The Securities and Exchange Commission (SEC) has approved the new Form ADV Part 2, requiring a “plain English” narrative approach to client disclosure requirements, instead of the “check-the-box” approach most registered investment advisers have used for years.

A lawyer might not be the first person you think of when looking for someone to help you with a “plain English” anything. The team at Pepper Hamilton, however, has helped advisers prepare disclosures, and we have recently completed several “plain English” Form ADV Part 2 disclosures for a reasonable fixed fee. Please read the following background on the SEC’s new requirements, and if you need assistance with your next Form ADV Part 2, give us a call.

Who Is Affected?

Investment advisers who (i) are currently registered with the SEC, (ii) want to register with the SEC or (iii) have to register with the SEC, pursuant to the Dodd-Frank Bill.

Who Benefits from the Change?

Any person or entity that wants to hire a registered investment adviser to make investments on their behalf.

When Does It Become Effective?

January 1, 2011 for new registrants and March 31, 2011 for current registrants who must update their Form ADV.

Background

Since 1979, the SEC has required investment advisers to file Form ADV, a disclosure form. Currently, Part 2 of Form ADV (Part 2) requires registered investment advisers (RIAs) to make certain minimum disclosures to clients or prospective clients (the RIA Clients). However, they have a choice of making these disclosures in a check-the-box format (which includes “multiple choice” or “fill in the blank” questions) or a narrative format. Few RIAs use the narrative format. Effective October 12, 2010, the SEC has made narrative disclosures mandatory. The SEC also amended certain related rules under the Investment Advisers Act of 1940 (the Act) and withdrew Rule 206(4) 4, which had required RIAs to disclose certain disciplinary and financial information on the grounds that the former Rule was duplicative.

The primary objective of Part 2 of Form ADV is to enable RIA Clients to make informed decisions when hiring RIAs. The new Part 2 requires an RIA to make “plain English” disclosures about the RIA’s business, conflicts of interests and the disciplinary history of the RIA’s personnel. To achieve this objective the SEC split Part 2 of Form ADV into Part 2A (Part 2A), which contains 18 disclosure items to be made by RIAs, and Part 2B (Part 2B), which will include information about RIA personnel on whom the RIA Clients rely on for investment advice.

Additionally, Part 2A (along with Part 1 of Form ADV) and any amendments to it will now be filed electronically via the Investment Adviser Registration Depository (IARD), and be available for public inspection on the SEC Web site. Part 2B does not have tobe filed with the SEC but must be given to clients before the commencement of the advisory relationship and offered annually thereafter.

Effective Dates: Investment advisers who register for the first time with the SEC after January 1, 2011, must file Part 2A as part of the application for registration on Form ADV. Upon registration, such new RIAs must deliver to their RIA Clients Part 2A and Part 2B completed in accordance with the amended rules. Similarly, current RIAs whose fiscal year ends on or after December 31, 2010, will have to prepare and file their annual amendments and file a new Part 2A, no later than March 31, 2011. Thereafter, they have 60 days to distribute the new Part 2A and Part 2B to all RIA Clients.

Required Disclosures: The amendment, will require RIAs to disclose in detail information that would help RIA Clients make an informed decision about hiring them. The information will cover who the RIAs are, their methods and strategies, modes of compensation, types of clients they serve and the conflicts of interests that arise as a result of their strategies and their dealings. Below are certain required disclosures:

  • Material Changes. RIAs will now be required to update information in Part 2 regularly, and describe how the information differs from the prior years Part 2.
  • Advisory Business. The different types of advisory services provided by the RIAs will have to be listed and RIAs will be required to state their assets under management (AUM). RIAs will be permitted to use different methods to compute AUM under Part 1 of Form ADV and Part 2, provided they keep documentation describing the different method.
  • Fees and Compensation. In Part 2, RIAs will need to answer questions about how they are compensated, their fee schedules, whether fees are negotiable, and whether RIA Clients are billed or their fees are deducted directly from the their accounts. Also, other costs, such as brokerage, custody fees and fund expenses will have to be disclosed.
  • Performance Based Fees. Any performance based fees that are charged will have to set out. If RIAs manage accounts where performance based fees are not charged, RIAs will have to address the conflict that may arise between RIA Clients who are charged performance based fees and those that are not.
  • Type of Clients. Besides disclosing the type of RIA Clients, information about account requirements, such as minimum account size, must be disclosed.
  • Method of Analysis, Investment Strategies and Risk of Loss. Investment strategies will have to be described, analyzed and the risks associated with such strategies candidly described. RIA Clients will have to be made aware of how the investment strategies could affect investment performance.
  • Disciplinary Information. RIAs will be expected to list all the material facts about any legal or disciplinary events that RIA Clients would find material to evaluating the integrity of the RIAs and their personnel.
  • Other Financial Industry Activities and Affiliations. Part 2 will require disclosure of any material relationships or arrangements that RIAs have with related financial industry participants and any conflicts of interest arising from such relationships. If RIAs suggest any other advisers to their RIA Clients, then the RIAs’ fee arrangements (i.e., referral or finder’s fees) with the other adviser and the conflicts that may arise have to be disclosed.
  • Code of Ethics, Participation or Interest in RIA Client Transactions and Personal Trading. Part 2 requires a brief description of the RIA’s Code of Ethics, any existing practice of buying and selling securities in which the RIA or the RIA’s related persons have a material financial interest, and practices of personal trading by the RIA or related persons in the same securities as the RIA Clients.
  • Brokerage and Soft Dollar Practices. RIAs will have to disclose the process of selecting brokers and the reasonableness of broker’s compensation, including any soft dollar arrangements, client referrals, directed brokerage, and trade aggregation.
  • Review of Accounts. The RIAs will have to state whether and how often the RIA reviews accounts or financial plans of the RIA Clients, and also identify who conducts the review and what circumstances trigger the need for reviews other than the regular reviews.
  • Client Referrals and Other Compensation. Arrangements with and compensation paid to other persons by the RIAs or their related persons for client referrals will have to set out in Part 2.
  • Custody. In the event RIAs have custody of RIA Clients’ assets, RIAs will have to explain that RIA Clients will receive accounts statements directly from qualified custodians, and that such accounts should be carefully reviewed.
  • Investment Discretions. If RIAs have discretionary authority over client accounts, then such authority and the ability of the RIA Clients to limit such authority has to be disclosed.
  • Voting Client Securities. Proxy voting practices of the RIAs, similar to the requirements of rule 206(4)-6 of the Act, have to be described.
  • Financial Information. If an RIA requires prepayment of fees, they will have to provide the RIA Clients financial information, including but not limited to an audited balance sheet showing the RIAs assets and liabilities at the end of most recent fiscal year. RIAs also will need to explain what financial condition would impair the RIAs’ ability to meet contractual commitments to RIA Clients.

Cost: The SEC estimates that the initial time required to draft the new Part 2 would be 15 hours for small advisers, 97.5 hours for medium-sized advisers, and 3,300 hours for each large adviser. These estimates are only to prepare the initial Part 2 and do not include time spent by the adviser to collect the information required by Part 2 and to change Part 2 due to change in personnel and strategies.

Pepper Points

  • Old Wine in New Bottles. New Form ADV Part 2 requires disclosure of much of the same information always required to be disclosed in old Part 2, but in much more detail.
  • No More Guessing Games for Clients. As an RIA, you will be required to provide in “plain-English” all information that would help a client decide whether or not to hire you as an adviser.
  • Man-Hour Costs. Depending on the size of your firm, you will have to invest some initial time to complete the information required by Part 2 and additional time to supplement data as it developed. But don’t delay. March 2011 is not that far away, especially if you need to develop new disclosures.