Of the trio of regulatory releases from the Securities and Exchange Commission last week, the one targeted at registered investment advisers is a little weird. It sets out the fiduciary duty of investment advisers, sort of, and proposes some new regulations.
One of the problems with the fiduciary duty is that it is not explicitly written into the statutes or regulations of the Investment Advisers Act. The SEC latched on to Section 206 and court cases have followed along. But if you look through the Act or the regulations you will not find a fiduciary duty stated. Last week’s regulatory release, at least in part, was to “reaffirm – and in some cases clarify – certain aspects of the fiduciary duty that an investment adviser owes to its clients under section 206 of the Advisers Act.”
Of course, if this reaffirmation and clarification don’t get codified in the regulations, they are just a secondary source and will stay harder to find. The SEC did ask for comment on whether it would be beneficial to codify this interpretation. I would give that a resounding “yes.”
What does the SEC think are the obligations of an investment adviser’s fiduciary duty?
The Duty of Care and the Duty of Loyalty.
The release draws heavily from the 1963 Supreme Court case SEC v. Capital Gains Research Bureau, Inc. that was the landmark case holding that the Investment Advisers Act imposes a fiduciary standard on registered investment advisers.
Duty of Care
The SEC breaks down the duty of care into three prongs.
- the duty to act and to provide advice that is in the best interest of the client,
- 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
- the duty to provide advice and monitoring over the course of the relationship.
Acting in the best interest of the client is the big prong and the SEC gives lots of examples of what advisers should be doing.
- duty to make a reasonable inquiry into a client’s financial situation, level of financial sophistication, experience, and investment objectives
- duty to provide personalized advice that is suitable for and in the best interest of the client based on the client’s investment profile
- update a client’s investment profile in order to adjust its advice to reflect any changed circumstances
- have a reasonable belief that the personalized advice is suitable for and in the best interest of the client based on the client’s investment profile.
- Take into account the costs of an investment strategy
- Take into account the liquidity, risks and benefits, volatility and likely performance in determining if the strategy is in the best interest
- Conduct a reasonable investigation into the investment sufficient to not base its advice on materially inaccurate or incomplete information.
- Independently or reasonably investigate securities before recommending them to clients
Duty of Loyalty
“The duty of loyalty requires an investment adviser to put its client’s interests first. An investment adviser must not favor its own interests over those of a client or unfairly favor one
client over another.”
The SEC makes a point that in not unfairly favoring one client over another, an adviser is not locked into making pro rata allocations of opportunities.
An adviser has to try to avoid conflicts of interest with its clients, and make full and fair disclosure to its clients of all material conflicts of interest that could affect the investment advisory relationship. But disclosure of a conflict alone is not always sufficient to satisfy the adviser’s duty of loyalty. The disclosure must be clear and detailed enough for the client to understand and make an informed decision.
Commentary
What do I see as the problems with these standards?
The first is its application to private funds and private fund advisers. The proposal is targeted at retail investors and separately-managed accounts. It skips any mention of the issues related to pooled investment vehicles like private funds. In those cases the client is the fund. For some advisers, there may also be a client that invests in the fund. The needs of the various investors in a fund may vary. The fund is a client and the fund investors may not be clients.
The SEC has danced around the private fund issues of the fiduciary duty and registration requirements for a decade. With the passage of Dodd-Frank, a bigger portion of the SEC’s registered investment advisers are private funds. It seems strange to have omitted them from this release.
I also think this release fails to clarify issues around the disclosure of conflicts in dealing with the duty of loyalty. The SEC hedges its statements. I expect we will see a fair amount of comments on this issue.
Sources:
- The New Standards for Investment Advisers and Broker-Dealers
- Proposed Investment Adviser Interpretation
- Capital Gains Research Bureau – Scalping as Fraud
- SEC v. Capital Gains Research Bureau, Inc. 375 U.S. 18 (December 9, 1963) (.pdf)
- SEC v. Capital Gains Research Bureau and the Investment Advisers Act of 1940 (.pdf) by Arthur B. Laby