Feeling your Pain: Advice for Updating Form ADV
March 31st is the deadline for many investment advisers to file their annual Form ADV amendment with the U.S. Securities and Exchange Commission (SEC). Despite having worked on this filing for about 25 years, I still struggle. It’s hard to say which questions are the most confusing, but based on the sheer number of questions received year after year, Section 5 on calculating regulatory assets under management ranks as one of the top three. This year the newly added Item 5.L, asking about marketing activities, has also sparked some interesting interpretation questions. Section 8 on participation or interest in client transactions remains one of the most indecipherable questions. The hands-down winner, however, for the most tortured wording is Section 9 on Custody.
Discussing all areas of confusion on the Form ADV could take years, and no one has time for that with the deadline looming. So, let’s tackle the more troublesome questions.
Item 1.F. Offices where you conduct advisory business
Item F.(1) asks advisers to list on Schedule 1.F. of Schedule D, “any office, other than your principal office and place of business, at which you conduct investment advisory business.” During the initial phase of the COVID-19 pandemic, many advisory employees were forced to work from home. The SEC posted an FAQ on March 16, 2020, stating that if firms have employees working from a temporary location (such as their homes), disclosing these new workplaces would not be required, as long as they were temporary and the firm maintained a physical office location.
Now that some of these work from home arrangements have become more permanent, firms should consider adding these home offices to Form ADV. Advisers Act Rule 222-1 defines “Place of Business” for an investment adviser to mean:
- An office at which the investment adviser representative regularly provides investment advisory services, solicits, meets with, or otherwise communicates with clients; and
- Any other location held out to the general public as a location at which the investment adviser representative provides investment advisory services, solicits, meets with, or otherwise communicates with clients.
Although firm employees or investment adviser representatives (IARs) may not meet with clients at their homes, they are still communicating with clients and providing advice from home. In SEC Release IA-3222, the SEC also took the position that an office or other location where an adviser regularly conducts research would be a place of business because research is intrinsic to the provision of investment advisory services. Remember to check the box indicating that the address is a private residence. However, firms would not need to include the home addresses of employees performing administrative or accounting work.
Firms must also consider whether they need to “notice” file whenever they do business in a new state. States can, and most due, require federally registered investment advisers (RIAs) to make “notice filings” and pay filing fees in those states where they do business and have clients. There are exemptions available for RIAs with five or fewer clients in a state, as long as they do not have a place of business in that state and only serve institutional clients. There are a few states where an RIA must submit a notice filing before doing business in that state, including Louisiana, Nebraska, New Hampshire, and Texas.
Additionally, the individuals responsible for providing investment advice, IARs, are regulated by the states where they do business and have clients. Under Advisers Act Rule 203A-3, a “Place of Business” for IARs is defined the same way as for advisory firms, including “An office at which the investment adviser representative regularly provides investment advisory services, solicits, meets with, or otherwise communicates with clients.”
Each state has its own requirements for IAR registration. Typically, IARs need to register in the state (or states) where they have a place of business. Since each state has different requirements, firms should discuss with the relevant state securities regulator about their situation.
Item 1.L. Location of books and records
Item 1.L. asks, “Do you maintain some or all of the books and records you are required to keep under Section 204 of the Advisers Act, or similar state law, somewhere other than your principal office and place of business?” If the answer is yes, advisers are required to completed Section 1.L. of Schedule D.
Many advisers wonder whether they must list the addresses of their cloud service providers, and, more specifically, the location of the servers. This is question that has not been settled by the SEC.
However, there are two no-action letters that address electronic storage of a firm’s original books and records. The First Call No-Action Letter (1995) states that if an adviser has immediate access to a record (on the adviser's proprietary system or otherwise) through a computer located at an office of the adviser (i.e., electronic records), then that record is being maintained “at an appropriate office of the adviser” as required by Advisers Act Rule 204-2(e)(1). This provides flexibility to advisers, allowing them to maintain records electronically and still satisfy Rule 204-2(e)1 because the records are deemed to be at their office. The Omgeo No-Action Letter (2009) expands the First Call No-Action letter to include Rule 204-2(a)(7), 204-2(b)(3) and 204-2(g), and specifically lifts any requirement to download or otherwise maintain separate copies of the records. The Omgeo No-Action letter references the First Call No-Action Letter and re-affirms that the books and records are being kept at the office of the adviser, provided there is “immediate access,” and the ability of the adviser to access that information at its principal office is sufficient to satisfy Advisers Act Rule 204-2.
Item 5.D. Types of clients and counting clients
In 2018, the SEC inserted questions in Form ADV about the actual number of clients and amount of regulatory assets under management attributable to specific categories. Many compliance officers initially struggled about defining and categorizing clients. The SEC’s FAQ on this topic provides little guidance aside from stating:
When answering Item 5.D, count clients the way you normally count them for your firm. Some advisers, for example, treat multiple members of the same family (and a family trust) as a single client, and other advisers treat multiple members of the same family (and a family trust) as separate clients. Similarly, an adviser could reasonably treat an individual and the individual’s IRA account as one–or two–clients, depending on the circumstances. (Updated September 29, 2017)
As suggested by the SEC, a solid approach to responding to these questions is to develop a process for classifying clients, apply it consistently, and document the results. Form ADV instructions state that firms should not double count clients, so if a client fits into more than one category, select the one that best represents the nature of that client. Keep in mind that the regulatory assets under management (RAUM) disclosed in this item should match the RAUM reported in Item 5.F.(2)(c). If the SEC disagrees with the firm’s classifications during an exam, having evidence of a reasonable process consistently applied can help avoid more serious consequences.
Item 5. Regulatory assets under management: What do “continuous and regular” mean?
Item 5.F. asks whether you “provide continuous and regular supervisory or management services to securities portfolios?” Advisers and the SEC staff may not always see eye to eye on the meaning of “continuous and regular.” Most advisers consider having trading authority, performing periodic monitoring, and having an annual client review as “continuous and regular supervisory or management services.” The SEC examination staff, however, can disagree. The Form ADV instructions state that an adviser does not provide “continuous and regular supervisory or management services” if the adviser:
- makes an initial asset allocation, without continuous and regular monitoring and reallocation; or
- provides advice on an intermittent or periodic basis (such as upon client request, in response to a market event, or on a specific date (e.g., the account is reviewed and adjusted quarterly).
So how do you prove to the SEC that your firm is providing “continuous and regular supervisory or management services?” The instructions identify three factors to consider. First, look at the terms of the investment management agreement to see whether the firm agrees to provide ongoing management services. Second, check out the firm’s compensation. Firms that charge a fee based on the average value of the client’s assets being managed over a specified period (e.g., a quarterly fee based on a percentage of assets under management), indicates continuous and regular services. Third, look at how the account is managed (i.e., how often are accounts reviewed and advice provided).
This third factor is where some firms stumble. For many “reviewing client accounts” refers to the annual process when an investment adviser representative (IAR) sits down to discuss account performance with their clients. But the SEC may not consider this limited review as meeting the definition of “continuous and regular supervisory or management services.”
Many firms, however, review client accounts outside the annual client review process. Accounts may be subject to an initial review by a supervisor to ensure the initial investments match up with the client’s stated investment objectives. IARs may review accounts periodically to ensure excess cash gets invested promptly, to determine whether rebalancing is required, to respond to requests to raise cash, or to revise the investment strategy based on a change in the client’s status. Accounts may be reviewed on a firm-wide basis when there is a material market or economic event, when changes are made to model investment strategies, or when investment products are removed from a firm’s approved list. These practices should be disclosed in Form ADV Part 2A in Item 13, Review of Accounts, and in a firm’s policies and procedures. The disclosures and standard operating procedures provide evidence of “continuous and regulatory supervisory or management services” to client accounts.
The SEC reiterated the importance of periodic client reviews in the Commission Interpretation Regarding Standard of Conduct for Investment Advisers, stating that “[a]n investment adviser’s duty of care also encompasses the duty to provide advice and monitoring at a frequency that is in the best interest of the client, taking into account the scope of the agreed relationship.”
Non-Discretionary Assets and “Arranging or Effecting”
According to the Form ADV Part 1A instructions, investment advisers can also count assets as RAUM where they don’t have discretion if two conditions are met. First, the adviser must have an ongoing responsibility to recommend investments based on the client’s needs. Second, if the client accepts the recommendation, the adviser is responsible for arranging or effecting the purchase or sale.
This is another area where there is a disconnect between how the SEC defines “arranging and effecting,” and how advisers view the term. For example, if an adviser is providing investment advice for a 401(k) plan sponsor as a 3(21) investment fiduciary under ERISA, that adviser has “discretion” over those plan assets under ERISA, even if the adviser does not implement the trades or make the final selection of investment products for the plan. The SEC does not allow an adviser to count these assets as RAUM, since the adviser does not “arrange or effect” the trades. This seems an incongruous result, since the adviser managing these assets has fiduciary liability for these assets that is not mitigated by the fact that it does not have trading authority.
Advisers that provide investment advice to a pension or 401(k) plan as an ERISA Section 3(38) investment manager may or may not be able to include these assets in the RAUM on Form ADV. Under Section 3(38) of ERISA, an investment manager is someone who:
- Has the power to manage, acquire, or dispose of any asset of a plan,
- Is a registered investment adviser, bank, or insurance company, and
- Has acknowledged in writing that he is a fiduciary with respect to the plan.
Section 3(38) fiduciaries make decisions about what to include in a 401(k) plan menu, implement it, and manage the investments. The 3(38) fiduciary may also have discretionary authority to direct the investment of funds, in which case those assets can be included in their RAUM. In a participant-directed plan, however, the 3(38) fiduciary does not have this authority so the adviser might not want to include those assets in the RAUM calculation.
Generally, the SEC views the definition of “arranging or effecting” narrowly. If the adviser is not pushing the button on the trade, then the firm cannot count the assets in the account in its RAUM.
Based on that definition, the following assets cannot be counted as an adviser’s RAUM:
- Assets reviewed as part of a financial plan
- Assets managed by a third-party money manager where the adviser does not have discretion to hire or fire the money manager
- Annuities (these are not securities)
- Assets in non-managed accounts (assets that may be held at the same custodian and included in the client’s account for reporting purposes, but the firm does not actually advise on)
- Assets in 401(k) plans where the adviser provides recommendations, but does not have the authority or capability to effect trades
- Assets reviewed or consulted only at the specific request of the client where implementation decision is left to the client
The SEC comes down hard on investment advisers that inflate their RAUM, so it’s important to have the evidence supporting the calculation. If you have doubts about certain assets, it may be best not to include them. Generally, advisers that under-report their RAUM are not referred to the SEC’s enforcement division.
Item 5.L. Marketing Activities
The SEC added new questions to Form ADV requiring disclosure about firm marketing activities. Here are a few that are causing confusion.
Item 5.L. (1)(b) asks “[d]o any of your advertisements include: A reference to specific investment advice provided by you (as that phrase is used in rule 206(4)-1(a)(5))?” The SEC appears to be asking whether a firm’s advertisements include “specific investment advice.” What makes this question confusing is the reference to Advisers Act Rule 206(4)-1(a)(5) (Marketing Rule) which says that an advertisement may not “[i]Include a reference to specific investment advice provided by the investment adviser where such investment advice is not presented in a manner that is fair and balanced.” In this item, is the SEC asking whether the firm provides specific investment advice in advertisements, or whether the firm provides investment advice in advertisements in a way that is not fair and balanced? If the latter, then all firms should answer no because answering yes would mean they are violating the Marketing Rule.
For a firm that includes investment advice in advertisements, it may be appropriate to answer “yes,” and include additional disclosure in the Miscellaneous Section of Schedule D stating that the firm answered “yes” to the question because it provides specific investment advice, but does so in compliance with the requirements of the rule, meaning that it is fair and balanced. Alternatively a firm could answer “no” to this question even if it provides investment advice in its advertisements, and include a similar comment in the Miscellaneous Section of Schedule D, stating that it answered “no” to the question because the investment advice provided in its advertisements meets the fair and balanced standard required under the Marketing Rule.
Here is another question that has advisers scratching their heads: Item 5.L.(1)(d), which asks “[d]o any of your advertisements include endorsements (other than those that satisfy rule 206(4)-1(b)(4)(ii))?” On the one hand, an adviser should respond “yes” if the firm uses endorsements in its advertising materials. But what about a situation where the adviser pays promoters for endorsements, such as solicitors or placement agents, without using endorsements in public-facing materials. The definition of “advertisement” specifically includes “any endorsement or testimonial for which an investment adviser provides compensation.” So an adviser in this situation should also check “yes” to this question, and consider adding a disclosure in Schedule D (Miscellaneous), stating that the firm answered “yes” to Item 5L(1)(d) solely because the firm compensates third parties for endorsements. The advertisements that the firm disseminates do not contain such statements.
Item 7. Financial Industry Affiliations and Private Fund Reporting: Do I need to File Schedule R?
Another Form ADV disclosure that can trip private fund advisers up is whether to complete a Schedule R for “Relying Advisers.” In 2012, the SEC published the ABA No-Action Letter permitting a private fund adviser to file a single Form ADV on behalf of itself as the filing adviser and other private fund advisers that operate as a single advisory business, known as “umbrella registration.” The no-action relief allowed investment advisers that created special purpose vehicles (SPVs) to act as a private fund’s general partner or managing member of their private funds to rely upon the parent adviser’s registration rather than separately register as an investment adviser. The adviser and the SPVs had to be controlled by or under common control with the filing adviser (relying advisers) and conduct their advisory business as a single entity.
The SEC seemingly formalized the process for “umbrella registration” by amending Form ADV to include a new Schedule R to be filed for each “relying adviser.” Schedule R filings are not mandatory, however, and only apply to certain relying advisers, specifically those that were discussed in the response to Question 4 of ABA 2012 No-Action Letter, summarized below:
- The filing adviser and each relying adviser advise only private funds and separate account clients that are qualified clients (as defined in Advisers Act Rule 205-3) and whose accounts pursue investment objectives and strategies that are substantially similar to those private funds.
- Each relying adviser, its employees and the persons acting on its behalf, are subject to the filing adviser’s supervision and control.
- The filing adviser has its principal office and place of business in the United States.
- The filing adviser and each relying adviser operate under a single code of ethics adopted in accordance with Advisers Act Rule 204A-1 and a single set of written policies and procedures adopted and implemented in accordance with Advisers Act Rule 206(4)-(7) and administered by a single chief compliance officer.
- The filing adviser discloses in its Form ADV (Miscellaneous Section of Schedule D) that it and its relying advisers are together filing a single Form ADV in reliance on the position expressed in this letter and identifies each relying adviser by completing a separate Section 1.B., Schedule D, of Form ADV for each relying adviser and identifying it as such by including the notation (relying adviser).
Other investment advisers with affiliated entities can still take advantage of umbrella registration, without having to file Schedule R. In the FAQs on Form ADV, the SEC noted that advisers that set up SPVs to act as a private fund’s general partner or managing member can still rely on the registered investment adviser’s registration under the no-action letters from 2005 and 2012. As discussed above, this requires the filing adviser disclose in the Miscellaneous Section of Schedule D that it and its relying advisers are relying on the 2012 ABA No-Action Letter and identifying each relying adviser by completing a separate Section 1.B., Schedule D.
Item 7.B. Private Fund Reporting, Section 7.(B)(1) Private Fund Reporting - Auditors
In Schedule D, item 7.B(1), question 23(h) asks whether all of the reports prepared by the auditing firm for the private fund since the last annual updating amendment contain unqualified opinions. Given the timing of the annual update, many private funds may not have received their funds’ audit reports for the most recently completed fiscal year, but received an unqualified opinion for the prior year. In this situation, should the firm answer “Yes” or “Report Not Yet Received”?
In the Form ADV amendments adopting release the SEC said, “As noted in the Proposing Release, this question has prompted questions from advisers regarding which report and what timeframe the question refers to. To clarify, we are revising the question, as proposed, to ask whether all of the reports prepared by the auditing firm since the date of the adviser’s last annual updating amendment contain unqualified opinions.” Based on this response, firms that file their Form ADV annual updating amendment at the end of March and expect to receive audited financial statements for their funds on April 15 should be able to answer “Yes” to this question.
Item 8. Participation or Interest in Client Transactions
In the proposing release for the 2018 updates to Form ADV, the SEC acknowledged that it received frequent questions from filers on Item 8.B.(2) of Part 1A. Here is how it looks on the form:
Do you or any related person: … (2) recommend to advisory clients, or act as a purchaser representative for advisory clients with respect to, the purchase of securities for which you or any related person serves as underwriter or general or managing partner?
This question is confusing for some private fund managers since they do not have clients aside from the funds they manage. The investors in these funds are technically not clients of the adviser. So if a private fund manager has no affiliated entities and only sells interests in its funds, the answer should be no.
If, however, the private fund manager has affiliates, including another registered investment adviser that recommends its clients invest in the private fund, then the answer would be yes.
Item 9.A. Custody
This section of Form ADV Part 1A is just as confusing as ever. Item 9.A. asks whether a firm has custody of any advisory clients (a) cash or bank accounts, and/or (b) securities. Custody is a defined term on the form and includes “[a]ny arrangement (including a general power of attorney) under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian.” Many firms deduct advisory fees directly from client accounts, and therefore have custody of client assets. However, the form states that you should answer “no” if you have custody solely because you deduct advisory fees directly from your clients’ accounts. Keep in mind that an adviser that deducts its advisory fee from client accounts must still comply with other provisions of the custody rule, such as using a qualified custodian and having a reasonable belief that that the custodian is sending out quarterly account statements directly to clients.
But that’s not the end of the issue. If a client signed a “standing letter of authorization” (SLOA) with their custodian instructing the custodian to transfer funds to a designated third-party upon the request of the adviser, this could also be considered custody. In February 2017, the SEC’s Division of Investment Management issued the Investment Adviser Association No-action letter, an IM-Guidance Update, and an update to the custody rule FAQs, which significantly changed prior interpretations of “custody.” In sum, the SEC found that an adviser with authority to disburse money to a third-party on the client’s behalf under an SLOA has custody.
What does this mean for advisers completing Form ADV? Advisers with third-party SLOA disbursement authority now must report the assets in the relevant client accounts under Item 9.A.(1) and (2). More significantly, advisers with this authority may also need to arrange for an annual surprise examination for those assets, unless they can qualify for the relief provided by the Investment Adviser Association No-Action Letter.
Hopefully this does not come as a surprise to many investment advisers. Most custodians have policies and procedures to help advisers comply with the conditions in the Investment Adviser Association No-Action Letter, but advisers still need to determine if there is an SLOA on client accounts, and whether that SLOA is broad enough to confer custody on the adviser, to respond this Item 9.A.(1) and (2). Custodians have allowed differing levels of authority under SLOAs, so for some advisers, this means reviewing all custody agreements to determine the amount of client funds and assets for which they have custody.
Practice Tips for the Next Form ADV Update
Here is some advice to make the process easier next time around.
- Make it a repeatable process. Document how you counted clients and how you classified them. Write down the process you went through to classify the types of investments. Develop a standard operating procedure that documents the source of the information, how the reports were created and what fields were used to pull the data, and how the data was scrubbed. Document the reasons for your answers, especially for questions that might have more than one interpretation, such as items 7, 8, and 11.
- Trust the data. The SEC expects to see evidence supporting your responses to Form ADV, and that evidence should be credible. As a result, there should be reports to substantiate the number of clients, types of investments, and assets under management. Instead of assuming that you have no non-United States clients, run a report of client addresses to confirm.
- Don’t go it alone. Form ADV is a public document that discloses important information about the firm. Firm management should be engaged in the process and aware of what it says. Many chief compliance officers require the president or chief executive officer to sign the Form ADV filing to ensure he or she takes ownership of the document. It’s important to get others in the firm to review the document to ensure its accuracy. And just as importantly, you do not want managers to be surprised when clients or prospects ask about certain disclosures.
- Answer the questions to the best of your knowledge and ability, and then move on. Form ADV has been a source of confusion and consternation for years. During an examination, the SEC may question your responses, and if in the staff’s view, you responded incorrectly, you will be asked to revise Form ADV. In many situations, if a firm has a reasonable explanation for the response and had no intent to defraud, the issue will not go any further.
- Ask for help. The SEC has been much more willing to respond to questions in recent years. For answers to interpretive questions, you can send an email to IARDLIVE@sec.gov or call the Investment Adviser Regulation Office at (202) 551-6999. You can also review other Forms ADV, or ask your colleagues at other firms how they are dealing with the same questions.
How we help
Filling out Form ADV, as well as creating and maintaining a compliance program that meets the form’s, and the SEC’s requirements year-round, can be a daunting task. We can provide a dedicated team of highly experienced professionals to help.
Introducing ACA Signature, a scalable solution curated to suit your firm’s unique compliance needs. ACA Signature provides financial firms with scalable consulting solutions that can be paired with innovative technology and managed services for staying on top of regulatory and daily obligations. Our team of regulatory experts can build, enhance, or manage your compliance program, helping to mitigate risks and increase operational efficiency.
Designed by former regulators and compliance experts, ACA Signature provides services and solutions tailored to fulfill your firm’s ongoing compliance obligations. Our team includes former SEC, FINRA, FCA, NFA, CFTC, and state regulators along with former Chief Compliance Officers and senior compliance managers from prominent financial institutions in the industry. With over 20 years’ experience in the compliance industry, ACA is synonymous with quality compliance support.
Reach out to your ACA consultant, or contact us to find out how ACA Signature can help transform your firm’s compliance program.
For more insights about completing Form ADV, check out these articles: