Client Alert

The SEC's Standard of Conduct Proposals Would Raise the Bar on Investment Advisers

26 Apr 2018

This alert is one in a series of Client Alerts on recent SEC proposals regarding regulation of broker-dealers and investment advisers.

Related alert:
SEC Proposes a New Standard of Care for Broker-Dealers: Regulation Best Interest
SEC Proposes Simplified Relationship Summary for Broker-Dealers and Investment Advisers to Use with Retail Investors

According to the Securities and Exchange Commission (SEC or “Commission”), its April 18, 2018 release proposing an interpretation of the standard of conduct for investment advisers (“Adviser Conduct Release”) is intended to “reaffirm – and in some cases clarify – certain aspects of the fiduciary duty that an investment adviser owes to its clients under section 206” of the Investment Advisers Act of 1940 (the “Advisers Act”).[1] As discussed in greater detail below, however, the proposed interpretation, if adopted, appears to expand the parameters of the fiduciary duty standard and could require advisers to take on additional regulatory obligations.

Even so, according to the Commission, the Adviser Conduct Release only highlights “principles relevant to an adviser’s fiduciary duty, [it is not] intended to be the exclusive resource for understanding” such principles.

The Investment Adviser Standard of Conduct: Fiduciary Duty

The Advisers Act and Commission rules established thereunder do not define the fiduciary duty standard for investment advisers. Nonetheless, it is well established that the fiduciary duty under the Advisers Act is comprised of a duty of care and a duty of loyalty.

Duty of Care

In the Adviser Conduct Release, the SEC states that, among other things, an adviser’s duty of care includes the duty to seek best execution of client transactions, the duty to provide ongoing advice and monitoring, and, of greatest significance, particularly in light of the Commission’s companion release proposing Regulation Best Interest, the duty to act in the best interest of the client.

According to the SEC, the best interest standard includes:

  • a duty to make a reasonable inquiry into a client’s investment profile (which includes the client’s financial situation, level of financial sophistication, investment experience, and investment objectives); and
  • “a duty to provide personalized advice that is suitable for and in the best interest of the client based on the client’s investment profile.”

The Commission previously proposed a rule that would have made explicit an adviser’s obligation to make suitable recommendations to its clients, but that rule was never adopted. In the Adviser Conduct Release, the SEC combined that suitability obligation with a fiduciary duty to act in the best interest of its clients and clarified that an adviser must have a reasonable belief that personalized advice provided to its clients meets that standard in light of on the client’s investment profile.

The Commission proposed the following factors upon which an adviser could make a reasonable determination that its advice is in the best interest of its client:

  • the costs (including fees and compensation) associated with providing investment advice;
  • an investment product’s or strategy’s investment objectives;
  • an investment product’s or strategy’s characteristics (including any special or unusual features);
  • the liquidity of an investment product or strategy;
  • the risks and potential benefits of an investment product or strategy; and
  • the investment product’s or strategy’s volatility and likely performance in a variety of market and economic conditions.

The SEC said that an adviser is not necessarily required to recommend the lowest cost investment product or strategy, but “[w]e believe 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.” Thus, under the SEC’s proposed interpretation of the fiduciary duty, an adviser must evaluate these – and potentially other – important factors, and make a reasonable investigation into whether lower cost but otherwise comparable products are available in the context of the client’s portfolio and its investment profile.

Duty of Loyalty

The duty of loyalty requires an investment adviser to put its client’s interests first. In addition, an investment adviser must not treat some clients favorably at the expense of other clients. Importantly, an adviser can shape the contours of its relationship with a client by providing full and fair disclosure of all material facts regarding the advisory relationship, including any conflicts of interest. These disclosures could be provided, in part, through Form CRS which the SEC has proposed be required for delivery to all retail clients who receive personalized investment advice. The SEC said, however, that disclosure of conflicts may not be sufficient to satisfy an adviser’s duty of loyalty. Accordingly, the Commission clarified that advisers have a duty to (1) obtain a client’s informed consent to disclosed conflicts of interest, or (2) eliminate the conflict or mitigate it sufficiently so that it can be better disclosed.

According to the Adviser Conduct Release, an adviser’s conflict of interest disclosure “should be sufficiently specific so that a client is able to decide whether to provide informed consent to the conflict of interest.” The Adviser Conduct Release was not specific with respect to whether or when an adviser must obtain affirmative (or explicit) informed consent as opposed to relying on deemed (or implicit) informed consent. The SEC does state, however, that accepting affirmative consent or inferring deemed consent would not be appropriate where either the client does not appear to understand the nature or importance of the conflict, or the material facts regarding the conflict could not be fully and fairly disclosed.

In cases where it is inappropriate for an adviser to accept or infer informed consent with respect to a conflict of interest, the SEC states that an adviser must “eliminate the conflict or adequately mitigate the conflict so that it can be more readily disclosed.” This clear expectation is a step further than the current regulatory scheme which, as the Commission noted, requires an adviser to “seek to avoid conflicts of interest with its clients and, at a minimum, make full and fair disclosure of all material conflicts of interest that could affect the advisory relationship.” Indeed, it seems to expand the congressional intent to “eliminate, or at least expose” conflicts of interest.[2]

Potential Proposals for Enhanced Regulation

In addition to its interpretation of the adviser standard of conduct, the Adviser Conduct Release also seeks comments about the possibility of imposing additional requirements on investment advisers. These requirements are borrowed from the broker-dealer regulatory framework and include: federal licensing and continuing education, financial responsibility requirements, and the provision of account statements. If adopted, such changes would further harmonize the regulation of investment advisers and broker-dealers.

Federal Licensing and Continuing Education

Advisory personnel are not currently obligated to obtain any licenses or educational degrees under the Investment Advisers Act, although some states do require certain licenses or educational degrees for certain advisory personnel. In considering a federal standard, the SEC suggested that such a requirement could be designed to address minimum and ongoing competency requirements. The possibility of imposing such a standard, however, raises many questions, including:

  • Which advisory personnel should be subject to competency requirements?
  • Should these individuals be required to register with the Commission and, if so, should the registration requirements mirror the requirements of existing Form U4 (used to register broker-dealer representatives) or should the Commission require additional or different information?
  • Should these individuals be required to pass examinations, such as the Series 65 exam required by most states, or to hold certain designations, as part of any registration requirements?
  • Should other steps be required as well, such as a background check or fingerprinting?

Financial Responsibility Requirements

Currently, investment advisers are not subject to any net capital requirements and are not required to obtain fidelity bonds. According to the Commission, “[w]hen we discover a serious fraud by an adviser, often the assets of the adviser are insufficient to compensate clients for their loss.” Accordingly, the SEC is considering whether to impose financial responsibility requirements on advisers, if, for example, commenters believe that the custody rule and other rules under the Advisers Act do not adequately address the potential for misappropriation of client assets and other financial responsibility concerns.

Provision of Account Statements

Currently, only advisers that have custody of client assets or serve as sponsor of certain managed account programs are required to provide clients with periodic account statements. The SEC asks whether all registered investment advisers should be required to deliver periodic account statements to clients. Among the questions asked by the Commission are questions about whether account statements should be provided through electronic delivery or through a notice-and-access process.

Our Take

In light of the heightened duties articulated by the Commission in the release, particularly on the issues of informed consent and enhanced regulatory requirements, we expect a robust response by the investment advisory community. In particular, we expect meaningful dialogue between the SEC and the industry about the distinctions between the adviser best interest standard, which includes an evaluation of suitability, and the new broker-dealer best interest standard, proposed as Regulation Best Interest, in the context of the existing broker-dealer suitability obligation. The Adviser Conduct Release does not explain why “suitability” is treated as a separate requirement for investment advisers when, in proposed Regulation Best Interest for broker-dealers, the suitability requirement appears to be subsumed within the best interest standard of care. In the final release, it will be important for the Commission to clarify what, if any, distinctions it is seeking to articulate in the standard of care for investment advisers.

Comments may be submitted on the Adviser Conduct Release for 90 days following its publication in the Federal Register.

[1] Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation, Rel. No. IA-4889 (April 18, 2018).

[2] SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963).



Unsolicited e-mails and information sent to Morrison & Foerster will not be considered confidential, may be disclosed to others pursuant to our Privacy Policy, may not receive a response, and do not create an attorney-client relationship with Morrison & Foerster. If you are not already a client of Morrison & Foerster, do not include any confidential information in this message. Also, please note that our attorneys do not seek to practice law in any jurisdiction in which they are not properly authorized to do so.