Spencer Fane LLP Logo

The SEC’s Fiduciary Proposal – Investment Adviser Standard of Conduct

Second in a Series

As described in our first article, the Securities and Exchange Commission voted on April 18 to issue a proposal package that includes two new rules and one interpretative release.  According to the SEC, each component of the proposal – Regulation Best Interest, Investment Adviser Standard of Conduct Interpretation, and Form CRS – Relationship Summary – is intended to enhance investor protections and regulatory clarity while maintaining investor access and choice.  Each component of the SEC’s proposal is available for public comment for 90 days after publication in the Federal Register.

This article is the second in a series and describes the Investment Adviser Standard of Conduct Interpretation portion of the SEC’s fiduciary proposal.

Investment Adviser Standard of Conduct Interpretation

While the Regulation Best Interest rule is applicable to broker-dealers, the SEC also issued a release that provides an Interpretation Regarding Standard of Conduct for Investment Advisers under the Investment Advisers Act of 1940 (the “Advisers Act”).  According to the SEC, the purpose of the release is to “affirm investments advisers’ understanding of the obligations they owe their clients, reduce uncertainty for advisers, and facilitate their compliance.”   In addition, the SEC is requesting comments on three specific areas that are addressed under the regulatory regime for broker-dealers, but may not be addressed with respect to investment advisers.  Those three areas are:  (1) federal licensing and continuing education, (2) provision of account statements, and (3) financial responsibility.

While the fiduciary duty owed by investment advisers to their clients is not defined under the Advisers Act, such a duty is well-established and recognized in the industry based on congressional intent when the Advisers Act was enacted and subsequent enforcement of the Act.  In the release, the SEC addresses each of the main components of an investment adviser’s fiduciary obligations – duty of care and duty of loyalty – and states that “…the adviser must, at all times, serve the best interest of its clients…” and that “…the investment adviser cannot disclose or negotiate away, and the investor cannot waive, the federal fiduciary duty.”

The SEC describes an investment adviser’s duty of care to include (at a minimum) three components:  (1) the duty to act and to provide advice that is in the best interest of the client, (2) the duty to seek best execution of a client’s transactions where the adviser has the responsibility to select broker-dealers to execute client trades, and (3) the duty to provide advice and monitoring over the course of the relationship.

To provide personalized advice in the best interest of the client, an investment adviser must reasonably inquire into a client’s financial situation, knowledge, experience and objectives so that the adviser understands a client’s investment profile before providing advice.  The exact nature and frequency of an investment adviser’s inquiry depends, in part, on the type and scope of advisory services agreed upon between the client and investment adviser.   However, the SEC expects an investment adviser to update a client’s investment profile and consider changes to previous advice if the adviser is aware of a change in a client’s circumstances, such as retirement or change in marital status.  In short, the SEC believes that “[a]n investment adviser must… 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.”

In addition, the SEC explains that an investment adviser should reasonably investigate an investment product and/or strategy to determine whether it is suitable and in the best interest of a client.  Such an investigation would include factors such as fees and compensation, investment objectives, risks and reward characteristics, and volatility.  Examples of investment strategies to which this obligation applies includes the engagement of a sub-adviser, as well as advice about whether to rollover a retirement account to an account for which the adviser provides services.

The SEC recognizes that automated investment advisers, commonly referred to as “robo-advisers,” have a unique business model.  Thus, as explained in our March 7, 2017 article, the SEC previously issued guidance reaffirming that robo-advisers are required to provide advice that is consistent with their fiduciary duty and other obligations under the Advisers Act.  In addition to this previous guidance, the SEC confirms that the interpretations in the release also apply to robo-advisers.  Alternatively, the release is not intended to address “…the extent to which the Advisers Act applies to different types of impersonal investment advice.”   As defined in Rule 203A-3 of the Advisers Act, “impersonal investment advice” is investment advisory services provided by means of written material or oral statements that do not purport to meet the objectives or needs of specific individuals or accounts.

Regarding best execution, the SEC summarizes an investment adviser’s obligation in the context of an adviser who has the responsibility to select broker-dealers to execute client trades.  In such a situation, the adviser’s goal should be to maximize value for the client at the time of the transaction and to monitor and evaluate the execution it receives for its client.

In the context of employer-sponsored retirement plans, it is common that a named fiduciary of the plan, such as the plan’s trustee, is responsible for selecting the broker-dealer(s) for trade execution.  Thus, investment advisers providing services in connection with such plans may not have responsibility for best execution if they do not select the broker-dealer executing client trades.

Over the course of the relationship with a client, an investment adviser’s duty of care also includes an obligation to provide monitoring.  The SEC acknowledges that this obligation is determined, in part, by whether the service arrangement between the client and adviser is an ongoing or limited relationship.  In any event, an adviser’s duty to monitor applies not only to the advice provided, but also to an assessment of whether the client’s account or program type, such as a wrap account, is (and continues to be) in the client’s best interest.

In addition to an investment adviser’s duty of care, the release describes an adviser’s obligations in connection with its duty of loyalty.  To fulfill its duty of loyalty, the SEC summarizes a prior release and the Form ADV instructions by stating that an investment adviser “must make full and fair disclosure to its clients of all material facts relating to the advisory relationship.”  An investment adviser is also required to avoid conflicts of interest (if possible) and to disclose all material conflicts that cannot be avoided.  The disclosure must be provided in a clear manner with sufficient facts to enable a client to understand the conflicts and determine whether to provide informed consent.  The SEC states that “[d]isclosure of a conflict alone is not always sufficient to satisfy the adviser’s duty of loyalty…”  Thus, as explained in the release and our February 20 article, an investment adviser disclosing that it “may” have a conflict is not considered sufficient disclosure when a conflict exists.

The SEC acknowledges that a client’s informed consent can be explicit or implicit, depending on the circumstances.  However, they caution advisers that reliance on a client’s consent is questionable if either (1) the situation indicates that the client did not understand the nature or importance of the adviser’s conflict of interest, or (2) the material facts of the conflict could not be fully and fairly disclosed.   If the conflict of interest is complex or extensive, it can be challenging for advisers to explain the conflict so that clients can understand and evaluate it.  The SEC expects advisers to eliminate or mitigate any conflict that is difficult to adequately disclose to clients.  If the adviser seeks to mitigate (rather than eliminate) the conflict, such efforts must result in the adviser being able to describe the conflict so that the disclosure is appropriately specific and understandable to clients.

The SEC further acknowledges in the release that investment advisers’ minimum disclosure requirements, including disclosure of certain conflicts, are provided for in the Form ADV, Part 2A, which must be delivered to prospective clients “at or before entering into a contract.”   However, the SEC is proposing that investment advisers also be required to provide clients with a relationship summary to enhance a client’s understanding of the relationship, including any conflicts of interest that may exist.  The details of the proposed relationship summary are described in a subsequent article.

In addition to providing insight into the SEC’s views regarding an investment adviser’s fiduciary duty, the release requests comments in connection with three specific areas in which the SEC believes there may be a gap in investor protections, depending on whether a client engages a broker-dealer or an investment adviser.  The SEC is requesting comments on the following:

  • Federal Continuing Education and Licensing. Unlike registered representatives of broker-dealers, investment adviser representatives are not required under federal securities laws to become licensed or meet qualification requirements.  Instead, investment adviser representatives are required to meet state registration, licensing, or qualification requirements.  Thus, the SEC is requesting comments on whether there should be federal licensing and continuing education requirements for representatives of SEC-registered investment advisers.
  • Account Statements. Broker-dealers are required to provide periodic account statements to their clients that describe, among other information, account activity during the period.  However, except in limited circumstances, investment advisers are not required to provide account statements to their clients.  The SEC believes that clients would benefit from periodic account statements that help them understand (at a minimum) the fees and expenses they paid for an adviser’s services and is requesting comments as to whether SEC-registered investment advisers should be required to provide client account statements.
  • Financial Responsibility. Broker-dealers are required to maintain minimum levels of net capital, as well as segregate client assets so the assets can be easily returned to clients in the event the broker-dealer fails.  In addition, broker-dealers are subject to a variety of recordkeeping, reporting and bonding requirements.  SEC-registered investment advisers are not subject to similar net capital or bonding requirements.  The SEC requests comments on whether these differences should be addressed by making SEC-registered investment advisers subject to financial responsibility requirements that mirror those to which broker-dealers are subject.

As described above, the release is intended to reaffirm and clarify certain aspects of an investment adviser’s fiduciary duty.  However, the SEC is clear that the release is not intended to be the sole resource for investment advisers to understand the full scope of their fiduciary duty.   Regarding the requested comments, the SEC states in the release that it intends to consider the comments it receives to determine the appropriateness of future proposed rules or other proposed regulatory actions.  Thus, it is unclear whether this portion of the SEC’s fiduciary proposal will impact investors or the current practices of investment advisers – for better or worse.

This blog post was drafted by Beth Miller, an attorney in the Spencer Fane LLP Overland Park, KS office. For more information, visit spencerfane.com.