Godfrey & Kahn Updates
September 10, 2010
On July 28, 2010, the SEC adopted long-anticipated final amendments to Part 2 of Form ADV and related rules under the Advisers Act, which will require SEC-registered investment advisers to provide clients with a narrative brochure. The amendments transform the current "check the box" format of the brochure to an entirely narrative format written in plain English. The amendments also impose additional disclosure requirements on advisers, including the requirement to provide clients with a brochure supplement containing information about certain adviser personnel who provide investment advice. Advisers will be required to file brochures electronically with the SEC, and the brochures will be made publicly available through the SEC's website.
The Brochure and the Brochure Supplement
The revised Form ADV Part 2 includes two subparts: Part 2A and Part 2B. Part 2A, referred to as the brochure, discusses the business practices, disciplinary history and conflicts of interest of the adviser. Part 2B, referred to as the brochure supplement, contains information about personnel of the adviser, including portfolio managers, upon whom clients rely for advice.
The SEC's adopting release instructs that an adviser must provide the information in the order of the items in Part 2 of Form ADV, using the headings provided by the form. If an item is inapplicable, the adviser must still include the heading and explain that the item does not apply. In preparing the Part 2 disclosure, an adviser should only discuss practices in which it engages or is reasonably likely to engage and conflicts of interest the adviser faces or is reasonably likely to face. Responses may include cross-references to other items. The SEC has emphasized that the brochure and brochure supplement should be written in "plain English" using short sentences, everyday words, the active voice and tables or bulleted lists.
Part 2A - Brochure
Part 2A of Form ADV contains 18 disclosure items that must be included in an adviser's brochure, including disclosure that advisers have long been required to make and certain additional disclosure items (as noted below):
- Item 1. Cover Page. An adviser must disclose certain identifying information on the cover page of its brochure. The cover page must also include a statement that the brochure has not been approved by the SEC or any state securities authority, and an adviser referring to itself as a "registered investment adviser" must include a disclaimer that registration does not imply a certain level of skill or training. (These are new disclosure requirements.)
- Item 2. Material Changes. An adviser amending its brochure must include a summary of material changes to the brochure since the last annual update. The summary may be presented either on the cover page, the page immediately following the cover page or as a separate document accompanying the brochure. (This is a new disclosure requirement.)
- Item 3. Table of Contents. An adviser must include a table of contents in its brochure that is detailed enough to permit clients to locate topics easily and that lists the items in the order and using the headings provided by Part 2. (This is a new disclosure requirement.)
- Item 4. Advisory Business. In contrast to the previous Part 2 "check the box" format concerning an adviser's services, an adviser will now be required to describe its advisory business, including the types of services offered, whether it holds itself out as specializing in a particular type of advisory service and the amount of client assets that it manages (the methodology for this calculation may differ from that used in Part 1A).
- Item 5. Fees and Compensation. An adviser must describe how it is compensated for its advisory services, provide a fee schedule and disclose whether fees are negotiable. The adviser must also describe the types of other costs that clients may pay in connection with the services provided, such as brokerage, custody fees and fund expenses. An adviser receiving compensation attributable to the sale of an investment product (e.g., brokerage commissions) must disclose this practice and the resulting conflict of interest and describe how the adviser addresses this conflict. Moreover, in this situation the adviser must also disclose that the client may purchase the same investment product from a non-affiliated broker.
- Item 6. Performance-Based Fees and Side-By-Side Management. An adviser that charges performance-based fees must disclose this practice. If, in addition to managing accounts in return for performance-based fees, such adviser manages accounts that do not pay performance-based fees, the adviser must explain the potential conflicts of interest arising from this simultaneous management. (This is a new disclosure requirement.)
- Item 7. Types of Clients. An adviser must describe the types of advisory clients it services and the adviser's requirements for opening or maintaining an account (e.g., minimum account size).
- Item 8. Methods of Analysis, Investment Strategies and Risk of Loss. An adviser must describe its significant investment strategies and the material risks that the strategies present and include disclosure that investing in securities involves risk of loss that clients should be prepared to bear. In addition, advisers are required to describe how strategies involving frequent trading can affect investment performance.
- Item 9. Disciplinary Information. An adviser must disclose material facts about any legal or disciplinary event that is material to a client's evaluation of the integrity of the adviser or its management personnel. (This item is subject to interim updates, as discussed further below.)
- Item 10. Other Financial Industry Activities and Affiliations. An adviser must describe material relationships or arrangements the adviser has with related financial industry participants and any material conflicts of interest that may result from these arrangements. If an adviser recommends other investment advisers to clients, the adviser must disclose any compensation arrangements or business relationships between the firms and any material conflicts of interest presented.
- Item 11. Code of Ethics, Participation or Interest in Client Transactions and Personal Trading. If an adviser recommends or trades in securities in which the adviser or a related person has a material financial interest, such practice and the related conflicts of interest must be discussed in the brochure. Additionally, the brochure must disclose personal trading by the adviser and its personnel and the resulting conflicts of interest. Each adviser must also describe briefly its code of ethics and state that a copy is available upon request.
- Item 12. Brokerage Practices. An adviser must describe how it selects brokers for client transactions and how it determines the reasonableness of brokers' compensation. Advisers must also disclose how they address conflicts of interest arising from their receipt of soft dollar benefits and describe their practices with respect to client referrals, directed brokerage and trade aggregation.
- Item 13. Review of Accounts. An adviser must disclose whether and how often it reviews clients' accounts or financial plans and who is responsible for the review.
- Item 14. Client Referrals and Other Compensation. An adviser must describe any arrangements under which it or its related persons compensate (using cash or non-cash compensation) another party for client referrals. In addition, an adviser must disclose any arrangement under which the adviser receives any economic benefit (e.g., sales awards or prizes) from a person who is not a client for providing services to clients.
- Item 15. Custody. An adviser with custody of client funds or securities must explain that clients will receive account statements directly from the qualified custodian, e.g., the bank or broker-dealer that maintains those assets. Advisers must also explain to clients that they should carefully review account statements received from qualified custodians and, if relevant, compare such account statements to the statements prepared by the adviser. (This disclosure requirement is similar to the requirement under the new custody rule.)
- Item 16. Investment Discretion. If an adviser has discretionary authority over client accounts, it must disclose this fact in the brochure, along with any limitations that clients may place on the authority.
- Item 17. Voting Client Securities. Advisers must disclose their proxy voting practices and whether they have or will accept authority to vote client securities. Advisers must also state that a copy of their proxy voting policies and procedures is available upon request.
- Item 18. Financial Information. An adviser that requires prepayment of fees, six months or more in advance, must give clients an audited balance sheet as of the end of its most recent fiscal year. Furthermore, an adviser must disclose any financial condition reasonably likely to impair the adviser's ability to meet contractual commitments to clients if the adviser: (1) has discretionary authority over client assets; (2) has custody over client funds; or (3) requires or solicits prepayments of more than $1,200 in fees per client and six months or more in advance.
Additional disclosure applicable only to state-registered advisers is also required in Part 2.
Part 2A Appendix I - The Wrap Fee Disclosure Program Brochure
Advisers that sponsor wrap fee programs will continue to be required to prepare a specialized brochure for their clients who utilize such programs. Appendix I to Part 2A contains the requirements for a wrap fee program brochure. These requirements are largely the same as those required in Schedule H of the previous Part 2 wrap fee program brochure.
Part 2B - Brochure Supplement
Part 2B of Form ADV adds a requirement that an adviser provide a client with a brochure supplement with information about each investment professional ("supervised person") who: (1) formulates investment advice for that particular client and has direct client contact; or (2) makes discretionary investment decisions for that client's assets, regardless of whether there is client contact. Advisers may prepare supplements for individuals or prepare combined group disclosures. The disclosure items required in the supplement include the following:
- Item 1. Cover Page. The cover page of the brochure supplement must identify the supervised person or persons covered by the supplement as well as the adviser.
- Item 2. Educational Background and Business Experience. The supplement must describe the formal education and business background of the supervised person for the past five years. If professional designations are included in the supplement, an explanation of the minimum qualifications required for the designation must be included.
- Item 3. Disciplinary Information. The supplement must describe any legal or disciplinary event during the last ten years that would be material to a client's evaluation of the integrity of a supervised person.
- Item 4. Other Business Activities. The supplement must describe any other business activities of the supervised person (in the investment industry or otherwise) and any conflicts of interest posed by such activities. In addition, information about any compensation the supervised person receives based on the sales of securities or other investment products and the related conflicts of interest must be disclosed.
- Item 5. Additional Compensation. If a non-client provides a supervised person with an economic benefit for providing advisory services, this arrangement must be described.
- Item 6. Supervision. The supplement must convey how the adviser monitors the advice provided by the particular supervised person. Moreover, the supplement must provide the client with the name, title and telephone number of the person responsible for supervising the advisory activities of the supervised person.
Delivery, Updates and Filing
Amendments to Rules 204-1 and 204-3 under the Advisers Act modify the delivery requirements for brochures, brochure supplements and updates to advisory clients. In addition, the brochure prepared pursuant to Part 2A of Form ADV must now be publicly filed with the SEC.
The brochure must be delivered to a client before or at the time the adviser enters into an advisory contract with a client (rather than within 48 hours of entering into a contract or at the time of entering into the agreement, subject to a five-day right to terminate by the client, as provided under the previous rules). An adviser is not required to deliver a brochure to clients that are federally registered investment companies, business development companies or clients who receive only impersonal investment advice for which the adviser charges less than $500 per year. Advisers that provide substantially different advisory services to different clients may deliver different brochures as long as each client receives all information about the services and fees that are applicable to that client.
A brochure supplement must be delivered to a client before or at the time that supervised person begins to provide investment advisory services to that client. Brochure supplements do not have to be delivered to:
- clients to whom an adviser is not required to deliver a brochure;
- clients who receive only impersonal investment advice; or
- certain "qualified clients" who also are officers, directors, employees and other persons related to the adviser.
Annual Delivery. Within 120 days after the end of an adviser's fiscal year, the adviser must provide its clients that are entitled to receive brochures with either:
- a copy of the current (updated) brochure that includes, or is accompanied by, the summary of material changes to the brochure; or
- the summary of material changes to the brochure with an offer to provide a copy of the current brochure.
These deliveries may be provided to clients electronically. Advisers are not required to deliver brochure supplements to clients annually.
Under the amended rules, an adviser will be required to deliver an updated brochure and/or brochure supplement whenever a new disciplinary event is added or a material change is made to the disciplinary information already disclosed.
An adviser must update its brochure promptly when any information in the brochure (except the summary of material changes and the amount of assets under management) becomes materially inaccurate. An adviser must deliver an updated brochure supplement only when there is new disclosure of a disciplinary event, or a material change to disciplinary information already disclosed. The brochure supplement must be amended promptly if information in it becomes materially inaccurate.
Advisers must electronically file the brochure with the SEC through the IARD system, as well the annual amendment (either the updated brochure or the summary of material changes) and any interim amendments required to keep the brochure from being materially inaccurate. The brochure supplement will not be required to be filed and need only be retained in the adviser's files for SEC examination.
Effective and Compliance Dates
- The amendments will be effective on October 12, 2010.
- SEC-registered advisers with fiscal years ending on or after December 31, 2010 will be required to include a new Part 2A to comply with the amendments with their next annual updating amendment filed with the SEC no later than March 31, 2011. Within 60 days of filing the amendment, the adviser must deliver a brochure and brochure supplement to its existing clients. Advisers with a fiscal year ending prior to December 31, 2010 will have the option of filing an annual update with a brochure that satisfies the requirements of the previous Part 2 or the new Part 2A.
- Advisers applying for registration with the SEC after January 1, 2011 will be required to file a brochure that meets the requirements of the new Part 2.
- The amended Form ADV directs advisers that are registered with or applying for registration with state securities authorities to contact the appropriate state regulator to determine whether the requirements in Part 2A and Part 2B are applicable to them.
Please do not hesitate to contact a member of Godfrey & Kahn's Investment Management Team if you have any questions regarding the amendments to Part 2 of Form ADV.