Gregory J. Nowak, Esquire, Partner at Pepper Hamilton LLP, contributed the following piece.
Many of the changes to Form ADV are housekeeping changes and clarifications, but several break new ground.
In a long-awaited move, the SEC released amendments to Form ADV, the uniform form used by investment advisers to register with, or report to, the SEC and state securities authorities. The changes are effective for filings made on or after October 1, 2017.
Many of the changes to Form ADV are housekeeping changes and clarifications. Others reflect an evolution of the asset management business. Still others ask for pointed information about certain aspects of traditional asset management businesses. Several of the changes, however, break new ground: They are addressed in this article.
Item 8, Participation or Interest in Client Transactions, Questions H and I
The amended form breaks Question 8.H. into two parts. The first asks for the adviser to state whether it or any “related person,” directly or indirectly, compensates any “person” that is not an “employee” for “client referrals.” These are all terms of art.
Under SEC definitions, the term “client” means any person to whom the adviser provides advisory services, even persons who receive such services but do not pay any compensation to the adviser. For example, uncompensated accounts are considered to be clients of the adviser if the adviser provides advisory services to the account. On the other hand, after the decision in Goldstein v. SEC, No. 04-1434 (D.C. Cir. 2006), the term “client” is narrowly construed to mean just the advisory clients of the firm. Investors in a fund are not clients of the adviser; they are investors in the fund for these purposes.
The term “related person” means all persons under common control with the adviser as well as all of its “advisory affiliates.” “Advisory affiliates” means (1) all of the adviser’s officers, partners or directors (or any person performing similar functions); (2) all persons directly or indirectly controlling or controlled by the adviser; and (3) all of the adviser’s current employees (other than employees performing only clerical, administrative, support or similar functions).
So now, if an adviser compensates any person who is not an employee for client referrals, the adviser will answer “yes” to Question 8.H.1.
With respect to Question 8.H.2., the question now reads: “Do you or any related person, directly or indirectly, provide any employee compensation that is specifically related to obtaining clients for the firm (cash or non-cash compensation in addition to the employee’s regular salary)?” The SEC has added the following as a clarification:
In responding to Items 8.H. and 8.I., consider all cash and non-cash compensation that you or a related person gave to (in answering Item 8.H.) or received from (in answering Item 8.I.) any person in exchange for client referrals, including any bonus that is based, at least in part, on the number or amount of client referrals.
On its face, this is a simple yes/no question. If an adviser pays an employee compensation that is tied to client referrals, the answer is “yes.” Also, looking at the definition of “client,” it is important to realize that we are talking about the clients of the adviser, i.e., new separately managed accounts, new fund mandates and other arrangements where the adviser is under an investment management agreement with the “client.” Note, the question is not asking for variable compensation tied to raising assets in a fund or other pooled investment vehicle.
At that, many advisers will breathe a sigh of relief. However, one must think several steps down the road, in particular, when the SEC arrives for a routine review. One of the things that the SEC always does is match the answers on Form ADV with the practices of the firm. The SEC representatives likely will ask for all employee compensation arrangements, and, because the adviser has subjected itself to the SEC’s jurisdiction by becoming a registered adviser, the adviser will be obliged to provide copies of, or descriptions of, those compensation arrangements.
If those compensation arrangements have not been tailored to pay for just raising “clients” of the adviser (but also address compensation arrangements for finding investors for the funds managed by the adviser that are considered clients of the adviser), there may be an issue. That is to say, if a manager runs both a separate account advisory business as well as a fund business, it is possible that the manager’s internal sales personnel are compensated in the same way for raising assets regardless of the vehicle for or in which they are raised. That is because an adviser does not generally want to emphasize one form of asset raising over another. It would be difficult to design compensation structures that provide certainty of compensation computation for those internal employees who are raising separate account assets but then provide that those same employees cannot count on any guaranteed compensation percentage or amount if the employee is successful in raising assets for a fund.
Why does this matter? The SEC has, on numerous occasions, made it clear that it believes that anyone, including an employee of an advisory firm, who is compensated directly with a “salesman” stake in referring investors to the funds is, in effect, selling securities and any compensation tied to the placement of securities either must fit an available exception (the narrow finder’s exception) or be paid only to a registered broker/dealer for further dissemination to persons who are registered representatives of that broker/dealer (i.e., the registered representatives must be affiliated with a registered broker/dealer even though they are also employees of the adviser).
The new Form ADV Question 8.H. asks about compensation paid for raising “client” assets. If a compensation program does not provide for a separate discretionary-only bonus for raising fund assets, the SEC’s review likely will encompass the details of the bonus program for raising fund assets that has not been separately administered.
The revised supplemental frequently asked questions (FAQs) that the SEC delivered with the revisions to Form ADV do not shed any additional light on the issue. This is one area where compliance, sales and operations need to be very careful and tailor a compensation program that meets the SEC’s requirements. That would mean that all variable compensation tied to raising assets for co-mingled pools managed by the adviser would need to be based on discretionary factors alone and not tied — through an explicit reference in the plan itself, or an email, or a “wink and a nod,” or some other arrangement — to the actual raising of fund assets, unless a registered broker dealer is interposed and the payees are licensed representatives of such broker dealer.
Item 8.I. makes it clear that an adviser cannot do an “end run” around these rules by having an affiliate, such as a parent company, compensate an employee directly or indirectly for client referrals.
Other Changes: Item 1, Identifying Information; Item 2, SEC Registration; Item 3, Form of Organization
Other changes to Form ADV include Item 1.I., where information about the firm on publicly available social medial platforms must be disclosed. If this information is not managed by the adviser, then the FAQs make it clear that the social media account can be ignored.
Item 1.O. states that, in disclosing whether or not the adviser has $1 billion or more in assets on the last day of its most recent fiscal year, the adviser should focus on just its own total proprietary assets and not assets that it manages on behalf of clients (whether or not they appear on the balance sheet of the adviser).
In deciding whether federal or state registration is appropriate, Item 2.B. now clarifies a previously misunderstood provision by tying the definitions of “venture capital funds” and of “private funds,” and of “assets under management” of private funds back to the relevant rules (in the case of venture capital funds, Adviser’s Act Rule 203(l)‑1, and, in the case of private funds and counting assets for private funds, Adviser’s Act Rule 203(m)‑1).
Item 3 acknowledges that the SEC has allowed the filing of umbrella registrations. Form ADV, however, is to be filled out with respect to the “filing adviser entity only.”
Item 5, Information About Your Advisory Business
New Item 5.K. focuses exclusively on separately managed account (SMA) clients. If an adviser manages SMAs, there is a whole new disclosure component added to Form ADV Schedule D. Form ADV now asks for whether the adviser engages in borrowing transactions on behalf of any of the SMA clients that the adviser advises. It also asks if the adviser engages in derivative transactions on behalf of SMA clients and then asks the adviser to determine if any custodian holds 10 percent or more of the regulatory assets under management after backing out those that are subject to borrowings and derivative transactions. New information must be provided in Schedule D for each custodian engaged in separate account management. New Item 5.K. is an increased recordkeeping burden for the adviser.
Item 7, Financial Industry Affiliations and Private Fund Reporting
Item 7 increases the focus on so-called “umbrella registrations” as well as the concept of “relying advisers.” So-called “relying advisers” are now reported on new Schedule R. In what is one of the more confusing aspects of the new form, however, Schedule R only applies to a certain class of relying advisers, namely those that were covered in the response to Question 4 of the 2012 ABA letter that the SEC preparedon January 18, 2012 (2012 Staff Letter).
The exception previously provided for in Question 4 now has been codified in Form ADV. If an adviser sets up special-purpose vehicles (SPVs) as described in a prior 2005 Staff Letter and the 2012 Staff Letter to the ABA to act as, for example, the general partner of a limited partnership, and where that SPV relies on the registered adviser’s registration with the SEC rather than separately registering as an adviser, the SEC had allowed that SPV to be listed on Form ADV. In response to the question of whether the new Form ADV and Schedule R are repealing that rule, the SEC stated:
No, the 2005 Staff Letter and 2012 Staff Letter continue to represent the staff’s position. The staff would not recommend enforcement action to the commission against an SPV that does not file a Schedule R but meets the fact patterns and conditions described in the 2005 Staff Letter (and described in the 2012 Staff Letter as the “2005 conditions”).
So, for example, if an adviser sets up an SPV to act as the general partner of a pooled investment vehicle and wants the SPV to be considered a registered adviser, it will still file and rely on the no-action letter position as set forth in the SEC’s 2005 and 2012 no-action staff letters.
Form ADV Schedule D at Section 1.I. requires all available social media platforms where the adviser controls the content to be listed, including all addresses for the accounts. The obvious question is why does the SEC care? And the answer is: These social media platforms constitute advertising. That means all statements must meet the advertising standards of the SEC — no puffery and no cherry picking, returns must be stated net of fees and expenses, model/back-tested data must be disclosed as such, and, of course, everything must be demonstrably accurate and true.
Certain Other Changes
On Schedule D, Section 5.K.(1), the SEC asks for substantial — and new — information about SMAs. In particular, the SEC asks for a breakdown of assets that are invested in derivatives, registered invested companies, business development companies and pooled investment vehicles, each being reported in these categories. For these purposes, cash equivalents could include bank deposits, certificates of deposit, bankers’ acceptances and similar bank instruments. Note, they do not include digital currency. For certain purposes, digital currencies are deemed to be securities and, just like any other investment, would be listed in other categories on the form. When it is not an actual investment/security, digital currency will be treated as a commodity under rulings by the Commodity Futures Trading Commission. The most important takeaway from here is that digital currency is not “currency” for these reporting purposes.
The continuation of Schedule D, Section 5.K.(2)(a), indicates that, if regulatory assets under management are at least $10 billion, the manager must complete new midyear and end-year reports under this item that show the amount outstanding with respect to various derivative positions. (For a small adviser, reduced reporting is required under Question (b)). The scope and tenor of these questions make it clear that the SEC is focused on systemic risk as manifest in securities lending and derivative transactions.
In Schedule D, Section 7.B.(1)A., dealing with private funds, at Question 23(h), the SEC has closed down what was viewed by some as a loophole to the GAAP reporting requirements. Now, the question states: “Do all of the reports prepared by the auditing firm for the private fund since your last annual updating amendment contain unqualified opinions?” It is no longer possible to get a GAAP opinion for the overall audit with an exception letter with respect to one or another reporting matter. For these purposes, “unqualified opinion” means an unqualified opinion for all reports from the auditor with respect to a private fund. (This is of significance for compliance under the SEC’s Custody Rule.)
Schedule R, as added by the amendment, is new and attempts to address, in the interests of comity, a simpler way to file reports for a large consolidated/integrated advisory business. Whether it is simpler to file a separate Form ADV or to file the Schedule R is a matter of opinion and would probably consume a number of firms in attempting to determine whether or not it is easier to separately register than file the Schedule R.
The revised form is to be used for “other than annual” amendments and all annual amendments that must be filed on or after October 1, 2017. For advisers with a December fiscal year end, the mandatory next use of this form will be for the annual amendment due by March 31, 2018. It is essential that compliance officers and operations personnel address the issues presented by the revised form between now and the end of the year in order to make sure all aspects of their reporting are as the firm wants them prior to the effective date of and due date of their next report.
If the reader has any questions, feel free to contact the author, Gregory J. Nowak.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.