SEC Interpretation Offers Clarification on an Investment Adviser’s Duties of Care and Loyalty

As part of its “Reg BI Package,” approved on June 5, 2019, the Securities and Exchange Commission (the “SEC”) sought to clarify the fiduciary duty that an investment adviser owes to its clients under the Investment Advisers Act of 1940 by including a “Commission Interpretation Regarding Standard of Conduct for Investment Advisers” (the “Interpretation”). The Interpretation explains that the SEC views an investment adviser’s fiduciary duty as consisting of two distinct components: a duty of loyalty and a duty of care.

Duty of Care

The Interpretation breaks the duty of care into three underlying components: (i) the duty to provide advice that is in the best interest of the client, (ii) the duty to seek best execution, and (iii) the duty to provide ongoing advice and monitoring for the duration of an advisory relationship.

(i) Duty to Provide Advice that is in the Best Interest of the Client

The Interpretation identifies the duty of an investment adviser to provide advice that is in the best interest of a client as a “critical component of the duty of care”. In order for an investment adviser to fulfill its duty to provide advice that is in the best interest of its client, the investment adviser must (i) make a reasonable inquiry into a client’s objectives and (ii) have a reasonable belief that the investment advice it provides is in the best interest of that client. The Interpretation provides detailed guidance to assist investment advisers with satisfying these two prongs.

Reasonable Inquiry into Client’s Objectives

The SEC acknowledges that how an investment adviser develops a reasonable understanding of a client’s objectives will depend on a number of factors, including whether a client is a retail client or an institutional client.

The Interpretation provides that an investment adviser providing investment services to a retail client must, at a minimum, make an inquiry into the client’s “investment profile”, which the Interpretation defines as a retail client’s financial situation, level of financial sophistication, investment experience and financial goals. Moreover, in circumstances where the investment relationship is on-going, the SEC expects an investment adviser to keep a client’s investment profile updated to reflect both new information received directly from the client and relevant industry updates of which an investment adviser may be aware (e.g., a change in tax law or a client’s retirement).

In comparison, the objectives of an institutional client are generally based on a specific investment mandate or, in the case of a registered investment product or private fund, investment guidelines and objectives. For example, an investment adviser engaged to manage a client’s bond portfolio must only develop a reasonable understanding of the objectives of the bond portfolio, not an understanding of the client’s entire investment portfolio. For institutional clients, and funds in particular, the Interpretation provides that the obligation of an investment adviser to update the client’s objectives would not be applicable except as may be set forth in the advisory agreement.

Reasonable Belief that Advice is in the Best Interest of the Client

The Interpretation also provides that all advice provided by an investment adviser (including advice regarding investment strategy and account type) must be based on the investment adviser’s reasonable belief that, when considering the objectives of a client, it is in the best interest of the client.

Generally, when making a determination of whether a product or strategy is in the best interests of a client, an investment adviser should conduct a reasonable investigation, so as to not base its advice on incomplete or inaccurate information. An investment adviser may consider, among other things, cost, liquidity, likely performance in a variety of market and economic conditions, volatility, time horizon, and cost of exit. More specifically, an investment adviser should consider whether a client’s investment objectives tolerate the amount and types of risk associated with a particular product or strategy. For example, an investment adviser should apply heightened scrutiny before recommending a high-risk investment (e.g., penny stocks, thinly-traded securities, or derivatives) to a retail investor, as it may fall outside a retail client’s risk tolerance. To further emphasize the importance of completing a reasonable but thorough investigation into each product or strategy, the Interpretation notes that the SEC has taken enforcement action against investment advisers who did not “independently or reasonably investigate securities before recommending them to clients.”

In circumstances where an investment adviser is considering similar products or strategies, the SEC notes that an investment adviser is not required to recommend the lowest-cost option. Rather, the SEC advises that recommending the lowest cost option without consideration of any other factors, does not fulfill an investment adviser’s fiduciary duty. Instead, the Interpretation provides that cost is only a part of the “best interest” analysis and an investment adviser should consider a client’s objectives and overall portfolio when making a recommendation. For example, an investment adviser could recommend a higher-cost product or strategy if the investment adviser reasonably concludes that the cost is outweighed by other factors that support a client’s objective, such as gaining exposure to an asset class that was appropriate in the context of the client’s overall portfolio.

Furthermore, an investment adviser’s duty to provide advice that is in a client’s best interest extends to advice about account type. The Interpretation notes that the duty applies to advice regarding whether to open or invest through a particular kind of account and to advice about whether to roll assets from one account (e.g., retirement accounts) into an account managed by the investment adviser or its affiliate. In addition, an investment adviser should consider all types of accounts offered by the investment adviser and disclose to a client when those account types are not in the client’s best interest.

(ii) Duty to Seek Best Execution

An investment adviser’s duty of care includes a duty to seek best execution of a client’s transactions where the adviser has the responsibility to select broker-dealers to execute client trades. An investment adviser fulfills this duty of care by seeking to obtain the execution of client transactions with a goal of maximizing a client’s value under the particular circumstances occurring at the time of the transaction. The Interpretation notes that maximizing value does not mean that an investment adviser is required to choose the broker offering the least expensive execution services. Instead, an investment adviser should qualitatively analyze and select a broker based on the range and quality of the broker’s services, which may include: (i) the value of provided research, (ii) commission rate, and (iii) responsiveness. The Interpretation further states that an investment adviser should periodically and systematically evaluate the execution it is receiving for clients.

(iii) Duty to Provide Ongoing Advice and Monitoring

The third component of an investment adviser’s duty of care requires that advice and account monitoring be provided on a schedule that is in the best interest of a client and based on the nature and duration of the investment relationship.

The SEC acknowledges that investment advisers have varied client relationships and, therefore, fulfilling the ongoing advice and monitoring duty will also be varied. For example, in relationships where an investment adviser receives periodic compensation for providing investment services, the investment adviser’s duty to provide advice and monitoring will be extensive and ongoing, regardless of whether the client is actively trading. Conversely, a relationship established for the purpose of providing a one-time financial plan for a one-time fee is unlikely to trigger the duty to monitor.

Duty of Loyalty

The Interpretation confirms that an investment adviser must put its clients’ interests ahead of its own, provide full and fair disclosure of all material facts about the advisory relationship, and eliminate or, at a minimum, fully and fairly disclose any conflicts of interest that may (consciously or unconsciously) influence the advice it provides to clients.

Material Facts About the Advisory Relationship

The Interpretation states that this disclosure is especially important for firms that are dually registered (as broker-dealers and investment advisers), noting that dually registered firms should disclose at the beginning of a relationship, through written or other means: (i) the circumstances under which they will act in each respective capacity, (ii) how a client will be notified if there is a change in capacity, and (iii) when advisory advice will be limited to affiliated broker/dealers or investment advisers.

Full and Fair Disclosure

The SEC defines full and fair disclosure as disclosure that is “clear and detailed enough for a client to make an informed decision regarding whether to consent to the conflict of interest or reject it.” In addition, while the Interpretation does not require an investment adviser to affirmatively confirm that a client’s consent is informed, investment advisers must provide disclosure sufficient to allow them to reasonably conclude that a client could understand that consent is being provided. The Interpretation, therefore, provides guidance on how to meet that standard, including the level of specificity of disclosure and considerations regarding disclosure of conflicts that may be created when allocating investment opportunities among clients.

The Interpretation provides that full and fair disclosure must be specific enough to allow a client to decide whether to consent to a conflict. Consequently, an investment adviser cannot simply assert that a conflict is too complex to disclose, state that conflicts exist because investment services are provided to other clients, or provide an exhaustive list of everything that “may” be a conflict of interest. Instead, investment advisers should either eliminate or mitigate a complex conflict so that full and fair disclosure is possible, disclose how conflicts between clients will be managed, and only use “may” when referencing possible future conflicts.

Finally, the Interpretation states that investment advisers must eliminate or disclose the conflicts created when allocating investment opportunities between clients. The Interpretation recommends that investment advisers should consider the nature and objectives of a client and the scope of the relationship and while the SEC does not require investment advisers to have a pro rata (or any other specific method) allocation policy, the policy must allow an investment adviser to provide advice that is in the best interest of its clients.

Conclusion

The Interpretation became effective on July 12, 2019. The guidance does not expand an investment adviser’s existing duties but does contain useful guidance on how the SEC views the nature and scope of an investment adviser’s existing fiduciary duties. Investment advisers should consider whether their current procedures and disclosures meet the expectations laid out in the Interpretation. Even with the legislative and legal uncertainties that currently surround the implementation of the “Reg BI Package,” the Interpretation offers a useful tool for investment advisers to fine tune policies and procedures relating to the duties of care and loyalty owed to clients.

For more information on the complete “Reg BI Package,” please see our previous alert, The Final Reg BI Package: What to Know and What’s Next or reach out to your contact within the Investment Management Group.