# Amendments to Form ADV

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URL: https://www.frixlaw.com/law-library/documents/fr%3A2010-19617

## Record

- **Collection:** Federal Register
- **Document type:** Rule
- **Published:** August 12, 2010
- **Citation:** 75 FR 49234

## Text

SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 275 and 279
[Release No. IA-3060; File No. S7-10-00]
RIN 3235-AI17
Amendments to Form ADV

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

The Securities and Exchange Commission is adopting amendments to Part 2 of Form ADV, and related rules under the Investment Advisers Act, to require investment advisers registered with us to provide new and prospective clients with a brochure and brochure supplements written in plain English. These amendments are designed to provide new and prospective advisory clients with clearly written, meaningful, current disclosure of the business practices, conflicts of interest and background of the investment adviser and its advisory personnel. Advisers must file their brochures with us electronically and we will make them available to the public through our Web site. The Commission also is withdrawing the Advisers Act rule requiring advisers to disclose certain disciplinary and financial information.

DATES:

Effective Date:
October 12, 2010.
Compliance Dates:
See Section V of this release.

FOR FURTHER INFORMATION CONTACT:

Vivien Liu, Senior Counsel, Don L. Evans, Senior Counsel, Daniel S. Kahl, Branch Chief, or Sarah A. Bessin, Assistant Director, at (202) 551-6787 or
IArules@sec.gov,
Office of Investment Adviser Regulation, Division of Investment Management, U.S. Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION:

The Securities and Exchange Commission (“Commission” or “SEC”) is adopting amendments to rules 203-1, 204-1, 204-2, and 204-3 [17 CFR 275.203-1, 275.204-1, 275.204-2, and 275.204-3] under the Investment Advisers Act of 1940 [15 U.S.C. 80b] (“Advisers Act” or “Act”);
1

and amendments to Form ADV [17 CFR 279.1] under the Advisers Act. The Commission also is withdrawing rule 206(4)-4 [17 CFR 275.206(4)-4] under the Advisers Act.

1
Unless otherwise noted, when we refer to rule 203-1, 204-1, 204-2, or 204-3, or any paragraph of these rules, we are referring to 17 CFR 275.203-1, 275.204-1, 275.204-2, or 275.204-3, respectively, of the Code of Federal Regulations in which these rules are published.

Table of Contents

I. Introduction

II. Discussion of Form ADV, Part 2

A. Part 2A: Brochure Format and Content

1. Format

2. Brochure Items

3. Delivery and Updating of Brochures

B. Part 2B: The Brochure Supplement

1. Format

2. Supplement Items

3. Delivery and Updating

C. Filing Requirements, Public Availability

D. Transition to New Requirements

III. Amendments to Form ADV Instructions and Glossary

IV. Amendments to Rule 204-2

V. Effective and Compliance Dates

VI. Paperwork Reduction Act

VII. Cost-Benefit Analysis

VIII. Final Regulatory Flexibility Analysis

IX. Efficiency, Competition, and Capital Formation

X. Statutory Authority

Text of Rule and Form Amendments

I. Introduction

Investment advisers provide a wide range of advisory services and play an important role in helping individuals and institutions make significant financial decisions. From individuals and families seeking to plan for retirement or save for college to large institutions managing billions of dollars, clients seek the services of investment advisers to help them evaluate their investment needs, plan for their future, develop and implement investment strategies, and cope with the ever-growing complexities of the financial markets. Today, the more than 11,000 advisers registered with us manage more than $38 trillion for more than 14 million clients.
2

2
These figures are based on data derived from investment advisers' responses to questions on Part 1A of Form ADV reported through the Investment Adviser Registration Depository (“IARD”) as of May 3, 2010. We note that these figures will change due to the Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010).

Under the Advisers Act, an adviser is a fiduciary whose duty is to serve the best interests of its clients, which includes an obligation not to subrogate clients' interests to its own.
3

An adviser must deal fairly with clients and prospective clients, seek to avoid conflicts with its clients and, at a minimum, make full disclosure of any material conflict or potential conflict.
4

A client may use this disclosure to select his or her own adviser and evaluate the adviser's business practices and conflicts on an ongoing basis. As a result, the disclosure clients and prospective clients receive is critical to their ability to make an informed decision about whether to engage an adviser and, having engaged the adviser, to manage that relationship.

3
Proxy Voting by Investment Advisers, Investment Advisers Act Release No. IA-2106 (Jan. 31, 2003) [68 FR 6585 (Feb. 7, 2003)] (“Proxy Voting Release”).

4
See
SEC
v.
Capital Gains Research Bureau, Inc.,
375 U.S. 180 (1963); In the Matter of Arleen W. Hughes, Exchange Act Release No. 4048 (Feb. 18, 1948).

To allow clients and prospective clients to evaluate the risks associated with a particular investment adviser, its business practices, and its investment strategies, it is essential that clients and prospective clients have clear disclosure that they are likely to read and understand. For example, such disclosure could enable a prospective client to screen advisers based on disciplinary history, financial industry affiliations or compensation methods. Such screening would allow clients to avoid advisers with a disciplinary history, should they wish to do so. Clients also would be able to choose advisers based on affiliations and compensation methods; in some cases, the client may not be comfortable with the conflicts of interest that those affiliations and compensation methods create, while other clients may value an advisory relationship that allows for broader access to other financial services and may seek an adviser with financial industry affiliates. A prospective client may seek modifications to an investment advisory agreement to better protect the client against an investment adviser's potential conflict of interest, either by better aligning the adviser's interest with that of the client or by prohibiting a particular practice in the client's account. If an adviser is unwilling to make such modifications, a prospective client may select a different adviser.

Since 1979, the Commission has required each adviser registered with us to deliver a written disclosure statement to clients pursuant to rule 204-3 under the Advisers Act.
5

An investment adviser may use this client disclosure statement to satisfy its disclosure

obligations as a fiduciary.
6

Part 2 of Form ADV sets out minimum requirements for this disclosure statement to clients, which is commonly referred to as the “brochure.”
7

5
Advisers use Form ADV to apply for registration with us (Part 1A) or with state securities authorities (Part 1B), and must keep it current by filing periodic amendments as long as they are registered. See rules 203-1 and 204-1. Form ADV has two parts. Part 1(A and B) of Form ADV provides regulators with information to process registrations and to manage their regulatory and examination programs. Part 2A contains the requirements for the disclosure “brochure” that advisers must provide to prospective clients initially and to existing clients annually, and Part 2B contains information about the advisory personnel providing clients with investment advice. Prior to the amendments we are adopting today, Part 2 was designated as “Part II.”

6
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)] (“1979 Adopting Release”).

7
Items in Part 2 of Form ADV may not address all conflicts an adviser may have, and may not identify all material disclosure that an adviser may be required to provide clients. As a result, delivering a brochure prepared under Form ADV's requirements may not fully satisfy an adviser's disclosure obligations under the Advisers Act. See Instruction 3 of General Instructions for Part 2 of Form ADV; rule 204-3(f).

In the past, Part 2 has required advisers to respond to a series of multiple-choice and fill-in-the-blank questions organized in a “check-the-box” format, supplemented in some cases with brief narrative responses. Advisers have had the option of providing information required by Part 2 in an entirely narrative format, but few have done so.

In 2008, we proposed a different approach to enhance the disclosure statement advisers provide to their clients.
8

Instead of the check-the-box format, each adviser registered with us would provide clients with a narrative plain English brochure that describes the adviser's business, conflicts of interest, disciplinary history, and other important information that would help clients make an informed decision about whether to hire or retain that adviser. Our proposal was designed to require advisers to disclose meaningful information in a clearer format.
9

In addition, we proposed that advisers be required to file their brochures with us electronically so that we could make them available to the public on our Web site.
10

8
Amendments to Form ADV, Investment Advisers Act Release No. 2711 (Mar. 3, 2008) [73 FR 13958 (Mar. 14, 2008)] (“Proposing Release”).

9
See Proposing Release, supra note 8 at n.6 and accompanying text.

10
Id. at Section II.A.3.

We received 81 letters commenting on the Proposing Release.
11

Commenters agreed with our proposal to move to a narrative brochure,
12

although many suggested modifications to certain requirements.
13

After careful consideration of these comment letters, we are adopting amendments to Part 2 of Form ADV and related rules under the Advisers Act. In light of our adoption of Part 2, we also are withdrawing rule 206(4)-4, which separately required advisers to disclose to clients certain financial and disciplinary information, because our amendments render that rule largely duplicative.

11
Comment letters submitted in File No. S7-10-00 are available on the Commission's Web site at:
http://www.sec.gov/rules/proposed/s71000.shtml.

12
See, e.g., comment letter of the American Bar Association, Section of Business Law, Committee on Federal Regulation of Securities and Committee on State Regulation of Securities (June 18, 2008) (“ABA Committees Letter”); comment letter of the Consumer Federation of America (July 2, 2008) (“Consumer Federation Letter”); comment letter of Citigroup Global Markets Inc. (May 16, 2008) (“CGMI Letter”); comment letter of Fried, Frank, Harris, Shriver & Jacobson LLP (May 2, 2008) (“Fried Frank Letter”); comment letter of the Investment Adviser Association (May 16, 2008) (“IAA Letter”); comment letter of the Investment Company Institute (May 16, 2008) (“ICI Letter”).

13
See, e.g., comment letter of Alternative Investment Compliance Association (May 16, 2008) (“AICA Letter”); comment letter of Capital Institutional Services, Inc. (May 16, 2008) (“CAPIS Letter”); comment letter of Shaun Eddy (May 9, 2008) (“Eddy Letter”); comment letter of the Financial Planning Association (May 16, 2008) (“FPA Letter”); Fried Frank Letter; IAA Letter; ICI Letter; comment letter of Janus Capital Management LLC (May 16, 2008) (“Janus Letter”); comment letter of Nancy Lininger (May 18, 2008) (“Lininger Letter”); comment letter of the National Association of Personal Financial Advisers (June 4, 2008) (“NAPFA Letter”); comment letter of National Compliance Services, Inc. (May 9, 2008) (“NCS Letter”); comment letter of National Regulatory Services (May 16, 2008) (“NRS Letter”); comment letter of L. A. Schnase (May 9, 2008) (“Schnase Letter”); comment letter of Sidley Austin LLP (May 23, 2008) (“Sidley Letter”); comment letter of USAA Investment Management Company/USAA Financial Planning Services Insurance Agency, Inc. (May 16, 2008) (“USAA Letter”); comment letter of Wellington Management Company, LLP (May 15, 2008) (“Wellington Letter”).

II. Discussion of Form ADV, Part 2

The revised Part 2 requirements that we are adopting today include two sub-parts, Part 2A and Part 2B.
14

Part 2A contains 18 disclosure items about the advisory firm that must be included in an adviser's brochure. We refer to Part 2B as the “brochure supplement,” which includes information about certain advisory personnel on whom clients rely for investment advice. In this section, we discuss our amendments relating to each of these sub-parts, which are addressed separately because they are subject to differing content, updating and delivery requirements.

14
Part 2 is a uniform form used by investment advisers registered with both the Commission and the state securities authorities. See Instruction 5 of General Instructions for Form ADV. This Release discusses the Commission's adoption of Form ADV and related rules applicable to advisers registered with the Commission. Form ADV is also used by state securities regulators to register investment advisers. It includes certain items and instructions to Part 2 (e.g., Item 19 of Part 2A, Item 10 of Appendix 1 to Part 2A, and Item 7 of Part 2B) that apply only to state-registered advisers. State-registered advisers are required by state, rather than federal, law to respond to these items. Completion of these items, therefore, is not an SEC requirement, and these items are not included in this Release as an SEC rule.

A. Part 2A: Brochure Format and Content

1. Format

We are adopting a requirement that investment advisers registered with us provide prospective and existing clients with a narrative brochure written in plain English.
15

Commenters supported use of a narrative format.
16

For example, one commenter stated that “the current check-the-box format does not always result in clear and meaningful client disclosure and it presents challenges for advisers in identifying and presenting all of the types of information that should be addressed in Part 2.”
17

Another commenter expressed the view that “the flexibility of a narrative format should result in clearer and more meaningful disclosures that make relevant information readily accessible to prospects and clients.”
18

We believe these amendments will greatly improve the ability of clients and prospective clients to evaluate firms offering advisory services and the firms' personnel, and to understand relevant conflicts of interest that the firms and their personnel face and their potential effect on the firms' services.

15
See Instructions 1 and 2 of General Instructions for Part 2 of Form ADV. In many instances where we refer to “client” in this release we are referring to both an existing and prospective client.

16
See ABA Committees Letter; comment letter of the American Institute of Certified Public Accountants (May 20, 2008) (“AICPA Letter”); CAPIS Letter; Consumer Federation Letter; CGMI Letter; Fried Frank Letter; IAA Letter; ICI Letter; Janus Letter; comment letter of Merrill Lynch, Pierce, Fenner & Smith, Incorporated (May 16, 2008) (“Merrill Lynch Letter”); comment letter of the Money Management Institute (May 16, 2008) (“MMI Letter”); comment letter of Morgan Stanley & Co. Incorporated (May 16, 2008) (“Morgan Stanley Letter”); NAPFA Letter; comment letter of the North American Securities Administrators Association, Inc. (May 16, 2008) (“NASAA Letter”); NRS Letter; comment letter of the National Society of Compliance Professionals Inc. (May 16, 2008) (“NSCP Letter”); comment letter of Charles Schwab & Co. and Charles Schwab Investment Management, Inc. (May 16, 2008) (“Schwab Letter”); Wellington Letter.

17
NAPFA Letter.

18
Wellington Letter.

We have added an instruction to Part 2 of Form ADV to require that an adviser provide the information in a specified format.
19

We are persuaded by commenters that this format for items in the brochure will facilitate investors' comparison of multiple advisers and are adopting this requirement.
20

An adviser

must respond to each item in the brochure, and must present the information in order of the items in the form, using the headings provided by the form. If an item is inapplicable to an adviser, the adviser must include the heading and an explanation that the information is inapplicable.
21

If information an adviser provides in response to one item is also responsive to another item, the adviser may cross-reference the information in the other item.
22

19
Instruction 1 of General Instructions for Part 2 of Form ADV.

20
See ABA Committees Letter; comment letter of First Allied Securities, Inc. (May 16, 2008) (“First Allied Letter”); comment letter of Mercer Advisors (May 2, 2008) (“Mercer Letter”); NCS Letter; NRS Letter; comment letter of Reed Smith on behalf of Federated Investors, Inc. (May 16, 2008) (“Federated Letter”).

21
Instruction 1 of General Instructions for Part 2 of Form ADV.

22
Id.

Also, it is critical that advisers communicate clearly to their clients and prospective clients in the brochure. Thus, instructions to Part 2 provide that, in drafting the brochure, advisers, among other things, should use short sentences; definite, concrete, everyday words; and the active voice. In addition, the brochure should discuss only conflicts the adviser has or is reasonably likely to have, and practices in which it engages in or is reasonably likely to engage.
23

If a conflict arises or the adviser decides to engage in a practice that it has not disclosed, supplemental information must be provided to the client.

23
Instruction 2 of General Instructions for Part 2 of Form ADV.

2. Brochure Items

Part 2A, as adopted, contains 18 separate items, each covering a different disclosure topic.
24

We have drawn the items in Part 2A largely from disclosure advisers have long been required to make in response to the previous Part 2, and have added items to address new concerns or developments. Much of the disclosure required in Part 2A addresses an adviser's conflicts of interest with its clients, and is disclosure that the adviser, as a fiduciary, must make to clients in some manner regardless of the form requirements.

24
Part 2A consists of 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—and requires disclosure similar to current Schedule H of Part 2 of Form ADV. See rule 204-3(d); Appendix 1 to Part 2A; infra note 182 and accompanying text.

Some commenters urged us to require fewer items and require advisers to provide less detailed information.
25

We have reviewed carefully these suggestions and have modified some of our items in response. In some cases, however, commenters urged us to eliminate particular proposed disclosures, such as the fee schedule, that have long been required in Part 2 and provide investors essential information. Elimination of such proposed disclosures would result in clients not receiving important information they currently receive from their advisers and on which they may rely. In many other cases, further cuts would not have reduced the amount of disclosure an adviser would have to make to clients, but rather would have permitted the disclosure to be made in a different document or manner. Thus, elimination of disclosure requirements in Part 2A suggested by some commenters would be unlikely to reduce burdens or eliminate the amount of information required to be provided to clients to satisfy an adviser's fiduciary obligations.
26

25
See, e.g., comment letter of the Financial Service Institute (May 16, 2008) (“FSI Letter”); Schwab Letter; comment letter of the Securities Industry and Financial Markets Association (May 16, 2008) (“SIFMA Letter”); comment letter of Sutherland Asbill & Brennan LLP (May 16, 2008) (“Sutherland Letter”).

26
Advisers with fewer conflicts and simpler business arrangements will be able to prepare shorter brochures.

We agree that disclosure to clients should be succinct and readable. We note that advisers, because of how they choose to present their programs or services to clients or the complexity of their disclosures, have the ability to take steps that would limit the length of their brochures. For example, advisers may create separate brochures for different types of advisory clients, each of which may be shorter, clearer, and contain less extraneous information than would a combined brochure.
27

Advisers that choose to disclose more than is required by the form (and their fiduciary obligations) will create lengthier brochures than those that take a more focused approach. Advisers with a more complicated offering of advisory services (or business arrangements) might consider including a summary in the beginning of their brochure, followed by a more detailed discussion of each item in the brochure. We have amended the instructions to clarify that including a summary is permissible.
28

27
See rule 204-3(e) (allowing advisers that provide substantially different advisory services to different clients to provide clients with different brochures as long as each client receives all information about the services and fees that are applicable to that client). Note that an adviser may not omit any information required by Item 9 of Part 2A (Disciplinary Information) in any brochure provided to any client, and that each brochure must be filed through IARD. See rule 204-3(a); see also Instruction 2 for Part 2A of Form ADV. An adviser that creates separate brochures must file each brochure through the IARD system. See Instruction 9 for Part 2A of Form ADV.

28
See Instruction 8 of Instructions for Part 2A of Form ADV. We have also added an instruction to Part 2 explaining that advisers must provide the client with sufficiently specific facts so that the client is able to understand the conflicts of interest the adviser has and the business practices in which it engages, and can give his or her informed consent to the transaction or practice that gives rise to the conflict or to reject the transaction or practice. See Instruction 3 of General Instructions for Part 2 of Form ADV.

Below, we discuss each of the items in the form and the modifications we have made from our proposal.

Item 1. Cover Page.
Item 1 requires that an adviser disclose on the cover page of its brochure the name of the firm, its business address, contact information, Web site (if it has one), and the date of the brochure. The cover page also must include a statement that the brochure has not been approved by the Commission or any state securities authority. If an adviser refers to itself as a “registered investment adviser,” it also must include a disclaimer that registration does not imply a certain level of skill or training.
29

29
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.

The item reflects one change from our proposal. Item 1 requires an adviser to disclose on the cover page of the brochure only a general telephone number and/or e-mail address that clients can use to contact the adviser if they have questions about the brochure. Commenters asserted that some larger advisers would find it cumbersome to comply with our proposal, which would have required the name and phone number of a specific individual or service center.
30

30
See First Allied Letter; IAA Letter; SIFMA Letter.

Item 2. Material Changes.
Item 2 requires that an adviser amending its brochure identify and discuss the material changes since the last annual update on the cover page or the following page or as a separate document accompanying the brochure.
31

This item is designed to make clients aware of information that has changed since the prior year's brochure and that may be important to them.

31
Advisers may include the summary in their brochure or in a separate document. Item 2 of Part 2A. A summary prepared as a separate document can be used to satisfy an adviser's annual client delivery obligations. See rule 204-3(b)(2), discussed in Section II.A.3 below. Summaries provided as a separate document must be filed with the Commission as an exhibit to Part 2. See Note to paragraphs (a) and (b) of rule 204-1; Instruction 6 for Part 2A of Form ADV. If an adviser includes the summary of material changes in its brochure, and amends its brochure on an interim basis between annual updating amendments, the adviser should consider whether it should update its summary of material changes to avoid confusing or misleading clients reading the updated brochure. See Note to Instruction 6 for Part 2A of Form ADV.

Several commenters supported this requirement, agreeing that advisers can achieve meaningful disclosure with an annual disclosure highlighting changes to the brochure.
32

Others expressed concern that advisers would write lengthy summaries to avoid liability.
33

We emphasize that we intend this document to be a summary that identifies and broadly discusses the material changes,
34

and that it should not be a lengthy discussion that replicates the brochure itself.
35

Instead, the summary need contain no more than necessary to inform clients of the substance of the changes to the adviser's policies, practices or conflicts of interests so that they can determine whether to review the brochure in its entirety or to contact the adviser with questions about the changes.

32
See ASG Letter; comment letter of the CFA Institute Centre for Financial Market Integrity (May 22, 2008) (“CFA Institute Letter”); Consumer Federation Letter; FPA Letter; IAA Letter; Janus Letter; NASAA Letter.

33
See AICA Letter; FSI Letter; ICI Letter; comment letter of Jackson, Grant Investment Advisers, Inc. (May 26, 2008) (“Jackson Letter”); comment letter of Katten Muchin Rosenman LLP (May 16, 2008) (“Katten Letter”); Mercer Letter; Morgan Stanley Letter; NSCP Letter; comment letter of the Financial Service Roundtable (May 16, 2008) (“Roundtable Letter”); SIFMA Letter; Sutherland Letter.

34
We have revised Item 2 to require advisers not only to identify, but also to “discuss” material changes to clarify our intent.

35
A few commenters also sought clarification of the term “material changes.” See comment letter of the American Council of Life Insurance (May 16, 2008) (“ACLI Letter”); Fried Frank Letter; FSI Letter; IAA Letter; Roundtable Letter; comment letter of T. Rowe Price Associates, Inc. (May 16, 2008) (“T. Rowe Letter”). The standard of materiality under the Advisers Act is whether there is a substantial likelihood that a reasonable investor (here, client) would have considered the information important. See
S.E.C.
v.
Steadman,
967 F.2d 636, 643 (D.C. Cir. 1992).
Cf. Basic Inc.
v.
Levinson
, 485 U.S. 224, 231-232 (1988);
TSC Industries
v.
Northway, Inc.,
426 U.S. 438, 445, 449 (1976). This is a facts and circumstances test, requiring an assessment of the “total mix of information,” in the characterization of the Supreme Court.
TSC Industries,
426 U.S. at 449. Given that materiality depends on the factual situation, which may vary with each situation, we do not believe that it is appropriate to specifically define or provide any bright line tests for what is and is not material.

Item 3. Table of Contents.
Item 3 requires each adviser to include in its brochure a table of contents detailed enough to permit clients and prospective clients to locate topics easily. Some commenters supported the use of a table of contents but urged the Commission to mandate a uniform format so that investors can compare brochures of multiple advisers more easily.
36

Others opposed a uniform format, arguing that flexibility would enable an adviser to best convey information about its firm to clients.
37

As discussed above, we are persuaded by commenters that a uniform format for items in the brochure will facilitate investors' comparison of multiple advisers and are adopting this requirement. We therefore added an instruction to Part 2 of Form ADV to require advisers to present the information in the order of the items in the form, using the headings provided by the form.
38

36
See supra note 20.

37
See Fried Frank Letter; Janus Letter; Lininger Letter.

38
Instruction 1 of General Instructions for Part 2 of Form ADV.

Item 4. Advisory Business.
Item 4 requires each adviser to describe its advisory business, including the types of advisory services offered, whether it holds itself out as specializing in a particular type of advisory service, and the amount of client assets that it manages. In computing the amount of client assets that it manages, an adviser may use a method that differs from the method used in Part 1A of Form ADV to report “assets under management.”
39

An adviser opting to use a different method must keep documentation describing the method used.
40

39
For an explanation of Part 1A's requirements for computing “assets under management,” see Instruction 5.B for Part 1A of Form ADV.

40
See rule 204-2(a)(14)(ii) and Note to Item 4.E of Part 2A.

Two commenters urged the Commission not to require that advisers make additional disclosure if they hold themselves out as specializing in a particular type of advisory service. One was concerned that advisers would have interpretive problems in defining specialized advisory services and that disclosure describing specialized services would not provide meaningful information to clients.
41

The other argued that Item 8 (Strategies and Risks) covers similar information.
42

As we explained in the Proposing Release, we require that advisers identify a specialized advisory service because we believe that clients likely will want to understand this before engaging that adviser.
43

Accordingly, we are adopting this item as proposed.

41
See NAPFA letter.

42
See Sutherland Letter.

43
See Proposing Release at Section II.A.2.

Commenters were divided on whether we should require investment advisers to calculate the amount of their assets in a manner consistent with the instructions for Part 1A in order to avoid confusion.
44

The methodology for calculating assets required under Part 1A is designed for a particular purpose (i.e., for making a determination as to whether an adviser should register with the Commission or with the states), rather than to convey meaningful information about the scope of the adviser's business. Thus, we are permitting advisers to use a different methodology for Part 2A disclosure.
45

44
The CFA Institute Letter, IAA Letter, Janus Letter, Mercer Letter, and NRS Letter argued that the calculation requirements should be the same. Others supported our proposal that would permit advisers to use a different calculation of assets under management than the one required for Part 1A, with most of these commenters arguing that this flexibility would allow advisers to more accurately portray the business of the firm and total assets managed. See comment letter of Ashland Compliance Group LLC (May 16, 2008) (“Ashland Letter”); Lininger Letter; MMI Letter; Morgan Stanley Letter.

45
For example, in calculating “assets under management,” for purposes of Part 1A, an adviser may include the entire value of a managed portfolio, but only if at least 50% of the portfolio's total value consists of securities. See current Form ADV: Instructions for Part 1A of Form ADV. Thus, for Part 1A purposes, an adviser will not include other assets (including securities) that it manages in a “non-securities” portfolio. The Part 1A formula for calculating assets under management was designed based on considerations related to the National Securities Markets Improvement Act of 1996 division of responsibility for regulation of advisers between the Commission and state securities regulatory authorities. Public Law 104-290, 110 Stat. 3416 (1996).

Finally, several commenters urged that we permit an adviser to update the amount of assets under management only in its annual updating amendment rather than (as we proposed) at the time an adviser makes an interim update to its brochure if the amount had become materially inaccurate.
46

We believe that our proposal appropriately balanced the burdens that would be imposed on advisers by having to amend their brochures repeatedly with the need to provide clients with reasonably current information. Therefore, we are adopting this instruction as proposed.
47

Advisers must update the amount of their assets under management annually (as part of their annual updating amendment) and make interim amendments only for material changes in assets under management when they are filing an “other than annual amendment” for a separate reason. As we have noted, as a fiduciary, an adviser has an ongoing obligation to inform its clients of any material information that could affect the advisory relationship, which could include a material change to assets under management.
48

46
See Morgan Stanley Letter; MMI Letter.

47
See Note to Instruction 4 of General Instructions for Form ADV.

48
Note to Instruction 2 of Instructions for Part 2A of Form ADV. Disclosure updating the adviser's assets under management could be provided to clients by means other than the brochure. We have brought enforcement actions charging advisers with engaging in fraud by misrepresenting their assets under management to advisory clients and

prospective clients, including in advisory brochures. See, e.g.,
SEC
v.
Locke Capital Management, Inc. and Leila C. Jenkins,
Litigation Release No. 20936 (Mar. 9, 2009) (settled order).

Item 5. Fees and Compensation.
Item 5 requires that an adviser describe in its brochure how it is compensated for its advisory services, provide a fee schedule, and disclose whether fees are negotiable.
49

An adviser must disclose whether it bills clients or deducts fees directly from clients' accounts, and how often it assesses fees (or bills clients).
50

The item also requires each adviser to describe the types of other costs, such as brokerage, custody fees and fund expenses that clients may pay in connection with the advisory services provided to them by the adviser.
51

An adviser charging fees in advance must explain how it calculates and refunds prepaid fees when a client contract terminates.
52

49
See Item 5.A of Part 2A.

50
See Item 5.B of Part 2A.

51
See Item 5.C of Part 2A.

52
See Item 5.D of Part 2A. Item 18 of Part 2A also requires the disclosure of certain financial information about an adviser that requires prepayment of fees.

Item 5 also requires an adviser that receives compensation attributable to the sale of a security or other investment product (e.g., brokerage commissions), or whose personnel receive such compensation, to disclose this practice and the conflict of interest it creates, and to describe how the adviser addresses this conflict.
53

Such an adviser also must disclose that the client may purchase the same security or investment product from a broker that is not affiliated with the adviser.
54

53
See Item 5.E of Part 2A. Because of this conflict of interest, advisers are required by the antifraud provisions of the Advisers Act to disclose their receipt of transaction-based compensation to clients. We have brought enforcement actions charging advisers with failures to make such disclosures. See, e.g., In the Matter of Financial Design Associates, Inc. and Albert L. Coles, Jr., Investment Advisers Act Release No. 2654 (Sept. 25, 2007) (settled order); In the Matter of IMS, CPAs & Associates, Vernon T. Hall, Stanley E. Hargrave, and Jerome B. Vernazza, Investment Advisers Act Release No. 1994 (Nov. 5, 2001) (settled order) (petitioners' appeal denied in
Vernazza
v.
SEC,
327 F.3d 851 (9th Cir. 2003)).

54
See Item 5.E.2 of Part 2A. In addition to the requirement in Item 5.E.2 of Part 2A, an adviser that receives more than half of its revenue from commissions and other sales-based compensation must explain that commissions are the firm's primary (or, if applicable, exclusive) form of compensation. See Item 5.E.3 of Part 2A. An adviser that charges advisory fees in addition to commissions or markups to an individual client must disclose whether it reduces its fees to offset the commissions or markups. See Item 5.E.4 of Part 2A.

Some commenters expressed strong support for these disclosure requirements, with one commenter stating that such disclosure is “essential to a healthy adviser-client relationship.”
55

Others argued generally that most of the information is not relevant for many clients, and specifically that providing a complete set of fee schedules would impose an undue burden on advisers.
56

We disagree with commenters who favored a broad elimination of fee information from the brochure. Information about fees is important to clients and can be used to compare fees of different advisers.
57

More persuasive, however, were arguments that brochure fee information is likely not useful to institutional and large, sophisticated clients who are often in a position to negotiate fee arrangements with their adviser and for whom, therefore, a fee table would have little utility.
58

These arguments have persuaded us to provide an exception which permits an adviser to omit disclosure of its fee schedule and the other information in Item 5.A in any brochure provided only to clients who are “qualified purchasers.”
59

55
See comment letter of the Certified Financial Planner Board of Standards, Inc. (May 29, 2008) (“CFP Board Letter”). The ASG Letter, the CFA Institute Letter, the Lininger Letter, and the NRS Letter also expressed strong support for most of these requirements.

56
See comment letter of Eric A. Brill (Apr. 26, 2008) (“Brill Letter”); IAA Letter. The IAA Letter stated that larger firms may have to prepare extremely long fee schedules. They urged the Commission to provide flexibility regarding fee schedule disclosure as long as the fee is fully disclosed in the advisory contract. One commenter suggested that we amend General Instruction 4, which permits advisers to update any change to its fee schedules only annually, reasoning that potential clients would need this updated information in selecting advisers. See NASAA Letter. The exception contained in the instruction is designed to prevent an adviser from having to make multiple interim amendments as a result of small changes in a fee schedule each of which may be material only to certain affected clients or prospective clients who would learn of them when considering whether to enter into an advisory agreement that would reflect a revised fee. On balance, we believe that an annual update may be sufficient.

57
This information may be particularly useful to clients searching for an adviser by comparing information on brochures that will be available on the Internet.

58
See IAA letter; Wellington Letter.

59
“Qualified purchasers,” as defined under section 2(a)(51)(A) of the Company Act [15 USC 80a-2(a)(51)(A)], include, among others, natural persons who own $5 million or more in investments and persons who manage $25 million or more in investments for their account or other accounts of other qualified purchasers.

A few commenters urged us to not require description of other types of fees or expenses because, among other things, such fees may vary significantly among clients and disclosure regarding them may confuse clients.
60

However, this simple and brief disclosure (which is not required to include the amount or range of the fees) may be helpful to investors unacquainted with the practices of an adviser or the ancillary costs of actively managed investing. Therefore, we are adopting this disclosure requirement, as proposed.

60
See NAPFA Letter; NRS Letter; NSCP Letter.

As noted above, Item 5 also requires an adviser that receives transaction-based compensation, or whose personnel receive such compensation, to disclose this practice and the conflict of interest it creates and to describe how the adviser addresses this conflict. Some commenters argued that this item inappropriately implies endorsement of a “fee-based” compensation structure over a “commission-based” structure.
61

That is not our intent. The item simply recognizes that an adviser that accepts compensation from the sale to a client of securities has an incentive to base investment recommendations on the amount of compensation it will receive, rather than on the client's best interests, and thus involves a significant conflict of interest.
62

As a result, we are adopting the requirement as proposed.
63

61
See FSI Letter; Sutherland Letter.

62
Moreover, the item is not, in substance, different from the previous Item 9 of Part 2, which, in recognition of this conflict, required an adviser to disclose whether the adviser effects securities transactions for clients. See also supra note 53; Applicability of the Investment Advisers Act to Financial Planners, Pension Consultants, and Other Persons Who Provide Investment Advisory Services as a Component of Other Financial Services, Investment Advisers Act Release No. 1092 (Oct. 16, 1987) [52 FR 38400 (Oct. 16, 1987)] (“Release 1092”).

63
We note that nothing in the Advisers Act precludes an adviser from accepting transaction-based compensation. However, an adviser that receives compensation in connection with the purchase or sale of securities should carefully consider the applicability of the broker-dealer registration requirements of the Securities Exchange Act of 1934.

Item 6. Performance-Based Fees and Side-By-Side Management.
Item 6 requires an adviser that charges performance-based fees or that has a supervised person who manages an account that pays such fees to disclose this fact. If such an adviser also manages accounts that are not charged a performance fee, the item also requires the adviser to discuss the conflicts of interest that arise from its (or its supervised person's) simultaneous management of these accounts, and to describe generally how the adviser addresses those conflicts.
64

64
As fiduciaries, advisers must disclose all material information regarding any proposed performance fee arrangements as well as any material conflicts posed by the arrangements. 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, at nn.13-14 and accompanying text (July 15, 1998) [63 FR 39022 (July 21, 1998)].

Two commenters explicitly supported this requirement.
65

Two other commenters urged us to eliminate it, arguing that the required disclosure already should be in Item 5 (Fees and Compensation) or is required by other items.
66

As discussed in the Proposing Release, an adviser charging performance fees to some accounts but not others faces a variety of conflicts of interest.
67

The number of advisers with these arrangements has grown, and we believe that it is important that clients and prospective clients receive disclosure regarding these conflicts and how the adviser addresses them.
68

While Item 5 requires disclosure of an adviser's fee arrangements, it does not specifically require disclosure of the conflicts any particular fee arrangement may create other than with respect to transaction-based compensation.

65
See CFA Institute Letter; Lininger Letter.

66
See IAA Letter; Schnase Letter.

67
See Proposing Release, at nn.51-53 and accompanying text. An adviser charging performance fees to some accounts faces a variety of conflicts because the adviser can potentially receive greater fees from its accounts having a performance-based compensation structure than from those accounts it charges a fee unrelated to performance (e.g., an asset-based fee). As a result, the adviser may have an incentive to direct the best investment ideas to, or to allocate or sequence trades in favor of, the account that pays a performance fee. We have brought enforcement actions charging advisers with undisclosed conflicts in regard to accounts that pay performance fees. See, e.g., In the Matter of Nevis Capital Management, LLC, et al., Investment Advisers Act Release No. 2214 (Feb. 9, 2004) (settled order). See also In the Matter of Alliance Capital Management, L.P., Investment Advisers Act Release No. 2205 (Dec. 18, 2003) (settled order).

68
According to data derived from investment advisers' responses to Item 5.E of Part 1A of Form ADV reported through IARD as of May 3, 2010, approximately 28% of SEC-registered investment advisers reported charging performance-based fees to some accounts but not others.

Item 7. Types of Clients.
Item 7 requires that the brochure describe the types of advisory clients the firm generally has, as well as the firm's requirements for opening or maintaining an account, such as minimum account size. One commenter recommended that we eliminate this proposed disclosure requirement, arguing that the information is not material to the decision of whether to hire or retain an investment adviser.
69

We disagree. We believe that many prospective clients would consider the type of clients to be an important factor in determining whether an adviser's business model is a good fit for them.
70

As a result, we are adopting Item 7 as proposed.

69
See Sutherland Letter.

70
We note that disclosure of this information is already required in the previous Item 2 of Part 2 of Form ADV.

Item 8. Methods of Analysis, Investment Strategies and Risk of Loss.
Item 8 requires that advisers describe their methods of analysis and investment strategies and disclose that investing in securities involves risk of loss which clients should be prepared to bear.
71

Item 8 also requires specific disclosure of how strategies involving frequent trading can affect investment performance. Finally, this item requires that advisers explain the material risks involved for each significant investment strategy or method of analysis they use and particular type of security they recommend, with more detail if those risks are unusual.

71
We have brought enforcement actions charging advisers with omissions and misrepresentations regarding investment strategies. See, e.g., In the Matter of George F. Fahey, Investment Advisers Act Release No. 2196 (Nov. 24, 2003) (settled order); In the Matter of Gary L. Hamby and Gary B. Ross, Investment Advisers Act Release No. 1668 (Sept. 22, 1997) (settled order).

Several commenters supported this proposed disclosure requirement as central to the adviser's fiduciary relationship with its client.
72

One objected, stating that the item creates a different disclosure obligation for multi-strategy firms because, as proposed, it only required advisers primarily using a particular strategy to discuss the risks involved in their strategy.
73

We agree that advisers should disclose material risks associated with their strategies that will be relevant to most clients, regardless of whether they use one strategy or many strategies. We have, therefore, modified the item to require that advisers explain the material risks involved for each significant investment strategy or method of analysis they use, rather than those they primarily use, as we believe this threshold for disclosure better captures those methods of analysis or strategies that will be relevant to most clients.
74

However, as we noted in the proposal, the brochure may not always be the best place for a multi-strategy adviser to disclose risks associated with all of its methods of analysis or strategies.
75

Disclosure of that information likely would lengthen the brochure unnecessarily given that different clients will be pursuing different strategies, each of which poses specific and different risks.

72
See CFA Institute Letter; Lininger Letter; NAPFA Letter; NRS Letter.

73
See NAPFA Letter.

74
For these purposes, we would view a method of analysis or strategy as significant if more than a small portion of the adviser's clients' assets are advised using the method or strategy.

75
See Proposing Release at Section II.A.2.

Some commenters urged us to define the term “frequent trading of securities,” which is used in Item 8.B, but did not suggest a definition in response to our request.
76

As commenters implicitly acknowledged, the phrase “frequent trading” is hard to define. We would expect advisers to respond to this item only if their intended investment strategies involve frequent trading of securities that a reasonable client would otherwise not expect in light of the other disclosures contained in the brochure.

76
See comment letter of Gary D. Case (May 12, 2008) (“Case Letter”); FSI Letter; IAA Letter; comment letter of ProEquities, Inc. (May 21, 2008) (“ProEquities Letter”); comment letter of the Trust Advisory Group (May 12, 2008) (“TAG Letter”); T. Rowe Price Letter.

Several commenters urged us to not require disclosure in the brochure of cash balance practices, arguing that such practices vary widely depending on the client, are typically addressed in the client's investment advisory agreement, and typically do not involve conflicts of interest.
77

We acknowledge that in many instances such practices do not involve conflicts of interest and have omitted the requirement from Part 2A. We note, however, that an adviser may have an obligation (independent of Part 2A) to disclose material information about its policies regarding the management of cash balances where the omission of such information would constitute a breach of the adviser's fiduciary duty (e.g., where the cash is not managed in the best interest of the client).
78

77
See ASG Letter; IAA Letter; T. Rowe Letter.

78
An adviser that is also registered as a broker-dealer may also have disclosure obligations relating to its cash balance practices arising under Commission and self-regulatory organization requirements. See NYSE information Memo No. 05-11 (Customer Account Sweeps to Banks) (Feb. 2005).

One commenter noted that, as proposed, Items 8.B and 8.C would require disclosure of all risks associated with using a particular investment strategy or primarily recommending a particular type of security, and not just material risks.
79

We intended these items to require disclosure only of material risks, and have amended these items accordingly.
80

79
See Schnase Letter.

80
See Items 8.B and 8.C of Part 2A (requiring disclosure of “material risks”).

This commenter also noted that Items 8.B and 8.C call for detailed discussions of “significant or unusual” risks, inquired whether this differed from “material” risks, and asked for clarification of this terminology. This requirement is intended to elicit from the adviser disclosure of significant risks associated with using a particular investment strategy or recommending a particular type of security that otherwise would not be apparent to the client from reading the adviser's

brochure. An adviser that describes a wide range of investment advisory activities in its brochure but, in fact, specializes, for example, in investing in leveraged exchange-traded funds should disclose such information in response to this item.

Item 9. Disciplinary Information.
Item 9 requires that an adviser disclose in its brochure material facts about any legal or disciplinary event that is material to a client's (or prospective client's) evaluation of the integrity of the adviser or its management personnel. These requirements incorporate into the brochure the client disclosure regarding disciplinary information required by rule 206(4)-4 under the Advisers Act.

Items 9.A, B, and C provide a list of disciplinary events that are presumptively material if they occurred in the previous 10 years. Item 9 cautions advisers, however, that the events listed in that item are those that are presumed to be material and do not constitute an exhaustive list of material disciplinary events. The list includes any convictions for theft, fraud, bribery, perjury, forgery, counterfeiting, extortion and violations of securities laws by the adviser or one of its executives. Events such as these reflect on the integrity of the adviser and its management personnel and, therefore, are presumptively material to clients. The adviser may rebut this presumption, in which case no disclosure to clients is required.
81

An adviser rebutting this presumption must document its determination in a memorandum and retain that record to enable our staff to monitor compliance with this important disclosure requirement.
82

81
Note to Item 9 of Part 2A (explaining four factors an adviser should consider when assessing whether the presumption can be rebutted).

82
Rule 204-2(a)(14)(iii).

As required by rule 206(4)-4, Item 9 requires that disciplinary events more than 10 years old be disclosed if the event is so serious that it remains material to a client's or prospective client's evaluation of the adviser and the integrity of its management. Three commenters requested that the Commission further define and clarify what disciplinary information is material in these circumstances.
83

We have determined not to do so, however, as advisers should evaluate their obligations to disclose information to clients under existing materiality standards adopted by the courts and the Commission.
84

We note that a prior disciplinary event involving an adviser would be important to clients for many reasons, including how it may reflect upon the adviser's integrity, the effect it may have on the degree of trust and confidence a client would place in the adviser, or if it imposed limitations on an adviser's activities.
85

83
See AICPA Letter; Sutherland Letter; Jackson Letter.

84
See supra note 35 for a discussion of materiality under the Advisers Act. See also the note at the end of Item 9 of Part 2A and Financial and Disciplinary Information that Investment Advisers Must Disclose to Clients, Investment Advisers Act Release No. 1035 (Sept. 19, 1986) [51 FR 34229 (Sept. 26, 1986)] (“ Rule 206(4)-4 Proposing Release”), at nn.12-13 and accompanying text. One commenter noted the use of the term “currently material” in Item 9 and asked if this phrase differed in meaning from “material.” See ABA Committees Letter. We did not intend this phrase to have a different meaning than “material” and, therefore, we have deleted the word “currently” in the Item 9 as adopted.

85
See Rule 206(4)-4 Proposing Release, at nn. 12-13 and accompanying text. The Commission has long viewed information about a prior disciplinary proceeding involving an adviser as important to clients and that failure to disclose such a proceeding may violate the antifraud provisions of sections 206(1) and 206(2) of the Advisers Act. See e.g., In the Matter of Jesse Rosenblum, Investment Advisers Act Release No. 913 (May 17, 1984).

Two other commenters addressed the rebuttable presumption of materiality under Item 9.
86

One commenter supported the flexibility of allowing advisers to rebut the presumption of materiality.
87

Other commenters suggested, however, that an adviser should not be permitted to rebut this presumption, stating that this would give advisers little incentive to disclose disciplinary information that may be considered material.
88

We note that an adviser, as a fiduciary, has an obligation to disclose material information to clients.
89

We believe that the legal consequences that flow from its failure to meet this obligation provide an incentive for an adviser to disclose material disciplinary information. Moreover, advisers that seek to exclude information from their brochures because they believe that they can rebut the presumption of materiality must memorialize the basis for that determination, which is subject to review by our staff.
90

86
See Morgan Stanley Letter; Sutherland Letter.

87
See IAA Letter.

88
See NASAA Letter; NCS Letter.

89
We note that failure to disclose material information to clients constitutes a violation of section 206 of the Advisers Act. We have brought enforcement actions charging advisers with failures to make such disclosures. See, e.g., Colley Asset Management, Inc., and John E. Colley, Investment Advisers Act Release No. 2363 (Feb. 25, 2005) (settled order).

90
We also note that an adviser is required in Part 1A of Form ADV to disclose disciplinary events regardless of whether they are material. Part 1A is filed electronically with the Commission and is publicly available on our website.

In the Proposing Release, we requested comment on whether we should require disclosure about arbitration awards and claims.
91

A few commenters supported arbitration disclosure, arguing that investors deserve the most complete information available to build a picture of an adviser's integrity.
92

Others objected, with some reasoning that arbitration claims are easy to make and that arbitration settlements and awards may not necessarily include findings of wrongdoing (i.e., parties may settle arbitration proceedings and/or arbitration awards may be granted even in the absence of legal violations).
93

For this reason, we have determined not to require disclosure of arbitration awards in the client brochure. Advisers should, however, carefully consider whether particular arbitration awards or settlements do, in fact, involve or implicate wrongdoing and/or reflect on the integrity of the adviser, and should be disclosed to clients in the brochure or through other means.
94

Because many disputes involving securities firms (including investment advisers) are resolved through arbitration or other methods of alternative dispute resolution, we will continue to assess whether we should require that these events be reported by firms registered with us.

91
See Proposing Release at Section II.A.2. We also requested comment in the Proposing Release on whether we should require that advisers subject to a Commission administrative order provide clients with a copy of that order. Commenters did not support such a requirement and stated that, when appropriate, we should require delivery of orders in individual proceedings. See Federated Letter; Fried Frank Letter; Morgan Stanley Letter; Sutherland Letter. We agree with commenters and Part 2A does not require that such orders be provided to advisory clients.

92
See Consumer Federation Letter; CFA Institute Letter; CFP Board Letter; NASAA Letter.

93
See comment letter from Michael Berlin (Apr. 28, 2008) (“Berlin Letter”); Federated Letter; First Allied Letter; Fried Frank Letter; IAA Letter; ICI Letter; Janus Letter; Mercer Letter; Morgan Stanley Letter; NRS Letter; SIFMA Letter; comment letter of R.C. Verbeck (May 12, 2008) (“Verbeck Letter”).

94
We note that failure to disclose material information to clients constitutes a violation of section 206 of the Advisers Act.

Item 9 requires that an adviser must disclose if it (or any of its management persons) has been involved in one of the events listed in that item. “Involved” is defined as “[e]ngaging in any act or omission, aiding, abetting, counseling, commanding, inducing, conspiring with or failing reasonably to supervise another in doing an act.”
95

Three commenters requested that we narrow the definition of “involved,” arguing that the proposed definition is both overbroad and vague.
96

Other commenters supported using the term

“involved,” as defined.
97

One of these commenters noted that this term also is used in Form BD and in Form U4 and, as such, changing the meaning of the term (or eliminating it from Part 2A) would undermine uniformity and create disparate reporting between broker-dealers and advisers.
98

We believe that, for purposes of consistency, it is appropriate to continue to define the term “involved” as currently defined in Form ADV. This term and definition has been used in Form ADV for over 9 years and on Form BD for over 14 years, and we believe its meaning should be well understood.
99

95
See the Glossary to Form ADV.

96
See Federated Letter; IAA Letter; Morgan Stanley Letter.

97
See CFA Institute Letter; NASAA Letter.

98
See NASAA Letter.

99
See Amendments to Form ADV, Investment Advisers Act Release No. 1897 (Sept. 12, 2000) [65 FR 57438 (Sept. 22, 2000)]; Form BD Amendments, Securities Exchange Act Release No. 37431 (July 12, 1996) [61 FR 37357 (July 18, 1996)].

Some commenters recommended that advisers be permitted to satisfy the obligation to disclose and update disciplinary events by referring clients to the Investment Adviser Public Disclosure system (IAPD) to obtain the firm's disclosures from Part 1A of Form ADV and providing a copy of the disciplinary disclosures to clients who do not have Internet access.
100

One commenter strongly opposed this recommendation, however, stating that “[a]rming investors with this information is one of the best tools we have to put investors on their guard so that they can protect their own interests.”
101

100
See comment letter of the Alternative Investment Management Association (May 16, 2008) (“AIMA Letter”); ASG Letter; Janus Letter; Morgan Stanley Letter; NRS Letter; SIFMA Letter; Sutherland Letter.

101
Consumer Federation Letter.

The disciplinary information provided in Part 1A is provided to the Commission primarily for registration purposes and not with an eye towards client disclosure. Part 1A, therefore, requires disclosure not just about the advisory firm and its management personnel, but also about all of its “advisory affiliates.” A firm's advisory affiliates include all of the firm's employees, officers, partners, or directors and all persons directly or indirectly controlling or controlled by the firm.
102

Having disciplinary information about this broad group is important to the Commission for regulatory purposes. However, many of the largest investment advisers may have a large number of advisory affiliates and voluminous disciplinary disclosure, much of which may be regarding advisory affiliates with no relationship to particular clients. Accordingly, we believe that requiring clients to sift through an advisory firm's Part 1A disciplinary disclosure is not the most effective client disclosure. Therefore, we are adopting the proposed requirement that the brochure affirmatively disclose disciplinary information about the adviser and its management personnel.

102
See Form ADV: Glossary. Firm employees that perform only clerical, administrative, support, or similar functions are excluded from the definition.

Because Part 2A, as amended, incorporates disciplinary disclosures formerly required by rule 206(4)-4 directly in the advisory brochure requirements, we are rescinding rule 206(4)-4.
103

The rescission of rule 206(4)-4 will be effective, with respect to any particular investment adviser, on the date by which that adviser must deliver its narrative brochure to existing clients and begin delivering its brochure to prospective clients under the rule and form amendments we are adopting today.
104

Some advisers, however, may have clients to whom they are not required to deliver a brochure, such as certain clients receiving only impersonal investment advice or those that are registered investment companies and business development companies.
105

For these advisers, their fiduciary duty of full and fair disclosure requires them to continue to disclose to all their clients material disciplinary and legal events and their inability to meet contractual commitments to their clients.
106

103
In addition to requiring disclosure of certain disciplinary information, rule 206(4)-4 requires an adviser to disclose certain financial information to clients. As with the disciplinary disclosure, we have incorporated this requirement into the new brochure. Similar to rule 206(4)-4(a)(1), Item 18.B of Part 2A requires certain advisers to disclose any financial condition that is reasonably likely to impair their ability to meet contractual commitments to clients. See infra note 177 and accompanying text.

104
See infra Section V.

105
Our requirements regarding to which clients an adviser must deliver a brochure are discussed in Section II.A.3 below. One commenter suggested that we retain rule 206(4)-4 to require only the delivery of disciplinary information to clients for whom the brochure delivery requirement does not apply. See ABA Committees Letter.

106
See Financial and Disciplinary Information that Investment Advisers Must Disclose to Clients, Investment Advisers Act Release No. 1035 (Sept. 19, 1986) (“Rule 206(4)-4 Adopting Release”) (“explaining that rule 206(4)-4 was designed to codify an investment adviser's fiduciary obligation to disclose material financial and disciplinary information to clients.”). We have brought enforcement actions charging advisers with failures to make such disclosures. See, e.g., In the Matter of Veritas Financial Advisors LLC, Veritas Advisors, Inc., Patrick J. Cox and Rita A. White, Investment Advisers Act Release No. 2577 (Dec. 29, 2006) (settled order); In the Matter of Harry Michael Schwartz, Investment Advisers Act Release No. 1833 (Sept. 27, 1999) (settled order); In the Matter of Renaissance Capital Advisors, Inc., and Richard N. Fine, Investment Advisers Act Release No. 1688 (Dec. 22, 1997) (settled order). In addition, under section 9(a) of the Company Act [15 USC 80a-9(a)] an investment adviser to a registered investment company may be prohibited from serving in certain capacities with the fund as a result of a disciplinary event.

Item 10. Other Financial Industry Activities and Affiliations.
Item 10 requires each adviser to describe in its brochure material relationships or arrangements the adviser (or any of its management persons) has with related financial industry participants, any material conflicts of interest that these relationships or arrangements create, and how the adviser addresses the conflicts.
107

In addition, if an adviser selects or recommends other advisers for clients, Item 10 requires that it disclose any compensation arrangements or other business relationships between the advisory firms, along with the conflicts created, and explain how it addresses these conflicts.
108

The disclosure that Item 10 requires highlights for clients their adviser's other financial industry activities and affiliations that can create conflicts of interest and may impair the objectivity of the adviser's investment advice.

107
This item is similar to Item 8 of the previous Part 2. Two commenters requested that we clarify or provide guidance regarding “materiality” in describing relations and arrangements with related persons, and conflicts of interest arising from these relations or arrangements. See IAA Letter; NRS Letter. We address this comment earlier in this Release. See supra note 35 for a further discussion of materiality under the Advisers Act.

108
We have brought enforcement actions charging advisers with failures to make such disclosures. See, e.g., In the Matter of Morgan Stanley & Co., Incorporated, Investment Advisers Act Release No. 2904 (July 20, 2009) (settled order); In the Matter of Yanni Partners, Inc. and Theresa A. Scotti, Investment Advisers Act Release No. 2642 (Sept. 5, 2007) (settled order).

Two commenters explicitly stated that they supported the disclosure required by this item.
109

At the suggestion of one commenter,
110

we have modified Item 10.D to require advisers that recommend other advisers to disclose, in particular, payments or business relationships that create material conflicts of interest with clients, so as not to capture all relationships.

109
See CFA Institute Letter; Lininger Letter.

110
See Sutherland Letter.

Item 11. Code of Ethics, Participation or Interest in Client Transactions and Personal Trading.

Code of Ethics. Item 11 requires each adviser to describe briefly its code of ethics and state that a copy is available upon request.
111

Two commenters strongly supported the proposed item, believing the required disclosure is

indicative of an adviser's commitment to its fiduciary duties.
112

One recommended that we instead simply require an adviser to note in the brochure that a copy of its code of ethics is available upon request.
113

We believe that a brief, concise summary of the code of ethics (as the item requires) will be helpful to prospective clients who may not wish or feel the need to request the entire code of ethics and will assist those clients in determining whether they would like to read the entire code of ethics.
114

111
This requirement is almost identical to the previous disclosure requirement in Item 9 of the previous Part 2.

112
See CFA Institute Letter; CFP Board Letter.

113
See Morgan Stanley Letter.

114
This summary should not be a reiteration of the entire code of ethics, but rather should provide enough information for the client to determine if it would like to read the full code of ethics and to understand generally the adviser's ethical culture and standards, how the adviser controls sensitive information, and what steps it has taken to prevent employees from misusing their inside positions at clients' expense. See Investment Adviser Code of Ethics, Investment Advisers Act Release No. 2256 (July 2, 2004), at text accompanying notes nn.66-67 [69 FR 41696 (July 9, 2004)].

Participation or Interest in Client Transactions. If the adviser or a related person recommends to clients, or buys or sells for client accounts, securities in which the adviser or a related person has a material financial interest, Item 11.B requires the brochure to discuss this practice and the conflicts of interest presented.
115

Conflicts could arise, for example, when an adviser recommends that clients invest in a pooled investment vehicle that the firm advises or for which it serves as the general partner,
116

or when an adviser with a material financial interest in a company recommends that a client buy shares of that company.
117

The item requires advisers to disclose any practices giving rise to these conflicts, the nature of the conflicts presented, and how the adviser addresses the conflicts. Two commenters expressed support for this requirement.
118

We are adopting Item 11.B. substantially as proposed, except that at the suggestion of three commenters, we have omitted the portion of the proposed item that required advisers to disclose “procedures” for making the disclosures to clients.
119

We agree with these commenters that the requirement was inconsistent with the Commission's general approach throughout the brochure of requiring disclosure about conflicts and how they are addressed, but not about “procedures.”

115
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. See Form ADV: Glossary. Items 11.B, 11.C, and 11.D are similar to Item 9 of the previous Part 2.

116
We have brought enforcement actions charging advisers with failures to make such disclosures. See, e.g., In the Matter of Thomson McKinnon Asset Management, L.P., Investment Advisers Act Release No. 1243 (July 26, 1990) (settled order).

117
We have brought enforcement actions charging advisers with failures to make such disclosures. See, e.g., In the Matter of Chancellor Capital Management, Inc., et al., Investment Advisers Act Release No. 1447 (Oct. 18, 1994) (settled order).

118
See CFA Institute Letter; CFP Board Letter.

119
See IAA Letter; ICI Letter; T. Rowe Letter.

Personal Trading. Items 11.C and 11.D require disclosure of personal trading by the adviser and its personnel.
120

Item 11.C requires an adviser to disclose whether it or a related person (e.g., advisory personnel) invests (or is permitted to invest) in the same securities that it recommends to clients, or in related securities (such as options or other derivatives). If so, the brochure must discuss the conflicts presented and describe how the firm addresses the conflicts. Item 11.D requires a similar discussion, but focuses 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.
121

In response to this item, an adviser should explain how its internal controls, including its code of ethics, prevent the firm and its staff from buying or selling securities contemporaneously with client transactions.

120
We have brought enforcement actions charging advisers with fraudulent personal trading. See In the Matter of Roger W. Honour, Investment Advisers Act Release No. 1527 (Sept. 29, 1995) (settled order).

121
We have brought enforcement actions charging advisers with inaccurate disclosure in this context. See, e.g., In the Matter of Hutchens Investment Management and William Hutchens, Investment Advisers Act Release No. 2514 (May 9, 2006) (settled order).

One commenter suggested that we specify a minimum amount of assets that must be managed by an adviser in order for that adviser to be required to disclose personal securities transactions, arguing that small firms' securities transactions are not large enough to generate a market impact and thus should not require disclosure.
122

We disagree. A small firm could still place a trade large enough to have a market impact, especially in a thinly traded security. In addition, given that an adviser's ability to place its own trades before or after client trades in the same security may affect the objectivity of the adviser's recommendations, we believe disclosure of this practice is warranted. As a result, we are adopting Items 11.C and 11.D as proposed.

122
See comment letter of Thaddeus Borek, Jr. (May 16, 2008).

Finally, we note that we have modified the note to Item 11 to clarify that Items 11.B, 11.C, and 11.D would not require disclosure with respect to securities that are not “reportable securities” under Advisers Act rule 204A-1(e)(10), such as shares in unaffiliated mutual funds.
123

As we indicated in the Proposing Release, such securities are not reportable under Advisers Act Rule 204A-1 because they appear to present little opportunity for front-running.
124

123
See Code of Ethics Adopting Release, supra note 114 at n.42 and accompanying text.

124
See Proposing Release, supra note 2, at n.85.

Item 12. Brokerage Practices.
Item 12 requires that advisers describe how they select brokers for client transactions and determine the reasonableness of brokers' compensation. This item also requires advisers to disclose how they address conflicts of interest arising from their receipt of soft dollar benefits (i.e., research or other products or services they receive in connection with client brokerage).
125

125
Item 12 is similar to Item 12.B in the previous Part 2.

Soft Dollar Practices. Many advisers receive brokerage and research services in reliance on section 28(e) of the Securities Exchange Act of 1934 (“Exchange Act”),
126

as well as other soft dollar products and services provided by brokers in connection with client transactions.
127

Use of client securities transactions to obtain research and other benefits creates incentives that result in conflicts of interest between advisers and their clients.
128

Because of these

conflicts, we have long required advisers to disclose their policies and practices with respect to their receipt of soft dollar benefits in connection with client securities transactions.
129

126
Section 28(e) of the Exchange Act provides a limited “safe harbor” for advisers with discretionary authority in connection with their receipt of soft dollar benefits. Under section 28(e), a person 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. Advisers must disclose their receipt of soft dollar benefits to clients, regardless of whether the benefits fall inside or outside of the safe harbor. See 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) [51 FR 16004 (Apr. 30, 1986)], at n.33 and accompanying text.

127
According to IARD data as of May 3, 2010, approximately 61% of advisers registered with the Commission report on Form ADV, Part 1A, Item 8.E that they or related persons receive soft dollar benefits in connection with client transactions.

128
Commission Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934, Exchange Act Release No. 54165 (July 18, 2006) [71 FR 41978 (July 24, 2006)] (“2006 Soft Dollar Release”) (“[u]se of client commissions to pay for research and brokerage services presents money managers with significant conflicts of interest, and may give incentives for managers to disregard their best execution obligations when directing orders to

obtain client commission services as well as to trade client securities inappropriately in order to earn credits for client commission services”).

129
See Item 12 of the previous Part 2.

Item 12 requires an adviser that receives soft dollar benefits in connection with client securities transactions to disclose its practices.
130

The description must be specific enough for clients and prospective clients to understand the types of products or services the adviser is acquiring and permit them to evaluate associated conflicts of interest. Disclosure must be more detailed for products or services that do not qualify for the safe harbor in section 28(e) of the Exchange Act, such as services that do not aid in the adviser's investment decision-making process.
131

130
See Item 12.A.1 of Part 2A.

131
See note to Item 12.A.1.e of Part 2A.

Item 12 also requires that an adviser discuss in its brochure the types of conflicts it has when it accepts soft dollar benefits and explain how it addresses those conflicts.
132

The item requires the adviser to explain whether it uses soft dollars to benefit all client accounts or only those accounts whose brokerage “pays” for the benefits, and whether the adviser seeks to allocate the benefits to client accounts proportionately to the soft dollar credits those accounts generate. The item also requires the adviser to explain whether it “pays up” for soft dollar benefits.
133

132
See Item 12.A.1. An adviser accepting soft dollar benefits must explain that (a) the adviser benefits because it does not have to produce or pay for the research or other products or services acquired with soft dollars, and (b) the adviser therefore has an incentive to select or recommend brokers based on the adviser's interest in receiving these benefits, rather than on the client's interest in getting the most favorable execution. See Item 12.A.1.a and b of Part 2A.

133
“Paying up” refers to an adviser causing a client account to pay more than the lowest available commission rate in exchange for soft dollar products or services.

Some commenters, including one association representing more than 130 pension funds, expressed their strong support for the soft dollar disclosure requirement.
134

Other commenters objected to various portions of this item.
135

Some of these commenters recommended elimination of the proposed requirements to disclose whether an adviser allocates soft dollar benefits to client accounts proportionately to the brokerage credits those accounts generate,
136

and to disclose the “procedures” it uses to direct client transactions to a particular broker-dealer.
137

Some of these commenters also questioned the conflicts we identified and expressed concern that the item will tend to create a misleading impression that the use of soft dollar arrangements is harmful.
138

134
See comment letter of the Council of Institutional Investors (May 16, 2008) (“CII Letter”); CFA Institute Letter; NRS Letter; comment letter of Carolina Capital Markets, Inc. (Aug. 8, 2008).

135
See, e.g., comment letter of the Alliance in Support of Independent Research (May 16, 2008) (“Alliance Letter”); CAPIS Letter; IAA Letter; ICI Letter; comment letter of Pickard and Djinis LLP (May 14, 2008) (“Pickard Letter”); SIFMA Letter; T. Rowe Letter.

136
See Alliance Letter; CAPIS Letter; IAA Letter; ICI Letter; Pickard Letter.

137
See Alliance Letter; CAPIS Letter; IAA Letter; ICI Letter.

138
See Alliance Letter; IAA Letter; ICI Letter; SIFMA Letter.

There are significant conflicts associated with soft dollar arrangements. Section 28(e) was enacted, in part, to address them.
139

We are not taking a view on the propriety of soft dollar arrangements, but rather are requiring full disclosure of arrangements that involve significant conflicts of interest.
140

Moreover, disclosure required by Item 12 is similar to disclosure requirements previously required in Part 2 of Form ADV.
141

We are adopting this requirement as proposed.

139
See 2006 Soft Dollar Release, supra note 128, at nn.4-6 and accompanying text.

140
We have brought enforcement actions charging advisers with not adequately disclosing soft dollar arrangements and related conflicts. See, e.g., In the Matter of Schultze Asset Management LLC and George J. Schultze, Investment Advisers Act Release No. 2633 (Aug. 15, 2007) (settled order); In the Matter of Rudney Associates, Inc. et al., Investment Advisers Act Release No. 2300 (Sept. 21, 2004) (settled order).

141
Item 12.B. of the previous Part 2 required, for example, that the adviser describe the factors considered in selecting brokers and determining the reasonableness of their commissions. In addition, if the value of products, research and services given to the adviser is a factor in selecting brokers, the adviser was required to, among other things, describe whether clients may pay commissions higher than those obtainable from other brokers in return for those products and services.

Client Referrals. If an adviser uses client brokerage to compensate or otherwise reward brokers for client referrals, it also must disclose this practice, the conflicts of interest 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).
142

Part 2 previously required that advisers disclose these arrangements, but did not specifically require that the description discuss the conflicts of interest created.
143

We did not receive any comments relating to this item and are adopting the requirement as it was proposed so that clients are aware that their adviser may have a bias toward referring brokers, a significant conflict of interest.
144

142
Item 12.A.2 of Part 2A.

143
See Item 13.B. of the previous Part 2.

144
We have brought enforcement actions charging advisers with failing to disclose to clients that they directed their brokerage commissions in return for client referrals. See, e.g., In the Matter of Fleet Investment Advisors, Inc., Investment Advisers Act Release No. 1821 (Sept. 9, 1999) (settled order).

Directed Brokerage. Item 12 requires an adviser that permits clients to direct brokerage to describe its practices in this area. Item 12 also requires that such an adviser explain that it may be unable to obtain the most favorable execution of client transactions if the client directs brokerage and that directing brokerage may be more costly for clients.
145

If, however, an adviser routinely recommends, requests or requires clients to direct brokerage, Item 12 also requires the adviser to describe this practice in its brochure, to disclose that not all advisers require directed brokerage, and to describe any relationship with a broker-dealer to which the brokerage may be directed that creates a material conflict of interest.
146

An adviser may omit disclosure regarding its inability to obtain best execution if directed brokerage arrangements are only conducted subject to the adviser's ability to obtain best execution.
147

145
See Item 12.A.3.b of Part 2A. As we discussed in the Proposing Release, clients sometimes instruct their adviser to send transactions to a specific broker-dealer for execution. Clients may initiate this type of arrangement for a variety of reasons, such as favoring a family member or friend or compensating the broker-dealer indirectly for services it provides to the client. But the arrangement also may 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.

146
See Item 12.A.3.a of Part 2A. We have brought enforcement actions charging advisers with failures to make such disclosures. See also In the Matter of Callan Associates, Investment Advisers Act Release No. 2650 (Sept. 19, 2007) (settled order); In the Matter of Jamison, Eaton & Wood, Inc., Investment Advisers Act Release No. 2129 (May 15, 2003) (settled order).

147
See note to Item 12.A.2 of Part 2A.

Two commenters addressed this requirement. One, representing pension funds, endorsed our proposal as supporting transparency in brokerage arrangements.
148

The other urged that we broaden the proposed exception in the item to all directed brokerage subject to best execution, whether recommended by the adviser or directed by the client. The commenter pointed out that such client-imposed limitations on direction of brokerage should

address the Commission's concerns in proposing the item.
149

We agree, and have revised the note following the item accordingly.

148
See CII Letter.

149
See Alliance Letter.

Trade Aggregation. Clients engaging an adviser can benefit when the adviser aggregates trades to obtain volume discounts on execution costs. Item 12 requires the adviser to describe whether and under what conditions it aggregates trades. If the adviser does not aggregate trades when it has the opportunity to do so, the adviser must explain in the brochure that clients may therefore pay higher brokerage costs. One commenter supported this disclosure, stating that it is helpful and meaningful to clients.
150

However, another commenter expressed concern that such disclosure would suggest that advisers should always aggregate orders, and noted that there are circumstances where an adviser may decide that it is better for the client not to do so, such as with multiple large trades that may create a market impact.
151

Other commenters argued that trade aggregation practices are not material to clients.
152

But aggregation practices may have a material effect on the quality of execution. Thus, we believe that such practices should be disclosed in the brochure.

150
See NRS Letter.

151
See IAA Letter.

152
See Fried Frank Letter.

Finally, one commenter suggested deleting the words “in quantities sufficient to obtain reduced transaction costs” from the first sentence of Item 12.B since there may be other circumstances in which advisers may aggregate client trades that should be disclosed to clients.
153

As this item was intended to require advisers to explain their aggregation practices along with the reasons for and consequences of those practices more generally, we have removed this limiting phrase.

153
See Schnase Letter.

Item 13. Review of Accounts.
Item 13 requires that an adviser disclose whether, and how often, it reviews clients' accounts or financial plans, and identify who conducts the review.
154

An adviser that reviews accounts other than regularly must explain what circumstances trigger an account review.

154
Item 13 is similar to Item 11 in the previous Part 2.

Three commenters addressed this item. One supported it as being helpful to clients.
155

Two thought that this item provided non-critical information that could be eliminated in the interest of providing a shorter brochure to clients.
156

We believe the disclosure, which can be brief, provides very useful information to clients about their advisers' management of their accounts. As a result, we are adopting this item substantially as it was proposed.
157

155
See CFA Institute Letter.

156
See SIFMA Letter; Sutherland Letter.

157
The Schnase Letter suggested changing the word “employee” in Item 13.A to “supervised person.” As defined in the Form ADV Glossary, “supervised person” means “any of your officers, partners, directors (or other persons occupying a similar status or performing similar functions), or employees, or any other person who provides investment advice on your behalf and is subject to your supervision or control.” For purposes of consistency throughout Part 2A, we are making the change suggested by the commenter. We also are substituting the word “supervised person” for the word “employee” in Item 14.B, Instruction 6 for Part 2A, Appendix 1 (the wrap fee program brochure), and Item 6.C of Part 2A, Appendix 1.

Item 14. Client Referrals and Other Compensation.
Item 14 requires an adviser to describe in its brochure any arrangement under which it or its related person compensates another for client referrals and describe the compensation. The brochure also must disclose any arrangement under which the adviser receives any economic benefit, including sales awards or prizes, from a person who is not a client for providing advisory services to clients.
158

158
Similar disclosure was previously required by Item 13 of Part 2.

We received three comments on this item. One supported the proposed item, stating that these areas involve practices that raise conflicts of interest.
159

Another suggested that it be omitted because certain disclosure required under this item is already required by rule 206(4)-3 under the Advisers Act (the “cash solicitation rule”).
160

The cash solicitation rule, however, applies only to certain types of payments and requires disclosure by the solicitor rather than the adviser.
161

Finally, one commenter urged that we amend the Item to disclose the conflicts of interest associated with these arrangements.
162

We agree. There are significant conflicts of interest when an adviser receives benefits from a third party for providing advisory services to a client, or when an adviser pays a third party for client referrals. We are revising Item 14.A from our proposal to require an adviser that accepts benefits from a non-client for providing advisory services to clients describe the arrangement, any conflicts of interests that arise from the arrangement, and how the adviser addresses those conflicts.

159
See CFA Institute Letter.

160
See Sutherland Letter.

161
Rule 206(4)-3 applies to advisers paying cash referral fees to solicitors, and thus does not require disclosure of non-cash benefits. The rule requires, among other things, that an unaffiliated solicitor provide the adviser's brochure and a separate disclosure document described in the rule to clients or prospective clients at the time of any solicitation activities. See rule 206(4)-3(a)(2)(iii).

162
See Schnase Letter. This commenter also suggested that we rename this item since Item 14.B relates only to payment for client referrals. In light of this comment, we are renaming this item “Client Referrals and Other Compensation.”

Item 15. Custody.
Item 15 requires an adviser with custody of client funds or securities to explain in its brochure that clients will receive account statements directly from the qualified custodian, such as a bank or broker-dealer that maintains those assets. Advisers must also explain to clients that they should carefully review the account statements they receive from the qualified custodian. In addition, if an adviser also sends clients account statements, the adviser's explanation must include a statement urging clients to compare the account statements they receive from the qualified custodian with those they receive from the adviser. Comparing statements will allow clients to determine whether account transactions, including deductions to pay advisory fees, are proper. This disclosure is very similar to the statement required to be made by advisers under our recently amended custody rule.
163

163
See Custody of Funds or Securities of Clients by Investment Advisers, Investment Advisers Act Release No. 2968 (Dec. 30, 2009) [75 FR 1456 (Jan. 11, 2010)] (“Custody Rule Adopting Release”) at section II.A.

We proposed an alternative disclosure requirement in Item 15 that we are not adopting today. Proposed Item 15.A. would have required that, if clients did not receive account statements from qualified custodians, the adviser must disclose the risks that clients would face as a result.
164

This alternative is no longer relevant because the amendments to the custody rule eliminated the option that permitted advisers to substitute their own account statements for those from a qualified custodian.
165

164
Id. We received two comments on proposed Item 15.A. See ICI Letter; ABA Committee Letter.

165
Custody Rule Adopting Release, see supra note 163.

Item 16. Investment Discretion.
Item 16 requires an adviser with discretionary authority over client accounts to disclose this fact in its brochure,
166

and any limitations clients may (or customarily do) place on this

authority.
167

Two commenters suggested that the Commission not require advisers to provide duplicative disclosure regarding discretionary authority as it likely would be incorporated into the description of the advisory business in Item 4.
168

We note that if the information is provided in response to Item 4, the adviser may cross-reference the information. We therefore are adopting this item as proposed.

166
An adviser has “discretionary authority” if it is authorized to make purchase and sale decisions for client accounts. See Form ADV Glossary. This definition of discretionary authority is derived from section 3(a)(35) of the Exchange Act [15 U.S.C. 78c(a)(35)]. An adviser also has discretionary authority if it is authorized to select other advisers for the client. This Item is similar to Item 12.A of the previous Part 2.

167
For example, clients may not understand that they may ask the adviser not to invest in securities of particular issuers.

168
See IAA Letter; Sutherland Letter. They argued that such information would already be disclosed under Items 4.B, 4.C and 4.E (advisory business) or Item 8 (strategies and risks).

Item 17. Voting Client Securities.
Item 17 requires advisers to disclose their proxy voting practices. This item parallels rule 206(4)-6 under the Advisers Act, which, among other things, requires advisers registered with the Commission to disclose certain information about their proxy voting practices.
169

Item 17 also requires advisers to disclose whether they have or will accept authority to vote client securities and, if so, to describe briefly the voting policies they adopted under rule 206(4)-6. Each adviser must describe whether (and how) clients can direct it to vote in a particular solicitation, how the adviser addresses conflicts of interest when it votes securities, and how clients can obtain information from the adviser on how the adviser voted their securities. Item 17 also requires an adviser to explain that clients may obtain a copy of the adviser's proxy voting policies and procedures upon request. Advisers that do not accept authority to vote securities must disclose how clients receive their proxies and other solicitations.
170

169
Proxy Voting Release, see supra note 3. Rule 206(4)-6 requires advisers to adopt and implement written voting policies and procedures. Advisers also are required to keep certain records relating to their voting. Advisers that exercise voting authority over client securities must describe their voting policies and procedures to clients and furnish clients with a complete copy upon request.

170
If an adviser accepts proxy voting authority for some accounts but not others, the adviser should disclose the relevant information required by this Item for each type of account unless the adviser has prepared separate brochures for the other accounts.

Some commenters suggested that we eliminate Item 17 in its entirety, arguing either that the required disclosure is not important to clients or that most of the information already is available in advisory contracts.
171

Others supported this disclosure requirement, noting that clients are interested in understanding the potential conflicts of interest that may arise from an adviser's proxy voting.
172

We agree that proxy voting practices and the conflicts arising from such practices are important information that should be disclosed, and note that rule 206(4)-6 independently would require the same disclosure even if we were to eliminate it from the brochure.
173

Accordingly, we are adopting Item 17, but with one modification.

171
See NAPFA Letter; Morgan Stanley Letter.

172
See CFA Institute Letter; CII Letter.

173
We have brought enforcement actions relating to advisers' proxy voting policies and procedures. See, e.g., In the Matter of INTECH Investment Management LLC and David E. Hurley, Investment Advisers Act Release No. 2872 (May 7, 2009) (settled order).

We had proposed to require detailed information about an adviser's use of third-party proxy voting services and how the adviser pays for proxy voting services. Most of the commenters addressing this proposed requirement argued that the information is not relevant for most clients.
174

In light of the Commission's Concept Release on the U.S. proxy system issued on July 14, 2010, which requests comment on a wide range of questions and issues relating to proxy advisory firms,
175

we are adopting Item 17 without this requirement. Clients interested in this information may obtain it from their advisers upon request.

174
See ASG Letter; Fried Frank Letter; IAA Letter; ICI Letter; Janus Letter; Lininger Letter. A few commenters supported this disclosure. See CFA Institute Letter; CII Letter.

175
Concept Release On The U.S. Proxy System, Investment Advisers Act Release No. IA-3052 (July 14, 2010) [75 FR 42982 (July 22, 2010)].

Item 18. Financial Information.
This item requires disclosure of certain financial information about an adviser when material to clients. Specifically, an adviser that requires prepayment of fees must give clients an audited balance sheet showing the adviser's assets and liabilities at the end of its most recent fiscal year.
176

The item also requires an adviser to disclose any financial condition reasonably likely to impair the adviser's ability to meet contractual commitments to clients if the adviser has discretionary authority over client assets, has custody of client funds or securities, or requires or solicits prepayment of more than $1,200 in fees per client and six months or more in advance.
177

For instance, disclosure may be required where a judgment or arbitration award was sufficiently large that payment of it would create such a financial condition. Under these circumstances, clients are exposed to the risk that their assets may not be properly managed—and prepaid fees may not be returned—if, for example, the adviser becomes insolvent and ceases to do business. Finally, Item 18 requires an adviser that has been the subject of a bankruptcy petition during the past ten years to disclose that fact to clients.
178

As discussed above, although we are rescinding rule 206(4)-4 we caution advisers that their fiduciary duty of full and fair disclosure may require them to continue to disclose any precarious financial condition promptly to all clients, even clients to whom they may not be required to deliver a brochure or amended brochure.
179

176
As proposed, we are increasing the threshold amount from the existing threshold, $500, to $1,200 to reflect the effects of inflation, based upon the Personal Consumption Expenditures Chain-Type Price Index as published by the U.S. Department of Commerce, since we adopted Form ADV in 1979. We also are requiring, as proposed, an audited balance sheet from advisers that solicit clients to prepay fees over $1,200. This portion of Item 18 is similar to Item 14 in the previous Part 2.

177
This disclosure was previously required by rule 206(4)-4. In the release adopting rule 206(4)-4, we noted that a determination about what constitutes financial condition reasonably likely to impair an adviser's ability to meet contractual commitments is inherently factual in nature but will generally include insolvency or bankruptcy. See Rule 206(4)-4 Adopting Release, supra note 106 at n.6.

178
This includes the obligation of an adviser that is organized as a sole proprietorship to disclose a personal bankruptcy. This requirement conforms to our view that bankruptcy generally constitutes a “financial condition of the adviser that is reasonably likely to impair the ability of the adviser to meet contractual commitments to clients” requiring disclosure under rule 206(4)-4. See Rule 206(4)-4 Adopting Release, supra note 106.

179
See supra note 106 and accompanying text.

One commenter recommended elimination of the balance sheet requirement, stating that the balance sheet gives an imperfect picture of the financial health of an adviser,
180

and another was concerned that disclosure of financial information would unduly discriminate against smaller advisers.
181

We believe that a client that becomes a creditor of an adviser because it prepays fees would want information about the adviser's condition. This information is currently required to be disclosed to clients, and commenters have not persuaded us that it should be omitted. As a result, we are adopting Item 18 as proposed.

180
See Fried Frank Letter.

181
See Verbeck Letter.

Item 19. Index.
We proposed to require that the brochure filed with us include an index of the items required by Part 2A indicating where in the brochure the adviser addresses each item. This index was intended to facilitate review by our staff for compliance with the requirements of Part 2A. As discussed above, we are now requiring advisers to provide their

responses to the items in Part 2 in the same order as the items appear in the form. As a result, the index would be duplicative of the table of contents and is no longer necessary. We therefore are not adopting this requirement.

Part 2A Appendix 1: The Wrap Fee Program Brochure.
Advisers that sponsor wrap fee programs
182

continue to be required to prepare a separate, specialized firm brochure (a “wrap fee program brochure” or “wrap brochure”) for clients of the wrap fee program in lieu of the sponsor's standard brochure.
183

The items in Appendix 1 to Part 2A contain the requirements for a wrap fee program brochure, and are substantially similar to those previously in Schedule H, the separate wrap fee program brochure in previous Part 2.
184

However, we are revising the requirements of Schedule H to incorporate many of our amendments to the Part 2A firm brochure.

182
Under wrap fee programs, which also are sometimes referred to as “separately managed accounts,” advisory clients pay a specified fee for investment advisory services and the execution of transactions. The advisory services may include portfolio management and/or advice concerning selection of other advisers, and the fee is not based directly upon transactions in the client's account.

183
We adopted the requirement for a separate brochure for wrap fee clients in 1994. See Disclosure by Investment Advisers Regarding Wrap Fee Programs, Investment Advisers Act Release No. 1411 (Apr. 19, 1994) [59 FR 21657 (Apr. 26, 1994)]. Advisers whose entire advisory business is sponsoring wrap fee programs will prepare a wrap brochure but will not be required to prepare a standard advisory firm brochure. See Instruction 10 of Instructions for Part 2A of Form ADV. An adviser will have to prepare both a standard firm brochure and a wrap fee program brochure if it both sponsors a wrap fee program and provides other types of advisory services, and will deliver both a standard and a wrap brochure to a client who receives both types of services. Wrap fee sponsors would, like other advisers, be required to provide brochure supplements to their wrap fee clients.

184
We have brought enforcement actions regarding wrap fee program disclosure. See, e.g., In re Banc of America Investment Services, Inc. and Columbia Management Advisors, LLC (as successor in interest to Banc of America Capital Management, LLC), Investment Advisers Act Release No. 2733 (May 1, 2008) (settled order).

We also are adopting an additional disclosure requirement to the wrap fee program brochure. It requires an adviser to identify whether any of its related persons is a portfolio manager in the wrap fee program and, if so, to describe the associated conflicts. For example, an adviser may have an incentive to select a related person to participate as a portfolio manager based on the person's affiliation with the adviser, rather than based on expertise or performance. This item requires advisers to disclose whether related person portfolio managers are subject to the same selection and review criteria as the other portfolio managers who participate in the wrap fee program and, if they are not, how they are selected and reviewed.

Two commenters requested clarification that an adviser can delegate its brochure delivery requirement to the sponsor of the wrap fee program,
185

and one of these commenters also requested clarification that the adviser could satisfy its recordkeeping obligations that evidence delivery of the brochure by such records being retained in the offices of the sponsor and not the adviser, as long as the adviser was able to provide the records to Commission staff upon request.
186

We confirm that a sponsor may deliver the adviser's brochures and maintain certain records as long as the sponsor, upon request of the Commission's staff, will produce promptly the records for the staff at the appropriate office of the adviser or the sponsor. This delegation does not relieve the adviser of its legal delivery obligation, however, and thus the adviser should take steps to assure itself that the sponsor is performing the tasks the adviser has delegated.

185
See Federated Letter; MMI Letter.

186
See MMI Letter. Rules 204-2(a)(14) and 204-2(e)(1) under the Advisers Act describe advisers' recordkeeping obligations relating to brochure delivery.

3. Delivery and Updating of Brochures

The Commission also is adopting amendments to rule 204-3; our rule under the Advisers Act that requires registered advisers to deliver their brochures and certain updates to clients and prospective clients.
187

187
The brochure delivery and updating obligations are the same for both a standard brochure and a wrap fee program brochure. See rule 204-3.

a. Delivery to Clients

Initial Delivery. Rule 204-3, as amended, requires an adviser to deliver a current brochure before or at the time it enters into an advisory contract with the client.
188

The rule does not require advisers to deliver brochures to certain advisory clients receiving only impersonal investment advice
189

or to clients that are investment companies registered under the Investment Company Act of 1940 (“Company Act”).
190

As proposed, we have expanded the latter exception to cover advisers to business development companies (“BDCs”) that are subject to section 15(c) of the Company Act, which requires a board of directors to request, and the adviser to furnish, information to enable the board to evaluate the terms of the proposed advisory contract.
191

Because of this safeguard, we believe that adopting an obligation for these advisers to deliver a brochure to these BDC clients is not necessary.
192

An adviser does not have to prepare (or file with us) a brochure if it does not have any clients to whom a brochure must be delivered.
193

188
See rule 204-3(b). Rule 204-3 requires a registered adviser to furnish each client and prospective client with a written disclosure statement which may be either a copy of the adviser's completed Part 2A or a written document containing the information required by Part 2A. Previously, such delivery had to occur at least 48 hours before entering into the advisory agreement, or at the time of entering into the agreement if the client has the right to terminate the agreement without penalty within five business days thereafter. We received two comments on this proposed change to the timing of the required initial brochure delivery, both in support. See Pickard Letter; T. Rowe Letter.

189
See rule 204-3(c)(2) and Instruction 1 for Part 2A of Form ADV. Advisers are not required to deliver brochures to advisory clients receiving only impersonal investment advice for which the adviser charges less than $500 per year. As proposed, we increased the dollar threshold triggering this exception from $200 to $500 to reflect the effects of inflation, based upon the Personal Consumption Expenditures Chain-Type Price Index, as published by the U.S. Department of Commerce, since rule 204-3 was adopted in 1979. We did not receive comments on this change.

190
See rule 204-3(c)(1) and Instruction 1 for Part 2A of Form ADV.

191
See supra note 190. As discussed above, an adviser's fiduciary duty of full and fair disclosure, however, may require it to continue to disclose any material legal event or precarious financial condition promptly to all clients, even clients to whom it may not be required to deliver a brochure or amended brochure. See supra note 106 and accompanying text.

192
Two commenters urged us to adopt an exception for “hedge funds,” or clarify that advisers to hedge funds are not required to deliver copies of brochures to their investors. See ABA Committees Letter; Fried Frank Letter. We note that rule 204-3 requires only that brochures be delivered to “clients.” We further note that the Court of Appeals for the D.C. Circuit stated that the “client” of an investment adviser managing a hedge fund is the fund itself, not an investor in the fund. Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).

193
See Instruction 7 for Part 2A of Form ADV.

Annual Delivery. Advisers must annually provide to each client to whom they must deliver a brochure either: (i) A copy of the current (updated) brochure that includes or is accompanied by the summary of material changes; or (ii) a summary of material changes that includes an offer to provide a copy of the current brochure.
194

As proposed, each adviser

must make this annual delivery no later than 120 days after the end of its fiscal year.
195

Advisers may deliver a brochure and summary of material changes or summary of material changes, along with an offer to provide the brochure to clients electronically in accordance with the Commission's guidelines regarding electronic delivery of information.
196

An adviser that does not include, and therefore file, its summary of material changes as part of its brochure (on the cover page or the page immediately following the cover) must file its summary as an exhibit, included with its brochure when it files its annual updating amendment with us, so that the summary of material changes is available to the public through IAPD.
197

194
See rule 204-3(b) and Item 2 to Part 2A of Form ADV. The offer also must be accompanied by a Web site address and a telephone number and e-mail address for obtaining the complete brochure pursuant to the Instructions for Part 2, as well as the Web site address for obtaining information about the adviser through IAPD. We also are adopting an amendment to our recordkeeping rule that will require the adviser choosing this approach to preserve a copy of the summary of material changes, so that our examination staff has access to such separately provided summaries. See rule 204-2(a)(14)(i). See Section IV below.

If an adviser includes the summary of material changes in its brochure, and amends its brochure

on an interim basis between annual updating amendments, the adviser should consider whether it should update its summary of material changes to avoid confusing or misleading clients reading the updated brochure.

195
See Rule 204-3(b) and Instruction 2 for Part 2A of Form ADV. As discussed below, rule 204-1 requires an adviser registered with the Commission to annually revise its Form ADV, including its brochure, within 90 days of its fiscal year end. Advisers typically provide clients with reports quarterly, and the 120-day period is designed to provide sufficient flexibility to allow advisers to include the updated brochure or summary in a routine quarterly mailing to clients. We expect that permitting an adviser to send this document together with these routine mailings could substantially reduce delivery costs. See Section VII below.

196
Use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment Advisers for Delivery of Information, Investment Advisers Act Release No. 1562 (May 9, 1996) [61 FR 24644 (May 15, 1996)] (“Electronic Media Release”).

197
See Instruction 6 for Part 2A of Form ADV. The adviser must upload its brochure and the summary (as an exhibit) together in a single, text-searchable file in Adobe Portable Document Format (PDF) on IARD. See Instruction 6 for Part 2A of Form ADV.

We proposed that each adviser annually deliver an updated brochure to its clients because we were concerned that clients may be relying on “stale” brochures. Many commenters representing advisers objected, arguing that this requirement would cause advisers to incur significant costs,
198

and that clients are not interested in receiving an annual brochure.
199

We believe our revised approach—permitting advisers to deliver annually the summary of material changes, which was suggested by several commenters
200

—addresses our concern that clients may today be relying on “stale” brochures, while alleviating commenters' concerns regarding the costs and burdens of annual delivery of the brochure.
201

198
See AICPA Letter; Eddy Letter; FPA Letter; IAA Letter; ICI Letter; Mercer Letter; Merrill Lynch Letter; Morgan Stanley Letter; MMI Letter; NAPFA Letter; NRS Letter; Pickard Letter; ProEquities Letter; Roundtable Letter; Schwab Letter; SIFMA Letter; Sutherland Letter; USAA Letter; comment letter of Wachovia Securities LLC (May 16, 2008) (“Wachovia Letter”); Wellington Letter, comment letter of Wall Street Financial Group (May 16, 2008) (“WSFG Letter”).

199
See, e.g., ASG Letter; comment letter of Clifford Swan Investment Counsel (May 5, 2008) (“Clifford Letter”); First Allied Letter; FPA Letter; FSI Letter; comment letter of Moody Aldrich Partners (May 15, 2008) (“Moody Aldrich Letter”); NRS Letter; Roundtable Letter; WSFG Letter.

200
See ASG Letter; Clifford Letter; Federated Letter; First Allied Letter; FPA Letter; FSI Letter; comment letter of the Investment Adviser Association (Aug. 26, 2008); Merrill Lynch Letter; Moody Aldrich Letter; NRS Letter; Roundtable Letter; Schnase Letter; WSFG Letter.

201
One commenter representing consumers agreed that such an approach could minimize the costs of delivery without significantly sacrificing investor protection. See Consumer Federation Letter.

Some commenters urged that we revise our electronic delivery guidance
202

so that disclosure placed on the adviser's web page or on IARD would be deemed to be delivered to its clients, regardless of whether the clients have provided consent to electronic delivery.
203

We note that an adviser's fiduciary duties may require it to obtain client consent to many of the disclosures required by Part 2 and that electronic access, without evidence that the adviser's delivery obligation has been met (such as by obtaining the client's consent to electronic delivery along with appropriate notice and access) would not, in our judgment, serve to adequately protect client interests.
204

202
See Electronic Media Release, see supra note 196.

203
See, e.g., ABA Committees Letter; IAA Letter; Mercer Letter; Roundtable Letter; Sutherland Letter; Wachovia Letter.

204
See Electronic Media Release, supra note 196 at Section II.A.3.

Some commenters recommended that advisers be required to send clients a notice providing a Web site link to where the brochure is posted on the Internet, rather than having to deliver the actual brochure to clients initially.
205

Another commenter objected, arguing that many investors are not yet willing to use the Internet to receive disclosure documents and that an approach that would rely on electronic delivery would be premature for retail investors.
206

We are not making such changes at this time, but will continue to consider different approaches to delivering financial information to investors.

205
See, e.g., ASG Letter; Borek Letter; FSI Letter; ICI Letter; Lininger Letter; Merrill Lynch Letter; MMI Letter; Morgan Stanley Letter; NAPFA Letter; Pickard Letter; SIFMA Letter; Wellington Letter.

206
See Consumer Federation Letter.

Interim Delivery. As proposed, rule 204-3 requires advisers to deliver an updated brochure (or a document describing the material facts relating to the amended disciplinary event) promptly whenever the adviser amends its brochure to add a disciplinary event or to change material information already disclosed in response to Item 9 of Part 2A.
207

One commenter opposed the interim updating requirement, expressing concern that it would result in “frequent interim disclosure of information of minimal relevance to clients.”
208

We disagree. We believe that disclosure of disciplinary information is highly relevant to clients because it reflects on the integrity of the investment adviser, may affect a client's trust and confidence in the adviser, and may be of even greater interest if the adviser is adding disciplinary information frequently. Therefore, we are adopting this requirement as proposed.

207
See rule 204-3(b)(4).

208
See FSI Letter.

b. Updating Part 2A of Form ADV

Similar to the existing requirements, the amended rules require advisers to keep the brochures they file with us current by updating them at least annually, and updating them promptly when any information in the brochures (except the summary of material changes and the amount of assets under management, which only has to be updated annually) becomes materially inaccurate.
209

In the case of both annual and interim updates, advisers will make changes to their brochures using their own computer systems and then simply file the revised versions of their brochures through IARD.
210

209
If an adviser is amending its brochure for a separate reason between annual amendments, and the amount of assets under management is materially inaccurate, the adviser should amend this disclosure. See Instruction 4 for Part 2A of Form ADV.

210
See rule 204-1(b).

In some cases, an adviser filing its annual updating amendment may not have any material changes to make to its brochure. If the adviser has not filed any interim amendments to its brochure since the last annual amendment and the

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2010-19617. Public record. Not legal advice.