RIA Client Suitability & Fiduciary Duty 2 — Questions and Answers
Question 1: When an investment adviser has a conflict of interest, the fiduciary duty requires:
- Avoiding all conflicts at all times
- Disclosing the conflict and obtaining informed consent, or eliminating the conflict (Correct answer)
- Only reporting conflicts to regulators
- Passing conflicted clients to other advisers
Correct answer: Disclosing the conflict and obtaining informed consent, or eliminating the conflict
Fiduciary duty requires either eliminating conflicts of interest or fully disclosing them to allow the client to give informed consent.
The SEC's fiduciary interpretation states advisers must eliminate or disclose material conflicts. If an adviser recommends a product that pays higher compensation to the adviser, they must disclose this conflict clearly enough for the client to understand the material facts and give informed consent. Simply disclosing in fine print is insufficient—disclosure must be full, plain, and specific enough for the client to appreciate the conflict's significance.
Question 2: Which scenario demonstrates a potential breach of fiduciary duty?
- Recommending low-cost index funds to a cost-sensitive client
- Recommending a proprietary fund without disclosing the adviser's financial interest in it (Correct answer)
- Declining to invest in speculative investments for a conservative client
- Charging fees disclosed in the ADV Part 2
Correct answer: Recommending a proprietary fund without disclosing the adviser's financial interest in it
Recommending proprietary products without disclosing the adviser's financial interest violates the duty of loyalty and disclosure requirements.
When advisers recommend proprietary products (funds managed by their firm or affiliates), they have a financial interest that may influence the recommendation. Failing to disclose this conflict violates the duty of loyalty. The disclosure must explain that the adviser earns additional compensation from the proprietary product and how this may affect the objectivity of the recommendation, allowing clients to make informed decisions.
Question 3: For elderly clients showing signs of cognitive decline, investment advisers should:
- Continue managing the account without changes
- Immediately liquidate all investments
- Take extra precautions, document interactions carefully, and consider involving trusted contacts (Correct answer)
- Transfer the account to a family member without consent
Correct answer: Take extra precautions, document interactions carefully, and consider involving trusted contacts
When cognitive decline is suspected, advisers should exercise extra care, document interactions, and may involve trusted contacts to protect the client's interests.
Advisers have a heightened duty of care for vulnerable clients, including elderly clients with potential cognitive decline. FINRA Rule 4512 and SEC guidance recommend designating trusted contacts, documenting client conversations carefully, being alert to financial exploitation, and potentially placing temporary holds on suspicious transactions. Many states have enacted senior financial exploitation laws. Fiduciary duty requires protecting vulnerable clients' best interests.
Question 4: Best execution requires investment advisers to:
- Always execute trades at the lowest possible price
- Seek the most favorable terms reasonably available under the circumstances (Correct answer)
- Use only one broker for all client trades
- Execute trades only during market hours
Correct answer: Seek the most favorable terms reasonably available under the circumstances
Best execution requires advisers to seek the most favorable terms reasonably available, considering price, speed, likelihood of execution, and other relevant factors.
Best execution is a core obligation of investment advisers when placing client orders. It considers: price, speed of execution, likelihood of execution and settlement, transaction costs, and any other relevant factors. Advisers must periodically evaluate the execution quality they receive from broker-dealers. Best execution doesn't always mean the lowest commission—quality of execution and research provided may justify higher commissions in certain circumstances.
Question 5: When must an investment adviser disclose material changes to Form ADV?
- Only at initial registration
- Annually, and promptly when material changes occur (Correct answer)
- Only when the SEC requests an update
- Every five years
Correct answer: Annually, and promptly when material changes occur
Form ADV must be updated annually and promptly amended when any information becomes materially inaccurate.
SEC Rule 204-1 requires registered investment advisers to update Form ADV at least annually within 90 days of fiscal year end. Additionally, advisers must promptly amend Form ADV when information becomes materially inaccurate between annual updates. Updated brochures (Part 2A) must be delivered to clients annually. Material changes include changes in ownership, disciplinary events, business practices, or conflicts of interest.
Question 6: The difference between a fiduciary standard and a suitability standard is that the fiduciary standard:
- Applies only to insurance products
- Requires advisers to put client interests first, not just recommend suitable investments (Correct answer)
- Is less stringent than the suitability standard
- Only applies to ERISA accounts
Correct answer: Requires advisers to put client interests first, not just recommend suitable investments
The fiduciary standard requires placing client interests above the adviser's own, while the suitability standard only requires recommendations be suitable—not necessarily best.
Under the suitability standard (traditionally applied to broker-dealers), recommendations must be suitable for the client but need not be the best option. An adviser could recommend a higher-cost product that still meets suitability requirements. The fiduciary standard requires recommending what is genuinely in the client's best interest, disclosing all conflicts, and prioritizing client interests over the adviser's compensation or other interests.
RIA Client Suitability & Fiduciary Duty 2
When an investment adviser has a conflict of interest, the fiduciary duty requires: