On July 21 — the same the day that President Obama signed into law a landmark piece of financial legislation that (among other things)  significantly increases the number of managers that will be required to register with the SEC as investment advisers — the SEC voted unanimously to adopt significant amendments to the Form ADV Part 2, which is the principal disclosure document (commonly referred to as the “brochure”) that an SEC-registered investment adviser must provide to its clients and prospective clients.

As described more fully below, the amendments will (among other things) require advisers to make their brochures publicly available via electronic filing, and will change the format of the brochure from its current “check the box” approach to a more narrative, “plain English” approach.

The amendments are intended to substantially improve the quality of the disclosures advisers provide to their clients.  As stated by SEC Chairman Mary L. Schapiro:

“These changes are designed to provide clients with greater information about the individuals who will provide them with investment advice.  These amendments will help transform the brochure into a plain English narrative that is well-suited to serve investors’ needs and describes the adviser’s conflicts, compensation, business activities, and disciplinary history.”

Background

Form ADV Part 2 is the principal disclosure document that a SEC-registered investment adviser must provide to its clients and prospective clients to explain its qualifications, investment strategies, and business practices.

Currently, Part 2 requires advisers to respond to a series of multiple-choice and fill-in-the-blank questions organized in a “check-the-box” format. In the SEC’s view, the current format frequently does not correspond well to an adviser’s business or adequately describe the adviser’s business or conflicts in a way that is truly accessible to the investor in a user-friendly manner.

The SEC originally proposed similar amendments to Part 2 in April 2000, which amendments were in large part re-proposed in March 2008.  The specific details of the final amendments adopted will be set forth in the adopting release, which is scheduled to be issued sometime this week.  Based on  review of the SEC press release and Chairman Schapiro’s Opening Statement made during the Open Meeting, the final amendments appear to be substantially similar to those contained in the 2008 proposal.

Summary of Proposed Amendments

1. Changed Format: The format of the brochure will be changed from its current “check the box” approach to a “plain English” narrative approach.
2. Internet Availability: Advisers will be required to electronically file brochures, which will be publicly available on the SEC’s website.
3. Expanded Content: The new brochure will require expanded disclosure and more specific detail on topics that the SEC views as most relevant to clients of investment advisers, particularly as relates to the adviser’s business practices, fees, conflicts of interest, and disciplinary information.  (See below for additional details on the new disclosure topics.
4. New Updating Requirements: Advisers will be required to provide each client with an annual summary of material changes to the brochure (which would be in addition to the current requirements to deliver the brochure before or at the time the adviser enters into an advisory contract with the client, and to offer to provide a complete updated brochure on an annual basis).
5. Supplements: Advisers will be required to deliver “brochure supplements” to new and prospective clients providing them with information about the specific individuals who will provide services to the clients. The supplement will contain brief resume-like disclosure about the educational background, business experience, other business activities, and disciplinary history of the individual, so that the client can assess the person’s background and qualifications. It will also include contact information for the person’s supervisor in case the client has a concern about the person.

Expanded Disclosure Topics

The new brochure addresses those topics the SEC believes are most relevant to clients, including:

Advisory business — An investment adviser must describe its advisory business, including the types of advisory services offered, state whether it holds itself out as specializing in a particular type of advisory service, and disclose the amount of client assets that it manages.

Fees and compensation — An investment adviser must describe how it is compensated for its advisory services, provide a fee schedule, and disclose whether fees are negotiable. The investment adviser must also describe the types of other fees or expenses, such as brokerage fees, custody fees, and fund expenses that clients may pay in connection with the services provided.

Performance-based fees and side-by-side management — An investment adviser that accepts performance-based fees, or that supervises an individual who accepts such fees, is required to disclose this fact. If the investment adviser also manages accounts that are not charged a performance fee, the adviser must explain the conflicts of interest that arise from the simultaneous management of these accounts and must describe how it addresses those conflicts.

Methods of analysis, investment strategies, and risk of loss — An investment adviser must describe its methods of analysis and investment strategies and explain that investing in securities involves risk of loss which clients should be prepared to bear. Investment advisers who use a particular method of analysis or strategy or who recommend a particular type of security are required to explain the material risks involved and discuss the risks in detail if those risks are unusual.

Disciplinary information — An investment adviser is required to disclose in its brochure material facts about any legal or disciplinary event that is material to a client’s evaluation of the advisory business or to the integrity of its management personnel. An investment adviser must deliver promptly to clients updated information when there is new disclosure of a disciplinary event or a material change to an existing disciplinary event.

Code of ethics, participation or interest in client transactions, and personal trading — An investment adviser is required to describe briefly its code of ethics and state that a copy is available upon request. The adviser must also disclose whether it or an affiliate recommends to clients, or buys or sells for client accounts, securities in which the adviser or an affiliate has a material financial interest and, if so, the conflicts of interest associated with that practice. The adviser also must disclose whether it or an affiliate invests (or is allowed to invest) in the same securities that it recommends to clients or in related securities, such as options or other derivatives, and must explain the conflicts involved and how it addresses those conflicts. In addition, an investment adviser that trades in the recommended securities at or around the same time as the client has to explain the specific conflicts inherent in that practice and how it addresses them.

Brokerage practices — An investment adviser is required to describe the factors considered in selecting or recommending broker-dealers for client transactions and determining the reasonableness of brokers’ compensation. Investment advisers also must disclose soft dollar practices (research or other products or services, other than execution, provided by brokers or a third party to the investment adviser in connection with client transactions); client referrals (using client brokerage to compensate brokers for client referrals); directed brokerage (asking or permitting clients to send trades to a specific broker for execution); and trade aggregation (bundling trades to obtain volume discounts on execution costs). Investment advisers must explain how they address the various conflicts of interest associated with these practices.

Implementation and Effective Date

The amended rules and forms will be effective 60 days after publication in the Federal Register. It is expected that most investment advisers will begin distributing and publicly posting new brochures in the first quarter of 2011.