SmartRIA Compliance Alert
A Registered Investment Adviser’s (RIA) and its Investment Adviser Representatives’ (IARs) obligations as fiduciaries are quite extensive. Even seasoned Investment Advisers may not fully understand their fiduciary obligations.
Fiduciary duty encompasses much more than just the duty to be honest and avoid negligence. Advisers also owe an affirmative duty of loyalty, which means RIAs and IARs must always put their clients’ interests ahead of their own.
The fiduciary duty owed by RIAs and IARs includes all of the following obligations:
  • Duty to give advice that is completely disinterested;
  • Duty to provide thorough written disclosures of potential or actual conflicts of interest in the RIA’s Form ADV Part 2 Brochure and Form CRS (if SEC Registered), along with the IAR’s Form ADV Part 2B Supplement and the firm’s advisory agreement;
  • Duty to maintain strict confidentiality; and
  • Duty to refrain from engaging in fraud and other misconduct.
The obligation to recommend suitable investments is just one element of an adviser’s fiduciary duty.
Cherry-picking is a clear-cut example of a breach of fiduciary duty. In a typical case, the RIA allocates profitable trades to its own account and losing trades to the client. One RIA’s cherry-picking scheme involved the purchase of securities in an omnibus account. The RIA waited until later in the day to allocate those purchases after determining which securities appreciated in value. The profitable trades were allocated to the RIA.
On February 12, 2020, the SEC filed a civil enforcement action against an RIA in California, as well as the firm’s co-owners, for breaching their fiduciary duty. The RIA and its co-owners allegedly failed to disclose significant financial conflicts of interest when they recommended private real estate fund investments to clients. The defendants recommended that clients invest and keep their money in certain funds, so they would receive additional compensation.
As investment advisers, the defendants owed their clients a fiduciary duty to act with loyalty, fairness, and good faith. According to the complaint, the defendants breached their fiduciary duty and defrauded their clients by failing to disclose glaring financial conflicts of interest and material facts. Because the defendants did not disclose these compensation arrangements, the RIA’s Form ADV filings were materially misleading.
An investment adviser’s fiduciary duty is more expansive than most IARs realize. RIAs and IARs owe a duty to obtain best execution of clients’ securities transactions, provided they recommend the broker-dealer to be used. Advisers must disclose any outside business activities that might create a conflict of interest. If an RIA agrees to vote proxies for clients, it must always act in their best interest when making those voting decisions.
As the threat from cyber-attacks increases, RIAs owe a fiduciary duty to implement a cybersecurity plan to guard against those risks. Advisers must also implement comprehensive business continuity plans to protect clients from harm if an event occurs that will disrupt the RIA’s services, either temporarily or permanently. Succession planning is one strategy to keep the firm operational if a key member of the RIA dies or becomes incapacitated.
On June 5, 2019, the SEC released the Commission Interpretation Regarding Standard of Conduct for Investment Advisers. The Interpretation highlights the principles relevant to an adviser’s fiduciary duty. It interprets Section 206 of the Investment Advisers Act, which applies to SEC and state-registered investment advisers. Section 206 also applies to investment advisers that are exempt from registration.
An adviser’s duty of loyalty requires an RIA to eliminate, if possible, or make full and fair disclosure of all conflicts of interest that might cause the IAR to offer advice that is not disinterested. If an adviser does not make full disclosure, the client is not capable of giving informed consent to the conflicts of interest.
Disclosures must be sufficiently specific, so clients are able to understand the material conflict of interest. Disclosing that an adviser “may” have a specific conflict of interest, which already exists, is not sufficient. Using the word “may” could be appropriate to disclose a potential conflict that does not currently exist, but that might reasonably be expected to arise at some point.
The Interpretation makes it clear that an adviser’s duty of care includes the:
  • Duty to provide advice that is in the client’s best interest;
  • Duty to seek best execution; and the
  • Duty to monitor the account throughout the relationship.
The duty of care also applies to an RIA’s engagement of a sub-adviser. Additionally, although it was not addressed in the Interpretation, keep in mind that an adviser’s fiduciary duty may extend to recommendations it makes regarding insurance products. IARs may not take off their fiduciary hat when they recommend insurance products.
The Interpretation states that the duty of care requires advisers to provide advice and monitoring in a manner that is consistent with the agreed upon advisory relationship. Advisers may curtail their obligations in an agreement that limits the duration of the investment advisory services provided or states how frequently the account will be monitored. Although the Interpretation clarifies that the federal fiduciary duty cannot be waived entirely, RIAs and clients can alter the adviser-client relationship, as long as there is full and fair disclosure and informed consent. The Interpretation did not take a position regarding the scope or substance of any fiduciary duty that is owed by an adviser under applicable state law.
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