New Form ADV Part 2 Update & Overview

Registered investment advisers (both SEC and state) will need to file their annual form ADV update within 90 days of the end of the fiscal year, which for most firms will be March 31, 2011.  For many firms this will mean that they will also need to draft and submit the new Form ADV 2 which was adopted by the SEC in July of 2010 (see previous post). As many firms have had many questions about the new form, including what new content is required and how long it will take to complete the new form, this article will provide a summary of:

  • Background on the new Part 2
  • The structure and disclosure items of the Firm Brochure (Part 2A)
  • The structure and disclosure items of the Brochure Supplement (Part 2B)
  • Overview of states which have adopted new Part 2

Background

On July 21, 2010, the Securities and Exchange Commission (“SEC”) adopted a new Part 2 that became effective October 12, 2010.  The old Part II (and Schedule F which qualifies much of the information on the old Part II) contained a series of check-the-box options and also provided much of the same information which is also provided on Form ADV.  The new Part 2 will no longer be in the check-the-box format.  Instead, it will take the form of a narrative brochure written in plain English–the purpose of which is to provide clients with a more clear disclosure of the adviser’s business practices, conflicts of interest, and background.

The new Part 2 consists of three parts:

  1. The “Firm Brochure” (Part 2A)
    • SEC-registered firms and firms registered in states that have adopted the new Part 2 must complete.
    • Filed electronically on the IARD system.
    • Publicly available.
  2. A Wrap Fee Program Brochure (Part 2A, Appendix 1)
  3. The “Brochure Supplement” (Part 2B)
    • SEC-registered firms and firms registered in states that have adopted the new Part 2 must complete.
    • Not filed electronically.
    • Not publicly available.

The SEC has not provided a specific form that IAs must use when preparing the new Part 2.  The following provides general guidelines on how to structure the Firm Brochure and Brochure Supplement, as well as what content to include.  A full version of the new Part 2 instructions is available here.  Firms applying for SEC registration for the first time after January 1, 2011 are required to use the new Part 2.  Existing SEC-registered firms may use either the old Part II or the new Part 2 between October 12, 2010 and December 31, 2010.  However, beginning January 1, 2011, firms will have to use the new Part 2 for their 2011 annual updating amendment.

More information about the filing and delivery deadlines for the new Part 2A and 2B are available here.

Firm Brochure (Part 2A)

The Firm Brochure requires an adviser to provide information about the firm’s business practices and conflicts of interest. Many of the disclosure items are similar to those required in the old Part II, such as a discussion of the advisory business and the types of clients.  However, new disclosure items include a discussion of material changes since the last annual amendment as well as a discussion of potential conflicts of interest and how the firm will address such conflicts.

The Brochure consists of 18 separate disclosure items for SEC-registrations and additional items specifically for state-registrations.  Each item must be addressed, even if it is not applicable to the adviser.  The adviser may simply state it is not applicable.  The following is a summary of the disclosure items in the Firm Brochure:

  • Item 1 – Cover Page
    • Firm name, business address, contact information, website (if any) and the date of the Brochure.
    • Specific disclaimer stating the Brochure was not approved by the SEC or any state authority.
    • If the firm refers to itself as a “registered investment adviser,” a specific disclaimer that registration does not imply a certain level of skill or training.
  • Item 2 – Material Changes
    • If the firm is making an annual update, the Brochure must discuss material changes in the Brochure since the last annual update in a summary.  The summary can also be a separate document attached to the Brochure.
  • Item 3 – Table of Contents
    • Must be detailed enough so that clients can locate topics easily.
    • Must list items in the same order as they are listed in the Brochure, and contain the same headings.
  • Item 4 – Advisory Business
    • Describe the firm, how long it’s been in business, and identify the principals.
    • Describe the types of advisory services offered.
      • If the firm specializes in a particular type of services, e.g. financial planning, quantitative analysis, etc. provide greater detail.
      • If the firm provides investment advice only with respect to limited types of investments, explain and disclose that advice is limited in such way.
    • Explain whether the firm tailors advisory services and whether clients can impose restrictions on investments.
    • If the firm participates in wrap fee programs, describe the differences in how such accounts are managed versus other accounts and disclose that the firm receives a wrap fee.
    • If the firm manages client assets, disclose the amount managed on a discretionary basis and the amount managed on a non-discretionary basis.
  • Item 5 – Fees and Compensation
    • Describe how the firm is compensated and provide a fee schedule.  Note: This requirement is not required for Brochures delivered solely to qualified purchasers.
    • Provide other compensation-related disclosures: whether fees are deducted from client assets or whether clients will be billed for fees; any other types of fees (custodian fees, mutual fund expenses, brokerage/transaction costs); payment of fees in advance or arrears; and asset-based sales charges or service fees.
  • Item 6 – Performance-Based Fees and Side-By-Side Management
    • Discuss whether the firm charges performance-based fees or supervised persons manage accounts that pay such fees; and discuss how the fees are charged.
    • In addition, if the firm or supervised persons also manage accounts that do not charge such fees, discuss the potential conflicts of interest and how the firm will address such conflicts.
  • Item 7 – Types of Clients
    • Describe the firm’s clients.
    • Describe any requirements for opening/maintaining an account.
  • Item 8 – Methods of Analysis, Investment Strategies and Risk of Loss
    • Describe the methods of analysis and investment strategies used to formulate investment advice.  Disclose that investing in securities involves risk of loss.
    • For significant investment strategies or methods of analysis, discuss material risks involved with such strategies and methods.  If there are significant or unusual risks, discuss in detail.  If strategies involve frequent trading, discuss how frequent trading affects performance.
    • If the firm recommends primarily a particular type of securities, explain the material risks.  If there are significant or unusual risks, discuss in detail.
  • Item 9 – Disciplinary Information
    • Disclose material facts about legal or disciplinary events about the firm or a management person.  This item lists events that are presumed to be material if they occurred in the prior 10 years, unless (1) the event was resolved in the firm’s or the management person’s favor, or was reversed, suspended or vacated, or (2) the firm rebutted the presumption of materiality to determine that the event is not material.
    • In the interest of full and fair disclosure of material facts, disclose events not on the list, events not presumed material, and/or events that are more than 10 years old.
    • The Firm can rebut events that are presumed material.
  • Item 10 – Other Financial Industry Activities and Affiliations
    • Discuss whether the firm or management persons are registered or have pending applications to register as broker-dealers, broker-dealer reps, FCMs, CPOs, CTAs, or associate persons.
    • Describe material relationships with related financial industry participants (e.g. broker-dealers, registered reps of broker-dealers, investment companies or other pooled investment vehicles, FCMs, CPOs, CTAs, accounting firms, law firms, real estate brokers, etc.).
    • Describe material conflicts of interest that arise from such relationships and how those conflicts are addressed.
    • If the firm selects or recommends other investment advisers for clients, the firm must disclose compensation arrangements (if any) with those advisers and any other business relationships with such advisers, as well as any material conflicts of interest and how the firm address them.
  • Item 11 – Code of Ethics, Participation or Interest in Client Transactions and Personal Trading
    • Include a summary of the code of ethics and state a copy is available upon request.
    • If the firm or a related person:
      • (i) recommends to clients, or buys or sells for client accounts, securities in which the firm or a related person has a material financial interest;
      • (ii) invests in the same securities (or related securities, e.g., warrants, options or futures) that the firm or a related person recommends to clients; or
      • (iii) recommends securities to clients, or buys or sells securities for client accounts, at or about the same time that the firm or a related person buys or sells the same securities for the firm’s own (or the related person’s own) account, then the firm must describe the practice and discuss conflicts of interest (including how such conflicts are addressed).
  • Item 12 – Brokerage Practices
    • Describe how the firm selects brokers and determines the reasonableness of brokers’ compensation
    • If the firm receives research or other products or services other than execution from a broker-dealer or a third party in connection with client securities transactions (“soft dollar benefits”), disclose the firm’s practices and discuss the conflicts of interest they create.  Provide more detail for products/services that do not qualify under the Section 28(e) safe harbor.
    • If the firm considers, in selecting or recommending broker-dealers, whether the firm or a related person receives client referrals from a broker-dealer or third party, disclose this practice and discuss the conflicts of interest it creates.
    • If the firm routinely recommends, requests or requires that a client direct the firm to execute transactions through a specified broker-dealer, describe the firm’s practice or policy.
    • If the firm permits a client to direct brokerage, describe the practice.
    • Describe whether and under what conditions the firm aggregates the purchase or sale of securities for various accounts.
  • Item 13 – Review of Accounts
    • If the firm periodically reviews client accounts, describe the frequency and nature of review, as well as the titles of the persons who conduct the review.
    • If accounts are reviewed on other than a period basis, describe what triggers review.
    • Describe the content and indicate the frequency of regular reports.
  • Item 14 – Client Referrals and Other Compensation
    • If a non-client provides economic benefit to the firm for providing investment advice or services to clients, describe the arrangement, potential conflicts of interest and how such conflicts are addressed.
    • If the firm or related persons compensate any non-supervised persons for referrals, describe the arrangement and compensation.
  • Item 15 – Custody
    • If the firm has custody of client assets and a qualified custodian sends quarterly, or more frequent, account statements directly to your clients, explain that clients will receive account statements from the broker-dealer, bank or other qualified custodian and that clients should carefully review those statements.
    • If the firm also provides statements, urge clients to compare such statements with those provided by the qualified custodian.
  • Item 16 – Investment Discretion
    • If the firm has discretionary authority over accounts, disclose this, along with any limitations clients may place on that authority.
    • Discuss procedures before discretionary authority is assumed.
  • Item 17 – Voting Client Securities
    • Describe voting policies for client securities, if any.  Discuss any conflicts of interest and how such conflicts are addressed.  Explain that a copy of the policies are available upon request.
    • If the firm does not vote client securities, disclose that fact.
  • Item 18 – Financial Information
    • If the firm requires or solicits prepayment of more than $1,200 in fees per client, 6 months or more in advance, include a balance sheet for the most recent fiscal year.
    • If the firm has discretionary authority over client assets, custody of client funds or securities, or require prepayment discussed above, discuss any financial conditions that purchase nolvadex are reasonably likely to impair the ability to meet contractual commitments with clients.
    • Discuss any bankruptcy petitions during the past 10 years.
  • Item 19 – Requirements for State-Registered Advisers
    • Identify and describe the formal education and business background of principal executive officers and management persons.
    • Describe any business in which the firm is actively engaged (other than the provision of investment advice) and amount of time spent.
    • In addition to the fees discussed in Item 5, if the firm or a supervised person is compensated for advisory services with a performance-based fee, explain how the fees are calculated and discuss the conflict of interest.
    • Disclose material facts about certain disciplinary items and other financial industry relationships or arrangements.

Brochure Supplement (Part 2B)

The Brochure Supplement requires an adviser to provide information about the certain advisory personnel.  The following is a summary of the disclosure items in the Brochure Supplement.

The Firm must prepare a Brochure Supplement for (i) any supervised person who formulates investment advice for the client and has direct client contact and (ii) any supervised person who has discretionary authority over the client’s assets.  A Supplement is not required if the supervised person has no direct client contact and has discretionary authority over client assets only as part of a team. Note: If investment advice is provided by a team of more than five supervised persons, Brochure Supplements only need to be prepared for the five supervised persons with the most significant responsibility for the day-to-day advice.

  • Item 1 – Cover Page
    • Identify the advisory firm and the supervised persons covered in the Supplement (include name, business address, and phone number).
    • Standard disclaimer similar to the one in the Firm Brochure.
  • Item 2 – Educational Background and Business Experience
    • Describe the supervised person’s formal education and business background for the past 5 years.
    • Include professional designations, if any.
  • Item 3 – Disciplinary Information
    • Discuss the material facts related to any legal or disciplinary events that are material to a (prospective) client’s evaluation of supervised persons. This item lists events that are presumed to be material if they occurred in the prior 10 years, unless (1) the event was resolved in the supervised person’s favor, or was reversed, suspended or vacated, or (2) the firm rebutted the presumption of materiality to determine that the event is not material.
    • In the interest of full and fair disclosure of material facts, disclose events not on the list, events not presumed material, and/or events that are more than 10 years old.
    • The Firm can rebut events that are presumed material.
    • Disclose any event for which the supervised person has 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), if the firm knows or should have known that the supervised person relinquished his or her designation or license.
    • Note: If a Brochure Supplement is delivered electronically, the firm may disclose that a supervised person has a disciplinary event and provide a ink to BrokerCheck or IAPD (along with an explanation of how the client can access the disciplinary history).
  • Item 4 – Other Business Activities
    • If the supervised person is actively engaged in any investment-related business, including registration (or pending registrations) as a broker-dealer, registered representative of a broker-dealer, futures commission merchant (“FCM”), commodity pool operator (“CPO”), commodity trading advisor (“CTA”), or an associated person of an FCM, CPO, or CTA, disclose this fact and describe the business relationship.
  • Item 5 – Additional Compensation
    • If a non-client provides an economic benefit to the supervised person, describe the arrangement (not including regular salary).
  • Item 6 – Supervision
    • Discuss how supervised persons are supervised, including how the firm monitors advice provided to clients.
    • Provide the name, title, and phone number of the person responsible for supervising the supervised persons.
  • Item 7 – Requirements for State-Registered Advisers
    • Disclose material facts about certain disciplinary items.
    • Discuss any bankruptcy petitions.

[Note: the SEC recently extended the date for compliance with Part 2B.]

States That Have Adopted the New Part 2

The following states have followed suit and adopted the new Part 2 or informally indicated an intent to do so.

  • Alaska – adopted the new Part 2 (more information available here)
    • October 12, 2010 – December 31, 2010: IA applicants and currently registered IAs may use either the old Part II or new Part 2.
    • As of January 1, 2011: IA applicants are required to use the new Part 2 and registered IAs must file the new Part 2 by no later than the registrant’s next amendment filing or its annual updating amendment filing, whichever comes first.
  • Arizona – adopted the new Part 2 (more information available here)
    • October 12, 2010 – January 1, 2011: currently registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update
    • As of January 1, 2011: IA applicants must use the new Part 2.
  • California – adopted the new Part 2 (more information available here)
    • October 12, 2010 – January 1, 2011: IA applicants and currently registered IAs may use either the old Part II or the new Part 2.
    • As of January 1, 2011: IA applicants will have to file the new Part 2 and registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.
  • Colorado – will require but not sure starting when
  • Connecticut – adopted the new Part 2 (more information available here)
    • October 12, 2011 – December 31, 2010: IA applicants and currently registered IAs may use either the old Part II or the new Part 2.
    • As of January 1, 2011: IA applicants will have to use the new Part 2 and registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.
    • As of January 1, 2011: IAs registered on or before December 31, 2010 should file the new Part 2, no later than June 1, 2011.
  • Illinois – will require but not sure starting when
  • Indiana – adopted the new Part 2 (timelines may have been updated) (more information available here)
    • October 12, 2010 – January 1, 2011: IA applicants and currently registered IAs may use either the old Part II or new Part 2.
    • As of January 1, 2011: IA applicants are required to use the new Part 2 and registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.
  • Maine – adopted the new Part 2 (more information available here)
    • October 12, 2010 – January 1, 2011: IA applicants and currently registered IAs may use either the old Part II or new Part 2.
    • As of January 1, 2010: IA applicants must use the new Part 2 and registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.
  • Maryland – adopted the new Part 2 (more information available here)
    • As of October 12, 2010: IA applicants must use the new Part 2 as part of its initial application and any amendment.
    • October 12, 2010 – December 31, 2010: currently registered IAs and those pending registration as of October 12, 2010 may use either the old Part II or the new Part 2 for any amendments
    • As of January 1, 2011: registered IAs must file the new Part 2 by no later than the registrant’s next amendment filing or its annual updating amendment filing, whichever comes first.
  • Massachusetts – adopted the new Part 2 (more information available here)
    • October 12, 2010 – December 31, 2010: currently registered IAs are required to file the registrant’s next annual updating amendment using the new Part 2; until such time, the registrant may use the old Part II for regular amendment filings.
  • Ohio – adopted the new Part 2 (more information available here)
    • October 12, 2010 – December 31, 2010: IA applicants and currently registered IAs filing amendment may use either the old Part II or the new Part 2.
    • As of January 1, 2011: currently registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.  IA applicants are required to use the new Part 2.
    • As of April 30, 2011: registered IAs must have converted to the new Part 2.
  • Oregon – adopted the new Part 2 (more information available here).
    • October 12, 2010 – January 1, 2011: IA applicants and currently registered IAs filing amendment may use either the old Part II or the new Part 2.
    • As of January 1, 2011: IA applicants must use the new Part 2 and registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.
  • Tennessee – adopted the new Part 2 (more information available here).
    • October 12, 2010 – December 31, 2010: IA applicants and currently registered IAs filing amendment may use either the old Part II or the new Part 2.
    • As of January 1, 2011: applicants must use the new Part 2 and registered IAs must file the new Part 2 by no later than the registrant’s next amendment filing or its annual updating amendment filing, whichever comes first.
  • Texas – currently in comment period, final approval expected in mid-2011, encouraging use of the new Part 2 (more information available here).

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Bart Mallon Esq. is a hedge fund attorney and provides hedge fund compliance services through Cole-Frieman & Mallon LLP.  He can be reached directly at 415-868-5345.

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