Electronic Filing by Investment Advisers; Proposed Amendments to Form ADV

Federal RegisterApr 17, 2000

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 200, 275, and 279

[Release No. IA-1862; 34-42620; File No. S7-10-00]

RIN 3235-AD21

Electronic Filing by Investment Advisers; Proposed Amendments to Form ADV

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rules.

SUMMARY:

The Commission and the state securities authorities are creating an electronic filing system for investment advisers. The system will permit investment advisers to satisfy their filing obligations with federal and state regulators with a single electronic filing made over the Internet. The system also will provide public access to information about investment advisers and persons who work for investment advisers. In connection with the development of the electronic filing system, we are proposing new rules under the Investment Advisers Act of 1940 and proposing to amend others. The new rules would require advisers to submit their filings electronically. Form ADV would be substantially updated and revised to accommodate electronic filing. Finally, we are proposing amendments that would require advisers to deliver to clients a narrative brochure written in plain English.

DATES:

Comments must be received on or before June 13, 2000.

ADDRESSES:

Comments should be submitted in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Comments also may be submitted electronically at the following e-mail address: rule-comments@sec.gov. All comment letters should refer to File No. S7-10-00; this file number should be included on the subject line if e-mail is used. Comment letters will be available for public inspection and copying in the Commission's Public Reference Room, 450 Fifth Street, NW., Washington, DC 20549. Electronically submitted comment letters also will be posted on the Commission's Internet web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT:

Lori H. Price, <pricel@sec.gov> or Jeffrey O. Himstreet, <himstreetj@sec.gov>, at (202) 942-0716, Task Force on Investment Adviser Regulation, Division of Investment Management, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0506.

SUPPLEMENTARY INFORMATION:

The Commission today is requesting public comment on proposed amendments to rules 30-5 and 30-11 of the SEC's Organization and Program Management rules (17 CFR 200.30-5 and 200.30-11), new rule 203-3 and Form ADV-H; proposed amendments to rules 0-2, 0-7, 203-1, 203-2, 203A-1, 203A-2, 204-1, 204-2, and 204-3 (17 CFR 275.0-2, 275.0-7, 275.203-1, 275.203-2, 275.203A-1, 275.203A-2, 275.204-1, 275.204-2, and 275.204-3); and Form ADV, Form ADV-W, and Form 4-R (17 CFR 279.1, 279.2, and 279.4) under the Investment Advisers Act of 1940 (15 U.S.C. 80b-1) (the Advisers Act or the Act). The Commission also is proposing to withdraw rules 204-5 and 206(4)-4 (17 CFR 275.204-5 and 275.206(4)-4) and Forms 5-R, 6-R, 7-R, and ADV-Y2K (17 CFR 279.5, 279.6, 279.7, and 279.9) under the Advisers Act.

Table of Contents

Executive Summary

I. Introduction

II. Discussion

A. The Investment Adviser Registration Depository

1. The Investment Adviser Filing System

2. The Public Disclosure System

3. System Implementation

4. Filing Fees

B. Proposed Amendments to SEC Rules

1. Applications for Registration on Form ADV

2. Amendments to Form ADV

3. Withdrawal from Registration

4. Hardship Exemptions

C. Proposed Transition to Electronic Filing

D. Proposed Revisions to Form ADV

1. Part 1

a. Part 1A

b. Part 1B

2. Part 2

a. Part 2A: The Firm Brochure

b. Part 2B: The Brochure Supplement

3. Execution Pages

E. Proposed Revisions to Form ADV-W

F. General Request for Comment

III. Cost/Benefit Analysis

IV. Paperwork Reduction Act

V. Summary of Initial Regulatory Flexibility Analysis

VI. Statutory Authority

Text of Proposed Rule and Form Amendments

Proposed Form ADV—Appendix A

Proposed form ADV-W—Appendix B

Proposed Form ADV-H—Appendix C

Proposed Form ADV-NR—Appendix D

Executive Summary

The Commission and the state securities authorities are creating an Internet-based system of electronic filing for investment advisers. The system, which we call the Investment Adviser Registration Depository (IARD), will permit investment advisers to satisfy filing obligations under state and federal laws by making a single electronic filing. Information contained in filings made through the IARD will be stored in a database that members of the public will be able to access free of charge through the Internet. The IARD, which is being built and will be operated for us by NASD Regulation, Inc. (NASDR), will give investors easy access to information about investment advisers.

Today we are proposing to amend our rules to require advisers to make filings with us through the IARD after the system begins to operate. In addition, we are proposing substantial amendments to our application, reporting, and disclosure requirements for investment advisers. Some of the amendments are designed to take advantage of electronic filing. Others reflect recent regulatory changes. And others are designed to improve the quality of information advisers must provide to their clients and prospective clients in their information statements (brochures).

I. Introduction

Since we implemented our EDGAR system in 1993, we have sought additional ways to take advantage of developments in information technology to provide investors with better access to market information.

More and more types of filings are made with us electronically each year.

As a

result, investors have timely access to the latest reports and filings made by public issuers. Last year, we required broker-dealers to begin to register with us electronically.

Today we are proposing a number of rules and rule amendments designed to bring electronic filing to investment advisers.

Our EDGAR (Electronic Data Gathering, Analysis, and Retrieval) system electronically receives, processes and disseminates documents required to be filed with us under the Securities Act of 1933 (15 U.S.C. 77a to -mm), the Securities Exchange Act of 1934 (15 U.S.C. 78a to -mm) (Exchange Act), the Public Utility Holding Company Act of 1935 (15 U.S.C. 79a to -79), the Trust Indenture Act of 1939 (15 U.S.C. 77sss to -bbbb), and the Investment Company Act of 1940 (15 U.S.C. 80a-1 to -64) (Investment Company Act).

In 1995, we required new Form 24F-2 (used by registered investment companies for annual notices required by rule 24f-2 under the Investment Company Act) to be filed through EDGAR.

See

Registration Fees for Certain Investment Companies, Investment Company Act Release No. 21332 (Sept. 1, 1995) (60 FR 47041 (Sept. 11, 1995)). In 1995, we also permitted electronic filing of Forms 3, 4 and 5 and notices of securities transactions on Form 144, required under the Exchange Act, as well as notices concerning proxy communications for limited partnership roll-up transactions.

See

Adoption of Updated EDGAR Filer Manual and Technical Rule Amendments, Securities Act Release No. 7241 (Nov. 13, 1995) (60 FR 57682 (Nov. 17, 1995)). In 1998, we allowed new mutual fund “profiles” to be filed through EDGAR.

See

New Disclosure Option for Open-End Management Investment Companies, Investment Company Act Release No. 23065 (Mar. 13, 1998) (63 FR 13968 (Mar. 23, 1998)). In 1999, we required Form 13F (filed by institutional investment managers), which we previously allowed to be filed electronically on a voluntary basis, to be filed electronically.

See

Rulemaking for EDGAR System,

Investment Company Act Release No. 23640 (Jan. 12, 1999) (64 FR 2843 (Jan. 19, 1999)). In 1999, we required Form N8-F (used to deregister a registered investment company), also previously filed electronically on a voluntary basis, to be filed electronically.

See

Deregistration of Certain Registered Investment Companies, Investment Company Act Release No. 23786 (Apr. 15, 1999) (64 FR 19469 (Apr. 21, 1999)). In 1999, we also required investment companies to file codes of ethics through EDGAR as an exhibit to their registration statements.

See

Personal Investment Activities of Investment Company Personnel, Investment Company Act Release No. 23958 (Aug. 20, 1999) (64 FR 46821 (Aug. 27, 1999)).

See

Broker-Dealer Registration and Reporting, Securities Exchange Act Release No. 41594 (July 2, 1999) (64 FR 37585 (July 12, 1999)) (amending Exchange Act rules 15b3-1, 15Ba2-2, and 15Ca2-1 (17 CFR 240.15b3-1, 240.15Ba2-2, and 240.15Ca2-1)).

Approximately 8,000 investment advisers are registered with the Commission under the Advisers Act. We estimate that another 12,000 are registered with state securities authorities. These advisers currently make filings with us and the states on paper, much as they have since 1940, when the Advisers Act was enacted. Investment adviser filings do not appear on our EDGAR system and are not easily accessible or widely available from other sources. In 1996, Congress passed legislation giving us authority to modernize our registration system and requiring us to provide investors with easy access to information about advisers.

National Securities Market Improvement Act of 1996, Pub. L. No. 104-290, 110 Stat. 3416 (1996) (codified in scattered sections of the United States Code) (NSMIA). Section 303 of NSMIA added new section 203A(d) of the Advisers Act (15 U.S.C. 80b-3a(d)), which provides that “(t)he Commission may, by rule, require an investment adviser—(1) to file with the Commission any fee, application, report, or notice required by this title or by the rules issued under this title through any entity designated by the Commission for that purpose; and (2) to pay the reasonable costs associated with such filing.” Section 306 of NSMIA provides that “(t)he Commission shall—(1) provide for the establishment and maintenance of a readily accessible telephonic or other electronic process to receive inquiries regarding disciplinary actions and proceedings involving investment advisers and persons associated with investment advisers; and (2) provide for prompt response to any inquiry described in paragraph (1).” Section 306 was not codified.

NASDR currently is building the IARD for us and the state securities authorities.

The IARD will permit advisers to make filings with the Commission and the states through the Internet. The information advisers submit will be stored in a database, and investors will have access to it by visiting a web site. The IARD will not only improve public access to information about advisers, it will also ease regulatory burdens on advisers by permitting a single electronic filing to satisfy SEC and state filing requirements.

It also will help us better monitor advisers and administer the federal securities laws. The IARD is described in Section II.A. of this Release.

NASDR is a wholly owned subsidiary of the National Association of Securities Dealers (NASD), a self-regulatory organization which supervises broker-dealers that conduct a public business in securities other than on an exchange of which the broker-dealer is a member.

In general, this Release discusses our rules and the changes we are proposing that affect advisers registered with us. The state securities authorities are likely to make similar changes that affect advisers registered with the states.

State-registered advisers filing through the IARD can also satisfy Department of Labor (DOL) filing requirements. A state-registered adviser currently must file Form ADV with DOL to be an “investment manager” for purposes of the Employee Retirement Income Security Act (ERISA). 29 U.S.C. 1002(38)(B)(ii). DOL will treat an adviser as having satisfied this filing requirement when its Form ADV is available to DOL “from a centralized electronic * * * database.”

See

Act of Nov. 10, 1997, Pub. L. No. 105-72, 111 Stat. 1457 (adding explanatory note “Availability of Documents Via Filing Depository” to 29 U.S.C. 1002).

Most of the filings made with the IARD will be on Form ADV, the Uniform Application for Investment Adviser Registration. Advisers use Form ADV to apply for registration with us and with the state securities authorities, and must keep it current by filing periodic amendments as long as they are registered.

We are proposing to require that new advisers apply for registration electronically, and that advisers currently registered with us re-submit their Form ADV to us through the IARD. The proposed new filing rules are described in Section II.B. and the proposed transition rules are described in Section II.C. of this Release.

See

rules 203-1 and 204-1.

Form ADV currently has two parts. Part I asks for information about an adviser's business, the persons who own or control the adviser, and whether the adviser or certain of its personnel have been sanctioned for violating the securities or other laws. It provides us with information we need to decide whether to grant an application for registration or to revoke a registration, and to manage our regulatory and examination programs. Our proposed changes to Part I are discussed in Section II.D.1. of this Release.

We are changing the numbering of the parts of Form ADV from Roman to Arabic numbers: Part I to Part 1, Part II to Part 2. References in this Release to Part I or Part II refer to current Form ADV; references to Part 1 or Part 2 refer to the proposed form. The paper version of Form ADV, as proposed to be amended, is included as Appendix A of this Release.

Part II, or a written brochure containing the same information, must be delivered to clients before they engage the adviser and then offered to them each year.

Part II provides clients with information about business practices, fees and conflicts of interest the adviser may have with its clients. We are proposing that all advisers provide clients with a narrative brochure containing disclosure about the advisory firm written in plain English, and update the brochure at least once a year to reflect changes. We also are proposing to require that the firm brochure be accompanied by a supplement containing important information about the advisory personnel with whom the client will be dealing. Proposed Part 2A sets forth the information about the advisory firm that an adviser must include in its brochure. Proposed Part 2B sets forth the information about advisory personnel that an adviser must include in brochure supplements. These proposed changes are described in Section II.D.2. of this Release.

See

rule 204-3.

II. Discussion

A. The Investment Adviser Registration Depository

The IARD is being built and will be operated by NASDR under contracts with the Commission and the North American Securities Administrators Association, Inc. (NASAA).

The IARD will be modeled on NASDR's Web Central Registration Depository (CRD), which is used by broker-dealers to make filings with us, state securities authorities, and NASDR.

NASDR will perform certain administrative tasks related to the filing and public disclosure systems described below. It will not, however, act as a self-regulatory organization for advisers.

NASAA represents the 50 U.S. state securities authorities responsible for the administration of state securities laws, also known as “blue sky laws.” Currently, 49 states (all except Wyoming), the District of Columbia, Guam, and Puerto Rico have investment adviser statutes.

See

<http://www.nasaa.org/search/memberslinks.html> (last visited Mar. 15, 2000).

For a description of the CRD system,

see

Securities Exchange Act Release No. 41594,

supra

note 3.

Only Congress can grant such authority.

See

The Maloney Act, Pub. L. 75-719, 52 Stat. 1070 (1938) (codified as amended at 15 U.S.C. 78

authorizing the Commission to register national securities associations).

1. The Investment Adviser Filing System

The IARD will be an Internet-based system that advisers will access through

computers in their offices, without the need for specialized hardware or software. An adviser will be able to use the system to apply for registration, amend its registration, and withdraw from registration.

An SEC-registered adviser will also be able to electronically send “notice filings” to the states and pay state fees through the IARD.

Institutional investment managers will continue to make Form 13F filings on our EDGAR system.

See

Investment Company Act Release No. 23640,

supra

note 2. Form 13F filings are made by many firms other than investment advisers, and it would not be feasible to include these filings on the IARD.

Many states require an SEC-registered adviser doing business in their state to provide them with copies of the adviser's SEC filings and to pay fees.

See

section 201(c) of the Uniform Securities Act (1999). These are usually referred to as “notice filings.”

See

section 307(a) of NSMIA (states are permitted to require SEC-registered advisers to file with them documents advisers filed with the Commission “solely for notice purposes * * * and (pay) any required fee”). Section 307 was not codified.

The IARD will contain a number of features designed to make it easy for persons to complete Form ADV, even if they are unfamiliar with the form. To use the system, an adviser will visit a designated web site, which it will be able to enter through our web site.

Persons visiting the web site to make a filing will indicate whether they wish to apply for registration, amend an existing registration, or withdraw from registration as an investment adviser. Persons wishing to register as an investment adviser will be presented with a blank Form ADV, which they would complete on-line. A partially completed form could be saved in draft form.

A “help” function will be available to answer questions,

and an on-line glossary will allow persons completing the form to review the definition of key terms used in the form.

In order to use the system, an adviser first will complete a paper request for IARD filer access and submit it to NASDR. NASDR then will assign a user name and password, which persons authorized to file on behalf of the adviser would be required to use to submit filings to the IARD.

An adviser will be able to save one draft of each form type for up to 60 days. While an adviser will be not able to download the draft form, it will be able to print either the entire draft form or selected pages.

The “help” function will provide answers to frequently asked questions and guidance for completing the electronic Form ADV. Our staff will formulate answers to the frequently asked questions and update them from time to time.

Defined terms appear in italic on the forms, both on the proposed paper forms and on the electronic forms in the IARD. The glossary is included in Appendix A of this Release.

The IARD will present an adviser completing Part 1 of Form ADV with only those items relevant to its application. An adviser indicating that it is registering with us, for example, will not see items that apply only to advisers registering with the states.

The system also will prevent an adviser from submitting an incomplete form or from entering inconsistent information at different places on the form.

These features should help prevent the most common errors we see in applications for registration under the Advisers Act and speed the registration process.

See

discussion of additional requirements for state-registered advisers

infra

at Section II.D.1.b. of this Release.

For example, if an adviser indicates that it has assets under management of less than $25 million, the system would preclude the adviser from indicating that it is eligible for SEC registration because it has assets under management of $25 million or more.

See

proposed Items 2.A(1) and 5.F(2)(c) of Part 1A of Form ADV.

We also have designed the system to provide efficiencies for firms registered with us as both an investment adviser on Form ADV through the IARD and a broker-dealer on Form BD

through the CRD. These advisers will be able to link their responses to common items to avoid entering the data twice.

17 CFR 249.501.

See

discussion of IARD functionality for the Disciplinary Reporting Pages (DRPs) and Schedules A and B,

infra

notes 85 and 101, respectively.

Unlike the check-the-box and multiple-choice format of proposed Part 1, proposed Part 2 of Form ADV would require the adviser to prepare a narrative brochure containing disclosure about the advisory firm.

NASDR will design the part of the system that will accept Part 2.

Once this part of the system is built, an adviser will be able to prepare its brochure on its own computer using its word processing software and transmit the file to the IARD.

We do not anticipate, however, that brochure supplements will be submitted to the IARD.

See

discussion of Part 2

infra

at Section II.D.2. of this Release.

See

discussion of system implementation

infra

at Section II.A.3. of this Release.

Using their word processing software, advisers may be required to convert the word processing file to a standard file format, such as HyperText Markup Language (HTML) or American Standard Code for Information Interchange (ASCII).

2. The Public Disclosure System

All current information submitted to the IARD by advisers will be available to members of the public through our web site without charge.

Interested persons will be able to search the database to retrieve information about advisory firms and persons associated with them.

Anyone with access to the Internet will be able to look up an adviser and review its Form ADV—including the disciplinary records of the adviser and persons associated with the adviser.

The IARD data will be available for commercial use, for a fee, and the proceeds will be used to maintain and upgrade the IARD.

Members of the public will be able to search the IARD for information about a specific individual once the system begins accepting investment adviser representative filings on Form U-4 (Uniform Application for Securities Industry Registration or Transfer) and Form U-5 (Uniform Termination Notice for Securities Industry Registration).

See

discussion of system implementation

infra

Section II.A.3. of this Release.

Section 15A(h)(3)(i) of the Exchange Act (15 U.S.C. 78

-3(h)(3)(i)) requires a registered securities association to establish and maintain a toll-free telephone listing to receive inquiries regarding disciplinary actions involving its members and their associated persons, and to promptly respond to any of these inquiries in writing. NASDR currently makes certain information about broker-dealers and their agents available on its web site. Disciplinary information about broker-dealers and their agents is not available on NASDR's web site, although NASDR will make it available in written form upon request. NASDR has not made broker-dealer disciplinary information available on its web site because the Exchange Act provides NASDR with immunity from lawsuits challenging the accuracy of disciplinary information it provides in

written

form. NASDR has asked Congress to amend the Exchange Act to provide legal immunity for information made available on the Internet.

See

Ruth Simon and Aaron Lucchett,

Disciplinary Records of Stockbrokers Won't be on Web this Spring After All,

Wall St. J., Jan. 18, 1999, at B7. If immunity is granted, we hope that the CRD and the IARD can be linked so that a single search will provide information from both databases. This may be helpful to an investor who is unsure whether a person or firm is registered as a broker-dealer or an adviser. Until then, the IARD will warn investors that they should consider contacting NASDR for possible additional disciplinary information.

3. System Implementation

We expect that the IARD will begin to receive filings later this year. We anticipate that the entire system will be “rolled out” in four separate releases:

We understand that some would prefer that all components of the system begin operating together at the earliest possible date. We share that preference. Implementing the system in stages, however, permits NASDR to reduce its programming costs, which would otherwise have to be offset by higher filing fees.

• First, SEC-registered advisers and applicants for SEC registration will begin using the system to file Part 1 with us and submit notice filings to state securities authorities.

We expect that most (if not all) state securities authorities will accept “notice filings” from SEC-registered advisers through the IARD at that time, and that many state securities authorities also will begin to require advisers registered with them to use the system. We understand, however, that some state securities authorities lack statutory authority to require advisers registered with them to file through the IARD and will postpone

full participation in the system until necessary legislation is enacted.

Section II.C. of this Release discusses our proposed transition process for advisers registered with us.

We understand that these state securities authorities are able to accept broker-dealer filings exclusively through the CRD because NASDR mandates the use of the CRD in its capacity as the self-regulator of its members. NASDR has no similar authority over investment advisers. Anyone interested in a particular state's participation in the IARD should contact the state's securities authority or NASAA.

• Second, NASDR will release the public disclosure system, which should begin operating a few months after the first filings are made on the system.

During the period of time after advisers begin to submit filings to the system and before the public disclosure system is operational, these filings will continue to be available from our public reference room.

• Third, NASDR will release the state investment adviser representative licensing system. We expect that it will begin operating a few months after the public disclosure system is released. It is likely that some states will not participate until their laws have been changed.

• Fourth, the IARD will begin to accept Part 2A of Form ADV.

4. Filing Fees

The Advisers Act permits the operator of the IARD to charge reasonable fees to cover system costs.

We will pay NASDR to build the system; filing fees will be used to pay for its operation and maintenance. NASDR will charge fees for initial applications and annual updating amendments.

These fees will be based on the amount of assets an adviser has under management and the number of states to which the adviser submits notice filings. We expect IARD annual filing fees to range from $200 for smaller advisers to $400 for the largest advisers.

We must approve any fee or fee change, and we will do so only if the proposed fees are reasonable and necessary to support proper operation of the IARD. The IARD also will collect registration, licensing and notice fees on behalf of state securities authorities.

All fee revenues will be segregated from NASDR's other assets and retained for the exclusive benefit of the IARD. The system will be audited annually by an independent public accountant, the results of which will be reported to us and NASAA. We will provide a copy of the report to interested persons.

Section 203A(d).

See supra

note 4 (section 203A(d) of the Advisers Act authorizes us to require advisers to pay the costs associated with electronic filing).

NASDR does not plan to charge fees for other amendments to Form ADV or for filing Form ADV-W (17 CFR 279.2), the Notice of Withdrawal from Registration as Investment Adviser.

As discussed in Section II.C. of this Release,

infra,

we will require advisers that are registered with us to re-submit their registration forms through the IARD. We expect that the IARD filing fees for these one-time submissions and for initial applications will be approximately twice the amount of the IARD annual filing fees. When the IARD accepts investment adviser representative filings on Form U-4 and Form U-5,

supra

note 27, NASDR will establish filing fees for these filings.

We do not charge any registration fees for investment advisers.

See

Changes Selected Rules In Order To Eliminate Fees Previously Adopted by the Commission Pursuant to the Independent Offices Appropriations Act of 1952, Investment Advisers Act Release No. 1578 (Sept. 17, 1996) (61 FR 49957 (Sept. 24, 1996)) (eliminating $150 initial application fee).

Advisers using the system will be required to establish an account with NASDR and maintain funds in the account necessary to pay state fees as well as IARD filing fees.

The IARD will automatically calculate the amount of the fees due based on information provided by the adviser on its Form ADV, debit the adviser's account, and remit amounts due to the appropriate state securities authorities. The IARD will not accept a filing if insufficient funds are on account to pay fees due.

Advisers that are members of the NASD (because they also are broker-dealers) will be able to use their existing CRD accounts to pay IARD filing fees as well as state registration and notice fees. We currently are exploring with NASDR ways for advisers to transfer funds to NASDR for filing and state fees.

The one-stop filing and fee collection functions of the IARD should substantially reduce regulatory burdens on advisers. Larger advisers, which typically will impose more costs on the system by submitting notice filings and paying fees in multiple states, will benefit the most. We believe, therefore, that it is appropriate that larger advisers pay higher fees to support the system.

B. Proposed Amendments to SEC Rules

To implement the IARD, we are proposing new rules and amendments to rules that govern the process by which advisers apply for registration with us, amend their registrations, and withdraw from registration.

This section discusses the proposed rules and rule amendments.

Under the proposed rule amendments, advisers will file Forms ADV and ADV-W through the IARD system. We receive relatively few filings on Form ADV-E (17 CFR 279.8), and accountants that conduct surprise inspections of advisers would continue to file that form with us on paper. We expect to receive few filings on proposed Form ADV-NR, the execution form for non-resident general partners and managing agents of investment advisers (which would be substantially similar to Form 7-R), and we therefore propose to require paper filings of this new form.

See

discussion of proposed Form ADV-NR

infra

at section II.D.3. of this Release and proposed Form ADV-NR is included as Appendix D of this Release. Advisers also would file requests for hardship exemptions in paper format.

See

discussion of proposed hardship exemptions

infra

at section II.B.4. and proposed Form ADV-H

infra

at Appendix C. of this Release.

In addition to the rule changes discussed in detail in this Release, we are proposing to withdraw rule 204-5 (Year 2000 Reports) and Form ADV-Y2K.

1. Applications for Registration on Form ADV

We propose to amend our rules under the Advisers Act to require all advisers applying for registration with us to file Form ADV through the IARD.

Each adviser currently registered with us would be required to re-submit its Form ADV to us using the IARD and the revised form.

We will publish a schedule of dates by which each adviser registered with us must re-submit its Form ADV through the IARD.

Paper filings would be accepted only if the adviser has obtained a continuing hardship exemption, as described below.

Proposed rule 203-1(b). The Advisers Act provides that, within 45 days after a person files an application for registration with us, we must either grant registration under the Act or institute a proceeding to determine whether registration should be denied. Section 203(c)(2) (15 U.S.C. 80b-3(c)(2)). Under the proposed amendments, an application for registration under the Act that is filed with the IARD would be considered filed with us on the date that it is accepted by the IARD. Proposed rule 203-1(c). As discussed above, the IARD will only accept filings that are complete and for which filing fees have been paid. Proposed rule 203-1(d).

We explained in a 1997 release that an adviser and its affiliates could submit a single registration on Form ADV.

See

Rules Implementing Amendments to the Investment Advisers Act of 1940, Investment Advisers Act Release No. 1633 (May 15, 1997) (62 FR 28112 (May 22, 1997)) at n.64. Our experience with advisers that have attempted such a registration has convinced us that Form ADV does not, and cannot be revised to, accommodate this registration, since each adviser may have different responses to the same items. Therefore each affiliated adviser would be required to file a separate Form ADV.

Proposed rule 204-1(b).

See

discussion of transition process

infra

Section II.C. of this Release. Until the date on which an adviser must re-submit its Form ADV, that adviser will continue to make all required amendments on paper using the current (

i.e.,

not revised) Form ADV. When we adopted Uniform Form ADV in 1985, we required all advisers registered with us to re-submit the form.

See

Uniform Investment Adviser Registration Application Form, Investment Advisers Act Release No. 991 (Oct. 15, 1985) (50 FR 42903 (Oct. 23, 1985)).

The proposed hardship exemptions are discussed

infra

in Section II.B.4. of this Release.

2. Amendments to Form ADV

After an adviser has submitted an application for registration on Form ADV or re-submitted its Form ADV through the IARD, the adviser will have to make all amendments through the system.

Our rules would continue to require each adviser to update its Form ADV at least once a year, or more frequently depending upon the information in the form that becomes

stale.

To amend its Form ADV, an adviser would access its Form ADV through the IARD and simply type over the stale information.

The adviser would then electronically “sign”

the form and submit it to the IARD.

The IARD would replace the stale information with the new information submitted and record the date of the change.

Proposed rules 203-1(b) and 204-1(b).

For the rules governing updating of Part 1A,

see

proposed rule 204-1(a) and proposed General Instruction 3 to Form ADV. For the rules governing updating of Part 2,

see

proposed rule 204-3, proposed Instruction 8 to Part 2A, and proposed Instruction 7 to Part 2B.

When an adviser makes its annual updating amendment, information it has previously submitted regarding the amount of its assets under management and other information relevant to its eligibility for SEC registration would not appear. As a result, an adviser would be forced to affirmatively restate its basis for continued eligibility. This approach is not substantively different than the current requirement to re-file Schedule I each year, even if none of the information has changed.

See

rule 204-1(a). As discussed below, we are proposing to bring the information requirements of Schedule I into Part 1A of the form as Item 2.A. and eliminate Schedule I.

See

discussion

infra,

Section II.D.1.a. of this Release.

The process of executing Form ADV and filing it through the IARD system will be an “electronic signature,” but not a “digital signature,” which is an electronic sequence of bits encrypted by a “key” belonging only to the person “signing” the document.

See generally

Information Security Committee, Electronic Commerce Division, Science and Technology Section, American Bar Association, Digital Signature Guidelines § 1.11 (Aug. 1, 1996) (available at <http://www.abanet.org/scitech/ec/isc/dsgfree.html> (last visited Mar. 15, 2000)).

See

discussion of electronic signatures and the proposed execution pages of Form ADV

infra

at Section II.D.3. of this Release. An adviser that has been granted a continuing hardship exemption would amend its Form ADV by submitting Page 1, the appropriate execution page, and each page on which a change is made with the item number circled for which the response is changed.

See

discussion of proposed hardship exemptions at Section II.B.4. of this Release and proposed General Instruction 13 to Form ADV.

All information replaced by the adviser will be retained on the IARD and will remain accessible, although not through the public disclosure system. The public disclosure system will provide access only to current information about each adviser, including disciplinary events occurring during the past ten years.

See

discussion of public disclosure system

supra

at Section II.A.2. of this Release.

3. Withdrawal From Registration

Investment advisers generally withdraw from SEC registration as a result of ceasing operations or switching to state registration.

In either case, an adviser would file Form ADV-W with the IARD.

The IARD will pre-populate the Form ADV-W with information from the adviser's most recent Form ADV filing; the adviser would then complete Form ADV-W, electronically sign it, and submit it to the IARD. We propose to make investment adviser withdrawals effective upon filing, eliminating the current 60-day waiting period.

Eliminating the 60-day waiting period for investment adviser withdrawals would smooth the transition process for advisers switching to state registration.

An adviser might “switch” from SEC to state registration because its assets under management have decreased to below $25 million and therefore it is no longer eligible for SEC registration.

See

section 203A(a) (15 U.S.C. 80b-3a).

Proposed rule 203-2. The proposed amendments to Form ADV-W are discussed

infra

at Section II.E. of this Release and proposed Form ADV-W is included as Appendix B of this Release.

When we adopted the 60-day waiting period of rule 203-2(b), our enforcement remedies were limited primarily to suspending or revoking an adviser's registration, and the waiting period was intended to give our staff the opportunity, in appropriate cases, to investigate or institute proceedings against the adviser before it withdrew its registration.

See

Adoption of Form ADV-W and Amendment of Rule 203-2 Under the Investment Advisers Act of 1940, Investment Advisers Act Release No. 213 (Nov. 13, 1967) (32 FR 16151 (Nov. 25, 1967)). This 60-day delay is no longer necessary, as we now have broader enforcement remedies that may be imposed on all advisers, registered or not.

See

sections 203(i) (fines), (j) (disgorgement), and (k) (cease and desist orders) (15 U.S.C. 80b-3(i), (j) and (k)). We also propose to amend our procedural rules to delete a provision allowing our staff to determine whether a withdrawal should become effective “sooner than the normal 60-day waiting period.”

See

rule 30-11(b)(2)(ii) (17 CFR 200.30-11(b)(2)(ii)).

An adviser withdrawing from SEC registration and switching to state registration currently has a grace period to allow time for the adviser to register with the states.

The preemptive provisions of the Advisers Act, however, preclude the states from regulating the adviser until it has withdrawn from SEC registration.

We propose to adopt a rule amendment that would suspend preemption of a state's laws when the adviser registers with that state.

Once registered with a state, an adviser would become subject to that state's adviser statute while also remaining subject to SEC regulation until it files Form ADV-W to withdraw from SEC registration.

Once the adviser has filed Form ADV-W with us, the adviser generally would be subject only to state regulation.

Rule 203A-1(c) (90 days).

Section 203A(b) of the Act (15 U.S.C. 80b-3a(b)) preempts state laws that would require the registration, qualification and licensing of investment advisers registered with the Commission.

See

Investment Advisers Act Release No. 1633,

supra

note 40 at II.H.1.

See

proposed rule 203A-1(b)(2)(ii). We also are proposing minor amendments to the rule for eligibility for SEC registration by redrafting the rule in plain English and revising it to reflect our interpretation that an adviser is “regulated or required to be regulated” if its principal office and place of business is in a state that has enacted an investment adviser statute.

See

Investment Advisers Act Release No. 1633

supra

note 40 at II.E.1.

An adviser no longer eligible for SEC registration may shorten the time it is subject to regulation by both the Commission and states by withdrawing from SEC registration promptly after registering with the appropriate states. We adopted a rule similar to the switching rule to assist the Ohio Securities Division in implementing a new investment adviser statute enacted in that state.

See

rule 203A-6 (17 CFR 275.203A-6) and Transition Rule for Ohio Investment Advisers, Investment Advisers Act Release No. 1794 (Mar. 25, 1999) (64 FR 15860 (Apr. 1, 1999)).

4. Hardship Exemptions

In proposing to require advisers to file electronically, we are assuming that advisers have computers and access to the Internet, and will be able to submit filings through the IARD.

We recognize, however, that there may be circumstances under which an adviser cannot make an electronic filing, and thus we are proposing two hardship exemptions that advisers could request by filing a short form with NASDR.

A 1998 industry survey of registered investment advisers noted that all respondents use the Internet. According to the survey, advisers “new to the business or those with less than $100 million of assets under management are more active users of the online channel than are higher-net-worth (advisers).”

See

Phil Clark, Cerrulli Survey; Advisers Flock to Internet for Research and Fund Data,

Fund Marketing Alert,

July 6, 1998 at 1. In 1999, the Institute of Certified Financial Planners (ICFP) and Morningstar also conducted a survey of financial planners and found that 99% of those surveyed had Internet access.

See

ICFP/Morningstar,

Work/Computer Environment Among RIAs

(available in File No. S7-10-00). Those advisers that cannot submit electronic filings themselves can obtain the assistance of a filing service—a firm that provides assistance to advisers and broker-dealers in preparing and making regulatory filings. We expect to maintain a list of filing services that an adviser may retain to submit filings on the IARD system.

All requests for a hardship exemption would be submitted on paper to NASDR on proposed Form ADV-H, which is included as Appendix C of this Release. The proposed hardship exemptions are similar to exemptions for issuers that make filings on our EDGAR system.

See

rules 201 and 202 of Regulation S-T (17 CFR 232.201 and 202).

An adviser that files electronically could request a temporary hardship exemption if unexpected difficulties prevent it from filing, such as a computer malfunction or electrical outage.

The exemption would be available upon filing and allow an adviser to delay the deadline for an electronic filing for seven business days.

A continuing hardship exemption

would be available only to an adviser that is a “small business”

and can demonstrate that the electronic filing requirements would create an undue hardship (

e.g.,

the adviser does not have a computer and is unable to

afford a filing service). If we grant a continuing hardship exemption, the adviser would file on paper with NASDR, which would then convert the filing to electronic format and charge the adviser an additional fee to cover conversion costs.

Since primarily larger advisers are registered with us, we expect that few would qualify for a continuing hardship exemption. We request comment on whether a continuing hardship exemption is necessary for SEC-registered advisers.

See

proposed rule 203-3(a)(1).

See

proposed rule 203-3(a)(3). If the circumstances causing the temporary hardship persist, the adviser would have to make other arrangements to file electronically.

An investment adviser generally is a small business if it (a) Manages assets of less than $25 million, (b) has total assets of $5 million or less, and (c) is not in a control relationship with another investment adviser that is not a small business. Rule 0-7 (17 CFR 275.0-7).

Although the adviser would submit Form ADV-H to NASDR, our staff, under authority delegated by us, would grant or deny all requests for a continuing hardship exemption.

See

proposed rule 30-5(e)(7) of our Organization and Program Management Rules (17 CFR 200.30-5(e)(7)).

C. Proposed Transition to Electronic Filing

When we adopt these amendments, we will provide an effective date that will correspond to the commencement of operations of the IARD. After that date, all applicants for registration must file their Form ADV and any amendments electronically through the IARD. We expect to publish a schedule by which advisers registered with us on the effective date will re-submit their registration forms to us through the IARD. We are asking for volunteers to be among the first group of advisers to submit their registration to the IARD.

We encourage advisers that have used the CRD to volunteer. The experiences of this first group will alert us to any problems with the system and allow NASDR to make adjustments. We request comment on our proposed transition process. How soon after the adoption of the new rules and revised form can advisers be ready to submit their Form ADVs through the IARD?

To volunteer, send an e-mail with the adviser's name, SEC 801 number, CRD number (if any), and the name, phone number, and e-mail address of a contact person to iard@sec.gov.

As discussed above, a later release of the IARD will ultimately accept Part 2A of Form ADV.

We propose to require each adviser to file its brochure with us when it makes its first annual update after the IARD begins to accept Part 2A.

During the interim period, advisers will not be required to submit their brochures to us (either in electronic or paper form), but will, instead, be required to keep them and make them available to our staff.

At the request of NASAA, we have included a provision in our proposed rules that a brochure retained by the adviser would be considered “filed” with us.

As a result, until advisers submit Part 2A to the IARD, the state securities authorities could require SEC-registered advisers to file a copy of Part 2A (on paper) with them.

As discussed in Section II.A.3. of this Release, only the firm brochure prepared in response to Part 2A will be submitted through the IARD. We are not proposing to require advisers to file their brochure supplements prepared in response to Part 2B.

We will notify advisers when the IARD begins to accept Part 2A of Form ADV and anticipate providing a grace period before requiring any advisers to file Part 2A electronically.

See

proposed rules 203-1(b)(2) and 204-1(c). Advisers would be required, however, to prepare their brochure in accordance with Part 2 of Form ADV, and to deliver and offer to deliver these brochures in accordance with amended rule 204-3, no later than the date by which all advisers must have re-submitted their Part 1A to the IARD. In addition, advisers would have a 30-day transition period, beginning on the date by which all advisers must have re-submitted their Part 1A to the IARD, to provide their new brochures and brochure supplements to existing advisory clients.

See

discussion of Part 2 and rule 204-3,

infra

at Section II.D. of this Release.

Proposed rule 203-1(b)(2).

See

discussion of “notice filings”

supra

note 14 and accompanying text. As a result of statutory changes made by NSMIA, a state securities authority can only require an SEC-registered adviser to file with the state copies of documents the adviser filed with us.

See

section 307(a) of NSMIA. To accommodate the state securities authorities' request to receive a copy of a document that we do not require SEC-registered advisers to file with us, we are proposing to deem that the filing was made with us.

D. Proposed Revisions to Form ADV

We are proposing substantial revisions to Form ADV.

We have redrafted many items in simpler, more direct language, and have included brief explanations (in the form) of why we need the requested information. We believe that these changes will make it easier for persons to complete the form. The items continue to be drafted broadly to apply to the different types of advisory organizations registered with us and the state securities authorities. We request comment generally on the organization of the form and the clarity of the language we have used.

The paper version of Form ADV would only be used by an adviser with a continuing hardship exemption from the requirement to file the form electronically. The electronic version of the form will elicit the same information but will have minor differences necessary to reflect and, in some cases take advantage of, an electronic environment. For example, the text of Item 2.B. on the paper form would require an adviser amending its Form ADV to circle the box next to the name of the state that is no longer marked and therefore should no longer receive the adviser's notice filings. On the electronic form, the adviser would be directed to “uncheck” the appropriate box.

1. Part 1

Part 1 of Form ADV asks for information about the adviser and persons associated with the adviser. We need this information to decide whether to grant an application for registration or revoke a registration, and to manage our regulatory and examination programs. Some of the changes we are proposing in Part 1 are necessary to accommodate electronic filing. Many are in response to developments since Uniform Form ADV was adopted in 1985.

The most significant regulatory development affecting investment advisers since 1985 occurred in 1996 when Congress passed NSMIA, dividing regulatory jurisdiction over investment advisers between the Commission and the states.

As a result, advisers are no longer required to register with both. Larger advisory firms (generally, those with at least $25 million of assets under management) register only with us, but often must send notice filings to the states and pay state fees.

Smaller advisers register with one or more states,

not with us, and most of our regulatory requirements do not apply to them.

Investment Advisers Act Release No. 991,

supra

note 42.

See

section 203A of the Advisers Act (codifying Section 303 of NSMIA).

See

discussion of “notice filings”

supra

note 14.

All advisers in Wyoming and the U.S. Virgin Islands (the only U.S. jurisdictions that do not have an investment adviser statute) and those whose principal office and place of business is in a foreign country register with us regardless of the amount of assets under management.

See

section 203A(a) of the Advisers Act.

The changes made by NSMIA have allowed us to substantially reorganize Part 1, which we propose to divide into two parts. All advisers would complete Part 1A, while only state-registered advisers would complete Part 1B.

This new organization would allow SEC-registered advisers (and persons applying for SEC registration) to avoid responding to items requiring information we do not need.

a. Part 1A

Part 1A would require an adviser to provide information describing itself and its business through a series of fill-in-the-blank, multiple-choice, and check-the-box questions. As proposed, Part 1A consists of 12 items that request information similar to that requested by current Form ADV.

We are proposing a number of changes, the most significant of which are discussed below.

Part 1B is discussed in Section II.D.1.b. of this Release.

Many of the items in Part 1A appear currently in Part I. Part 1A also includes several items that appear currently in Part II.

See

proposed Items 5.D., 5.E., 5.G., 6, 7, and 8. As proposed, Part 2 will not require advisers to enter data in discrete fields.

See

discussion of Part 2 of Form ADV

infra

Section II.D.2. of this Release.

Identifying Information

. We propose to revise the identifying information we require about the adviser to reflect new information we need. For example, we

would ask for the CRD number of the adviser (if it has one), any web site addresses of the adviser,

an e-mail address of a person we can contact about the form, and the fax number of the adviser.

The identifying information would be included in Item 1 of Part 1A of the form, and multiple or additional narrative responses to certain sub-items would be included on Schedule D.

Schedule I, which currently requires information relevant to whether the adviser should be registered with us or the state securities authorities, would be incorporated into the body of Form ADV in a new Item 2A.

We visit web sites sponsored by advisers registered with us as part of our routine examinations.

See

proposed Items 1.E., 1.I., 1.J. and 1.F(4), respectively, of Part 1A of Form ADV. We are proposing to ask for the social security number and date of birth of control persons reported on Schedules A and B and persons for whom a Disciplinary Reporting Page is filed (discussed below) to permit the IARD to distinguish between persons who share the same name. To protect the privacy of these persons, the social security numbers will

not

be available on the public disclosure system.

See

Amendments to Forms and Schedules to Remove Voluntary Provision of Social Security Numbers, Securities Act Release No. 7424 (June 25, 1997) (62 FR 35338 (July 1, 1997)) (removing social security numbers from filings publicly available on EDGAR). Similarly, the public disclosure system will not report the home address of a sole proprietor (required by proposed Item 1.H.), unless the adviser's home address is also its principal office and place of business (required by proposed Item 1.F.).

Proposed Schedule D would be the continuation schedule for Part 1A. Unlike current Schedule E, proposed Schedule D is structured and formatted based on the specific information to be entered on it.

In addition, proposed Item 6.A. would ask whether the adviser is actively engaged in business as a bank. Recently-enacted legislation requires a bank, or a separately identifiable department or division of a bank, that advises a registered investment company to register with us as an investment adviser.

See

section 217 of the Gramm-Leach-Bliley Act, Pub. L. No. 106-102 (1999).

ii.

Educational and Business Background

. We propose to delete the requirements that an adviser report the educational and business background of its personnel.

Instead, advisers would be required to provide this information to clients in the adviser's brochure or brochure supplements.

Item 12 of Part I of Form ADV currently requires an adviser to provide this information to us for certain control individuals, and to a “jurisdiction” (

i.e.

, a state securities authority) for all individuals giving investment advice in that jurisdiction.

See

Investment Advisers Act Release No. 991,

supra

note 42 at n.5.

See

discussion of Part 2

infra

at Section II.D.2. of this Release.

iii.

Disciplinary Disclosure

. We propose several amendments to the item requiring disclosure of disciplinary information about the adviser and certain of its advisory personnel.

Many of these amendments update the form, and reflect changes that we have made to Form BD over the years.

These changes will also permit advisers that are registered as broker-dealers to electronically copy and link disciplinary disclosure made in response to Form BD on NASDR's CRD system without re-typing the data into the IARD.

As proposed, each adviser—

Proposed Item 11 of Part 1A.

We have substantively amended Form BD several times over the years. When we proposed amendments to Form BD in 1991, we noted that we were considering proposing similar amendments to Form ADV.

See

Amendments to Form BD, Securities Exchange Act Release No. 29643 (Sept. 3, 1991) (56 FR 44029 (Sept. 6, 1991)).

There will remain, however, differences in the scope of disciplinary reporting between advisers and broker-dealers. Form ADV would continue to require advisers to disclose information about the disciplinary record of the adviser and its “advisory affiliates.” The term “advisory affiliate” would continue to be defined to include persons who control or are controlled by the adviser.

See

Item 11 of Part I of Form ADV and proposed Item 11 of Part 1A. Form BD requires broker-dealers to disclose disciplinary information about the broker-dealer and its “control affiliates.” While the term “control affiliate” is defined to include persons who control or are controlled by the broker-dealer, it also includes persons under common control with the broker-dealer.

See

Explanation of Terms, Form BD at page 2. This difference results from differences between the Advisers Act and the Exchange Act, under which broker-dealers are regulated.

Compare

Section 202(a)(17) of the Advisers Act (15 U.S.C. 80b-2(a)(17)) (defining “person associated with an investment adviser”) and Section 3(a)(18) of the Exchange Act (15 U.S.C. 78c(a)(18)) (defining “person associated with broker”).

Another difference between the two terms is that “advisory affiliate” includes all non-clerical employees while “control affiliate” includes only those employees who perform executive duties or have senior policy making authority. Since the disciplinary history of registered representatives of broker-dealers is submitted to NASDR on Form U-4, we previously concluded that it is only necessary for us to require broker-dealers to file on Form BD disciplinary information about broker-dealer employees in “control-type” positions.

See

Requests for Comments on Proposed Amendments to Broker-Dealer Successor Rules, Securities Exchange Act Release No. 21981 (Apr. 26, 1985) (50 FR 19196 (May 7, 1985)).

• Would complete a Disciplinary Reporting Page (DRP) if it responds affirmatively to any of the disciplinary questions.

We are proposing three DRPs, one each for criminal, civil, and regulatory actions. The DRPs would elicit details regarding each disciplinary event in a structured format and replace current Schedules D and E.

The structured format, which we currently use in Form BD, is designed to yield better information than the free-text format of the current schedules.

In completing Form ADV's disciplinary questions on the IARD, an adviser that is registered as a broker-dealer will be presented with a list of all disciplinary events reported on Disciplinary Reporting Pages (DRPs) to its Form BD. The adviser will indicate which of its Form BD DRPs should be included on its Form ADV. These linked DRPs will be incorporated into the adviser's Form ADV. If the adviser subsequently amends its Form BD and modifies any information in a linked DRP, the IARD will alert the adviser that it must either accept the change for its Form ADV or reject the change and unlink the DRP from its Form BD. If the adviser unlinks a DRP, it must maintain separately the Form ADV DRP and the Form BD DRP.

We first replaced Form BD's single DRP with six customized DRPs in 1996.

See

Form BD Amendments, Securities Exchange Act Release No. 37431 (July 12, 1996) (61 FR 37357 (July 18, 1996)). We recently amended Form BD's DRPs for electronic filing in 1999.

See

Securities Exchange Act Release No. 41594,

supra

note 3. The three Form BD DRPs that we are not proposing to include with Part 1A of Form ADV relate to disciplinary questions that we are not proposing to ask in Part 1A. The state securities authorities have included two of these questions (Items 2.C. and 2.D. of Part 1B) and a requirement for two corresponding DRPs (bond and judgment/lien) in proposed Part 1B. We recently amended Form BD's DRPs for electronic filing in 1999.

See

Securities Exchange Act Release No. 41594,

supra

note 3.

Item 11 of Part I currently requires an adviser, for a “yes” answer to one of the disciplinary questions, to describe the action on Schedule E (if the action involved a partnership, corporation or other organization) or Schedule D (if the action involved an individual). Specifically, the adviser must provide the names of the individuals or organizations involved, the title and date of the action, the court or body taking the action, and a description of the action. The information advisers provide has been, in many cases, vague and imprecise. Use of the DRPs has elicited better information from broker-dealers.

• Would only report disciplinary events occurring in the past ten years.

Currently, some questions limit reporting to events that occurred no more than ten years ago, but others have an unlimited reporting period.

Our authority to deny or revoke an adviser's registration for the most serious events—those involving criminal convictions—is limited to ten years following conviction,

a limitation recently reaffirmed by Congress.

Although we have authority to deny or revoke registration based upon lesser (civil or administrative) sanctions

occurring more than ten years ago, we typically do not use that authority.

Over the years, however, we have received many complaints from advisers that are required to report minor disciplinary events occurring decades ago, but that have no other disciplinary events.

This ten-year limit would apply only to disciplinary information required by proposed Item 11 of Part 1A.

See

proposed Item 11 of Part 1A. Advisers may be required to include disciplinary events that occurred more than ten years ago in their brochure and brochure supplements.

See

discussion of Part 2A

infra

at Section II.D.2.a. of this Release. At the request of NASAA, state-registered advisers would continue to be required to report events more than ten years old in response to some questions. Each of the three DRPs we are proposing contain the following item: “This DRP should be removed from the ADV record because the event occurred more than ten years ago.” Checking this item would result in the DRP being removed from the current information about the adviser. All such DRPs, however, would be retained in the IARD.

The reporting periods for the current items generally reflect our authority to deny or revoke the registration of an adviser.

See

section 203(e) (15 U.S.C. 80b-3(e)).

See

section 203(e)(2) and (3) (15 U.S.C. 80b-3(e)(2) and (3)).

See

section 305 of NSMIA (expanding to all felonies our authority to take action against an adviser, while retaining the ten year time limitation) (codified in Section 203(e)(2) and (3) of the Advisers Act).

In response to amendments we proposed to Form BD in 1992, a commenter suggested that we limit all of Form BD's disciplinary questions to ten years. At that time, we noted that Form BD also is used by the state securities authorities and the self-regulatory organizations, which require the disclosure of disciplinary information dating beyond ten years. We therefore decided not to limit the disciplinary reporting obligation in Form BD.

See

Adoption of Form Amendments, Securities Exchange Act Release No. 30958 (July 27, 1992) (57 FR 34028 (July 31, 1992)) at n.13.

These advisers have pointed out that had they committed a more serious infraction and been convicted by a court of a crime, Form ADV would not require any reporting.

• Would not report an unsatisfied judgment or lien; bankruptcy; or bond denial, payout, or revocation.

These disclosures generally are not relevant to our authority to grant or deny registration. An adviser also would not report a finding by a self-regulatory organization that the adviser violated a rule designated as “minor” under a plan approved by the Commission if the sanction imposed consists of a fine of $2,500 or less and the sanctioned person does not contest the fine.

This information is currently required by Items 11.H., 11.I., 11.J., and 11.K. of Part I. These reporting requirements were originally included in the form to “accommodate the regulatory interests of the (states).” Investment Advisers Act Release No. 991,

supra

note 42 at II.C. We are proposing to amend Part 2 of the form to require advisers (and supervised persons) to disclose to their clients whether they have been the subject of a bankruptcy petition during the past ten years and whether the adviser is in a precarious financial condition.

See

proposed Items 18.B. and 18.C. of Part 2A, and proposed Item 7 of Part 2B.

See

Securities Exchange Act Release No. 30958 (making a similar change to Form BD),

supra

note 92.

• Would be required to report actions of foreign courts and regulatory authorities,

and cease-and-desist orders issued by the Commission.

Advisers also would be required to report felony criminal indictments and informations, and misdemeanor informations involving certain offenses,

as well as report military court convictions, misdemeanor perjury convictions, and conspiracy to commit certain offenses.

See

proposed Items 11.A., 11.B., and 11.D. of Part 1A . The International Securities Enforcement Cooperation Act of 1990 (Pub. L. No. 101-550, 104 Stat. 2713 (Nov. 15, 1990) (codified in the Advisers Act at 15 U.S.C. 80b-2(a) and 80b-3)) gave us explicit authority to bar, suspend, or restrict the activities of advisers based on the findings of a foreign court or foreign securities authority. The Exchange Act was similarly amended (codified at 15 U.S.C. 78c(a) and 78o(b)), and Form BD contains substantively similar disclosure requirements.

See

Securities Exchange Act Release No. 30958,

supra

note 92 at n.11.

See

proposed Item 11.C(5) of Part 1A. The Securities Enforcement Remedies and Penny Stock Reform Act (Pub. L. No. 101-429, 104 Stat. 931 (Oct. 15, 1990) (codified in the Advisers Act at 15 U.S.C. 80b-3 and 80b-9)) (Remedies Act of 1990) gave us authority to seek civil monetary penalties in court proceedings and to impose monetary penalties and order disgorgement in administrative proceedings. The Remedies Act also provided us with both temporary and permanent cease-and-desist authority to prevent violations of the securities laws. The Exchange Act was similarly amended (codified at 15 U.S.C. 78u-2 and 78u-3), and Form BD contains substantively similar reporting requirements.

See

Securities Exchange Act Release No. 30958,

supra

note 92 at n.12.

These additional reporting requirements result from our proposed definition of the term “proceeding,” which we have incorporated from Form BD.

See

Broker-Dealer Registration and Reporting, Securities Exchange Act Release No. 31398 (Nov. 4, 1992) (57 FR 53261 (Nov. 9, 1992)). We also are proposing to incorporate from Form BD definitions of the following terms: “charged,” “felony,” “misdemeanor,” “found,” “enjoined,” and “minor rule violation.”

See

Securities Exchange Act Release No. 37431,

supra

note 86.

See

also Glossary of Terms included in Appendix A of this Release.

These changes further conform Form ADV's disciplinary questions to those of Form BD.

See

Form BD Amendments, Securities Exchange Act Release No. 35224 (Jan. 12, 1995) (60 FR 4040 (Jan. 19, 1995)) (proposing), and Form BD Amendments, Securities Exchange Act Release No. 37431,

supra

note 86 (adopting). Similarly, proposed Item 4, asking whether the adviser is succeeding to the business of a registered investment adviser, would conform to Form BD Item 5.

See

Adoption of Revised Form BD and Revised Form BDW, Securities Exchange Act Release No. 20406 (Nov. 22, 1983) (48 FR 54436 (Dec. 2, 1983)).

• Could omit disciplinary information for advisory affiliates no longer associated with the adviser.

100

Form ADV currently provides no easy way for an adviser to indicate that a person for whom the adviser has submitted a Schedule D reporting a disciplinary event is no longer employed by the adviser. Each of the three DRPs we are proposing contains the following item: “This DRP should be removed from the ADV record because the advisory affiliate(s) is no longer associated with the adviser.” Checking this item would result in the DRP being removed from the current information about the adviser and thus not available through the public disclosure system. All such DRPs, however, would be retained in the IARD and would be available to regulators.

iv.

Control Person Disclosure.

We are proposing revisions to the requirements for identifying persons who own or control the investment adviser. These changes, which are reflected in proposed Schedules A, B, and C, conform to the corresponding schedules of Form BD.

101

They should clarify and simplify the reporting of indirect interests in the adviser when, for example, the adviser is part of a large corporate structure. An adviser generally would no longer be required to report an indirect owner unless the indirect owner owned twenty-five percent of a direct owner.

102

Similarly, the instructions to these schedules clarify the requirements for imputing beneficial ownership of an adviser for reporting purposes.

103

101

These schedules to Form BD were adopted in 1992.

See

Securities Exchange Act Release No. 30958,

supra

note 92. As part of its initial application for registration, an adviser would list its direct owners and executive officers on Schedule A, and if an adviser had indirect owners, these owners would be listed on Schedule B. An adviser with a continuing hardship exemption would use Schedule C to amend the information it filed on Schedules A and B. Advisers will not “complete” Schedule C when filing through the IARD; they will simply make changes on Schedules A and B.

Similar to the way the Form BD DRPs submitted by an adviser that also is broker-dealer can be linked to the adviser's Form ADV, the Schedules A and B for such an adviser would be linked. Because the definition of control is the same for Form BD and Form ADV, however, the information submitted in Schedules A and B by an adviser that is a registered broker-dealer must be the same. IARD therefore will require an adviser that is a registered broker-dealer, in completing its Form ADV on the IARD, to acknowledge and accept every change it makes to its Schedules A and B of Form BD.

102

For purposes of Schedule B, the 25% ownership interest is determined based on the form of organization. For a corporation, ownership is based on whether the indirect owner owns 25% or more of a class of voting securities. For a partnership or limited liability company, ownership is based on whether the indirect owner has the right to receive upon dissolution, or has contributed, 25% or more of the partnership's or limited liability company's capital.

In proposing that advisers report only 25% owners of a direct owner, we have attempted to strike a balance between our need to know who controls an adviser and the burden on advisers to collect information about indirect owners. We recognize that it is often difficult for foreign-owned advisers, for example, to obtain ownership information about remote interests.

See

Securities Exchange Act Release No. 30958,

supra

note 92 at Section II.C.1 (describing difficulties for foreign-owned broker-dealers to obtain ownership information). An adviser, however, would be required by proposed Item 10 of Part 1A to identify an indirect owner who owns less than 25% of a direct owner but nonetheless can influence the management or policies of the adviser.

Cf.

Securities Exchange Act Release No. 30958,

supra

note 92 at Section II.C.1(b) (adopting similar reporting requirements for Form BD).

103

See

Securities Exchange Act Release No. 30958,

supra

note 92 at Section II.C.1(a).

Small Businesses.

We are proposing to add a new Item 12 that would request information we need to determine whether the adviser is a small business. We are required by the Regulatory Flexibility Act to consider the effects of our regulations on small businesses and need to know how many advisers registered with us are small businesses.

104

Generally, only those SEC-registered advisers with assets under management of less than $25 million would be required to respond to this item.

105

104

5 U.S.C. 603.

105

See

discussion of rule 0-7,

supra

note 61 (definition of “small business” or “small entity” for purposes of the Advisers Act).

b. Part 1B

Part 1B of Form ADV has been prepared by NASAA on behalf of the

state securities authorities. It would require state-registered advisers to provide information about bonding, arbitration actions, other civil and regulatory actions, and whether sole proprietors have taken certain qualifying exams or attained various professional designations. Most of this information is currently required by the state securities authorities.

Only state-registered advisers will be required to complete Part 1B.

106

Completion of this part of the form, therefore, is not an SEC requirement, and Part 1B is not included in this Release as a proposed SEC rule. We will accept any comments and forward them to NASAA for consideration by the state securities authorities.

107

106

State-registered advisers would be required by state rather than federal law to complete Part 1B.

See

proposed General Instruction 2 to Form ADV.

107

We request that you clearly indicate in your comment letter which of your comments relate to Part 1B.

2. Part 2

Currently, Part II of Form ADV contains the requirements for the disclosure statement that advisers must provide to prospective clients and offer to clients annually. The disclosure statement contains information about the adviser's fees, business practices, and conflicts of interest. Advisers are required to provide clients either a copy of Part II or a narrative brochure that contains at least the information required in Part II.

108

Most advisers provide clients with Part II, which asks a series of multiple-choice and fill-in-the-blank questions supplemented in some cases by narrative schedules.

108

Rule 204-3(a) (17 CFR 275.204-3(a)).

Our experience over the 15 years since Uniform Form ADV was adopted has convinced us that we need a better approach to client disclosure. First, the format of Part II does not lend itself to meaningful, clear disclosure. In some cases, an adviser's response to a question may be accurate but paint an inaccurate picture of its practices. For example, an adviser may truthfully respond to current Item 4.C. by indicating it uses all of the strategies listed by the item, but a client may not appreciate that the adviser's principal strategy involves, for example, risky options trading. In other cases, clients must draw inferences from an adviser having checked a box. For example, if an adviser is paid through commissions on securities that it advises clients to purchase or sell, a checked box in current Item 1.C. will disclose this practice, but not the conflict of interest the adviser has as a result. Advisers can use Part II's narrative schedules to expand on a check-the-box answer, but the schedules are physically separate from the checked box and are often written in legalese or technical jargon.

Second, because the information in Part II concerns the advisory

firm

, clients may not receive information they want and need about the firm's employees with whom they have contact and on whom they rely for investment advice. In the case of smaller firms, the current disclosure requirements, which focus on the senior executives of the advisory firm, may be adequate.

109

But in a growing number of large advisory firms, clients may never meet the firm's senior executives, who may be located in a different city and may have only an indirect effect on the advice given to the client. We believe clients of these firms may be more interested in the background and qualifications of the individuals with whom they are dealing than in the background and qualifications of executive officers.

109

Items 5 and 6 of current Part II.

We propose to address these concerns (and others, described below) by extensively revising the format of advisers' disclosure requirements. Under the proposed rules, each adviser would be required to give clients a narrative brochure written in plain English.

110

Items in Part 2 would specify the disclosure required in the brochure, but advisers would be generally free to structure the disclosure and order the topics in a manner that best conveys the required information. Our model is Schedule H to Form ADV, which currently requires wrap fee program sponsors to give clients a narrative brochure describing the wrap program.

111

Our experience with the wrap fee brochure suggests that narrative firm brochures will provide advisers' clients with better, more understandable disclosure.

110

See

proposed General Instructions 1 and 2 to Part 2 of Form ADV.

111

Schedule H to Form ADV; rule 204-3(f)(1) (17 CFR 275.204-3(f)(1)).

The new adviser brochures would be organized in two parts, a firm brochure and a brochure supplement for each individual who provides advisory services to clients on the adviser's behalf. As described in more detail below, advisers would be required to deliver a brochure to each client, and would be required to deliver an individual's supplement only to those clients to whom that individual will provide advisory services. Part 2A would contain the requirements for the firm brochure, and Part 2B for the brochure supplements.

a. Part 2A: The Firm Brochure

Each adviser registered with us would be required to deliver its brochure at the start of the advisory relationship,

112

and to offer to deliver the brochure annually.

113

Advisers would be required to use their new brochures and brochure supplements to meet these delivery requirements by the end of the first “roll out” phase of the IARD.

114

To allow advisers to make a smooth transition, we are proposing a further 30-day transition period to allow advisers to provide the new brochures and supplements to existing advisory clients.

115

112

The adviser would be required to deliver the brochure before or at the time it enters into an advisory agreement with the client. Proposed amended rule 204-3(b)(1)(A) and Instruction 1 to Part 2A. Our proposed rule and the proposed instructions would clarify that the brochure must be delivered whether the advisory agreement is oral or in writing. For a discussion of proposed supplement delivery requirements,

see infra

text accompanying notes 212-215.

113

Proposed amended rule 204-3(b)(1)(A) and Instruction 1 to Part 2A. Advisers would not be required to deliver or offer a brochure to a client that is a registered investment company or to a client who receives only impersonal advisory services costing less than $500 per year. These exceptions are contained in current rule 204-3(c)(2) (17 CFR 275.204-3(c)(2)), except that the dollar amount threshold would increase from $200 to $500 to reflect the effects of inflation since the rule was adopted in 1979.

See

Investment Adviser Requirements Concerning Disclosure, Recordkeeping, Applications for Registration and Annual Filings, Investment Advisers Act Release No. 664 (Jan. 30, 1979) (44 FR 7870 (Feb. 7, 1979)).

114

See

proposed rule 204-3(i)(1);

see also

Monitored Assets Corp., Investment Advisers Act Release No. 1195 (Aug. 28, 1989) (advisers that refunded prepaid advisory fees only to certain clients violated anti-fraud provisions of the Act).

117

Proposed Instruction 3 to Part 2A. We understand that some advisers have taken the position that the partnership is the “client” and thus the adviser need only deliver the brochure to the general partner,

i.e.

, itself. This position results, for all practical purposes, in the delivery of no brochure, and is inconsistent with the remedial

purposes of the rule. The position is, we understand, based on provisions in rule 203(b)(3)-1(a)(2) (17 CFR 275.203(b)(3)-1(a)(2)), which permit an adviser to treat a partnership as a single client under certain conditions. However, that rule is limited by its terms to counting clients for determining eligibility for the “small adviser exception” to the registration requirements. See section 203(b)(3) (15 U.S.C. 80b-3(b)(3)) and Investment Advisers Act Release No. 1633,

supra

note 40 at section II.G. (“rule 203(b)(3)-1 * * * define(s) the term ‘client’ only for purposes of counting clients under section 203(b)(3) * * * (p)ersons that are grouped together for purposes of (this) section may be required to be treated as separate clients for other purposes under the Advisers Act * * *”). We note the application of the anti-fraud provisions of the Advisers Act to limited partners.

See Abrahamson

Fleschner

, 568 F.2d 862 (2d Cir. 1977),

cert. denied

, 436 U.S. 913 (1978).

118

See

proposed rule 204-3(f).

119

The annual offer, and delivery if the client accepts the offer, is required under current rules 204-3(c)(1) and (4).

120

We have taken enforcement action against advisers under the anti-fraud provisions of the Advisers Act for failing to disclose new conflicts of interest.

See, e.g.

, Renaissance Capital Advisors, Inc., Investment Advisers Act Release No. 1688 (Dec. 22, 1997) (adviser failed to inform clients that it had begun paying for non-research expenses with soft dollar credits).

We believe it is incumbent upon an adviser, as a fiduciary, to keep its clients apprised of material changes in its operations, its fees, key advisory personnel, and other information provided in the advisory brochure. Mutual fund shareholders are not required to rely on information in stale prospectuses; we see no reason why advisory clients should rely on stale brochures. Therefore, we are proposing to require that an adviser provide clients with written brochure updates whenever information in the brochure becomes materially incorrect, and include these updates with brochures delivered to prospective clients.

121

These updates can take the form of either a reprinted brochure or a “sticker,” a piece of paper identifying the stale information and providing the current information.

122

Advisers that deliver their brochure to clients electronically could also deliver stickers electronically.

123

121

As discussed below, advisers would be permitted to use a correction slip or “sticker” to update their brochure if they preferred not to revise the brochure itself. Advisers choosing to update using a sticker could deliver just the sticker to existing clients; advisers choosing to revise the brochure would be required to provide the revised brochure to existing clients in order to notify them of the updated information.

122

See

proposed Instruction 8 to Part 2A. The adviser's choice between reprinting the brochure and using a sticker would apply only to the brochure that the adviser distributes to clients and maintains in its files under our recordkeeping rules. Once the IARD accepts electronic filings of Part 2A, an adviser amending its brochure would be required to refile a revised brochure through the IARD, regardless of whether the adviser has chosen to give clients a sticker or a reprinted brochure. Thus, members of the public viewing the brochure on-line would have access to current information about the adviser.

123

We have published interpretive guidelines for advisers' delivery of disclosure through electronic media.

See

Use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment Advisers for Delivery of Information; Additional Examples Under the Securities Act of 1933, Securities Exchange Act of 1934, and Investment Company Act of 1940, Investment Advisers Act Release No. 1562 (May 9 1996) (61 FR 24644 (May 15, 1996)) (available at <www.sec.gov/rules/concept/33-7288.txt> (last visited Mar. 15, 2000)). Our proposed instructions to Part 2 remind advisers of this option, and provide this website address.

As proposed, advisers could use stickers to update a firm brochure in the same way that sponsors of wrap fee programs currently use stickers to update their narrative wrap fee program brochures.

124

Generally, an adviser could use a sticker for any amendment(s) so long as the brochure remains readable and clear. We would, however, require the adviser to revise (and reprint) its brochure each year as part of its annual updating amendment. Thus, the current brochure that the adviser offers clients annually would be a “clean” document that incorporates the text from all existing stickers. We request comment on this proposal. How many stickers would advisers expect to accumulate over one year? How many changes would those stickers effect, and how complex would they be? Would clients be confused if advisers were required to reprint their brochures only every two or three years, rather than every year?

124

See

current Schedule H to Form ADV.

The information required in a firm brochure would be specified by Part 2A of Form ADV.

125

Part 2A would consist of 19 separate items, each of which elicits required disclosure on a distinct topic.

126

We have drawn the items in Part 2A largely from current Part II, redrafting them as necessary to reflect the narrative format of the new brochure.

127

Some Part 2A items are new, or have been revised to reflect new concerns or developments in the investment adviser industry. Much of the information required in the proposed narrative brochure concerns an adviser's conflicts of interest with its clients, and is disclosure the adviser already must make to clients, as a fiduciary, under the anti-fraud provisions of the Advisers Act.

128

Thus, many of the proposed disclosure items will serve to give advisers guidance on fulfilling their statutory disclosure obligations to clients.

125

Advisers would be permitted to include non-required information in their brochures, provided it does not obscure required information. For example, an adviser could elect to include in its brochure the annual privacy notice required under section 504 of the Gramm-Leach-Bliley Act. P.L. No. 106-102, 113 Stat. 1338 (1999). The Gramm-Leach-Bliley Act, which was signed into law last November, requires investment advisers (among other financial service providers) in certain circumstances to provide initial and annual privacy notices to individuals. The notices must state (i) the adviser's policies and practices regarding its disclosure of nonpublic personal information to other parties, and (ii) how individuals can “opt-out,” that is, prevent the adviser from disclosing their information to nonaffiliated third parties. The Commission proposed rules implementing these privacy notice requirements on March 2, 2000. See Privacy of Consumer Financial Information (Regulation S-P), Investment Advisers Act Release No. 1856 (Mar. 2, 2000) [65 FR 12354 (Mar. 8, 2000)]. Advisers that use their brochure to transmit their annual privacy notice would, of course, need to deliver, not merely offer, the brochure each year.

126

Proposed Part 2A has a main body and an appendix, Appendix 1. Appendix 1 contains the requirements for a specialized type of firm brochure—a wrap fee program brochure. As discussed below, Appendix 1 would require disclosure similar to that required by current Schedule H. In the main body of Part 2A, an additional item, Item 20, sets out additional disclosure that state securities authorities will require of advisers registered with them. Advisers registered only with us would be required to respond only to Items 1 through 19. Item 20 of Part 2A would be a state, rather than an SEC, requirement and therefore we are not requesting comment on it. We will, however, pass on to NASAA any comments we receive on Item 20.

127

In addition, we propose to move other disclosure requirements from current Part II into new Part 2B, for the brochure supplement, and to delete some current Part II items we believe are no longer necessary. We have redrafted the instructions to Part 2 to make them easier to understand and to clarify advisers' obligations under the Advisers Act. The proposed instructions remind advisers that they are fiduciaries and have an obligation to make full and fair disclosure of all material conflicts with clients. The instructions require advisers to use plain English principles in drafting their brochures, provide guidance on preparing different brochures for different clients, explain the special rules for preparing wrap fee brochures, and explain how advisers without an operating history should respond to items. The instructions also explain the brochure rule's delivery requirements, explain brochure updating requirements, remind advisers that under certain conditions they can deliver the brochure electronically, and explain our filing requirements.

128

Section 206 (15 U.S.C. 80b-6).

The items in proposed Part 2A will not, of course, cover every possible conflict. As a result, delivering a brochure (and supplements) prepared in accordance with Part 2 may not fully satisfy an adviser's disclosure obligations. We make this point clear in both the proposed Form and brochure

rule.

129

We request comment whether there are other common disclosures advisers make to clients that we should also include in the items of Part 2.

129

See

proposed General Instruction 3 to Part 2; proposed rule 204-3(g).

Item 1. Cover Page.

The brochure cover page would be required to identify the advisory firm, its business address, and telephone number; the date of the brochure; and the name of a person who can be contacted for further information. The cover page would also include a statement that the brochure has not been approved by the Commission or any state securities authority. If the adviser holds itself out as being “registered,” the cover page must also explain that registration does not imply that the adviser possesses a certain level of skill or training.

130

The cover page would also provide the address of a web site so that a client or prospective client can obtain additional information about the adviser through the IARD.

130

We have observed that the emphasis on SEC registration, in some advisers' marketing materials, appears to suggest that registration either carries some official imprimatur or indicates that the adviser has attained a particular level of skill or ability. Section 208(a) of the Advisers Act (15 U.S.C. 80b-8(a)) makes such suggestions unlawful.

See, e.g.

, Money Machine, Investment Advisers Act Release No. 783 (Nov. 12, 1981) (adviser violated section 208(a) by representing or implying that the Commission had passed upon the adviser's abilities and qualifications); Advanced Analysis, Inc., Investment Advisers Act Release No. 397 (Jan. 18, 1974) (adviser violated section 208(a) by representing that the Commission had passed upon the adviser's qualifications and methods of security analysis).

Item 2. Material Changes.

The brochure would include a summary of material changes since its last annual update, to help clients identify new or revised information. The summary would appear on the cover page of the brochure or immediately thereafter, or could be included in a separate letter sent to clients accompanying the brochure.

131

An adviser including the summary in a separate letter to clients would not be required to file the letter with us, but a proposed amendment to our recordkeeping rule would require the adviser to preserve a copy.

See

proposed rule 204(a)(14)(i).

Item 3. Table of Contents.

The new brochures would include a table of contents detailed enough to permit clients to locate topics easily.

Item 4. Advisory Business.

Advisers would be required to include background information about the advisory firm, including how long it has been in business and the names of its principal owners. The brochure would also describe the firm's advisory business—the types of advisory services offered, whether the adviser tailors services to clients' individual needs, and whether clients may impose individual investment restrictions.

132

Proposed Item 4, together with proposed Item 7, incorporate requirements of current Item 3 of Part II. Proposed Item 4 also incorporates requirements of current Items 1.A. and 1.D. of Part II.

We are not proposing to require all advisers to disclose the details of how they manage client assets. For many advisers, descriptions of how they formulate advice or manage client portfolios are likely to be either too generalized or too client-specific to be helpful. However, we propose to require an adviser that holds itself out as specializing in a particular service to explain its specialty in detail,

133

and to require an adviser that provides advice about only limited types of securities to explain its services and their limitations. In addition, advisers that manage assets would disclose the amount they manage with investment discretion, and the amount without. Wrap fee portfolio managers would explain any differences in their portfolio management for wrap fee and non-wrap clients, as well as identifying the wrap programs they participate in and disclosing that they receive part of the wrap fee.

134

133

In response to proposed Item 7, advisers offering specialized services would also be required to disclose any specific risks their specialty involves.

See

discussion of proposed Item 7,

infra

, text accompanying notes 143-144.

134

Proposed Item 4.F. Item 4.F. would apply only to advisers that

manage portfolios

in wrap fee programs; these advisers would provide wrap fee clients with their regular firm brochure. Advisers that

sponsor

wrap fee programs would prepare a separate “wrap fee brochure” for their wrap fee clients in compliance with Part 2A Appendix 1.

See infra

text accompanying note 202.

Item 5. Fees and Compensation.

The brochure would describe how the adviser is paid for providing advisory services.

135

The adviser would be required to disclose its fee schedule, disclose whether fees are negotiable, discuss whether the firm bills clients or deducts fees directly from the clients' accounts, and explain how often the firm assesses fees. Advisers charging fees in advance would also be required to explain how they calculate and refund prepaid fees when a client contract terminates.

136

135

Proposed Item 5 incorporates requirements of current Items 1.C., 1.D., and 9.B. of Part II.

136

Advisers must refund prepaid unearned advisory fees to clients when the advisory relationship terminates.

See, e.g.

, Jason Baker Tuttle, Sr.,

supra

note 116.

Advisory clients may not appreciate that they will bear other costs in addition to advisory fees. Thus, in addition to information about advisory fees, we propose to require the brochure to describe the types and amounts (or ranges) of other costs, such as brokerage, custody fees, and fund expenses, that clients may pay in connection with advisory services.

In some cases, the type of compensation an adviser receives will involve a conflict of interest. An adviser that receives commissions or other payments for sales of securities to clients (transaction-based compensation) has a serious conflict of interest with its clients.

137

This practice gives the adviser and its personnel an incentive to base investment recommendations on the amount of compensation they will receive rather than on the client's best interests.

138

We propose to require advisers who receive transaction-based compensation (or whose personnel receive transaction-based compensation) to disclose this practice and the conflict of interest, and to describe the firm's control procedures for addressing the conflict.

139

Item 5 would also require these advisers to disclose that clients may purchase the same securities or investment products from other brokers.

140

Should proposed Item 5 also require an adviser to discuss its conflict of interest in charging performance or incentive fees, or should

we continue to rely on anti-fraud provisions to require disclosure when this type of fee structure presents a material conflict?

141

137

A congressional committee has characterized the practice of an adviser receiving transaction-based compensation as “(o)ne of the most serious and frequent conflicts of interest that advisers have with clients.” H.R. Rep. No. 75, 103d Cong., 1st Sess. 19 (1993).

138

Because of this conflict, advisers are required by the anti-fraud provisions of the Advisers Act to disclose their receipt of such compensation to clients. We have brought enforcement actions against advisers who failed to make such disclosures.

See

Carona & Hodges Management, Inc., and James G. Carona, Investment Advisers Act Release No. 1403 (Feb. 8, 1994) (adviser invested client assets in risky, developmental-stage companies without disclosing that the adviser received loan fees from those companies for doing so); Westmark Financial Services Corp., Investment Advisers Act Release No. 1117 (May 17, 1988) (adviser and principal failed to state that they would receive commissions on certain securities they recommended to clients); and John S. Lalonde, Investment Advisers Act Release No. 1103 (Jan. 25, 1988) (adviser failed to disclose commissions received on sales of limited partnership interests).

139

As discussed below, advisers may engage in practices that must be disclosed under both proposed Item 5 and proposed Item 10.A., which would require disclosure when the adviser has a financial interest in securities that it recommends to clients, or under both proposed Item 5 and proposed Item 13, which would require disclosure when the adviser receives an economic benefit from a non-client. A brochure would not need to repeat information simply because the information is responsive to more than one item.

140

E.g.

, Westmark Financial Services Corp., Investment Advisers Act Release No. 1117 (May 16, 1988) (adviser failed to disclose that clients could purchase securities from other broker-dealer). In addition, an adviser that receives more than 50% of its revenue from commissions and other sales-based compensation would explain that commissions are the firm's primary (or, if applicable, exclusive) form of compensation, and an adviser that charges

both

advisory fees and commissions would disclose whether it reduces its fees to offset the commissions.

141

See

Exemption To Allow Investment Advisers To Charge Fees Based Upon a Share of Capital Gains Upon or Capital Appreciation of a Client's Account, Investment Advisers Act Release No. 1731 (July 15, 1998) (63 FR 39022 (July 21, 1998)).

Item 6. Types of Clients.

The brochure would describe the types of advisory clients the firm generally has. The adviser would also disclose its requirements, such as minimum account size, for opening or maintaining an account.

142

Proposed Item 6 incorporates requirements of current Items 2 and 10 of Part II.

Item 7. Methods of Analysis, Investment Strategies and Risk of Loss.

Item 7 would require the brochure to describe the adviser's methods of analysis and investment strategies. As noted earlier, Item 4 of Part II currently asks for the adviser's methods of analysis, sources of information, and investment strategies through a series of check boxes. The current format necessarily covers a limited number of analytical methods and strategies. Moreover, clients may not appreciate the meaning of the methods listed, or may not understand the implications for how client accounts are actually managed using a particular method.

143

We believe that an adviser's narrative description will provide clients with more useful information.

143

See

current Item 4 of Part II. Proposed Item 7 also incorporates requirements of current Item 3 of Part II.

We are also proposing that the brochure discuss the risks clients face in following the adviser's advice or permitting the adviser to manage assets. Advisers that offer a wide variety of advisory services could simply explain that investing in securities involves a risk of loss; we would not require these advisers to list the risks involved in each type of security or trading strategy. Advisers that use primarily a particular method of analysis, strategy, or type of security would be required to explain the specific risks involved,

144

with more detail if those risks are significant or unusual.

144

Advisers whose primary strategy involves frequent trading would have to explain how the strategy may affect performance, due to higher transaction costs and taxes.

Item 8. Disciplinary Information.

We propose to require an adviser's brochure to disclose information about the firm's disciplinary history. This disclosure would include descriptions of, among other events, any convictions for theft, fraud, bribery, perjury, forgery and violations of securities laws by the adviser or one of its executives. Disciplinary events such as these reflect on the integrity of the adviser and its management persons. Thus, disclosure of this information is material to clients.

Although we have long viewed the anti-fraud provisions of the Advisers Act as requiring advisers to disclose disciplinary information,

145

we have not required this disclosure to be included in Part II of Form ADV or the client brochure.

146

One of our anti-fraud rules, rule 206(4)-4, requires advisers to inform clients and prospective clients promptly about any “legal or disciplinary event that is material to an evaluation of the adviser's integrity or ability to meet contractual commitments to clients.”

147

The rule provides a list of events that are presumed to be material if they occurred in the previous ten years.

148

The adviser may (but is not required to) make this disclosure in its brochure, and may make it orally.

145

See, e.g.

, Jesse Rosenblum, Investment Advisers Act Release No. 913 (May 17, 1984) (adviser who failed to tell prospective clients about an injunction obtained against the adviser by state securities authority “omitted a material fact that was essential to an evaluation of his qualifications as an investment adviser * * * (and that) investors surely would have wanted to know (about the injunction) before entrusting their funds to (the adviser's) management”).

146

When we proposed Uniform Form ADV in 1985, we considered requiring advisers' brochures to contain substantially the same disciplinary information advisers must report to us, which includes disciplinary information not only about the adviser and its management persons but also about its advisory personnel. Uniform Investment Adviser Registration Application Form, Investment Advisers Act Release No. 967 (Apr. 24, 1985) (50 FR 18500 (May 1, 1985)). When we adopted Uniform Form ADV later in 1985, we excluded this requirement because of concerns that, in some cases, the information could be voluminous. Investment Advisers Act Release No. 991,

supra

note 42. Under the current proposal, as discussed above, the disciplinary information in the firm's brochure would be limited to information about the firm and its management persons and, as discussed below, would be similar to that currently presumed to be material under rule 206(4)-4. Disciplinary information about advisory personnel would be included in brochure supplements.

See

discussion of proposed Item 3 of Part 2B,

infra

Section II.D.2.b. of this Release.

147

Rule 206(4)-4(a)(2) (17 CFR 275.206(4)-4(a)(2)).

148

Rule 206(4)-4(b) (17 CFR 275.206(4)-4(b)).

Information about an adviser's illegal or unethical conduct is very important to a client who is deciding whether to engage or continue to engage the adviser. When assessing whether an adviser will fulfill its obligations to clients, an investor would likely give great weight to whether the adviser has met its fiduciary and other legal obligations in the past. Because of the importance of this information to clients, we are proposing to require it be in writing and included in the brochure along with other material information about the adviser.

149

A writing requirement will also permit us to better monitor compliance with this disclosure requirement.

150

We request comment on this proposal, specifically whether disciplinary information should appear in a separate written document accompanying the brochure, rather than the brochure itself, in order to highlight its importance to advisory clients. We also request comment whether there are other approaches to achieve these same disclosure and compliance objectives.

149

In addition, the IARD will permit a client or prospective client to view an adviser's reports of disciplinary events in response to proposed Item 11 of Part 1A of Form ADV. However, we would not rely on the IARD to inform clients and prospective clients of disciplinary events. We believe that advisers have an affirmative obligation under the Advisers Act to disclose material disciplinary events to clients and prospective clients, and that clients and prospective clients should not bear the burden of engaging in such a search (and updating it continuously). We also note that proposed Item 8 of Part 2A and current rule 206(4)-4 both require disclosure of all material disciplinary events, which is broader than proposed Item 11 of Part 1A would require.

150

Under rule 206(4)-4, an adviser must disclose a disciplinary event to clients “promptly.” As a result, including this information in the brochure (under current rules) may not satisfy rule 206(4)-4, because the brochure must only be delivered to clients at the beginning of the advisory relationship and offered annually thereafter.

See

note appended to rule 206(4)-4. Our proposed revisions to the updating requirement would resolve the differences in the delivery requirements.

See supra

Section II.D.2.a. of this Release.

We have modeled proposed Item 8 on rule 206(4)-4, which we propose to rescind. Item 8 would require an adviser's brochure to disclose all material facts about any legal or disciplinary event material to evaluating the adviser's business or the integrity of its management. An adviser must

presume

that certain disciplinary events described in Item 8 are material if the event involved the adviser or a management person and occurred in the previous ten years.

151

The adviser may overcome (rebut) this presumption, in which case no disclosure is required. A note in Item 8 would explain four factors the adviser should consider when assessing whether the presumption can be rebutted.

152

propose to require advisers registered with us to keep a file memorandum if the adviser does not disclose an event described in Item 8. The memorandum will memorialize the adviser's determination, avoid later disagreements as to the basis for the determination, and better permit our staff to monitor compliance with this important disclosure requirement.

153

151

An adviser's “management persons” are anyone with the power to exercise, directly or indirectly, a controlling influence over the adviser's management or policies, or to determine the general investment advice given to the adviser's clients.

See

Glossary of Terms, definition of “management person.”

152

These factors are: (1) The proximity of the person involved in the disciplinary event to the advisory function; (2) the nature of the infraction that led to the disciplinary event; (3) the severity of the disciplinary sanction; and (4) the time elapsed since the date of the disciplinary event. These are the same factors advisers use to determine materiality under current rule 206(4)-4.

See

Financial and Disciplinary Information that

Investment Advisers Must Disclose to Clients, Investment Advisers Act Release No. 1083 (Sept. 25, 1987) (52 FR 36915 (Oct. 2, 1987)).

153

The memorandum would be required to explain the adviser's determination and to discuss the four factors set forth in Item 8. Proposed rule 204-2(a)(14)(ii). Proposed Item 3 of Part 2B requires a brochure supplement to contain disclosure of legal or disciplinary events involving the adviser's supervised persons. Proposed rule 204-2(a)(14)(ii) would require the same memorandum in the event the adviser does not disclose an event described in Item 3 of Part 2B.

We are proposing several revisions to the provisions in the list of disciplinary events that would move from rule 206(4)-4 into new Item 8. First, we would update some of the provisions to reflect changes in the law.

154

Second, we would make certain clarifying revisions to the listed events.

155

Finally, we would require an adviser subject to one of our administrative orders to provide clients and prospective clients with a copy of that order for a period of one year following the date of the order.

156

154

First, all felonies (not only those involving investment-related statutes) would be presumed material. Congress amended section 203 of the Advisers Act in 1996 to permit us to deny or revoke an adviser's registration, or bar, suspend or limit an adviser's activities, if the adviser has been convicted of

any

felony within the past ten years. Section 305 of NSMIA,

supra

note 91. Current Item 11.A. of Part I already requires advisers to report all felonies to us. Second, actions of foreign courts and financial regulatory authorities would be included. Congress's 1990 amendments to the Advisers Act permit us to deny or revoke an adviser's registration, or bar, suspend or limit an adviser's activities based on the findings of a foreign court or foreign securities authority.

See supra

note 96. Third, monetary penalties in administrative proceedings would be required to be disclosed. Congress gave us authority to impose monetary penalties in administrative proceedings in the Remedies Act of 1990.

See supra

note 97.

155

These proposed changes clarify that: (a) A conviction for conspiracy to commit any felony or to commit any listed misdemeanor is a criminal conviction that must be disclosed; (b) a military court is a court of competent jurisdiction; and (c) an order enjoining the adviser or a management person from violating an investment-related statute, rule, or order must be disclosed.

See

proposed Item 8.A. We have also added explanatory text to the definition of “management person.”

See

Glossary of Terms, definition of “management person.”

156

This requirement would apply if the date of the order is on or after the effective date of these revisions to Form ADV. As a condition of settlement in administrative proceedings against certain investment advisers, we have required the advisers to send copies of our orders to existing clients and, for one year, to prospective clients.

E.g.

, Capital Markets Research Co., Investment Advisers Act Release No. 1834 (Sept. 27, 1999); Boston Investment Counsel, Inc., Investment Advisers Act Release No. 1801 (June 10, 1999); Valicenti Advisory Services, Inc., Investment Advisers Act Release No. 1774 (Nov. 18, 1998); Renaissance Capital Advisors, Inc., Investment Advisers Act Release No. 1688 (Dec. 22, 1997); Account Management Corporation, Investment Advisers Act Release No. 1529 (Sept. 29, 1995). Because our orders include findings of the facts underlying the violations, requiring that a client receive a copy of that order provides us with greater assurance that the client will be accurately informed of the adviser's behavior. The Second Circuit recently affirmed our authority to impose this form of remedy. Valicenti Advisory Services,

Inc.

SEC,

No. 99-4002, 1999 U.S. App. LEXIS 35879 (Nov. 30, 1999, amended Feb. 9, 2000) (

per curiam

Rule 206(4)-4 requires an adviser to disclose a civil action in which the adviser is found to have violated an investment-related statute.

157

Today, however, many disputes between securities firms and their customers are resolved through arbitration or other alternative dispute resolution, rather than civil lawsuits. As a result, there may now be more violations of investment-related statutes that are not presumed to be material under rule 206(4)-4 and therefore are not typically disclosed to clients. In Item 20 of Part 2A, state securities authorities have included a requirement that state-registered advisers disclose certain arbitration liability if the claim was in excess of $2,500. Should we include a similar requirement in Item 8? If so, should our requirement be limited to arbitration

awards

for $2,500 rather than

claims

for $2,500? Should the amount be higher? Since some arbitrators may not issue reports of their findings, how should we draft Item 8 to distinguish arbitrations involving matters that do not reflect upon the integrity of the adviser (such as some contract disputes), from those that do? Should we limit the requirement to arbitrations in which the arbitrator finds a violation of an investment-related statute? If we do, will advisers and their affiliates decline to agree to use arbitrators who make findings?

157

Rule 206(4)-4(b)(1)(ii) (17 CFR 275.206(4)-4(b)(1)(ii)).

Item 9. Other Financial Industry Activities and Affiliations.

We propose to require advisers to disclose information about their other financial industry activities and affiliations. These other activities and affiliations may create conflicts of interest between the advisory firm and its clients, and may impair the objectivity of the investment advice given.

Proposed Item 9 would require an adviser to disclose whether it (or any of its management persons) is registered or has applied to register as a broker or commodities professional. The brochure would also describe material arrangements the adviser (or any of its management persons) has with related financial industry participants. Advisers must currently provide similar disclosure under Item 8 of Part II. The brochure would also describe any material conflict of interest with advisory clients that the relationship or arrangement creates with clients, and the restrictions or other control procedures the adviser uses to address the conflict.

158

In addition, if the adviser selects or recommends other advisers for clients, proposed Item 9 would require disclosure of any compensation arrangements and other business relationships between the two advisory firms, as well as of the conflicts created.

158

Brochure supplements would be required to contain similar disclosure, concerning the other business activities of the adviser's supervised persons.

See

proposed Item 4 of Part 2B and the discussion below at Section II.D.2.b. of this Release.

Item 10. Participation or Interest in Client Transactions; Personal Trading.

Item 10 would require the brochure to discuss the conflicts of interest the adviser faces when the advisory firm or a “related person” has a financial interest in, or trades in, securities they recommend to clients.

159

Advisers would be required to disclose any practices giving rise to these conflicts, the nature of the conflicts presented, and any procedures and controls the adviser uses to address the conflicts.

160

159

This item incorporates many of the disclosure requirements of Item 9 of Part II. An adviser's related persons are: (1) the adviser's officers, partners, or directors (or any person performing similar functions); (2) all persons directly or indirectly controlling, controlled by, or under common control with the adviser; (3) all of the adviser's current employees; and (4) any person providing investment advice on the adviser's behalf.

160

Many advisers have extensive procedures in place to monitor and control employees' personal securities trades and financial interests; these procedures may include pre-clearance, restricted lists, blackout periods, or periodic reporting. Section 204A (15 U.S.C. 80b-204a) of the Advisers Act requires most advisers to establish policies and procedures to prevent misuse of material, nonpublic information, and rules 204-2(a)(12) and (13) (17 CFR 275.204-2(a)(12) and (13)) require advisers to keep records of their securities transactions and those of their “adviser representatives.” In addition, our rules under the Investment Company Act require advisory firms that advise registered investment companies to adopt a written “code of ethics” to address conflicts arising out of personal trading, and to file those codes with us. We recently revised those rules in order to provide greater protection against improper personal trading by persons who have access to information about mutual funds' purchases and sales of securities. Investment Company Release No. 23958 (adopting amendments to rule 17j-1 under the Investment Company Act (17 CFR 270.17j-1)),

supra note

Proposed Item 10 is designed to shed sunlight on two types of practices that can harm advisory clients. The first is

when an advisory firm (or a related person) has a material financial interest in an issuer of securities it recommends to clients. For example, the adviser may recommend that clients invest in an investment company that the firm advises, or a partnership for which the firm is the general partner.

161

Similarly, the adviser may recommend that a client buy securities in a public offering underwritten by the adviser's affiliate. Or, an adviser with a material financial interest in a company may recommend that a client buy shares in that company's public offering, when the success of the offering could increase the value of the adviser's investment.

162

An adviser engaging in these practices has an incentive to base its advice on its own financial interests rather than the interests of clients, and the proposed item is designed to help a client understand the conflict. Item 10.A. would require full disclosure of these conflicts and provide guidance on the types of conflicts covered.

163

We request comment whether additional guidance would be useful to advisers.

161

See

Thomson McKinnon Asset Management, L.P., Investment Advisers Act Release No. 1243 (July 26, 1990) (adviser failed to disclose that it received advisory fees from a money market fund into which it “swept” clients' cash balances).

162

See, e.g.,

Chancellor Capital Management, Inc., Investment Advisers Act Release No. 1447 (Oct. 18, 1994) (adviser failed to disclose, when recommending publicly traded securities of an issuer to client, that adviser's related person owned non-publicly traded securities of the same issuer).

163

We are proposing an exception, in Item 10.A., for advisers' investments in mutual funds that they recommend to clients. These investments typically do not raise conflicts because the securities are valued at their net asset value; however, an adviser would still be required to disclose the conflict created when it receives a

fee

from a fund it recommends to clients.

See

Example 3 of proposed Item 10.A.

See

Thomson McKinnon,

supra

note 161.

The second practice involves personal trading abuses. Because of the information they have, advisers and their personnel can “front run” client trades or otherwise abuse their positions. For example, an adviser may be able to sell (or sell short) its own position in a security in advance of large client sell orders that could be expected to drive down the price of that security. Similarly, an adviser may acquire a position in a stock, advise clients to buy the same stock, and profit by the resulting increase in price.

164

These practices not only may affect the adviser's recommendations, but also can harm clients by affecting adversely the prices at which clients buy or sell securities.

164

See

Roger Honour, Investment Advisers Act Release No. 1527 (Sept. 29, 1995).

Under proposed Item 10.B., an adviser would disclose whether it or a related person (

e.g.,

advisory personnel) invest—or are permitted to invest—in the same securities as their clients, or in related securities such as options or other derivatives.

165

Firms engaging in or permitting this practice would discuss the conflicts presented, and describe the firm's restrictions and/or internal procedures to address the conflicts. Item 10.C. would require a similar discussion, but focus on the specific conflicts an adviser has when it (or a related person) trades in the same securities at or about the same time as a client. In response to this item, an adviser might explain how its internal controls prevent the firm and its staff from buying or selling securities in advance of client transactions.

Item 11. Brokerage Practices.

Item 11 would require the brochure to describe the adviser's policies and practices in selecting brokers for client transactions, and in determining the reasonableness of brokers' compensation. As we explain in more detail below, the item would require the adviser to disclose its policies and practices with respect to “soft dollars,”

i.e.,

the receipt of benefits such as research for the allocation of client brokerage.

Soft Dollar Practices.

Advisers often receive “soft dollar” benefits from using particular brokers for client trades.

166

Client brokerage, however, is an asset of the client—not of the adviser. When, in connection with client brokerage, an adviser receives products or services that it would otherwise have to produce itself (or pay for), the adviser's interest may conflict with those of its clients. For example, soft dollar arrangements may cause an adviser to violate its best execution obligation by directing client transactions to brokers who are not able to adequately execute the transactions, or may give the adviser incentive to trade client securities more often than it would absent the benefits the adviser receives. Because of these conflicts, we have required advisers to disclose their policies and practices on use of client brokerage to obtain soft dollar benefits.

167

165

Some situations, such as when an adviser owns shares in a company it recommends to clients, may be covered by both proposed Items 10.A. and 10.B. Others, such as when an adviser sells its holdings of a security it purchases for clients, would come under 10.B, and potentially 10.C. A brochure would not need to repeat disclosure simply because it is responsive to more than one item.

166

Section 28(e) of the Exchange Act (15 U.S.C. 78bb(e)) provides a limited “safe harbor” for advisers with discretionary authority in connection with their receipt of soft dollar benefits.

See

discussion of this safe harbor,

infra

note 176.

167

Item 12 of current Part II.

During 1997-98, our staff conducted a wide-ranging examination of advisers' soft dollar practices and disclosure. Our Office of Compliance Inspections and Examinations found widespread use of soft dollars by investment advisers that manage client portfolios.

168

The Office concluded that advisers' disclosure often failed to provide sufficient information for clients or potential clients to understand the adviser's soft dollar practices and the conflicts those practices present. In its report, the Office noted that most advisers' descriptions were simply boilerplate, and urged that we consider amending Form ADV to require better disclosure.

169

Today we are acting on those recommendations.

170

168

Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds (Sept. 22, 1998) (Soft Dollar Report).

169

Id.

at 3, 50-51.

170

The Office also recommended further rulemaking in this area, which we may consider in the future. Among the suggestions detailed in the Soft Dollar Report were: (a) requiring advisers to provide clients with client-specific itemizations of soft dollar benefits the adviser received during the previous period, and (b) requiring advisers to maintain certain records of soft dollar benefits received and the adviser's allocation of so-called “mixed-use” items between research and non-research functions.

Id.

at 49-51.

Item 11 would require an adviser that receives research or other products or services in connection with client securities transactions (soft dollar benefits) to disclose the adviser's practices and discuss the conflicts of interest that result.

171

The brochure's description of soft dollar practices must be specific enough for clients to understand the types of products or services the adviser is acquiring and permit them to evaluate conflicts.

172

Disclosure must be more detailed for products or services not used in the adviser's investment decision-making process.

171

The soft dollar benefits covered include any research, products or services, whether created or developed by the broker-dealer itself or by a third party.

See

note to proposed Item 11.A.1. of Part 2A.

172

In this regard, the proposed item would incorporate the standard for advisers we set out in our 1986 interpretive release on soft dollars. Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters, Exchange Act Release No. 23170 (Apr. 23, 1986) (1986 Soft Dollar Release).

Item 11 would describe the types of conflicts the adviser must disclose when it accepts soft dollar benefits,

173

and

require the adviser to disclose its procedures for directing client transactions to brokers in return for soft dollar benefits.

174

The item would require the adviser to explain whether it uses soft dollars to benefit all clients

175

or just those accounts whose brokerage “pays” for the benefits, and whether the adviser seeks to allocate the benefits to client accounts proportionately to the brokerage credits those accounts generate. The item would also require the adviser to explain whether it “pays up” for soft dollar benefits.

176

173

An adviser accepting soft dollar benefits would have to explain that (a) the adviser benefits because it does not have to produce or pay for the research, other products, or services acquired with soft dollars, and (b) the adviser therefore has an incentive to select or recommend broker-dealers based on the adviser's interest in receiving these benefits, rather than on the client's interest in getting the best execution services at the lowest available rates.

174

See

proposed Item 11.A.1.e. of Part 2A, which is substantively the same as current Item 12.B. of Part II.

175

Using one client's brokerage to obtain research or other products that benefit another client's account is often called “cross-subsidization.”

176

“Paying up” refers to a manager causing a client account to pay more than the lowest available commission rate. Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor for managers who pay up to obtain research from brokers. Under section 28(e), someone who exercises investment discretion over a client account has not acted unlawfully or breached a fiduciary duty

solely

by causing the account to pay more than the lowest commission rate available, so long as that person determines in good faith that the commission amount is reasonable in relation to the value of the brokerage and research services provided. The 1986 Soft Dollar Release clarified the Commission's interpretation of section 28(e). Section 28(e), however, does not speak to an adviser's disclosure obligations—advisers must disclose their receipt of soft dollar benefits to clients whether the benefits fall inside or outside of the safe harbor.

See

1986 Soft Dollar Release,

supra

note 172.

Client Referrals.

The brochure would also be required to discuss the adviser's practice in using client brokerage to reward brokers that refer clients.

177

This practice also presents advisers with serious conflicts of interest since they may have a bias towards referring brokers. The brochure would have to disclose this practice, the conflict it creates, and any procedures the adviser used to direct client brokerage to referring brokers during the last fiscal year,

i.e.,

the system of controls used by the adviser when allocating brokerage.

177

Proposed Item 11.A.2. of Part 2A.

See

Fleet Investment Advisors, Inc., Investment Advisers Act Release No. 1821 (Sept. 9, 1999) (adviser failed to disclose to clients that it directed brokerage commissions in exchange for client referrals).

Transaction Costs.

Clients engaging an adviser can benefit when the adviser negotiates lower commissions or “bunches” trades to obtain volume discounts on execution costs.

178

Item 11 would require the adviser to describe these practices. If the adviser does not bunch trades when it has the opportunity, the brochure would be required to explain that clients may pay higher brokerage costs. Similarly, if the adviser does not negotiate commissions, or limits the extent to which it negotiates them, the brochure would be required to explain that clients may pay higher brokerage costs as a result.

179

178

Broker-dealers may, for example, offer better prices, including lower commission costs, and/or better execution for larger orders. Generally, our staff has not recommended enforcement action against advisers that aggregate trade orders on behalf of clients, so long as the adviser allocates the trades in a way that treats all clients fairly.

E.g.,

Pretzel & Stouffer, SEC No-Action Letter (Dec. 1, 1995); SMC Capital Inc., SEC No-Action Letter (Sept. 5, 1995). However, advisers violate the Advisers Act's anti-fraud provisions if they fail to disclose allocation policies that disadvantage a client.

See

Account Management Corporation,

supra

note 156 (adviser failed to disclose that it allocated shares in “hot” initial public offerings only to limited number of eligible client accounts);

cf.

Nicholas Applegate Capital Management, Investment Advisers Act Release No. 1741 (Aug. 12, 1998) (adviser failed to supervise senior trader who allocated profitable day trades to his own personal account rather than to client account).

179

Proposed Item 11.B.

See

Mark Bailey & Co., Investment Advisers Act Release No. 1105 (Feb. 24, 1988) (adviser that failed to disclose that it did not negotiate commissions on directed trades, failed to disclose that the adviser would be in a better position to negotiate commissions in batched transactions for non-directed trades, and failed to inform clients that commissions might be lower on non-directed trades, violated anti-fraud provisions of Advisers Act).

Directed Brokerage.

Clients sometimes instruct their adviser to send transactions through a specific broker. Clients may initiate this type of arrangement for a variety of reasons: the client may wish to favor a family member or friend, or the client may be using its own brokerage to pay for services the broker provides to the client.

180

But the arrangement may also be initiated by the adviser, who may benefit, for example, when brokerage is directed to its affiliated broker-dealer. In either case, clients directing (or agreeing to direct) brokerage need to understand the consequences of directing brokerage, including the possibility that their accounts will pay higher commissions and receive less favorable execution.

181

180

A client may also direct its transactions to a broker that agrees to make cash rebates to the client. As noted in the Soft Dollar Report, this directed brokerage practice is referred to as “commission recapture.” Soft Dollar Report,

supra

note 168 at n.42. We are proposing a separate disclosure requirement, discussed below, relating to commission recapture.

181

1986 Soft Dollar Release,

supra

note 172 at n.44.

If an adviser

permits

clients to direct brokerage, we would require the brochure to explain that the adviser may be unable to get best execution, and that directing brokerage may cost clients more money. If, however, the adviser

routinely requests or requires

clients to direct brokerage, the brochure would also be required to describe the adviser's policy or practice, to disclose that not all advisers require directed brokerage, and to discuss any broker-dealer relationship that creates a material conflict of interest.

182

Proposed Item 11.A.3.b. of Part 2A.

Commission Recapture.

183

An adviser that sends brokerage to a firm providing commission recapture would describe how recapture works, explain the benefits of recapture, and explain how a client could participate in recapture. We request comment on this disclosure requirement: which types of clients can generally participate in commission recapture programs, and how do clients currently learn that such programs are available?

183

As discussed

supra

at note 180, commission recapture involves directing brokerage in exchange for cash rebates made to the client.

Item 12. Review of Accounts.

The brochure would disclose whether, and how often, the adviser reviews clients' accounts or financial plans, and would identify who conducts the review.

184

Advisers that review accounts, but not regularly, would explain what circumstances would trigger an account review.

184

Proposed Item 12 of Part 2A incorporates requirements currently in Item 11 of Part II.

Item 13. Payment for Client Referrals.

The brochure would describe any payment, whether in cash or otherwise, that the adviser or a related person makes for client referrals. The brochure would also disclose whether the adviser receives any benefit, including sales awards or prizes, from a non-client for providing advisory services to clients.

185

Proposed Item 13 of Part 2A incorporates requirements in current Item 13 of Part II. Proposed Item 13 would require advisers to disclose economic benefits to the firm; as discussed below, proposed Item 5 of Part 2B would require advisers to disclose economic benefits to a supervised person.

See infra

Section II.D.2.b. of this Release.

Item 14. Custody.

Advisers that accept custody of client funds or securities would say so in their brochure and would describe any special reports they give to those clients.

186

Advisers that

require

custody of client assets would also explain that most advisers do not impose this requirement.

187

The brochure would also disclose that clients face greater risk than if an independent custodian held their assets.

188

186

Item 14 would retain the same definition of “custody” as now in Form ADV.

See

Glossary of Terms to proposed Form ADV and Instruction 5 to current Form ADV. Advisers have custody if, for example, they hold client funds or securities or they have the ability to appropriate client assets such as having signatory power over a client's checking account. Advisers also may be deemed to have custody of client assets because a related person of the adviser has custody of those assets. Our staff has provided guidance on the factors to be considered in determining whether an adviser in this circumstance is deemed to have custody.

See

Crocker Investment Management Corp., SEC No-Action Letter (Apr. 14, 1978) (setting out a five-factor test).