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Additional Materials for Proposed Rule: |
No. | ||
Investment Advisers and Adviser Representatives |
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Federated Investors Inc. |
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Lehrer Management Company, Inc. |
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Wellington Management Company, llp |
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American Express Financial Advisors, Inc. and |
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Thomson Financial |
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Investment Performance Services, LLC |
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Teachers Insurance and Annuity Association |
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Standish, Ayer & Wood, Inc. |
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Charles Schwab & Co. |
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D.E. Shaw |
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Merrill Lynch, Pierce, Fenner & Smith, Incorporated |
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PaineWebber Incorporated |
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Securities America Advisors, Inc. |
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Legg Mason, Inc. |
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Metropolitan Life Insurance Company |
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Frank Russell Securities, Inc. |
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United Services Planning Association, Inc. |
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Salomon Smith Barney Inc. |
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Dean R. Lycas |
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Yasmin Mansoor |
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Michael James Skinner |
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Chuck White |
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Richard E. Vodra, CFP |
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Terry W. Treiber, CFP |
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Judy Goldman, CFP |
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Greenville Capital Management |
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Prof. Aaron Brown |
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Paul J. Toohey, CFP |
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Richard K. Schroeder, CFP |
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Milton Kuninsky |
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Cornerstone Capital Management |
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The Omega Group (Donald M. Rembert) |
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Financial Management Services |
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Advanced Financial Management (Donald Steinmann) |
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Trade or Professional Associations |
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The National Association of Personal Financial Advisors |
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Association for Investment Management and Research, Advocacy Advisory Committee |
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American Institute of Certified Public Accountants |
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Consumer Federation of America |
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Investment Company Institute |
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The Financial Planning Association |
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Investment Management Consultants Association |
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Securities Industry Association |
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Council of Institutional Investors |
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Certified Financial Planner Board of Standards, Inc. |
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Investment Counsel Association of America |
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The Alliance In Support of Independent Research |
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State Securities Authorities |
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Pennsylvania Securities Commission |
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State of Washington Department of Financial Institutions, Securities Division |
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Law Firms |
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Davis Polk & Wardwell |
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Dechert Price & Rhoads |
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Jane Katz Crist |
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Wilmer, Cutler & Pickering |
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Skadden, Arps, Slate, Meagher & Flom llp |
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Pickard and Djinis llp |
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Compliance and Pension Consultants |
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MarieElena V. Ness |
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The Consortium (Nancy Lininger) |
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National Regulatory Services |
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Becker, Burke Associates |
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Individuals |
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Other |
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(investment manager for the Florida Retirement System Trust Fund) |
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(institutional stockbrokers) |
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On April 5, 2000, the Securities and Exchange Commission (the "Commission") issued a release proposing the use of an electronic filing system by investment advisers and the adoption of related rules and forms (the "Proposing Release"). The comment period closed on June 13, 2000. The Commission received 70 comment letters -- 36 of which were from investment advisers or investment adviser representatives, twelve from trade groups, two state securities authorities, six law firms, five pension consultants, three individuals, and six others. The following outline summarizes the views of those commenters who expressed general views on the Commission's proposals.1
Most commenters strongly endorsed the goals and concepts of the Commission's proposals, saying that the proposals were forward-looking and imaginative,2 were thoughtful and comprehensive in scope,3 would strengthen investor protections,4 were effective means to simplify and modernize the registration process for advisers,5 would appropriately meet the needs of both investors and advisers,6 and would enhance disclosure to investors.7 One commenter credited the proposals as "effecting the most far-reaching and comprehensive restructuring of investment adviser regulation in a generation."8 Two commenters pointed out that the Commission's initiative was timely because more investors rely on the services of investment advisers today.9 Two commenters thought the proposals also would help regulators.10
TIAA-CREF wrote that the Commission "has identified and addressed the most troublesome issues under the current regime and that the proposed rules would improve the registration process and strengthen investor protections."
Only one commenter expressed strong overall opposition to the Commission's proposals. Lehrer said that, as a single investment adviser, it would be "worse off" due to significantly increased costs versus marginal benefits from the proposed changes.11
Although supportive of the Commission's overall proposals, eleven commenters expressed specific concerns that the proposed rules would burden advisers without commensurate benefit to investors, particularly sophisticated institutional investors.12 One commenter summarized these problems by stating that the Commission needs to "strike a more reasonable balance" between costs and potential benefits from the proposed increased disclosures by advisers.13
The Investment Adviser Registration Depository (IARD) will allow advisers to make SEC and state filings over the Internet from an office computer. IARD is modeled after WebCRD, will establish a web-based database of information on advisers, and is designed to provide special filing efficiencies for state and CRD dual registrants.
Commenters on IARD were overwhelmingly in favor of the Commission's decision to create an Internet-based filing system.14 They cited the advantages of one-stop filing,15 and the simplification, increased efficiencies and modernization of the filing process for investment advisers16 as reasons for supporting the creation of IARD. The IARD was viewed as benefiting both the financial industry and investing public.17 One trade association noted that electronic filing would ease the regulatory burden on its members.18 A third industry commenter stated that electronic filing would simplify an adviser's obligation to make notice filings and recommended that states receiving notice filings be required to get them electronically.19 Lehrer agreed that the ability to file with both the Commission and various states through the Internet would save time and money, but concluded that the costs of creating and supporting the system were not justified by filing conveniences.20
Other commenters expressed support for IARD because the investing public would benefit from expanded, free Internet access to information on advisers.21 One concluded that IARD would provide the most comprehensive source of statistical information on advisers ever available and would serve as a critical database on the investment adviser industry.22 Two commenters thought IARD would encourage more uniform disclosure by advisers, which would assist the investing public.23 Two felt that if properly implemented, IARD could facilitate comparison-shopping for advisory services by the investing public.24
Several commenters had specific concerns related to the technology used in the IARD system. One commenter wanted Form ADV put on-line with the ability to complete the form using a word processor.25 One commenter thought IARD data should be distributed through the Commission's EDGAR system, pointing out that EDGAR has a proven track record for successful information dissemination.26 Another wanted advisers to be able to use alternative data systems with functionality that is not available from standard web-based interface.27
The public will have free access, through the Internet, to data advisers file through the IARD. IARD's database will include current information on advisory firms and their associated persons, including disciplinary history.
Nineteen commenters spoke positively about the benefits to the investing public of Internet access to IARD's database and disclosures written in plain English.28 One commenter acknowledged that Internet access to adviser information could benefit clients and the general public, but saw little or no benefit to advisers from this arrangement.29
Some commenters expressed concerns about making personal and proprietary information on Form ADV widely available to the public.30 Two commenters objected to having information about fees or proprietary information disclosed to competing firms or commercial users;31 one of these commenters said such disclosure amounted to unsound business practices and raised antitrust concerns.32 DE Shaw requested clarification that public disclosure of an adviser's Form ADV would not jeopardize a non-public offering of a fund managed by the adviser.
One recommended providing an educational benefit to the public by including information on IARD about current professional designations or certifications held by advisers.33 One commenter wanted to know how the public would access historical information about advisers from past paper filings, and asked if the Commission's public reference room would continue to provide copies of historical records at minimal cost to the public once electronic filing began.34 One commenter wanted an 800 number available to members of the public who don't own or use computers.35
IARD will be built and operated by NASDR under a contract with the Commission. The design of IARD is modeled after WebCRD.
Nine commenters addressed the decision to have IARD built and operated by the NASDR.36 Four expressed support for the Commission's clarifying statement in the release that the NASDR was serving only as the vendor for IARD and not as a self-regulatory organization for advisers.37
One commenter endorsed the decision to use the NASDR, citing the NASDR's proven and effective methodology for maintaining centralized files and fee payments to the states through CRD.38 One commenter asked that NASDR costs be held down and an industry advisory panel be used to monitor future costs.39
Five commenters were critical of the decision to use NASDR because of performance problems with WebCRD. One commenter questioned the capability of the NASDR to disseminate IARD data properly, alleging that in the past the NASDR had lost CRD data sent to it by the Commission.40 One commenter expressed concern that IARD looked like a "copycat" of CRD, said this was unacceptable, that CRD was a cumbersome system to use,41 and sought assurances that IARD would not be saddled with the most troublesome features of CRD.42 Another commenter said the Commission appeared to have designed some IARD filing requirements inappropriately to conform to broker-dealer activities rather than focusing on the distinctive characteristics of the advisory business.43 This commenter also said that there had been problems with CRD completeness checks expressed concern that IARD filings not be held up because of similar problems. This commenter also suggested the use of an IARD number rather than a CRD number.44 One commenter viewed with alarm the use of CRD, citing its cumbersomeness and difficulty in producing an understandable CRD document.45 One commenter said the WebCRD experience reflected an inefficient and slow web-based interface and asked that IARD filers have the ability to bypass this interface and to maintain local databases of information sent to IARD so duplicate data entry tasks could be avoided.46
NASDR will charge IARD filing fees for initial applications and annual updating amendments, and these revenues will be applied to IARD development, operation, and maintenance costs. The Proposing Release stated that the Commission expects annual filing fees to range from $200 for the smaller advisers to $400 for the largest advisers; an initial fee of approximately twice the annual filing fee will be charged when advisers make their initial IARD filing.
Five commenters expressed concern that the IARD filing fees of $200 for small firms was disproportional to the $400 fee proposed for large firms.47 They asserted that small firms are more likely to be registered with only state regulators and also are subject to state filing fees. Additionally, they felt that the large firms with many registered representatives and multiple offices around the country were the principal beneficiaries of one-stop filing and the economies of scale inherent in electronic filing. One commenter pointed out that filing on the IARD was going to be significantly more expensive for small, single-state firms under the proposed fee structure. These commenters agreed with the Commission's determination that the costs of maintaining the IARD should be borne primarily by large advisory firms and that the differential between fees for small firms and large firms should be greater.
Two other commenters asked for information about the status of an IARD filing made when the adviser's account had insufficient funds due to an error by someone other than the adviser.48 They wondered if the filing would be lost or stored in a deficiency queue. One commenter objected to having the NASDR maintain IARD accounts for advisers and wanted the Commission either to bill advisers for all fees or have the states send bills directly to advisers.49 This commenter also requested that an interactive calculator be available on the IARD site for use in calculating what an adviser owed each regulator.50
Another commenter thought the Commission's release suggested that the NASDR had fee setting authority for IARD rather than the Commission and sought assurances that only the Commission and NASAA could set fees.51
Proposed General Instructions for Form ADV provide an overview of the investment adviser registration process, including an explanation of how Form ADV is organized, an introduction to the electronic filing process and hardship exemptions, a summary of how and when an adviser must "switch" between state and SEC registration, and contacts for additional information.
Washington State recommended that instructions on "how to get further information" be moved up to the front of the General Instructions. ICAA objected to wording in proposed Instruction 8 indicating that states require an SEC-registered adviser "doing business" in that state to notice file; ICAA felt the Instruction should more accurately describe the de minimis standard effective in all but four states.52 ICAA also suggested that Instruction 9 explain that an adviser registering with the SEC may withdraw its state registration.
Proposed Instructions for Part 1A offer detail on how certain advisers should complete Items 1-5 and 10 of Part 1A.
Two commenters stated they found the instructions helpful.53 One of these, ICAA, recommended that the Commission explain how the paper and electronic versions of Form ADV will differ, and was concerned that advisers will need to see and comment on the online instructions. Crist recommended the Commission clarify the instruction to Part 1A, Item 2.A(6), regarding the scope of the pension consultant exemption.54
Washington State suggested several additions to the factors for determining whether an adviser provides "continuous and regular supervisory or management services." 55
The proposed Forms ask for identifying information in several places in order for the IARD to distinguish between individuals sharing the same name -- Schedules A and B and Disciplinary Reporting Pages would ask for a CRD number, or alternatively for a Social Security Number and date of birth. A sole proprietor would also be asked for his or her residential address, if different from the adviser's principal office and place of business. The Proposing Release explained that Social Security Numbers are needed to distinguish between persons having the same name, but that the IARD's public disclosure system would "block" Social Security Numbers and the separate residential address to protect individuals' privacy. The proposed form also would require the adviser to list a "contact person" that Commission staff can call with questions about the filing.
Ten commenters raised concerns about public access to personal identifying information or residential addresses in Part 1A.56 Commenters supported efforts to keep Social Security Numbers and residential addresses from the public, and two commenters opposed requiring disclosure of individual Social Security Numbers even on the non-public portion of IARD.57 Reasons included protecting individuals' privacy, security, and guarding against identity theft. Five commenters had similar objections, for the same reasons, to disclosure of an individual's birth date;58 one suggested that the Form require only the year of birth, not the exact date.59 Wilmer and PaineWebber suggested resolving the "same name" problem by requiring each covered person to obtain a CRD or other identifying number.60 FPA took strong exception to the proposed requirements to provide addresses. FPA pointed out that IARD would not block the address of a sole proprietor whose home was also her principal office and place of business,61 of an advisory affiliate who maintains a home office, nor of the location of the adviser's books and records.
Three commenters objected to making an adviser's contact employee information, proposed to be required in Item 1.J, publicly accessible.62 Lycas specifically objected to public disclosure of an e-mail address and fax number, to protect the adviser from being inundated with unsolicited offers, while Mansoor requested that an adviser be able to indicate it does not wish to receive calls or take on new clients.
Proposed Item 1 asks for identifying information about the advisory firm.
Apart from comments on shielding residential addresses and contact e-mail addresses, discussed above, the Commission received one comment on this Item. ICAA opposed Form ADV's use of CRD numbers, recommending that a separate IARD number be used for this separate system, but also suggested that the adviser be asked for a CRD or IARD identification number, or both. ICAA noted that this would require a conforming change on each page of Form ADV, including execution pages.
Proposed Item 2 asks for information concerning the adviser's eligibility for registration with the SEC.
No comments were received on this proposed Item.
Proposed Item 3 asks for information concerning the adviser's form and jurisdiction of organization, and its fiscal year.
No comments were received on this proposed Item.
Proposed Item 4 asks whether the adviser is succeeding to the business of another registered adviser.
ICAA commented that the instructions to this item, which require advisers that have previously reported a succession to leave this item blank, may cause problems with a completeness check. ICAA suggested that advisers be instructed to check "no" in this case.
Proposed Item 5 asks for information about the adviser's business, including the number of employees (and independent contractors) performing listed functions, number and type of clients, forms of compensation, assets under management, and types of advisory services.
Two commenters objected to a question asking how many of the adviser's employees (or independent contractors) are registered representatives of a broker-dealer. These commenters felt the information was not relevant to most advisers.63 One commenter recommended deleting a question asking for the number of employees and contractors who solicit clients for the adviser.64
ICAA objected to requiring an adviser to categorize its clients by type, arguing the task would be difficult and time-consuming for large advisers.
Proposed Item 5.F asks whether the adviser provides continuous and regular supervisory or management services to securities portfolios, and if so, asks for the dollar value of the adviser's assets under management and for the number of accounts. The adviser would be required to provide separate data for its discretionary and non-discretionary client accounts.
The proposed Item directs the adviser to follow Part 1A Instruction 5.b, which explains how to calculate assets under management when responding to the Item. ICAA found this insufficient, recommending adding another cross-reference to explain the term "securities portfolios."
NAPFA asked for clarification of which accounts the adviser should consider "discretionary."65 Washington State recommended requiring the same data for accounts not receiving continuous and regular supervisory or management services.66
Proposed Item 5.H would require an adviser to state how many clients it provided financial planning services to during the past fiscal year.
FPA raised concerns that financial planners may misinterpret the proposed Item, and asked that the Commission clarify whether "financial planning" should include portfolio management.67 ICAA, however, stated that the proposed Item did not seem important, and suggested eliminating it.
Proposed Item 5.I would require advisers that serve as portfolio managers in wrap fee programs to list those programs, and name the sponsors of those programs, on Schedule D. The adviser would be required to update this list when submitting its annual updating amendment.
The Commission received four comments on proposed Item 5.I.68 Three commenters opposed requiring portfolio managers to list wrap fee programs on Schedule D.69 Two of these argued that the list could be extremely lengthy for firms with extensive wrap fee business.70 The third, Crist, argued that since the list would likely change frequently, but be updated only annually, it would be of limited use, while ICAA and T. Rowe Price argued that advisers would find it too difficult and burdensome to keep the list current.71 The fourth commenter asked for additional guidance on what constituted a "wrap fee program."72
FPA suggested adding a question to Item 5 asking whether the adviser provides advisory services primarily or exclusively through the Internet.73
Proposed Item 6 asks for information about the advisory firm's other active business activities. Item 6.A provides a checklist of other businesses, and Item 6.B asks about other business activities not covered in 6.A. Item 6.B(3) asks whether the adviser sells products or provides services other than investment advice to advisory clients.
Commenters suggested asking whether the adviser is an accountant74 or attorney.75 One commenter, however, opposed questions on whether the adviser is also the registered representative of a broker-dealer or is another financial product salesperson, arguing the questions are inapplicable to firms.76 Regarding Item 6.B(3), Washington State recommended requiring a description of the products or other services on Schedule D, and ICAA asked the Commission to clarify whether an adviser selling interests in private investment companies should answer "yes."
Proposed Item 7.A asks about the financial affiliations and activities of the adviser and its related persons. The Item identifies areas of potential conflict of interest between the adviser and its clients. Item 7.B asks whether the adviser or a related person is a general partner in a limited partnership, and requires the adviser to list each limited partnership on Schedule D.
Two commenters opposed, as irrelevant, requiring the adviser to disclose whether it or a related person is a lawyer or accountant.77 ICAA wanted more guidance on the definition of "related person," believing that advisers would make errors in disclosing whether any related person was a real estate broker, pension consultant, or limited partnership sponsor/syndicator.
The Commission received four letters commenting on Item 7.B. Two commenters thought the question should be expanded to include situations where the adviser or a related person is the managing member of a limited liability company78 and one would also include acting as general partner in a general partnership.79 Another commenter would limit the question to investment-related limited partnerships.80 The fourth, in order to avoid lengthy filings by advisers in large financial organizations, suggested requiring disclosure only of those limited partnerships that the adviser actually recommends to clients or for which the adviser itself serves as general partner.81
Proposed Item 8 asks several questions concerning the participation or interest an adviser, or a related person, may have in client transactions. The proposed Item identifies areas in which an adviser and client may have conflicting interests.
FPA welcomed the Commission's increased emphasis on potential conflicts of interest in advisory activities. FPA supported focus on proprietary and sales interests in client transactions, investment or brokerage discretion, and client referrals and strongly supported greater transparency of these adviser activities to the consumer.
On a question asking whether the adviser recommends securities to clients in which the firm or a related person has a sales interest other than commissions, Crist asked for clarification whether the exclusion for commissions also excludes mutual fund 12b-1 fees.
Proposed Item 9 asks whether the adviser or any related person of the adviser has custody of any advisory client's cash, bank account, or securities.
ICAA asked for clarification on how advisers with "constructive custody" should respond to Item 9.82
Proposed Item 10 requires the adviser to identify, on Schedules A or B (or in some cases D), all persons who control it, directly or indirectly.
Comments received relating to this proposed Item more directly affected Schedules A, B and C, and are discussed below.
Proposed Item 11 asks for disciplinary history of the advisory firm and its advisory affiliates. The adviser would be required to complete a Disciplinary Reporting Page (DRP) to provide details of any event yielding a "yes" answer to a question in Item 11.
Two commenters stated they supported making disciplinary information easily accessible to the public.83 CFP Board noted that it makes its own disciplinary actions public and is "well aware" of the benefit and deterrent effects of disclosure.
Three commenters objected to disciplinary reporting requirements that they felt were redundant.84 They argued that advisers should not be required to report the same disciplinary information in response to Part 1A and again in the client brochure.85 ICAA suggested that the information not be repeated because the Commission will ultimately receive both Part 1A and the firm's brochure, while PaineWebber opposed being required to deliver the information to clients because the public would have access to the information through the public IARD database.
One commenter, CFP Board, objected to an adviser's ability to remove disciplinary information for advisory associates no longer associated with the adviser - the commenter felt that removal should not be permitted in cases where the adviser's oversight policies played a part in the infraction.
ICAA commented that the scope of the term "advisory affiliates" is unclear. ICAA said that because the current Form ADV specifically excludes persons who perform "support or similar functions," and the proposed form does not, it raises the question of whether persons functioning in support role are included in the proposed definition.
Finally, one adviser expressed concern that requiring the firm to disclose disciplinary information about its supervised persons would require the adviser to take on liability for information that employees may withhold from the adviser.86
As proposed, SEC-registered advisers would be permitted to limit their Item 11 responses to disciplinary events occurring in the preceding 10 years. State-registered advisers, however, would be required to continue reporting some older events.
The Commission received nine letters commenting on the proposed 10-year limit. Five commenters supported the limit,87 while three opposed it and recommended the Commission reconsider the proposal.88 The ninth commenter suggested that the Commission and states agree on uniform standards.89
One supporter noted that the limit would eliminate an inconsistency in the current Form, under which advisers must report criminal and injunctive actions only for 10 years, but other events without any time limitation.90 Opponents, however, noted that the public as well as regulators will look to this disciplinary disclosure and that members of the public may find older information relevant. One commenter argued that all prior felony convictions of an advisory firm or its investment professionals should be reported, regardless of when they occurred.91
Proposed Items 11.A(2) and 11.B(2) would ask whether the adviser or an advisory affiliate had, in the previous 10 years, been charged with any felony or with an investment-related misdemeanor. Current Form ADV asks whether the adviser or an affiliate is now the subject of a proceeding. The change would conform the questions in Form ADV to those in Item 11 of Form BD.
The Commission received seven letters commenting on these changes. All were opposed, three of them strongly.92 ICI felt that requiring disclosure of charges that had not resulted in either a conviction or a plea of guilty or nolo contendere was inappropriate, prejudicial, and at odds with principles of presumed innocence. Two commenters argued that any such disclosure be limited to charges currently pending,93 and one of these urged that the adviser be permitted to remove the disclosure immediately if the charge were dropped or the person acquitted.94 Two commenters also pointed out that employment counsel have instructed advisory firms not to inquire as to criminal charges in hiring or retaining employees, and that the proposed questions may therefore place advisers in a difficult position.95
Pennsylvania asked for an additional disciplinary question, requiring disclosure of settled customer complaints. The commenter stated that a pattern of settling numerous customer complaints may indicate that an adviser engages in abusive practices but avoids formal proceedings. Pennsylvania felt that this disclosure would assist not only prospective clients but also alert regulators to schedule an examination of the adviser.
The Commission received three letters addressing the breadth of coverage of the disclosure Item 11 of Part 1A requires, as well as differences in the disciplinary reporting standards between Part 1A and Part 2 of the Form.96
Each of these commenters had a separate recommendation for limiting the scope of Item 11 of Part 1A. All focused on whose disciplinary events should be reported, and on whether disclosure should be limited to material disciplinary events.
· AmEx suggested limiting disclosure to (in addition to the disciplinary history of the adviser) the disciplinary history of the adviser's executive officers, directors, and direct and indirect owners.97 AmEx also suggested that Part 2's materiality standard be used throughout Item 11 of Part 1A.
· Securities America suggested that an adviser reporting a disciplinary event of an affiliated firm be permitted to cross-reference to the affiliate's CRD or IARD number and web address, rather than restate details of the event, unless the disclosures would have material impact on this adviser's ability to provide advisory services. Securities America also suggested that Part 2's materiality standard be used throughout Item 11 of Part 1A.98
· ICI recommended limiting disclosure to the disciplinary history of the adviser, control persons listed on Schedules A and B, and persons affiliated with the firm in a managerial or supervisory capacity. Disciplinary history of other advisory affiliates would be included only if the information would be material to the Commission's evaluation of the advisory business or the integrity of management.99
Proposed Item 12 would ask questions necessary for the Commission to determine whether the adviser is a "small business."
No comments were received on this proposed Item.
Advisers would identify their direct owners and executive officers on Schedule A and their indirect owners on Schedule B. Paper filers would report changes in this information on Schedule C; electronic filers would not use Schedule C, but would change the information directly on Schedule A or B.
SIA supported the proposed simplified approach to control person disclosure and felt that the amended form will provide information about persons truly in a position to influence the adviser.
Two other commenters addressed Schedules A and B. Lininger supported having the same ownership schedules regardless of the adviser's form of organization.100 ICAA suggested that for further simplicity Schedules A and B could be incorporated into the text of Part 1A or combined with one other.
Schedule C would exist only for paper filers and would show just the change being effected to the adviser's ownership (it would not restate the adviser's ownership structure). Lininger found this approach confusing, and ICAA thought the release should make it clear that Schedule C will not actually exist online.101
ICAA asked for a few clarifications and instructions. ICAA asked that Schedule A question 2.a give more guidance as to who "individuals with similar status or functions" were, and suggested this term be limited to persons exercising executive responsibility or presumed to have control. ICAA also suggested defining "indirect owner" in Schedule A question 3 and stating in Schedule B question 2 that all persons fitting the listed descriptions are "indirect owners." Finally, ICAA asked, on both Schedules A and B, whether the adviser must list the enumerated relatives of any person with greater than 5% ownership.102
Advisers would use Schedule D to report additional information for specific items in Part 1A.
ICAA felt that, in an electronic environment, Schedule D, particularly multiple Schedule Ds (which an adviser would use to provide multiple responses), should be unnecessary. Lininger agreed that requiring separate pages for multiple responses could create too long a document; she specifically noted that using a separate page for each "other office" location would create a very long filing, particularly for state-registered advisers.103 Lininger would have preferred a more open or flexible format for Schedule D, comparable to the current continuation pages. Thomson suggested revising the structure of Part 1A to include more information, and, like Lininger, preferred a free-text format for Schedule D.
Lininger noted that there seemed to be no way to delete data from the "other business name" and web site fields. CFP Board thought the instruction to list all World Wide Web addresses would confuse advisers that have multiple web addresses; CFP Board recommended requiring only the URL to a home page that would function as a portal.
FPA believed that section 1.K assumed that the adviser's books and records were not at the branch office locations specified in section 1.F, but asked for clarification.
One commenter opposed the requirement to list all affiliated advisers on Schedule D.104 A large financial organization could be required to submit a lengthy schedule that would change each time the organization acquired or divested of an entity; further, each affiliated adviser in the organization would have to provide this list. The commenter suggested that, if an organization has more than three affiliated advisers, the advisers choose one of their number as the primary reporting firm and the others be permitted merely to cross-reference to the primary list. This commenter also suggested that the Commission could use Schedule D to identify "participating affiliates" (foreign affiliates that give advice to the registered adviser's U.S. clients).
ICAA suggested eliminating section 7.B's question as to the cost per unit of limited partnerships sold in the past year. ICAA noted that some limited partnerships are not sold in units, and believed that the information was not useful.
The Commission proposed to revise the format of Part II by replacing multiple-choice and fill-in-the-blank questions with a narrative brochure written in plain English. Advisers would be free to structure their disclosure in Part 2 in any way they believe best conveys the required information. The proposed format is modeled on current Schedule H, which requires wrap fee program sponsors to give clients a narrative disclosure brochure.
Commenters overwhelmingly supported a narrative format for Part 2 as an improvement over the current format. They believed a narrative format would facilitate more effective communication to clients.105 ICAA supported the new format as "a logical and meaningful step toward improving disclosure for clients." AIMR supported the proposed format "wholeheartedly," and stated it believes clients would find the brochure more useful, as would an adviser who would have "sufficient flexibility to present and explain its business practices in a meaningful way" and be able to "describe itself and its services in a way that is most relevant to the types of clients it seeks." Securities America specifically supported basing the brochure on current Schedule H, saying Schedule H's narrative format has been more useful in providing clients material information than current Part II and Schedule F.106
Three commenters indicated that they would prefer greater standardization of the brochure's format to facilitate comparison-shopping by investors.107 CFA believed that the table of contents minimizes this concern, but that a question-and-answer format similar to that often included in mutual fund prospectuses would be more helpful to investors.108 Standish thought that a check-the-box format (instead of a narrative) could be used to indicate that advisers had written policies, etc., and that advisers should be required to furnish them to clients upon request, instead of being required to describe them in the brochure. NRS said that eliminating the check-the-box format will hinder the Commission's and consumers' ability to ascertain common information among advisers and, thus, to determine adviser characteristics or to track industry trends.109
The proposed rules for brochure delivery requirements are substantially similar to the current rules -- an adviser must deliver its brochure at the start of the advisory relationship and offer to deliver it annually. The proposed rule would preserve the existing brochure rule exceptions for advisory clients that are investment companies, and certain clients receiving only impersonal investment advice, and would clarify that advisers to a limited partnership are required to deliver their brochures to each limited partner.
Federated and Wellington urged that advisers be exempt from delivering brochures to sophisticated clients.110 They argued that the RFP and other tailored disclosures these investors receive from an adviser are sufficient disclosure and that these investors are capable of evaluating an adviser without mandatory disclosure. Federated and DE Shaw suggested defining sophisticated investors as "qualified purchasers"111 under Section 3(c)(7) of the Investment Company Act for purposes of an exemption.
Dechert, DE Shaw, SIA and ICI recommended that limited partners not be considered clients of advisers for purposes of the brochure rule.112 The commenters argued that limited partners are similar to shareholders in a mutual fund, and are investing in securities rather than hiring an adviser. They also asserted that the offering memorandum and other documents that limited partners receive under the federal securities laws provide sufficient disclosure, and that any additional disclosure is unnecessary and may cause greater confusion.
Skadden argued specifically that investors in private funds should not be viewed as advisory clients, and therefore should not be subject to disclosure requirements. To support its view, Skadden submitted a lengthy memo arguing that 1) advisers do not now deliver brochures to investors in private funds because they do not consider them "clients" under the Advisers Act, 2) the offering documents make it unnecessary for these investors to receive further disclosure, and 3) a case decided in the Second Circuit in 1977, holding that investors in private funds are advisory clients, was wrongly decided.113 Skadden suggested that, instead, the Commission could adopt a new rule requiring that offering materials for private funds include information concerning the adviser and its relationship to the fund that is material to investors. Dechert also commented that the Commission should specify that brochure deliveries are not required either for private funds not registered under the Investment Company Act or for off-shore funds.
Dechert requested that, if advisers are required to give a brochure to limited partners, the adviser be allowed to include the brochure disclosure in the offering memo and any person authorized to deliver the offering memo, such as a placement agent, be allowed to fulfill the adviser's delivery requirements. Dechert also asked that the Commission expressly state that the treatment of limited partners as advisory clients is strictly limited to brochure delivery rules.
ICI was the only commenter that specifically discussed adviser-trustees. ICI suggested that disclosures by adviser-trustees be limited to primary trust beneficiaries. ICI argued that the "appropriate" person would then receive the disclosure, alleviating any confusion as to how broadly an adviser must distribute its brochure.
Proposed rules would require advisers, for the first time, to provide clients with updates promptly whenever information in the brochure became materially inaccurate. Proposed revised Form ADV would allow the adviser to deliver the update by providing clients with either a revised brochure or a "sticker" explaining the inaccuracy and providing updated information. The Commission explained that this proposal was designed to prevent clients from relying on stale disclosure.
Five commenters supported the proposed stickering requirement.114 CFA argued that the stickering requirement gave advisers a "clear mechanism" for fulfilling their updating responsibilities.115 AIMR thought that the sticker proposal "was a good one" and alleviated its concerns that the Commission would require delivery of the entire brochure when a change was made.
Commenters representing advisers strongly opposed the stickering requirement.116 They complained that delivering stickers would be very burdensome.117 Some commenters argued that the sticker requirement would inundate clients with unwanted information.118 Several asserted that delivering stickers was unnecessary because clients will have access to the updated information on the IARD.119 Several commenters suggested language be added to the brochure informing clients of the availability of this information.120 CFA, however, argued that simply making the revised information available on-line would not satisfy an adviser's fiduciary obligations. According to CFA, "it is absurd to expect that even those clients most sophisticated in the use of the Internet would routinely check their adviser's brochure on the IARD website to determine whether it had been updated."
CFA specifically disagreed with commenters that asserted that stickering would be too burdensome. It pointed out that advisers can eliminate these concerns under the proposed rules by using multiple brochures tailored to different groups, which will prevent clients from receiving notifications of changes not relevant to their accounts.
Many commenters would prefer that the Commission continue to rely on the anti-fraud provisions of the Act, which require advisers to inform clients about material conflicts but allow advisers to use different methods of disseminating the information.121 Merrill explained that it kept its clients updated through use of letters, e-mails, account statements, meetings, notices, contract amendments, and telephone calls. To many commenters, this approach has the advantage of permitting advisers to deliver updating information to only those clients for whom the information is relevant, whereas the stickering requirement would mandate that all clients receive information about any material change.122 SIA argued that the current system is more flexible and minimizes investor confusion.
Dechert urged that updating be limited to certain critical areas of information such as changes in fees, changes in key advisory personnel, conflicts of interest, disciplinary actions involving the adviser, and developments affecting the adviser's financial viability. Wellington would limit updating to when information in the brochure becomes "materially misleading" (rather than materially inaccurate). Lininger and AICPA stated that it would be helpful if Form ADV contained a (non-exclusive) list of changes that would require stickers.
ICAA agreed that the current system, under which an adviser must annually offer a new brochure, does not work well because few clients request the brochure. ICAA suggested requiring advisers to annually deliver a new brochure to clients each year and that the brochure contain a notice informing clients how to get interim updates from the adviser's web site. ICI recommended that advisers be able to use e-mail, postcards or equivalent means to inform clients of any material change, the subject matter of the revision, and how to obtain a revised brochure. Mansoor specifically opposed such an approach, however, arguing that clients are likely to "toss out" the annual brochure because it contains more information than they want to "sift through." Merrill favored using stickers to brochures for new clients, but not existing clients.
The proposed rule requires that advisers provide clients with written brochure updates promptly after the information in the brochure becomes materially inaccurate.
ICI requested clarification of the term "promptly." ICI specifically recommended that advisers be allowed to update brochures quarterly, to coincide with quarterly statements. ICI also recommended that advisers be given flexibility to provide some changed information annually, instead of promptly, to some clients.123
Eight commenters requested additional guidance on what events would trigger the proposed updating requirement.124 DP&W suggested that the triggering events be "reduced significantly." Securities America and AmEx recommended that "materiality" be based on whether the adviser's integrity or ability to meet contractual demands is threatened.125 ICI and Dechert suggested that only information critical to the advisory relationship be considered material. Three other commenters requested that the Commission publish a list of the material inaccuracies that would prompt the updating requirement.126
NRS requested clarification on whether "material inaccuracy" means only undisclosed conflict; if "material inaccuracy" includes more, NRS requested specific guidance on the definition of material. NRS warned of a "veritable avalanche" of brochure amendments and stickers as a result of a broad interpretation of the term.127
Currently advisers can deliver different brochures to different clients when they provide "substantially different advisory services" to the clients.128 Although the proposing release does not propose a change to the current rule, and the Commission did not ask comment on it, a number of commenters addressed this provision of the brochure rule.
CFA supported the current rule, commenting that firms' ability to use multiple brochures "tailored to the specific services provided particular groups of clients" would eliminate concerns with the proposed updating requirements because clients will not receive notifications of changes not relevant to their account.129
In contrast, commenters from the advisory industry wanted more flexibility to tailor brochures to particular clients.130 Federated and ICAA suggested that advisers should be able to prepare different types of brochures for delivery to institutional and retail clients. They argued that institutional clients use an RFP process or other methods to obtain detailed information about advisers and that the additional, more "generic" disclosure in the brochure is not useful to those institutional clients.131 ICI would go further and permit advisers to customize brochures for each client by omitting information that is not relevant to a particular client, i.e., they would have the rule contain no criteria for creation of separate brochures.
The proposed rule would require advisers to prepare a revised brochure annually, incorporating any stickers previously distributed, and annually offer the new brochure to clients. The proposing release requested comment on how many stickers advisers would expect to distribute each year.
Eight commenters supported preparing a new brochure annually.132 Pennsylvania recommended applying the reprint requirement only when information in the brochure has changed during the year and noted that annual reprinting would coincide with adviser's annual renewals with state regulators. Merrill said that reprinting would cause all updated information to be regularly incorporated into the brochure.
Securities America and AmEx said they thought that allowing 2 or 3 years between reprints would not be confusing to clients. Both commenters, which are advisers, stated that they do reprint their brochures each year, but advocated that reprint determinations be left to each adviser's judgment. They also noted that allowing 2 or 3 years between reprints will be less of a concern because the latest brochure would also be available online.
Mansoor and Schroeder said they thought the reprint requirement in general was too burdensome, and that clients don't want more paper.133 Schroeder recommended allowing transmission of the updated brochure by e-mail and/or postings on the adviser's website.
The CFA stated that "[t]he Commission has done a good job of outlining the information that firms should be required to provide in order to meet their obligations as fiduciaries as well as their statutory disclosure obligations to clients."
A number of commenters representing advisers, however, argued that the items would require too much detailed information and that the new brochures would be too long and complicated.134 FPA and ICAA asserted that clients are already overwhelmed with information, and will be discouraged from reviewing the brochure because of its length.135
FPA warned that requirements generally should not encourage advisers to "over-disclose," and, along with other commenters, felt that "redundancies" should be eliminated.136 Wellington argued that the brochure should not require descriptions of "internal policies and procedures," as the disclosure would be "lengthy, technical in nature, and arduous to read."
To reduce the size of a Part 2 brochure, ICI suggested that disclosure should be limited to the level of detail necessary for a client to evaluate an adviser and that advisers should be allowed to substitute general summaries for more detailed descriptions of certain items. ICAA and Standish recommended that a brochure not be required to contain details of the adviser's policies and procedures regarding conflicts, but instead that the adviser offer to provide clients with further information upon request.137
Proposed instructions to Part 2A cover a number of areas related to preparing and delivering the brochure and, to some extent, describe provisions of the brochure rule the comments on which are summarized above. Commenters offered a few additional comments.
T. Rowe Price and FPA objected to a statement made in Instruction 8(d) that "the state securities authorities require you to send them paper copies of the brochures," arguing that this is not an accurate statement of law in all states. They urged that the word "may" be inserted before "require." Crist and Thomson recommended that an adviser be required to respond only to those items relevant to its business.138
CFA urged that the Commission require that where investment advice is offered as one component of "an integrated practice" (such as financial planning), disclosure obligations should cover the full range of advisory services offered.
Proposed Item 1 contains information required on the cover page of each brochure. This would include certain identifying information and disclaimers that the SEC or state regulators have not approved the brochure. Advisers that hold themselves out as being "registered" would be required to explain that registration does not imply a level of skill or training.
Four commenters urged that the Commission not require the cover page to name a contact person.139 These commenters were concerned that this would require frequent updating as personnel changed. One stated that it would be impractical for a large firm to have a single contact person.140 Suggestions included permitting an adviser to provide the title of a person;141 referring callers to a service center,142 and not requiring advisers to update the brochure as a result of changes in the name of the contact person.143
One commenter suggested the form permit cover page information to appear on the inside cover page to give room for cover design.144 Another urged that the cover page be required to contain the adviser's home page URL and primary e-mail address to assist investors using electronic research methods.145 Another urged the addition of an 800 number by which investors could get information from the IARD, and a statement that information about the firm's registration status and disciplinary history is also available.146
FPA commented that the new disclosure requirement should state that registration "may not" imply a certain level of skill or training (instead of "does not"). FPA pointed out that many state statutes, applicable to both state and SEC registered advisers, require investment adviser representatives to pass a competency examination or possess other professional credentials.147
Under the proposed rule a new brochure must be created each year and offered to clients. Clients receiving a new brochure may not be able to discern disclosure that is new from the previous year's brochure. Therefore, Item 2 would require that the adviser prepare a summary of material changes. The summary could be immediately following the cover page or in a separate letter.
CFA strongly supported this item, asserting that the information is "essential to ensure that clients can easily locate and identify those changes." DP&W, however, opposed the item, calling it "unnecessary." Instead, DP&W urged a continuation of the current approach on Form ADV amendments filed with the Commission -- item numbers containing amendments are circled.
Three commenters were concerned that a summary of all material changes would be too long.148 ICAA suggested that the summary only list those changes that would significantly affect a reasonable client's decision to hire or retain an adviser. Lininger wrote that the summary should list those that the adviser determines warrant highlighting, but acknowledged that disciplinary information might warrant highlighting in all cases.
One commenter, CFA, supported the table of contents requirements as important to permit investors to locate topics easily. CFA would prefer, however, that the Commission mandate uniform formats for brochures so that investors could more easily compare brochures and find key information.
Item 4 would require an adviser's brochure to include information about its firm, including (a) a description of the advisory services it offers; (b) a discussion of whether and how it tailors advisory services to individual clients; (c) the amount of discretionary assets it manages; (d) a list of any periodicals it issues about securities; and (e) a list of any wrap fee programs in which the adviser participates. If the adviser participates in a wrap fee program, its brochure also would have to explain the differences between how the adviser manages wrap fee accounts versus other accounts and that the adviser receives a portion of the wrap fee.
Four commenters supported general disclosure requirements for the types of advisory services offered,149 with AIMR specifically supporting disclosure of whether the services are tailored to a client's individual needs and whether the adviser may impose individual investment restrictions. Three commenters,150 however, urged the Commission not to require specialized advisers to make additional risk disclosure, which Greenville argued could mislead clients that specialized advisers pose a greater risk than other advisers.151 CFP Board similarly objected to classifying financial planners as a specialized type of investment adviser.
ICI opposed requiring advisers to list all periodicals and reports about securities that they issue, arguing that this information would not be material to a person considering whether to hire a particular adviser.152 ICAA and Crist opposed requiring an adviser to include in its brochure a list of all of the wrap fee programs in which it participates, arguing that such disclosure "could require weekly updates to the firm brochure,"153 and is not "meaningful information for a prospective client."154 Instead, ICAA suggested that the Commission permit an adviser to state that it provides portfolio management services in wrap fee programs and that a list of sponsors is available on request.
ICAA further commented that "specialized" services needs to be better defined. ICAA also suggested that advisers be required to use the same date and method for calculating their assets under management under both Parts 1 and 2 of Form ADV.155 ICAA explained that otherwise the inconsistency would create an opportunity for advisers to select a particularly "good" month to display.
Item 5A would require an adviser to describe how it is compensated for its advisory services, provide a fee schedule, and disclose whether fees are negotiable.
Five commenters supported the proposed item.156 Standish, for example, stated that fees and fee changes are among the items that "clients would find useful in an initial and annual disclosure format."
Three commenters urged changes.157 The SIA pointed out that many advisers have different fee schedules applicable to different clients. To avoid having to prepare multiple brochures, the SIA argued that advisers should be permitted to deliver a separate document containing only the fee schedule applicable to the client. ICAA stated that the brochure should only describe generally how the adviser is compensated. Kunisky objected to making information about fees available to its competitors through the IARD.158
Item 5C would require an adviser to describe other fees or expenses that clients may pay in connection with advisory services (such as custodian fees, brokerage commissions, and mutual fund expenses) and state the amount or range of the fees.
AIMR and CFA supported disclosure of costs that may be charged to the client in excess of advisory fees, including the amounts and ranges of the fees. CFA said that investors will benefit greatly from the disclosure of these costs because it will give them "a clearer picture of the total costs" they will incur.
Eleven commenters representing investment advisers urged the Commission not to require advisers to disclose the amount or range of other fees that clients may pay.159 They argued that these fees are typically negotiated directly between the client and the other service providers,160 the adviser does not always know the amount of the fees,161 and that the third party often discloses the fees directly to the client.162 DP&W added that a "negotiated fee schedule" is considered proprietary information.163 Some commenters recommended that the item permit a general statement describing the other costs and fees that clients will incur in connection with the receipt of advisory services.164
Item 5E would require an adviser to disclose whether it (or any supervised person of the adviser) receives compensation from the sale of securities or other investment products. If so, the adviser would be required to explain that this practice presents a conflict of interest.
CFA strongly supported disclosure of transaction-based compensation and the resulting conflict of interest. According to CFA, this information should "dramatically improve the quality of information provided to clients" and may encourage firms to minimize conflicts.
CFP Board, AmEx, and Vodra disagreed that an adviser accepting commissions for the sale of securities necessarily has a conflict of interest with its clients. Dechert stated that the disclosure was useful but, to shorten the length of the brochure, suggested requiring the adviser to disclose only that it has adopted policies to address a particular conflict and offer to provide the policies to clients upon request. ICAA sought clarification that Item 5E would not require advisers to disclose payments made to employees or solicitors for obtaining new advisory accounts.
Item 5E also would require an adviser that accepts commissions to explain that clients have the option of purchasing investment products through unaffiliated brokers. CFP Board objected to the requirement, arguing that it "may lead customers to suspect that this is either preferable or required." CFP Board also objected to the proposed requirement that an adviser disclose whether it reduces its advisory fees to offset any commissions received because the disclosure might suggest to consumers that offsetting should be standard.
The Commission also requested comment on whether an adviser should be required to include in its brochure a discussion of the conflict of interest in charging performance fees.
AIMR, AICPA, and Pennsylvania supported brochure disclosure about performance fee arrangements, but did not explain why. Four opposed.165 Two of these argued that too few clients enter into performance fee arrangements to warrant brochure disclosure.166 Only those clients that meet rule 205-3's sophistication tests have performance fee arrangements, and their advisers are obligated to fully disclose the fees and the conflicts under the Act's anti-fraud rules.167 These obligations were explained in a recent Commission release adopting amendments to rule 205-3.
Item 6 would require a brochure to describe the types of clients whom the adviser generally provides advice and any minimum account requirements.
The one commenter that addressed this item, FPA, commented favorably.
Item 7 would require an adviser to describe the method(s) of analysis and investment strategies used in formulating investment advice or managing assets. If the adviser primarily uses a single method of analysis or strategy, it would be required to explain the specific risks involved. If the adviser's strategy involves the frequent trading of securities, it would be required to include in its brochure a discussion of the effects of transaction costs and taxes.
CFA and AIMR supported requiring advisers to disclose specific risks if they rely on a particular method of analysis. AIMR stated that disclosure such as this "lies at the heart of the fiduciary relationship between the client and the adviser."
Greenville and DE Shaw argued that requiring greater disclosure by advisers that primarily use a single type of investment strategy would place specialized advisers at a disadvantage -- "multi-product" advisers would not be required to provide the same level of disclosure. Thomson similarly urged the Commission to eliminate this "enhanced" disclosure and recommended that advisers only be required to disclose "to the most unsophisticated clients" that investing in securities involves a risk of loss.
Two other commenters recommended that that the Commission define the term "frequent trading of securities."168 The commenters noted that 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),169 and to the security being traded.170
ICAA also commented that practices regarding cash balances in client accounts vary so much depending on the types of accounts and directions from clients that meaningful disclosure about these practices would be difficult.
Item 8 would require an adviser to disclose in its brochure all material facts about any legal or disciplinary event involving the firm or a management person that is material to evaluating the adviser's business or the integrity of its management. The proposed item includes a list of events that, if they occurred within the past 10 years, are presumptively material. The effect of this new item would be to (i) move disciplinary disclosure currently required by Rule 206(4)-4 into the brochure,171 and (ii) expand the types of disciplinary events listed as presumptively material to reflect recent revisions to Form BD and statutory changes. The Commission requested comment on whether disciplinary disclosure should, instead, appear in a separate written document.
Most commenters addressing this item agreed with the Commission's proposal to include the disciplinary disclosure in the brochure, rather than in a separate document.172 CFA observed that including the disciplinary disclosure in the brochure offers the best approach to ensuring that clients and potential clients receive this essential information in a timely manner. USPA disagreed, asserting that the brochure should not provide detailed information but rather provide information on how an investor can obtain disciplinary information.173
Most of the disciplinary events presumed material by Item 8 would trigger a requirement to file a Schedule DRP by Item 11 of Part 1A. FPA and ICAA questioned the need to require the same or similar disciplinary information in several different places on the form. Securities America suggested that, to promote compliance, the disciplinary events presumed material by Item 8 should be the same ones reported in Part 1A. ICI and AmEx recommended that the Commission clarify that disciplinary information advisers provide in their brochures should be a summary and need not include all the information that must be included on a DRP. Pennsylvania wanted advisers to be required to place the disciplinary information at the beginning of the brochure.174 CFA recommended that disciplinary information be prominently displayed with a separate, mandatory subheading.
Several commenters addressed the scope of the presumption contained in the item. Florida Board and AIMR argued that information about all disciplinary events, particularly felony convictions, is relevant to investors and thus would not limit the presumption to events occurring within the last ten years. FPA, SIA175 and ICAA argued against presuming that pending, investment-related criminal proceedings are material.176 These commenters argued that advisers should be required to disclose only disciplinary events that are the result of a final order or judgment.177 Pennsylvania, however, recommended that advisers also be required to disclose settled customer complaints.178
If an adviser did not disclose a disciplinary event because the adviser determined that it had rebutted the presumption of materiality, the adviser would be required to keep a file memorandum to memorialize the adviser's determination.
ICAA, the only commenter that addressed this proposal, supported it.
Item 8 would require advisers subject to an SEC administrative order to provide clients and prospective clients with a copy of that order for a period of one year following the date of the order. This would be a new requirement reflecting the remedy included in the settlement of several SEC administrative proceedings.
Seven commenters opposed requiring advisers provide clients with copies of SEC administrative orders.179 Six argued that this should remain a subject for settlement negotiations.180 T. Rowe Price commented that "[a]lthough it may be appropriate to require delivery of an Order as a condition of settlement, it is not appropriate to impose a blanket requirement." AmEx and ICI argued that not all orders would be material to clients.181 PaineWebber and Wilmer argued that this requirement may complicate the resolution of administrative proceedings.182 Lininger recommended that, rather than requiring advisers to deliver copies of SEC orders, advisers should offer in their brochures to deliver copies of SEC orders.
The proposing release requested comment whether SEC-registered advisers should be required to disclose certain arbitration proceedings if the claim was in excess of $2,500; whether the requirement should be limited to arbitration awards rather than claims; whether the threshold amount should be higher; and how the types of arbitrations that must be disclosed could be limited to those that are material.
Four commenters, Pennsylvania, AICPA, Lininger, and CFA, supported required arbitration disclosure. Pennsylvania and AICPA would limit disclosure to arbitration awards (not just claims).183 Lininger supported requiring disclosure of claims so that the disclosure required of SEC-registered advisers would be uniform with the proposed state arbitration disclosure requirements in Item 20 of Part 2A.
CFA supported disclosure of all claims and awards. CFA acknowledged that today it is not possible to distinguish arbitrations that reflect upon the integrity of the adviser because arbitrators do not necessarily publish findings with their awards. CFA argued that this is the result of a securities industry decision not to require arbitrators to publish findings. CFA argued that therefore, "[u]ntil the industry agrees to require findings as part of the arbitration process for securities disputes, reporting should extend to all arbitration awards, not just those in which an arbitrator finds a violation of an investment-related statute."
Eleven commenters opposed required disclosure of any arbitration liability.184 Wilmer asserted that an arbitration award is not an indication of wrongdoing, and AmEx argued that an arbitration award does not necessarily reflect on the integrity of the adviser. SIA and ICI noted that arbitration proceedings may, if warranted, result in SRO or other regulatory actions that an adviser would be required to disclose. DP&W characterized disclosure of any arbitration claims or awards as "unduly prejudicial" and having a "chilling effect on the use of arbitration."
Commenters who opposed arbitration disclosure urged that, if the Commission does require disclosure of arbitration liability, any disclosure requirement be limited to arbitration awards, and also suggested threshold amounts ranging from $10,000 to $50,000.185 Four wanted disclosure further limited to arbitrations involving "investment-related statutes."186 One would limit disclosure to those arbitrations that reflect on the integrity of the adviser and resulted in an award of more than $20,000.187
FPA took no position on whether the Commission should require disclosure of arbitrations, but argued that, if the Commission does impose such a requirement, only arbitrations resulting in an award of at least $10,000 should be disclosed.
Item 9 would require an adviser's brochure to include information about the adviser's other financial industry activities and affiliations, and to describe any conflicts these arrangements or affiliations present and the practices or procedures the adviser follows to address the conflicts.
CFA strongly supported the item. Its comment letter noted that these activities and affiliations create significant conflicts, and that the required disclosure will "significantly enhance client understanding of these relationships."
FPA asked for clarification of the interaction between Item 9(D) (conflicts when the adviser recommends other advisers from whom it receives compensation or has a material business relationship) and Item 13(B) (description of cash solicitation arrangements). FPA asked which item picks up compensation-sharing arrangements, and argues that 13(B) is the better item. FPA also requested clarification of what a "business relationship" would be and whether it would include providing business referrals. Thomson also asked for greater clarification as to what would constitute a material business relationship.
CFP Board urged that the item not combine advisers and financial planners because the public will think they are one and the same. ICAA argued that advisers should not be required to disclose internal procedures.
Item 10 would require advisers' brochures to discuss the conflicts of interest advisers face when the advisory firm or a related person has a financial interest in, or trades in, securities they recommend to clients. This item would require disclosure of an adviser's policies on personal trading by employees.
Most commenters who commented on this item acknowledged that advisers must disclose these conflicts of interest to their clients.188 Five commenters generally supported disclosure of personal trading policies in advisers' brochures.189 ICI, ICAA, Dechert, and Wellington expressed concern that this item would require too much detailed disclosure and would add substantially to the length of advisers' brochures. ICAA and ICI recommended that advisers be required to describe policies and procedures in only general terms; ICAA and Wellington suggested that advisers should be required to offer to provide further information.190 Dechert and Standish suggested that advisers merely state whether they have adopted policies addressing these issues and offer to provide them to clients upon request.
Standish opposed disclosure of policies, practices and procedures in advisers' brochures, arguing that this information is not useful to clients.
AICPA asked for additional guidance as to when an adviser has a material financial interest in an issuer of securities it recommends to clients, and when an adviser has a material financial interest and recommends that clients buy shares of a company's IPO. AICPA suggested that in both of these instances advisers be required to disclose the advisers' interest.
The Commission proposed to require an adviser's brochure to describe the adviser's policies and practices in selecting brokers for client transactions, and in determining the reasonableness of brokers' compensation. The Item then goes on to specify some of the required disclosure regarding conflicts.
Commenters generally supported disclosure regarding the adviser's policies and practices in selecting brokers and their compensation, which is currently required brochure disclosure.191 The Alliance, however, asserted that advisers are not usually in a position to determine the reasonableness of spreads and supported amending the item to exclude such a requirement.
Five commenters expressed concern that this item would require too much detailed disclosure and would add substantially to the length of advisers' brochures.192 ICAA and ICI recommended that advisers be required to describe policies and procedures in only general terms; ICAA and Wellington suggested that advisers should be required to offer to provide further information. Dechert and Standish suggested that advisers be required only to state whether they have adopted policies addressing these issues and offer to provide them to clients upon request.
Item 11 would require an adviser that receives research or other products or services in connection with client securities transactions (soft dollar benefits) disclose the adviser's practices and discuss the conflicts of interest that result. An adviser accepting soft dollar benefits would be required to explain that the adviser benefits because it does not have to produce or pay for the benefits acquired with soft dollars, and explain that the adviser therefore has an incentive to select or recommend brokers based on its interest in receiving the benefits rather than the clients interest in getting the best execution services at the lowest cost. In addition, an adviser would disclose whether it seeks to allocate soft dollar benefits to client accounts proportionately to the soft dollar credits the accounts generate.
While some commenters acknowledged that soft dollar practices by advisers create conflicts with clients,193 many objected to the conflicts the Commission identified for disclosure.194 A common complaint was that the requirements inappropriately cast aspersions on soft dollar practices and may cause clients to avoid advisers that have soft dollar arrangements, which themselves are not per se illegal.195 SIA argued that advisers should have flexibility in the way they describe their soft dollar practices and any resulting conflicts of interest.196
ICI and Vodra were concerned that the required disclosures could lead clients to infer that soft dollar arrangements are harmful and therefore adverse to the client's interest. The Alliance objected to disclosure that an adviser benefits from soft dollar arrangements, because the adviser typically is under no obligation to produce or purchase the research that it obtained (through soft dollars) for the benefit of clients.197 The Alliance also disagreed with what it called "the assumption of [the] disclosure item" -- that brokers providing soft dollar benefits charge higher commissions. ICI argued that the disclosure suggested that advisers would violate their best execution obligation.198
Three commenters objected to requiring an adviser to disclose that it does not allocate benefits proportionately to brokerage credits generated.199 The Alliance asserted that advisers, as a practical matter, cannot attribute commissions paid by certain accounts to benefits and that this is reflected in Section 28(e), which specifically permits advisers to disregard account attribution. The ICI suggested that advisers be required to make the same disclosure required today - whether research is used to service all accounts or just those that paid for it.
Frank Russell and The Alliance applauded the Commission in drafting the item to require disclosure of both proprietary and third-party research. Florida Board generally supported the Item.
Client Referrals: The brochure also would be required to discuss the adviser's practice in using client brokerage to reward brokers that refer clients.CFA supported the requirement that advisers disclose payments for client referrals or other benefits.200
Transaction Costs: Item 11 would require the adviser to describe whether it negotiates commissions, and bunches trades to obtain volume discounts on execution costs.Four commenters opposed requiring advisers to disclose whether they negotiate commissions.201 The Alliance argued that it is incorrect to assume that brokers who negotiate commissions provide lower cost executions, and that advisers may be able to obtain lower commissions without negotiating by simply selecting brokers who charge lower commissions. ICAA asserted that the requirement to disclose whether an adviser negotiates commissions could penalize small firms that are not able to negotiate commissions.
The Alliance objected to the proposed bunching disclosure and, in particular, to the proposed requirement that an adviser disclose that a failure to bunch trades when the opportunity exists will impose costs on clients. The Alliance argued that whether bunched trades would result in lower execution costs depends on the facts and circumstances of each trade, and that whether an adviser has the opportunity to bunch is a highly subjective determination.
Item 11 would require the adviser to explain the consequences of clients directing brokerage, including the possibility that their accounts will pay higher commissions and receive less favorable execution.
Two commenters disagreed that clients who direct brokerage get worse execution or pay higher costs.202 Frank Russell observed that client direction is frequently qualified by the requirement that the adviser direct trades only to the extent that best execution can be achieved.203 Frank Russell argued that advisers should be permitted to decide the extent of any disclaimer.204 The Alliance did not oppose disclosure regarding directed brokerage and commission recapture, but expressed concern that advisers may not be in a position to assess whether such an arrangement will in fact cost a client more money.
CFA strongly supported requiring advisers that require clients to direct brokerage to specified broker-dealers to disclose that not all advisers require this and, if the adviser is affiliated with the broker-dealer, to describe the conflict of interest it presents.205 ICAA supported the requirement that advisers state whether they permit clients to request directed brokerage arrangements. Florida Board generally supported the proposed Item.
Two commenters requested that the Commission clarify the term "paying up."206
Frank Russell suggested that, rather than including under directed brokerage (in Item 11.A.3.a) the practice where an adviser requires clients use a particular broker, adding a new section, Mandatory Brokerage Practices, that would require an adviser to disclose whether it (1) requires that a particular broker be used or (2) conditions to the level of fees or services upon the selection of the broker.
Item 11 would require certain advisers to provide information about commission recapture programs.
BNY ESI and Florida Board supported the requirement that advisers be required to help their clients to establish commission recapture programs.
Seven commenters opposed the requirement that advisers disclose certain information about commission recapture programs.207 ICI and ICAA argued that these programs do not carry the same potential for conflicts of interest as other brokerage arrangements covered by Item 11 because the benefits inure to the client. ICI also stated that because a recapture program usually is an arrangement between a client and a broker-dealer, it is inappropriate to require disclosure by the client's adviser. SIA argued that commission recapture is largely a client- or broker-initiated arrangement. T. Rowe Price suggested that such disclosure may imply that the adviser endorses these programs or that the adviser is in a position to assist clients in setting up such programs. The Alliance and DP&W objected to the requirement because it could have the effect of promoting commission recapture arrangements.208
Item 12 would require an adviser to discuss how often accounts are reviewed, the circumstances that would trigger a special review, and how often client reports are disseminated.
FPA indicated it supported the item as consistent with CFP requirements and helpful to clients in understanding the financial planning process. CFA also supported the item, noting that clients may find this information useful when comparing the level of services offered by different advisers.
Item 13 would require an adviser to disclose payments made to persons for client referrals, and whether the adviser receives any benefit, including sales awards and prizes, for providing advisory services to clients.
CFA supported the item, and urged that the Commission clarify that it covers benefits for related services.
Item 14 would require advisers that have custody of client assets to make certain disclosures regarding the risk attendant to this practice. Advisers that are banks, insurance companies or broker-dealers would not have to make the risk disclosure.
CFA supported the proposed item. ICAA agreed with the proposed Item as it would apply to an adviser with actual custody, but called for clarification with respect to advisers having "constructive" custody. CFP Board opposed the proposed risk disclosure because it believes that such disclosure implie