Substantive Requirements for a Registered Investment Adviser under the U.S. Investment Advisers Act of 1940
Alternative investment fund managers and other investment advisory firms that are registered with U.S. Securities and Exchange Commission (the “SEC”) as investment advisers under the U.S. Investment Advisers Act of 1940 (the “Advisers Act”) are subject to significant substantive requirements on the conduct of their businesses and to SEC examination to insure compliance with those requirements. The following is a brief summary of certain of the substantive provisions of the Advisers Act. We do not address in this summary the panoply of additional regulations to which registered investment advisers are subject, including U.S. federal and state and non-U.S. laws that address, for example, consumer privacy, bribery/corruption issues, brokerage activity and anti-money laundering regulations.
A. Registration and Other Regulatory Reporting
An investment adviser registers with the SEC by filing a Form ADV. Form ADV is divided into three parts: (i) Part 1A requires general identification and financial
information about the adviser and its business; (ii) Part 2A of Form ADV (the
“Brochure”) is designed to be a client disclosure document, including descriptions, in narrative form, of among other things, its advisory services, fees and compensation, methods of analysis and investment strategies (and related risks), disciplinary
information, material relationships with other financial industry participants, material financial conditions and potential conflicts of interest with clients; and (iii) Part 2B of Form ADV (the “Brochure Supplement”) provides information about the educational background, business experience and disciplinary history (if any) of the supervised persons who provide advisory services to the client. Parts 1A and 2A of Form ADV are publicly available on the SEC website. Part 2B of Form ADV is not filed with the SEC, but must be maintained by the investment adviser. A registered investment adviser is required to update its Form ADV at least annually and promptly under certain other circumstances, such as a material change to the information in Part 2A of Form ADV.
The SEC may bar a firm from registering as an investment adviser if the firm or certain persons associated with the firm have committed certain disciplinary infractions.
A registered investment adviser with greater than $150 million in assets under management attributable to alternative investment funds is also required to file Form PF, a report that is designed to allow the SEC and other financial regulators to assess any potential for systemic risks related to alternative investment funds. The frequency and level of detail required by Form PF depend on the adviser’s assets under management relating to alternative investment funds and the types of alternative investment funds the adviser manages, but Form PF must be updated and filed at least annually.
B. SEC Review of Registration Statements; Basis for Denying Registration The major focus of the SEC’s review of an adviser’s Form ADV is on the disciplinary history of the firm and its personnel. The adviser must provide information with respect to its disciplinary history as well as the disciplinary history of its “advisory affiliates” -- that is, the firm’s employees (other than those performing purely clerical or ministerial functions), officers, partners or directors and all persons directly or indirectly controlling or controlled by the adviser.
An adviser must disclose disciplinary history with respect to a variety of matters, including felony convictions, certain misdemeanor convictions and proceedings related to violations of investment-related laws and regulations (whether U.S. or non-U.S.) as well as suspensions of the authorization to practice as an investment adviser and proceedings brought by self-regulatory agencies. Generally, disciplinary events that occurred within the prior 10 years must be disclosed.
Based on this disciplinary disclosure, the SEC may deny registration or impose limits on the activities of the investment adviser. In addition, subsequent to registration, the SEC may, in its discretion, censure, place limitations on the activities or suspend for a period not exceeding 12 months or revoke the registration of any adviser if it finds that the adviser or any person associated with the adviser has been subject to these types of disciplinary action. The disciplinary events that the SEC may use as a basis to deny registration or take these other actions include, among other things:
• making a false or misleading statement in any material required to be filed with the SEC;
• conviction of a felony or misdemeanor or of a substantially equivalent crime by a foreign court within the prior 10 years (i) involving the purchase or sale of any security or involving fraud, (ii) arising out of the conduct of an investment adviser, broker, dealer, bank or similar financial service businesses or (iii) involving larceny, theft or misappropriation of funds or securities;
• conviction, within the prior 10 years, of any crime that is punishable by imprisonment for one or more years;
• being permanently or temporarily enjoined from acting as an investment adviser, broker, dealer or in similar capacities;
• a willful violation of the U.S. securities laws, causing another person to have willfully violated those laws or failing to supervise a person who commits such a violation;
• becoming subject to an order of the SEC barring or suspending the right of the person to be associated with an investment adviser;
• a finding by a foreign financial regulatory authority of having (i) made a false statement in any materials required to be filed with a foreign securities authority, (ii) violated any foreign statute or regulation regarding transactions in securities or (iii) aided or abetted the violation by any other person of a foreign statute or regulation involving transactions in securities; and
• becoming subject to a bar by a state regulatory agency that regulates certain financial service companies.
C. Disclosure and Delivery Requirements
A registered investment adviser must provide advisory clients with a copy of its Brochure and Brochure Supplement before or at the time the adviser enters into an advisory contract with the client. Thereafter, an investment adviser must deliver its Brochure and Brochure Supplement to its clients on an annual basis or deliver a summary of material changes to the Brochure since it was last delivered, accompanied by an offer to provide the Brochure. Also, as discussed below, an investment adviser is a fiduciary and must make full disclosure to clients of all material facts relating to the advisory relationship, including full disclosure of all material conflicts of interest that could affect the advisory relationship, even if not specifically required by Part 2 of Form ADV.
D. Books and Records
The Advisers Act imposes extensive books and records requirements. An adviser must keep true, accurate and current books and records reflecting its financial affairs and describing transactions for and communications with its clients. An adviser must also maintain all accounts, books, internal working papers and any other documents necessary to form the basis for, or demonstrate the calculation of, the performance information used in advertising. In the case of an alternative investment fund manager (such as an adviser to a hedge fund or private equity fund), the adviser’s books and records include the books and records of the fund.
E. SEC Examination
The SEC actively monitors compliance with the Advisers Act through its examination program. An examination typically involves an SEC visit to an adviser’s offices. During an SEC inspection, an adviser’s books and records are usually the subject of careful review. An SEC inspection often occurs within a year after initial registration;
the frequency of examinations thereafter depends upon the SEC’s assessment of the firm’s risk profile. SEC examinations can last anywhere from a week or more to many months, depending on the focus of the exam and the size and complexity of the adviser.
Violations of the Advisers Act may result in the imposition of civil or administrative sanctions by the SEC, as well as substantial monetary penalties.
In 2012, the SEC launched an initiative to conduct focused, risk-based examination of AIFMs that recently registered with the SEC.1 This initiative is still ongoing. As discussed below, risk management is a major focus of the SEC’s examination program.
F. Coordinated Compliance Program and Risk Management
Registered investment advisers—which includes most U.S. alternative investment fund managers—are required to adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act by the adviser or any of its supervised persons. In adopting Rule 206(4)-7, the rule that requires such policies, the SEC did not impose a set of specific elements that advisers must include in their policies and procedures. As discussed below, however, in other contexts the SEC has identified certain minimum requirements with respect to the policies and procedures.
Rule 206(4)-7 also requires a registered investment adviser (i) to review its policies and procedures annually to determine their adequacy and the effectiveness of their implementation and (ii) to designate a chief compliance officer to administer its compliance policies and procedures. The SEC’s guidelines indicate that the chief compliance officer should be competent and knowledgeable regarding the Advisers Act and should be empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the investment adviser.
An important component of an adviser’s compliance program is risk management.
In adopting Rule 205(4)-7, the SEC stated that an adviser, in designing its policies and procedures, “should first identify conflicts and other compliance factors creating risk exposure for the firm and its clients in light of the firm's particular operations, and then design policies and procedures that address those risks.” Risk management has continued to be emphasized by the SEC in address adviser compliance.
The SEC expects that an investment adviser’s compliance program will cover the following risk areas (certain of which are addressed in more detail below):
• Portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with clients’
investment objectives, disclosures by the adviser, and applicable regulatory restrictions;
1 See http://www.sec.gov/about/offices/ocie/letter-presence-exams.pdf.
• Trading practices, including procedures by which the adviser satisfies its best execution obligation;
• Proprietary trading of the adviser and personal trading activities of its employees;
• The accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements;
• Safeguarding of client assets from conversion or inappropriate use by advisory personnel;
• The accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;
• Marketing advisory services, including the use of solicitors;
• Processes to value client holdings and assess fees based on those valuations; and
• Safeguards for the privacy protection of client records and information.
In examining a registered investment adviser, the SEC staff will request information about the compliance risks that the firm has identified and the written policies and procedures the firm has established and implemented to address each of those risks to provide an understanding of the firm's compliance risks and corresponding controls.2 Among other things, the SEC staff requests (i) an inventory of compliance risks that forms the basis for policies and procedures and notations regarding changes made to the inventory; (ii) documents mapping the inventory of risks to written policies and procedures; and (iii) written guidance provided to employees regarding compliance risk assessment process and procedures to mitigate and manage compliance risks.
As relevant, the SEC staff has also emphasized the need for advisers to consider liquidity issues. For example, in the public fund context, the SEC staff has urged fund advisers to generally assess overall fund liquidity and funds’ ability to meet potential redemptions in light of potential market volatility, including assessing their sources of liquidity (such as cash holdings and other assets that would not require selling into declining or dislocated markets if volatility or market stress increases). In this
2 See Office of Compliance Inspections and Examination, “Investment Adviser Examinations: Core Initial Request for Information” available at http://www.sec.gov/info/cco/requestlistcore1108.htm.
connection, the staff has urged fund advisers to consider assessing the impact (beyond just liquidity) of various stress-tests and/or other scenarios on funds.3
G. Code of Ethics; Personal Securities Trading
A registered investment adviser must adopt a code of ethics that sets forth, among other things, a standard of conduct for its employees and requires compliance with federal securities laws. The code of ethics also must require the adviser’s “access persons” (employees with access to certain types of information) to periodically report their personal securities transactions and holdings to the adviser’s chief compliance officer or other designated persons. Certain types of personal securities transactions (such as purchases of IPOs and private placements) are subject to an enhanced review and approval process. The code of ethics must also require the adviser to review these reports. The transaction reports must be retained in the investment adviser’s books and records for SEC review.
H. Policies to Prevent the Misuse of Non-public Information
A registered investment adviser must establish, maintain and enforce written policies and procedures reasonably designed to prevent the misuse of material non-public information by the investment adviser or any person associated with the investment adviser.
I. Antifraud Provisions
The antifraud provisions are at the heart of the Advisers Act and are the basis for many SEC enforcement proceedings. The statutory anti-fraud provision makes it
unlawful for any investment adviser (i) to employ any device, scheme, or artifice to defraud any client or prospective client or (ii) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client. This provision also prohibits an adviser from engaging in certain principal and agency transactions with its clients without client consent. The Advisers Act’s antifraud provisions have been interpreted to impose on the adviser an affirmative duty of utmost good faith to act solely in the best interests of its clients and to make full and fair disclosure of all material facts, particularly where the adviser’s interests conflict with those of its clients.
The SEC also has adopted a number of specific antifraud rules governing, among other things, advertisements, the custody of client assets, the use of client solicitors,
3 SEC Division of Investment Management Guidance Update No. 2014-1, “Risk Management in Changing Fixed Income Market Conditions,” available at
http://www.sec.gov/divisions/investment/guidance/im-guidance-2014-1.pdf.
political contributions and proxy voting. These rules are described below. In addition, as described above, the SEC has adopted Rule 206(4)-7, which requires, among other
things, the adoption of compliance policies and procedures and the appointment of a chief compliance officer. The SEC has also adopted a general antifraud rule (Rule 206(4)-8) that prohibits conduct that defrauds investors or prospective investors in pooled
investment vehicles managed by the investment adviser.
1. Advertising Restrictions
Generally, the Advisers Act prohibits registered advisers from distributing any advertisement that, among other things, contains untrue statements of material fact or that is otherwise false or misleading. Rule 206(4)-1 prohibits, among other things, the use of testimonials in adviser advertisements and sets forth conditions for disclosing prior recommendations of the investment adviser. In addition, the SEC has issued a number of
“no-action” letters setting forth its views on the manner in which prior performance may be presented.
2. Custody of Client Assets
The safeguarding of client assets is a key concern of the SEC. Rule 206(4)-2 (the
“Custody Rule”) requires that a registered investment adviser having “custody” of client funds or securities maintain them with a “Qualified Custodian” such as a bank, registered broker-dealer, registered futures commission merchant or foreign financial institution that customarily holds financial assets for its customers. The Custody Rule also requires, among other things, that an independent accountant verify the existence of the client funds and securities either through a “surprise” examination or, if the client is a pooled investment vehicle, an annual audit.
The term “custody” is broadly defined under the Custody Rule. An adviser has custody if “it holds, directly or indirectly, client funds or securities or has any authority to obtain possession of them” either directly or through a related person. For example, the general partner of an alternative investment fund (and any manager that is a related person of the general partner) is deemed to have custody of the fund’s assets.
3. Use of Solicitors
Some advisory firms retain solicitors to assist them in establishing client
relationships. Rule 206(4)-3 under the Advisers Act requires that the adviser enter into a written agreement with any such solicitor addressing certain matters, oversee the
activities of the solicitor and arrange for the solicitor to provide certain disclosures to clients.
4. Pay-to-Play Prohibitions
Rule 206(4)-5 under the Advisers Act is designed to prohibit certain practices relating to the solicitation of business from U.S. state and local governments (generally characterized as “pay to play” practices). The rule, in effect, imposes significant restrictions on the political contributions and certain other fundraising activities by an investment adviser and its affiliates, officers and employees when the investment adviser provides (or is seeking to provide) advice to local or state government entities, whether directly or through a alternative investment fund.
5. Proxy Voting
A registered investment adviser must have written proxy voting policies and procedures that are reasonably designed to ensure that the adviser votes proxies in the best interest of clients. In addition, a registered investment adviser must disclose to clients information about its proxy voting policies and procedures and about how clients may obtain information on how the adviser has voted their proxies.
J. Performance-Based Fees; Management Agreements
A registered investment adviser may not enter into an investment advisory contract that provides for compensation based on a share of capital appreciation, unless the client is a qualified sophisticated investor or a non-U.S. person. In addition, any investment advisory agreements with clients must contain (i) a provision requiring the client’s consent to an “assignment” of the agreement (including transfers of a controlling interest in the firm) and (ii) if the investment advisory firm is organized as a partnership, a provision requiring notification to the client of any change in the partners.
K. Business Continuity Plans
While not required by any rule, the SEC expects a registered investment adviser to develop a business continuity plan identifying procedures relating to an emergency or significant business disruption.
L. Client Privacy
The SEC’s Regulation S-P requires investment advisers to “adopt policies and procedures that address administrative, technical, and physical safeguards for the protection of customer records and information.” The SEC’s identity theft red flags rules require certain registered investment advisers to adopt a written identity theft program that includes policies and procedures designed to:
• Identify relevant types of identity theft red flags;
• Detect the occurrence of those red flags;
• Respond appropriately to the detected red flags; and
• Periodically update the identity theft program.
Investment advisers that are required to adopt identity theft programs also must provide for the administration of the program, including staff training and oversight of service providers.
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