Keywords: Form ADV Part 2, updates, investment advisers
As we enter the fourth quarter of 2012, investment advisers registered with the US Securities and Exchange Commission (SEC) should begin thinking about the annual update to Form ADV Part 2 (the Brochure). An early start can be particularly helpful for advisers to private funds that may be in the midst of preparing their first Forms PF—an intensive undertaking (as advisers that filed Form PF in August 2012 can attest). Whether you are about to encounter Form PF for the first time, or you are approaching the annual update of your Brochure for the end of March deadline, you might want to start the process sooner rather than later.
With that in mind, there are a few lessons from the past three quarters that are worth keeping in mind as you prepare for your annual update.
Verify Professional Designations and Other Personnel Disclosures. Consider verifying all professional designations used by supervised persons in your Form ADV Part 2B brochure supplements. In a recent case, the SEC noted that an adviser failed to verify an employee’s claim that he was a Chartered Financial Analyst (CFA).1 The employee faked an email from the CFA Institute congratulating him on passing the Level III CFA exam and provided it to the adviser’s compliance department. Among other things, the SEC faulted the adviser for failing to verify the employee’s claim while allowing the employee to use the CFA designation in firm marketing materials. For many professional designations, the adviser can take reasonable steps to verify credentials simply by searching membership directories available online for each applicable organization—for example, the CFA Institute’s directory is searchable; for other organizations, a phone call or email may be required. Advisers should also consider whether to verify other information, such as educational background and prior employers (some firms have already done these reviews as part of background checks and OFAC reviews upon hiring). These reviews can take time, so an early start is important.
Review Firm Ownership Disclosures in Form ADV. Take a closer look at how the firm’s ownership is disclosed on Schedules A and B of Form ADV. The SEC recently sanctioned an adviser for, among other things, failing to properly disclose the ultimate owners of an intermediary holding company on the adviser’s Schedule B.2 In the case of a closely held adviser with intermediate owners, it may be helpful to refer to an organizational chart and ask at each level: Is this entity disclosed? Is there an owner, a general partner, a managing member or a trustee of this entity that needs to be disclosed?
Assess Your Conflicts of Interest Inventory. Review your disclosure regarding when and how the adviser may purchase securities for client accounts in which the adviser, or its related persons, has a financial interest. The same case discussed immediately above also involved a failure to disclose conflicts of interest in the Brochure. The adviser invested its clients’ discretionary accounts in a start-up without disclosing to those clients that the owner/managing member and a former principal of the adviser were founders and shareholders of that start-up company.3
Re-assessing your inventory of conflicts of interest when updating your Brochure is always a good idea. If your inventory identifies new conflicts, make sure that (i) all conflicts are properly disclosed to clients in your Brochure and otherwise; (ii) you have adequate policies and procedures in place to address those conflicts; and (iii) the policies and procedures are summarized appropriately in your Brochure.
Follow the Money. When taking inventory of your conflicts of interest, it is always a good idea to “follow the money.&rdquo This point was driven home in a recent SEC action against an adviser alleging, among other things, several violations stemming from the adviser’s failure to disclose how it was being compensated. For example, the SEC alleged that the adviser failed to disclose a revenue sharing arrangement with a broker that created an incentive for the adviser to recommend certain mutual funds to clients.4 When reviewing your Brochure, identify and list all revenue streams and ask yourself: Have we disclosed this source of revenue? Does this source of revenue create conflicts that we should address (and if they are addressed, have we disclosed to clients how we address them)?
Do not Forget to “Check” Your (New) CFTC Status. Given all of the changes in regulations from the Commodity Futures Trading Commission this year, many advisers have registered or filed exemptions from registration as commodity pool operators and commodity trading advisors. Do not forget to update your answers to Form ADV Part 1 Items 6.A(3) and 7.A(6), and Section 7.A(5)(f) in Schedule D. These questions ask whether you or any affiliate are commodity pool operators or commodity trading advisors—whether registered as such or exempt from registration.
Impact of Form PF. Because Form PF is triggered by advising “private funds” (i.e., funds relying on the exceptions in Section 3(c)(1) or (7) under the Investment Company Act of 1940), advisers seeking to avoid a Form PF filing obligation—particularly real estate managers—may want to look at whether alternative exceptions are available. However, in doing so, keep in mind that classifying a fund as not being a “private fund” can affect your calculation of “regulatory assets under management” in Form ADV, as “private funds” are treated differently for ADV AUM calculation purposes than other pooled investment vehicles. However, if Form PF is unavoidable (not to mention Section 7.B of Form ADV Schedule D), exercise caution when characterizing your private funds.
As defined, the term “hedge fund” may, due to leverage or other considerations, encompass some private funds that might commonly, outside of the context of these forms, be referred to as “private equity” or “real estate” funds (e.g., give careful consideration to mortgages and other leverage incurred by special purpose vehicles that purchase property on behalf of a fund).
As a general matter, remember that any material updates to your Brochure need to be reported in Item 2 as material changes. Newly disclosed conflicts of interest should generally be considered a material change.
Originally published October 11, 2012
1 See In the Matter of Jason A. D’Amato, SEC Release No. 34-67773 (Aug. 31, 2012), available at http://www.sec.gov/litigation/admin/2012/34-67773.pdf.
2 See In the Matter of Belsen Getty, LLC, Terry M. Deru, and Andrew W. Limpert, SEC Release No. 33-9336 (July 11, 2012), available at http://www.sec.gov/litigation/admin/2012/33-9336.pdf.
4 See In the Matter of Focus Point Solutions, The H Group, Inc., and Christopher Keil Hicks, SEC Release No. IA-3458 (Sept. 6, 2012), available at http://www.sec.gov/litigation/admin/2012/ia-3458.pdf.
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