NEW FORM ADV PROPOSED; 
ELECTRONIC FILING TO BECOME MANDATORY





May 8, 2000

The Securities and Exchange Commission (SEC) recently released its proposal for revisions to Form ADV and for an electronic filing system under which investment advisers will file the revised Form ADV electronically. Among the reasons advanced by the SEC for revamping the investment adviser registration process are (i) the desire to take advantage of technological developments and to improve the quality of information provided to clients and prospective clients and (ii) the need to have the system conform to the dual SEC-State registration system created by recent regulatory changes stemming from the adoption of the National Securities Markets Improvement Act of 1996 (NSMIA). 

The new filing system, called the Investment Adviser Registration Depository (IARD), will eventually permit investment advisers to satisfy their filing obligations with both the SEC and the state securities commissions in a single electronic filing. All of the information filed with the IARD will be made available to the public free of charge via an Internet web site. The IARD is being modeled after the Central Registration Depository (CRD) currently used by broker dealers to make their filings with the SEC, state securities commissions and NASD Regulation, Inc. (NASDR). Like the CRD, the IARD will be operated by NASDR. 

Among the changes being proposed for Form ADV are:

o     the replacement of the current "brochure" consisting of Part II and Schedule F of the existing Form ADV by a narrative brochure written in plain English;

o     the addition of information required by state securities regulators (which will be completed exclusively by state registered investment advisers); and 

o     disclosure requirements for a wider group of advisory personnel.

THE INVESTMENT ADVISER REGISTRATION DEPOSITORY

The key benefits espoused by the SEC in proposing the IARD are the ease with which investment advisers will be able to apply for registration, amend active registrations, and withdraw from registration using desktop computers without specialized equipment or software. The system will also permit SEC registered advisers to send their periodic "notice filings" to the state securities commissions and pay state filing fees through the IARD. After obtaining an IARD user name and password from NASDR (utilizing a paper request), anyone wishing to register as an investment adviser will be able to access the new Form ADV online. He will then have the option of completing it online or saving a partially completed draft of the Form. The SEC contends that the new Form ADV will be a smart form. An interactive process of completing the Form will filter out questions that are not relevant to the particular applicant. Thus, an adviser indicating that he is applying for SEC registration will not see the items that relate solely to state registrations. Allegedly, the Form will also identify inconsistent responses and prevent a form containing errors from being filed.

The IARD is anticipated to begin receiving electronic filings towards the end of the year 2000. However, the SEC anticipates that the system will be "rolled out" in four separate releases as follows: 

o     SEC registered advisers and applicants for SEC registration will be the first to use the system for the purpose of filing Part 1 of the new Form ADV and submitting notice filings to state securities commissions.

o     NASDR will release the internet-accessible public disclosure system a few months after the first IARD filings have been made.

o     NASDR will release the investment adviser representative licensing system administered by the state securities commissions. 

o     Lastly, the IARD will accept Part 2A of Form ADV, the new plain English brochure. 
Advisers using the IARD will be required to establish an account with NASDR and to maintain sufficient funds in the account to pay IARD filing fees (which are anticipated to range from $200 to $400 per year), as well as the fees of the various state securities commissions to which they submit filings. 

The SEC has announced that it will publish a schedule of dates by which all currently registered investment advisers will be required to resubmit Form ADV in the electronic format for posting on the IARD. Although the SEC anticipates that most state securities commissions will be on board at the appropriate time, some state securities commissions will not be able to join the system until they receive legislative authority to require advisers to file through the IARD. The final part of IARD implementation, the acceptance of Part 2A, has not yet been designed. The SEC has stated, however, that investment advisers will be able to prepare their "Brochures" using any word processor and transmit the file to the IARD without special processing.

PROPOSED REVISIONS TO FORM ADV

The existing Form ADV consists of two parts. Part I asks for information to be supplied by responding to fill-in-the-blank, multiple choice or check-the-box type questions. The information solicited has to do with the adviser's business, the persons who own or control the advisory firm, and whether the adviser or certain members of its key personnel have ever been sanctioned for violating securities laws or similar laws embodying concepts relating to integrity. Part I is used by the SEC principally to decide whether or not an application for registration should be approved or whether an effective registration should be revoked.

Part II of existing Form ADV addresses particular business practices engaged in by the adviser, fees that the adviser may charge, and conflicts of interest that an adviser may face while providing money management services. Part II (supplemented by Schedule F), or a written brochure containing the same information, must be delivered to a prospective client before an investment adviser enters into an arrangement with the client. In addition Part II must be offered to every client at least annually. The proposals incorporate substantial revisions to Form ADV, including the redrafting of items in simpler, plainer language. 

PART 1

Part I of the current Form ADV will be replaced by Part 1 of the revised Form ADV. As a result of the adoption of NSMIA and the withdrawal from Federal registration of most investment advisers managing less than $25 million in assets, the majority of advisers in the United States are now registered exclusively with the states rather than with the SEC. As a consequence, the new Part 1 will consist of two Subparts. All advisers will complete Part 1A, but only state registered advisers will complete Part 1B.

Part 1A. Part 1A will be similar to existing Part I. It will ask for information through a series of fill-in-the-blank, multiple choice and check the box questions. The principal differences between the proposed Part 1A and the existing Part I are the following:

o     Identifying Information. The new Form will ask for an adviser's CRD number (if any), any web site addresses and e-mail addresses the adviser uses, as well as the adviser's fax number. 

o     Educational and Business Background. The often redundant incorporation of this information in both Part I and Schedule F of Part II in the existing Form ADV will be eliminated. Educational and business background information will appear exclusively in the adviser's brochure and brochure supplements.

o     Disciplinary Proceedings. All questions will be limited to events occurring during the past ten years and will require separate forms called Disciplinary Reporting Pages (DRPs) for reporting the details of (a) criminal proceedings, (b) civil proceedings, and (c) regulatory proceedings. Other minor revisions are anticipated.

o     Control Person Disclosure. Indirect ownership interests of less than 25% will no longer have to be disclosed.

o     Small Businesses. A new question will be added to identify whether an adviser is a small business. Only those SEC registered advisers with less than $25 million of assets under management (a very small number) will respond to this item. 

o     Schedule A, B, C. All three of these schedules will be eliminated.

Part 1B. Part 1B has been designed by the North American Securities Administrators Association (NASAA) on behalf of the several state securities commissions. It will be completed exclusively by investment advisers who are not SEC registered. Part 1B will solicit information about bonding, arbitration actions, other civil and regulatory actions, and whether sole proprietors have satisfied certain qualifying examination requirements or obtained certain professional designations. 

PART 2

Part II of the current version of Form ADV, which most advisers deliver to their clients to satisfy the SEC's "brochure rule," has long been recognized to be a less than ideal vehicle for the communication of meaningful information to clients. Its combination of fill-in-the-blank, multiple choice and check-the-box questions supported by narrative disclosure in a separate Schedule F has never been a model of clarity. For example, the check-the-box approach to disclosure of an investment adviser's available trading strategies provides no insight into the ways an investment adviser actually employs any one or more of the trading strategies. An adviser can check all of the boxes without indicating to what extent any particular strategy is more or less important than others. Similarly, Part II asks for information only about an advisory firm, its principal executive officers and the members of its investment committee, if any. In larger advisory firms information about the individual employees who actually service client accounts may never be revealed to clients. 

Although Part 2 of the revised, electronic Form ADV will specify what disclosure will be required in the brochure, advisers will be free to structure the disclosure and order the topics in whatever manners they choose. Existing Schedule H to Form ADV, regarding wrap fee programs, is an example of this format. An unannounced benefit of an electronic brochure is the flexibility is will provide investment advisers in delivering their brochures to clients and prospective clients. So long as an investment adviser complies with the SEC's guidelines for the delivery of disclosure documents through electronic media, paper delivery will not be required. Those advisers who have not already done so, will be well advised to begin preparing an e-mail address directory for their clients. Appropriate security precautions should, of course, be implemented.

Part 2 will also be broken down into two Subparts. Part 2A will contain the requirements for the firm brochure and Part 2B will contain requirements for brochure supplements. Under the proposal, a brochure supplement will be required for each individual employee rendering investment advice for a firm (a "supervised person"). Unlike the firm brochure, which must be delivered to all clients, the brochure supplements will only need to be delivered to the clients for whom the supervised person described in the supplement is rendering services. 

Part 2A (Firm Brochure). As is the case under the existing brochure rule, each adviser will be required to deliver a copy of the firm brochure to a prospective client prior to establishing an advisory relationship and to offer to deliver the brochure annually. A transition rule will cover the change over from existing Part II to the revised Part 2A during the first "roll out" phase of the IARD. Two notable differences will exist under the revised brochure rule, one of which is of particular significance to general partners of investment limited partnerships. Under the proposed new rule, an adviser acting as the general partner for an investment limited partnership will have to provide a copy of the firm brochure and an annual offer to each and every limited partner. 

Analogizing to the information mutual fund shareholders receive, the SEC will also require that brochures be updated whenever any of the information in them becomes materially incorrect. In addition each brochure update will have to be delivered to each client (including limited partners) as changes occur. Again, borrowing from the concept of a mutual fund prospectus, these updates may be provided either as reprinted brochures or as "stickers." Investment advisers who deliver brochures electronically will also be able to deliver electronic stickers. As currently proposed, however, a brochure would have to be reprinted in its entirety at least annually.

Part 2A of the electronic Form ADV will consist of nineteen separate items covering nineteen distinct topics. The information will be largely the same as in the current Part II but the questions will be redrafted to reflect the narrative format required by the new brochure. Items that will be new or substantially revised include the following:

o  A cover page containing basic information about the adviser such as name, address, web site address and telephone number will be mandatory. The cover will have to state that the brochure has not been approved by the SEC or any state securities authority and that registration does not imply that the adviser has attained any particular level of skill or training.

o  Every brochure will have to contain a detailed table of contents and a summary of material changes since the last annual update of the brochure. The summary will appear either on the cover page or immediately behind it or in a separate letter to existing clients that would accompany each new brochure.

o  A description of advisory fees and other compensation the investment adviser will receive and any fund expenses client may have to pay will continue to be required, but under the proposals investment advisers will also have to describe all other fees that a client may be charged in connection with the management of its accounts, including brokerage and custody fees. 

Advisers who charge management fees in advance will have to provide an explanation of how they will refund fees if a client contract terminates before the end of a fee period. Advisers who receive commissions or other transaction based compensation will be required to disclose all of the conflicts of interest associated with that practice and to describe their firm's control procedures. 

The SEC has asked for comment as to whether disclosure of the conflict of interest inherent in charging a performance fee should be mandated. 

o  A narrative description of the firm's methods of analysis, investment strategies and sources of information will replace the current check-the-box disclosure. New to Form ADV will be required disclosure of (i) the effect that the costs of high turnover (if relevant) have on investment performance and (ii) the risk factors associated with the investment adviser's advice. The new disclosure will have to be tailored to the particular investment strategies and analytical methods employed by each advisory firm.

o  Information about the disciplinary history and integrity of an advisory firm and its management is being moved from Part I of the current Form ADV to the revised brochure, and is being expanded. In addition, if an advisory firm or management person is subject to an SEC administrative order, the firm will be required to deliver a copy of that order to every client and prospective client for a period of one year following the date of the order. Disciplinary information requirements for other individuals appear in Part 2B discussed below. 

The SEC has asked for comment as to whether disciplinary history information should appear in a separate written document apart from the brochure as a means of emphasizing the significance of the information when communicating it to clients. The SEC has also asked for comment as to whether certain kinds of arbitration liability should be included with the disclosure on disciplinary proceedings. Because so many securities law-related disputes are resolved through arbitration and, thus, never cross the existing threshold for mandatory disclosure, the state securities authorities are adopting a rule requiring this kind of information if an arbitration claim exceeds $2,500.00. 

o    The conflicts of interest faced when an investment adviser or any related person has a financial interest in securities that are recommended to clients will have to be disclosed under the proposal. The new requirements will include an obligation to disclose "practices giving rise to these conflicts, the nature of the conflicts presented, and any procedures and controls the adviser uses to address the conflict." Thus, a firm's policies designed to prevent front running, scalping and other abuses will have to appear in the new Form ADV. At a minimum, firms will have to provide a summary description of their trading policies and codes of ethics. 

o     As now, a description of an advisory firm's policies and practices in selecting brokers for client transactions and in determining the reasonableness of brokers compensation, including soft dollar practices, will be required. The electronic Form ADV, however, will include a more detailed list of specific disclosure requirements. Among other things, a detailed description of products or services received that are not used in the investment decision-making process and a discussion of practices such as "bunching" transactions, rewarding brokers with commission business in exchange for client referrals, adviser initiated directed brokerage arrangements, and any available commission recapture programs, will become mandatory. All related conflicts of interest will also have to be disclosed.

o     Proxy voting policies will have to be disclosed for the first time. Included in this item will be disclosure regarding an adviser's voting policies, practices and procedures (i.e., how it votes portfolio proxies and what process it uses to determine how it will vote). Because the SEC is concerned that a conflict of interest may exist if, for example, fund advisers vote to please company directors in order to get or retain corporate pension fund business management, any potential conflicts of interest that an adviser may have with respect to a shareholder vote will also have to be disclosed. If an adviser does not vote client proxies, that adviser will be required to explain how clients will receive proxies and whether the client can discuss voting issues with the investment adviser. 

o     If an adviser advertises or reports investment performance, the standards employed to calculate or present performance information will have to be described. The "standards" concept may include proprietary standards in addition to industry standards. Additional disclosure will include whether or not any third party reviews the adviser's performance information, either for accuracy or for compliance with applicable standards. This information has been required in the past only with respect to wrap fee programs.

o     The brochure filed with the SEC will have to include an index of the items required by Part 2A. This is similar to the index Schedule H now requires and may resemble the cross reference sheet required for registration statements filed under the Securities Act of 1933..

o     Appendix 1: The revised Form ADV will include wrap fee program disclosure in a separate "wrap brochure" that would substitute for the sponsor's standard firm brochure. The wrap brochure will include ten items of information substantially similar to what is currently asked for in Schedule H. 

Part 2B (Brochure Supplements). Part 2B will describe the requirements for "brochure supplements" that will provide information regarding an advisory firm's "supervised persons." This is a broader requirement than the existing obligation to provide information about executive officers and members of a firm's investment committee because the term supervised persons includes all of an advisory firm's officers, directors or partners (or others performing similar functions) and all employees and others who provide investment advice on behalf of the firm.

Each supplement will contain the same background information called for by Part 2A for management persons. Firms will have the option of providing all Part 2B information in their firm brochures and avoiding the use of brochure supplements altogether. Smaller investment advisers, in particular, may find this extremely helpful. Firms that elect to prepare brochure supplements will only be required to give a client the supplement providing information about the particular supervised person who will provide advisory services to that client. The brochure supplements are anticipated not to exceed a page in length and are expected to be delivered with the firm brochure in the same way that a resume would be provided. The delivery requirements for the brochure supplement will be the same as those for the firm brochure. 

Brochure supplements will not be filed through the IARD, or even with the SEC. They will need to be retained by the advisory firm for review by SEC examiners, however. An individual's disciplinary history will be available through the IARD in any event because it will be included in the DRPs included with Part 1 of the new Form ADV.

Part 2B will include the following seven categories of information:

1.     A cover page identifying the supervised person and the firm;

2.     The educational and business background of the supervised person for the past five years (professional designations or achievements will also be disclosed);

3.     The supervised person's disciplinary history (any new disciplinary information will have to be easily identifiable in each update of the brochure supplement, and may have to appear on its cover);

4.     A description of the supervised person's other business activities, especially those involving participation in financial markets (as is the case for the firm brochure, the potential for conflicts of interest must be addressed, especially if the supervised person receives commissions or other transaction based compensation, including bonuses and non-cash compensation); 

5.     Whether the supervised person receives compensation or any other economic benefit from someone other than a client;

6.     Identification of the individuals who formulate the investment advice that the supervised person will be giving to clients or, if the supervised person formulates advice for clients, a description of how the firm monitors the advice provided, along with the name, title, and telephone number of the person who supervises the supervised person having contact with the client; and 

7.     If the individual was to subject to a bankruptcy petition during the past ten years, a statement to that effect.


* * * * * *

It is anticipated that some firms will develop different brochures for different clients in order to keep all of the information in any brochure delivered to a client relevant to that client. Brochure supplements covering groups of supervised persons will also be permitted although the SEC has requested comments on how to disciplinary information updates should be provided in the context of a group brochure supplement.

The SEC has requested comments on all aspects of the proposal, not only the items referenced in this advisory. Comments will be accepted until June 13, 2000. Some firms have already requested that the SEC provide guidance as to how to prepare the new firm brochure. The SEC staff, however, does not want firms imitating its work, but rather to develop individualized disclosure documents. The SEC does plan to respond to written questions later in the year.

Hedge fund managers may note an overall similarity between the disclosure requirements of the new brochure rule and the content of those sections of a hedge fund's confidential private offering memorandum that describe the hedge fund's investment manager or its general partner. Much of the newly mandatory disclosure consists of information that hedge fund offering memoranda have always disclosed to prospective investors. In fact, although a hedge fund's offering memorandum is a document used principally to market interests in the hedge fund, many such documents do in fact market the skill and expertise of the hedge fund's investment advisers as well. In developing a narrative brochure, it may be well to consider the document as a new type of offering memorandum designed to market an investment adviser's services rather than an investment in a hedge fund.

 

If you would like further information about investment adviser registration requirements or to discuss other issues relating to hedge funds and their investment managers, contact Howard A. Neuman at (212) 818-9200 or visit the Satterlee Stephens Burke & Burke LLP Website at:

To take action on any of the information contained in this report, you should seek professional advice.

For more information, please contact Howard Neuman in the firm's New York office at (212)818-9200.

 

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