SEC Adopts New Form ADV Part 3 (Form CSR) Along With Fiduciary Duty Interpretations Under the Investment Advisers Act
The Securities and Exchange Commission (the “SEC”) recently adopted new rule 204-5 under the Investment Advisers Act of 1940 (the “Advisers Act”), amendments to Form ADV to add a new Part 3 along with new interpretations under the Advisers Act. These changes come at the same time as the SEC’s adoption of Regulation Best Interest: The Broker-Dealer Standard of Conduct under the Securities Exchange Act of 1934, with the intent of reducing retail investor confusion in the marketplace for brokerage and investment advisory services and to assist retail investors with the process of engaging and maintaining relationships with advisers and broker-dealers.
Form ADV Part 3 (Form CRS Relationship Summary)
The SEC adopted new Form ADV Part 3 (Form CRS) to require advisers to create a brief relationship summary containing information for retail investors. The summary includes information regarding (i) the types of client and customer relationships and services the firm offers; (ii) the fees, costs, conflicts of interest, and required standard of conduct associated with those relationships and services; (iii) whether the firm and its financial professionals currently have reportable legal or disciplinary history; and (iv) how to obtain additional information about the firm.
Form ADV Part 3 is required only for advisers to retail investors—natural persons, or their legal representatives, who seek to receive or receive services primarily for personal, family, or household purposes. Similar to Form ADV Part 2 requirements, exempt reporting advisers are not required to complete Part 3.
For those of you worried about the extra Form ADV work, the good news is Part 3 must not exceed two pages in paper format. Importantly, advisers may not include disclosure in Part 3 other than disclosure that is required or permitted by the instructions and the applicable item.
All investment advisers registered or applying for registration with the SEC with retail investor clients must prepare, file, and deliver Form ADV Part 3 in accordance with its instructions and Advisers Act rules. Advisers must also make a copy of Part 3 available upon request without charge.
As with Form ADV Parts 1 and 2, Form ADV Part 3 must be filed electronically through the Investment Adviser Registration Depository (IARD). For advisers who are registered or have an application for registration pending before June 30, 2020, advisers must file their initial Part 3 beginning on May 1, 2020, and by no later than June 30, 2020, either as: (i) other-than-annual amendments or (ii) part of their initial application or annual updating amendment. New registrations filing on or after June 30, 2020, must include Part 3 in their initial application.
For initial delivery, Form ADV Part 3 must be delivered to each retail investor before or at the time the adviser enters into an investment advisory contract (whether written or oral) with the retail investor. Thereafter, Part 3 must be delivered to existing retail investor clients before or at the time the adviser: (i) opens a new account that is different from the retail investor’s existing account(s); (ii) recommends the retail investor roll over assets from a requirement account into a new or existing account or investment; or (iii) recommends or provides a new brokerage or investment advisory service or investment that does not necessarily involve the opening of a new account and would not be held in an existing account (e.g., a direct-sold mutual fund).
Advisers must update Part 3 within 30 days whenever any information becomes materially inaccurate and communicate (without charge) any changes to retail investors within 60 days after the updates are required to be made. Amendments must include an attached exhibit highlighting the most recent changes by marking the revised text or summarizing the material changes.
Investment Advisers Fiduciary Duty
The SEC also released an interpretation of the fiduciary duty of investment advisers under the Advisers Act (the “ Interpretation”). Unlike the new regulations that apply to broker-dealers, the Interpretation is not intended to establish new standards of conduct for investment advisers, but, rather reaffirm, clarify, and synthesize the SEC’s understanding of the fiduciary duty as it has been established in previous rulings and regulations.
The specific obligations that flow from an investment adviser’s fiduciary duty vary and depend on the nature of the services it provides to its client and the nature of the client itself. The Interpretation emphasized the sophisticated nature of institutional clients and distinguished the obligations of investment advisers to retail clients from institutional clients.
Investment advisers are expected to provide advice in the best interests of the client, make a reasonable inquiry into their client’s objectives, seek the best execution of a client’s transactions where the adviser has the responsibility to select broker-dealers to execute client trades, provide advice and monitoring throughout the relationship, and supersede the client’s interests to their own.
For investment advisers with institutional clients, this means:
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Gaining a reasonable understanding of their client’s investment mandate;
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Seeking to obtain the execution of securities transactions on behalf of a client with the goal of maximizing value for the client under the particular circumstances occurring at the time of the transaction;
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Providing monitoring that is consistent with the extensiveness of the relationship or with any agreements between the adviser and the client, provided that there is full and fair disclosure and informed consent when necessary;
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Disclosing material facts relating to the advisory relationship, including the capacity in which the firm is acting with respect to the advice provided. This is particularly relevant for firms or individuals that are dually registered as broker dealers and investment advisers and who serve the same client in both an advisory and a brokerage capacity; and
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Eliminating or at least exposing through full and fair disclosure all conflicts of interest which might incline an investment adviser—consciously or unconsciously—to render advice which was not disinterested. Full and fair disclosure must:
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Be sufficiently specific so that a client may understand the material fact or conflict of interest and make an informed decision whether to provide consent;
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Describe the conflict, the nature of the relationship, and how the adviser intends to address the conflict; and
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Be tailored to a client’s level of expertise and sophistication. Disclosure for institutional clients may differ signification in specificity, level of detail, and explanation of terminology for disclosure for retail clients.
In addition to the above requirements, investment advisers with retail clients must also:
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Gain a reasonable understanding of their client’s financial situation, level of financial sophistication, investment experience, and financial goals;
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Update their client’s investment profile in order to maintain a reasonable understanding of the client’s objectives and adjust the advice to reflect any changed circumstances; and
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In all cases where disclosure that is sufficiently specific and understandable cannot be provided such that the client can provide informed consent, eliminate or adequately mitigate (i.e., modify practices to reduce) the conflict such that full and fair disclosure and informed consent are possible.
Additional Resources
For a more in-depth conversation on issues affecting investment advisers and SEC hot topics, we invite you to join Troutman Sanders LLP’s Private Funds Forum on September 26, 2019. For more information, please contact Genna Garver or Cannelle Trouillot.
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