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.
