Update on Investment Advisers Regulation: The Proposed IARD and Compliance Issues

Editor:

Phyllis Bernstein, CPA
Director
AICPA
Jersey City, NJ

Editor’s note: Ms. Bernstein is Director of the AICPA Personal Financial Planning Team. The author's views, as expressed in this column, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specified committee procedures, due process and deliberation. If you would like more information about this column, contact Ms. Bernstein at (201) 938-3663 or pbernstein@aicpa.org .

On May 23, 2000, the U. S. Securities and Exchange Commission (SEC) held a roundtable on regulation of investment advisers. Chairman Levitt opened the roundtable with a keynote address, followed by a series of panel discussions moderated by officials from the SEC's Division of Investment Management.

Topics of the roundtable discussion included:

• Modernization of adviser regulation;
• Distinctions between advisers and broker-dealers;
• Persons excluded from the definition of investment adviser;
• Adviser trading practices, including the use of soft dollars and the obligation to seek best execution;
• Personal trading and other conflict-of-interest issues;
• Pay-to-play practices;
• Advertising and performance reporting; and
• Technology and adviser regulation, including a new electronic filing and registration system for investment advisers.

The first panel debated the scope of the Investment Advisors Act of 1940 (Act); among the participants was the AICPA's Director of Personal Financial Planning. The majority of the participants agreed that financial planning and investment advising are not the same thing; as such, there was no need for a self-regulatory organization for financial planning or investment advising. The president of the Financial Planning Association felt differently, expressing concern that the law is not uniformly applied to cover those who functionally provide financial planning and financial advising. He also clearly expressed that regulation for financial planning is needed, as investment advice is only one type of financial advice and the Certified Financial Planners (CFP) Board, currently the voluntary regulator, regulates only the 34,000 who hold the CFP designation.

It was interesting to note that the SEC staff view some financial planning activities as investment advisory and not others, commenting that it is theoretically possible to be a financial planner and not give any advice about securities.

While it is very likely there will be changes, the specific nature of those changes is difficult to forecast. The SEC can be expected to consider developing new rules on books and records, soft dollars, custody, advertising and performance reporting. It is very difficult to anticipate whether it will revise the definitions, and exclusions from the definition, of investment adviser.

The PFP Section of the AICPA will provide updates on changes to the investment adviser regulations and will continue to make its views known on how these changes might affect CPA financial planners and their clients.

IARD

The SEC and the state securities authorities are creating an Internet-based system of electronic filing for investment advisers. The system, which is called the Investment Adviser Registration Depository (IARD), will permit investment advisers to satisfy filing obligations under state and Federal laws by making a single electronic filing. Information contained in filings made through the IARD will be stored in a database that will be publicly accessible free of charge.

The IARD, which is being built and will be administered and operated by NASD Regulation, Inc. (NASDR), will give investors easy access to information about investment advisers. It was developed by North American Securities Administrators Association, Inc. and the SEC. Approximately 8,000 investment advisers are registered with the SEC under the Act; the SEC estimates that another 12,000 are registered with state securities authorities. These advisers currently make filings on paper.

Form ADV, the Uniform Application for Investment Adviser Registration, will be used for most of the filings on the IARD. Form ADV currently has two parts. Part I asks for information about an adviser's business, the persons who own or control the adviser and whether the adviser or certain of its personnel have been sanctioned for violating securities or other laws. It provides information that regulators need to decide whether to grant an application for registration or to revoke a registration, and to manage their regulatory and examination programs. Part II, or a written brochure containing the same information, must be delivered to clients before they engage the adviser and then offered to them each year. Part II provides clients with information about business practices, fees and conflicts of interest the adviser may have with its clients.

The SEC's proposal is for sweeping Form ADV revision. Part I will accommodate electronic filing and state-specific requirements. Part II will be revised to a more narrative format, similar to schedule H for wrap fee programs.

The SEC is proposing that all advisers provide clients with a narrative brochure containing disclosure about the advisory firm written in plain English, and updated at least once a year to reflect any changes. The SEC is also proposing that the firm brochure be accompanied by a supplement containing important information about the advisory personnel with whom the client will be dealing. Proposed Part 2A sets forth the information about the advisory firm that an adviser must include in its brochure. Proposed Part 2B sets forth the information about advisory personnel that an adviser must include in brochure supplements.

Expected fees increase. At the end of July, the SEC approved filing fees for a new online ADV registration system. At the same time, the SEC gave its long-awaited blessing to the NASD to establish and maintain the system.

Initial startup fees for advisers with less than $25 million of assets under management (AUM) is $150, with an $100 annual update fee. For advisers with AUM of $25 million to $100 million, the initial fee is $800 and the annual update fee is $400. And for those with more than $100 million AUM, the initial fee is $1,100 and the annual update fee is $550. Funding for the new system will come from filing fees paid by advisers to NASDR when they submit an application for registration and file their annual amendment to their Forms ADV. (The SEC must approve any changes in fees.)

Delivery requirement. The proposed delivery requirements would be similar to current requirements (i.e., an adviser would deliver its brochure at the start of the advisory relationship and make a written offer to deliver the brochure annually), with one important difference. Advisers would be required to provide clients with written brochure updates whenever information in the brochure becomes materially incorrect, and include these updates with brochures delivered to prospective clients.

Part 2A—Firm brochure. The disclosure required by proposed Part 2A generally is similar to that currently required by Part II of Form ADV. One noteworthy difference, however, is the proposal's enhanced focus on potential conflicts of interest. In several areas that may give rise to potential conflicts of interest with clients, the proposal would require disclosure of the adviser's practice, a discussion of the conflict raised by the practice and a description of the adviser's control procedures for addressing the conflict. These areas include:

• Receipt of transaction-based compensation;
• Participation or interest in client transactions;
• Personal trading; and
• Brokerage practices, including the use of soft dollars and the allocation of brokerage in exchange for client referrals.

Part 2B —Brochure supplement. The SEC's proposal would require a supplement to the brochure for investment adviser employees who are "supervised persons" of the investment adviser. Generally, these are employees who have a direct involvement with clients; they either communicate with or formulate investment advice for clients, or make discretionary investment decisions for client assets. The investment adviser would be required to provide a paper brochure supplement to a client no later than the time the supervised person begins providing advisory services to the client.

Under the proposal, firm brochures would be accompanied by a brochure supplement that provides information about the adviser's advisory personnel. Advisers would provide each client with a supplement describing the educational, business and disciplinary background of the supervised person who will provide advisory services to that client. The requirements for updating a brochure supplement and delivering the corrected information to clients would be essentially the same as for the firm brochure.

The contents of a brochure supplement would include:

• Description of the supervised person's formal education and business background for the past five years, including an identification of his professional designations or attainments;
• Disclosure of the disciplinary history of the supervised person, including any proceeding revoking or suspending his professional attainment, designation or license;
• Description of any other business activities of the supervised person, including (if applicable) a description of any related conflict of interest and any procedures the adviser uses to address the conflict;
• Disclosure as to whether the supervised person receives transaction-based compensation, including bonuses and noncash compensation;
• Discussion of who formulates the advice given to clients and, if the supervised person formulates the advice, an explanation of how the firm monitors the advice provided; and
• Name, title and telephone number of the person responsible for supervising the advisory activities of the supervised person; and disclosure as to whether he was the subject of a bankruptcy petition during the past 10 years.

The SEC expects the entire new system will be rolled out in four separate stages of implementation, and is expected to go online next year. Participation in the IARD will be mandatory for Federally registered advisers. The SEC anticipates that most (if not all) states will participate in the system as well.

• Stage 1: ADV Part 1A and ADV-W to process SEC and state applications, amendments, withdrawals and state notice filings. Many state securities authorities will begin to require advisers registered with them to use the system. However, some state securities authorities lack statutory authority to require advisers registered with them to file through the IARD and will postpone full participation in the system until necessary legislation is enacted.
• Stage 2: ADV Part 1B for public disclosure of firms. NASDR will release the public disclosure system, which should begin operating a few months after the first filings are made on the system.
• Stage 3: ADV Part 2A—Firm brochure and electronic processing for advisors. NASDR will release the state investment adviser representative licensing system. This is expected to begin operating a few months after the public disclosure system is released. It is likely that some states will not participate until their laws have been changed.
• Stage 4: ADV Part 2B —Brochure supplement for investment advisory representatives. The IARD will begin to accept Part 2B of Form ADV.

The AICPA has strongly supported the SEC's efforts to redesign Form ADV to make it more meaningful for investors. A user-friendly document, written in "plain English" that simultaneously satisfies both Federal and state requirements, is a significant step in streamlining the investment adviser and investment adviser representative registration process, encouraging more uniform disclosures on one hand and less "boilerplate" on the other. The AICPA PFP Executive Committee has reviewed the proposal and provided its comments to the SEC. This (and other) comment letters can be found at the SEC Website (www.sec.gov).

Note: The SEC anticipates that it will take 22 hours to complete the new Form ADV and that it took nine hours to complete the old form. CPA financial planners should be ready to spend much more time to prepare the required narrative descriptions.

The AICPA will provide updates on the status of the proposal so that practitioners can be ready for this sweeping change.