On July 28, 2010, the Securities and Exchange Commission adopted amendments to Part 2 of Form ADV, the form used by investment advisers to register with the SEC and state securities regulators.  These amendments are effective for filings made on or after October 12, 2010.  Also affecting advisers are changes made as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, or the Financial Reform Act, which President Obama signed into law on July 21, 2010. Both the SEC's recent action and the Financial Reform Act make a variety of changes to the Investment Advisers Act of 1940.

This Update summarizes the reporting and filing requirements for Form ADV and highlights the amendments to the Investment Advisers Act that may have the most significant and immediate impact on investment companies, brokers-dealers, and registered investment advisers.

Form ADV Part 2: The Brochure and Brochure Supplements

Part 2 of Form ADV will now consist of two parts: Part 2A, the brochure, and Part 2B, the brochure supplement. The SEC intends the amendments to Form ADV Part 2 to provide the clients of advisers with easy-to-understand, meaningful disclosure about the business practices, conflicts of interest and background of their advisers and their advisory personnel.  This disclosure will allow clients to compare advisers side by side based on their responses in the brochure.

Unlike the check-the-box format of the current Form ADV, the amended form requires advisers to provide a narrative, in plain English and in a format that follows the form, on topics including material changes, conflicts, compensation, business activities and disciplinary history. The amendments require advisers to file Part 2 on the Investment Adviser Registration Depository system.

The Brochure.  An adviser must deliver a current brochure before, or at the time that, it enters into an advisory contract with a client.  Part 2A of Form ADV contains 18 items, each covering a different disclosure topic. The required disclosures include:

• • Material Changes. The adviser must summarize any material changes that have occurred since the last annual update. The summary, which may be included on the cover page or the following page or as a separate document attached to the brochure, should include a brief explanation of the substantive changes to the adviser's policies, practices or conflicts of interest.
  • Advisory Business. The adviser must describe its advisory business, including the type of advisory services it offers, whether the adviser specializes in a particular type of advisory service and the amount of client assets it manages. In calculating the assets under its management, the adviser may use a different method of calculation than that used in Part 1 as long as it retains documentation on the method used.
  • Fees and Compensation. The adviser must describe its compensation arrangements, provide a fee schedule and disclose whether the fees are negotiable. In addition, the adviser must disclose whether it bills clients or deducts fees directly from client accounts, how often fees are assessed, and other fees and expenses (such as brokerage fees, custody fees and fund expenses). If applicable, the adviser must disclose the fact that it or its personnel receives brokerage commissions or transaction-based compensation, its brokerage practices, the conflicts of interest its brokerage practices creates and how it addresses those conflicts.
  • Performance-Based Fees and Side-by-Side Management. If applicable, the adviser must disclose if it charges performance-based fees or has a supervised person who manages an account that pays performance-based fees. Where the adviser also manages accounts that are not charged a performance fee, it must discuss the conflicts of interest that arise from its simultaneous management of those accounts and describe, generally, how it addresses those conflicts.
  • Types of Clients. The adviser must describe the clients it has (for example, high-net worth individuals, institutions, endowments, pension funds, etc.) and the requirements for opening and maintaining an account, such as minimum account size.
  • Methods of Analysis, Investment Strategies and Risk of Loss. The adviser must describe its methods of analysis and investment strategies and disclose the fact that investing in securities involves risk of loss. If applicable, the adviser must disclose how strategies involving frequent trading can affect investment performance and explain the material risks for each "significant" investment strategy or method of analysis it uses and the particular types of securities it recommends. More detailed disclosure is required for risks that are unusual.
  • Disciplinary Information. The adviser must disclose material facts about any legal or disciplinary event that is material to a client's (or a prospective client's) evaluation of the integrity of the adviser or its management personnel. Certain disciplinary events are presumed material if they occurred within the prior 10 years (such as convictions for theft, fraud, bribery, perjury, forgery, counterfeiting, extortion and violations of securities laws by the adviser or one of its executives) and require disclosure. An adviser may rebut the presumption that events occurring within the prior 10-year period are material based on an analysis of several specified factors. An adviser who does so and chooses not to disclose the event must retain documentation of its determination.
  • Code of Ethics, Participation or Interest in Client Transactions and Personal Trading. The adviser must briefly describe its code of ethics and state that a copy is available upon request. In addition, the adviser must disclose the fact that it or a related person recommends to clients, or buys or sells for client accounts, securities in which it has a material financial interest. The brochure must discuss the conflict of interest and how the adviser addresses these conflicts. The adviser must also disclose the fact that it or a related person invests, or is permitted to invest in, the securities it recommends to clients or in related securities, the conflicts presented and how it addresses those conflicts.
  • Brokerage Practices. The adviser must describe the factors it considers in selecting or recommending broker-dealers for client transactions, how it determines the reasonableness of brokers' fees, soft dollar practices, client referrals, directed brokerage, trade allocation, the conflicts of interest created by such practices and how it addresses those conflicts.

An adviser that sponsors a wrap fee program must continue to prepare a separate, specialized brochure for clients of the wrap program. This wrap brochure will be an appendix to the adviser's Form ADV rather than Schedule H of Form ADV. The adviser must identify if any of its related persons is a portfolio manager in the wrap fee program and describe any associated conflicts.

The Brochure Supplement.  A brochure supplement must accompany each brochure that is required to be provided to clients,  The brochure supplement provides information about the advisory personnel who actually provide the investment advice and interact with the client. This information would not necessarily be included in the firm brochure.  An adviser may include supplemental information within the firm's brochure or prepare separate supplements for different groups of supervised persons.

Part 2B of Form ADV consists of the following six items:

• • Cover Page. Each brochure supplement must include on the cover page or at the top of the supplement's first page the name, address, and telephone number of each supervised person that the supplement covers as well as the name of the adviser. It must also include statements saying that the document is a supplement to the brochure, the recipient should have received a copy of the brochure and, if not, or if the recipient has questions concerning the brochure or supplement, who to call. 
  • Educational Background and Business Experience. The brochure supplement must describe each person's formal education and his or her business experience for the past five years. If the person has no high school education, no formal education, or no business experience in the past five years, this must be disclosed.
  • Disciplinary Information. The brochure supplement must disclose any legal or disciplinary event that is material to a client's evaluation of the supervised person's integrity, including events occurring during the last 10 years, which are presumed to be material by the SEC. 
  • Other Business Activities. The brochure supplement must describe other business activities of its supervised persons and any material conflicts of interest these activities may create. It must also include information about compensation – bonus or non-cash –that the supervised person receives based on the sales of securities or other investment products and an explanation of the incentives this type of compensation creates.
  • Additional Compensation. The brochure supplement must describe any arrangements in which someone other than the client provides the supervised person with an economic benefit, such as a sales award or other prize, for providing advisory services.
  • Supervision. The brochure supplement must explain how an adviser supervises the supervised individual, including how it monitors the advice the supervised individual provides to the client. It must also provide the name, title and telephone number of the individual's supervisor.

Effective and Compliance Dates.  The amended Form ADV Part 2 will become effective October 12, 2010.

Currently registered advisers having a fiscal year-end on or after December 31, 2010 must include in their next annual updating amendment a brochure meeting the requirements for Form ADV Part 2. Thus, advisers with a fiscal year-end of December 31, 2010 must file an annual updating amendment with the new brochure no later than March 31, 2011.

Advisers applying for SEC registration beginning January 1, 2011 must file with their registration a Form ADV Part 2 that complies with the new form. Upon registering, these advisers must begin delivering the brochure and brochure supplement(s) to their clients and prospective clients.

Transition Period; Subsequent Delivery Requirements.  Advisers will have 60 days from their initial SEC filing to deliver the new brochure and any brochure supplements to existing clients. After its initial filing, each adviser must deliver the new brochure to new and prospective clients at or before entry into an advisory contract. The brochure supplement must be provided to a client at or before the time that a specific supervised person begins providing advisory services to that client. Brochure supplements and brochures may be delivered on paper or electronically.

An adviser must amend and promptly deliver an updated brochure and brochure supplement whenever there is a new disclosure of a disciplinary event or a material change to information previously disclosed. In addition, advisers must deliver annually to clients to whom it must deliver a brochure either (a) a current brochure that includes or is accompanied by a summary of material changes; or (b) a summary of material changes and an offer to provide a copy of the current brochure. Generally, advisers must make this annual delivery within 120 days of their fiscal year-end and may do so electronically in accordance with the SEC's electronic delivery guidelines. An adviser is not required to deliver brochure supplements to existing clients annually.

Advisers must keep brochures electronically filed with the Investment Adviser Registration Depository current by updating them at least annually and promptly whenever any information in the brochure becomes materially inaccurate. If the brochure continues to be accurate in all material respects, the adviser need not prepare or file an updated brochure as part of its annual updating amendment nor must it prepare and deliver to clients a summary of material changes. However, with any interim amendment, an adviser must file a summary of material changes describing each interim amendment along with an updated brochure as part of its annual amendment filing. The SEC's website will only make the most recent version of an adviser's brochure available to the public. An adviser is not required to file brochure supplements or supplement amendments with the SEC, but must maintain copies of all supplements and amendments.

Trap for the Unwary In its adopting release, the SEC stated that it believes advisers can provide the information required by Form ADV Part 2 without jeopardizing their reliance on private offering exemptions for private funds and the safe harbor for offshore transactions under the Securities Act of 1933. Some commentators expressed concern that the public disclosure may be deemed to violate the prohibition on general solicitation or general advertising of such private offering exemptions.  However, the SEC noted that providing private fund information beyond that required in Part 2, such as subscription instructions, performance information and financial statements, may jeopardize such reliance by constituting a private offering or conditioning the market for securities offered by such funds.

The Financial Reform Act

Client Accounts.  Section 223 of the Financial Reform Act requires a registered investment adviser to take the steps necessary to safeguard any client asset over which the registered investment adviser has custody. These steps may include verification of the assets by an independent public accountant.

Fiduciary Standards.  The Financial Reform Act requires the SEC to conduct a study on the effectiveness of existing standards of care for brokers, dealers and investment advisers when providing personalized investment advice to "retail customers," including considering the potential impact of eliminating the broker and dealer exclusion from the definition of "investment adviser" under Section 202(a)(11)(C) of the Investment Advisers Act. The SEC accepted public comment regarding issues related to the study in August and have made comments available.

The Financial Reform Act requires the SEC to submit a report of its findings and conclusions to Congress by January 21, 2011. Once done, the SEC may adopt rulemaking to require broker-dealers and investment advisers providing personalized investment advice about securities to a retail customer to act in the best interest of the customer without regard for the financial or other interest of the broker-dealer or investment adviser. Any standard of conduct promulgated by the SEC must be no less stringent than the standard applicable to an investment adviser under Section 206(1) and (2) of the Investment Advisers Act. The Financial Reform Act defines a "retail customer" for purposes of these provisions as "a natural person, or the legal representative of such natural person, who (A) receives personalized investment advice about securities from a broker, dealer, or investment adviser; and (B) uses such advice primarily for personal, family, or household purposes."

Investment Adviser Examinations. The Financial Reform Act requires the SEC to review and analyze the need for enhancing investment adviser examinations, and to report its findings to Congress by January 21, 2011.

Disclosure Requirements.  The Financial Reform Act authorizes the SEC to require broker-dealers who sell only proprietary or other limited ranges of products to provide notice to each retail customer and obtain each customer's consent or acknowledgment. The Financial Reform Act requires the SEC to (1) facilitate the provision of simple and clear disclosures to investors regarding the terms of their relationships with broker-dealers and investment advisers and (2) examine and, where appropriate, propagate rules that prohibit or restrict certain sales practices, conflicts of interest, and compensation schemes for broker-dealers and investment advisers that the SEC deems contrary to the public interest and the protection of investors. No time frame is designated for the promulgation of these rules. The Financial Reform Act amends Section 15 of the Securities Exchange Act of 1934 and authorizes the SEC to issue rules to require disclosure of certain documents or information by a broker-dealer to a retail investor (a term not defined in the Financial Reform Act) before the retail investor purchases an investment product or service.

Additional Information

This update is intended only as a summary of the amendments to the Form ADV and of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The SEC release announcing adoption of the amendments has been published in the Federal Register and is available here. You can read the full text of the Financial Reform Act, as enacted here.  You can find other discussions about the Financial Reform Act on our website.

© 2010 Perkins Coie LLP

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