In April 2018, the Securities and Exchange Commission (the “SEC” or “Commission”) proposed a series of rules and forms intended to elevate the standard of conduct for broker dealers. In connection with these publications, the SEC also published a separate proposal regarding the standard of conduct for investment advisers under the Investment Advisers Act of 1940 (“Advisers Act”). On June 5, 2019, the SEC subsequently released a final comprehensive interpretation of the standard of conduct for investment advisers (the “Release”), which will become immediately effective upon publication in the Federal Register (anticipated July 2019).
The Commission’s Interpretation Regarding Standard of Conduct for Investment Advisers
The SEC’s oversight of the investment advisory landscape has traditionally been anchored by a “principles-based” approach. While this framework accords market participants a measure of flexibility with regard to implementing their compliance programs, it has also drawn criticism due to a perceived lack of clear, consistent, practical guidelines. For example, Rule 206(4)-1 (the “Advertising Rule) prohibits “the use of advertisements that are false or misleading in any way.” While the specific text of this rule is fairly straightforward, its effective application demands a thorough awareness and understanding of the myriad enforcement actions, no-action letters, and interpretive guidance that serve as guideposts for actual SEC expectations.
For a broader example, consider how the principle of fiduciary duty is meant to govern an investment advisory relationship. While federal law has long established that an investment adviser is a fiduciary1, practitioners are left to sift through tomes of case law, legislative history, and historical SEC releases, among other sources, to obtain a clear explanation of the fiduciary standard of conduct imposed upon investment advisers.
Consequently, the SEC articulates several key considerations in the Release with a view to providing investment advisers with additional clarity on how the Commission expects the principles of fiduciary duty, which include the duty of care and the duty of loyalty, to govern client arrangements. A summary of these considerations follows:
- Advisers Owe their Clients a Duty of Care
Principle: The duty of care requires an adviser to serve the best interest of its client, based on the client’s objectives. The Release notes, in particular, that the duty of care extends i) to providing advice that is in the client’s best interest, ii) to seeking best execution, and iii) to monitoring the relationship and client objectives on an ongoing basis.
Practical Implications: Advisers, especially those to retail clients, may need to consider re-evaluating existing documentation protocols to more readily demonstrate that they have i) made reasonable inquiry into a client’s objectives, ii) established a reasonable belief that advice is rendered in the best interest of the client in light of the particular client’s level of sophistication, iii) sought to obtain best execution with the goal of maximizing value for the client under the particular circumstances of the transaction, and iv) administered the appropriate level of monitoring and formal touchpoints over the course of a client relationship.
- Advisers Owe their Clients a Duty of Loyalty
Principle: The duty of loyalty demands that an adviser refrain from subordinating its clients’ interests to its own, and requires that conflicts of interest and all material facts relating to the advisory relationship are fully and fairly disclosed to obtain the client’s “informed consent.”
Whether a client’s consent is “informed” generally turns on the strength (or “fullness and fairness”) of an adviser’s disclosures. According to the Release, whether disclosure is “full and fair” depends upon the nature (i.e., sophistication) of the client, the scope of the services, and the particular conflict at issue. The Release provides two specific examples to illustrate this view. First, disclosing that an adviser “may” have a particular conflict, without additional explanation, is inadequate when the conflict actually exists. Second, an adviser must eliminate or expose through disclosure the conflicts associated with its policies regarding the allocation of investment opportunities. While an adviser need not adopt any particular method of allocation, the adviser’s methods must not prevent it from providing advice that is in the best interest of its clients.
Practical Implications: Advisers may be encouraged to take a fresh look at existing disclosures in light of current business practices to re-evaluate the conflicts that do (or may) exist, and perhaps craft additional or enhanced disclosures to incorporate the factors articulated in the Release. As a potential starting point, it may be worth reconciling Form ADV Part 2A disclosure language (which requires mention of all material conflicts of interest) with the Release’s clarified standard to “make full and fair disclosure of all conflicts of interest.” This point is particularly important for advisers to the retail space, where Form ADV is often the primary avenue of disclosure.
Ultimately, the Release appears to provide textual support for the principles that have long informed the SEC’s examination and enforcement efforts. While the full impact of this interpretation remains unknown, the implications to registrants will likely differ depending on the nature of their client relationships.
Advisers to registered investment companies or private funds may find themselves relatively insulated from the effects of this Release, as their agreements tend to define the scope of services and limitations on authority with “substantial specificity” through multiple avenues of comprehensive disclosure (including private placement memoranda and limited partnership agreements, often drafted with a significant level of detail). Nonetheless, these firms should evaluate other forms of conflicts governance (e.g., the use of limited partner advisory committees (LPACs)) and revisit the approach they use to select which conflicts should be disclosed and which conflicts should be eliminated. Throughout this selection process, firms should carefully consider whether the conflict implicates the duty of care or the duty of loyalty.
Advisers operating in the retail space, on the other hand, may end up bearing the brunt of the Release’s impact, as these firms more commonly provide comprehensive advisory services to potentially unsophisticated counterparties across more limited disclosure channels.
How ACA Can Help
As the interpretive guidance set forth in the Release goes into effect, advisers may benefit from a third-party review of the firm’s process for identifying, documenting, mitigating, and disclosing conflicts of interest. ACA can assist your firm with the identification and remediation (or disclosure) of these matters as well as provide guidance on best practices for conflicts governance. With over 4,000 ongoing client relationships, including significant market coverage in the alternatives space as well as the traditional investment adviser space, ACA is in a unique position to provide actionable insight with a view to both regulator expectations and peer firms’ best practices. Such an assessment may include the following:
- A comprehensive conflicts review and diagnosis
- Development of a conflicts log or registry
- Cross referencing of existing or potential conflicts with various disclosure documents and marketing materials
- Advice as to how best to address existing conflicts, whether through enhanced disclosure or other avenues of remediation
Stay tuned for Part 2 of this Alert, where we will discuss Form CRS and its impact on the investment advisory landscape.