Compliance Alert! New Regulatory Initiatives

Dear Compliance Professional,

Big doings are certainly afoot in the regulatory world. Did I say big? These “doings” are of gargantuan proportions – earth shattering, paradigm shifting, game changing doings that will affect every financial services firm including all SEC and state-registered investment advisers. No, it is not one of my increasingly rare blog updates, but rather, the enactment into law of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Reform Act”) and the SEC’s approval of sweeping changes to Part 2 of the Form ADV.

If I sound a bit giddy, please excuse. For a compliance aficionado (read: nerd) such as myself, the confluence of these two events creates a limitless supply of compliance issues (read: work). But enough about me and on to what it means for you – the registered investment adviser.

The Reform Act

The near-term impact of the Reform Act on registered investment advisers will be somewhat limited, but the potential impact may be quite significant. The uncertainly arises from the fact that the Reform Act is, in many ways, an empty vessel waiting for the various agencies to fill it up with new rules and convoluted regulations (much in the same way the SEC regulations under the Investment Advisers Act of 1940 give meaning to the provisions of the Advisers Act itself).

Although the date for compliance has not yet been finalized, one aspect of the Reform Act that will have an immediate impact is a provision that raises the threshold for registration with the the SEC from the current $30 million to $100 million in assets under management.  This will affect approximately 4,000 SEC-registered investment advisers that will now need to de-register from the SEC and transition to registration with one or more states. Before the remaining SEC-registered advisers breath too big a sigh of relief, just remember that as a result of this mass exodus of your brethren from the ranks of the SEC, you will now be far more susceptible to SEC examination. To further enhance the odds of being examined, the SEC has requested a budget increase to add some 800 new employees.

Conversely, for those transitioning advisers that think compliance on the state-level is a walk in the park, you are cautioned to remember that a significant number of states have previously  incorporated many of the SEC’s more onerous rules (e.g, compliance, proxy voting, record keeping, privacy). In addition, some states have already beefed up their compliance staffs in anticipation of the passage of the Reform Act.

Of future – and far more reaching – concern are two provisions in the Wall Street Reform Act that could expand the jurisdiction of FINRA to all investment advisers. The Reform Act contains a requirement that the SEC study the effectiveness of the different standards of customer care governing broker-dealers and investment advisers and, if necessary, write rules aligning the standards.  A provision in the Reform Act requires the SEC to evaluate the adequacy of its oversight of investment advisers and recommend whether Congress should designate one or more self-regulatory organizations to bolster SEC supervision. This may result in investment advisers being subject to FINRA’s onerous rules-based approach.

Form ADV Part 2

First proposed in 2000, then re-proposed in 2008, sweeping amendments to Part 2 of the Form ADV have finally been approved by the SEC. The changes transform the ADV Part 2 from its current “check-the-box” format into a publicly viewable, prospectus-like brochure with narrative disclosures. The new ADV Part 2 consists of two parts – Part 2A, the “firm brochure”, which contains 19 items which the investment adviser must address and Part 2B, the “brochure supplement”, which would contain disclosures about certain key investment professionals of the advisory firm.

Some random musings on the changes . . .

Increased Liability

Will investment advisers face increased liability as a result of the proposed changes?

While many commentators will focus only on the specific changes to the ADV Part 2, there are greater issues beyond the mechanics of what the new ADV Part 2 requires.  The increased scrutiny attendant to filing Part 2 electronically; the requirement that all information be communicated in plain English; and the requirement that advisers disclose their disciplinary history all add up to a significant increase in an investment adviser’s exposure to lawsuits.  Much as securities attorneys now examine every word of a prospectus when a securities offering turns bad, imprecise language in a disclosure brochure may be used against an adviser in a lawsuit initiated by a dissatisfied client.

Increased Scrutiny

Will officials at the SEC’s Office of Compliance Inspections and Examinations be paying close attention to an adviser’s electronically filed Form ADV Part 2?

Under the new rule, SEC-registered advisers will be required to file Part 2 electronically via the IARD system.   The increased scrutiny that comes along with making a document open to the public puts advisers at greater risk of being hung by their own words (or conversely, by a lack there of).  Before these changes, SEC-registered advisers had significant control over the dissemination of their disclosure documents.  Usually provided only to potential and existing clients, an SEC-registered adviser’s ADV Part 2 has typically not been a widely circulated document. In fact, the SEC had the opportunity to view Part 2 of an adviser’s Form ADV only after an examination had commenced and the disclosure brochure specifically requested.  This meant that in most cases the SEC was not using an adviser’s primary disclosure document as part of their initial assessment of an adviser’s risk profile. As a result of the proposed changes, an adviser’s ADV Part 2will be the primary document by which the SEC determines an adviser’s risk profile.

Plain English

Will poor grammar become this year’s equivalent of the late-trading scandal?

The new rule will require investment advisers to deliver to clients and prospective clients a brochure written in plain English.  The SEC has described plain English as the use of short sentences, definite, concrete, everyday language, active voice, tabular presentation of complex information, no legal or business jargon, and no multiple negatives.  In short, the opposite of the language currently used in 99% of disclosure brochures today. When looking to other SEC documents for additional guidance, I stumbled upon an 1998 publication entitled “A Plain English Handbook – How to Create Clear SEC Disclosure Documents”.  The Handbook states that “a plain English document uses words economically and at a level the audience can understand.”  Does this require advisers who have clients with different educational backgrounds and investment experience have multiple disclosure documents?  Probably not, but focusing on the audience rather than the business usually takes far more work and, quite frankly, writing ability.



Without a doubt, there will be much more to come on both these subjects. Indeed, I suspect that volumes of information about the Reform Act and the changes to the ADV Part 2 will make its way to your email in-boxes over the next several months (some of it even from me). This Compliance Alert was simply meant to give you a taste of what is going to be a rather tumultuous year (yet again!) for investment advisers. Not to worry. Like the sure-footed Sherpa guiding a climber up Everest, I will lead you – carry you if I must – to the pinnacle of compliance. Of course, the sad reality is that during any climbing season there is always one or two individuals that step off into the abyss. On a totally unrelated subject . . . have all of you recently updated your business succession plans?