This winter has been especially cold and brutal. Normally, this would add to the many reasons we welcome the warmth of spring. However, this year spring brings with it an unwelcome guest – regulation. If you are not yet ready, it’s time to get started. As a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act, fund managers have to start thinking of themselves as “investment advisers” required both to register with either the Securities and Exchange Commission (SEC) or the state(s) in which they operate and comply with a wide array of reporting, operational and behavioral obligations – all by July 21, 2011.
Fund managers have a lot to do before they register. This article will introduce some of the action items required to register and comply with the Investment Advisers Act including: gathering relevant information; completing the Form ADV; obtaining a CRD number for the Investment Advisers Registration Depository (IARD); appointing a Chief Compliance Officer (CCO); training personnel; updating record keeping procedures; assessing their business and operations; and developing appropriate compliance programs, manuals and code of ethics, to name a few.
In order to register as an investment adviser, an applicant must file the investment adviser registration form (Form ADV) with the SEC. To do this, every investment adviser must first establish an IARD User Account by submitting a properly executed paper copy of the IARD Entitlement Package to the Financial Industry Regulatory Authority (FINRA). Upon completing the Entitlement Program submissions an adviser will be assigned a CRD identification number, and will be given a user ID and password to access the IARD. After receiving access, advisers must deposit funds into an account with FINRA. The appropriate fees will then be deducted from the adviser’s account when Form ADV is filed.
There are two parts to Form ADV: Part 1 provides information about the investment adviser and its affiliated persons, and Part 2 is a narrative “brochure” provided to clients (until recently this had been designated “Part II”). Part 1 is divided into two sub-parts: Part 1A, which must be completed by all investment advisers registering with the SEC or with state securities authorities, and Part 1B, which must only be completed by those investment advisers registering with state securities authorities. Part 2 is also divided into two sub-parts: Part 2A, also known as a “brochure,” and Part 2B, also known as a “brochure supplement.”
Part 1A and Part 2A of Form ADV must be filed electronically through the IARD. The brochure and brochure supplement must also generally be delivered to each client of an investment adviser at or prior to when the adviser enters into an advisory agreement with such client.
Upon submission of Part 1 of Form ADV by an investment adviser, the SEC will examine the filing for compliance with the Investment Advisers Act and, within 45 days after such filing, grant registration or institute a proceeding to determine whether to deny registration. Managers should note, however, that the SEC may grant registration substantially faster, since Forms ADV are not typically given detailed preliminary review. Managers should therefore be certain that it is fully compliant in all respects with the Investment Advisers Act, and ready to file Form ADV no later than June 6, 2011. Additional time should be allotted if disciplinary actions are disclosed in Form ADV.
In Part 1 of Form ADV, an investment adviser must provide information with respect to itself and persons associated with it. This information includes basic identifying information including: names under which it conducts business; contact information; corporate organization/employees; general information about clients; how the adviser is compensated and the adviser’s assets under management; the identity of persons controlling the adviser; and the disciplinary history of the adviser, its employees, officers, directors, owners and other related persons.
Disclosures relating to this last point are a red flag for additional scrutiny by the SEC, resulting in delays in the registration process and, potentially, denial of registration. These disclosures broadly include (i) criminal or civil actions where the adviser or a management person of the adviser was convicted, pleaded guilty or “no contest,” or was subject to certain disciplinary actions with respect to conduct involving investment-related businesses, statutes, regulations or activities; fraud, false statements or omissions; wrongful taking of property; or bribery, forgery, counterfeiting or extortion; (ii) administrative proceedings before the SEC, other federal regulatory agencies, or any state agency where the adviser’s or a management person’s activities were found to have caused an investment-related business to lose its authorization to do business; or where such person was involved in a violation of an investment-related statute or regulation and was the subject of specific disciplinary actions taken by the agency; and (iii) self-regulatory organization (SRO) proceedings in which the adviser or a management person was found to have caused an investment-related business to lose its authorization to do business; or was found to have been involved in a violation of the SRO’s rules and was the subject of specific disciplinary actions taken by the organization.
Part 2A of Form ADV, typically called the “brochure,” requires an adviser to provide certain information that is typically found in a fund’s offering memorandum. The disclosure in the brochure, however, must be presented in succinct and clear narrative form and include the items specified by the SEC. These include descriptions of: advisory business and services; assets under management; how the adviser is compensated (including performance fees); expenses clients are required to bear; types of clients; methods of analysis and investment strategies; and disclosure of disciplinary events that would be material to the evaluation of the adviser’s business or integrity.
Part 2B of Form ADV requires an adviser to disclose information regarding the “supervised persons” who formulate investment advice for clients of the adviser or who have discretionary authority over an adviser’s clients. In the case of a private investment fund, where direct advisory contact with investors is not the norm, these persons are typically the members of the fund’s investment committee and other senior investment professionals. The information required to be included in a brochure supplement includes information regarding the supervised person’s educational background and business experience, disciplinary information, other business activities, additional compensation and supervision.
Each registered adviser is required to establish and maintain policies and procedures reasonably designed to prevent violations of the Investment Advisers Act and of rules and regulations related to that Act as well as to detect and correct violations that occur. Since the Investment Adviser’s Act is – for the first time – being made applicable to managers of private equity funds, many of the practices that are common to investment advisers and fund managers in the public securities markets will have only limited relevance to a private equity fund manager. Nevertheless, the culture of compliance that all investments advisers are expected to inculcate in their operations is of crucial importance to the SEC, and a fund manager should consider ways to implement all of the referenced policies, rather than seeking reasons to avoid adopting them.
Since the SEC has the authority to conduct a compliance audit of the books, records and operations of every registered adviser, it is strongly advised that all fund managers keep in the forefront of their planning how these policies are documented, how their records are maintained, and how easy it will be to demonstrate to an SEC auditor that the fund operates in compliance with the Investment Advisers Act.
Every registered adviser must designate one person as the CCO – a title often added to the firms existing Chief Financial Officer. The CCO must be senior enough to enforce the fund manager’s policies and procedures, must have access to all relevant information and, ideally, should be as separate as possible from the conflicts of interest that the manager’s compliance policies are designed to detect.
Every registered adviser must establish and maintain compliance policies and procedures in a written compliance manual. The compliance policies and procedures should address the practices and risks present at each adviser. No one standard set of policies and procedures will address the requirements of the SEC for all advisers because each adviser is different, has different business relationships and affiliations, and, therefore, has different conflicts of interest. Because the facts and circumstances that can give rise to violations of the Investment Advisers Act are unique for each adviser, each adviser should identify its unique set of risks, both as the starting point for developing its compliance policies and procedures and as part of its periodic assessment of the continued effectiveness of these policies and procedures. This process of assessing factors that may cause violations of the Investment Advisers Act is often called a “Risk Assessment,” a “Gap Analysis,” or the compilation of a “Risk Inventory.”
The compliance manual should address the following issues, among others, to the extent that they are relevant to the adviser’s business: conflicts of interest including allocations of investment opportunities among funds and managed accounts; the accuracy of disclosures made to investors, clients and regulators, including account statements and advertisements; personal trading activities of the adviser’s supervised persons and insider trading; accurate creation and retention of required records (including email); and business continuity/disaster recovery plans.
In addition, each investment adviser is required to adopt a code of ethics which sets forth the standards of business conduct expected of supervised persons including, for example, prohibitions on insider trading and other violations of securities laws; this, in turn, encourages an honest, open and ethical compliance culture and environment. While ethical practices are generally consistent among advisers, the code of ethics should include procedures to detect and correct ethical lapses based on the individual adviser’s business and operations.
Eric D. Young is of counsel to the law firm Morrison Cohen.
