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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Fiduciary Duty: Return to First Principles


Lori A. Richards

Director, Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission

Eighth Annual Investment Adviser Compliance Summit
Washington, D.C.
February 27, 2006

As a matter of policy, the SEC disclaims responsibility for any private statement by an employee. The views expressed here today are my own and do not necessarily reflect those of the Commission, the Commissioners or other members of the staff.

Good morning. I am pleased to be here, as you consider practical methods to address the range of compliance issues that you face. Nothing could be more important to us at SEC than helping to ensure that advisers prevent, detect and correct compliance problems. I want to thank David Tittsworth and Hugh Kennedy for inviting me to speak with you today.

As we look at the compliance environment today, there are some facts worth noting. First, there are a significant number of newly-registered investment advisers. In fact, there are approximately 10,000 advisers registered with the SEC. About 2,000 of these firms, or 20% of the total, have just registered in the last year. These firms vary — they may be recently formed, have simply grown to exceed the 25$ million assets under management threshold, or have been operational for some time, but are registering with the SEC now because of the Commission's new rules requiring the registration of hedge fund advisers. As new registrants, these firms may be new to the Investment Advisers Act of 1940.

A second fact worth noting is that all advisory firms, whatever their size, type or history in the business, owe their advisory clients a fiduciary duty. Many firms are acutely aware of their fiduciary obligation and ensure that it informs, educates and guides their dealings and decisions. But, one only has to look at our enforcement actions and deficiencies found in exams to draw the conclusion that the application of fiduciary duty is not as embedded in many firms' cultures as it could be. In fact, I'm far from certain that all advisory firms understand their fiduciary obligations, and how they apply in the context of their own operations. Some advisers have seemed to be aware of the fiduciary duty in kind of an ethereal way — "I know it's out there but I don't really know what it is." Others have looked at fiduciary duty as strictly a compliance or legal function — not fully appreciating its significance to all employees of the firm. Either view is dangerous.

Fiduciary Duty

Understanding "fiduciary duty" is critical, because it is at the core of being a good investment adviser. In a very practical sense, if an adviser and the adviser's employees understand the meaning of fiduciary duty and incorporate this understanding into daily business operations and decision-making, clients should be well served, and the firm should avoid violations and scandal. Indeed, I believe that, even if advisory staff are not aware of specific legal requirements, if their decisions large and small and everyday are motivated and informed by doing what's right by the client, in all likelihood, the decision will be right under the securities laws.

This is why, as an examiner, I care about advisers' fiduciary duties. I think that knowledge and familiarity with one's fiduciary duty can help firms avoid compliance violations. And, avoidance of violations is in everyone's best interests — yours, your clients and our markets. As examiners, we prefer to find highly compliant firms with strong compliance controls that prevent violations. To demonstrate this point, I wanted to share with you some of the most common deficiencies that we find in our examinations of investment advisers, each of which have fiduciary implications.

But first, I'd like to look more closely at the concept of fiduciary duty. Many different types of professions owe a fiduciary duty to someone — for example, lawyers to their clients, trustees to beneficiaries, and corporate officers to shareholders. Fiduciary duty is the first principle of the investment adviser — because the duty comes not from the SEC or another regulator, but from common law. Some people think "fiduciary" is a vague word that's hard to define, but it's really not difficult to define or to understand. Fiduciary comes from the Latin word for "trust." A fiduciary must act for the benefit of the person to whom he owes fiduciary duties, to the exclusion of any contrary interest.1

Now, some might wonder why the concept of fiduciary duty came to be applied to advisers. The Investment Advisers Act does not call an adviser a fiduciary. In fact, that word does not appear in the Act. But, the Supreme Court recognized congressional intent and held that the Advisers Act: "reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship, as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser - consciously or unconsciously - to render advice which was not disinterested."2 And, the Court said that: investment advisers are fiduciaries with "an affirmative duty of 'utmost good faith and full and fair disclosure of all material facts,' as well as an affirmative obligation 'to employ reasonable care to avoid misleading' clients."3

I would suggest that an adviser, as that trustworthy fiduciary, has five major responsibilities when it comes to clients. They are:

  1. to put clients' interests first;
  2. to act with utmost good faith;
  3. to provide full and fair disclosure of all material facts;
  4. not to mislead clients; and
  5. to expose all conflicts of interest to clients.

These responsibilities overlap in many ways. If an adviser is putting clients' interests first, then the adviser will not mislead clients. And, if the adviser is not misleading clients, then it is providing full and fair disclosure, including disclosure of any conflicts of interest.

How do the responsibilities of a fiduciary translate into an adviser's obligations to clients each and every day? This is a key question. Probably no statute or set of rules could contemplate the variety of factual situations and decisions that an advisory firm faces. Can you imagine the number of rules and releases and regulations that this would require? Instead, the Advisers Act incorporates an adviser's fiduciary duty under Section 206, and envisions that, in whatever factual scenario, the adviser will act in the best interests of his clients.

This is a simple statement to make, but one that is more difficult to apply. In thinking about compliance with your fiduciary obligation as an adviser, start by thinking about the areas where there is a conflict of interest — between one's own interests, the interests of the firm, and/or the interests of advisory clients. These are the areas in which compliance with fiduciary obligations are likely to be most challenging. The Compliance Rule envisions this analysis, and the Commission suggested in the release adopting the rule that advisers conduct a risk assessment to identify areas of conflicts of interest.4

This is not a one-time effort — the nature of an adviser's relationship with its clients is full of conflicts, and those conflicts change when an adviser's business changes. Addressing and disclosing conflicts of interest is an ongoing process. While some conflicts of interest stand out, others can be very subtle, so an adviser must look, with more than a casual glance, at every aspect of its business, and its relationship with clients, and carefully consider whether it has a conflict of interest. Importantly, at this stage, the question is not whether the adviser acts appropriately in the conflicted situation, but merely whether the conflict itself exists.

The next step, of course, is to disclose material conflicts of interest in a "full and fair" manner and to ensure your clients understand any material conflicts of interest before taking action. Because you are a fiduciary, you should not allow your client to enter the advisory relationship without a clear understanding of all material conflicts.

As I said, and in keeping with the theme of this conference — to provide practical and not just theoretical information on compliance issues — I wanted today to describe the top 5 deficiencies that we find in our exams. It's my hope also that this information may be helpful to newly-registered advisers who are seeking to better understand common compliance pitfalls, conflicts of interest and fiduciary duties. Last year, we examined over 1,500 investment advisers. In those exams, the most common deficiencies were the following:

  • Deficient disclosure — I'll spend more time talking about disclosure in a minute.
  • Deficiencies in portfolio management — Problems in this area included inadequate controls to ensure that investments for clients are consistent with their mandates, risk tolerance and goals, and to ensure that required records are kept. Fiduciary duty is implicated in this area because advisers have a duty to ensure that they are managing their clients' money in a manner that is consistent with the clients' direction.
  • Deficiencies with respect to advisory employees' personal trading — Problems in this area included a lack of controls, a lack of required codes of ethics, and failure to implement stated procedures to monitor employees' personal trades to prevent employees from placing their own interests above those of their clients, by for example, front-running clients' trades, trading on non-public information, taking investment opportunities for themselves over clients — to ensure that the fiduciary is acting with the loyalty and "utmost good faith" envisioned by the Supreme Court.
  • Deficiencies in performance calculations — Problems in this area included overstated performance results, comparing results to inappropriate indices, failing to disclose material information about how the performance results were calculated, using prohibited testimonials, and advertising past results in a misleading manner. In this area, a fiduciary must calculate and set forth its past performance in an honest way, and must provide information that is not misleading.
  • Deficiencies in brokerage arrangements and execution — Deficiencies in this area included poor or no controls to ensure that the adviser obtains "best execution," and secretly using clients' money to pay for client referrals, and for other goods and services that benefit the adviser. Simply stated, because brokerage money belongs to the client and not to the adviser, the adviser has a fiduciary duty to ensure that it is used appropriately and that the client is aware of how his/her money will be and is being spent by the adviser.

Inadequate Disclosure

Inadequate disclosure has been on the "top 5" list of most frequent deficiencies for some time. And, as it is the most frequently-found deficiency, it's an area that clearly deserves more attention by advisory firms. As such, I'd like to spend some time this morning talking about disclosure and the adviser's fiduciary duty.

Approximately half of the deficiencies that we find in this area relate to inaccurate, incomplete, and even misleading information in Forms ADV, and half include problematic disclosure of business practices and fees charged to clients. Whether you use Form ADV or other disclosure techniques, you should take care to ensure that you are in fact providing full, accurate and complete disclosure, and written in a comprehensible language, designed to be understood by your clients.

So what should you not do? Let me illustrate with a few examples from recent examinations.

  • Clients were not informed of the real method used to calculate the adviser's fee. Fees appeared to be lower than they were in fact.
  • An adviser failed to disclose that he recommends securities to clients in which he has a proprietary interest.
  • An adviser failed to disclose the risks to clients that existed by having their assets invested in private investments.
  • An adviser failed to disclose that clients with directed brokerage arrangements may not achieve best execution.
  • An adviser does not accurately describe the types of products and services it obtains with clients' soft dollars.
  • Clients whose assets were invested in mutual funds were not told that they pay both a direct management fee to their adviser and an indirect management fee to the adviser of their mutual funds.
  • An adviser stated that it did not have custody of client assets when in fact it did.
  • An adviser did not disclose that it receives economic benefit from a non-client in connection with giving advice to clients.
  • An adviser did not disclose that even if clients direct that their securities transactions be executed through a certain broker-dealer, the adviser did not actually execute most transactions through that firm.
  • An adviser had not amended its ADV for several years although the rules require that it be amended at least annually and more frequently if required, information was therefore out-of-date.
  • An adviser incorrectly stated that it did not have discretion to direct trades to specific broker-dealers, when in fact it did.
  • Clients were provided with incorrect information about the adviser's review of their accounts, and the frequency of those reviews.

Some of the disclosure deficiencies that we find seem to come from inattention — the failure of the adviser to make sure its Form ADV reflects its current business operations. To my mind, this type of problem stems from lax controls and perhaps from an underfunded infrastructure. Other disclosure deficiencies, however, occur because the adviser either failed to identify a conflict of interest or, having spotted it, chose not to disclose it. In the former case, some advisers appear not to be giving adequate thought to what constitutes a conflict of interest. Importantly, all material conflicts of interest must be disclosed, even if the adviser has taken steps to mitigate those conflicts to ensure that it acts appropriately. And, whether intentional, inattentive or inept, the result is the same — advisory clients are not being provided with accurate information about the adviser.

Disclosure is at the heart of our securities regulatory framework, and as you would assume, it is also at the heart of our examination process. At the start of every exam, SEC examiners review the information that the adviser disseminates about its business, which includes Form ADV, parts I and II. They look at this information to see how an adviser describes its business as well as any business practices that pose potential conflicts of interest between the adviser and its clients. Throughout the exam, the examiners will continue seeking information about how an adviser's business works and what services are provided to clients. When discrepancies or omissions between the firm's written disclosures and its actual practice are identified, this will trigger heightened scrutiny by the exam staff. As a fiduciary, it is fundamental that what you tell your clients is, in fact, how you conduct your business.

How does an adviser guard against disclosure problems? As you know, the Compliance Rule requires an adviser to adopt and implement policies and procedures to prevent violations, including disclosure violations. To implement this, some firms conduct a periodic in-depth review of the adviser's ADV, along with all other written materials provided to clients and to the public — and then, they compare these disclosures against the firm's actual business operations. The review is conducted by a group of knowledgeable employees who represent all aspects of the firm — from compliance to portfolio management to trading desk to business operations. This is important, because disclosures must reflect actual practice, and who better to know the nature of the firm's actual practices than those who are actually doing it. This practice also helps keep disclosures "real," and not simply aspirational or marketing literature. Then, any required changes to disclosures are made promptly. Some firms also perform this same sort of review of client portfolios to ensure that portfolio transactions are consistent with disclosures to and instructions from the client.

Whatever compliance technique is used, because disclosure is so important in ensuring that advisers meet their fiduciary obligations, I would hope that all advisers spend a considerable amount of time ensuring that they have provided accurate, full and fair information to clients.

Now, and particularly for newly-registered advisers, some "tips" on SEC examinations:

  • It warrants saying that the SEC conducts examinations as part of its statutory mandate to protect investors. We conduct exams to help ensure that investors are being treated fairly and that firms operate consistently with the securities laws. Understanding our purpose — and that we're not out to "get you" — may help advisory staff understand the exam process better. Probably no one will ever like being examined, but the process is important for the protection of investors. And, it can help firms to identify and take steps to fix smaller problems before they can escalate!

  • The best way to "prepare for an exam" is not really to prepare for an exam at all — it is to have a strong compliance infrastructure that is used effectively to prevent, detect and correct problems every day.

  • A critical part of our examination process includes gaining an understanding of the firm's compliance history: 1) to evaluate the firm's compliance with the "Compliance Rule," which requires effective compliance programs to prevent, detect and correct violations; and 2) to determine the strengths and weaknesses of the firm's compliance controls to aid examiners' determination of areas to focus on in the examination. Areas where compliance controls are strong will receive relatively less scrutiny than areas that appear to be weak. To understand this, we ask the firm about any material compliance issues that the firm has faced during the examination period. Because in the past we had encountered situations where firms were less than candid in providing this information, we asked that a senior employee of the firm provide this information in writing. With CCOs at all firms now, we will seek this information from the firm during the examination process.

  • While our work on-site will be visible to you, our work off-site will not be. Our exam teams do quite a lot of analysis and other exam work after they return to SEC offices. This includes communicating with relevant SEC staff about any novel facts or interpretive issues to ensure that our findings appropriately reflect the Commission's legal interpretations. In these cases, our deficiency letters reflect the input of relevant legal staff. If you disagree with a deficiency letter, of course, say so in your response!

  • Finally, and in the same vein, we urge firms to communicate openly and honestly with exam staff about the firm's operations, its compliance program and any issues or concerns they have about the exam process. We find that most issues, from document production to deficiencies found, can be understood with some honest dialogue. There are lots of opportunities for this at every stage of the exam process, and certainly at the exit interview. If you have questions or concerns, we urge you to talk with the exam staff about them. And, we also have an ExamHotline for you to express concerns, anonymously or not. The phone number is: 202-551-3926, or ExamHotline@sec.gov.


In closing, and returning to first principles again — if an adviser incorporates the qualities of a fiduciary as I've discussed here today, and puts the clients' interests first, the adviser will indeed be someone its clients can trust.

Thank you for your time and attention.



Modified: 02/28/2006