Tag: Release No. IA-4889

Proposed Enhanced Investment Adviser Regulation

Yesterday I pointed out the fiduciary duty obligations laid out in the SEC’s new release. The other half of the release is a request for comment on three new proposals to enhance investment adviser regulation.

  • Federal Licensing and Continuing Education
  • Provision of Account Statements
  • Financial Responsibility

The SEC notes these as areas where the broker-dealer framework provides investor protections that do not have counterparts in the registered investment adviser framework.

Federal Licensing and Continuing Education

The federal securities laws do not impose licensing or qualification requirements on investment advisers. Broker-dealers, through FINRA, are subject to licensing, qualification, and continuing education requirements. The first question of should RIA reps be licensed seems like a done deal. I believe the SEC is looking for comments on the requirements, avoiding duplication for dual-registered personnel and the exam process. I assume that FINRA is going to step in and take over this process.

Provision of Account Statements

I found this request to be a bit strange. Broker-dealers have to send account statements and transaction confirmations. Registered investment advisers rely on the custodian to do this.

From my perspective, the SEC also needs to focus on how these additional deliveries would work for non-retail investment adviser clients, like private funds.

Financial Responsibility

Broker-dealers are subject to capital requirements. The firms need to have minimum levels of net capital and liquidity. Of course, broker-dealers are holding customer assets directly while investment advisers have the client assets with a qualified custodian.

I suspect any of these proposals would have a big impact on smaller registered investment advisers. I thought the Custody Rule was supposed to address these concerns.

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All of Your Fiduciary Duty in One Place

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.

  1. the duty to act and 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.

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.

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The New Standards for Investment Advisers and Broker-Dealers

One of the challenges that consumers face when dealing with a financial adviser is what it means to be a “financial adviser.” The terms financial planner, wealth consultant, stockbroker, investment adviser, financial consultant, and others get thrown around, leaving you how that person gets paid for helping you with your money.

The Securities and Exchange Commission is trying to help consumers with a trio of proposals.

On the Broker-Dealer side, the SEC is proposing Regulation Best Interest. This would create a new standard of conduct for broker-dealers and their representatives when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer. The proposed standard of conduct is to

  • act in the best interest of the retail customer
  • at the time a recommendation is made
  • without placing the financial or other interest of the broker-dealer or natural person who is an associated person making the recommendation ahead of the interest of the retail customer

This new standard would be satisfied if:

  1. broker-dealer, before or at the time of the recommendation reasonably discloses to the retail customer, in writing, the material facts relating to the scope and terms of the relationship, and all material conflicts of interest associated with the recommendation;
  2. broker-dealer, in making the recommendation, exercises reasonable diligence, care, skill, and prudence; the broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and at a minimum disclose, or eliminate, all material conflicts of interest that are associated with such recommendations;
    and
  3. broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations.

For item 1, there would be a new Form CRS. Broker-dealers would provide this to their clients.

For registered investment advisers, there would be a new Part 3 to Form ADV that would be Form CRS.

There is a lot in this package. SEC Chairman Clayton summarized them:

We propose to fill these gaps through (1) mandating clear disclosures — specifically, addressing how BDs and IAs identify themselves to investors and requiring them to provide investors with a standardized disclosure document of no more than four pages in length, highlighting among other things the principal services offered, legal standards of conduct that apply, fees the customer will pay, and certain conflicts of interest that exist, (2) raising the standard of conduct applicable to BDs to make it clear, among other things, that they cannot put their interests ahead of the interests of their retail customers, and (3) reaffirming, and in some cases clarifying, our views on the standard of conduct applicable to investment advisers.

There will be lots of commentary on these proposed regulations from all sides. One of those critics is SEC Commissioner Kara M. Stein:

 I am concerned that this rule will not only confuse retail investors, but also broker-dealers. In particular, the lack of a definition of best interest, the use of similar terms to mean different things, the use of different terms to mean the same things, and the possibility that the SEC and FINRA interpret the same language in their suitability standards differently. All of these concerns would make it difficult for the industry to discern a clear compliance path. Any resulting confusion may well result in higher compliance costs for broker-dealers, which will likely be passed onto the investor. What’s more, the lack of a clear standard is not likely to give investors more confidence in the broker-dealer business model.

There is over 1000 pages in these proposals. I’ll share more thoughts on them this week.

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