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SEC Adopts New Disclosure Form CRS and Issues Official Guidance Regarding Investment Advisers’ Fiduciary Duty

Quarles & Brady Quarterly Securities Newsletter Jonathan W. Hackbarth, Joshua M. Hufford

On June 5, 2019, the Securities and Exchange Commission approved new regulations applicable to broker-dealers and investment advisers registered with the SEC: Form CRS and Regulation Best Interest. On the same day, the SEC issued a new official interpretation regarding the standard of conduct applicable to investment advisers under the Investment Advisers Act of 1940 (the Advisers Act). This update discusses these recent actions as they generally apply to SEC-registered investment advisers.

Executive Summary

  • Beginning June 30, 2020, SEC-registered investment advisers will have to begin providing clients with new Form ADV Part 3 (Form CRS).
  • Form CRS is a brief disclosure document intended to provide retail clients with a basic overview of certain factual information about the investment adviser.
  • The SEC also clarified its position on the fiduciary duty owed by investment advisers to their clients. The clarification suggested that investment advisers may avoid many obligations the SEC would otherwise impose under the general fiduciary duty owed by advisers under the Advisers Act by defining a clear scope of services in the client agreement. While appearing to weaken the standards under the Advisers Act, we believe the impact of the new interpretation will be nominal.

Form ADV Part 3 – Form CRS
Form CRS, adopted under the Advisers Act as Form ADV Part 3, is a succinct summary of factual information important to retail clients. The SEC designed Form CRS to assist retail investors in deciding whether to engage, or continue their relationship with, a particular investment adviser or broker-dealer and to otherwise generally help reduce confusion in the retail market for investment advisory and brokerage services.

Form CRS requires firms to disclose certain factual information, such as: (1) the types of client and customer relationships and services the firm offers; (2) the fees, costs, conflicts of interest, and standard of conduct associated with those relationships and services; (3) the legal and disciplinary history of the firm and its financial professionals (if applicable); and (4) instructions on where to find additional information about the firm.

Certain sections of Form CRS require firms to include specific “conversation starters” meant to aid clients in gaining a better understanding of the various aspects of the services they offer. Conversation starters required for investment advisers include, but are not limited to, the following, each of which must be set apart and made more noticeable than other text in the form:

  • “Given my financial situation, should I choose an investment advisory service? Why or why not?”
  • “How will you choose investments to recommend to me?”
  • “What is your relevant experience, including your licenses, education and other qualifications? What do these qualifications mean?”
  • “Help me understand how these fees and costs might affect my investments. If I give you $10,000 to invest, how much will go to fees and costs, and how much will be invested for me?”
  • “What are your legal obligations to me when acting as my investment adviser? How else does your firm make money and what conflicts of interest do you have?”

The SEC encourages firms to provide information using charts, graphs, tables, and other graphics when preparing their respective Form CRS. But space is limited, as Form CRS may not be longer than two pages (four for dual registrants consolidating their disclosures in one form) and should follow the formatting recommendations provided in the form’s instructions. Firms opting to provide Form CRS exclusively in electronic form are limited to the equivalent of what would be two printed pages.

Investment advisers will be able to submit Form CRS to the SEC through the IARD platform (the same system currently used to submit Form ADV) beginning May 1, 2020, and must do so no later than June 30, 2020. Beginning June 30, 2020, each firm must provide a copy of its Form CRS to each retail client before or at the time it enters into an advisory agreement.

Firms must update Form CRS and file the updated version within 30 days whenever information contained in the form becomes materially inaccurate. Existing clients must be notified of any changes within 60 days of any required update to Form CRS either by providing the new version of the form or other form of communication which, in each case, highlights the changes made via an exhibit to the unmarked amended form.

Investment Adviser Standard of Conduct
In addition to implementing Form CRS, the SEC concurrently issued a new interpretation regarding the standard of conduct applicable to investment advisers. While the interpretation is new, it generally reaffirms and clarifies the SEC’s existing approach in one consolidated release and, according to the SEC, “does not itself create any new legal obligations for advisers.”

In the interpretation, the SEC confirmed its view that fiduciary duties applicable to investment advisers do not arise from a specific provision under the Advisers Act or the regulations promulgated thereunder, but rather from Congressional recognition of “the delicate fiduciary nature of an investment advisory relationship” in passing the Advisers Act itself. Under the Advisers Act, investment advisers owe their clients a duty of care and a duty of loyalty.

Duty of Care
The SEC believes that the duty of care includes, among others, a duty to provide advice in the client’s best interest, a duty to seek best execution of client transactions, and a duty to provide advice and monitoring over the course of the client relationship.

  • Duty to Provide Advice in Client’s Best Interest

To provide advice in a client’s best interest, investment advisers must, among other factors, have a reasonable understanding of the client’s current investment objectives, have a reasonable belief that investments recommended are appropriate for the client (which may include conducting a reasonable investigation into the investment product), and consider the costs of any proposed strategy or recommended product.

The SEC does not require any specific methods to satisfy the duty to provide advice in a client’s best interest. Instead, and in line with the its view that the fiduciary duties owed by investment advisers are principles-based and dependent on the contours of the client relationship, the SEC recognizes that advisors may satisfy their fiduciary duties in a number of ways based on the individual facts and circumstances of any given relationship, including the type of client, scope of services provided, and nature and complexity of advice provided.

  • Duty to Seek Best Execution

Where advisers are responsible for selecting broker-dealers to execute client transactions, they have a duty to seek best execution of client transactions. While costs are important to the analysis, advisers fulfill this duty by seeking to maximize value to clients in the execution of securities transactions. In doing so, advisers 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.”

  • Duty to Provide Advice and Monitoring Over Course of Relationship

The SEC recognizes that one of the basic functions of investment advisers is providing ongoing, unbiased, and competent advice to clients. Absent a clear understanding or agreement limiting the scope or duration of services provided, the SEC considers the provision of advice and monitoring over the course of the client relationship as part of an advisers duty of care, the scope of which would be determined by the duration and nature of the agreed-upon services provided by the adviser.

Duty of Loyalty
The duty of loyalty requires that investment advisers do not subordinate clients’ interests to their own—in other words, investment advisers may not place their own interests ahead of those of their clients. To meet this duty, investment advisers must provide full and fair disclosure of the material facts and applicable conflicts related to the advisory relationship.

In order for a disclosure to be “full and fair,” it should be sufficiently specific so that its recipient is able to understand the facts and circumstances behind the conflict or material fact in question to be in a position to make an informed decision as to whether to provide consent. “Full and fair” disclosure also depends on the nature of the client, the services provided by the investment adviser, and the nature of the particular material fact or conflict.

In this context, the SEC highlighted situations in which it believes the use of “may” in disclosures is inappropriate, such as when a conflict actually exists with respect to some—but not all—types of clients or advice serviced or offered, respectively, by a firm, and provided one example of where the use of “may” could be appropriate: situations where a potential conflict does not currently exist but could reasonably arise in the future.

Waiver and Contract
Under the Advisers Act, the above-mentioned fiduciary duties apply to the entire relationship between the investment adviser and client and cannot be waived by contract—a contract provision that purports to generally waive an adviser’s fiduciary duty will not be permitted. The new interpretation does not weaken or reduce the fiduciary standard of care owed by advisers in any way, but the SEC did clarify that duties owed will be based upon the scope of the relationship between the adviser and client as stated in the advisory agreement between the parties.

Previously, the SEC expressly permitted advisers to limit certain obligations arising from the fiduciary duties, such as the duty to vote proxies in discretionary accounts, so long as any limitations or restrictions were clearly disclosed to and agreed upon by the client. The new interpretation clarifies that the fiduciary duty is applied in a manner that reflects the scope of the relationship between adviser and client, which may be customized by negotiating individualized terms with clients in the investment agreement.

This means that advisers may contractually limit certain obligations arising from their fiduciary duty in investment agreements and are no longer confined to the specific situations previously approved. While advisers may not be able to disclaim all fiduciary duties owed, they now have a greater ability to limit certain regulatory obligations to clients so long as the services provided—and not provided—are disclosed to the client.

Impact of the Interpretation of Standard of Conduct and Form CRS
Limiting certain obligations that arise under an adviser’s fiduciary duty may be attractive to advisers as a way to reduce liability, minimize administrative costs, or streamline disclosure processes. Indeed, many advisers already limit at least some obligations in areas previously authorized by the SEC and have found these limitations to be beneficial. The new interpretation provides greater clarity as to what duties advisers may limit in their client agreements and how the SEC will enforce fiduciary obligations owed to clients going forward.

If broadly limiting as many obligations as possible in client agreements—short of a blanket waiver of fiduciary duties—becomes the standard, disclosing the applicable standard of conduct will not likely affect a potential client’s decision to hire a particular firm. Clients would likely base their decision on who to hire on other factors such as cost or client engagement.

On the other hand, if some firms maintain their current offerings and do not limit any obligations owed while others do limit certain obligations, clients should be able to determine the differing standards relatively easily given the required format of Form CRS and the disclosures it requires. Because of the emphasis placed on the standard of conduct in Form CRS, prospective clients may put greater weight on the standard of conduct when making certain investment-related decisions and may perceive advisers who limit obligations to be less protective of their interests.

Overall, we believe that the new interpretation will have limited direct impact on firms given that it largely reiterates the SEC’s previously held positions in one consolidated release. Additionally, most of the duties that the SEC clarified could be limited must be limited via the client agreement—unless repapering all client agreements, firms would only be able to rely on limitations put in place on a prospective basis.

Recommended Actions
In response to the SEC's recent actions, we recommend that investment advisers, at a minimum:

  • Review current client agreements to ensure they clearly state what services are and, to the extent necessary for clarity, are not provided.
  • Review current statements and disclosures for use of equivocal language such as "may" to describe clear or nearly certain situations or conflicts.

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