After significant effort and time, the Securities and Exchange Commission ("SEC") finally has adopted amendments to Form ADV and related brochure filing and delivery requirements ("Part 2 Amendments").1 Form ADV Part II, currently a "check-the-box" form supported by a disclosure schedule, will now be replaced with Form ADV Part 2, which in most cases will require each SEC-registered investment adviser ("RIA") to produce a narrative, plain English disclosure document, sequenced in a specified order to promote comparability among registrants. Form ADV Part 2 will be required to be (i) provided to clients and prospects, (ii) filed with regulators and (iii) made available to the general public through the SEC-sponsored Investment Adviser Public Disclosure website ("IAPD") (http//www.adviserinfo.sec.gov). The Part 2 Amendments are intended to ensure that current and prospective clients receive clear, meaningful and useful information about the RIA and relevant personnel who provide advice to and/or interface with clients.
The Part 2 Amendments will significantly change the manner in which RIAs describe to clients, the RIA's business, investment practices and potential conflicts of interest and will result in greater transparency about the approximately 11,000 RIAs currently registered with the SEC – as well as the significant number of new registrants expected to register with the SEC as a result of the provisions of the Private Fund Investment Advisers Registration Act of 2010, enacted as Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank").2 Many of these new registrants, including in particular a large number of private equity and hedge fund managers in the United States and abroad, which previously relied on the "Private Adviser Exemption" provided by Section 203(b)(3) of the Investment Advisers Act of 1940, as amended ("Advisers Act"), are likely to face particular challenges in responding to the disclosure requirements imposed by the Part 2 Amendments.
Background
In 2000, the SEC proposed amendments to the entire Form ADV.3 At that time, only the amended Form ADV Part 1 (and related electronic filing requirement for that portion of the Form ADV) was adopted, leaving the revisions to Part II of Form ADV in a state of limbo for eight years. In 2008, the SEC re-proposed amendments to Part II of Form ADV,4 which have been adopted, with some modification, as the Part 2 Amendments. While the Part 2 Amendments are clearly based on the portions of 2000 Proposal (and related comments), the Part 2 Amendments also reflect many of the "hot issues" of the past ten years.
The "New Part 2" includes:
- Part 2A, which replaces the existing Part II and Schedule F (referred to herein as the "Brochure");
- Part 2A, Appendix 1, which replaces the existing Part II, Schedule H and must be completed by sponsors of wrap fee programs (referred to herein as the "Wrap Fee Brochure"); and
- Part 2B, the Brochure supplement, which provides clients with biographical and disciplinary information about relevant personnel of the RIA (referred to herein as the "Supplement").5
Changes to General Delivery and Filing Requirements
Current Requirements for RIAs
Currently, each RIA must: (i) prepare and maintain Form ADV Part II or a brochure containing all the information in Form ADV Part II ("Part II Brochure"); (ii) provide the Part II Brochure to each prospective client not later than the time when an advisory relationship has been created; (iii) update the Part II Brochure promptly if information in the Part II Brochure becomes materially inaccurate; (iv) offer to provide an updated Part II Brochure to each client annually; and (v) hold within the RIA's records and make available to the SEC staff a copy of each such Part II Brochure (in lieu of filing a Part II Brochure directly with the SEC).6 Additionally, certain states have required that paper versions of the Part II Brochure of each RIA that makes a notice filing in that state (as well as State-Only RIAs registered in the state) be filed with the relevant state official or agency.
Significant Changes
The Part 2 Amendments significantly alter certain of the delivery and filing requirements:
- Brochures and Wrap Fee Brochures must be Filed and Available to All Online. Perhaps the most significant change to the filing and delivery requirements is that every RIA that is required to maintain a Brochure will be required to file that Brochure through the Investment Adviser Registration Depository system ("IARD") in PDF format. 7 Current Brochures will be publicly available online and can be viewed by any interested person through the IAPD.8 Because Brochures will be posted in PDF format, they will be searchable using full text search features included in widely available PDF software.9
- Not All Clients Must Receive a Brochure and Not All RIAs Must Maintain a Brochure. The SEC has slightly expanded the types of clients to which an RIA need not provide a Brochure ("Excepted Clients") to include: (i) registered investment companies; (ii) persons receiving only impersonal advisory services; and (iii) any business development company ("BDC") whose contract with the RIA is subject to the contract approval provisions contained in Section 15 of the Investment Company Act of 1940, as amended ("1940 Act").10 Significantly, an RIA that has only Excepted Clients will not be required to maintain or file a Brochure.11 Note, however, that requirements may vary for State-Only RIAs.
- Annual Delivery of Substantive Disclosure Information Is Now Mandated. Currently, every RIA is required to offer each of its non-Excepted Clients a revised Part II Brochure, within 90 days after the end of its fiscal year, but is not required to: (i) notify its non-Excepted Clients about changes to its Brochure or (ii) highlight or specifically clarify the information in the Part II Brochure that has changed (even if an updated Brochure is provided to its non-Excepted Clients). Citing concern that non-Excepted Clients may be relying on "stale" Part II Brochures, the SEC determined to require RIAs to provide substantive disclosure summarizing any material changes to a Brochure since the previous annual updating amendment ("Material Changes Summary")12 to any client that has received a prior version of the relevant Brochure.13 Thus, in contrast to current requirements for the Part II Brochure, the Part 2 Amendments require an RIA whose Brochure has materially changed since the RIA's last annual updating amendment to deliver to each of its non-Excepted Clients, within 120 days after the end of its fiscal year,14 either: (i) a current amended Brochure (which includes a Material Changes Summary) or (ii) a separate document containing (a) the Material Changes Summary and (b) an offer to provide the relevant current relevant Brochure without charge.15 Interim delivery of a Brochure or notification of changes to disclosure information will be mandated only with respect to changes in disclosure related to disciplinary events.16 As is currently the case with a Part II Brochure, delivery of a Brochure (including a Wrap Fee Brochure or Supplement) can be made in paper form or, assuming compliance with relevant law and guidance, electronically. 17
- Five-Day Termination Provision Is Rescinded. Although the initial delivery requirement remains the same, RIAs will no longer be required to offer their clients a five day termination right if the Brochure was not delivered at least 48 hours prior to entering into the investment advisory agreement.18 Thus, RIAs will now be obligated to provide a current Brochure to any client (other than an Excepted Client) "before or at the time [the RIA] enter[s] into an investment advisory agreement with that client."19
- Supplements. RIAs must prepare and provide
Supplements with respect to each supervised person who: (i)
formulates investment advice for and has direct contact with the
client or (ii) makes discretionary investment decisions for the
client, even if the person will have no direct client
contact.20 Updating would be required only if a
Supplement becomes materially inaccurate. While new clients would
be provided with the most current version of each relevant
Supplement, those clients that previously received a Supplement
need not be provided with an updated Supplement unless there have
been material changes to relevant disciplinary information.
21
Unlike the Brochure and the Wrap Fee Brochure, SEC-registered advisers need not file Supplements through the IARD system and, thus, Supplements will not be publicly available through IAPD. Instead, as is currently the case for Part II Brochures, such Supplements would be maintained by each RIA in its records and available to the SEC or its staff upon request. However, State- Only RIAs will generally be required to file on the IARD a copy of the Supplement for each supervised person doing business in the relevant state.22 - Phase-In and Transition to New Form ADV Part
2. To allow advisers sufficient time to prepare a
Brochure: (i) those advisers that apply for registration after
January 1, 2011, must file Brochure(s) meeting the requirements of
the Part 2 Amendments as part of their applications for
registration on Form ADV; and (ii) existing RIAs whose fiscal year
ends on or after December 31, 2010, must include a Brochure that
complies with the Part 2 Amendments in their next annual updating
amendment to Form ADV (e.g., March 31, 2011, for an RIA
with a December 31 fiscal year end). Delivery of a new Brochure to
all current Non-Excepted Clients is required during the initial
period (as discussed later), with delivery required to be made not
later than 60 days after filing the Brochure through the IARD
system.23 As such, filings are required within 90 days
after the end of the RIA's fiscal year and an existing RIA will
have 150 days following the end of its fiscal year that began in
2010 to deliver the necessary Brochure(s) to its Non-Excepted
Clients certain Brochure items. Supplements will include up to six
separate disclosure items, each requiring a narrative description
about the relevant individual.
While certain of the disclosure items required in a Brochure are similar to items in the current Part II Brochure and other items elicit disclosures that, while not explicitly required by the current Form ADV Part II, are disclosed as a matter of best practice by many RIAs, a few items will require RIAs to provide information that has not, historically, been disclosed by most RIAs. As fiduciaries, RIAs may be required (or wish) to provide clients with information beyond that which is required to appear in a Brochure. The Part 2 Amendments permit an RIA to include certain information not explicitly required by the Form's instructions in their Brochure, Wrap Fee Brochure or Supplement.24 For example, a Brochure may, but is not required to, include a summary "at the beginning of" the Brochure ("Permissible Summary").25
The following provides a functional description of some of the more significant types of disclosure that an RIA is likely to include in its Brochure following the Part 2 Amendments.26
Part 2A: The Brochure
An RIA will have significant freedom to craft Brochure disclosures in a manner that is appropriate to its advisory business or business lines or products, provided that all items in the Form ADV Part 2 are included under the item headings and in the order set forth in the Form.27 If a particular item is not relevant to an RIA's business, the RIA must include the item's heading and specifically state that such item is not applicable. Cross-references may be included to direct the client's attention to disclosure that is responsive to more than one item. Brochures must be written in plain English, taking into consideration the RIA clients' level of financial sophistication, and "should use, among other things, short sentences; definite, concrete, everyday words; and the active voice."28
Brochures will include the following disclosures, among others:
- Cover Page and Summary of Material Changes.29 The cover page must include similar information to that currently required by the Part II Brochure (e.g., the RIA's name, address, website (if any), phone number and the date of the Brochure) and, additionally, must include a general telephone number and/or email address that clients could contact for further information.30 An RIA must include, on the cover page, disclosure that neither the SEC nor any state regulatory authority has approved the Brochure and, in the case of an RIA that holds itself out as registered, the cover page must also state that "registration does not imply a certain level of skill or training."31 Additionally, as noted above, an RIA will be required to file and to provide to recipients of a previous Brochure a Material Changes Summary.32 An RIA may choose to include the Material Changes Summary in the Brochure itself or through a separate communication. If the former option is chosen, the Material Changes Summary must appear on or immediately following the cover page of the Brochure. If the latter option is chosen, the communication must: (i) offer to provide a current Brochure without charge; (ii) include a website address, email address and/or telephone number by which a client may obtain the current Brochure; and (iii) be filed as an exhibit to the Brochure on the IARD system.33
- Table of Contents.34 While the Part II Brochure includes a table of contents, the current table of contents applies only to the check-the-boxportion of the form and does not provide the location of relevant disclosures within the narrative portion (i.e., Schedule F) of an existing Brochure. The new Part 2A requires that a table of contents must be "detailed enough so that . . . clients can locate topics easily" within the Brochure.
- Description of the RIA's Advisory Business and
Services.35 An RIA will be required to include
a narrative general description of its advisory business or
businesses, including: (i) the types of services offered; (ii)
whether the RIA holds itself out as specializing in a particular
type of service; (iii) the amount of client assets it currently
manages; 36 (iv) how long the firm has been in business;
and (v) identification of the RIA's principal
owners.37 Additionally, more specific disclosure will be
required regarding: (i) the types of clients the RIA generally
services; (ii) any requirements for opening or maintaining
accounts; (iii) how the RIA reviews client accounts; and (iv) the
RIA's investment methods and strategies, as well as the risk of
loss associated with such methods and strategies. Currently, the
Part II Brochure requires some degree of description of the general
advisory services offered, the types of clients serviced, account
requirements, the RIA's investment methods and strategies, and
account reviews.
In many cases, RIAs that currently offer specialized services provide particular information about (or focus attention on) the specialized services, though there is no current requirement that RIAs disclose specializations as such.38 In addition, many RIAs currently do not include significant or specific investment risk disclosures in their Part II Brochures. Thus, following the Part 2 Amendments, an RIA will likely need to increase the level of detail about its investment process, and related risks, that is included in the Brochure.39 For example, not only will each RIA be required to include in its Brochure disclosure of specific risks regarding significant or specialized strategies employed by the RIA, but any RIA that "specializes" must provide even more detailed disclosures regarding "risks clients face in following the [RIA]'s advice or permitting the [RIA] to manage assets."40 An RIA that does not specialize "could simply explain that investing in securities involves a risk of loss."41 An RIA that trades fre- quently must disclose how "frequent trading"42 may affect investment performance. Although the SEC retreated from a proposed requirement that a Brochure disclose an RIA's "cash balance practices," the Adopting Release noted that an RIA "may have an obligation (independent of Part 2A requirements) to disclose material information about its policies regarding the management of cash balances."43 - Disclosure of Advisory Fees, Performance Compensation and Conflicts related to "Side-by-Side Management."44 An RIA will continue to be required to provide its clients with information about its advisory fees,45 including fee schedules and whether those fee schedules are negotiable. 46 An RIA must also disclose information about other expenses that may be imposed on its clients receiving advisory services.47 As is the case with the current Part II Brochure, when an RIA charges, or allows clients to pay, fees in advance, the Brochure must include clear information as to how: (i) a client could obtain a refund in the event the advisory relationship is terminated before the entire pre-paid fee is earned and (ii) how such refunds would be calculated. Specific disclosures would be required where the RIA (or any of its supervised persons) receives commissions, trail payments or similar payments with respect to the sale of securities or other investment products, including: (i) the nature of the conflict and how it is addressed; (ii) that clients could purchase such products through other firms or sources; (iii) if such payments represent more than 50% of the RIA's revenue, a statement that such payments are the RIA's principal compensation, provided such statement is accurate; and (iv) if advisory fees are charged in addition to commissions, whether such commissions can be used to offset such advisory fees.48 Special disclosures are also necessary when an RIA (or any supervised person of the RIA) charges performance fees.49 In particular, where an RIA manages both performance fee and nonperformance fee accounts, the RIA must explain relevant conflicts and how the RIA addresses them.50
- Disclosures Related to Authority over Client
Assets.51 Currently, an RIA is required to: (i)
disclose in its Part II Brochure the degree of discretion that it
may exercise over client accounts with respect to investments and
brokerage and (ii) provide narrative disclosure regarding relevant
policies, practices and procedures. Many RIAs also choose to meet
certain disclosure requirements imposed by Rule 206(4)-6 under the
Advisers Act (i.e., "Proxy Voting Rule") through
disclosure in their Part II Brochures.52
The Part 2 Amendments require RIAs to continue to provide many of these same disclosures in Brochures, although further detail regarding, among other things, soft dollar arrangements,53 directed brokerage, trade aggregation54 and a client's ability to impose reasonable investment restrictions,55 may need to be included in the Brochure to comply with the Part 2 Amendments. Additionally, if an RIA considers client referrals when allocating brokerage, the RIA's Brochure must include enhanced conflicts disclosure.56 An RIA having custody over its clients' assets must disclose this fact and explain that clients will receive account statements from a qualified custodian. 57 An RIA also must disclose information about its proxy voting practices. An RIA that does not accept proxy voting authority from its clients must disclose how clients will receive proxy solicitation materials and whether (and, if so, how) a client may contact the RIA about a particular proxy. An RIA that accepts proxy voting authority must provide information about the RIA's proxy voting policies and procedures, consistent with the Proxy Voting Rule.58 - Disclosures Relating to the RIA's Dealings with
Affiliates, Clients and Others.59 An RIA's
dealings with its affiliates, its clients and others (such as
third-party solicitors) may give rise to conflicts of interest or
cause a client to reasonably question the impartiality of the
RIA's advice.
The Part 2 Amendments do not significantly alter the current disclosure requirements with respect to financial industry or client conflicts or the use of third party solicitors.60 An RIA will still be required to disclose its own financial industry activities (e.g., where an RIA is also registered as a broker-dealer, commodity trading advisor, futures commission merchant or the like) and those of its related persons, to the extent the RIA maintains arrangements with such related persons, which are material to the RIA or its clients. In addition, "managers of managers" (i.e., an RIA that, as part of its advisory services, advises clients as to the selection of other advisers) must include additional disclosures (regardless of whether such other advisers are affiliates of the RIA) as to any compensation derived, directly or indirectly, from such advisers.61
The Part 2 Amendments also retain the requirement that an RIA disclose information about its code of ethics (including that such code will be provided to clients and prospective clients on request), as well as requiring narrative disclosure with respect to identified business dealings with clients (e.g., principal transactions, personal or proprietary investments in the same securities that are recommended to clients, or recommendations of investment products to which the RIA or its affiliates provide advisory or other services). Finally, an RIA must disclose information about its use of cash solicitation arrangements, as well as circumstances where the RIA receives an economic benefit from a non-client in connection with advice provided to clients and the attendant conflicts of interest.62 - Disciplinary and Financial
Events.63 Currently, disclosures with respect
to disciplinary events are included in Part 1 of Form ADV. Also,
Rule 206(4)-4 under the Advisers Act requires an RIA to make
affirmative disclosure of specified legal or disciplinary events or
changes in the RIA's financial condition that might call into
question the soundness or integrity of the RIA.64 Going
forward, these disclosures will be made in the Brochure and
relevant Supplements.65
The Part 2 Amendments will require an RIA to disclose in the Brochure specified disciplinary information regarding the RIA or its "management persons"66 for at least ten years following the date of the relevant event,67 if such information is material.68 An RIA whose lack of financial soundness might result in client losses is subject to special disclosure requirements with respect to its financial condition, including: (i) any such RIA that charges significant fees more than six months in advance must provide a balance sheet to its clients;69 (ii) any such RIA, as well as any RIA that has custody or exercises discretionary authority, must disclose "any financial condition that is reasonably likely to impair [the RIA's] ability to meet contractual commitments to clients;"70 and (iii) any RIA that has "been the subject of a bankruptcy petition at any time during the past ten years [would be required to] disclose this fact, the date the petition was first brought, and the current status."71 As noted above, an RIA that adds or materially revises disciplinary event disclosure must make interim delivery of the Brochure.72
Footnotes
1 See Final Rule: Amendments to Form ADV, Rel. No. IA-3020 (July 28, 2010); 75 FR 49234 (Aug. 12, 2010) ("Adopting Release"). Page references herein refer to the Federal Register version of the Adopting Release and other relevant SEC releases. Except as otherwise stated, rule and section references are to the Advisers Act and rules thereunder and "item numbers" refer to the relevant item in Part II or in Part 2A, Part 2A Appendix 1 or Part 2B, as applicable.
2 Although Form ADV remains a "Uniform Application for Investment Adviser Registration" used at both the federal and state levels, the Form ADV contains certain items, including Item 19 of Part 2A, that need to be answered only by state-registered advisers and imposes different disclosure thresholds with respect to financial and disciplinary event disclosure depending upon whether the Form ADV is being used to register with the SEC or with a state regulatory authority. Advisers switching from federal to state registration as a result of Dodd-Frank should carefully consider these differing obligations when preparing their Form ADV filings. This DechertOnPoint addresses, principally, requirements applicable to RIAs registered with the SEC and, unless otherwise noted, the term "RIA," as used herein, refers to federally registered advisers. Advisers registered only with one or more states, territories or the District of Columbia may be referred to herein as "State- Only RIAs."
3 See Proposed Rule: Electronic Filing by Investment Advisers; Proposed Amendments to Form ADV, Rel. No. IA-1862 (Apr. 5, 2000); 65 FR 20524 (Apr. 17, 2000) ("2000 Proposal").
4 See Proposed Rule: Amendments to Form ADV, Rel. No. IA-2711 (Mar. 3, 2008); 73 FR 13958 (Mar. 14, 2008) ("2008 Part 2 Proposal"). The 2008 Part 2 Proposal was shaped largely by the 2000 Proposal and related comments.
5 With respect to certain delivery and maintenance requirements or for ease of reference, Brochures, Wrap Fee Brochures and Supplements may be referred to collectively herein as "Brochures."
6 Currently, an RIA is not subject to the Brochure delivery and offer requirements with respect to clients who are registered investment companies or who receive only impersonal advisory services and pay fees of less than $200 per year. However, under the current rules, an RIA must still maintain a Brochure, even if the RIA has no client to whom a Brochure must be offered or delivered.
7 The Part 2 Amendments continue to allow an RIA having distinct business lines or client types to maintain separate Brochures. Each such Brochure must be included in the RIA's Form ADV filing. Where no changes are necessary to a Brochure, the RIA would be required to indicate that fact and would not be required to attach a new Brochure to the related Form ADV filing.
8 The IARD allows an RIA to file its Form ADV that, once filed, is available to the public through IAPD. Whereas the IARD is hosted by FINRA, IAPD is available through a link on the SEC's website or at http://www.adviserinfo.sec.gov. Only current Brochure(s) will be publicly accessible through the IAPD. However, prior Brochures would be available to the SEC and its staff and could be obtained by others through the SEC's Public Reference Room. Given the increased potential value of the narrative disclosure proposed to be included in the new Part 2, as compared with the check-the-box Part 1, it is possible that outside providers (e.g., Lexis, Westlaw or LiveEdgar) could choose to maintain, in searchable format, copies of Brochures much as they currently do with mutual fund prospectuses. In reassuring commenters who expressed concern about the public availability of information included in a Brochure, the SEC noted that it "reviewed [the Brochure] requirements and do[es] not believe that they would require disclosure of proprietary or confidential business information." Adopting Release, supra note 1, at 49252. As such, an RIA that believes that information proposed to be included in a Brochure is proprietary or confidential should carefully consider the scope of relevant disclosure requirements and determine whether such information is truly necessary to respond to the Form ADV. It is likely that, even where such information might be material to certain clients, it is beyond the scope of the relevant item of the Form. Such information could, therefore, be provided supplementally to relevant clients rather than included in a publicly filed Brochure.
9 The SEC noted that the use of PDF format would also benefit RIAs by allowing the "IARD to accept [B]rochures that include graphics and charts, so that [RIAs] who choose to use more elaborate [B]rochures need not also prepare a plain text version solely for the purpose of filing it." 2008 Part 2 Proposal, supra note 4, at 13975.
10 Additionally, the Part 2 Amendments increase, from $200 to $500 per year, the amount of fees that trigger a Brochure delivery obligation with respect to clients receiving only impersonal advisory services. Rule 204-3(c)(1)(ii).
11 As noted below, Excepted Clients also would not need to be provided with a Supplement.
12 The Material Changes Summary is intended "to be a summary that identifies and broadly discusses the material changes [rather than] a lengthy discussion that replicates the [B]rochure itself" so that clients "can determine whether to review the [B]rochure in its entirety or to contact the [RIA] with questions about the changes" (emphasis in original Adopting Release). Adopting Release, supra note 1, at 49237.
13 General Instruction 5 to Form ADV Part 2. Because the delivery and disclosure obligation relates to changes made to a Brochure previously provided to a client, it would appear that when an RIA maintains multiple Brochures, each Material Changes Summary should be specific to the particular Brochure and should be provided only to clients that have previously received the relevant Brochure. Thus, if a Brochure has not been materially amended since the previous annual updating amendment, an RIA is not required to provide to clients a Material Changes Summary relevant to that Brochure or to file a Material Changes Summary with respect to that Brochure through the IARD, even if one or more of the RIA's other Brochures has been updated. Additionally, State-Only RIAs should be aware that applicable state regulators may still require an annual delivery or offer even where there have been no material changes to a Brochure.
14 This 120-day period contrasts with the 90-day requirement for updating Part 1 of Form ADV. The SEC explained that the additional time was granted "to provide sufficient flexibility to allow [RIAs] to include the updated [B]rochure in a routine quarterly mailing." Adopting Release, supra note 1, at n. 195.
15 An RIA choosing the latter means of delivering a Material Changes Summary must include with the Material Changes Summary a website address and email address (if either is available) and telephone number by which a client may obtain the current relevant Brochure, as well as the website address for the IAPD so that clients may obtain additional information about the RIA through the IAPD system.
16 To the extent that other changes represent information or disclosures that are material to clients, an RIA may have a separate duty to make affirmative disclosure to its clients. An adviser may choose to make such disclosure by delivering an updated Brochure or through alternative means. Instruction 2 to Form ADV, Part 2A.
17 See Use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment Advisers for Delivery of Information, Rel. No. IA-1562 (May 9, 1996); 61 FR 24644 (May 15, 1996). During the SEC's open meeting to adopt the Part 2 Amendments, Commissioner Paredes encouraged the SEC staff "to continue considering different means for the delivery of information to investors" given investors' increased access to email and the internet and society's general increased use of electronic media in everyday life.
18 Rule 204-3(b). See Adopting Release, supra note 1, at n. 188.
19 This change in the timing requirement, however, does not alter the requirement under Rule 206(4)-3 that, when using a third-party solicitor, an RIA must require that the solicitor provide the client with a Brochure "at the time of any solicitation activities for which compensation is paid or to be paid by the [RIA]." Rule 206(4)-3(a)(2)(iii)(A)(3).
20 Clients must receive only those Supplements discussing the personnel who "touch" the client's account.
21 See Adopting Release, supra note 1, at 49252. See also Instruction 3 to Form ADV, Part 2B and Rule 204-3.
22 Instruction 9 to Form ADV, Part 2B.
23 Rule 204-3(g).
24 See General Instruction 3 to Form ADV Part 2. An RIA may also make these disclosures to clients through means other than the Brochure and should consider doing so if the additional information or disclosures are so voluminous as to obscure the required information items.
25 General Instruction 8 to Form ADV Part 2A. Although neither the Adopting Release nor the Instructions include a clear discussion regarding the placement of the Permissible Summary (other than that it can be "at the beginning" of the Brochure), it would seem reasonable to place the Permissible Summary either directly before or following the Brochure's table of contents. It should be noted that: (i) the option to include a Permissible Summary is distinct from the requirement to provide a Material Changes Summary to prior recipients of a Brochure and (ii) the Permissible Summary may not serve as a substitute for the Material Changes Summary. If the Material Changes Summary is included in the Brochure itself (rather than, as permitted by the Part 2 Amendments, through a separate document), the Permissible Summary cannot precede the required Material Changes Summary (which is required to be placed on or immediately following the Brochure's cover page).
26 Although the items must be presented in sequential order, it is useful to consider the disclosures that will be required in a Brochure on a functional basis, as doing so may assist an RIA in transitioning from its existing Part II Brochure(s) or other disclosure documents (e.g., private fund PPMs for advisers that anticipate registering as a result of Dodd-Frank).
27 The 2008 Part 2 Proposal would not have required the Brochure to present information in any specified order. 2008 Part 2 Proposal, supra n. 4, at 14005. In adopting the requirement that an RIA present information under the headings and in the order set forth in the instructions to Form ADV, the SEC explained that consistent formatting would "facilitate investors' comparison of multiple advisers." Adopting Release, supra note 1, at 49235.
28 General Instruction 2 to Form ADV Part 2.
29 Items 1 and 2, respectively, of Form ADV Part 2A.
30 Item 1.B of Form ADV Part 2A requires, substantively, the following disclosure: This brochure provides information about the qualifications and business practices of [RIA]. If you have any questions about the contents of this brochure, please contact [name and telephone contact information]. The information in this Brochure has not been approved or verified by the United States Securities and Exchange Commission or by any state securities authority. Additional information about [RIA] also is available on the Internet at http://www.adviserinfo.sec.gov.
31 Item 1.C of Form ADV Part 2A. While it is not generally misleading to truthfully disclose an RIA's registration status, Section 208(a) makes it unlawful to represent or imply that such registered status means that the RIA's "abilities or qualifications have in any respect been passed upon by the United States or any agency or any officer thereof."
32 The Adopting Release states that the Material Changes Summary "should not be a lengthy discussion that replicates the Brochure itself. Instead, the summary need contain no more than necessary to inform clients of the substance of the changes to the [RIA's] policies, practices or conflicts of interests so that they can determine whether to review the [B]rochure in its entirety or to contact the [RIA] with questions about the changes." Adopting Release, supra note 1, at 49237 (emphasis in original).
33 In these cases, the Material Changes Summary must be included in the same text-searchable PDF as the Brochure to which it relates. The Instructions to Form ADV Part 2A also note that if an RIA includes the Material Changes Summary in the Brochure itself and "update[s its] Brochure between annual updating amendments, [the RIA] should consider whether [it] should update the summary as part of that[,] other than annual[,] updating amendment." Instruction 6 to Form ADV Part 2A.
34 Item 3 of Form ADV Part 2A.
35 Items 4 (Advisory Business), 7 (Types of Clients) and 8 (Methods of Analysis, Investment Strategies and Risk of Loss) of Form ADV, Part 2A.
36 An RIA is not currently required to include, in its Part II Brochure(s), information about its assets under management. Rather, Part 1 of Form ADV includes, in Item 5.F(2), a requirement that assets under management be disclosed annually in order to establish whether an RIA has sufficient assets to be eligible for registration with the SEC. As a result, Part 1 uses a calculation mechanism different from those often used by RIAs when, for example, responding to requests for proposals ("RFPs"). To allow an RIA to provide its clients a better sense of its advisory business, the Part 2 Amendments allow an RIA to calculate assets under management in a manner different from that used for Item 1, provided that the RIA maintains (in a separate document that need not be provided to clients or included in the Brochure filing) records describing that calculation mechanism.
37 Currently, Part II does not require identification of principal owners (as such), though various items of Part II may have the effect of causing an RIA to include information about a principal owner (e.g., Item 6, which requires biographies of principal officers and investment personnel, might cause an RIA to disclose a principal owner who is a natural person or Item 8, which requires disclosure of an RIA's material business relationships with certain affiliates, might cause an RIA to disclose a principal owner that is an entity). Schedules A and B of Part 1 also require disclosure of an RIA's owners.
38 According to Item 4.B of Form ADV Part 2A, specialized services would include, among others: quantitative analysis, market timing and financial planning. Some degree of disclosure about these services is currently required by Part II (e.g., Item 1.B requires an RIA to disclose if it refers to any of its advisory services as "financial planning or some similar term" and Item 1.A(8) requires an RIA to disclose the percentage of its billings that result from providing a "timing service"). In addressing concerns raised about this requirement in connection with the 2000 Proposal, the 2008 Part 2 Proposal carefully noted that the "reason for requiring [RIAs] to identify their specialized advisory services . . . is not that [the SEC] believe[d] that those specialties inherently pose additional risks to clients."
39 For example: Item 1 of the existing Part II requires an RIA to disclose the nature of the advisory services it provides; Item 2 of the existing Part II requires an RIA to disclose the types of clients it services; Item 3 of existing Part II requires an RIA to disclose the types of investment instruments as to which it provides advice; Item 4 of existing Part II requires an RIA to disclose information about its analytical methods and investment strategies; Item 10 of existing Part II requires an RIA to disclose information about account requirements (including investment minimums); and Item 11 of existing Part II requires an RIA to disclose how it reviews and reports on client accounts. An RIA may choose to describe, on Schedule F, specific information about relevant risks, but the current form does not explicitly require such disclosure.
40 The SEC cautions additionally that "more detail [would be required] if those risks are unusual." This "is intended to elicit from the [RIA] disclosure of significant risks associated with using a particular investment strategy or recommending a particular type of security that otherwise would not be apparent to the client from reading the [RIA's] brochure." Adopting Release, supra note 1, at 49239-40.
41 Although an RIA that offers generalized or a wide variety of advisory services need not include specific disclosure about particular risks in its Brochure, such an RIA may still be required to disclose relevant material risks to its clients. However, "the [B]rochure may not always be the best place for a multi-strategy adviser to disclose risks associated with some or all of its methods of analysis or strategies [as such disclosure] likely would lengthen the [B]rochure unnecessarily given that different clients would be pursuing different strategies, each of which poses specific and different risks," while clients may only wish to consider the risks to which they are exposed. Adopting Release, supra note 1, at 49239. While an RIA is permitted to include all relevant risk disclosure in a single Brochure if it so desires, RIAs are cautioned to observe the Plain English requirements and other expectations as to clarity and ease of use set forth in the form instructions and the Adopting Release. Where a Brochure would become so long as to be of limited use to clients if all strategyspecific risks and related disclosures were to be included, an RIA may wish to consider other avenues for making such disclosure available to its clients, including through client contracts, supplemental disclosure documents or offering documents relevant to a particular strategy, which would be provided together with a streamlined Brochure disclosing general risk factors in a manner consistent with the Adopting Release, as described above. Alternately, as noted above, the RIA could create different Brochures to better describe the particular services offered to its different clients.
42 In the 2008 Part 2 Proposal, the SEC requested comment as to whether and, if so, how "frequent trading" should be defined and noted that commenters to the 2000 Proposal had pointed out that "the term 'frequent' is relative both to the client (i.e., an investment strategy involving frequent trading that is inappropriate for one type of client may be appropriate for another), and to the security being traded." 2008 Part 2 Proposal, supra note 4, at 13963. Although the SEC declined to define the term "frequent trading," the Adopting Release indicates that the SEC "would expect [RIAs] to respond to this item only if their intended investment strategies involve frequent trading of securities that a reasonable client would otherwise not expect in light of the other disclosures contained in the [B]rochure." Adopting Release, supra note 1, at 49239. Thus, whether an RIA has to include frequent trading disclosure may depend on the nature of the strategy and how it is executed. In some cases, a strategy may, inherently, involve frequent trading while, in other cases, an RIA may need to make this disclosure if it executes trades at a frequency which is materially in excess of the norm for a particular strategy.
43 Adopting Release, supra note 1, at 49239.
44 Items 5 and 6, respectively, of Form ADV Part 2A.
45 Brochures delivered only to "qualified purchasers," as defined in the 1940 Act, need not include a description of how the RIA is compensated for its services (including fee schedules and negotiability). It seems reasonable that if the only clients to whom an RIA must deliver a Brochure are qualified purchasers, the RIA should be able to omit fee schedules and related disclosure from the Brochure(s) that it files through the IARD. A note to Item 5.A of Form ADV Part 2A indicates that this exception is available only to an RIA that is registered with the SEC. Thus, State-Only RIAs will need to consult with the relevant state authorities to determine whether such disclosure is required to be made to their qualified purchaser clients.
46 The current Part II Brochure requires an RIA to indicate the types of fees charged and to disclose, among other things: (i) their "basic fee schedule; (ii) how fees are charged; and (iii) whether fees are negotiable [as well as] when compensation is payable, and if [in advance,] how a client may get a refund or may terminate an investment advisory contract before its expiration date." Items 1.C and 1.D of Form ADV Part II. Although the current Part II does not explicitly require disclosure of conflicts of interest related to advisory fees, many RIAs do disclose relevant conflicts in their Brochures.
47 Such other expenses may include commissions, commission equivalents and other expenses associated with the custody or trading of portfolio securities, fund expenses where an account is invested in funds, etc. An RIA may wish to cross-reference the portion of the Brochure that discusses the RIA's brokerage and custody practices in connection with this disclosure.
48 An RIA that primarily recommends to its clients investments in mutual funds would be required to indicate whether the RIA recommends no-load funds.
49 Currently, Part II does not explicitly require any disclosure regarding an RIA's performance fee arrangements. However, an RIA charging such fee is required to check Item 1.C(6) of Form ADV Part II (indicating that it charges a type of fee not otherwise listed in Item 1.C) and typically must include some disclosure with respect to such performance fee (including the rate of the performance fee in connection with relevant fee schedules) in its Part II Brochure.
50 The classical "side-by-side management" situation exists when an RIA manages a hedge fund that charges a performance fee and a registered fund that does not. However, RIAs should be aware that these conflicts relate to the types of fees charged to (as well as other interests the RIAs may have in) the respective accounts and not to the type of client.
51 Items 12 (Brokerage Practices), 15 (Custody), 16 (Investment Discretion) and 17 (Voting Client Securities) of Form ADV Part 2A.
52 Item 12 of current Part II.
53 Such arrangements would need to be described with sufficient particularity for recipients of the Brochure to "understand the types of products or services the [RIA] is acquiring and permit them to evaluate associated conflicts of interest." Adopting Release, supra note 1, at 49243. Additionally, an RIA would be required to "[d]isclose whether [the RIA] seek[s] to allocate soft dollar benefits to client accounts proportionately to the soft dollar credits the accounts generate." Id. Depending on the nature of the soft dollar items used, such an allocation may not be possible.
54 An RIA that does not aggregate trades would be expected to disclose this fact and the resulting potential costs to clients as a result of not aggregating.
55 With respect to investment (as opposed to brokerage) discretion, the SEC expressed concern that, for example, "clients may not understand that they may ask the [RIA] not to invest in securities of particular issuers." Adopting Release, supra note 1, at n. 167.
56 Disclosure of cash solicitation arrangements is covered in a separate item.
57 An RIA that separately provides its own account statements must include language "urging" clients to compare such statements with those received from their qualified custodian. Although not addressed in the Instructions or the Adopting Release, it would seem appropriate that an RIA that has custody only as a result of its management of a private fund for which it or a related person is a general partner or managing member and which relies on delivery of annual audit reports to investors ("annual audit method"), rather than custodial statements, could either disclose its use of the annual audit method or answer this item as "not applicable." An RIA should also note recent amendments to Part 1 of Form ADV, effected in connection with recent amendments to Rule 206(4)-2 under the Advisers Act ("Custody Rule"), that require an RIA to disclose additional information about its custodial arrangements in response to Items 7 and 9 of Part 1 and Section 7.A of Schedule D (the "Part 1 Custody Amendments"). See Custody of Funds or Securities of Clients by Investment Advisers, Rel. No. IA-2968 (Dec. 30, 2009); 75 FR 1456 (Jan. 10, 2010).
58 Item 17 of Form ADV Part 2 requires disclosure regarding whether (and, if so, how) clients may direct the RIA regarding a particular proxy solicitation.
59 Items 10 (Other Financial Industry Activities and Affiliations), 11 (Code of Ethics, Participation or Interest in Client Transactions and Personal Trading) and 14 (Payment for Client Referrals).
60 Currently, this information is disclosed in response to Items 8, 9 and 13.B, respectively, of Part II. Of these, only Item 9 explicitly requires disclosure of the conflicts related to such arrangements. However, as a practical matter, most RIAs that disclose that they engage in such relationships also provide information about the related conflicts and how such conflicts are addressed.
61 For example, where an RIA receives compensation directly from such advisers, or the amount of fees an RIA receives increases or decreases based on the fees charged by such advisers (i.e., where the advisory fee does not change on an overall basis but the RIA keeps more or less of the fee depending on the fees charged by such advisers), the RIA would need to disclose that fact, as well as the nature of related conflicts and any processes the RIA has in place to address them.
62 While the new Part 2 would not require disclosure, in the Part 2A Brochure, regarding cash payments to employees in respect of client solicitations, such information must be included in the relevant Supplement, as discussed below. Moreover, as noted above, the new Part 2 addresses circumstances where an RIA directs brokerage to compensate a broker for client referrals in Item 12 (Brokerage Practices). In some cases, it may be appropriate to crossreference that discussion.
63 Items 9 and 18, respectively.
64 Item 11 of Part 1 and related DRPs (disclosure reporting pages) require an RIA to check-the-box and provide supporting details (including limited narrative) with respect to certain criminal, civil or regulatory actions involving the RIA or its related persons. Rule 206(4)-4 requires affirmative disclosure of some (but not all) of these events, as well as information about financial infirmities. While Rule 206(4)-4 does not mandate that such disclosure be included in an RIA's Part II Brochure, some RIAs choose to use the Part II Brochure to make such disclosures.
65 In connection with the Part 2 Amendments, the SEC has withdrawn Rule 206(4)-4 as duplicative. Adopting Release, supra note 1, at 49235.
66 For purposes of Part 2, the term "management person" would include "[a]nyone with the power to exercise, directly or indirectly, a controlling influence over [the RIA]'s management or policies, or to determine the general investment advice given to . . . clients." Item 23 of Form ADV Glossary. This would appear to create a narrower scope than that of Part 1, Item 11, which requires disclosure of events involving the RIA or its "advisory affiliates."
67 An event which is "so serious that it remains material" would need to be disclosed even beyond the ten year period. Item 9 of the new Part 2.
68 Item 9 of the new Part 2 sets forth a list of actions and proceedings presumed to be material. However an RIA would not be required to disclose events if the RIA determines that the materiality presumption is rebutted. In making this determination, RIAs must consider (i) the proximity of the person involved to the advisory function; (ii) the nature of the infraction; (iii) the severity of related sanctions; and (iv) the time elapsed. If an RIA chooses to exclude an event for which it determines it has rebutted the materiality presumption, the RIA must retain, in its records, a memorandum explaining the grounds for such determination.
69 Item 14 of Form ADV Part II imposes a similar requirement (though the Part 2 Amendments adjust the dollar threshold for an RIA other than a State-Only RIA upwards from $500 to $1,200). The balance sheet requirement does not apply to any RIA that is: (i) a qualified custodian under the Custody Rule or (ii) an insurance company. State-Only RIAs will need to confirm these requirements with applicable state regulators.
70 Item 18.B of Form ADV Part 2A.
71 Item 18.C of Form ADV Part 2A.
72 Oddly, no similar interim delivery requirement is included in the Part 2 Amendments with respect to new or revised financial event disclosures, although such disclosure may be necessary given the fiduciary nature of advisory relationships. An RIA could discharge an obligation to disclose such information by means other than interim Brochure delivery.
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