Disclosures & fees

*The registration process for federal-covered and state-registered advisers is relatively the same. Assume the same process exists for advisers registering with the Securities and Exchange Commission (SEC) or the state administrator.

The required disclosures for investment advisers during the registration process are fairly similar to the required disclosures for broker-dealers. While broker-dealers use Form BD to register, investment advisers use Form ADV. There are three distinct sections of Form ADV - parts 1, 2A, and 2B. Let’s dive in!

Form ADV Part 1

Form ADV Part 1 is divided into two sections - Part 1A and 1B. Regardless, the exam generally refers to both as ‘Part 1.’ The purpose of this Form ADV segment is to identify the business, its characteristics, and key employees.

These are the important disclosures on Part 1, many of which are the same required disclosures for broker-dealers:

Basics of the business

• Name
• EIN (tax reporting number)
• Business address
• Contact person

Other jurisdictions

• Disclosure of registration with other states

Business structure

• Corporation, partnership, sole proprietorship, or LLC

Business dynamics

• Firm executives (officers, directors, partners)
• Types of products and services to be offered
• Amount of assets under management (AUM)
• If the adviser maintains custody (discussed below)

Business history

• Qualifications (financial and legal)
• Any legal actions ruled against the firm or its advisory affiliates
• Any regulatory events related to the firm or its advisory affiliates (e.g., another state administrator revoked registration)
• Any criminal events related to the firm or its advisory affiliates

Definitions

Advisory affiliate

Defined as any of the following:

• Any current employee (except for clerical roles)
• All officers, directors, and/or partners
• Any other person controlling the firm (making big business decisions)

The most significant difference between a broker-dealer and an investment adviser is what they offer to investors. Broker-dealers generally offer custodial services and execute securities transactions, while investment advisers provide advice on what securities transactions should be performed. Investment advisers can deliver a wide range of advisory services, including:

• General securities advice and/or market commentary
• Financial planning
• Portfolio management (including discretionary accounts)
• Wrap accounts

Definitions

Discretionary account

An account that provides the adviser with investment control; requires trading authorization or power of attorney (POA). This type of account is required for the adviser to make any of the following choices on behalf of an investor:

• Action (buy or sell)
• Amount (how much)
• Asset (what security)

Wrap account

An investment account that offers a wide range of services, including investment management, trade execution, and financial planning, with all services “wrapped” up into one single fee

All of the products and services listed above are considered advisory business, which may only be offered by registered investment advisers (or those that may claim an exemption or exclusion). In the real world, most investment advisers stick to offering advisory products and services. However, it’s possible an adviser may additionally operate in similar ways to broker-dealers.

In particular, it’s possible an investment adviser offers custodial services for its clients. Securities regulators define custody as:

Definitions

Custody

Holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them

Obviously, investors need financial firms to hold their cash and securities in their accounts. It may not seem like a big deal, but maintaining custody of client assets is more difficult than it may seem. We’ll cover custodial rules and requirements for investment advisers in a future chapter. For now, assume some investment advisers take custody, and those that do must disclose this on Part 1 of Form ADV.

The following video summarizes the key points relating to Form ADV Part 1:

Form ADV Part 2A (the brochure)

In a nutshell, the items a client of an investment adviser would care most about are disclosed in Form ADV Part 2A. This section of the registration form includes compensation structures, the investment philosophy of the adviser, and conflicts of interest. The SEC and North American Securities Administrators Association (NASAA) (the association that represents all state administrators) are concerned with investors understanding the information provided in this document, so they impose the following standards for Part 2A:

• Narrative format
• Plain English
• Disclosure of fiduciary obligations
• Full and truthful disclosure

This is NASAA’s way of saying “don’t over-complicate this document with jargon, difficult-to-understand language, or complex terms.” This is the primary reason why Form ADV Part 2A is referred to as “the brochure” (brochures are usually easy-to-read and understand). In addition, the adviser must disclose their fiduciary obligation and provide truthful insights into the business. In their own words, NASAA describes the fiduciary duty as:

[The requirement for] the adviser to hold the client’s interest above its own in all matters

Basically - make the client the priority, not the profits or success of the company. Part of fulfilling the adviser’s fiduciary duty includes disclosing conflicts of interest. Any circumstance, relationship, or event that may compromise an adviser’s fiduciary obligation is considered a conflict of interest. There are endless examples of these; here are a few:

• An adviser is paid by a third party to recommend a specific security to its clients
• An adviser recommends the securities of an affiliated or parent company
• An adviser recommends a purchase of a security that will be sold from their own inventory

Think about it this way - if you would be upset at your adviser for not disclosing a circumstance, relationship, or event related to their business, it’s probably a conflict of interest. Advisers must always disclose conflicts, and additionally mitigate (reduce) the conflict as much as possible.

Now that you know the general requirements of the brochure, let’s go over the specific disclosures required:

General business characteristics

• Description of the business
• How long the adviser has been in business
• Types of advisory services offered, including any specialties
• How the advisor tailors their business to clients
• Description of wrap fee programs
• How much of the business is dedicated to discretionary services

Fees and compensation

• How the adviser is compensated
• Payment logistics (how clients may pay)
• Fees collected outside of advisory services
• If fees may be prepaid, and if they are refundable
• If the adviser is paid by parties other than clients

Types of clients

• Type of client the adviser typically handles
• Any prerequisites for doing business with adviser (e.g. having a minimum amount to invest)

Investment philosophy

• Types of securities recommended
• Methods of securities analysis
• Description of risks clients are exposed to

Disciplinary information

• Convictions of any felony or a securities-related misdemeanor
• Any regulatory action taken against the adviser or its controlling affiliates

Conflicts of interest

• Relationships with relevant third parties
• Payments received by third parties
• Any other item that may compromise the fiduciary obligation

The following video summarizes the key points relating to Form ADV Part 2A:

This video shows a real-world example of Form ADV Part 2A:

Form ADV Part 2B

Typically referred to as the “brochure supplement,” Form ADV Part 2B is a personnel document. Investment adviser representatives (IARs) providing advice to clients and those that act in a discretionary capacity (possibly an IAR that does invests client assets but doesn’t meet with them) are included in this form. Clients are able to gather the following information about these investment adviser employees:

• Educational background*
• Business experience
• Disciplinary information
• Other business activities (outside of the adviser)
• Additional compensation (outside of normal compensation)
• Supervision details

*Although educational background is disclosed on the brochure supplement, there are no minimum educational requirements for IARs

The following video summarizes the key points relating to Form ADV Part 2B:

This video shows a real-world example of Form ADV Part 2B:

Consent to service of process

Similar to all other persons, the consent to service of process must be signed and submitted with every initial registration application (never needs to be renewed). It’s no different with investment advisers. Visit the broker-dealer chapter that describes this document in detail for a refresher.

Filing fees

Again, similar to all other persons, a filing fee must be paid alongside the registration paperwork. Visit the broker-dealer chapter to revisit the dynamics of filing fees.

Sidenote

Form ADV for federal-covered advisers

As was noted at the beginning of this chapter, state-registered advisers file Form ADV with the state administrator, while federal-covered advisers file Form ADV with the SEC. Each corresponding regulator enforces rules and regulations on the investment advisers that register with them. Meaning, the SEC provides regulatory oversight over federal-covered advisers while generally avoiding state-registered advisers. And vice versa; the state administrators provide regulatory oversight over state-registered advisers, while generally avoiding federal-covered advisers.

While federal-covered advisers don’t interact much with the state administrators, they are still required to notify them prior to operating in their states. Known as a notice filing, federal-covered advisers submit the following to each state administrator in order to legally operate in their state:

• Copy of Form ADV submitted to the SEC
• Filing fee

Once submitted to the state administrator, federal-covered advisers have little contact with the state administrator. The SEC is their regulator that will enforce appropriate rules and laws. Even if the state administrator wanted to “flex” on a federal-covered adviser and tell them how to run their business or investigate their business practices, they generally wouldn’t have any legal power to do so.

However, state regulators aren’t completely powerless in regard to SEC-registered advisers. If the state administrator suspects a federal-covered adviser is engaging in fraudulent practices in their state, they have the power to investigate and pursue action against the adviser (sometimes in tandem with the SEC).

Key points

Form ADV

• Investment adviser registration form

Form ADV Part 1

• Discloses the basics of the business, including:
  • General business information
  • Other jurisdictions
  • Business structure
  • Business dynamics
  • Business history

Form ADV Part 2A

• Also known as the “brochure”
• Discloses important information relating to clients, including:
  • General business characteristics
  • Fees and compensation
  • Types of clients serviced
  • Investment philosophy
  • Disciplinary information
  • Conflicts of interest

Form ADV Part 2B

• Also known as the “brochure supplement”
• Discloses information on IARs involved in:
  • Providing securities advice
  • Roles exercising discretion
• Disclosed information:
  • Educational background*
  • Business experience
  • Disciplinary information
  • Other business activities
  • Additional compensation
  • Supervision details

Federal-covered advisers

• File Form ADV with SEC
• Must provide notice filing to state, which includes:
  • Copy of Form ADV submitted to the SEC
  • Filing fee
• The state administrator may not regulate these advisers
  • If fraud is suspected, administrator may investigate