Articles Tagged with Fiduciary Duty

The SEC, on June 5th, adopted a comprehensive set of rules and interpretations that will have a profound effect on the brokerage and advisory industries going forward, first and foremost by revising the standard-of-conduct applicable to broker-dealers and their registered representatives in dealings with retail customers. Even casual observers will likely be familiar with the various proceedings just concluded at the SEC, which resolve debates that have raged in the investment industry for decades as to the need to align the higher fiduciary “standard-of-conduct” applicable to investment advisers with the lesser suitability standard applicable to broker-dealers. While the June 5th releases do not equalize the two standards—as many commentators would have desired—they do significantly raise the standard applicable to broker-dealers from suitability to “best interests.” The SEC’s releases number four separate documents, each covering a distinct aspect of the standard-of-conduct controversy, and run over 1200 pages. Accordingly, this note will seek to identify the major headlines from the various releases. Look for future writings, wherein we will explore the nuances of the June 5th releases in greater detail.

As noted, the SEC released a package of Final Rules and Interpretive Releases comprising four separate components: (1) Final Rules implementing Regulation Best Interest (“Reg BI”), the new enhanced standard for brokers; (2) Final Rules implementing a new Form CRS Relationship Summary (“Form CRS”), a new disclosure document applicable to both brokers and advisers (that, for advisers, will function as a new Part 3 to Form ADV); (3) an Interpretive Release clarifying the SEC’s views of the fiduciary duty that investment advisers owe to their clients; and (4) an Interpretive Release intended to more clearly delineate when a broker-dealer’s performance of advisory activities causes it to become an investment adviser within the meaning of the Advisers Act. All four components of the regulatory package were approved by a 3-1 vote of the SEC’s Commissioners, with Commissioner Robert Jackson being the sole dissenter.

While the June 5th releases are the culmination of a decades-long controversy, they are the proximate result of a formal rulemaking commenced on April 18, 2018, at which time the SEC published initial proposed versions of Reg BI, Form CRS and the advisory interpretations. The Final Rules for Reg BI and Form CRS will become effective 60 days after they are formally published in the Federal Register; however, firms will be given a transition period until June 30, 2020 to come into compliance. The two Interpretive Releases will become effective upon formal publication.  Continue reading

A recent decision handed down by the DC Circuit Court of Appeals in a case involving SEC action against an adviser for failure to disclose material conflicts of interest provides potentially significant precedent for SEC enforcement proceedings going forward. See The Robare Group, Ltd., et al. v. SEC, No. 16-1453, (D.C. Cir. April 30, 2019). The Robare decision is a mixed bag for the SEC in that, while it affirmed the SEC’s findings of negligence against the adviser under one section of the Advisers Act, it threw out the SEC’s findings that the adviser “willfully” violated a second Advisers Act provision based on the same negligent conduct. Notably, the Court predicated its holding against the SEC on negligent behavior and willful behavior being “mutually exclusive.” The significance of this holding is that the SEC has traditionally applied a standard of willfulness in enforcement proceedings that falls short of the level of intent required by Robare. Accordingly, unless Robare is reversed or modified, the SEC will be forced to reconsider its prior practice of assuming that all voluntary conduct constitutes “willful” behavior going forward.

Robare involved an appeal by a Houston-based adviser, The Robare Group (“TRG”), of SEC administrative findings that TRG had violated Advisers Act Sections 206(2) and 207, and Rule 206(4)-7 under the Advisers Act, as a result of TRG’s inadequate disclosure of a “revenue sharing” arrangement with Fidelity Investments, whereby Fidelity compensated TRG in return for TRG clients investing in certain funds offered on Fidelity’s online platform. While TRG received approximately $400,000 over an eight year period from Fidelity under this arrangement, the SEC alleged that, during that same period, TRG failed (at first entirely and then inadequately) to disclose to its clients and to the SEC the compensation received from Fidelity and the conflicts of interest arising from that compensation.

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A recent pair of SEC enforcement Orders against registered investment adviser Talimco, LLC and its Chief Operating Officer Grant Rogers highlight the need for advisers to be ever-mindful of their fiduciary duties to both clients when effecting cross trades between such clients.

Cross trading occurs whenever an adviser arranges a securities transaction between two parties, both of whom being advisory clients of the firm. While “principal trading” (where the adviser buys or sells for its own proprietary account) and “agency cross trading” (where the adviser acts as a broker and receives compensation) are accorded heightened scrutiny and require additional disclosures and consents, this recent pair of Orders show that even ordinary cross trades can be highly problematic when one client is favored over another.

In this particular case, the SEC alleges that Talimco and Rogers went so far as to manipulate the auction price of a commercial loan participation in a sham transaction between two of its clients that distinctly advantaged one client over the other. Continue reading

In February, the Securities and Exchange Commission’s Enforcement Division announced the Share Class Selection Disclosure Initiative (the “SCSD Initiative”), encouraging investment advisers to self-report violations of federal securities laws. Specifically, the SEC is concerned with protecting advisory clients from undisclosed conflicts of interest related to 12b-1 fees charged by advisers. The SEC requests that investment advisers self-report violations of the federal securities laws relating to certain mutual fund share class selection issues prior to June 12, 2018, in exchange for more lenient treatment regarding the violations. A detailed explanation of Eligibility for the SCSD Initiative is available here. In May, the SEC also published a list of frequently asked questions and answers related to the SCSD Initiative.

Under Section 206 of the Investment Advisers Act of 1940, investment advisers have a fiduciary duty to act in their clients’ best interests. Included is an affirmative duty for the adviser to fully disclose all material facts, such as conflicts of interest. The SEC is concerned with conflicts associated with mutual fund share class selection, which the SCSD Initiative aims to address. In the SCSD Initiative, the SEC cautions that investment advisers must be mindful of their duties when recommending and selecting share classes for clients. Of particular concern are conflicts related to 12b-1 fees earned in the selection of classes of funds – conflicts which must be disclosed to clients. As explained by the SEC, a conflict of interest arises when an adviser receives compensation for selecting a more expensive mutual fund share class for a client when a less expensive share class for the same fund is available and appropriate. Such a conflict of interest must be disclosed. Compensation received either directly or indirectly through an affiliated broker-dealer is subject to scrutiny under the SCSD Initiative. As such, if the adviser failed to disclose a conflict of interest associated with the receipt of 12b-1 fees by the adviser, its affiliates, or its supervised persons for investing advisory clients, such funds are subject to disgorgement, and civil monetary penalties may be appropriate.  Continue reading

On March 15, 2018, the United States Court of Appeals for the Fifth Circuit elected, in a 2-1 decision, to vacate the Department of Labor’s (DOL’s) Fiduciary Rule (Chamber of Commerce of the U.S.A., et al. v. U.S. Dep’t of Labor, et al.).  In doing so, the Fifth Circuit overturned the Fiduciary Rule in its entirety, including its new definition of fiduciary advice under the Employee Retirement Income Security Act of 1975 (ERISA) and the Internal Revenue Code (Code), as well as the various new exemptions and revisions to existing exemptions that it features.  It is uncertain whether the DOL will request that the Fifth Circuit rehear the case, appeal the case to the United States Supreme Court, or do nothing.  The Fifth Circuit’s decision, however, has not deterred the Securities and Exchange Commission (SEC) from continuing to discuss implementing its own fiduciary rule.

According to the Fifth Circuit’s majority opinion, the DOL exceeded its authority in adopting the new fiduciary investment advice definition in the Fiduciary Rule, finding the definition inconsistent with the plain text of ERISA and the Code. The Fifth Circuit also concluded that the DOL acted “arbitrarily and capriciously” in, among other things, requiring people providing services to IRAs to sign a contract under the Best Interest Contract exemption in which they admit that they are fiduciaries and can be sued. Therefore, the Fifth Circuit concluded that “the Rule fails to pass the tests of reasonableness of the [Administrative Procedures Act].” Continue reading

On June 2, 2017, Brian Sandoval, the Governor of Nevada, approved proposed amendments to a Nevada statute that regulates so-called “financial planners.”  According to the statute in question, a “financial planner” is “a person who for compensation advises others upon the investment of money or upon provision for income to be needed in the future, or who holds himself or herself out as qualified to perform either of these functions.”  Before the amendments, the statute carved out exclusions for investment advisers and broker-dealers from the definition of a financial planner.  The amendments, however, will remove those exclusions.  This will result in investment advisers and broker-dealers being identified as financial planners.  The amendments became effective on July 1, 2017.

The amendments will also result in investment advisers and broker-dealers having a fiduciary duty with respect to advice they give Nevada clients.  According to another Nevada statute, a financial planner must “disclose to a client, at the time advice is given, any gain the financial planner may receive… if the advice is followed.”  A financial planner is also required to make a comprehensive examination of each initial client and continually update information regarding a client’s financial situation and goals.

Investment advisers and broker-dealers with Nevada clients may also face potential liability if certain conditions are met.  Nevada law provides that if a client incurs losses after receiving advice from a financial planner, that client can recover from the financial planner if specified circumstances are present.  For a client to recover, it must be established that either the financial planner breached any part of his or her fiduciary duty, the financial planner was grossly negligent in choosing the method of action advised, in light of the client’s circumstances that the financial planner knew, or the financial planner broke any Nevada law in endorsing the investment or service.

On January 25, 2017, the Securities and Exchange Commission (“SEC”) filed a complaint in the District Court for the District of Massachusetts (“District Court”) against Strategic Capital Management, LLC (“SCM”), an investment advisory firm, and its owner, Michael J. Breton.  The complaint alleges that Breton, through SCM, garnered about $1.3 million by defrauding clients using what is known as a “cherry-picking” scheme.  The action follows a similar action brought by the SEC last October.

According to the SEC, cherry-picking occurs when an investment adviser “defrauds clients by purchasing stock and then waiting to see if the stock price goes up, or down, before deciding whether to keep the trades… or to put the trades into clients’ accounts.”  Cherry-picking typically involves the investment adviser allocating more profitable trades to its own accounts and allocating less profitable ones to client accounts.  It is a breach of fiduciary duty because it entails an investment adviser placing its interests above those of its clients.

The SEC’s complaint alleges that from about January 2010 through August 2016, Breton and SCM were investment advisers to numerous client accounts.  Breton, through SCM, bought public companies’ securities using a block trading omnibus account known as a “Master Account.”  Through this Master Account, Breton was permitted to make orders for both his personal accounts and his clients’ accounts.

On March 23, 2016, the Securities and Exchange Commission (“SEC”) approved the adoption of FINRA Rule 2273, a rule first proposed by the Financial Industry Regulatory Authority (“FINRA”) on December 16, 2015.  Rule 2273 provides that member firms who hire or associate with a registered representative must provide an “educational communication” to the representative’s former and current customers.  The education communication is designed to provide customers with guidance regarding their decision whether to remain customers of that representative.  Rule 2273 went into effect on November 11, 2016.

FINRA’s stated purpose for proposing Rule 2273 was to provide “customers with a more complete picture of the potential implications of a decision to transfer assets.”  The belief was that otherwise, customers would simply rely on their “experience and confidence” with the representative.  FINRA found that such experiences alone do not always guarantee that staying with the representative will be in the customers’ best interests.  Thus, FINRA proposed the educational communication, which contains a number of questions that FINRA believes customers should ask themselves before deciding to remain with the representative. Continue reading

On October 18, 2016, Parker MacIntyre hosted a seminar addressing legal issues that registered investment advisers (“RIAs”) often face, including developing cybersecurity guidance and implications of the new Department of Labor Fiduciary Rule.  The attendees consisted of sixteen individuals representing thirteen RIAs registered from around the southeast.  Both SEC-registered and state-registered RIAs were represented among the attendees.

Parker MacIntyre was pleased to welcome Noula Zaharis, the Director of the Securities and Charities Division of the Secretary of State of Georgia, as a guest speaker.  She began the seminar with a presentation on how the Georgia Secretary of State registers and regulates investment advisers and common deficiencies encountered by the Georgia regulators.  Highlights from another presentation, entitled “Common Deficiencies, Exam Priorities, and Regulatory Initiatives,” included common deficiencies found in RIA examinations, exam priorities that RIAs should ideally be aware of, and the Secretary of State’s regulatory initiatives. Continue reading

The Massachusetts Securities Division (the “Division”) recently issued regulatory guidance for state investment advisers who use third-party robo-advisers to provide advisory services to clients.  Robo-advisers have enjoyed a significant growth in popularity in the financial services industry based on perceived simplicity, ease of accessibility, and ability to service investment advisory clients who may not have sufficient assets to begin a relationship with a traditional investment adviser.  As discussed previously, the Division issued a policy statement in April 2016 declaring that because automated robo-advisers cannot provide fiduciary duties to clients as traditional human investment advisers can, the Division will evaluate their Massachusetts registration applications on a case-by-case basis.

The new regulatory guidance provides that to the extent a state-registered investment adviser (“state-registered adviser”) uses a third-party robo-adviser’s services to provide asset allocation and trading functions to clients, the state-registered adviser must meet a minimum of six requirements.  These six requirements are as follows: Continue reading