As an increasing number of investment management firms experience financial distress, we often are asked whether there are any minimum capital requirements imposed on investment advisers. Although it may sometimes feel as though investment advisers are substantially and extensively regulated, the Investment Advisers Act of 1940, as amended, actually does not impose a comprehensive and specific regulatory regime for investment advisers. The Act does not impose any objective minimum financial requirements on investment advisers, as other applicable regulation does on other financial services providers, including banks and brokerage firms. Instead, it imposes on investment advisers a broad fiduciary duty to act in the best interests of their clients. As a fiduciary, an investment adviser owes its clients more than a duty of “mere honesty and good faith” alone. This concept is embodied in the antifraud provisions of the Act, even though the duty is not specifically set forth in the Act. Fiduciary duties are imposed on an adviser by operation of law because of the nature of the relationship between an adviser and its clients. The duty is made enforceable by Section 206 of the Act, the Act’s antifraud provisions.
A number of obligations flow from an investment adviser’s fiduciary duties. Under the Act, an investment adviser has an affirmative obligation of utmost good faith and full and fair disclosure of all facts material to the clients’ engagement of the adviser, as well as a duty to avoid misleading them. A fact is material if there is a substantial likelihood that a reasonable client would consider the information important.
Although the investment adviser’s financial condition is not typically considered to pose a “conflict of interest,” the Securities and Exchange Commission historically has taken the position that an investment adviser has an obligation to disclose to clients and prospective clients material facts about the investment adviser’s financial condition, especially if that is reasonably likely to impair the investment adviser’s ability to meet contractual commitments to clients.
Therefore, although the Act does not impose any minimum capital requirements on investment advisers, if an investment adviser is experiencing financial distress and/or the imminent possibility of bankruptcy, it is likely that such conditions would impair the investment adviser’s ability to meet its fiduciary obligations to its clients and therefore would need to be clearly disclosed to those clients.
Just recently, on June 28, 2016, the SEC proposed new Rule 206(4)4 under the Act, which would require registered investment advisers to adopt and implement written business continuity and transition plans reasonably designed to address operational and other risks related to a significant disruption in their operations. The SEC also proposed to require registered investment advisers to make and keep all business continuity and transition plans that are currently in effect or that were in effect at any time within the past five years.
The proposal would formalize a longstanding implicit expectation of the SEC staff. In a prior release dated December 17, 2003, which adopted Advisers Act Rule 206(4)7 (the Compliance Program Rule), the SEC stated that it expected an adviser’s compliance policies and procedures, at a minimum, should address a number of issues which included business continuity plans.
In its prior written guidance, the SEC did not identify critical components of advisers’ business continuity plans or discuss specific issues or areas that advisers should consider in developing one. Under proposed new Rule 206(4)4, the content of an SECregistered adviser’s business continuity and transition plan would be based upon risks associated with the adviser’s operations and would be required to include policies and procedures designed to minimize material service disruptions, including policies and procedures that address a number of specific areas including, without limitation, a plan of transition that accounts for the possible winding down of the investment adviser’s business or the transition of the adviser’s business to others in the event that the adviser is unable to continue providing advisory services.
Under proposed new Rule 206(4)4, the business transition components of a business continuity and transition plan would be required to include, among other provisions, the identification of any material financial resources available to the adviser; and an assessment of the applicable law and contractual obligations governing the adviser and its clients, including pooled investment vehicles (e.g., mutual funds), implicated by the adviser’s transition.
For purposes of the proposed rule, business continuity situations generally would include natural disasters, acts of terrorism, cyberattacks, equipment or system failures, or the unexpected loss of a service provider, facilities, or key personnel. Business transitions generally would include situations where the adviser exits the market and thus is no longer able to serve its clients, including when it merges with another adviser, sells its business or a portion thereof, or enters bankruptcy proceedings. The proposed rule would require that the plan be reasonably designed (the same standard as under the Compliance Program Rule) to address the operational and other risks of each particular adviser. Thus, an adviser would need only take into account the risks associated with its particular operations, including the nature and complexity of the adviser’s business, its clients, and its key personnel.
Under proposed new Rule 206(4)4, each registered adviser would be required to review the adequacy of its business continuity and transition plan, and the effectiveness of its implementation, at least annually. The SEC stated in the proposal that the review generally should consider any changes to the adviser’s products, services, operations, critical thirdparty service providers, structure, business activities, client types, location, and any regulatory changes that might suggest a need to revise the business continuity and transition plan. In addition, proposed amendments to Advisers Act Rule 2042 would require registered advisers to maintain records documenting the adviser’s annual review of its business continuity and transition plan.