Monday, January 7, 2019

Part 4 of a Series on the Regulation of Financial and Investment Advice

Part IV: Meaningful Reforms to the Regulation of Investment Advice are Possible

There are ways to fix the S.E.C.’s current irrational oversight of investment advice. And, along the way, to enact meaningful consumer protections and to facilitate the emergence of a true profession. But don’t expect the S.E.C. to act anytime soon. Instead, several of the steps will likely step in to fill the vacuum.

As seen in Parts I, II and III of this series, the S.E.C. has deeply flawed proposals with its Regulation BI and Form CRS – so deeply flawed that the S.E.C. should return to the drawing board. The S.E.C. has struggled to preserve the line between “sellers” of securities and those who provide “investment advice.” In this fourth article, I set forth my own proposals for reforming who is subject to the Advisers Act, and how fiduciary duties are applied.


For nearly eight decades the U.S. Securities and Exchange Commission has struggled with drawing the line between “sales” and “investment advice.” The reality is that it is not all that difficult to draw the line – it just takes courage, and common sense, both of which in recent decades S.E.C. Chairs have sorely lacked.

In this article I set forth two major rules the SEC could adopt, in lieu of its current proposed Reg BI. 
  • The first rule would be adopted under the Advisers Act and would define, correctly, the scope of the broker-dealer exemption from the requirement to register under the Advisers Act.
  • The second major rule herein would define the scope of the investment adviser’s fiduciary obligation, in order to correct misunderstandings that might otherwise have resulted over time.


Rule 1: Rationally Drawing the Line Between Product Sales and Investment Advice

In this proposed rule, the term “investment strategy” means the adoption of a set of rules or policies or tactics or guidelines designed to guide the broker-dealer, agent or adviser and/or the client as to the design of an investment portfolio for a client and/or the allocation of a client’s capital, and may include (but is not limited to) the selection of asset classes, the use of factors in investing, combining financial instruments in the design of an investment portfolio for the client to match the client’s need to achieve certain levels of risk or expected return, the placement of assets to achieve certain tax efficiencies, the annuitization of a portion of the client’s portfolio, or other tactics relating to investments. And the term “financial instrument” includes, but is not limited to, securities, other investments such as certificates of deposit or other banking products, and annuity and insurance products.

Definition of Investment Advice.

Investment advice is a communication to a client (including a prospective client) regarding the appropriateness of any particular investment strategy or financial instrument to meet the personal needs or objectives of that client. Notwithstanding any other provision of this rule, all investment advice provided by broker-dealers, agents, or advisers shall be provided in a fiduciary-client relationship.

Non-Advice Education Exception.

When a broker-dealer, agent or adviser provides investment-related education, the fiduciary standard of conduct applies. However, and notwithstanding the foregoing, the fiduciary standard of conduct will not apply to a broker-dealer, agent or adviser when the education provided is only general in nature as defined by this rule.

Examples of education which is general in nature includes providing general information via publications or in group educational sessions regarding standard financial and investment concepts, such as diversification, risk and return, tax-deferred investments, historic differences in the volatility and rates of return of different assets classes, the effects of inflation, methods to estimate future retirement or other financial needs, methods utilized to assess risk tolerance or risk capacity, and general investment strategies not involving a discussion of any specific strategic asset allocation or specific financial products.

Education is not general in nature if, in providing such education, the broker-dealer, agent or adviser:
  • Advises or suggests a specific asset allocation for the recipient of the educational information;
  • Provides information on the volatility and/or historical returns of specific asset allocation models;
  • Advises or suggests the use of a specific financial product to meet some or all of the goals of the recipient of the educational information;
  • Advises the move of assets from one bank or brokerage or other form of account to another; or
  • Undertakes any other investment recommendation to a client, wherein a “recommendation” is defined as any communication or series of communications that, based on its/their content, context, and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular investment-related course of action.
Non-Advice Sales Exception.

Investment advice does not include communications which solely describe a financial instrument, its features, and characteristics, where no communication exists to the client (or prospective client) as to whether the financial instrument would meet or seek to meet the personal needs and objectives of that client. Such communications arise in a seller-purchaser relationship, which shall be an arms-length relationship.

However, and notwithstanding the foregoing, and regardless of any agreement with the client or disclosures undertaken to the client (inasmuch as fiduciary status is determined primarily by the law and the facts and circumstances of the relationship between the parties, rather than by the agreement between the parties), the broad fiduciary duties described herein shall be applicable, and the relationship between the broker-dealer, agent, or adviser and the client shall be that of a fiduciary-client relationship, when any of the following circumstances exist:

(A) The adviser is registered solely as a registered investment adviser or investment adviser representative, and is not registered as a broker-dealer or agent;

(B) The broker-dealer, agent or adviser voluntarily assumes fiduciary status through agreement with the client, express or implied;

(C) The broker-dealer, agent or adviser is in a relationship of trust and confidence with the client;

(D) The broker-dealer, agent, or adviser actually provides to the client investment advice, as defined above;

(E) The broker-dealer, agent, or adviser possesses de jure or de facto discretion over any of the client’s accounts;

(F) The broker-dealer, agent or adviser communicates its, her, or his function or job title or task description, or describes its services through marketing or other means, or undertakes other communications or descriptions (including but not limited to those contained in the descriptions of certifications or designations awarded by any firm or organization) that by their nature provide the inference that investment advice will be provided or that an investment advisory relationship exists, including but not limited to the use of “financial” or “investment” or “portfolio” or “wealth” or “senior” or “retirement” in conjunction with the “adviser” or “advisor” or “consultant” or “manager”; or

(G) The broker-dealer, agent, or adviser is required to provide investment advice or financial advice or financial planning or other advice as a “fiduciary,” or the broker-dealer, agent, or adviser is required to act either in the “sole interest(s)” or “best interest(s)” or “interest(s)” of the client, when any of the foregoing requirements arises from:

(1) any law or regulation or other regulatory requirement or legal interpretation thereof, including without limitation any rule or pronouncement issued by the U.S. Securities and Exchange Commission (SEC) or the Financial Industry Regulatory Authority (FINRA); or

(2) the code of ethics or standards of conduct or similar ethical or conduct rules of the broker-dealer firm, the registered investment adviser firm, or any industry or professional association to which the broker-dealer, agent or adviser belongs or as to which the broker-dealer, agent or adviser is an employee, agent, member, certificant or designee thereof.

Fiduciary Status Extends to the Entire Relationship.

When a fiduciary standard of conduct applies to a relationship between a broker-dealer, agent, or adviser and the client, it applies to the entirety of the relationship between such broker-dealer, agent or adviser and that client, as to any and all financial products provided by such broker-dealer, agent or adviser to that client, and as to any and all financial or investment advice provided by such broker-dealer, agent or adviser to that client.

A Dual Registrant May Choose Whether to Provide “No Advice” or “Fiduciary Investment Advice,” with Respect to Each Client.

A dual registrant (i.e., a broker-dealer and registered investment adviser, and/or an agent of a broker-dealer and an investment adviser representative) may act as a fiduciary with respect to some clients, and as a non-fiduciary with respect to other clients. The broker-dealer, agent or adviser shall ensure that the client understands whether the relationship is a fiduciary-client relationship or an arms-length (sales) relationship. However, and notwithstanding the foregoing, the determination of whether investment advice is provided, or whether the relationship is a fiduciary-client relationship or an arms-length relationship, shall be determined by the application of this rule. When fiduciary investment advice is provided by a dual registrant, fiduciary status extends over the dual registrant to the entirety of the commercial relationship with the client. Furthermore, when a fiduciary relationship exists between a dual registrant and a client, any switch to a non-fiduciary relationship with the client should only be undertaken when such change would be clearly beneficial for the client, given all of the facts and circumstances.

Rule 2: An Elicitation of the Fiduciary Principle, to Guide Both Investment Advisers and Their Clients.

Delineation of the Duties of Fiduciaries When Investment Advice is Provided.

When a fiduciary standard of conduct applies, such investment advice shall be provided in the best interests of the client, observing the fiduciary duties owed to the client by such broker-dealer, agent, or adviser acting in such fiduciary capacity. The fiduciary duties possessed by such fiduciary in connection with the provision of such investment advice include, but are not limited to:

Duty of due care.

(a) The fiduciary must provide advice that reflects the due care, skill, prudent and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, risk capacity, need to take on risk, financial circumstances, and other needs of the client.

(b) In connection therewith, where ongoing monitoring of the client’s investment portfolio (or any portion thereof) is to be provided, there exists the duty to provide advice and monitoring over the course of the relationship. The duty of due care includes a duty to make a reasonable inquiry into a client’s financial situation, level of financial sophistication, investment experience, and investment objectives (which is referred to collectively as the client’s “investment profile”) and a duty to provide personalized advice that is suitable for and in the best interest of the client based on the client’s investment profile. The nature and extent of the inquiry by the fiduciary turn on what is reasonable under the circumstances, including the nature and extent of the agreed-upon advisory services, the nature and complexity of the anticipated investment advice, and the investment profile of the client. The fiduciary must update a client’s investment portfolio periodically in order to adjust the fiduciary’s advice to reflect any changed circumstances. The frequency with which the adviser must update the information in order to consider changes to any advice the adviser provides would turn on many factors, including whether the adviser is aware of events that have occurred that could render inaccurate or incomplete the investment profile on which it currently bases its advice. For example, a change in the relevant tax law or knowledge that the client has retired or experienced a change in marital status might trigger an obligation to make a new inquiry.

(c) The cost (including fees and compensation) associated with investment advice and the recommended investments would generally be one of many important factors – such as the investment product’s or strategy’s investment objectives, characteristics (including any special or unusual features), liquidity, risks and potential benefits, volatility and likely performance in a variety of market and economic conditions – to consider when determining whether a security or investment strategy involving a security or securities is in the best interest of the client. Accordingly, the fiduciary duty does not necessarily require an adviser to recommend the lowest cost investment product or strategy. However, a recommended security is in the best interest of a client if it is higher cost than a security that is otherwise nearly identical or substantially similar. Given the substantial academic evidence supporting the proposition that higher-cost investment products on average provide lower returns than similar low-cost investment products, an examination of the fees and costs of the investment product is likely to be a primary consideration. However, a fiduciary would not satisfy its fiduciary duty to provide advice with due care by simply advising its client to invest in the least expensive product or strategy without any further analysis of other factors in the context of the client’s investment portfolio and the client’s investment profile.

(d) The fiduciary must conduct a reasonable investigation into the investment strategy and financial product that is sufficient to ensure that the fiduciary not base the advice on materially inaccurate or incomplete information.

(e) The fiduciary possesses a duty to seek best execution.

(f) In assessing the due care undertaken by the fiduciary, the fiduciary shall be judged as an expert in the provision of investment advice, as the standard of due care is relational. While not conclusive, industry association standards are often highly probative when further defining the standard of care.

Duty of loyalty.

The fiduciary provides investment advice that is in the best interests of the client, and such advice is without regard to the financial or other interests of the broker-dealer, agent, adviser, or their affiliated entities. In connection therewith:

(a) The fiduciary 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.

(b) The fiduciary must reasonably seek to avoid conflicts of interest with its clients. The fiduciary owes the obligation to the client to not be in a position where there is a substantial possibility of conflict between self-interest and duty. The fiduciary duty of loyalty requires the fiduciary to adopt the client’s goals, objectives, or ends as her or his or its own.

(c) However, in recognition of the fact that not all conflicts of interest can reasonably be avoided, and whenever a material conflict of interest exists the fiduciary shall comply with all of the following requirements:

  • (1) The fiduciary shall affirmatively disclose to the client the conflict of interest, all material facts relating thereto, and the ramifications of the conflict of interest for the client; a fact is considered material if there is a substantial likelihood that a reasonable investor would consider the information to be important in making an investment decision.
  • (2) The disclosure must be timely; it must be provided prior to the completion of the transaction that is contemplated.
  • (3) The disclosure must be undertaken affirmatively to the client. Access to the disclosure by the client, alone and without more, is not affirmatively undertaken disclosure. The fiduciary must ensure that the disclosure is received and reviewed by the client.
  • (4) The disclosure must be sufficient for the client to be clearly advised so as to obtain a full understanding of the conflict.
  • (5) The disclosure must be frank, full and forthright. The disclosure must lay bare the truth, without ambiguity or reservation, in all its stark significance.
  • (6) The fiduciary must ensure that the client achieves an understanding of the conflict of interest, the material facts relating thereto, and the ramifications of the conflict of interest.
  • (7) The client must provide informed consent. Mere consent to a breach of fiduciary obligation does not suffice. Mere consent does not permit the fiduciary to avail themselves of the defenses of estoppel and waiver in an action involving breach of a fiduciary obligation, due both to public policy considerations (the Uniform Security Act’s foremost objective being to protect investors). The client’s consent must be intelligent, independent and informed.
  • (8) Additionally, the transaction proposed to the client must be, and must remain, substantively fair to the client.
Exception When ERISA Applies

Notwithstanding the foregoing, when ERISA “sole interests” fiduciary standard of conduct and prohibited transaction rule requirements apply to an account, to the rollover of an account from an ERISA-covered account, or to a relationship between a provider of investment advice and the client, the fiduciary duty shall be that set forth by ERISA and the regulations promulgated thereunder.

Duty of utmost good faith.

The fiduciary must exercise the utmost good faith in the fiduciary’s dealings with the client. This requires the fiduciary to act with the highest degree of honesty and candor toward the client, and to not act recklessly.

Duty to receive only reasonable compensation.

The recommended course of action or transaction will not cause the broker-dealer, agent, or adviser to receive, either directly or indirectly (including but not limited to receipt of compensation by affiliated entities), to receive compensation which is in excess of reasonable compensation.

Duty to not undertake any misleading statements.

Any statements or other communications made to the client (including prior to the time of entry into the fiduciary-client relationship) regarding any recommended transactions, investment strategies, financial products, fees and compensation received by the fiduciary, material conflicts of interest, and any other matter relevant and material to the client’s investment decisions, will not be materially misleading at the time such statements are made.

Ron A. Rhoades, JD, CFP® is the Director of the Personal Financial Planning Program at Western Kentucky University’s Gordon Ford College of Business. A professor of finance, tax and estate planning attorney, investment adviser, and Certified Financial Planner™, he has long written about application of fiduciary law as the delivery of financial planning and investment advice. This article represents his personal views, and are not necessarily the views of any institution, organization, nor firm with whom he may be associated.

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