The SEC Interprets Investment Advisers’ Fiduciary Duty to Customersby Andrew Whiteman
The SEC Interprets Investment Advisers’ Fiduciary Duty to Customers
On June 5, 2019, the United States Securities and Exchange Commission issued Release No. IA-5248, titled Commission Interpretation Regarding Standard of Conduct for Investment Advisers (herein, “SEC Interpretation”). The same day, the SEC issued Release No. 34-86031, titled Regulation Best Interest: The Broker-Dealer Standard of Conduct (herein, “Regulation BI”). The SEC Interpretation applies to investment advisers registered under the Investment Advisers Act of 1940 (“Advisers Act”). Regulation BI applies to broker-dealers registered under the rules of the Financial Industry Regulatory Authority (“FINRA”). The SEC Interpretation and Regulation BI provide similar “best interest” standards to govern dealings between financial professionals and their customers. To allow sufficient time for financial professionals to implement the new requirements, the new rules become effective on June 30, 2020. This blog discusses the SEC Interpretation. A prior blog covered Regulation BI.
The SEC Interpretation is not a rule, like Regulation BI. As such, the SEC Interpretation merely provides the SEC’s views on the nature and extent of the fiduciary duty owed by investment Advisers under the Advisers Act. The Advisers Act itself does state that investment advisers are fiduciaries to their customers. Courts have held that section 206 of the Act (29 U.S.C. § 80b-6) establishes federal fiduciary standards to govern the conduct of investment advisers. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963) (“Courts have imposed on a fiduciary an affirmative duty of ‘utmost good faith, and full and fair disclosure of all material facts,’ as well as an affirmative obligation ‘to employ reasonable care to avoid misleading’ his clients.”).
The fiduciary duty owed by investment advisers encompasses both a duty of care and a duty of loyalty. In Capital Gains, the U.S. Supreme Court wrote that section 206 of the Advisers Act reflects a Congressional recognition “of the delicate fiduciary nature of an investment advisory relationship” as well as a Congressional intent to “eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser – consciously or unconsciously – to render advice which was not disinterested.” 375 U.S. at 191-92.
Best Interest = Duty of Care and Duty of Loyalty
The SEC used the term “best interest” to encompass both the duty of care and the duty of loyalty. SEC Interpretation, p. 8. The duty of care requires the investment adviser to provide advice in the best interest of its client, based on the client’s financial situation and goals. Id. Importantly, the SEC does not require that an adviser avoid all conflicts of interest in its dealings with its clients. Instead, the SEC Interpretation states that an adviser satisfies its duty of loyalty if it “makes full and fair disclosure of all conflicts of interest which might incline an investment advisor – consciously or unconsciously – to render advice which is not disinterested such that a client can provide informed consent to the conflict.” Id.
Duty of Care
According to the SEC, the duty of care is primarily satisfied by providing investment recommendations that are “suitable” for the client. Interpretation. p. 12. “Suitability” is a concept borrowed from the regulation of broker-dealers by FINRA. See FINRA Rule 2111. Investment adviser recommendations must be “suitable” for the customer in light of information disclosed by the customer concerning the customer’s investment profile, ie. the client’s financial situation, level of financial sophistication, investment experience, and financial goals. Interpretation, p. 9.
Duty of Loyalty
The SEC Interpretation states that the duty of loyalty requires that “an advisor not subordinate its clients’ interests to its own” and “not place its own interest ahead of its client’s interests.” However, this duty of loyalty is met, not by requiring that the adviser “put its client’s interests first,” which was the language of the 2018 Proposed Interpretation, but by making “full and fair disclosure to its clients of all material facts relating to the advisory relationship.”
The SEC Interpretation gives several examples of matters that require full and fair disclosure. Dual-registered broker-dealers and investment advisors must disclose “the circumstances in which they intend to act in their brokerage capacity and the circumstances in which they intend to act in their advisory capacity.” Disclosure of the capacity in which the adviser is acting may be made at the commencement of the relationship. A dual registrant acting in its advisory capacity should disclose any circumstances in which its advice will be limited to a menu of certain products offered through an affiliated broker-dealer or an affiliated investment adviser. SEC Interpretation, p. 22. In addition, an adviser must eliminate or “expose through full and fair disclosure all conflicts of interest which might incline the investment adviser – consciously or unconsciously – to render advice which was not disinterested.” While such disclosure and the client’s informed consent prevent the presence of the conflicts from violating the adviser’s fiduciary duty, such disclosure and consent do not themselves satisfy the adviser’s duty to act in the client’s best interest. SEC Interpretation, p. 23. The SEC sees the advisers’ delivery to their clients of the “brochure,” under Part 2A of Form ADV, as the primary means for advisers to satisfy their duty of disclosure.
Best Interest? What’s That?
Strangely, given the importance of the term “best interest,” nowhere in the Interpretation does the SEC define. it. All the SEC Interpretation tells us is that “an investment advisor’s obligation to act in the best interest of its client is an overarching principle that encompasses both the duty of care and the duty of loyalty.” SEC Interpretation, p. 23, at n.58. The SEC’s failure to be more definite about when “best interest” is and is not satisfied is unfortunate and unhelpful.
To say that full and fair disclosure of material facts and conflicts of interest satisfies the adviser’s fiduciary duty but not necessarily the duty to act in the customer’s best interest begs the question – what exactly is the adviser’s duty to its clients? The SEC’s formulation resembles a dog that chases its tail but never catches it. An adviser’s fiduciary duty, we are told, consists of a duty of care and a duty of loyalty. Care and loyalty require the adviser to “act in the ‘best interest’ of the client at all times.” SEC Interpretation, p. 8. To meet its duties, the adviser’s recommendation must be “suitable.” While never mentioning the FINRA suitability standard applicable to broker-dealers under FINRA Rule 2111, the SEC Interpretation for the first time adopts it as the standard applicable to investment advisers. SEC Interpretation, pp. 12-18.
The duty of loyalty requires that an adviser may not place its own interest ahead of those of its client. Disclosures made in a “brochure” provided at the outset of the adviser-client relationship may satisfy the adviser’s fiduciary duty, but disclosure and consent “do not themselves satisfy the adviser’s duty to act in the client’s best interest.”
The SEC Interpretation has been widely criticized on many grounds. For one thing, the Proposed Interpretation stated explicitly that “the duty of loyalty requires an investment adviser to put its client’s interests first.” Proposed Interpretation, p. 15. The version adopted by the Commission replaced that sentence with the statement that the duty of loyalty “requires that an adviser not subordinate its clients’ interests to its own,” which the SEC explained means that an advisor cannot favor its own interests over those of a client. SEC Interpretation, p. 21. In an accompanying footnote, the SEC stated that it had made a mistake by referring to “placing clients’ interests first” in the Proposed Interpretation. According to the SEC, it had previously adopted the formulation that the best interest duty “includes the obligation not to subrogate clients’ interests to its own.” The SEC conceded that advisers commonly used “a plain English formulation” – putting the client’s interests first – as a means of explaining their duty of loyalty in a way “that may be more understandable to retail clients,” but argued that this was not the legal standard. SEC Interpretation, pp. 21-22, at n.54.
The failure to require advisers to place their clients’ interests first is the main point stressed by Commissioner Robert L. Jackson, the lone dissenter to both the SEC Interpretation and Regulation Best Interest. In a statement released on the day the Commission voted, Commissioner Jackson pointed to empirical evidence. According to Commissioner Jackson, the vast majority of firms that describe their fiduciary duty to their clients tell the public that they place their clients’ interests first. The Commission’s Interpretation retreats from that standard. In Commissioner Jackson’s words, “the Commission is wrapping a policy choice in legalese” and the Commission’s refusal to require advisers to place client interests first is contrary to the prevailing standard of care.
 On April 18, 2018, the Commission published for comment a proposed interpretation regarding the standard of conduct for investment advisers. See Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation, Investment Advisers Act Release No. 4889 (Apr. 18, 2018) (“Proposed Interpretation). The SEC Interpretation was adopted after the SEC considered comments made in response to the Proposed Interpretation.
© Andrew Whiteman 2019
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