SEC Adopts Amendments to Form ADV

On July 21, 2010, the Securities and Exchange Commission (the “SEC”) unanimously adopted changes to Part 2 of Form ADV. Part 2 of Form ADV, commonly referred to as the “brochure,” is the principal disclosure document that federally registered investment advisers must provide to their clients. The new requirements expand the disclosures that federally registered investment advisers must make and require that disclosures be made in a specified format. The changes are designed to provide clear disclosure that investors are likely to read and understand. The impact of these changes is magnified by the DoddFrank Wall Street Reform and Consumer Protection Act, which, effective July 21, 2011, will require many previously exempt investment advisers – including private fund managers – to register with the SEC and provide disclosure in accordance with the new requirements. As revised, Part 2 of Form ADV consists of two narrative components: Part 2A (the “brochure”) and Part 2B (the “brochure supplement”). The key amendments are summarized below.

PART 2A – BROCHURE

Format

The prior check-the-box or fill-in-theblank approach is replaced with a “plain English” narrative organized in a consistent, uniform manner that describes an investment adviser’s business, potential conflicts of interest and disciplinary history. “Plain English” means using “short sentences; definite, concrete, everyday words; and the active voice.” The brochure should discuss practices in which the adviser engages or is likely to engage and conflicts it has or is likely to have. If an adviser engages in practices or has conflicts with respect to some (but not all) clients, the adviser should so indicate rather than disclosing that it “may” engage in the practice or have the conflict.

The revised brochure must cover eighteen (18) required disclosure items. The responses must be presented in the order the items appear on the form with the headings provided on the form. If an item is inapplicable to an adviser, the adviser must include the heading and an explanation that the information is inapplicable. Cross references may also be used where the information would be duplicative under multiple headings.

If an adviser offers substantially different types of advisory services, it may create separate brochures for different types of advisory clients, each of which may be shorter and contain less extraneous information than would be included in a combined brochure. For example, an adviser offering a wide variety of advisory services might have a summary in the beginning of its brochure, followed by a more detailed discussion of each specific item.

Disclosure

As stated, the revised brochure contains eighteen (18) required disclosure items. For a detailed list of the disclosure items on the brochure, see Annex A on page 4. The new requirements are substantially different from the current form and will require advisers to modify nearly every section of their existing brochure. The disclosure items include, among others, an adviser’s advisory business; fees and compensation; performance-based fees and side-by-side management of client accounts; methods of analysis, investment strategies, and risk of loss; disciplinary information; code of ethics, participation or interest in client transactions, and personal trading; and brokerage activities. The revised brochure requires disclosure of disciplinary information that previously was only disclosed in Part 1 and was not delivered to the client.

Delivery and Update Requirements

Initially, the brochure must be delivered to a client before or at the time the adviser enters into an advisory agreement with the client. Previously, advisers were required to deliver the brochure 48 hours before entering into the advisory contract or grant the investor a five-day cancellation right. After the initial delivery, an adviser must file with the SEC (via the Investment Adviser Registration Depository (the “IARD”) system discussed in more detail below) an annual updating amendment to the brochure within 90 days of the adviser’s fiscal year end. The annual updating amendment must be provided to clients within 120 days of the adviser’s fiscal year end. Advisers may elect to provide clients with either (i) a copy of the current (updated) brochure that includes or is accompanied by a summary of material changes, or (ii) a summary of material changes that includes an offer to a provide a copy of the current brochure and information on how to obtain the current brochure. If advisers elect the second option, the updated brochure filed with the SEC via the IARD system must attach the summary of material changes as an exhibit. A summary of material changes was not required in the past, and identifying what to include in the summary may be one of the more challenging aspects of the new requirements. In addition to the required annual updating amendment, advisers must update the brochure promptly when information therein becomes materially inaccurate and must also deliver an updated brochure to clients promptly whenever an update adds a disciplinary event or a material change to a disciplinary event already disclosed.

The brochure and any amendments to the brochure are required only to be delivered to an adviser’s “clients.” The SEC has confirmed that in the case of an investment adviser to a hedge fund, private equity fund or other pooled investment fund, the “client” is the fund itself and not the ultimate investors. Thus, advisers must deliver the brochure to funds but not fund investors. As under the prior rule, the brochure does not need to be provided to: clients receiving only impersonal investment advice for which the adviser charges less than $500 per year, registered investment companies or certain business development companies.

Advisers may deliver the brochure to clients electronically in accordance with the SEC’s interpretive guidelines regarding electronic delivery of documents (available at http://www.sec.gov/rules/concept/33-7288.txt), which require, among other things, that a client consent to electronic delivery.

PART 2B – BROCHURE SUPPLEMENT

Disclosure and Format

The brochure supplement provides information about the personnel who service a particular client’s account. The brochure supplement is a new requirement and can be either a stand-alone document or incorporated into the brochure. If the brochure supplement is incorporated into the brochure, it must be at the end of the brochure. The brochure supplement is expected to look similar to a resume but will be much more extensive. For a detailed list of the required disclosure items on the brochure supplement, see Annex B on page 6. The brochure supplement includes information regarding the individual’s educational background, business experience, other business activities, compensation, disciplinary history and contact information for the person responsible for supervising the advisory activities of the individual.

The brochure supplement must be provided for any individual (i) who formulates investment advice for a client and has direct client contact or (ii) who makes discretionary investment decisions for a client’s assets, regardless of whether the individual has direct client contact. Like the brochure, the brochure supplement must be written in plain English; however, an adviser has more flexibility to tailor the information in a format that best suits its business and clients. For example, advisers may elect to prepare a supplement for each supervised person or prepare separate supplements for different groups of supervised persons. 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.

Delivery and Update Requirements

The brochure supplement must be delivered to the client before or at the time the specific individual begins to provide investment advisory services to the client. As with the brochure, the brochure supplement may be delivered to clients electronically in accordance with the SEC’s interpretive guidelines regarding electronic delivery of documents. Advisers who send brochure supplements to clients electronically may include hyperlinks to disciplinary information available through the FINRA BrokerCheck System (“BrokerCheck”) and the IAPD. The brochure supplement does not need to be provided to: clients to which the adviser is not required to deliver a brochure, clients that receive only impersonal investment advice, and certain officers, directors, employees and other persons related to the adviser who would be “qualified clients” of the adviser under Rule 205-3(d)(1)(iii).

Unlike the brochure, the information in the brochure supplement is unlikely to become materially inaccurate over time, and thus there is no requirement to deliver annual updated brochure supplements. However, advisers are required to promptly amend a brochure supplement if any information contained therein becomes materially inaccurate and must promptly deliver an amended brochure supplement to clients whenever an update adds a disciplinary event or a material change to a disciplinary event already disclosed. If a brochure supplement is delivered electronically and references disciplinary information available through BrokerCheck or IAPD, advisers must electronically deliver an updated brochure supplement indicating that the disciplinary information has changed and providing the hyperlinks. When determining which clients need to receive amendments to the brochure supplement, advisers will need to track which changes affect which clients as different brochure supplements (and amendments) will be provided to different clients depending on the personnel who service the particular client’s account.

FILING REQUIREMENTS AND PUBLIC AVAILABILITY

In the past, the brochure was only available to clients and prospective clients and not publicly available. Under the new rule, the brochure and any amendments to the brochure will be required to be filed with the SEC electronically in Adobe Portable Document Format (“PDF”) via the IARD system, making them publicly available. The brochure supplements do not need to be filed with the SEC via the IARD system but must be maintained by the adviser and made available for SEC inspection upon request.

The SEC has advised that an adviser is not required to comply with the new requirements until it submits its annual updating amendment to Form ADV for its first fiscal year ending on or after December 31, 2010. Thus, investment advisers with a fiscal year ending December 31, 2010 have 90 days, or until March 31, 2011, to file a brochure that complies with the new rule. An investment adviser with a fiscal year ending prior to December 31, 2010 will have 90 days from its fiscal year ending in 2011 to file a brochure that complies with the new rule. For example, an adviser with an October 31 fiscal year end will have until January 29, 2012 to file a brochure that meets the new requirements. The SEC has provided registered investment advisers a one-time extension for delivering the brochure, giving them 60 days from the date they are first required to electronically file their first annual updating amendment to deliver the new brochure to clients. In subsequent years, advisers must deliver (or offer to deliver) to clients the updated brochure within 120 days of their fiscal year end. An adviser first registering on or after January 1, 2011 will be required to file the brochure with the SEC and deliver such brochure to clients in accordance with the new requirements.

ANNEX A: BROCHURE DISCLOSURE ITEMS

• Item 1: Cover Page – disclose the name of the adviser’s firm, its business address, contact details, website (if any) and the date of the brochure. The cover page must also state that the brochure has not been approved by the SEC or any state securities regulator and, if the adviser refers to itself as a “registered investment adviser,” the adviser must include a disclaimer that registration does not imply a certain level of skill or training.
• Item 2: Summary of Material Changes – provide each existing client to whom the brochure is delivered an annual summary of material changes. The summary may be included in the brochure or provided as a separate document accompanying the brochure. A summary prepared as a separate document can be used to satisfy an adviser’s annual delivery obligations. A summary provided as a separate document must be filed with the SEC as an exhibit to the brochure.
• Item 3: Table of Content – include a table of contents that permits easy identification of disclosure items, containing the same headings as set forth in the form.
• Item 4: Advisory Business – describe the advisory business, including types of advisory services offered, whether the adviser specializes in a particular type of advisory service and the amount of client assets managed. An adviser may use a method that differs from the method used in Part 1A of Form ADV to report “assets under management” but must keep documentation describing the method used.
• Item 5: Fees and Compensation – describe compensation arrangements (including a fee schedule) and other types of costs, such as brokerage, custody fees and fund expenses that clients may pay in connection with advisory services. An adviser that receives compensation attributable to the sale of a security or other investment product must disclose this practice, the conflict of interest it creates and how the adviser addresses this conflict. There is an exception that permits an adviser to omit disclosure of its fee schedule and the other information in Item 5 in any brochure provided only to clients that are “qualified purchasers,” as defined in the Investment Company Act of 1940.
• Item 6: Performance Fees and Side-By-Side Management – disclose imposition of performance fees, if applicable. An adviser that also manages accounts not charged performance fees must discuss the conflicts that arise from its simultaneous management of these accounts and describe generally how it addresses those conflicts.
• Item 7: Types of Clients – disclose the types of clients it serves (i.e., individuals, trusts, investment companies, etc.), together with any requirements for opening or maintaining an account (for example, minimum account size).
• Item 8: Methods of Analysis, Investment Strategies and Risk of Loss – describe methods of analysis and investment strategies. Explain the material risks involved for each significant investment strategy or method of analysis used and particular type of security recommended, with more detail if those risks are significant or unusual. If the primary strategy involves frequent trading of securities, advisers must include specific disclosure regarding how frequent trading can affect investment performance, especially through increased costs and taxes.
• Item 9: Disciplinary Information – disclose material facts about any legal or disciplinary event – including criminal, civil and regulatory actions – that is “material to a client’s evaluation of the integrity of the adviser or its management. Item 9 provides a list of disciplinary events that are presumptively material if they occurred in the past ten years. An adviser can rebut this presumption, with no disclosure required, but the determination must be documented and the record retained for SEC inspection.
• Item 10: Other Financial Industry Activities and Affiliations – describe material relationships or arrangements with related financial industry participants, any material conflicts of interest created and how the conflicts are addressed.
• Item 11: Code of Ethics, Participation or Interest in Client Transactions and Personal Trading – describe briefly the adviser’s code of ethics. Additional conflict of interest disclosure is required if the adviser (i) buys or sells for clients securities in which the adviser has a material financial interest, (ii) invests, or is permitted to invest, in the same securities that it recommends to clients or (iii) trades in the same securities at or about the same time as a client.
• Item 12: Brokerage Practices – describe how brokers are selected and how reasonableness of compensation is determined. Specific disclosure is required regarding all soft dollar products and services received, as well as a discussion of the conflicts of interest such practices create. Additional disclosure must be provided if the adviser (i) uses client brokerage to reward brokers for client referrals, (ii) routinely recommends, requests or requires that a client direct the adviser to execute transactions through a specified broker or (iii) engages in trade aggregation or “bunching” practices.
• Item 13: Review of Accounts – disclose whether and the frequency with which client accounts or financial plans are reviewed, the nature of such reviews, and the titles of the persons conducting the reviews. If accounts are reviewed other than periodically, the factors triggering a review must be described. The adviser must also describe the content of reports provided to clients, and the frequency with which such reports are provided.
• Item 14: Client Referrals and Other Compensation – describe any payments for client referrals and disclose whether the adviser receives any benefit, including sales awards or prizes, from a nonclient for providing advisory services to clients (and the conflicts of interest involved).
• Item 15: Custody – disclose adviser custody of client funds or securities. An adviser with custody of client funds or securities must explain that clients will receive account statements directly from the qualified custodian that maintains those assets, which they should review carefully. If an adviser also sends account statements to clients, the adviser must include a statement urging clients to compare the account statements they receive from the qualified custodian with those they receive from the adviser.
• Item 16: Investment Discretion – an adviser that accepts discretionary authority is required to disclosure that fact, describe any limitation clients may (or customarily do) place on the authority, and describe the procedures the adviser follows before assuming such authority.
• Item 17: Voting Client Securities – disclose whether the adviser has authority to vote client securities and, if so, briefly describe voting policies and how conflicts of interest are addressed. An adviser that does not have authority to vote securities, it must disclose how clients will receive their proxies and other solicitations.
• Item 18: Financial Information – an adviser that requires prepayment of more than $1,200 in fees per client, six or more months in advance, must include in its brochure an audited balance sheet for its most recent fiscal year. An adviser that requires such prepayment or has discretionary authority or custody of client assets must disclose “any financial condition reasonably likely to impair the adviser’s ability to meet contractual commitments to clients.”

ANNEX B: BROCHURE SUPPLEMENT DISCLOSURE ITEMS

• Item 1: Cover Page – disclose the supervised person’s name, business address, telephone number, the firm’s name, business address, and telephone number, and the date of the brochure supplement.
• Item 2: Educational Background and Business Experience – disclose supervised person’s name, age, formal education after high school and business background for the past five years. If supervised person has no formal education or business background, disclose this fact.
• Item 3: Disciplinary Information – disclose any legal or disciplinary event that is “material to a client’s evaluation of the supervised person’s integrity.” Item 3 includes certain disciplinary events that the SEC presumes are material to such an evaluation if they occurred during the past 10 years. An adviser can rebut this presumption, with no disclosure required, but the determination must be documented and the record retained for SEC inspection. With respect to disciplinary information available on either BrokerCheck or the IAPD system, the adviser may disclose in a supplement delivered electronically that the supervised person has a disciplinary event and provide a hyperlink to the pertinent system.
• Item 4: Other Business Activities – disclose other business activities of the supervised person, including (i) other capacities in which he or she participates in any investmentrelated business and any material conflicts of interest such participation may create and (ii) noninvestment-related business activities or occupations that involve a substantial amount of time or pay.
• Item 5: Additional Compensation – disclose 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.
• Item 6: Supervision – disclose information with respect to how the firm monitors the advice provided by its supervised person, including the name, title and telephone number of his or her supervisor.