There is a general understanding that investment advisers have a fiduciary relationship with their clients – in other words, that they are required to act in the client's best interests. But although this concept makes sense in the abstract, it isn't always clear what an adviser needs to do to fulfill their fiduciary duty in real-life situations.
In 2019, the SEC released a Commission Interpretation that separated the obligation of RIAs to act in their clients' best interests into separate duties of care (to provide investment advice in the best interest of the client) and loyalty (to eliminate or disclose all potential conflicts of interest with the client). But while that interpretation clarified at a high level the SEC's view on what constitutes an adviser's fiduciary duty, it didn't provide many actionable takeaways for RIAs to shape their conduct.
So in April 2023, SEC staff released a Staff Bulletin (which, although not an 'official' pronouncement of the SEC, does represent the views of the staff who actually conduct adviser examinations and pursue enforcement of the SEC's regulations) to further explain the investment adviser's duty of care, particularly as it regards to working with retail investor clients.
According to the Staff Bulletin, there are 3 overarching components involved in performing an adviser's duty of care: 1) An understanding of the potential risks, rewards, and costs of a recommended investment; 2) an understanding of the client's overall financial picture as it relates to the investment; and 3) a reasonable basis for concluding that the recommendation is in the client's best interest. These 3 components in practice make up a core part of the adviser's fiduciary duty to their clients.
The Staff Bulletin also includes some best practices to help advisers show that they followed the standard of care, such as inventorying all investment products deployed in client accounts and performing a reasonable investigation into how each product works; analyzing the total cost of each investment (including fees, commissions, and taxes); creating an 'investment profile' of relevant information for each client (for which the bulletin provides a list of specific items to consider); and considering a range of possible alternatives to each investment in order to have a reasonable basis to believe the one chosen is indeed in the client's best interests.
Additionally, the Staff Bulletin includes details for registered broker-dealer representatives subject to the SEC's Regulation Best Interest (Reg BI) rule. Most notably, while the bulletin states that the fiduciary obligations are generally the same between RIAs and broker-dealers whose fiduciary obligations are triggered under Reg BI, dually registered broker-dealer representatives are also obliged to disclose the capacity in which they are acting (i.e., as a broker-dealer representative or an investment adviser representative) and to consider whether a brokerage account or an advisory account is better suited for a client (depending on whether the client is just looking to purchase a product, or whether they're seeking ongoing advice and management).
Ultimately, although many advisers may find the numerous requirements for ongoing due diligence and documentation daunting, the reality is that the Staff Bulletin simply seeks to enumerate how advisers can fulfill their already existing fiduciary responsibilities, many of which were previously left open to interpretation (and often only clarified when the SEC decided to pursue an enforcement action against a firm for breaching those duties). Which hopefully means that it will be easier for firms to understand how specifically to serve as fiduciaries for their clients, since they now have a clear (or at least clearer) path for doing so!
It is well understood that investment advisers are fiduciaries that owe a duty of care and a duty of loyalty to their investor clients. What is less well understood is what this actually means to advisers from a practical implementation perspective. In other words, how exactly should an adviser conduct itself in the day-to-day operation of its business and in the course of interacting with clients in order to satisfy its fiduciary obligations?
With the release of an April 20, 2023, Staff Bulletin entitled "Standards of Conduct for Broker-Dealers and Investment Advisers Care Obligations" (which we will simply refer to here as the "Staff Bulletin"), staff of the SEC attempted to at least point advisers in the right direction. Though somewhat overly verbose (pot kettle black, I know) and laden with footnotes (79 in total), the Staff Bulletin does contain quite a few actionable nuggets that can be directly implemented by advisers to help satisfy their inherent fiduciary duties.
By undertaking a mining operation with respect to such nuggets, I will endeavor to extract the salient takeaways from the Staff Bulletin and translate them into action items for advisers to evaluate and implement if needed.
The Fiduciary Funnel – Fiduciary Duty Simplified
Let's start with an overly simplified explanation of an adviser's fiduciary duty – what I visualize as the fiduciary funnel.
Fiduciary Duty Generally – The Top Of The Funnel
At the top of the funnel is the overarching tenet that an adviser is a fiduciary, which is ultimately rooted in equitable common law as applied to principals (clients) and agents (advisers) and applies to the entire adviser-client relationship. This duty is not statutorily defined in either the Investment Advisers Act of 1940 or the rules promulgated thereunder, but was instead read into the anti-fraud section of the Advisers Act by the seminal 1963 SEC v. Capital Gains Research Bureau, Inc. Supreme Court case due to the special relationship of trust and confidence as between advisers and their clients.
To cite a 2019 SEC interpretation regarding advisers' standards of conduct (which will simply be referred to here as the "Commission Interpretation" ):
In our view, an investment adviser's obligation to act in the best interest of its client is an overarching principle that encompasses both the duty of care and the duty of loyalty.
Notwithstanding that an adviser's fiduciary duty "applies to the entire relationship between the adviser and its client," the Commission Interpretation clarifies that an adviser's fiduciary duty is principles-based, such that it "follows the contours of the relationship between the adviser and its client, and the adviser and its client may shape that relationship by agreement, provided that there is full and fair disclosure and informed consent. [...] [T]he specific obligations that flow from the adviser's fiduciary duty depend upon what functions the adviser, as agent, has agreed to assume for the client, its principal."
The Commission Interpretation acknowledges that the relationship between an adviser providing a one-time financial plan for a retail client with minimal investment knowledge and an adviser implementing a sophisticated trading strategy through a private fund vehicle for an institutional client are 2 very different principal-agent relationships. The different "contours" of such relationships are what allow the corresponding malleability in the duties and responsibilities of the adviser.
Though an adviser's fiduciary duty will apply "in a manner that reflects the agreed-upon scope of the relationship," it cannot be waived:
A contract provision purporting to waive the 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 of interest, 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 prohibition against fiduciary duty waivers in advisory agreements is what ultimately underlies the SEC's recent focus on what it refers to as impermissible "hedge clauses", contractual provisions that purport to limit one party's potential liability to the other party.
The Duties Of Care And Loyalty – The Middle Of The Funnel
This gets us to the next level of the fiduciary funnel, which includes the separate but related duties of care and loyalty.
The duty of care is what underlies an adviser's obligation to act with prudence and reasonableness, while the duty of loyalty is what underlies an adviser's obligation not to subrogate clients' interests to the adviser's own interests.
To again cite the Commission Interpretation:
In our view, the duty of care requires an investment adviser to provide investment advice in the best interest of its client, based on the client's objectives. Under its duty of loyalty, an investment adviser must eliminate or make full and fair disclosure of all conflicts of interest which might incline an investment adviser – consciously or unconsciously – to render advice which is not disinterested such that a client can provide informed consent to the conflict.
The terms "best interest", "full and fair disclosure", "conflicts of interest", and "informed consent" should all be familiar terms for those of us
with no lives who pay close attention to the throughlines that tie various SEC rules, publications, enforcement actions, and speeches together. In this respect, the Commission Interpretation wasn't exactly anything revolutionary or terribly controversial; instead, it simply coalesced such concepts into an 'official' interpretation of the actual SEC Commissioners (as opposed to the Staff Bulletin, which simply reflects the views of the staff of the SEC and not the Commissioners themselves, and therefore is not a rule, regulation, or statement of the SEC; to wit, the first footnote of the Staff Bulletin makes it clear that the SEC "has neither approved nor disapproved the content of these documents and, like all staff statements, they have no legal force or effect, do not alter or amend applicable law, and create no new or additional obligations for any person.”).
Even though the 2019 Commission Interpretation may represent the 'official' views of the SEC itself and the 2023 Staff Bulletin may represent only the views of the staff of the SEC, it is the staff of the SEC that actually conduct adviser examinations, that are the first interpreters of whether an adviser has actually satisfied its fiduciary duties, and that make referrals up the chain to pursue enforcement actions for breaches of such fiduciary duties. In other words, when the SEC staff speaks (or writes), you should still pay attention and give their views the respect they deserve.
Moreover, the Staff Bulletin is more concretely actionable than the Commission Interpretation, which is instead more theoretical and conceptual. The Staff Bulletin thus builds on the foundational fiduciary duty theories set forth in the Commission Interpretation, and attempts to translate such theories to action for advisers.
Actionable Takeaways Borne Out Of The Duty Of Care – The Bottom Of The Funnel
Whereas the 2019 Commission Interpretation addressed both the duty of care and the duty of loyalty, the 2023 Staff Bulletin zeroed in exclusively on the duty of care; it did not delve into the duty of loyalty and is constructed as a series of questions and answers about such duty of care. Because the contours of the duty of care will differ between an institutional investor and a retail investor, the Staff Bulletin is more acutely focused on the duty of care contours to be applied to retail investors (i.e., the average 'mom-n-pop' investors that likely constitute the majority of the clientele of our adviser readers).
In the context of providing investment advice and recommendations to retail investors, the care obligations generally include 3 overarching and intersecting components. As discussed in more detail in the following questions and answers, these components are:
- Understanding the potential risks, rewards, and costs associated with an investment product, strategy, account type, or series of transactions;
- Having a reasonable understanding of the specific retail investor's investment profile, which generally includes the retail investor's financial situation (including current income) and needs; investments; assets and debts; marital status; tax status; age; investment time horizon; liquidity needs; risk tolerance; investment experience; investment objectives and financial goals; and any other information the retail investor may disclose in connection with the recommendation or advice; and
- Based on the understanding of the first 2 components, as well as a consideration of reasonably available alternatives, having a reasonable basis to conclude that the recommendation or advice provided is in the retail investor's best interest.
There's a lot to extract just from these 3 foundational components, so let's dive in.
Understanding The Investment Or Investment Strategy
Yes, the SEC staff felt it necessary to explain that all advisers must indeed understand the investment products and strategies recommended to clients. As plainly obvious as this may seem, there continue to be occasional SEC enforcement actions that are borne out of an adviser's failure to understand how a particular investment product or strategy actually works, such product or strategy's key attributes, and the downside risks that are entailed (See, e.g., Frontier Wealth Management, LLC and Shawn Sokolosky, Investment Advisers Act Release No. 5847 (September 3, 2021) (settled action) and UBS Financial Services, Inc., Investment Advisers Act Release No. 6060 (June 29, 2022) (settled action)).
Typically, such matters involve particularly complex or risky products or strategies that blow up, which make it easier for the SEC to justify a finding that an adviser made "unsuitable" recommendations for which there was no demonstrable belief that the product or strategy was in the best interest of clients. The Staff Bulletin thematically suggests that advisers should apply "heightened scrutiny" to whether a risky or complex product or strategy is in a client's best interest.
Factors To Consider
According to the Staff Bulletin, the following represents a "non-exhaustive" list of factors that may be relevant for advisers to consider when conducting a "reasonable investigation" of an investment product or strategy's potential risks, rewards, and costs:
- Objectives (such as whether it is designed to provide income, principal protection, growth, or exposure to a specific market sector or is designed to be held for a long or short term);
- Initial and ongoing costs (such as direct, indirect, and potential costs (e.g., a redemption fee));
- Key characteristics and risks (such as liquidity or volatility) or other features that may impact the investment (e.g., margin call terms or early repayment of debt underlying a securitized product);
- Likely performance in a variety of market and economic conditions;
- Expected returns, expected payout rates, and potential losses;
- Any special or unusual features (such as tax advantages or guaranteed payments); and
- The role within the context of the retail investor's actual or anticipated investment portfolio.
If a client has engaged an adviser purely to provide a one-time investment allocation recommendation (e.g., as part of a financial planning engagement), the adviser's reasonable investigation of the factors above is essentially a one-and-done exercise without any ongoing responsibility to further reevaluate such products or strategies over time.
On the other hand, if a client has engaged an adviser to provide ongoing discretionary investment management, the factors above should be periodically reevaluated by the adviser over the course of the client relationship as circumstances warrant (e.g., due to changes in the client's financial situation or investment objectives, changes in a product or strategy's risk profile or cost structure, or perhaps even changes to the general market or tax environment). Such reevaluation can be memorialized as part of a quarterly portfolio review, an annual client review meeting, or with another reasonable cadence.
To reiterate, the factors described above are both "non-exhaustive" and "may" be relevant, which is to say that the particular factors to be evaluated will vary from advisory firm to advisory firm, and from one product or strategy to another. The nature and extent of such consideration must, at the end of the day, be "reasonable" in light of the particular advisory firm, the nature of the product or strategy, and the client that is on the receiving end of such product or strategy.
In other words, the records memorializing an evaluation of the factors described above will likely look very different for a large, nationwide asset manager that offers sophisticated, complex products as opposed to a solo advisory firm that primarily recommends Vanguard exchange-traded funds.
Advisers do not have a fiduciary duty to always recommend the lowest-cost investment product or strategy (setting aside lower-cost share classes within the same mutual fund, which is a whole other can of worms). An adviser cannot satisfy its duty of care by simply selecting the lowest-cost investment or strategy option for a client. However, cost must 'always' be considered when recommending a product or strategy.
More specifically, an adviser should consider a product or strategy's "total potential costs", which include the following:
- Commissions, markups or markdowns, and other transaction costs;
- Sales loads or charges;
- Advisory or management fees;
- Other fees or expenses that may affect a retail investor's return (such as Rule 12b-1 fees, other administrative and service fees, revenue sharing, and transfer agent fees);
- Trading and other costs associated with an investment strategy (such as the need to continually buy and sell options or futures contracts or pay margin interest, daily rebalance fees, and any structural features of the investment that could magnify investor losses);
- The costs of exiting an investment or investment strategy (such as deferred sales charges or liquidation costs);
- Any relevant tax considerations; and
- The likely impacts of those costs over the retail investor's expected time horizon.
This cost analysis requires more than a simple review of a trade confirmation or custodian account statement.
An adviser should be particularly sensitive when evaluating the costs of products and strategies for which there exists some sort of financial incentive or conflict of interest for the adviser. The recommendation of higher-cost products that result in additional compensation to the adviser is particularly problematic if such additional compensation (i.e., a financial incentive for the adviser to recommend a particular product) is not properly disclosed, and the SEC continues to bring a variety of enforcement actions in this regard (See, e.g., In the Matter of Centaurus Financial, Inc., Investment Advisers Act Release No. 5744 (June 2, 2021) (settled action); In the Matter of Cowen Prime Advisors, LLC, Investment Advisers Act Release No. 5874 (September 27, 2021) (settled action); In the Matter of O.N. Investment Management Company, Investment Advisers Act Release No. 5944 (January 11, 2022) (settled action); In the Matter of Rothschild Investment Corp., Investment Advisers Act Release No. 5860 (September 13, 2021) (settled action)).
Firm Vs. Individual Advisor Expectations
Even if an advisory firm maintains an 'approved' list of investment products or strategies from which its advisory personnel can select when making recommendations to clients, the Staff Bulletin makes it clear that the existence of such an approved list does not eliminate advisory personnel's independent responsibility to understand the products and strategies themselves. In other words, the duty of care applies both to the advisory firm and to its advisory personnel.
While the firm may bear the responsibility for educating and training its advisory personnel about the firm's approved investment products or strategies, it is the advisory personnel's responsibility to individually and independently understand such products and strategies and bridge the gap with respect to their applicability to specific clients.
Understanding The Client's Investment Profile
I have to imagine most advisers would agree that their profession is part art and part science. Understanding an investment product or strategy in a vacuum is only half the battle – the 'science' half of the equation. Applying investment product or strategy knowledge to a particular client is when the 'art' half of the equation begins to take center stage.
Said another way, isolated investment product or strategy knowledge is rather meaningless unless it can be uniquely adapted to the specific needs of each client's unique financial situation. Conversely, isolated knowledge of a particular client's unique financial situation is rather meaningless unless there is sufficient investment product and strategy knowledge to actually make recommendations that are in such a client's best interest as a fiduciary. The art and science of investment advice go hand in hand.
To unite the art and science of investment advice, according to the Staff Bulletin, an adviser must "obtain and evaluate enough information about the retail investor to have a reasonable basis to believe that the recommendation or advice is in the retail investor's best interest." This "information" in compiled form is referred to as a client's "investment profile".
What constitutes the gathering of "enough information" for a client's investment profile? The short answer is that it depends.
The long answer, according to the Staff Bulletin, is the following:
…the amount and type of information obtained for an investment profile is viewed in the context of the agreed-upon scope of the relationship and, accordingly, may involve consideration of a subset of the relevant factors depending on the services to be provided and the duration of the relationship.
In other words, the components of a client's investment profile will vary based on the specific facts and circumstances, including the nature of the client, the scope of the adviser-client relationship, and the nature and complexity of the anticipated investment advice.
Components Of A Client Investment Profile
All that said, the Staff Bulletin does enumerate what it believes advisers "should" seek to obtain and consider:
- Financial situation (including current income) and needs;
- Assets and debts;
- Marital status;
- Tax status;
- Investment time horizon;
- Liquidity needs;
- Risk tolerance;
- Investment experience;
- Investment objective and financial goals; and
- Any other information the retail investor may disclose to you in connection with the recommendation or advice.
As usual, the Staff Bulletin caveats the list above by noting that it is non-exhaustive and that additional or different factors may need to be considered under the specific facts and circumstances of the retail investor or the recommendation or advice:
For example, when making account recommendations, the staff believes that you should consider, without limitation, the retail investor's anticipated investment strategy (e.g., buy and hold versus more frequent trading); level of financial sophistication; preference for making their own investment decisions or relying on advice from a financial professional; and need or desire for account monitoring or ongoing account management.
But what's an adviser to do if the client can't or won't provide sufficient information to form a complete investment profile?
There are effectively 2 options: either (a) render the investment advice or recommendation regardless of the incomplete investment profile and document why the adviser can nonetheless form a reasonable belief that the particular investment product or strategy is in such client's best interest; or (b) decline to provide any advice or recommendations until such time as the missing investment profile components are obtained.
Regardless of the exact manner in which such client data points are collected, the point is that they should be collected and analyzed by an adviser in order to form a reasonable belief that the investment product and strategy recommendations to be made are in such a client's best interest.
Frequency Of Client Information Gathering
Unless a client has engaged the adviser purely for a one-time financial plan or investment allocation recommendation, gathering a client's investment profile is not a once-and-done exercise: "What constitutes sufficient information may change based on the investments or investment strategy being recommended or advised, or where the firm is aware or has reason to be aware that information in the investment profile has changed (e.g., birth of a child, marriage/divorce, retirement) or contains information that is inconsistent (e.g., a profile that contains multiple investment objectives that appear inconsistent with each other)."
Consideration Of Investment Alternatives
One of the more challenging and, in my opinion, unrealistic sections of the Staff Bulletin is one in which the staff discusses its expectations with respect to an adviser's contemporaneous consideration of investment products and strategies other than what is ultimately recommended to clients:
It would be difficult for firms and their financial professionals to form a reasonable basis to believe a recommendation or advice is in the retail investor's best interest without considering alternatives that are reasonably available to achieve the investor's investment objectives.
This consideration of alternatives seems to present a bit of a slippery slope, at least at first blush. Must advisers consider all conceivable alternative investment products or strategies that may be made available to clients? Must advisers perform the same level of due diligence and analysis of investment products and strategies they don't recommend as those that they do? To what extent does this consideration of alternatives need to be memorialized?
The answers to these questions are only partially addressed in the Staff Bulletin and, frankly, create more questions than answers. Let's take the following example from the Staff Bulletin:
For example, when a firm or financial professional is evaluating a mutual fund to recommend to a retail investor or to include in the investor's investment portfolio, the staff likely would not view a firm as having sufficiently considered reasonably available alternatives if it merely considers different share classes of one fund. Rather, in the staff's view, the evaluation should, for example, begin with consideration of other investments and investment types that are reasonably available to investors through the firm and could be used to achieve the investor's investment objectives. The firm or financial professional, in the view of staff, should conduct a comparative assessment of these alternatives in order to identify the investments or investment strategies that they reasonably believe are in the retail investor's best interest.
Taken to the extreme, this line of reasoning seems to suggest that a single mutual fund to be incorporated into a client's investment portfolio would trigger a consideration of, for example, all other mutual funds, exchange-traded funds, or direct stock/bond holdings that are "reasonably available" and "could" be used to achieve the client's investment objectives.
To again quote the Staff Bulletin, advisers should start by "identifying the investments or investment strategies that generally can be made available to their retail investors by a firm's financial professionals." From there, advisers should consider "a broader array of investments or investment strategies that are generally consistent with the retail investor's investment profile, and then narrow[...] to a smaller universe of potential investments or investment strategies as the analysis is more focused on meeting the best interest of a particular retail investor."
To me, the TLDR version seems to stand for the proposition that advisers should consider what investment products or strategies are reasonably available to them, are reasonably consistent with the client's investment profile, and then zero in on a particular product or strategy from there. As I'm sure any mortal adviser with a mere 24 hours in a day and without a legion of investment analysts would agree, such a consideration is simply not feasible.
Advisers can take some solace in the fact that the Staff Bulletin does at least partially acknowledge advisers' difficulty in complying with this expectation, but the acknowledgment is only moderately helpful:
The staff recognizes that certain firms may have business models sufficiently broad in scope that it may be difficult for financial professionals to be familiar with every investment available to investors. In such cases, a financial professional does not have to evaluate every possible alternative available through the firm. On the other hand, the staff believes that financial professionals would still need to evaluate a range of potential alternatives sufficient to have a reasonable basis to believe a recommendation or advice is in the best interest of the retail investor. As discussed above, in the staff's view, the scope of alternative investments and investment strategies that might be considered will depend on the facts and circumstances, including but not limited to the nature of the firm's business, the retail investor's investment profile, the scope of its relationships with its customers and clients, and the reasonable availability of alternative investments or investment strategies.
Again, there remain open questions about what "range of potential alternatives" would be considered "sufficient." The best we have to work with at this point is the SEC's favorite catchphrase, "It depends on the facts and circumstances."
The Staff Bulletin technically addresses the standard of conduct for both investment advisers (under the fiduciary duty of care) and broker-dealers (as promulgated through Regulation Best Interest, or Reg BI), but the unique nuances of Reg BI are beyond the scope of this article. This omission may be more form over substance, as the Staff Bulletin ultimately concludes that "although the specific application of Reg BI and the IA fiduciary standard may differ in some respects and be triggered at different times, in the staff's view they generally yield substantially similar results in terms of the ultimate responsibilities owed to retail investors."
That said, advisory personnel who are also registered representatives of a broker-dealer (whether through a dually registered broker-dealer/investment adviser, an affiliated broker-dealer, or through an unaffiliated broker-dealer) do have a few additional hoops to jump through in order to satisfy their duty of care (and Reg BI's best interest standard). Namely, dually registered advisory personnel must disclose the capacity in which they are acting when rendering advice or making a recommendation (i.e., as a registered representative of a broker-dealer or an investment adviser representative of an investment adviser).
In addition, dually registered advisory personnel must also consider whether a brokerage account (through the broker-dealer) or an advisory account (through the investment adviser) is better suited given a client's particular investment profile, and which investments or investment strategies should be deployed into each such account(s). This evaluation should include, among other factors, the following:
any account level costs, such as commissions, advisory fees on assets under management, or, as relevant, tax consequences, over the expected life of the investment. For example, a retail investor whose objective is to buy and hold a long-term investment may be better off paying a one-time commission to a broker-dealer for the purchase of that investment rather than paying an ongoing advisory fee merely to hold the same investment. However, it may be more cost effective or otherwise appropriate for that same investor to hold investments in an advisory account because the overall costs to the retail investor are lower or because the retail investor (or the type of investment) will require regular, ongoing advice with respect to those investments or investment strategies.
As this example illustrates, the appropriateness of a brokerage account versus an advisory account can vary based on whether the client has engaged simply to acquire a product or portfolio of products without ongoing investment management or financial planning advice, or whether the client has engaged to receive ongoing investment management and/or financial planning services beyond a mere 'point-of-sale' transaction.
It should be noncontroversial that investment advisers and their personnel are fiduciaries and owe a duty of care (and loyalty) to their clients, but the nuances of how this fiduciary duty is to be personified in the actions of advisers and their personnel is what the Staff Bulletin attempted to set forth – at least from the view of SEC staff.
For additional resources, readers may also wish to peruse 2 other SEC Staff Bulletins regarding the Standards of Conduct for Broker-Dealers and Investment Advisers Account Recommendations for Retail Investors and Standards of Conduct for Broker-Dealers and Investment Advisers Conflicts of Interest, which shed further light on the SEC staff's views with respect to account type recommendations and conflicts of interest (the latter of which is a perennial hot topic for the SEC).