In the simplest terms, a fiduciary duty is a legal responsibility to act in another party’s best interests. From a practical perspective, determining what types of action constitute a violation of an existing fiduciary duty can be challenging. While certain instances in which a breach of fiduciary duty is clear and obvious, there are also many other scenarios in which the breach can be more nuanced—especially in certain industries where there are differing standards of care that professionals are obligated to meet.
Certainly this is the case when it comes to securities, as the Securities and Exchange Commission (SEC) adopted a comprehensive interpretation of the fiduciary duties that investment advisers owe to their clients per the Investment Advisers Act of 1940. Although numerous Supreme Court rulings have established that the 1940 statute creates a federal fiduciary standard for investment advisers, these cases did not explicitly define a practical definition of fiduciary duties.
The SEC has now clarified that the Advisers Act imposes both the duty of care and the duty of loyalty and acknowledges that differing applications of the fiduciary duties are necessary for retail and institutional clients.
Duty of Loyalty
The duty of loyalty of an adviser means they cannot subordinate their clients’ interests to their own. The SEC’s interpretation about this duty requires advisers to eliminate or make full and fair disclosure of all potential or existing conflicts of interest, which might influence an adviser to either consciously or unconsciously provide advice that is not disinterested, such that the client can provide informed consent to the conflict of interest. For disclosures to be deemed full and fair from the SEC’s perspective, they should be adequately specific so that a client can comprehend the material fact or conflict of interest and subsequently make an informed decision whether to offer their consent. For example, it would not be adequate for the adviser to merely disclose that they have other clients without explaining how the adviser will manage potential conflicts between clients if and when they come about, or to disclose that the adviser has conflicts without a more detailed explanation.
Whether or not a disclosure qualifies as ‘full and fair’ is also dependent on the client themselves, as institutional clients with considerable sophistication and familiarity with financial markets may need a less detailed description than clients who possess a more limited scope of knowledge. The client can provide either explicit or implicit informed consent; however, the adviser may not infer or accept consent if they should reasonably know that the client does not fully understand the nature and impact of the associated conflict of interest. In instances where there is a particularly complex or extensive conflict dealing with an unsophisticated retail client, advisers should either eliminate or sufficiently mitigate said conflict so that the client can provide total informed consent with full and fair disclosures.
Duty of Care
The SEC also mandates that advisers must always serve their clients’ best interest based on the stated financial goals. This ‘duty of care’ is comprised of the duties to:
- Offer advice that is in the client’s best interest;
- Seek best execution; and
- Act and offer advice and monitoring throughout the relationship.
In the case of retail clients, advisers should make a reasonable inquiry regarding the client’s financial situation, level of financial understanding, investment experience, and financial objectives.
Alternatively, the nature and extent for reasonable inquiry for institutional clients are dependent on the specific investment mandate from those clients. Institutional client advisers are permitted to infer that their obligation to provide advice is limited to a specific investment directive and not the client’s entire portfolio. The SEC reads the duty of care requirement as imposing an obligation on advisers to make an attempt in securities transactions on behalf of their client(s). This is to optimize value for the client during the transaction. It also includes considerations regarding the value of research offered, execution capability, commission rate, financial responsibility, and responsiveness.
Disclosing Away or Modifying Fiduciary Duties via Contractual Agreement
The SEC has made it clear that federal fiduciary duties cannot be totally waived via contractual agreement between the adviser and client. However, the parties can modify the context of their relationship, assuming there is full and fair disclosure and informed consent. The SEC has emphasized that any comprehensive release of an investment adviser from their fiduciary duties is inconsistent with the Advisers Act notwithstanding the sophistication of their client.
State-Imposed Fiduciary Duties & Indemnification Considerations
Most partnership agreements executed in the private funds industry are governed by either Delaware or Cayman jurisdictional precedent. The contractual terms are mainly interpreted depending on the state or territory in which the partnership is under purview. For example, the standard of care of gross negligence does not exist in the Cayman Islands. As such, a partnership governed by Cayman law will typically still include the term “gross negligence”, but require that the specific clause be interpreted per Delaware law.
Indemnification provisions generally apply to instances in which a claim is brought against an adviser regarding to its advisory capacity. The Delaware law concerning breach of fiduciary duty comprises the same two elements imposed by the SEC—albeit with slightly different standards of care: (1) a duty of care and (2) a duty of loyalty—in which the duty of care is a simple negligence standard and the duty of loyalty mandates that advisers put the interests of its investors before their own.