The SEC recently approved amendments (the “Amendments”) to Part 2 of Form ADV, the form that investment advisers (“Advisers”) use to register with the SEC and state securities regulators. Part 2 has typically formed the basis of, and has been used as, an investment adviser’s written disclosure statement, or “brochure,” required by Rule 204-3(a) under the Investment Advisers Act of 1940 (the “Advisers Act”). The Amendments generally (a) change the form and some of the substance of Form ADV, Part 2, (b) require various supplements to be delivered to new and prospective clients that provide information concerning those individuals at the Adviser who will be providing advisory services to clients, and (c) require Advisers to file part of Part 2 on the Investment Adviser Registration Depository (“IARD”) system, thus making it accessible to investors through the SEC’s website. Advisers currently file only Part 1 of Form ADV through the IARD. The Amendments also amend various SEC rules under the Advisers Act that generally relate to applications to register as an investment adviser with the SEC and Adviser disclosure obligations to clients and prospective clients.
The Amendments, among other things, divide Form ADV, Part 2 into two sections. The first section, Part 2A, includes information about an Adviser and its business, including fees, clients, investment strategies and risks, disciplinary information, other financial industry activities and affiliates. It also includes, as an appendix, information concerning wrap fee programs that are sponsored by the Adviser. As discussed below, Part 2A must also include a summary of material changes with the annual updating amendment. The second section, Part 2B, is intended as a supplement to an Adviser’s brochure, and includes information about the Adviser’s advisory personnel from whom the client receiving the brochure may expect to receive advice.
Amended Form ADV, Part 2 instructs each Adviser to draft its brochure in plain English and in a narrative format. The Adviser also must present specifically identified information in the order proscribed by amended Form ADV, Part 2, using the headings provided by the form. If an item is inapplicable to the Adviser, the Adviser must include the heading and an explanation that the information is inapplicable. If information provided in response to one item is also responsive to another item, the Adviser may cross-reference the information. Amended Form ADV, Part 2 also instructs each Adviser to include in its brochure descriptions of only those conflicts that the Adviser has or is reasonably likely to have, and practices in which it engages or in which it is reasonably likely to engage. If a conflict arises or the Adviser decides to engage in a practice that it has not disclosed, supplemental information must be provided to the client.
The Amendments also amend the following SEC rules under the Advisers Act:
Rule 203-1 (which concerns applications for investment adviser registration) and Rule 204-1 (which concerns amendments to applications for investment adviser registration) to provide for the electronic filing of Form ADV, Part 2A and amendments with the IARD;
Rule 204-2 (which concerns books and records to be maintained by investment advisers) to require the Adviser maintain, among other things, copies of the brochure supplements (Part 2B) in addition to copies of the brochure; and
Rule 204-3 (which concerns the delivery of brochures and brochure supplements) to require delivery to clients of the brochure, brochure supplements and wrap fee program brochure, subject to certain exceptions.
The Amendments also rescind Rule 206(4)-4, which concerns financial and disciplinary information that must be disclosed to clients. The substance of that rule has been incorporated into Part 2A.
Amendments to Form ADV, Part 2
Part 2A: Brochure Items
Part 2A of amended Form ADV contains eighteen separate items, each covering a different disclosure topic. The instructions to Form ADV, Part 2A state that an Adviser may include a summary of the brochure at the beginning of the brochure followed by more detailed discussions of each item later in the brochure. The instructions also state that an Adviser may include in its brochure information that is not required by an item in Form ADV, provided that the Adviser does not include so much information that it obscures the required information.
The eighteen separate items include, among other things:
Material Changes. A brochure must identify and discuss in summary form the material changes that have occurred since the last annual update on the cover page or the following page, or as a separate document accompanying the brochure.
- Advisory Business. Each Adviser must describe its advisory business, including the types of advisory services offered, whether it holds itself out as specializing in a particular advisory service and the amount of client assets that it manages. In describing the client assets it manages, an Adviser may calculate assets under management using different methodologies than what is required under Part 1A of Form ADV, so long as records are kept documenting the methodology used. Also, amended Form ADV states that Advisers are expected to update their assets under management annually and make interim amendments only for material changes in assets under management.
- Fees and Compensation. An Adviser must describe how it is compensated for its advisory services, provide a fee schedule and disclose whether fees are negotiable. An Adviser must also disclose whether it bills clients or deducts fees directly from client accounts and how often it assesses fees, as well as describe other costs (e.g., brokerage, custody fees, and fund expenses that clients may pay). In addition, an Adviser must disclose, if applicable, that it or its personnel may receive compensation attributable to the sale of an instrument (e.g., brokerage commissions), describe the practice, the conflicts of interest it creates and how such conflicts are addressed.
- Performance-Based Fees and Side-by-Side Management. An Adviser that charges performance-based fees or that has a supervised person who manages an account that pays such fees must disclose that fact. If the Adviser also manages accounts that are not charged a performance fee, the Adviser must also discuss the conflicts of interest that arise from its simultaneous management of these accounts and generally describe how it addresses those conflicts.
- Types of Clients. The brochure must describe the types of clients the firm generally has, as well as the firm’s requirements for opening or maintaining an account.
- Methods of Analysis, Investment Strategies and Risk of Loss. An Adviser must describe its methods of analysis and investment strategies and disclose that investing in securities involves risk of loss. An Adviser must also provide specific disclosures of how strategies involving frequent trading can affect investment performance and explain the material risks involved for each “significant” (i.e., that is relevant to most investors) investment strategy or method of analysis used and particular type of security it recommends, with more detail if those risks are unusual.
- Disciplinary Information. An Adviser must disclose material facts about any legal or disciplinary event (but not an arbitration event) that is material to a client’s (or a prospective client’s) evaluation of the integrity of the Adviser or its management personnel. Disciplinary events that are required to be disclosed include events that are more than 10 years old, but do not include events concerning advisory affiliates. The Adviser also must provide a list of disciplinary events that are presumptively material, but the Adviser is permitted to rebut the presumptions if, among other things, it maintains records to enable the SEC staff to monitor compliance with such disclosure requirement.
- Other Financial Industry Activities and Affiliations. An Adviser is required to describe material relationships or arrangements it (or any of its management persons) has with related financial industry participants, any material conflicts of interest that these relationships or arrangements create, and how the Adviser addresses such conflicts.
- Codes of Ethics, Participation or Interest in Client Transactions and Personal Trading. Each Adviser must briefly describe its code of ethics and state that a copy is available upon request. In addition, if an Adviser or a related person recommends to clients, or buys or sells for client accounts, securities in which the Adviser has a material financial interest, the brochure must discuss this practice and the conflicts of interest presented by it. An Adviser must also disclose whether it or its related persons invests (or is permitted to invest) in the same securities that it recommends to clients, or in related securities (other than securities excepted from the definition of “reportable securities” under Rule 204A-1(e)(10) under the Advisers Act), and whether such investments may occur at or about the same time as a client’s investments. If so, the brochure must discuss the conflicts presented and describe how the Adviser addresses the conflicts.
- Brokerage Practices. An Adviser must disclose the existence of several practices associated with brokerage transactions that could involve conflicts of interest, including soft dollar practices, client referrals, directed brokerage and trade aggregations.
- Soft Dollars. An Adviser must describe (a) how it selects brokers for client transactions and determines the reasonableness of brokers’ commissions, (b) how it addresses conflicts of interest arising from the receipt of soft dollar benefits, (c) whether the benefits from soft dollars are used for all client accounts or only those accounts whose brokerage “pays” for such benefits, (d) whether the Adviser seeks to allocate the benefits to client accounts proportionately to the soft dollar benefits those accounts generate, and (e) whether it pays more than the lowest available commission rate to obtain soft dollar benefits.
- Client Referrals. If an Adviser uses client brokerage to compensate or reward brokers for client referrals, it must disclose this practice, the conflicts of interest it creates, and any procedures used to direct client brokerage to referring brokers during the last fiscal year.
- Directed Brokerage. An Adviser that permits clients to direct brokerage must describe its practices in this area and explain that it may be unable to obtain the most favorable execution of client transactions, and that it may be more costly for clients. If the Adviser routinely recommends, requests or requires clients to direct brokerage, it must describe the practice, disclose that not all investment advisers require directed brokerage, and describe any relationship with a broker-dealer that creates a material conflict of interest.
- Trade Aggregation. An Adviser must describe whether and under what conditions it aggregates trades. If the Adviser does not aggregate trades when it has the opportunity to do so, it must explain that clients may pay higher brokerage costs.
- Review of Accounts. An Adviser must disclose whether and, if so, how often, it reviews clients’ accounts or financial plans and identify who conducts the review. An Adviser that does not review accounts regularly must explain what circumstances trigger an account review.
- Client Referrals and Other Compensation. An Adviser must describe any arrangement under which it or a related person compensates another for client referrals, describe the compensation and disclose any arrangement under which the Adviser receives any economic benefit, including sales prizes, from a person who is not a client for providing advisory services to clients.
- Custody. An Adviser with custody of client funds or securities must explain that clients will receive account statements directly from the qualified custodian that maintains those assets, explain that clients should carefully review those account statements, and, if the Adviser also sends client account statements, include a statement urging clients to compare the account statement from the qualified custodian and Adviser.
- Investment Discretion. An Adviser with discretionary authority over client accounts must disclose that fact and any limitations clients may (or customarily do) place on the authority.
- Voting Client Securities. An Adviser must disclose its proxy voting practices, including whether it accepts or will accept authority to vote client securities and, if so, describe its voting policies under Rule 206(4)-6 under the Advisers Act. An Adviser also must describe whether (and how) clients can direct it to vote in a particular solicitation, how the Adviser addresses conflicts of interest when it votes securities, and how clients can obtain information form the Adviser on how the Adviser voted securities. An Adviser must also disclose that clients may obtain a copy of its proxy voting policies and procedures upon request. If an Adviser does not accept authority to vote securities, it must disclose how clients receive their proxies and other solicitations. An Adviser is not required to provide disclosure about its use of third-party proxy voting services or how it pays for such services.
- Financial Information. An Adviser is required to disclose certain financial information when that information is material to clients. An Adviser that requires prepayment of fees must provide an audited balance sheet showing the Adviser’s assets and liabilities at the end of its most recent fiscal year. In addition, an Adviser is required to disclose any financial condition reasonably likely to impair the Adviser’s ability to meet contractual commitments to clients if the Adviser has discretionary authority over client assets, and it is required to disclose whether it has been the subject of a bankruptcy petition during the past ten years.
- Appendix – Wrap Fee Programs. An Adviser that sponsors a wrap fee program will continue to be required to prepare a separate, specialized firm brochure for clients of the wrap program. Such brochure will be an appendix to the Adviser’s Form ADV, Part 2A rather than Schedule H of Form ADV. In addition, the Adviser must identify whether any of its related persons is a portfolio manger in the wrap fee program and describe any associated conflicts.
Delivery and Updating the Brochure
The Amendments remove the general requirement that the brochure be delivered at least 48 hours prior to entering into an advisory contract as well as the alternative, that the brochure be delivered at the time the Adviser enters into an advisory contract provided that the client has five business days to terminate the contract. As amended, Rule 204-3 generally requires only that an Adviser deliver a current brochure before or at the time it enters into an advisory contract with the client.
Amended Rule 204-3 also requires an Adviser annually to provide to each client to whom they must deliver a brochure, either: (i) a copy of the current brochure that includes or is accompanied by the summary of material changes; or (ii) a summary of material changes that includes an offer to provide a copy of the current brochure. One or both of those documents must be provided no later than 120 days after the end of its fiscal year. Delivery may be done electronically pursuant to the SEC’s electronic delivery guidelines. In addition, the Amendments require an Adviser to deliver an updated brochure promptly whenever the Adviser amends its brochure to add a disciplinary event or to change material information already disclosed regarding a disciplinary event.
An Adviser must also update its brochures filed electronically on the IARD at least annually and when any information becomes materially inaccurate (except the summary of material changes, which only has to be updated annually). If the brochure continues to be accurate since the last annual amendment, the Adviser would not have to prepare or file an updated firm brochure as part of its annual updating amendment. However, with any interim amendment, including those to correct a material inaccuracy, an Adviser would have to file a summary of material changes describing each interim amendment along with an updated firm brochure as part of its annual amendment filing. Although previously filed versions of a brochure will remain in the IARD, only the most recent version of the brochure will be available to the public through the SEC’s website.
Part 2B: The Brochure Supplement
As amended, Rule 204-3 also requires that an Adviser’s brochure be accompanied by brochure supplements providing information about the advisory personnel from whom the particular client receives advice. An Adviser may include supplement information within the firm’s brochure. Alternatively, an Adviser may prepare separate supplements for different groups of supervised persons. To promote comparability, a brochure supplement must be organized in the same order, and contain the same headings, as the items appear in the form, whether provided in a brochure or separately.
The brochure supplement consists of the following six items:
- Cover Page. The cover page must include, among other things, the name of the Adviser, the name of each supervised person covered by the supplement, as well as the addresses and telephone numbers. It also must include a statement stating that the document is a supplement to the brochure, that the recipient should have received a copy of the brochure and if not, of if the recipient has any question concerning the brochure or supplement who to call.
- Educational Background and Business Experience. The supplement must describe each supervised person’s formal education and his or her business background for the past five years, including whether the supervised person has no high school education, no formal education after high school or no business background. The business background section must also identify the supervised person’s positions at prior employers. The Adviser may list any professional designations held by a supervised person. If such are listed, disclosure must provide a sufficient explanation of the minimum qualifications required for the designation.
- Disciplinary Information. The supplement must disclose any legal or disciplinary event that is material to a client’s evaluation of the supervised person’s integrity, including certain disciplinary events that the SEC presumes are material. This includes the relinquishment of professional designations or licenses when the Adviser knew or should have known that the supervised person relinquished such designation or license. If an Adviser delivers a supplement electronically, it may satisfy this requirement by notifying clients of the supervised person’s disciplinary history and including in the supplement hyperlinks to disciplinary information available through the FINRA BrokerCheck system (“BrokerCheck”) or the SEC’s Investment Adviser Public Disclosure system (“IAPD”).
- Other Business Activities. An Adviser must describe in the supplement other business activities of its supervised persons, specifically with respect to any investment-related business or any business that involves a substantial amount of time or pay, and any material conflicts of interest such activities may create. In addition, an Adviser must describe information about any compensation the supervised person receives based on the sales of securities or other investment products to show any incentive for the supervised person to base investment recommendations on his or her own compensation rather than the clients’ best interests.
- Additional Compensation. The supplement must include a description of any arrangements in which someone other than a client gives the supervised person an economic benefit (such as a sales award) for providing advisory services.
- Supervision. An Adviser must explain in the supplement how the firm monitors the advice provided by the supervised person addressed in the brochure supplement. It also must provide the name, title and telephone number of the person responsible for supervising the advisory activities of the supervised person.
Delivery and Updating
A client must generally be given a brochure supplement for each supervised person who: (i) formulates investment advice for that client and has direct client contact; or (ii) makes discretionary investment decisions for the client’s assets. If investment advice is provided by a team consisting of more than five supervised persons, only the five supervised persons with the most significant responsibility for the day-to-day advice provided to the client need be disclosed. An Adviser does not need to deliver supplements to three types of clients: (i) clients to whom an Adviser is not required to deliver a firm brochure; (ii) clients who receive only impersonal investment advice, and (iii) certain “Qualified Clients” who are officers, directors, employees and other persons related to the Adviser. A supplement initially must be given to each client at or before the time when that specific supervised person begins to provide advisory services to that specific client.
Advisers must deliver an updated supplement to clients only when there is new disclosure of a disciplinary event, or a material change to disciplinary information already disclosed. When a reference to BrokerCheck or IAPD is made in an electronic supplement, a new supplement must be electronically delivered when either BrokerCheck or IAPD is updated with new disclosure of a disciplinary event or a material change to disciplinary information already disclosed. As with the brochure, the supplement must be amended promptly if the information in it becomes materially inaccurate. An Adviser is not required to deliver supplements to existing clients annually, as the information in the supplement is unlikely to become materially inaccurate over time.
Form ADV, Part 2A must be filed electronically through IARD, which may be filed in text-searchable PDF format. An Adviser is not required to file brochure supplements or supplement amendments with the SEC, but must maintain copies of all supplements and amendments.
In the adopting release relating to the Amendments, the SEC stated that it believes that Advisers can provide information required by Part 2, without jeopardizing reliance on private offering exemptions for private funds in the Securities Act of 1933 and the safe harbor for offshore transactions in Section 5 of the statute, though it noted that providing private fund information beyond that required in Part 2 may jeopardize such reliance by constituting a private offering or conditioning the market for securities offered by such funds.
Transition to New Requirements and Compliance and Effective Dates
The amended rules and forms will be effective 60 days after publication of the rule in the Federal Register. A new Adviser applying for registration after January 1, 2011 must file a brochure or brochures that meet the requirements of amended Part 2A. An existing Adviser whose fiscal year ends on or after December 31, 2010 must include in its next annual updating amendment to its Form ADV a brochure or brochures that meet the requirements of the amended form. Thus, each existing Adviser must file an annual updating amendment with the new brochures no later than March 31, 2011. Within 60 days of filing such amendment, the Adviser must deliver to its existing clients a brochure and brochure supplement that meet the requirements of the Amendments. Each Adviser must after its initial filing begin to deliver the new brochure and brochure supplements to new and prospective clients.