SEC assigns 'duty of loyalty' for financial advisers

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The Securities and Exchange Commission finally waded into the discussion about who is and isn’t a fiduciary by releasing its own set of proposed regulations that would govern the behavior of both broker-dealers and registered investment advisers.

The rules, as they pertain to RIAs, are essentially a reaffirmation of behavior that already is acknowledged in the industry plus a few clarifications, says Jim Lundy, a partner in Drinker Biddle & Reath LLP’s Chicago office and a securities lawyer.

“The takeaway is this is not new guidance,” he says. It reaffirms aspects of fiduciary duty that are spelled out under Section 206 of the Investment Advisers Act. But the words “fiduciary duty” never appear in the advisers act, he adds.

“It is based on common law, in particular SEC v. Capital Gains Research Bureau from 1963. From that case and its interpretation, the SEC enforced fiduciary duty under Section 206 of the Advisers Act. The industry accepted it and built up around that duty,” he says.

The SEC’s latest proposal clarifies an RIA’s duty of care and duty of loyalty obligations when dealing with clients.

The duty of care includes an adviser’s duty to provide advice in a client’s best interest, to make reasonable inquiry into a client’s financials, experience and investment objectives and to personalize investment advice based on the client’s investment profile. They also have a duty to seek the best execution, meaning that they must consider a full range of services and the cost within those when making recommendations. They also have a duty to act and provide advice and monitoring over the course of their relationship with a particular client.

See also: SEC’s Regulation Best Interest falls short of making broker-dealers fiduciaries

Fred Reish, a partner at Drinker Biddle & Reath LLP in Los Angeles, says that “while Regulation Best Interest for broker-dealers is limited to advice to retail customers about financial transactions and strategies” the RIA interpretation “applies to all advice to all accounts.” That means both retail consumers, plan sponsors and their plan participants.

The duty of loyalty means that registered investment advisers can’t favor their own interests ahead of clients and they can’t favor certain clients over others. For example, they can’t favor clients that pay higher fees than other clients, Lundy says.

The next aspect of duty of loyalty is how an adviser deals with conflicts of interest and disclosure.

The SEC proposal “requires an RIA avoid conflicts of interest and disclose conflicts that do exist. They must be clear and detailed enough so the client can make a decision to consent to such practices or reject them. If a conflict does exist it is not sufficient that an adviser says it ‘may’ exist,” Lundy says.

He points out that the Securities and Exchange Commission has brought enforcement actions against advisers who told clients they ‘may’ have a conflict of interest when they knew they already had a conflict of interest.

The proposed regulation states that disclosure is required but if an adviser can’t adequately disclose the conflict, it must eliminate the conflict.

“I can’t think of a situation where an adviser has a conflict that is so severe it couldn’t be mitigated by full disclosure,” says Andrew Raby, a partner in Drinker Biddle & Reath’s Chicago office. “In my experience, the more unusual and stronger the conflict, the more robust the disclosure has to be. I fail to think of a situation where you have to change your business practice to eliminate the conflict.”

Lundy agreed, saying that “no matter how serious the conflict, I think there’s been acceptance if it is fully and fairly disclosed and if the client has an appropriate understanding of that, explicit or implicit, that could be reasonable.”

Bruce Ashton, a partner in Drinker Biddle’s Los Angeles office, says that most RIAs that fall under the SEC’s proposed rules would probably already be subject to the Employee Retirement Income Security Act’s five-part test.

“The SEC interpretation seems to be very similar to ERISA standards and best interest standards described in what is going to be the defunct best interest contract exemptions,” Ashton says.

He points out that ERISA includes a duty of loyalty and requires advisers to engage in prudent process when working with clients. It also requires that the fiduciary not subordinate a client’s interest to its own. The big difference is that ERISA doesn’t prohibit conflicts while the SEC requires disclosure.

When working with retirement plans, advisers need to keep in mind that ERISA and the Internal Revenue Code require that compensation received by an adviser be reasonable. The SEC interpretation “doesn’t impose a similar standard,” Ashton says. The standard there is disclosure of compensation.

While the fiduciary rule has been vacated and the SEC’s proposed rules are not final, advisers should look at what is being proposed and see how closely their own policies align with the proposals. If they don’t align at all, or gaps are identified, Raby suggests using the proposed rules as a road map for proactively remediating any problems.

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