated its views with respect to seeking best execution of client securities transactions. An adviser fulfills its best execution obligation by seeking to obtain the execution of securities transactions on behalf of a client with the goal of maximizing value for the client under the particular circumstances occurring at the time of the transaction. Maximizing value involves more than just minimizing cost. Citing familiar precedent, the SEC stressed that the determinative factor is whether the transaction represents the best qualitative execution. It also stressed that this duty involves periodically and systematically evaluating the execution it is receiving for clients.
Advice and Monitoring
The SEC stated that the duty of care encompasses the duty to provide advice and monitoring at a frequency that is in the best interest of the client, taking into account the scope of the agreed relationship. Absent any limitation or expansion, the scope of the duty to monitor will be indicated by the duration and nature of the agreed relationship and extends to all personalized advice it provides to the client.
Duty of Loyalty
The SEC stated that the duty of loyalty dictates that the adviser not place its own interests ahead of its client’s interests, and to fulfill its duty of loyalty the adviser must make full and fair disclosures to its clients of all material facts relating to the advisory relationship.3 According to the SEC, an adviser must eliminate or at least expose through full and fair disclosure all conflicts of interest which might incline it to render advice which is not disinterested.
In the SEC’s view, in order for disclosure to be full and fair, it should be sufficiently specific so that a client is able to understand the material fact or conflict of interest and make an informed decision whether to provide consent. The SEC stated that it would, for example, be inadequate to disclose that the adviser has other clients without describing how the adviser will manage conflicts between clients if and when they arise or to disclose that the adviser has conflicts without further description. The SEC also stressed that disclosure that an adviser “may” have a particular conflict without more is inadequate when the conflict actually exists. According to the SEC, whether disclosure is full and fair will depend on the nature of the client, the scope of the services and the material fact or conflict.
The SEC stated that in allocating investment opportunities among eligible clients, an adviser must eliminate or at least expose through full and fair disclosure the conflicts associated with its allocation policies such that a client can provide informed consent. The SEC acknowledged that when allocating investment opportunities an adviser is permitted to consider the nature and objectives of the client and the scope of the relationship and that an adviser need not have pro rata allocation policies or any particular method of allocation.
The SEC also acknowledged that informed consent does not require an adviser to make an affirmative determination that a particular client understood the disclosure and the client’s consent was informed. Rather, the disclosure should be designed to put a client in a position to be able to understand and provide informed consent to the conflict. The SEC cautioned that it would not be consistent with an adviser’s fiduciary duty to infer or accept client consent where the adviser was aware, or reasonably should have been aware, that the client did not understand the nature and import of the conflict. The SEC noted, however, that in all cases where an adviser cannot fully and fairly disclose a conflict of interest to a client such that the client can provide informed consent, the adviser should either eliminate the conflict or adequately mitigate the conflict such that full and fair disclosure and informed consent are possible.
As described by the SEC, the Interpretation is intended to reaffirm in a single location the SEC’s long-standing views regarding the fiduciary duty owed by investment advisers to their clients and in some respects to further clarify aspects of the fiduciary duty. Taken in that context, the Interpretation does not seek to impose new obligations on advisers. While that may be the case, the Interpretation clearly highlights the SEC’s continued focus on ensuring that advisers satisfy their fiduciary obligations, and the need for advisers to provide clients with full and fair disclosure regarding their business practices, particularly those involving conflicts of interest. Accordingly, advisers should take the opportunity to review their existing practices and disclosures (e.g., Form ADV, fund documents, and managed account agreements, etc.) to ensure they are comfortable that those existing practices and disclosures are in fact consistent with the principles outlined by the SEC in the Interpretation.
1 See Commission Interpretation Regarding Standard of Conduct of Investment Advisers, SEC Release No. IA-5248 (June 5, 2019), 84 FR 33669 (www.sec.gov/rules/interp/2019/ia-5248.pdf). The Interpretation became effective on July 12, 2019.
2 The SEC also clarified that (i) the cost associated with advice is but one factor in determining whether a security or investment is in the best interest of the client and (ii) the fiduciary duty applies to all investment advice the adviser provides to clients, including advice about investment strategy, engaging a subadviser and account type (e.g., commission-based brokerage account).
3 A fact is material under the Advisers Act if there is a substantial likelihood that a reasonable client would consider the information important. According to the SEC, a material fact relating to the advisory relationship includes the capacity in which the adviser is acting, which is particularly relevant for firms registered as both a broker-dealer and an investment adviser.