(Article from Registered Funds Alert, June 2018)
For more information, please visit the Registered Funds Alert Resource Center.
The SEC issued three highly anticipated and significant proposals earlier this year that have the potential to significantly alter the regulation of broker-dealers and investment advisers. These proposals address enhanced standards of conduct for broker-dealers and propose an interpretation clarifying the fiduciary duty owed by investment advisers. In the aftermath of the United States Court of Appeals for the Fifth Circuit’s decision to vacate the Department of Labor’s “fiduciary rule,” the SEC’s proposals have been widely followed by broker-dealers and advisers looking for clarity as to the scope of their duties and liabilities. During the open meeting to consider these proposals, the SEC’s commissioners expressed a healthy range of views and concerns, but in voting four to one in favor of submitting the proposals for public comment the commissioners signaled to broker-dealers and advisers that they recognize the uncertainties surrounding fiduciary standards and are willing to take substantial steps towards transparency.
The first proposal, “Proposed Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation,” interprets the SEC’s views of the fiduciary duties advisers owe their clients and requests comments on whether the SEC should propose rules to impose certain licensing, continuing education, and other FINRA-like obligations on advisers. The second proposal, “Regulation Best Interest,” would require a broker-dealer to act in a retail customer’s best interest when it makes securities recommendations—i.e., the proposed regulation is designed to prohibit a broker-dealer from putting its financial interests ahead of its retail customers. The third proposal, “Form CRS Relationship Summary; Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles,” would mandate that advisers and broker-dealers provide retail customers with summary information about the nature of the client relationship, and would restrict certain broker-dealers from using the terms “adviser” or “advisor” as part of their name or title when dealing with retail customers.
This Alert focuses on the SEC’s interpretation of advisers’ standard of care, but the importance of the proposals relating to broker-dealer duties and disclosure applicable to retail investors cannot be overstated in light of the SEC’s effort to enhance the quality and transparency of retail investor relations.
Standard of Conduct for Investment Advisers
The SEC’s proposed interpretation reaffirms and clarifies certain standards of conduct applicable to advisers under the Investment Advisers Act of 1940 (the “Advisers Act”). The federal fiduciary standard for advisers under the Advisers Act comprises two broad duties: the duty of care and the duty of loyalty. The identity of fiduciaries and the scope of their responsibilities are sometimes open to debate. The Department of Labor’s attempted fiduciary rule did not succeed in establishing clear fiduciary standards, but, with a few exceptions, the SEC’s proposal does. Our thoughts on the SEC’s interpretation of advisers’ duty of care and duty of loyalty are summarized below, including a key criticism related to the SEC’s apparent view regarding how advisers allocate investments across multiple eligible client accounts.
Duty of Care
According to the proposal, an adviser’s duty of care to a client includes, among other things: (i) the duty to act and to provide advice that is in the best interest of the client; (ii) 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 (iii) the duty to provide advice and monitoring over the course of the relationship.
(i) Duty to Provide Advice that is in the Client’s Best Interest
When providing personalized investment advice, the duty of care requires that an adviser make a reasonable inquiry into a client’s financial situation, level of financial sophistication, investment experience and investment objectives, which the proposal refers to as the client’s “investment profile.” Understanding a client’s investment profile allows an adviser to provide suitable advice that is consistent with the best interests of the client. Advisers typically engage in suitability analyses when allocating investment opportunities amongst client accounts. The proposal establishes a reasonableness standard to assess an adviser’s inquiry into its clients’ investment profiles, the nature and extent of which turn on what is reasonable under the circumstances, including the agreed-upon advisory services, the complexity of the anticipated investment advice and the investment profile of the client.
The proposal notes that, when allocating investments, advisers should consider a client’s risk tolerance and the costs of such investments (among other things). Contrary to the belief that swept through the industry and contributed to the proliferation of “clean shares” after the Department of Labor’s fiduciary rule was adopted, the SEC’s proposal recognizes that context matters and notes that the duty of care does not require that an adviser recommend the lowest cost investment to its clients. However, the proposal qualifies this statement by explaining that the SEC’s view is that an adviser could not reasonably believe that a security is in the best interest of a client if it has a higher cost than a security that is otherwise identical. The proposal notes that, if an adviser advises a client to invest in a mutual fund share class that is more expensive than other available options when the adviser is receiving compensation that creates a potential conflict and that may reduce the client’s return, the adviser may violate its fiduciary duties and the antifraud provisions of the Advisers Act if it does not, at a minimum, provide full and fair conflicts disclosure and obtain informed consent to such conflicts. The interpretation recognizes that a more expensive product’s suitability depends on a client’s investment profile and the context in which the adviser manages the portfolio. For example, it could be consistent with an adviser’s fiduciary duty to advise a client with a high risk tolerance and significant investment experience to invest in a private equity fund with relatively higher fees if other factors, such as diversification and potential performance benefits, support the investment as being in the client’s best interest.
(ii) Duty to Seek Best Execution
The proposal provides that an adviser’s duty of care extends to its selection of broker-dealers to execute client trades. The proposal describes “best execution” to mean a client’s total cost or proceeds from a transaction must be the most favorable under the circumstances. An adviser fulfills this duty by executing transactions with the goal of maximizing value for the client under the given circumstances, and the SEC recognizes that maximizing value entails more than minimizing cost.
In seeking best execution, the proposal notes that advisers should consider the full range and quality of a broker’s services, including the value of research provided. Institutional advisers commonly use soft dollar credits to execute trades with broker-dealers in exchange for research; there is no indication the SEC intends to reign in this practice by viewing execution costs in a vacuum.
(iii) Duty to Act and to Provide Advice and Monitoring Over the Course of the Relationship
Asserting a perpetual nature of the duty of care, the proposal states that an adviser must provide advice and monitoring over the course of the client relationship at a frequency that is in the best interest of the client and consistent with the scope of the agreed-upon advisory services. The proposal highlights this duty for advisers that have ongoing client relationships, specifically referencing advisers that are compensated with a periodic asset-based fee (as opposed to transaction-based fees) or that have discretionary authority over client assets, which generally applies to advisers to registered funds.
Duty of Loyalty
The proposal interprets the duty of loyalty broadly to require that an adviser put its clients’ interests ahead of its own and refrain from unfairly favoring one client over another. To meet this duty, the proposal provides that an adviser must make full and fair disclosure to its clients of all material facts relating to the advisory relationship and all material conflicts that could affect the advisory relationship. The prominence of conflicts disclosure in the interpretation reaffirms that an adviser’s duty to avoid conflicts with its clients and, at a minimum, disclose such conflicts is a cornerstone of the duty of loyalty. The proposal further states that advisers need to describe conflicts with sufficient specificity to give investors the ability to provide informed consent. This is not a new concept, but that statement will further empower examiners to push for more specificity in conflicts disclosure. The proposal notes that disclosing the mere possibility of a potential conflict is not adequate when such conflict actually exists, a point which was emphasized at the SEC’s annual Compliance Outreach Program National Seminar in April 2018.[1] As such, advisers may wish to consider amending their Form ADV brochures and other sources of conflicts disclosure to disclose conflicts in definite terms rather than in the abstract.
The proposal interprets the duty of loyalty to include a duty not to treat some clients favorably at the expense of other clients. Thus, when allocating investment opportunities among eligible clients, the proposal said that an adviser must treat all clients fairly. We note that the proposal stops short of saying that clients must be treated “equally.” Without further guidance as to the SEC’s definition of “fairly,” the proposal could be interpreted to prohibit the common practice among advisers to allocate specific investment opportunities to clients with priority rights on certain types of investments, even though other clients might have eligible investment profiles. The proposal cites to an article that provides that an adviser must not give preferential treatment to some clients or systematically exclude eligible clients from participating in specific opportunities without providing the clients with the appropriate disclosure regarding the treatment. The proposal further notes that an adviser’s allocation policies must be fair and, if they present a conflict, the adviser must fully and fairly disclose such conflict that a client can provide informed consent.[2] The proposal stops short of deeming it permissible to exclude certain clients from investments if the adviser has disclosed its practice to do so, but by citing to this article, it may have incorporated this position by reference.
An adviser’s conflicts disclosure should include a clear methodology for allocating investment and disposition opportunities across multiple eligible client accounts. It is not uncommon for such methodologies to contemplate strategic relationships with individual clients, other third parties or affiliates that provide for preferential “first rights” on certain investments or categories of investments. An otherwise eligible client may be excluded from an investment opportunity if an adviser has such a strategic relationship. The proposal’s fairness standard does not necessarily conflict with first-rights allocation methodologies. Advisers may enter into strategic relationships for a variety of reasons, including to receive referrals, reliable liquidity and reciprocal first rights. Preferential allocations are not inherently “unfair” (when clearly disclosed), as the benefits of strategic relationships are generally shared among clients, but we expect continued uncertainty on this point without further clarification from the SEC.
[1] The SEC has found an adviser’s disclosure inadequate because it stated the adviser may receive compensation from a broker as a result of facilitating client transactions through the broker and that these arrangements may create a conflict of interest when the adviser was actually receiving such payments and had such a conflict. See In the Matter of The Robare Group, Ltd., et al., Investment Adviser Act Release No. 4566 (Nov. 7, 2016).
[2] This requirement is consistent with an advisers’ responsibility to maintain policies and procedures that address allocation of investment opportunities and disclosure, and to provide clients with sufficiently specific facts so that the client is able to understand the adviser’s conflicts of interest and give informed consent to such conflicts or reject them. See Investment Advisers Act Release No. 2204 (Dec. 17, 2003); General Instructions for Part 2 of Form ADV.