New Form to Require More Disclosure
On July 21, the SEC approved changes to the Form ADV Part II which are designed to provide more and better information to investors. Currently Part II (and Schedule F which qualifies much of the information on Part II) contains a series of check the box options and also provides much of the same information which is also provided on Form ADV. The changed proposed below will go into effect 60 days from the publication in the Federal Register which means that most advisers will need to have the new Part II in place by the first quarter of 2011. In addition to traditional investment advisers, the new Part II disclosure requirements will also be applicable to hedge fund managers who are subject to registration after the passage of the Dodd-Frank reform bill.
The proposed major changes include the following:
- Increased narrative – currently Part II and Schedule F are composed of a series of check the box answers describing an adviser’s business. The SEC wants to move towards more of a narrative, “plain English” approach to disclosure which will be “clear and concise”.
- Discussion of advisory business and fee structure – more disclosure will be required about the advisor’s business and the fee structure. Increased disclosure will be required about expenses like brokerage and custody fees.
- Performance fee discussion – the big issue is that if a manager charges performance fees to some accounts and not others, the manager will need to explain the conflicts of interest which are involved.
- Discussion of investment methodology and risk factors – the manager will be required to explain the material risks involved in the investment program.
- Disciplinary information – all disciplinary information material to the adviser’s business will need to be disclosed. If there is new disciplinary disclosures which become necessary after the relationship has been established, the adviser will need to promptly update the client.
- Supplements – the adviser will need to provide supplements to the client regarding the specific person who will be providing investment advice to the client. This supplement will include information about the person’s education, business experience, disciplinary history, etc.
After the changes become effective, both hedge fund managers and other investment advisers will need to update their forms and also update their compliance manuals and policies and procedures. Managers should also note that the information included in Part II will be publicly available online.
While we completely agree with appropriate and easy to understand disclosure, some of the proposed changes may have the unintended effect of creating brochures which are so long and comprehensive that investors will simply not read them. For example, we have discussed “prospectus creep” and there is the possibility for this to happen with the Part II -especially with respect to risk disclosures. Managers and lawyers will certainly err on the side of over-disclosure instead of under-disclosure when faced with a potential risk factor which may or may not be “material” in the eyes of the SEC (see, especially, the Goldman case).
What we see with the supplements is essentially a first step towards developing a self-regulatory organization (SRO) to oversee investment advisers. FINRA has shown a willingness to take on this responsibility and it has become an even greater likelihood as the SEC is tasked with greater responsibilities under the Dodd-Frank bill. While we believe that a SRO can relieve much of the regulatory burden of a government agency (see the NFA), we must note that all SROs have their own issues and this must be weighed against the increased costs (both in time and money) to investment advisers.
Text of Chairman Shapiro’s speech can be found here.
SEC News Release can be found here.
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Cole-Frieman & Mallon LLP provides legal support and hedge fund compliance services to all types of investment managers. Bart Mallon, Esq. can be reached directly at 415-868-5345.