The U.S. Securities and Exchange Commission recently issued a final rule under the Investment Advisers Act of 1940 requiring investment advisers registered with the SEC to provide new and prospective clients with a brochure and brochure supplements that are written in plain English. Advisers must file their brochure electronically with the SEC, and the SEC will make these brochures available to the public through its website.
Investment advisers must prepare Part II of Form ADV and must provide it, or a brochure which contains substantially similar information, to each client or prospective client. Part II of Form ADV provides clients and prospective clients with a description of the adviser, the adviser’s services and fees, conflicts of interest, and the adviser’s business practices. Currently Part II is in a check-the-box format with a limited amount of narrative explanation.
Under the new final rule, the check-the-box format of Part II will be eliminated. The revised Part II will have to be written in plain English.
Preparing a proper brochure will require time, effort, and the making of a few decisions regarding presentation. For example, when preparing the new brochure an adviser must keep its fiduciary duty in mind so that all necessary disclosures are made and clients and prospective clients can understand such disclosures. The adviser also must properly draft the new brochure(s). For example, the SEC stated in the new final rule that advisers must “communicate clearly” by using “short sentences; definite, concrete, everyday words; and the active voice.” The brochure “should be succinct and readable.” To limit the length of the brochure, “advisers may create separate brochures for different types of advisory clients, each of which may be shorter, clearer, and contain less extraneous information than would a combined brochure.”
Components of the New Brochure
The revised Part II will be in two sub-parts: (1) 18 disclosure items about the advisory firm and (2) a supplement which includes information about advisory personnel on whom clients rely for investment advice.
The 18 disclosure items include the following:
1. On a cover page, an adviser shall include the name of the firm, its business address, contact information, website (if applicable), the date of the brochure, and a statement that the brochure has not been approved by any securities regulator. If the adviser refers to itself as a “registered investment adviser,” the cover page must also include a disclaimer that registration does not imply a certain level of skill or training.
2. An adviser shall identify and discuss material changes since the prior year’s brochure.
3. An adviser shall include a table of contents that is detailed enough to permit clients and prospective clients to locate information easily.
4. An adviser shall provide a description of its business that includes the types of advisory services offered, whether the adviser holds itself out as specializing in a particular type of advisory service, and the amount of client assets that it manages.
5. Regarding fees and compensation, an adviser shall describe how it is compensated for its advisory services; provide a fee schedule; and disclose whether fees are negotiable, its billing practices, and information about other costs to the client.
6. An adviser shall disclose whether the adviser charges performance-based fees or whether a supervised person manages an account that pays such a fee and, if so, the adviser shall discuss the conflicts of interest.
7. An adviser shall describe the types of advisory clients the firm generally has and the requirements (e.g., minimum account size) for opening or maintaining an account.
8. An adviser shall describe the methods of analysis and investment strategies used and the fact that investing in securities involves risk of loss. An adviser shall also disclose risks due to frequent trading and risks for each investment strategy or method of analysis and particular type of security it recommends.
9. An adviser shall disclose material facts about any legal or disciplinary event that is material to a client’s or prospective client’s evaluation of the adviser’s or its management’s integrity.
10. An adviser shall disclose material relationships or arrangements that the adviser has with related financial industry participants, related material conflicts of interest and how such conflicts are addressed, and information about selecting or recommending other advisers.
11. An adviser shall disclose its code of ethics and any participation or interest in client transactions and the conflicts of interest presented by such participation or interest.
12. An adviser shall disclose its brokerage practices.
13. An adviser shall disclose whether, and how often, it reviews clients’ accounts or financial plans, and identify who conducts the review.
14. An adviser shall disclose any arrangement under which it compensates another for a client referral and shall describe such compensation. An adviser shall also disclose any economic benefit (e.g., sales prizes) received from a person, who is not a client, for providing advisory services to clients.
15. An adviser with custody shall disclose that clients will receive account statements directly from a qualified custodian and that clients should carefully review these account statements. If the adviser also sends account statements, the adviser shall further disclose that clients should compare the account statements provided by the qualified custodian to the account statements provided by the adviser.
16. An adviser with discretionary authority over client accounts shall disclose its discretionary authority and any limitations clients may place on this authority.
17. An adviser shall disclose its proxy voting practices.
18. An adviser shall disclose certain material financial information about the adviser.
Advisers that sponsor a wrap fee program continue to be required to prepare a separate, specialized brochure for clients of the wrap fee program in lieu of the sponsor’s standard brochure.
The supplement to Part II shall include, among other things, information about the education, experience, and disciplinary history of the supervised person(s) who provides advisory services to the client.
Effective Date
Each adviser applying for initial registration with the SEC after January 1, 2011 must file a brochure pursuant to the new final rule.
Advisers who are already registered with the SEC must comply with the requirements of the new final rule when they file their first annual updating amendment to Form ADV for the fiscal year ending on or after December 31, 2010. Therefore, for advisers whose fiscal year ends on December 31, 2010, they must file a new brochure pursuant to the new final rule by March 31, 2011, and immediately begin to distribute the new brochure to new and prospective clients. Within 60 days of filing the new brochure, existing SEC-registrants must deliver the new brochure to existing clients.
Applicability to Advisers Registered with the South Carolina Securities Division
I am not aware of any statement by the Securities Division about whether it will require advisers to file Part II pursuant to the requirements of the SEC’s new final rule. In fact, South Carolina law is vague on what form an adviser must file at all. S.C. Code Ann. § 35-1-406(a)(1) merely states that an applicant shall file “the information or record required for the filing of a uniform application,” but it does not define “uniform application.” The Securities Division historically has required the form required by the SEC. I expect that the Securities Division will want state-registered advisers to file Part II pursuant to the requirements of the SEC’s new final rule.
Tuesday, August 31, 2010
Wednesday, August 18, 2010
SEC Seeks Public Input on the Standard of Care for Brokers, Dealers, and Investment Advisers
The Dodd-Frank Wall Street Reform and Consumer Protection Act requires the U.S. Securities and Exchange Commission to conduct a study regarding the standard of care of brokers, dealers, and investment advisers. That process has already begun. The SEC has issued a request for comment in which it is seeking public input, comments, and data regarding the standard of care imposed or to be imposed upon these financial industry professionals. Comments are due by August 30, 2010.
Current law imposes a higher standard of care on investment advisers (i.e., a fiduciary duty) while imposing a lesser standard of care on brokers (i.e., a suitability standard). Regulators have long been concerned that retail customers do not understand the differences in these standards of care.
In announcing the SEC’s request for comments, Chairman Shapiro stated, “At the completion of this study, we will have the authority to write rules that would create a uniform standard of conduct for professionals who provide personalized investment advice to retail customers. And, the new law requires that this standard be ‘no less stringent’ than the standard applicable to investment advisers.” Therefore, this study is important because it likely will result in the SEC issuing new rules that will impose a greater standard of care on brokers and dealers.
In the study, the SEC will evaluate the effectiveness of the existing legal or regulatory standards of care for brokers, dealers, investment advisers, and persons associated with them for providing personalized investment advice and recommendations about securities to retail customers. The SEC will also evaluate whether there are legal or regulatory gaps, shortcomings, or overlaps in legal or regulatory standards in the protection of retail customers.
Specifically, the SEC requests comment on fourteen issues, including the following:
1. The effectiveness of the existing legal or regulatory standards of care for brokers, dealers, investment advisers, and associated persons.
2. Whether there are legal or regulatory gaps, shortcomings, or overlaps in legal or regulatory standards in the protection of retail customers relating to the standards of care for brokers, dealers, investment advisers, and associated persons.
3. Whether retail customers understand that there are different standards of care applicable to brokers and investment advisers.
4. The regulatory, examination, and enforcement resources devoted to enforcement of the standards of care.
5. The potential impact on retail customers of imposing a higher standard of care on brokers, dealers, and their associated persons.
6. The varying level of services provided by brokers and investment advisers.
7. Potential additional costs and expenses to retail customers and to brokers, dealers, and investment advisers.
Current law imposes a higher standard of care on investment advisers (i.e., a fiduciary duty) while imposing a lesser standard of care on brokers (i.e., a suitability standard). Regulators have long been concerned that retail customers do not understand the differences in these standards of care.
In announcing the SEC’s request for comments, Chairman Shapiro stated, “At the completion of this study, we will have the authority to write rules that would create a uniform standard of conduct for professionals who provide personalized investment advice to retail customers. And, the new law requires that this standard be ‘no less stringent’ than the standard applicable to investment advisers.” Therefore, this study is important because it likely will result in the SEC issuing new rules that will impose a greater standard of care on brokers and dealers.
In the study, the SEC will evaluate the effectiveness of the existing legal or regulatory standards of care for brokers, dealers, investment advisers, and persons associated with them for providing personalized investment advice and recommendations about securities to retail customers. The SEC will also evaluate whether there are legal or regulatory gaps, shortcomings, or overlaps in legal or regulatory standards in the protection of retail customers.
Specifically, the SEC requests comment on fourteen issues, including the following:
1. The effectiveness of the existing legal or regulatory standards of care for brokers, dealers, investment advisers, and associated persons.
2. Whether there are legal or regulatory gaps, shortcomings, or overlaps in legal or regulatory standards in the protection of retail customers relating to the standards of care for brokers, dealers, investment advisers, and associated persons.
3. Whether retail customers understand that there are different standards of care applicable to brokers and investment advisers.
4. The regulatory, examination, and enforcement resources devoted to enforcement of the standards of care.
5. The potential impact on retail customers of imposing a higher standard of care on brokers, dealers, and their associated persons.
6. The varying level of services provided by brokers and investment advisers.
7. Potential additional costs and expenses to retail customers and to brokers, dealers, and investment advisers.
Tuesday, August 10, 2010
Some Changes Related to Accredited Investors under Dodd-Frank Are Already Applicable
Regulation D of the Securities Act of 1933 includes rules governing the limited offerings and sales of securities that are not registered under the 1933 Act. “Accredited investor” is an important term that is defined and used throughout Regulation D.
Since unregistered, Regulation D offerings and sales of securities are often used to raise funds, any change to the definition of an accredited investor is critical. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted on July 21, 2010, changed the definition of accredited investor and allows for subsequent changes to that definition.
First, Dodd-Frank immediately changed the definition of accredited investor. Effective on the date of enactment of Dodd-Frank, the net worth standard for a natural person remains at $1,000,000; however, the value of the investor’s primary residence now must be excluded from that person’s net worth. This change is effective from July 21, 2010, through July 21, 2014.
This amendment to the net worth standard for an accredited investor requires immediate attention. It impacts how an issuer or manager conducts its business. For example, a fund’s subscription agreement may need to be changed, and an adviser’s policies and procedures may need to be amended.
Second, within four years of July 21, 2010, the U.S. Securities and Exchange Commission may review and modify by regulation the definition of accredited investor as the term applies to a natural person. Any modification shall not affect the exclusion of the primary residence from the net worth of the individual. Also, every four years thereafter, the SEC shall review the definition of accredited investor and may make changes by regulation.
Third, by July 21, 2013, the Comptroller General of the United States shall study, and submit its report to Congress, the following: the appropriate financial thresholds or other criteria needed to qualify as an accredited investor and eligibility to invest in private funds. Congress could then enact additional legislation affecting Regulation D offerings and accredited investors.
Since unregistered, Regulation D offerings and sales of securities are often used to raise funds, any change to the definition of an accredited investor is critical. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted on July 21, 2010, changed the definition of accredited investor and allows for subsequent changes to that definition.
First, Dodd-Frank immediately changed the definition of accredited investor. Effective on the date of enactment of Dodd-Frank, the net worth standard for a natural person remains at $1,000,000; however, the value of the investor’s primary residence now must be excluded from that person’s net worth. This change is effective from July 21, 2010, through July 21, 2014.
This amendment to the net worth standard for an accredited investor requires immediate attention. It impacts how an issuer or manager conducts its business. For example, a fund’s subscription agreement may need to be changed, and an adviser’s policies and procedures may need to be amended.
Second, within four years of July 21, 2010, the U.S. Securities and Exchange Commission may review and modify by regulation the definition of accredited investor as the term applies to a natural person. Any modification shall not affect the exclusion of the primary residence from the net worth of the individual. Also, every four years thereafter, the SEC shall review the definition of accredited investor and may make changes by regulation.
Third, by July 21, 2013, the Comptroller General of the United States shall study, and submit its report to Congress, the following: the appropriate financial thresholds or other criteria needed to qualify as an accredited investor and eligibility to invest in private funds. Congress could then enact additional legislation affecting Regulation D offerings and accredited investors.
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