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On June 5, 2019, the SEC issued an Interpretive Release designed to “reaffirm, and in some cases clarify, the standard of conduct that investment advisers owe to their clients.” The Interpretive Release highlights existing principles relevant to an adviser’s fiduciary duty; it does not create any new regulation.

SEC Clarifies Investment Adviser Standard of Conduct

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On June 5, 2019, the SEC issued an Interpretive Release designed to “reaffirm, and in some cases clarify, the standard of conduct that investment advisers owe to their clients.” The Interpretive Release highlights existing principles relevant to an adviser’s fiduciary duty; it does not create any new regulation.The Interpretive Release sets forth the SEC’s views on the application of Section 206 of the Investment Advisers Act of 1940 (the “Advisers Act”) to SEC-registered advisers, state‑registered advisers and investment advisers that are exempt from registration (including exempt reporting advisers) or that are subject to a prohibition on registration under the Advisers Act. In short, any entity or individual that meets the definition of “investment adviser” set forth in the Advisers Act will be held to the standards outlined in the Interpretive Release.Investment Advisers’ Fiduciary DutiesNotwithstanding that nothing in the Investment Advisers Act and its related regulations specifically states that an investment adviser has a fiduciary obligation to its clients, it is well established that an investment adviser owes its clients the duty of care and the duty of loyalty. This principles-based approach has worked well over time, and the Interpretive Release makes it clear that such an approach should continue, “as it expresses broadly the standard to which investment advisers are held while allowing them flexibility to meet that standard in the context of their specific services.” The Interpretive Release reaffirms a disclosure-based approach to the fiduciary duty owed by an adviser to its clients. That is, the requirement to “eliminate, or at least to expose, all conflicts which might incline an investment adviser – consciously or unconsciously – to render advice which [is] not disinterested.”The Interpretive Release clarifies that specific fiduciary obligations will be shaped by the terms of the agreement reached between an adviser and its clients and acknowledges that investment advisers may provide advice to a wide variety of clients, ranging from retail clients with “limited assets and investment knowledge and experience” to institutional clients with “substantial knowledge, experience and analytical resources.” The Interpretive Release distinguishes between the obligations of an adviser providing “comprehensive, discretionary advice” in a retail client relationship and the obligations of an adviser to a registered investment company or private fund, where the terms of the relationship are established in a negotiated contract. That said, however, “the relationship in all cases remains that of a fiduciary to the client . . . [and] an adviser’s federal fiduciary duty may not be waived.” Moreover, an investment adviser’s fiduciary duty applies to the entire adviser–client relationship.  Duty of CareThe Interpretive Release expounds on specific provisions of the duty of care including, among other things: (i) the duty to provide advice that is in the best interest of a client, (ii) the duty to seek best execution of a client’s transactions when the adviser has the responsibility to select broker-dealers to execute client trades, and (iii) the duty to provide advice and monitoring over the course of the relationship.   Advice in a Client’s Best Interest. In order to ensure that its advice is in a client’s best interest, an adviser must determine whether such advice is suitable for the client based on a reasonable understanding of its client’s objectives. In the case of a retail client, an investment adviser should understand the client’s “investment profile”; that is, the client’s financial situation, level of financial sophistication, investment experience, and financial goals. An investment adviser should also consider, among other things, whether a client can tolerate the risks of a particular investment in light of its potential benefits. In the case of institutional clients, the Interpretive Release suggests that an adviser should evaluate suitability based on a client’s specific investment mandate and objectives as agreed between the adviser and the client. In either case, an adviser should conduct an investigation into a potential investment sufficient to ensure that the adviser is not basing its advice on materially inaccurate or incomplete information. The Interpretive Release also makes it clear that all advice provided by an adviser must be in its clients’ best interest.  Thus, an adviser should consider client suitability when providing advice about investment strategy, engaging a sub-adviser, recommending a particular type of account, or advising whether to roll over assets from one account (e.g., a retirement account) into a new or existing account managed by the adviser or its affiliates. According to the SEC, when providing advice about account type, an adviser should provide its clients with information about other account types offered by the adviser and why the adviser believes such accounts are not in the client’s best interest.Best Execution. The duty of care also obligates an adviser to seek “best execution” of transactions on behalf of a client for whom the adviser has responsibility to choose executing brokers. According to the Interpretive Release, an adviser can fulfill this duty by seeking tomaximize value for the client under the circumstances at the time of the transaction. The SEC clarified, however, that maximizing value does not mean just minimizing cost. Rather, an adviser should consider “the full range and quality of a broker’s services in placing brokerage including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness.” Providing Advice and Monitoring Over the Course of a Relationship. The SEC stated that an adviser should provide advice and monitoring at a frequency that is in the best interest of the client, in light of the agreed upon scope of the relationship. Among other things, this may be reflected in the type of fees paid by a client. For example, if an adviser is compensated by a periodic asset-based fee, the adviser’s obligation to monitor the client’s account may be relatively extensive versus the monitoring responsibility for a client who pays a one-time fee for receipt of a financial plan. In an on-going relationship, the adviser also has an obligation to consider whether the specific type of account in which a client’s assets are held continued to be suitable for that client.Duty of LoyaltyThe duty of loyalty requires that an adviser not subordinate its clients’ interests to its own interests. According to the SEC, an adviser must make full and fair disclosure of all material facts related to the advisory relationship with its clients and the conflicts of interest that may result from such relationships in order for a client to provide informed consent. Such disclosure may occur through delivery of a brochure (i.e., Part 2A of Form ADV) or a written agreement between an adviser (particularly a dually-registered adviser) and its clients that sets forth the capacity in which the adviser is hired.The SEC clarified that while full and fair disclosure of all material facts related to the advisory relationship or conflicts of interest, coupled with a client’s consent, will prevent such material fact or conflicts of interest from violating the adviser’s fiduciary duty, such disclosure and consent do not alone satisfy the adviser’s duty to act in a client’s best interest. In some cases, conflicts may be of a nature and extent that it would be difficult to provide disclosure adequate to convey the material facts or the magnitude and potential effect of the conflicts such that a client can provide fully informed consent. In such cases, the Interpretive Release suggests that an adviser should either eliminate the conflict or adequately mitigate it, through policies and procedures, such that full and fair disclosure and informed consent are possible.Specificity of Disclosure. In order for disclosure to meet the standard of care applicable to an investment adviser, the adviser must disclose existing or potential conflicts of interest with an appropriate level of specificity. Among other things, the SEC cautioned that it is not appropriate to state that an adviser “may” have a conflict, without additional disclosure, if the conflict actually exists. Similarly, an adviser cannot disclose that it has “other clients” without describing how the adviser manages conflicts among its clients. In other words, disclosure regarding conflicts of interest must be clear and adequately detailed to enable a client to give its informed consent to the conflict of interest.Allocation of Transactions. An adviser may have conflicts of interest among its clients with respect to the allocation of investment opportunities and must ensure that disclosure related to its allocation policies and related conflicts of interest is complete, accurate and fair so that a client can provide informed consent. The Interpretive Release makes it clear, however, that an adviser can consider its clients’ objectives, and the scope of the relationship with its clients, when allocating investment opportunities, and need not simply adopt a pro rata allocation policy. Allocation polices must, however, not prevent an adviser from operating in the best interests of its clients. Our TakeThe Interpretive Release does not include new regulation. It does, however, provide clarity regarding the type of disclosure, policies and procedures that should be adopted by an adviser to ensure it continues to operate in a manner consistent with its fiduciary obligations. Investment advisers should take the opportunity to review their disclosure, including their Form ADV Part 2A, to ensure that the disclosure in such document is full, fair and not misleading. Advisers should also consider whether their policies and procedures are reasonably designed to ensure that they continue to meet the standards outlined in the Interpretive Release.