Tuesday, June 24, 2008

ABA Securities Committees Comment on SEC Form ADV Amendments

By Jay Fishman, J.D.

On June 18, 2008 the ABA Committees on Federal and State Securities Regulation submitted comments to the SEC about the SEC’s proposed amendments to Form ADV and about rules under the Investment Advisers Act of 1940. Comments concerned electronic filing of Part 2 of Form ADV through the Investment Adviser Registration Depository (IARD) ["brochure delivery requirement"], as well as the brochure delivery requirements for investment advisers to their private fund clients, custodial fees, custody of client funds in Rule 206(4)-2 of the Investment Advisers Act of 1940 and disciplinary information requirements in Rule 206(4)-4.

The Committees thanked the SEC for working with the North American Securities Administrators Association (NASAA), the umbrella organization representing Blue Sky interests, to create a single form with standard definitions and reporting requirements so that federal covered and state investment advisers can more easily progress from federal to state investment adviser status and visa versa. The Committees were also encouraged about the SEC's adoption of a more uniform brochure format to better provide actual and prospective advisory clients, and the SEC, with more meaningful disclosures.

Comments:

Brochure delivery requirement. Regarding completion of Part 2 of Form ADV [the "brochure delivery requirement"], the Committees request that the Form ADV instructions specify that in those instances when an investment adviser is not required to deliver the brochure because the clients are in the "no delivery required" category, the investment adviser can simply complete Part 2 by stating that preparation and delivery of a brochure is not required.

Private funds. The Committees also believe that as a result of Goldstein v. SEC, 451 F.3d 873, 877 (D.C. Cir. 2006) that deemed a fund rather than the fund's investors to be the client of an investment adviser, an exemption from the Part 2 brochure preparation and delivery requirement should apply to private funds that are the only client of a registered investment adviser acting as promoter, as well as to funds in which a registered investment adviser or one of its affiliates is the general partner or limited partner of a limited partnership or managing member of a limited liability company; and also that the investment adviser be identified as a "promoter." The Committees also believe the exemption should extend to investment advisers of private funds that are exempt from registration as investment companies under Sections 3(c)(1), 3(c)(5), 3(c)(7) and 3(c)(9) of the Investment Company Act of 1940.

Annual update. The Committees request that instead of the SEC's proposal to require an adviser to provide each client with an annual update of the adviser's brochure's material changes, the SEC adopts the "access equals delivery" approach used for 1933 Act prospectuses, whereby the SEC would allow an adviser to place the updated brochure on its website and then send an email notification of the material changes to the clients telling them where on the website they can navigate to the updated brochure.

Custodial fees. The Committees request that a proposal requiring investment advisers to disclose their custodial fees to clients take into account those cases where a client enters into an agreement with a custodian unaffiliated with the client's investment adviser, in which case the investment adviser would be unaware of the fee. The Committees recommend that investment advisers only be required to disclose custodial fees when they, themselves, have entered into a custodial agreement with their clients and/or have discretionary authority to hire the custodian.

Custody of client funds. The Committees believe that Item 15A in the Form ADV instructions is unnecessary in its requiring an investment adviser to disclose certain additional risks as defined in rule 206(4)-2 of the Investment Advisers Act of 1940 if the adviser has custody of it's clients' funds and the adviser, rather than the custodian, sends the clients the required account statements. The Committees emphasize the already existing safeguards contained in rule 206(4)-2, including a mandate that an adviser must arrange its own surprise audit with an independent public accountant if it, rather than the custodian, sends the quarterly account statements to the clients.

Disciplinary information and Rule 206(4)-4. The Committees ask that the term "currently material" be eliminated from proposed Item 9 of the Form ADV instructions pertaining to disclosure of disciplinary events, to avoid having to distinguish between an event that is "within the 10-year cut-off but not material" from one that is "after the 10-year cut-off but not currently material." The Committees believe the test should be whether an event is material to a client's or prospective client's evaluation of the investment adviser, regardless of whether the event is on the list or whether or not it occurred within the past 10 years. Also, proposed Item 9 states that the 10-year period for disclosing disciplinary violations begins at the time a final order, judgment or decree is issued against the investment adviser or at the time an appeal of a preliminary order, judgment or decree has lapsed. The Committees request that proposed Item 9 also contain the much more unlikely situation, that if a final order, judgment or decree is not issued, the 10-year period for disclosing the disciplinary violation begins at the time proceedings are instituted against the investment adviser. Lastly, the Committees believe Rule 206(4)-4 should be amended to continue to require only the delivery of disciplinary information to clients for whom the brochure delivery requirements do not apply.