The New Form ADV Part 2: Convergence of ERISA and Securities Law Disclosure

This is one of a series of Bulletins about the convergence of employee benefits and securities law and its impact on our clients. This Bulletin will generally discuss the new Form ADV Part 2 disclosure rules, and point out a few items of interest to those investment advisers with ERISA clients. It is critical for financial service providers to the retirement plan industry as well as plan fiduciaries, to understand and integrate both bodies of law.  The SEC and DOL continue to promulgate far-reaching proposed or final rules1 that address common questions such as: What are the critical components of requisite disclosure? When must disclosures be provided? By whom and to who are disclosures made? What are the consequences for failure to satisfy disclosure obligations?

Form ADV Part 2 (“Part 2,” previously known as Part II) has long served as the basis for disclosure required under the Act by registered investment advisers (“RIA”), as well as a convenient vehicle for additional disclosures made voluntarily or pursuant to other laws. This Bulletin will highlight some of the key areas under the SEC final rule2 (“Final Rule”) that creates a new Part 2 and amends related rules under the Act for items such as filing and delivery. The Final Rule significantly changes the way an RIA provides disclosures to both clients and the general public – a “game changer” in several respects. The Final Rule is intended to provide more transparency for clients, and facilitate the comparison of multiple investment advisers. Shifting from a “check the box” to written narrative format, while maintaining a compliant and effective disclosure document, is going to be a challenge for many RIAs.

Our clients with ERISA advisory relationships will also have to consider the practical effect of coordinating ERISA and Act disclosures. For one thing, RIAs need to determine if Part 2 is to be used for delivering ERISA disclosures, rather than other documents. In some instances, Part 2 disclosure tracks similar ERISA disclosure obligations, such as the DOL Interim Final Regulation for Section 408(b) (2) (the “Interim Final”). In other cases, Part 2 and ERISA require disclosure of discrete categories of information. For example, the Final Rule requires the RIA to describe the nature of various conflicts rising from participation or interests in client transactions, and how it addresses such conflicts. The DOL has moved away from this specific requirement in the Interim Final, intending to now identify and raise conflicts of interest through a more limited, but focused, discussion of direct and indirect compensation received by plan service providers.

Background

Since 2000, the SEC has issued and considered several proposals for change to the old Form ADV Part II and related Act rules. The Final Rule, effective this past October, creates the new Part 2 that contains three separate documents:

• Part 2A: Commonly referred to as the “Brochure;” it replaces the old Part II and Schedule F.
• Part 2A, Appendix 1: The “Wrap Brochure;” it is used solely for Wrap Fee Programs and replaces Schedule H.
• Part 2B: The “Supplement;” it contains relevant biographical and disciplinary information of certain “supervised persons.”

Summary of Major Changes

• The nature of the RIA’s business structure and relationships, along with information about fees, services, conflicts of interest, methods of analysis and investment strategies and risks of loses, brokerage practices, and other significant matters such as disciplinary history and financial condition, are now required to be presented in the Brochure in a sequenced order and written in “plain English” - a narrative form intended for the client to make an informed decision about hiring the RIA and managing that relationship. Sequencing will allow clients to compare RIA firms more efficiently. A Brochure will contain up to 18 separate disclosure items.
• The Wrap Brochure carries over many disclosure items from Schedule H, and contains many of the same changes as the Brochure. These changes include the requirement for the RIA to identify whether any related persons are portfolio managers and if so, to identify conflicts of interest and how they are addressed. RIAs must also disclose whether related portfolio managers are subject to the same selection and review criteria as other portfolio managers and if not, to explain how the related portfolio managers are selected.
• Electronic filing of Brochure and Wrap Brochure in PDF format is now required with the SEC—a major change, thus making it available to the public at large. Previously only Form ADV Part 1A was required to be filed. Interestingly, an RIA with distinct lines of service or clients may continue to maintain a separate Brochure. For example an RIA may want to use a separate Brochure for its retirement plan business than is used for its wealth management platform or financial planning services to individual retail clients. The development of a separate Brochure for retirement plan business, though not required, will provide a convenient way to address the ERISA disclosure rules and describe ERISA specific services using special definitions such as “fiduciary” or “education” that are easily confused with other investment advisory service platforms.

Many of our clients are beginning to use “Retirement Plan Services” as the basis for a Brochure unique to ERISA and other retirement plan clients, with separate Brochures for other lines of business. Special care must be given to track the preparation, update, filing, and delivery of each Brochure maintained by a single RIA.

• The Final Rule requires an RIA whose Brochure has materially changed since the last annual updating amendment to deliver to each of its clients (unless otherwise excepted3) within 120 days after the end of the fiscal year either (i) a current amended Brochure which includes a Material Changes Summary, or (ii) a separate document containing the Material Changes Summary and an offer to provide the relevant amended Brochure without charge.

Compare this with the Interim Final, which requires ERISA service providers to provide notice of “any” change to required information, rather than only a “material” change.

Under the prior rules, an RIA was required only to offer a revised Brochure within 90 days after the end of the fiscal year but was not required to notify clients about the changes or highlight the changes in the updated Brochure, even if it was provided. The Final Rule thus mandates that substantive disclosure information will be delivered annually. Interim delivery of an updated Brochure or notification of changes to disclosures is required only with regard to disciplinary events. As before, the use of electronic media such as email or website access is permissible provided that SEC guidelines or relevant law is satisfied.

A note of caution: When a change or event is subject to any disclosure requirement of Part 2, the RIA must always consider whether it should nonetheless be disclosed sooner, and perhaps through alternative means.

Affirmative disclosure obligations may arise under a separate duty under the Act, or under another law such as ERISA or state law.

Similarly, when a matter does not fall under the Part 2 disclosure regime, the RIA must still consider whether it has a duty to disclose the information under another aspect of the Act, another law, or simply on a voluntary basis to reflect best investment practices.

Clients are no longer required to receive a 5 day termination right, without penalty, if the Brochure is not delivered at least 48 hours in advance of entering into the advisory agreement. The Final Rule obligates the RIA to deliver a current Brochure to any client before or at the time the RIA enters into the advisory agreement with the client.
This is less stringent than the Interim Final counterpart for disclosures, which must be made “reasonably in advance of the date the contract or arrangement for services with the plan is entered into.”

Both ERISA and the Act still require that, upon termination of an advisory agreement, the final accounting of fees should be pro rata. In other words, any unearned fee based on advance payment should be returned, and conversely, any fees paid in arrears should be prorated accordingly.

• Supplements containing up to six disclosure items, must be prepared with respect to each “supervised person” of the RIA upon whom the client receiving the Brochure relies on for investment advice. This means that Supplements must only discuss personnel who formulate investment advice for and have direct contact with the client, or make discretionary investment decisions if there is no direct client contact. Biographical information of principal executives, traditionally set out in the old Schedule F, is no longer relevant for the most part. The Supplement does not need to be filed with the SEC, unlike the Brochure or Wrap Brochure. Each RIA must maintain and deliver a Supplement to new clients, and make it available from its records to the SEC upon request. State registered investment advisers will generally have to file electronically a copy of the Supplement for each supervised person doing business in that state. There is no requirement to deliver an updated Supplement to a client that has already received a Supplement unless there have been material changes to relevant disciplinary information.
• RIAs must consider the transitional rules for compliance with the Final Rule, as they are fast approaching. An RIA that first applies for SEC registration after January 1, 2011 must, upon registration, deliver to existing and prospective clients the Brochure. An RIA that is previously registered, with a fiscal year ending on or after December 31, 2010, must deliver to each existing client the Brochure within 60 days of filing its first annual updating amendment. For example, an RIA whose fiscal year end is December 31, 2010, will be required to deliver the Brochure to existing clients by May 31, 2011 (60 days following its deadline for its first annual updating amendment); and starting on March 31, 2011 it must deliver the Brochure to new and prospective clients.
• The SEC has just announced an extension, in response to industry concerns, for compliance dates with regard to the delivery of the Supplement5. (This does not extend the compliance dates for filing and delivery of the Brochure.) All investment advisers registered with the SEC as of December 31, 2010, and having a fiscal year ending on December 31, 2010, through April 30, 2011, have until July 31, 2011, to begin delivering Supplements to new and prospective clients, and until September 30, 2011, to deliver Supplements to existing clients. All newly registered investment advisers filing their applications for registration from January 1, 2011, through April 30, 2011, have until May 1, 2011, to begin delivering Supplements to new and prospective clients, and until July 1, 2011, to deliver Supplements to existing clients. The compliance dates for delivering Supplements for existing registered investment advisers with fiscal years ending after April 30, 2011, and for newly-registered investment advisers filing applications for registration after April 30, 2011, remain unchanged. Where possible, we are advising RIA clients to prepare the Supplement information and attach it to the Brochure, in order to avoid a regulatory calendar that calls for different compliance dates between the Brochure and the Supplement.

Part 2A Disclosure6 - Some Observations

Part 2 disclosures must follow a prescribed order. If an item is not relevant, the RIA must specifically state that the item is not applicable to the RIA’s business. “Plain English” is required to take into account the client level of financial sophistication and should use short sentences, everyday words, and the active voice. Certain items not expressly required for Part 2 disclosure may nonetheless be provided if the RIA feels it is a reflection of best practices or is required under another regulatory standard.

• Cover Page: Must include a disclaimer that “registered” status does not imply a level of expertise.
• Advisory Business (Item 4): The RIA must provide a description of its advisory business that includes the types of services offered, and whether the RIA represents itself as specializing in a particular service. This is clearly an elevated level of detail from the old Part II, and perhaps more in depth than the Interim Final may demand of a plan service provider in describing its services.
• Fees and Compensation (Item 5): Extensive disclosure around fees and compensation is required, including how the RIA is compensated for advisory services, the fee schedule, and whether the fees are negotiable. The RIA must also disclose whether it bills the client directly or deducts fees from the client account, the timing of fee payments, and the other fees paid in connection with advisory services, such as brokerage and custody fees. If the RIA or any of its personnel receives compensation attributable to securities sales, such as brokerage commissions, it must disclose this fact and the resulting conflicts and how they are addressed, and if the advisory fees are charged in addition to commissions, whether such commissions are used to offset the advisory fees. An RIA that primarily recommends mutual funds to its clients must disclose whether the recommended funds are no-load funds.
• Methods of Analysis, Investment Strategies, and Risk of Loss (Item 8): For each significant investment strategy or method of analysis, or particular type of security recommended, the material risks must be explained—the first time this has been required as a specific disclosure. RIAs that are recommending third party managed funds, such as target date funds, will likely rely on the disclosures in the fund documentation.

From an ERISA perspective, it raises interesting questions. How would an RIA describe the criteria it uses for investment selection appropriate to long term investment and retirement needs? Is the process of account review, or third party investment manager selection, prudent from an ERISA perspective?

• Disciplinary Information (Item 9): Any legal or disciplinary event that is material to the client evaluation of the integrity of the RIA or its management must be disclosed. Much of this is provided in Form ADV Part 1, but is required now in the Brochure, which is to be filed and delivered. The instructions provide a list of events that are presumptively material if they occurred within the past ten years. An RIA may rebut this, and not make a disclosure, but should document its rationale and maintain it as a record for SEC inspection.
• Other Financial Industry Activities and Affiliations; Participation or Interest in Client Transactions, and Brokerage Practices (Items 10, 11 and 12): As compared to the prior ADV Part II, the instructions for Part 2 now emphasize that more focus and detail should be provided on describing potential conflicts of interest and how they are managed.

Of course, under ERISA certain conflicts of interest are absolutely prohibited and disclosure does not “cure” that violation.

Part 2B Supplement

Supplements cover six items, including educational background and experience. Information regarding professional designations and certifications is permitted if it includes a sufficient explanation of the minimum qualifications required for the designation to allow clients to understand the value of the designation. Given the numerous programs offering designations under the general cover of “employee benefits specialist,” “fiduciary specialist,” and “investment specialist,” it will be a challenge to disclose the notable achievements of the individual in a way that is not deemed to be materially false or misleading by suggesting, for example, that the designation implies more qualifications or experience than the actual designation requires.

Conclusion

The range and depth of disclosure in new Part 2 has increased significantly. (This Bulletin has not attempted to itemize every detail of the Brochure, the Wrap Brochure, or the Supplement.) Not only has the content changed, but the distinct rules for preparing, updating, filing, and delivering each of the three documents must be carefully followed. Timing is critical because of the first deadline for December 31 year-end RIAs. The entire Part 2 process must be considered not only with respect to its preparation, but the overall implications for the RIA’s business processes, investment services, and internal compliance and training procedures. Making the disclosures in Part 2 does not necessarily mean that the additional overlay of the antifraud provisions under the Act are satisfied, nor that specific and distinct ERISA disclosure requirements are satisfied with regard to retirement plan clients.

ENDNOTES

1For example, the DOL recently issued a proposed regulation requiring plan fiduciaries to provide enhanced disclosures about target date funds and clarifying the investment information that must be disclosed about a plan’s qualified default investment alternative even if it is not a target date fund. (See 75 Fed. Reg. 73987). The DOL has also issued a proposed regulation to change the definition of “fiduciary” for ERISA purposes. (See 75 Fed. Reg. 65263). FINRA Regulatory Notice 10-54 requests comment on a “concept proposal” to require member firms to provide substantial written disclosures to “retail investors” at or before commencing a business/ account relationship with investors, including disclosures of all fees associated with each account. This has been called FINRA’s own version of Form ADV Part 2. Rulemaking under Dodd-Frank rule continues to develop from the SEC.
2See SEC Rel. No. IA-3060 (July 28, 2010), adopting the Final Rule effective on October 12, 2010. See also SEC Rel. No. IA-3110 (November 19, 2010), containing a Proposed Rule for amendments to the Act and Form ADV Part 1 to reflect changes to investment adviser registration imposed under Title IV of Dodd-Frank. The Proposed Rule, which deals in part with the new thresholds for SEC registration, will be the subject of a separate Bulletin. Both are available at the SEC website at www.sec.gov.
3An excepted client includes a registered investment company, and persons receiving only impersonal advisory services. The RIA does not have to maintain or file a Brochure if it only has excepted clients. The Final Rule increases from $200 to $500 annually, the amount of fees that require a Brochure delivery requirement with respect to clients receiving only impersonal advisory services. Impersonal delivery services are defined as investment advisory services that do not purport to meet the objectives or needs of specific individuals or accounts. Plan participants that are receiving “education” and not “investment advice” for ERISA purposes may be considered as the recipients of “impersonal services.”
4DOL Interim Final Regulation Section 2550.408b-2(c)(1)(v)(A).
5See SEC Release No. IA-3129 (December 28, 2010) The North American Securities Administrators Association has recommended that the state regulators provide the same extensions for state-registered investment advisers. Each state should be contacted, however, to determine the effective dates for compliance.
6Wrap Brochure and Supplement components will not be specifically discussed in this Bulletin. Suffice it to say they are generally of the same nature as the Brochure, and share common definitional terms.

Disclaimer Required by IRS Rules of Practice:
Any discussion of tax matters contained herein is not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed under Federal tax laws.