What Disclosures Should be Considered for Your Form ADV Amendments

Now that we are in the first quarter of the new year, most registered investment advisers (“RIA” or “Firm”) are busy preparing their annual Form ADV amendment.  This annual amendment is due within 90 days of the end of the Firm’s fiscal year, and the majority of RIAs have a fiscal year end of December 31.

 What Disclosures Should be Considered for Your Form ADV Amendments

Updating the Form ADV can be a struggle for Firms, especially when trying to determine what items need to be disclosed. The level of anxiety caused by this requirement is understandable given that improper disclosures or a lack thereof in Form ADV can lead to enforcement actions and monetary sanctions by regulators.

 Below are some examples:

  • Allison, LLC and Stephen D. Allison, Inv. Adv. Act Rel. No. 4673 (March 29, 2017) – In this particular enforcement action, Stephen D. Alison and Alison, LLC (“ALLC”), a registered investment adviser wholly owned and controlled by Alison, were cited for, among other things, repeatedly failing to disclose in ALLC’s Form ADV that ALLC’s distressed financial condition was reasonably likely to impair the Firm’s ability to meet contractual commitments to clients. Additionally, the SEC found Alison and ALLC had a conflict of interest with their clients as they were incentivized to choose fund share classes that carried 12b-1 fees over those that did not. Alison and ALLC did not disclose this conflict of interest and misrepresented in ALLC’s Forms ADV and updating amendments that Alison did not receive 12b-1 fee payments. As a result, the SEC stated willful violation of Sections 206(2), 207 and 204(a) of the Advisers Act,[1] and revoked the Firm’s registration as an investment adviser.
  • Source Financial Advisors, LLC and Michelle M. Smith. Inv. Adv. Act Rel. No. 3345 (May 5, 2017) - In this enforcement action, the SEC sited Michelle M. Smith (“Smith”) and Source Financial Advisors, LLC (“Source”), the registered investment adviser that Smith founded, for misrepresentations in Smith’s Form ADV Part 2B, which falsely stated that Smith had earned a marketing degree from Radford University. In addition, the SEC found that from 2012 through 2016, Source had misrepresented in marketing materials distributed to clients and prospective clients that Smith held the Certified Financial Planner (“CFP”) credential, when in fact, Smith had only taken CFP coursework. As a result, the SEC stated that Source and Smith had violated Sections 206(2) and 207 of the Advisers Act and mandated they inform clients in writing of the Order and pay a penalty in the amount of $35,000.[2]

Not having adequate and appropriate disclosures in Form ADV is one of the biggest regulatory risks for RIAs. Unfortunately, there is no all-inclusive manual outlining everything that should be included in Form ADV.  The closest to this is the Form ADV Instructions[3], which leaves a lot to interpretation.  

When working on the Form ADV annual amendment, there are several conflict areas to consider. The below chart can serve as a helpful guide[4] in inventorying disclosable areas, events, and conflicts of interest.  Remember, all material conflicts of interest must be disclosed, along with details on how the Firm addresses the conflicts.

 

 

 

 

Brokerage and Trading

  • Custodian arrangements
  • Best execution and use of soft dollars
  • Directed brokerage arrangements
  • Trading with affiliated broker-dealers
  • Cross trading and principal transactions
  • Prime brokerage arrangements and step out trades
  • Trade aggregation, allocation and rotation
  • Trading in proprietary accounts

 

 

 Code of Ethics

  • Obtaining insider non-public information
  • Political and charitable contributions
  • Giving and receiving gifts and certain entertainment
  • Outside business activities
  • Employee personal trading

 

 

 

Compensation (direct and indirect)

  • Performance fees vs. asset-based fees
  • Compensation received by employees for their outside business activities
  • Referral/Solicitation fees
  • Revenue sharing arrangements
  • Valuation of client holdings (fees charged based on valuations)
  • Indirect benefits from custodial/brokerage arrangements
  • Using affiliates to provide services to firm and/or clients
  • Expense payments
  • Householding client assets to achieve a breakpoint

 

 

 

Custody

  • Adviser and/ or General Partner to a Private Fund
  • Employees acting as trustee, co-trustee or executor of client account
  • Debiting fees directly from client accounts
  • Receiving cash, checks or securities from clients or third parties
  • Having custody (e.g., due to check writing authority, bill paying services, Standing Letters of Authorization (SLOA) arrangements, etc.)

 

 

 

 Portfolio Management

  • Side by side management of different types of accounts
  • Allocation of investment opportunities
  • Selecting investments on a discretionary basis that provide direct or indirect compensation to firm and/or IARs
  • Proxy voting
  • Due diligence of investments
  • Research (soft dollars, insider trading etc.)
  • Selective disclosure of portfolio holdings
  • Providing different services for similarly situated clients

 

 

Other Considerations

  • Outside business activities
  • Passive investments (including private securities transactions and ownership interests
  • Loans to principals from the company
  • Significant liability events
  • Material disciplinary events pertaining to firm and/or employees

 

Conclusion

Form ADV is the main disclosure document for your clients.  It’s accuracy and completeness is important, not only from a regulatory standpoint but from a fiduciary standpoint as well.  Firms should be sure to put an appropriate amount of care and consideration into drafting the disclosures in Form ADV and when in doubt of how much to disclose, err on the side of transparency.  Allocating appropriate resources is crucial and utilizing compliance consultants and/or legal counsel when drafting Form ADV amendments can be very beneficial given their extensive knowledge and experience.

For information on how Core Compliance can assist firms with implementing technology  for their compliance programs, please contact us at info@corecls.com, at (619) 278- 0020, or visit us at www.corecls.com.

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Author: Kurt Nuñez, Compliance Consultant; Editor: Tina Mitchell, Lead Sr. Compliance Consultant Core Compliance & Legal Services (“Core Compliance”).  Core Compliance works extensively with investment advisers, broker-dealers, investment companies, hedge funds, private equity firms and banks on regulatory compliance issues.

 

This article is for information purposes and does not contain or convey legal or tax advice. The information herein should not be relied upon in regard to any particular facts or circumstances without first consulting with a lawyer and/or tax professional.

 

[1]  See https://www.sec.gov/litigation/admin/2017/34-80335.pdf

[2] See https://www.sec.gov/litigation/admin/2017/ia-4702.pdf

[3] See https://www.sec.gov/about/forms/formadv.pdf

[4] Does not include all conflicts applicable to investment advisers