Wednesday, January 19, 2011

New Form ADV Rules for Registered Investment Advisers

On July 28, 2010, the Securities and Exchange Commission (“SEC”) amended Part 2 of Form ADV and certain rules under the Investment Advisers Act of 1940 to require registered investment advisers (“RIAs”) to provide clients with a brochure and brochure supplements written in plain English. See Final Release

Starting in in the summer of 2011, RIA’s clients will receive new and more extensive disclosure. According to the SEC, currently in the United States there are more than 11,000 RIAs that manage more than $38 trillion for more than 14 million clients. 81% of RIAs have 10 or fewer advisors. Over 65% have five or fewer advisors. The new rules are warranted. RIAs owe fiduciary duties to their clients and clients have to receive sufficient information about the RIAs (their affiliates, compensation, disciplinary actions, etc.) to be able to make informed decisions when choosing an adviser.

Form ADV has two parts. Part 1(A and B) is used to register RIAs with state and federal authorities. Part 2A contains the requirements for the disclosure “brochure” that advisers must provide to prospective clients initially and to existing clients annually, and Part 2B contains information about the advisory personnel providing clients with investment advice.

Part 2A contains 18 disclosure items about the advisory firm itself. It is now required to be provided in narrative form in a specified format rather than “check the box” format. There need to be headings and narrative answers with respect to each of the 18 items. Much of the disclosure required in Part 2A addresses RIA’s conflicts of interest with its clients. Importantly, new Item 8 requires that advisers describe their investment strategies and how strategies involving frequent trading can affect portfolio performance, as well as the material risks involved with each significant investment strategy. There are concerns that such disclosure requirement may cause some RIAs to lose their competitive advantage.

Part 2B contains six items and focuses on disclosure regarding supervisory personnel of the RIAs, including their educational and professional background, disciplinary actions, and other substantial business activities. The disclosure is made more meaningful given that the clients will receive information about specifically those supervisors who formulate their investment advice, have direct client contact with them or make discretionary investment decisions for such client’s assets. Unlike Part 2A, Part 2B will not be made publicly available.

Complying with the new rules will not be easy or cheap. The SEC estimates that, on average, a small RIA will spend about 15 hours putting together the initial revised Form ADV, a medium-sized adviser – 97.5 hours, and a large adviser - 1,989 hours. Given that there are more small advisers than large ones, this would average to 36.24 hours per adviser. A small adviser will also have to spend about $3,200 for legal services on Part 2, medium-sized adviser - $4,400 and large adviser - $10,400. It remains to be seen whether these estimates accurately reflect the reality.

On December 28, 2010, the SEC extended the compliance dates for delivering brochure supplements. In particular, all existing RIAs that are registered with the SEC as of year-end 2010 have until July 31, 2011 to begin delivering brochure supplements to new and prospective clients and until September 30, 2011 to deliver brochure supplements to existing clients. New RIAs (that file applications for registration in January-April 2011) have until May 1, 2011 to begin delivering brochure supplements to new and prospective clients and until July 1, 2011 to deliver brochure supplements to existing clients.

As with any new rule, this one strives to preserve a balance between the necessity for additional and more accurate disclosure while not placing undue financial burden on the RIAs. After all, the burden of complying with the new ADV rules will be mostly felt during the first year of compliance, when the brochure and its supplement have to be written from scratch. The following years, advisers will be able to update and supplement the information without having to re-write it (that is, of course, if the disclosure requirements do not change again).

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

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