Adviser conduct interpretation and Form CRS: implication for institutional managers

28 June 2019

The SEC adopted a package of rules and interpretations this month designed to enhance the quality and transparency of retail investors’ relationships with investment advisers and broker-dealers. On first impressions institutional asset managers might disregard some of the package, but there is plenty here to take notice of.

The package of rules and interpretations announced by the US Securities and Exchange Commission on June 5 consisted of four components.

  1. Regulation Best Interest (Rule 15/-1 of the Exchange Act)
  2. Form CRS (Rule 204-5 of the Investment Advisers Act and Rule 17a-14 of the Exchange Act)
  3. Interpretation on Adviser Conduct Standard and Fiduciary Duty
  4. Interpretation of “Solely Incidental” in Advisers Act Section 202(A)(11)(c)

There has been significant publicity around the adoption of these rules and interpretations. Setting aside the portions directed at broker-dealers (Regulation Best Interest and the interpretation of “solely incidental”), upon first glance, institutional asset managers may dismiss Form CRS as applicable only in the context of “retail investors” and the interpretations of the conduct standard and fiduciary duty as confirmation of existing standard. However, institutional asset managers should not be so dismissive.

Application to Institutional Asset Managers

Adviser Conduct Standard and Fiduciary Duty

All investment advisers subject to the Advisers Act, including private fund advisers, should consider the guidance from the SEC as it is intended “to reaffirm – and in some cases clarify – certain aspects of the fiduciary duty that an investment adviser owes to its clients.” Our most relevant takeaways are as follows:

  • The SEC reaffirmed and clarified the disclosure-based Advisers Act fiduciary duty meaning an adviser has a duty to its clients that is outlined by the advance disclosure that the adviser gives to its clients.
  • Investment advisers have a duty to “eliminate, or at least to expose, all conflicts which might incline an investment adviser – consciously or unconsciously – to render advice which is disinterested.”
  • Advisers fiduciary duty is two-pronged – (1) duty of care and (2) duty of loyalty
  • The duty of care consists of (1) the duty to act and provide advice that is in the best interest of the client, (2) the duty to seek best execution of the client’s transactions, and (3) the duty to provide advice and monitoring.
    • The duty of care requires an investment adviser to have a “reasonable understanding of the client’s objectives” in order to provide that is in the best interests of its clients. For institutional clients, this requires an understanding of the investment mandate meaning the reasonable understanding of the fund’s investment guidelines and objectives.
  • An Adviser’s existing obligations with respect to best execution remains unchanged
  • An Adviser’s duty of loyalty, an Adviser’s duty to put its clients’ interests ahead of its own, can be satisfied through disclosure.
  • Investment advisers must eliminate or disclose conflicts of interest. In a situation where a conflict cannot be fully and fairly disclosed, an Adviser should either eliminate or adequately mitigate the conflict to put the client in a position to be able to give informed consent.

Form CRS

Rule 204-5 of the Advisers Act, as adopted, requires a firm to deliver to retail investors its current Form CRS. A firm that does not have any retail investors to whom the firm would be required to deliver a Form CRS is not required to prepare or file a Form CRS.

The SEC defines “retail investor” as “a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family or household purposes.” The definition includes natural persons irrespective to a natural person’s assets or net worth. As interpreted, investors in a private fund are not included in the adopted definition of retail investor.  “Legal representative,” as used in the definition, is limited to “non-professional” legal representatives intended to include persons who are acting on behalf of a natural person and “who are not regulated financial services professionals retained… to exercise independent professional judgment.”

However, institutional managers are not totally out of the woods with Form CRS. A family office that is not required to register as an investment adviser under Rule 202(a)(11)(G)-1 of the Advisers Act could be a retail investor for purposes of Form CRS. Therefore, for retail investor clients, institutional managers will need to focus on if a regulated financial services professional exercising independent professional judgment is between the institutional manager and the natural person.

 

How Bovill can help

 

  • Analysis of application of Rule 204-5
  • Creation of Form CRS
  • Form ADV drafting inline with Fiduciary Duty guidance

Analysis of conflicts of interest, development and implementation of conflict mitigation processes

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