On the day that the SEC issued Regulation Best Interest (“Reg BI”), the long-awaited rule proscribing the standard of care that broker-dealers owe their clients, the SEC also issued an interpretation of the standard of care that investment advisers owe their clients (the “Interpretation”). Ostensibly a companion document to Reg BI that would allow investors to compare the standard of care broker-dealers and investment advisers owe their respective clients, the Interpretation is also valuable resource for investment advisers.
Definition of Fiduciary Duty
It is well established that investment advisers owe their clients a fiduciary duty. However, because “fiduciary duty” is not defined within the Investment Advisers Act of 1940 (the “Advisers Act”) or any rule thereunder, what the duty entails has largely been fleshed out by various pieces of SEC guidance and court opinions. The Interpretation is perhaps the SEC’s most comprehensive effort to articulate its view of the fiduciary duty to date. As a starting point, the SEC announced its view that the fiduciary duty includes both a duty of care and a duty of loyalty broadly applicable to the entire adviser-client relationship.
Duty of Care
The duty of care, as explained in the Interpretation, includes (i) the duty to provide advice in the best interest of the client, based on the client’s objectives; (ii) the duty to seek best execution of a client’s transactions (absent a directed brokerage arrangement); and (iii) the duty to provide both advice and monitoring over the course of the relationship.
Satisfying the duty of care requires an investment adviser to (i) possess both a reasonable understanding of the client’s objectives and knowledge of the recommended investment; and (ii) monitor a client’s investments commensurate with the client’s sophistication, the scope of the relationship, and the recommended investment. Under the Interpretation, the duty of care has countless variations depending on the particular facts and circumstances and the burden is on the adviser to find and meet the appropriate standard. However, when considering similar investment products or strategies, the fiduciary duty does not necessarily require an adviser to recommend the lowest cost investment product or strategy.
Duty of Loyalty
The duty of loyalty, as explained in the Interpretation, requires an investment adviser to (i) make full and fair disclosure of all material facts relating to the advisory relationship; and (ii) avoid placing its own interests above those of its clients. “Material facts” include the capacity in which the adviser is acting with respect to a recommendation (i.e., as a broker or an investment adviser) and whether the investment adviser’s recommendations are limited to a prescribed universe (i.e., securities offered through its affiliated broker-dealer). “Full and fair disclosure” means that “the disclosure must be clear and detailed enough for the client to make an informed decision to consent to the conflict of interest or reject it.”
Satisfying the duty of loyalty requires an investment adviser to carefully assess real and potential conflicts of interest to ensure that disclosures do not misstate their likelihood or otherwise mislead clients. For example, disclosure that an adviser “may” have a particular conflict, without more, is not adequate when the conflict actually exists. In addition, investment advisers must be more careful in disclosing conflicts to clients, giving particular attention to whether the client is sophisticated enough to give informed consent to the particular conflict, and making careful decisions about how to eliminate or mitigate conflicts where the investment adviser does not believe the client can give informed consent.
Implications of a Principals-Based Approach
Despite requests from some commentators for a rule defining “fiduciary duty”, the SEC elected to maintain its principals-based approach. Under that approach, the descriptions of the fiduciary duty and its components above are generally true, but “[t]he fiduciary duty follows the contours of the relationship between the adviser and its client, and the adviser and its client may shape that relationship by agreement, provided that there is full and fair disclosure and informed consent.” While the Interpretation provides investment advisers and their clients with great flexibility, there are limits. For example, under no circumstances is an investment adviser able to avoid the fiduciary duty altogether and any language in an advisory contract purporting to waive the fiduciary duty (e.g., by a statement that the adviser is not a fiduciary or that all conflicts of interest are waived) is deemed to be inconsistent with the Advisers Act. Accordingly, investment advisers should be thoughtful about their obligations to each client and avoid over-reliance on contractual waivers and representations.
The Interpretation, as perhaps the most comprehensive articulation by the SEC of the “fiduciary duty” investment advisers owe their clients, presents investment advisers with an opportunity to evaluate their practices against the SEC’s standards. However, investment advisers must understand that the SEC may be less forgiving of perceived violations of the fiduciary duty following the release of the Interpretation; because, after all, they’ve now been warned. We encourage investment advisers to carefully review the Interpretation, particularly the instances in which the SEC provides examples of compliant and non-compliant behavior, and consider whether their current advisory agreements, disclosure documents, policies and procedures, or practices should be amended in response.