SEC Provides Guidance on Investment Adviser Disclosures Related to Participation in the Paycheck Protection Program

The Securities and Exchange Commission (SEC) provided guidance on April 27, 2020 on the disclosure obligations of a registered investment adviser (RIA) participating in the Paycheck Protection Program (PPP) implemented by the Small Business Administration.¹

In an update to its COVID-19 frequently asked questions guidance, the SEC’s Division of Investment Management added Question II.4 stating that: (1) RIAs participating in the PPP must disclose their participation if the circumstances that led to the RIA taking the loan constitute material facts relating to their advisory relationship with clients, and (2) RIAs should also consider whether their current circumstances constitute conditions that are reasonably likely to impair their ability to meet contractual commitments to their clients that are required to be disclosed in Item 18 of Form ADV Part 2A and/or in Appendix 1 of a wrap fee program brochure.

The new FAQ Question II.4 reads:

Question II.4.

Q. I am a small advisory firm that meets the requirements of the Paycheck Protection Program (PPP) established by the U.S. Small Business Administration in connection with COVID-19. If I receive or have received a PPP loan, what are my regulatory reporting obligations under the Investment Advisers Act of 1940 to my firm’s clients?

A. As a fiduciary under federal law, you must make full and fair disclosure to your clients of all material facts relating to the advisory relationship. If the circumstances leading you to seek a PPP loan or other type of financial assistance constitute material facts relating to your advisory relationship with clients, it is the staff’s view that your firm should provide disclosure of, for example, the nature, amounts and effects of such assistance. If, for instance, you require such assistance to pay the salaries of your employees who are primarily responsible for performing advisory functions for your clients, it is the staff’s view that you would need to disclose this fact. In addition, if your firm is experiencing conditions that are reasonably likely to impair its ability to meet contractual commitments to its clients, you may be required to disclose this financial condition in response to Item 18 (Financial Information) of Part 2A of Form ADV (brochure), or as part of Part 2A, Appendix 1 of Form ADV (wrap fee program brochure). (Posted April 27, 2020)

Analysis

I. Is Disclosure Required in Item 18 of Form ADV Part 2A and/or in Appendix 1 of a Wrap Fee Program Brochure?

As highlighted in new FAQ Question II.4, Item 18 of Form ADV Part 2A requires each RIA who has discretionary authority or custody of client assets, or that asks for prepayment of more than $1,200 in fees six months or more in advance, to disclose any financial condition that is “reasonably likely to impair your ability to meet contractual commitments to clients.” This is a fairly high standard as an RIA could experience substantial declines in revenue, employee departures, breaches of its banking covenants and other significant negative financial circumstances, all without having any problems meeting their obligations to clients. However, financial impairments that do keep an RIA from providing the services clients signed up for — such as no longer being able to employ portfolio managers to trade client assets — are possible and would need to be disclosed in Item 18.

Any updates to Form ADV Part 2A should be made promptly after the response to Item 18 becomes materially inaccurate.²

II. Disclosure of PPP Loans Generally.

Additionally, the FAQ also discusses whether an RIA has an obligation to disclose a PPP loan to their clients (regardless of whether Item 18 of the ADV needs to be updated): “If the circumstances leading you to seek a PPP loan or other type of financial assistance constitute material facts relating to your advisory relationship with clients, it is the staff’s view that your firm should provide disclosure of, for example, the nature, amounts and effects of such assistance. If, for instance, you require such assistance to pay the salaries of your employees who are primarily responsible for performing advisory functions for your clients, it is the staff’s view that you would need to disclose this fact.”

This is a lower standard than the Item 18 disclosure and does not require RIAs to say that clients could be affected. Given the lower standard and the example of salaries for advisory staff, the SEC seems to be taking the view that PPP loans should generally be disclosed in light of their materiality to the business. Nevertheless, the FAQ leaves open the possibility that a PPP loan may not need to be disclosed depending on the circumstances. The PPP application requires each applicant to certify in good faith that the PPP funds are both (1) “necessary to support the ongoing operations,” and (2) “will be used to retain workers and maintain payroll or make mortgage interest payments, lease payments, and utility payments.” Accordingly, RIAs electing not to disclose a PPP loan should take care to document why the loan was both “necessary” to fund operations but not “required” to pay salaries, etc., as described in the SEC’s example. Interestingly, the guidance suggests that no disclosure is required if the loan is not approved.

Practice Points

The SEC’s COVID-19 guidance and relief has generally been seen as accommodating to RIAs and other industry participants. However, each RIA should expect the SEC at some point to come calling with questions about how the crisis affected their business, whether they took a PPP loan and what disclosures they made to investors.

Further, RIAs participating in the PPP loan program should be prepared to demonstrate:

1. Why they decided to participate in the PPP
2. Assuming no updates were made to Item 18, why none of the reasons for participating in the program were reasonably likely to cause the RIA to fail to meet its commitments to clients. For example, RIAs would benefit from having a memo in their files showing why it would not fail to meet client obligations if the RIA had to reduce compensation, reduce staff, operate at a loss for some period of time, etc.
3. How the RIA determined whether or not to disclose the PPP participation to clients
4. If they did determine to give notice to clients, how that notice was given

Regarding point 4 above, to date the SEC has not provided guidance on how an RIA participating in the PPP should provide notice to their clients (assuming no update of Item 18 is needed). Often firms will include this type of disclosure in their next investor letter or report.

RIAs making a disclosure to clients in an investor letter or similar communication may want to also update their ADV with a similar disclosure. While not required by the Form ADV instructions, an ADV update is consistent with Part 2A’s status as the RIA’s disclosure brochure and will ensure that each client and prospective client gets the PPP disclosure. We expect most firms will include any ADV disclosures not required by Item 18 in a paragraph that covers the impact of COVID-19 on the markets and the RIA, including their participation in the PPP loan program.

As the number of cases around the world grows, Faegre Drinker’s Coronavirus Resource Center is available to help you understand and assess the legal, regulatory and commercial implications of COVID-19.