SEC Votes to Change Form ADV

As if there wasn’t enough uncertainty swirling around the financial services industry at present, the Securities and Exchange Commission (SEC) wants to make changes to Form ADV.

The SEC has voted unanimously to adopt changes to the Form ADV, Part 2, the principal disclosure document that SEC-registered investment advisers must provide to their clients and prospective clients.

The brochure in its current format requires advisers to respond to a series of multiple-choice and fill-in-the-blank questions organized in a “check-the-box” format that the SEC says “frequently does not correspond well to an adviser’s business”. In some cases, the required disclosure may not describe the adviser’s business or conflicts in a way that is truly accessible to the investor, according to the SEC.  Of course the Form ADV, commonly referred to as the “brochure” is supposed to outline an investment adviser’s qualifications, investment strategies, and business practices.

“These changes are designed to provide clients with greater information about the individuals who will provide them with investment advice,” said SEC Chairman Mary L. Schapiro. “These amendments will help transform the brochure into a plain English narrative that is well-suited to serve investors’ needs and describes the adviser’s conflicts, compensation, business activities, and disciplinary history.”

The SEC says that the amendments adopted will:

  • Improve the format and update the requirements of the brochure.
  • Expand the content to better include details most relevant to the clients of investment advisers.
  • Require brochure “supplements” to be delivered to new and prospective clients to give resume-like information about the individuals at an investment advisory firm who will provide services to the clients.
  • Ensure investors have easy access to the brochures as investment advisers are required to file them electronically for posting on the SEC’s website.

In announcing the change, the SEC noted that many state-registered investment advisers also currently file Form ADV with their regulators, and has therefore authorized its staff to delay publication of the revised Form ADV, Part 2 for five business days “in order to work with the states to accommodate technical, state-specific changes to the items and instructions of the form”. This process would enable publication of Form ADV, Part 2 as a uniform SEC-state form, according to the SEC.

The amended rules and forms will be effective 60 days after publication in the Federal Register. Most investment advisers will begin distributing and publicly posting new brochures in the first quarter of 2011, according to the SEC.

The Amendments

Improved Format and Updating Requirements. Advisers are required to prepare a narrative, plain English, brochure, presented in a consistent, uniform manner that will make it easier for clients to compare different advisers’ disclosures. The clear and concise narrative descriptions provided in the brochure will improve the ability of clients and prospective clients to evaluate advisers and to understand conflicts of interest that the firms and their personnel face, the effects of those conflicts on the firms’ services, and the steps the adviser takes to address the conflicts.

Advisers must deliver the brochure to a client before or at the time the adviser enters into an advisory contract with the client. In addition, advisers must provide each client an annual summary of material changes to the brochure and either deliver a complete updated brochure or offer to provide the client with the updated brochure.

Expanded Content. The new brochure addresses those topics the Commission believes are most relevant to clients, including:

Advisory business — An investment adviser must describe its advisory business, including the types of advisory services offered, state whether it holds itself out as specializing in a particular type of advisory service, and disclose the amount of client assets that it manages.

Fees and compensation — An investment adviser must describe how it is compensated for its advisory services, provide a fee schedule, and disclose whether fees are negotiable. The investment adviser must also describe the types of other fees or expenses, such as brokerage fees, custody fees, and fund expenses that clients may pay in connection with the services provided.

Performance-based fees and side-by-side management — An investment adviser that accepts performance-based fees, or that supervises an individual who accepts such fees, is required to disclose this fact. If the investment adviser also manages accounts that are not charged a performance fee, the adviser must explain the conflicts of interest that arise from the simultaneous management of these accounts and must describe how it addresses those conflicts.

Methods of analysis, investment strategies, and risk of loss — An investment adviser must describe its methods of analysis and investment strategies and explain that investing in securities involves risk of loss which clients should be prepared to bear. Investment advisers who use a particular method of analysis or strategy or who recommend a particular type of security are required to explain the material risks involved and discuss the risks in detail if those risks are unusual.

Disciplinary information — An investment adviser is required to disclose in its brochure material facts about any legal or disciplinary event that is material to a client’s evaluation of the advisory business or to the integrity of its management personnel. An investment adviser must deliver promptly to clients updated information when there is new disclosure of a disciplinary event or a material change to an existing disciplinary event.

Code of ethics, participation or interest in client transactions, and personal trading — An investment adviser is required to describe briefly its code of ethics and state that a copy is available upon request. The adviser must also disclose whether it or an affiliate recommends to clients, or buys or sells for client accounts, securities in which the adviser or an affiliate has a material financial interest and, if so, the conflicts of interest associated with that practice. The adviser also must disclose whether it or an affiliate invests (or is allowed to invest) in the same securities that it recommends to clients or in related securities, such as options or other derivatives, and must explain the conflicts involved and how it addresses those conflicts. In addition, an investment adviser that trades in the recommended securities at or around the same time as the client has to explain the specific conflicts inherent in that practice and how it addresses them.

Brokerage practices — An investment adviser is required to describe the factors considered in selecting or recommending broker-dealers for client transactions and determining the reasonableness of brokers’ compensation. Investment advisers also must disclose soft dollar practices (research or other products or services, other than execution, provided by brokers or a third party to the investment adviser in connection with client transactions); client referrals (using client brokerage to compensate brokers for client referrals); directed brokerage (asking or permitting clients to send trades to a specific broker for execution); and trade aggregation (bundling trades to obtain volume discounts on execution costs). Investment advisers must explain how they address the various conflicts of interest associated with these practices.

Supplements. An adviser is required to deliver “brochure supplements” to new and prospective clients providing them with information about the specific individuals who will provide services to the clients. The supplement will contain brief résumé-like disclosure about the educational background, business experience, other business activities, and disciplinary history of the individual, so that the client can assess the person’s background and qualifications. It will also include contact information for the person’s supervisor in case the client has a concern about the person.

Internet Availability. Advisers are required to electronically file brochures, which will be publicly available on the SEC’s website.