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The SEC Investment Adviser Standard of Conduct: A Breakdown

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On June 5, the Securities and Exchange Commission adopted a rulemaking package that is applicable to investment advisers and broker-dealers. The package includes two final rules and two interpretations — Regulation Best Interest, the Investment Adviser Standard of Conduct Interpretation, Form CRS – Relationship Summary, and Solely Incidental Broker-Dealer Exclusion Interpretation. This is the second in a series of articles describing the SEC’s rulemaking package. Check out the first installment here: SEC’s Regulation Best Interest: A Breakdown.

In an effort to clarify and reaffirm the fiduciary duty that SEC-registered investment advisers owe their clients under the Investment Advisers Act of 1940, the SEC published for comment a proposed interpretation of the standard last year. The final interpretation of the standard of conduct is consistent with the proposal.

The fiduciary duty owed by investment advisers to their clients is based on congressional intent and is enforceable under the anti-fraud provisions of the Advisers Act. This fiduciary duty requires investment advisers to act in the best interest of their clients through their duty of care and duty of loyalty.

The SEC believes that the duty of care “requires an investment adviser to provide investment advice in the best interest of its client, based on the client’s objectives.” The duty of loyalty dictates that “an investment adviser must eliminate or make full and fair disclosure of all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to render advice which is not disinterested such that a client can provide informed consent to the conflict.”

In describing each of these obligations, the SEC recognized that an investment adviser’s fiduciary duty must be viewed in the context of the scope of the relationship between the adviser and the client. However, the SEC also determined that the fiduciary duty is principles-based. Thus, the duty is flexible enough to apply regardless of the type of client or service provided.

Duty of Care

The SEC describes an investment adviser’s duty of care to include three components: (1) The duty to provide advice that is in the best interest of the client, (2) 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 (3) the duty to provide advice and monitoring over the course of the relationship.

An investment adviser’s duty to provide advice in the best interest of the client includes a duty to provide advice that is suitable for the client. To fulfill these duties, the SEC believes that an investment adviser must develop a reasonable understanding of the client’s objectives. Thus, an investment adviser should reasonably inquire into the client’s financial situation, level of financial sophistication, investment experience and financial goals so that the adviser understands the client’s investment profile (or investment mandate for institutional clients) before providing advice.

An investment adviser is also required to maintain its understanding of the client’s investment profile by periodically updating the profile to incorporate any change in the client’s circumstances. The SEC acknowledges that the frequency for updating a client’s profile is a facts-and-circumstances analysis.

For example, the interpretation clarifies that “… updating would not be needed with one-time investment advice.” Thus, the nature and extent of the client relationship will impact the frequency with which updates are required.

In addition to understanding a client’s investment profile, an investment adviser “must have a reasonable belief that the advice it provides is in the best interest of the client based on the client’s objectives.” To establish a reasonable belief, an investment adviser should evaluate the advice in the context of the client’s portfolio for which the adviser is providing services.

An investment adviser also must reasonably investigate an investment product and/or strategy to ensure that the advice is based on complete and accurate information. Such an investigation might include factors such as fees and compensation, investment objectives, risk and reward characteristics and volatility. Examples of investment strategies to which this investigation obligation applies include the engagement of a sub-adviser, as well as advice about whether to roll over a retirement account to an account for which the adviser provides services.

The SEC’s interpretation summarizes an investment adviser’s best execution obligation in the context of an adviser who has the responsibility to select broker-dealers to execute client trades. The interpretation maintains the SEC’s position that in such a situation the adviser’s goal should be to maximize value for the client at the time of the transaction and to monitor and evaluate the execution it receives for its client.

The interpretation also affirms that an investment adviser’s duty of care includes an obligation to provide monitoring. The SEC acknowledges that an investment adviser’s monitoring obligation is determined, in part, by the “duration and nature” of the agreed-upon service arrangement.

Duty of Loyalty

The SEC believes that an investment adviser also has a duty of loyalty. This duty prohibits advisers from favoring their own interests over a client’s interests.

To fulfill the duty of loyalty, an investment adviser “must make full and fair disclosure to its clients of all material facts relating to the advisory relationship.” For example, dually registered firms must identify the capacity in which the firm is acting when providing advice. In addition, firms must disclose any limitations on the advice they provide, for example, if advice is limited to an investment menu that is offered through an affiliated investment adviser or broker-dealer.

As part of its disclosure obligation, an investment adviser is also required to disclose all conflicts of interest that might prevent the investment adviser’s advice from being disinterested. In the interpretation, the SEC emphasizes that “full and fair disclosure” of conflicts requires an appropriate level of specificity. Disclosures must be clear and detailed enough so that a client is able to understand the material fact or conflict of interest and make an informed decision whether to provide consent.

The SEC acknowledges in the interpretation that a client’s informed consent can be explicit or implicit, depending on the circumstances.

According to the interpretation, the use of certain qualifiers in conflict disclosures may be problematic. For instance, the SEC “would consider the use of ‘may’ inappropriate when the conflict exists with respect to some types or classes of clients, advice or transactions … [or] if it simply precedes a list of all possible or potential conflicts …” Investment advisers must either eliminate or mitigate a conflict of interest if it is so complex that providing specific disclosure so a client can understand the conflict is not feasible.

An investment adviser may also encounter conflicts between its own interests and those of a client, when allocating investment opportunities. Under such circumstances, the adviser must “eliminate or at least expose through full and fair disclosure the conflicts associated with its allocation policies, including how the adviser will allocate investment opportunities, such that a client can provide informed consent.”

Because the interpretation is merely a summary and restatement of what the SEC believes to be existing rules, it became effective upon publication in the Federal Register on July 12.

Beth Miller is an attorney with Spencer Fane LLP in the firm’s Overland Park, Kansas, office. Her practice focuses on helping clients by identifying practical solutions to a wide variety of legal matters in the areas of employer-sponsored retirement plans, executive compensation, fiduciary obligations and advisory services. She can be reached at [email protected]