Ten years after it was originally proposed, the Securities and Exchange Commission (the “SEC”) recently adopted long-anticipated amendments to Part 2 of Form ADV1 – the uniform form used by investment advisers to register with both the SEC and state securities authorities. The amendment largely adopts language proposed by the SEC in 2008, and significantly alters the presentation (and, in some cases, the substance) of disclosure regarding business practices, conflicts of interest, fees and disciplinary information. The goal of the amendments is to encourage disclose of meaningful information in a more clear format in order to facilitate understanding. In particular, the changes required by the amendments focus on disclosure of the particular personnel servicing the client receiving the Form ADV Part 2, relevant conflicts of interest, and the potential effect of those conflicts on the firm’s service to the client.
Prior to these amendments, Form ADV Part 2 required that investment advisers respond to a series of multiple- choice “check-the-box” disclosure statements, supplemented by a brief narrative explanation of certain answers. Currently, Form ADV Part 2, commonly known as “the brochure,” is required to be delivered to clients at the time of entering into an advisory arrangement and must be offered to clients at least annually. When the new Form ADV Part 1 went into effect a decade ago, Form ADV Part 2 was not updated. Moreover requirements were changed at the time such that it was no longer required to be filed with the SEC. Instead it has been required to be maintained in the files of the adviser, and generally only reviewed by the SEC during routine examinations.
Due to the formulaic and limited nature of the questions contained in the Form ADV Part 2, over the years, the staff of the SEC has informally created additional disclosure requirements through comments during routine examinations of advisers (and sometimes through comments in releases on various topics). These additional disclosures were often inserted as explanations for questions that seemed to have very little relation to the disclosure. Accordingly, clients and prospective clients have had to deal with a disclosure document that contained information that oftentimes seemed unclear and just plain confusing.
The amended Form ADV Part 2 consists of three different sections:
- Part 2A, the part that will continue to be referred to as “the brochure,” requires that investment advisers provide clients and prospective clients with a standardized, plain English disclosure statement that they are likely to read and understand. Amongst other items, the disclosure must describe the investment adviser’s business, conflicts of interest, disciplinary history and other important information that will help clients make an informed decision about whether to hire or retain that adviser.
- Appendix 1 to Part2A, known as the “wrap fee program brochure,” will contain information substantially similar to that which was disclosed in Schedule H to the former Part 2. Advisers that sponsor wrap fee programs, or separately managed accounts that include investment advice, brokerage and often custody for a single fee, will need to file and distribute the wrap fee program brochure in lieu of the adviser’s standard brochure.
- Part 2B is new and is referred to as the “brochure supplement.” The brochure supplement includes information about specific individuals under the investment adviser’s supervision who either (i) formulate investment advice for a specific client and have direct client contact; or (ii) make discretionary investment decisions with respect to a specific client’s assets.
The amended rules and forms will be effective 60 days after publication in the Federal Register, or October 12, 2010. According to the rules, each adviser applying for registration with the SEC after January 1, 2011, must file brochures that meet the requirements of the amended Part 2A as part of their application for registration on Form ADV. Each adviser registered with the SEC whose fiscal year ends on or after December 31, 2010, must include a brochure that conforms with amended Part 2A when it files its next annual updating amendment and in any event, no later than March 31, 2011. The amended forms contain the minimum information an investment adviser is required to file with the SEC and/or deliver to clients and prospective clients. In the Adopting Release, the SEC stressed that compliance with the new Form ADV does not supersede any duties an investment adviser has as a fiduciary. Additionally, the SEC noted that an adviser may have an additional duty to disclose material changes to information that could affect the advisory relationship, even if those changes do not trigger delivery of an interim amendment under the amended rules.
Part 2A – The Brochure
The SEC’s stated goal in amending Part 2A is to ensure all registered investment advisers provide prospective and existing clients with a narrative brochure written in plain English. The new amended rules stress that advisers should use short sentences; definite, concrete, everyday words; and the active voice in drafting the brochure. A brochure produced under the new rules should focus on the adviser’s practices that are pertinent to its specific audience(s), and should only discuss conflicts that the adviser has or is reasonably likely to have; the SEC made clear that the new brochure is not to be treated as a general waiver of liability.
Form and Content
The General Instructions to Part 2 mandate that an adviser provide its information in a specified format. An adviser must respond to each item in the form, and must present the information in the order of the items listed in the form, using headings provided by the form. The specified format is intended to facilitate an investor’s comparison of multiple advisers. However, advisers have been given some flexibility to tailor their brochure(s). For instance, an adviser may create separate brochures for different types of advisory clients. The separate brochure may then be shorter, clearer and contain less extraneous information than would a combined brochure. This essentially formalizes an informal position of the staff of the SEC that historically permitted an adviser to use multiple Part 2 brochures. Advisers offering more complicated advisory services might also prefer to include a summary at the beginning of their brochure, followed by more detailed discussions of each item.
The new brochure must contain a written response for 18 separate items, each covering a different disclosure topic. Much of the disclosure required under the amended Part 2A consolidates disclosure statements an adviser would have previously had to disclose as a fiduciary. The new rules place particular importance on disclosing conflicts of interest, but also require that the adviser explain how each conflict or potential conflict will be addressed. In addition to including organizational items such as a cover page and a table of contents, of note, an amended Part 2A brochure must contain:
A summary of material changes in an adviser’s brochure since the previous annual update.
The types of services that an adviser or advisory firm offers, as well as whether it holds itself out as specializing in a particular type of advisory service, and the amount of client assets it manages.
Fees and Compensation
A description of how an adviser is compensated for its advisory services, a fee schedule, a disclosure as to which fees, if any, are negotiable, payment methods, the frequency with which fees are assessed and a description of the types of other fees or expenses that clients may pay. Should an adviser receive compensation on a performance- based model for some, but not all, accounts, the adviser must also disclose the conflicts of interest that may arise from its simultaneous management of these accounts and how it addresses these conflicts.
Methods of Analysis, Investment Strategies and Risk of Loss
A description of the adviser’s methods of analysis and investment strategies, including the material risks involved for significant investment strategies and methods of analysis and for any type of security that the adviser primarily recommends. Advisers should specifically explain how strategies involving frequent trading can affect investment performance, particularly through increased costs and taxes, and generally disclose that investing in securities involves risk of loss that clients should be prepared to bear.
A comprehensive disclosure about any legal or disciplinary event that is material to a client’s evaluation of the integrity of the adviser or its management personnel. Certain events listed in this item, such as fraud or theft, are presumed to be material, and must be disclosed if they occurred within the past 10 years. Should an adviser add new disciplinary information, or should material information that was previously disclosed change, an adviser must promptly provide clients with updated information on the disciplinary event.
Financial Industry Activities and Affiliations
A description of any material relationships the adviser or its managing personnel has with related financial industry participants. Specifically, an adviser must address how the relationships might impair the adviser’s ability to give objective investment advice and how the adviser addresses those conflicts. Code of Ethics, Participation or Interest in Client
Transactions and Personal Trading
A description of an adviser’s code of ethics and a statement that a copy of the code of ethics is available upon request. Additional disclosures are required if the adviser (i) recommends to clients, or buys or sells for client accounts, securities in which the adviser has a material financial interest; (ii) invests in the same securities that it recommends to clients or in related securities; or (iii) trades in recommended securities at or around the same time as a client.
An explanation of how the adviser selects brokers for client transactions and determines the reasonableness of brokers’ compensation. Advisers must also disclose practices involving the receipt of soft dollar benefits; use of a particular broker as a reward for client referrals; routinely recommending, requesting, or requiring that clients be directed to a particular broker; and trade aggregation, or bundling trades to obtain volume discounts on execution costs, and conflicts of interest arising from these practices.
Proxy Voting Practices
A description the firm’s proxy voting policies, much like that required under the proxy voting rule (Rule 206(4)-6). Of note, the SEC did not adopt a proposed requirement to provide detailed information regarding the adviser’s use of third-party proxy voting services and how the adviser pays for such services.
As should be obvious to registered advisers, many of these topics are ones already covered by Part 2. However, the new focus on comprehensive and plain English disclosure set forth in the amendments will require a complete re-write of Part 2. Now, instead of simply responding to questions, the Part 2 will be much more like a short prospectus or private placement memorandum in its look, feel and objective.
Delivery and Updates
With these amendments, advisers will now, once again, be required to file their Form ADV Part 2 with the SEC and keep their filed brochures current by updating them with the SEC at least annually, which will be available to the public online. An adviser must also promptly update its brochure when any information other than the amount of assets under management materially changes. Annual and interim updates of an adviser’s brochures should be created using a text-searchable Adobe Portable Document Format (“PDF”) and must be filed electronically through the SEC’s Investment Adviser Registration Depository (“IARD”).
The new rules somewhat relax the requirements for delivery to clients and prospective clients. The current rules require delivery to a client at least 48 hours before entering into the advisory agreement (or at the time of entering into an agreement if the client has the right to terminate the agreement without penalty within five business days). The amended rules simply require that an adviser deliver a current brochure before or at the time it enters into an advisory contract with the client. Moreover, the amended rules do not require an adviser to deliver brochures to certain advisory clients receiving only impersonal investment advice or to clients that are designated as business development companies or investment companies registered under the Investment Company Act of 1940.
In another departure from the old rules, the amended rules require that advisers provide clients with an annual update to their brochure within 120 days after the end of their fiscal year. The annual update must consist of either: (i) a copy of the current brochure including or accompanied by the summary of material changes; or (ii) a summary of material changes that includes an offer to provide a copy of the current brochure. Advisers must promptly provide clients with an interim updated brochure only if the adviser amends its brochure to add a disciplinary event or to change material information pertaining to disciplinary information previously disclosed.
Appendix 1 to Part 2A – The Wrap Fee Program Brochure
The disclosure items contained in the wrap fee program brochure are substantially similar to Schedule H of the previous Part 2. Under the amended rules, advisers that sponsor a wrap fee program will prepare and distribute a wrap fee program brochure in lieu of a brochure completed according to the information required in Part 2A. An investment adviser may prepare a single wrap fee program brochure describing all the wrap fee programs it sponsors, or it may prepare separate wrap fee program brochures to describe one or more wrap fee program.
An investment adviser must file an updated wrap fee program brochure each year at the time it files an annual updating amendment. Also, an adviser must promptly file an update whenever any information in the wrap fee program brochure becomes materially inaccurate. The wrap fee program brochure must be delivered only to those clients subject to the wrap fee agreement, and it must address only the wrap fee programs sponsored by the adviser. Like the Part 2A brochure, the wrap fee program brochure must be accompanied by all of the applicable brochure supplements.
Part 2B – The Brochure Supplement
Each brochure must be accompanied by brochure supplements providing information about the advisory personnel servicing the particular client receiving the brochure. The supplement is intended to provide a client or prospective client with insight to the character and integrity of those who actually provide investment advice and interact with the client. An adviser need not file the brochure supplement or any amendments with the SEC, and they will not be available on the SEC’s public website.
Form and Content
Much like the brochure, the brochure supplement must be written in plain English. However, an adviser is given substantial flexibility to present the information in a format best suited to the particular advisory firm. For instance, advisers may include the supplement information within the firm’s brochure, an approach that may be attractive to smaller firms with few persons for whom they will have to prepare supplements. Alternatively, an adviser can elect to prepare a separate brochure supplement for each supervised person or for different groups of supervised persons. Consistent with the spirit of the amended rules to promote comparability of information, the brochure supplement must be organized in the same order and contain the same headings as the items appear in the form.
The amended Part 2B provides information regarding supervised persons in a fashion that essentially amounts to a standardized resume. The brochure supplement consists of the following six items:
- Cover page identifying the supervised persons;
- Formal educational background and business experience for the past five years;
- Disciplinary information that is “material to a client’s evaluation of the supervised person’s integrity;”
- Other business activities in which a supervised person participates;
- Additional compensation from someone other than the client, e.g., sales award or other prize, for providing advisory services; and
Delivery and Updates
Subject to certain exceptions, an adviser must deliver a brochure supplement for each supervised person who: (i) formulates investment advice for the particular client and has direct client contact; or (ii) has discretionary authority over the particular client’s assets, even if the supervised person has no direct client contact. In the event that a specific client will receive discretionary advice from a team comprised of more than five supervised persons, the brochure supplement need only be provided for the five supervised persons with the most significant responsibility for the day-to-day discretionary advice provided to that client. A supplement must initially be given to each client at or before the time the supervised person begins to provide advisory services to that particular client. There is no requirement that advisers deliver an annual supplement to existing clients.
As with the brochure, advisers must promptly amend a brochure supplement if information in it becomes materially inaccurate. Specifically, an updated brochure supplement is required to be delivered if a new disciplinary event is disclosed, or if there is a material change to disciplinary information already disclosed. New clients to whom the adviser is obligated to deliver a supplement under the amended rule must be given either an amended supplement, or an ‘old’ supplement and a sticker.
The amended rules substantially alter the way investment advisers prepare their client disclosure brochures and annual renewal amendments. The minimal thought often given to the offer of the Form ADV Part 2 at the end of March, will be replaced this time with a significant project requiring a complete re-write of the brochure disclosure. The changes are largely designed to provide clients and prospective clients with a succinct and plain English set of disclosures that allows them to compare the integrity, qualifications and background of advisers in competing firms. Although the specific requirements of the amended rules are designed to promote full disclosure, investment advisers may need to disclose additional information to satisfy their fiduciary duty to clients, and careful thought should be given to the additional information that would be relevant to a client.