Through the course of the last several years, the inspection staff of the United States Securities and Exchange Commission has issued some terrific compliance guidance for investment advisers. Over the next few days I will be featuring the most helpful snippets of information.

Duty To Disclose

Fundamental to the Advisers Act is an adviser’s fiduciary obligation to act in the best interests of its clients and to place its clients’ interests before its own. As part of its fiduciary duty to clients, an adviser has an affirmative obligation of utmost good faith and full and fair disclosure of all material facts to clients. Advisers are required to disclose any facts that might cause the adviser to render advice that is not disinterested. When an adviser fails to disclose information regarding potential conflicts of interest, clients are unable to make informed decisions about entering into or continuing the advisory relationship.

During inspections, the examination staff review an adviser’s filings with the Commission and other materials provided to clients to ensure that the adviser’s disclosures are accurate, timely, and do not omit material information. Examples of failures to disclose material information to clients would include:

• An adviser fails to disclose all fees that a client would pay in connection with the advisory contract, including how fees are charged, and whether fees are negotiable;
• An adviser fails to disclose its affiliation with a broker-dealer or other securities professionals or issuers; and
• An adviser with discretionary assets under management fails to disclose that it is in a precarious financial condition that is likely to impair its ability to meet contractual commitments to clients.

Filing and Updating

Advisers are required to promptly file an amended Part 1 of their Form ADV if information the adviser provided in response to Item 1 (Identifying Information); Item 3 (Form of Organization); or Item 11 (Disclosure Information) becomes inaccurate in any way or information the adviser provided in response to Item 4 (Successions); Item 8 (Interest in Client Transactions); or Item 10 (Control Persons) become materially inaccurate in any way. In addition, an adviser is required to amend Part II of the Form ADV if becomes materially inaccurate in any way.

Many states now require state-registered advisers to file all amendments to Form ADV Part II and Schedule F via the IARD system. Advisers should note that they will not be able to just “download” their existing Form ADV Part II or Schedule F and must go to the web site of the North American Securities Administrators Association (www.nasaa.org) to obtain the appropriate form. Advisers should be aware our initial experience has been that these forms are not exactly user friendly.

Recordkeeping

Advisers must keep a copy of their disclosure document and each amendment or revision to such document that was given, or offered to be given, to any client or prospective client who subsequently becomes a client. An adviser must also keep a record of the dates that each disclosure document and each amendment or revision was offered or sent to clients. We suggest that advisers print out a list of clients to whom the Form ADV Part II was offered and staple a copy of that specific version of Part II to such list. There is no need for an adviser to save a copy of the annual offer in each separate client file.

Lessons Learned

Beyond lack of disclosures, beyond incomplete disclosures and even beyond failure to disclose conflicts of interest, the most problematic disclosure issue is when there are discrepancies between an adviser’s disclosure documents. Examiners take an especially harsh view of investment advisers that fail to reconcile their disclosure documents. In the words of one examiner, the presence of conflicting disclosure documents is evidence that an adviser lacks a commitment to the disclosure process. Examiners will not afford an adviser the benefit of the doubt when confronted with such an abject disregard for their disclosure obligations. Therefore, we suggest that at a minimum, every adviser pull out Parts 1 and II of their Form ADV, their Schedule F and their advisory contract and make sure it all adds up. If you report in Part 1 that you have investment or brokerage discretion, your Part II better report the same thing. It sounds obvious, but at least 60% of our audit clients had some form of inconsistent disclosures. While adviser should review their disclosure documents in their entirety, special attention should be paid in Part 1 of their Form ADV to Items 7 (Financial Industry Affiliations) and 8 (Interest in Client Transactions) and the corresponding Items in their Form ADV Part II (e.g., Items 8, 9, 12 and 13). This is typically where examiners find the most inconsistencies.

Disclose, Disclose, Disclose (and then disclose some more!)

If the three most important words in real estate are “location, location, location” then the three most important words in compliance are “disclose, disclose, disclose.” Any time an adviser comes across a questionable situation our advice is to thoroughly disclose the issue. After all, why give an examiner even the slightest opportunity to question whether a disclosure should have been made? Perhaps one of the most important points to remember about the Investment Advisers Act is that short of fraud or other malfeasance, disclosure is the often the antidote to many of the issues that arise in the course of an investment adviser’s business.

Conflicts of Interest

The most common disclosure issue that arises during an examination is the inadequate reporting of conflicts of interest. Specifically, the types of roles the adviser and/or its affiliates play with regard to a client may create conflicts of interest. Some of the situations involving conflicts of interest examiners often look for include:

· Conflicts where the investment adviser is also the broker-dealer or the broker-dealer is an affiliate of the investment adviser;

· Conflicts where the investment adviser or its representatives has an ownership interest (or especially a controlling interest) in an issuer whose securities the adviser or its representatives recommends to its clients;

· Conflicts relating to the use of solicitors and finder’s fees;

· Conflicts between the investment adviser’s interest in trading for the adviser own account and the interests of clients;

· Conflicts where the adviser or its personnel participate in limited investment opportunities along with clients;

· Conflicts relating to the allocation of investment opportunities among clients;

· Conflicts relating to the aggregation and allocation of client trades;

· Conflicts relating to the use of client commissions to obtain soft dollar items; and

· Conflicts relating to side by side management of accounts that do and do not charge performance fees.

In order to determine whether a conflict exists, examiners will review client correspondences, complaints and statement of accounts or by operational review of the investment adviser itself and interviews with advisory personnel and clients. Once examiners determine that a conflict of interest does exist, they will expect that the adviser has disclosed any such conflict in the proper manner.

In all conflict situations the key issue is the effect of the conflict on the client. Has the client been told of the conflict? Has the client consented to the transaction despite the disclosed conflict? If the client consented, was the client in a position to evaluate the effect of the conflict on the client’s interest? Advisers must taken into account the client’s financial sophistication and investment experience as the more vulnerable or unsophisticated the client, the greater the burden is on the investment adviser to show that the client has knowingly consented to the conflict. Accordingly, disclosure and client consent may not always be sufficient remedies for conflicts of interest.

“Disclosure” is really a catchall phrase for what an investment adviser reports on Parts 1 and II of Form ADV and describes in the Schedule F narrative (or equivalent disclosure brochure). It also includes the information an adviser sets forth in their advisory agreement, marketing material, due diligence questionnaire and just about any other document that makes into the public domain.

What Must Be Disclosed?

While the specifics of what must be disclosed is dependent on each adviser’s business, there are certain “absolutes” that all regulators will expect in an adviser’s disclosure documents. These include:

· What advisory services are being provided;

· Who is providing those services;

· What is the client being charged for the services; and

· What conflicts of interest might exist for the adviser.

Certainly, no surprises here and indeed, most advisers touch upon at least the first three categories (more on conflicts of interest below).

There are, however, two additional categories of additional disclosures of which advisers are not as readily aware. The first type of event requiring additional disclosure is when an investment adviser experiences a financial condition that is reasonably likely to impair the ability of the adviser to meet its contractual obligations (but only if the adviser has discretionary authority or if the adviser requires prepayment of advisory fees of more than $500, six months or more in advance). The second type of event requiring additional disclosure is when an adviser experiences a legal or disciplinary event that is material to an evaluation of the adviser’s integrity or ability to meet contractual conditions.

When Must Disclosures Be Made?

There is (we hope) not an investment adviser in business today that does not know that they are required to provide their advisory clients and prospective clients with a written disclosure document. Most advisers also know that they may provide advisory clients and prospective clients with either Part II of Form ADV (including Schedule F) or with another document that contains, at a minimum, the information required to be disclosed in Part II of Form ADV (the so-called “disclosure brochure”). Most advisers are also aware that their disclosure document must be delivered to prospective clients at least 48 hours before entering into an advisory agreement with the client or, if it is delivered concurrently with the client’s execution of the advisory agreement, then the client must be given 5 business days to terminate the agreement without penalty. Finally, although some advisers seem to be a bit hazy on the details, each year they must deliver or offer in writing to deliver their disclosure document to each client without charge.

As to an event specifically involving financial distress or disciplinary action, disclosure must be made to an adviser’s existing clients promptly and to a prospective client at least 48 hours prior to entering into an advisory agreement or after the advisory agreement is executed; provided, however, that the client has 5 days to terminate the agreement. Such disclosure may be made by an adviser through the Form ADV or through a separate written communication to clients.