Essential ADV Reminders
Main Contributor: Meghan Sundquist, Compliance Associate, with contributions from Elizabeth Cope, CPA, CSCP, CIPM, CEO & Lead Consultant
Background
It’s that time of year again! ADV season comes around each year like clockwork, often bringing the same kinds of questions and potential headaches. Every Registered Investment Adviser (RIA) is required to file their Annual ADV amendment within 90 days of their fiscal year end. For most RIAs, fiscal year ends on December 31st meaning annual amendments are due March 31st (March 30th during leap years). While the SEC FAQ and instructions for Part 1 and Parts 2A/B are important and helpful, compliance professionals may find themselves in unique scenarios not always addressed in these documents. Over the years at SCS, we have reviewed hundreds of ADVs and have seen common areas where RIAs get stuck or confused. We’ve compiled some of these observations in this article to hopefully bring some direction to various ADV scenarios.
Consistency
Perhaps the most common issue with ADV annual amendments is consistency. Updating these disclosures takes a lot of time, requires a lot of calculations, and involves attention to detail no matter how complex your firm is. Be sure to cross reference Form ADV Parts 1 and 2A, Form CRS, advisory agreements, as well as your firm’s compliance policies and procedures to ensure all information is consistent. This includes checking fee calculations, conflict of interest disclosures, trade aggregation and allocation procedures, personal trading procedures and marketing disclosures. Additionally, compare Part 2Bs with U4s, when applicable.
Form ADV Part 1
There are several sections of Part 1 that prove tricky for advisors. Let’s dive in:
Item 9.F - “If you or your related persons have custody of client funds or securities, how many persons, including, but not limited to, you and your related persons, act as qualified custodians for your clients in connection with advisory services you provide to clients?” This custody question is asking advisors to indicate the number of custodial relationships the advisor has in which the client assets are custodied and where the advisor has custody. In this context, custody will include the ability to have fees directly debited from the custodial accounts. (As a side note, the ability to deduct fees directly from custodial accounts does not require a response to Item 9A and 9B.)
Section 5.K – This section requires advisors to only provide answers related to separately managed accounts. This includes all of the advisor’s clients except (if applicable) mutual funds, private funds, and business development companies. We have seen advisors mistakenly update to include the excluded client types.
Categorization under Item 5.K(1) – For separately managed accounts, you must categorize the security types held in their portfolios. This applies to all clients under your management. Mutual funds and exchange traded funds should be counted in row (ix) Securities issued by Registered Investment Companies or Business Development companies. We have commonly seen advisors mistakenly categorize exchange traded funds within row (i) Exchange traded equity securities. If a security type fits in more than one category, use your best judgment to select the category that you think best fits. Be sure to keep internal documentation to support your methodology.
Schedule D – Don’t forget to confirm whether any updates are needed here! When completing the annual amendment, the system will keep previous answers and will not trigger an error during the completeness check. It’s easy to forget to manually check these!
Private Funds: Section 7.B(1).23(g) and (h)
Item 23(g) asks if the private fund’s audited financial statements for the most recently completed fiscal year have been distributed to the fund’s investors. If the fund’s financial statements have not yet been delivered, but the advisor has engaged an auditor and the audited statements will be delivered as required, then check Yes to this question.
Item 23(h) asks if all the reports prepared by the auditing firm for the private fund since the last annual update contain unqualified opinions. If the financials have not yet been delivered, then select “Report not received.” Once the financials have been distributed, the advisor will need to timely file an other-than-annual amendment. We recommend setting a calendar reminder for this step!
Item 8.G – This section of the Part 1 deals with soft dollar benefits. It asks if the advisor receives any soft dollar benefits and if these benefits are eligible research or brokerage services. There are various ways to interpret this question. One stance often taken at SCS is that the benefits received from having a relationship with a broker dealer that are not paid for with client commission would not be considered soft dollars, thus checking “No.” However, advisors should still disclose that they do not have soft dollar arrangements in Part 2A as well as describe the additional services they do receive from their relationship with broker dealer(s). If the advisor wants to check yes and include similar disclosures in Part 2A, that is also an option. The important factor is clear disclosure in Part 2A.
Advisor and/or Related Persons – Wording is very important in questions in Part 1. In some cases, the form will say “you” and “your” which refers solely to the advisory firm. In other cases, the form will include or ask about related parties, which includes the firm’s officers, directors, employees, affiliates, and persons associated in a similar capacity.
Form CRS
Also known as Form ADV Part 3, Form CRS has very specific formatting instructions. We highly recommend reviewing the instructions to ensure you didn’t miss anything! We’ve seen multiple deficiencies around lack of following the precise formatting instructions. Another important factor – the upload process for Form CRS is different from uploading the ADV brochures. For the Form CRS, the advisor will upload prior to submitting Form ADV, but the advisor will upload the ADV Part 2A and 2Bs after you submit the Form. The advisor should be sure to check “amend” on Part 2, otherwise he/she will not be able to upload Parts 2A and 2B (for state advisors only). Also, advisors should note that Part 2B is not required to be filed with the firm’s annual amendment when registered with the SEC. Some advisors do upload it separately or wrap it into their 2A as a Part 2 Brochure.
Form ADV Part 2A
This administration is placing increased scrutiny on conflicts of interest and the adequacy of disclosures. Firms should use this amendment cycle to reassess whether all material conflicts are clearly and fully disclosed, not just technically addressed in policy.
One common area of deficiency we continue to see relates to trade aggregation and allocation disclosures in Item 12, Brokerage Practices. Even when ADV language mirrors firm policy, the SEC has taken issue where firms fail to disclose the inherent limitations and conflicts in their processes. For example, having a systematic allocation methodology does not guarantee that all clients receive identical pricing, and that limitation should be disclosed.
Firms should also take time to reassess custody determinations and ensure all forms of custody are accurately disclosed in Item 15, Custody. In one instance, an adviser appropriately identified custody due to having client login credentials and obtained a surprise custody examination. However, the SEC cited the firm for inadequate disclosure because the ADV failed to explain that providing login credentials to an adviser can reduce certain customer service protections typically offered by custodians.
Finally, review disclosures for overuse of the word “may.” If a conflict, practice, or risk is known to occur, it should be disclosed as a fact. Examiners routinely view conditional language as misleading when the underlying activity is already happening.
Save Your Work
Having consistent data across brochures, understanding question wording, and clear disclosures are all important parts of the ADV Amendment process. At the same time, one of the most valuable steps to take during this process is to document, document, document! Advisors should keep documentation to substantiate data provided as well as save notes on any conclusions or reasoning behind certain responses. This documentation can come in handy during an SEC exam and can be tremendously helpful when it’s ADV season again the following year. It’s easy to forget the process and methodology when a process is only done annually.
Conclusion
This list is not exhaustive, but we hope it helps provide some direction in areas that can be confusing as well as some helpful reminders for the process as a whole. Don’t forget to check out the SEC FAQ, the ADV Instructions for Part 1 and Parts 2A/B, and the instructions for Form CRS. As always, reach out to your SEC contact with any questions, or schedule a call!
