[Federal Register Volume 84, Number 134 (Friday, July 12, 2019)]
[Rules and Regulations]
[Pages 33669-33681]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-12208]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 276
[Release No. IA-5248; File No. S7-07-18]
RIN 3235-AM36
Commission Interpretation Regarding Standard of Conduct for
Investment Advisers
AGENCY: Securities and Exchange Commission.
ACTION: Interpretation.
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SUMMARY: The Securities and Exchange Commission (the ``SEC'' or the
``Commission'') is publishing an interpretation of the standard of
conduct for investment advisers under the Investment Advisers Act of
1940 (the ``Advisers Act'' or the ``Act'').
DATES: Effective July 12, 2019.
FOR FURTHER INFORMATION CONTACT: Olawal[eacute] Oriola, Senior Counsel;
Matthew Cook, Senior Counsel; or Jennifer Songer, Branch Chief, at
(202) 551-6787 or [email protected], Investment Adviser Regulation
Office, Division of Investment Management, Securities and Exchange
Commission, 100 F Street NE, Washington, DC 20549-8549.
SUPPLEMENTARY INFORMATION: The Commission is publishing an
interpretation of the standard of conduct for investment advisers under
the Advisers Act [15 U.S.C. 80b].\1\
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\1\ 15 U.S.C. 80b. Unless otherwise noted, when we refer to the
Advisers Act, or any paragraph of the Advisers Act, we are referring
to 15 U.S.C. 80b of the United States Code, at which the Advisers
Act is codified, and when we refer to rules under the Advisers Act,
or any paragraph of these rules, we are referring to title 17, part
275 of the Code of Federal Regulations [17 CFR 275], in which these
rules are published.
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Table of Contents
I. Introduction
A. Overview of Comments
II. Investment Advisers' Fiduciary Duty
A. Application of Duty Determined by Scope of Relationship
B. Duty of Care
1. Duty To Provide Advice That Is in the Best Interest of the
Client
2. Duty To Seek Best Execution
3. Duty To Provide Advice and Monitoring Over the Course of the
Relationship
C. Duty of Loyalty
III. Economic Considerations
A. Background
B. Potential Economic Effects
I. Introduction
Under federal law, an investment adviser is a fiduciary.\2\ The
fiduciary duty an investment adviser owes to its client under the
Advisers Act, which comprises a duty of care and a duty of loyalty, is
important to the Commission's investor protection efforts. Also
important to the Commission's investor protection efforts is the
standard of conduct that a broker-dealer owes to a retail customer when
it makes a recommendation of any securities transaction or investment
strategy involving securities.\3\ Both investment advisers and broker-
dealers play an important role in our capital markets and our economy
more broadly. Investment advisers and broker-dealers have different
types of relationships with investors, offer different services, and
have different compensation models. This variety is important because
it presents investors with choices regarding the types of relationships
they can have, the services they can receive, and how they can pay for
those services.
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\2\ SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180,
194 (1963) (``SEC v. Capital Gains''); see also infra footnotes 34-
44 and accompanying text; Investment Adviser Codes of Ethics,
Investment Advisers Act Release No. 2256 (July 2, 2004); Compliance
Programs of Investment Companies and Investment Advisers, Investment
Advisers Act Release No. 2204 (Dec. 17, 2003); Electronic Filing by
Investment Advisers; Proposed Amendments to Form ADV, Investment
Advisers Act Release No. 1862 (Apr. 5, 2000). Investment advisers
also have antifraud liability with respect to prospective clients
under section 206 of the Advisers Act.
\3\ See Regulation Best Interest, Exchange Act Release No. 34-
86031 (June 5, 2019) (``Reg. BI Adoption''). This final
interpretation regarding the standard of conduct for investment
advisers under the Advisers Act (``Final Interpretation'')
interprets section 206 of the Advisers Act, which is applicable to
both SEC- and state-registered investment advisers, as well as other
investment advisers that are exempt from registration or subject to
a prohibition on registration under the Advisers Act. This Final
Interpretation is intended to highlight the principles relevant to
an adviser's fiduciary duty. It is not, however, intended to be the
exclusive resource for understanding these principles. Separately,
in various circumstances, case law, statutes (such as the Employee
Retirement Income Security Act of 1974 (``ERISA'')), and state law
impose obligations on investment advisers. In some cases, these
standards may differ from the standard enforced by the Commission.
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On April 18, 2018, the Commission proposed rules and forms intended
to enhance the required standard of conduct for broker-dealers \4\ and
provide retail investors with clear and succinct information regarding
the key aspects of their brokerage and advisory relationships.\5\ In
connection with the publication of these proposals, the Commission
published for comment a separate proposed interpretation regarding the
standard of conduct for investment advisers under the Advisers Act
(``Proposed Interpretation'').\6\ We stated in the Proposed
Interpretation, and we continue to believe, that it is appropriate and
beneficial to address in one release and reaffirm--and in some cases
clarify--certain aspects of the fiduciary duty that an investment
adviser owes to its clients under section 206 of the Advisers Act.\7\
After
[[Page 33670]]
considering the comments received, we are publishing this Final
Interpretation with some clarifications to address comments.\8\
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\4\ Regulation Best Interest, Exchange Act Release No. 83062
(Apr. 18, 2018) (``Reg. BI Proposal'').
\5\ Form CRS Relationship Summary; Amendments to Form ADV;
Required Disclosures in Retail Communications and Restrictions on
the use of Certain Names or Titles, Investment Advisers Act Release
No. 4888 (Apr. 18, 2018) (``Relationship Summary Proposal'').
\6\ Proposed Commission Interpretation Regarding Standard of
Conduct for Investment Advisers; Request for Comment on Enhancing
Investment Adviser Regulation, Investment Advisers Act Release No.
4889 (Apr. 18, 2018).
\7\ Further, the Commission recognizes that many advisers
provide impersonal investment advice. See, e.g., Advisers Act rule
203A-3 (defining ``impersonal investment advice'' in the context of
defining ``investment adviser representative'' as ``investment
advisory services provided by means of written material or oral
statements that do not purport to meet the objectives or needs of
specific individuals or accounts''). This Final Interpretation does
not address the extent to which the Advisers Act applies to
different types of impersonal investment advice.
\8\ In the Proposed Interpretation, the Commission also
requested comment on: Licensing and continuing education
requirements for personnel of SEC-registered investment advisers;
delivery of account statements to clients with investment advisory
accounts; and financial responsibility requirements for SEC-
registered investment advisers, including fidelity bonds. We are
continuing to evaluate the comments received in response.
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A. Overview of Comments
We received over 150 comment letters on our Proposed Interpretation
from individuals, investment advisers, trade or professional
organizations, law firms, consumer advocacy groups, and bar
associations.\9\ Although many commenters generally agreed that the
Proposed Interpretation was useful,\10\ some noted the challenges
inherent in a Commission interpretation covering the broad scope of the
fiduciary duty that an investment adviser owes to its clients under the
Advisers Act.\11\ Some of these commenters suggested modifications to
or withdrawal of the Proposed Interpretation.\12\ Although most
commenters agreed that an investment adviser's fiduciary duty comprises
a duty of care and a duty of loyalty, as described in the Proposed
Interpretation, they had differing views on aspects of the fiduciary
duty and in some cases sought clarification on its application.\13\
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\9\ Comment letters submitted in File No. S7-09-18 are available
on the Commission's website at https://www.sec.gov/comments/s7-09-18/s70918.htm. We also considered those comments submitted in File
No. S7-08-18 (Comments on Relationship Summary Proposal) and File
No. S7-07-18 (Comments on Reg. BI Proposal). Those comments are
available on the Commission's website at https://www.sec.gov/comments/s7-08-18/s70818.htm and https://www.sec.gov/comments/s7-07-18/s70718.htm.
\10\ See, e.g., Comment Letter of North American Securities
Administrators Association (Aug. 23, 2018) (``NASAA Letter'')
(stating that the Proposed Interpretation is a ``useful resource'');
Comment Letter of Invesco (Aug. 7, 2018) (``Invesco Letter'')
(agreeing that ``there are benefits to having a clear statement
regarding the fiduciary duty that applies to an investment
adviser'').
\11\ See, e.g., Comment Letter of Pickard Djinis and Pisarri LLP
(Aug. 7, 2018) (``Pickard Letter'') (noting the Commission's
``efforts to synthesize case law, legislative history, academic
literature, prior Commission releases and other sources to produce a
comprehensive explanation of the fiduciary standard of conduct'');
Comment Letter of Dechert LLP (Aug. 7, 2018) (``Dechert Letter'')
(``It is crucial that any universal interpretation of an adviser's
fiduciary duty be based on sound and time-tested principles. Given
the difficulty of defining and encompassing all of an adviser's
responsibilities to its clients, while also accommodating the
diversity of advisory arrangements, interpretive issues will arise
in the future.''); Comment Letter of the Hedge Funds Subcommittee of
the Federal Regulation of Securities Committee of the Business Law
Section of the American Bar Association (Aug. 24, 2018) (``ABA
Letter'') (``We note at the outset that it is difficult to capture
the nature of an investment adviser's fiduciary duty in a broad
statement that has universal applicability.'').
\12\ See, e.g., Comment Letter of L.A. Schnase (Jul. 30, 2018)
(urging the Commission not to issue the Proposed Interpretation in
final form, or at least not without substantial rewriting or
reshaping); Comment Letter of Money Management Institute (Aug. 7,
2018) (``MMI Letter'') (urging the Commission to ``revise the
interpretation so that it reflects the common law principles in
which an investment adviser's fiduciary duty is grounded''); Dechert
Letter (recommending that we withdraw the Proposed Interpretation
and instead rely on existing authority and sources of law, as well
as existing Commission practices for providing interpretive
guidance, in order to define the source and scope of an investment
adviser's fiduciary duty).
\13\ See, e.g., Comment Letter of Cambridge Investment Research
Inc. (Aug. 7, 2018) (``Cambridge Letter'') (stating that ``greater
clarity on all aspects of an investment adviser's fiduciary duty
will improve the ability to craft such policies and procedures, as
well as support the elimination of confusion for retail clients and
investment professionals''); Comment Letter of Institutional Limited
Partners Association (Aug. 6, 2018) (``ILPA Letter 1'')
(``Interpretation will provide more certainty regarding the
fiduciary duties owed by private fund advisers to their clients.'');
Comment Letter of New York City Bar Association (Jun. 26, 2018)
(``NY City Bar Letter'') (stating that the uniform interpretation of
an investment adviser's fiduciary duty is necessary).
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Some commenters requested that we adopt rule text instead.\14\ The
relationship between an investment adviser and its client has long been
based on fiduciary principles not generally set forth in specific
statute or rule text. We believe that this principles-based approach
should continue as it expresses broadly the standard to which
investment advisers are held while allowing them flexibility to meet
that standard in the context of their specific services. In our view,
adopting rule text is not necessary to achieve our goal in this Final
Interpretation of reaffirming and in some cases clarifying certain
aspects of the fiduciary duty.
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\14\ Some commenters suggested that we codify the Proposed
Interpretation. See, e.g., Comment Letter of Roy Tanga (Apr. 25,
2018); Comment Letter of Financial Engines (Aug. 6, 2018)
(``Financial Engines Letter''); ILPA Letter 1; Comment Letter of
AARP (Aug. 7, 2018) (``AARP Letter''); Comment Letter of Gordon
Donohue (Aug. 6, 2018); Comment Letter of Financial Planning
Coalition (Aug. 7, 2018) (``FPC Letter'').
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II. Investment Advisers' Fiduciary Duty
The Advisers Act establishes a federal fiduciary duty for
investment advisers.\15\ This fiduciary duty is based on equitable
common law principles and is fundamental to advisers' relationships
with their clients under the Advisers Act.\16\ The investment adviser's
fiduciary duty is broad and applies to the entire adviser-client
relationship.\17\ The fiduciary duty to which advisers are subject is
not specifically defined in the Advisers Act or in Commission rules,
but reflects a Congressional recognition ``of the delicate fiduciary
nature of an investment advisory relationship'' as well as 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.'' \18\ An adviser's fiduciary duty is imposed under the
Advisers Act in recognition of the nature of the relationship between
an investment adviser and a client and the desire ``so far as is
presently practicable
[[Page 33671]]
to eliminate the abuses'' that led to the enactment of the Advisers
Act.\19\ It is made enforceable by the antifraud provisions of the
Advisers Act.\20\
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\15\ Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11,
17 (1979) (``Transamerica Mortgage v. Lewis'') (``Sec. 206
establishes federal fiduciary standards to govern the conduct of
investment advisers.'') (quotation marks omitted); Santa Fe
Industries, Inc. v. Green, 430 U.S. 462, 471, n.11 (1977) (in
discussing SEC v. Capital Gains, stating that the Supreme Court's
reference to fraud in the ``equitable'' sense of the term was
``premised on its recognition that Congress intended the Investment
Advisers Act to establish federal fiduciary standards for investment
advisers''); SEC v. Capital Gains, supra footnote 2; Amendments to
Form ADV, Investment Advisers Act Release No. 3060 (July 28, 2010)
(``Investment Advisers Act Release 3060'') (``Under the Advisers
Act, an adviser is a fiduciary whose duty is to serve the best
interests of its clients, which includes an obligation not to
subrogate clients' interests to its own,'' citing Proxy Voting by
Investment Advisers, Investment Advisers Act Release No. 2106 (Jan.
31, 2003) (``Investment Advisers Act Release 2106'')).
\16\ See SEC v. Capital Gains, supra footnote 2 (discussing the
history of the Advisers Act, and how equitable principles influenced
the common law of fraud and changed the suits brought against a
fiduciary, ``which Congress recognized the investment adviser to
be'').
\17\ The Commission has previously recognized the broad scope of
section 206 of the Advisers Act in a variety of contexts. See, e.g.,
Investment Advisers Act Release 2106, supra footnote 15; Timbervest,
LLC, et al., Advisers Act Release No. 4197 (Sept. 17, 2015)
(Commission Opinion) ('' [O]nce an investment advisory relationship
is formed, the Advisers Act does not permit an adviser to exploit
that fiduciary relationship by defrauding his client in any
investment transaction connected to the advisory relationship.'');
see also SEC v. Lauer, 2008 WL 4372896, at 24 (S.D. Fla. Sept. 24,
2008) (``Unlike the antifraud provisions of the Securities Act and
the Exchange Act, Section 206 of the Advisers Act does not require
that the activity be `in the offer or sale of any' security or `in
connection with the purchase or sale of any security.' ''); Thomas
P. Lemke & Gerald T. Lins, Regulation of Investment Advisers (2013
ed.), at Sec. 2:30 (``[T]he SEC has . . . applied [sections 206(1)
and 206(2)] where fraud arose from an investment advisory
relationship, even though the wrongdoing did not specifically
involve securities.'').
\18\ See SEC v. Capital Gains, supra footnote 2; see also In the
Matter of Arleen W. Hughes, Exchange Act Release No. 4048 (Feb. 18,
1948) (``Arleen Hughes'') (Commission Opinion) (discussing the
relationship of trust and confidence between the client and a dual
registrant and stating that the registrant was a fiduciary and
subject to liability under the antifraud provisions of the
Securities Act of 1933 and the Securities Exchange Act of 1934).
\19\ See SEC v. Capital Gains, supra footnote 2 (noting that the
``declaration of policy'' in the original bill, which became the
Advisers Act, declared that ``the national public interest and the
interest of investors are adversely affected . . . when the business
of investment advisers is so conducted as to defraud or mislead
investors, or to enable such advisers to relieve themselves of their
fiduciary obligations to their clients. It is hereby declared that
the policy and purposes of this title, in accordance with which the
provisions of this title shall be interpreted, are to mitigate and,
so far as is presently practicable to eliminate the abuses
enumerated in this section'') (citing S. 3580, 76th Cong., 3d Sess.,
Sec. 202 and Investment Trusts and Investment Companies, Report of
the Securities and Exchange Commission, Pursuant to Section 30 of
the Public Utility Holding Company Act of 1935, on Investment
Counsel, Investment Management, Investment Supervisory, and
Investment Advisory Services, H.R. Doc. No. 477, 76th Cong. 2d
Sess., 1, at 28) (emphasis added).
\20\ Id.; Transamerica Mortgage v. Lewis, supra footnote 15
(``[T]he Act's legislative history leaves no doubt that Congress
intended to impose enforceable fiduciary obligations.''). Some
commenters questioned the standard to which the Advisers Act holds
investment advisers. See, e.g., Comment Letter of Stark & Stark, PC
(undated) (``The duty of care at common law and under the Advisers
Act only requires that advisers not be negligent in performing their
duties.'') (internal citation omitted); Comment Letter of
Institutional Limited Partners Association (Nov. 21, 2018) (``ILPA
Letter 2'') (``The Advisers Act standard is a lower simple
`negligence' standard.''). Claims arising under Advisers Act section
206(2) are not scienter-based and can be adequately pled with only a
showing of negligence. Robare Group, Ltd., et al. v. SEC, 922 F.3d
468, 472 (D.C. Cir. 2019) (``Robare v. SEC''); SEC v. Steadman, 967
F.2d 636, 643, n.5 (D.C. Cir. 1992) (citing SEC v. Capital Gains,
supra footnote 2) (``[A] violation of Sec. 206(2) of the Investment
Advisers Act may rest on a finding of simple negligence.''); SEC v.
DiBella, 587 F.3d 553, 567 (2d Cir. 2009) (``the government need not
show intent to make out a section 206(2) violation''); SEC v. Gruss,
859 F. Supp. 2d 653, 669 (S.D.N.Y. 2012) (``Claims arising under
Section 206(2) are not scienter-based and can be adequately pled
with only a showing of negligence.''). However, claims arising under
Advisers Act section 206(1) require scienter. See, e.g., Robare v.
SEC; SEC v. Moran, 922 F. Supp. 867, 896 (S.D.N.Y. 1996); Carroll v.
Bear, Stearns & Co., 416 F. Supp. 998, 1001 (S.D.N.Y. 1976).
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An investment adviser's fiduciary duty under the Advisers Act
comprises a duty of care and a duty of loyalty.\21\ This fiduciary duty
requires an adviser ``to adopt the principal's goals, objectives, or
ends.'' \22\ This means the adviser must, at all times, serve the best
interest of its client and not subordinate its client's interest to its
own. In other words, the investment adviser cannot place its own
interests ahead of the interests of its client. This combination of
care and loyalty obligations has been characterized as requiring the
investment adviser to act in the ``best interest'' of its client at all
times.\23\ 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. As discussed
in more detail below, 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.\24\ We believe this is another part of an
investment adviser's obligation to act in the best interest of its
client.
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\21\ See, e.g., Investment Advisers Act Release 2106, supra
footnote 15. These duties were generally recognized by commenters.
See, e.g., Comment Letter of Consumer Federation of America (Aug. 7,
2018) (``CFA Letter''); Comment Letter of the Investment Adviser
Association (Aug. 6, 2018) (``IAA Letter''); Comment Letter of
Investments & Wealth Institute (Aug. 6, 2018); Comment Letter of
Raymond James (Aug. 7, 2018); FPC Comment Letter. But see Dechert
Letter (questioning the sufficiency of support for a duty of care).
\22\ Arthur B. Laby, The Fiduciary Obligations as the Adoption
of Ends, 56 Buffalo Law Review 99 (2008); see also Restatement
(Third) of Agency, Sec. 2.02 Scope of Actual Authority (2006)
(describing a fiduciary's authority in terms of the fiduciary's
reasonable understanding of the principal's manifestations and
objectives).
\23\ Investment Advisers Act Release 3060, supra footnote 15
(adopting amendments to Form ADV and stating that ``under the
Advisers Act, an adviser is a fiduciary whose duty is to serve the
best interests of its clients, which includes an obligation not to
subrogate clients' interests to its own,'' citing Investment
Advisers Act Release 2106, supra footnote 15). See SEC v. Tambone,
550 F.3d 106, 146 (1st Cir. 2008) (``SEC v. Tambone'') (``Section
206 imposes a fiduciary duty on investment advisers to act at all
times in the best interest of the fund . . .''); SEC v. Moran, 944
F. Supp. 286, 297 (S.D.N.Y 1996) (``SEC v. Moran'') (``Investment
advisers are entrusted with the responsibility and duty to act in
the best interest of their clients.''). Although most commenters
agreed that an adviser has an obligation to act in its client's best
interest, some questioned whether the Proposed Interpretation
appropriately considered the best interest obligation as part of the
duty of care, or whether it instead should be considered part of the
duty of loyalty. See, e.g., MMI Letter; Comment Letter of Investment
Company Institute (Aug. 7, 2018) (``ICI Letter'').
\24\ See infra footnotes 67-70 and accompanying text for a more
detailed discussion of informed consent and how it is generally
considered on an objective basis and may be inferred.
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A. Application of Duty Determined by Scope of Relationship
An adviser's fiduciary duty is imposed under the Advisers Act in
recognition of the nature of the relationship between an adviser and
its client--a relationship of trust and confidence.\25\ The adviser's
fiduciary duty is principles-based and applies to the entire
relationship between the adviser and its client. The fiduciary duty
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.\26\ With regard to the scope of the adviser-client
relationship, we recognize that investment advisers provide a wide
range of services, from a single financial plan for which a client may
pay a one-time fee, to ongoing portfolio management for which a client
may pay a periodic fee based on the value of assets in the portfolio.
Investment advisers also serve a large variety of clients, from retail
clients with limited assets and investment knowledge and experience to
institutional clients with very large portfolios and substantial
knowledge, experience, and analytical resources.\27\ In our experience,
the principles-based fiduciary duty imposed by the Advisers Act has
provided sufficient flexibility to serve as an effective standard of
conduct for investment advisers, regardless of the services they
provide or the types of clients they serve.
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\25\ See, e.g., Hearings on S. 3580 before Subcommittee of the
Senate Committee on Banking and Currency, 76th Cong., 3d Sess.
(leading investment advisers emphasized their relationship of
``trust and confidence'' with their clients); SEC v. Capital Gains,
supra footnote 2 (citing same).
\26\ Several commenters asked that we clarify that an adviser
and its client can tailor the scope of the relationship to which the
fiduciary duty applies through contract. See, e.g., MMI Letter;
Financial Engines Letter; ABA Letter.
\27\ This Final Interpretation also applies to automated
advisers, which are often colloquially referred to as ``robo-
advisers.'' Automated advisers, like all SEC-registered investment
advisers, are subject to all of the requirements of the Advisers
Act, including the requirement that they provide advice consistent
with the fiduciary duty they owe to their clients. See Division of
Investment Management, Robo Advisers, IM Guidance Update No. 2017-02
(Feb. 2017), available at https://www.sec.gov/investment/im-guidance-2017-02.pdf (describing Commission staff's guidance as to
three distinct areas under the Advisers Act that automated advisers
should consider, due to the nature of their business model, in
seeking to comply with their obligations under the Advisers Act).
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Although all investment advisers owe each of their clients a
fiduciary duty under the Advisers Act, that fiduciary duty must be
viewed in the context of the agreed-upon scope of the relationship
between the adviser and the client. In particular, the 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. For example, the obligations
[[Page 33672]]
of an adviser providing comprehensive, discretionary advice in an
ongoing relationship with a retail client (e.g., monitoring and
periodically adjusting a portfolio of equity and fixed income
investments with limited restrictions on allocation) will be
significantly different from the obligations of an adviser to a
registered investment company or private fund where the contract
defines the scope of the adviser's services and limitations on its
authority with substantial specificity (e.g., a mandate to manage a
fixed income portfolio subject to specified parameters, including
concentration limits and credit quality and maturity ranges).\28\
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\28\ See, e.g., infra text following footnote 35.
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While the application of the investment adviser's fiduciary duty
will vary with the scope of the relationship, the relationship in all
cases remains that of a fiduciary to the client. In other words, an
adviser's federal fiduciary duty may not be waived, though it will
apply in a manner that reflects the agreed-upon scope of the
relationship.\29\ 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,\30\ regardless of the sophistication of the client.\31\
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\29\ Because an adviser's federal fiduciary obligations are
enforceable through section 206 of the Advisers Act, we would view a
waiver of enforcement of section 206 as implicating section 215(a)
of the Advisers Act, which provides that ``any condition,
stipulation or provision binding any person to waive compliance with
any provision of this title . . . shall be void.'' See also
Restatement (Third) of Agency, Sec. 8.06 Principal's Consent (2006)
(``[T]he law applicable to relationships of agency as defined in
Sec. 1.01 imposes mandatory limits on the circumstances under which
an agent may be empowered to take disloyal action. These limits
serve protective and cautionary purposes. Thus, an agreement that
contains general or broad language purporting to release an agent in
advance from the agent's general fiduciary obligation to the
principal is not likely to be enforceable. This is because a broadly
sweeping release of an agent's fiduciary duty may not reflect an
adequately informed judgment on the part of the principal; if
effective, the release would expose the principal to the risk that
the agent will exploit the agent's position in ways not foreseeable
by the principal at the time the principal agreed to the release. In
contrast, when a principal consents to specific transactions or to
specified types of conduct by the agent, the principal has a focused
opportunity to assess risks that are more readily identifiable.'').
\30\ See sections 206 and 215(a). Commenters generally agreed
that a client cannot waive an investment adviser's fiduciary duty
through agreement. See Dechert Letter; Comment Letter of Ropes &
Gray LLP (Aug. 7, 2018) (``Ropes & Gray Letter''), at n.20; see also
supra footnote 29. In the Proposed Interpretation, we stated that
``the investment adviser cannot disclose or negotiate away, and the
investor cannot waive, the federal fiduciary duty.'' One commenter
disputed this broad statement, believing that it called into
question ``the ability of an investment adviser and client to define
the scope of the adviser's services and duties.'' ABA Letter; see
also Financial Engines Letter. We have modified this statement to
clarify that a general waiver of the fiduciary duty would violate
that duty and to provide examples of such a general waiver.
\31\ Some commenters mentioned a 2007 No-Action Letter in which
staff indicated that whether a clause in an advisory agreement that
purports to limit an adviser's liability under that agreement (a so-
called ``hedge clause'') would violate sections 206(1) and 206(2) of
the Advisers Act depends on all of the surrounding facts and
circumstances. Heitman Capital Management, LLC, SEC Staff No-Action
Letter (Feb. 12, 2007) (``Heitman Letter''). A few commenters
indicated that the Heitman Letter expanded the ability of investment
advisers to private funds, and potentially other sophisticated
clients, to disclaim their fiduciary duties under state law in an
advisory agreement. See, e.g., ILPA Letter 1; ILPA Letter 2. The
commenters' descriptions of the Heitman Letter suggest that it may
have been applied incorrectly. The Heitman Letter does not address
the scope or substance of an adviser's federal fiduciary duty;
rather, it addresses the extent to which hedge clauses may be
misleading in violation of the Advisers Act's antifraud provisions.
Another commenter agreed with this reading of the Heitman Letter.
See Comment Letter of American Investment Council (Feb. 25, 2019).
In response to these comments, we express below the Commission's
views about an adviser's obligations under sections 206(1) and
206(2) of the Advisers Act with respect to the use of hedge clauses.
Accordingly, because we are expressing our views in this Final
Interpretation, the Heitman Letter is withdrawn.
This Final Interpretation makes clear that an adviser's federal
fiduciary duty may not be waived, though its application may be
shaped by agreement. This Final Interpretation does not take a
position on the scope or substance of any fiduciary duty that
applies to an adviser under applicable state law. See supra footnote
3. The question of whether a hedge clause violates the Advisers
Act's antifraud provisions depends on all of the surrounding facts
and circumstances, including the particular circumstances of the
client (e.g., sophistication). In our view, however, there are few
(if any) circumstances in which a hedge clause in an agreement with
a retail client would be consistent with those antifraud provisions,
where the hedge clause purports to relieve the adviser from
liability for conduct as to which the client has a non-waivable
cause of action against the adviser provided by state or federal
law. Such a hedge clause generally is likely to mislead those retail
clients into not exercising their legal rights, in violation of the
antifraud provisions, even where the agreement otherwise specifies
that the client may continue to retain its non-waivable rights.
Whether a hedge clause in an agreement with an institutional client
would violate the Advisers Act's antifraud provisions will be
determined based on the particular facts and circumstances. To the
extent that a hedge clause creates a conflict of interest between an
adviser and its client, the adviser must address the conflict as
required by its duty of loyalty.
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B. Duty of Care
As fiduciaries, investment advisers owe their clients a duty of
care.\32\ The Commission has discussed the duty of care and its
components in a number of contexts.\33\ 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 has the responsibility to
select broker-dealers to execute client trades, and (iii) the duty to
provide advice and monitoring over the course of the relationship.
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\32\ See Investment Advisers Act Release 2106, supra footnote 15
(stating that under the Advisers Act, ``an adviser is a fiduciary
that owes each of its clients duties of care and loyalty with
respect to all services undertaken on the client's behalf, including
proxy voting,'' which is the subject of the release, and citing SEC
v. Capital Gains supra footnote 2, to support this point). This
Final Interpretation does not address the specifics of how an
investment adviser might satisfy its fiduciary duty when voting
proxies. See also Restatement (Third) of Agency, Sec. 8.08
(discussing the duty of care that an agent owes its principal as a
matter of common law); Tamar Frankel & Arthur B. Laby, The
Regulation of Money Managers (updated 2017) (``Advice can be divided
into three stages. The first determines the needs of the particular
client. The second determines the portfolio strategy that would lead
to meeting the client's needs. The third relates to the choice of
securities that the portfolio would contain. The duty of care
relates to each of the stages and depends on the depth or extent of
the advisers' obligation towards their clients.'').
\33\ See, e.g., Suitability of Investment Advice Provided by
Investment Advisers; Custodial Account Statements for Certain
Advisory Clients, Investment Advisers Act Release No. 1406 (Mar. 16,
1994) (``Investment Advisers Act Release 1406'') (stating that
advisers have a duty of care and discussing advisers' suitability
obligations); Interpretive Release Concerning the Scope of Section
28(e) of the Securities Exchange Act of 1934 and Related Matters,
Exchange Act Release No. 23170 (Apr. 28, 1986) (``Exchange Act
Release 23170'') (``an adviser, as a fiduciary, owes its clients a
duty of obtaining the best execution on securities transactions'').
We highlight certain contexts, but not all, in which the Commission
has addressed the duty of care. See, e.g., Investment Advisers Act
Release 2106, supra footnote 15.
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1. Duty To Provide Advice That Is in the Best Interest of the Client
The duty of care includes a duty to provide investment advice that
is in the best interest of the client, including a duty to provide
advice that is suitable for the client.\34\ In order to provide such
[[Page 33673]]
advice, an adviser must have a reasonable understanding of the client's
objectives. 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.\35\ The duty to provide advice that is in the best
interest of the client based on a reasonable understanding of the
client's objectives is a critical component of the duty of care.
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\34\ In 1994, the Commission proposed a rule that would have
made express the fiduciary obligation of investment advisers to make
only suitable recommendations to a client. Investment Advisers Act
Release 1406, supra footnote 33. Although never adopted, the rule
was designed, among other things, to reflect the Commission's
interpretation of an adviser's existing suitability obligation under
the Advisers Act. In addition, we do not cite Investment Advisers
Act Release 1406 as the source of authority for the view we express
here, which at least one comment letter suggested, but cite it
merely to show that the Commission has long held this view. See
Comment Letter of the Managed Funds Association and the Alternative
Investment Management Association (Aug. 7, 2018) (indicating that
the Commission's failure to adopt the proposed suitability rule
means ``investment advisers are not subject to an express
`suitability' standard under existing regulation''). We believe that
this obligation to make only suitable recommendations to a client is
part of an adviser's fiduciary duty to act in the best interest of
its client. Accordingly, an adviser must provide investment advice
that is suitable for its client in providing advice that is in the
best interest of its client. See SEC v. Tambone, supra footnote 23
(``Section 206 imposes a fiduciary duty on investment advisers to
act at all times in the best interest of the fund. . . .''); SEC v.
Moran, supra footnote 23 (``Investment advisers are entrusted with
the responsibility and duty to act in the best interest of their
clients.'').
\35\ Several commenters stated that the duty to make a
reasonable inquiry into a client's investment profile may not apply
in the institutional client context. See, e.g., Comment Letter of
BlackRock, Inc. (Aug. 7, 2018); Comment Letter of Teachers Insurance
and Annuity Association of America (Aug. 7, 2018); Comment Letter of
Allianz Global Investors U.S. LLC (Aug. 7, 2018) (``Allianz
Letter''); Comment Letter of John Hancock Life Insurance Company
(U.S.A.) (Aug. 3, 2018). Accordingly, we are describing the duty as
a duty to have a reasonable understanding of the client's
objectives. While not every client will have an investment profile,
every client will have objectives. For example, an institutional
client's objectives may be ascertained through its investment
mandate.
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Reasonable Inquiry Into Client's Objectives
How an adviser develops a reasonable understanding 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.
In order to develop a reasonable understanding of a retail client's
objectives, 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 (which we
refer to collectively as the retail client's ``investment profile'').
For example, an adviser undertaking to formulate a comprehensive
financial plan for a retail client would generally need to obtain a
range of personal and financial information about the client such as
current income, investments, assets and debts, marital status, tax
status, insurance policies, and financial goals.\36\
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\36\ Investment Advisers Act Release 1406, supra footnote 33.
After making a reasonable inquiry into the client's investment
profile, it generally would be reasonable for an adviser to rely on
information provided by the client (or the client's agent) regarding
the client's financial circumstances, and an adviser should not be
held to have given advice not in its client's best interest if it is
later shown that the client had misled the adviser concerning the
information on which the advice was based.
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In addition, it will generally 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 objectives and
adjust the advice to reflect any changed circumstances.\37\ The
frequency with which the adviser must update the client's investment
profile in order to consider changes to any advice the adviser provides
would itself turn on the facts and circumstances, including whether the
adviser is aware of events that have occurred that could render
inaccurate or incomplete the investment profile on which the adviser
currently bases its advice. For instance, in the case of a financial
plan where the investment adviser also provides advice on an ongoing
basis, a change in the relevant tax law or knowledge that the client
has retired or experienced a change in marital status could trigger an
obligation to make a new inquiry.
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\37\ Such updating would not be needed with one-time investment
advice. In the Proposed Interpretation, we stated that an adviser
``must'' update a client's investment profile in order to adjust the
advice to reflect any changed circumstances. We believe that any
obligation to update a client's investment profile, like the nature
and extent of the reasonable inquiry into a retail client's
objectives, turns on what is reasonable under the circumstances.
Accordingly, we have revised the wording of this statement in this
Final Interpretation.
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By contrast, in providing investment advice to institutional
clients, the nature and extent of the reasonable inquiry into the
client's objectives generally is shaped by the specific investment
mandates from those clients. For example, an investment adviser engaged
to advise on an institutional client's investment grade bond portfolio
would need to gain a reasonable understanding of the client's
objectives within that bond portfolio, but not the client's objectives
within its entire investment portfolio. Similarly, an investment
adviser whose client is a registered investment company or a private
fund would need to have a reasonable understanding of the fund's
investment guidelines and objectives. For advisers acting on specific
investment mandates for institutional clients, particularly funds, we
believe that the obligation to update the client's objectives would not
be applicable except as may be set forth in the advisory agreement.
Reasonable Belief That Advice Is in the Best Interest of the Client
An investment adviser must have a reasonable belief that the advice
it provides is in the best interest of the client based on the client's
objectives. The formation of a reasonable belief would involve
considering, for example, whether investments are recommended only to
those clients who can and are willing to tolerate the risks of those
investments and for whom the potential benefits may justify the
risks.\38\ Whether the advice is in a client's best interest must be
evaluated in the context of the portfolio that the adviser manages for
the client and the client's objectives.
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\38\ Item 8 of Part 2A of Form ADV requires an investment
adviser to describe its methods of analysis and investment
strategies and disclose that investing in securities involves risk
of loss which clients should be prepared to bear. This item also
requires that an adviser explain the material risks involved for
each significant investment strategy or method of analysis it uses
and particular type of security it recommends, with more detail if
those risks are significant or unusual. Accordingly, investment
advisers are required to identify and explain certain risks involved
in their investment strategies and the types of securities they
recommend. An investment adviser needs to consider those same risks
in determining the clients to which the adviser recommends those
investments.
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For example, when an adviser is advising a retail client with a
conservative investment objective, investing in certain derivatives may
be in the client's best interest when they are used to hedge interest
rate risk or other risks in the client's portfolio, whereas investing
in certain directionally speculative derivatives on their own may not.
For that same client, investing in a particular security on margin may
not be in the client's best interest, even if investing in that same
security without the use of margin may be in the client's best
interest. However, for example, when advising a financially
sophisticated client, such as a fund or other sophisticated client that
has an appropriate risk tolerance, it may be in the best interest of
the client to invest in such derivatives or in securities on margin, or
to invest in other complex instruments or other products that may have
limited liquidity.
Similarly, when an adviser is assessing whether high risk
products--such as penny stocks or other thinly-traded securities--are
in a retail client's best interest, the adviser should generally apply
heightened scrutiny to whether such investments fall within the retail
client's risk tolerance and objectives. As another example,
[[Page 33674]]
complex products such as inverse or leveraged exchange-traded products
that are designed primarily as short-term trading tools for
sophisticated investors may not be in the best interest of a retail
client absent an identified, short-term, client-specific trading
objective and, to the extent that such products are in the best
interest of a retail client initially, they would require daily
monitoring by the adviser.\39\
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\39\ See Exchange-Traded Funds, Securities Act Release No. 10515
(June 28, 2018); SEC staff and FINRA, Investor Alert, Leveraged and
Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold
Investors (Aug. 1, 2009); SEC Office of Investor Education and
Advocacy, Investor Bulletin: Exchange-Traded Funds (ETFs) (Aug.
2012); see also FINRA Regulatory Notice 09-31, Non-Traditional
ETFs--FINRA Reminds Firms of Sales Practice Obligations Relating to
Leveraged and Inverse Exchange-Traded Funds (June 2009).
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A reasonable belief that investment advice is in the best interest
of a client also requires that an adviser conduct a reasonable
investigation into the investment sufficient not to base its advice on
materially inaccurate or incomplete information.\40\ We have taken
enforcement action where an investment adviser did not independently or
reasonably investigate securities before recommending them to
clients.\41\
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\40\ See, e.g., Concept Release on the U.S. Proxy System,
Investment Advisers Act Release No. 3052 (July 14, 2010) (indicating
that a fiduciary ``has a duty of care requiring it to make a
reasonable investigation to determine that it is not basing its
recommendations on materially inaccurate or incomplete
information'').
\41\ See, e.g., In the Matter of Larry C. Grossman, Investment
Advisers Act Release No. 4543 (Sept. 30, 2016) (Commission Opinion)
(``In re Grossman'') (in connection with imposing liability on a
principal of a registered investment adviser for recommending
offshore private investment funds to clients), stayed in part,
Investment Advisers Act No. 4563 (Nov. 1, 2016), response to remand,
Investment Advisers Act Release No. 4871 (Mar. 29, 2018)
(reinstating the Sept. 30, 2016 opinion and order, except with
respect to the disgorgement and prejudgment interest in light of the
Supreme Court's decision in Kokesh v. SEC, 137 S. Ct. 1635 (2017)).
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The cost (including fees and compensation) associated with
investment advice would generally be one of many important factors--
such as an investment product's or strategy's investment objectives,
characteristics (including any special or unusual features), liquidity,
risks and potential benefits, volatility, likely performance in a
variety of market and economic conditions, time horizon, and cost of
exit--to consider when determining whether a security or investment
strategy involving a security or securities is in the best interest of
the client. When considering similar investment products or strategies,
the fiduciary duty does not necessarily require an adviser to recommend
the lowest cost investment product or strategy.
Moreover, an adviser would not satisfy its fiduciary duty to
provide advice that is in the client's best interest by simply advising
its client to invest in the lowest cost (to the client) or least
remunerative (to the investment adviser) investment product or strategy
without any further analysis of other factors in the context of the
portfolio that the adviser manages for the client and the client's
objective. Rather, the adviser could recommend a higher-cost investment
or strategy if the adviser reasonably concludes that there are other
factors about the investment or strategy that outweigh cost and make
the investment or strategy in the best interest of the client, in light
of that client's objectives. For example, it might be consistent with
an adviser's fiduciary duty to advise a client with a high risk
tolerance and significant investment experience to invest in a private
equity fund with relatively higher fees and significantly less
liquidity as compared with a fund that invests in publicly-traded
companies if the private equity fund was in the client's best interest
because it provided exposure to an asset class that was appropriate in
the context of the client's overall portfolio.
An adviser's fiduciary duty applies to all investment advice the
investment adviser provides to clients, including advice about
investment strategy, engaging a sub-adviser, and account type.\42\
Advice about account type includes advice about whether to open or
invest through a certain type of account (e.g., a commission-based
brokerage account or a fee-based advisory account) and advice about
whether to roll over assets from one account (e.g., a retirement
account) into a new or existing account that the adviser or an
affiliate of the adviser manages.\43\ In providing advice about account
type, an adviser should consider all types of accounts offered by the
adviser and acknowledge to a client when the account types the adviser
offers are not in the client's best interest.\44\
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\42\ In addition, with respect to prospective clients,
investment advisers have antifraud liability under section 206 of
the Advisers Act, which, among other things, applies to
transactions, practices, or courses of business which operate as a
fraud or deceit upon prospective clients, including those regarding
investment strategy, engaging a sub-adviser, and account type. We
believe that, in order to avoid liability under this antifraud
provision, an investment adviser should have sufficient information
about the prospective client and its objectives to form a reasonable
basis for advice before providing any advice about these matters. At
the point in time at which the prospective client becomes a client
of the investment adviser (e.g., at account opening), the fiduciary
duty applies. Accordingly, while advice to prospective clients about
these matters must comply with the antifraud provisions under
section 206 of the Advisers Act, the adviser must also satisfy its
fiduciary duty with respect to any such advice (e.g., regarding
account type) when a prospective client becomes a client.
\43\ We consider advice about ``rollovers'' to include advice
about account type, in addition to any advice regarding the
investments or investment strategy with respect to the assets to be
rolled over, as the advice necessarily includes the advice about the
account type into which assets are to be rolled over. As noted
below, as a general matter, an adviser's duty to monitor extends to
all personalized advice it provides to the client, including, for
example, in an ongoing relationship, an evaluation of whether a
client's account or program type (for example, a wrap account)
continues to be in the client's best interest. See infra text
accompanying footnote 52.
\44\ Accordingly, in providing advice to a client or customer
about account type, a financial professional who is dually licensed
(i.e., an associated person of a broker-dealer and a supervised
person of an investment adviser (regardless of whether the
professional works for a dual registrant, affiliated firms, or
unaffiliated firms)) should consider all types of accounts offered
(i.e., both brokerage accounts and advisory accounts) when
determining whether the advice is in the client's best interest. A
financial professional who is only a supervised person of an
investment adviser (regardless of whether that advisory firm is a
dual registrant or affiliated with a broker-dealer) may only
recommend an advisory account the adviser offers when the account is
in the client's best interest. If a financial professional who is
only a supervised person of an investment adviser chooses to advise
a client to consider a non-advisory account (or to speak with other
personnel at a dual registrant or affiliate about a non-advisory
account), that advice should be in the best interest of the client.
This same framework applies in the case of a prospective client, but
any advice or recommendation given to a prospective client would be
subject to the antifraud provisions of the federal securities laws.
See supra footnote 42 and Reg. BI Adoption, supra footnote 3.
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2. Duty To Seek Best Execution
An investment adviser's duty of care includes a duty to seek best
execution of a client's transactions where the adviser has the
responsibility to select broker-dealers to execute client trades
(typically in the case of discretionary accounts).\45\ In meeting this
obligation, an adviser must seek to obtain the execution of
transactions for each of its clients such that the client's total cost
or proceeds in each transaction are the most favorable under the
circumstances. An adviser fulfills this duty by seeking to obtain the
execution of securities transactions on behalf of a client with
[[Page 33675]]
the goal of maximizing value for the client under the particular
circumstances occurring at the time of the transaction. Maximizing
value encompasses more than just minimizing cost. When seeking best
execution, an adviser should consider ``the full range and quality of a
broker's services in placing brokerage including, among other things,
the value of research provided as well as execution capability,
commission rate, financial responsibility, and responsiveness'' to the
adviser.\46\ In other words, the ``determinative factor'' is not the
lowest possible commission cost, ``but whether the transaction
represents the best qualitative execution.'' \47\ Further, an
investment adviser should ``periodically and systematically'' evaluate
the execution it is receiving for clients.\48\
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\45\ See Commission Guidance Regarding Client Commission
Practices Under Section 28(e) of the Securities Exchange Act of
1934, Exchange Act Release No. 54165 (July 18, 2006) (stating that
investment advisers have ``best execution obligations''); Investment
Advisers Act Release 3060, supra footnote 15 (discussing an
adviser's best execution obligations in the context of directed
brokerage arrangements and disclosure of soft dollar practices); see
also Advisers Act rule 206(3)-2(c) (referring to adviser's duty of
best execution of client transactions).
\46\ Exchange Act Release 23170, supra footnote 33.
\47\ Id.
\48\ Id. The Advisers Act does not prohibit advisers from using
an affiliated broker to execute client trades. However, the
adviser's use of such an affiliate involves a conflict of interest
that must be fully and fairly disclosed and the client must provide
informed consent to the conflict. See also Interpretation of Section
206(3) of the Investment Advisers Act of 1940, Investment Advisers
Act Release No. 1732 (Jul. 17, 1998) (discussing application of
section 206(3) of the Advisers Act to certain principal and agency
transactions). Two commenters requested that we prescribe specific
obligations related to best execution. Comment Letter of the Healthy
Markets Association (Aug. 7, 2018); Comment Letter of ICE Data
Services (Aug. 7, 2018). However, prescribing specific requirements
of how an adviser might satisfy its best execution obligations is
outside of the scope of this Final Interpretation.
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3. Duty To Provide Advice and Monitoring Over the Course of the
Relationship
An investment adviser's duty of care also encompasses the duty to
provide advice and monitoring at a frequency that is in the best
interest of the client, taking into account the scope of the agreed
relationship.\49\ For example, when the adviser has an ongoing
relationship with a client and is compensated with a periodic asset-
based fee, the adviser's duty to provide advice and monitoring will be
relatively extensive as is consistent with the nature of the
relationship.\50\ Conversely, absent an express agreement regarding the
adviser's monitoring obligation, when the adviser and the client have a
relationship of limited duration, such as for the provision of a one-
time financial plan for a one-time fee, the adviser is unlikely to have
a duty to monitor. In other words, in the absence of any agreed
limitation or expansion, the scope of the duty to monitor will be
indicated by the duration and nature of the agreed advisory
arrangement.\51\ As a general matter, an adviser's duty to monitor
extends to all personalized advice it provides to the client,
including, for example, in an ongoing relationship, an evaluation of
whether a client's account or program type (for example, a wrap
account) continues to be in the client's best interest.\52\
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\49\ Cf. SEC v. Capital Gains, supra footnote 2 (describing
advisers' ``basic function'' as ``furnishing to clients on a
personal basis competent, unbiased, and continuous advice regarding
the sound management of their investments'' (quoting Investment
Trusts and Investment Companies, Report of the Securities and
Exchange Commission, Pursuant to Section 30 of the Public Utility
Holding Company Act of 1935, on Investment Counsel, Investment
Management, Investment Supervisory, and Investment Advisory
Services, H.R. Doc. No. 477, 76th Cong. 2d Sess., 1, at 28)). Cf.
Barbara Black, Brokers and Advisers--What's in a Name?, 32 Fordham
Journal of Corporate and Financial Law XI (2005) (``[W]here the
investment adviser's duties include management of the account, [the
adviser] is under an obligation to monitor the performance of the
account and to make appropriate changes in the portfolio.''); Arthur
B. Laby, Fiduciary Obligations of Broker-Dealers and Investment
Advisers, 55 Villanova Law Review 701 (2010) (``Laby Villanova
Article'') (stating that the scope of an adviser's activity can be
altered by contract and that an adviser's fiduciary duty would be
commensurate with the scope of the relationship) (internal citations
omitted).
\50\ However, an adviser and client may scope the frequency of
the adviser's monitoring (e.g., agreement to monitor quarterly or
monthly and as appropriate in between based on market events),
provided that there is full and fair disclosure and informed
consent. We consider the frequency of monitoring, as well as any
other material facts relating to the agreed frequency, such as
whether there will also be interim monitoring when there are market
events relevant to the client's portfolio, to be a material fact
relating to the advisory relationship about which an adviser must
make full and fair disclosure and obtain informed consent as
required by its fiduciary duty.
\51\ See also Laby Villanova Article, supra footnote 49, at 728
(2010) (``If an adviser has agreed to provide continuous supervisory
services, the scope of the adviser's fiduciary duty entails a
continuous, ongoing duty to supervise the client's account,
regardless of whether any trading occurs. This feature of the
adviser's duty, even in a non-discretionary account, contrasts
sharply with the duty of a broker administering a non-discretionary
account, where no duty to monitor is required.'') (internal
citations omitted).
\52\ Investment advisers also may consider whether written
policies and procedures relating to monitoring would be appropriate
under Advisers Act rule 206(4)-7, which requires any investment
adviser registered or required to be registered under the Advisers
Act to adopt and implement written policies and procedures
reasonably designed to prevent violation of the Advisers Act and the
rules thereunder by the adviser and its supervised persons.
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C. Duty of Loyalty
The duty of loyalty requires that an adviser not subordinate its
clients' interests to its own.\53\ In other words, an investment
adviser must not place its own interest ahead of its client's
interests.\54\ To meet its duty of loyalty, an adviser must make full
and fair disclosure to its clients of all material facts relating to
the advisory relationship.\55\ Material facts relating to the advisory
relationship include the capacity in which the firm is acting with
respect to the advice provided. This will be particularly relevant for
firms or individuals that are dually registered as broker-dealers and
investment advisers and who serve the same client in both an advisory
and a brokerage capacity. Thus, such firms and individuals generally
should provide full and fair disclosure about the circumstances in
which they intend to act in their
[[Page 33676]]
brokerage capacity and the circumstances in which they intend to act in
their advisory capacity. This disclosure may be accomplished through a
variety of means, including, among others, written disclosure at the
beginning of a relationship that clearly sets forth when the dual
registrant would act in an advisory capacity and how it would provide
notification of any changes in capacity.\56\ Similarly, a dual
registrant acting in its advisory capacity should disclose any
circumstances under which its advice will be limited to a menu of
certain products offered through its affiliated broker-dealer or
affiliated investment adviser.
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\53\ Investment Advisers Act Release 3060, supra footnote 15
(adopting amendments to Form ADV and stating that ``[u]nder the
Advisers Act, an adviser is a fiduciary whose duty is to serve the
best interests of its clients, which includes an obligation not to
subrogate clients' interests to its own,'' citing Investment
Advisers Act Release 2106, supra footnote 15). The duty of loyalty
applies not just to advice regarding potential investments, but to
all advice the investment adviser provides to an existing client,
including advice about investment strategy, engaging a sub-adviser,
and account type. See supra text accompanying footnotes 42-43.
\54\ For example, an adviser cannot favor its own interests over
those of a client, whether by favoring its own accounts or by
favoring certain client accounts that pay higher fee rates to the
adviser over other client accounts. The Commission has brought
numerous enforcement actions against advisers that allocated trades
to their own accounts and allocated less favorable or unprofitable
trades to their clients' accounts. See, e.g., SEC v. Strategic
Capital Management, LLC and Michael J. Breton, Litigation Release
No. 23867 (June 23, 2017) (partial settlement) (adviser placed
trades through a master brokerage account and then allocated
profitable trades to adviser's account while placing unprofitable
trades into the client accounts in violation of fiduciary duty and
contrary to disclosures). In the Proposed Interpretation, we stated
that the duty of loyalty requires an adviser to ``put its client's
interest first.'' One commenter suggested that the requirement of an
adviser to put its client's interest ``first'' is very different
from a requirement not to ``subordinate'' or ``subrogate'' clients'
interests, and is inconsistent with how the duty of loyalty had been
applied in the past. See Comment Letter of the Asset Management
Group of the Securities Industry and Financial Markets Association
(Aug. 7, 2018) (``SIFMA AMG Letter''). Accordingly, we have revised
the description of the duty of loyalty in this Final Interpretation
to be more consistent with how we have previously described the
duty. See Investment Advisers Act Release 3060, supra footnote 15
(``Under the Advisers Act, an adviser is a fiduciary whose duty is
to serve the best interests of its clients, which includes an
obligation not to subrogate clients' interests to its own.'')
(citing Investment Advisers Act Release 2106, supra footnote 15). In
practice, referring to putting a client's interest first is a plain
English formulation commonly used by investment advisers to explain
their duty of loyalty in a way that may be more understandable to
retail clients.
\55\ See SEC v. Capital Gains, supra footnote 2 (``Failure to
disclose material facts must be deemed fraud or deceit within its
intended meaning.''); Investment Advisers Act Release 3060, supra
footnote 15 (``as a fiduciary, an adviser has an ongoing obligation
to inform its clients of any material information that could affect
the advisory relationship''); see also General Instruction 3 to Part
2 of Form ADV (``Under federal and state law, you are a fiduciary
and must make full disclosure to your clients of all material facts
relating to the advisory relationship.'').
\56\ See also Reg. BI Adoption, supra footnote 3, at 99.
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In addition, an adviser must eliminate or at least expose through
full and fair disclosure all conflicts of interest which might incline
an investment adviser--consciously or unconsciously--to render advice
which was not disinterested.\57\ We believe that while full and fair
disclosure of all material facts relating to the advisory relationship
or of conflicts of interest and a client's informed consent prevent the
presence of those material facts or conflicts themselves from violating
the adviser's fiduciary duty, such disclosure and consent do not
themselves satisfy the adviser's duty to act in the client's best
interest.\58\ To illustrate what constitutes full and fair disclosure,
we are providing the following guidance on (i) the appropriate level of
specificity, including the appropriateness of stating that an adviser
``may'' have a conflict, and (ii) considerations for disclosure
regarding conflicts related to the allocation of investment
opportunities among eligible clients.
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\57\ In the Proposed Interpretation, we stated that an adviser
must seek to avoid conflicts of interest with its clients. Proposed
Interpretation, supra footnote 6. Some commenters requested clarity
on what it means to ``seek to avoid'' conflicts of interest. See,
e.g., Comment Letter of Schulte Roth & Zabel LLP (Aug. 8, 2018); ABA
Letter (stating that this wording could be read to require an
adviser to first seek to avoid a conflict, before addressing a
conflict through disclosure, rather than being able to provide full
and fair disclosure of a conflict, and only seek avoidance if the
conflict cannot be addressed through disclosure). The Commission
first used this phrasing when adopting amendments to the Form ADV
Part 2 instructions. See Investment Advisers Act Release 3060, supra
footnote 15 and General Instruction 3 to Part 2 of Form ADV (``As a
fiduciary, you also must seek to avoid conflicts of interest with
your clients, and, at a minimum, make full disclosure of all
material conflicts of interest between you and your clients that
could affect the advisory relationship.''). The release adopting
this instruction clarifies the Commission's intent that it capture
the fiduciary duty described in SEC v. Capital Gains and Arleen
Hughes. See Investment Advisers Act Release 3060, supra footnote 15,
at n.4 and accompanying text (citing SEC v. Capital Gains, supra
footnote 2, and Arleen Hughes, supra footnote 18, as the basis of
this language). Both of these cases emphasized that the adviser, as
a fiduciary, should seek to avoid conflicts, but at a minimum must
make full and fair disclosure of the conflict and obtain the
client's informed consent. See SEC v. Capital Gains, supra footnote
2 (``The Advisers Act thus 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.''); Arleen Hughes,
supra footnote 18 (``Since loyalty to his trust is the first duty
which a fiduciary owes to his principal, it is the general rule that
a fiduciary must not put himself into a position where his own
interests may come in conflict with those of his principal'' but if
a fiduciary ``chooses to assume a role in which she is motivated by
conflicting interests, . . . she may do so if, but only if, she
obtains her client's consent after disclosure . . .''). We believe
the Commission's reference to ``seek to avoid'' conflicts in the
Form ADV Part 2 instructions is consistent with the Final
Interpretation's statement that an adviser ``must eliminate or at
least expose all conflicts of interest which might incline an
investment adviser--consciously or unconsciously--to render advice
which was not disinterested'' as well as the substantively identical
statements in SEC v. Capital Gains, supra footnote 2, and Arleen
Hughes, supra footnote 18. While an adviser may satisfy its duty of
loyalty by making full and fair disclosure of conflicts of interest
and obtaining the client's informed consent, an adviser is
prohibited from overreaching or taking unfair advantage of a
client's trust.
\58\ As noted above, 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. See SEC
v. Tambone, supra footnote 23 (stating that Advisers Act section 206
``imposes a fiduciary duty on investment advisers to act at all
times in the best interest of the fund . . . and includes an
obligation to provide `full and fair disclosure of all material
facts' '') (emphasis added) (citing SEC v. Capital Gains, supra
footnote 2). We describe above in this Final Interpretation how the
application of an investment adviser's fiduciary duty to its client
will vary with the scope of the advisory relationship. See supra
section II.A.
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In order for disclosure to be full and fair, it should be
sufficiently specific so that a client is able to understand the
material fact or conflict of interest and make an informed decision
whether to provide consent.\59\ For example, it would be inadequate to
disclose that the adviser has ``other clients'' without describing how
the adviser will manage conflicts between clients if and when they
arise, or to disclose that the adviser has ``conflicts'' without
further description.
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\59\ Arleen Hughes, supra footnote 18, at 4 and 8 (stating,
``[s]ince loyalty to his trust is the first duty which a fiduciary
owes to his principal, it is the general rule that a fiduciary must
not put himself into a position where his own interests may come in
conflict with those of his principal. To prevent any conflict and
the possible subordination of this duty to act solely for the
benefit of his principal, a fiduciary at common law is forbidden to
deal as an adverse party with his principal. An exception is made,
however, where the principal gives his informed consent to such
dealings,'' and adding that, ``[r]egistrant has an affirmative
obligation to disclose all material facts to her clients in a manner
which is clear enough so that a client is fully apprised of the
facts and is in a position to give his informed consent.''); see
also Hughes v. Securities and Exchange Commission, 174 F.2d 969
(1949) (affirming the SEC decision in Arleen Hughes); General
Instruction 3 to Part 2 of Form ADV (stating that an adviser's
disclosure obligation ``requires that [the adviser] provide the
client with sufficiently specific facts so that the client is able
to understand the conflicts of interest [the adviser has] and the
business practices in which [the adviser] engage[s], and can give
informed consent to such conflicts or practices or reject them'');
Investment Advisers Act Release 3060, supra footnote 15; Restatement
(Third) of Agency Sec. 8.06 (``Conduct by an agent that would
otherwise constitute a breach of duty as stated in Sec. Sec. 8.01,
8.02, 8.03, 8.04, and 8.05 [referencing the fiduciary duty] does not
constitute a breach of duty if the principal consents to the
conduct, provided that (a) in obtaining the principal's consent, the
agent (i) acts in good faith, (ii) discloses all material facts that
the agent knows, has reason to know, or should know would reasonably
affect the principal's judgment unless the principal has manifested
that such facts are already known by the principal or that the
principal does not wish to know them, and (iii) otherwise deals
fairly with the principal; and (b) the principal's consent concerns
either a specific act or transaction, or acts or transactions of a
specified type that could reasonably be expected to occur in the
ordinary course of the agency relationship.''). See infra footnotes
67-70 and accompanying text for a more detailed discussion of
informed consent and how it is generally considered on an objective
basis and may be inferred.
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Similarly, disclosure that an adviser ``may'' have a particular
conflict, without more, is not adequate when the conflict actually
exists.\60\ For example, we would consider the use of ``may''
inappropriate when the conflict exists with respect to some (but not
all) types or classes of clients, advice, or transactions without
additional disclosure specifying the types or classes of clients,
advice, or transactions with respect to which the conflict exists. In
addition, the use of ``may'' would be inappropriate if it simply
precedes a list of all possible or potential conflicts regardless of
likelihood and obfuscates
[[Page 33677]]
actual conflicts to the point that a client cannot provide informed
consent. On the other hand, the word ``may'' could be appropriately
used to disclose to a client a potential conflict that does not
currently exist but might reasonably present itself in the future.\61\
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\60\ We have brought enforcement actions in such cases. See,
e.g., In the Matter of The Robare Group, Ltd., et al., Investment
Advisers Act Release No. 4566 (Nov. 7, 2016) (Commission Opinion)
(finding, among other things, that adviser's disclosure that it may
receive a certain type of compensation was inadequate because it did
not reveal that the adviser actually had an arrangement pursuant to
which it received fees that presented a potential conflict of
interest); aff'd in part and rev'd in part on other grounds Robare
v. SEC, supra footnote 20; In re Grossman, supra footnote 41
(indicating that ``the use of the prospective `may' in [the relevant
Form ADV disclosures] is misleading because it suggested the mere
possibility that [the broker] would make a referral and/or be paid
`referral fees' at a later point, when in fact a commission-sharing
arrangement was already in place and generating income''). Cf.
Dolphin & Bradbury, Inc. v. SEC, 512 F.3d 634, 640 (D.C. Cir. 2008)
(``The Commission noted the critical distinction between disclosing
the risk that a future event might occur and disclosing actual
knowledge the event will occur.'') (emphasis in original). For Form
ADV Part 2 purposes, advisers are instructed that when they have a
conflict or engage in a practice with respect to some (but not all)
types or classes of clients, advice, or transactions, to indicate as
such rather than disclosing that they ``may'' have the conflict or
engage in the practice. General Instruction 2 to Part 2 of Form ADV.
\61\ We have added this example of a circumstance where ``may''
could be appropriately used in response to the request of some
commenters. See, e.g., Pickard Letter; ICI Letter; Ropes & Gray
Letter; IAA Letter.
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Whether the disclosure is full and fair will depend upon, among
other things, the nature of the client, the scope of the services, and
the material fact or conflict. Full and fair disclosure for an
institutional client (including the specificity, level of detail, and
explanation of terminology) can differ, in some cases significantly,
from full and fair disclosure for a retail client because institutional
clients generally have a greater capacity and more resources than
retail clients to analyze and understand complex conflicts and their
ramifications.\62\ Nevertheless, regardless of the nature of the
client, the disclosure must be clear and detailed enough for the client
to make an informed decision to consent to the conflict of interest or
reject it.
---------------------------------------------------------------------------
\62\ Arleen Hughes, supra footnote 18 (the ``method and extent
of disclosure depends upon the particular client involved,'' and an
unsophisticated client may require ``a more extensive explanation
than the informed investor'').
---------------------------------------------------------------------------
When allocating investment opportunities among eligible clients, an
adviser may face conflicts of interest either between its own interests
and those of a client or among different clients.\63\ If so, the
adviser must eliminate or at least expose through full and fair
disclosure the conflicts associated with its allocation policies,
including how the adviser will allocate investment opportunities, such
that a client can provide informed consent.\64\ When allocating
investment opportunities, an adviser is permitted to consider the
nature and objectives of the client and the scope of the
relationship.\65\ An adviser need not have pro rata allocation
policies, or any particular method of allocation, but, as with other
conflicts and material facts, the adviser's allocation practices must
not prevent it from providing advice that is in the best interest of
its clients.\66\
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\63\ See Restatement (Third) of Agency, Sec. 8.01 General
Fiduciary Principle (2006) (``Unless the principal consents, the
general fiduciary principle, as elaborated by the more specific
duties of loyalty stated in Sec. Sec. 8.02 to 8.05, also requires
that an agent refrain from using the agent's position or the
principal's property to benefit the agent or a third party.'').
\64\ The Commission has brought numerous enforcement actions
alleging that advisers unfairly allocated client trades to preferred
clients without making full and fair disclosure. See Staff of the
U.S. Securities and Exchange Commission, Study on Investment
Advisers and Broker-Dealers As Required by Section 913 of the Dodd-
Frank Wall Street Reform and Consumer Protection Act (Jan. 2011),
available at https://www.sec.gov/news/studies/2011/913studyfinal.pdf, at 23-24 (citing enforcement actions). This Final
Interpretation sets forth the Commission's views regarding what
constitutes full and fair disclosure. See, e.g., supra text
accompanying footnote 59; see also Barry Barbash and Jai Massari,
The Investment Advisers Act of 1940; Regulation by Accretion, 39
Rutgers Law Journal 627 (2008) (stating that under section 206 of
the Advisers Act and traditional notions of fiduciary and agency
law, an adviser must not give preferential treatment to some clients
or systematically exclude eligible clients from participating in
specific opportunities without providing the clients with
appropriate disclosure regarding the treatment).
\65\ An adviser and a client may even agree that certain
investment opportunities or categories of investment opportunities
will not be allocated or offered to a client.
\66\ In the Proposed Interpretation, we stated that ``in
allocating investment opportunities among eligible clients, an
adviser must treat all clients fairly.'' Some commenters interpreted
this statement to mean that it would be impermissible for an adviser
to allocate a particular investment to one eligible client instead
of a second eligible client, even when the second client had
received full and fair disclosure and provided informed consent to
such an investment being allocated to the first client. See, e.g.,
Ropes & Gray Letter; SIFMA AMG Letter. We have removed that sentence
from this Final Interpretation and replaced it with this discussion
that clarifies our views regarding allocation of investment
opportunities.
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While most commenters agreed that informed consent is a component
of the fiduciary duty, a few commenters objected to what they saw as
subjectivity in the use of the term ``informed'' to describe a client's
consent to a disclosed conflict.\67\ The fact that disclosure must be
full and fair such that a client can provide informed consent does not
require advisers to make an affirmative determination that a particular
client understood the disclosure and that the client's consent to the
conflict of interest was informed. Rather, disclosure should be
designed to put a client in a position to be able to understand and
provide informed consent to the conflict of interest. A client's
informed consent can be either explicit or, depending on the facts and
circumstances, implicit.\68\ We believe, however, that it would not be
consistent with an adviser's fiduciary duty to infer or accept client
consent where the adviser was aware, or reasonably should have been
aware, that the client did not understand the nature and import of the
conflict.\69\ In some cases, conflicts may be of a nature and extent
that it would be difficult to provide disclosure to clients that
adequately conveys the material facts or the nature, magnitude, and
potential effect of the conflict sufficient for a client to consent to
or reject it.\70\ In other cases, disclosure may not be specific enough
for a client to understand whether and how the conflict could affect
the advice it receives. For retail clients in particular, it may be
difficult to provide disclosure regarding complex or extensive
conflicts that is sufficiently specific, but also understandable. In
all of these cases where an investment adviser cannot fully and fairly
disclose a conflict of interest to a client such that the client can
provide informed consent, the adviser should either eliminate the
conflict or adequately mitigate (i.e., modify practices to reduce) the
conflict such that full and fair disclosure and informed consent are
possible.
---------------------------------------------------------------------------
\67\ See, e.g., Comment Letter of LPL Financial LLC (Aug. 7,
2018); Ropes & Gray Letter.
\68\ We do not interpret an adviser's fiduciary duty to require
that full and fair disclosure or informed consent be achieved in a
written advisory contract or otherwise in writing. For example, an
adviser could provide a client full and fair disclosure of all
material facts relating to the advisory relationship as well as full
and fair disclosure of all conflicts of interest which might incline
the adviser, consciously or unconsciously, to render advice that was
not disinterested, through a combination of Form ADV and other
disclosure and the client could implicitly consent by entering into
or continuing the investment advisory relationship with the adviser.
\69\ See Arleen Hughes, supra footnote 18 (``Registrant cannot
satisfy this duty by executing an agreement with her clients which
the record shows some clients do not understand and which, in any
event, does not contain the essential facts which she must
communicate.''). In the Proposed Interpretation, we stated that
inferring or accepting client consent to a conflict would not be
consistent with the fiduciary duty where ``the material facts
concerning the conflict could not be fully and fairly disclosed.''
Some commenters expressed agreement with this statement. See, e.g.,
CFA Letter (agreeing that ``advisers should be precluded from
inferring or accepting client consent to a conflict'' where the
material facts concerning the conflict could not be fully and fairly
disclosed). Other commenters expressed doubt that such disclosure
could be impossible. See, e.g., Allianz Letter (``[W]e have not
encountered a situation in which we could not fully and fairly
disclose the material facts, including the nature, extent, magnitude
and potential effects of the conflict.''). In response to
commenters, we have replaced the general statement about an
inability to fully and fairly disclose material facts about the
conflict with more specific examples of how advisers can make such
full and fair disclosure. See supra text accompanying footnotes 59-
66.
\70\ As discussed above, institutional clients generally have a
greater capacity and more resources than retail clients to analyze
and understand complex conflicts and their ramifications. See supra
text accompanying footnote 62.
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Full and fair disclosure of all material facts relating to the
advisory relationship, and all conflicts of interest which might
incline an investment adviser--consciously or unconsciously--to render
advice which was not disinterested, can help clients and prospective
clients in evaluating and selecting investment advisers. Accordingly,
we require advisers to deliver to their clients a ``brochure,'' under
Part 2A of Form ADV, which sets
[[Page 33678]]
out minimum disclosure requirements, including disclosure of certain
conflicts.\71\ Investment advisers are required to deliver the brochure
to a prospective client at or before entering into a contract so that
the prospective client can use the information contained in the
brochure to decide whether or not to enter into the advisory
relationship.\72\ In a concurrent release, we are requiring all
investment advisers to deliver to retail investors, at or before the
time the adviser enters into an investment advisory agreement, a
relationship summary, which would include, among other things, a plain
English summary of certain of the firm's conflicts of interest, and
would encourage retail investors to inquire about those conflicts.\73\
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\71\ Investment Advisers Act Release 3060, supra footnote 15;
General Instruction 3 to Part 2 of Form ADV (``Under federal and
state law, you are a fiduciary and must make full disclosure to your
clients of all material facts relating to the advisory relationship.
As a fiduciary, you also must seek to avoid conflicts of interest
with your clients, and, at a minimum, make full disclosure of all
material conflicts of interest between you and your clients that
could affect the advisory relationship. This obligation requires
that you provide the client with sufficiently specific facts so that
the client is able to understand the conflicts of interest you have
and the business practices in which you engage, and can give
informed consent to such conflicts or practices or reject them.'').
See also Robare v. SEC, supra footnote 20 (``[R]egardless of what
Form ADV requires, [investment advisers have] a fiduciary duty to
fully and fairly reveal conflicts of interest to their clients.'').
\72\ Investment Advisers Act rule 204-3. See Investment Advisers
Act Release 3060, supra footnote 15 (adopting amendments to Form ADV
and stating that, ``A client may use this disclosure to select his
or her own adviser and evaluate the adviser's business practices and
conflicts on an ongoing basis. As a result, the disclosure clients
and prospective clients receive is critical to their ability to make
an informed decision about whether to engage an adviser and, having
engaged the adviser, to manage that relationship.''). To the extent
that the information required for inclusion in the brochure does not
satisfy an adviser's disclosure obligation, the adviser ``may have
to disclose to clients information not specifically required by Part
2 of Form ADV or in more detail than the brochure items might
otherwise require'' and this disclosure may be made ``in [the]
brochure or by some other means.'' General Instruction 3 to Part 2
of Form ADV.
\73\ Form CRS Relationship Summary; Amendments to Form ADV;
Required Disclosures in Retail Communications and Restrictions on
the use of Certain Names or Titles, Investment Advisers Act Release
No. 5247 (June 5, 2019) (``Relationship Summary Adoption'').
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III. Economic Considerations
As noted above, this Final Interpretation is intended to reaffirm,
and in some cases clarify, certain aspects of an investment adviser's
fiduciary duty under the Advisers Act. The Final Interpretation does
not itself create any new legal obligations for advisers. Nonetheless,
the Commission recognizes that to the extent an adviser's practices are
not consistent with the Final Interpretation provided above, the Final
Interpretation could have potential economic effects. We discuss these
potential effects below.
A. Background
The Commission's interpretation of the standard of conduct for
investment advisers under the Advisers Act set forth in this Final
Interpretation would affect investment advisers and their associated
persons as well as the clients of those investment advisers, and the
market for financial advice more broadly.\74\ As of December 31, 2018,
there were 13,299 investment advisers registered with the Commission
with over $84 trillion in assets under management as well as 17,268
investment advisers registered with states with approximately $334
billion in assets under management and 3,911 investment advisers who
submit Form ADV as exempt reporting advisers.\75\ As of December 31,
2018, there are approximately 41 million client accounts advised by
SEC-registered investment advisers.\76\
---------------------------------------------------------------------------
\74\ See Relationship Summary Proposal, supra footnote 5, at
section IV.A (discussing the market for financial advice generally).
\75\ Data on investment advisers is based on staff analysis of
Form ADV, particularly Item 5.F.(2)(c) of Part 1A for Regulatory
Assets under Management. Because this Final Interpretation
interprets an adviser's fiduciary duty under section 206 of the
Advisers Act, this interpretation would be applicable to both SEC-
and state-registered investment advisers, as well as other
investment advisers that are exempt from registration or subject to
a prohibition on registration under the Advisers Act.
\76\ Item 5.F.(2)(f) of Part 1A of Form ADV.
---------------------------------------------------------------------------
These investment advisers currently incur ongoing costs related to
their compliance with their legal and regulatory obligations, including
costs related to understanding the standard of conduct. We believe,
based on the Commission's experience, that the interpretations set
forth in this Final Interpretation are generally consistent with
investment advisers' current understanding of their fiduciary duty
under the Advisers Act.\77\ However, we recognize that as the scope of
the adviser-client relationship varies and in many cases can be broad,
there may be certain current circumstances where investment advisers
interpret their fiduciary duty to require something less, and other
current circumstances where they interpret their fiduciary duty to
require something more, than this Final Interpretation. We lack data to
identify which investment advisers currently understand their fiduciary
duty to require something different from the standard of conduct
articulated in this Final Interpretation. Based on our experience over
decades of interacting with the investment management industry as its
primary regulator, however, we generally believe that it is not a
significant portion of the market.
---------------------------------------------------------------------------
\77\ See supra section II.B.i. For example, some commenters
asked that we clarify from the Proposed Interpretation that an
adviser and its client can tailor the scope of the relationship to
which the fiduciary duty applies, through contract. See, e.g., MMI
Letter; Financial Engines Letter; ABA Letter. See supra footnotes
67-69 and accompanying text, including clarifications addressing
these commenters' concerns. More generally, some commenters
requested clarifications from the Proposed Interpretation, and we
are issuing this Final Interpretation to address those issues raised
by commenters, as discussed in more detail above.
---------------------------------------------------------------------------
One commenter suggested that the Proposed Interpretation's
discussion of how an adviser fulfills its fiduciary duty appeared to be
based in the context of having as a client an individual investor, and
not a fund.\78\ This commenter indicated its concerns about the ability
of a fund manager to infer consent from a client that is a fund, and
that issues regarding inferring consent from funds could significantly
increase compliance costs for venture capital funds.\79\ Our discussion
above in this Final Interpretation includes clarifications to address
comments, and expressly acknowledges that while all investment advisers
owe each of their clients a fiduciary duty, the specific application of
the investment adviser's fiduciary duty must be viewed in the context
of the agreed-upon scope of the adviser-client relationship.\80\ This
Final Interpretation, as compared to the Proposed Interpretation,
includes significantly more examples of the application of the
fiduciary duty to institutional clients, and clarifies the Commission's
interpretation of what constitutes full and fair disclosure and
informed consent, acknowledging a number of comments on this topic.\81\
We believe that these clarifications will help address some of this
commenter's concerns with respect to increased compliance costs for
venture capital funds, in part by clarifying how the fiduciary duty can
apply to institutional clients. We continue to believe, based on our
experience with investment advisers to different types of clients, that
advisers understand their fiduciary
[[Page 33679]]
duty to be generally consistent with the standards of this Final
Interpretation.
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\78\ See Comment Letter of National Venture Capital Association
(Aug. 7, 2018) (``NVCA Letter'').
\79\ Id.
\80\ See supra section II.A.
\81\ In particular, this Final Interpretation expressly notes
our belief that a client generally may provide its informed consent
implicitly ``by entering into or continuing the investment advisory
relationship with the adviser'' after disclosure of a conflict of
interest. See supra footnote 68.
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B. Potential Economic Effects
Based on our experience as the long-standing regulator of the
investment adviser industry, the Commission's interpretation of the
fiduciary duty under section 206 of the Advisers Act described in this
Final Interpretation generally reaffirms the current practices of
investment advisers. Therefore, we expect there to be no significant
economic effects from this Final Interpretation. However, as with other
circumstances in which the Commission speaks to the legal obligations
of regulated entities, we acknowledge that affected firms, including
those whose practices are consistent with the Commission's
interpretation, incur costs to evaluate the Commission's interpretation
and assess its applicability to them. Further, to the extent certain
investment advisers currently understand the practices necessary to
comply with their fiduciary duty to be different from those discussed
in this Final Interpretation, there could be some economic effects,
which we discuss below.
Clients of Investment Advisers
The typical relationship between an investment adviser and a client
is a principal-agent relationship, where the principal (the client)
hires an agent (the investment adviser) to perform some service
(investment advisory services) on the principal's behalf.\82\ Because
investors and investment advisers are likely to have different
preferences and goals, the investment adviser relationship is subject
to agency problems, including those resulting from conflicts: That is,
investment advisers may take actions that increase their well-being at
the expense of investors, thereby imposing agency costs on
investors.\83\ A fiduciary duty, such as the duty investment advisers
owe their clients, can mitigate these agency problems and reduce agency
costs by deterring investment advisers from taking actions that expose
them to legal liability.\84\
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\82\ See, e.g., James A. Brickley, Clifford W. Smith, Jr. &
Jerold L. Zimmerman, Managerial Economics and Organizational
Architecture (2004), at 265 (``An agency relationship consists of an
agreement under which one party, the principal, engages another
party, the agent, to perform some service on the principal's
behalf.''); see also Michael C. Jensen & William H. Meckling, Theory
of the Firm: Managerial Behavior, Agency Costs and Ownership
Structure, 3 Journal of Financial Economics 305-360 (1976) (``Jensen
and Meckling'').
\83\ See, e.g., Jensen and Meckling, supra footnote 82.
\84\ See, e.g., Frank H. Easterbrook & Daniel R. Fischel,
Contract and Fiduciary Duty, 36 Journal of Law & Economics 425-46
(1993).
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To the extent this Final Interpretation causes a change in behavior
of those investment advisers, if any, who currently interpret their
fiduciary duty to require something different from this Final
Interpretation, we expect a potential reduction in agency problems and,
consequently, a reduction of agency costs to the client.\85\ For
example, an adviser that, as part of its duty of loyalty, fully and
fairly discloses \86\ a conflict of interest and receives informed
consent from its client with respect to the conflict may reduce agency
costs by increasing the client's awareness of the conflict and
improving the client's ability to monitor the adviser with respect to
this conflict. Alternatively, the client may choose to not consent
given the information the adviser discloses about a conflict of
interest if the perceived risk associated with the conflict is too
significant, and instead try to renegotiate the contract with the
adviser or look for an alternative adviser or other financial
professional. In addition, the obligation to fully and fairly disclose
a current conflict may cause the adviser to take other actions, for
example eliminating or adequately mitigating (i.e., modifying practices
to reduce) that conflict rather than taking the risk that the client
will not provide informed consent or will look for an alternative
adviser or other financial professional. The extent to which agency
costs would be reduced by such a disclosure is difficult to assess
given that we are unable to ascertain the total number of investment
advisers that currently interpret their fiduciary duty to require
something different from the Commission's interpretation,\87\ and
consequently we are not able to estimate the agency costs such advisers
currently impose on investors. In addition, we believe that there may
be potential benefits for clients of those investment advisers, if any,
to the extent this Final Interpretation is effective at strengthening
investment advisers' understanding of their obligations to their
clients. Further, to the extent that this Final Interpretation enhances
the understanding of any investment advisers of their duty of care, it
may potentially raise the quality of investment advice and also lead to
increased compliance with the duty to monitor, for example whether
advice about an account or program type remains in the client's best
interest, thereby increasing the likelihood that the advice fits with a
client's objectives.
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\85\ To the extent that this Final Interpretation clarifies the
fiduciary duty for investment advisers, one commenter suggested it
may then clarify what clients expect of their investment advisers.
See Cambridge Letter (stating that ``greater clarity on all aspects
of an investment adviser's fiduciary duty will improve the ability
to craft such policies and procedures, as well as support the
elimination of confusion for retail clients and investment
professionals'').
\86\ As discussed above, whether such a disclosure is full and
fair will depend upon, among other things, the nature of the client,
the scope of the services, and the conflict. See supra section II.C.
\87\ One commenter did not agree that the discussion of
fiduciary obligations in the Proposed Interpretation applied to
advisers to funds as well as advisers to retail investors. See NVCA
Letter. As discussed above, this Final Interpretation has clarified
the discussion to address this commenter's concerns and acknowledges
that the application of the fiduciary duty of an adviser to a retail
client would be different from the specific application of the
fiduciary duty of an adviser to a registered investment company or
private fund.
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In addition, to the extent that this Final Interpretation causes
some investment advisers to properly identify circumstances in which
conflicts may be of a nature and extent that it would be difficult to
provide disclosure to clients that adequately conveys the material
facts or nature, magnitude, and potential effect of the conflict
sufficient for clients to consent to it or reject it, or in which the
disclosure may not be specific enough for clients to understand whether
and how the conflict could affect the advice they receive, this Final
Interpretation may lead those investment advisers to take additional
steps to improve their disclosures or to determine whether adequately
mitigating (i.e., modifying practices to reduce) the conflict may be
appropriate such that full and fair disclosure and informed consent are
possible. This Final Interpretation may also cause some investment
advisers to conclude in some circumstances that they cannot fully and
fairly disclose a conflict of interest to a client such that the client
can provide informed consent. We would expect that these advisers would
either eliminate the conflict or adequately mitigate (i.e., modify
practices to reduce) the conflict such that full and fair disclosure
and informed consent would be possible. Thus, to the extent this Final
Interpretation would cause investment advisers to better understand
their obligations and therefore to modify their business practices in
ways that (i) reduce the likelihood that conflicts and other agency
costs will cause an adviser to place its interests ahead of the
interests of the client or (ii) help those advisers to provide full and
fair disclosure, it would be expected to ameliorate the agency conflict
between investment advisers and their clients. In
[[Page 33680]]
turn, this may improve the quality of advice that the clients receive
and therefore produce higher overall returns for clients and increase
the efficiency of portfolio allocation. However, as discussed above, we
would generally expect these effects to be minimal because we believe
that the interpretations we are setting forth in this Final
Interpretation are generally consistent with investment advisers'
current understanding of their fiduciary duty under the Advisers Act.
Finally, this Final Interpretation would also benefit clients of
investment advisers to the extent it assists the Commission in its
oversight of investment advisers' compliance with their regulatory
obligations.
Investment Advisers and the Market for Investment Advice
In general, we expect this Final Interpretation to affirm
investment advisers' understanding of the fiduciary duty they owe their
clients under the Advisers Act, reduce uncertainty for advisers, and
facilitate their compliance. Further, by addressing in one release
certain aspects of the fiduciary duty that an investment adviser owes
to its clients under the Advisers Act, this Final Interpretation could
reduce investment advisers' costs associated with comprehensively
assessing their compliance obligations. We acknowledge that, as with
other circumstances in which the Commission speaks to the legal
obligations of regulated entities, affected firms, including those
whose practices are consistent with the Commission's interpretation,
incur costs to evaluate the Commission's interpretation and assess its
applicability to them. Moreover, as discussed above, there may be
certain investment advisers who currently understand their fiduciary
duty to require something different from the fiduciary duty described
in this Final Interpretation. Those investment advisers would
experience an increase in their compliance costs as they change their
systems, processes, disclosures, and behavior, and train their
supervised persons, to align with this Final Interpretation. However,
this increase in costs would be mitigated by potential benefits in
efficiency for investment advisers that are able to understand aspects
of their fiduciary duty by reference to a single Commission release
that reaffirms--and in some cases clarifies--certain aspects of the
fiduciary duty.\88\ In addition, and as discussed above, in the case of
an investment adviser that believed it owed its clients a lower
standard of conduct, there will be client benefits from the ensuing
adaptation of a higher standard of conduct and related change in
policies and procedures.
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\88\ As noted above, supra footnote 3, this Final Interpretation
is intended to highlight the principles relevant to an adviser's
fiduciary duty. It is not, however, intended to be the exclusive
resource for understanding these principles.
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Moreover, to the extent any investment advisers that understood
their fiduciary duty to require something different from the fiduciary
duty described in this Final Interpretation change their behavior to
align with this Final Interpretation, there could also be some economic
effects on the market for investment advice. For example, any improved
compliance may not only reduce agency costs in current investment
advisory relationships and increase the value of those relationships to
current clients, it may also increase trust in the market for
investment advice among all investors, which may result in more
investors seeking advice from investment advisers. This may, in turn,
benefit investors by improving the efficiency of their portfolio
allocation. To the extent it is costly or difficult, at least in the
short term, to expand the supply of investment advisory services to
meet an increase in demand, any such new demand for investment advisory
services could put some upward price pressure on fees. At the same
time, however, if any such new demand increases the overall
profitability of investment advisory services, then we expect it would
encourage entry by new investment advisers--or hiring of new
representatives by current investment advisers--such that competition
would increase over time. Indeed, the recent growth in the investment
adviser segment of the market, both in terms of number of firms and
number of representatives,\89\ may suggest that the costs of expanding
the supply of investment advisory services are currently relatively
low.
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\89\ See Relationship Summary Proposal, supra footnote 5, at
section IV.A.1.d.
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Additionally, we acknowledge that to the extent certain investment
advisers recognize, as a result of this Final Interpretation, that
their fiduciary duty is stricter than the fiduciary duty as they
currently interpret it, it could potentially affect competition.
Specifically, this Final Interpretation of certain aspects of the
standard of conduct for investment advisers may result in additional
compliance costs for investment advisers seeking to meet their
fiduciary duty. This increase in compliance costs, in turn, may
discourage competition for client segments that generate lower
revenues, such as clients with relatively low levels of financial
assets, which could reduce the supply of investment advisory services
and raise fees for these client segments. However, the investment
advisers who already are complying with the understanding of their
fiduciary duty reflected in this Final Interpretation, and who may
therefore currently have a comparative cost disadvantage, could find it
more profitable to compete for the clients of those investment advisers
who would face higher compliance costs as a result of this Final
Interpretation, which would mitigate negative effects on the supply of
investment advisory services. Further, as noted above, there has been a
recent growth trend in the supply of investment advisory services,
which is likely to mitigate any potential negative supply effects from
this Final Interpretation.\90\
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\90\ Beyond having an effect on competition in the market for
investment adviser services, it is possible that this Final
Interpretation could affect competition between investment advisers
and other providers of financial advice, such as broker-dealers,
banks, and insurance companies. This may be the case if certain
investors base their choice between an investment adviser and
another provider of financial advice, at least in part, on their
perception of the standards of conduct each owes to their customers.
To the extent that this Final Interpretation increases investors'
trust in investment advisers' overall compliance with their standard
of conduct, certain of these investors may become more willing to
hire an investment adviser rather than one of their non-investment
adviser competitors. As a result, investment advisers as a group may
become more competitive compared to that of other types of providers
of financial advice. On the other hand, if this Final Interpretation
raises costs for investment advisers, they could become less
competitive with other financial advice providers.
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One commenter discussed that, in its view, any statement in the
Proposed Interpretation that certain circumstances may require the
elimination of material conflicts, rather than full and fair disclosure
or the mitigation of such conflicts, could lead to an effect on the
market and costs to advisers, if such a requirement would cause
advisers who had not shared that interpretation to change their
business models or product offerings or the ways in which they interact
with clients.\91\ We disagree that this Final Interpretation includes a
requirement to eliminate conflicts of interest. As discussed in more
detail above, elimination of a conflict is one method of addressing
that conflict; when appropriate advisers may also address the conflict
by providing full and fair disclosure such that a client can provide
informed consent to the
[[Page 33681]]
conflict.\92\ Further, we believe that any potential costs or market
effects resulting from investment advisers addressing conflicts of
interest may be decreased by the flexibility advisers have to meet
their federal fiduciary duty in the context of the specific scope of
services that they provide to their clients, as discussed in this Final
Interpretation.
---------------------------------------------------------------------------
\91\ See Dechert Letter.
\92\ See supra section II.C.
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The commenter also drew particular attention to the question of
whether the Commission's discussion of the fiduciary duty in the
Proposed Interpretation applied to advisers to institutional clients as
well as those to retail clients. The same commenter indicated that
failing to accommodate the application of the concepts in the Proposed
Interpretation to sophisticated clients could risk changing the
marketplace or limiting investment opportunities for sophisticated
clients, increasing compliance burdens for advisers to sophisticated
clients, or chilling innovation. As explained above, this Final
Interpretation, as compared to the Proposed Interpretation, discusses
in more detail the ability of investment advisers and different types
of clients to shape the scope of the relationship to which the
fiduciary duty applies.\93\ In particular, this Final Interpretation
acknowledges that while advisers owe each of their clients a fiduciary
duty, the specific obligations of, for example, an adviser providing
comprehensive, discretionary advice in an ongoing relationship with a
retail client will be significantly different from the obligations of
an adviser to an institutional client, such as a registered investment
company or private fund, where the contract defines the scope of the
adviser's services and limitations on its authority with substantial
specificity.\94\
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\93\ See supra footnotes 78-81 and accompanying text.
\94\ See supra section II.A.
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Finally, to the extent this Final Interpretation causes some
investment advisers to reassess their compliance with their duty of
loyalty, it could lead to a reduction in the expected profitability of
advice relating to particular investments for which compliance costs
would increase following the reassessment.\95\ As a result, the number
of investment advisers willing to advise a client to make these
investments may be reduced. A decline in the supply of investment
adviser advice regarding these types of investments could affect
efficiency for investors; it could reduce the efficiency of portfolio
allocation for those investors who might otherwise benefit from
investment adviser advice regarding these types of investments and are
no longer able to receive such advice. At the same time, if providing
full and fair disclosure and appropriate monitoring for highly complex
products (e.g., those with a complex payout structure, such as those
that include variable or contingent payments or payments to multiple
parties) results in these products becoming less profitable for
investment advisers, investment advisers may be discouraged from
supplying advice regarding such products. However, investors may
benefit from (1) no longer receiving inadequate disclosure or
monitoring for such products, (2) potentially receiving advice
regarding other, less complex or expensive products that may be more
efficient for the investor, and (3) only receiving recommendations for
highly complex or high cost products for which an investment adviser
can provide full and fair disclosure regarding its conflicts and
appropriate monitoring.
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\95\ For example, such products could include highly complex,
high cost products with risk and return characteristics that are
hard for retail investors to fully understand, or where the
investment adviser and its representatives receive complicated
payments from affiliates that create conflicts of interest that are
difficult for retail investors to fully understand.
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List of Subjects in 17 CFR Part 276
Securities.
Amendments to the Code of Federal Regulations
For the reasons set out above, the Commission is amending Title 17,
chapter II of the Code of Federal Regulations as set forth below:
PART 276--INTERPRETATIVE RELEASES RELATING TO THE INVESTMENT
ADVISERS ACT OF 1940 AND GENERAL RULES AND REGULATIONS THEREUNDER
0
1. Part 276 is amended by adding Release No. IA-5428 and the release
date of June 5, 2019, to the end of the list of interpretive releases
to read as follows''
----------------------------------------------------------------------------------------------------------------
Subject Release No. Date FR vol. and page
----------------------------------------------------------------------------------------------------------------
* * * * * * *
Commission Interpretation Regarding IA-5248 June 5, 2019............. [Insert FR Volume Number] FR
Standard of Conduct for Investment [Insert FR Page Number].
Advisers.
----------------------------------------------------------------------------------------------------------------
By the Commission.
Dated: June 5, 2019.
Vanessa A. Countryman,
Acting Secretary.
[FR Doc. 2019-12208 Filed 7-11-19; 8:45 am]
BILLING CODE 8011-01-P