SEC Reaffirms and Clarifies the Meaning of an Investment Adviser’s Fiduciary Duty

As part of its June 5^th landmark issuance of multiple final rules and interpretive releases dealing with broker and advisory standards-of-conduct—which included the long-awaited Regulation Best Interest (or “Reg BI”) for broker/dealers—the SEC also published a detailed interpretive release clarifying and interpreting an investment adviser’s fiduciary duty (the “Fiduciary Release”). While this blog has already provided an analysis of the high-level contours of the SEC’s entire package of rules and releases, we now write to give readers a closer look at the Fiduciary Release, which should be of particular interest to the advisory community.

The Fiduciary Release is the culmination of a regulatory process begun on April 18, 2018, with the SEC’s publication of a draft release on advisory fiduciary duties. The SEC also published draft releases of Reg BI and the Form CRS Relationship Summary (“Form CRS”)(a new disclosure document for advisers and brokers) on that date as well. However, we note at the outset that, unlike the final Reg BI and Form CRS rules—which will not be implemented until June 30, 2020—the Fiduciary Release is effective upon formal publication in the Federal Register. Since that formal publication has already occurred, the Fiduciary Release is now effective. Additionally, we note that the Fiduciary Release is legally applicable to not only SEC-registered investment advisers, but also to state-registered advisers and other investment advisers that are exempt from registration under the federal Advisers Act.

The SEC’s stated objective in issuing the Fiduciary Release is to “reaffirm” and “clarify” the longstanding fiduciary duty of an investment adviser as expressed in section 206 of the Advisers Act. Recognizing that this fiduciary standard has been developed over decades via case law in the form of judicial opinions as well as through SEC enforcement proceedings and no-action letters, the SEC notes that the Fiduciary Release is not intended to be the “exclusive resource” for articulating the fiduciary standard. Importantly, the Fiduciary Release does not explicitly declare any revisions to the advisory standard of conduct (as does Reg BI vis-à-vis broker/dealers).

The Fiduciary Duty of an Investment Adviser.

At its most basic level, the SEC sees an adviser’s fiduciary duty as being comprised of two constituent duties: (i) a duty of care; and (ii) a duty of loyalty. As stated by the SEC, “the duty of care requires an investment adviser to provide investment advice in the best interest of its client, based on the client’s objectives.” In turn, an investment adviser’s duty of loyalty requires that it “eliminate or make full and fair disclosure of all conflicts of interest which might incline an investment adviser—consciously or unconsciously—to render advice which is not disinterested such that a client can provide informed consent to the conflict.”

Importantly, an investment adviser’s fiduciary duty may not be waived by contract or otherwise. That said, an adviser’s fiduciary duty may be customized to fit the specific principal-agent relationship agreed upon contractually as between client (principal) and adviser (agent). The SEC articulates this nuance by way of example, noting that the fiduciary obligations of an adviser providing comprehensive, discretionary advice to a retail client will be significantly different than those of an adviser to an institutional client, such as a mutual fund, hedge fund, or other pooled vehicle. But, no matter the type of client or advisory functions being performed, any “blanket waiver” of either an adviser’s fiduciary duties or prevailing conflicts of interest would be “inconsistent with the Advisers Act, regardless of the sophistication of the client.”

The Duty of Care

As noted above, the SEC interprets an adviser’s duty of care as requiring the adviser to provide advice that is in conformity with the best interests of its client based upon that client’s objectives. The Fiduciary Release further clarifies that this duty includes the duty to provide advice that is suitable. In order to do this, the adviser essentially must have a reasonable understanding of the client’s objectives. While the mechanics as to how an adviser establishes this “reasonable understanding” will vary based on the facts and circumstances, for a retail client, an adviser should, “at a minimum, make a reasonable inquiry into the client’s financial situation, level of financial sophistication, investment experience, and financial goals.” Additionally, an investment adviser must conduct a reasonable investigation into the investment itself, sufficient so that it does not base its advice on materially inaccurate or incomplete information.

The Fiduciary Release also interprets this duty of care as including (i) a duty to seek best execution of a client’s trades in situations where the adviser selects the client’s broker-dealer, and (ii) a duty to provide a steady level of advice and monitoring over the course of the adviser-client relationship. According to the Fiduciary Release, an adviser meets its best execution obligation by “maximizing value” in the context of the “particular circumstances occurring at the time of the transaction.” Notably however, “maximizing value” is not the same as “minimizing cost.” Indeed, an adviser must consider a broker’s full menu of services, which would include the broker’s research, as well as execution capability, commission rate, financial responsibility, and responsiveness.

As for the “advice and monitoring” prong of the duty of care, the Fiduciary Release articulates this obligation as being satisfied where advice and monitoring is done at intervals that are frequent enough to be in the best interest of the client given the scope and context of the advisory relationship. By way of example, the SEC explains that where the adviser is compensated with a periodic asset-based fee, the adviser’s duty to provide advice and monitoring will be relatively extensive. Alternatively, where the relationship is of “limited duration” or even “one-time,” as in the case of financial planning, the advice and monitoring obligation will be minimal.

The Duty of Loyalty

According to the Fiduciary Release, the duty of loyalty, in a nutshell, requires that the adviser “must not place its own interest ahead of its client’s interests.” This effectively means that an adviser “must make full and fair disclosure to its clients of all material facts relating to the advisory relationship.” In turn, such material facts will include, among other things, the capacity in which the firm is acting. Importantly, full and fair disclosure mandates an adviser to “eliminate or at least expose . . . all conflicts of interest which might incline an investment adviser—consciously or unconsciously—to render advice which was not disinterested.” This serves the purpose of enabling the client to properly understand the conflict and, in turn, provide informed consent.

Indeed, informed consent to prevailing conflicts is a cornerstone of the duty of loyalty. While the Fiduciary Release explains that informed consent may be either explicit or implicit, and does not require advisers to independently confirm that a particular client actually understands a disclosure or that such client’s consent is truly “informed,” advisers may not infer or accept client consent where the adviser knows or has reason to know the client did not comprehend the nature or importance of the conflict. As the SEC explains, in some cases, a conflict may be too difficult to describe or too complicated to explain. In other cases, the client may not be able to understand the conflict no matter how detailed the explanation. Again, this may be especially problematic for retail clients. Simply put, in such cases “where an investment adviser cannot fully and fairly disclose a conflict of interest to a client such that the client can provide informed consent, the adviser should either eliminate the conflict or adequately mitigate . . . the conflict such that full and fair disclosure and informed consent are possible.”

Part and parcel of providing full and fair disclosure is ensuring that it is sufficiently specific for the client to, in turn, be able to provide an informed consent. In this regard, the Fiduciary Release conveys guidance on the appropriateness of an adviser stating that it “may” have a conflict in certain situations. On this score, the Fiduciary Release explains that an adviser’s disclosure that it “may” have a particular conflict is improper in cases where the conflict actually exists. As the SEC explains, the word “may” is only appropriate in cases where a potential conflict, that might present itself in the future, does not currently exist. Notably, the Fiduciary Release recognizes the recent Robare case (examined by us in a recent blog post), in which the DC Circuit Court of Appeals found that disclosure that an adviser “may” receive a certain form of compensation was wholly inadequate where that adviser actually did have an arrangement whereby it received exactly that type of compensation.