Investment Advisers: The Independent Duties of Care and Loyalty

Key Takeaways

  • Recent SEC guidance has clarified that the investment adviser duties of care and loyalty are separate, independent duties.
  • A reasonable interpretation of the SEC and Staff guidance is that the satisfaction of one will not satisfy the other–both must be individually satisfied.
  • As a result, the SEC appears to be saying that, even if a conflict is disclosed, that does not, in and of itself, satisfy the duty of care. For example, if an adviser discloses that the adviser will receive compensation related to an investment decision or recommendation, e.g., revenue sharing, but the revenue sharing share class of a mutual fund is more expensive for the investor, the duty of care may be violated even though the duty of loyalty was satisfied.

There appear to be conflicting views of whether an investment adviser’s duty of care can be satisfied by disclosures that satisfy the duty of loyalty. That is, if an adviser discloses the receipt of additional compensation from investments or service providers, can the adviser then recommend or select that investment even though it may be more expensive for the client?  In recent years, the SEC has issued guidance that seems to answer that question…and the answer appears to be “no.” Based on its 2019 Commission Interpretation Regarding Standard of Conduct for Investment Advisers, and the two 2022 SEC Staff Bulletins, the position of the SEC (and of the Staff) is that the duties of care and loyalty (together referred to as the duty to act in the best interest of investors) are separate and distinct, and that they each must be independently satisfied.

For example, the 2019 Interpretation says:

“We believe that while full and fair disclosure of all material facts relating to the advisory relationship or of conflicts of interest and a client’s informed consent prevent the presence of those material facts or conflicts themselves from violating the adviser’s fiduciary duty, such disclosure and consent do not themselves satisfy the adviser’s duty to act in the client’s best interest.

In the SEC Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Conflicts of Interest, the SEC Staff stated its position unequivocally:

While firms should disclose the existence and potential effects of such conflicts, the staff reminds firms that disclosure of conflicts alone does not satisfy a firm’s obligation to act in the retail investor’s best interest.

As a result of this guidance, investment advisers should separately evaluate recommendations under both the duty of loyalty standard and the duty of care standard. The duty of loyalty requires that investment advisers disclose their conflicts of interest with sufficient detail to appropriately inform investors (so that the disclosure is adequate to support deemed consent by the investors). Separately, investment advisers should evaluate the cost of investments to determine if the conflicted payment to the adviser has resulted in higher costs to the investor. Where the investment recommendation or decision results in a higher cost to the investor, an investment adviser would need to justify how the higher cost is in the best interest of the investor, that is, how is the duty of care satisfied. It is likely that the SEC will scrutinize those transactions and could assert a violation of care unless the adviser can justify the benefit to the investor. In some cases that could be difficult to justify. But, in other cases it could be justified. For example, if an adviser is using a short-term trading strategy, it may be prudent to use higher cost share classes to avoid transaction fees. But, where the holdings are for a longer term, the fiduciary duty of care suggests that the lower cost alternative in that scenario should be used, which would be to pay the transaction fees.

As an aside, in a case I handled involving trading of mutual funds in retirement plans, the DOL took the position that it could be prudent to use the higher cost share classes to avoid transaction fees where the strategy was active trading (and holding for a short period), but where the holdings would be longer, the prudent man rule would require that the transaction fee funds be used, since  that produces a lower cost for the investor over the contemplated holding period.

For both the SEC and the DOL, the analysis appears to be….Which approach would produce the lower cost for the investor over the anticipated holding period?

In addition to retirement plans, the DOL’s approach would apply to IRAs where PTE 2020-02 was being used. That is, the PTE’s best interest standard would likely require that investment advisers consider the lower cost over the holding period. (The PTE would only need to be used if there were a conflict of interest, which in this case would be the revenue sharing from the custodian.)

However, the PTE only applies to non-discretionary advice. There isn’t any relief for revenue sharing from custodians for discretionary investment management decisions. As a result, if an adviser is managing an IRA with discretion, the adviser should completely avoid revenue sharing (unless it has to be offset dollar-for-dollar against the adviser’s stated fee). While the SEC standards may be satisfied if the revenue sharing payments do not violate the adviser’s fiduciary duty of care, there is not a similar exception under the prohibited transaction rules in ERISA and the Code. In other words, this is an area where the revenue sharing could be permissible under SEC standards, but not under the Code and ERISA standards. That creates a scenario where an investment adviser could use one approach for personal accounts, but would be required to use a different approach for the same investor’s retirement accounts.

Concluding Thoughts

 The main point of this article is that investment advisers should be aware that the duties of loyalty and care are separate and distinct duties, and the satisfaction of one does not automatically satisfy the other. Any time that an investment adviser receives additional compensation due to an investment recommendation or decision, the adviser should consider whether that could result in a violation of the adviser’s duty of care.

With regard to retirement accounts, investment advisers also need to appreciate the differences between the SEC’s fiduciary approach to conflicts of interest and the ERISA and Code limitations on prohibited transactions (which are basically conflicted compensation resulting from fiduciary recommendations or decisions). While the two regulators—the SEC and DOL—may be gradually aligning their views, they are limited by differences in the laws that they enforce. The prohibited transaction rules in the Code and ERISA are so restrictive that they will not allow complete harmonization.

The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Faegre Drinker.