Wednesday, December 18, 2013

Investment Adviser Fiduciary Duty Standard Requires Reasonable Basis for Client Recommendation

The Securities and Exchange Commission regulates investment advisers under the Investment Advisers Act of 1940 (the “Act”). Perhaps the most significant provision of the Act is Section 206, which prohibits advisers from defrauding their clients. The Supreme Court has interpreted this provision as imposing on advisers a fiduciary obligation to their clients. See Transamerica Mortgage Advisors, Inc. (TAMA) v. Lewis, 444 U.S. 11, 17 (1979) (“[T]he Act’s legislative history leaves no doubt that Congress intended to impose enforceable fiduciary obligations.”).

The federal fiduciary standard requires that an investment adviser act in the “best interest” of its advisory client. Belmont v. MB Inv. Partners, Inc., 708 F.3d 470, 503 (3d Cir. 2013) (citing SEC v. Tambone, 550 F.3d 106, 146 (1st Cir.2008) (“[15 U.S.C. § 80b–6] imposes a fiduciary duty on investment advisers to act at all times in the best interest of the fund and its investors.”). Under a “best interest” test, an adviser may benefit from a transaction with or by a client, but the details of the transaction must be fully disclosed. See SEC v. Capital Gains Research Bureau, 375 U.S. 180, 191-92 (1963) (stating that Advisers Act was meant to “eliminate, or at least to expose, all conflicts of interest which might incline as investment adviser–consciously or unconsciously–to render advice which was not disinterested”).

A number of obligations to clients flow from the fiduciary duty imposed by the Act, including the duty to fully disclose any material conflicts the adviser has with its clients, to seek best execution for client transactions, to provide only suitable investment advice, and to have a reasonable basis for client recommendations. See Registration Under the Advisers Act of Certain Hedge Fund Advisers, SEC Release No. IA-2333; Status of Investment Advisory Programs under the Investment Company Act of 1940, SEC Release No. IA-1623.

As noted by the Third Circuit in Belmont, even when a private litigant brings a cause of action for common law breach of fiduciary duty “the evolution of duties governing investment advisers as fiduciaries appears to have been shaped exclusively by the Advisers Act and federal common law.” 708 F.3d at 500-01. The Belmont court noted that one might reasonably wonder why the cause of action is presented as springing from state law if one looks to federal law for the statement of the duty and the standard to which investment advisers are to be held. 708 F.3d at 502. However, the court found that the answer was straightforward: no federal cause of action is permitted. Id. The court found that while “[t]hat reality ought to call into serious question whether a limitation in federal law can be circumvented simply by hanging the label ‘state law’ on an otherwise forbidden federal claim, that is the labeling game that has been played in this corner of the securities field, and the confusion it engenders may explain why there has been little development in either state or federal law on the applicable standards.” Id.

Based on the foregoing, a common law breach of fiduciary duty claim can in all likelihood be based on an investment adviser’s failure to have a “reasonable basis” for making a client recommendation. The question then becomes what constitutes a “reasonable basis” in the context of making such recommendations? This is not an issue that has been faced by many courts in the context of private causes of action brought by clients against investment advisers. For example, no Missouri case has addressed the issue.

However, in other situations where a reasonableness standard is employed, Missouri courts utilize an objective standard. See Graham v. McGrath, 243 S.W.3d 459, 463 (Mo. Ct. App. 2007) (noting that when damages are capable of ascertainment for purposes of statutes of limitations, Missouri utilizes an objective reasonable person standard); Robin Farms, Inc. v. Bartholome, 989 S.W.2d 238, 247 (Mo. Ct. App. 1999) (noting that the test for determining disqualification of a judge based on bias is whether a reasonable person would have factual grounds to doubt the impartiality of the court, “which is an objective standard[.].”).

As such, in Missouri and other jurisdictions that utilize the objective standard for reasonableness in other situations, the determination of whether an investment adviser had a “reasonable basis” for making a particular recommendation will likely be measured by an objective standard. This means that the fact finder will have to determine whether a reasonable person in the investment adviser’s circumstances might have made the same recommendation as the investment adviser, and need not consider what the adviser may have honestly -- but perhaps mistakenly -- believed.

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