Fiduciary Duties of Investment Advisers and the recent SEC Treatment of Hedge Clauses

As an Investment Adviser what are the fiduciary duties owed to my client?

The Investment Advisers Act of 1940 (“Advisers Act”) lays out the two basic fiduciary duties that all investment advisers owe to their clients: the duty of care and the duty of loyalty. An adviser must always serve the best interests of its client and cannot put its own interests ahead of the interests of its client. The intent behind an advisers’ fiduciary duty is to help eliminate or mitigate all conflicts of interest which might cause an adviser to provide investment advice that may not be impartial, whether the adviser acted consciously or not.[1] Where such conflicts cannot be fully eliminated, the Advisers Act requires a registrant to disclose the conflict to its client so that the client can provide informed consent to the conflict.

In this month’s JLG Risk Management Tip, we will review the U.S. Securities and Exchange Commission’s (“SEC”) recent guidance on the Duty of Care and Duty of Loyalty.  Among other things, we will visit concepts raised in the SEC’s Interpretation Regarding Standard of Conduct for Investment Advisers,[2] and provide practical tips for investment advisers to consider in their day-to-day operations.

The Duty of Care

An investment adviser is a fiduciary that owes its clients a duty of care, which includes three main components: (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, and (iii) the duty to provide advice and monitoring over the course of the relationship.

       1. The Duty to Provide Advice

The duty to provide advice that is in the best interest of the client includes the duty to provide advice that is suitable for the client. To provide suitable advice, advisers must have a reasonable understanding and make a reasonable inquiry into the client’s financial objectives. For retail clients, the adviser may need to implement the use of a client profile questionnaire, to capture in its books and records information about the client, including the client’s investment experience, age, net worth, and ultimately, long and short-term financial goals. Importantly, an investment adviser’s relationship with a client extends beyond a one-time investment or transaction; the adviser must routinely review with the client the client’s financial circumstances and update the client’s investment profile to reflect changes in the client’s circumstances that may affect their investment goals and objectives.

When providing investment advice, the adviser must reasonably believe that the investment advice rendered is in the best interest of the client. For example, based on the facts and circumstances of the client an adviser may recommend certain riskier investments 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.

The duty to provide investment advice that serves the best interest of a client also requires that an adviser conduct a reasonable investigation into the investment. This due diligence must be reasonably sufficient. An adviser cannot base its advice on materially inaccurate or incomplete information. In fact, the SEC has routinely taken enforcement action where an investment adviser did not independently or reasonably investigate securities prior to recommending them to clients.

         2. The Duty to Seek Best Execution

The duty to seek best execution of a client’s transactions traditionally arises where an investment adviser has discretionary authority over the client’s account. In meeting this obligation, an adviser must seek to execute the transaction to provide the greatest value to the client. Maximizing the value to the client routinely involves more than just minimizing cost. In considering the best execution, an adviser should analyze the value of research provided as well as execution capability, commission rate, financial responsibility, responsiveness to the adviser, and other applicable circumstances.

        3. The Duty to Provide Ongoing Monitoring

Investment advisers have a duty to provide ongoing monitoring.  In practice, this means advisers should “periodically and systematically” evaluate its execution methods to ensure that the adviser does not breach its duty of care.

The duty of care also encompasses the duty for investment advisers to provide advice and monitoring at a frequency that is in the best interest of the client. This duty also takes into account the scope of the agreed relationship. For example, if the adviser and client have a relationship where the adviser will provide on-going investment management, the adviser will have an extensive duty to monitor and provide advice to the client. However, if, for example, the adviser is providing a one-time financial plan for singular flat fee the adviser is unlikely to have any duty to monitor and provide ongoing advice to the client.

The Duty of Loyalty

The duty of loyalty requires that an investment adviser not put its own interests before the interest of its clients. To meet its duty of loyalty, the adviser must make full and fair disclosures to its clients of all material facts that could affect the advisory relationship. Further, there are two aspects that the adviser should consider in maintaining its duty of loyalty: (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.

In providing full and fair disclosure of any conflict, the disclosure should be specific enough so that a client is able to understand the material fact or conflict of interest so that the client can make an informed decision on whether to consent to the conflict.

A topic that often comes up when discussing drafting disclosures with the needed specificity is the use of the word “may.” A disclosure that simply states an adviser “may” have a conflict of interest would likely be insufficient when the conflict exists with some, but not all, types of clients, advice, or transactions without additional disclosure specifying the types or classes of clients, advice, or transactions that the conflict is applicable. The use of “may” would also likely be inappropriate in a disclosure if it followed by a list of all possible or potential conflicts without taking into consideration the likelihood of the conflict. Thus, a disclosure that was drafted broadly to cover every possible conflict would not be able to provide the needed clarity for a client to provide informed consent.

However, there is not a complete bar on the use of the word “may” in disclosing conflicts of interests. The use of the word “may” would likely be appropriate in disclosing a conflict that might reasonably present itself in the future, but at the time of disclosure is not currently a conflict.

One conflict of interest that every investment adviser will encounter is having multiple clients. Merely disclosing to your clients that you have other clients would be insufficient to meet the adviser’s duty of loyalty. Rather, the adviser must also provide disclosures on how the adviser handles these conflicts between clients, if, and when they arise. When allocating investment opportunities among eligible clients, an adviser may encounter conflicts between its own interests and those of a client or among different clients. When these conflicts arise, the adviser has a duty to either eliminate the conflict or fully and fairly disclose the conflict to its client. Where the conflict is not eliminated, the adviser’s disclosure should address the conflicts associated with its allocation policies, including how the adviser will allocate investment opportunities. Then, the adviser needs to implement an effective policy for handling conflicts that arise during investment allocations to ensure that clients’ interests are protected.

Practical Application: Consideration of Hedge Clauses

Recently, the SEC provided additional insight into the adviser’s duty of care and duty of loyalty through the Division of Examinations’ Risk Alert dated January 27, 2022.[3] Although the Risk Alert specifically addressed advisers of private funds, the insight received can be widely applied to most if not all investment advisers. One specifically interesting area that the Risk Alert addressed was the use of “hedge clauses” in agreements and disclosure documents provided to investors.

As an adviser’s fiduciary duties cannot be waived and are enforceable through section 206 of the Advisers Act, the adviser must always uphold their fiduciary duties. This includes providing disclosures to clients that are full and fair, and not misleading to clients. The industry has seen a shift in SEC treatment of hedge clauses. Recently, we have seen the SEC warn that any clause that purports to waive an adviser’s fiduciary duties, or is drafted in such a way that is likely to mislead clients in to believing that after consenting to the agreement they would have no legal recourse against an adviser for any cause of action outside of certain express exceptions (such as a non-appealable judicial finding of gross negligence, willful misconduct, or fraud) is likely in violation of Section 206 of the Advisers Act.

Conclusion                                                                                                        

Investment Advisers are fiduciaries and thus, the duty of care and the duty of loyalty must always be considered for the business.  Consider conflicts and risks that exist, address them through disclosure and internal controls and strategically review client agreements, disclosure documents and policies and procedures to consider if the areas outlined in this Risk Management Tip have been addressed.

Our team at Jacko Law Group understands the importance of the fiduciary relationship between an investment adviser and its clients and that it is vital that this relationship is based in trust and transparency. We recommend that advisers be proactive in meeting these fiduciary duties and all obligations owed to its clients to avoid potential scrutiny by both clients and the SEC.

If you have a question regarding conflicts and disclosures, it is best to consult with a team of experienced professionals who understand and can help you navigate and update your agreements especially as your business grows and legal needs shift.

Author: Jeremiah Baba Pagano, Attorney; Editor: Michelle L. Jacko, Managing Partner, Jacko Law Group, PC (“JLG”).  JLG works extensively with investment advisers, broker-dealers, investment companies, private equity and hedge funds, banks and corporate clients on securities and corporate counsel matters.  For more information, please visit https://www.jackolg.com/.

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[1] See https://www.sec.gov/rules/interp/2019/ia-5248.pdf

[2] See 17 CFR 276 available at https://www.sec.gov/rules/interp/2019/ia-5248.pdf.

[3] See https://www.sec.gov/files/private-fund-risk-alert-pt-2.pdf.

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