In 1963, the United States Supreme Court held in SEC v. Capital Gains Research Bureau, Inc., that Section 206 of the Investment Advisers Act of 1940 imposes a fiduciary duty on investment advisors by operation of law. Section 206 of the Act (generally referred to as the “anti-fraud” provision) makes it unlawful for an investment advisor to engage in fraudulent, deceptive, or manipulative conduct.
The general purpose of an investment advisor’s fiduciary duty is to eliminate conflicts of interest, and to prevent an advisor from taking unfair advantage of a client’s trust. In order to fulfill this duty, an investment advisor is required to always act in its clients’ best interests and to make full and fair disclosure of all material facts, especially when the advisor’s interests may conflict with those of his clients.
Specifically, the Supreme Court in Capital Gains indicated that Congress and the SEC intended that “[an investment advisor] should continuously occupy an impartial and disinterested position, as free as humanly possible from the subtle influence of prejudice, conscious or unconscious; he should scrupulously avoid any affiliation, or any act, which subjects his position to challenge in this respect.” The SEC has continuously confirmed an advisor’s fiduciary duty subsequent to Capital Gains in several Investment Advisers Act Releases. In Release No. 1393 (November 29, 1993), the SEC, referencing Capital Gains, stated: “the Investment Advisers Act imposes on investment advisers an affirmative duty to their clients of utmost good faith, full and fair disclosure of all material facts, and an obligation to employ reasonable care to avoid misleading their clients.”
What does this mean? Certainly, an advisor’s fiduciary responsibility permeates its entire business operations and client relationships. It requires more than a mere attempt at compliance. Rather, it requires that the advisor undertake reasonable ongoing and continuous efforts to comply with its obligations under the Advisers Act and in its dealings with clients. Here are a few examples of how an advisor’s fiduciary duty impacts its advisory operations.
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Although neither the Act nor SEC rules currently impose an express suitability requirement on investment advisors, the SEC maintains that advisors have a fiduciary duty to reasonably determine that the investment advice and/or services that they provide to their clients are suitable, taking into consideration the client’s financial situation, investment experience, and investment objectives. Accordingly, each firm should be prepared to demonstrate that it has a policy to obtain (and maintain) sufficient information regarding the client’s circumstances to enable the firm to determine whether particular advice or services are suitable, initially and thereafter. Examples of the type of corresponding documents that advisors may determine to implement include client questionnaires, fact sheets, investment objective(s) confirmation letters, and investment policy statements (IPSs).
Some form of IPS should be obtained and maintained by an investment advisor. However, longer does not mean better! Too many times, especially when defending advisory firms in litigation or arbitration proceedings, we see advisors falling victim to their own sloppy documents (a “canned” questionnaire or ambiguous form that is a minefield for conflicting responses). If the client indicates on page two that her objective is a 10% annual return, but on page five (clearly, in our view, too long a document already) that she can only tolerate a principal loss of 5%, we have a conflict. Therefore, the advisor, as a “fiduciary,” should not begin the investment management process until the client’s objectives and risk parameters are clarified and consistent, and written confirmation thereof has been obtained.
Our general recommendation is to keep the client “intake” process simple. Have a new client information document that requires the client to indicate, in his own handwriting, his risk parameters and investment objectives, and, most importantly, any reasonable restrictions that the client desires to impose on your investment management services.
Have the client complete and execute the document, including a written indication if she wants to impose any reasonable restrictions. If there are none, have the client, in her own handwriting, indicate “none.” Thereafter, before commencing the investment management process, confirm the information obtained in a written investment objectives or policy statement, either to be executed by the client or, in the alternative, advising the client to notify you immediately, in writing, if his understanding is contrary to that stated.
In addition, the confirming document should advise the client to immediately notify you if there has been a change in his financial situation or investment objectives, or if he desires to impose, add, or modify any reasonable restrictions to the management of his account. Thereafter, the advisor annually should send a letter to the client confirming that you continue to manage the accounts in accordance with the client’s previously designated investment objectives, and that it remains the client’s responsibility to advise you if there has been a change in his financial situation or investment objectives, or if he desires to impose, add, or modify any reasonable restrictions to the management of his accounts.