On June 5, 2019, the US Securities and Exchange Commission adopted a comprehensive package of rulemakings and interpretations governing the standard of conduct applicable to broker-dealers and the fiduciary duty applicable to SEC-registered investment advisers. The centerpiece of the package is the adoption of a new rule (captioned as “Regulation Best Interest”) establishing a standard of conduct for broker-dealers and associated persons when making recommendations to retail customers. Since most timberland investment management organizations (TIMOs) that are SEC-registered investment advisers are not broker-dealers, Regulation Best Interest and other components of the regulatory package will not have a direct impact on their operations.
One component of the regulatory package will be of keen interest to all TIMOs—an interpretation of the fiduciary duty applicable to all SEC-registered investment advisers (Release No. IA-5248, the “Interpretation”). The Interpretation reflects the SEC’s belief that “it is appropriate and beneficial to address in one release and reaffirm—and in some instances clarify—certain aspects of the fiduciary duty that an investment adviser owes to its clients.” The Interpretation does not plow new ground and in many respects confirms the common understanding of investment advisers and their legal advisers as to the scope of the fiduciary duty. However, the SEC’s guidance in the Interpretation requires TIMOs to consider the adequacy of their disclosures to clients.
The fiduciary duty owed by an SEC-registered investment adviser is based on equitable common law principles and is not expressly set forth in the Investment Advisers Act of 1940 or its regulations. Accordingly, it is helpful at the outset to restate the scope of the fiduciary duty. In the SEC’s view, an investment adviser is obligated to act in the best interest of its client in all aspects of the adviser-client relationship, which encompasses the duties of care and loyalty. The SEC acknowledges that this fiduciary duty is not “one size fits all” and that the application of the duty “follows the contours of the relationship between the adviser and its client.” The relationship may be shaped by the adviser and the client by agreement, provided that there is full and fair disclosure and informed consent. In this context, the SEC recognizes a clear distinction between “retail” clients and institutional investor clients.
Duty of care. In the SEC’s view, an adviser’s duty of care to its client includes the:
- Duty to provide advice that is in the best interest of the client, which requires a reasonable understanding of the client’s objectives and a reasonable belief that the advice is in the best interest of the client;
- Duty to seek the best execution of a client’s transactions; and
- Duty to provide advice and monitoring over the course of the relationship.
In the timberland investment context, with its focus on institutional investors, the first and third elements are typically addressed in the investment management agreements for separately managed accounts or the governing and subscription agreements for commingled funds, as the case may be, which set forth investment guidelines and management and reporting obligations. The “best execution” element is more of a securities trading concept, but can be adapted to the timberland investment context as requiring an adviser to effect timberland transactions efficiently using qualified advisers. The Interpretation makes clear that “best execution” means the best qualitative execution, not the lowest cost execution.
Duty of loyalty. The duty of loyalty requires an investment adviser not to place its own interest ahead of its client’s interest. To meet this duty, an adviser must make full and fair disclosure to its client of all material facts relating to the advisory relationship. In addition, an adviser must either eliminate or expose through full and fair disclosure all conflicts of interest that might incent an adviser to render advice that is not disinterested. 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.
In perhaps the most notable aspect of the Interpretation for TIMOs, the SEC endeavors to illustrate what constitutes “full and fair disclosure” by providing guidance on:
- The appropriate level of specificity, including the appropriateness of stating that an adviser “may” have a conflict; and
- Disclosures regarding conflicts related to the allocation of investment opportunities among eligible clients.
These illustrations have practical application to a TIMO with respect to the disclosure of conflicts between the adviser and client and among the adviser’s clients. In particular, the SEC counsels advisers not to state that a conflict “may” exist when a conflict does in fact exist.
In the timberland investment context, a TIMO has to address four broad areas of potential conflict of interest in its day-to-day operations:
- TIMO purchase of timberland for its own account;
- Buy/hold/sell decisions;
- Allocation of investment opportunities among clients; and
- Allocation of operational opportunities among clients.
This Alert does not address the inherent conflict of interest and other potential regulatory issues present in a timberland transaction between clients of a TIMO that is facilitated by the TIMO, which should be analyzed on a case specific basis.
TIMO purchase for own account. If a TIMO is in the market purchasing timberland for its own account, it is in an obvious conflict position with its clients. In that circumstance, the TIMO has a clear disclosure obligation to its clients and should provide full and fair disclosure so that they can make an informed consent decision. In addition, the adviser will be well advised to mitigate the conflict through the adoption of practices and procedures, such as adhering to a robust investment allocation policy.
In our experience, it is not typical for a TIMO to be in the timberland market solely for its own account; however, TIMOs are sometimes asked to invest alongside a separate account client to have “skin in the game” and typically have an equity interest in commingled funds that they sponsor and manage. While those economic interests are usually nominal, they nonetheless put the TIMO in a conflict position with other clients and should be disclosed and mitigated.
Buy/hold/sell decisions. A TIMO is also in a conflict position with its client when the TIMO has the discretionary authority to purchase and sell timberland for the benefit of the client. From a management fee perspective, the TIMO has an incentive to acquire and hold timberland for the client. While a sophisticated institutional investor client will undoubtedly understand this conflict, the TIMO should nonetheless expressly disclose the conflict and the measures it takes to mitigate the conflict, such as adopting and adhering to client-specific investment guidelines and performing regular hold/sell analyses on acquired timberlands. A TIMO can also mitigate the “buy” conflict by keeping the client fully informed of a proposed acquisition and giving the client the opportunity to express its views on the opportunity, even if the TIMO is not obligated to do so under the applicable governing agreement. A TIMO should also consider the impact of acquisition or disposition fees, if part of the fee structure, on the buy/hold/sell conflict.
Allocation of investment opportunities among clients. In our experience, TIMOs generally have done a good job disclosing this conflict to clients and mitigating the conflict by adopting and adhering to written investment allocation policies.
Allocation of operational opportunities among clients. Conflicts between or among clients for market opportunities, such as a timber sale, can be acute if a TIMO has multiple clients owning timberland in a single market. A TIMO should disclose potential operational conflicts to clients and the practices and procedures it has adopted to mitigate any such conflict. In allocating operational opportunities, a TIMO must also consider any interest that it may have in the opportunity, such as a harvesting fee, that arguably makes the TIMO less than disinterested in the allocation.
All TIMOs should consider the adequacy of their conflict of interest disclosures in light of the SEC’s guidance in the Interpretation. As a starting point, SEC-registered TIMOs should review their disclosure of conflicts in their “brochures” (Part 2A of Form ADV) delivered to clients. All TIMOs should review their conflict of interest provisions in their preferred forms of investment management agreement for separately managed accounts and in their offering materials with respect to commingled timberland investment funds.