On June 5, 2019, the Securities and Exchange Commission (the “SEC”) released a long-anticipated interpretation of investment adviser fiduciary duty under Section 206 of the US Investment Advisers Act of 1940 (“the Advisers Act”), a provision applicable to both SEC and state-registered investment advisers, as well as other investment advisers that are subject to the territorial jurisdiction of the Advisers Act but are not required to be registered under it.  The Release is intended to benefit market participants by “reaffirming and clarifying” the nature and scope of the duty in one place.  As a restatement of an existing body of law, the SEC says its interpretation should create no new duties.  

The Release is a companion to three other releases announced by the SEC on the same day, one establishing a “best interest” conduct standard for broker-dealers when acting for retail customers, another establishing Form CRS as an additional mandatory disclosure document for use by broker-dealers with retail customers and registered investment advisers with retail clients, and the third providing interpretive guidance on the conditions under which a broker-dealer may rely on the Adviser Act’s exclusion from the definition of the term “investment adviser” for investment advisory services that are “solely incidental” to the conduct of a broker-dealer business. Read our previous alert on these three releases.

Investment advisers with retail clients or who are dually registered or have affiliated broker-dealers will need to review this package of releases as a whole.  The two interpretive releases (one addressing an investment adviser’s fiduciary duty and the subject of this alert, and the other addressing the “solely incidental” definition) are effective upon their publication in the Federal Register.  The two rulemaking releases (establishing Regulation Best Interest and Form CRS, respectively) are effective 60 days after publication in the Federal Register and have delayed compliance dates of June 30, 2020.

Components of the federal fiduciary duty under the Advisers Act

The Advisers Act is often described as establishing a federal fiduciary duty for investment advisers, made enforceable by the Act’s antifraud provisions.  Perhaps surprisingly, however, that duty does not explicitly appear in the language of the statute and has never been defined by rule.  It thus—even after publication of this Release—exists only in a series of court and SEC cases and statements.

As laid out in the Release, an investment adviser’s fiduciary duty is broad, applies to the entire adviser-client relationship, and reflects a Congressional intent to “eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser—consciously  or unconsciously—to render advice which was not disinterested.”^[1]  The duty comprises both a duty of care and a duty of loyalty.

Duty of Care

The duty of care includes, among other things: (i) the duty to provide advice that is in the best interest of the client, (ii) the duty to seek best execution of a client’s transactions where the adviser is responsible for selecting broker-dealers to execute client trades, and (iii) the duty to provide advice and monitoring throughout the relationship.  The duty of care requires an adviser to make a reasonable inquiry into its clients’ objectives and to have a reasonable belief that the advice it provides is in the best interest of the client based on those objectives.

Duty of Loyalty

The duty of loyalty requires that an adviser not subordinate its clients’ interests to its own.  To fulfill its duty of loyalty, an adviser must make full and fair disclosure to its clients of all material facts relating to the advisory relationship, including the capacity in which the firm is acting with respect to the advice provided.  Additionally, an adviser must eliminate or expose through disclosure all conflicts of interest that might incline the adviser to render advice that is not disinterested.

Disclosures must be considered in light of all the facts

Whether disclosure is full and fair depends on, among other things, the nature of the client, the scope of the services, and the client’s ability to understand any material fact or conflict.  The Release emphasizes that full and fair disclosure for an institutional client can differ significantly from full and fair disclosure for a retail client because the former generally have a greater capacity and more resources than retail clients to analyze and understand complex conflicts and their ramifications.  Nevertheless, disclosures must be clear and detailed enough for every client, regardless of its nature, to make an informed decision to consent to the conflict or reject it.  For retail clients in particular, the Release acknowledges that it may be difficult to provide disclosure regarding complex or extensive conflicts that is both sufficiently specific and understandable.  In these cases where an investment adviser cannot fully and fairly disclose a conflict to a client such that the client can provide informed consent, advisers are instructed to eliminate the conflict or adequately mitigate the conflict such that full and fair disclosure and informed consent are possible.

“Putting the client first” versus “not subordinating the client interest”

The Release comes more than a year after the SEC’s initial draft interpretation, which proposed to interpret that the law “requires an investment adviser to put its client’s interests first.”^[2]  The Final Interpretation uses somewhat different language: an investment adviser must “not subordinate its clients’ interest to its own.”

Commissioner Jackson, in the sole dissenting vote among the Commissioners, took issue with this subtle revision, noting that, according to a study conducted by his office, firms representing 89 percent of total assets under management told investors in their disclosures that they put investors first.^[3]

Fiduciary duty varies depending on the client

What constitutes a reasonable understanding of a client’s investment profile varies depending on the client

The duty of care includes not only a duty to provide investment advice that is in the best interest of the client, but also a duty to provide investment advice that is suitable for the client.  To provide such advice, an adviser must have a reasonable understanding of the client’s investment objectives and the Release acknowledges that how an adviser develops such a reasonable understanding differs between retail investors and institutional investors.  The basis for such a reasonable understanding generally would include, for retail clients, an understanding of the investment profile, or for institutional clients, an understanding of the investment mandate.   For retail clients, the Release suggests an adviser should, at a minimum, make a reasonable inquiry into the client’s financial situation, level of financial sophistication, investment experience and financial goals – what is commonly called, in sum, the client’s investment profile.  Additionally, it generally will be necessary for an adviser to a retail client to update the client’s investment profile in order to maintain a reasonable understanding of the client’s investment objectives and adjust the advice to any changed circumstances.

By contrast, the nature and extent of the reasonable inquiry into an institutional client’s objectives generally is shaped by the specific investment mandates from those clients.  The Release provides that an adviser engaged to advise on a particular portfolio of an institutional client would need to gain a reasonable understanding of the client’s objective within that portfolio, but not the client’s objectives within its entire investment portfolio.

There’s no waiving away the fiduciary duty

An adviser’s fiduciary duty is principles-based, applies to the entire relationship between the adviser and its client, and follows the contours of the relationship—so that the adviser and its client may shape the relationship by agreement, provided there is full and fair disclosure and informed consent.  The Release opines that this principles-based fiduciary duty has provided sufficient flexibility to serve as an effective standard of conduct for advisers, regardless of the clients they serve.  Although the scope of the fiduciary duty will vary with the scope of the relationship, it may not be waived.  Rather, it will apply in a manner that reflects the agreed-upon scope of the relationship.  An agreement to waive an adviser’s federal fiduciary duty generally, such as (i) a statement that the adviser will not act as a fiduciary, (ii) a blanket waiver of all conflicts, or (iii) a waiver of any specific obligation under the Advisers Act, would be inconsistent with the Advisers Act, regardless of the sophistication of the client.  This is perhaps uncontroversial; but one can imagine many specific types of waivers that will be accepted as appropriate between clients and their adviser, and this language presents at least the possibility of second-guessing.

Our Take

Setting aside Commissioner Jackson’s dissent and some very negative reactions to the broader rulemaking package by a number of politicians and consumer groups, the Release appears to have been accepted as at least broadly in line with common understanding of an investment adviser’s fiduciary duty.  As such, and given that the entire document clocks in at a trim 41 pages (hundreds less than the typical SEC release), and its concepts permeate the operations of virtually every investment advisory business, we expect it will become widely read by investment adviser legal, compliance and executive staff across the industry.  We also expect, however, that some points highlighted above hold the potential for confused results over time.