The SEC’s interpretation of the investment adviser standard of conduct appears to refine the contours of the fiduciary duty that investment advisers owe their clients under the Advisers Act, enhance disclosure obligations, and expand initial and ongoing suitability considerations. In a companion interpretation, the SEC also clarified when investment advice by broker-dealers is “solely incidental” to brokerage for purposes of the exclusion from SEC investment adviser registration.
Is there a new standard of conduct for investment advisers? Under the Interpretation, an investment adviser has an obligation to act in the best interest of its clients, which the US Securities and Exchange Commission (SEC) characterizes as a broad and overarching principle that encompasses both the duty of care and the duty of loyalty.
The Interpretation affirms the SEC’s longstanding position that Sections 206(1) and (2) of the Advisers Act establish a federal fiduciary standard governing the conduct of investment advisers. In contrast to Regulation Best Interest, the fiduciary standard for investment advisers, as clarified in the Interpretation, is a flexible principles-based standard based on the scope and nature of the advisory relationship.
Observation: While the principles-based approach is helpful to investment advisers in creating the flexibility to conduct business and build appropriate controls based on the nature of the advisory services they provide, the Interpretation also gives the SEC examination and enforcement staff a significant amount of flexibility to interpret and enforce this best interest obligation in any particular situation.
Is the Interpretation limited to advice provided to retail clients? No. Unlike Regulation Best Interest, which focuses exclusively on advice provided to retail customers, the Interpretation applies to investment advice provided to all clients—both retail and institutional. The Interpretation acknowledges that investment advisers provide advice to a range of clients, from retail investors in digital advisory services to institutional investors such as pooled investment vehicles, endowments, and foundations. In response to a number of comments, the SEC made an effort to differentiate the impact of the Interpretation on retail and institutional clients in certain circumstances.
Does the fiduciary duty vary based on the type of advice provided to a client? No, the components of the fiduciary duty—duty of loyalty and duty of care—do not vary based on the type of advice provided. Further, the Interpretation states that the fiduciary duty applies to the “entire relationship” between an adviser and its client. However, the SEC acknowledged that an adviser and its client are free to define the scope of the advisory relationship by contract—and, in particular, the specific functions and responsibilities that the adviser, “as agent, has agreed to assume for the client, its principal.”
Observation: Many advisory agreements are drafted with a broad grant of discretion to give advisers maximum flexibility. Going forward, advisers may wish to consider defining the scope of their services in a narrower manner, and to focus on describing the limitations of their authority and responsibility to more clearly delineate the scope of the fiduciary duty that attaches to those services. This is particularly true in the case of multi-adviser relationships (e.g., advisory/sub-advisory agreements, co-advisory relationships, advisory services distributed through investment adviser intermediaries, and wrap programs that rely on sponsors, portfolio managers, and overlay managers) where advisory responsibilities are allocated among a number of different advisers that each play distinct roles.
Can an investment adviser disclaim its fiduciary duty? No. The SEC recognizes in the Interpretation that the scope and extent of an investment adviser’s services and responsibilities can be shaped by agreement, but states that advisers cannot disclaim their fiduciary duty. According to the SEC, contract provisions that broadly disclaim an adviser’s fiduciary responsibility, act as a blanket waiver of conflicts of interest, or waive specific obligations under the Advisers Act are inconsistent with an adviser’s fiduciary duty for retail and institutional clients alike. The SEC withdrew the SEC staff’s 2007 Heitman no-action letter, in part because the SEC was concerned that the letter was being misinterpreted as defining the scope of an adviser’s fiduciary duty, rather than identifying circumstances where a hedge clause (a clause in an advisory agreement that attempts to limit an adviser’s liability) would be misleading such that it would violate Section 206 of the Advisers Act. The SEC reaffirmed the concept that whether a hedge clause violates the antifraud provisions of the Advisers Act depends on the facts and circumstances, including the sophistication of the client. Although the SEC withdrew Heitman, it left in place the 1974 Auchincloss SEC staff no-action letter allowing the use of savings clauses to clarify that certain exculpatory provisions are not intended to “constitute a waiver or limitation of any rights which the [client] may have under any federal securities laws.” However, the SEC stated its view that there are “few (if any) circumstances in which a hedge clause in an agreement with a retail client would be consistent” with the antifraud provisions of the Advisers Act, “even where the agreement otherwise specifies that the client may continue to retain its non-waivable rights”—in effect making the point that a savings clause will not save an otherwise impermissible hedge clause.
Observation: Advisers should review their advisory agreements to assess whether there are any contractual provisions that could be viewed as waiving a client’s nonwaivable rights, notwithstanding the presence of a general savings clause that clients retain all rights that they would otherwise have from an Advisers Act or fiduciary perspective. The Interpretation does not change the advisability of using a savings clause indicating that clients will not be deemed to have waived any of their nonwaivable rights. However, including the savings clause language in a contract will not protect a hedge clause that otherwise purports to waive an adviser’s fiduciary duty.
When do investment advisers have to comply with the Interpretation? The Interpretation took effect on July 12, 2019, upon publication in the Federal Register. There is no implementation period as in the case of Regulation Best Interest and Form CRS, which both have a compliance date of June 30, 2020.
Observation: The immediate effectiveness of the Interpretation reflects the SEC’s stated conclusion that the Interpretation was not intended to create new legal obligations for investment advisers. In the SEC’s view, the Interpretation is intended to “reaffirm—and in some cases clarify—certain aspects of the fiduciary duty that an investment adviser owes to its clients under section 206 of the Advisers Act.” Reasonable minds may differ, however, about whether the Interpretation is simply a restatement of an investment adviser’s fiduciary duty or whether it expands the fiduciary duty in significant ways (e.g., by creating an overarching best interest obligation, applying the fiduciary duty to advice about account types). Firms might consider revisiting and, in some cases, enhancing existing practices and disclosures to conform to the Interpretation, as discussed below.
How will the SEC enforce compliance with this Interpretation? The SEC did not adopt a rule codifying the standard of conduct for investment advisers, even though the SEC has authority in Section 206(4) to define by rule “any act, practice, or course of business which is fraudulent, deceptive, or manipulative” and in Section 211(g) to adopt a “best interest” standard—authority that was granted by Congress just nine years ago in Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Rather, the SEC decided to issue an interpretation of an investment adviser’s fiduciary duty. This means that the SEC’s authority to bring actions to enforce compliance with the Interpretation is limited to Advisers Act Sections 206(1) and (2), which have been construed by the federal courts as limited to common law principles.
Observation: The Interpretation is designed to consolidate SEC guidance on the federal fiduciary duty in one place, although the Interpretation seemingly stakes out new ground in some key respects. As a result, the Interpretation will effectively become the standard the SEC examination and enforcement staff will look to in evaluating whether an investment adviser breached its fiduciary duty under Sections 206(1) and (2). Whether the positions articulated in the Interpretation go beyond the common law principles underpinning Sections 206(1) and (2) may well be an issue for debate in SEC examinations and enforcement actions. Regardless of how that debate plays out, advisers should read the Interpretation from the perspective of how they can document—through policies, procedures, disclosure, supervision and surveillance—that they are addressing the various fiduciary obligations described in the Interpretation when providing advice.
What is the duty of care that investment advisers owe to their clients? The Interpretation states that investment advisers owe their clients a duty of care, which includes (among others) the duty to
Does the best interest standard only apply in the case of a recommendation? No. Unlike Regulation Best Interest, which is triggered by a recommendation, the SEC stated that the duty to provide advice that is in the client’s best interest applies to “all investment advice” that an adviser provides. This includes advice about investment strategies, engagement of a subadviser, and significantly, account type, which the SEC characterizes (but does not define) as including the type of accounts that a client may open (e.g., fee-based advisory or commission-based brokerage) and advice about retirement plan (such as 401(k) plans and IRAs) rollovers. The SEC asserted that rollover advice incorporates advice around account type. According to the SEC, the best interest component of the duty of care requires advisers to “consider all types of accounts offered by the adviser and acknowledge to a client when the account types the adviser offers are not in the client’s best interest.”
Observation: Under longstanding SEC guidance, “[t]he relationship of a broker or dealer to his brokerage customers does not become an investment advisory relationship merely because the broker or dealer is a registered investment adviser,” and the Advisers Act applies only to those accounts to which the broker-dealer provides investment advice that is not solely incidental to brokerage services or for which the firm receives special compensation. The SEC’s articulated obligation to consider all types of accounts offered by the adviser will be challenging for dual registrants and advisers that have supervised persons that are also registered representatives of a broker-dealer. In order to manage these obligations, advisers might consider how to define their relationships with clients and the universe of available account types. Advisers might also consider ways to aid representatives in documenting account choice, perhaps even revisiting tools, approaches, and training modules developed in regard to implementing the now-vacated Department of Labor (DOL) Fiduciary Rule (e.g., onboarding tools and pull-downs, client-facing educational brochures, and decision trees).
What fiduciary obligations are owed to prospective clients? According to the SEC, an investment adviser has an obligation to confirm that advice regarding account type that it provides to prospective clients continues to be appropriate at the inception of the fiduciary relationship. The SEC acknowledges that an adviser is not acting in a fiduciary capacity prior to the inception of the advisory relationship, and states that the relationship with a prospective client is governed by the general antifraud provisions of Section 206. The SEC asserts that once an advisory relationship is established, the adviser “must satisfy its fiduciary duty” with respect to account type and other advice that predates the inception of the advisory relationship.
Observation: Although the Interpretation does not appear to go so far as to make an investment adviser’s fiduciary duty retroactive to advice that predates the inception of the advisory relationship, it does highlight the importance of having appropriate controls around the advice provided to prospective clients, including with investment proposals and account type selection. Additionally, advisers should consider the need to revisit any advice provided to prospective clients to determine whether there are additional factors that might change or better inform that advice if and when a prospect becomes a client. Moreover, firms should consider revising disclosures on materials provided to prospective clients (including investment proposals) to indicate that the information provided is based on the initial discussion and information collected as part of the proposal process, reflects the adviser’s perspective at that particular point in time, and will not be updated prior to the inception of the advisory relationship.
How can an investment adviser satisfy its obligation to provide advice in the best interest of the client? According to the SEC, an investment adviser is required to have a “reasonable understanding” of the client’s objectives in order to render advice that is suitable for and in the best interest of the client. In order to form such a “reasonable understanding,” an adviser must make a “reasonable inquiry” into the client’s objectives.
What is a “reasonable inquiry” for retail clients? According to the SEC, an adviser would, at a minimum, have to inquire into a retail client’s “investment profile,” which includes financial situation, level of financial sophistication, investment experience, and financial goals. In addition, the SEC states that an adviser is required to update the client’s investment profile “to maintain a reasonable understanding of the client’s objectives and adjust its advice to reflect any changed circumstances,” and that the frequency of updates would turn on a number of factors, including the extent to which the adviser is aware of events that could render the client’s investment profile inaccurate or incomplete.
Observation: Advisers will want to consider how the concept of an “investment profile” applies to their business and whether they have or retain information that sufficiently constitutes an investment profile for their clients. The Interpretation leaves unanswered how frequently an investment adviser is required to update a client’s investment profile and under what situations an investment adviser would be deemed to be “aware of” new information that could cause the investment profile to become inaccurate or incomplete. This is particularly the case where advisory clients have additional financial relationships with their adviser or its affiliates (e.g., banking, brokerage, insurance) and the affiliate receives information about the client that may affect the investment profile.
What is a reasonable inquiry for institutional clients? The SEC stated that when advising institutional clients, the nature and extent of an adviser’s “reasonable inquiry” into the client’s objectives depends on the specific investment mandate, guidelines, and objectives. In contrast to retail investors, advisers acting on specific investment mandates for institutional clients—“particularly funds”—would not have an obligation to ”update a client’s objectives” unless required under the terms of the advisory agreement.
How can an adviser satisfy the obligation to have a “reasonable belief” that advice is in the best interest of a client? The Interpretation states that an investment adviser is required to “have a reasonable belief that the advice it provides is in the best interest of the client based on the client’s objectives.” The concept of a reasonable belief will depend on the particular facts and circumstances of the advisory relationship, including the overall portfolio that the adviser manages for the client, as well as its objectives. According to the SEC, the adviser must also consider the risks of the investment strategies and securities it recommends, and conduct a reasonable investigation into the investment that is “sufficient not to base its advice on materially inaccurate or incomplete information.”
How do fees and expenses impact the best interest obligation? The SEC asserts that the fees and compensation associated with an investment are not solely determinative of whether that investment is in the best interest of a client. Rather, fees and compensation are “one of many important factors” that must be considered—along with investment objectives, characteristics, liquidity, risks and potential benefits, volatility, likely performance in different market and economic conditions, time horizon, and cost of exit. According to the SEC, “when considering similar investment products or strategies, the fiduciary duty does not necessarily require an adviser to recommend the lowest cost investment product or strategy.” The SEC stated that an adviser would not satisfy its fiduciary duty to provide advice that is in a client’s best interest by “simply advising its client to invest in the lowest cost (to the client) or least remunerative (to the investment adviser) investment product or strategy” without considering other factors.
Observation: While the Interpretation makes clear that an adviser could recommend a higher-cost investment or strategy if the adviser reasonably believes that there are other factors that outweigh cost, as a practical matter it may be difficult to satisfy the standard in the case of identical investments—such as mutual fund share classes—where the only differences are the fees and expenses paid by the client and the remuneration to the adviser or its affiliates. As many firms experienced in attempting to implement processes for the DOL Fiduciary Rule, applying a fiduciary standard to an open-architecture platform may prove challenging.
Does the Interpretation affect an investment adviser’s duty to seek best execution? No, the Interpretation appears to reconfirm existing SEC guidance that an investment adviser has the duty to seek best execution of client transactions where the adviser has the responsibility to select executing broker-dealers for the transactions. The Interpretation cites to prior guidance for the proposition that “the ‘determinative factor’ is not the lowest possible commission cost, ‘but whether the transaction represents the best qualitative execution,’” and that advisers should periodically and systematically evaluate execution quality.
Observation: In the Interpretation, the SEC again declined to provide affirmative guidance on the application of best execution to mutual fund share class selection. Despite having brought charges against investment advisers for failure to obtain best execution in the context of mutual fund share class selection in a number of settled enforcement actions, the SEC did not lay the foundation for this theory of best execution.
What is the duty to provide ongoing advice and monitoring? In what may be the most significant change from SEC guidance, the SEC stated that the duty of care also requires advisers to provide advice and monitoring at a frequency that is in the best interest of the client. Previously, advisers were (and remain) required to disclose in Form ADV Part 2A limited information on account reviews, including if they periodically review client accounts. Under the Interpretation, the scope of the duty takes into account the nature of the relationship with the client, and consequently, ongoing advisory relationships where advisers receive asset-based fees will have more extensive duties than in more limited advisory relationships. The SEC stated that advisers and clients may define the scope and frequency of monitoring obligations provided there is full and fair disclosure and informed consent. According to the SEC, the duty would extend to all personalized advice including, in an ongoing relationship, “an evaluation of whether a client’s account or program type (for example, a wrap fee program account) continues to be in the client’s best interest.” The SEC also stated that monitoring frequency is a material point of disclosure for clients, and suggested that advisers should consider adopting written policies and procedures governing monitoring for purposes of meeting their compliance obligations under Rule 206(4)-7.
Did the SEC change the formulation of the duty of loyalty set forth in the Proposed Interpretation? Yes. The Proposed Interpretation stated that “the duty of loyalty requires an investment adviser to put its client’s interests first.” The SEC refined this standard in the Interpretation to say that an investment adviser may not place its own interest ahead of its client’s interest. The SEC reformulated the standard in response to comments it received, which argued that there is a material difference between putting client interests first and the requirement not to subordinate or subrogate client interests. The SEC noted that the refined standard is more consistent with how it has previously described the duty of loyalty.
How does the SEC define a conflict of interest? The SEC’s statements around conflicts of interest reflect a shift from the standard articulated in the Proposed Interpretation, which is that an adviser “must seek to avoid conflicts of interest with its clients” and at a minimum, make “full and fair disclosure of all material conflicts of interest that could affect the advisory relationship.” (Emphasis added.) Under the Interpretation, advisers must “eliminate or at least expose through full and fair disclosure all conflicts of interest which might incline an investment adviser—consciously or unconsciously—to render advice which was not disinterested.”
The critical difference is that the standard for disclosure in the Interpretation does not have a materiality component. Rather, the limiting factor is whether the conflict might cause an investment adviser to provide advice that is not disinterested. This construction appears to be a departure from the instructions to Instruction 3 of Form ADV, Part 2A, which states:
Under federal and state law, you are a fiduciary and must make full disclosure to your clients of all material facts relating to the advisory relationship. As a fiduciary, you also must seek to avoid conflicts of interest with your clients and, at a minimum, make full disclosure of all material conflicts of interest between you and your clients that could affect the advisory relationship.
(Emphasis added.) In the Interpretation, the SEC effectively reads out the “material conflict” concept in the second sentence above and emphasizes the first part of the instruction for the premise that in order to satisfy the duty of loyalty, an adviser must disclose “all material facts relating to the advisory relationship.”
The Interpretation states that the duty to disclose material facts relating to the advisory relationship includes disclosure about the capacity in which the firm is acting, including, in the case of dual registrants or individuals that are dually licensed, the circumstances where the adviser would be acting in its capacity as a broker-dealer. Disclosure about capacity (and any changes thereto) can be accomplished through a variety of means, including written disclosure at the beginning of the advisory relationship that clearly lays out when the adviser would be acting in a brokerage capacity. The Interpretation also states that, when providing investment advisory services to clients, dual registrants should disclose any circumstances under which their investment offerings will be limited to a menu of products offered through their affiliated broker-dealers or advisory channels.
Observation: Under longstanding SEC and staff statements, as well as the text of Form ADV, investment advisers have only been required to make full disclosure of material conflicts. While the SEC stated in Regulation Best Interest that “it would be difficult to envision a ‘material fact’ that must be disclosed pursuant to the Disclosure Obligation that is not related to a conflict of interest that is also material,” it is unclear how this plays out in practice, including whether the SEC ultimately takes the position that the existence of a conflict is a material fact that must be disclosed without regard to the materiality of the conflict and how this impacts conflicts that advisers have deemed immaterial and excluded from disclosures.
Does the SEC view disclosure as sufficient to satisfy the duty of loyalty, or do advisers have to mitigate or eliminate certain conflicts of interest? The Interpretation does not itself create an obligation to eliminate or mitigate conflicts. However, the SEC suggested that elimination or mitigation may be required if an adviser cannot provide sufficiently specific disclosure to obtain informed consent.
The SEC’s position is that disclosure of conflicts is sufficient to satisfy the duty of loyalty, but that disclosure incorporates an informed consent element that requires disclosure to clients around conflicts of interest to be sufficiently specific such that clients can understand the conflict of interest and make “an informed decision” about whether to consent. The Proposed Interpretation stated that “[d]isclosure of a conflict alone is not always sufficient to satisfy the adviser’s duty of loyalty and section 206 of the Advisers Act.” This statement called into question whether the SEC was backing away from the fundamental common law foundation of the fiduciary duty of loyalty, as well as SEC precedent, both of which do not prohibit an investment adviser from benefitting from a transaction with a client if the investment adviser provides appropriate disclosure of the conflicts of interest related to the transaction and the client consents. A client may generally consent to a conflict of interest that would otherwise constitute a breach of the duty of loyalty where the adviser has provided appropriate disclosure of the conflict.
In response to comments, the SEC softened the prior language implying that disclosure is per se insufficient to address conflicts in certain circumstances and focused instead on how to obtain informed consent. However, the Interpretation retains the concept that, if a conflict of interest cannot be fully and fairly disclosed, advisers should either “eliminate the conflict or adequately mitigate (i.e., modify practices to reduce) the conflict such that full and fair disclosure and informed consent are possible.”
How does an adviser know if it has obtained informed consent? According to the SEC, advisers must make full and fair disclosure of conflicts of interest such that they obtain the informed consent of clients. The Interpretation clarifies that “informed consent” is not a subjective standard that would require advisers to make an affirmative determination that each particular client understood the disclosure. According to the SEC, the focus for advisers is whether their disclosure is designed to put clients in a position to be able to understand and provide informed consent to the conflict of interest. Further, informed consent does not need to be explicit in all cases. The SEC believes informed consent can be implicit, including through a client’s continued receipt of advisory services following full and fair disclosure.
Does the Interpretation identify specific conflicts where informed consent would be difficult? Yes, but the guidance is minimal. The SEC believes that such conflicts are “of [such] a nature and extent that it would be difficult to provide disclosure to clients that adequately conveys the material facts or the nature, magnitude, and potential effect of the conflict” such that the client would be able to consent to or reject it. The Interpretation identifies “complex or extensive conflicts” as an area where understandable and sufficiently specific disclosure to retail investors may be difficult, on the theory that institutional investors “have a greater capacity and more resources . . . to understand” complex conflicts as compared to retail investors.
Observation: The net effect of the Interpretation with respect to the disclosure of conflicts seems to be that the SEC is attempting to restate the standard for when disclosures are sufficient to produce informed consent. Accordingly, to the extent they have not already done so, investment advisers should revisit disclosure around significant conflicts to determine whether they need to more clearly articulate the material facts of the conflict and have an appropriate level of detail in their disclosure to put clients in a position to understand the nature of the conflict and provide informed consent.
May advisers use conditional “may”-based disclosure? In the SEC’s view, “may”-based disclosure could be appropriately used only in cases where the disclosure identifies a potential conflict that does not currently exist but might “reasonably present itself in the future.” Otherwise, the Interpretation formalized the view—first articulated in various enforcement actions—that disclosing that an adviser “may” have a particular conflict, is not adequate when that conflict actually exists. According to the SEC, investment advisers should not use “may” to explain that a conflict exists only with respect to a subset of clients or services it provides, unless the “may”-based disclosure specifies the subset of clients or services where the conflict applies. In the SEC’s view, “may”-based disclosure that precedes a list of all possible or potential conflicts regardless of likelihood has the effect of “obfuscating” actual conflicts to a point that clients cannot provide informed consent.
Observation: Advisers that have not already done so should revisit their disclosures and client agreements to consider and—to the extent appropriate—eliminate “may”-based disclosures. The SEC continues to attack “may”-based disclosure, perhaps emboldened by a recent federal court decision that upheld findings of inadequate “may”-based disclosure. However, in so doing, the SEC neither acknowledged nor reconciled federal court precedent cited by commenters that has rejected differences between “will” and “may” in the disclosure context as “semantic quibbling” and not material omissions in and of themselves under the federal securities law.
Section 202(a)(11)(C) of the Advisers Act excludes from the definition of “investment adviser” any broker-dealer whose advice is “solely incidental” to its brokerage business and who does not receive “special compensation” for that advice. In this interpretation, the SEC sought to clarify its views as to the “solely incidental” prong in light of Regulation Best Interest.
The SEC stated that it interprets the “solely incidental” prong to mean that a broker-dealer’s provision of advice does not make it an investment adviser if the advice is “provided in connection with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions.” (Emphasis added.) According to the SEC, whether such advice is provided on a solely incidental basis is based on the facts and circumstances surrounding the broker-dealer’s business, the specific services offered, and the relationship between the broker-dealer and the customer. The SEC stated that the “quantum or importance” of investment advice provided by a broker-dealer is not determinative of whether it is “solely incidental” to brokerage activity, affirming that even consequential broker-dealer investment advice can fall within the exclusion provided it meets the standard above. The SEC provided guidance for two applications of investment advisory activity, as detailed below, but noted that it will consider further comment on its interpretation of the solely incidental prong to evaluate whether to issue additional guidance.
The SEC stated that it views a broker-dealer’s exercise of “unlimited discretion”—defined as the ability or authority to buy and sell securities on behalf of a customer without consulting the customer—as indicating that the client relationship is “primarily advisory in nature” and therefore outside the solely incidental prong. However, the SEC carved out certain instances of investment discretion granted by a customer on a temporary or limited basis. The SEC defined discretion in such situations as limited in “time, scope, or other manner” and lacking “the comprehensive and continuous character of investment discretion.” For example, the SEC pointed to (among others) discretion over time and price of execution, the isolated or infrequent purchase or sale of a security or type of security when the customer is unavailable for a limited period of time, cash management such as the exchange of money market funds or other cash equivalents, the sale of specific bonds “or other securities” in order to permit a customer to realize a tax loss on the original position, and the purchase or sale of securities to satisfy margin requirements or other customer obligations “specified” by the customer. The “primarily advisory in nature” test is troubling in that it is both new and not clearly articulated.
The SEC also provided some guidance around whether monitoring of customer accounts (as discussed in Regulation Best Interest) is advice that is solely incidental to brokerage. The SEC disagreed with commenters who suggested that any account monitoring is necessarily outside of the solely incidental prong, and stated that “[a] broker-dealer that agrees to monitor a retail customer’s account on a periodic basis for purposes of providing buy, sell, or hold recommendations may still be considered to provide advice in connection with and reasonably related to effecting securities transactions.” (Emphasis added; citations omitted.) The SEC also made clear that broker-dealers would not generally be acting in a primarily advisory nature if they voluntarily and without any agreement review customer account holdings for purposes of determining whether to provide a securities recommendation. In contrast, the SEC said that if a broker-dealer separately contracts for or charges a separate fee for account monitoring, that activity would likely fall outside the solely incidental prong and require investment adviser registration.
Observation: The SEC’s reformulation of the broker exclusion as permitting only advice that is “provided in connection with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions” and the corresponding test looking to whether a broker’s services are “primarily advisory in nature”—as well as the SEC’s positions on agreed account monitoring—reflect changes that were not explicitly proposed or articulated in the Proposed Interpretation or past SEC or staff guidance, and are murky. The SEC’s reformulated broker exclusion appears lifted from dicta in Thomas v. Metropolitan Life Insurance Co., where the US Court of Appeals for the Tenth Circuit affirmed the SEC’s prior interpretation of the broker exclusion but incorrectly paraphrased the SEC’s prior interpretation. The new interpretation appears inconsistent with the point validated in the Thomas decision, and repeated by the SEC, that “the solely incidental prong does not hinge upon ‘the quantum or importance’ of a broker-dealer’s advice.” Although the SEC addressed exercise of discretion in prior guidance (including in Rule 202(a)(11)-1, which was vacated by the US Court of Appeals for the District of Columbia Circuit in Financial Planning Association v. SEC), the “primary business of effecting securities transactions” and “primarily advisory in nature” tests are entirely new. Similarly, although the SEC requested comments on account monitoring, it did not articulate a proposed interpretation of when agreed account monitoring would fall outside the “solely incidental” prong. As such, the SEC’s reformulated interpretation of the broker exception raises significant questions, especially given recent Supreme Court and other federal court decisions rejecting agency interpretations absent notice and comment.
We note that in the Proposed Interpretation, the SEC requested comment on three potential areas of new rulemaking for SEC-registered investment advisers. The areas identified were also discussed in the SEC staff’s 2011 Study on Investment Advisers and Broker-Dealers conducted pursuant to Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These areas include federal licensing and continuing education requirements for personnel of SEC-registered investment advisers; rules requiring investment advisers to provide account statements; and SEC-registered investment advisers being subjected to a financial responsibility program similar to those that apply to broker-dealers. The SEC also requested comment on a number of subsidiary issues relating to these topics. The Interpretation does not address these issues, and notes that the SEC is continuing to evaluate the comments that it has received in response to its request.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Christine M. Lombardo
John V. Ayanian
Brian J. Baltz
Ivan P. Harris
Thomas S. Harman
Lindsay B. Jackson
Daniel R. Kleinman
Amy Natterson Kroll
Monica L. Parry
Michael B. Richman
Ignacio A. Sandoval
Steven W. Stone
Kyle D. Whitehead
 Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Investment Advisers Act Rel. No. 5248 (Interpretation); Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation, Investment Advisers Act Rel. No. 4889 (Proposed Interpretation).
 Auchincloss & Lawrence Inc., SEC Staff No-Action Letter (Feb. 8, 1974).
 Advisers Act Rel. No. 626 (Apr. 27, 1978); see, e.g., Goldman, Sachs & Co., SEC No-Action Letter (Feb. 22, 1999) (pertaining to the applicability of Advisers Act restrictions on principal trades to transactions effected for clients of the broker-dealer’s prime brokerage services).
 The Interpretation specifically calls out inverse and leveraged ETFs as investment products that are designed as short-term trading tools for sophisticated investors and, absent an “identified, short-term, client-specific trading objective,” may not be in the best interest of a retail client. The guidance also adds that to the extent that an adviser determines inverse or leveraged ETFs are in a retail client’s best interest given identified short-term trading objectives, use of such products would require daily monitoring by the adviser. See Interpretation at n.39. It is by no means clear that the fact that these ETFs seek their objective on a daily basis translates into a need for daily monitoring.
 See Interpretation at text accompanying n.92 (“We disagree that this Final Interpretation includes a requirement to eliminate conflicts of interest. As discussed in more detail above, elimination of a conflict is one method of addressing that conflict; when appropriate advisers may also address the conflict by providing full and fair disclosure such that a client can provide informed consent to the conflict.”).
 See Robare Grp., Ltd., et al. v. SEC, 922 F.3d 468 (D.C. Cir. 2019).
 See, e.g., Mendell v. Greenberg, 927 F.2d 667, 679 (2d Cir. 1990) (even if the disclosure at issue used the word “may” instead of “will,” “a reasonable investor would still have been on notice that additional [financial] incentives were most likely and should have been anticipated”); Hoffman v. UBS-AG, 591 F. Supp. 2d 522, 534 (S.D.N.Y. 2008) (“Defendants’ prospectuses were not misleading or incomplete to the extent that they disclosed the possibility of entering into a shelf-space arrangement . . . . The language used in Defendants’ prospectuses gave investors adequate notice of the possibility of shelf-space agreements, arrangements about which investors could have inquired if they felt that such agreements would compromise the service that they were receiving.”).
 Commission Interpretation Regarding the Solely Incidental Prong of the Broker-Dealer Exclusion from the Definition of Investment Adviser, Investment Advisers Act Rel. No. 5249 (June 5, 2019).
 631 F.3d 1153 (10th Cir. 2011).
 482 F.3d 481 (D.C. Cir. 2007).
 See, e.g., Kisor v. Wilkie, No. 18-15, 588 U.S. ___, slip op. (June 26, 2019) (stating “a court may not defer to a new interpretation . . . that creates “unfair surprise” to regulated parties. * * * Even though a court might defer to an agency’s interpretation of a regulation, the agency’s interpretation itself never forms the basis for an enforcement action. Rather, an agency bringing an enforcement action must always rely on a rule that went through notice and comment. And courts, in turn, always retain the final authority to approve—or not—an agency’s reading of that notice-and-comment rule. * * * This Court, for example, recently refused to defer to an interpretation that would have imposed retroactive liability on parties for longstanding conduct that the agency had never before addressed.”).