SEC Adopts Amendments to Form ADV and Advisers Act Books and Records Rule
September 27, 2016
By Fred Burak, CPA
On August 25, 2016, the Securities and Exchange Commission adopted amendments to Form ADV and to Rule 204-2 (books and records rule) under the Investment Advisers Act of 1940 (the “Advisers Act”) (collectively referred to as the “Final Rules”).1 These amendments are intended to improve the depth and quality of information that the SEC and clients receive and to facilitate the SEC’s ability to carry out its risk-based examination program and other risk assessment and monitoring activities. Under the Final Rules, the Form ADV amendments fall into 4 primary categories:
- Increased Disclosure of Separately Managed Accounts (“SMAs”);
- Umbrella Registration of Private Fund Advisers with Multiple Legal Entities, Including Relying Advisers;
- Additional Information Regarding Registered Investment Advisers; and
- Clarifying, Technical and Other Amendments to Form ADV.
The adopted amendments under the Final Rules to the books and records rule under the Advisers Act require advisers to maintain additional records in connection with the calculation and distribution of performance information.
These amendments will become effective October 31, 2016 and investment advisers will need to comply with the amendments beginning October 1, 2017. Therefore, an investment adviser filing an initial Form ADV or an amendment to an existing Form ADV on or after October 1, 2017 will be required to comply and provide responses to the form revisions.
Increased Disclosure of Separately Managed Accounts
Several amendments to Form ADV require investment advisers to report more information about their SMAs. The SEC does not specifically define “separately managed accounts;” however, for purposes of Form ADV amendments, SMAs include accounts other than those that are pooled investment vehicles, including (i) investment companies; (ii) business development companies; and (iii) other pooled investment vehicles that are not registered ( such as private funds ). The amendments require increased reporting of aggregated information related to an investment adviser’s SMAs by adding specific questions in Item 5 of Form ADV with respect to the percentages and types of assets held, the use of derivatives and borrowings, and identification of custodians.
Disclosure of Asset Categories
Section 5.k.(1) of Schedule D of the amended Form ADV will require investment advisers to report the approximate percentage of aggregate SMA regulatory assets under management (“RAUM” ) they advise in 12 broad asset categories:
- Exchange traded equity securities
- Non-exchange traded equity securities
- U.S. government bonds
- U.S. state and local bonds
- Sovereign bonds
- Corporate bonds – investment grade
- Corporate bonds – non-investment grade
- Securities issued by registered investment companies and business development companies
- Securities issued by other pooled investment vehicles
- Cash and cash equivalents
In acknowledging assets could fall into more than one category, the SEC is allowing investment advisers to use their own internal methodologies and the conventions of their service providers to determine how to categorize assets within the 12 identified categories. Advisers’ internal methodologies must be reasonable and consistently applied and consistent with the information the advisers report internally and to current and prospective clients. When reporting SMA asset types, advisers should not “look through” investments in other funds as the SEC wants to evaluate the extent to which SMA assets are invested in funds as well as other types of assets.
Advisers with at least $10 billion in RAUM will report, on an annual basis, both their mid-year and year-end information. Advisers with less than $10 billion in RAUM will report information only as of year-end. Sub-advisers to SMAs are required to provide information only about the portion of the account that they sub-advise.
Disclosure of Derivatives and Borrowings
Under the Final Rules, Section 5.k.(2) of Schedule D of the amended Form ADV will now require advisers with at least $500 million but less than $10 billion in RAUM attributable to SMAs to report the amount of such RAUM and the dollar amount of borrowings attributable to those assets that correspond to 3 levels of gross notional exposures ((a) less than 10%; (b) 10 – 149%; and (c) 150% or more). Gross notional exposure of an account is calculated by dividing the sum of (a) the dollar amount of borrowings and (b) the gross notional value of all derivatives by RAUM of the account. Advisers with at least $10 billion in RAUM attributable to SMA’s will be required to report this information as well as derivative exposures across 6 categories of derivatives:
- Interest rate
- Foreign exchange
An adviser may exclude from the aggregated information any SMA with assets of less than $10 million. To the extent that advisers are concerned that disclosure of gross notional metrics would be misleading, they could provide in Section 5.k.(2) an additional narrative description regarding their use of derivatives in these accounts.
Identification of Custodians
Item 5.K.(3) of the amended Form ADV requires investment advisers to identify any custodians that account for at least 10% of total RAUM attributable to SMAs and disclose the amount of RAUM attributable to SMAs held at each such custodian.
The SEC noted that this information would allow its examination staff to identify advisers whose clients use the same custodian in the event a concern is raised about a particular custodian.
Umbrella Registration of Private Fund Advisers
The amended Form ADV codifies SEC no-action relief granted in 2012 addressing umbrella registration of advisers whereby a registered investment adviser (i.e., the “filing adviser”) would be permitted to file a single Form ADV on behalf of itself and other investment advisers that were controlled by or under common control with the filing adviser (each, a “relying adviser”), provided that all the investment advisers conducted a single advisory business. The SEC has stated that it considers the following factors to be indicia of a single advisory business: (a) commonality of advisory services and clients, (b) a consistent application of the Advisers Act and the rules thereunder to all advisers in the business and (c) a unified compliance program.
The amendments to Form ADV’s instructions establish conditions for an adviser to assess whether umbrella registration is available in line with the 2012 no-action relief. The conditions stated in the Final Rules include:
- The filing adviser and each relying adviser advise only private funds and clients in SMAs that are qualified clients (as defined in rule 205-3 under the Advisers Act) and are otherwise eligible to invest in private funds advised by the filing adviser or a relying adviser and whose accounts pursue investment objectives and strategies that are substantially similar or otherwise related to those private funds. The SEC made clear in the Final Rules that this condition would limit eligibility of Umbrella Registration to private fund advisers with a commonality of advisory services and clients.
- The filing adviser has its principal office and place of business in the United States and, therefore, all of the substantive provisions of the Advisers Act and the rules thereunder apply to the filing adviser’s and each relying adviser’s dealings with each of its clients, regardless of whether any client or any filing adviser or relying adviser providing the advice is a United States person.
- Each relying adviser, its employees and the persons acting on its behalf are subject to the filing adviser’s supervision and control.
- The advisory activities of each relying adviser are subject to the Advisers Act and the rules thereunder, and each relying adviser is subject to examination by the SEC.
- The filing adviser and each relying adviser operate under a single Code of Ethics adopted in accordance with Rule 204A-1 under the Adviser’s Act and a single set of written policies and procedures adopted and implemented in accordance with Rule 206(4)-(7) under the Advisers Act and administered by a single chief compliance officer (“CCO”) in accordance with that rule.
With respect to the aforementioned conductions, the SEC noted in the Final Rules that conditions 2 and 4 are designed to aid Commission staff in examining filing advisers and relying advisers with the understanding that the Advisers Act and its rules fully apply to all advisers and clients under the umbrella registration. The Final Rules also note that conditions 3 and 5 are designed to fulfill the requirement that the filing adviser and relying advisers are governed by a unified compliance program.
The revisions to the instructions to Form ADV also specify those questions that should be answered solely with respect to the filing adviser and those that require the filing adviser to answer on behalf of itself and its relying advisers. The filing adviser will need to complete a new schedule R to Part 1A of Form ADV for each relying adviser. Schedule R requests the following information: (a) identifying information, (b) basis for SEC registration, (c) form of organization and (d) control persons and information regarding the relying adviser’s owners and executive officers. Additionally, a filing adviser must distinguish whether it or any of its relying advisers manage or sponsor the private funds that are reported in Section 7.B.(1) of Schedule D on Form ADV.
Additional Information Regarding Registered Investment Advisers
The SEC has also adopted several other amendments to Form ADV to require advisers to disclose potentially significant amounts of information, including:
- All of its Central Index Key (“CIK” ) numbers regardless of public reporting status;
- All websites and publicly available social media platforms used to promote the adviser’s business and for which it controls the content ( e.g. Twitter, Facebook, LinkedIn );
- The total number of offices at which they conduct investment advisory business. For each of an adviser’s 25 largest offices, as measured by the number of employees, additional information must be reported about each office including (a) each office’s Central Registration Depository (“CRD”) branch number; (b) number of employees who perform advisory functions from each office; (c) securities-related business activities conducted from each office; and (d) a description of any other investment-related business conducted from each office
- Whether an adviser’s CCO is compensated or employed by any person other than the adviser or a related person of the adviser (unless it is a registered investment company advised by the adviser), and if so, the name and IRS employer identification number, if any, of that person. This data seeks to provide identification of outsourced CCOs.
- The adviser’s own assets (as distinguished from assets under management) within 3 ranges: (a) $1 billion to less than $10 billion; (b) $10 billion to less than $50 billion; and (c) $50 billion or more
- The number of clients (or if fewer than 5 clients, that fact) and the amount of RAUM attributable to each category of clients in Item 5 of Form ADV. In addition, an adviser must report the number of clients for which it provides advisory services even where the client’s assets are not part of the adviser’s RAUM. To the extent that an adviser is a sub-adviser to a registered investment company, business development company, or pooled investment vehicle, it should include in Item 5 those sub-advised assets as well;
- The approximate amount of their total RAUM attributable to non-U.S. clients;
- The RAUM of all parallel managed accounts related to a registered investment company or business development company that they advise. A parallel managed account is considered to be any managed account or other pool of assets that the adviser advises that pursues substantially the same investment objective and strategy and invests side-by-side in substantially the same positions as the identified registered investment company or business development company that they advise;
- Whether the adviser participates in a wrap-fee program, and if so, the total amount of RAUM attributable to acting as a sponsor to or portfolio manager for a wrap-fee program. Advisers must provide any SEC file number and CRD number for sponsors to those wrap-fee programs for which the adviser serves as portfolio manager;
- If an adviser to a private fund that qualifies for the exclusion from the definition of investment company under section 3(c )(1) of the Investment Company Act of 1940, whether it limits sales of such fund to qualified clients as defined in Rule 205-3 under the Advisers Act; and
- The Public Company Accounting Oversight Board (“PCAOB”) assigned number of the auditor of a private fund, if applicable.
Each of the aforementioned items is designed to provide the SEC greater clarity on certain aspects of the adviser’s business. These aspects, which likely will be reviewed during an examination, include: (a) social media practices; (b) business activities outside the main office (including non-U.S. offices); (c) CCO outsourcing (if any); (d) number of clients and distribution of RAUM across client type; (e) RAUM outside the U.S.; (f) RAUM for mutual funds or business development companies; (g) participation in wrap-fee programs; (h) sale of private funds to entities other than accredited investors or qualified purchasers, or possible use of the general solicitation practices; and (i) identification of accountants for private funds as PCAOB-registered.
Clarifying, Technical and other Amendments to Form ADV
The SEC also adopted several other technical and clarifying amendments to Form ADV. Advisers should read the form instructions carefully to ensure that their answers are consistent with the amended form and instructions. Two significant clarifying changes to section 7.B.(1) of Schedule D relate to solicitation of an investment adviser’s clients and audited financial statements:
- Advisers should not consider feeder funds as “clients” when answering question 19 as to whether the adviser’s clients are solicited to invest in the private fund; and
- Question 23(g) has been revised to ask if the fund’s audited financial statements are distributed to the private fund’s investors for the most recently completed fiscal year. Question 23(h) has been revised to ask if the report prepared by the auditing firm contains an unqualified opinion since the date of the adviser’s last annual updating amendment.
Advisers Act Books and Records Rule Amendments
The SEC adopted amendments to Rule 204-2 which will require advisers to maintain additional written materials related to the calculation and distribution of performance information:
- The amendments to Rule 204-2(a)(16) of the Advisers Act will now require advisers to maintain the materials listed in such rule that demonstrate the calculation of the performance or rate of return in any communication that the adviser circulates or distributes, directly or indirectly, to any person. Previously, advisers were only required to maintain records supporting performance claims that were distributed to 10 or more persons; and
- The amendments to Rule 204-2(a)(7) of the Adviser’s Act will now require advisers to maintain originals of all written communications received and copies of written communications sent by an investment adviser relating to the performance or rate of return of any or all managed accounts or securities recommendations. The SEC considers emails to be written communications for purposes of the rule.
Investment advisers will need to comply with the updated books and records rule with respect to any communications or materials that are circulated or distributed after October 1, 2017 that includes performance information, including information on performance that that predates the effective date of these amendments.
Business practices and organization structure will largely determine the extent of additional disclosures on the Form ADV. When combined with the amended books and records rule, all advisers will likely require updates to their compliance manuals to account for these amendments. As such, investment advisers are advised to conduct a thorough review of their organizations to ensure effective compliance with the Final Rules.