Investment advisory firms are required to file disclosure documents with the Securities and Exchange Commission (SEC). These documents help consumers learn about some of the risks or potential conflicts of interest associated with a specific firm or compare two different investment firms.
In the past, investment advisors had to complete two forms each year: ADV Part 1 and ADV Part 2. This past year the SEC published new rules for the second document required by investment advisory firms like ours. The requirement changed from a checkbox response to a “plain English” narrative brochure. Even if the nature of a firm’s business has not changed, added information and the new format are mandatory.
ADV Part 1, filed online, is available at http://www.sec.gov/divisions/investment/iard.shtml on the SEC’s website. Click “Check Adviser Info on IAPD” and then “Investment Adviser Search.” Select “Investment Adviser Firm,” type the firm name and then click “Go.” Select the appropriate business name and you can start browsing your firm’s ADV.
Click “View All Pages” to scroll through the entire ADV Part 1. First look at Item 5. Section E. Compensation Arrangements. There are seven possible checkboxes. Fee-only advisors can use a percentage of assets, hourly charges or fixed fees. These are normally the boxes I would expect to see. The next two checkboxes, commissions and performance-based fees, are more worrisome. These forms of compensation create potential conflicts of interest.
On the left of the main page, click on “Part 2 Brochures” to see a PDF of the firm’s new disclosure brochure. This publication informs clients and prospective clients about the firm and the qualifications, business practices and nature of its services to consider carefully before becoming an advisory client. The content of this brochure has not been approved or verified by the SEC or any other state or federal authority. Although advisory firms are required to be registered, it does not imply a certain level of skill or training on the part of the firm or its associated personnel.
The ADV Part 2 Brochure is divided into 20 items in part A. Item 2 discusses and summarizes the specific changes the firm has made to the brochure. It is given to existing clients within 120 days of the close of the fiscal year and references the date of the firm’s last annual update. This year, because of the completely new format and content, you are encouraged to review the entire brochure.
Checkboxes were easy. Writing a compliance document in plain English for every client and prospective client is a strange exercise. Compliance documents are typically written in legalese. The reading level is a stretch for many people. But plain text is often less precise. And consumers often perceive such a document as a marketing tool touting a firm’s services rather than listing its disclosures.
The SEC did not offer specific guidelines for each section. When it was time to write Item 6, “Performance-Based Fees and Side-by-Side Management,” we could have just written “None,” equivalent to checking “No” on the old form.
On a marketing document listing services, “None” shows a lack of services other firms might have. On a compliance document, “None” means the firm lacks the conflict of interests that such practices can entail. We took the opportunity to engage both in education as well as compliance in these two paragraphs:
“Our investment supervisory service fees are not based on a share of the capital gains or capital appreciation of the funds in a client’s account, also known as ‘performance-based’ fees. We choose not to use a performance-based fee structure because of the potential conflict of interest it may create. Performance-based compensation can pose an incentive for an advisor to recommend an investment that may carry a higher degree of risk to the client in order to potentially earn higher fees.
“We do not engage in side-by-side management, which refers to an advisor simultaneously managing accounts that do pay performance-based fees (typically hedge funds) and those that do not. This can create potential conflicts of interest.”
This text ultimately offers valuable information about the practice of performance-based fees or side-by-side management. But neither of these practices has anything to do with our firm. And I am certain hedge fund managers (often exempt from this compliance anyway) would use this section to write about the so-called wonders of performance-based fees.
I’m satisfied with the ADV Part 2 our firm has written even as I am skeptical about the value of the SEC’s requirement. The SEC estimated that completing the brochure would take between 15 and 60 hours. They also anticipated that most registered investment advisors would have to retain outside compliance assistance at a cost of $3,000 or more to meet the new requirements. Within our firm it took over 60 hours. On the old form, comparing checkboxes was quick and easy. No matter how readable our text is, it will be difficult to compare it to other firms. Furthermore, recent reports suggest that nearly a third of advisors may have missed the March 31 filing deadline or submitted an incomplete, hastily done document.
Unfortunately, our society tends to pass feel-good legislation aimed at making people feel safer without actually making them safer. First they make it illegal to run a Ponzi scheme. Then they require firms to disclose if they are running a Ponzi in their annual filing. Then they make it illegal to lie on their annual disclosure. Next they require a designated chief compliance officer in the firm who will check that the firm’s paperwork is in order. And finally they make it an offense for the chief compliance officer to fail to review the firm’s compliance annually.
None of this impedes the few real crooks who are willing to boldly certify their own lies.
Now that the filing deadline is past, firms have until May 31 to send the new brochure to existing clients. We posted our ADV Part 2 on our website at emarotta.com/brochure in addition to filing it with the SEC and mailing a paper copy to existing clients. View this as an opportunity to compare your financial advisor to others in an item-by-item comparison.