Form ADV Drafting Tips

Purpose of the Form ADV

1. Know who is completing the form. The Form ADV Part 1 uses the term “you” throughout the document. The Form ADV Part II uses the term “applicant” throughout the document. These terms are used to refer to the registered investment advisor firm. They are not used to describe the owners of the firm, the individual investment advisor representatives, or other associated persons of the firm. When answering any question on the Form ADV, answer the question from the perspective of the investment advisor firm.
    
   For example, the Form ADV Part 1A, Item 6 requests other business activities of the investment advisor firm. Unless the investment advisor firm is registered as a sole proprietorship, “registered representative of a broker/dealer” should not be checked because the investment advisor firm is not a registered representative of a broker/dealer. The individuals associated with the investment advisor firm may be, but the registered investment advisor is not.
    
2. Know who your related persons are. While the Form ADV is focused on the registered investment advisor, information about the registered investment advisor’s related persons must also be provided. Most questions are asked about “you” or “applicant” (i.e. the firm) and its related persons. A related person includes all advisory affiliates. An advisory affiliate is an entity or natural person that is controlled by or controls the registered investment advisor. A related person also includes other entities that are under common control (i.e. ownership) with the registered investment advisor.
    
3. Understand how to calculate assets under management. The main factor when determining whether a registered investment advisor should be registered with the SEC or the individual state securities regulator is assets under management.  All things being equal, investment advisor firms with assets under management of $25 million or less must register with the state securities regulators. Investment advisor firms with assets under management of $30 million or greater must register with the SEC. Investment advisor firms with assets in between these thresholds have the option of registering with either securities regulator.
    
   What is considered assets under management and what is not can often be tricky and confusing. The SEC provides considerable guidance for calculating assets under management in its instructions for Form ADV Part 1A, Item 5.F. The SEC has provided a multi-level test to determine what investment advisory client assets should be reported as assets under management. Those levels include:
    
   1. Securities Portfolios. An account is a securities portfolio if at least 50% of the total value of the account consists of securities. For purposes of this 50% test, you may treat cash and cash equivalents (i.e., bank deposits, certificates of deposit, banker’s acceptances, and similar bank instruments) as securities. You may include securities portfolios that are:
       
      • Your family or proprietary accounts (unless you are a sole proprietor, in which case your personal assets must be excluded);
      • Accounts for which you receive no compensation for your services; and
      • Accounts of clientswho are not U.S. residents.
         
   2. Value of Portfolio. Include the entire value of each securities portfolio for which you provide continuous and regular supervisory or management services. If you provide continuous and regular supervisory or management services for only a portion of a securities portfolio, include as assets under management only that portion of the securities portfolio for which you provide such services.
       
   3. Continuous and Regular Supervisory or Management Services. In general a registered investment advisor provides continuous and regular supervisory or  management services with respect to an account if:
       
      • The registered investment advisor has discretionary authorityover and provides on-going supervisory or management services with respect to the account; or
      • The registered investment advisor does not have discretionary authority over the account, but does have on-going responsibility to select or make recommendations, based upon the needs of the client, as to specific securities or other investments the account may purchase or sell and, if such recommendations are accepted by the client, the registered investment advisor is responsible for arranging or effecting the purchase or sale.
         
   The most controversial and confusing part of calculating assets under management is the third level, when trying to determine what constitutes continuous and regular supervisory or management services. When a registered investment advisor is provided trading authorization over a client account, it can be one clear indication of assets under management, particularly when done on a discretionary basis. However, the frequency of reviews is an integral part of assets under management. In order to include client assets, the registered investment advisor must provide active and frequent service. A buy-and-hold strategy or reviewing accounts and holdings quarterly or less will likely not meet the frequency test.
    
   There are two other factors to consider when calculating assets under management: (1) What does the client agreement say? Does it provide for ongoing management services? (2) How is compensation received? If the investment advisor firm is compensated on a per-transaction basis or solely on the time spent with a client, such compensation would not suggest assets under management. However, if the investment advisor firm is compensated based on the average value of client assets over a specified period of time, it would suggest assets under management.
    
   While what to consider as assets under management can be confusing, it is clear that the following should not be considered assets under management:  (1) assets reviewed as part of a financial plan; (2) assets managed by a third party money manager where the registered investment advisor firm does not have discretion to hire or fire the money manager; (3) assets held in an account where the registered investment advisor firm is paid a commission and is not responsible for ongoing management services; (4) assets reviewed or consulted on by the registered investment advisor only at the specific request of the client and the final implementation decision is left to the client.
    
4. Fully describe the firm’s advisory services and fees. The Schedule F needs to have a full description of the investment advisory services offered and investment advisory fees charged. This is an important disclosure as it should provide material information about what the registered investment advisor firm does and how it is compensated. At a minimum the language needs to describe what investment advisory services are provided to clients, the investment advisor fees received from clients, the fee arrangements, types of clients of the registered investment advisor firm, and a description of the firm’s investment strategy.
    
   The language should explain when investment advisory fees are due, how they are calculated, if they are negotiable, the negotiating factors, and how the investment advisory fees are payable. Investment advisory fee schedules or a description of the different fee schedules must also be provided in the Schedule F. Language informing clients how services can be terminated and if the investment advisory fees are paid in advance, and how a refund may be received by the client, must also be included in the Schedule F.
    
5. Describe the registered investment advisor firm and its associated person’s other businesses and services. As part of its fiduciary duty to clients, a registered investment advisor is required to provide transparency of its other business services and arrangements. Therefore, an accurate description of the registered investment advisor firm and its related person’s outside business activities must be provided.
    
   Other business activities include, but are definitely not limited to: being registered as a broker/dealer, a registered representative of a broker/dealer, insurance activities, real estate activities, commodity operations, creating and selling limited partnerships, accounting activities, pension consulting, and law practice. If your registered investment advisor firm or its related persons are engaged in any of these activities, a description of the activity and their relationship to advisory clients must be disclosed. Moreover, in the event that such outside business activities of the registered investment advisor firm or its related persons creates a conflict of interest, then Schedule F should include disclosure language identifying this conflict of interest as described below.
    
6. Disclose all conflicts of interest. The disclosure of conflicts of interest is a duty of a registered investment advisor and one of the key functions of the Schedule F. While the Form ADV does not have a specific question that says, “Please disclose all conflicts of interest,” it is critical that all conflicts are disclosed.  Not only do securities regulators require registered investment advisors to disclose conflicts of interest as part of their fiduciary duty to clients, such disclosure also protects the registered investment advisor firm.  However, this leads a registered investment advisor to several questions such as, "What is a conflict of interest and how does an investment advisor firm identify their conflicts of interest?"
    
   When trying to determine conflicts of interest, a registered investment advisor should start with a fundamental question. How do we make money and who do we pay?  Once you figure out all sources of revenue and expenditures of the investment advisor firm, you can then follow that trail to try and determine where conflicts of interest present themselves. The following are some classic situations that can incur conflicts of interest for a registered investment advisor.
    
   1. Affiliations with broker-dealer, third-party money managers and issuers of securities.
   2. Investment advisor representatives acting as registered representatives of a broker/dealer and/or insurance agents.
   3. Receipt of 12(b)-1 fees, commissions, and other fees.
   4. Receiving or providing compensation for referring clients.
   5. Providing preferential treatment to certain clients including family members and employees of the firm.
   6. Not disclosing hidden fees such as service charges, wrap fees, expenses reimbursed by others, and fees charged to the client but retained by other parties such as brokers and custodians.
   7. Directing client transactions for soft dollar arrangements.
   8. Recommending investments that the firm or its associated persons also own.
   9. Recommending investments that the firm or its related person has a proprietary or other financial interest.
   10. The recommendation or requirement to use a specific broker/dealer or custodian.
   11. Not providing adequate disclosure to clients when the client directs the firm to use a particular broker/dealer or custodian, i.e, client-directed brokerage arrangements.
   12. Including related persons’ accounts in block trades.
        
   It is important to note that a conflict of interest is not necessarily a prohibited activity. There are often good business and operational reasons to implement a certain arrangement, but still be considered a conflict of interest. The key is to disclose the conflict of interest so that the client can make an informed decision before retaining the registered investment advisor. In addition, the registered investment advisor should develop and implement supervisory procedures to monitor such conflicts of interest.
    
7. Have an understanding of the issues that should be disclosed in the Schedule F that are not specifically requested on Form ADV. Not all required disclosures of a registered investment advisor are set forth specifically in the Form ADV questions. Therefore it is important to have an understanding of relevant SEC no-action letters, rule making initiatives, and other guidance from regulators. A registered investment advisor may fully answer all questions posed on Form ADV and still have an inadequate disclosure if the registered investment advisor firm was not aware of other Form ADV mandates set by regulators. The following are just a few of those issues.
    
   1. Disclosure of the firm’s proxy-voting policies and procedures. If your firm will vote client proxies, a summary of the firm’s policy along with information telling clients how to attain a complete copy of the policy and view proxy records must be provided. If your registered investment advisor firm does not vote proxies, but does have discretionary authority over client accounts, language describing your investment advisor firm’s non-voting policy must be included.
   2. If a registered investment advisor firm has custody of client funds (which simply means having access to or control over client funds) Form ADV Part 1A, Item 9 needs to be properly answered and a description of that activity along with how the firm complies with the custody requirements needs to be provided in Schedule F. The following are some common activities of investment advisors that fall under the definition of custody.
      • Having authorization to deduct advisory fees directly from client accounts. The SEC has stated if this is the only form of custody the firm has, Form ADV Part 1A, Item 9.A. can be marked no.
      • Holding funds and securities on a client’s behalf.
      • Signing checks on a client’s behalf.
      • Serving on the board of directors of an organization that is also a client of the firm.
      • Serving as a trustee for any non-family client trust or estate.
      • Receiving funds from the proceeds of any sale of a client’s securities in the name of the firm or its advisory representatives.
      • Having authorization to wire funds from a client’s account to any account other than one registered in the same manner as the       original account.
   3. Disclosure of trading practices such as: block trading, best execution disclosures, and recommendations of broker/dealers and custodians. When disclosing the recommendation of broker/dealers and custodians it is necessary to provide the reasons for a recommendation and material considerations used to select a broker/dealer or custodian.
   4. While it is now requested in the Form ADV Part II instructions, many registered investment advisor firms still fail to provide a summary of the investment advisor’s code of ethics and the availability of the entire code of ethics policy upon a client’s request. This is a requirement for SEC registered investment advisor firms and most state registered firms.
   5. While not required to be disclosed in the Form ADV, many registered investment advisor firms elect to include their customer privacy policy notice in the body of Schedule F. This will ensure the initial delivery of the policy notice to investment advisory clients (assuming the Schedule F is delivered to clients). Registered investment advisors must still deliver a complete copy of the privacy policy notice to all clients at least annually.
       
8. Make sure all required disciplinary and financial disclosures are made. Form ADV Part 1A, Item 11 requires registered investment advisors to provide a response to numerous disciplinary questions. In connection with an Item 11 “yes” answer, the firm must then complete a Disclosure Reporting Page (DRP) to provide details regarding the event.
    
   Reportable events include felonies and investment-related misdemeanors, regulatory disciplinary actions, court judgments related to violations of investment-related statutes and regulations by the investment advisor and its affiliated persons. That’s right; a firm must report disciplinary events of its affiliated persons which include advisory personnel. This is true even if the disciplinary event occurred at another firm or occurred prior to the individual’s affiliation with your firm. SEC registered investment advisor firms must only report events occurring within the previous 10 years; however, state registered investment advisors must report events for the time period specified in the DRP.
    
   State registered investment advisors are also required to report on Form ADV Part 1B information about a surety bond if required by the investment advisor’s home state; information about unsatisfied judgment and liens, and investment-related arbitrations and civil judicial action. These additional reporting requirements are a big difference between SEC and state registered investment advisors.
    
   Finally, Rule 206(4)-4 of the Advisers Act addresses “financial and disciplinary information registered investment advisors must disclose to clients.”  In addition to the disclosure information required on Form ADV Part 1A and Part 1B, certain events that fall under Rule 206(4)-4 of the Advisers Act must be disclosed all clients. This is a significant difference from disclosure in Form ADV Part 1A and 1B. While the public is able to view Form ADV Part 1A and Part 1B through the Investment Adviser Public Disclosure website, a registered investment adviser is not required to provide details of such events to each client. However, disclosures required under Rule 206(4)-4 must be provided to all clients. For simplicity, such disclosure can generally be provided in the Schedule F as long as all requirements of the rule are met.
    
9. Update material changes in a timely manner. Registered investment advisor firms are required to update the Form ADV no less than annually. However, there are certain updates that must be promptly made when there is a material change. A material change includes most items disclosed on the Schedule F, such as the registered investment advisor firm’s services, investment advisory fee arrangements, relationships with related persons and outside entities, changes to advisory personnel, and changes to the organization.
    
10. Visit the SEC’s website on this topic. The SEC provides help to complete the Form ADV. For more guidance about completing the Form ADV, RIA Compliance Consultants suggests consult the SEC's IARD FAQs regarding this topic.
     
    RIA Compliance Consultants provides a Form ADV drafting service as part of its turn-key Investment Advisor Registration Service for new investment advisor applicants. Additionally, we also offer a Form ADV Review and Revision service to existing registered investment advisors. For more information, please call us at 877-345-4034.

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