SEC Commission’s New Interpretation on Standards of Conduct for All Investment Advisers and Their Application to Advisers to VC Funds

July 12, 2019

By: Gil B. Selinger

Earlier this month the SEC Commission (“Commission”) published its “Commission Interpretation Regarding Standard of Conduct for Investment Advisers,” Release No. IA-5248 (June 5, 2019), available here (the “Standard Interpretation”). The Standard Interpretation is part of its four part package of rules and interpretations governing the standards of conduct of broker-dealers and investment advisers and their associated persons and related disclosure requirements (collectively, the “Best Interest Rules”). This “standard interpretation” of Section 206 of the Investment Advisers Act of 1940 (the “Advisers Act”) applies to the standard of conduct for all SEC and state registered investment advisers and for all advisers who are exempt from such registration. The Standard Interpretation reaffirms and clarifies certain aspects of two fiduciary duties (duty of care and duty of loyalty) that an investment adviser owes to its clients under the Advisers Act. The Standard Interpretation becomes effective upon publication in the Federal Register.

This memorandum focuses on the Commission’s interpretation of principles relevant to an adviser’s fiduciary duties only insofar as it applies to exempt reporting advisers to venture capital funds. This memorandum is not intended for advisers to capital pools that do not meet the definition of “venture capital funds” under Section 203(l) of the Advisers Act. However, since the standard of conduct discussed in the Standard Interpretation is intended by the Commission to be the same for all investment advisers, it is likely that many of the statements made herein are directly applicable to all private fund advisers. It should be noted that federal and state statutes and case law also impose obligations on investment advisers apart from standards enforced by the Commission.

The Commission’s Standard Interpretation goes out of its way to emphasize that its interpretation of the appropriate standard of conduct for exempt reporting advisers to venture capital funds differs from the interpretation of that standard expressed by the National Venture Capital Association in its comment letter of August 7, 2018 (“NVCA Letter”) [regarding the earlier Proposed Interpretation (see below)]. At the end of this memorandum we provide some commentary on this difference. 

We also provide in closing some advice regarding necessary actions to be taken now by exempt reporting advisers to venture capital funds.

Under federal law an investment adviser is a fiduciary. Under federal law a broker dealer is not a fiduciary. Under the Obama Administration, the US Department of Labor proposed and adopted a ‘fiduciary duty’ rule which applied to broker dealers and investment advisers providing advice to ERISA plans, including Section 401(k) plans. Under the Trump Administration, the implementation of the DOL ‘fiduciary duty’ rule has been effectively stayed.  In lieu of the DOL “fiduciary duty” rule, however, on April 18, 2018 the Commission proposed rules and forms intended to enhance the required standard of conduct for broker dealers and reaffirm the standard for investment advisers. See “Regulation Best Interest,” IA Release No. 83062 (Apr. 18, 2018) (“Reg. BI Proposal”). In connection with the Reg. BI Proposal the Commission also published for comment a separate proposed interpretation regarding the standard of conduct for investment advisers. See “Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers,” IA Release No. 4889 (Apr. 18, 2018) (“Proposed Interpretation”). The Standard Interpretation includes express reactions to comments on the Proposed Interpretation.

Commission’s Standard Interpretation Summarized
Section 206 of the Advisers Act establishes a federal fiduciary duty for investment advisers. The duty is broad and applies to the entire adviser-client relationship. It is made enforceable by the antifraud provisions of the Advisers Act. The duty is comprised of a duty of care and a duty of loyalty. The adviser must, at all times, serve the best interest of its client and not subordinate its client’s interest to its own. The duty of care requires an investment adviser to provide investment advice in the best interest of its client based on the client’s objectives. The duty of loyalty requires that an investment adviser eliminate or make full and fair disclosure of all conflicts of interest which might incline an investment adviser to render advice which is not disinterested so that a client can provide informed consent to the conflict.

The adviser’s fiduciary duty is principles-based and follows “the contours of the relationship;” thus the client and the adviser may shape that relationship by agreement, provided that there is full and fair disclosure and informed consent. However, the fiduciary duty serves as the effective standard of conduct for all investment advisers, regardless of the services they provide or the types of clients they serve. It may not be waived “regardless of the sophistication of the client.”

The duty of care includes, among other things, the duty to provide advice that is in the best interest of the client and the duty to provide advice and monitoring over the course of the relationship. The former requires a reasonable inquiry into the client’s objectives and the formation of a reasonable belief that advice is in the best interest of the client; the latter requires, when “the adviser has an ongoing relationship with a client and is compensated with a periodic asset-based fee,” proper performance which includes a “relatively extensive” duty to provide advice and monitoring “consistent with the nature of the relationship.”

The duty of loyalty requires that the adviser not subordinate its clients’ interests to its own. The adviser must make full and fair disclosure to its clients of all material facts relating to the advisory relationship, including the capacity in which the adviser is acting with respect to the advice provided.  “…[A]n adviser must eliminate or at least expose through full and fair [specific] disclosure all conflicts of interest which might incline an investment adviser – consciously or unconsciously - to render advice which was not disinterested.” The disclosure must include a description of how the adviser will manage conflicts if and when they arise. If the client cannot provide informed consent, the adviser must either eliminate the conflict or modify its practices to reduce the conflict such that full and fair disclosure and informed consent are possible.

The Commission believes that the Standard Interpretation does not itself create any new legal obligations for advisers. 

The Commission notes, however, that “some advisers’ current practices” may not be consistent with the Standard Interpretation. Referencing the over 3,900 exempt reporting advisers submitting reports on Form ADV, and noting that it lacks data to identify which investment advisers currently understand their fiduciary duty “to require something different from the standard of conduct” set forth in the Standard Interpretation, the Commission then explicitly refers to the NVCA Letter. “This commenter indicated its concerns about the ability of a fund manager to infer consent from a client that is a fund, and that issues regarding inferring consent from funds could significantly increase compliance costs for venture capital funds.” The Commission responds to those NVCA concerns, noting “that while all investment advisers owe each of their clients a fiduciary duty, the specific application of the investment adviser’s fiduciary duty must be view in the context of the agreed-upon scope of the adviser-client relationship.” The Commission, with explicit reference to the compliance costs cited by the NVCA, goes on to state:

“…[W]e are unable to ascertain the total number of investment advisers that currently interpret their fiduciary duty to require something different from the Commission’s interpretation [noting that the NVCA did not agree that the Commission’s discussion of fiduciary obligations in the proposed interpretation applied to advisers to funds]…. In addition, we believe that there may be potential benefits for clients of those investment advisers, if any, to the extent this Final Interpretation is effective at strengthening investment advisers’ understanding of their obligations to their clients. Further, to the extent that this Final Interpretation enhances the understanding of any investment advisers of their duty of care, it may potentially raise the quality of investment advice and also lead to increased compliance with the duty to monitor, … thereby increasing the likelihood that the advice fits with a client’s objectives.”

F&W Commentary on Commission’s Standard Interpretation and Approach to Venture Fund Advisers
The Standard Interpretation, insofar as it relates to investment advisers which are exempt reporting advisers to venture capital funds, represents the most explicit single statement to date by the SEC Commission of the duties which exempt reporting advisers owe to their funds (and, in some cases, to the investors in their funds).  There is little here which represents a fundamental shift by the Commission when considering the legal duties of unregistered investment advisers under Section 206, taken as a whole (the duties of fiduciaries under state statutes and common law are often broader than those expressed here). The Standard Interpretation is a logical extension of the views expressed by the SEC when in 2011 it adopted its final rules applicable to investment advisers to venture capital funds pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”).  See, e.g., “SEC Adopts Final Rules Regarding Advisers to ‘Venture Capital Funds’ Exempt from Registration as Investment Advisers,” (April 11, 2011). There is no obvious discrepancy between the views expressed by the Commission when it adopted its exempt reporting adviser rules in 2011 and those expressed in the Standard Interpretation (contrary to an opinion expressed in the NVCA Letter). However, the Commission did make an effort to clear up certain “misconceptions” upon which exempt reporting advisers (and their legal counsel) may have relied in the past.  Among other issues, not only did the Commission address the NVCA’s dissenting opinions in the NVCA Letter, but also, for example, the Commission withdrew a 2007 no action letter (the Heitman Letter), which was apparently being incorrectly relied upon by some to justify ‘hedge’ clauses - which purport to disclaim fiduciary duties under state laws - to limit liabilities otherwise arising under advisory agreements for breaches of federal fiduciary duties under Section 206 of the Advisers Act. 

F&W Commentary on Possible Effects of NVCA Letter re Commission and Staff
The Commission’s ‘calling out’ of exempt reporting advisers in its reaction to the NVCA Letter is unfortunate. It is not too difficult to believe that the Commission’s comments in the Standard Interpretation foreshadow increased regulation of exempt reporting advisers through, for example, audit examinations and enforcement actions. If the SEC staff determines that the venture capital community has been acting and continues to act, for example, as if it is unnecessary or advisers are unable to obtain an informed consent from a fund (or in some cases investors in a fund) prior to providing advice, there is nothing to stand in the way of the Office of Compliance, Inspections, and Enforcement (OCIE) becoming much more proactive with regard to exempt reporting advisers. The SEC staff has been hinting at this for several years. In any event, the Commission clearly does not believe that “unnecessary additional costs” is any excuse for exempt reporting advisers not getting in step with the Standard Interpretation.

Apart from the references to it in the Standard Interpretation, a review of the NVCA Letter itself (available in the comments folder for the Proposed Interpretation) also reveals at least two over-generalizations which were likely obvious to the Commission staff. For one, the NVCA in its Letter asserts repeatedly that “venture capital funds don’t include retail investors;” however, since the release of two no action letters in March 2013 it has been clear that retail investors can come together in “angel” funds which satisfy the definitions of “venture capital fund” in the SEC rules.  For another, the NVCA also asserts several times that obtaining explicit consent is unnecessary since the venture capitalists also serve as the general partners in capital funds (to the implied exclusion of others); however, not only are the advisory boards of venture funds populated by passive investors, but also the general partner entities of venture capital limited partnerships (as is apparent from Form ADVs filed annually by exempt reporting advisers since 2012) often have non venture capitalist persons as members. It would be well for the NVCA to approach commenting on future proposed SEC actions and compliance with the Standard Interpretation with an understanding of the broad perspective of the SEC’s actual knowledge, rather than the limited perspective of persons exemplifying the ‘typical’ VC. 

What to Do Now 
It is past time for good business practices for exempt reporting advisers to become universal. It is past time to comply with Dodd Frank and the SEC rules governing the activities of investment advisers to venture capital funds. In the event that an unregistered investment adviser to venture capital funds has not yet filed its Form ADV reports (either initially or annually thereafter), it is past time to do so (there are hefty civil penalties for non-compliance).  In the event that the “best practice” compliance procedures have not been put in place to satisfy the requirements which the Advisers Act (and other federal laws such as Gramm-Leach-Bliley, the anti-money laundering and banking secrecy laws, and the PATRIOT Act, and relevant state laws) imposes on unregistered investment advisers generally and upon exempt reporting advisers explicitly, it is past time to do so. Any such compliance procedures drafted or in place prior to the release of the Standard Interpretation need to be reviewed and amended to take into account the SEC’s likely approaches to enforcing compliance with its interpretation of the duty of care and the duty of loyalty as expressed in the Standard Interpretation. Compliance procedures as amended need to be put into place and rolled out to all staff members in each adviser’s offices. Documentation of actual compliance with the enhanced understanding of the fiduciary relationship between each fund and its adviser needs to be done. Informal, advance consents to identified conflicts need to be obtained and actual conflicts of interest need to be managed in accordance with established procedures.

The effective date for the Standard Interpretation has arrived. Each exempt reporting adviser is advised to contact its lawyers in regard to the foregoing.

For more information regarding the content of this memorandum, please do not hesitate to contact John A. Eckstein, 303.894.4448, or Gil B. Selinger, 303.894.4478.