SEC Re-Proposes Amendments to ADV Part 2 Form

Date: April 08, 2008

Overview

On March 3, 2008, the Securities and Exchange Commission (SEC) re-proposed amendments to Part 2 of Form ADV and related rules under the Investment Advisers Act of 1940 (the "Advisers Act") that would require investment advisers registered with the SEC to deliver to clients and prospective clients a narrative brochure written in plain English.[1] Much of the information that would be required to be disclosed in the brochure concerns conflicts between an adviser's own interests and the interests of its clients, and generally is disclosure that an adviser already makes to its clients.[2] The brochure would replace the current Form ADV Part II format, which consists of a series of multiple choice and fill-in-the-blank questions organized in a "check-the-box" format, supplemented with brief narrative responses. As proposed, advisers would file their brochures with the SEC electronically and the brochures would be available to the public through the SEC's website. In addition, the proposed amendments would require advisers to deliver to a client a brochure supplement that provides information about advisory personnel who provide services to that particular client.[3]

Finally, in light of the changes to Form ADV Part 2, the SEC is proposing to withdraw Rule 206(4)-4 under the Advisers Act, which requires disclosure of certain disciplinary and financial information. This information would now be disclosed in the brochure and the brochure supplement.

The proposed amendments are designed to produce clearer, more meaningful disclosure that will improve the ability of clients and prospective clients to evaluate a firm's advisory services and personnel, and to understand relevant conflicts of interest that the firm and its personnel face. Comments on the proposed amendments are due by May 16, 2008.

Part 2A: The Firm Brochure

The SEC is proposing that a registered adviser provide to prospective and existing clients a narrative brochure written in plain English. The brochure would describe an adviser's services, fees, business practices and conflicts of interest with clients. Advisers would file the brochure electronically through IARD and the public would be able to access each adviser's brochure though the SEC's website.

Brochure Items

As proposed, the brochure would contain 19 separate items, each covering a different disclosure topic.[4] An adviser would be required to respond only to those items that apply to its business and would not need to repeat information in the brochure simply because the information is responsive to more than one item. In addition, an adviser that offers substantially different services to different advisory clients could prepare separate brochures, each of which could omit information that does not apply to the advisory fees and services it describes. Finally, advisers would be required to explain succinctly how conflicts of interest are addressed, rather than disclosing lengthy, technical policies and dense procedures.

The following items comprise proposed Part 2A of Form ADV:

  • Item 1: Cover Page. The cover page would disclose the adviser's name, business address and telephone number; the name and telephone number of a person or services center that a client or prospective client could call for further information; and the date of the brochure. The cover page also would include a statement that the brochure has not been approved by the SEC or any state securities authority. If the adviser holds itself out as being registered, the cover page also must explain that registration with the SEC does not imply that the adviser possesses a certain level of skill or training.

  • Item 2: Material Changes. An adviser would be required to provide clients with a summary of any material changes to its brochure since the last annual update. The summary would appear on the cover page of the brochure or immediately after, or could be included in a separate communication that would accompany the brochure. An adviser would not be required to provide the summary of material changes to clients or prospective clients who have not received a previous version of the adviser's brochure. In addition, the summary would not be required to be filed with the SEC and, if included in a separate communication with the client, would not be available on the SEC's website.[5]

  • Item 3: Table of Contents. An adviser would be required to include a table of contents in its brochure that is detailed enough to permit clients and prospective clients to locate topics easily.

  • Item 4: Advisory Business. The proposal would require an adviser to describe its advisory business. The description would be required to include the types of advisory services offered, whether the adviser holds itself out as specializing in a particular type of advisory service, and the amount of assets managed.[6]

  • Item 5: Fees and Compensation. This item could require an adviser to describe how it is compensated for providing advisory services, including whether the adviser bills clients or deducts fees from a client's assets, how often fees are assessed and whether fees are paid in advance or arrears. An adviser also would be required to provide its fee table, disclose whether fees are negotiable and describe other fees or expenses, such as custodian fees, mutual fund expenses, brokerage and other transaction costs, that clients may pay in connection with the receipt of advisory services. If an adviser or any of its supervised persons receive compensation for the sale of securities or other investment products, it must disclose that fact and conflicts of interest that this practice creates. Such an adviser also must describe how it addresses this conflict, including procedures for disclosing the conflict to clients.[7] Finally, an adviser engaging in this practice must explain that clients have the option of purchasing investment products recommended by the adviser from brokers that are not affiliated with the adviser.

  • Item 6: Performance Fees and Side-by-Side Management. An adviser that charges performance fees would be required to disclose that fact. If the adviser also manages accounts that are not charged performance fees, the adviser would be required to discuss the conflicts of interest that arise from its simultaneous management of these types of accounts and to describe generally how these conflicts are addressed.

  • Item 7: Types of Clients. This item would require a description of the types of clients to whom the adviser generally provides investment advice, such as individuals, trusts, investment companies or pension plans. Any requirements for opening or maintaining an account, such as minimum account size, also would need to be disclosed.

  • Item 8: Methods of Analysis, Investment Strategies and Risk of Loss. Item 8 would require an adviser to describe the methods of analysis and investment strategies used in formulating advice and managing assets. An adviser also would be required to explain the risks of investing in securities in general. If an adviser primarily recommends a particular type of security or primarily uses a particular method of analysis or strategy in managing assets, the adviser would be required to explain the specific risks involved in an investment in the recommended security or associated with the particular method of analysis or strategy employed by the adviser. An adviser employing multiple strategies, each of which poses different and specific risks, would not be required to list in the brochure the risks associated with each type. Rather, the adviser would be required to separately provide to each client risk disclosure with respect to the particular strategies used in managing that client's account.

  • Item 9: Disciplinary History. The proposal would require an adviser to disclose in its brochure facts about any legal or disciplinary event that is material to a client's or prospective client's evaluation of the integrity of the adviser and its management. Items 9.A, 9.B and 9.C list specific legal and disciplinary events that are presumptively material and that must be disclosed if they occurred in the last 10 years. An adviser may rebut the presumption, in which case no disclosure is required.[8] However, an adviser rebutting a presumption of materiality would be required to prepare and maintain a memorandum of the determination. Because advisers would be required to include disciplinary disclosures in their brochures, the SEC is proposing to rescind Rule 206(4)-4, which requires disclosure of disciplinary information, but does not specify the means of delivering the disclosure.

  • Item 10: Other Financial Industry Activities and Affiliations. An adviser would be required to describe material relationships or arrangements the adviser or any of its management persons has with related financial industry participants, any material conflicts of interest such relationships or arrangements create, and how the adviser addresses such conflicts. Also, if an adviser recommends or selects other investment advisers for its clients and directly or indirectly receives compensation in return, the adviser must disclose the practice and discuss the conflicts of interest the practice creates and how the adviser addresses them.

  • Item 11: Code of Ethics, Participation or Interest in Client Transactions and Personal Trading. Item 11 would require that an adviser briefly describe its code of ethics and explain that a copy is available upon request. This item also would require an adviser to disclose whether (1) it (or a related person) recommends securities to clients, or buys or sells securities for clients, in which it has a material financial interest, (2) it (or a related person) invests in the same securities (or related securities) that it recommends to clients, or (3) it (or a related person) recommends securities to clients, or buy or sells securities for a client's account, at or about the same time that it (or a related person) buys or sells the same securities for its own account (i.e., personal trading).[9] If an adviser engages in these practices, the brochure must describe the practice, discuss the conflicts inherent in such practices and describe how the conflicts are addressed.

  • Item 12: Brokerage Practices. Proposed Item 12 would require an adviser to describe how it selects brokers for client transactions and determines the reasonableness of broker compensation. In addition, an adviser receiving soft dollar benefits would be required to describe its soft dollar practices, disclose the conflicts that arise when it accepts soft dollar benefits, and explain how it addresses those conflicts. The disclosure must be specific enough for the client to understand the types of products and services the adviser is receiving and to permit them to evaluate possible conflicts of interest. An adviser also would be required to disclose if it uses client brokerage to reward brokers for client referrals, aggregates (or "bunches") client trades, or requires or permits directed brokerage.[10] The brochure must disclose any conflicts of interest that arise from these practices and explain how the conflicts are addressed.

  • Item 13: Review of Accounts. An adviser would be required to disclose whether and how frequently it reviews a client's account or financial plans. If an adviser reviews accounts, but not regularly, it must explain the factors that trigger a review.

  • Item 14: Payment for Client Referrals. The proposal would require an adviser to describe any cash or other payment that it or a related person makes to a third party (i.e., to a non-employee) for client referrals. Item 14 also would require an adviser to describe any arrangement in which a non-client provides an economic benefit to the adviser for providing investment advice or other advisory services to a client. An economic benefit would include sales awards and other prizes.

  • Item 15: Custody. An adviser that has custody of client assets would be required to explain that clients will receive account statements from their custodian and that clients should read the statements carefully. If clients do not receive quarterly statements from the custodian, an adviser with custody must state that it has custody and explain the risks that clients face as a result.

  • Item 16: Investment Discretion. If an adviser accepts investment discretion to manage securities on behalf of clients, it would be required to disclose this fact and describe any limitations clients may (or customarily do) place on such authority.

  • Item 17: Voting Client Securities. If an adviser has, or will accept, authority to vote client securities, Item 17 would require the adviser to briefly describe its voting policies and procedures and explain how a client can obtain a copy of the adviser's proxy voting policies and procedures.[11] An adviser also must describe whether and how clients can direct the adviser to vote in a particular solicitation, how the adviser addresses conflicts of interest when it votes securities, and how a client can obtain information from the adviser about how the adviser voted their securities. If an adviser routinely uses a third-party proxy voting service to advise it on voting proxies, this item would require the adviser to list the proxy voting services that the adviser uses, describe how the proxy voting services are selected, and state whether clients are permitted to direct the use of particular proxy voting services. Finally, an adviser would be required to disclose how it pays for proxy voting services.

  • Item 18: Financial Information. An adviser that requires prepayment of more than $1,200 in fees per client six or more months in advance would be required to give clients an audited balance sheet as of the end of the most recent fiscal year.[12] An adviser with discretionary authority or custody of client assets, or that requires prepayment of more than $1,200 in fees per client six or more months in advance, must disclose any financial condition that is reasonably likely to impair its ability to meet contractual commitments to its clients. Finally, an adviser that has been subject to a bankruptcy petition during the past 10 years must disclose that fact to its clients.

  • Item 19: Index. The brochure would be required to include an index indicating where in the brochure the adviser addresses each item. The index would not be delivered to the client, but would be used to facilitate review by the SEC. If an item is not included in the brochure, that fact would be required to be noted on the index.
An adviser sponsoring a wrap fee program would be required to prepare a separate, specialized brochure for clients of the wrap fee program. The disclosure requirements for the wrap fee program brochure are set out in Appendix 1 to Proposed Part 2A of Form ADV and are substantially similar to the requirements of current Schedule H.
Brochure Delivery And Updating Requirements

Initial Delivery

The SEC is proposing to amend Rule 204-3 under the Advisers Act to require an adviser to deliver a current firm brochure before or at the time it enters into an advisory contract with a client.[13] An adviser would not be required to deliver a brochure to clients that are investment companies registered under the Investment Company Act of 1940 (the "1940 Act") or to clients who receive only impersonal investment advice for which the adviser charges less than $500 per year. If an adviser does not have any clients to whom a brochure must be delivered, the adviser would not be required to prepare a brochure.[14]

Annual and Interim Delivery

The proposed amendments to Rule 204-3 would require an adviser to deliver its current brochure to existing clients at least once per year no later than 120 days after the end of the adviser's fiscal year.[15] An adviser would be required to deliver an interim update to clients only when the adviser amends its brochure to add a disciplinary event, or to materially change information already disclosed, in response to Item 9 of Part 2A.[16] Brochures can be delivered electronically or on paper.[17]

Updating the Brochure

The proposed amendments would require an adviser to keep brochures they file with the SEC current by updating them at least annually (if necessary), and updating them promptly when any information in the brochure becomes materially inaccurate. Brochures would not need to be updated merely because the amount of client assets has changed or solely because a client's fee schedule has changed, unless the changes are material. Annual and interim updates would be submitted through IARD. Although previously filed versions of an adviser's brochure would remain stored as SEC records in the IARD system, only the most recent version of an adviser's brochure would be available to the public through the SEC website.

Part 2B: The Brochure Supplement

The SEC is proposing that an adviser's brochure be accompanied by a brochure supplement written in plain English that provides information about the advisory personnel on whom clients rely for investment advice. The brochure supplement, which the SEC estimates would be ordinarily less than a page long, would contain information about the educational background, business experience and disciplinary history of the supervised person who provides advisory services to a particular client.An adviser can prepare separate brochure supplements for each supervised person, or prepare separate brochure supplements for different groups of supervised persons.[18] However, brochure supplements do not need to be separate documents.[19] If an adviser's brochure includes all the information required to be in the brochure supplement, the adviser does not need a separate supplement. In addition, if an adviser's brochure contains some, but not all, of the brochure supplement information, the brochure supplement can refer the client or prospective client to the appropriate section(s) of the brochure and describe the types of information being referred to rather than repeating that information in the brochure supplement.

Brochure Supplement Items

The brochure supplement would consist of the following six items:

  • Item 1: Cover Page. The cover page would include information identifying the supervised person and the firm, including the supervised person's name, business address and telephone number.

  • Item 2: Educational Background and Business Experience. Item 2 would require disclosure of the supervised person's name, age (or year of birth), formal education after high school and business background for the preceding five years. If the supervised person has no formal education after high school, that fact must be disclosed.

  • Item 3: Disciplinary Information. Similar to Item 9 of Part 2A, the proposal would require an adviser to disclose any legal or disciplinary events material to a client's or prospective client's evaluation of the supervised person's integrity. Items 3.A, 3.B and 3.C list specific legal and disciplinary events that are presumptively material and that must be disclosed for 10 years following the date of the event, unless the event was resolved in the supervised person's favor, or was reversed, suspended or vacated, or the adviser has determined that the event is not material.[20] Any revocation or suspension of a supervised person's professional attainment, designation or license would need to be disclosed only if the action resulted from a violation of rules relating to professional conduct. Similarly, an adviser would be required to describe any event over which the supervised person resigned or relinquished a professional attainment, designation or license in anticipation of it being suspended or revoked (other than for failure to pay membership dues).

  • Item 4: Other Business Activities. This item requires an adviser to describe other business activities of its supervised persons. Specifically, Item 4 would require disclosure of other capacities in which the supervised person participates in any investment-related business, any material conflicts that participation may create, and how those conflicts are addressed. Any compensation, including bonuses and non-cash compensation, that the supervised person receives based on the sale of securities would need to be disclosed along with an explanation of the incentives this type of compensation creates. Finally, if a supervised person is actively engaged in any business or occupation for compensation that is not otherwise disclosed, and such activity provides a substantial source of the supervised person's income or involves a substantial amount of the supervised person's time, the adviser must disclose that fact and describe the nature of the business.

  • Item 5: Additional Compensation. An adviser would be required to describe arrangements in which someone other than a client provides an economic benefit to the supervised person for providing advisory services. An economic benefit would include a sales award or other prize, but not the supervised person's regular salary. Any bonus that is based at least in part on the number or amount of sales, client referrals or new accounts would be considered an economic benefit, but other regular bonuses would not.

  • Item 6: Supervision. Item 6 would require an adviser to explain how the firm monitors the advice provided by the supervised person. This item also would require an adviser to provide the client with the name, title and telephone number of the person responsible for supervising the advisory activities of the supervised person.
Brochure Supplement Delivery and Updating Requirements

Initial Delivery

The SEC is proposing that an adviser be required to deliver to a client or prospective client, at or before the time a particular supervised person begins to provide advisory services to that client, a brochure supplement for each supervised person who (1) formulates investment advice for the client and has direct client contact or (2) makes discretionary investment decisions for the client's assets, even if the supervised person has no direct client contact.[21] An adviser would not be required to deliver a brochure supplement to a client (1) to whom the adviser is not required to deliver a firm brochure (e.g., registered investment companies and business development companies), (2) who receives only impersonal investment advice, regardless of the amount of fees paid, (3) who is a qualified purchaser under Section 2(a)(51)(A) of the 1940 Act, or (4) who would be a qualified client of the firm under Rule 205-3(d)(iii) under the Advisers Act.[22] As with the firm brochure, brochure supplements can be delivered electronically or on paper.[23]

Updating Requirements

The proposed amendments would require an adviser to update the brochure supplement promptly when any information in the brochure supplement becomes materially inaccurate. Any new clients who would be required to be given that supplement must be given the amended version.

Annual and Interim Delivery

An adviser would not be required to deliver a brochure supplement annually. However, an adviser would be required to deliver an updated brochure supplement for a supervised person who provides advisory services to a client when the adviser amends the brochure supplement to add a disciplinary event, or to materially change information already disclosed, in response to Item 3 of Part 2B.

Filing Requirements

Advisers would be required to file new brochures with the SEC electronically through the IARD system, which would permit the SEC to make the brochures publicly available through its website. Instead of completing Part 2A online as advisers currently do for Part 1, advisers would create brochures on their own computers and then attach a PDF version of the completed document to their filings on IARD. An adviser who does not need to file a brochure because it is not required to deliver one will be prompted by the IARD system to confirm that it is not required to file a brochure.

The IARD system would not accept an adviser's annual ADV updating amendment without an updated brochure. However, if no changes to the brochure are necessary when an adviser is submitting the annual ADV updating amendment, the adviser will have the option of indicating on IARD that the current brochure does not contain any materially inaccurate information.

Advisers would not be required to file brochure supplements or supplement amendments with the Commission and these documents would not be available on the SEC's website.

Transition Period

New applicants for registration would not be required to include a brochure as part of their initial registration until six months after the effective date the proposed amendments. An adviser already registered with the SEC would be required to comply with the new Part 2A requirements by the date it must make its annual updating amendment to Form ADV following the date the revised form becomes effective. In no case, however, would any adviser be required to comply with the new requirements earlier than six months after the revised form becomes effective.

Footnotes

[1] Amendments to Form ADV, Investment Advisers Act Release No. 2711 (March 3, 2008) [73 FR 13958 (March 14, 2008)]. The SEC originally proposed similar amendments in April 2000. Electronic Filing by Investment Advisers; Proposed Amendments to Form ADV, Investment Advisers Act Release No. 1862 (April 5, 2000) [65 FR 20524 (April 17, 2000)].

[2] The SEC takes pains to emphasize that proposed Part 2A (the firm brochure) of Form ADV does not cover every possible conflict and that delivering a brochure prepared in accordance with Part 2A may not fully satisfy an adviser's disclosure obligations.

[3] Proposed Part 2 of Form ADV consists of two parts, the firm brochure in Part 2A and the brochure supplement in Part 2B.

[4] Disclosure of wrap fee programs would be included in an appendix to the brochure.

[5] The SEC also is proposing amendments Rule 204-2(a) under the Advisers Act to require advisers to preserve copies of summaries of material changes that are not included in a brochure or brochure supplement. See proposed Rule 204-2(a)(14)(i).

[6] In calculating managed assets, an adviser would be permitted to use a method different from the method used in Part 1A of Form ADV to report assets under management. Proposed Rule 204-2(a)(14)(ii) would require that an adviser keep documentation describing the method used to compute managed assets for purposes of Item 4.E of Part 2A of Form ADV if the method differs from the method used to compute assets under management in Item 5.F of Part 1A of Form ADV.

[7] An adviser that receives more than 50% of its revenue from commissions and other sales-based compensation would be required to explain that commissions are the firm's primary form of compensation.

[8] In determining materiality, advisers are instructed to consider all of the following factors: (1) the proximity of the person involved in the disciplinary event to the advisory function; (2) the nature of the infraction that led to the disciplinary event; (3) the severity of the disciplinary sanction; and (4) the time elapsed since the date of the disciplinary event.

[9] Advisers would not be required to provide this disclosure with respect to securities that are not "reportable securities" under Rule 204A-1.

[10] An adviser may omit directed brokerage disclosure if the adviser only permits clients to direct brokerage subject to the adviser's ability to obtain best execution.

[11] Advisers that do not have authority to vote client securities would have to explain how clients will receive proxies and other solicitations.

[12] Advisers that are qualified custodians or insurance companies are excluded from this requirement.

[13] Currently, delivery of an adviser's Form ADV Part II must occur at least 48 hours before entering into an advisory contract or at the time of entering into an advisory contract if the client has the right to terminate the contract without penalty within five business days.

[14] See Proposed Instruction 5 to Part 2A.

[15] Currently, advisers are required to annually deliver, or offer to deliver upon request, either a copy of the adviser's Form ADV Part II or a brochure containing the same information.

[16] The proposing release reminds advisers that as fiduciaries, they have ongoing obligations to inform clients of material information that could affect the advisory relationship. As a result, the SEC notes that advisers may be required to disclose material changes to clients between annual updating amendments even if those changes would not otherwise trigger delivery of any interim update.

[17] See proposed Instruction 3 to Part 2A.

[18] A group supplement, or a firm brochure containing supplement information, must present information in a separate section for each supervised person.

[19] See proposed Instruction 6 to Part 2B.

[20] When reviewing a legal or disciplinary event involving a supervised person for materiality, advisers are instructed to consider all of the following factors: (1) the proximity of the supervised person to the advisory function; (2) the nature of the infraction that led to the disciplinary event; (3) the severity of the disciplinary sanction; and (4) the time elapsed since the date of the disciplinary event. If an adviser concludes that an event is immaterial, it must prepare and maintain a file memorandum of the determination for its records.

[21] See proposed Rule 204-3(b). An adviser would not have to provide a brochure supplement for a supervised person who provides discretionary advice only as part of a team and who has no direct client contact.

[22] See proposed Rule 204-3(c)(2).

[23] See proposed Instruction 4 to Part 2B.