Amendments to Form ADV

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SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 275 and 279 [Release No. IA-2711; 34-57419; File No. S7-10-00] RIN 3235-AI17 Amendments to Form ADV AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule and form amendments.

SUMMARY:

The Securities and Exchange Commission is reproposing amendments to Part 2 of Form ADV, and related rules under the Investment Advisers Act, to require investment advisers registered with us to deliver to clients and prospective clients a brochure written in plain English. These amendments are designed to require advisers to provide clients and prospective clients with clear, current, and more meaningful disclosure of the business practices, conflicts of interest (including those related to soft dollar practices), and background of investment advisers and their advisory personnel. Advisers would file their brochures with us electronically, and we would make them available to the public through our Web site. The Commission also is proposing to withdraw, as duplicative, the Advisers Act rule requiring advisers to disclose certain disciplinary and financial information.

DATES:

Comments should be received on or before May 16, 2008.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's Internet comment form ( http://www.sec.gov/rules/proposed.shtml ); or

• Send an e-mail to rule-comments@sec.gov. Please include File Number S7-10-00 on the subject line; or

• Use the Federal eRulemaking Portal ( http://www.regulations.gov ). Follow the instructions for submitting comments.

Paper Comments

• Send paper comments in triplicate to Nancy M. Morris, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.

ng comments.

Paper Comments

• Send paper comments in triplicate to Nancy M. Morris, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.

All submissions should refer to File Number S7-10-00. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site ( http://www.sec.gov/rules/proposed.shtml ). Comments are also available for public inspection and copying in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549 on official business days between the hours of 10 a.m. and 3 p.m. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT:

David W. Blass, Assistant Director, Daniel S. Kahl, Branch Chief, or Vivien Liu, Senior Counsel, 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 20549-5041.

SUPPLEMENTARY INFORMATION:

The Securities and Exchange Commission (“Commission”) is proposing 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]; and amendments to Form ADV [17 CFR 279.1] under the Investment Advisers Act of 1940 [15 U.S.C. 80b] (“Advisers Act” or “Act”). 1 The Commission is also proposing to withdraw 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. Background II

s also proposing to withdraw rule 206(4)-4 [17 CFR 275.206(4)-4] under the Advisers Act.

Table of Contents

I. Background II. Discussion Of Form Adv, Part 2 A. Part 2A: The Firm Brochure 1. Proposed Format 2. Brochure Items 3. Delivery and Updating of Brochures B. Part 2B: The Brochure Supplement 1. Delivery and Updating 2. Format 3. Supplement Items C. Filing Requirements, Public Availability, and Transition III. Amendments to Form ADV Instructions and Glossary IV. Amendments to Rule 204-2 V. General Request for Comment VI. Paperwork Reduction Act VII. Cost-Benefit Analysis VIII. Initial Regulatory Flexibility Analysis IX. Efficiency, Competition, And Capital Formation X. Statutory Authority Text of Rule and Form Amendments I. Background

Investment advisers provide a wide range of investment advice to numerous types of clients. From individuals and families seeking to save for college and plan for retirement to multinational institutions managing billions of dollars, clients seek the services of investment advisers to help them evaluate their investment needs, plan for their economic future, develop and implement investment strategies, and cope with the ever-growing complexities of the financial markets. Today, the more than 10,000 advisers registered with us provide advice to nearly 20 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 January 31, 2008.

Unlike the laws of many other countries, the U.S. federal securities laws do not prescribe minimum experience or qualification requirements for persons providing investment advice

ts. 2

Unlike the laws of many other countries, the U.S. federal securities laws do not prescribe minimum experience or qualification requirements for persons providing investment advice. They do not establish maximum fees that advisers may charge. Nor do they preclude advisers from having substantial conflicts of interest that might adversely affect the objectivity of the advice they provide. Rather, investors have the responsibility, based on disclosure they receive, for selecting their own advisers, negotiating their own fee arrangements, and evaluating their advisers' conflicts. Therefore, it is critical that clients and prospective clients receive sufficient information about the adviser and its personnel to permit them to make an informed decision about whether to engage an adviser, and having engaged the adviser, how to manage that relationship.

Since 1979, the Commission has required investment advisers registered with us to provide clients and prospective clients with a disclosure statement providing information about the adviser, its business practices, the fees it charges, and its conflicts of interest. 3 Part 2 of Form ADV, the form advisers use to register with us under the Advisers Act, sets out the requirements for the disclosure statement. 4 Today, Part 2 requires

3 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)] (adopting rule 204-3 requiring brochure delivery to advisory clients and prospective clients).

4 Advisers use Form ADV to apply for registration with us or with state securities authorities, and must keep it current by filing periodic amendments as long as they are registered. See rules 203-1 and 204-1

l Filings, Investment Advisers Act Release No. 664 (Jan. 30, 1979) [44 FR 7870 (Feb. 7, 1979)] (adopting rule 204-3 requiring brochure delivery to advisory clients and prospective clients).

In April 2000, we proposed to require each adviser registered with us to give clients a narrative brochure that describes the adviser's business, conflicts of interest (including conflicts resulting from the adviser's receipt of “soft dollar” benefits), disciplinary history, and other important information necessary to make an informed decision about whether to rely on the adviser for advice. 5 Our proposal was designed to require advisers to disclose this information in a clearer, more meaningful format than the current check-the-box approach. 6 We received more than 70 comments in response to our 2000 proposal. 7 We continue to believe that we need a better approach to client disclosure than the current “check-the-box” approach. In light of the time that has passed since the original proposal, and in order to provide all persons who are interested in this matter an opportunity to comment on some of the modifications, we have made in response to comments on our 2000 proposal, we are today reproposing amendments to Part 2 of Form ADV and related rules under the Advisers Act. 8 In light of the changes we are proposing to Part 2, the Commission also is proposing to withdraw rule 206(4)-4 (requiring advisers to disclose certain financial and disciplinary information to clients).

t of the changes we are proposing to Part 2, the Commission also is proposing to withdraw rule 206(4)-4 (requiring advisers to disclose certain financial and disciplinary information to clients).

5 Electronic Filing by Investment Advisers; Proposed Amendments to Form ADV, Investment Advisers Act Release No. 1862 (Apr. 5, 2000) [65 FR 20524 (Apr. 17, 2000)] (“Proposing Release”) at Section II.D.2. We noted in the Proposing Release that in some cases an adviser's response to a question using a check-the-box approach may be accurate but a client may, because of the mandated format of the disclosure, not accurately perceive the adviser's practices.

6 In the Proposing Release, we also proposed extensive amendments to Part 1 of Form ADV, including changes necessary to permit advisers to file that part of the form with us electronically. In September 2000, we adopted amendments to Part 1A and related rules, but, as we noted at the time, we deferred adoption of amendments to Part 2 so that we could consider more fully the many comments we received on Part 2. Electronic Filing by Investment Advisers; Amendments to Form ADV, Investment Advisers Act Release No. 1897 (Sept. 12, 2000) [65 FR 57438 (Sept. 22, 2000)] (“Electronic Filing Adopting Release”). Today, all SEC-registered advisers must file Part 1A (as well as amendments) electronically through IARD. IARD was built and is maintained for the Commission and the state securities administrators by the Financial Industry Regulatory Authority (“FINRA”). In September 2001, we launched a Web site ( http://www.adviserinfo.sec.gov ), which provides free public access to information that advisers file on Part 1A. As we discuss in more detail in Section II.C below, firms' brochures would be available on the Commission's Web site.

ss to information that advisers file on Part 1A. As we discuss in more detail in Section II.C below, firms' brochures would be available on the Commission's Web site.

7 The comment letters and a summary of the comments prepared by Commission staff are available for public inspection and photocopying in the Commission's Public Reference Room, 100 F. Street, NE., Washington, DC (File No. S7-10-00). Comments submitted to us electronically are available at http://www.sec.gov/rules/proposed/s71000.shtml. The summary of comments is available at http://www.sec.gov/rules/extra/iardsumm.htm.

8 In addition, we note that Form ADV is used by advisers both to register with the Commission and with state regulatory authorities. In general, this Release discusses the Commission's proposed rules and amendments that would affect advisers registered with the Commission. We understand that the state securities authorities intend to make similar changes that affect advisers registered with the states. The draft form accompanying today's reproposal contains certain proposed items and instructions for Part 2 (proposed Item 20 of Part 2A, proposed Item 11 of Appendix 1 to Part 2A, and proposed Item 7 of Part 2B) that would be applicable only to state-registered advisers. State-registered advisers would be required by state, rather than federal law, to respond to these items. Completion of these items, therefore, would not be an SEC requirement, and these items are not included in this Release as a proposed SEC rule. We will accept any comments and forward them to the North American Securities Administrators Association (“NASAA”) for consideration by the state securities authorities. We request that you clearly indicate in your comment letter which of your comments relate to these items. Commenters alternatively may send comments relating to these items directly to NASAA at the following e-mail address: part2comments@nasaa.org.

II. Discussion of Form ADV, Part 2

A. Part 2A: The Firm Brochure

s Association (“NASAA”) for consideration by the state securities authorities. We request that you clearly indicate in your comment letter which of your comments relate to these items. Commenters alternatively may send comments relating to these items directly to NASAA at the following e-mail address: part2comments@nasaa.org.

II. Discussion of Form ADV, Part 2

A. Part 2A: The Firm Brochure

1. Proposed Format

We are proposing to require registered advisers to provide prospective and existing clients with a narrative brochure written in plain English. 9 The brochure would describe the adviser's services, fees, business practices, and conflicts of interest with clients. Advisers would file their brochures electronically through the IARD, and the public would benefit by having access to these brochures through the Commission's Web site. We believe that the amendments we are proposing today 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.

9 Proposed General Instructions 1 and 2 to Part 2 of Form ADV.

Commenters supported the narrative format we proposed in 2000 and agreed that it would promote more effective client communications. 10 One stated that it would give an adviser “sufficient flexibility to present and explain its business practices in a meaningful way.” 11 Another stated that the new narrative format would eliminate a number of problems identified with the current form. 12

10 See, e.g. , Comment Letter of Consumer Federation of America (June 22, 2000) (“CFA Letter”); Comment Letter of Teachers Insurance and Annuity Association and College Retirement Equities Fund (June 13, 2000) (“TIAA-CREF Letter”).

11 Comment Letter of Association for Investment Management and Research, Advocacy Advisory Committee (June 13, 2000) (“AIMR Letter”).

12 TIAA-CREF Letter

form. 12

11 Comment Letter of Association for Investment Management and Research, Advocacy Advisory Committee (June 13, 2000) (“AIMR Letter”).

12 TIAA-CREF Letter.

We request further comment on the proposed narrative format, including comment on whether it is the right approach. Will the flexibility of the form allow advisers to present clear and meaningful disclosure to their clients? Will this flexibility minimize the burden on advisers in preparing their brochures? In considering our proposed amendments to Part 2 in their entirety, commenters should consider whether there are disclosures that are best made in a tabular or other non-narrative format and whether our proposal provides sufficient flexibility to permit that type of disclosure.

2. Brochure Items

We are proposing a Part 2A for advisers that would contain nineteen separate items, each covering a different disclosure topic. 13 The topics covered are generally the same as proposed in 2000. 14 Much of the information that 15 Thus, many of the proposed disclosure requirements are designed to give advisers guidance on fulfilling their statutory disclosure obligations to clients. 16

13 Part 2A would have 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 would require disclosure similar to current Schedule H of Part 2 of Form ADV. We are reproposing Appendix 1 with changes described below.

brochure—and would require disclosure similar to current Schedule H of Part 2 of Form ADV. We are reproposing Appendix 1 with changes described below.

14 Today's proposal does not include an item (which we proposed as Item 17 in 2000) that would have required advisers that advertise or report their investment performance to describe any standards they use to calculate or present that performance. The Securities Industry Association (“SIFMA”) argued that the disclosure would be voluminous because many advisers use different types of composites. Comment Letter of the Securities Industry Association (June 13, 2000) (“SIFMA Letter”) (the Securities Industry Association has since changed its name to the Securities Industry and Financial Markets Association). The Financial Planning Association (“FPA”) argued that the disclosure of calculation standards may not be helpful to investors (Comment Letter of the Financial Planning Association (June 13, 2000) (“FPA Letter”)), and the Investment Counsel Association of America (“IAA”) argued that clients

15 Under the Advisers Act, an adviser has an affirmative obligation of utmost good faith and full and fair disclosure of all material facts to its clients, as well as a duty to avoid misleading them. 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). See also Advisers Act section 206 [15 U.S.C. 80b-6].

16 The items in proposed Part 2A will not cover every possible conflict. As a result, delivering a brochure prepared in accordance with Part 2 may not fully satisfy an adviser's disclosure obligations. We make this point clear in both the proposed form and the brochure rule. See proposed General Instruction 3 to Part 2; proposed rule 204-3(g).

Some commenters applauded our 2000 proposal as appropriately identifying information that advisers should disclose to clients

As a result, delivering a brochure prepared in accordance with Part 2 may not fully satisfy an adviser's disclosure obligations. We make this point clear in both the proposed form and the brochure rule. See proposed General Instruction 3 to Part 2; proposed rule 204-3(g).

Some commenters applauded our 2000 proposal as appropriately identifying information that advisers should disclose to clients. 17 Others, however, maintained that the proposed form contained too many items and would require too much detailed information, in particular with respect to advisers' policies and procedures. 18 These commenters raised legitimate concerns, which we have addressed in three ways. First, our instructions to Part 2A would clarify that an adviser must respond only to the items that apply to its business. 19 Second, we have incorporated into our proposed Part 2A many suggestions from commenters for improving the form, including omitting some information that commenters convinced us is not necessary. 20

17 See, e.g. , CFA Letter; TIAA-CREF Letter.

18 See, e.g. , June 2000 IAA Letter; Comment Letter of the Investment Company Institute (June 13, 2001) (“ICI Letter”).

19 Proposed General Instruction 1 to Part 2 of Form ADV. An adviser whose business is solely financial planning, for example, would not need to discuss how it manages client assets in response to Items 4.D and 4.E of Part 2A. An adviser that receives only asset-based fees need not discuss conflicts resulting from commission-based compensation payments in response to Item 5.E of Part 2A. An adviser without disciplinary information would not need to respond to Item 9 of Part 2A. An adviser that does not have custody of client funds or securities would not need to respond to Item 15 of Part 2A

tems 4.D and 4.E of Part 2A. An adviser that receives only asset-based fees need not discuss conflicts resulting from commission-based compensation payments in response to Item 5.E of Part 2A. An adviser without disciplinary information would not need to respond to Item 9 of Part 2A. An adviser that does not have custody of client funds or securities would not need to respond to Item 15 of Part 2A.

Additionally, as currently permitted by existing rule 204-3(d), an adviser that offers substantially different types of advisory services to different advisory clients, would retain the option to prepare separate brochures so long as each client receives all information about the services and fees that are applicable to that client. See proposed rule 204-3(f) and proposed Instruction 6 to Part 2A. Each brochure may omit information that does not apply to the advisory fees and services it describes. For example, an adviser's brochure describing a particular advisory service need not include the fee schedule for a different advisory service that is not discussed in that particular brochure.

20 For example, in response to comments, we are proposing to omit the requirement that advisers list all the wrap fee programs in which they participate.

Third, we have re-written several items to require advisers to explain succinctly how they address the conflicts of interest they identify, rather than disclosing their “policies and procedures” as we originally proposed. 21 As commenters noted, requiring disclosure of policies and procedures could result in disclosure that would be lengthy, technical in nature, difficult to read, and that ultimately may not help clients understand how firms address their conflicts. 22 As re-written, we believe these items would give advisers the flexibility to give clients a general understanding of how they address their conflicts

1 As commenters noted, requiring disclosure of policies and procedures could result in disclosure that would be lengthy, technical in nature, difficult to read, and that ultimately may not help clients understand how firms address their conflicts. 22 As re-written, we believe these items would give advisers the flexibility to give clients a general understanding of how they address their conflicts. For example, an adviser with an affiliated financial service provider might simply explain that it does not recommend investment products sold by its affiliate, or an adviser with an affiliated broker-dealer might explain that it executes client securities transactions through its affiliated broker-dealer only if it believes that, in doing so, it would obtain best execution of client transactions. 23

21 See, e.g. , Proposed Items 5, 6, and 11 of Part 2A.

22 June 2000 IAA Letter; ICI Letter; Comment Letter of Wellington Management Company, LLP (June 22, 2000) (“Wellington Letter”).

23 By giving these examples we do not mean to suggest that these are the only ways for an adviser to address these conflicts of interest.

We request comment on whether our revisions to proposed Part 2A adequately respond to commenters' concerns about our 2000 proposal. Specifically, we request comment on our new approach regarding disclosure of policies and procedures that would require advisers to explain generally how they address conflicts of interest, instead of requiring them to describe their policies and procedures. Also, we request comment on our general instructions that clarify that an adviser need not repeat information in its brochure simply because that information is responsive to more than one item

regarding disclosure of policies and procedures that would require advisers to explain generally how they address conflicts of interest, instead of requiring them to describe their policies and procedures. Also, we request comment on our general instructions that clarify that an adviser need not repeat information in its brochure simply because that information is responsive to more than one item. Will our proposed instruction give advisers sufficient flexibility to avoid unnecessary detail while also providing clients and prospective clients with enough information to make an informed decision about whether to hire or retain an adviser or whether to rely on the investment advice provided by the adviser? If not, commenters should suggest alternative approaches.

Below, we discuss each of the items in our proposed form and the more significant changes we have made from our 2000 proposal. In addition to our specific requests for comment detailed below, we also request comment generally on each of the proposed items.

Item 1. Cover Page. We would require an adviser to disclose on the cover page of its brochure the name of the firm, its business address and telephone number, and the date of the brochure. The cover page also would include a statement that the brochure has not been approved by the Commission or any state securities authority. 24 This information already is required by current Part 2 of Form ADV.

If the adviser holds itself out as being “registered,” the cover page also must explain that registration with the SEC does not imply that the adviser possesses a certain level of skill or training. 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

e adviser possesses a certain level of skill or training. 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. In addition, we would require advisers to disclose on the cover page the name and telephone number of a person or service center that a client or prospective client could contact for further information. At the suggestion of commenters, we revised our 2000 proposal to permit an adviser to identify a service center, rather than only an individual, as a contact for further information. 25 Other commenters suggested that advisers be required to present a home page URL to assist investors using electronic search methods. 26 While we recognize the value of this information, we understand that not all advisers maintain Web sites. Thus, we are proposing to require advisers to disclose a Web site address on the brochure cover page only if they have one.

25 See FPA Letter; Securities America Advisors, Inc. and Securities America, Inc. (June 12, 2000) (“Securities America Letter”).

26 See, e.g. , CFA Letter.

Item 2. Material Changes. We are proposing a requirement that advisers provide clients with a summary of any material changes to their brochures since the last annual update. 27 This 28 The summary would appear on the cover page of the brochure or immediately thereafter, or could be included in a separate communication that would accompany the brochure. 29

27 As discussed in more detail in Section II.A.3 below, we are proposing to require advisers to

28 See Proposing Release at Section II.D.2.a.

munication that would accompany the brochure. 29

27 As discussed in more detail in Section II.A.3 below, we are proposing to require advisers to

28 See Proposing Release at Section II.D.2.a.

29 An adviser would not be required to provide this information to a client or prospective client who has not received a previous version of the adviser's brochure. See proposed Note to Item 2 of Part 2A. Additionally, an adviser would not be required to file the summary with us, and therefore it would not be available on our public disclosure Web site, if the summary is included in a separate communication to clients. This is because the information contained in such a summary is intended to provide existing clients with means to easily identify changes from one annual brochure update to the next. We do not believe that such a summary would be relevant to persons who do not have the previous version of an adviser's brochure. We are, however, proposing an amendment to our recordkeeping rule that would require the adviser to preserve a copy of the communication, so that our staff has access to such separately provided summaries. See proposed rule 204-2(a)(14)(i). See Section IV below.

One commenter strongly supported the required summary. 30 Others expressed concern that the summary might be too long. 31 One commenter, the IAA, supported the option of having the summary be a separate letter to existing clients rather than part of the brochure. We request comment on our proposed approach to highlighting material changes to an adviser's brochure. If we do not adopt this approach, how else could clients know of potentially significant changes to the services they receive or the risk of new conflicts? Should we require that it be included in an adviser's brochure? Commenters who believe a summary of material changes would result in disclosure that is too lengthy should suggest other methods for ensuring that clients are made aware of important changes from one year to the next.

30 CFA Letter

nts know of potentially significant changes to the services they receive or the risk of new conflicts? Should we require that it be included in an adviser's brochure? Commenters who believe a summary of material changes would result in disclosure that is too lengthy should suggest other methods for ensuring that clients are made aware of important changes from one year to the next.

30 CFA Letter.

31 Comment Letter of the Consortium (June 12, 2000) (“Consortium Letter”); Comment Letter of Jane Katz Crist (June 12, 2000) (“Crist Letter”); June 2000 IAA Letter.

Item 3. Table of Contents. We propose to require advisers to include in their brochures a table of contents detailed enough to permit clients and prospective clients to locate topics easily. 32 In response to our 2000 proposal, one commenter, the Consumer Federation of America (“CFA”), supported the use of a table of contents but urged that the Commission mandate a uniform format so that investors could compare brochures of multiple advisers more easily. We are of the initial view that the wide variety of business activities of the large number of advisers registered with us makes it impractical to develop a uniform format. We request comment on whether our view is correct. Is there a uniform brochure format that would be useful to clients and prospective clients of all the types of advisers registered with us? If we were to mandate a uniform format, how should it look? For example, should we require advisers to present information in their brochures in a standardized order? Should we adopt standardized titles for each separate section of a brochure? Do commenters have other suggestions for making the brochures easier for clients and prospective clients to compare?

32 Current Part 2 of Form ADV also includes a table of contents.

Item 4. Advisory Business

ok? For example, should we require advisers to present information in their brochures in a standardized order? Should we adopt standardized titles for each separate section of a brochure? Do commenters have other suggestions for making the brochures easier for clients and prospective clients to compare?

32 Current Part 2 of Form ADV also includes a table of contents.

Item 4. Advisory Business . Proposed Item 4 would require an 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 would be permitted, as originally proposed, to use a method that differs from the method used in Part 1A of Form ADV to report “assets under management.” 33 We believe that because the Part 1A methodology for calculating assets is designed for a particular purpose ( i.e. , for making a bright line determination as to whether an adviser should register with the Commission or with the states), permitting a different methodology for Part 2 disclosure may be appropriate to enable advisers to make disclosure that is more indicative to clients about the nature of their business. 34 Although we are proposing to permit advisers to choose a different method for their brochure disclosure, we also are proposing to require such advisers to keep records describing the method used. 35 We request comment on this provision and on the proposed recordkeeping requirement. We also request comment as to whether we should require such advisers to disclose why they have elected to use a different method.

33 One commenter suggested that advisers be required to use the same methodology in their brochures as is required in Part 1A. See June 2000 IAA Letter

describing the method used. 35 We request comment on this provision and on the proposed recordkeeping requirement. We also request comment as to whether we should require such advisers to disclose why they have elected to use a different method.

33 One commenter suggested that advisers be required to use the same methodology in their brochures as is required in Part 1A. See June 2000 IAA Letter.

34 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 percent of the portfolio's total value consists of securities. See current Form ADV: Instructions for Part 1A. Thus, for Part 1A purposes an adviser would 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 (“NSMIA”) division of responsibility for regulation of advisers between the Commission and state securities regulatory authorities. Pub. L. 104-290, 110 Stat. 3416 (1996) (as a result of NSMIA, advisers with less than $25 million of assets under management generally are regulated by one or more state securities authority, while the Commission generally regulates those advisers with at least $25 million of assets under management).

35 Proposed rule 204-2(a)(14)(ii) and proposed Note to Item 4.E of Part 2A.

Commenters largely supported the proposed item, to which we propose to make two revisions. 36 First, we are not proposing to require advisers to list all wrap fee programs in which they participate. Commenters persuaded us that this requirement likely would lengthen brochures unnecessarily. 37 Second, we are eliminating the proposed requirement that advisers list and describe all periodicals or periodic reports that they issue about securities

to which we propose to make two revisions. 36 First, we are not proposing to require advisers to list all wrap fee programs in which they participate. Commenters persuaded us that this requirement likely would lengthen brochures unnecessarily. 37 Second, we are eliminating the proposed requirement that advisers list and describe all periodicals or periodic reports that they issue about securities. While Part 2 currently requires this, we believe that clients and prospective clients should be able to understand the nature of an adviser's services without knowing the names of each of its publications. 38

36 Current Part 2 presently requires disclosure of similar information to that we are now proposing except in a different format, including information regarding advisory services provided, types of investments that advice is offered on, and investment strategies used. See current Form ADV, Part 2, Item 1 and Item 3.

37 See Crist Letter; June 2000 IAA Letter.

38 See Item 1.D of current Part 2 (requiring all advisers to name any publication or report they issue for a fee or on a subscription basis).

Some commenters urged the Commission not to require advisers to make additional disclosure if they hold themselves out as specializing in a particular type of advisory service, asserting that this could mislead clients into believing that advisers who specialize pose a greater risk than other advisers. 39 Our reason for requiring advisers to identify their specialized advisory services, however, is not that we believe that those specialties inherently pose additional risks to clients, although we would expect the adviser to disclose specific risks if a specialized advisory service poses those risks. Instead, our proposal simply acknowledges that a client likely would want to know whether an adviser provides specialized advisory services before engaging that adviser. 40 The

39 See Comment Letter of Greenville Capital Management (May 12, 2000) (“Greenville Letter”). See also Comment Letter of DE Shaw & Co

adviser to disclose specific risks if a specialized advisory service poses those risks. Instead, our proposal simply acknowledges that a client likely would want to know whether an adviser provides specialized advisory services before engaging that adviser. 40 The

39 See Comment Letter of Greenville Capital Management (May 12, 2000) (“Greenville Letter”). See also Comment Letter of DE Shaw & Co. (July 6, 2000) (“DE Shaw Letter”); Comment Letter of Thomson Financial (June 22, 2001) (“Thomson Letter”).

40 We note that one commenter objected to our characterizing financial planning as a specialized See, e.g., Conrad S. Ciccotello et al., Will Consult For Food! Rethinking Barriers To Professional Entry In The Information Age, 40 Am. Bus . L. J. 905 (2003) at 921 (“Personal financial planning as a distinct profession is quite new”).

Item 5. Fees and Compensation . Item 5 would require an adviser to describe how it is compensated for providing advisory services and 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. 41 As we proposed in 2000, the adviser would be required to disclose its fee schedule and whether its fees are negotiable, discuss whether the firm bills clients or deducts fees directly from the clients' accounts, and explain how often the firm assesses fees. An adviser charging fees in advance also would be required to explain how it calculates and refunds prepaid fees when a client contract terminates.

41 Proposed Items 5.A and 5.C of Part 2A. Part 2 currently requires similar disclosure regarding an adviser's fee schedule, how fees are charged, whether fees are negotiable, and when and how compensation is payable. See Item 1 of current Form ADV.

We are also proposing in Item 5 a requirement that advisers that receive compensation attributable to the sale of a security or other investment product ( e.g

ed Items 5.A and 5.C of Part 2A. Part 2 currently requires similar disclosure regarding an adviser's fee schedule, how fees are charged, whether fees are negotiable, and when and how compensation is payable. See Item 1 of current Form ADV.

We are also proposing in Item 5 a requirement that advisers that receive compensation attributable to the sale of a security or other investment product ( e.g. , brokerage commissions), or whose personnel receive such compensation, must disclose this practice and the conflict of interest it creates and describe how the adviser addresses this conflict. 42 Such an adviser also would be required to disclose to clients that the client may purchase the same securities or investment products from brokers that are not affiliated with that adviser. 43 Some commenters argued that an adviser that receives commissions or other payments for sales of securities to clients does not necessarily have a conflict of interest with its clients. 44 This practice, however, gives the adviser and its personnel an incentive to base investment recommendations on the amount of compensation they will receive rather than on the client's best interests. 45 Moreover, disclosure regarding commissions and other similar economic benefits already is required by current Part 2. 46

42 Proposed Item 5.E of Part 2A. Advisers may engage in practices that would be required to be disclosed under multiple items. For example, an adviser may have a financial interest in securities that it recommends to clients (which would be disclosed in response to proposed Items 5 and 10) or the adviser may receive an economic benefit from a non-client (which would be disclosed in response to proposed Items 5 and 12). As noted above, a brochure would not need to repeat information simply because the information is responsive to more than one item. Proposed General Instruction 1 to Part 2.

43 Proposed Item 5.E.2 of Part 2A

would be disclosed in response to proposed Items 5 and 10) or the adviser may receive an economic benefit from a non-client (which would be disclosed in response to proposed Items 5 and 12). As noted above, a brochure would not need to repeat information simply because the information is responsive to more than one item. Proposed General Instruction 1 to Part 2.

43 Proposed Item 5.E.2 of Part 2A. In addition, an adviser that receives more than half of its revenue from commissions and other sales-based compensation would be required to explain that commissions are the firm's primary (or, if applicable, exclusive) form of compensation. Proposed Item 5.E.3 of Part 2A. An adviser that charges both advisory fees and commissions would disclose whether it reduces its fees to offset the commissions. Proposed Item 5.E.4 of Part 2A.

44 E.g., Comment Letter of American Express Financial Advisors (June 12, 2000) (“AmEx Letter”); CFP Board Letter; Comment Letter of Richard E. Vodra (Apr. 29, 2000).

45 Because of this conflict of interest, advisers are required by the anti-fraud provisions of the Advisers Act to disclose their receipt of transaction-based compensation to clients. See Proposing Release at n. 137-38 and accompanying text.

46 See current Form ADV, Part 2, Item 13.

We are not proposing a requirement that advisers must disclose the amount or range of mutual fund fees or other third-party fees that clients may pay. 47 Commenters explained that these expenses vary so greatly that attempts to quantify them or describe their range likely would not be useful to clients. 48 Several of these commenters further argued that these fees are typically negotiated directly between the client and the other service providers, the adviser does not always know the amount of the fees, and that the third party often discloses the fees directly to the client

ese expenses vary so greatly that attempts to quantify them or describe their range likely would not be useful to clients. 48 Several of these commenters further argued that these fees are typically negotiated directly between the client and the other service providers, the adviser does not always know the amount of the fees, and that the third party often discloses the fees directly to the client. 49 Would our proposed requirement that advisers disclose information about mutual fund or other third-party fees, while not disclosing the range of those fees, adequately inform clients that they will bear other costs in addition to advisory fees?

47 The current version of Part 2 does not require disclosure of this information.

48 E.g., AmEx Letter; Consortium Letter; Comment Letter of Davis Polk & Wardwell (June 13, 2000) (“DP&W Letter”); ICI Letter; June 2000 IAA Letter; Comment Letter of National Regulatory Services (June 12, 2000); SIFMA Letter; Comment Letter of T. Rowe Price Associates (June 12, 2000) (“T. Rowe Price Letter”).

49 See Greenville Letter; DE Shaw Letter; DP&W Letter; June 2000 IAA Letter; ICI Letter; SIFMA Letter.

Item 6. Performance Fees and Side-By-Side Management. New Item 6 would require an adviser that charges performance fees (or who has a supervised person who manages an account that charges such fees) to disclose this fact. 50 If such an adviser also manages accounts that are not charged a performance fee, the item also would require the adviser to discuss the conflicts that arise from its (or its supervised persons') simultaneous management of these accounts, and to describe generally how the adviser addresses those conflicts. 51

50 Proposed Item 6. “Performance fees ” would be any fees an adviser receives that are based on a share of the capital gains on, or capital appreciation of, the assets of a client

lso would require the adviser to discuss the conflicts that arise from its (or its supervised persons') simultaneous management of these accounts, and to describe generally how the adviser addresses those conflicts. 51

50 Proposed Item 6. “Performance fees ” would be any fees an adviser receives that are based on a share of the capital gains on, or capital appreciation of, the assets of a client. Current Form ADV, Part 2 does not specifically require similar disclosure of performance fees, although an adviser who offers advisory services in exchange for such fees would be required to respond accordingly by marking “Other” in response to current Form ADV, Part 2, Item 1.C(6).

51 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 n 13-14 and accompanying text (July 15, 1998) [63 FR 39022 (July 21, 1998)].

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. Additionally, conflicts stemming from their clients' differing investment strategies ( e.g. , clients that pay performance fees who engage in significant short selling) may put an adviser at odds with other clients ( e.g. , clients who hold long positions)

ve 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. Additionally, conflicts stemming from their clients' differing investment strategies ( e.g. , clients that pay performance fees who engage in significant short selling) may put an adviser at odds with other clients ( e.g. , clients who hold long positions). 52 The growth in the number of hedge funds, which typically pay performance-based fees to advisers that may have other advisory clients, makes 53 It is important to note that the conflicts of interest that result from the simultaneous management of performance fee accounts and other accounts are not limited to hedge fund advisers. For example, an adviser would face conflicts of interest if it were to manage a proprietary account that paid performance fees side-by-side other client accounts that did not pay performance fees.

52 “Another concern is the risk that mutual fund [not paying a performance fee] trades may appear to benefit a hedge fund [paying a performance fee], such as where mutual fund long positions in a security are sold after the hedge fund sells the same security short, or where large mutual fund purchases of a security are made after a hedge fund has purchased the same security.” Kenneth R. Gerstein, Alternative Investments in the Mutual Fund World, Materials prepared for ICI/IBA 2001 Mutual Funds and Investment Management Conference, at XII-8.

53 In a 2003 report, our Division of Investment Management highlighted its concerns regarding disclosure of conflicts of interest by advisers that advise hedge funds at the same time they advise other clients that do not pay a performance fee. See Implications of the Growth of Hedge Funds, Staff Report to the United States Securities and Exchange Commission (“Staff Report on the Implications of Hedge Funds”), available at http://www.sec.gov/spotlight/hedgefunds.htm

d its concerns regarding disclosure of conflicts of interest by advisers that advise hedge funds at the same time they advise other clients that do not pay a performance fee. See Implications of the Growth of Hedge Funds, Staff Report to the United States Securities and Exchange Commission (“Staff Report on the Implications of Hedge Funds”), available at http://www.sec.gov/spotlight/hedgefunds.htm. The staff noted that because performance fees paid to hedge fund advisers are significantly higher than the asset-based fees paid on traditional accounts, advisers have additional incentives to favor their hedge fund clients over other clients by allocating investment opportunities to a hedge fund.

We request comment on our approach requiring disclosure of conflicts arising from side-by-side management of accounts that pay performance fees and those that do not. Would our proposed requirement elicit sufficient information to allow a client to understand the conflicts that arise when an adviser manages performance fee accounts alongside accounts that do not charge performance fees? If not, what additional information would be helpful?

Item 7. Types of Clients. We are proposing Item 7 in the same form as we proposed it in 2000. 54 The one commenter that addressed this item, the FPA, commented favorably on it. As proposed, the brochure would 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. 55 We request comment on this approach.

54 As originally proposed, this was Item 6. Because we have added a new proposed Item 6 (described above), this and subsequent items have been renumbered.

55 Proposed Item 7 of Part 2A. Current Part 2 requires “check-the-box” disclosure regarding types of advisory clients. See current Form ADV, Part 2 Item 2

ning an account, such as minimum account size. 55 We request comment on this approach.

54 As originally proposed, this was Item 6. Because we have added a new proposed Item 6 (described above), this and subsequent items have been renumbered.

55 Proposed Item 7 of Part 2A. Current Part 2 requires “check-the-box” disclosure regarding types of advisory clients. See current Form ADV, Part 2 Item 2. Existing Part 2 currently also requires disclosure regarding whether an adviser providing certain advisory services imposes a minimum dollar value of assets or other conditions for starting or maintaining accounts. See current Form ADV, Part 2 Item 10.

Item 8. Methods of Analysis, Investment Strategies and Risk of Loss. We also are proposing Item 8 in the same form as we proposed it in 2000. This item would require advisers to describe their methods of analysis and investment strategies. 56 In addition, proposed Item 8 would require an adviser to discuss the risks clients face in following the adviser's advice or permitting the adviser to manage assets. Advisers that offer a wide variety of advisory services could simply explain that investing in securities involves a risk of loss. Advisers that use primarily a particular method of analysis, strategy, or type of security would be required to explain the specific material risks involved, with more detail if those risks are significant or unusual.

56 Presently, Item 4 of current Part 2 requires check-the-box disclosure of similar information regarding methods of analysis and investment strategies used. See current Form ADV, Part 2 Item 4.

Some commenters supported this proposed disclosure requirement as central to the adviser's fiduciary relationship with the client. 57 Others questioned why multi-strategy firms would not be required to make the same level of disclosure. 58 Multi-strategy advisers must already disclose the risks associated with strategies that they recommend to clients, but the brochure may not be the best place to make that disclosure

rted this proposed disclosure requirement as central to the adviser's fiduciary relationship with the client. 57 Others questioned why multi-strategy firms would not be required to make the same level of disclosure. 58 Multi-strategy advisers must already disclose the risks associated with strategies that they recommend to clients, but the brochure may not be the best place to make that disclosure. For example, disclosure of this information may lengthen the brochure unnecessarily given that different clients would be pursuing different strategies, each of which poses specific and different risks, and clients may only need to understand the risks to which they are exposed. 59 Accordingly, we would not require these advisers to list in the brochure the risks involved in each type of security or trading strategy. In such cases, required risk disclosure with respect to particular strategies could be made separately to those clients to whom such disclosure is relevant. We request comment on our approach. Also, we request comment on whether there are particular risks associated with particular strategies, analyses, or securities that warrant specific disclosure, and if so what are they?

57 AIMR Letter; CFA Letter.

58 DE Shaw Letter; Greenville Letter.

59 Advisers utilizing multiple strategies would, of course, be free to disclose in their brochures the risks associated with each strategy.

in their brochures the risks associated with each strategy.

Item 8 also would require specific disclosure of how strategies involving frequent trading can affect investment performance. Commenters on this proposal in 2000 noted that an amount of trading that is inappropriately frequent for one type of security or client may be appropriate in the context of a different type of security or client. 60 Does our proposal provide advisers enough flexibility to explain the degree to which frequent trading is appropriate in the context of their business? Also, two commenters recommended that the Commission define the term “frequent trading of securities.” 61 We have not proposed a definition, but instead propose to permit firms some flexibility in determining whether strategies they employ involve frequent trading. As those commenters pointed out, the term “frequent” is relative both to the client ( i.e. , an investment strategy involving frequent trading that is inappropriate for one type of client may be appropriate for another), and to the security being traded. We are concerned that a definition of the term “frequent trading” may not be sufficiently flexible to accommodate different types of securities or the different types of advisory clients. We request comment on our concern. Should we define the term “frequent trading”? If so, commenters are invited to submit suggested text for such a definition.

60 June 2000 IAA Letter; T. Rowe Price Letter.

61 June 2000 IAA Letter; T. Rowe Price Letter.

Finally, our proposed Item 8 would require advisers to discuss their practices regarding cash balances in client accounts. The IAA commented that these practices vary depending on the types of accounts and directions from clients and that meaningful disclosure about these practices would be difficult. Our proposal does not require exhaustive disclosure about, for example, all possible directions that all of an adviser's clients may give it

advisers to discuss their practices regarding cash balances in client accounts. The IAA commented that these practices vary depending on the types of accounts and directions from clients and that meaningful disclosure about these practices would be difficult. Our proposal does not require exhaustive disclosure about, for example, all possible directions that all of an adviser's clients may give it. Instead, the proposal would require a concise, general explanation of the adviser's practices with respect to situations in which a particular client has not provided the adviser specific directions for handling cash balances. Does our proposal provide advisers with enough flexibility to explain their practices in a meaningful manner? If not, commenters are invited to suggest how to make the disclosures more meaningful.

Item 9. Disciplinary Information. We are proposing Item 9 to require an adviser to disclose in its brochure material facts about any legal or disciplinary event that is material to a client's evaluation of the integrity of the adviser or its management. These requirements are similar, though as discussed below, not identical to those we proposed in 2000, and they would continue to incorporate into the brochure the disciplinary disclosure currently required by rule 206(4)-4. Under that rule, advisers can make disciplinary disclosure to clients either orally or in writing. Because of the importance of this information to clients, we proposed in 2000 and now 62

62 Current Part 2 of Form ADV does not include an item related to disciplinary issues, however, Item 11 in Part 1A of Form ADV does require disclosure of specified disciplinary events. Such disclosure is filed with the Commission as part of the firm's filing on IARD, but may not in all cases be provided to clients.

As proposed (and as currently reflected in rule 206(4)-4), Items 9.A, B, and C would provide a list of disciplinary events that are presumptively material if they occurred in the previous 10 years

of Form ADV does require disclosure of specified disciplinary events. Such disclosure is filed with the Commission as part of the firm's filing on IARD, but may not in all cases be provided to clients.

As proposed (and as currently reflected in rule 206(4)-4), Items 9.A, B, and C would provide a list of disciplinary events that are presumptively material if they occurred in the previous 10 years. 63 The list would include, among other events, any convictions for theft, fraud, bribery, perjury, forgery, and violations of securities laws by the adviser or one of its executives. Disciplinary events such as these reflect the integrity of the adviser and its management persons and therefore are presumptively material to clients. 64 The adviser would be permitted to rebut this presumption, in which case no disclosure to clients would be required. We would, however, require an adviser rebutting a presumption of materiality to document that determination in a memorandum and retain that record in order to better permit our staff to monitor compliance with this important disclosure requirement. 65 A note in Item 9 would explain four factors the adviser should consider when assessing whether the presumption can be rebutted. 66

63 The list of disciplinary events is similar to the list of events currently presumed material under existing rule 206(4)-4(b). Reproposed 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.

64 See Proposing Release at n. 145-150 and accompanying text.

65 Proposed rule 204-2(a)(14)(iii), discussed below in Section IV. Proposed Item 3 of Part 2B, discussed below, requires a brochure supplement to contain disclosure of legal or disciplinary events involving the adviser's supervised persons. Proposed rule 204-2(a)(14)(iii) would require the same memorandum in the event the adviser does not disclose an event described in Item 3 of Part 2B

ng text.

66 These factors are: (1) The proximity of the person involved in the disciplinary event to the advisory function; (2) the nature of the infraction that led to the disciplinary event; (3) the severity of the disciplinary sanction; and (4) the time elapsed since the date of the disciplinary event. These are the same factors advisers use to assess materiality under current rule 206(4)-4. See Financial and Disciplinary Information that Investment Advisers Must Disclose to Clients, Investment Advisers Act Release No. 1083 (Sept. 25, 1987) [52 FR 36915 (Oct. 2, 1987)] (“Rule 206(4)-4 Adopting Release”). We have removed, as unnecessary, a sentence from the note that was contained in the Proposing Release that explained that an adviser's determination is not binding on us or a court.

We request comment with respect to the list of disciplinary events that are presumptively material. Are there additional types of disciplinary events that we should list? Are there disciplinary events listed that we should remove or modify? Should we expand the list to include disclosure of all cease and desist and censure orders entered against an adviser or its management persons? In addition, we request comment on the terms we use in this item. For example, we propose to state in Item 9 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. We propose to continue to define the term “involved” using the same definition that currently exists in Form ADV

d against an adviser or its management persons? In addition, we request comment on the terms we use in this item. For example, we propose to state in Item 9 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. We propose to continue to define the term “involved” using the same definition that currently exists in Form ADV. 67 We request comment on the proposed use of the term “involved” in this item and our proposed use of the current definition of that term.

67 The current Glossary to Form ADV defines the term “involved ” to mean “Engaging in any act or omission, aiding, abetting, counseling, commanding, inducing, conspiring with or failing reasonably to supervise another in doing an act.”

As proposed in 2000, this item also would have required advisers subject to a Commission administrative order to provide clients with a copy of that order. Several commenters urged us not to require advisers to deliver copies of Commission administrative orders to all clients, arguing among other things, that not all orders would be material to clients and that rather than imposing a blanket requirement, delivery of orders should remain a subject of settlement negotiation. 68 We are not proposing this requirement because we agree with commenters' suggestion that we are able to require, where appropriate, delivery of orders in individual proceedings. Nonetheless, we request further comment as to whether we should require delivery of all or, alternatively, some specific category of administrative orders. Commenters supporting delivery of orders should explain how clients would benefit from delivery.

68 E.g., AmEx Letter; ICI Letter; Comment Letter of PaineWebber Incorporated and Mitchell Hutchins Asset Management Inc. (June 19, 2000) (“Paine Webber Letter”); T. Rowe Price Letter; Comment Letter of Wilmer, Cutler & Pickering (June 13, 2000) (“Wilmer Letter”)

fic category of administrative orders. Commenters supporting delivery of orders should explain how clients would benefit from delivery.

In the Proposing Release, we also specifically requested comment about whether we should require disclosure of certain arbitration awards or claims. Several commenters urged us to include arbitration claims or awards in the list of disciplinary events because that information could be useful to the evaluation of an adviser's integrity, 69 while others urged us not to require that disclosure at all, arguing that arbitration claims and awards are not necessarily an indication of wrongdoing. 70 We request further comment on whether we should require disclosure of arbitration awards, settlements, or claims. Also, should we require disclosure of damages in a civil proceeding? Should we require disclosure of such damages, or arbitration claims, settlements, or awards above a specified amount? If so, would $10,000 be an appropriate amount? If not, what would be an appropriate threshold amount?

69 AICPA Letter; CFA Letter; Comment Letter of the Pennsylvania Securities Commission (June 12, 2000) (“Penn. Securities Commission Letter”).

70 See, e.g. , Amex Letter; DP&W Letter; Wilmer Letter.

Because advisers would include disciplinary disclosures in their advisory brochures if this proposal is adopted, we propose to rescind rule 206(4)-4, which requires disclosure of disciplinary information, but does not specify the means of conveying this disclosure. 71 If we adopt our proposed amendments to Item 9, we would expect to make rescission of rule 206(4)-4 effective on the date by which advisers must deliver their narrative brochures to existing clients and begin delivering their brochures to prospective clients

rescind rule 206(4)-4, which requires disclosure of disciplinary information, but does not specify the means of conveying this disclosure. 71 If we adopt our proposed amendments to Item 9, we would expect to make rescission of rule 206(4)-4 effective on the date by which advisers must deliver their narrative brochures to existing clients and begin delivering their brochures to prospective clients. Some advisers, however, may have clients to whom they are not required to deliver a brochure, for example certain clients receiving impersonal investment advice or registered investment companies and business development companies. 72 For these advisers, their fiduciary duty of full and fair disclosure would require them to continue to disclose to all their clients any material disciplinary or legal events or inability to meet contractual commitments. 73 Nonetheless, we request comment about whether we should rescind rule 206(4)-4. Should we retain the rule to clarify the disclosure obligations of advisers in situations in which they have no brochure delivery obligations?

71 In addition to requiring disclosure of certain disciplinary information, rule 206(4)-4 currently requires an adviser to disclose certain financial information to clients. As with the disciplinary disclosure, this requirement would also be incorporated into the new brochure. Similar to current rule 206(4)-4(a)(1), proposed Item 18.B of Part 2A would require certain advisers to disclose any financial condition that is reasonably likely to impair their ability to meet contractual commitments to clients. See note 125 below and accompanying text.

72 Our proposed requirements for which clients an adviser must deliver a brochure are discussed in Section II.A.3 below.

73 See generally Rule 206(4)-4 Adopting Release (explaining that rule 206(4)-4 was designed to “remind advisers of their obligation to disclose to clients material facts about precarious financial conditions and certain disciplinary events”).

Item 10

and accompanying text.

72 Our proposed requirements for which clients an adviser must deliver a brochure are discussed in Section II.A.3 below.

Item 10. Other Financial Industry Activities and Affiliations. We are proposing Item 10 to require advisers to describe material relationships or arrangements the adviser (or any of its management persons) has with related 74 In addition, if an adviser selects or recommends other advisers for clients, proposed Item 10 would require it to disclose any compensation arrangements or other business relationships between the two advisory firms, as well as the conflicts created. 75 The disclosure that Item 10 would require would help clients be more aware of advisers' other financial industry activities and affiliations that can create conflicts of interest and impair the objectivity of investment advice.

74 Currently, Part 2 of Form ADV requires disclosure regarding an adviser's other financial industry or affiliations, but does not specifically state that an adviser must describe the related conflicts of interest and how they are addressed. See current Form ADV, Part 2 Item 8.

75 In 2005, our Office of Compliance Inspections and Examinations issued a report of their targeted exams of pension consultants that highlighted some of the conflicts faced by pension consultants who have business relationships with money managers they recommend to their pension clients: Staff Report Concerning Examinations Of Select Pension Consultants (May 16, 2005), available at http://www.sec.gov/news/studies/pensionexamstudy.pdf

nspections and Examinations issued a report of their targeted exams of pension consultants that highlighted some of the conflicts faced by pension consultants who have business relationships with money managers they recommend to their pension clients: Staff Report Concerning Examinations Of Select Pension Consultants (May 16, 2005), available at http://www.sec.gov/news/studies/pensionexamstudy.pdf. The report noted that, for a number of pension consulting firms, compensation received from money managers comprised a significant part of their annual revenue but that pension consultants often did not provide adequate disclosure of the conflicts created by this practice to pension plan clients. Proposed Item 10 recognizes that these potential conflicts of interest are not limited to pension consultants and thus, would require disclosure by any adviser to whom it is relevant.

One commenter, the CFA, applauded the disclosure required by this proposed item, stating that it would “significantly enhance client understanding of these relationships.” Others requested clarification about, among other things, the interaction of the disclosure required by this item and that required by other items, the amount of detail advisers must provide to clients about their internal procedures, and what constitutes a material relationship. 76 Because of the considerable variety among the types of advisers registered with us and the diverse range of their relationships and affiliations in the financial industry, we do not propose to define which relationships or arrangements are material. We request comment on whether, despite the breadth of the financial industry, we should attempt to do so. If so, commenters are invited to provide suggestions of how to craft such a definition so as to capture relationships or arrangements involving material conflicts of interest.

76 See, e.g. , FPA Letter; June 2000 IAA Letter; Thomson Letter

ne which relationships or arrangements are material. We request comment on whether, despite the breadth of the financial industry, we should attempt to do so. If so, commenters are invited to provide suggestions of how to craft such a definition so as to capture relationships or arrangements involving material conflicts of interest.

76 See, e.g. , FPA Letter; June 2000 IAA Letter; Thomson Letter. We note that Item 8 of current Part 2 already requires an adviser to disclose certain relationships with a related person “that are material to its advisory business or its clients.”

We request further comment on our proposed Item 10. Will the disclosure required by Item 10 be adequate to allow a client to evaluate the conflicts of an adviser, and therefore better manage its relationship with the adviser? If not, what additional or more specific information should an adviser be required to disclose?

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

Code of Ethics. Proposed Item 11.A would require each adviser to describe briefly its code of ethics and to state that a copy is available upon request. In 2004, we adopted rule 204A-1 77 under the Advisers Act and amended current Item 9, which, as a result, today requires advisers to make this same disclosure. 78 The description of an adviser's code of ethics required by proposed Item 11.A may include matters also responsive to other items, including those discussed below and, in particular, personal trading by advisory personnel. If so, the disclosure need not be repeated. 79

77 17 CFR 275.204A-1.

78 Investment Adviser Codes of Ethics, Investment Advisers Act Release No. 2256 (July 2, 2004) [69 FR 41696 (July 9, 2004)] (“Code of Ethics Adopting Release”).

79 Proposed General Instruction 1 to Part 2.

Participation or Interest in Client Transactions

ed below and, in particular, personal trading by advisory personnel. If so, the disclosure need not be repeated. 79

77 17 CFR 275.204A-1.

78 Investment Adviser Codes of Ethics, Investment Advisers Act Release No. 2256 (July 2, 2004) [69 FR 41696 (July 9, 2004)] (“Code of Ethics Adopting Release”).

79 Proposed General Instruction 1 to Part 2.

Participation or Interest in Client Transactions. If the adviser or a related person recommends to clients or buys or sells for clients securities in which the adviser or a related person has a material financial interest, Item 11.B would require the brochure to discuss this practice and the conflicts presented. 80 Conflicts could arise, for example, when an adviser recommends that clients invest in a pooled investment vehicle that the firm advises or serves as the general partner, or when an adviser with a material financial interest in a company recommends that a client buy shares in that company's public offering. An adviser engaging in these practices may have an incentive to base its advice on its own financial interests rather than the interest of clients, and the item is designed to help clients understand that conflict. The item would require advisers to disclose any practices giving rise to these conflicts, the nature of the conflicts presented, and how the adviser addresses the conflicts. 81 The requirements of the proposed item are similar to the disclosures presently required under Item 9 of current Part 2. 82

80 Proposed Item 11.B. This item incorporates many of the disclosure requirements of current Item 9 of Part 2 and is identical to the Item 10.B we proposed in 2000. 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

we proposed in 2000. 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.

81 We are not proposing to require an adviser that relies on our recently adopted rule 206(3)-3T under the Advisers Act with respect to its principal trades with its advisory clients to disclose in Part 2 of Form ADV the information required by paragraph (a)(3) of that rule. Rule 206(3)-3T(a)(3) [17 CFR 275. 206(3)-3T(a)(3)]. See also Temporary Rule Regarding Principal Trades with Certain Advisory Clients, Investment Advisers Act Release No. 2653 (Sept. 24, 2007) [72 FR 55022 (Sept. 28, 2007)]. Rule 206(3)-3T sets out an alternative means for advisers that also are registered broker-dealers to comply with their obligations under section 206(3) of the Advisers Act with respect to principal trades with their clients. One condition of the rule is that an adviser relying on it must provide its clients with prospective written disclosure to the advisory client explaining (i) the circumstances under which the investment adviser directly or indirectly may engage in principal transactions, (ii) the nature and significance of conflicts with its client's interests as a result of the transactions, and (iii) how the investment adviser addresses those conflicts. Although we do not propose to require advisers to disclose this information in their brochures, they may do so if they wish.

82 See current Form ADV, Part 2 Item 9.

We request that commenters consider the proposed item and evaluate whether it would require sufficient disclosure to address our concerns.

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

uire advisers to disclose this information in their brochures, they may do so if they wish.

82 See current Form ADV, Part 2 Item 9.

We request that commenters consider the proposed item and evaluate whether it would require sufficient disclosure to address our concerns.

Personal Trading . Items 11.C and 11.D would require disclosure regarding personal trading by the adviser and its personnel. Because of the information they have, advisers and their personnel are in a position to abuse clients' positions by, for example, placing their own trades before or after client trades are executed in order to benefit from any price movements due to the clients' trades. 83 These practices not only may affect the objectivity of the adviser's recommendations, but also can harm clients by adversely affecting the prices at which their trades are executed. Item 11.C would require 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 would require 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. 84 In response to this item, an 85 Similar disclosure is already required under Item 9.E of current Part 2.

83 This practice is known as “front-running.” See Investment Adviser Codes of Ethics , Investment Advisers Act Release No. 2209 (Jan. 20, 2004) [69 FR 4040 (Jan. 27, 2004)] at n. 18 and accompanying text.

84 Some situations, such as when an adviser owns shares in a company it recommends to clients, may

elease No. 2209 (Jan. 20, 2004) [69 FR 4040 (Jan. 27, 2004)] at n. 18 and accompanying text.

84 Some situations, such as when an adviser owns shares in a company it recommends to clients, may

85 Advisers would not be required to provide this disclosure with respect to securities that are not “reportable securities” under rule 204A-1, such as shares in unaffiliated mutual funds. See rule 204A-1. Such securities are not reportable under rule 204A-1 because they appear to present little opportunity for front-running. See Code of Ethics Adopting Release, above note 78, at n. 42 and accompanying text.

We proposed a similar item in 2000 on which we received no comment. Since that time, advisers have adopted codes of ethics that must address personal trading by certain advisory personnel and thus must address, at least in part, the concerns raised by this item. In light of this, should we further revise the item? If so, how?

Item 12. Brokerage Practices . Proposed Item 12 would require advisers to describe how they select brokers for client transactions and determine the reasonableness of brokers' compensation. The item also would require advisers to disclose how they address conflicts arising from their receipt of “soft dollars,” i.e. , the receipt of benefits such as research in connection with client brokerage.

This item, which we discuss in more detail below, is largely the same as originally proposed, but with two changes urged by commenters. First, we have omitted a proposed requirement that advisers disclose in their brochures whether they negotiate commissions. 86 Commenters informed us that few advisers “negotiate” commission rates in the literal sense suggested by the Proposing Release. 87 Second, we have omitted the proposed requirement that advisers disclose whether they participate in commission recapture programs. We understand that these programs are not typically sponsored or promoted by advisers, but are more likely driven by client demands

ons. 86 Commenters informed us that few advisers “negotiate” commission rates in the literal sense suggested by the Proposing Release. 87 Second, we have omitted the proposed requirement that advisers disclose whether they participate in commission recapture programs. We understand that these programs are not typically sponsored or promoted by advisers, but are more likely driven by client demands. We request comment on our understanding of these practices. Should we require brochure disclosure in either instance?

86 See Proposing Release at n. 178-179 and accompanying text.

87 June 2000 IAA Letter; SIFMA Letter. Of course, advisers must consider commission rates as part of their duty to seek best execution. 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)] (“1986 Soft Dollar Release”) at Section V.

Soft Dollar Practices . Many advisers receive brokerage and research services in reliance on section 28(e) of the Exchange Act, as well as other “soft dollar” products and services, provided by particular brokers in connection with client transactions. 88 As we have previously noted, use of client securities transactions to obtain research and other benefits creates incentives that can result in conflicts of interest between advisers and their clients. 89 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. 90 Some commenters questioned the conflicts we identified and complained that the item would tend to cast aspersions on the use of soft dollar arrangements that are commonplace, such as those that fit within the safe harbor established by section 28(e)

s to disclose their policies and practices with respect to their receipt of soft dollar benefits in connection with client securities transactions. 90 Some commenters questioned the conflicts we identified and complained that the item would tend to cast aspersions on the use of soft dollar arrangements that are commonplace, such as those that fit within the safe harbor established by section 28(e). 91 Our intent is not to create a negative impression regarding soft dollars arrangements, but rather to require full disclosure of arrangements that we believe involve significant conflicts of interest.

88 Nearly 60 percent of advisers registered with the Commission report on Form ADV, Part 1A, Item 8.E that they or a related person receive soft dollar benefits in connection with client transactions. (IARD Data as of Sept. 30, 2007).

89 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”). 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

r 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 1986 Soft Dollar Release, above note 87, at n. 33.

90 Item 12 of current Part 2.

91 Comment Letter of the Alliance In Support of Independent Research (June 13, 2000) (“Alliance Letter”); ICI Letter; SIFMA Letter.

Our 2000 proposal responded to a 1998 report from our Office of Compliance Inspections and Examinations that concluded that advisers' disclosure often failed to provide sufficient information for clients or prospective clients to understand the advisers' soft dollar practices and the conflicts those practices present. 92 In its report, OCIE noted that most advisers' descriptions were simply boilerplate, and urged that we consider amending Form ADV to require better disclosure. 93 We request comment on whether our proposed item would achieve this goal.

92 Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds (Sept. 22, 1998), available at http://www.sec.gov/news/studies/softdolr.htm .

93 Id .

Item 12 would require an adviser that receives soft dollar benefits in connection with client securities transactions to disclose its practices. 94 The proposed item would require a brochure's description of soft dollar practices to 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 conflicts. 95 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 research that does not aid in the adviser's investment decision-making process. Will the proposed disclosure be sufficient to adequately inform clients?

94 The soft dollar benefits covered include any research, or other products or services, whether created or developed by the broker-dealer itself or by a third party. See note to proposed Item 12.A.1 of Part 2A.

95 In this regard, the proposed item would incorporate the standard for advisers we set out in our 1986 Soft Dollar Release. Our 2006 Soft Dollar Release preserved this provision of the 1986 Soft Dollar Release. See 2006 Soft Dollar Release, above note 89, at n. 68 and accompanying text.

Item 12 also would require an adviser to describe the types of conflicts it has when it accepts soft dollar benefits 96 and to disclose how it addresses those conflicts. 97 The item would require 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 would require 98 As we noted above, some commenters to our 2000 proposal questioned our description of the conflicts of interest identified in the item. 99 We ask commenters to consider these descriptions

hose 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 would require 98 As we noted above, some commenters to our 2000 proposal questioned our description of the conflicts of interest identified in the item. 99 We ask commenters to consider these descriptions.

96 An adviser accepting soft dollar benefits would have to explain that (a) the adviser benefits because it does not have to produce or pay for the research 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 best execution.

97 See proposed Item 12.A.1.f of Part 2A, which is substantively the same as Item 12.B of current Part 2.

98 “Paying up” refers to a manager causing a client account to pay more than the lowest available commission rate in exchange for soft dollar products or services. Item 12 of current Part 2 requires advisers to disclose “whether clients pay commissions higher than those obtainable from other brokers in return for * * * products and services.”

99 See above note 91 and accompanying text.

Client Referrals . If an adviser uses client brokerage to reward brokers for client referrals, it also would be required to disclose this practice, the conflict it creates, and any procedures the adviser used to direct client brokerage to referring brokers during the last fiscal year, i.e. , the system of controls used by the adviser when allocating brokerage. 100 This practice presents advisers with significant conflicts of interest because they may have a bias towards referring brokers. 101 Part 2 currently requires advisers to disclose these arrangements, but does not specifically require that such description discuss the conflicts of interest created. 102

100 Proposed Item 12.A.2 of Part 2A

f controls used by the adviser when allocating brokerage. 100 This practice presents advisers with significant conflicts of interest because they may have a bias towards referring brokers. 101 Part 2 currently requires advisers to disclose these arrangements, but does not specifically require that such description discuss the conflicts of interest created. 102

100 Proposed Item 12.A.2 of Part 2A.

101 See Proposing Release at n. 177 and accompanying text.

102 See current Form ADV, Part 2, Item 13.B.

Proposed Item 12.A.2 is substantially the same as we proposed in 2000. The one commenter that addressed it—CFA—expressed support for the item as proposed, and we request further comment.

Trade Aggregation . Clients engaging an adviser can benefit when the adviser negotiates lower commissions or “bunches” trades to obtain volume discounts on execution costs. 103 Item 12 would require the adviser to describe whether and under what conditions it engages in these practices. If the adviser does not bunch trades when it has the opportunity to obtain discounts, the adviser would be required to explain in the brochure that clients may pay higher brokerage costs. We request comment on this requirement. Should we also require an adviser to discuss whether and under what conditions it breaks up large orders to purchase or sell securities ( e.g. , to mitigate the impact of the transaction on the market value of the securities)?

103 Broker-dealers may, for example, offer lower commission costs.

Directed Brokerage . 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 may also be initiated by the adviser, who may benefit, for example, when brokerage is directed to its affiliated broker-dealer

ansactions 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 may also be initiated by the adviser, who may benefit, for example, when brokerage is directed to its affiliated broker-dealer. In either case, clients directing (or agreeing to direct) brokerage need to understand the consequences of directing brokerage, including the possibility that their accounts will pay higher commissions and receive less favorable execution. 104

104 1986 Soft Dollar Release, above note 87 at n. 44.

If an adviser permits clients to direct brokerage, we would require the brochure to explain that the adviser may be unable to obtain best execution, and that directing brokerage may cost clients more money. 105 If, however, the adviser routinely recommends, requests or requires clients to direct brokerage, the adviser also would be required to describe in its brochure the adviser's practice, to disclose that not all advisers require directed brokerage, and to discuss any broker-dealer relationship that creates a material conflict of interest. 106

105 Proposed Item 12.A.3.b of Part 2A.

106 Proposed Item 12.A.3.a of Part 2A. Currently, Item 12 of Part 2 requires disclosure of similar information in cases where an adviser or a related person suggests brokers to clients and where an adviser has authority to determine the broker or dealer to be used.

a related person suggests brokers to clients and where an adviser has authority to determine the broker or dealer to be used.

Commenters favored the item. 107 One pointed out, however, that many clients direct brokerage subject to best execution. 108 In such situations, the disclosure required by proposed Item 12.A.3.b is not relevant because the adviser would be required to seek best execution. To avoid disclosure that may not be helpful to clients, we have modified the item to permit advisers to omit the disclosure if the adviser only permits clients to direct brokerage subject to the adviser's ability to obtain best execution. We request further comment on the proposed disclosures regarding directed brokerage.

107 CFA Letter; Comment Letter of the Florida State Board of Administration (June 13, 2000) (“Florida Board Letter”); June 2000 IAA Letter.

108 Comment Letter of Frank Russell Securities (June 13, 2000).

Item 13. Review of Accounts . Proposed Item 13 would require an adviser to disclose whether, and how often, it reviews clients' accounts or financial plans, and to identify who conducts the review. An adviser that reviews accounts, but not regularly, would explain what circumstances trigger an account review. This disclosure is similar to that presently required by Item 11 of current Part 2. 109 Commenters who addressed this item supported it as being helpful to clients. 110 We are proposing this item with no change from the 2000 proposal and we request further comment on it.

109 See current Form ADV, Part 2, Item 11.

110 CFA Letter; FPA Letter.

Item 14. Payment for Client Referrals . Item 14 would require an adviser to describe any cash or other payment that it or a related person makes for client referrals. The brochure also would disclose whether the adviser receives any benefit, including sales awards or prizes, from a non-client for providing advisory services to clients. 111 This item is the same as we proposed it in 2000 and we request further comment on it

t Referrals . Item 14 would require an adviser to describe any cash or other payment that it or a related person makes for client referrals. The brochure also would disclose whether the adviser receives any benefit, including sales awards or prizes, from a non-client for providing advisory services to clients. 111 This item is the same as we proposed it in 2000 and we request further comment on it. Similar disclosure is already required by current Part 2 which requires an adviser to disclose whether it has any arrangements where it directly or indirectly compensates any person for client referrals and to describe such arrangements. 112 Current Part 2 also requires an adviser to disclose whether it receives a cash payment or some economic benefit from non-clients in connection with giving advice to clients. 113 We request further comment on our proposed Item 14.

111 Proposed Item 14 would require advisory firms to disclose economic benefits they receive. As discussed below in Section II.B.3 of this Release, Part 2B would require advisers to disclose economic benefits a supervised person receives.

112 See current Form ADV, Part 2, Item 13.B.

113 See current Form ADV, Part 2, Item 13.A.

Item 15. Custody . We have updated this item from our 2000 proposal to reflect subsequent amendments to rule 206(4)-2 (our investment adviser custody rule). 114 The protections afforded clients as a result of compliance with the amended rule reduce the need for much of the disclosure requirements we proposed in 2000. Today, most advisers that have custody of client securities or funds comply with the rule by maintaining these client assets with a qualified custodian (such as a broker-dealer or bank) that directly sends account 115 These advisers would be required only to explain that clients will receive these account statements from their custodians and should review them carefully

ements we proposed in 2000. Today, most advisers that have custody of client securities or funds comply with the rule by maintaining these client assets with a qualified custodian (such as a broker-dealer or bank) that directly sends account 115 These advisers would be required only to explain that clients will receive these account statements from their custodians and should review them carefully. If, however, clients do not receive, from one or more qualified custodians, account statements covering all of the funds and securities over which an adviser has custody, Item 15 would require the adviser to disclose that it has custody and to explain the risks that clients will face as a result. 116

114 See Custody of Funds or Securities of Clients by Investment Advisers , Investment Advisers Act Release No. 2176 (Sep. 25, 2003) [68 FR 56692 (Oct. 1, 2003)] (“Custody Rule Release”). “Custody” would have the same meaning as it currently has in Form ADV and is based on the term as defined in rule 206(4)-2. See Form ADV: Glossary . An adviser has custody if it, directly or indirectly, holds client funds or securities, has any authority to obtain possession of them, or has the ability to appropriate them. For example, an adviser has custody if it has a general power of attorney over a client's account or signatory power over a client's checking account. For a more detailed discussion of what activity constitutes “custody,” see Custody Rule Release, at Section II.A.

115 Rule 206(4)-2 defines a “qualified custodian” as a bank, a savings association, a broker-dealer, a futures commission merchant (but only with respect to clients' funds, security futures, and other securities incidental to transactions in futures), or a foreign financial institution that customarily holds financial assets for its customers and segregates the advisory clients' assets from its proprietary assets

2 defines a “qualified custodian” as a bank, a savings association, a broker-dealer, a futures commission merchant (but only with respect to clients' funds, security futures, and other securities incidental to transactions in futures), or a foreign financial institution that customarily holds financial assets for its customers and segregates the advisory clients' assets from its proprietary assets. Under the rule, a registered adviser with custody must either have a reasonable basis for believing that the qualified custodian sends quarterly account statements directly to the client or send its own quarterly account statements to the client, in which case the adviser must also undergo an annual surprise examination by an independent public accountant to verify client funds and securities.

116 We note that current Part 2 of Form ADV does not have an equivalent to Item 15 of reproposed Part 2A.

We request comment on this proposed disclosure item. In particular, we request comment about whether we should further revise this item in light of the amended investment adviser custody rule.

Item 16. Investment Discretion . Item 16 would require advisers with discretionary authority over client accounts to disclose these arrangements in their brochure, 117 and any limitations clients may (or customarily do) place on this authority. 118 This item is the same as originally proposed. Both of the commenters who addressed the proposed item supported it. 119 We request further comment on our proposed Item 16.

117 Currently, Items 12.A and 12.B of Part 2 require information about the adviser's investment discretion and any limitations on it. We propose to continue requiring this information but to clarify, through our proposed definitions in Form ADV, that an adviser has “discretionary authority” if it is authorized to make purchase and sale decisions for client accounts. This definition of discretionary authority is derived from section 3(a)(35) of the Exchange Act [15 U.S.C. 78c(a)(35)]

vestment discretion and any limitations on it. We propose to continue requiring this information but to clarify, through our proposed definitions in Form ADV, that an adviser has “discretionary authority” if it is authorized to make purchase and sale decisions for client accounts. 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.

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

119 CFA Letter; FPA Letter.

Item 17. Voting Client Securities . Item 17 would require advisers to disclose their proxy voting practices. We have revised the item to reflect the adoption of 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. 120 We also have added a new requirement, discussed below, to describe information about an adviser's use of third-party proxy voting services.

120 See Proxy Voting by Investment Advisers , Investment Advisers Act Release No. 2106 (Jan. 31, 2003) [68 FR 6585 (Feb. 7, 2003)]. Rule 206(4)-6 requires advisers to adopt and implement written voting policies and procedures. Advisers are also 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.

Item 17 would require advisers to disclose whether they will accept authority to vote client securities and, if so, to briefly describe the voting policies they adopted under rule 206(4)-6

rds 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.

Item 17 would require advisers to disclose whether they will accept authority to vote client securities and, if so, to briefly describe the voting policies they adopted under rule 206(4)-6. In addition, each adviser must describe whether (and how) clients can direct the advisers 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 would require 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 have authority to vote securities would have to disclose how clients will receive their proxies and other solicitations.

Finally, we have added a new paragraph B of Item 17. If advisers routinely rely on one or more third-party proxy voting services to advise them in connection with voting client securities, then the advisers would be required to list the proxy voting services that the advisers use and to describe how they select the proxy voting services. The paragraph also would require disclosure of whether these advisers permit clients to direct the use of a particular proxy voting service with respect to the securities held in the clients' accounts. An adviser would not need to identify a proxy voting service that a client directs the adviser to use unless the adviser uses the service for the purpose of voting the securities of other clients. Finally, the new paragraph would require advisers to disclose how they pay for proxy voting services

use of a particular proxy voting service with respect to the securities held in the clients' accounts. An adviser would not need to identify a proxy voting service that a client directs the adviser to use unless the adviser uses the service for the purpose of voting the securities of other clients. Finally, the new paragraph would require advisers to disclose how they pay for proxy voting services.

We believe that clients are interested in knowing whether their adviser is outsourcing its proxy analysis or otherwise using third-party proxy voting services, whether it is doing so in response to direction from another client, and how the adviser is paying for those services. We believe that clients would want to know of potential conflicts of interest that may arise from an adviser's use of proxy voting services, including possibly accommodating one client by hiring a proxy voting service to influence the voting of another client's securities.

Several commenters favored the item when we proposed it in 2000. 121 We request comment on our proposed revisions. Rule 206(4)-6 already requires advisers to disclose much of the information that the proposed item would require. Thus, one principal effect of the item would be to require the rule 206(4)-6 disclosure in the brochure. Should any of that disclosure not be required in the brochure?

121 See Comment Letter of Professor Aaron Brown, Yeshiva University (May 10, 2000); Comment Letter of Council of Institutional Investors (June 12, 2000); Florida Board Letter; Comment Letter of The Corporate Monitoring Project (June 3, 2000); Comment Letter of James McRitchie (May 24, 2000); Comment Letter of Paul Nissenbaum (May 9, 2000). Four commenters were concerned about the length of the disclosure that a description of proxy procedures would entail. See AmEx Letter; June IAA 2000 Letter; Comment Letter of Charles Schwab & Co. (June 14, 2000) (“Schwab Letter”); Thomson Letter; Wellington Letter

Monitoring Project (June 3, 2000); Comment Letter of James McRitchie (May 24, 2000); Comment Letter of Paul Nissenbaum (May 9, 2000). Four commenters were concerned about the length of the disclosure that a description of proxy procedures would entail. See AmEx Letter; June IAA 2000 Letter; Comment Letter of Charles Schwab & Co. (June 14, 2000) (“Schwab Letter”); Thomson Letter; Wellington Letter. We note in response to these commenters' concerns that the proposed item would only require a brief description of an adviser's policies and procedures and not verbatim incorporation of them.

Should we require disclosure of the circumstances relating to an adviser's use of third-party proxy voting services? Specifically, would clients be interested in knowing the identity of the proxy voting services that are utilized by their advisers and how these services are selected? Would clients be interested in knowing whether advisers permit their clients to direct the use of particular proxy voting services? Would clients be interested in knowing the amounts that advisers pay third-party proxy voting services? Would clients be interested in knowing whether their advisers are paying for the services directly or through soft dollars? 122

122 For a discussion of whether proxy voting services and other proxy services are within the safe harbor under section 28(e) of the Exchange Act, see 2006 Soft Dollar Release, above note 89, at section III.C.5.

Item 18. Financial Information. This item would require disclosure of certain financial information about the adviser when material to clients. Proposed Item 18 of Part 2A would continue to require each adviser that requires prepayment of fees to give clients an audited balance sheet showing the adviser's assets and liabilities at the end of its most recent fiscal year. 123 Prepayment of fees 124 These clients are exposed to the risk that their assets may not be properly managed if the adviser becomes insolvent and ceases to do business

. Proposed Item 18 of Part 2A would continue to require each adviser that requires prepayment of fees to give clients an audited balance sheet showing the adviser's assets and liabilities at the end of its most recent fiscal year. 123 Prepayment of fees 124 These clients are exposed to the risk that their assets may not be properly managed if the adviser becomes insolvent and ceases to do business. 125 Finally, proposed Item 18 would require an adviser that has been the subject of a bankruptcy petition during the past ten years to disclose that fact to clients. 126

123 Currently, Item 14 of existing Part 2 requires (through Schedule G) an audited balance sheet if the adviser requires prepayment of more than $500 in fees per client and six or more months in advance. We would increase the threshold amount from $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. As in the 2000

124 This disclosure is currently required by rule 206(4)-4. In its release adopting rule 206(4)-4 the Commission 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 would generally include insolvency or bankruptcy. See Rule 206(4)-4 Adopting Release, above note 66 at n. 6.

125 As discussed above, we propose to rescind rule 206(4)-4. We caution advisers, however, that their fiduciary duty of full and fair disclosure may require them to continue to disclose any material legal event or precarious financial condition promptly to all clients, even clients to whom they may not be required to deliver a brochure or amended brochure. See Rule 206(4)-4 Adopting Release, above note 66 at n. 2-3 and accompanying text

scind rule 206(4)-4. We caution advisers, however, that their fiduciary duty of full and fair disclosure may require them to continue to disclose any material legal event or precarious financial condition promptly to all clients, even clients to whom they may not be required to deliver a brochure or amended brochure. See Rule 206(4)-4 Adopting Release, above note 66 at n. 2-3 and accompanying text.

126 This requirement conforms with our already stated position that bankruptcy generally constitutes a `financial condition reasonably likely to impair the adviser's ability to meet contractual commitments to clients' requiring disclosure under rule 206(4)-4. See Rule 206(4)-4 Adopting Release, above note 66 at n. 6.

This item is largely the same as the one we proposed in 2000, which commenters generally supported. 127 However, we have made revisions to reflect subsequent amendments to Form ADV that were made in conjunction with changes to the adviser custody rule. 128 As a result, Item 18 no longer would require an adviser to supply clients with an audited balance sheet solely because the adviser has custody. Moreover, we now propose to exclude advisers from the balance sheet requirement if they require prepaid fees but are qualified custodians or insurance companies. These firms are subject to capital and regulatory requirements, designed to guard against insolvency, that eliminate the need for an adviser to deliver a balance sheet. Are there other circumstances in which it would be unnecessary for an adviser to deliver a balance sheet to its clients? Alternatively, are there additional circumstances in which it would be appropriate for us to require an adviser to deliver a balance sheet?

127 See, e.g. , CFA Letter; June 2000 IAA Letter. Although some commenters to our 2000 proposal raised concerns regarding exceptions to delivery of balance sheets, the Commission subsequently considered and addressed this issue in adopting its changes to the custody rule. See Custody Rule Release, above note 114

ich it would be appropriate for us to require an adviser to deliver a balance sheet?

128 See Custody Rule Release, above note 114.

Item 19. Index. The brochure filed with us would be required to include an index of the items required by Part 2A indicating where in the brochure the adviser addresses each item. 129 This index is intended to facilitate review by our staff for compliance with the requirements of Part 2A. The adviser would not be required to provide the index to its clients. The index would, however, be required to be appended to the brochure as filed through the IARD. We proposed the same index requirement in 2000. 130 We request further comment on our proposal to require advisers to include an index in their brochures.

129 Although an index is not required by current Part 2 of Form ADV, the requirement in Proposed Item 19 is similar to the index that current Schedule H now requires.

130 In their comments responding to the 2000 proposal, the ICI and IAA opposed this item, arguing that requiring both an index and a table of contents seemed redundant. See ICI Letter; June 2000 IAA Letter. The CFA, however, endorsed the requirement. See CFA Letter.

Part 2A Appendix 1: The Wrap Fee Program Brochure. Advisers that sponsor wrap fee programs 131 would 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 advisory firm brochure. 132 The items in proposed Appendix 1 to Part 2A would contain the requirements for a wrap fee program brochure, and would be substantially similar to those currently in Schedule H

ld 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 advisory firm brochure. 132 The items in proposed Appendix 1 to Part 2A would contain the requirements for a wrap fee program brochure, and would be substantially similar to those currently in Schedule H. However, as we did in 2000, today we are proposing some changes from current Schedule H to incorporate many of our proposed amendments to the Part 2A firm brochure. We also are proposing an additional disclosure requirement to the wrap fee brochure.

131 Under wrap fee programs, which are also 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.

132 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)] (adopting rules to require wrap fee sponsors to give wrap fee clients separate brochures). As proposed in 2000, advisers whose entire advisory business is sponsoring wrap fee programs would prepare a wrap brochure but would not be required to prepare a standard advisory firm brochure. See proposed Instruction 7 to Part 2A of Form ADV. An adviser would have to prepare both a standard firm brochure and a wrap fee brochure if it both sponsors a wrap fee program and provides other types of advisory services, and would 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

orm ADV. An adviser would have to prepare both a standard firm brochure and a wrap fee brochure if it both sponsors a wrap fee program and provides other types of advisory services, and would 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.

We propose to require an adviser to disclose whether any of its related persons are portfolio managers in the program and to describe the conflicts that may be present. 133 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. The item would require advisers to disclose whether related person portfolio managers are subject to the same selection and review as the other portfolio managers who participate in the wrap fee program and, if they are not, how they are selected and reviewed.

133 Proposed Item 6.B of Appendix 1. We propose to redesignate the item originally proposed as Item 6.B (requiring additional disclosures if the wrap fee sponsor or any of its employees act as a portfolio manager for a wrap fee program described in the wrap brochure) as new Item 6.C.

tem 6.B (requiring additional disclosures if the wrap fee sponsor or any of its employees act as a portfolio manager for a wrap fee program described in the wrap brochure) as new Item 6.C.

We request comment on this proposed modification to Appendix 1 to Part 2A. Wrap fee programs have evolved in the marketplace, resulting in many different models that all meet the definition of wrap fee program. 134 As a result of these various structures, are there other disclosures that we should consider including in Appendix 1 that would enhance a client's ability to understand the conflicts of interest in wrap fee programs? Are there disclosure items in proposed Appendix 1 that are unnecessary or would not be useful to clients?

134 For example, some wrap fee program sponsors have begun to transition from platforms offering a selection of individual portfolio managers to those instead offering a selection of model portfolios.

3. Delivery and Updating of Brochures

The Commission also is proposing amendments to rule 204-3, our rule under the Advisers Act that requires registered advisers to update and deliver their brochures to clients and prospective clients.

a. Delivery to Clients

Initial Delivery. Similar to the existing requirements, an adviser would be required to deliver a current firm brochure before or at the time it enters into an advisory contract with the 135 As provided under the current rule, advisers would not be required to deliver brochures to certain advisory clients receiving only impersonal investment advice 136 or to clients that are investment companies registered under the Investment Company Act of 1940 (“Company Act”). 137 We propose expanding the latter exception to cover advisers to business development companies (“BDCs”) that are subject to section 15(c) of the Company Act. That section requires the boards of directors to request, and the adviser to furnish, information to enable the board to evaluate the terms of the proposed advisory contract

istered under the Investment Company Act of 1940 (“Company Act”). 137 We propose expanding the latter exception to cover advisers to business development companies (“BDCs”) that are subject to section 15(c) of the Company Act. That section requires the boards of directors to request, and the adviser to furnish, information to enable the board to evaluate the terms of the proposed advisory contract. 138 Because of this safeguard, we believe that proposing a separate obligation for those types of entities to deliver a brochure is not necessary. We note that an adviser would not have to prepare a brochure if it does not have any clients to whom a brochure would have to be delivered, thus saving advisers time and expense. 139

135 Proposed rule 204-3(b)(1). Rule 204-3 currently 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 2 or a written document containing the information required by Part 2. Currently, such delivery must 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 are proposing to simply require that the adviser deliver the brochure before or at the time of entering into the agreement.

136 Proposed rule 204-3(c)(1) and proposed Instruction 1 to Part 2A. Advisers would not be required to deliver brochures to advisory clients receiving only impersonal investment advice for which the adviser charges less than $500 per year. Currently, the dollar amount threshold to trigger this exception is $200. See rule 204-3. We are proposing to increase this threshold 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

t advice for which the adviser charges less than $500 per year. Currently, the dollar amount threshold to trigger this exception is $200. See rule 204-3. We are proposing to increase this threshold 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.

137 Proposed rule 204-3(c)(1) and proposed Instruction 1 to Part 2A. This does not suggest, however, that investment company directors would no longer receive the disciplinary and financial information that the fund's adviser currently provides under existing rule 206(4)-4, which we are proposing to move into the brochure. Section 15(c) of the Investment Company Act [15 U.S.C. 80a-15(c)] separately requires fund directors to request and evaluate information about the adviser in connection with annual renewal of the advisory contract, and requires the adviser to provide it.

138 See note 137 above.

139 Proposed Instruction 5 to Part 2A.

Annual and Interim Delivery. Currently, rule 204-3 requires advisers to annually deliver, or offer to deliver upon request, a written disclosure statement (either a copy of the adviser's Part 2 or a brochure containing the information required by Part 2) to each of its advisory clients. 140 In 2000, we proposed to require advisers to deliver an updated brochure, or a “sticker” identifying the stale information and including the updated information, whenever information in the brochure became materially incorrect during the year. 141 We expressed concern that few clients requested an updated brochure and were instead relying on “stale” brochures. We analogized our updating proposal to the obligations of mutual funds to update their prospectuses and expressed the view that the additional costs the proposed updating requirements might impose could be reduced by electronic delivery of the updating information

during the year. 141 We expressed concern that few clients requested an updated brochure and were instead relying on “stale” brochures. We analogized our updating proposal to the obligations of mutual funds to update their prospectuses and expressed the view that the additional costs the proposed updating requirements might impose could be reduced by electronic delivery of the updating information. We also pointed out that, as fiduciaries, advisers must already provide their clients with updated information to comply with their obligations under the anti-fraud provisions of the Advisers Act.

140 Rule 204-3(c). An adviser's offer to deliver the disclosure statement must be in writing.

141 See Proposing Release at Section II.D.2.

Several commenters supported our proposal, particularly the proposal to require advisers to update their brochures throughout the year. 142 Other commenters objected, primarily citing the burden on advisers. 143 Some commenters argued that advisers currently meet their obligations under the anti-fraud provisions through different types of communications with clients, some of which are informal, and urged us not to impose a formal updating requirement. 144 One commenter, the IAA, expressed agreement with our concern that clients may be relying on stale information and urged a compromise approach under which the Commission would require advisers to deliver their brochure to clients annually, but would not specify the means of updating information between the annual updates. 145

142 See, e.g. , AIMR Letter; CFA Letter; Comment Letter of Yasmin Mansoor (May 28, 2000); Penn. Securities Commission Letter; Securities America Letter.

143 See, e.g. , AmEx Letter; Crist Letter; DP&W Letter; ICI Letter; SIFMA Letter.

144 See, e.g. , Comment Letter of Merrill Lynch, Pierce, Fenner & Smith, Inc. (June 22, 2000) (“Merrill Letter”); Paine Webber Letter; Schwab Letter.

145 Comment Letter of the IAA (May 24, 2001) (“May 2001 IAA Letter”)

Yasmin Mansoor (May 28, 2000); Penn. Securities Commission Letter; Securities America Letter.

143 See, e.g. , AmEx Letter; Crist Letter; DP&W Letter; ICI Letter; SIFMA Letter.

144 See, e.g. , Comment Letter of Merrill Lynch, Pierce, Fenner & Smith, Inc. (June 22, 2000) (“Merrill Letter”); Paine Webber Letter; Schwab Letter.

145 Comment Letter of the IAA (May 24, 2001) (“May 2001 IAA Letter”).

Today, we are proposing an approach similar to the one suggested by the IAA, which we believe may strike an appropriate balance between our concerns and those expressed by commenters. In addition to the initial delivery requirement, the proposed amendments would require each registered adviser to deliver its current brochure to existing clients at least once each year no later than 120 days after the end of the adviser's fiscal year. 146 Thus, clients would receive an updated brochure about the same time each year (identifying changes from the previous year's brochure) shortly after the date by which advisers are already required to file their amended Form ADV with us. 147

146 Proposed amended rule 204-3(b) and proposed Instruction 2 to Part 2A.

147 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 proposed 120-day period is designed to provide sufficient flexibility to allow advisers to include the updated brochure in a routine quarterly mailing to clients. We expect that permitting an adviser to send the brochure together with these routine mailings could substantially reduce delivery costs. See Section VII below. Advisers may, of course, deliver updated brochures electronically with client consent, in which case they would bear significantly lower delivery costs. Proposed Instruction 3 to Part 2A

brochure in a routine quarterly mailing to clients. We expect that permitting an adviser to send the brochure together with these routine mailings could substantially reduce delivery costs. See Section VII below. Advisers may, of course, deliver updated brochures electronically with client consent, in which case they would bear significantly lower delivery costs. Proposed Instruction 3 to Part 2A. See also 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)] (publishing Commission interpretive guidance with respect to use of electronic media to fulfill investment advisers' disclosure delivery obligations).

We are proposing to require an adviser to deliver an interim update to clients only when the adviser amends its brochure to add a disciplinary event, or to materially change information already disclosed, in response to Item 9 of Part 2A. 148 We believe that such circumstances warrant a formal delivery requirement because of the importance of disciplinary information to clients. 149 We believe such disciplinary events are important because, unlike some of the other disclosure items, they are more likely to reflect directly upon an adviser's integrity and may affect a client's trust and confidence in the adviser.

148 Proposed rule 204-3(e). Nonetheless, as fiduciaries advisers have an ongoing obligation to inform their clients of any material information that could affect the advisory relationship. As a result, advisers may be required to disclose material changes to clients between annual updating amendments even if those changes do not trigger delivery of an interim update. See Note to Proposed Instruction 2 to Part 2A; see also Form ADV: General Instruction 4.

149 Currently, existing rule 206(4)-4 requires disclosure of such disciplinary events. The proposed requirement of interim updates to the brochure would require that such disclosure be written

es to clients between annual updating amendments even if those changes do not trigger delivery of an interim update. See Note to Proposed Instruction 2 to Part 2A; see also Form ADV: General Instruction 4.

149 Currently, existing rule 206(4)-4 requires disclosure of such disciplinary events. The proposed requirement of interim updates to the brochure would require that such disclosure be written.

We request comment generally on our proposed delivery requirement and, in particular, on the proposed requirements regarding delivery of updates. Should we require delivery of interim updates of the brochure in additional circumstances besides those involving disclosure of disciplinary information in response to Item 9? Should we require brochure delivery

b. Updating Part 2 of Form ADV

Similar to the existing requirements, the proposed rules would 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 becomes materially inaccurate. 150 In the case of both annual and interim updates, advisers will be able to make changes to their brochures using their own computers and then simply submit the revised versions of their brochures through IARD. 151 In some cases, an adviser will be required to submit an annual updating amendment, but may not have any changes to make to its brochure (because the currently filed brochure does not contain any materially inaccurate information). The IARD system will give the adviser the option of indicating on IARD that its current brochure does not contain any materially inaccurate information and that the adviser is not attaching another brochure. Although previously-filed versions of an adviser's brochures will remain stored as Commission records in the IARD system, as with an adviser's Part 1A filings, only the most recent version of an adviser's brochure will be available through the Commission's public disclosure Web site

chure does not contain any materially inaccurate information and that the adviser is not attaching another brochure. Although previously-filed versions of an adviser's brochures will remain stored as Commission records in the IARD system, as with an adviser's Part 1A filings, only the most recent version of an adviser's brochure will be available through the Commission's public disclosure Web site. 152 The purpose of the public disclosure Web site is to provide the public with current information about advisers, rather than historic information. 153

150 See proposed amended rule 204-3(g), and proposed Instruction 4 to Form ADV, Part 2A. As discussed above, the proposed updating requirement would be similar to the existing standard. See current rule 204-1 and Form ADV: General Instruction 4. Additionally, proposed Instruction 4 to Part 2A and a proposed Note to Item 4.E would state that an adviser does not need to update its brochure solely because the amount of its client assets has materially changed. This proposed instruction reflects our understanding that in most cases the amount of an adviser's assets under management will likely continually change over the course of a year due to market fluctuations, and that requiring advisers to update their brochure in each instance would be burdensome and of limited value. This approach is similar to that we currently take with respect to advisers' obligations to update assets under management reported in Item 5 of Form ADV, Part 1A. See Form ADV: General Instruction 4. For similar reasons, proposed Instruction 4 to Part 2A also would state that an adviser does not need to update its brochure solely because its fee schedule has changed. Advisers would, however, be required to update their brochure to reflect material changes with respect to listed assets and fee schedules if they are otherwise updating their brochure for a separate reason.

151 Proposed rule 204-1(b).

152 See note 6 above

Instruction 4 to Part 2A also would state that an adviser does not need to update its brochure solely because its fee schedule has changed. Advisers would, however, be required to update their brochure to reflect material changes with respect to listed assets and fee schedules if they are otherwise updating their brochure for a separate reason.

151 Proposed rule 204-1(b).

152 See note 6 above. In the case of an adviser that prepares, files and delivers to clients separate brochures for the various different advisory services it offers, the most recent version of each of its brochures would be available via the public disclosure Web site.

153 Advisers' historic brochure filings would be available for public inspection and copying in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549.

We request comment generally with respect to our proposed requirements for updating brochures. We request comment specifically about the proposal to require ongoing updating. Should we develop different updating requirements for the different disclosure items of the brochure in a manner similar to the updating requirements for Form ADV, Part 1A ( e.g. , require more frequent updating with respect to changes to an adviser's listed fee schedule)? We also request comment about whether we should make advisers' historical brochure filings available via the Commission's public disclosure Web site.

B. Part 2B: The Brochure Supplement

In 2000, we expressed our concern that, because the information in current Part 2 concerns the advisory firm, clients may not receive information they want and need about the firm's employees with whom they have contact and on whom they rely for investment advice. 154 In the case of smaller advisers, the current disclosure requirements, which focus on the senior executives of the advisory firm, may be adequate

xpressed our concern that, because the information in current Part 2 concerns the advisory firm, clients may not receive information they want and need about the firm's employees with whom they have contact and on whom they rely for investment advice. 154 In the case of smaller advisers, the current disclosure requirements, which focus on the senior executives of the advisory firm, may be adequate. But in large advisory firms, which account for a significant number of SEC-registered advisers, clients may never meet the firm's senior executives, who may be located in a different city and may have only an indirect effect on the advice given to the client. 155 We believe clients of these firms also are interested in the background, disciplinary record (if any), and qualifications of the individuals with whom they are dealing.

154 For example, current Part 2 requires background information only on firm executives and members of the firm's “investment committee.” Item 6 of Part 2 of Form ADV.

155 Based on advisers' responses to questions on Part 1A of Form ADV as of September 30, 2007, more than 475 of the investment advisers registered with the Commission report on Part 1A of their Form ADV that they have more than 50 employees who perform investment advisory functions on behalf of the firm. (IARD Data as of Sept. 30, 2007).

Therefore, we proposed in 2000, and are today reproposing, a requirement that adviser brochures be accompanied by brochure supplements that provide information about the advisory personnel on whom clients rely for investment advice. A brochure supplement ordinarily would be less than a page long and would contain information about the educational background, business experience, and disciplinary history (if any) of the supervised person who provides advisory services to that client. 156

156 156 Proposed rule 204-3(b)(2).

We received a large number of comments on the brochure supplement proposal

rely for investment advice. A brochure supplement ordinarily would be less than a page long and would contain information about the educational background, business experience, and disciplinary history (if any) of the supervised person who provides advisory services to that client. 156

156 156 Proposed rule 204-3(b)(2).

We received a large number of comments on the brochure supplement proposal. Several commenters, including those representing financial planners, investment consultants, and consumer groups, praised the supplement as a highly practical and beneficial tool for informing clients about the qualifications and background of the individuals on whom they rely for investment advice. 157 Several others, including a number of investment advisers, argued that ensuring proper distribution of supplements at large firms would be costly and burdensome. 158 Some maintained that clients do not want the information that would be contained in a supplement. 159 Another commenter, the IAA, acknowledged that consumers hiring professionals in any field often inquire about the individuals' credentials in addition to the firm's reputation, but urged that we narrow the rule so as not to require advisers to deliver the supplement to institutional clients. 160

157 E.g. , AIMR Letter; CFA Letter; Consortium Letter; FPA Letter; Comment Letter of the Investment Management Consultants Association (June 12, 2000).

158 E.g. , AmEx Letter; June 2000 IAA Letter; ICI Letter; Comment Letter of Legg Mason, Inc. (June 13, 2000) (“Legg Mason Letter”); Merrill Letter; Paine Webber Letter; Comment Letter of Salomon Smith Barney Inc. (June 13, 2000) (“Salomon Letter”); Schwab Letter; SIFMA Letter; TIAA-CREF Letter; T. Rowe Price Letter; Comment Letter of United Services Planning Association, Inc. and Independent Research Agency for Life Insurance, Inc. (June 12, 2000) (“USPA Letter”); Wellington Letter.

159 Merrill Letter; Salomon Letter; Schwab Letter; SIFMA Letter.

160 May 2001 IAA Letter

ter of Salomon Smith Barney Inc. (June 13, 2000) (“Salomon Letter”); Schwab Letter; SIFMA Letter; TIAA-CREF Letter; T. Rowe Price Letter; Comment Letter of United Services Planning Association, Inc. and Independent Research Agency for Life Insurance, Inc. (June 12, 2000) (“USPA Letter”); Wellington Letter.

159 Merrill Letter; Salomon Letter; Schwab Letter; SIFMA Letter.

160 May 2001 IAA Letter.

We continue to believe that information contained in the brochure supplement may be very important to clients. In response to commenters' concerns, however, we have made a number of changes that are intended to reduce burdens on advisers subject to the rule. As discussed in more detail below, we would modify the delivery requirement, reduce the number of types of clients to whom advisers would be required to provide supplements, clarify the format of the supplements to maximize the amount of flexibility advisers have in preparing a supplement, and limit the information

1. Delivery and Updating

We originally proposed to require that each adviser provide its clients with a brochure supplement for each supervised person who provides advisory services to that client. 161 In response to comments, we are limiting the circumstances in which an adviser would be required to deliver the supplement. 162

161 See Proposing Release at Section II.D.2.

162 See note 158 above. A number of commenters argued that advisers should only be required to deliver brochure supplements of supervised persons who actually formulated investment advice. Crist Letter; June 2000 IAA Letter; ICI Letter; TIAA-CREF Letter; T. Rowe Price Letter. Nine commenters argued that brochure supplements should not be required of supervised persons who act as solicitors. Crist Letter; DP&W Letter; Comment Letter of Federated Investors Inc. (June 13, 2000) (“Federated Letter”); FPA Letter; June 2000 IAA Letter; ICI Letter; TIAA-CREF Letter; T. Rowe Price Letter; USPA Letter

er; June 2000 IAA Letter; ICI Letter; TIAA-CREF Letter; T. Rowe Price Letter. Nine commenters argued that brochure supplements should not be required of supervised persons who act as solicitors. Crist Letter; DP&W Letter; Comment Letter of Federated Investors Inc. (June 13, 2000) (“Federated Letter”); FPA Letter; June 2000 IAA Letter; ICI Letter; TIAA-CREF Letter; T. Rowe Price Letter; USPA Letter. Some commenters urged limiting delivery to certain types of clients, such as “retail” clients, but not to sophisticated or institutional clients.

The proposed amendments would require that a client be given a brochure supplement for each supervised person who (i) formulates investment advice for that client and has direct client contact, 163 or (ii) makes discretionary investment decisions for that client's assets, even if the supervised person has no direct client contact. 164 We believe that requiring supplements for these categories of supervised persons would provide clients with the information they want and need about the particular individuals on whom they will rely for investment advice. We originally proposed, but have eliminated, a provision requiring delivery of a supplement for a supervised person who merely communicates investment advice. Commenters pointed out that our original proposal would have required disclosure of the backgrounds of client service representatives who transmit investment advice to clients, but who have no influence on the advice given. To limit disclosure about employees with whom a client may have no contact or about employees who do not influence the advice given to the client, we have more narrowly tailored the proposed supplement delivery requirements so that a particular client would receive disclosure specifically about those persons on whom he relies for investment advice.

163 An adviser would not have to provide a supplement for a third-party solicitor because solicitors already must deliver a disclosure document to potential advisory clients

given to the client, we have more narrowly tailored the proposed supplement delivery requirements so that a particular client would receive disclosure specifically about those persons on whom he relies for investment advice.

163 An adviser would not have to provide a supplement for a third-party solicitor because solicitors already must deliver a disclosure document to potential advisory clients. Rule 206(4)-3 [17 CFR 275.206(4)-3].

164 An adviser would not, however, have to provide a supplement for a supervised person who provides discretionary advice only as part of a team and has no direct client contact as we believe that when investment advice is formulated by a team, specific information about each individual team member takes on less importance. Proposed Instruction 1 to Part 2B.

The supervised person's supplement must be given to the client at or before the time that supervised person begins to provide advisory services to that client. Proposed rule 204-3(b)(2) and proposed Instruction 3 to Part 2B. Although the amendments we are proposing today would require the advisory firm to deliver the brochure supplement, we recognize that in most cases advisers' supervised persons will actually deliver the required supplements to clients on behalf of the advisory firm.

As reproposed, an adviser generally would be required to provide its clients with a brochure supplement for each supervised person who provides advisory services as described above. However, advisers would not be required to deliver supplements to four types of clients: (i) Clients to whom an adviser is not required to deliver a firm brochure ( e.g. , registered investment companies and business development companies); (ii) clients who receive only impersonal investment advice; 165 (iii) clients who are “qualified purchasers;” 166 and (iv) certain “qualified clients” who also are officers, directors, employees and other persons related to the adviser

of clients: (i) Clients to whom an adviser is not required to deliver a firm brochure ( e.g. , registered investment companies and business development companies); (ii) clients who receive only impersonal investment advice; 165 (iii) clients who are “qualified purchasers;” 166 and (iv) certain “qualified clients” who also are officers, directors, employees and other persons related to the adviser. 167 An adviser that does not have any clients to whom a supplement would have to be delivered would not have to prepare any supplements. Similarly, an adviser would not have to prepare a supplement for any supervised person who does not have clients to whom the adviser must deliver a supplement.

165 This exception from the supplement delivery requirement differs slightly from the exception from the brochure delivery requirement, in that it does not depend on the cost of the impersonal advisory services involved. This is because in situations involving impersonal advisory services, the nature of the services are such that supervised persons of the adviser are unlikely to be directly providing advisory services to clients. As a result, we believe that in such situations requiring supplement delivery would result in an unnecessary expense with little appreciable benefit. We believe, however, that delivery of a firm brochure would be useful where the cost of the impersonal advisory services is significant, that is $500 or above.

166 “Qualified purchasers,” as defined under section 2(a)(51)(A) of the Investment Company Act of 1940 [15 U.S.C. 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

onal advisory services is significant, that is $500 or above.

167 Rule 205-3(d)(1)(iii) defines certain related persons of an adviser as “qualified clients,” including: (i) Any executive officers, directors, trustees, general partners, or persons serving in a similar capacity, of the advisory firm; and (ii) any employees of the advisory firm (other than employees performing solely clerical, secretarial or administrative functions) who, in connection with their regular functions or duties, participate in the investment activities of the firm and have been performing such functions or duties for at least 12 months.

The first two categories of clients were included in our 2000 proposal. Commenters did not address these exceptions to the supplement delivery requirement. We propose to add the latter two exceptions in response to several commenters' arguments that certain institutional and sophisticated clients do not need the protections of the brochure supplement requirement because they are in a position to obtain, and frequently do obtain, information about the advisory personnel on whom they rely for investment advice. 168

168 See DE Shaw; Federated Letter; June 2000 IAA Letter; T. Rowe Price Letter; Wellington Letter.

ion about the advisory personnel on whom they rely for investment advice. 168

168 See DE Shaw; Federated Letter; June 2000 IAA Letter; T. Rowe Price Letter; Wellington Letter.

We request comment on our assumption that some clients do not need the protections afforded by a requirement that an adviser deliver a brochure supplement even though we would continue to require delivery of the brochure. Should we use a higher threshold to exclude clients, such as “Qualified Institutional Buyers?” 169 Should we use a lower one, and exclude all clients who are “qualified clients” under rule 205-3, rather than just those qualified clients that are officers, directors and employees of the adviser? 170 In December 2006, the Commission proposed, but has not adopted, new rules 509 and 216 under the Securities Act of 1933, that would define the term “accredited natural person.” 171 We ask for comment on whether we should create an exclusion from supplement delivery for accredited natural persons. In particular, with respect to natural persons, we request comment on whether “accredited 172

169 “Qualified Institutional Buyer,” as defined under rule 144a of the Securities Act of 1933 [17 CFR 230.144a], includes entities that own and invest on a discretionary basis at least $100 million in securities.

170 “Qualified client,” as defined under rule 205-3 of the Advisers Act [17 CFR 275.205-3], includes natural persons with $750,000 under management with the adviser and individuals who have a net worth of $1.5 million.

adviser and individuals who have a net worth of $1.5 million.

171 Proposed new rules 509 and 216 under the Securities Act of 1933 would add to the existing definition of “accredited investor” and apply to private offerings of certain unregistered investment pools. As proposed, these rules would define the term “accredited natural person” under Regulation D and Section 4(6) of the Securities Act. “Accredited natural person” would be any natural person who meets either the net worth or income test specified in rule 501(a) or rule 215, as applicable, and who owns at least $2.5 million in investments. See Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles; Accredited Investors in Certain Private Investment Vehicles , Investment Advisers Act Release No. 2576 (Dec. 27, 2006) [72 FR 400 (Jan. 4, 2007)]. In August 2007, we proposed further general amendments to the definition of accredited investor. See Revisions of Limited Offering Exemptions in Regulation D , Securities Act Release No. 8828 (Aug. 3, 2007) [72 FR 45116 (Aug. 10, 2007)].

172 See note 166 above.

In 2000, we proposed to require that advisers promptly deliver to existing clients a revised supplement (or a sticker) whenever information in the supplement became materially inaccurate. 173 Today, we propose to reduce the frequency with which advisers would have to deliver clients an updated supplement so that they would only deliver them to existing clients when new disclosure of a disciplinary event, or a material change to disciplinary information already disclosed, in response to proposed Part 2B, Item 3, which we believe is critical information for clients. As we noted above, we believe disciplinary information is important because it reflects upon the supervised person's integrity and may affect a client's trust and confidence in that person.

173 Proposing Release at n. 215

linary event, or a material change to disciplinary information already disclosed, in response to proposed Part 2B, Item 3, which we believe is critical information for clients. As we noted above, we believe disciplinary information is important because it reflects upon the supervised person's integrity and may affect a client's trust and confidence in that person.

173 Proposing Release at n. 215.

As with the brochure, advisers would have to amend a brochure supplement promptly if information in it becomes materially inaccurate, and any new clients who would be required to receive that supplement must be given the amended version (or the “old” supplement and a sticker). Supplements, like brochures, could be delivered on paper or electronically. 174 However, unlike the delivery requirement for firm brochures, and because we believe most information in the supplement is less likely to become materially inaccurate over time, advisers would not be required to deliver supplements to existing clients annually. We request comment generally on the proposed updating and delivery requirements for brochure supplements. We also request comment on our proposal to require advisers to deliver updated supplements to clients describing changes to disciplinary information. Should we also require updated supplements to be delivered if other information changes?

174 Proposed Instruction 4 to Part 2B.

2. Format

The proposed amendments would require advisers to write their supplements in plain English, but would give advisers considerable flexibility in presenting information in a format that best suits their firms. 175 This flexibility is designed to reduce the cost of preparing and delivering supplements. Advisers would be permitted to include supplement information in the firm's brochure, an approach that may be attractive to smaller firms with few persons for whom they would be required to prepare supplements

isers considerable flexibility in presenting information in a format that best suits their firms. 175 This flexibility is designed to reduce the cost of preparing and delivering supplements. Advisers would be permitted to include supplement information in the firm's brochure, an approach that may be attractive to smaller firms with few persons for whom they would be required to prepare supplements. 176 Advisers could also elect to prepare a supplement for each supervised person, or alternati

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