On episode 52, we talk about the SEC's issued interpretive guidance on an adviser’s standard of conduct, as mandated under the Investment Advisers Act of 1940.
CCO Buzz: Hello and welcome back to the Buzz. For today’s episode, 52, we’re going to talk about the SEC’s position on duty of care and duty of loyalty, as outlined in the guidance. With that, let’s get started.
Simultaneous with the adoption of The Best Interest Rule, the Securities and Exchange Commission issued interpretive guidance on an adviser’s standard of conduct mandated under the Investment Advisers Act of 1940. Not surprisingly, the guidance specifies that advisers, as fiduciaries, owe their clients a duty of care and loyalty and therefore must always put the clients’ interests ahead of its own.
The duty of care has three parts. The first one is the duty to provide advice that is in the best interest of the client. This involves, among other things, obtaining information on the client’s investment objectives, making only suitable recommendations and investments, reasonably investigating securities so advice is not based on inaccurate or incomplete information, and recommending appropriate account types.
The second duty of care is the requirement to seek best execution when placing client transactions for execution. In doing this, an adviser needs to consider not just price, but a number of factors such as execution capability, research provided, transaction costs, the financial responsibility of the broker, and their responsiveness. As part of this duty, firms also are required to perform and document periodic reviews of the executions received by clients.
The third duty of care is to provide advice and monitoring over the full course of the relationship. This is especially relevant in arrangements where the adviser charges an asset based annual fee. While the adviser and client may agree upon the frequency of the monitoring, it must be consistent with the nature of the relationship and the advice being provided.
The duty of loyalty means that an adviser cannot provide advice to clients that would benefit the adviser over the client. The main component of this duty requires advisers to address all material conflicts and provide full and fair disclosures to prospects and clients. As part of the disclosure, advisers need to outline the capacity in which they are acting, especially when the firm is dually registered as an investment adviser and broker-dealer. An adviser also must provide clear disclosures and avoid using the word “may” unless appropriate. An example the SEC provided in the guidance is that they would consider the use of the word “may” to be inappropriate when it precedes a list of all possible or potential conflicts, rather than actual conflicts, thus preventing a client from providing informed consent. Appropriate use can be when the adviser discloses a potential conflict that could happen in the future.
Full and fair disclosures will circle around the nature of the client, the extent of services offered, and material conflicts. While disclosures may differ by type of client, for example retail clients vs. institutional clients, all disclosures must be clear and detailed enough for clients to make informed decisions. The SEC clarified in the release that advisers are not required to affirmatively determine that a client understands the disclosures and consents to the conflicts and their consent can be either explicit or implicit. They also said that disclosures can be delivered through a combination of ways, including Form ADV and other documents. The guidance also stated that if there are cases where an adviser cannot fully and fairly disclose a conflict to allow for informed consent, it must be eliminated, or mitigated to the extent that allows informed consent.
At the same time this interpretive guidance was issued, the SEC also adopted a rule requiring advisers to provide retail investors with a plain English relationship summary, referred to as Form CRS, containing certain conflicts of interest and encouraging the investor to ask about such conflicts.
For more information or if you need assistance with drafting disclosures and the new Form CRS, please contact us at 619.278.0020.