SEC Proposes Interpretation of Standard of Conduct for Investment Advisers

This LawFlash describes the key questions raised by the US Securities and Exchange Commission’s new proposed interpretation of the standard of conduct for investment advisers and discusses its potential impact on the existing interpretation of fiduciary duty.

As described in our prior LawFlash, the US Securities and Exchange Commission (SEC) recently voted to propose an interpretation of the standard of conduct for investment advisers under the Investment Advisers Act of 1940 (Advisers Act).[1] The proposed interpretation is part of a package of proposed rulemaking and interpretative guidance on the standards of conduct for broker-dealers and investment advisers.[2] Rather than adopt a uniform standard of conduct that would apply equally to investment advisers and broker-dealers when providing advice to retail investors, the SEC retained two standards in recognition of the differences in the types of relationships that broker-dealers and investment advisers have with their clients and different models for providing advice. The SEC proposed a new best interest standard for broker-dealers (Regulation Best Interest) and separately proposed this interpretation, which seeks to “reaffirm” and “clarify” certain aspects of the fiduciary duty an investment adviser owes to its clients.

The SEC’s proposed interpretation raises many questions about the ongoing applicability of longstanding interpretations of an investment adviser’s fiduciary duty under Section 206(1) and (2) of the Advisers Act. Some of the key questions raised by the proposed interpretation include:

• Does the SEC’s interpretation of Section 206(1) and (2) remain grounded in common law concepts of fraud, or is the SEC seeking to define fraud more broadly – which the SEC can do by rule under Section 206(4)?
• Under the common law, an adviser’s obligation to act in the client’s best interest is part of the duty of loyalty – is the SEC establishing new obligations for investment advisers by creating an overarching obligation to act in the client’s best interest (separate and apart from the duty of loyalty) or by interpreting the duty of care as also including a best interest obligation?
• What is the impact on longstanding principles under the Advisers Act and common law that the scope of an investment adviser’s fiduciary duties depends on the extent of the adviser’s authority and the client’s reliance on the adviser?
• Are there instances in which disclosure alone is not enough to satisfy the duty of loyalty? If so, what types of conflicts cannot be addressed through disclosure and must be avoided?
• Are the SEC’s statements about the need for specificity in conflict disclosure and the use of “may-based” disclosure supported under the common law?
• Does the proposed interpretation create an obligation for investment advisers to collect specific information and implement practices similar to the “know-your-customer” and suitability requirements applicable to broker-dealers?

In addition to the proposed interpretation, the SEC has also requested comments on whether to require investment advisers to satisfy federal licensing and continuing education requirements, provide account statements to clients, and meet financial responsibility requirements. Below we summarize the Staff’s proposed interpretation, and provide our observations on the practical implications. We also highlight areas where investment advisers would benefit from additional clarity from the SEC, both as to how this interpretation impacts existing practices and how it compares to the proposed standard of conduct for broker-dealers under Regulation Best Interest.

Investment Adviser Standard of Conduct

The proposed interpretation would affirm the SEC’s longstanding position that Section 206(1) and (2) of the Advisers Act establish a federal fiduciary standard governing the conduct of investment advisers.[3] As described in the proposed interpretation, an investment adviser’s fiduciary duty under the Advisers Act is based on common law principles and includes a duty of loyalty and a duty of care. While the proposed interpretation would reinforce that an adviser’s obligations will vary among clients based on the contours of a particular advisory relationship and as agreed upon with the client by contract, the SEC stated that “the relationship in all cases remains that of a fiduciary to a client” and that an adviser “cannot disclose or negotiate away, and the investor cannot waive, the federal fiduciary duty.”[4]

It is important to note that the proposed interpretation would apply to all investment advisers – including those providing advice to institutional investors and pooled investment vehicles such as mutual funds and private funds. Unlike Regulation Best Interest, which is focused exclusively on advice provided to retail investors, the proposed interpretation does not differentiate between advice provided to retail and institutional clients.

Proposed Interpretation of the Duty of Care

The proposed interpretation seeks to clarify an investment adviser’s duty of care in the context of personalized advice[5], and focuses specifically on the duty to

• provide advice that is suitable for and in the best interest of the client;
• seek best execution of client transactions where an adviser has the responsibility to select executing broker-dealers; and
• provide advice and monitoring over the course of the relationship.

An investment adviser’s duty of care extends to all services provided on a client’s behalf. For purposes of the proposed interpretation, however, the SEC has emphasized only the three areas noted above.

Duty to Provide Advice that Is Suitable and in the Best Interest of the Client

According to the SEC, an investment adviser is required “to make a reasonable inquiry into a client’s” investment profile, including the client’s “financial situation, level of financial sophistication, investment experience, and investment objectives,” and “provide personalized advice that is suitable for and in the best interest of the client based on the client’s investment profile.”

• The proposed interpretation would require an investment adviser to make a reasonable inquiry into a client’s investment profile before providing any “personalized” investment advice, and as appropriate thereafter.[6] According to the SEC, this inquiry would turn on what is reasonable under the circumstances, including the nature and extent of the advisory services to be provided, the nature and complexity of the advice, and the client’s investment profile. While, as a general matter, investment advisers already require retail clients to complete investor questionnaires (or similar forms) in advance of the provision of advice in many contexts, the SEC’s comments call into question whether advisers will be expected to adopt more robust practices in their onboarding processes to ensure that the adviser captures and analyzes the sufficient client information in order to provide appropriate investment advice.
• In addition, the SEC stated that an investment adviser would be required to “update a client’s investment profile in order to adjust its advice to reflect any changed circumstances,” except advice that is not provided on an ongoing basis, such as providing a one-time financial plan. The SEC explained that the frequency with which an investment adviser must update a client’s investment profile and adjust its advice to reflect any changed circumstances would turn on a number of factors, including the extent to which the adviser is aware of events that could render the client’s investment profile inaccurate or incomplete. Indeed, investment advisers in the separate account space generally have at least annual touchpoints with clients in order to, among other things, assess whether the client’s financial circumstances have changed. The SEC’s statements, however, suggest that an adviser may need to make this assessment on a more frequent periodic basis or ad hoc basis in response to outside events that could impact clients, including changes in law or the employment or marital status of the client. This would cause a shift in practice for many investment advisers, particularly in cases where clients are contractually required to inform the adviser should their financial circumstances change, and could create practical and operational challenges.
• Under the proposed interpretation, an investment adviser would be required to “have a reasonable belief that the personalized advice is suitable for and in the best interest of the client based on the client’s investment profile.”[7] The SEC stated that whether personalized advice is in a particular client’s best interest must be evaluated taking into account the client’s investment profile and the client’s portfolio that the adviser manages. In addition, the SEC believes that the cost associated with advice “would generally be one of many important factors” to consider, and that “the fiduciary duty does not necessarily require an adviser to recommend the lowest cost investment product or strategy.” Notwithstanding this general statement, the SEC went on to state its belief that “an adviser could not reasonably believe that a recommended security is in the best interest of a client if it is higher cost than a security that is otherwise identical, including any special or unusual features, liquidity, risks and potential benefits, volatility and likely performance.” For example, advising a client to purchase a more expensive mutual fund share class when the adviser receives compensation that creates a potential conflict and reduces the client’s return may violate the adviser’s fiduciary duty and the antifraud provisions of the Advisers Act, if the adviser “does not, at a minimum, provide full and fair disclosure of the conflict and its impact on the client and obtain informed client consent to the conflict.”

Duty to Seek Best Execution

The proposed interpretation reconfirms an investment adviser’s duty to seek best execution of client transactions where the adviser has the responsibility to select executing broker-dealers for the transactions. The proposed interpretation would provide that the duty to seek best execution requires an investment adviser to seek to obtain execution of transactions for each client such that the client’s total cost or proceeds in each transaction are the most favorable under the circumstances.[8] According to the SEC, “the determinative factor is not the lowest possible commission cost but whether the transaction represents the best qualitative execution,” and that advisers should periodically and systematically evaluate execution quality.

The proposed interpretation does not appear to change existing standards for best execution. Interestingly, despite having brought charges against investment advisers for failure to obtain best execution in the context of mutual fund share class selection in a number of settled enforcement actions,[9] the SEC did not state that an investment adviser’s duty to seek best execution requires selection of the lowest cost share class. We believe the fact that the SEC did not address this issue supports the argument that best execution should not apply to mutual fund share class selection. Under longstanding SEC interpretation, an investment adviser’s duty to seek best execution is focused on broker selection, and not to the sale of mutual funds or other investment products that trade at the applicable public offering price. Moreover, the application of the duty to seek best execution has always included consideration of a range of quantitative and qualitative factors that is not limited solely to cost or price. The best execution claims in settled enforcement actions, in contrast, focus exclusively on whether the adviser offered the lowest cost share class.

Duty to Provide Ongoing Advice and Monitoring

The proposed interpretation would also require that an investment adviser “provide advice and services to a client over the course of the relationship at a frequency that is both in the best interest of the client and consistent with the scope of advisory services agreed upon between the investment adviser and the client.” The SEC stated that this duty is particularly important in ongoing relationships with a client, but “may be relatively circumscribed” where the adviser and client have agreed by contract to limit the duration of the relationship. According to the SEC, the duty would extend to all personalized advice, “including an evaluation of whether a client’s account or program type (for example, a wrap fee program account) continues to be in the client’s best interest.”

Proposed Interpretation of the Duty of Loyalty

The proposed interpretation would reinforce the existing standard that “[t]he duty of loyalty requires an investment adviser to put its client’s interests first.” The SEC stated that this means an adviser has “an obligation not to subordinate its clients’ interests to its own,” whether by favoring its own accounts or favoring certain clients over others (e.g., those paying higher fee rates). For example, in allocating investment opportunities, the SEC believes an adviser must treat all clients fairly – namely “that an adviser’s allocation policies must be fair and, if they present a conflict, the adviser must fully and fairly disclose the conflict such that a client can provide informed consent.”

The SEC also believes that “[a]n adviser must seek to avoid conflicts of interest with its clients, and, at a minimum, make full and fair disclosure to its clients of all material conflicts of interest that could affect the advisory relationship.” According to the SEC, the disclosure must be clear and detailed enough and contain sufficiently specific facts to allow the client to make a reasonably informed decision whether to consent to the conflicts. In this regard, the SEC stated that “an adviser disclosing that it ‘may’ have a conflict is not adequate disclosure when the conflict actually exists.”

The proposed interpretation also discusses when an investment adviser can infer or accept client consent to a conflict. In particular, the SEC states that an adviser would violate its fiduciary duty if it infers or accepts consent to a conflict where “(i) the facts and circumstances indicate that the client did not understand the nature and import of the conflict, or (ii) the material facts concerning the conflict cannot be fully and fairly disclosed.”[10] According to the SEC, this could involve conflicts for which disclosure cannot “adequately convey[] the material facts or the nature, magnitude and potential effect of the conflict” or disclosure that is not specific enough to allow clients to understand whether and how the conflict will affect the advice they receive. The SEC expects that, in these instances, the adviser would eliminate the conflict or adequately mitigate the conflict so that it can be more readily disclosed.

In addition, the SEC asserts that disclosure alone might not be enough to satisfy the duty of loyalty and Section 206 of the Advisers Act. Importantly, however, the SEC does not describe situations where disclosure is not sufficient and it is not clear whether the SEC is saying that certain conflicts constitute a per se breach of fiduciary duty and must be eliminated, or whether it is saying that such conflicts may stand if the adviser takes additional steps to mitigate the conflict, in addition to providing appropriate disclosure. Of course, under common law the duty of loyalty does not prohibit an investment adviser from benefitting from a transaction with a client if the investment adviser provides appropriate disclosure of the conflicts of interest related to the transaction and the client consents.[11] A client may generally consent to a conflict of interest that would otherwise constitute a breach of the duty of loyalty where the adviser has provided appropriate disclosure of the conflict.[12]

The SEC’s assertion that disclosure alone may not be enough to satisfy the duty of loyalty has a potentially significant impact for advisers to both retail and institutional clients. In particular, suggesting that disclosure is not a sufficient mechanism to address conflicts of interests would cause widely adopted practices to be called into question. To the extent the SEC’s proposed approach to disclosure is inconsistent with common law principles, it will also cause a disconnect between SEC and non-SEC fiduciaries (like banks, trust companies, etc.) that provide fiduciary advice in a coordinated way such as through delegation or dual hatting arrangements.

Comparison to Regulation Best Interest

The following chart summarizes the key differences between the interpretation of a broker-dealer’s obligations under Regulation Best Interest and an investment adviser’s obligations under the federal fiduciary standard, as articulated in the proposed interpretation.

Request for Comment on Areas of Enhanced Investment Adviser Regulation

The SEC also requested comment on three areas of potential additions to the regulatory regime for SEC-registered investment advisers. The areas identified were also discussed in the SEC Staff’s 2011 Study on Investment Advisers and Broker-Dealers conducted pursuant to Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.[13]

Federal Licensing and Continuing Education

The SEC requested comment on whether there should be federal licensing and continuing education requirements for personnel of SEC-registered investment advisers. In requesting comment, the SEC noted that associated persons of broker-dealers are required to meet qualification requirements under Financial Industry Regulatory Authority (FINRA) rules and most states impose registration, licensing, or qualification requirements on investment adviser representatives with a place of business in the state. The SEC requested comment on, among others: whether to require licensing and continuing education for personnel of advisers; which advisory personnel should be covered by the requirements; how the requirements should be structured, and whether there should be any specific minimum qualifications; how to avoid possible duplication with other regulatory regimes; and whether the SEC should play a role in registering investment adviser representatives.

Provision of Account Statements

The SEC also requested comment on whether to propose rules requiring investment advisers to provide account statements. Although many advisory clients already receive account statements from custodians pursuant to Advisers Act Rule 206(4)-2 and Rule 3a-4 under the Investment Company Act of 1940, investment advisers are not currently required to provide clients with account statements under the Advisers Act. The SEC stated its belief that periodic account statements that specified the dollar amounts of fees and expenses would allow clients to understand and evaluate the cost of the services they are receiving from an investment adviser. The SEC requested comment on, among others: whether clients would benefit from a requirement that they enter into a written agreement with advisers specifying the fees and expenses to be paid before they receive any advice; what information beyond fees and expenses would be most useful for retail clients to receive in account statements; and the frequency with which clients should receive such account statements.

Financial Responsibility

Finally, the SEC requested comment on whether SEC-registered investment advisers should be subject to a financial responsibility program similar to those that apply to broker-dealers. Broker-dealers are required to meet minimum net capital requirements; ensure customer assets are readily available to be returned to customers should the broker-dealer fail; complete an annual audit and make audited balance sheets available to customers; and become members of the Securities Investor Protection Corporation. In comparison, SEC-registered investment advisers are not subject to any net capital requirements, although they are required to disclose any material financial condition that impairs their ability to provide services to clients. The SEC noted that many advisers have relatively small amounts of capital; in the event of serious fraud, the adviser’s assets are often insufficient to compensate clients for their loss; and are not required to obtain fidelity bonds. The SEC requested comment on, among others: whether Advisers Act Rule 206(4)-2 (the Custody Rule) and other rules adequately address the potential for misappropriation of client assets; whether advisers should be subject to annual audit or fidelity bonding requirements; the frequency and severity of client losses due to advisers’ inability to satisfy a judgment or compensate a client for losses due to the adviser’s wrongdoing; and whether advisers should be required to maintain some form of reserve capital.

THOUGHT LEADERSHIP

Morgan Lewis is continuing to closely follow this rulemaking process and will provide updates on new developments as they occur. Click on any of the links below to read prior Morgan Lewis thought leadership covering the SEC proposed standards of conduct for broker-dealers and investment advisers:

SEC Proposes Rules of the Road for Brokers Giving Advice to Retail Investors >>

SEC Proposes Standards of Conduct for Broker-Dealers, Investment Advisers >>

CONTACTS

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Boston
David C. Boch

New York
Christine M. Lombardo 

Washington, DC
Thomas S. Harman
Charles M. Horn
Lindsay B. Jackson
Daniel R. Kleinman
Amy Natterson Kroll
Michael B. Richman
Ignacio A. Sandoval
Steven W. Stone
Kyle D. Whitehead