[Federal Register Volume 75, Number 155 (Thursday, August 12, 2010)]
[Rules and Regulations]
[Pages 49234-49312]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2010-19617]
[[Page 49233]]
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Part III
Securities and Exchange Commission
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17 CFR Parts 275 and 279
Amendments to Form ADV; Final Rule
Federal Register / Vol. 75 , No. 155 / Thursday, August 12, 2010 /
Rules and Regulations
[[Page 49234]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 275 and 279
[Release No. IA-3060; File No. S7-10-00]
RIN 3235-AI17
Amendments to Form ADV
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission is adopting amendments
to Part 2 of Form ADV, and related rules under the Investment Advisers
Act, to require investment advisers registered with us to provide new
and prospective clients with a brochure and brochure supplements
written in plain English. These amendments are designed to provide new
and prospective advisory clients with clearly written, meaningful,
current disclosure of the business practices, conflicts of interest and
background of the investment adviser and its advisory personnel.
Advisers must file their brochures with us electronically and we will
make them available to the public through our Web site. The Commission
also is withdrawing the Advisers Act rule requiring advisers to
disclose certain disciplinary and financial information.
DATES: Effective Date: October 12, 2010. Compliance Dates: See Section
V of this release.
FOR FURTHER INFORMATION CONTACT: Vivien Liu, Senior Counsel, Don L.
Evans, Senior Counsel, Daniel S. Kahl, Branch Chief, or Sarah A.
Bessin, Assistant Director, at (202) 551-6787 or [email protected],
Office of Investment Adviser Regulation, Division of Investment
Management, U.S. Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-8549.
SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission
(``Commission'' or ``SEC'') is adopting amendments to rules 203-1, 204-
1, 204-2, and 204-3 [17 CFR 275.203-1, 275.204-1, 275.204-2, and
275.204-3] under the Investment Advisers Act of 1940 [15 U.S.C. 80b]
(``Advisers Act'' or ``Act''); \1\ and amendments to Form ADV [17 CFR
279.1] under the Advisers Act. The Commission also is withdrawing rule
206(4)-4 [17 CFR 275.206(4)-4] under the Advisers Act.
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\1\ Unless otherwise noted, when we refer to rule 203-1, 204-1,
204-2, or 204-3, or any paragraph of these rules, we are referring
to 17 CFR 275.203-1, 275.204-1, 275.204-2, or 275.204-3,
respectively, of the Code of Federal Regulations in which these
rules are published.
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Table of Contents
I. Introduction
II. Discussion of Form ADV, Part 2
A. Part 2A: Brochure Format and Content
1. Format
2. Brochure Items
3. Delivery and Updating of Brochures
B. Part 2B: The Brochure Supplement
1. Format
2. Supplement Items
3. Delivery and Updating
C. Filing Requirements, Public Availability
D. Transition to New Requirements
III. Amendments to Form ADV Instructions and Glossary
IV. Amendments to Rule 204-2
V. Effective and Compliance Dates
VI. Paperwork Reduction Act
VII. Cost-Benefit Analysis
VIII. Final Regulatory Flexibility Analysis
IX. Efficiency, Competition, and Capital Formation
X. Statutory Authority
Text of Rule and Form Amendments
I. Introduction
Investment advisers provide a wide range of advisory services and
play an important role in helping individuals and institutions make
significant financial decisions. From individuals and families seeking
to plan for retirement or save for college to large institutions
managing billions of dollars, clients seek the services of investment
advisers to help them evaluate their investment needs, plan for their
future, develop and implement investment strategies, and cope with the
ever-growing complexities of the financial markets. Today, the more
than 11,000 advisers registered with us manage more than $38 trillion
for more than 14 million clients.\2\
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\2\ These figures are based on data derived from investment
advisers' responses to questions on Part 1A of Form ADV reported
through the Investment Adviser Registration Depository (``IARD'') as
of May 3, 2010. We note that these figures will change due to the
Dodd-Frank Wall Street Reform and Consumer Protection Act, Public
Law 111-203, 124 Stat. 1376 (2010).
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Under the Advisers Act, an adviser is a fiduciary whose duty is to
serve the best interests of its clients, which includes an obligation
not to subrogate clients' interests to its own.\3\ An adviser must deal
fairly with clients and prospective clients, seek to avoid conflicts
with its clients and, at a minimum, make full disclosure of any
material conflict or potential conflict.\4\ A client may use this
disclosure to select his or her own adviser and evaluate the adviser's
business practices and conflicts on an ongoing basis. As a result, the
disclosure clients and prospective clients receive is critical to their
ability to make an informed decision about whether to engage an adviser
and, having engaged the adviser, to manage that relationship.
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\3\ Proxy Voting by Investment Advisers, Investment Advisers Act
Release No. IA-2106 (Jan. 31, 2003) [68 FR 6585 (Feb. 7, 2003)]
(``Proxy Voting Release'').
\4\ See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180
(1963); In the Matter of Arleen W. Hughes, Exchange Act Release No.
4048 (Feb. 18, 1948).
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To allow clients and prospective clients to evaluate the risks
associated with a particular investment adviser, its business
practices, and its investment strategies, it is essential that clients
and prospective clients have clear disclosure that they are likely to
read and understand. For example, such disclosure could enable a
prospective client to screen advisers based on disciplinary history,
financial industry affiliations or compensation methods. Such screening
would allow clients to avoid advisers with a disciplinary history,
should they wish to do so. Clients also would be able to choose
advisers based on affiliations and compensation methods; in some cases,
the client may not be comfortable with the conflicts of interest that
those affiliations and compensation methods create, while other clients
may value an advisory relationship that allows for broader access to
other financial services and may seek an adviser with financial
industry affiliates. A prospective client may seek modifications to an
investment advisory agreement to better protect the client against an
investment adviser's potential conflict of interest, either by better
aligning the adviser's interest with that of the client or by
prohibiting a particular practice in the client's account. If an
adviser is unwilling to make such modifications, a prospective client
may select a different adviser.
Since 1979, the Commission has required each adviser registered
with us to deliver a written disclosure statement to clients pursuant
to rule 204-3 under the Advisers Act.\5\ An investment adviser may use
this client disclosure statement to satisfy its disclosure
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obligations as a fiduciary.\6\ Part 2 of Form ADV sets out minimum
requirements for this disclosure statement to clients, which is
commonly referred to as the ``brochure.'' \7\
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\5\ Advisers use Form ADV to apply for registration with us
(Part 1A) or with state securities authorities (Part 1B), and must
keep it current by filing periodic amendments as long as they are
registered. See rules 203-1 and 204-1. Form ADV has two parts. Part
1(A and B) of Form ADV provides regulators with information to
process registrations and to manage their regulatory and examination
programs. Part 2A contains the requirements for the disclosure
``brochure'' that advisers must provide to prospective clients
initially and to existing clients annually, and Part 2B contains
information about the advisory personnel providing clients with
investment advice. Prior to the amendments we are adopting today,
Part 2 was designated as ``Part II.''
\6\ See Investment Adviser Requirements Concerning Disclosure,
Recordkeeping, Applications for Registration and Annual Filings,
Investment Advisers Act Release No. 664 (Jan. 30, 1979) [44 FR 7870
(Feb. 7, 1979)] (``1979 Adopting Release'').
\7\ Items in Part 2 of Form ADV may not address all conflicts an
adviser may have, and may not identify all material disclosure that
an adviser may be required to provide clients. As a result,
delivering a brochure prepared under Form ADV's requirements may not
fully satisfy an adviser's disclosure obligations under the Advisers
Act. See Instruction 3 of General Instructions for Part 2 of Form
ADV; rule 204-3(f).
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In the past, Part 2 has required advisers to respond to a series of
multiple-choice and fill-in-the-blank questions organized in a ``check-
the-box'' format, supplemented in some cases with brief narrative
responses. Advisers have had the option of providing information
required by Part 2 in an entirely narrative format, but few have done
so.
In 2008, we proposed a different approach to enhance the disclosure
statement advisers provide to their clients.\8\ Instead of the check-
the-box format, each adviser registered with us would provide clients
with a narrative plain English brochure that describes the adviser's
business, conflicts of interest, disciplinary history, and other
important information that would help clients make an informed decision
about whether to hire or retain that adviser. Our proposal was designed
to require advisers to disclose meaningful information in a clearer
format.\9\ In addition, we proposed that advisers be required to file
their brochures with us electronically so that we could make them
available to the public on our Web site.\10\
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\8\ Amendments to Form ADV, Investment Advisers Act Release No.
2711 (Mar. 3, 2008) [73 FR 13958 (Mar. 14, 2008)] (``Proposing
Release'').
\9\ See Proposing Release, supra note 8 at n.6 and accompanying
text.
\10\ Id. at Section II.A.3.
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We received 81 letters commenting on the Proposing Release.\11\
Commenters agreed with our proposal to move to a narrative
brochure,\12\ although many suggested modifications to certain
requirements.\13\ After careful consideration of these comment letters,
we are adopting amendments to Part 2 of Form ADV and related rules
under the Advisers Act. In light of our adoption of Part 2, we also are
withdrawing rule 206(4)-4, which separately required advisers to
disclose to clients certain financial and disciplinary information,
because our amendments render that rule largely duplicative.
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\11\ Comment letters submitted in File No. S7-10-00 are
available on the Commission's Web site at: http://www.sec.gov/rules/proposed/s71000.shtml.
\12\ See, e.g., comment letter of the American Bar Association,
Section of Business Law, Committee on Federal Regulation of
Securities and Committee on State Regulation of Securities (June 18,
2008) (``ABA Committees Letter''); comment letter of the Consumer
Federation of America (July 2, 2008) (``Consumer Federation
Letter''); comment letter of Citigroup Global Markets Inc. (May 16,
2008) (``CGMI Letter''); comment letter of Fried, Frank, Harris,
Shriver & Jacobson LLP (May 2, 2008) (``Fried Frank Letter'');
comment letter of the Investment Adviser Association (May 16, 2008)
(``IAA Letter''); comment letter of the Investment Company Institute
(May 16, 2008) (``ICI Letter'').
\13\ See, e.g., comment letter of Alternative Investment
Compliance Association (May 16, 2008) (``AICA Letter''); comment
letter of Capital Institutional Services, Inc. (May 16, 2008)
(``CAPIS Letter''); comment letter of Shaun Eddy (May 9, 2008)
(``Eddy Letter''); comment letter of the Financial Planning
Association (May 16, 2008) (``FPA Letter''); Fried Frank Letter; IAA
Letter; ICI Letter; comment letter of Janus Capital Management LLC
(May 16, 2008) (``Janus Letter''); comment letter of Nancy Lininger
(May 18, 2008) (``Lininger Letter''); comment letter of the National
Association of Personal Financial Advisers (June 4, 2008) (``NAPFA
Letter''); comment letter of National Compliance Services, Inc. (May
9, 2008) (``NCS Letter''); comment letter of National Regulatory
Services (May 16, 2008) (``NRS Letter''); comment letter of L. A.
Schnase (May 9, 2008) (``Schnase Letter''); comment letter of Sidley
Austin LLP (May 23, 2008) (``Sidley Letter''); comment letter of
USAA Investment Management Company/USAA Financial Planning Services
Insurance Agency, Inc. (May 16, 2008) (``USAA Letter''); comment
letter of Wellington Management Company, LLP (May 15, 2008)
(``Wellington Letter'').
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II. Discussion of Form ADV, Part 2
The revised Part 2 requirements that we are adopting today include
two sub-parts, Part 2A and Part 2B.\14\ Part 2A contains 18 disclosure
items about the advisory firm that must be included in an adviser's
brochure. We refer to Part 2B as the ``brochure supplement,'' which
includes information about certain advisory personnel on whom clients
rely for investment advice. In this section, we discuss our amendments
relating to each of these sub-parts, which are addressed separately
because they are subject to differing content, updating and delivery
requirements.
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\14\ Part 2 is a uniform form used by investment advisers
registered with both the Commission and the state securities
authorities. See Instruction 5 of General Instructions for Form ADV.
This Release discusses the Commission's adoption of Form ADV and
related rules applicable to advisers registered with the Commission.
Form ADV is also used by state securities regulators to register
investment advisers. It includes certain items and instructions to
Part 2 (e.g., Item 19 of Part 2A, Item 10 of Appendix 1 to Part 2A,
and Item 7 of Part 2B) that apply only to state-registered advisers.
State-registered advisers are required by state, rather than
federal, law to respond to these items. Completion of these items,
therefore, is not an SEC requirement, and these items are not
included in this Release as an SEC rule.
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A. Part 2A: Brochure Format and Content
1. Format
We are adopting a requirement that investment advisers registered
with us provide prospective and existing clients with a narrative
brochure written in plain English.\15\ Commenters supported use of a
narrative format.\16\ For example, one commenter stated that ``the
current check-the-box format does not always result in clear and
meaningful client disclosure and it presents challenges for advisers in
identifying and presenting all of the types of information that should
be addressed in Part 2.'' \17\ Another commenter expressed the view
that ``the flexibility of a narrative format should result in clearer
and more meaningful disclosures that make relevant information readily
accessible to prospects and clients.'' \18\ We believe these amendments
will greatly improve the ability of clients and prospective clients to
evaluate firms offering advisory services and the firms' personnel, and
to understand relevant conflicts of interest that the firms and their
personnel face and their potential effect on the firms' services.
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\15\ See Instructions 1 and 2 of General Instructions for Part 2
of Form ADV. In many instances where we refer to ``client'' in this
release we are referring to both an existing and prospective client.
\16\ See ABA Committees Letter; comment letter of the American
Institute of Certified Public Accountants (May 20, 2008) (``AICPA
Letter''); CAPIS Letter; Consumer Federation Letter; CGMI Letter;
Fried Frank Letter; IAA Letter; ICI Letter; Janus Letter; comment
letter of Merrill Lynch, Pierce, Fenner & Smith, Incorporated (May
16, 2008) (``Merrill Lynch Letter''); comment letter of the Money
Management Institute (May 16, 2008) (``MMI Letter''); comment letter
of Morgan Stanley & Co. Incorporated (May 16, 2008) (``Morgan
Stanley Letter''); NAPFA Letter; comment letter of the North
American Securities Administrators Association, Inc. (May 16, 2008)
(``NASAA Letter''); NRS Letter; comment letter of the National
Society of Compliance Professionals Inc. (May 16, 2008) (``NSCP
Letter''); comment letter of Charles Schwab & Co. and Charles Schwab
Investment Management, Inc. (May 16, 2008) (``Schwab Letter'');
Wellington Letter.
\17\ NAPFA Letter.
\18\ Wellington Letter.
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We have added an instruction to Part 2 of Form ADV to require that
an adviser provide the information in a specified format.\19\ We are
persuaded by commenters that this format for items in the brochure will
facilitate investors' comparison of multiple advisers and are adopting
this requirement.\20\ An adviser
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must respond to each item in the brochure, and must present the
information in order of the items in the form, using the headings
provided by the form. If an item is inapplicable to an adviser, the
adviser must include the heading and an explanation that the
information is inapplicable.\21\ If information an adviser provides in
response to one item is also responsive to another item, the adviser
may cross-reference the information in the other item.\22\
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\19\ Instruction 1 of General Instructions for Part 2 of Form
ADV.
\20\ See ABA Committees Letter; comment letter of First Allied
Securities, Inc. (May 16, 2008) (``First Allied Letter''); comment
letter of Mercer Advisors (May 2, 2008) (``Mercer Letter''); NCS
Letter; NRS Letter; comment letter of Reed Smith on behalf of
Federated Investors, Inc. (May 16, 2008) (``Federated Letter'').
\21\ Instruction 1 of General Instructions for Part 2 of Form
ADV.
\22\ Id.
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Also, it is critical that advisers communicate clearly to their
clients and prospective clients in the brochure. Thus, instructions to
Part 2 provide that, in drafting the brochure, advisers, among other
things, should use short sentences; definite, concrete, everyday words;
and the active voice. In addition, the brochure should discuss only
conflicts the adviser has or is reasonably likely to have, and
practices in which it engages in or is reasonably likely to engage.\23\
If a conflict arises or the adviser decides to engage in a practice
that it has not disclosed, supplemental information must be provided to
the client.
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\23\ Instruction 2 of General Instructions for Part 2 of Form
ADV.
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2. Brochure Items
Part 2A, as adopted, contains 18 separate items, each covering a
different disclosure topic.\24\ We have drawn the items in Part 2A
largely from disclosure advisers have long been required to make in
response to the previous Part 2, and have added items to address new
concerns or developments. Much of the disclosure required in Part 2A
addresses an adviser's conflicts of interest with its clients, and is
disclosure that the adviser, as a fiduciary, must make to clients in
some manner regardless of the form requirements.
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\24\ Part 2A consists of a main body and an appendix, Appendix
1. Appendix 1 contains the requirements for a specialized type of
firm brochure--a wrap fee program brochure--and requires disclosure
similar to current Schedule H of Part 2 of Form ADV. See rule 204-
3(d); Appendix 1 to Part 2A; infra note 182 and accompanying text.
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Some commenters urged us to require fewer items and require
advisers to provide less detailed information.\25\ We have reviewed
carefully these suggestions and have modified some of our items in
response. In some cases, however, commenters urged us to eliminate
particular proposed disclosures, such as the fee schedule, that have
long been required in Part 2 and provide investors essential
information. Elimination of such proposed disclosures would result in
clients not receiving important information they currently receive from
their advisers and on which they may rely. In many other cases, further
cuts would not have reduced the amount of disclosure an adviser would
have to make to clients, but rather would have permitted the disclosure
to be made in a different document or manner. Thus, elimination of
disclosure requirements in Part 2A suggested by some commenters would
be unlikely to reduce burdens or eliminate the amount of information
required to be provided to clients to satisfy an adviser's fiduciary
obligations.\26\
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\25\ See, e.g., comment letter of the Financial Service
Institute (May 16, 2008) (``FSI Letter''); Schwab Letter; comment
letter of the Securities Industry and Financial Markets Association
(May 16, 2008) (``SIFMA Letter''); comment letter of Sutherland
Asbill & Brennan LLP (May 16, 2008) (``Sutherland Letter'').
\26\ Advisers with fewer conflicts and simpler business
arrangements will be able to prepare shorter brochures.
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We agree that disclosure to clients should be succinct and
readable. We note that advisers, because of how they choose to present
their programs or services to clients or the complexity of their
disclosures, have the ability to take steps that would limit the length
of their brochures. For example, 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.\27\ Advisers that choose to disclose more than is required by
the form (and their fiduciary obligations) will create lengthier
brochures than those that take a more focused approach. Advisers with a
more complicated offering of advisory services (or business
arrangements) might consider including a summary in the beginning of
their brochure, followed by a more detailed discussion of each item in
the brochure. We have amended the instructions to clarify that
including a summary is permissible.\28\
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\27\ See rule 204-3(e) (allowing advisers that provide
substantially different advisory services to different clients to
provide clients with different brochures as long as each client
receives all information about the services and fees that are
applicable to that client). Note that an adviser may not omit any
information required by Item 9 of Part 2A (Disciplinary Information)
in any brochure provided to any client, and that each brochure must
be filed through IARD. See rule 204-3(a); see also Instruction 2 for
Part 2A of Form ADV. An adviser that creates separate brochures must
file each brochure through the IARD system. See Instruction 9 for
Part 2A of Form ADV.
\28\ See Instruction 8 of Instructions for Part 2A of Form ADV.
We have also added an instruction to Part 2 explaining that advisers
must provide the client with sufficiently specific facts so that the
client is able to understand the conflicts of interest the adviser
has and the business practices in which it engages, and can give his
or her informed consent to the transaction or practice that gives
rise to the conflict or to reject the transaction or practice. See
Instruction 3 of General Instructions for Part 2 of Form ADV.
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Below, we discuss each of the items in the form and the
modifications we have made from our proposal.
Item 1. Cover Page. Item 1 requires that an adviser disclose on the
cover page of its brochure the name of the firm, its business address,
contact information, Web site (if it has one), and the date of the
brochure. The cover page also must include a statement that the
brochure has not been approved by the Commission or any state
securities authority. If an adviser refers to itself as a ``registered
investment adviser,'' it also must include a disclaimer that
registration does not imply a certain level of skill or training.\29\
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\29\ We have observed that the emphasis on SEC registration, in
some advisers' marketing materials, appears to suggest that
registration either carries some official imprimatur or indicates
that the adviser has attained a particular level of skill or
ability. Section 208(a) of the Advisers Act [15 U.S.C. 80b-8(a)]
makes such suggestions unlawful.
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The item reflects one change from our proposal. Item 1 requires an
adviser to disclose on the cover page of the brochure only a general
telephone number and/or e-mail address that clients can use to contact
the adviser if they have questions about the brochure. Commenters
asserted that some larger advisers would find it cumbersome to comply
with our proposal, which would have required the name and phone number
of a specific individual or service center.\30\
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\30\ See First Allied Letter; IAA Letter; SIFMA Letter.
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Item 2. Material Changes. Item 2 requires that an adviser amending
its brochure identify and discuss the material changes since the last
annual update on the cover page or the following page or as a separate
document accompanying the brochure.\31\ This item is designed to make
clients aware of information that has changed since the prior year's
brochure and that may be important to them.
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\31\ Advisers may include the summary in their brochure or in a
separate document. Item 2 of Part 2A. A summary prepared as a
separate document can be used to satisfy an adviser's annual client
delivery obligations. See rule 204-3(b)(2), discussed in Section
II.A.3 below. Summaries provided as a separate document must be
filed with the Commission as an exhibit to Part 2. See Note to
paragraphs (a) and (b) of rule 204-1; Instruction 6 for Part 2A of
Form ADV. If an adviser includes the summary of material changes in
its brochure, and amends its brochure on an interim basis between
annual updating amendments, the adviser should consider whether it
should update its summary of material changes to avoid confusing or
misleading clients reading the updated brochure. See Note to
Instruction 6 for Part 2A of Form ADV.
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Several commenters supported this requirement, agreeing that
advisers can achieve meaningful disclosure with an annual disclosure
highlighting changes to the brochure.\32\ Others expressed concern that
advisers would write lengthy summaries to avoid liability.\33\ We
emphasize that we intend this document to be a summary that identifies
and broadly discusses the material changes,\34\ and that it should not
be a lengthy discussion that replicates the brochure itself.\35\
Instead, the summary need contain no more than necessary to inform
clients of the substance of the changes to the adviser's policies,
practices or conflicts of interests so that they can determine whether
to review the brochure in its entirety or to contact the adviser with
questions about the changes.
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\32\ See ASG Letter; comment letter of the CFA Institute Centre
for Financial Market Integrity (May 22, 2008) (``CFA Institute
Letter''); Consumer Federation Letter; FPA Letter; IAA Letter; Janus
Letter; NASAA Letter.
\33\ See AICA Letter; FSI Letter; ICI Letter; comment letter of
Jackson, Grant Investment Advisers, Inc. (May 26, 2008) (``Jackson
Letter''); comment letter of Katten Muchin Rosenman LLP (May 16,
2008) (``Katten Letter''); Mercer Letter; Morgan Stanley Letter;
NSCP Letter; comment letter of the Financial Service Roundtable (May
16, 2008) (``Roundtable Letter''); SIFMA Letter; Sutherland Letter.
\34\ We have revised Item 2 to require advisers not only to
identify, but also to ``discuss'' material changes to clarify our
intent.
\35\ A few commenters also sought clarification of the term
``material changes.'' See comment letter of the American Council of
Life Insurance (May 16, 2008) (``ACLI Letter''); Fried Frank Letter;
FSI Letter; IAA Letter; Roundtable Letter; comment letter of T. Rowe
Price Associates, Inc. (May 16, 2008) (``T. Rowe Letter''). The
standard of materiality under the Advisers Act is whether there is a
substantial likelihood that a reasonable investor (here, client)
would have considered the information important. See S.E.C. v.
Steadman, 967 F.2d 636, 643 (D.C. Cir. 1992). Cf. Basic Inc. v.
Levinson, 485 U.S. 224, 231-232 (1988); TSC Industries v. Northway,
Inc., 426 U.S. 438, 445, 449 (1976). This is a facts and
circumstances test, requiring an assessment of the ``total mix of
information,'' in the characterization of the Supreme Court. TSC
Industries, 426 U.S. at 449. Given that materiality depends on the
factual situation, which may vary with each situation, we do not
believe that it is appropriate to specifically define or provide any
bright line tests for what is and is not material.
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Item 3. Table of Contents. Item 3 requires each adviser to include
in its brochure a table of contents detailed enough to permit clients
and prospective clients to locate topics easily. Some commenters
supported the use of a table of contents but urged the Commission to
mandate a uniform format so that investors can compare brochures of
multiple advisers more easily.\36\ Others opposed a uniform format,
arguing that flexibility would enable an adviser to best convey
information about its firm to clients.\37\ As discussed above, we are
persuaded by commenters that a uniform format for items in the brochure
will facilitate investors' comparison of multiple advisers and are
adopting this requirement. We therefore added an instruction to Part 2
of Form ADV to require advisers to present the information in the order
of the items in the form, using the headings provided by the form.\38\
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\36\ See supra note 20.
\37\ See Fried Frank Letter; Janus Letter; Lininger Letter.
\38\ Instruction 1 of General Instructions for Part 2 of Form
ADV.
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Item 4. Advisory Business. Item 4 requires each adviser to describe
its advisory business, including the types of advisory 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. In computing the amount of client assets that it manages, an
adviser may use a method that differs from the method used in Part 1A
of Form ADV to report ``assets under management.'' \39\ An adviser
opting to use a different method must keep documentation describing the
method used.\40\
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\39\ For an explanation of Part 1A's requirements for computing
``assets under management,'' see Instruction 5.B for Part 1A of Form
ADV.
\40\ See rule 204-2(a)(14)(ii) and Note to Item 4.E of Part 2A.
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Two commenters urged the Commission not to require that advisers
make additional disclosure if they hold themselves out as specializing
in a particular type of advisory service. One was concerned that
advisers would have interpretive problems in defining specialized
advisory services and that disclosure describing specialized services
would not provide meaningful information to clients.\41\ The other
argued that Item 8 (Strategies and Risks) covers similar
information.\42\ As we explained in the Proposing Release, we require
that advisers identify a specialized advisory service because we
believe that clients likely will want to understand this before
engaging that adviser.\43\ Accordingly, we are adopting this item as
proposed.
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\41\ See NAPFA letter.
\42\ See Sutherland Letter.
\43\ See Proposing Release at Section II.A.2.
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Commenters were divided on whether we should require investment
advisers to calculate the amount of their assets in a manner consistent
with the instructions for Part 1A in order to avoid confusion.\44\ The
methodology for calculating assets required under Part 1A is designed
for a particular purpose (i.e., for making a determination as to
whether an adviser should register with the Commission or with the
states), rather than to convey meaningful information about the scope
of the adviser's business. Thus, we are permitting advisers to use a
different methodology for Part 2A disclosure.\45\
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\44\ The CFA Institute Letter, IAA Letter, Janus Letter, Mercer
Letter, and NRS Letter argued that the calculation requirements
should be the same. Others supported our proposal that would permit
advisers to use a different calculation of assets under management
than the one required for Part 1A, with most of these commenters
arguing that this flexibility would allow advisers to more
accurately portray the business of the firm and total assets
managed. See comment letter of Ashland Compliance Group LLC (May 16,
2008) (``Ashland Letter''); Lininger Letter; MMI Letter; Morgan
Stanley Letter.
\45\ For example, in calculating ``assets under management,''
for purposes of Part 1A, an adviser may include the entire value of
a managed portfolio, but only if at least 50% of the portfolio's
total value consists of securities. See current Form ADV:
Instructions for Part 1A of Form ADV. Thus, for Part 1A purposes, an
adviser will not include other assets (including securities) that it
manages in a ``non-securities'' portfolio. The Part 1A formula for
calculating assets under management was designed based on
considerations related to the National Securities Markets
Improvement Act of 1996 division of responsibility for regulation of
advisers between the Commission and state securities regulatory
authorities. Public Law 104-290, 110 Stat. 3416 (1996).
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Finally, several commenters urged that we permit an adviser to
update the amount of assets under management only in its annual
updating amendment rather than (as we proposed) at the time an adviser
makes an interim update to its brochure if the amount had become
materially inaccurate.\46\ We believe that our proposal appropriately
balanced the burdens that would be imposed on advisers by having to
amend their brochures repeatedly with the need to provide clients with
reasonably current information. Therefore, we are adopting this
instruction as proposed.\47\ Advisers must update the amount of their
assets under management annually (as part of their annual updating
amendment) and make interim amendments only for material changes in
assets under management when they are filing an ``other than annual
amendment'' for a separate reason. As we have noted, as a fiduciary, an
adviser has an ongoing obligation to inform its clients of any material
information that could affect the advisory relationship, which could
include a material change to assets under management.\48\
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\46\ See Morgan Stanley Letter; MMI Letter.
\47\ See Note to Instruction 4 of General Instructions for Form
ADV.
\48\ Note to Instruction 2 of Instructions for Part 2A of Form
ADV. Disclosure updating the adviser's assets under management could
be provided to clients by means other than the brochure. We have
brought enforcement actions charging advisers with engaging in fraud
by misrepresenting their assets under management to advisory clients
and prospective clients, including in advisory brochures. See, e.g.,
SEC v. Locke Capital Management, Inc. and Leila C. Jenkins,
Litigation Release No. 20936 (Mar. 9, 2009) (settled order).
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[[Page 49238]]
Item 5. Fees and Compensation. Item 5 requires that an adviser
describe in its brochure how it is compensated for its advisory
services, provide a fee schedule, and disclose whether fees are
negotiable.\49\ An adviser must disclose whether it bills clients or
deducts fees directly from clients' accounts, and how often it assesses
fees (or bills clients).\50\ The item also requires each adviser to
describe the types of other costs, such as brokerage, custody fees and
fund expenses that clients may pay in connection with the advisory
services provided to them by the adviser.\51\ An adviser charging fees
in advance must explain how it calculates and refunds prepaid fees when
a client contract terminates.\52\
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\49\ See Item 5.A of Part 2A.
\50\ See Item 5.B of Part 2A.
\51\ See Item 5.C of Part 2A.
\52\ See Item 5.D of Part 2A. Item 18 of Part 2A also requires
the disclosure of certain financial information about an adviser
that requires prepayment of fees.
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Item 5 also requires an adviser that receives compensation
attributable to the sale of a security or other investment product
(e.g., brokerage commissions), or whose personnel receive such
compensation, to disclose this practice and the conflict of interest it
creates, and to describe how the adviser addresses this conflict.\53\
Such an adviser also must disclose that the client may purchase the
same security or investment product from a broker that is not
affiliated with the adviser.\54\
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\53\ See Item 5.E of Part 2A. Because of this conflict of
interest, advisers are required by the antifraud provisions of the
Advisers Act to disclose their receipt of transaction-based
compensation to clients. We have brought enforcement actions
charging advisers with failures to make such disclosures. See, e.g.,
In the Matter of Financial Design Associates, Inc. and Albert L.
Coles, Jr., Investment Advisers Act Release No. 2654 (Sept. 25,
2007) (settled order); In the Matter of IMS, CPAs & Associates,
Vernon T. Hall, Stanley E. Hargrave, and Jerome B. Vernazza,
Investment Advisers Act Release No. 1994 (Nov. 5, 2001) (settled
order) (petitioners' appeal denied in Vernazza v. SEC, 327 F.3d 851
(9th Cir. 2003)).
\54\ See Item 5.E.2 of Part 2A. In addition to the requirement
in Item 5.E.2 of Part 2A, an adviser that receives more than half of
its revenue from commissions and other sales-based compensation must
explain that commissions are the firm's primary (or, if applicable,
exclusive) form of compensation. See Item 5.E.3 of Part 2A. An
adviser that charges advisory fees in addition to commissions or
markups to an individual client must disclose whether it reduces its
fees to offset the commissions or markups. See Item 5.E.4 of Part
2A.
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Some commenters expressed strong support for these disclosure
requirements, with one commenter stating that such disclosure is
``essential to a healthy adviser-client relationship.'' \55\ Others
argued generally that most of the information is not relevant for many
clients, and specifically that providing a complete set of fee
schedules would impose an undue burden on advisers.\56\ We disagree
with commenters who favored a broad elimination of fee information from
the brochure. Information about fees is important to clients and can be
used to compare fees of different advisers.\57\ More persuasive,
however, were arguments that brochure fee information is likely not
useful to institutional and large, sophisticated clients who are often
in a position to negotiate fee arrangements with their adviser and for
whom, therefore, a fee table would have little utility.\58\ These
arguments have persuaded us to provide an exception which permits an
adviser to omit disclosure of its fee schedule and the other
information in Item 5.A in any brochure provided only to clients who
are ``qualified purchasers.''\59\
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\55\ See comment letter of the Certified Financial Planner Board
of Standards, Inc. (May 29, 2008) (``CFP Board Letter''). The ASG
Letter, the CFA Institute Letter, the Lininger Letter, and the NRS
Letter also expressed strong support for most of these requirements.
\56\ See comment letter of Eric A. Brill (Apr. 26, 2008)
(``Brill Letter''); IAA Letter. The IAA Letter stated that larger
firms may have to prepare extremely long fee schedules. They urged
the Commission to provide flexibility regarding fee schedule
disclosure as long as the fee is fully disclosed in the advisory
contract. One commenter suggested that we amend General Instruction
4, which permits advisers to update any change to its fee schedules
only annually, reasoning that potential clients would need this
updated information in selecting advisers. See NASAA Letter. The
exception contained in the instruction is designed to prevent an
adviser from having to make multiple interim amendments as a result
of small changes in a fee schedule each of which may be material
only to certain affected clients or prospective clients who would
learn of them when considering whether to enter into an advisory
agreement that would reflect a revised fee. On balance, we believe
that an annual update may be sufficient.
\57\ This information may be particularly useful to clients
searching for an adviser by comparing information on brochures that
will be available on the Internet.
\58\ See IAA letter; Wellington Letter.
\59\ ``Qualified purchasers,'' as defined under section
2(a)(51)(A) of the Company Act [15 USC 80a-2(a)(51)(A)], include,
among others, natural persons who own $5 million or more in
investments and persons who manage $25 million or more in
investments for their account or other accounts of other qualified
purchasers.
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A few commenters urged us to not require description of other types
of fees or expenses because, among other things, such fees may vary
significantly among clients and disclosure regarding them may confuse
clients.\60\ However, this simple and brief disclosure (which is not
required to include the amount or range of the fees) may be helpful to
investors unacquainted with the practices of an adviser or the
ancillary costs of actively managed investing. Therefore, we are
adopting this disclosure requirement, as proposed.
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\60\ See NAPFA Letter; NRS Letter; NSCP Letter.
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As noted above, Item 5 also requires an adviser that receives
transaction-based compensation, or whose personnel receive such
compensation, to disclose this practice and the conflict of interest it
creates and to describe how the adviser addresses this conflict. Some
commenters argued that this item inappropriately implies endorsement of
a ``fee-based'' compensation structure over a ``commission-based''
structure.\61\ That is not our intent. The item simply recognizes that
an adviser that accepts compensation from the sale to a client of
securities has an incentive to base investment recommendations on the
amount of compensation it will receive, rather than on the client's
best interests, and thus involves a significant conflict of
interest.\62\ As a result, we are adopting the requirement as
proposed.\63\
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\61\ See FSI Letter; Sutherland Letter.
\62\ Moreover, the item is not, in substance, different from the
previous Item 9 of Part 2, which, in recognition of this conflict,
required an adviser to disclose whether the adviser effects
securities transactions for clients. See also supra note 53;
Applicability of the Investment Advisers Act to Financial Planners,
Pension Consultants, and Other Persons Who Provide Investment
Advisory Services as a Component of Other Financial Services,
Investment Advisers Act Release No. 1092 (Oct. 16, 1987) [52 FR
38400 (Oct. 16, 1987)] (``Release 1092'').
\63\ We note that nothing in the Advisers Act precludes an
adviser from accepting transaction-based compensation. However, an
adviser that receives compensation in connection with the purchase
or sale of securities should carefully consider the applicability of
the broker-dealer registration requirements of the Securities
Exchange Act of 1934.
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Item 6. Performance-Based Fees and Side-By-Side Management. Item 6
requires an adviser that charges performance-based fees or that has a
supervised person who manages an account that pays such fees to
disclose this fact. If such an adviser also manages accounts that are
not charged a performance fee, the item also requires the adviser to
discuss the conflicts of interest that arise from its (or its
supervised person's) simultaneous management of these accounts, and to
describe generally how the adviser addresses those conflicts.\64\
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\64\ As fiduciaries, advisers must disclose all material
information regarding any proposed performance fee arrangements as
well as any material conflicts posed by the arrangements. See
Exemption To Allow Investment Advisers To Charge Fees Based Upon a
Share of Capital Gains Upon or Capital Appreciation of a Client's
Account, Investment Advisers Act Release No. 1731, at nn.13-14 and
accompanying text (July 15, 1998) [63 FR 39022 (July 21, 1998)].
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[[Page 49239]]
Two commenters explicitly supported this requirement.\65\ Two other
commenters urged us to eliminate it, arguing that the required
disclosure already should be in Item 5 (Fees and Compensation) or is
required by other items.\66\ As discussed in the Proposing Release, an
adviser charging performance fees to some accounts but not others faces
a variety of conflicts of interest.\67\ The number of advisers with
these arrangements has grown, and we believe that it is important that
clients and prospective clients receive disclosure regarding these
conflicts and how the adviser addresses them.\68\ While Item 5 requires
disclosure of an adviser's fee arrangements, it does not specifically
require disclosure of the conflicts any particular fee arrangement may
create other than with respect to transaction-based compensation.
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\65\ See CFA Institute Letter; Lininger Letter.
\66\ See IAA Letter; Schnase Letter.
\67\ See Proposing Release, at nn.51-53 and accompanying text.
An adviser charging performance fees to some accounts faces a
variety of conflicts because the adviser can potentially receive
greater fees from its accounts having a performance-based
compensation structure than from those accounts it charges a fee
unrelated to performance (e.g., an asset-based fee). As a result,
the adviser may have an incentive to direct the best investment
ideas to, or to allocate or sequence trades in favor of, the account
that pays a performance fee. We have brought enforcement actions
charging advisers with undisclosed conflicts in regard to accounts
that pay performance fees. See, e.g., In the Matter of Nevis Capital
Management, LLC, et al., Investment Advisers Act Release No. 2214
(Feb. 9, 2004) (settled order). See also In the Matter of Alliance
Capital Management, L.P., Investment Advisers Act Release No. 2205
(Dec. 18, 2003) (settled order).
\68\ According to data derived from investment advisers'
responses to Item 5.E of Part 1A of Form ADV reported through IARD
as of May 3, 2010, approximately 28% of SEC-registered investment
advisers reported charging performance-based fees to some accounts
but not others.
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Item 7. Types of Clients. Item 7 requires that the brochure
describe the types of advisory clients the firm generally has, as well
as the firm's requirements for opening or maintaining an account, such
as minimum account size. One commenter recommended that we eliminate
this proposed disclosure requirement, arguing that the information is
not material to the decision of whether to hire or retain an investment
adviser.\69\ We disagree. We believe that many prospective clients
would consider the type of clients to be an important factor in
determining whether an adviser's business model is a good fit for
them.\70\ As a result, we are adopting Item 7 as proposed.
---------------------------------------------------------------------------
\69\ See Sutherland Letter.
\70\ We note that disclosure of this information is already
required in the previous Item 2 of Part 2 of Form ADV.
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Item 8. Methods of Analysis, Investment Strategies and Risk of
Loss. Item 8 requires that advisers describe their methods of analysis
and investment strategies and disclose that investing in securities
involves risk of loss which clients should be prepared to bear.\71\
Item 8 also requires specific disclosure of how strategies involving
frequent trading can affect investment performance. Finally, this item
requires that advisers explain the material risks involved for each
significant investment strategy or method of analysis they use and
particular type of security they recommend, with more detail if those
risks are unusual.
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\71\ We have brought enforcement actions charging advisers with
omissions and misrepresentations regarding investment strategies.
See, e.g., In the Matter of George F. Fahey, Investment Advisers Act
Release No. 2196 (Nov. 24, 2003) (settled order); In the Matter of
Gary L. Hamby and Gary B. Ross, Investment Advisers Act Release No.
1668 (Sept. 22, 1997) (settled order).
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Several commenters supported this proposed disclosure requirement
as central to the adviser's fiduciary relationship with its client.\72\
One objected, stating that the item creates a different disclosure
obligation for multi-strategy firms because, as proposed, it only
required advisers primarily using a particular strategy to discuss the
risks involved in their strategy.\73\ We agree that advisers should
disclose material risks associated with their strategies that will be
relevant to most clients, regardless of whether they use one strategy
or many strategies. We have, therefore, modified the item to require
that advisers explain the material risks involved for each significant
investment strategy or method of analysis they use, rather than those
they primarily use, as we believe this threshold for disclosure better
captures those methods of analysis or strategies that will be relevant
to most clients.\74\ However, as we noted in the proposal, the brochure
may not always be the best place for a multi-strategy adviser to
disclose risks associated with all of its methods of analysis or
strategies.\75\ Disclosure of that information likely would lengthen
the brochure unnecessarily given that different clients will be
pursuing different strategies, each of which poses specific and
different risks.
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\72\ See CFA Institute Letter; Lininger Letter; NAPFA Letter;
NRS Letter.
\73\ See NAPFA Letter.
\74\ For these purposes, we would view a method of analysis or
strategy as significant if more than a small portion of the
adviser's clients' assets are advised using the method or strategy.
\75\ See Proposing Release at Section II.A.2.
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Some commenters urged us to define the term ``frequent trading of
securities,'' which is used in Item 8.B, but did not suggest a
definition in response to our request.\76\ As commenters implicitly
acknowledged, the phrase ``frequent trading'' is hard to define. We
would expect advisers to respond to this item only if their intended
investment strategies involve frequent trading of securities that a
reasonable client would otherwise not expect in light of the other
disclosures contained in the brochure.
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\76\ See comment letter of Gary D. Case (May 12, 2008) (``Case
Letter''); FSI Letter; IAA Letter; comment letter of ProEquities,
Inc. (May 21, 2008) (``ProEquities Letter''); comment letter of the
Trust Advisory Group (May 12, 2008) (``TAG Letter''); T. Rowe Price
Letter.
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Several commenters urged us to not require disclosure in the
brochure of cash balance practices, arguing that such practices vary
widely depending on the client, are typically addressed in the client's
investment advisory agreement, and typically do not involve conflicts
of interest.\77\ We acknowledge that in many instances such practices
do not involve conflicts of interest and have omitted the requirement
from Part 2A. We note, however, that an adviser may have an obligation
(independent of Part 2A) to disclose material information about its
policies regarding the management of cash balances where the omission
of such information would constitute a breach of the adviser's
fiduciary duty (e.g., where the cash is not managed in the best
interest of the client).\78\
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\77\ See ASG Letter; IAA Letter; T. Rowe Letter.
\78\ An adviser that is also registered as a broker-dealer may
also have disclosure obligations relating to its cash balance
practices arising under Commission and self-regulatory organization
requirements. See NYSE information Memo No. 05-11 (Customer Account
Sweeps to Banks) (Feb. 2005).
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One commenter noted that, as proposed, Items 8.B and 8.C would
require disclosure of all risks associated with using a particular
investment strategy or primarily recommending a particular type of
security, and not just material risks.\79\ We intended these items to
require disclosure only of material risks, and have amended these items
accordingly.\80\
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\79\ See Schnase Letter.
\80\ See Items 8.B and 8.C of Part 2A (requiring disclosure of
``material risks'').
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This commenter also noted that Items 8.B and 8.C call for detailed
discussions of ``significant or unusual'' risks, inquired whether this
differed from ``material'' risks, and asked for clarification of this
terminology. This requirement is intended to elicit from the adviser
disclosure of significant risks associated with using a particular
investment strategy or recommending a particular type of security that
otherwise would not be apparent to the client from reading the
adviser's
[[Page 49240]]
brochure. An adviser that describes a wide range of investment advisory
activities in its brochure but, in fact, specializes, for example, in
investing in leveraged exchange-traded funds should disclose such
information in response to this item.
Item 9. Disciplinary Information. Item 9 requires that an adviser
disclose in its brochure material facts about any legal or disciplinary
event that is material to a client's (or prospective client's)
evaluation of the integrity of the adviser or its management personnel.
These requirements incorporate into the brochure the client disclosure
regarding disciplinary information required by rule 206(4)-4 under the
Advisers Act.
Items 9.A, B, and C provide a list of disciplinary events that are
presumptively material if they occurred in the previous 10 years. Item
9 cautions advisers, however, that the events listed in that item are
those that are presumed to be material and do not constitute an
exhaustive list of material disciplinary events. The list includes any
convictions for theft, fraud, bribery, perjury, forgery,
counterfeiting, extortion and violations of securities laws by the
adviser or one of its executives. Events such as these reflect on the
integrity of the adviser and its management personnel and, therefore,
are presumptively material to clients. The adviser may rebut this
presumption, in which case no disclosure to clients is required.\81\ An
adviser rebutting this presumption must document its determination in a
memorandum and retain that record to enable our staff to monitor
compliance with this important disclosure requirement.\82\
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\81\ Note to Item 9 of Part 2A (explaining four factors an
adviser should consider when assessing whether the presumption can
be rebutted).
\82\ Rule 204-2(a)(14)(iii).
---------------------------------------------------------------------------
As required by rule 206(4)-4, Item 9 requires that disciplinary
events more than 10 years old be disclosed if the event is so serious
that it remains material to a client's or prospective client's
evaluation of the adviser and the integrity of its management. Three
commenters requested that the Commission further define and clarify
what disciplinary information is material in these circumstances.\83\
We have determined not to do so, however, as advisers should evaluate
their obligations to disclose information to clients under existing
materiality standards adopted by the courts and the Commission.\84\ We
note that a prior disciplinary event involving an adviser would be
important to clients for many reasons, including how it may reflect
upon the adviser's integrity, the effect it may have on the degree of
trust and confidence a client would place in the adviser, or if it
imposed limitations on an adviser's activities.\85\
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\83\ See AICPA Letter; Sutherland Letter; Jackson Letter.
\84\ See supra note 35 for a discussion of materiality under the
Advisers Act. See also the note at the end of Item 9 of Part 2A and
Financial and Disciplinary Information that Investment Advisers Must
Disclose to Clients, Investment Advisers Act Release No. 1035 (Sept.
19, 1986) [51 FR 34229 (Sept. 26, 1986)] (`` Rule 206(4)-4 Proposing
Release''), at nn.12-13 and accompanying text. One commenter noted
the use of the term ``currently material'' in Item 9 and asked if
this phrase differed in meaning from ``material.'' See ABA
Committees Letter. We did not intend this phrase to have a different
meaning than ``material'' and, therefore, we have deleted the word
``currently'' in the Item 9 as adopted.
\85\ See Rule 206(4)-4 Proposing Release, at nn. 12-13 and
accompanying text. The Commission has long viewed information about
a prior disciplinary proceeding involving an adviser as important to
clients and that failure to disclose such a proceeding may violate
the antifraud provisions of sections 206(1) and 206(2) of the
Advisers Act. See e.g., In the Matter of Jesse Rosenblum, Investment
Advisers Act Release No. 913 (May 17, 1984).
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Two other commenters addressed the rebuttable presumption of
materiality under Item 9.\86\ One commenter supported the flexibility
of allowing advisers to rebut the presumption of materiality.\87\ Other
commenters suggested, however, that an adviser should not be permitted
to rebut this presumption, stating that this would give advisers little
incentive to disclose disciplinary information that may be considered
material.\88\ We note that an adviser, as a fiduciary, has an
obligation to disclose material information to clients.\89\ We believe
that the legal consequences that flow from its failure to meet this
obligation provide an incentive for an adviser to disclose material
disciplinary information. Moreover, advisers that seek to exclude
information from their brochures because they believe that they can
rebut the presumption of materiality must memorialize the basis for
that determination, which is subject to review by our staff.\90\
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\86\ See Morgan Stanley Letter; Sutherland Letter.
\87\ See IAA Letter.
\88\ See NASAA Letter; NCS Letter.
\89\ We note that failure to disclose material information to
clients constitutes a violation of section 206 of the Advisers Act.
We have brought enforcement actions charging advisers with failures
to make such disclosures. See, e.g., Colley Asset Management, Inc.,
and John E. Colley, Investment Advisers Act Release No. 2363 (Feb.
25, 2005) (settled order).
\90\ We also note that an adviser is required in Part 1A of Form
ADV to disclose disciplinary events regardless of whether they are
material. Part 1A is filed electronically with the Commission and is
publicly available on our website.
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In the Proposing Release, we requested comment on whether we should
require disclosure about arbitration awards and claims.\91\ A few
commenters supported arbitration disclosure, arguing that investors
deserve the most complete information available to build a picture of
an adviser's integrity.\92\ Others objected, with some reasoning that
arbitration claims are easy to make and that arbitration settlements
and awards may not necessarily include findings of wrongdoing (i.e.,
parties may settle arbitration proceedings and/or arbitration awards
may be granted even in the absence of legal violations).\93\ For this
reason, we have determined not to require disclosure of arbitration
awards in the client brochure. Advisers should, however, carefully
consider whether particular arbitration awards or settlements do, in
fact, involve or implicate wrongdoing and/or reflect on the integrity
of the adviser, and should be disclosed to clients in the brochure or
through other means.\94\ Because many disputes involving securities
firms (including investment advisers) are resolved through arbitration
or other methods of alternative dispute resolution, we will continue to
assess whether we should require that these events be reported by firms
registered with us.
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\91\ See Proposing Release at Section II.A.2. We also requested
comment in the Proposing Release on whether we should require that
advisers subject to a Commission administrative order provide
clients with a copy of that order. Commenters did not support such a
requirement and stated that, when appropriate, we should require
delivery of orders in individual proceedings. See Federated Letter;
Fried Frank Letter; Morgan Stanley Letter; Sutherland Letter. We
agree with commenters and Part 2A does not require that such orders
be provided to advisory clients.
\92\ See Consumer Federation Letter; CFA Institute Letter; CFP
Board Letter; NASAA Letter.
\93\ See comment letter from Michael Berlin (Apr. 28, 2008)
(``Berlin Letter''); Federated Letter; First Allied Letter; Fried
Frank Letter; IAA Letter; ICI Letter; Janus Letter; Mercer Letter;
Morgan Stanley Letter; NRS Letter; SIFMA Letter; comment letter of
R.C. Verbeck (May 12, 2008) (``Verbeck Letter'').
\94\ We note that failure to disclose material information to
clients constitutes a violation of section 206 of the Advisers Act.
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Item 9 requires that an adviser must disclose if it (or any of its
management persons) has been involved in one of the events listed in
that item. ``Involved'' is defined as ``[e]ngaging in any act or
omission, aiding, abetting, counseling, commanding, inducing,
conspiring with or failing reasonably to supervise another in doing an
act.'' \95\ Three commenters requested that we narrow the definition of
``involved,'' arguing that the proposed definition is both overbroad
and vague.\96\ Other commenters supported using the term
[[Page 49241]]
``involved,'' as defined.\97\ One of these commenters noted that this
term also is used in Form BD and in Form U4 and, as such, changing the
meaning of the term (or eliminating it from Part 2A) would undermine
uniformity and create disparate reporting between broker-dealers and
advisers.\98\ We believe that, for purposes of consistency, it is
appropriate to continue to define the term ``involved'' as currently
defined in Form ADV. This term and definition has been used in Form ADV
for over 9 years and on Form BD for over 14 years, and we believe its
meaning should be well understood.\99\
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\95\ See the Glossary to Form ADV.
\96\ See Federated Letter; IAA Letter; Morgan Stanley Letter.
\97\ See CFA Institute Letter; NASAA Letter.
\98\ See NASAA Letter.
\99\ See Amendments to Form ADV, Investment Advisers Act Release
No. 1897 (Sept. 12, 2000) [65 FR 57438 (Sept. 22, 2000)]; Form BD
Amendments, Securities Exchange Act Release No. 37431 (July 12,
1996) [61 FR 37357 (July 18, 1996)].
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Some commenters recommended that advisers be permitted to satisfy
the obligation to disclose and update disciplinary events by referring
clients to the Investment Adviser Public Disclosure system (IAPD) to
obtain the firm's disclosures from Part 1A of Form ADV and providing a
copy of the disciplinary disclosures to clients who do not have
Internet access.\100\ One commenter strongly opposed this
recommendation, however, stating that ``[a]rming investors with this
information is one of the best tools we have to put investors on their
guard so that they can protect their own interests.'' \101\
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\100\ See comment letter of the Alternative Investment
Management Association (May 16, 2008) (``AIMA Letter''); ASG Letter;
Janus Letter; Morgan Stanley Letter; NRS Letter; SIFMA Letter;
Sutherland Letter.
\101\ Consumer Federation Letter.
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The disciplinary information provided in Part 1A is provided to the
Commission primarily for registration purposes and not with an eye
towards client disclosure. Part 1A, therefore, requires disclosure not
just about the advisory firm and its management personnel, but also
about all of its ``advisory affiliates.'' A firm's advisory affiliates
include all of the firm's employees, officers, partners, or directors
and all persons directly or indirectly controlling or controlled by the
firm.\102\ Having disciplinary information about this broad group is
important to the Commission for regulatory purposes. However, many of
the largest investment advisers may have a large number of advisory
affiliates and voluminous disciplinary disclosure, much of which may be
regarding advisory affiliates with no relationship to particular
clients. Accordingly, we believe that requiring clients to sift through
an advisory firm's Part 1A disciplinary disclosure is not the most
effective client disclosure. Therefore, we are adopting the proposed
requirement that the brochure affirmatively disclose disciplinary
information about the adviser and its management personnel.
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\102\ See Form ADV: Glossary. Firm employees that perform only
clerical, administrative, support, or similar functions are excluded
from the definition.
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Because Part 2A, as amended, incorporates disciplinary disclosures
formerly required by rule 206(4)-4 directly in the advisory brochure
requirements, we are rescinding rule 206(4)-4.\103\ The rescission of
rule 206(4)-4 will be effective, with respect to any particular
investment adviser, on the date by which that adviser must deliver its
narrative brochure to existing clients and begin delivering its
brochure to prospective clients under the rule and form amendments we
are adopting today.\104\ Some advisers, however, may have clients to
whom they are not required to deliver a brochure, such as certain
clients receiving only impersonal investment advice or those that are
registered investment companies and business development
companies.\105\ For these advisers, their fiduciary duty of full and
fair disclosure requires them to continue to disclose to all their
clients material disciplinary and legal events and their inability to
meet contractual commitments to their clients.\106\
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\103\ In addition to requiring disclosure of certain
disciplinary information, rule 206(4)-4 requires an adviser to
disclose certain financial information to clients. As with the
disciplinary disclosure, we have incorporated this requirement into
the new brochure. Similar to rule 206(4)-4(a)(1), Item 18.B of Part
2A requires certain advisers to disclose any financial condition
that is reasonably likely to impair their ability to meet
contractual commitments to clients. See infra note 177 and
accompanying text.
\104\ See infra Section V.
\105\ Our requirements regarding to which clients an adviser
must deliver a brochure are discussed in Section II.A.3 below. One
commenter suggested that we retain rule 206(4)-4 to require only the
delivery of disciplinary information to clients for whom the
brochure delivery requirement does not apply. See ABA Committees
Letter.
\106\ See Financial and Disciplinary Information that Investment
Advisers Must Disclose to Clients, Investment Advisers Act Release
No. 1035 (Sept. 19, 1986) (``Rule 206(4)-4 Adopting Release'')
(``explaining that rule 206(4)-4 was designed to codify an
investment adviser's fiduciary obligation to disclose material
financial and disciplinary information to clients.''). We have
brought enforcement actions charging advisers with failures to make
such disclosures. See, e.g., In the Matter of Veritas Financial
Advisors LLC, Veritas Advisors, Inc., Patrick J. Cox and Rita A.
White, Investment Advisers Act Release No. 2577 (Dec. 29, 2006)
(settled order); In the Matter of Harry Michael Schwartz, Investment
Advisers Act Release No. 1833 (Sept. 27, 1999) (settled order); In
the Matter of Renaissance Capital Advisors, Inc., and Richard N.
Fine, Investment Advisers Act Release No. 1688 (Dec. 22, 1997)
(settled order). In addition, under section 9(a) of the Company Act
[15 USC 80a-9(a)] an investment adviser to a registered investment
company may be prohibited from serving in certain capacities with
the fund as a result of a disciplinary event.
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Item 10. Other Financial Industry Activities and Affiliations. Item
10 requires each adviser to describe in its brochure material
relationships or arrangements the adviser (or any of its management
persons) has with related financial industry participants, any material
conflicts of interest that these relationships or arrangements create,
and how the adviser addresses the conflicts.\107\ In addition, if an
adviser selects or recommends other advisers for clients, Item 10
requires that it disclose any compensation arrangements or other
business relationships between the advisory firms, along with the
conflicts created, and explain how it addresses these conflicts.\108\
The disclosure that Item 10 requires highlights for clients their
adviser's other financial industry activities and affiliations that can
create conflicts of interest and may impair the objectivity of the
adviser's investment advice.
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\107\ This item is similar to Item 8 of the previous Part 2. Two
commenters requested that we clarify or provide guidance regarding
``materiality'' in describing relations and arrangements with
related persons, and conflicts of interest arising from these
relations or arrangements. See IAA Letter; NRS Letter. We address
this comment earlier in this Release. See supra note 35 for a
further discussion of materiality under the Advisers Act.
\108\ We have brought enforcement actions charging advisers with
failures to make such disclosures. See, e.g., In the Matter of
Morgan Stanley & Co., Incorporated, Investment Advisers Act Release
No. 2904 (July 20, 2009) (settled order); In the Matter of Yanni
Partners, Inc. and Theresa A. Scotti, Investment Advisers Act
Release No. 2642 (Sept. 5, 2007) (settled order).
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Two commenters explicitly stated that they supported the disclosure
required by this item.\109\ At the suggestion of one commenter,\110\ we
have modified Item 10.D to require advisers that recommend other
advisers to disclose, in particular, payments or business relationships
that create material conflicts of interest with clients, so as not to
capture all relationships.
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\109\ See CFA Institute Letter; Lininger Letter.
\110\ See Sutherland Letter.
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Item 11. Code of Ethics, Participation or Interest in Client
Transactions and Personal Trading.
Code of Ethics. Item 11 requires each adviser to describe briefly
its code of ethics and state that a copy is available upon
request.\111\ Two commenters strongly supported the proposed item,
believing the required disclosure is
[[Page 49242]]
indicative of an adviser's commitment to its fiduciary duties.\112\ One
recommended that we instead simply require an adviser to note in the
brochure that a copy of its code of ethics is available upon
request.\113\ We believe that a brief, concise summary of the code of
ethics (as the item requires) will be helpful to prospective clients
who may not wish or feel the need to request the entire code of ethics
and will assist those clients in determining whether they would like to
read the entire code of ethics.\114\
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\111\ This requirement is almost identical to the previous
disclosure requirement in Item 9 of the previous Part 2.
\112\ See CFA Institute Letter; CFP Board Letter.
\113\ See Morgan Stanley Letter.
\114\ This summary should not be a reiteration of the entire
code of ethics, but rather should provide enough information for the
client to determine if it would like to read the full code of ethics
and to understand generally the adviser's ethical culture and
standards, how the adviser controls sensitive information, and what
steps it has taken to prevent employees from misusing their inside
positions at clients' expense. See Investment Adviser Code of
Ethics, Investment Advisers Act Release No. 2256 (July 2, 2004), at
text accompanying notes nn.66-67 [69 FR 41696 (July 9, 2004)].
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Participation or Interest in Client Transactions. If the adviser or
a related person recommends to clients, or buys or sells for client
accounts, securities in which the adviser or a related person has a
material financial interest, Item 11.B requires the brochure to discuss
this practice and the conflicts of interest presented.\115\ Conflicts
could arise, for example, when an adviser recommends that clients
invest in a pooled investment vehicle that the firm advises or for
which it serves as the general partner,\116\ or when an adviser with a
material financial interest in a company recommends that a client buy
shares of that company.\117\ The item requires advisers to disclose any
practices giving rise to these conflicts, the nature of the conflicts
presented, and how the adviser addresses the conflicts. Two commenters
expressed support for this requirement.\118\ We are adopting Item 11.B.
substantially as proposed, except that at the suggestion of three
commenters, we have omitted the portion of the proposed item that
required advisers to disclose ``procedures'' for making the disclosures
to clients.\119\ We agree with these commenters that the requirement
was inconsistent with the Commission's general approach throughout the
brochure of requiring disclosure about conflicts and how they are
addressed, but not about ``procedures.''
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\115\ An adviser's related persons are: (1) The adviser's
officers, partners, or directors (or any person performing similar
functions); (2) all persons directly or indirectly controlling,
controlled by, or under common control with the adviser; (3) all of
the adviser's current employees; and (4) any person providing
investment advice on the adviser's behalf. See Form ADV: Glossary.
Items 11.B, 11.C, and 11.D are similar to Item 9 of the previous
Part 2.
\116\ We have brought enforcement actions charging advisers with
failures to make such disclosures. See, e.g., In the Matter of
Thomson McKinnon Asset Management, L.P., Investment Advisers Act
Release No. 1243 (July 26, 1990) (settled order).
\117\ We have brought enforcement actions charging advisers with
failures to make such disclosures. See, e.g., In the Matter of
Chancellor Capital Management, Inc., et al., Investment Advisers Act
Release No. 1447 (Oct. 18, 1994) (settled order).
\118\ See CFA Institute Letter; CFP Board Letter.
\119\ See IAA Letter; ICI Letter; T. Rowe Letter.
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Personal Trading. Items 11.C and 11.D require disclosure of
personal trading by the adviser and its personnel.\120\ Item 11.C
requires an adviser to disclose whether it or a related person (e.g.,
advisory personnel) invests (or is permitted to invest) in the same
securities that it recommends to clients, or in related securities
(such as options or other derivatives). If so, the brochure must
discuss the conflicts presented and describe how the firm addresses the
conflicts. Item 11.D requires a similar discussion, but focuses on the
specific conflicts an adviser has when it or a related person trades in
the same securities at or about the same time as a client.\121\ In
response to this item, an adviser should explain how its internal
controls, including its code of ethics, prevent the firm and its staff
from buying or selling securities contemporaneously with client
transactions.
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\120\ We have brought enforcement actions charging advisers with
fraudulent personal trading. See In the Matter of Roger W. Honour,
Investment Advisers Act Release No. 1527 (Sept. 29, 1995) (settled
order).
\121\ We have brought enforcement actions charging advisers with
inaccurate disclosure in this context. See, e.g., In the Matter of
Hutchens Investment Management and William Hutchens, Investment
Advisers Act Release No. 2514 (May 9, 2006) (settled order).
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One commenter suggested that we specify a minimum amount of assets
that must be managed by an adviser in order for that adviser to be
required to disclose personal securities transactions, arguing that
small firms' securities transactions are not large enough to generate a
market impact and thus should not require disclosure.\122\ We disagree.
A small firm could still place a trade large enough to have a market
impact, especially in a thinly traded security. In addition, given that
an adviser's ability to place its own trades before or after client
trades in the same security may affect the objectivity of the adviser's
recommendations, we believe disclosure of this practice is warranted.
As a result, we are adopting Items 11.C and 11.D as proposed.
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\122\ See comment letter of Thaddeus Borek, Jr. (May 16, 2008).
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Finally, we note that we have modified the note to Item 11 to
clarify that Items 11.B, 11.C, and 11.D would not require disclosure
with respect to securities that are not ``reportable securities'' under
Advisers Act rule 204A-1(e)(10), such as shares in unaffiliated mutual
funds.\123\ As we indicated in the Proposing Release, such securities
are not reportable under Advisers Act Rule 204A-1 because they appear
to present little opportunity for front-running.\124\
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\123\ See Code of Ethics Adopting Release, supra note 114 at
n.42 and accompanying text.
\124\ See Proposing Release, supra note 2, at n.85.
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Item 12. Brokerage Practices. Item 12 requires that advisers
describe how they select brokers for client transactions and determine
the reasonableness of brokers' compensation. This item also requires
advisers to disclose how they address conflicts of interest arising
from their receipt of soft dollar benefits (i.e., research or other
products or services they receive in connection with client
brokerage).\125\
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\125\ Item 12 is similar to Item 12.B in the previous Part 2.
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Soft Dollar Practices. Many advisers receive brokerage and research
services in reliance on section 28(e) of the Securities Exchange Act of
1934 (``Exchange Act''),\126\ as well as other soft dollar products and
services provided by brokers in connection with client
transactions.\127\ Use of client securities transactions to obtain
research and other benefits creates incentives that result in conflicts
of interest between advisers and their clients.\128\ Because of these
[[Page 49243]]
conflicts, we have long required advisers to disclose their policies
and practices with respect to their receipt of soft dollar benefits in
connection with client securities transactions.\129\
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\126\ Section 28(e) of the Exchange Act provides a limited
``safe harbor'' for advisers with discretionary authority in
connection with their receipt of soft dollar benefits. Under section
28(e), a person who exercises investment discretion over a client
account has not acted unlawfully or breached a fiduciary duty solely
by causing the account to pay more than the lowest commission rate
available, so long as that person determines in good faith that the
commission amount is reasonable in relation to the value of the
brokerage and research services provided. Advisers must disclose
their receipt of soft dollar benefits to clients, regardless of
whether the benefits fall inside or outside of the safe harbor. See
Interpretive Release Concerning the Scope of Section 28(e) of the
Securities Exchange Act of 1934 and Related Matters, Exchange Act
Release No. 23170 (Apr. 23, 1986) [51 FR 16004 (Apr. 30, 1986)], at
n.33 and accompanying text.
\127\ According to IARD data as of May 3, 2010, approximately
61% of advisers registered with the Commission report on Form ADV,
Part 1A, Item 8.E that they or related persons receive soft dollar
benefits in connection with client transactions.
\128\ Commission Guidance Regarding Client Commission Practices
Under Section 28(e) of the Securities Exchange Act of 1934, Exchange
Act Release No. 54165 (July 18, 2006) [71 FR 41978 (July 24, 2006)]
(``2006 Soft Dollar Release'') (``[u]se of client commissions to pay
for research and brokerage services presents money managers with
significant conflicts of interest, and may give incentives for
managers to disregard their best execution obligations when
directing orders to obtain client commission services as well as to
trade client securities inappropriately in order to earn credits for
client commission services'').
\129\ See Item 12 of the previous Part 2.
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Item 12 requires an adviser that receives soft dollar benefits in
connection with client securities transactions to disclose its
practices.\130\ The description must be specific enough for clients and
prospective clients to understand the types of products or services the
adviser is acquiring and permit them to evaluate associated conflicts
of interest. Disclosure must be more detailed for products or services
that do not qualify for the safe harbor in section 28(e) of the
Exchange Act, such as services that do not aid in the adviser's
investment decision-making process.\131\
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\130\ See Item 12.A.1 of Part 2A.
\131\ See note to Item 12.A.1.e of Part 2A.
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Item 12 also requires that an adviser discuss in its brochure the
types of conflicts it has when it accepts soft dollar benefits and
explain how it addresses those conflicts.\132\ The item requires the
adviser to explain whether it uses soft dollars to benefit all client
accounts or only those accounts whose brokerage ``pays'' for the
benefits, and whether the adviser seeks to allocate the benefits to
client accounts proportionately to the soft dollar credits those
accounts generate. The item also requires the adviser to explain
whether it ``pays up'' for soft dollar benefits.\133\
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\132\ See Item 12.A.1. An adviser accepting soft dollar benefits
must explain that (a) the adviser benefits because it does not have
to produce or pay for the research or other products or services
acquired with soft dollars, and (b) the adviser therefore has an
incentive to select or recommend brokers based on the adviser's
interest in receiving these benefits, rather than on the client's
interest in getting the most favorable execution. See Item 12.A.1.a
and b of Part 2A.
\133\ ``Paying up'' refers to an adviser causing a client
account to pay more than the lowest available commission rate in
exchange for soft dollar products or services.
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Some commenters, including one association representing more than
130 pension funds, expressed their strong support for the soft dollar
disclosure requirement.\134\ Other commenters objected to various
portions of this item.\135\ Some of these commenters recommended
elimination of the proposed requirements to disclose whether an adviser
allocates soft dollar benefits to client accounts proportionately to
the brokerage credits those accounts generate,\136\ and to disclose the
``procedures'' it uses to direct client transactions to a particular
broker-dealer.\137\ Some of these commenters also questioned the
conflicts we identified and expressed concern that the item will tend
to create a misleading impression that the use of soft dollar
arrangements is harmful.\138\
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\134\ See comment letter of the Council of Institutional
Investors (May 16, 2008) (``CII Letter''); CFA Institute Letter; NRS
Letter; comment letter of Carolina Capital Markets, Inc. (Aug. 8,
2008).
\135\ See, e.g., comment letter of the Alliance in Support of
Independent Research (May 16, 2008) (``Alliance Letter''); CAPIS
Letter; IAA Letter; ICI Letter; comment letter of Pickard and Djinis
LLP (May 14, 2008) (``Pickard Letter''); SIFMA Letter; T. Rowe
Letter.
\136\ See Alliance Letter; CAPIS Letter; IAA Letter; ICI Letter;
Pickard Letter.
\137\ See Alliance Letter; CAPIS Letter; IAA Letter; ICI Letter.
\138\ See Alliance Letter; IAA Letter; ICI Letter; SIFMA Letter.
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There are significant conflicts associated with soft dollar
arrangements. Section 28(e) was enacted, in part, to address them.\139\
We are not taking a view on the propriety of soft dollar arrangements,
but rather are requiring full disclosure of arrangements that involve
significant conflicts of interest.\140\ Moreover, disclosure required
by Item 12 is similar to disclosure requirements previously required in
Part 2 of Form ADV.\141\ We are adopting this requirement as proposed.
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\139\ See 2006 Soft Dollar Release, supra note 128, at nn.4-6
and accompanying text.
\140\ We have brought enforcement actions charging advisers with
not adequately disclosing soft dollar arrangements and related
conflicts. See, e.g., In the Matter of Schultze Asset Management LLC
and George J. Schultze, Investment Advisers Act Release No. 2633
(Aug. 15, 2007) (settled order); In the Matter of Rudney Associates,
Inc. et al., Investment Advisers Act Release No. 2300 (Sept. 21,
2004) (settled order).
\141\ Item 12.B. of the previous Part 2 required, for example,
that the adviser describe the factors considered in selecting
brokers and determining the reasonableness of their commissions. In
addition, if the value of products, research and services given to
the adviser is a factor in selecting brokers, the adviser was
required to, among other things, describe whether clients may pay
commissions higher than those obtainable from other brokers in
return for those products and services.
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Client Referrals. If an adviser uses client brokerage to compensate
or otherwise reward brokers for client referrals, it also must disclose
this practice, the conflicts of interest it creates, and any procedures
the adviser used to direct client brokerage to referring brokers during
the last fiscal year (i.e., the system of controls used by the adviser
when allocating brokerage).\142\ Part 2 previously required that
advisers disclose these arrangements, but did not specifically require
that the description discuss the conflicts of interest created.\143\ We
did not receive any comments relating to this item and are adopting the
requirement as it was proposed so that clients are aware that their
adviser may have a bias toward referring brokers, a significant
conflict of interest.\144\
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\142\ Item 12.A.2 of Part 2A.
\143\ See Item 13.B. of the previous Part 2.
\144\ We have brought enforcement actions charging advisers with
failing to disclose to clients that they directed their brokerage
commissions in return for client referrals. See, e.g., In the Matter
of Fleet Investment Advisors, Inc., Investment Advisers Act Release
No. 1821 (Sept. 9, 1999) (settled order).
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Directed Brokerage. Item 12 requires an adviser that permits
clients to direct brokerage to describe its practices in this area.
Item 12 also requires that such an adviser explain that it may be
unable to obtain the most favorable execution of client transactions if
the client directs brokerage and that directing brokerage may be more
costly for clients.\145\ If, however, an adviser routinely recommends,
requests or requires clients to direct brokerage, Item 12 also requires
the adviser to describe this practice in its brochure, to disclose that
not all advisers require directed brokerage, and to describe any
relationship with a broker-dealer to which the brokerage may be
directed that creates a material conflict of interest.\146\ An adviser
may omit disclosure regarding its inability to obtain best execution if
directed brokerage arrangements are only conducted subject to the
adviser's ability to obtain best execution.\147\
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\145\ See Item 12.A.3.b of Part 2A. As we discussed in the
Proposing Release, clients sometimes instruct their adviser to send
transactions to a specific broker-dealer for execution. Clients may
initiate this type of arrangement for a variety of reasons, such as
favoring a family member or friend or compensating the broker-dealer
indirectly for services it provides to the client. But the
arrangement also may be initiated by the adviser, who may benefit,
for example, when brokerage is directed to its affiliated broker-
dealer. In either case, clients directing (or agreeing to direct)
brokerage need to understand the consequences of directing
brokerage, including the possibility that their accounts will pay
higher commissions and receive less favorable execution.
\146\ See Item 12.A.3.a of Part 2A. We have brought enforcement
actions charging advisers with failures to make such disclosures.
See also In the Matter of Callan Associates, Investment Advisers Act
Release No. 2650 (Sept. 19, 2007) (settled order); In the Matter of
Jamison, Eaton & Wood, Inc., Investment Advisers Act Release No.
2129 (May 15, 2003) (settled order).
\147\ See note to Item 12.A.2 of Part 2A.
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Two commenters addressed this requirement. One, representing
pension funds, endorsed our proposal as supporting transparency in
brokerage arrangements.\148\ The other urged that we broaden the
proposed exception in the item to all directed brokerage subject to
best execution, whether recommended by the adviser or directed by the
client. The commenter pointed out that such client-imposed limitations
on direction of brokerage should
[[Page 49244]]
address the Commission's concerns in proposing the item.\149\ We agree,
and have revised the note following the item accordingly.
---------------------------------------------------------------------------
\148\ See CII Letter.
\149\ See Alliance Letter.
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Trade Aggregation. Clients engaging an adviser can benefit when the
adviser aggregates trades to obtain volume discounts on execution
costs. Item 12 requires the adviser to describe whether and under what
conditions it aggregates trades. If the adviser does not aggregate
trades when it has the opportunity to do so, the adviser must explain
in the brochure that clients may therefore pay higher brokerage costs.
One commenter supported this disclosure, stating that it is helpful and
meaningful to clients.\150\ However, another commenter expressed
concern that such disclosure would suggest that advisers should always
aggregate orders, and noted that there are circumstances where an
adviser may decide that it is better for the client not to do so, such
as with multiple large trades that may create a market impact.\151\
Other commenters argued that trade aggregation practices are not
material to clients.\152\ But aggregation practices may have a material
effect on the quality of execution. Thus, we believe that such
practices should be disclosed in the brochure.
---------------------------------------------------------------------------
\150\ See NRS Letter.
\151\ See IAA Letter.
\152\ See Fried Frank Letter.
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Finally, one commenter suggested deleting the words ``in quantities
sufficient to obtain reduced transaction costs'' from the first
sentence of Item 12.B since there may be other circumstances in which
advisers may aggregate client trades that should be disclosed to
clients.\153\ As this item was intended to require advisers to explain
their aggregation practices along with the reasons for and consequences
of those practices more generally, we have removed this limiting
phrase.
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\153\ See Schnase Letter.
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Item 13. Review of Accounts. Item 13 requires that an adviser
disclose whether, and how often, it reviews clients' accounts or
financial plans, and identify who conducts the review.\154\ An adviser
that reviews accounts other than regularly must explain what
circumstances trigger an account review.
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\154\ Item 13 is similar to Item 11 in the previous Part 2.
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Three commenters addressed this item. One supported it as being
helpful to clients.\155\ Two thought that this item provided non-
critical information that could be eliminated in the interest of
providing a shorter brochure to clients.\156\ We believe the
disclosure, which can be brief, provides very useful information to
clients about their advisers' management of their accounts. As a
result, we are adopting this item substantially as it was
proposed.\157\
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\155\ See CFA Institute Letter.
\156\ See SIFMA Letter; Sutherland Letter.
\157\ The Schnase Letter suggested changing the word
``employee'' in Item 13.A to ``supervised person.'' As defined in
the Form ADV Glossary, ``supervised person'' means ``any of your
officers, partners, directors (or other persons occupying a similar
status or performing similar functions), or employees, or any other
person who provides investment advice on your behalf and is subject
to your supervision or control.'' For purposes of consistency
throughout Part 2A, we are making the change suggested by the
commenter. We also are substituting the word ``supervised person''
for the word ``employee'' in Item 14.B, Instruction 6 for Part 2A,
Appendix 1 (the wrap fee program brochure), and Item 6.C of Part 2A,
Appendix 1.
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Item 14. Client Referrals and Other Compensation. Item 14 requires
an adviser to describe in its brochure any arrangement under which it
or its related person compensates another for client referrals and
describe the compensation. The brochure also must disclose any
arrangement under which the adviser receives any economic benefit,
including sales awards or prizes, from a person who is not a client for
providing advisory services to clients.\158\
---------------------------------------------------------------------------
\158\ Similar disclosure was previously required by Item 13 of
Part 2.
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We received three comments on this item. One supported the proposed
item, stating that these areas involve practices that raise conflicts
of interest.\159\ Another suggested that it be omitted because certain
disclosure required under this item is already required by rule 206(4)-
3 under the Advisers Act (the ``cash solicitation rule'').\160\ The
cash solicitation rule, however, applies only to certain types of
payments and requires disclosure by the solicitor rather than the
adviser.\161\ Finally, one commenter urged that we amend the Item to
disclose the conflicts of interest associated with these
arrangements.\162\ We agree. There are significant conflicts of
interest when an adviser receives benefits from a third party for
providing advisory services to a client, or when an adviser pays a
third party for client referrals. We are revising Item 14.A from our
proposal to require an adviser that accepts benefits from a non-client
for providing advisory services to clients describe the arrangement,
any conflicts of interests that arise from the arrangement, and how the
adviser addresses those conflicts.
---------------------------------------------------------------------------
\159\ See CFA Institute Letter.
\160\ See Sutherland Letter.
\161\ Rule 206(4)-3 applies to advisers paying cash referral
fees to solicitors, and thus does not require disclosure of non-cash
benefits. The rule requires, among other things, that an
unaffiliated solicitor provide the adviser's brochure and a separate
disclosure document described in the rule to clients or prospective
clients at the time of any solicitation activities. See rule 206(4)-
3(a)(2)(iii).
\162\ See Schnase Letter. This commenter also suggested that we
rename this item since Item 14.B relates only to payment for client
referrals. In light of this comment, we are renaming this item
``Client Referrals and Other Compensation.''
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Item 15. Custody. Item 15 requires an adviser with custody of
client funds or securities to explain in its brochure that clients will
receive account statements directly from the qualified custodian, such
as a bank or broker-dealer that maintains those assets. Advisers must
also explain to clients that they should carefully review the account
statements they receive from the qualified custodian. In addition, if
an adviser also sends clients account statements, the adviser's
explanation must include a statement urging clients to compare the
account statements they receive from the qualified custodian with those
they receive from the adviser. Comparing statements will allow clients
to determine whether account transactions, including deductions to pay
advisory fees, are proper. This disclosure is very similar to the
statement required to be made by advisers under our recently amended
custody rule.\163\
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\163\ See Custody of Funds or Securities of Clients by
Investment Advisers, Investment Advisers Act Release No. 2968 (Dec.
30, 2009) [75 FR 1456 (Jan. 11, 2010)] (``Custody Rule Adopting
Release'') at section II.A.
---------------------------------------------------------------------------
We proposed an alternative disclosure requirement in Item 15 that
we are not adopting today. Proposed Item 15.A. would have required
that, if clients did not receive account statements from qualified
custodians, the adviser must disclose the risks that clients would face
as a result.\164\ This alternative is no longer relevant because the
amendments to the custody rule eliminated the option that permitted
advisers to substitute their own account statements for those from a
qualified custodian.\165\
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\164\ Id. We received two comments on proposed Item 15.A. See
ICI Letter; ABA Committee Letter.
\165\ Custody Rule Adopting Release, see supra note 163.
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Item 16. Investment Discretion. Item 16 requires an adviser with
discretionary authority over client accounts to disclose this fact in
its brochure,\166\ and any limitations clients may (or customarily do)
place on this
[[Page 49245]]
authority.\167\ Two commenters suggested that the Commission not
require advisers to provide duplicative disclosure regarding
discretionary authority as it likely would be incorporated into the
description of the advisory business in Item 4.\168\ We note that if
the information is provided in response to Item 4, the adviser may
cross-reference the information. We therefore are adopting this item as
proposed.
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\166\ An adviser has ``discretionary authority'' if it is
authorized to make purchase and sale decisions for client accounts.
See Form ADV Glossary. This definition of discretionary authority is
derived from section 3(a)(35) of the Exchange Act [15 U.S.C.
78c(a)(35)]. An adviser also has discretionary authority if it is
authorized to select other advisers for the client. This Item is
similar to Item 12.A of the previous Part 2.
\167\ For example, clients may not understand that they may ask
the adviser not to invest in securities of particular issuers.
\168\ See IAA Letter; Sutherland Letter. They argued that such
information would already be disclosed under Items 4.B, 4.C and 4.E
(advisory business) or Item 8 (strategies and risks).
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Item 17. Voting Client Securities. Item 17 requires advisers to
disclose their proxy voting practices. This item parallels rule 206(4)-
6 under the Advisers Act, which, among other things, requires advisers
registered with the Commission to disclose certain information about
their proxy voting practices.\169\ Item 17 also requires advisers to
disclose whether they have or will accept authority to vote client
securities and, if so, to describe briefly the voting policies they
adopted under rule 206(4)-6. Each adviser must describe whether (and
how) clients can direct it to vote in a particular solicitation, how
the adviser addresses conflicts of interest when it votes securities,
and how clients can obtain information from the adviser on how the
adviser voted their securities. Item 17 also requires an adviser to
explain that clients may obtain a copy of the adviser's proxy voting
policies and procedures upon request. Advisers that do not accept
authority to vote securities must disclose how clients receive their
proxies and other solicitations.\170\
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\169\ Proxy Voting Release, see supra note 3. Rule 206(4)-6
requires advisers to adopt and implement written voting policies and
procedures. Advisers also are required to keep certain records
relating to their voting. Advisers that exercise voting authority
over client securities must describe their voting policies and
procedures to clients and furnish clients with a complete copy upon
request.
\170\ If an adviser accepts proxy voting authority for some
accounts but not others, the adviser should disclose the relevant
information required by this Item for each type of account unless
the adviser has prepared separate brochures for the other accounts.
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Some commenters suggested that we eliminate Item 17 in its
entirety, arguing either that the required disclosure is not important
to clients or that most of the information already is available in
advisory contracts.\171\ Others supported this disclosure requirement,
noting that clients are interested in understanding the potential
conflicts of interest that may arise from an adviser's proxy
voting.\172\ We agree that proxy voting practices and the conflicts
arising from such practices are important information that should be
disclosed, and note that rule 206(4)-6 independently would require the
same disclosure even if we were to eliminate it from the brochure.\173\
Accordingly, we are adopting Item 17, but with one modification.
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\171\ See NAPFA Letter; Morgan Stanley Letter.
\172\ See CFA Institute Letter; CII Letter.
\173\ We have brought enforcement actions relating to advisers'
proxy voting policies and procedures. See, e.g., In the Matter of
INTECH Investment Management LLC and David E. Hurley, Investment
Advisers Act Release No. 2872 (May 7, 2009) (settled order).
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We had proposed to require detailed information about an adviser's
use of third-party proxy voting services and how the adviser pays for
proxy voting services. Most of the commenters addressing this proposed
requirement argued that the information is not relevant for most
clients.\174\ In light of the Commission's Concept Release on the U.S.
proxy system issued on July 14, 2010, which requests comment on a wide
range of questions and issues relating to proxy advisory firms,\175\ we
are adopting Item 17 without this requirement. Clients interested in
this information may obtain it from their advisers upon request.
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\174\ See ASG Letter; Fried Frank Letter; IAA Letter; ICI
Letter; Janus Letter; Lininger Letter. A few commenters supported
this disclosure. See CFA Institute Letter; CII Letter.
\175\ Concept Release On The U.S. Proxy System, Investment
Advisers Act Release No. IA-3052 (July 14, 2010) [75 FR 42982 (July
22, 2010)].
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Item 18. Financial Information. This item requires disclosure of
certain financial information about an adviser when material to
clients. Specifically, an adviser that requires prepayment of fees must
give clients an audited balance sheet showing the adviser's assets and
liabilities at the end of its most recent fiscal year.\176\ The item
also requires an adviser to disclose any financial condition reasonably
likely to impair the adviser's ability to meet contractual commitments
to clients if the adviser has discretionary authority over client
assets, has custody of client funds or securities, or requires or
solicits prepayment of more than $1,200 in fees per client and six
months or more in advance.\177\ For instance, disclosure may be
required where a judgment or arbitration award was sufficiently large
that payment of it would create such a financial condition. Under these
circumstances, clients are exposed to the risk that their assets may
not be properly managed--and prepaid fees may not be returned--if, for
example, the adviser becomes insolvent and ceases to do business.
Finally, Item 18 requires an adviser that has been the subject of a
bankruptcy petition during the past ten years to disclose that fact to
clients.\178\ As discussed above, although we are rescinding rule
206(4)-4 we caution advisers that their fiduciary duty of full and fair
disclosure may require them to continue to disclose any precarious
financial condition promptly to all clients, even clients to whom they
may not be required to deliver a brochure or amended brochure.\179\
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\176\ As proposed, we are increasing the threshold amount from
the existing threshold, $500, to $1,200 to reflect the effects of
inflation, based upon the Personal Consumption Expenditures Chain-
Type Price Index as published by the U.S. Department of Commerce,
since we adopted Form ADV in 1979. We also are requiring, as
proposed, an audited balance sheet from advisers that solicit
clients to prepay fees over $1,200. This portion of Item 18 is
similar to Item 14 in the previous Part 2.
\177\ This disclosure was previously required by rule 206(4)-4.
In the release adopting rule 206(4)-4, we noted that a determination
about what constitutes financial condition reasonably likely to
impair an adviser's ability to meet contractual commitments is
inherently factual in nature but will generally include insolvency
or bankruptcy. See Rule 206(4)-4 Adopting Release, supra note 106 at
n.6.
\178\ This includes the obligation of an adviser that is
organized as a sole proprietorship to disclose a personal
bankruptcy. This requirement conforms to our view that bankruptcy
generally constitutes a ``financial condition of the adviser that is
reasonably likely to impair the ability of the adviser to meet
contractual commitments to clients'' requiring disclosure under rule
206(4)-4. See Rule 206(4)-4 Adopting Release, supra note 106.
\179\ See supra note 106 and accompanying text.
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One commenter recommended elimination of the balance sheet
requirement, stating that the balance sheet gives an imperfect picture
of the financial health of an adviser,\180\ and another was concerned
that disclosure of financial information would unduly discriminate
against smaller advisers.\181\ We believe that a client that becomes a
creditor of an adviser because it prepays fees would want information
about the adviser's condition. This information is currently required
to be disclosed to clients, and commenters have not persuaded us that
it should be omitted. As a result, we are adopting Item 18 as proposed.
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\180\ See Fried Frank Letter.
\181\ See Verbeck Letter.
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Item 19. Index. We proposed to require that the brochure filed with
us include an index of the items required by Part 2A indicating where
in the brochure the adviser addresses each item. This index was
intended to facilitate review by our staff for compliance with the
requirements of Part 2A. As discussed above, we are now requiring
advisers to provide their
[[Page 49246]]
responses to the items in Part 2 in the same order as the items appear
in the form. As a result, the index would be duplicative of the table
of contents and is no longer necessary. We therefore are not adopting
this requirement.
Part 2A Appendix 1: The Wrap Fee Program Brochure. Advisers that
sponsor wrap fee programs\182\ continue to be required to prepare a
separate, specialized firm brochure (a ``wrap fee program brochure'' or
``wrap brochure'') for clients of the wrap fee program in lieu of the
sponsor's standard brochure.\183\ The items in Appendix 1 to Part 2A
contain the requirements for a wrap fee program brochure, and are
substantially similar to those previously in Schedule H, the separate
wrap fee program brochure in previous Part 2.\184\ However, we are
revising the requirements of Schedule H to incorporate many of our
amendments to the Part 2A firm brochure.
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\182\ Under wrap fee programs, which also are sometimes referred
to as ``separately managed accounts,'' advisory clients pay a
specified fee for investment advisory services and the execution of
transactions. The advisory services may include portfolio management
and/or advice concerning selection of other advisers, and the fee is
not based directly upon transactions in the client's account.
\183\ We adopted the requirement for a separate brochure for
wrap fee clients in 1994. See Disclosure by Investment Advisers
Regarding Wrap Fee Programs, Investment Advisers Act Release No.
1411 (Apr. 19, 1994) [59 FR 21657 (Apr. 26, 1994)]. Advisers whose
entire advisory business is sponsoring wrap fee programs will
prepare a wrap brochure but will not be required to prepare a
standard advisory firm brochure. See Instruction 10 of Instructions
for Part 2A of Form ADV. An adviser will have to prepare both a
standard firm brochure and a wrap fee program brochure if it both
sponsors a wrap fee program and provides other types of advisory
services, and will deliver both a standard and a wrap brochure to a
client who receives both types of services. Wrap fee sponsors would,
like other advisers, be required to provide brochure supplements to
their wrap fee clients.
\184\ We have brought enforcement actions regarding wrap fee
program disclosure. See, e.g., In re Banc of America Investment
Services, Inc. and Columbia Management Advisors, LLC (as successor
in interest to Banc of America Capital Management, LLC), Investment
Advisers Act Release No. 2733 (May 1, 2008) (settled order).
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We also are adopting an additional disclosure requirement to the
wrap fee program brochure. It requires an adviser to identify whether
any of its related persons is a portfolio manager in the wrap fee
program and, if so, to describe the associated conflicts. For example,
an adviser may have an incentive to select a related person to
participate as a portfolio manager based on the person's affiliation
with the adviser, rather than based on expertise or performance. This
item requires advisers to disclose whether related person portfolio
managers are subject to the same selection and review criteria as the
other portfolio managers who participate in the wrap fee program and,
if they are not, how they are selected and reviewed.
Two commenters requested clarification that an adviser can delegate
its brochure delivery requirement to the sponsor of the wrap fee
program,\185\ and one of these commenters also requested clarification
that the adviser could satisfy its recordkeeping obligations that
evidence delivery of the brochure by such records being retained in the
offices of the sponsor and not the adviser, as long as the adviser was
able to provide the records to Commission staff upon request.\186\ We
confirm that a sponsor may deliver the adviser's brochures and maintain
certain records as long as the sponsor, upon request of the
Commission's staff, will produce promptly the records for the staff at
the appropriate office of the adviser or the sponsor. This delegation
does not relieve the adviser of its legal delivery obligation, however,
and thus the adviser should take steps to assure itself that the
sponsor is performing the tasks the adviser has delegated.
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\185\ See Federated Letter; MMI Letter.
\186\ See MMI Letter. Rules 204-2(a)(14) and 204-2(e)(1) under
the Advisers Act describe advisers' recordkeeping obligations
relating to brochure delivery.
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3. Delivery and Updating of Brochures
The Commission also is adopting amendments to rule 204-3; our rule
under the Advisers Act that requires registered advisers to deliver
their brochures and certain updates to clients and prospective
clients.\187\
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\187\ The brochure delivery and updating obligations are the
same for both a standard brochure and a wrap fee program brochure.
See rule 204-3.
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a. Delivery to Clients
Initial Delivery. Rule 204-3, as amended, requires an adviser to
deliver a current brochure before or at the time it enters into an
advisory contract with the client.\188\ The rule does not require
advisers to deliver brochures to certain advisory clients receiving
only impersonal investment advice\189\ or to clients that are
investment companies registered under the Investment Company Act of
1940 (``Company Act'').\190\ As proposed, we have expanded the latter
exception to cover advisers to business development companies
(``BDCs'') that are subject to section 15(c) of the Company Act, which
requires a board of directors to request, and the adviser to furnish,
information to enable the board to evaluate the terms of the proposed
advisory contract.\191\ Because of this safeguard, we believe that
adopting an obligation for these advisers to deliver a brochure to
these BDC clients is not necessary.\192\ An adviser does not have to
prepare (or file with us) a brochure if it does not have any clients to
whom a brochure must be delivered.\193\
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\188\ See rule 204-3(b). Rule 204-3 requires a registered
adviser to furnish each client and prospective client with a written
disclosure statement which may be either a copy of the adviser's
completed Part 2A or a written document containing the information
required by Part 2A. Previously, such delivery had to occur at least
48 hours before entering into the advisory agreement, or at the time
of entering into the agreement if the client has the right to
terminate the agreement without penalty within five business days
thereafter. We received two comments on this proposed change to the
timing of the required initial brochure delivery, both in support.
See Pickard Letter; T. Rowe Letter.
\189\ See rule 204-3(c)(2) and Instruction 1 for Part 2A of Form
ADV. Advisers are not required to deliver brochures to advisory
clients receiving only impersonal investment advice for which the
adviser charges less than $500 per year. As proposed, we increased
the dollar threshold triggering this exception from $200 to $500 to
reflect the effects of inflation, based upon the Personal
Consumption Expenditures Chain-Type Price Index, as published by the
U.S. Department of Commerce, since rule 204-3 was adopted in 1979.
We did not receive comments on this change.
\190\ See rule 204-3(c)(1) and Instruction 1 for Part 2A of Form
ADV.
\191\ See supra note 190. As discussed above, an adviser's
fiduciary duty of full and fair disclosure, however, may require it
to continue to disclose any material legal event or precarious
financial condition promptly to all clients, even clients to whom it
may not be required to deliver a brochure or amended brochure. See
supra note 106 and accompanying text.
\192\ Two commenters urged us to adopt an exception for ``hedge
funds,'' or clarify that advisers to hedge funds are not required to
deliver copies of brochures to their investors. See ABA Committees
Letter; Fried Frank Letter. We note that rule 204-3 requires only
that brochures be delivered to ``clients.'' We further note that the
Court of Appeals for the D.C. Circuit stated that the ``client'' of
an investment adviser managing a hedge fund is the fund itself, not
an investor in the fund. Goldstein v. SEC, 451 F.3d 873 (D.C. Cir.
2006).
\193\ See Instruction 7 for Part 2A of Form ADV.
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Annual Delivery. Advisers must annually provide to each client to
whom they must deliver a brochure either: (i) A copy of the current
(updated) brochure that includes or is accompanied by the summary of
material changes; or (ii) a summary of material changes that includes
an offer to provide a copy of the current brochure.\194\ As proposed,
each adviser
[[Page 49247]]
must make this annual delivery no later than 120 days after the end of
its fiscal year.\195\ Advisers may deliver a brochure and summary of
material changes or summary of material changes, along with an offer to
provide the brochure to clients electronically in accordance with the
Commission's guidelines regarding electronic delivery of
information.\196\ An adviser that does not include, and therefore file,
its summary of material changes as part of its brochure (on the cover
page or the page immediately following the cover) must file its summary
as an exhibit, included with its brochure when it files its annual
updating amendment with us, so that the summary of material changes is
available to the public through IAPD.\197\
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\194\ See rule 204-3(b) and Item 2 to Part 2A of Form ADV. The
offer also must be accompanied by a Web site address and a telephone
number and e-mail address for obtaining the complete brochure
pursuant to the Instructions for Part 2, as well as the Web site
address for obtaining information about the adviser through IAPD. We
also are adopting an amendment to our recordkeeping rule that will
require the adviser choosing this approach to preserve a copy of the
summary of material changes, so that our examination staff has
access to such separately provided summaries. See rule 204-
2(a)(14)(i). See Section IV below.
If an adviser includes the summary of material changes in its
brochure, and amends its brochure on an interim basis between annual
updating amendments, the adviser should consider whether it should
update its summary of material changes to avoid confusing or
misleading clients reading the updated brochure.
\195\ See Rule 204-3(b) and Instruction 2 for Part 2A of Form
ADV. As discussed below, rule 204-1 requires an adviser registered
with the Commission to annually revise its Form ADV, including its
brochure, within 90 days of its fiscal year end. Advisers typically
provide clients with reports quarterly, and the 120-day period is
designed to provide sufficient flexibility to allow advisers to
include the updated brochure or summary in a routine quarterly
mailing to clients. We expect that permitting an adviser to send
this document together with these routine mailings could
substantially reduce delivery costs. See Section VII below.
\196\ Use of Electronic Media by Broker-Dealers, Transfer
Agents, and Investment Advisers for Delivery of Information,
Investment Advisers Act Release No. 1562 (May 9, 1996) [61 FR 24644
(May 15, 1996)] (``Electronic Media Release'').
\197\ See Instruction 6 for Part 2A of Form ADV. The adviser
must upload its brochure and the summary (as an exhibit) together in
a single, text-searchable file in Adobe Portable Document Format
(PDF) on IARD. See Instruction 6 for Part 2A of Form ADV.
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We proposed that each adviser annually deliver an updated brochure
to its clients because we were concerned that clients may be relying on
``stale'' brochures. Many commenters representing advisers objected,
arguing that this requirement would cause advisers to incur significant
costs,\198\ and that clients are not interested in receiving an annual
brochure.\199\ We believe our revised approach--permitting advisers to
deliver annually the summary of material changes, which was suggested
by several commenters \200\--addresses our concern that clients may
today be relying on ``stale'' brochures, while alleviating commenters'
concerns regarding the costs and burdens of annual delivery of the
brochure.\201\
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\198\ See AICPA Letter; Eddy Letter; FPA Letter; IAA Letter; ICI
Letter; Mercer Letter; Merrill Lynch Letter; Morgan Stanley Letter;
MMI Letter; NAPFA Letter; NRS Letter; Pickard Letter; ProEquities
Letter; Roundtable Letter; Schwab Letter; SIFMA Letter; Sutherland
Letter; USAA Letter; comment letter of Wachovia Securities LLC (May
16, 2008) (``Wachovia Letter''); Wellington Letter, comment letter
of Wall Street Financial Group (May 16, 2008) (``WSFG Letter'').
\199\ See, e.g., ASG Letter; comment letter of Clifford Swan
Investment Counsel (May 5, 2008) (``Clifford Letter''); First Allied
Letter; FPA Letter; FSI Letter; comment letter of Moody Aldrich
Partners (May 15, 2008) (``Moody Aldrich Letter''); NRS Letter;
Roundtable Letter; WSFG Letter.
\200\ See ASG Letter; Clifford Letter; Federated Letter; First
Allied Letter; FPA Letter; FSI Letter; comment letter of the
Investment Adviser Association (Aug. 26, 2008); Merrill Lynch
Letter; Moody Aldrich Letter; NRS Letter; Roundtable Letter; Schnase
Letter; WSFG Letter.
\201\ One commenter representing consumers agreed that such an
approach could minimize the costs of delivery without significantly
sacrificing investor protection. See Consumer Federation Letter.
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Some commenters urged that we revise our electronic delivery
guidance \202\ so that disclosure placed on the adviser's web page or
on IARD would be deemed to be delivered to its clients, regardless of
whether the clients have provided consent to electronic delivery.\203\
We note that an adviser's fiduciary duties may require it to obtain
client consent to many of the disclosures required by Part 2 and that
electronic access, without evidence that the adviser's delivery
obligation has been met (such as by obtaining the client's consent to
electronic delivery along with appropriate notice and access) would
not, in our judgment, serve to adequately protect client
interests.\204\
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\202\ See Electronic Media Release, see supra note 196.
\203\ See, e.g., ABA Committees Letter; IAA Letter; Mercer
Letter; Roundtable Letter; Sutherland Letter; Wachovia Letter.
\204\ See Electronic Media Release, supra note 196 at Section
II.A.3.
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Some commenters recommended that advisers be required to send
clients a notice providing a Web site link to where the brochure is
posted on the Internet, rather than having to deliver the actual
brochure to clients initially.\205\ Another commenter objected, arguing
that many investors are not yet willing to use the Internet to receive
disclosure documents and that an approach that would rely on electronic
delivery would be premature for retail investors.\206\ We are not
making such changes at this time, but will continue to consider
different approaches to delivering financial information to investors.
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\205\ See, e.g., ASG Letter; Borek Letter; FSI Letter; ICI
Letter; Lininger Letter; Merrill Lynch Letter; MMI Letter; Morgan
Stanley Letter; NAPFA Letter; Pickard Letter; SIFMA Letter;
Wellington Letter.
\206\ See Consumer Federation Letter.
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Interim Delivery. As proposed, rule 204-3 requires advisers to
deliver an updated brochure (or a document describing the material
facts relating to the amended disciplinary event) promptly whenever the
adviser amends its brochure to add a disciplinary event or to change
material information already disclosed in response to Item 9 of Part
2A.\207\ One commenter opposed the interim updating requirement,
expressing concern that it would result in ``frequent interim
disclosure of information of minimal relevance to clients.'' \208\ We
disagree. We believe that disclosure of disciplinary information is
highly relevant to clients because it reflects on the integrity of the
investment adviser, may affect a client's trust and confidence in the
adviser, and may be of even greater interest if the adviser is adding
disciplinary information frequently. Therefore, we are adopting this
requirement as proposed.
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\207\ See rule 204-3(b)(4).
\208\ See FSI Letter.
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b. Updating Part 2A of Form ADV
Similar to the existing requirements, the amended rules require
advisers to keep the brochures they file with us current by updating
them at least annually, and updating them promptly when any information
in the brochures (except the summary of material changes and the amount
of assets under management, which only has to be updated annually)
becomes materially inaccurate.\209\ In the case of both annual and
interim updates, advisers will make changes to their brochures using
their own computer systems and then simply file the revised versions of
their brochures through IARD.\210\
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\209\ If an adviser is amending its brochure for a separate
reason between annual amendments, and the amount of assets under
management is materially inaccurate, the adviser should amend this
disclosure. See Instruction 4 for Part 2A of Form ADV.
\210\ See rule 204-1(b).
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In some cases, an adviser filing its annual updating amendment may
not have any material changes to make to its brochure. If the adviser
has not filed any interim amendments to its brochure since the last
annual amendment and the brochure continues to be accurate in all
material respects, the adviser would not have to prepare or deliver a
summary of material changes to clients. The adviser also would not have
to prepare and file an updated firm brochure as part of its annual
updating amendment. If there was an interim amendment or the brochure
contained a material inaccuracy, however, the adviser would have to
file a summary of material changes describing any interim amendment(s)
along with an updated firm brochure as part of its annual
[[Page 49248]]
amendment filing. Although previously filed versions of an adviser's
brochures will remain in the IARD system, only the most recent version
of an adviser's brochure will be available to the public through the
Commission's Web site.\211\ The purpose of the public disclosure Web
site is to provide the public with current information about advisers,
rather than historic information.\212\
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\211\ In the case of an adviser that prepares, files and
delivers to clients separate brochures for the various different
advisory services it offers, the most recent version of each of its
brochures will be available via the public disclosure Web site.
\212\ Instructions for obtaining historic brochure filings may
be found at http://www.sec.gov/answers/publicdocs.htm.
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B. Part 2B: The Brochure Supplement
Rule 204-3 also requires that each firm brochure be accompanied by
brochure supplements providing information about the advisory personnel
on whom the particular client receiving the brochure relies for
investment advice.\213\ Among other things, the brochure supplements
will contain information about the educational background, business
experience, and disciplinary history (if any) of the supervised persons
who provide advisory services to the client. The brochure supplement
thus includes information that would not necessarily be included in the
firm brochure about supervised persons of the adviser who actually
provide the investment advice and interact with the client.
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\213\ See rule 204-3(b)(3). We believe that brochure supplements
will be important to advisory clients in selecting an adviser
because clients place great weight on the supervised person's
qualifications and events that may reflect on the integrity of
advisory personnel. See Proposing Release, supra note 8, at Section
II.B.1.
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Several commenters supported the brochure supplement
requirement.\214\ One stated that the brochure supplement's ``greater
personal relevance to investors will make [it] among the most widely
read of the disclosure documents they receive, particularly if they
receive it in a timely fashion.'' \215\ Another stated that the
brochure items addressed areas of interest to clients and stated that
``information on the qualifications and background of those who
influence clients in connection with their investments are as relevant,
if not more relevant, than the information currently required by Part 2
on senior executives of the firm that may have little or no direct
contact with the client.'' \216\
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\214\ See ASG Letter; Consumer Federation Letter; CFA Institute
Letter; FPA Letter; IAA Letter; Lininger Letter; NASAA Letter.
\215\ Consumer Federation Letter.
\216\ CFA Institute Letter.
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Several advisers that also are registered as broker-dealers,
however, urged that we not require a brochure supplement, arguing that
the brochure supplement would prove excessively costly, that at least
some of the information is available on the Financial Industry
Regulatory Authority's (FINRA) web-based BrokerCheck system,\217\ and
that information not available through BrokerCheck (such as the
``Educational Background,'' ``Other Business Activities,'' ``Additional
Compensation,'' and ``Supervision'' sections) is either not important
to clients or could be covered by general disclosure in the firm
brochure about the firm's policies and procedures.\218\ We disagree. We
believe that the additional information required by the supplement will
be important to many clients and, particularly for large advisers,
cannot be sufficiently described by firm policies and procedures. For
large advisers, such policies will by necessity tend to be general
because they must cover a large number of supervised persons with a
range of ancillary activities and conflicts. For example, we do not
believe that a prospective client would find it particularly helpful to
read in the firm brochure that all of the adviser's associated persons
had earned a college degree. Or that some of their associated persons
had additional business activities that may involve conflicts of
interest. Disclosure of such generalized information about the firm's
associated persons is unlikely to be meaningful to clients seeking to
understand the background, particular conflicts and outside business
activities of the individual providing investment advice to them.
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\217\ Another commenter argued against reliance on BrokerCheck.
See Consumer Federation Letter.
\218\ See, e.g., CGMI Letter; Merrill Lynch Letter; Morgan
Stanley Letter; Schwab Letter; SIFMA Letter. BrokerCheck, which is
designed to help investors check the professional background of
current and former FINRA-registered securities firms and brokers, is
available at http://www.finra.org/Investors/ToolsCalculators/BrokerCheck/index.htm. The following commenters argued that we
should not require the brochure supplement because it would provide
little new or useful information but would create significant costs
and burdens. See, e.g., NAPFA Letter; Pickard Letter; Roundtable
Letter; USAA Letter; comment letter of John H. Vineyard (Mar. 18,
2008) (``Vineyard Letter''). For the reasons discussed in the text,
we disagree.
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Commenters have, however, persuaded us to permit advisers to make
use of BrokerCheck as well as the IAPD system to disclose disciplinary
information available on those systems when the client has received a
brochure supplement electronically.\219\ The instructions for Part 2B
of Form ADV provide that the adviser may disclose in a supplement
delivered electronically that the supervised person has a disciplinary
event and provide a hyperlink to either the BrokerCheck or the IAPD
systems.\220\ We believe that this accommodation addresses commenters'
concerns regarding duplication of disclosure requirements, while
meeting our objective of providing advisory clients with convenient
access to information necessary to assess the individuals they are
relying on for investment advice.\221\ In addition to this
accommodation, we have made several other changes to the proposed
brochure supplement requirements in response to comments, which we
discuss below.
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\219\ IAPD was recently enhanced to allow investors to obtain
disciplinary history of supervised persons. See http://www.nasaa.org/NASAA_Newsroom/Current_NASAA_Headlines/12811.cfm
for a press release announcing the launch of an enhancement to IAPD
to allow users to search for individuals.
\220\ See Instruction 3 for Part 2B of Form ADV.
\221\ We also believe that this approach addresses the concern
expressed by one commenter that reliance on BrokerCheck would hurt
those investors who are least sophisticated and therefore are most
likely to need this information, but who are the very ones that are
least likely to seek it out. See Consumer Federation Letter.
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1. Format
As proposed, the amendments require advisers to write their
supplements in plain English, but offer an adviser flexibility in
presenting information in a format that is best suited to the advisory
firm. This flexibility is designed to reduce the cost of preparing and
delivering supplements. Advisers may include supplement information
within the firm's brochure, an approach that may be attractive to
smaller firms with few persons for whom they will be required to
prepare supplements.\222\ Advisers may elect to prepare a supplement
for each supervised person. Alternatively, they can prepare separate
supplements for different groups of supervised persons (e.g., all
supervised persons in a particular office or work group). To promote
comparability of brochure supplements, we are requiring that a brochure
supplement must be organized in the same order, and contain the same
headings, as the items appear in the form, whether provided in a
brochure or separately.\223\
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\222\ IARD data as of May 3, 2010 indicate that 81% of advisers
registered with us have 10 or fewer employees performing investment
advisory functions on their behalf. Over 65% have five or fewer
employees performing advisory functions.
\223\ If provided in a brochure, supplements must be included at
the end of the brochure and be sequenced for each supervised person.
See Instruction 1 of General Instructions for Part 2 of Form ADV and
Instruction 6 for Part 2B of Form ADV.
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[[Page 49249]]
2. Supplement Items
Part 2B, as we proposed and as we are adopting it today, consists
of six items. Many commenters who addressed the specific proposed items
supported the content of the brochure supplements generally.\224\
Others offered specific comments on certain items; we address these
comments below.
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\224\ See, e.g., CFA Institute Letter, CFP Board Letter; FPA
Letter.
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Item 1. Cover Page. Each supplement's cover page must include
information identifying the supervised person (or persons) covered by
the supplement as well as the advisory firm. One commenter stated that
the brochure supplement should not require a separate cover page.\225\
We intended Item 1 of the brochure supplement to require that the
information specified in the item be included on the front page of the
supplement, not that this be the only information on a cover page. We
have modified Item 1 accordingly to clarify that the information
required by the item may be presented either on a separate cover page
or at the top of the first page of the brochure supplement.
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\225\ See ASG Letter.
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Item 2. Educational Background and Business Experience. Item 2
requires the supplement to describe the supervised person's formal
education and his or her business background for the past five
years.\226\ If the supervised person either has no high school
education, no formal education after high school, or no business
background, the adviser must disclose this fact in the supplement. The
business background section must identify the supervised person's
positions at prior employers and not merely list the names of prior
employers.\227\
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\226\ Previously, Item 6 of Part 2 of Form ADV required this
information about the adviser's principal executive officers and
about individuals who determine general investment advice on behalf
of the adviser.
\227\ For example, clients may be interested in knowing that a
supervised person was previously employed as an analyst at a hedge
fund as opposed to being employed as a computer support specialist
at a hedge fund.
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Advisers may include information about professional designations in
the supplement if they so choose. One commenter urged the Commission to
require the listing of any professional designations held as long as
the designations conform to the North American Securities
Administrators Association (NASAA) model rules and state regulations
that prohibit the misleading use of designations or
certifications.\228\ A few other commenters encouraged the Commission
to require disclosure about the minimum qualifications required for any
disclosed professional designation.\229\ We are not electing to require
a listing of professional designations as we do not require, nor do we
endorse, any designations. We are concerned that the Commission
requiring such disclosure could cause clients to mistakenly believe
that we do endorse designations. We do believe, however, that some
clients may be interested in learning of professional designations held
by the individuals providing them with investment advice. However, we
do not believe that such disclosure is meaningful without an
explanation of the minimum qualifications required to obtain the
designation. Accordingly, we are adding a requirement that if
professional designations are disclosed in the supplement, the
supplement must also provide a sufficient explanation of the minimum
qualifications required for the designation to allow clients and
potential clients to understand the value of the designation. The
disclosure, of course, also cannot be materially false or misleading by
suggesting, for example, that the designation implies more
qualifications or experience than the actual designation standards
require.\230\
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\228\ See CFP Board Letter.
\229\ See ASG Letter; First Allied Letter; NASAA Letter. But see
Vineyard Letter (stating that the supplement should not allow
descriptions of professional designations since such disclosure
could imply that the Commission advocated obtaining the particular
designation).
\230\ We note that our staff and other securities regulators
have warned that investors may be confused by some professional
designations, such as those that imply expertise in providing
services to seniors. See Protecting Senior Investors: Report of
Securities Firms Providing ``Free Lunch'' Sales Seminars, Joint
Report by the Staff of the Commission's Office of Compliance
Inspections and Examinations, NASAA, and FINRA (available at
http:[sol][sol]www.sec.gov/spotlight/seniors/freelunchreport.pdf);
Staff Update, ``Senior'' Specialists and Advisors: What You Should
Know About Professional Designations (available at
http:[sol][sol]www.sec.gov/investor/pubs/senior-profdes.htm). While
we acknowledge that a number of well-regarded professional
designations and attainments exist, the required credentials,
training, and experience associated with different designations vary
widely. FINRA has established and maintains a database of
designations used across the financial services industry that
contains basic information about the designation, such as the
issuing organization, prerequisites, and educational requirements.
http:[sol][sol]apps.finra.org/DataDirectory/1/prodesignations.aspx.
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Item 3. Disciplinary Information. Item 3 requires disclosure of any
legal or disciplinary event that is material to a client's evaluation
of the supervised person's integrity. It includes certain disciplinary
events that the Commission presumes are material to such an evaluation
if they occurred during the last 10 years.\231\ Several commenters
supported this requirement, and stated that such information would be
of great interest to clients.\232\
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\231\ This list parallels the list of legal and disciplinary
events in Item 9 of Part 2A that must be disclosed in the firm
brochure and which are derived from the prior disclosure
requirements set out in rule 206(4)-4. The list also is
substantially similar to the list of disciplinary events advisers
and their advisory affiliates are already required to disclose in
response to Item 11 of Form ADV, Part 1A.
As under Item 9 of Part 2A, Item 3 of Part 2B permits an adviser
to rebut the presumption with respect to a particular event, in
which case no disclosure to clients about the event will be
required. We require an adviser rebutting a presumption of
materiality to document that determination in a memorandum and
retain that record in order to better permit our staff to monitor
compliance with this important disclosure requirement. As under Item
9 of Part 2A, a note in Item 3 explains four factors the adviser
should consider when assessing whether the presumption can be
rebutted.
\232\ See CFA Institute Letter; CFP Board Letter; Consumer
Federation Letter; FPA Letter; NASAA Letter.
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As proposed, Item 3 of the supplement would have required
disclosure of any event for which the supervised person had ever
resigned or otherwise relinquished a professional attainment,
designation or license in anticipation of it being suspended or revoked
(other than for suspensions or revocations for failure to pay
membership dues). Two commenters recommended that we not require this
particular disclosure, stating that an adviser would not know a
supervised person's reason for relinquishing a designation or
license.\233\ We recognize that an adviser may not always know why a
supervised person is relinquishing a designation or license. We are
modifying this requirement to clarify that this disclosure need only be
made if the adviser knew or should have known that the supervised
person relinquished his or her designation or license.
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\233\ See First Allied Letter; IAA Letter.
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As discussed above, we are modifying Item 3 to permit advisers that
send supplements electronically to clients to include hyperlinks to
disciplinary information available through the FINRA BrokerCheck system
as well as the IAPD system. A number of supervised persons of
investment advisers also are registered representatives of a broker-
dealer firm or are subject to state investment adviser reporting
requirements and thus may have disciplinary disclosure available
through BrokerCheck or IAPD. Permitting advisers to hyperlink to these
systems may minimize the costs of brochure supplements by leveraging
[[Page 49250]]
existing infrastructure established by broker-dealer and adviser
regulation. To take advantage of this provision, the brochure
supplement must be delivered electronically and must include: (i) A
statement that the supervised person has a disciplinary history, the
details of which can be found on BrokerCheck or the IAPD (as the case
may be); and (ii) a hyperlink to the relevant system with a brief
explanation of how the client can access the disciplinary history.
Two commenters recommended that the Commission reconcile the
disclosure requirements in Item 3 of the brochure supplement with Item
14 of Form U4, the uniform form used by broker-dealer and state
investment advisory representatives to register (which includes certain
disciplinary disclosure and is the source of such information that is
available on BrokerCheck), stating that a lack of uniformity would
complicate compliance.\234\ We may consider in the future whether the
disclosure requirements in Item 3 and in Form U4 should be conformed,
as we recognize the substantial overlap between these disclosure items.
We note, however, that although the disclosure requirements are not
phrased identically, any disclosure required by the brochure supplement
would also have to be disclosed on Form U4.
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\234\ See ICI Letter; NASAA Letter.
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Item 4. Other Business Activities. Item 4 requires an adviser to
describe other business activities of its supervised persons. The item
specifically requires disclosure with respect to other capacities in
which the supervised person participates in any investment-related
business and any material conflicts of interest such participation may
create.\235\ In addition, the item requires the supplement to include
information about any compensation, including bonuses and non-cash
compensation, the supervised person receives based on the sales of
securities or other investment products, as well as an explanation of
the incentives this type of compensation creates.\236\ We are adopting
this item substantially as proposed. We believe that disclosure of any
such compensation is important because it creates an incentive for the
supervised person to base investment recommendations on his or her own
compensation rather than on clients' best interests.
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\235\ See Item 4.A of Part 2B.
\236\ See Item 4.A.2 of Part 2B.
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We also are adopting a requirement to disclose other business
activities or occupations that the supervised person engages in if they
involve a substantial amount of time or pay.\237\ Clients may have
different expectations of an individual whose sole business is
providing investment advice than of an individual who is engaged in
other substantial business activities. Several commenters supported
inclusion of this item.\238\ A few commenters urged that we not require
disclosure of this information,\239\ with one commenter arguing that
such information is irrelevant to the adviser's competence in providing
investment advice,\240\ and another stating that such a requirement
would be burdensome.\241\ We are retaining this requirement because we
believe that investors will find this information helpful in assessing
the conflicts created by those activities.
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\237\ See Item 4.B of Part 2B.
\238\ See, e.g., Berlin Letter; CFA Institute Letter; CFP Board
Letter; NASAA Letter. The NASAA Letter urged disclosure of all
outside business activities regardless of whether they occupied a
substantial amount of that person's time or income.
\239\ See IAA Letter; ProEquities Letter; Vineyard Letter.
\240\ See IAA Letter.
\241\ See ProEquities Letter.
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Finally, some commenters stated that the Commission should define
``substantial sources of income'' and ``substantial amount of time'' by
reference to specific percentages or in some other manner.\242\ We
believe that what amounts to ``substantial'' in many cases depends on
particular facts and circumstances, and thus we are not establishing
any specific definition of what is and is not substantial. However, we
do understand the concern that there is likely some level at which a
source of income or amount of time would rarely interfere or conflict
with an adviser's business of providing investment advice. Accordingly,
we are allowing advisers to make a presumption that if the other
business activities represent less than 10 percent of the supervised
person's time and income, they are not substantial.\243\
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\242\ See Case Letter; FSI Letter; ProEquities Letter; TAG
Letter.
\243\ See Item 4.B of Part 2B.
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Item 5. Additional Compensation. This item requires that the
supplement describe arrangements in which someone other than a client
gives the supervised person an economic benefit (such as a sales award
or other prize) for providing advisory services.\244\
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\244\ Bonuses based (in part or whole) on sales, client
referrals or new accounts trigger required disclosure, but other
bonuses do not. Regular salaries need not be disclosed.
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Two commenters suggested that we not require this disclosure, with
one of these commenters stating that disclosure of any conflicts
arising out of such compensation arrangements is already required by an
adviser's fiduciary duty and that firms should be free to make such
disclosure in the firm's brochure or investment advisory contract,
rather than in the brochure supplement.\245\ We are adopting Item 5 as
proposed. We believe clients need to know if their individual adviser
has these arrangements in order to assess the advisory services of that
particular supervised person and that general disclosure of this
conflict in a firm-wide brochure or advisory contract is not an
adequate substitute. As we stated above, general disclosure of this
type of conflict in many firm-wide brochures or advisory contracts will
by necessity tend to be general because it must cover a variety of
supervised persons with a range of compensation arrangements. Such
general disclosure is unlikely to be meaningful to clients seeking to
understand the particular compensation arrangements and associated
conflicts of the individual providing investment advice to them.
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\245\ See Morgan Stanley Letter; Schwab Letter. Morgan Stanley
made the comment regarding fiduciary duties.
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Item 6. Supervision. This item requires an adviser to explain how
the firm monitors the advice provided by the supervised person
addressed in the brochure supplement. It also requires a firm to
provide the client with the name, title, and telephone number of the
person responsible for supervising the advisory activities of the
supervised person.
We are adopting Item 6 as proposed. One commenter supported this
requirement, stating that it is important for clients to have the
ability to locate a person within a firm to whom they can direct
questions or voice concerns about their accounts.\246\ Some commenters
recommended that the Commission not require this item, asserting that
investors would not be interested in this information and that this
requirement would not make sense for smaller advisory firms.\247\ We
believe that it is important for clients to be able to contact an
appropriate person at an advisory firm, regardless of the firm's size,
if they have any questions or complaints about the handling of their
account. This will allow clients to determine appropriate redress for
their complaints without having to go through the particular supervised
person that is the focus of the complaint. Therefore, we are requiring
this disclosure.
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\246\ See CFA Institute Letter.
\247\ See FPA Letter; FSI Letter; IAA Letter; Sutherland Letter.
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Several commenters requested that the Commission permit advisers to
[[Page 49251]]
furnish clients with a general contact number and email address instead
of the name and contact information for the supervisor because
supervisory personnel may change frequently, triggering the need for
updated supplements, and because some supervised persons have multiple
supervisors.\248\ We do not agree with commenters' suggestion and are
adopting this requirement as proposed. We believe that providing the
name and telephone number of a specific individual responsible for
supervising the representative's advisory activities will ensure that
the client has ready access to the supervisor if the client has any
complaints or concerns. In the unlikely event that a supervised person
has more than one direct supervisor of his or her advisory services,
the adviser may identify any one of those supervisors as long as that
supervisor has the authority to respond to the client's question or
complaint (or can raise the issue to a higher-level supervisor, if
appropriate).
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\248\ See FPA Letter; FSI Letter; Roundtable Letter; USAA
Letter; Wachovia Letter.
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3. Delivery and Updating
a. Delivery
We are requiring as proposed that a client be given a brochure
supplement for each supervised person who: (i) Formulates investment
advice for that client and has direct client contact; or (ii) makes
discretionary investment decisions for that client's assets, even if
the supervised person has no direct client contact. We believe that
clients are most interested in learning about the background and
experience of these individuals from whom they receive investment
advice.
In the Proposing Release, we stated that an adviser would not,
however, have to provide a supplement for a supervised person who
provides discretionary advice only as part of a team and has no direct
client contact.\249\ We explained our view that, when investment advice
is formulated by a team, specific information about each individual
team member takes on less importance. A few commenters stated that all
representatives providing advice as part of a team will likely have
direct client contact from time to time, and thus that the Commission's
proposed exemption from the brochure supplement delivery requirement
for supervised persons that provide advice as part of a team and that
have no direct client contact, in fact, would not exempt any team
members from this requirement as a practical matter, despite the
limited utility of disclosure about each supervised person comprising a
large advisory team.\250\ We agree with commenters that volumes of
disclosure about a large group of supervised persons likely would not
be meaningful to investors. Accordingly, we are modifying this
requirement, as suggested by one commenter,\251\ based on the approach
to disclosure under the Company Act where a team of individuals is
jointly and primarily responsible for the day-to-day management of a
mutual fund's portfolio.\252\ If investment advice is provided by a
team comprised of more than five supervised persons, brochure
supplements need only be provided for the five supervised persons with
the most significant responsibility for the day-to-day advice provided
to the client.\253\
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\249\ See Proposing Release, supra note 8, at n.164.
\250\ See, e.g., Federated Letter; ICI Letter; NAPFA Letter.
\251\ See ICI Letter.
\252\ See Instruction 2 for Item 5(b) of Form N-1A.
\253\ See rule 204-3(b)(3).
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Another commenter urged the Commission to exempt from the brochure
supplement requirement any supervised persons providing non-
discretionary advice (even if not part of a team).\254\ A commenter
representing investors strongly opposed this recommendation, arguing
that investors do not differentiate the advice they receive on this
basis.\255\ We believe that, where a supervised person is providing
investment advice directly to a client, disclosure relating to the
background and integrity of that person would be important to a client.
It assists the client in evaluating the value of that investment
advice, an evaluation we believe clients make regardless of whether the
advice is non-discretionary.\256\
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\254\ See SIFMA Letter.
\255\ See Consumer Federation Letter.
\256\ We note that an adviser's fiduciary duties to its clients
under the Advisers Act do not turn on whether its advice is provided
on a discretionary or non-discretionary basis.
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An adviser generally must provide its clients with a brochure
supplement for each supervised person who provides the advisory
services as described above. However, advisers are not required to
deliver supplements to three types of clients: (i) Clients to whom an
adviser is not required to deliver a firm brochure (e.g., registered
investment companies and business development companies); (ii) clients
who receive only impersonal investment advice; \257\ and (iii) certain
``qualified clients'' who also are officers, directors, employees and
other persons related to the adviser.\258\ An adviser that does not
have any clients to whom a supplement will have to be delivered will
not have to prepare any supplements.\259\ Similarly, an adviser will
not have to prepare a supplement for any supervised person who does not
have clients to whom the adviser must deliver a supplement.
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\257\ This exception from the supplement delivery requirement
differs slightly from the exception from the brochure delivery
requirement, in that it does not depend on the cost of the
impersonal advisory services involved. This is because in situations
involving impersonal advisory services, the nature of the services
are such that supervised persons of the adviser are unlikely to be
directly providing advisory services to clients. As a result, we
believe that in such situations requiring supplement delivery will
result in an unnecessary expense with little appreciable benefit. We
believe, however, that delivery of a firm brochure will be useful
where the cost of the impersonal advisory services is significant,
that is $500 or above.
\258\ Rule 205-3(d)(1)(iii) also defines certain related persons
of an adviser as ``qualified clients,'' including: (i) Any executive
officers, directors, trustees, general partners, or persons serving
in a similar capacity, of the advisory firm; or (ii) any employees
of the advisory firm (other than employees performing solely
clerical, secretarial or administrative functions) who, in
connection with their regular functions or duties, participate in
the investment activities of the firm and have been performing such
functions or duties for at least 12 months.
\259\ See note to rule 203-1(a) and (b); Instruction 1 for Part
2B of Form ADV.
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We proposed exempting advisers from delivering the brochure
supplement to certain sophisticated clients,\260\ and received several
comments from those representing advisers supporting the exemption or
urging its expansion.\261\ The brochure supplement is intended to
contain fundamental information about the qualifications of persons
providing investment advice. Sophisticated clients are likely to
request this type of information, even if not affirmatively provided by
an investment adviser. Given that advisers will be preparing and
delivering brochure supplements anyway, we believe the incremental
burden of meeting the rule's obligations with respect to these
sophisticated clients will be minimal and would not justify an
exemption. We are therefore requiring that advisers deliver brochure
supplements to all clients other than, as described above: (i) Those
clients to whom the adviser is not required to deliver a firm brochure;
(ii) clients who receive only impersonal investment advice; and (iii)
certain ``qualified clients'' who also are officers, directors,
employees and other persons related to the adviser.
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\260\ See Proposing Release at Section II.B.1.
\261\ See, e.g., IAA Letter; ICI Letter; Pickard Letter; T. Rowe
Letter.
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The supervised person's supplement initially must be given to each
client at or before the time when that specific supervised person
begins to provide advisory services to that specific
[[Page 49252]]
client.\262\ A few commenters argued that a large adviser with
thousands of supervised persons may have staff changes on any given day
and suggested that delivery be permitted promptly after the time the
supervised person begins providing advisory services to the
client.\263\ But the brochure supplement is intended to assist
investors in determining whether to retain the services of a particular
adviser and in evaluating the individual advice they are receiving.
This function could not be fully served if a client did not receive the
supplement until after the supervised person already had begun
providing advice to the client. As a result, we are adopting this
delivery requirement as proposed.
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\262\ See rule 204-3(b)(3) and Instruction 3 for Part 2B of Form
ADV.
\263\ See IAA Letter; ICI Letter.
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b. Updating
We are adopting as proposed, the requirement that advisers deliver
an updated supplement to clients only when there is new disclosure of a
disciplinary event, or a material change to disciplinary information
already disclosed, in response to Item 3 of Part 2B.\264\ Because the
final rule allows advisers to reference BrokerCheck or IAPD for
disclosure of a supervised person's disciplinary information when the
supplement is delivered electronically, if the supplement refers to
BrokerCheck or IAPD a change in disclosure required by Part 2B would
require the adviser to electronically deliver an updated supplement (or
sticker) to clients when BrokerCheck or IAPD has been updated with new
disclosure of a disciplinary event, or a material change to
disciplinary information already disclosed, with the updated supplement
(or sticker) indicating that the disciplinary information for the
supervised person has changed and providing a hyperlink to BrokerCheck
or IAPD. We believe this information is critical for clients because it
reflects upon the supervised person's integrity and may affect a
client's trust and confidence in that person and the adviser that
employs the supervised person.
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\264\ See rule 204-3(b)(4). We note that an adviser's fiduciary
duty may require it to inform a client of material changes to
disclosures in the supplement even if rule 204-3 does not require
delivery of an updated supplement to clients.
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As with the brochure, advisers must amend a brochure supplement
promptly if information in it becomes materially inaccurate.\265\ Any
new clients to whom the adviser is obligated to deliver a supplement
under our amended rule must be given an amended supplement (or the
``old'' supplement and a sticker). Supplements, like brochures, may be
delivered on paper or electronically.\266\ Because we believe most
information in the supplement is unlikely to become materially
inaccurate over time, advisers are not required to deliver supplements
to existing clients annually. These requirements have not been modified
from the proposal.
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\265\ See Instruction 4 for Part 2B of Form ADV.
\266\ See Instruction 5 for Part 2B of Form ADV.
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C. Filing Requirements, Public Availability
The Commission is amending rule 204-1 to require advisers to file
their new brochures with us electronically through the IARD
system.\267\ Advisers are not required to file brochure supplements or
supplement amendments with the Commission, and they will not be
available on the Commission's public website.\268\Advisers are required
to maintain copies of all supplements and amendments in their
files.\269\
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\267\ Rule 204-1 had required advisers to file only ``Part 1A of
Form ADV'' electronically. We are amending it to require Part 1A and
Part 2A of Form ADV to be filed electronically.
\268\ See rules 203-1(a) and 204-1(b) and Instruction 9 for Part
2B of Form ADV. Because brochure supplements would not be filed with
us, they would not be deemed filed and would not be required as part
of any state notice filing. Section 307(a) of the National
Securities Market Improvement Act of 1996, Public Law 104-290, 110
Stat. 3416 (1996) (state securities authorities may only require
SEC-registered advisers to file with the states copies of those
documents advisers have filed with the Commission).
\269\ See rule 204-2(a)(14)(i) and Instruction 9 for Part 2B of
Form ADV.
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The IARD will accept brochure filings using the text-searchable
Adobe Portable Document Format (``PDF'').\270\ The IARD provides
advisers with online access to the Part 2A Items and instructions.
Instead of completing Part 2A online, advisers will create their
brochure on their own computers, convert it to a PDF, and then attach
the completed document to their filing on IARD, much like attaching a
document to an e-mail. To update brochures, advisers will make the
necessary changes to the source file on their own computers and then
attach the revised versions to their IARD filing. The IARD will not
accept an annual updating amendment without an updated brochure, a
representation by that adviser that the brochure on file does not
contain any materially inaccurate information, or a representation that
the adviser does not have to prepare a brochure because it does not
have to deliver it to any clients (e.g., the adviser's clients are
limited to registered investment companies). The IARD also will not
accept an annual updating amendment without a representation that the
summary of material changes is attached as an exhibit to or included in
the updated brochure or a representation that no summary of material
changes is required because there have been no material changes to the
adviser's brochure since its last annual updating amendment.\271\ If an
adviser using multiple brochures discontinues using a particular
brochure, the IARD system will permit the adviser to eliminate that
brochure from its current filing.\272\
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\270\ FINRA will assist investment advisers with converting
brochures into a text-searchable PDF format using software available
to the adviser or, if necessary, providing the adviser with PDF
conversion software.
\271\ If the adviser's summary of material changes is a separate
document, the adviser must attach the summary as an exhibit to its
brochure and upload the brochure and the summary in one single,
text-searchable, PDF file on IARD.
\272\ Similarly, if an adviser is no longer required to prepare
a brochure for delivery, the IARD system will permit the adviser to
eliminate that brochure from its current filing.
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Most commenters addressing electronic filing supported the new
filing requirement and public availability of the brochures.\273\ Some,
however, expressed concern that public disclosure of advisers'
brochures through IAPD could reveal proprietary and confidential
business information to competitors.\274\ We have reviewed our
requirements and do not believe that they would require disclosure of
proprietary or confidential business information. Indeed, the
information that would be disclosed is very similar to that which we
have long required to be disclosed by advisers in their brochures and
which until 2000 was filed in paper with the Commission and publicly
available.\275\ We believe that there is a substantial public interest
in having this information readily available to prospective clients,
which may assist them in their search for an investment adviser. In
addition, we believe that public disclosure will have a beneficial
effect on business practices by, for example, discouraging advisers
[[Page 49253]]
from engaging in certain practices because those practices would have
to be publicly disclosed.
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\273\ See CGMI Letter; Fried Frank Letter; CFA Institute Letter;
Katten Letter; NAPFA Letter; NASAA Letter; NRS Letter; NSCP Letter;
Sidley Letter.
\274\ See comment letter of Brown & Brown Financial Services,
Inc. (Mar. 27, 2008) (``Brown Letter''), comment letter of Executive
Advisers, Inc. (May 14, 2008); comment letter of Larry Laws and
Associates, Inc. (May 14, 2008); comment letter of James E. Wernli
(May 20, 2008) (``Wernli Letter'').
\275\ Until 2000, our rules required advisers to file both Part
I and Part 2 of Form ADV with us and it was available in our public
reference room. See Section I.C.2 of Electronic Filing by Investment
Advisers; Amendments to Form ADV, Investment Advisers Act Release
No. 1897 (Sept. 12, 2000) [65 FR 57438 (Sept. 22, 2000)].
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Other commenters expressed concern that a fund adviser's required
public disclosure of Part 2 through IAPD could jeopardize the reliance
of any private funds that it advised on the private offering exemption
in the Securities Act of 1933 and the safe harbor for offshore
transactions from the registration provisions in Section 5 of that
statute.\276\ We believe registrants can provide information required
by Part 2 without jeopardizing reliance on those exemptions. The
inclusion of private fund information beyond that required in Part 2,
however, such as subscription instructions, performance information,
and financial statements, may jeopardize such reliance by constituting
a public offering or conditioning the market for the securities issued
by those funds.
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\276\ 15 U.S.C. 77e. Some expressed specific concern that the
public disclosure may be deemed to violate the prohibition on
``general solicitation'' and ``general advertising'' that applies to
private offerings conducted in accordance with Rule 506 of
Regulation D. See AICA Letter; AIMA Letter; Fried Frank Letter;
Janus Letter; NSCP Letter. One mentioned that the public disclosure
could raise questions as to whether there are ``directed selling
efforts'' in the United States, which would be inconsistent with the
rules applicable to offshore offerings under Regulation S under the
Securities Act. See Sidley Letter.
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D. Transition to New Requirements
As discussed below in the discussion of compliance and effective
dates,\277\ we are adopting transition requirements that, as proposed,
provide advisers with at least six months to comply with the amended
rules and forms.\278\ While a few commenters asked for more time to
prepare the brochures and brochure supplements,\279\ we believe the
proposed transition period is sufficient. Advisers that are currently
registered with us will have at least 8 months (from the end of July
2010 through the end of March 2011) to prepare and file narrative
brochures as a result of the compliance dates discussed below. We also
note that we have changed the period by which firms must deliver the
new brochure and brochure supplements to their existing clients after
this electronic filing compliance date from 30 days to 60 days to make
sure that advisers have enough time to comply with the
requirement.\280\
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\277\ See Section V of this Release.
\278\ Rule 204-1(c). We proposed a transition schedule requiring
advisers to comply with the new Part 2 requirements by the date they
must make their next annual updating amendment to Form ADV following
six months after the date the revised form becomes effective.
\279\ See AICPA Letter; First Allied Letter; NAPFA Letter; T.
Rowe Letter.
\280\ Two commenters suggested a rolling transition over several
months to avoid an inordinate demand on outside consulting and legal
services by many advisers at the same time. See Fried Frank Letter;
NAPFA Letter. We believe that the transition period we have provided
to comply with the new Part 2 requirement permits advisers to work
with their service providers in advance of the date their filings
are required.
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III. Amendments to Form ADV Instructions and Glossary
Together with the Part 2 amendments, we also are making conforming
amendments to the General Instructions and the Glossary of Terms for
Form ADV. We are amending the General Instructions to Form ADV to
include instructions regarding brochure filing requirements. Similarly,
we are amending the Glossary of Terms to add the following five terms
that are used in Part 2: (i) ``brochure;'' \281\ (ii) ``brochure
supplement;'' \282\ (iii) ``custody;'' \283\ (iv) ``investment adviser
representative;'' \284\ (v) ``supervised person;'' \285\ and (vi)
``wrap brochure or wrap fee program brochure.'' \286\ We also are
updating the Glossary to reflect cross-references to these new terms,
and cross-references to existing Glossary entries used in the revised
portions of the Form.
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\281\ ``Brochure'' means: ``A written disclosure statement that
you must provide to clients and prospective clients.'' See Form ADV:
Glossary.
\282\ ``Brochure supplement'' means: ``A written disclosure
statement containing information about certain of your supervised
persons that your firm is required by Part 2B of Form ADV to provide
to clients and prospective clients.'' See Form ADV: Glossary.
\283\ ``Custody'' means ``holding, directly or indirectly,
client funds or securities, or having any authority to obtain
possession of them. You have custody if a related person holds,
directly or indirectly, client funds or securities, or has any
authority to obtain possession of them, in connection with advisory
services you provide to clients. Custody includes: (i) Possession of
client funds or securities (but not of checks drawn by clients and
made payable to third parties) unless you receive them inadvertently
and you return them to the sender promptly but in any case within
three business days of receiving them; (ii) Any arrangement
(including a general power of attorney) under which you are
authorized or permitted to withdraw client funds or securities
maintained with a custodian upon your instruction to the custodian;
and (iii) Any capacity (such as general partner of a limited
partnership, managing member of a limited liability company or a
comparable position for another type of pooled investment vehicle,
or trustee of a trust) that gives you or your supervised person
legal ownership of or access to client funds or securities.'' See
rule 206(4)-2(d)(2).
\284\ ``Investment adviser representative'' means: ``Any of your
firm's supervised persons (except those that provide only impersonal
investment advice) is an investment adviser representative, if--(i)
the supervised person regularly solicits, meets with, or otherwise
communicates with your firm's clients, (ii) the supervised person
has more than five clients who are natural persons and not high net
worth individuals, and (iii) more than ten percent of the supervised
person's clients are natural persons and not high net worth
individuals.'' See Form ADV: Glossary. Cf. rule 203A-3(a).
\285\ ``Supervised person'' means: ``Any of your officers,
partners, directors (or other persons occupying a similar status or
performing similar functions), or employees, or any other person who
provides investment advice on your behalf and is subject to your
supervision or control.'' See Form ADV: Glossary.
\286\ ``Wrap brochure or wrap fee program brochure'' means:
``The written disclosure statement that sponsors of wrap fee
programs are required to provide to each of their wrap fee program
clients.'' See Form ADV: Glossary.
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We also are updating the Glossary to correct a discrepancy in the
definition of ``Non-Resident'' to make it consistent with the
definition in rule 0-2, the Advisers Act rule related to the procedures
for serving process, pleadings, and other papers on non-resident
investment advisers, and advisers' non-resident general partners and
managing agents. This revision properly reflects the Commission's
intent at the time the Glossary was originally adopted, that the
definition of ``Non-Resident'' in the Glossary be the same as that in
rule 0-2.\287\ Although technical in nature, this amendment may
potentially result in an increased number of corporate entities
qualifying as non-resident general partners or managing agents of
registered advisers. Certain entities will need to file Form ADV-NR
with the Commission to appoint agents for service of process because
they relied on the glossary definition and therefore were not required
to file the form. We received no comments on these changes and are
adopting them as proposed.
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\287\ This amendment will change the definition of ``Non-
Resident'' to include ``a corporation incorporated in or having its
principal place of business in any place not subject to the
jurisdiction of the United States.'' (emphasis added). See rule 0-
2(b)(2) [17 CFR 275.0-2(b)(2)].
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IV. Amendments to Rule 204-2
We also are adopting conforming amendments to Advisers Act rule
204-2, the rule that sets forth the requirements for maintaining and
preserving specified books and records, to require registered
investment advisers to retain copies of each brochure, brochure
supplement, and each amendment to the brochure and supplements that are
prepared as required under the rule 204-3.\288\ Additionally, the
amendments require registered advisers to prepare and preserve
documentation of the method they use to calculate managed assets for
purposes of Item 4.E in Part 2A of Form
[[Page 49254]]
ADV, if that method differs from the method used to calculate ``assets
under management'' in Part 1A of Form ADV.\289\ The amendments also
require advisers to prepare and preserve a memorandum describing any
legal or disciplinary event listed in Item 9 in Part 2A and Item 3 in
Part 2B for the period the event is presumed material, if the event is
not disclosed in the adviser's brochure or the relevant brochure
supplement.\290\ These records will be required to be maintained in the
same manner, and for the same period of time, as other books and
records required to be maintained under rule 204-2(a). We received no
comments on these changes and are adopting them as proposed.
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\288\ See rule 204-2(a)(14)(i). The rule also will require
advisers to keep and maintain a copy of the summary of material
changes that is not included in the brochure, as well as a record of
the dates that each brochure, amendment, and summary of material
change was given to any client.
\289\ See discussion at supra note 40 and accompanying text.
\290\ See discussion at supra notes 86--89 and accompanying
text.
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V. Effective and Compliance Dates
The amended rules and forms will be effective on October 12, 2010.
A. New Investment Advisers
Each adviser applying for registration with the Commission after
January 1, 2011 must file a brochure or brochures that meet the
requirements of amended Part 2A as part of the application for
registration on Form ADV.\291\ Such advisers must, upon registering,
begin to deliver to their clients and prospective clients a brochure
and brochure supplements that meet the requirements of the amended form
in accordance with the amended rules discussed above.\292\
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\291\ Rule 203-1(b). This requirement applies only if the
adviser is required to deliver a brochure. See note to Rule 203-1.
\292\ Rule 204-3(b).
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B. Registered Advisers
Each adviser registered with the Commission whose fiscal year ends
on or after December 31, 2010, must include in its next annual updating
amendment to its Form ADV a brochure or brochures that meet the
requirements of the amended form.\293\ Accordingly, each adviser with a
fiscal year end of December 31, 2010 must file an annual updating
amendment with the new brochures no later than March 31, 2011. Within
60 days of filing such amendment, the adviser must deliver to its
existing clients a brochure and brochure supplement that meet the
requirements of amended Form ADV.\294\ Each adviser must, after the
initial filing of the brochures, begin to deliver to new clients and
prospective clients a new brochure and brochure supplements in order to
satisfy its obligations under the brochure rule.\295\
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\293\ Rule 204-1(c). This filing requirement applies only if the
adviser is required to deliver a brochure. See note to Rule 203-1.
\294\ Rule 204-3(g)(1).
\295\ Rule 204-3(g)(2).
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VI. Paperwork Reduction Act
As explained in the Proposing Release, certain provisions of the
rule and form amendments that we are adopting today contain
``collection of information'' requirements within the meaning of the
Paperwork Reduction Act of 1995 (``PRA'').\296\ In the Proposing
Release, the Commission published notice soliciting comment on the
collection of information requirements. The Commission submitted the
collection of information requirements to the Office of Management and
Budget (``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5
CFR 1320.11, and OMB approved these collections of information under
control numbers 3235-0049 (expiring 2/28/2011), 3235-0278 (expiring 3/
31/2011), 3235-0047 (expiring 2/28/2011), and 3235-0345 (expiring 3/31/
2011). The titles for these collections of information are ``Form
ADV,'' ``Rule 204-2,'' ``Rule 204-3,'' and ``Rule 206(4)-4,''
respectively, all under the Advisers Act. An agency may not conduct or
sponsor, and a person is not required to respond to, a collection of
information unless it displays a currently valid control number.
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\296\ 44 U.S.C. 3501.
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The respondents to the collections of information are investment
advisers registered or applying for registration with us. We use the
information to determine eligibility for registration with us and to
manage our regulatory and examination programs. Clients use certain of
the information to determine whether to hire or retain an adviser.
The rule and form amendments that we are adopting involve three
distinct ``collections of information'' for purposes of the Paperwork
Reduction Act. The first is the collection of information connected
with Form ADV itself, specifically our amendments to Part 2 of Form
ADV. The second collection of information involved is that under the
amendment to rule 204-2, which requires advisers to maintain and
preserve specified books and records. The third collection involved is
that related to an amendment to rule 204-3, which requires advisers to
deliver certain information required under Form ADV to their clients.
In addition, we are withdrawing rule 206(4)-4, the rule requiring
advisers to disclose certain disciplinary and financial information,
because the disclosure required by that rule is incorporated into the
amendments to Part 2 of Form ADV that we are adopting.
A. Summary of Comment Letters
We requested comment on the Paperwork Reduction Act analysis
contained in the Proposing Release. A number of commenters expressed
concerns that the paperwork burdens associated with our proposed
amendments to Part 2 of Form ADV were understated.\297\ Several
commenters stated that our estimates of the burdens of preparing and
delivering brochure supplements were too low and that the requirement
would impose heavy burdens on advisers, in particular, large advisory
firms with thousands of employees and clients.\298\ Several commenters
noted that these costs would increase particularly in the context of
wrap fee programs.\299\ In response to comments on the requirements of
Form ADV Part 2, we have made several substantive modifications to the
proposed amendments that we believe in general will reduce the
paperwork burdens associated with the rule and form amendments. For
example, we have modified the annual brochure delivery requirement to
allow it to be satisfied by delivering just a summary of material
changes in the brochure. We have revised Item 5 so that advisers do not
need to include a fee schedule in brochures provided only to clients
that are ``qualified purchasers.'' We have not adopted proposed
disclosure of cash balance practices and proxy voting services from
Items 8 and 17, respectively. We are permitting supervised persons with
certain disciplinary information disclosed through FINRA's BrokerCheck
system or the IAPD system to refer clients to that information in their
brochure supplements (if they are provided electronically and contain a
hyperlink to the BrokerCheck or the IAPD system, as relevant) rather
than reproducing that information. When investment advice is provided
to a client by a team, we are requiring that brochure supplements need
only be provided for the five supervised persons with the most
significant responsibility for the day-to-day advice provided to the
client.
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\297\ See ASG Letter; Berlin Letter; Federated Letter; First
Allied Letter; Fried Frank Letter; FSI Letter; IAA Letter; Jackson
Letter; NAPFA Letter; NRS Letter; Pickard Letter; Sutherland Letter;
Vineyard Letter.
\298\ See Merrill Lynch Letter; Morgan Stanley Letter; Schwab
Letter; SIFMA Letter; Sutherland Letter.
\299\ See Federated Letter; MMI Letter; Morgan Stanley Letter.
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[[Page 49255]]
B. Revisions to Paperwork Reduction Act Burden Estimates
After considering commenters' concerns that the Commission's
estimated paperwork burdens for firms complying with the amended Form
ADV Part 2 were too low, and in light of revisions we have made to our
proposed amendments to Part 2, we are revising our estimates for
purposes of the Paperwork Reduction Act.
1. Amendments to Form ADV
a. Part 2 of Form ADV
The information required by the amendments to Form ADV is
mandatory. Advisers are required to disclose this information to their
clients and, therefore, it is not kept confidential. The currently
approved total annual burden for all advisers completing, amending, and
filing revised Form ADV with us is 132,599 hours. As stated in the
Proposing Release, we continue to believe that most of the paperwork
burden will be incurred in advisers' initial preparation of a revised
brochure and brochure supplements, as most advisers will have to draft
a narrative brochure and all advisers will have to prepare new brochure
supplements, and that over time this burden will decrease substantially
because the paperwork burden will be limited to updating information.
The paperwork burdens of preparing a narrative firm brochure and
brochure supplements are likely to vary substantially among advisers,
because Part 2 gives an adviser considerable flexibility in structuring
its disclosure, the amount of disclosure required will vary among
advisers, and the number of supplements that will need to be prepared
depends on the number of supervised persons at a firm that provide
investment advice. We believe that the revisions to Part 2 will impose
a small burden on advisers in collecting information because there is a
significant overlap between the information required by the previous
Part 2 and the new Part 2A requirements and because advisers already
collect information on the business background and disciplinary
histories of their supervised persons to comply with state investment
adviser representative registration requirements.\300\ Accordingly, we
expect that most of the paperwork burden from amended Part 2 will arise
from an adviser drafting the narrative disclosure for its brochure and
brochure supplements based on disclosures it and its supervised persons
already made in Schedule F of Part 2 and in Form U4, and in expanding
its discussion of how the adviser addresses certain conflicts of
interest.
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\300\ There are three entirely new items in the Part 2A we are
adopting today--Item 2's summary of material changes, Item 6's
performance fee disclosure requirement, and Item 15's custody
disclosure requirement. The remainder of the items in Part 2A either
were generally covered by the previous Part 2 or were required
disclosure under other Advisers Act rules, such as rule 206(4)-6
regarding proxy voting and rule 206(4)-4 regarding financial and
disciplinary information. In addition, most states require that
supervised persons of SEC-registered investment advisers that are
investment adviser representatives file Form U4, which requires
similar business background and disciplinary information as the
brochure supplement.
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As noted above, we have revised our estimated burdens for purposes
of the Paperwork Reduction Act to take into account comments received
as well as substantive modifications to Part 2 from the form that was
proposed.
In the Proposing Release, we estimated the average initial annual
burden associated with Form ADV to be 5 hours for smaller
advisers.\301\ We received several comments that provided estimates of
the paperwork burden associated with the proposed rule and form
amendments for small advisers. One commenter estimated that preparing
the initial Form ADV Part 2 would require 16 to 40 hours, depending on
the nature of the firm's business, and that each subsequent amendment
to that form would take 10 to 32 hours, depending on the nature of the
amendments.\302\ Another said that a small firm would take 60 hours to
draft the initial brochure.\303\ A small firm commenter estimated that
it would take 40 to 60 hours to prepare the initial brochure and
another 20 to 40 hours per year thereafter to update it.\304\ A
compliance consulting firm estimated that it would take on average 15
hours for a small firm to prepare the initial brochure.\305\ One law
firm estimated that smaller advisers would spend at least 44.5 hours
preparing the new brochure.\306\ We do not believe that small advisers
will require as many as 60 hours for their initial revision of Part 2A
because, as discussed above, firms already have collected much of the
information for Part 2A, many of the disclosures were already required
under previous Part 2 requirements or other Advisers Act rules or as a
result of the adviser's fiduciary obligations, and small advisers are
unlikely to have extensive conflicts of interest that would necessitate
lengthy brochure disclosures. We have reviewed several brochures of
small investment advisers drafted in a narrative format that would
appear to be generally responsive to the requirements we are adopting
today, and these brochures are short, likely because of the relative
simplicity of most small advisers' business models.\307\ We also do not
believe that small advisers will spend significant amounts of time
preparing brochure supplements because they have a small number of
supervised persons. Based on these considerations, we estimate that the
average initial annual burden associated with Form ADV to be at the low
end of the 15 to 60 hour range provided by commenters, or 15 hours for
each small adviser.
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\301\ For purposes of the estimates in this section, we have
categorized small advisers as those with 10 or fewer employees,
medium-sized advisers as those with between 11 and 1,000 employees,
and large advisers as those with over 1,000 employees. Unless
otherwise noted, the IARD data cited below is based on advisers'
responses to questions on Part 1A of Form ADV as of May 3, 2010.
\302\ ASG Letter.
\303\ NAPFA Letter.
\304\ Jackson Letter.
\305\ NCS Letter.
\306\ Fried Frank Letter.
\307\ We note that advisers that choose to disclose more than is
required by Part 2A (or their fiduciary obligations) will create
lengthier brochures than those that take a more focused approach.
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In the Proposing Release, we estimated that the average initial
annual burden associated with Form ADV for medium-sized advisers would
be approximately 50 hours. We received a comment from a medium-sized
adviser stating that it currently spends approximately 45 hours per
year to update its Part 2 brochure.\308\ This commenter did not
estimate how long it took to prepare its initial Part 2 brochure under
the prior format and did not estimate how long it would take to prepare
or update the new Part 2A brochure and brochure supplements. We
received a comment from another medium-sized adviser estimating that it
would take a minimum of 163 hours for the initial preparation and
internal handling of the brochure supplement.\309\ Most of our medium-
sized advisers are closer to the size of small advisers than large
advisers, with 77% of medium-sized advisers having between 11 and 50
employees.\310\ Accordingly, we expect that while these advisers will
have a higher burden than smaller advisers due to the greater size and
complexity of their business model, the majority will not have burdens
dramatically greater than small advisers. We also estimated that each
medium adviser, on average, will require 30 minutes to prepare each
brochure supplement, based on an estimate of
[[Page 49256]]
brochure supplement preparation time provided by one medium adviser
commenter.\311\ Based on these considerations and the comments on small
firm burdens, we have revised our estimate of the average initial
annual burden associated with Form ADV for each medium-sized adviser to
be 97.5 hours.\312\
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\308\ See Federated Letter.
\309\ See First Allied Letter. The First Allied Letter stated
that it had approximately 325 investment advisory representatives
and assumed that each supplement would take 30 minutes to prepare.
\310\ Based on IARD data as of May 3, 2010.
\311\ First Allied Letter.
\312\ We assume that preparing Part 1 and Part 2A of Form ADV
would take each medium adviser on average 60 hours per year based on
our estimate for smaller advisers, the fact that the average medium
adviser is closer in size to a small adviser than a large adviser,
the discussion above that advisers already have much of the
information required by the new Part 2A and it is largely a matter
of converting it to a narrative format, and the one comment we did
receive from a medium sized adviser on the time it took to amend its
brochure annually. We estimate that each medium adviser, on average,
has 75 supervised persons based on the average number of employees
performing investment advisory functions at medium sized advisers
according to IARD data. We thus estimated that each medium adviser
on average would spend 37.5 hours preparing the initial brochure
supplements (75 supervised persons x 30 minutes per supervised
person = 37.5 hours per year), for a total of 97.5 hours for the
initial preparation of all of Form ADV.
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Finally, in the Proposing Release we estimated that the average
initial annual burden associated with Form ADV for large advisers would
be approximately 3,300 hours. We received no estimates from commenters
of the burden on large advisers from preparing the new brochure. We
received estimates from two of the largest advisers that the brochure
supplement would require between 30,000 to 45,000 hours initially.\313\
Unlike with respect to small and medium advisers, the brochure
supplement dramatically increases the estimated burden associated with
preparing Form ADV for large advisers because of their significantly
larger number of employees that provide investment advice (some with
over 1,000 per firm according to IARD data). The primary difference
between the burden associated with preparing the brochure for large and
smaller firms is the likelihood that there will be additional items to
which large firms will have to respond and the likelihood that large
firms will have additional conflicts of interest to address. We
estimate that these additional brochure disclosures will add a
relatively small amount compared to the burden estimate for medium
advisers, but that the brochure supplement requirement will add a
significant burden compared to medium advisers. We do not expect the
burden for most large firms to be as substantial, on average, as
estimated in the Merrill Lynch and Morgan Stanley comment letters,
however, because these firms based their estimate on substantially more
supervised persons providing investment advisory services than an
average large adviser.\314\ We estimate that preparing Part 1 and Part
2A of Form ADV would take each large adviser on average 100 hours per
year.\315\ Based on commenters' estimates, we now estimate that the
brochure supplement will take each large adviser on average 30 minutes
per supervised person to collect and prepare a supplement.\316\ As a
result, we now estimate the initial average burden associated with
preparing Form ADV for each large adviser to be 1,989 hours.\317\
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\313\ The Merrill Lynch Letter estimated that the brochure
supplement requirement would require 45,000 hours per year. The
Morgan Stanley Letter estimated that it would take in the range of
30,000 to 35,000 hours for it to comply with the brochure supplement
requirement initially and 8,000 to 10,000 hours annually to comply
going forward. In their comment letters, Merrill Lynch and Morgan
Stanley stated that approximately 8,000 and 14,000 employees,
respectively, performed investment advisory functions at their
firms. These employee numbers place these two commenters at the
highest end of the range of the 36 advisers in our large category
with only four other firms reporting as of May 3, 2010 that they had
8,000 or more employees performing such functions.
\314\ See supra note 114.
\315\ This estimate is based on our estimate for medium
advisers, the discussion above that advisers already have much of
the information required by the new Part 2A and it is largely a
matter of converting it to a narrative format, and our view that the
additional disclosure required by large advisers' business models is
not so substantial as to require dramatically more brochure
preparation time than medium advisers.
\316\ We estimate that each large adviser, on average, has 3,777
supervised persons based on the average number of employees
performing investment advisory functions at large advisers according
to IARD data. The Merrill Lynch Letter estimated that each
supplement would require 3 hours to prepare. We believe that this
estimate includes the burden to track and update brochure
supplements which we discuss and account for separately, and which
are not part of this burden estimate. We do not expect that brochure
supplements for supervised persons at large advisers are likely to
require more preparation time than supplements at medium advisers,
particularly when more supervised persons at large advisers than
medium advisers are likely to have information available through
BrokerCheck or the IAPD that can be referenced in those supervised
persons' supplements, reducing supplement preparation time. Brochure
supplements consist of only 6 disclosure items, several of which
(i.e., cover page, supervision, education) are simple to collect and
draft in a few minutes). Accordingly, we estimate that an adviser
would spend 30 minutes per supervised person to collect and prepare
a supplement.
\317\ We estimate that each large adviser on average would spend
1,889 hours preparing the initial brochure supplements (3,777
supervised persons x 30 minutes per supervised person = 1,889 hours
per year), for a total of 1,989 hours per year on average per large
adviser for the initial preparation of all of Form ADV.
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In the Proposing Release, we estimated that an average investment
adviser's collection of information burden associated with initial
preparation of Form ADV would be 22.25 hours per year. According to
IARD data, there are 9,482 small advisers, 2,140 medium-sized advisers,
and 36 large advisers. Based on the revised hourly burden estimates
discussed above, we now believe that 36.24 hours is an accurate
reflection of the time that it will take the average adviser to
initially complete revised Form ADV (including both Parts 1 and
2).\318\ This is an increase of 13.99 hours over our initial estimate.
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\318\ 9,482 small advisers x an estimated 15 hours/adviser +
2,140 medium-sized advisers x an estimated 97.5 hours/adviser + 36
large advisers x an estimated 1,989 hours/adviser = 422,484 hours
total. 422,484 hours/11,658 total advisers = 36.24 hours/adviser.
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Respondents under this collection of information will be advisers
registered with the Commission as well as new applicants for investment
adviser registration with the Commission. We estimate that
approximately 1000 new investment advisers will register with us each
year.\319\ Thus, in combination with the approximately 11,658 existing
investment advisers registered with the Commission, we estimate that
the total number of respondents under this collection of information
will be 12,658 advisers. Based on the estimated average collection of
information burden of 36.24 hours per adviser, the total initial
collection of information would amount to 458,726 hours for new
registrants and for currently registered advisers that re-file Form ADV
(including Part 2) through the IARD system.\320\ Amortizing this total
burden imposed by Form ADV over a three-year period to reflect the
anticipated period of time that advisers would use the revised Form
would result in an average burden of an estimated 152,909 hours per
year,\321\ or 12.08 hours per year for each new applicant and for each
adviser currently registered with the Commission that would re-file
through the IARD.\322\
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\319\ Based on IARD data over the last five years.
\320\ (12,658 advisers x 36.24 hours) = 458,726 hours.
\321\ 458,726 hours/3 years = 152,909 hours/year.
\322\ 152,909 hours/12,658 advisers = 12.08 hours/adviser.
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We estimate that some advisers may incur a one-time initial cost
for outside legal and compliance consulting fees in connection with
preparation of Part 2 of Form ADV. While we received no specific
comments on our estimate regarding outside legal costs in the Proposing
Release, one commenter did state that compliance consultants assist a
significant percentage of advisers in preparing their Form ADV.\323\ As
a result, we are changing our estimate to reflect a quarter of small
advisers using compliance consulting services and a
[[Page 49257]]
quarter of small advisers using outside legal services and to reflect
half of medium advisers using compliance consulting services in lieu of
outside legal services and a quarter of medium advisers still using
outside legal services. We estimate that the initial per adviser cost
for legal services related to preparation of Part 2 of Form ADV would
be $3,200 for small advisers, $4,400 for medium-sized advisers, and
$10,400 for larger advisers.\324\ We estimate that the initial per
adviser cost for compliance consulting services related to initial
preparation of the amended Form ADV will range from $3,000 for smaller
advisers to $5,000 for medium-sized advisers.\325\ We estimate that a
quarter of small and half of medium advisers, or 2,371 and 1,070
advisers, respectively, are likely to seek outside compliance
consulting services in their preparation of Form ADV.\326\ We estimate
that a quarter of small advisers, or 2,370 advisers, and a quarter of
medium advisers, or 535 advisers, are likely to engage outside legal
services.\327\ We estimate that all of the 36 large advisers will
engage outside legal services in preparation of Form ADV. Thus, we
estimate that approximately 2,941 advisers will elect to obtain outside
legal assistance and approximately 3,441 advisers will elect to obtain
outside consulting services, for a total cost among all respondents of
$22,775,400.\328\
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\323\ See NCS Letter.
\324\ Outside legal fees are in addition to the projected hourly
per adviser burden discussed above. $400 per hour for legal services
x 8 hours per small adviser = $3,200. $400 per hour for legal
services x 11 hours per medium-sized adviser = $4,400. $400 per hour
for legal services x 26 hours per large adviser = $10,400. The
hourly cost estimate of $400 on average is based on our consultation
with advisers and law firms who regularly assist them in compliance
matters.
\325\ Outside compliance consulting fees are in addition to the
projected hourly per adviser burden discussed above. Based on
consultation with compliance consulting firms who regularly assist
investment advisers in Form ADV preparation, we estimate that small
advisers will incur expenses of $3000 per year for the initial
preparation of the new Form ADV and medium advisers will incur
expenses of $5000 per year for the initial preparation of the new
Form ADV.
\326\ 9,482 small advisers x 0.25 = 2,371. 2,140 medium-sized
advisers x 0.5 = 1,070.
\327\ 2,140 medium-sized advisers x 0.25 = 535.
\328\ For outside legal services, ($4,400 x 535 medium advisers)
+ ($3,200 x 2,370 small advisers)) + ($10,400 x 36 large advisers) =
$ 10,312,400. For compliance consulting services, ($3,000 x 2,371
small advisers) + ($5,000 x 1,070 medium advisers) = $12,463,000.
$10,312,400+$12,463,000 = $22,775,400
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In addition to the burdens associated with initial completion and
filing of the revised form, we estimate that, on average, each adviser
filing Form ADV through the IARD system will likely amend its form two
times during the year.\329\ A few commenters believed that we had
underestimated the information burden associated with amending Form
ADV.\330\ As a result, we are revising our estimate of the collection
of information burden for preparing amendments. One of the two
amendments that firms on average make each year will be an interim
updating amendment, and we estimate that this amendment will require
0.5 hours per amendment because interim amendments typically only amend
one or two items \331\ in Form ADV and thus should not require much
time to prepare. The other amendment is the firm's annual updating
amendment of Form ADV. Part 2A requires only a few additional
requirements with the annual updating amendment than is required
throughout the year--the summary of material changes since the last
annual updating amendment, an updated fee schedule, and an updated
figure for assets under management. We also expect that advisers will
not have to spend a significant amount of time generally reviewing
their brochure before filing their annual updating amendment as the
instructions to the form and their fiduciary obligations require them
to keep information they provide to clients free of material
inaccuracies. Based on these considerations, we estimate that the
average adviser will spend 6 hours per year completing their annual
updating amendment to Form ADV. Finally, we believe that the
information required in the brochure supplements is unlikely to change
frequently for any particular supervised person, and, as a result, that
brochure supplements will be amended infrequently.\332\ We also
estimate that changes to most of the supplement information is already
tracked by advisers in order to allow them to keep Forms U4 for their
investment advisory representatives current, and that tracking changes
to this information for brochure supplement purposes as well will
impose negligible additional costs. Accordingly, we estimate that it
will require an average burden per adviser of one hour per year for
interim amendments to brochure supplements, for a total burden on all
advisers of 11,658 hours per year.\333\ Thus, we estimate that the
total paperwork burden on advisers of amendments to Form ADV will be
87,435 hours per year.\334\
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\329\ In the Proposing Release, we estimated that each adviser,
on average, filing Form ADV through the IARD system amended its form
1.5 times per year. We have updated this estimate based on IARD
system data regarding the number of filings of Form ADV amendments.
\330\ In the Proposing Release, we estimated that each adviser,
on average, would spend 0.75 hours per year amending its Form ADV.
The ASG Letter estimated that amendments to Part 2 would take 10 to
32 hours, depending on the nature of the amendments. The Jackson
Letter estimated that it would take small firms 20 to 40 hours per
year to update Part 2. The Federated Letter stated that they
currently spend approximately 45 hours per year amending the
previous Part 2.
\331\ Based on IARD system data.
\332\ Largely for this reason, we have not broken down our
estimated burden for preparing the annual updating amendment to Form
ADV based on the size of the adviser since most of the difference in
the initial Form ADV preparation burden was driven by the brochure
supplement. We also do not believe that the burden for preparing an
annual updating amendment to Part 2A of Form ADV will vary
significantly based on the size of the adviser.
\333\ 1 hour per year x 11,658 advisers = 11,658 hours per year.
\334\ 11,658 advisers x 1 interim brochure amendment per year x
0.5 hours = 5,829 hours per year for interim amendments. 11,658
advisers x 1 annual brochure amendment per year x 6 hours = 69,948
hours per year for annual amendments. 11,658 advisers x 1 hour per
year for supplement amendments = 11,658 hours per year for
supplement amendments. 5,829 + 69,948 + 11,658 = 87,435 hours.
---------------------------------------------------------------------------
Commenters also highlighted the fact that the particular supervised
persons for whom the adviser will have to deliver brochure supplements
to particular clients will change over time and that these changes will
generate costs.\335\ The adviser may hire new employees who may begin
providing investment advisory services that require preparation of a
brochure supplement. We estimate that advisers on average will hire two
new supervised persons each year for which a brochure supplement would
have to be prepared.\336\ We further estimate that, on average, an
adviser will spend 0.5 hours preparing each new brochure
supplement.\337\ Preparation of these new supplements thus would
require all advisers to spend 11,658 hours per year.\338\
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\335\ See, e.g., Schwab Letter; SIFMA Letter; Sutherland Letter.
\336\ Estimate is weighted average based on analysis of changes
in aggregate responses to Item 5.B(1) of Part 1A of Form ADV over
the last 5 years and the number of investment advisers registered
with the Commission.
\337\ See discussion at supra note 311 and accompanying text.
\338\ Two new supervised persons per year x 0.5 hours per
supplement x 11,658 investment advisers = 11,658.
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The revised total annual collection of information burden for
advisers to file and complete the revised Form ADV (Parts 1 and 2),
including the initial burden for both existing and anticipated new
registrants plus the burden associated with amendments to the form as
well as creating new supplements for new employees, is estimated to be
approximately 252,002 hours per
[[Page 49258]]
year.\339\ This burden represents an increase of 151,026 hours over
that estimated in the Proposing Release.\340\ This increase is
attributable primarily to our increased estimates of the hourly
preparation burden associated with Part 2 in response to comments. As
discussed in the Proposing Release, in addition to these estimated
burdens, under this collection of information there is also a burden of
16,455 hours associated with advisers' obligations to deliver to
clients copies of their adviser codes of ethics upon request.\341\
Thus, the estimated revised total annual hourly burden under this
collection of information would be 268,457 hours.\342\ This represents
an increase of 135,858 hours per year from the currently approved
burden.\343\
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\339\ 152,909 hours per year attributable initial preparation of
Form ADV + 87,435 hours per year for amendments to Form ADV + 11,658
hours per year for supplements for new employees = 252,002 hours.
\340\ Revised burden 252,002 hours - proposing release burden of
100,976 hours = 151,026 hours.
\341\ See Code of Ethics Adopting Release, supra note 114. As we
estimated in the Proposing Release (and on which we received no
comment), we estimate that only one percent of an adviser's clients
actually request a copy the adviser's code of ethics. 0.01 x 1,300
(the estimated average number of clients per adviser) = 13 requests
per registrant. See infra note 357 regarding the estimated average
number of clients. We continue to estimate that responding to each
such request involves a burden of 0.10 hours, amounting to an annual
burden of 1.3 hours for each adviser stemming from the obligation to
deliver copies of their codes of ethics to clients. 13 requests per
adviser x 0.10 hours = 1.3 hours/adviser. This obligation applies to
both currently-registered (11,658 respondents) and newly-registered
advisers (1000 respondents), for a total annual burden of 16,455
hours. 12,658 respondents x 1.3 hours = 16,455 hours.
\342\ 16,455 hours + 252,002 hours = 268,457 hours.
\343\ Revised burden 268,457 hours - currently approved burden
of 132,599 hours = 135,858 hours.
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b. Rule 206(4)-4
Rule 206(4)-4 currently requires advisers to disclose certain
disciplinary and financial information to clients. We are rescinding
rule 206(4)-4 and incorporating its substantive provisions into Part 2
of Form ADV. The collection of information burden associated with the
requirements of rule 206(4)-4 has been incorporated into the collection
of information requirements for Form ADV, discussed above. Thus, the
currently approved burden estimate for Form ADV already includes an
estimate of the burdens associated with the disclosure of disciplinary
and financial information connected with Part 2.
2. Rule 204-2
This requirement is found at 17 CFR 275.204-2 and is mandatory. The
Commission staff uses the collection of information in its examination
and oversight program, and the information generally is kept
confidential.\344\ The likely respondents to this collection of
information requirement are all of the approximately 11,658 advisers
currently registered with the Commission.
---------------------------------------------------------------------------
\344\ See section 210(b) of the Advisers Act (15 U.S.C. 80b-
10(b)).
---------------------------------------------------------------------------
The amendments to rule 204-2 require advisers to prepare and
preserve a memorandum describing any legal or disciplinary event listed
in Item 9 in Part 2A of Form ADV and Item 3 in Part 2B of Form ADV, if
the event is not disclosed in the adviser's brochure or the relevant
brochure supplement. Additionally, the amendments require advisers to
prepare and preserve documentation of the method they use to calculate
managed assets for purposes of Item 4.E. in Part 2A of Form ADV, if
that method differs from the method used to calculate ``assets under
management'' in Part 1A of Form ADV. These records are required to be
maintained in the same manner, and for the same period of time, as
other books and records required to be maintained under rule 204-2(a).
As we stated in the Proposing Release, we believe that the
amendments to rule 204-2 will result in an increased burden of four
hours for each adviser subject to the additional requirements. We
received no comments on the Commission's burden estimates relating to
rule 204-2 and are leaving these estimates unchanged, except to update
collection estimates based on IARD data.
We estimate that 350 advisers will use a method for calculating
managed assets in Part 2A that differs from the method used to compute
assets under management in Part 1A and thus would be required to
prepare and preserve documentation describing the method used in Part
2A.\345\ We also estimate that 156 advisers will conclude that the
materiality presumption in Part 2 has been overcome with respect to a
legal or disciplinary event, will determine not to disclose that event,
and therefore would be required to prepare and preserve a memorandum
describing the event.\346\
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\345\ Based on the Commission staff's conversations with
industry professionals, we anticipate that approximately three
percent of the 11,658 advisers registered with us as of May 3, 2010
will use a method for computing managed assets in Part 2A of Form
ADV that differs from the method used to compute assets under
management in Part 1A of Form ADV. 11,658 advisers x 0.03 = 350
advisers.
\346\ Approximately 1,559 advisers registered with the
Commission report disciplinary information in Part 1A of their Form
ADV as of May 3, 2010. We anticipate that most of these advisers
will include all disciplinary information in their brochures and
supplements, but that approximately 10% of these advisers, or 156,
will need to prepare and preserve a memorandum explaining their
basis for not disclosing a legal or disciplinary event listed in
Part 2 in their brochures and supplements. 1,559 advisers x 0.10 =
156 advisers.
---------------------------------------------------------------------------
We estimate that a total of 506 advisers will have to prepare and
preserve additional records in accordance with amendments to rule 204-
2.\347\ Only 487 of these are already accounted for in the currently
approved burden estimate. We estimate that adding 19 advisers to those
subject to the amended provisions of rule 204-2 will yield a 76 hour
increase in burden under the rule.\348\
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\347\ 350 advisers that we estimate would prepare memoranda
regarding an alternative method for calculating assets under
management + 156 advisers that we estimate would prepare memoranda
regarding unreported nonmaterial disciplinary events = 506 advisers.
\348\ 506 advisers-487 advisers = 19 advisers. 19 advisers x 4.0
hours = 76 hours.
---------------------------------------------------------------------------
The approved annual aggregate burden for rule 204-2 is currently
1,954,109 hours based on an estimate of 10,787 registered advisers, or
181.15 per registered adviser.\349\ Taking into account the estimated
increased burden of 76 hours as discussed above, as well as an increase
of 871 registered advisers,\350\ the revised annual aggregate burden
for all respondents to the recordkeeping requirements under rule 204-2
is therefore estimated to be 2,111,967 total hours.\351\
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\349\ 1,954,109 hours/10,787 registered advisers = 181.15 hours
per adviser.
\350\ As stated above, our IARD data show that as of May 3, 2010
there were 11,658 advisers registered with the SEC. 11,658-10,787 =
871.
\351\ (1,954,109 current burden hours + 76 hours due to an
increase in the estimated number of registered advisers subject to
additional recordkeeping under the amendments + (871 due to an
increase of total number of registered advisers x 181.15 hours per
adviser)) = 2,111,967. The annual average burden per registered
adviser is therefore 181.16 hours. 2,111,967 total hours/11,658
advisers = 181.16 hours per adviser.
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We further estimate that some advisers may incur a one-time cost
for outside legal fees in connection with preparing a memorandum
explaining their basis for not disclosing a legal event listed in Part
2 in their brochures and supplements. We estimate this one-time cost
would include fees for approximately three hours of outside legal
review and would amount on average to approximately $1,200 per
adviser.\352\ We believe that approximately 80 percent of the advisers
preparing such memoranda would likely engage outside legal services to
assist in their preparation.\353\
[[Page 49259]]
Thus, we estimate that approximately 125 advisers will incur these
costs, for a total cost among all respondents of $150,000.\354\
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\352\ Outside legal fees are in addition to the projected hourly
per adviser burden discussed above. $400 per hour for legal services
x 3 hours per adviser = $1,200. The hourly cost estimate is based on
our consultation with advisers and law firms who regularly assist
them in compliance matters.
\353\ We made the same estimate in the Proposing Release and
received no comment on this estimate.
\354\ 156 advisers x 0.80 = 125. $1,200 x 125 = $150,000.
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3. Rule 204-3
Rule 204-3 contains a collection of information requirement. This
collection of information is found at 17 CFR 275.204-3 and is
mandatory. Responses are not kept confidential. The likely respondents
to this information collection are the approximately 11,658 investment
advisers registered with the Commission.
Rule 204-3 previously required an investment adviser to deliver to
clients, at the start of an advisory relationship, a copy of Part 2 of
Form ADV or a written document containing at least the information
required by Part 2. The rule previously required no further brochure
delivery unless the client accepted the adviser's required annual
offer. The brochure assists the client in determining whether to hire
or retain an adviser.
The amendments to rule 204-3 require advisers to deliver their
brochures and brochure supplements at the start of an advisory
relationship and to deliver annually thereafter the full updated
brochure or a summary of material changes to their brochure.\355\ The
amendments also require that advisers deliver an amended brochure or
brochure supplement (or just a statement describing the amendment) to
clients only when disciplinary information in the brochure or
supplement becomes materially inaccurate.\356\
---------------------------------------------------------------------------
\355\ See rule 204-3(b).
\356\ See rule 204-3(b).
---------------------------------------------------------------------------
The total annual burden currently approved by OMB for rule 204-3 is
6,902,278 hours. This currently approved burden is based on each
adviser having, on average, an estimated 670 clients. Our records now
currently indicate that the 11,658 advisers registered with the
Commission have, on average, 1,300 clients.\357\ This change, along
with our amendments permitting annual delivery of a summary of material
changes to the brochure (instead of the entire brochure) alters the
collection of information burden from that currently approved.
---------------------------------------------------------------------------
\357\ This average is based on advisers' responses to Item 5.C
of Part 1A of Form ADV as of May 3, 2010, excluding the three
advisers that reported the largest number of clients. Those advisers
account for over 50% of all advisory clients of SEC registrants and
not excluding them would raise the average client count to 2,576
clients. These three firms provide advisory services primarily over
the Internet and currently meet their brochure obligations
electronically, thus essentially entirely eliminating for these
advisers any PRA burden associated with delivery under this rule.
Therefore, we believe that it is appropriate to exclude these firms
from our calculations.
---------------------------------------------------------------------------
We expect that advisers will send their brochure or summary of
material changes annually in a ``bulk mailing'' to clients that may
include clients' account statements, periodic reports, or other
important documents. We estimate that, with a bulk mailing, an adviser
will require no more than 0.02 hours to send the adviser's brochure or
summary of material changes to each client, or an annual burden of 26
hours per adviser.\358\ Thus, we estimate the total burden hours for
11,658 advisers to distribute their firm brochure to existing clients
initially and annually thereafter to be 303,108 hours per year.\359\ We
have revised our estimate of the amount of time it will take an adviser
to deliver its brochure or summary of material changes based on our
view that most advisers will make their annual delivery as part of the
mailing of an account statement or other periodic report that they
already make to clients, and thus the additional burden will be adding
a few pages to the mailing.
---------------------------------------------------------------------------
\358\ (0.02 hours per client x 1,300 clients per adviser based
on IARD data as of May 3, 2010) = 26 hours per adviser. We note that
the burden for preparing brochures is already incorporated into the
burden estimate for Form ADV discussed above. The Proposing Release
estimated that it would require 0.25 hours to send the adviser's
brochure to each client. Upon further consideration we determined
that it would not take an adviser 15 minutes to mail or e-mail an
adviser's brochure to a client.
\359\ (0.02 hours per client x 1,300 clients per adviser) x
11,658 advisers based on IARD data as of May 3, 2010 = 303,108
hours.
---------------------------------------------------------------------------
Advisers also will be required to distribute interim updates
disclosing new or revised disciplinary information in their brochure or
supplements. We anticipate that in any given year, the number of such
interim updates that advisers will be required to deliver is
approximately 583.\360\ We further estimate that an adviser will
require no more than 0.1 hours per client for delivery of each such
update.\361\ This represents about 130 hours per interim update.\362\
Thus, the aggregate annual hour burden for affected advisers to deliver
interim updates to their brochures or supplements will be approximately
75,790 hours per year.\363\
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\360\ Of the advisers registered with the Commission, 13% report
disciplinary events on their Form ADVs (as of May 10, 2010, only
1,559 of all 11,658 registered advisers indicated at least one
``yes'' answer to a question related to disciplinary events in Form
ADV, Part 1A, Item 11). Thus, we anticipate that a correspondingly
small number of advisers will be required to disclose new or updated
disciplinary information. The Commission staff estimates that in any
given year, 5% of advisers will be required to deliver a single
interim update to each of their clients, resulting in a total of
approximately 583 interim updates per year. 0.05 x 11,658 x 1 update
= 583 updates.
\361\ This burden estimate relates only to the amount of time it
will take advisers to deliver interim updates to clients, as
required by the rule amendments. The burden for preparing interim
updates is already incorporated into the burden estimate for Form
ADV discussed above. Since this mailing may not be included with a
mailing of a statement or other periodic report, we estimate that it
will take slightly more time than to deliver the annual brochure or
summary of material changes. We also revised this estimate based on
our belief that it would only take one or two minutes, not fifteen
minutes to mail a brochure or summary of material changes. See supra
note 358.
\362\ 0.1 hours per client x 1,300 clients per adviser = 130
hours per update.
\363\ 583 updates x 130 hours = 75,790 hours.
---------------------------------------------------------------------------
Several commenters noted that some advisers will incur costs in
creating systems to track which brochure supplements need to be
delivered to which clients as supervised persons providing investment
advice to particular clients change over time.\364\ Because most medium
advisers tend to resemble small advisers in terms of the number of
employees providing investment advisory services,\365\ we estimate that
only large advisers will need to design and implement systems to track
changes in supervised persons providing investment advice to particular
clients. We estimate that on average each of the 36 large advisers will
spend 200 hours per year designing and implementing such systems, for a
total of 7,200 hours per year.\366\
---------------------------------------------------------------------------
\364\ See, e.g., Schwab Letter; SIFMA Letter; Sutherland Letter.
\365\ According to IARD data, only 4% of medium advisers report
in response to Item 5.B(1) of Part 1A of Form ADV that more than 250
employees perform investment advisory functions.
\366\ 36 large advisers x 200 hours per year per large adviser =
7,200 hours per year.
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Thus, the rule amendments requiring annual delivery and interim
updating of advisers' brochures and supplements yields a total
collection of information burden for rule 204-3 of 386,098 hours per
year, or 33.1 hours per adviser.\367\ This represents a decrease of
6,516,180 hours from the currently approved PRA burden.\368\ The
decreased burden results primarily from our revised estimate of the
time it will take firms to deliver their brochures, supplements and
amendments.
---------------------------------------------------------------------------
\367\ 303,108 hours (initial and annual delivery) + 75,790 hours
(interim delivery of updates to disciplinary information) + 7,200
(supplement tracking systems) = 386,098 hours. 386,098 hours/11,658
advisers = 33.1 hours per adviser.
\368\ 6,902,278 hours - 386,098 hours = 6,516,180 hours.
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VII. Cost-Benefit Analysis
A. Background
The Commission is sensitive to the costs and benefits of its rules.
This rulemaking will revise Part 2 of Form
[[Page 49260]]
ADV to require advisers to prepare plain English narrative brochures
discussing their business practices and conflicts of interest and to
prepare brochure supplements discussing the background and disciplinary
history of certain supervised persons who formulate investment advice
or exercise investment discretion for clients. The revisions to the
form also essentially move into the form itself existing rule
provisions that require advisers to disclose certain disciplinary and
financial information.\369\
---------------------------------------------------------------------------
\369\ Accordingly, the Commission is withdrawing rule 206(4)-4
as duplicative.
---------------------------------------------------------------------------
The amendments require that advisers deliver this narrative
brochure to clients at the outset of the advisory relationship and
deliver an updated brochure or a summary of material changes to that
brochure annually thereafter. Advisers generally will have to deliver
to each client an initial brochure supplement for each supervised
person who provides advisory services to that client. Advisers must
deliver to clients interim updates to their brochure and brochure
supplements that involve a change to disciplinary information required
by Part 2. The rules provide exceptions to the brochure and supplement
delivery requirements for certain types of clients, and excuse the
adviser from preparing a brochure and supplements if there is no client
to whom they must be delivered. The rule amendments also require
advisers to file their narrative brochures electronically through the
IARD, and to keep certain records relating to the brochures and
supplements.
We have identified certain costs and benefits, discussed below,
that may result from the rule and form amendments. In the Proposing
Release,\370\ we analyzed costs and benefits of the proposed amendments
to Part 2 and the related rules and requested comment and data on the
effect they would have on individual investment advisers and on the
advisory industry as a whole. Several commenters thought that the costs
of the proposed annual brochure delivery requirement would be
substantial and would not be offset by a significant corresponding
benefit since they believed that few clients would read the brochure on
an annual basis.\371\ We note that, in response to these concerns, we
have made several changes that are designed to reduce costs to
advisers, including eliminating the proposed requirement for advisers
to deliver an updated brochure annually to clients and instead allowing
advisers to deliver to clients a summary of the material changes made
to the brochure. Several commenters also argued that the Proposing
Release had underestimated the costs of the brochure supplement, and
urged that we not impose this disclosure requirement.\372\ For many of
the same reasons we discussed in the Paperwork Reduction Act section
above, we are revising certain estimates of costs as described below.
---------------------------------------------------------------------------
\370\ See supra note 8.
\371\ See, e.g., Berlin Letter; CGMI Letter; FSI Letter; Jackson
Letter; Merrill Lynch Letter.
\372\ See supra note 298 and accompanying text. These commenters
often asserted that the costs of the supplement outweighed any
benefits but did not discuss the benefits the supplement would
provide to clients and how these benefits may outweigh the costs. In
addition to the supplement cost estimates in the Merrill Lynch
Letter and the Morgan Stanley Letter discussed above, the Schwab
Letter estimated that it would cost it in excess of $5 million to
design, build, and implement systems associated with supplement
creation and compliance for its approximately 1,600 investment
advisory representatives. The SIFMA Letter estimated that the
supplement would impose industry-wide costs in excess of $100
million.
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B. Form ADV Part 2 and IARD Filing
As discussed above, the revisions to Part 2 require substantially
all advisers to prepare plain English narrative brochures.\373\
Advisers file their brochures electronically through the IARD in a
process much like attaching a file to an e-mail.
---------------------------------------------------------------------------
\373\ Under the amendments, advisers that are not required to
deliver a brochure to clients are not required to prepare one.
Advisers that provide only impersonal advice costing less than $500
per year per client, and advisers only to registered investment
companies or business development companies, therefore, are not
required to prepare a brochure. We estimate, based on information
filed with us on Form ADV, that approximately 292 advisers provide
their services only to registered investment companies and therefore
would not need to prepare a brochure. Based on Form ADV filings, we
estimate that 14 advisers offer advisory services only by publishing
periodicals and newsletters. We estimate that approximately half of
these charge less than $500 per year per client and would not need
to prepare a brochure. Moreover, because advisers need not deliver
supplements to clients that do not receive a brochure, these
advisers also would be excused from preparing any brochure
supplements.
---------------------------------------------------------------------------
The new narrative brochures and electronic filing provide
substantial benefits to advisory clients and prospective clients. The
brochures present clients with critically important information they
need to determine whether to hire or continue the services of a
particular adviser. This information will be presented in a uniform
format easy for most investors to understand. Investors searching for
an adviser will be able to access the firm's brochures through our
public disclosure Web site even before contacting the firm, and thus
will be in a better position to know whether they wish to inquire
further about the services the firm is offering or conflicts raised by
the adviser's business activities or practices. The narrative brochure
will enable prospective clients to determine more easily whether they
wish to engage an adviser that does not have certain conflicts, that
does not have a disciplinary history, or that does not engage in
certain business practices. The electronic availability of the
brochures will provide further benefits. Clients will be able to
compare business practices, strategies, and conflicts of a number of
advisers, which may help them to select the most appropriate adviser
for them. Third parties will be able to access adviser brochure
information, which would allow academics, businesses and others to
access additional information about registered investment advisers,
which they can use to study the industry.
Brochure supplements will provide benefits to clients and
prospective clients by providing them, for the first time, with
information about the educational background, business experience,
disciplinary history (if any) and conflicts of the individuals
providing them with investment advice. This information will allow
clients and prospective clients to determine whether there are
safeguards or precautions that they would like to take before receiving
investment advice from that person or whether they would prefer to
receive investment advice from someone else. A prospective client could
be satisfied with its selection of an advisory firm based on the firm
brochure disclosures, but then determine that the firm is not the right
fit once he or she reviewed the supplements of the actual individuals
that would provide investment advice to him or her. Alternatively, the
prospective client could retain the firm but request that other
individuals provide advice in their place, potentially preventing
costly or disruptive replacement or termination at a later date. This
is a substantial improvement over the more limited information
available today to clients and prospective clients about individuals in
which clients place great trust.
To the extent that clients and prospective clients feel more
confident as a result of the revised brochure that they understand the
business, practices, and conflicts of an adviser, these clients may be
more willing to place their trust in investment advisers, seek
professional investment advice, and invest their financial assets. This
could have benefits for the clients, and possibly impact capital
formation and the economy.
[[Page 49261]]
Most commenters strongly supported the narrative, plain English
format, and viewed it as a significant improvement over the current
form.\374\ They agreed that the new brochures would greatly benefit
clients by requiring advisers to present important information about
their firms in a clear and more meaningful way.\375\ They observed that
the enhanced disclosure required by the revised form would benefit
clients by improving their ability to thoroughly evaluate advisers,
their business practices and their conflicts of interest,\376\ and by
better equipping them with the knowledge to make informed decisions
about whether to hire or retain a particular adviser.\377\ Commenters
also generally supported making the brochures available to the public
through the Commission's Web site.\378\
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\374\ See supra note 16.
\375\ See, e.g., ICI Letter; MMI Letter; NASAA Letter;
Wellington Letter.
\376\ See, e.g., AICPA Letter; Janus Letter.
\377\ See Consumer Federation Letter.
\378\ See, e.g., AICPA Letter; CAPIS Letter; CFA Institute
Letter; CGMI Letter; Fried Frank Letter; NAPFA Letter; NASAA Letter;
NRS Letter. But see, e.g., Brown Letter; Wernli Letter (stating that
public Web site disclosure of Part 2 was a violation of an adviser's
privacy).
---------------------------------------------------------------------------
The new amendments provide significant guidance to advisers in
terms of highlighting the types of disclosures they, as fiduciaries,
are already required to make. We believe the enhanced clarity provided
by the new form will yield substantial benefits for advisers.
We recognize, however, that revised Part 2 also imposes costs on
advisers. Advisers will be required to replace their previous Part 2
with the new narrative brochure and brochure supplements, and will be
required to file their brochures electronically with us. In addition,
the disclosure in the new brochure may be more extensive than what was
previously required, although there is significant overlap between the
items in new and old Part 2. Drafting the new narrative brochure will
likely entail additional expenses. As discussed above, we believe that
most of the costs that advisers will incur in connection with preparing
the new narrative firm brochure and supplements will be in the initial
drafting of these documents. We do not, however, expect advisers to
face substantial costs in gathering the required disclosure. Advisers
already are required to provide us and/or their clients with much of
the information required in the new narrative brochure. In addition,
much of the information needed for the brochure supplements can be
found in an adviser's current Form ADV or an investment adviser
representative's registration application (i.e., Form U4) filed with
state securities authorities.
The cost of preparing a narrative brochure likely will vary
significantly among advisers, depending on the complexity of their
operations and the choices advisers make about how to structure their
disclosure given the flexibility permitted by Part 2. Some firms may
choose to prepare multiple brochures for several different services.
These firms likely will face only incrementally higher drafting costs
than an advisory firm that uses a single brochure to make the required
disclosure about the services it provides because there will be
substantial overlap between the multiple brochures of such advisers. We
understand that some smaller- and medium-sized firms outsource the
initial preparation of their brochures to compliance consultants. These
compliance consultants likely will achieve certain economies of scale
in preparing many brochures complying with the new Form ADV Part 2
requirements which may lessen the costs imposed by the amendments on
these advisers. Because compliance consultants work on many firms Part
2 disclosures and are familiar with industry practices generally, they
will begin their review of a firm's Part 2 with more familiarity with
the requirements of Part 2 and conflicts that should be addressed.
Most of the comments relating to the costs of the brochure focused
not on the costs of brochure preparation, but rather on the costs of
annual delivery of an updated brochure. As noted above, in the rule
amendments we are adopting today, we are permitting advisers to satisfy
their annual brochure delivery obligation by delivering a summary of
material changes to the brochure with information about how clients can
receive the full updated brochure if they desire. This change should
reduce costs significantly for advisers relating to annual brochure
delivery but should improve client experiences with the disclosures
they receive by focusing their attention on the material changes in the
brochure. The timing of brochure and supplement delivery should allow
these documents to be included in other packages that the adviser is
already mailing to clients, providing additional cost savings. The
primary comment we received on brochure preparation cost was that we
had underestimated the time and thus costs of drafting the new
narrative brochure. As noted above, we have increased this estimate in
response to these comments.
Similarly, the costs of preparing brochure supplements will vary
from one adviser to the next. Costs will vary most significantly
depending on the number of supervised persons for whom an adviser must
provide disclosure. An adviser with very few supervised persons for
whom a supplement must be prepared will incur lower costs than a large
adviser. Costs associated with preparing supplements also will vary
greatly depending on the amount of disciplinary information, if any,
required to be disclosed about a particular supervised person. Many
large advisers, who will have to prepare the largest number of brochure
supplements, have significant numbers of supervised persons that are
also registered representatives of broker-dealers and thus may be able
to reference the BrokerCheck or IAPD systems for disciplinary
disclosure, which will reduce preparation costs of the supplement for
these firms. The preparation of brochure supplements would be most
demanding for those few advisers whose supervised persons have
disciplinary records that must be disclosed, and less taxing for the
vast majority of advisers, whose supervised persons have no
disciplinary records and whose supplements would therefore likely be a
page or less in length.\379\
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\379\ As of May 3, 2010, IARD data indicate that in response to
Item 11 in Part 1A of Form ADV, only 1,559, or 13%, of the 11,658
advisers registered with us report any disciplinary information
about their firms or advisory affiliates, including their advisory
employees.
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Many comments on the brochure supplement asserted that for a large
adviser registered both as an investment adviser and as a broker-
dealer, the supplement would impose substantial costs in creating
systems to track this information among a changing group of supervised
persons providing investment advice. Yet these same commenters also
often stated that much of the information required by the supplement is
available on FINRA's BrokerCheck system and thus collected on Form U4.
Accordingly, we assume that these firms already have in place systems
to track much of this information for a changing workforce (because
Form U4 also must be updated as responses to its information requests
change). Therefore, we believe that the supplement should impose
negligible new costs in this regard since we believe these same systems
could be used for supplement information tracking at negligible
additional costs. We also are allowing advisers that have supervised
persons with disciplinary information available through
[[Page 49262]]
BrokerCheck or IAPD to reference that information in their
electronically delivered supplements rather than reproducing that
information in the supplement. This also should further decrease the
costs and burdens cited by these firms in their comment letters. We do
recognize, however, that large advisers may need to implement systems
to track which supplements need to be provided to which clients as
personnel advising clients will change from time to time. In our
Paperwork Reduction Act analysis, we added an estimate of the burden
for designing and implementing these systems and the cost estimate for
this burden is reflected below.
We expect that only a few advisers would incur substantial costs in
preparing supplements. IARD data indicate that less than one third of
one percent of advisers registered with us has over 1,000 employees
performing investment advisory functions on their behalf.\380\ Indeed,
less than five percent of our registrants have over 50 employees
performing investment advisory functions. The vast majority of SEC-
registered advisers--approximately 81 percent--have 10 or fewer
employees performing advisory functions on their behalf. We believe
most, if not all, of these firms may choose to incorporate required
information about their supervised persons into their firm brochures
instead of preparing separate brochure supplements, thus reducing costs
of preparation.
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\380\ Moreover, it may not be necessary to prepare a brochure
supplement for all of these employees.
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For purposes of the Paperwork Reduction Act, we have estimated the
number of hours the average adviser would spend in the initial
preparation of its brochure and supplements.\381\ Based on those
estimates, we estimate that advisers would incur costs of approximately
$33,639,980 in drafting these documents in the first year.\382\
Furthermore, for Paperwork Reduction Act purposes we also have
estimated that advisers may incur costs of approximately $22,775,400 in
connection with their use of outside legal services and compliance
consulting services to assist in preparation of their Form ADV.
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\381\ See Section VI.A of this Release. Unless otherwise noted,
the IARD data cited below is based on advisers' responses to
questions on Part 1A of Form ADV as of May 3, 2010.
\382\ We expect that this function will most likely be performed
by a senior compliance examiner at small firms, a compliance manager
at medium firms, and a compliance attorney at large firms. Data from
the Securities Industry and Financial Markets Association's Report
on Management & Professional Earnings in the Securities Industry
2008, modified to account for an 1,800-hour work-year and multiplied
by 5.35 to account for bonuses, firm size, employee benefits and
overhead, suggest that costs for these positions are $212, $258, and
$270 per hour, respectively. Based on the number of small, medium
and large advisers (and assuming that the 1,000 additional advisers
per year are small advisers as is typically the case), this results
in a blended rate of $220 per hour. ((10,482 small advisers x $212)
+ (2,140 medium advisers x $258) + (36 large advisers x $270))
divided by 12,658 advisers = $220. 152,909 hours x $220 per hour =
$33,639,980.
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Advisers will incur annual expenses in addition to the initial
costs of preparing firm brochures and supplements, but we believe these
costs will be modest and similar to current costs. The rule amendments,
similar to the current requirements, would require advisers to revise
their disclosure documents promptly when any information in them
becomes materially inaccurate, and would require advisers to update
their brochures each year at the time of their required annual updating
amendment. For Paperwork Reduction Act purposes, we have estimated that
advisers in the aggregate would spend 87,435 hours per year on Part 2
amendments. We estimate that advisers would incur annual costs of
$12,153,465 in meeting these requirements.\383\ We also estimated for
Paperwork Reduction Act purposes that advisers would spend some time
creating brochure supplements for new employees hired each year. We
estimate that advisers would incur annual costs of $1,620,462 in
creating these new supplements.\384\
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\383\ We expect that preparing the amendments to Part 2 will
also most likely be performed equally by compliance managers (as
described in supra note 382) and compliance clerks. Data from the
Securities Industry and Financial Markets Association's Report on
Management & Professional Earnings in the Securities Industry 2008,
modified to account for an 1,800-hour work-year and multiplied by
2.93 to account for bonuses, firm size, employee benefits and
overhead, suggest that costs for a compliance clerk is $63 per hour.
Blending this rate with the blended rate for a compliance manager of
$215 per hour results in a cost per hour of $139. ($63 x 0.5) +
($215 x 0.5) = $139. 87,435 hours per year for amendments x $139 per
hour = $12,153,465.
\384\ We expect that preparing the new supplements will most
likely be performed equally by compliance managers (as described in
supra note 382) and compliance clerks. The blended rate for this
work is $139 per year. See supra note 383. 11,658 hours per year for
new supplements x $139 per hour = $1,620,462.
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Finally, advisers would incur some costs in filing their brochures
with us through the IARD. Advisers would prepare their brochures on
their own computers and, as noted earlier, the filing of a brochure
would be similar to attaching a file to an email.\385\ We believe
conversion of an adviser's brochure to PDF format and filing of that
brochure through the IARD would impose minimal costs on advisers.
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\385\ We note that all advisers registered with the Commission
currently file Form ADV electronically via the IARD system and,
since implementation of the electronic filing requirements in 2000,
no adviser has applied for a permanent hardship exemption available
to advisers for whom filing electronically would constitute an undue
hardship. See rule 203-3(b) [17 CFR 275.203-3(b)].
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C. Brochure and Supplement Delivery
Advisers will be required to deliver their updated brochure or a
summary of material changes in their brochure to clients annually. The
amended rules require that, between annual brochure deliveries,
advisers deliver brochure and supplement amendments to existing clients
only if there is an addition or change to disciplinary disclosure.
Advisers already are required to deliver a copy of Part 2 to new
clients. Thus, this requirement should present no new costs to
advisers. Moreover, we believe that because advisers must deliver
brochures to new clients, the cost of delivering brochure supplements
to new clients should not increase the existing cost of delivery.
Annual delivery of the updated brochures or summary of material changes
in the advisers' brochures will benefit advisory clients by ensuring
that they are kept apprised of material changes to their advisers'
business practices and procedures for managing conflicts and will
enable clients to make decisions with respect to the adviser using the
most currently available information. The shorter summary will focus
clients' attention on the material changes in its adviser's business
practices and conflicts and, unlike the prior annual offer requirement,
permit them to evaluate when they would like a full copy of the
brochure or to determine whether they want to take some other action in
response to the change. Previously, clients were just given notice that
they could request an updated brochure. In those circumstances, the
client would have to read through the entire brochure and try to
determine what had changed. Many clients may have determined that this
would not be a fruitful exercise and thus declined to request the
brochure. Now clients will be able to easily determine what has changed
in the brochure and thus decide if they would like to take any action
in response.
In addition, we believe that changes to disciplinary information
disclosed in the brochure and supplements are of such importance to
clients that they merit interim delivery of these amendments. This
disciplinary information reflects on the integrity of the advisory firm
and the individuals providing the client with advice. Given
[[Page 49263]]
that clients entrust their financial assets and financial well being to
these firms and individuals, this information is vital to clients.
Moreover, advisers are already required to make disclosures regarding
disciplinary information under rule 206(4)-4. Based on the experiences
of examination staff, we believe that most advisers likely already make
these disclosures in writing so that they can demonstrate compliance
with the requirements of rule 206(4)-4 and thus are unlikely to incur
additional costs as a result of this requirement. The brochure
supplement will increase costs relating to disseminating disciplinary
disclosure, but it will not impose new costs in collecting this
information since firms already had to collect this information to
respond to Part 1A of Form ADV. The cost of disseminating brochure
supplements is reflected below.
For Paperwork Reduction Act Purposes, we have estimated that the
total annual paperwork burden associated with annual and interim
delivery of brochures, supplements and the summary of material changes
is approximately 386,098 hours. This includes estimated time for large
advisers to design and implement systems to track that the right
supplements are delivered to the right clients as personnel providing
investment advice to those clients change. We estimate the burden
associated with annual and interim delivery of brochures, supplements
and the summary of material changes would represent an annual cost of
$18,918,802.\386\
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\386\ Based on data from the Securities Industry and Financial
Markets Association's Report on Management & Professional Earnings
in the Securities Industry 2008, modified to account for an 1,800-
hour work-year and multiplied by 2.93 to account for bonuses, firm
size, employee benefits and overhead, we expect that delivery of
amendments to Part 2 will also most likely be performed by a clerk
at an estimated cost for a general clerk of $49 per hour. 386,098
hours x $49 = $18,918,802. We estimate that advisers will not incur
any incremental postage costs in these mailings because we assume
that advisers will mail annual summary of material changes with
another mailing the adviser was already delivering to clients and
that advisers were already delivering to clients disclosure of new
material disciplinary events on an interim basis under rule 206(4)-
4.
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Advisers may significantly minimize the costs associated with
delivery of brochures, supplements and the summary of material changes
by arranging to deliver these documents to some or all clients by
electronic media.\387\ Advisers also may minimize delivery costs by
mailing some of these documents along with quarterly statements or
other routine mailings they already send to clients. No commenters
indicated the extent to which they collectively mail such documents.
Our rule and form amendments do not require advisers to take advantage
of any of these cost saving options--advisers alone bear this choice.
Accordingly, the extent to which advisers will take advantage of these
and other techniques to reduce costs is difficult to predict, but we
believe it will be significant.
---------------------------------------------------------------------------
\387\ See Instruction 3 for Part 2A of Form ADV, which refers to
the Commission's interpretive guidance on electronic delivery. See
also supra note 198 for additional discussion of electronic
delivery.
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D. Amendments to Rule 204-2
The amendments to rule 204-2 require registered advisers to retain
certain records relating to brochures and supplements. These records
will benefit our examination staff by enhancing their ability to
determine advisers' compliance with Form ADV's requirements. One of the
revisions to the rule requires advisers to retain copies of brochure
supplements and separate summaries of material changes prepared as
required by Part 2. This provision generally imposes no additional
costs because advisers currently are required to retain records
relating to materials they distribute to their clients. Other revisions
to the rule require advisers to maintain certain records in the event
they use an alternative method to calculate assets under management in
response to Item 4.E of Part 2A and if they do not disclose in their
brochure a presumptively material legal or disciplinary event listed in
Item 9 of Part 2A or Item 3 of Part 2B. These provisions benefit
advisers by permitting them flexibility in drafting their firm
brochures and supplements while providing for maintenance of records
needed by our examination staff. Because we anticipate that only a
relatively small number of advisers will be subject to these
provisions, we expect that the cost of maintaining these records will
be relatively minimal. We estimate that advisers would incur annual
costs of $595,280 in meeting these requirements.\388\
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\388\ For Paperwork Reduction Act purposes we estimate that only
506 advisers will be required to prepare additional records in
accordance with the amendment to rule 204-2 and that each adviser
would spend approximately four hours to satisfy the obligation for a
total burden of 2,024 hours per year and that such advisers will
incur $150,000 per year in outside legal expenses relating to such
records. We expect that preparing the records will most likely be
performed by compliance managers (as described in supra note 382).
2,024 hours x $220 per hour = $445,280. $445,280 + $150,000 =
$595,280.
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VIII. Final Regulatory Flexibility Analysis
We have prepared this Final Regulatory Flexibility Analysis (FRFA)
in accordance with section 4(a) of the Regulatory Flexibility Act
(RFA).\389\ It relates to the amendments to rules 203-1, 204-1, 204-2,
204-3, and 206(4)-4, and Form ADV under the Advisers Act. The rule and
form amendments are designed to improve the disclosure that investment
advisers provide to their clients. These amendments also revise the
instructions for updating and filing Form ADV (including adviser
brochures). We also are adopting conforming rule amendments that revise
the recordkeeping requirements relating to Part 2 of Form ADV.
---------------------------------------------------------------------------
\389\ 5 U.S.C. 604(a).
---------------------------------------------------------------------------
We included in the Proposing Release an Initial Regulatory
Flexibility Analysis (IFRA). We received no comments specifically on
that IRFA.
A. Need for the Rule and Form Amendments
The rule and form amendments are necessary to improve the quality
of disclosure that advisers provide to their clients.\390\ Form ADV
with its two parts was adopted by the Commission in 1979 and advisers
use it to register with the Commission (Part 1A) and to provide clients
disclosure about their advisory firm and personnel (Part 2).\391\ Over
the years, however, experience has shown that the format and content of
the previous Part 2 of Form ADV did not lend themselves to disclosure
that is easy for clients to understand. Clients need clearer
information about an adviser's services, fees, business practices, and
conflicts of interests to be able to make an informed decision about
whether to hire or retain that adviser.
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\390\ Sections I through IV of this Release describe in more
detail the reasons for the amendments.
\391\ See 1979 Adopting Release, supra note 6.
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B. Significant Issues Raised by Public Comment
In the Proposing Release, we requested comment on the IRFA. None of
the comment letters specifically addressed the IRFA. A few commenters
made specific comments about the proposed rule and form amendments'
impact on smaller advisers. One commenter was concerned that disclosure
of assets under management and financial information would unduly
discriminate against smaller advisers.\392\ As we discussed above with
respect to Item 18 of Part 2, we believe that a client that becomes a
creditor of an adviser because it prepays fees would
[[Page 49264]]
want information about the adviser's financial condition. In addition,
this information is currently required to be disclosed to clients, and
the commenter did not persuade us that it should be omitted. Another
commenter stated that Item 8's requirement that advisers primarily
using a particular strategy discuss the risks involved in its strategy
discriminates against smaller firms who are less likely to be multi-
strategy firms.\393\ As discussed earlier in this Release,\394\ we
agree that advisers should disclose material risks associated with
their strategies, regardless of whether they use one strategy or many
strategies but believe that the brochure may not always be the best
place for a multi-strategy adviser to disclose these risks. Another
commenter suggested that we permit smaller advisers to provide short-
form brochures.\395\ As discussed earlier in the release,\396\ we have
not determined to shorten the brochure for any type of advisers because
we believe that the brochure contains important information upon which
clients rely and much of which advisers are already required to make to
satisfy their fiduciary duty to their clients. We have, however,
allowed advisers to satisfy their annual brochure delivery obligation
by delivering a summary of material changes in their brochure to their
clients.
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\392\ Verbeck Letter.
\393\ NAPFA Letter.
\394\ See supra notes 71-75 and accompanying text.
\395\ NSCP Letter.
\396\ See supra notes 25-28 and accompanying text.
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C. Small Entities Subject to the Rules
In developing the amendments, we have considered their potential
impact on small entities that may be affected. The rule and form
amendments will affect all advisers registered with the Commission,
including small entities. Under Commission rules, for purposes of the
Regulatory Flexibility Act, an investment adviser generally is a small
entity if it: (i) Has assets under management having a total value of
less than $25 million; (ii) did not have total assets of $5 million or
more on the last day of its most recent fiscal year; and (iii) does not
control, is not controlled by, and is not under common control with
another investment adviser that has assets under management of $25
million or more, or any person (other than a natural person) that had
$5 million or more on the last day of its most recent fiscal year.\397\
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\397\ See rule 0-7 [17 CFR 275.0-7].
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Our rule and form amendments will not affect most advisers that are
small entities (``small advisers'') because they are generally
registered with one or more state securities authorities and not with
us. Under section 203A of the Advisers Act, most small advisers are
prohibited from registering with the Commission and are regulated by
state regulators.\398\ The Commission estimates that as of May 3, 2010,
of the 11,658 registered with us, there were approximately 708 that
were small entities that would be affected by the amendments.\399\
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\398\ National Securities Markets Improvement Act of 1996 (Pub.
L. 104-290, 110 Stat. 3438) (1996) (``NSMIA''). As a result of
NSMIA, advisers with less than $25 million of assets under
management generally are regulated by one or more state securities
authority, while the Commission generally regulates those advisers
with at least $25 million of assets under management. See section
203A of the Advisers Act [15 USC 80b-3a].
\399\ This estimate is based on information advisers have filed
with the Commission on Part 1A of Form ADV as of May 3, 2010.
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D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
The rule and form amendments impose certain reporting and
compliance requirements on small advisers, requiring them to create and
update narrative brochures containing certain information regarding
their advisory business. The amendments also require advisers to
deliver their brochures to clients and to file them electronically
through the IARD. The amendments also impose new recordkeeping
requirements. These requirements and the burdens on small advisers are
discussed below.\400\
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\400\ Sections I through IV of this Release describe these
requirements in more detail.
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1. Amendments to Part 2 of Form ADV
The amendments to Part 2, because they require registered advisers
to prepare and disseminate narrative brochures, impose additional costs
on all registered advisers, including small advisers. We assume that
all small advisers previously distributed Part 2 of Form ADV and did
not draft the optional narrative brochure. If our assumption is
correct, these advisers would have to redraft their brochures
completely to comply with the new format, although a lot of information
in the previous Part 2 will be transferable to the new narrative
brochures.
The costs associated with preparing the new brochures will depend
on the size of the adviser, the complexity of its operations, and the
extent to which its operations present conflicts of interest with
clients. Many of the new items imposing the most rigorous disclosure
requirements may not apply to certain small advisers because, for
example, those advisers may not have soft dollar or directed brokerage
arrangements, or may not have custody of client assets. However,
certain of the brochure compliance costs may be fixed and thus impose a
disproportionate impact on small advisers. To the extent that some of
the new disclosure burdens would apply to small advisers, these
advisers are already obligated to make the disclosures to clients under
the Advisers Act's antifraud provisions, although the disclosure
currently is not required to be in the firm's written brochure.
For the first time, advisers also will be required to prepare and
disseminate brochure supplements for certain supervised persons of
their firm. To reduce the burdens on small advisers, however, we have
drafted the new supplement rules so that firms with few employees would
be permitted to include supplement information in their firm brochures
and may choose to avoid preparing and distributing separate brochure
supplements. We believe many small advisers would take advantage of
this option and reduce their compliance burden. We also note that small
advisers are unlikely to have many supervised persons for whom a
brochure supplement is required, so the supplement should impose a
proportionately smaller burden on small advisers. The rule amendments
may increase compliance costs for investment advisers. Certain of these
increased compliance costs attributable to supplements may be fixed and
thus impose a disproportionate impact on small advisers.
2. Updating and Delivery Requirements
The amended rules, like the prior rules, require advisers to update
their brochures and supplements whenever information in them becomes
materially inaccurate. In updating its brochure and supplements on an
interim basis, an adviser may minimize its burden by delivering a
statement describing this updated information instead of reprinting its
entire brochure or supplement.
The amendments require advisers to deliver an updated brochure or a
summary of material changes in the adviser's brochure to clients
annually and to deliver interim updates of the brochure and supplements
to clients to disclose new or revised disciplinary information. To
minimize the burden of delivery, advisers are permitted with client
consent to deliver brochures, supplements and the summary of material
changes, as well as updates, electronically.\401\ To the extent that
small advisers are more likely to have
[[Page 49265]]
fewer advisory clients than larger advisers, the delivery requirements
should impose lower costs on small advisers than on larger firms.
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\401\ See supra notes 196-198.
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3. Recordkeeping Requirements
The amendments impose new recordkeeping requirements on advisers,
including small advisers. As under the previous rules, advisers will be
required to maintain copies of their brochures. The amendments also
require all advisers to maintain copies of their brochure supplements.
Advisers will be required to maintain a copy of any summary of material
changes in their brochure that is separate from the brochure. In
addition, the amendments require advisers, including small advisers, to
maintain certain records if they determine that a disciplinary event
that is presumptively material does not have to be disclosed, or if
they calculate their managed assets for purpose of their brochures
differently than in Part 1A of Form ADV.
E. Agency Action To Minimize Effect on Small Entities
We have considered various alternatives in connection with the rule
and form amendments that might minimize their effect on small advisers,
including: (i) Establishing different compliance or reporting
requirements or timetables that take into account the resources
available to small advisers; (ii) clarifying, consolidating, or
simplifying compliance and reporting requirements under the proposed
amendments for small advisers; (iii) using performance rather than
design standards; and (iv) exempting small advisers from coverage of
all or part of the proposed amendments.
Regarding the first alternative, the Commission believes that
establishing different compliance or reporting requirements for small
advisers would be inappropriate under these circumstances. The
amendments are designed to improve the quality and timeliness of
critically important disclosure that advisory clients receive from
their advisers. To establish different disclosure requirements for
small entities would diminish this investor protection for clients of
small advisers. We note, however, that small advisers, by the nature of
their business, likely would spend fewer resources in completing their
brochures and any brochure supplements. Small advisers have few
supervised persons providing investment advice, so they will need to
prepare few brochure supplements. Moreover, certain rule and form
amendments were designed specifically to reduce the burden on small
advisers. For example, the Part 2 instructions give advisers the
flexibility to incorporate required information about their supervised
persons into their firm brochures rather than presenting it in separate
brochure supplements, thereby saving additional printing and mailing
costs.
Regarding the second alternative, the amendments clarify
requirements for all advisers, including small advisers. The amended
Part 2 instructions are designed to present requirements for advisers'
brochures and supplements clearly and simply to all advisers, including
small entities.
Regarding the third alternative, the Commission believes that the
amendments already appropriately use performance rather than design
standards in many instances. The amendments permit advisers flexibility
in designing their brochures and supplements so as best to communicate
the required information to clients. In preparing brochure supplements,
advisers also have the flexibility of adapting the format of the
supplements to best suit their firm. An adviser may: (i) Prepare a
separate supplement for each supervised person; (ii) prepare a single
supplement containing the required information for all of its
supervised persons; (iii) prepare multiple supplements for groups of
supervised persons (e.g., all supervised persons in a particular office
or work group); or (iv) include all information about supervised
persons in the firm brochure and prepare no separate supplements.\402\
The amendments clarify that advisers may, with client consent, deliver
their brochures and supplements, along with any updates, to clients
electronically.\403\ Advisers may incorporate their supplements into
the brochure or provide them separately.
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\402\ See Section II.B of this Release. A brochure supplement,
however, must be organized in the same order, and use the same
headings, as the items appear in the form, whether incorporated in a
brochure or provided separately. See Instruction 1 of General
Instructions for Part 2 of Form ADV.
\403\ See supra notes 196-198.
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Regarding the fourth alternative, it would be inconsistent with the
purposes of the Advisers Act to exempt small advisers from the rule and
form amendments. The information in an adviser's brochure is necessary
for the client to evaluate the adviser's services, fees, and business
practices, and to apprise the client of potential conflicts of interest
and, when necessary, of the adviser's financial condition. Since we
view the protections of the Advisers Act to apply equally to clients of
both large and small advisers, it would be inconsistent with the
purposes of the Act to specify different requirements for small
entities.
IX. Efficiency, Competition, and Capital Formation
Section 23(a)(2) of the Exchange Act requires the Commission, in
adopting rules under the Exchange Act, to consider the impact that any
new rule would have on competition, and prohibits the Commission from
adopting any rule that would impose a burden on competition not
necessary or appropriate in furtherance of the purposes of the Exchange
Act.\404\ Section 3(f) of the Exchange Act requires the Commission,
when engaging in rulemaking that requires it to consider or determine
whether an action is necessary or appropriate in the public interest to
consider, in addition to the protection of investors, whether the
action will promote efficiency, competition, and capital
formation.\405\ Section 202(c) of the Advisers Act requires the
Commission, when engaging in rulemaking that requires it to consider or
determine whether an action is necessary or appropriate in the public
interest, to consider, in addition to the protection of investors,
whether the action will promote efficiency, competition, and capital
formation.\406\
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\404\ 15 U.S.C. 78w(a)(2).
\405\ 15 U.S.C. 78c(f).
\406\ 15 U.S.C. 80b-2(c).
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In the Proposing Release, we solicited comment on whether, if
adopted, the proposed rule and form amendments would promote
efficiency, competition and capital formation. We further encouraged
commenters to provide empirical data to support their views on any
burdens on efficiency, competition or capital formation that might
result from adoption of the proposed amendments. We did not receive any
empirical data in this regard concerning the proposed amendments. We
received one comment stating that the proposed amendments would not
promote efficiency, competition, and capital formation, but the
commenter did not state why.\407\ Accordingly, since the
[[Page 49266]]
adopted rule and form amendments are similar to the proposed rule and
amendments, we continue to believe the amendments will contribute to
efficiency, competition and capital formation.
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\407\ Jackson Letter. Another commenter stated that the
requirement to disclose the amount of assets under management in the
brochure would discriminate against smaller firms because of a
perceived notion that a larger company does a better job. See
Verbeck Letter. As discussed at supra 181 and accompanying text,
assets under management is an objective measure that provides
important information to clients. Clients have different preferences
and some, for example, may view a smaller adviser as being more
likely to provide more personal service. In addition, the NAPFA
Letter stated that Item 8's requirement that advisers primarily
using a particular strategy discuss the risks involved in its
strategy discriminates against smaller firms who are less likely to
be multi-strategy firms. As discussed at supra notes 72-75 and
accompanying text, we disagree.
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Today the Commission is adopting amendments to Part 2 of Form ADV
and related Advisers Act rules that would require investment advisers
registered with us to deliver to clients and prospective clients
brochures and brochure supplements written in plain English. We believe
that the rule and form amendments that we are adopting today are likely
to promote efficiency and competition in the marketplace for advisory
services provided by advisers registered with us by improving the
disclosure that they must provide to clients.\408\ These amendments are
designed to require advisers to provide clients and prospective clients
with clear, current, and more meaningful disclosure of the business
practices, conflicts of interest, and background of investment advisers
and the advisory personnel on whom clients rely for investment advice.
As a result, we believe that advisory clients will be provided with
improved disclosure from advisers that will allow them to select an
adviser based on a clearer and more thorough understanding of the
business practices, conflicts of interest, and disciplinary information
than exists with the check-the-box format of the current brochure.
While advisers currently have the option of providing a narrative
brochure, few do so. Absent the actions we are taking today, based on
our experience with administering the Advisers Act brochure requirement
and inefficiencies in the marketplace, we do not believe that advisers
have adequate incentives to produce clear and understandable brochures.
We expect the amendments we are adopting today, by requiring clearer
and more understandable brochures, are likely to increase competition
among advisers.
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\408\ Along with the brochure amendments, the Commission also is
adopting conforming amendments to the General Instructions and
Glossary of Form ADV to include instructions regarding brochure
filing requirements and to add glossary terms and definitions that
are used in Part 2. Additionally, the Commission also is adopting
conforming amendments to the Advisers Act books and records rule.
These amendments require advisers to maintain copies of their
brochures, brochure supplements, amendments, and summaries of
material changes, and are intended to update the books and records
rule in light of our changes to Part 2. None of these conforming
amendments are expected to have an independent impact on efficiency,
competition, or capital formation. To the extent that they
facilitate the purposes of the amendments, the conforming amendments
may, however, contribute to the expected effects on efficiency,
competition and capital formation that would stem from the
amendments and which are discussed below.
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Advisers will file their brochures with us electronically, and we
will make them available to the public through our website. Today,
while advisers' brochures are ``deemed'' filed with us, it is difficult
for the public to obtain them unless the adviser provides a brochure
upon request or makes it available on its own website, which also makes
it very difficult for prospective clients to compare more than a few
investment advisers. With the public availability through our website
of more thorough and current disclosure of advisers' services, fees,
business practices and conflicts of interests, investors will be able
to make more informed decisions about whether to hire or retain a
particular adviser and will have an easier time comparing investment
advisers. The supplements will allow clients and prospective clients to
compare the qualifications and conflicts not only of the advisory firm
but also of the personnel that will be providing investment advice to
them. By having more information about the individuals and firms
providing investment advice to them, as well as the ability to compare
advisory firms, a client may be more likely to select initially an
appropriate investment adviser for that client, promoting competition
on the basis of improved disclosure of conflicts of interest and
business practices and avoiding the burdens and costs associated with
switching advisers or supervised persons at a later date, and thereby
potentially creating efficiency gains in the marketplace. The
availability of this information about advisers and their personnel
also may enhance competition if, for example, firms and personnel with
better disciplinary records outcompete those with worse records.
Secondarily, the electronic filing requirements are expected to
expedite and simplify the process of filing firm brochures and
amendments for the advisory firms, thus improving the efficiency of
advisers that are required to file and update the brochure.
A few commenters stated that certain information required to be
disclosed in the brochure is duplicative of information required to be
reported in Part 1A of Form ADV and that such information should only
be required disclosure in one place in Form ADV.\409\ While we are
conscious of these commenters' goal of generating efficiency by
eliminating duplicative disclosure in Form ADV, we do not believe that
it is appropriate to allow disclosure in Part 1A to satisfy disclosure
obligations in Part 2B, or vice versa, because, these parts serve
different functions and clients and prospective clients access these
documents in different ways. Part 1A is used for regulatory purposes
and thus the information it collects is that which our examination
staff has identified as important for us to have for our examination
program and other regulatory functions. While an adviser's responses to
Part 1A of Form ADV generally are available to the public through our
website, they are not delivered to clients or prospective clients and
they are not written in a manner designed to be meaningful to clients
or prospective clients--rather they are largely a series of ``check-
the-box'' responses. Part 2A of Form ADV, on the other hand, is
disclosure aimed at and delivered to clients and prospective clients.
Accordingly, while certain topics of disclosure may be covered by both
parts, we believe the different functions of, and delivery methods for,
these two parts justifies the replication of disclosure topics.
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\409\ See, e.g., ACLI Letter; IAA Letter.
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On the other hand, the amendments we are adopting today are
designed to generate efficiencies and reduce duplicative disclosure by
allowing an adviser who sends supplements electronically, and whose
supervised persons have disciplinary disclosure available on FINRA's
BrokerCheck system or the IAPD system, to respond to those portions of
Item 3 of the brochure supplement by including in the brochure
supplement (i) a statement that the supervised person has a
disciplinary history, the details of which can be found on FINRA's
BrokerCheck system or the IAPD, and (ii) a hyperlink to the relevant
system with a brief explanation of how the client can access the
disciplinary history. In this instance, we believe that permitting
cross-referencing is appropriate since it will only be allowed if the
supplement is delivered electronically and the disclosure is
duplicative. The BrokerCheck and IAPD systems are aimed at investor
disclosure and are designed to be user-friendly, and clients will still
receive delivery of a supplement which contains the other information
(e.g., educational background and other business activities) about that
supervised person.
In addition to the competitive impact mentioned above, we believe
that the rule amendments may have certain other impacts on competition.
The brochure supplement may impose greater costs on larger advisers
that have
[[Page 49267]]
to create systems to track appropriate delivery of supplements that
smaller advisers would not need. To the extent these costs are passed
on to clients, a client's choice of investment advisers may be
impacted. As we noted in the Cost-Benefit Analysis section above,
however, many of these systems costs should be mitigated by systems
that large advisers already have in place to track Form U4 information
for their investment advisory representatives and broker-dealer
registered representatives, which these firms should be able to
leverage for use in the brochure supplement context. The rule
amendments also may increase compliance costs for investment advisers.
Certain of these increased compliance costs may be fixed and thus
impose a disproportionate impact on small advisers, which may have
anticompetitive impacts on small advisers.
The competitive impacts discussed previously primarily focused on
the impact of the rule amendments on investment advisers that are
registered with us. We acknowledge that there may also be competitive
impacts as a result of the amendments between those persons providing
investment advice that are, and those that are not, registered with us
as investment advisers. For example, banks, insurance companies,
broker-dealers, and exempt advisers provide financial services that may
compete, in some cases, for the same clients that would retain SEC-
registered investment advisers. We have carefully considered the
potential competitive implications of these rule amendments and do not
believe that they will put advisers registered with us at a significant
competitive disadvantage. Moreover, notwithstanding the potential
competitive effect, we believe that the concerns that the amendments
are designed to address justify adoption of the rule amendments.
Pursuant to Section 23(a)(2) of the Exchange Act, the Commission does
not believe that the amendments to Form ADV impose a burden on
competition that is not necessary or appropriate in furtherance of the
purposes of the Exchange Act.
As stated previously, the rule amendments are designed to provide
advisory clients with clearer, more concise and understandable
information regarding the business practices and conflicts of interest
of investment advisers. Improved disclosure by SEC-registered
investment advisers could result in enhanced efficiencies for clients
in selecting an investment adviser and improved allocation of client
assets among investment advisers. To a more limited extent, if better
disclosure increases clients' and prospective clients' trust in
investment advisers, it may encourage them to seek professional
investment advice and encourage them to invest their financial assets.
This also may enhance capital formation by making more funds available
for investment and enhancing the allocation of capital generally. On
the other hand, if the rule amendments increase costs at investment
advisers and these costs increases are passed on to clients, this may
deter clients from seeking professional investment advice and investing
their financial assets. This may result in inefficiencies in the market
for advisory services and hinder capital formation.
X. Statutory Authority
We are adopting amendments to rule 203-1 under sections 203(c)(1),
204, and 211(a) of the Investment Advisers Act of 1940 [15 U.S.C. 80b-
3(c)(1), 80b-4, and 80b-11(a)].
We are adopting amendments to rule 204-1 under sections 203(c)(1)
and 204 of the Investment Advisers Act of 1940 [15 U.S.C. 80b-3(c)(1)
and 80b-4].
We are adopting amendments to rule 204-2 under sections 204 and
206(4) of the Investment Advisers Act of 1940 [15 U.S.C. 80b-4 and 80b-
6(4)].
We are adopting amendments to rule 204-3 under sections 204,
206(4), and 211(a) of the Investment Advisers Act of 1940 [15 U.S.C.
80b-4, 80b-6(4), and 80b-11(a)].
We are adopting amendments to rule 279.1, Form ADV, under section
19(a) of the Securities Act of 1933 [15 U.S.C. 77s(a)], sections 23(a)
and 28(e)(2) of the Securities Exchange Act of 1934 [15 U.S.C. 78w(a)
and 78bb(e)(2)], section 319(a) of the Trust Indenture Act of 1939 [15
U.S.C. 77sss(a)], section 38(a) of the Investment Company Act of 1940
[15 U.S.C. 78a-37(a)], and sections 203(c)(1), 204, and 211(a) of the
Investment Advisers Act of 1940 [15 U.S.C. 80b-3(c)(1), 80b-4, and 80b-
11(a)].
We are removing and reserving rule 206(4)-4 under section 206(4) of
the Investment Advisers Act of 1940 [15 U.S.C. 80b-6(4)].
List of Subjects in 17 CFR Parts 275 and 279
Reporting and recordkeeping requirements; Securities.
Text of Rule and Form Amendments
0
For the reasons set out in the preamble, Title 17, Chapter II of the
Code of Federal Regulations is amended as follows:
PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940
0
1. The general authority citation for Part 275 continues to read as
follows:
Authority: 15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(17), 80b-3, 80b-
4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless otherwise noted.
* * * * *
0
2. Section 275.203-1 is amended by revising paragraphs (a) and (b) to
read as follows:
Sec. 275.203-1 Application for investment adviser registration.
(a) Form ADV. Subject to paragraph (b), to apply for registration
with the Commission as an investment adviser, you must complete Form
ADV [17 CFR 279.1] by following the instructions in the form and you
must file Part 1A of Form ADV and the firm brochure(s) required by Part
2A of Form ADV electronically with the Investment Adviser Registration
Depository (IARD) unless you have received a hardship exemption under
Sec. 275.203-3. You are not required to file with the Commission the
brochure supplements required by Part 2B of Form ADV.
(b) Transition to electronic filing. If you apply for registration
after January 1, 2011, you must file a brochure(s) that satisfies the
requirements of Part 2A of Form ADV electronically with the IARD,
unless you have received a continuing hardship exemption under Sec.
275.203-3.
Note to paragraphs (a) and (b): Information on how to file with the
IARD is available on the Commission's Web site at http://www.sec.gov/iard. If you are not required to deliver a brochure to any clients, you
are not required to prepare or file a brochure with the Commission. If
you are not required to deliver a brochure supplement to any clients
for any particular supervised person, you are not required to prepare a
brochure supplement for that supervised person.
* * * * *
0
3. Section 275.204-1 is amended by removing the notes to paragraphs (a)
and (c) and revising paragraphs (b) and (c) to read as follows:
Sec. 275.204-1 Amendments to application for registration.
* * * * *
(b) Electronic filing of amendments. (1) Subject to paragraph (c),
you must file all amendments to Part 1A of Form ADV and Part 2A of Form
ADV electronically with the IARD, unless you have received a continuing
hardship exemption under Sec. 275.203-3. You are not required to file
with the Commission amendments to brochure
[[Page 49268]]
supplements required by Part 2B of Form ADV.
(2) If you have received a continuing hardship exemption under
Sec. 275.203-3, you must, when you are required to amend your Form
ADV, file a completed Part 1A and Part 2A of Form ADV on paper with the
SEC by mailing it to FINRA.
Note to paragraphs (a) and (b): Information on how to file with the
IARD is available on our Web site at http://www.sec.gov/iard. For the
annual updating amendment: summaries of material changes that are not
included in the adviser's brochure must be filed with the Commission as
an exhibit to Part 2A in the same electronic file; and if you are not
required to prepare a summary of material changes or an annual updating
amendment to your brochure, you are not required to file them with the
Commission. See the instructions for Part 2A of Form ADV.
(c) Transition to electronic filing. If your fiscal year ends on or
after December 31, 2010, you must amend your Form ADV by electronically
filing with the IARD one or more brochures that satisfy the
requirements of Part 2A of Form ADV (as amended effective October 12,
2010) as part of the next annual updating amendment that you are
required to file.
* * * * *
0
4. Section 275.204-2is amended by revising paragraph (a)(14) to read as
follows:
Sec. 275.204-2 Books and records to be maintained by investment
advisers.
(a) * * *
(14)(i) A copy of each brochure and brochure supplement, and each
amendment or revision to the brochure and brochure supplement, that
satisfies the requirements of Part 2 of Form ADV [17 CFR 279.1]; any
summary of material changes that satisfies the requirements of Part 2
of Form ADV but is not contained in the brochure; and a record of the
dates that each brochure and brochure supplement, each amendment or
revision thereto, and each summary of material changes not contained in
a brochure was given to any client or to any prospective client who
subsequently becomes a client.
(ii) Documentation describing the method used to compute managed
assets for purposes of Item 4.E of Part 2A of Form ADV, if the method
differs from the method used to compute assets under management in Item
5.F of Part 1A of Form ADV.
(iii) A memorandum describing any legal or disciplinary event
listed in Item 9 of Part 2A or Item 3 of Part 2B (Disciplinary
Information) and presumed to be material, if the event involved the
investment adviser or any of its supervised persons and is not
disclosed in the brochure or brochure supplement described in paragraph
(a)(14)(i) of this section. The memorandum must explain the investment
adviser's determination that the presumption of materiality is
overcome, and must discuss the factors described in Item 9 of Part 2A
of Form ADV or Item 3 of Part 2B of Form ADV.
* * * * *
0
5. Section 275.204-3 is revised to read as follows:
Sec. 275.204-3 Delivery of brochures and brochure supplements.
(a) General requirements. If you are registered under the Act as an
investment adviser, you must deliver a brochure and one or more
brochure supplements to each client or prospective client that contains
all information required by Part 2 of Form ADV [17 CFR 279.1].
(b) Delivery requirements. Subject to paragraph (g), you (or a
supervised person acting on your behalf) must:
(1) Deliver to a client or prospective client your current brochure
before or at the time you enter into an investment advisory contract
with that client.
(2) Deliver to each client, annually within 120 days after the end
of your fiscal year and without charge, if there are material changes
in your brochure since your last annual updating amendment:
(i) A current brochure, or
(ii) The summary of material changes to the brochure as required by
Item 2 of Form ADV, Part 2A that offers to provide your current
brochure without charge, accompanied by the Web site address (if
available) and an e-mail address (if available) and telephone number by
which a client may obtain the current brochure from you, and the Web
site address for obtaining information about you through the Investment
Adviser Public Disclosure (IAPD) system.
(3) Deliver to each client or prospective client a current brochure
supplement for a supervised person before or at the time that
supervised person begins to provide advisory services to the client;
provided, however, that if investment advice for a client is provided
by a team comprised of more than five supervised persons, a current
brochure supplement need only be delivered to that client for the five
supervised persons with the most significant responsibility for the
day-to-day advice provided to that client. For purposes of this
section, a supervised person will provide advisory services to a client
if that supervised person will:
(i) Formulate investment advice for the client and have direct
client contact; or
(ii) Make discretionary investment decisions for the client, even
if the supervised person will have no direct client contact.
(4) Deliver the following to each client promptly after you create
an amended brochure or brochure supplement, as applicable, if the
amendment adds disclosure of an event, or materially revises
information already disclosed about an event, in response to Item 9 of
Part 2A of Form ADV or Item 3 of Part 2B of Form ADV (Disciplinary
Information), respectively, (i) the amended brochure or brochure
supplement, as applicable, along with a statement describing the
material facts relating to the change in disciplinary information, or
(ii) a statement describing the material facts relating to the change
in disciplinary information.
(c) Exceptions to delivery requirement. (1) You are not required to
deliver a brochure to a client:
(i) That is an investment company registered under the Investment
Company Act of 1940 [15 U.S.C. 80a-1 to 80a-64] or a business
development company as defined in that Act, provided that the advisory
contract with that client meets the requirements of section 15(c) of
that Act [15 U.S.C. 80a-15(c)]; or
(ii) Who receives only impersonal investment advice for which you
charge less than $500 per year.
(2) You are not required to deliver a brochure supplement to a
client:
(i) To whom you are not required to deliver a brochure under
subparagraph (c)(1) of this section;
(ii) Who receives only impersonal investment advice; or
(iii) Who is an officer, employee, or other person related to the
adviser that would be a ``qualified client'' of your firm under Sec.
275.205-3(d)(1)(iii).
(d) Wrap fee program brochures. (1) If you are a sponsor of a wrap
fee program, then the brochure that paragraph (b) of this section
requires you to deliver to a client or prospective client of the wrap
fee program must be a wrap fee program brochure containing all the
information required by Part 2A, Appendix 1 of Form ADV. Any additional
information in a wrap fee program brochure must be limited to
information applicable to wrap fee programs that you sponsor.
(2) You do not have to deliver a wrap fee program brochure if
another sponsor of the wrap fee program delivers, to the client or
prospective client of the wrap fee program, a wrap fee program
[[Page 49269]]
brochure containing all the information required by Part 2A, Appendix 1
of Form ADV.
Note to paragraph (d): A wrap fee program brochure does not take
the place of any brochure supplements that you are required to deliver
under paragraph (b) of this section.
(e) Multiple brochures. If you provide substantially different
advisory services to different clients, you may provide them with
different brochures, so long as each client receives all information
about the services and fees that are applicable to that client. The
brochure you deliver to a client may omit any information required by
Part 2A of Form ADV if the information does not apply to the advisory
services or fees that you will provide or charge, or that you propose
to provide or charge, to that client.
(f) Other disclosure obligations. Delivering a brochure or brochure
supplement in compliance with this section does not relieve you of any
other disclosure obligations you have to your advisory clients or
prospective clients under any federal or state laws or regulations.
(g) Transition rule. (1) Within 60 days after the date by which you
are first required by Sec. 275.204-1(c) to electronically file your
brochure(s) with the Commission, you must deliver to each of your
existing clients your current brochure and all current brochure
supplements as required by Part 2 of Form ADV.
(2) As of the date by which you are first required to
electronically file your brochure(s) with the Commission, you must
begin using your current brochure and current brochure supplements as
required by Part 2 of Form ADV to comply with the requirements of this
section pertaining to initial delivery to new and prospective clients.
(h) Definitions. For purposes of this section:
(1) Impersonal investment advice means investment advisory services
that do not purport to meet the objectives or needs of specific
individuals or accounts.
(2) Current brochure and current brochure supplement mean the most
recent revision of the brochure or brochure supplement, including all
amendments to date.
(3) Sponsor of a wrap fee program means an investment adviser that
is compensated under a wrap fee program for sponsoring, organizing, or
administering the program, or for selecting, or providing advice to
clients regarding the selection of, other investment advisers in the
program.
(4) Supervised person means any of your officers, partners or
directors (or other persons occupying a similar status or performing
similar functions) or employees, or any other person who provides
investment advice on your behalf.
(5) Wrap fee program means an advisory program under which a
specified fee or fees not based directly upon transactions in a
client's account is charged for investment advisory services (which may
include portfolio management or advice concerning the selection of
other investment advisers) and the execution of client transactions.
Sec. 275.206(4)-4 [Removed and Reserved]
0
6. Section 275.206(4)-4 is removed and reserved.
PART 279--FORMS PRESCRIBED UNDER THE INVESTMENT ADVISERS ACT OF
1940
0
7. The authority citation for Part 279 continues to read as follows:
Authority: 15 U.S.C. 80b-1, et seq.
0
8. Form ADV [referenced in Sec. 279.1] is amended by:
0
a. In the instructions to the form, revising the section entitled
``Form ADV: General Instructions.'' The revised version of Form ADV:
General Instructions is attached as Appendix A;
0
b. In the instructions to the form, revising the section entitled
``Glossary of Terms.'' The revised version of Glossary of Terms is
attached as Appendix B; and
0
c. Removing Form ADV, Part II, and adding Form ADV, Part 2. Form ADV,
Part 2 is attached as Appendix C.
Note: The amendments to and text of Form ADV will not appear in
the Code of Federal Regulations.
* * * * *
BILLING CODE 8011-01-P
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Dated: July 28, 2010.
By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2010-19617 Filed 8-11-10; 8:45 am]
BILLING CODE 8011-01-C