(Article from Registered Funds Alert, October 2018)
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Earlier this year, the SEC issued a package of regulatory proposals interpreting and enhancing the standards of conduct for broker-dealers and investment advisers. In our previous Alert, we focused on the SEC’s interpretation of advisers’ standards of conduct. In this Alert, we will summarize the industry response to the proposals based on comment letters that were submitted to the SEC.
By the expiration of the 90-day public comment period, the SEC had received:
- nearly 150 comments to the proposal relating to the SEC’s interpretation of the fiduciary duties owed by investment advisers to their clients;
- over 2,500 comments to the proposal relating to enhancing broker-dealers’ standards of conduct towards retail clients; and
- over 270 comments to the proposal relating to new disclosure requirements for advisers and broker-dealers on Form CRS.
The SEC has continued to receive additional comments since the expiration of the formal comment period.
This Alert summarizes three primary concerns noted in comments to the proposal interpreting advisers’ fiduciary duties towards their clients. The comments consistently noted:
- the inconsistency between the proposal’s interpretation of advisers’ duty of loyalty and established precedent;
- the need for further clarification on advisers’ abilities to define the scope of the advisory relationship by contract and on the meaning of “informed consent” with respect to conflicts of interest; and
- the lack of distinction between fiduciary duties owed to retail and institutional clients.
This Alert also summarizes, at a high level, the concerns noted in comments to the proposals relating to broker-dealers’ standards of conduct and Form CRS.
Proposed Investment Adviser Interpretation
The proposal’s interpretation of advisers’ duty of loyalty is inconsistent with established precedent and industry practices.
The proposal interpreted the duty of loyalty broadly to require an adviser to put its clients’ interests ahead of its own and to refrain from unfairly favoring one client over another. To meet this duty, the proposal required that an adviser make “full and fair disclosure to its clients of all material facts relating to the advisory relationship.” In this regard, the proposal is consistent with the U.S. Supreme Court’s decision in SEC v. Capital Gains Research Bureau, in which the Court noted, “[c]ourts 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’ [its] clients.”
But the proposal goes one step further by suggesting advisers should eliminate conflicts that are too complex to disclose with sufficient specificity. Several commenters noted that this interpretation is inconsistent with Capital Gains, which provided that the Investment Advisers Act of 1940 (the “Advisers Act”) reflects “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 [emphasis added].” Commenters pointed to this language as evidence that clear disclosure of conflicts should be sufficient without the need to eliminate such conflicts. As one commenter noted, “the suggestion that some conflicts are too complex for an investment adviser to be able to fulfill its fiduciary duty through disclosure is not supported in the law.”
Advisers address complex conflicts in a number of different ways. For example, firms may erect information walls to restrict an adviser’s access to material non-public information (“MNPI”) obtained by affiliates, including requiring that employees certify that they do not and have not shared MNPI. To further address this conflict, the adviser may disclose that it could be deemed to possess MNPI, despite the fact that such MNPI was obtained by an affiliate. In addition, strategic relationships between firms and investors whereby an investor makes capital commitments to an adviser and multiple affiliates often give rise to complex conflicts due to the additional rights that inure to the benefit of the investor in consideration of its aggregate commitment. Advisers typically address these conflicts by clearly disclosing the existence and implications of strategic relationships.
The proposal’s suggestion that certain conflicts are too complex or expansive to be understood by clients is inconsistent with industry practice and existing disclosure requirements. When completing Form ADV, advisers are required to disclose conflicts in plain English and instructed to use tables or bullet lists for complex material and to avoid legal jargon or highly technical business terms unless advisers explain them or believe their clients will understand them.
In sum, the industry emphasized to the SEC that the proposal’s suggestion that disclosure and informed consent may be insufficient to satisfy an adviser’s fiduciary duty of loyalty is inconsistent with the current state of the law and industry practice.
The SEC should clarify advisers’ abilities to define the scope of the advisory relationship by contract and the meaning of “informed consent” with respect to conflicts of interest.
Commenters highlighted inconsistencies between the proposal and industry practice, in addition to within the proposal itself, with respect to an adviser’s ability to define the scope of its duties through contract, and the proposal’s lack of specificity when describing what constitutes “informed consent,” which the proposal did not clearly define.
While the proposal explained that advisers and clients may shape their relationship through contract when the client receives full and fair disclosure and provides informed consent, it goes on to assert that an adviser “cannot disclose or negotiate away, and the investor cannot waive, the federal fiduciary duty.” One commenter noted that this assertion is not supported by any case law or the realities of the marketplace, explaining that advisers often engage in practices that present potential conflicts that could be inconsistent with their fiduciary duties (e.g., using client brokerage commissions to pay for research that may not directly benefit the client) after clearly disclosing such conflicts and obtaining client consent via contract; however, in these cases, the adviser does not generally waive its duties as a fiduciary. This commenter suggested that, to avoid confusion over an adviser’s ability to enter into agreements defining the scope of its services and duties, the assertion that an adviser “cannot disclose or negotiate away, and the investor cannot waive, the federal fiduciary duty” should be limited to situations involving a blanket waiver of all conflicts or the use of disclosure that is not reasonably designed to be full and fair to the client. Similarly, another commenter submitted that the SEC should clarify this assertion to reaffirm the ability of an adviser and its clients to contractually agree to terms that modify the scope of services and duties of the adviser, provided the client is given full and fair disclosure.
Commenters were critical of the proposal’s lack of specificity regarding what constitutes “informed consent” and the process by which such consent is obtained. One commenter noted that this omission implies that whether a client’s consent is “informed” is a highly subjective determination. The commenter stated that, for advisers that offer a strategy or account to many different clients, making a subjective, case-by-case determination whether each client’s consent is “informed” may be extraordinarily costly, if not impossible, and that it should be sufficient to infer informed consent if the adviser has employed reasonable care to avoid misleading its clients with respect to those conflicts. The commenter suggested that, assuming adequate disclosure, unless an adviser has reason to believe that a client does not understand or agree to the existence of the disclosed potential or actual conflict, the client’s willingness to continue the business relationship should be deemed to be sufficient evidence of informed consent.
The SEC should recognize that fiduciary duties may lead to different problems with respect to retail and institutional clients.
Commenters expressed concern that the proposal did not distinguish between fiduciary duties owed to retail and institutional clients. In practice, such distinctions are commonplace. Advisers distinguish between retail and institutional clients when assessing the suitability of an investment for a particular client and describing conflicts of interest, for example. Disparate treatment resulting from differences in financial sophistication are appropriate to ensure clients receive advisory services tailored towards their respective goals, risk profiles and liquidity needs. With respect to disclosure, the SEC recognizes the appropriateness of such distinctions, instructing advisers to consider their clients’ level of financial sophistication when completing Form ADV.
One commenter noted that the proposal’s contention that certain conflicts may be too complex to be adequately disclosed weakens the historical reliance on disclosure that has served as a key underpinning of the Advisers Act. The commenter stated that this contention is unwarranted with respect to institutional investors that have received full and fair disclosure, and noted that the federal securities laws recognize that sophisticated investors do not require the same level of protection as retail investors (e.g., “qualified purchasers” invest in unregistered funds and “accredited investors” participate in private offerings).
While the proposal interprets an adviser’s duty of care to include a duty to make a reasonable inquiry into a client’s level of financial sophistication to ensure the suitability of investment advice, it does not provide further guidance on the appropriateness of disparate conduct based on a client’s sophistication. One commenter stated that the proposal’s assertion that “[a]n investment adviser has a fiduciary duty to all of its clients, whether or not the client is a retail investor,” suggests that advisers must treat institutional and retail clients the same and over-simplifies “the duties that have been articulated vis-à-vis different types of clients.” In the proposal, such duties principally relate to the suitability of personalized investment advice in light of clients’ varying risk tolerances.
The commenter noted that statements in the proposal “about the adequacy of disclosure and the ability to negotiate the scope of an investment adviser’s duties appear to be aimed more at investment advisers’ interactions with retail clients.” This observation is consistent with Chairman Clayton’s Statement at the Open Meeting on Standards of Conduct for Investment Professionals in April, where he stated that the SEC “has focused on how to best bridge any gaps between what retail investors reasonably expect from their investment professionals and what our laws and regulations require, while ensuring that investor access and investor choice are preserved.”
Further highlighting the differences between retail and institutional clients, one commenter noted that the proposal interpreted an adviser’s fiduciary obligations to require the adviser to make a reasonable inquiry into a client’s investment profile and update it as necessary to reflect changes in circumstances, which may not apply to advisers to institutional clients. For example, rather than a subadviser to a fund periodically updating the fund’s “investment profile,” it would provide advice based on the terms of the subadvisory agreement and the fund’s investment objectives. Similarly, the proposal interpreted an adviser’s duty of care to include the duty to provide advice and monitoring over the course of a client relationship. The commenter believes that this interpretation is an overly broad statement of law given the variety of advisory relationships and models that exist, including institutional mandates that may be more limited or specific. Rather, the commenter suggested the SEC acknowledge that the extent of an adviser’s advice and duty to monitor are established by agreement between the adviser and the client.
Proposed Regulation Best Interest
Proposed Regulation Best Interest would a “best interest” standard of conduct for broker-dealers, requiring that broker-dealers act in the best interest of their retail customers without placing their financial or other interests ahead of their customers’. The proposal provides that the best interest standard would be satisfied if broker-dealers meet certain disclosure, care and conflicts obligations.
The relatively large number of individual comments to the proposal appear to be the result of an AARP campaign encouraging the public to submit comments requesting a higher standard than the one imposed by Regulation Best Interest. In AARP’s own comment letter, it criticizes the proposal for failing to impose a fiduciary standard and pressed the SEC to better define the contours of the best interest standard. Regulation Best Interest does not definitively define “best interest,” instead leaving broker-dealers to interpret the standard based on the facts and circumstances surrounding an investment recommendation. AARP encouraged the SEC to revise the proposal to adopt a fiduciary standard that would require that recommendations are made “solely in the interest” of the customer and with the “care, skill, prudence, and diligence that a prudent person acting in a like capacity and familiar with such matters would use,” which was substantially the same standard adopted under the Department of Labor’s now-defunct fiduciary rule.
Other commenters echoed this sentiment, noting concerns that Regulation Best Interest did not provide clear guidance on the types of conduct that would be impermissible under the new standard, and that such ambiguity subjects the standard to differing interpretations based on facts and circumstances.
Proposed Form CRS Relationship Summary
Proposed Form CRS would require that advisers and broker-dealers provide a brief relationship summary to retail investors. While commenters generally supported requirements mandating clear disclosures about how financial professionals describe the retail customer relationship, they encouraged the SEC to adopt a less confusing, more flexible approach to disclosure. For example, one commenter noted that the proposed Form CRS for dually-registered broker-dealers and advisers could confuse investors by presenting information that may not be relevant to them, including a substantial percentage of retail investors who do not qualify for advisory services that require a minimum account balance.
The proposal also included two new rules under the Securities Exchange Act of 1934 aiming to reduce investor confusion in the marketplace for firm services. The first rule would restrict broker-dealers, when communicating with a retail investor, from using the term “adviser” or “advisor” in specified circumstances. The second rule would require broker-dealers and advisers disclose in retail investor communications the firm’s registration status with the SEC. While these rules did not garner as much attention as its headline-grabbing counterparts, one commenter noted that the new rule restricting brokers’ use of names, which is intended to reduce investor confusion, is unnecessary because proposed Form CRS would require clear and concise disclosure about the client relationship. The commenter also suggested that the new rule regarding registration status disclosure be eliminated because a firm would already be required to disclose its registration status in proposed Form CRS.
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While the financial industry generally supports the proposals and welcomed the leadership of the SEC in enhancing and clarifying the standards of conduct applicable towards investment advisers and broker-dealers, commenters raised valid concerns that may result in a final set of rules and regulations substantially different from what was proposed. We will continue to monitor these developments and discuss them in future Alerts.