You've Filed a Form ADV. Now What?

You’ve Filed a Form ADV. Now What?

              

Recently, I met an investment adviser of a hedge fund who was about to file his Form ADV with SEC.  Doing so adds extra responsibilities and reporting requirements on the adviser.  I thought I would make a blog post about the added responsibilities and requirements that an investment adviser must comply with once registered.  With great power, comes great responsibility. Once an adviser is registered and subject to additional SEC oversight, they are able to do more in terms of the number and type of clients they serve. 

                

“As an investment adviser, you are a ‘fiduciary’ to your advisory clients.”  Being a fiduciary means that you have a fundamental obligation to act in the best interests of your clients, provide advice in your client’s best interests and owe your clients a duty of undivided loyalty and utmost good faith.  Additionally, the adviser cannot engage in any activity in conflict with the interest of the client and the adviser must take steps to avoid misleading the client.  This includes not misleading clients with the information in your Form ADV.  Not acting as a fiduciary to your clients warrants its own enforcement action. An additional blog post will follow soon on what it means to be a fiduciary to your clients and the duties a fiduciary owes their clients.   

Compliance Programs

As a registered investment adviser (“RIA”), you are required to adopt and implement written policies and procedure that are reasonably designed to prevent violations of the Investment Advisers Act of 1940 (“IAA”).  These procedures must be reviewed at least annually and the adviser must designate a chief compliance officer (“CCO”) who is responsible for administering those policies and procedures.  See Rule 206(4)-7 under the IAA.

                  

The Commission has stated that it expects these policies and procedures, at a minimum, to address the following issues relevant the adviser:

(1)    Portfolio management processes, including allocation among clients and consistency of portfolios with clients’ investment objectives;

(2)   The accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements;

(3)    Proprietary trading by the adviser and the personal trading activities of supervised persons;

(4)   Safeguarding of client assets from conversion or inappropriate use by personnel; the accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;

(5)   Safeguards for the privacy protection of client records and information;

(6)   Trading practices, including procedures by which you satisfy your best execution obligation, use client brokerage to obtain research and services (soft dollars), and allocate aggregated trades among clients;

(7)   Marketing advisory services;

(8)   Processes to value client holdings and assess fees on those valuations; and

(9)   Business continuity plans. 

Notably, this is quite a bit of additional work that must be done for an investment adviser without a prior in-place compliance program. (emphasis added)  It is extremely important for RIA's compliance programs to be in accordance with all of the above. Not doing so is a violation of the securities laws and will warrant enforcement action.

Advisers Must Prepare Certain Reports and File Certain Reports with the SEC

As a registered investment adviser, you are required to file an annual update as Part 1A of the registration form (Form ADV) through the Investment Advisers Registration Depository (IARD).  The adviser must also file an annual updating amendment to the Form ADV within 90 days after the end of the fiscal year.  In addition, the adviser must promptly file an amendment to their Form ADV whenever certain information contained in the Form ADV becomes inaccurate.  Notably, inaccurate, misleading, or omitted Form ADV disclosures are the most frequently cited finding from the SEC’s examinations of investment advisers. 

Investment Advisers Must Provide Clients and Prospective Clients with a Written Disclosure Statement

Registered investment advisers are required to provide their advisory clients and prospective clients with a written disclosure document. See Rule 204-3 under the IAA.  An adviser can comply with this requirement by providing clients with Part 2 of the Form ADV.  This should be delivered to your prospective clients before or at the time of entering into an advisory contract. Each year, the adviser should also deliver Part 2 or a summary of material changes to each client, without charge.  A copy of each disclosure document needs to be retained and each amendment or revision that was sent to clients or prospective clients, along with a record reflecting the dates on which such disclosure was given or offered to be given to any client or prospective client who subsequently became a client.

Investment Advisers Must Have a Code of Ethics Governing Their Employees and Enforce Certain Insider Trading Procedures

 As a RIA, you are required to adopt a code of ethics. See Rule 204A-1 under the IAA.  Your code of ethics should set forth the standards of business conduct expected of your “supervised persons,” and it must address personal securities trading by these people.

The SEC has set forth certain topics that a code of ethics should include regarding personal securities traded by advisory personal.  They should include the following requirements:

(1)    Adviser’s “access persons” must report their personal securities transactions to the CCO or to another designated person each quarter.  “Access persons” are any of the supervised persons who have access to non-public information regarding client transactions or holdings, make securities recommendations to clients or have access to such recommendations, and, for most advisers, all officers, directors and partners.

(2)    “Access persons” must submit a complete report of the securities that they hold at the time they first become an access person, and then at least once each year after that. The code of ethics must also require that the access persons obtain an approval prior to investing in initial public offerings or private placements or other limited offerings, including pooled investment vehicles.

(3)   The CCO or another designated person in addition to the CCO must review these personal securities transaction reports.

(4)   The supervised persons must promptly report violations of the code of ethics (i.e., including the federal securities laws) to the CCO or to another person designated.  The adviser must also keep a record of these reported breaches.

Further, the adviser is required to establish, maintain, and enforce written policies and procedure 
that are reasonably designed to prevent the misuse of material non-public information (under Section
204A of the Advisers Act).  These policies should encompass the activities of the advisers and those
supervised by the adviser. Often included is a prohibition on insider trading within the Code of
Ethics discussed above.  Copies of the Code of Ethics are to be distributed to any supervised person,
and the adviser should obtain a written acknowledgement from the supervised person that he/she has
received it. The Code of Ethics should be described in Part 2, Item 11, of the Advisers Form ADV
and a copy should be provided to advisory clients, if they request it. 

Investment Advisers are Required to Maintain Certain Books and Records

                

As a RIA, the adviser must make and keep true, accurate and current books and records relating to the investment advisory business.  See Rule 204-2 under the IAA.  The books and records that you must make and keep include:

(1)    Advisory business financial and accounting records, including: cash receipts and disbursement journals; income and expense account ledgers; checkbooks; bank account statements; advisory business bills; and financial statements.

(2)    Records that pertain to providing investment advice and transactions in client accounts with respect to such advice.

(3)    Records that document the authority of the advisor to conduct business in client accounts, including: a list of accounts in which the adviser has discretionary authority; documentation granting the authority; and written agreements with clients, such as advisory contracts.

(4)    Advertising and performance records, including: newsletters; articles; and computational worksheets demonstrating performance returns.

(5)    Records related to the Code of Ethics Rule, including those addressing personal securities transaction reporting by access persons.

(6)    Records regarding the maintenance and delivery of your written disclosure document and disclosure documents provided by certain solicitors who seek clients on your behalf.

(7)    Policies and procedure adopted and implemented under the Compliance Rule, including any documentation prepared in the course of your annual review.

Generally, most books and records must be kept for five years from the last day of the fiscal year in
which the last entry was made on the document or the document was disseminated.  Some records
may have to be kept longer.  See Rule 204-2, paragraph (e) under the IAA.  The records must be kept
in an easily accessible location.

Investment Advisers Must Seek to Obtain the Best Price and Execution for Their Clients’ Securities Transactions

As a fiduciary, the adviser is required to act in the best interests of their advisory clients, and to seek to obtain the best price and execution for their securities transactions.  “Best execution” means seeking the best price for a security in the marketplace as well as ensuring that, in executing client transactions, clients do not incur unnecessary brokerage costs and charges.  This does not mean getting the lowest possible cost, but the best qualitative execution for your clients. A complete post on the best execution requirement will come soon. 

The SEC staff has stated that, “in directing orders for the purchase or sale of securities, you may aggregate or “bunch” orders on behalf of two or more client accounts, so long as the bunching is done for the purpose of achieving best execution, and no client is systematically advantaged or disadvantaged by the bunching.

The adviser should also seek to obtain the best price and execution when the adviser enters into transactions for clients on a “principal” or “agency cross” basis.  See Rule 206(3)-2 under the IAA.

Requirements for Investment Advisers’ Contracts with Clients

As a RIA, your contracts with your advisory clients must include some specific provisions (which are set forth in Section 205 of the IAA.  These contracts (whether written or oral) must convey that they advisory services may not be assigned to another other person without prior consent of the client.

Investment Advisers May be Examined by the SEC Staff

              

 As a RIA, your books and records are subject to compliance examinations by the SEC staff (under Section 204 of the IAA). More about examinations will be discussed in a further post and can be found at http://www.sec.gov/about/offices/ocie/ocie_exambrochure.pdf.

Requirements for Investment Advisers that Vote Proxies of Clients’ Securities

As a RIA, if you have voting authority over proxies for clients’ securities, you must adopt policies and procedures reasonably designed to ensure that you: vote proxies in the best interests of clients; disclose information to clients about those policies and procedures; and describe to clients how they may obtain information about how you have voted their proxies (these requirements are in Rule 206(4)-6 under the IAA).  Records of the proxy vote must also be retained.

                      Requirements for Investment Advisers that Advertise Their Services

                 

Certain advertisements are prohibited by RIAs.  An “advertisement” includes any communication addressed to more than one person that offers any investment advisory service with regard to securities.  Advertising must not be false or misleading and must not contain any untrue statement of material fact.  Specifically prohibited advertising includes testimonials; the use of past specific recommendations that were profitable, unless the adviser includes a list of all recommendations made during the past year; a representation that any chart, graph, or formula can and of itself be used to determine which securities to buy or sell; and advertisements stating that any report, analysis, or service is free, unless it is really free.

Note: Be cautious of free services.  This service must be ABSOLUTELY free.  If there is any sort of hidden charge it can warrant enforcement action. 

Requirements for Investment Advisers that have Custody or Possession of Clients’ Funds or Securities

RIA’s that have “custody” or “possession” of client assets must take specific measures to protect client assets from loss or theft (under “the Custody Rule”) – Rule 206(4)-2 under the IAA. 

 If you have custody of client assets, you must maintain these funds and securities at a “qualified custodian.”  This includes most banks and insured savings associations, SEC-registered broker-dealers, Commodity Exchange Act-registered futures commission merchants, and certain foreign financial institutions. With a limited exception, for client accounts over which you have custody, you must have a reasonable basis, after due inquiry, for believing that the client (or a designated representative) receives periodic reports directly from the custodian that contain specific information with respect to the funds and securities in custody.  With respect to pooled investment vehicles over which you have custody, the qualified custodian must send account statements for the pooled vehicle directly to each investor.

 If you have custody of client funds or securities that you or a related person maintains as a qualified custodian, then you must have an internal control report completed by an independent public accountant registered with, and subject to regular inspection by the PCAOB.

Requirements for Investment Advisers to Disclose Certain Financial and Disciplinary Information.

               

As a RIA, you may be required to disclose certain financial and disciplinary information (under Rule 206(4)-4 under the IAA).  This includes:

(1)    Criminal or civil actions;

(2)    Administrative proceedings before the SEC; and

(3)    Self-regulatory organization proceedings.

For more information, please visit https://www.sec.gov/divisions/investment/advoverview.htm, and consult the IAA, ICA, and the SEC website.

Section 206 of the Investment Advisers Act

Section 206 - Anti-fraud

Due to the recent charges brought against Investment Advisers by the SEC, I thought I would do a short review on Section 206 of the Investment Advisers Act of 1940 ("IAA"). 

Pursuant to Section 2(a)(11) of the IAA, an investment adviser is any person who: (1) for compensation; (2) engages in the business of advising others; (3) as to the value of securities.  An investment adviser is a fiduciary, has a higher level of responsibility with regard to their clients, and owes certain duties to its clients with regards to its practices.  See SEC v. Capital Gains.  A fiduciary has a legal obligation to act in its client's best interest and owes its clients a duty of undivided loyalty & utmost good faith.  Specifically, an investment adviser has the obligation to disclose conflicts of interests or material information and to employ reasonable care to avoid misleading its clients.  Further, through the fiduciaries duty of loyalty, a fiduciary must present investment opportunities to its client first, treat all clients equally (for example, through aggregation/allocation), and see best execution for its clients.  Material information, with regard to disclosure under the IAA, is information that would be significant and affect an investor's decision to continue its services with the adviser.  

Fiduciary obligations are effectively enforced through Section 206 of the IAA.  Section 206 of the IAA contains the anti-fraud provisions relating to investment advisers. Specifically, section 206 states, "It shall be unlawful for any investment adviser, by use of mails or any means or instrumentality of interstate commerce, directly or indirectly, to employ any device, scheme, or artifice to defraud any client or prospective client."  Section 206(1) of the IAA is scienter based fraud. 

Section 206(2) of the IAA states, "It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client."  Section 206(2) of the IAA is non-scienter based fraud.  Intent is not necessary for the SEC to bring an enforcement action under section 206(2) of the IAA.  It is important to note that if a person fits into an exclusion under section 202 of the IAA, the antifraud provisions of the IAA do not apply.  However, if the person fits into an exemption in section 2033 of the IAA, the anti-fraud provisions do apply.

IAA Section 206(3) states, "It shall be unlawful for any investment adviser ... acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction."  While still dealing with truthfulness of the adviser, 206(3) is a much more stringent in what it is trying to prevent as opposed to section 206(1) and (2) anti-fraud.

There are also several other rules under the IAA that may apply.  For example, Rule 206(4)-7 mandates that an investment adviser must have written policies and procedures reasonably designed to prevent violations, conduct annual reviews of the adequacy of such procedures, and designate a CCO.  Rule 206(4)-8 under the IAA mandates that investment advisers to pooled investment vehicles must not make any untrue statement of a material fact to any investor or prospective investor in the pooled investment vehicle or otherwise engage in
any act, practice, or course of business that is fraudulent with respect to any investor or prospective investor in that pooled investment vehicle.

As any securities practitioner will know Section 10(b) and Rule 10(b)-5 of the Securities Exchange Act, it is important to note the anti-fraud provisions that apply to investment advisers.  A later post will detail the rules under the IAA.  As a practitioner is is important to realize that a 206(1) violation holds a much heavier weight than a 206(2) violation due to the scienter requirement. 

What is a Hedge Fund?

What is a Hedge Fund?

          
           For my first post, I thought I would discuss the what makes a fund a "hedge fund" and the two main regulations that hedge funds rely on in order to be excluded from the Investment Company Act of 1940 ("ICA").
            
           Interestingly, "hedge fund" is not defined statutorily.  Historically a hedge fund was defined by what it was not, which is a registered fund under the ICA (aka a mutual fund).  "The term 'hedge fund' refers generally to a privately offered investment vehicle that pools the contributions of its investors in order to invest in a variety of asset classes, such as securities, futures contracts, options, bonds, and currencies."[i]  This closely resembles a mutual fund, however, it is privately offered and tends to operate outside of ICA registration. More recently, the SEC promulgated form PF, which is a reporting regime for private funds.  If a fund meets the required thresholds, the form needs to filled out and reported.  I will do a more detailed post on Form PF later.  This form, however, is not the same as reporting under the ICA.
           

             Hedge funds typically wish to remain outside of regulation.  Therefore, in order to be excluded from the definition of investment company under Section 3(a)(1) of the ICA, they must rely on some exclusion.  First, I will go over the definition of Investment Company under the ICA.
          
             Under Section 3(a)(1), an investment company means any issuer which:
           
            (A) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing reinvesting, or trading in securities;
            (B) is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificates outstanding; or
            (C) is engaged or proposes to engage in the business of investing, reinvesting, owning,      holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer's total assets (exclusive of Government securities and cash items) on an unconsolidated basis.
            
 Typically, any company considered a "hedge fund" will fall within 3(a)(1)(A).  Therefore, in order to stay outside of regulation the fund must rely on an exclusion or exemption from the definition of investment company.  To do this, hedge funds typically rely on Section 3(c)(1) or Section 3(c)(7) of the ICA.  
           
 Section 3(c) states, "Notwithstanding subsection (a), none of the following persons is an investment company within the meaning of this title:
           
            (1) Any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities.  Such issuer shall be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) governing the purchase or other acquisition by such  issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer....
            (7)(A) Any issuer, the outstanding securities of which are owned exclusively by persons    who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities. 
            Qualified purchaser is defined in Section 2(a)(51)(A) as any person who owns not less than $5,000,000 in investments or any company that owns not less than $5,000,000 in investments. 
           
            Therefore, a company will remain outside the definition of investment company if, without a public offering, it's outstanding securities are owned by less than 100 persons or all of its outstanding securities are owned solely by qualified purchasers.
           
            More and more funds are choosing to operate as a 3(c)(7) company due to the unlimited amount of investors in their fund and the ability to charge a performance fee (this will be discussed in a future post).  Most private fund managers, however, do meet the definition of investment adviser under the Investment Advisers Act of 1940 ("IAA") and do have to register themselves.

I am going to try to keep changing up the size of my blogs.  I didn't want to keep them extraordinarily long so this will do for now.  In a later post I will be going into the charging of performance fees and other aspects of operating outside the ICA.

Please feel free to leave any comments.  All feedback is appreciated.

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[i] THE SECRETARY OF THE TREASURY, THE BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, THE SECURITIES AND EXCHANGE COMMISSION, A REPORT TO CONGRESS IN ACCORDANCE WITH § 356(c) OF THE USA PATRIOT ACT OF 2001 (2002).

Introduction to the Blog!

Welcome to Securities Regulation Update! This is my blog that I am going to use to keep on top of the securities regulatory field.  I will be posting updates on what is going on at the SEC and just general history posts on the federal securities laws.  I hope that I can gather some discussion and improve my understanding of the law.  Enjoy.