Form ADV is perhaps the most important document a registered investment adviser will prepare in the entirety of its life cycle – at least from a regulatory perspective. This is not only because it is filed with the SEC and/or state securities regulatory authorities, but also because it is publicly available and ostensibly relied upon by prospective clients when evaluating whether or not to entrust their life savings with a particular adviser.
The SEC positioned the importance of Form ADV to the investing public as follows in a 2016 Investor Bulletin:
To allow clients and prospective clients to evaluate the risks associated with a particular investment adviser, its business practices, and its investment strategies, it is essential that clients and prospective clients have clear disclosure that they are likely to read and understand.
Yet, despite its foundational importance, the SEC’s Form ADV Instructions (consisting of Part 1 Instructions, Part 2 Instructions, and Part 3 Instructions) and Frequently Asked Questions (consisting of Part 1 FAQs, Part 2 FAQs, and Part 3 FAQs) can nonetheless afford advisers an intimidating degree of latitude to interpret how certain information is to be presented.
At least anecdotally, I see many Form ADV questions answered by advisers incorrectly or insufficiently – and hardly ever due to any intentional actions or omissions by the adviser. Since most advisory firms are likely in the throes of preparing to file their annual Form ADV amendment by the end of March, the initial focus will be on Form ADV Part 1 – the part that requires the most attention during the annual Form ADV amendment process. Some of the most common deficiencies I encounter (let’s call them “opportunities for improvement”) as well as best practices to keep in mind are discussed below.
Form ADV Structure
For a more thorough breakdown of Form ADV and its various underlying components, readers are encouraged to peruse this prior article, Upfront And Ongoing RIA Compliance Obligations Of State Vs SEC-Registered Investment Advisers, regarding SEC versus State application and ongoing compliance differences (see the section entitled “Parts of Form ADV for RIAs”).
At a high level, Form ADV is the foundational registration document that must be submitted by any investment adviser seeking to become registered with the SEC or the states. The term “Form ADV” is actually an umbrella term that encompasses four sub-parts:
- Part 1 (not deemed worthy of a nickname)
- Part 2A (aka the “Brochure”) and/or Part 2A Appendix 1 (aka the “Wrap Fee Program Brochure”)
- Part 2B (aka the “Brochure Supplement”)
- Part 3 (aka “Form CRS” or the “Relationship Summary”)
Each part, in turn, is comprised of multiple sub-parts, items, schedules, Disclosure Reporting Pages (DRPs), and, with respect to the Brochure, a potential appendix. Some Form ADV parts, sub-parts, items, schedules, DRPs, and appendices are required to be submitted solely by SEC-registered advisers, some are required to be submitted solely by state-registered advisers, and some are required to be submitted by both SEC and state-registered advisers.
Each registered investment adviser’s Form ADV Part 1 and Brochure is publicly available on the SEC’s Investment Adviser Public Disclosure (IAPD) website, as is the Brochure Supplement for each state-registered investment adviser. The Relationship Summary is also publicly available for all SEC-registered investment advisers with clients that are “retail investors” (as well as for Rhode Island state-registered investment advisers, which is the only state I’m aware of that requires the Relationship Summary).
Form ADV Part 1: Common Issues And Best Practices
Unfortunately, at least for state-registered advisers, even state securities regulatory authorities themselves can interpret the various instructions and FAQs for Form ADV differently, which means that the same question may need to be answered differently depending on the state(s) in which an adviser is required to register. For several examples of these state differences, refer again to this prior article (see the section entitled “Other Notable Issues For Ongoing RIA Compliance (State Vs SEC)”).
Thus – for simplicity – the following discussion will focus on the common missteps and best practices applicable to SEC-registered advisers (though most – but not all – are universally applicable to state-registered advisers as well).
In addition, it is worth having the Form ADV Glossary handy when preparing or updating the Form ADV (see p. 26). Any italicized word appearing in Form ADV is generally a defined term included in the Form ADV Glossary. The Form ADV Glossary is thus a key document to have at hand when trying to decipher how a particular Form ADV question is to be answered. It is bookmarked in my browser and I refer to it at least weekly, as it is common for a particular term’s definition to not always be sensible or intuitive (see, e.g., the definition of “Employee,” discussed below).
TERMINOLOGY GENERALLY
When preparing responses to the Form ADV instructions, conjure an image of former President Bill Clinton testifying before a grand jury in 1998: “It depends on what the meaning of the word ‘is’ is.” In other words, definitions matter, and the definitions (or lack thereof) ascribed to certain terms in Form ADV are not always intuitive. Below are a few examples.
Use of the Term “You” and “Your”
Form ADV Part 1 is littered with imprecise pronoun usage – especially with respect to the use of the terms “you” and “your”. For example, Item 6(A) states, “You are actively engaged in business as a (check all that apply)”, and Item 7(A) states, “This part of Item 7 requires you to provide information about you and your related persons, including foreign affiliates. Your related persons are all of your advisory affiliates and any person that is under common control with you. You have a related person that is a (check all that apply)”.
At first blush, it may not be clear to the Form ADV respondent whether the use of “you” and “your” is intended to refer to just the registered investment adviser firm or whether it also extends to the supervised persons within the firm. However, the literal (and correct) way to construe such pronouns unless instructed otherwise is to mean the registered investment adviser firm only – which can dramatically affect the responses to certain questions.
Separately Managed Accounts
What constitutes a “separately managed account” in the industry’s lexicon is very different from what the SEC considers to be a separately managed account. Historically, it’s fair to say that a separately managed account was understood by the industry to mean just that – an investor’s account that was not managed directly by the advisory firm itself but was managed instead by a third-party advisory firm that managed the investor’s account pursuant to a specific investment directive that was distinct from the advisory firm’s other accounts. When the SEC adopted various revisions to Form ADV Part 1 in late 2016, however, it took the opportunity to turn this understanding on its head:
For purposes of reporting on Form ADV, we consider advisory accounts other than those that are pooled investment vehicles (i.e., registered investment companies, business development companies and pooled investment vehicles that are not registered (including, but not limited to, private funds)) to be separately managed accounts.
In other words, unless an advisory firm is an adviser to an investment company (a mutual fund or [typically] an exchange traded fund), a Business Development Company (BDC), or an unregistered pooled investment vehicle (e.g., a hedge fund), the accounts advised or managed by the advisory firm are considered to be separately managed accounts.
A separately managed account has nothing to do with whether the account is managed by a third-party, but instead has everything to do with whether the account is pooled with or unpooled from (i.e., separate from) other accounts.
ITEM 1
Item 1 is essentially a collection of identifying/demographic information regarding the advisory firm’s name, address, phone number, websites, and a few other odds and ends. This Item may appear relatively straightforward, but there are a few important nuances to bear in mind.
Item 1.F.(1) and (5) – Principal Office And Place Of Business
A post office box or virtual mail service location cannot be used as an adviser’s principal office and place of business, even if listing the physical street address of the post office box or virtual mail service. The instructions require that a physical location be listed, even if it is a residential address.
If an advisory firm is comprised of multiple advisors that all work remotely from home offices, the advisory firm will ultimately need to select one such home office address to serve as the principal office and place of business.
To aid in this determination, look to the definition of “Principal Office and Place of Business” in the Form ADV Glossary (starting on p. 26), which offers the following definition:
Your firm’s executive office from which your firm’s officers, partners, or managers direct, control, and coordinate the activities of your firm.
If an advisory firm also maintains on-demand professional workspace(s) (for client meetings, conference facilities, mail service, etc.) from which personnel occasionally work, such office(s) should be listed in Schedule D, Section 1.F.
Also – to avoid a residential address being made publicly-available through the IAPD, be sure to check the box that reads “If this address is a private residence, check this box.” That will mask such address from the public and nefarious web crawling services.
Item 1.I – Social Media Websites And Accounts
Select “yes” if the advisory firm has any websites or publicly available social media accounts, and list the URLs for such websites and accounts in Schedule D, Section 1.I. There’s no need to provide the addresses of websites or accounts on publicly available social media platforms where the advisory firm does not control the content (e.g., an unclaimed Yelp page, unclaimed online directory listing, etc.).
Importantly, do not provide the addresses of employee accounts on publicly available social media platforms. As the SEC states in its Form ADV Part 1 FAQs, “this item is not intended to extend to the social media accounts of an adviser’s employees regardless of whether the adviser controls the content of such accounts.”
The only potential exception is if an employee’s personal social media account (typically a solo owner’s personal social media account) is the sole means by which an advisory firm markets its services online and there is no distinct account for the advisory firm itself.
Item 1.L – Location Of Maintained Books And Records
There is no need to list each location – whether electronic or physical – where an adviser maintains duplicate back-up copies of its documents and files if such records are kept at the adviser’s principal office and place of business. Thus, if an adviser stores its documents and files electronically on the computers located or accessible from its principal office and place of business, but also syncs such files to a cloud-based storage provider, the adviser need not list such cloud storage provider in Schedule D, Section 1.L.
SEC exam staff basically just need to know where they can obtain a complete set of the advisory firm’s files and documents. I think we can all agree that the SEC is unlikely to show up to the headquarters of Google or Microsoft and expect to be presented with an advisory firm’s documents and files, and thus such locations generally need not be listed in Schedule D, Section 1.L.
ITEM 5
Item 5 peels back the onion of an advisory firm a few more layers, and calls for specific information regarding employee head count, client types, discretionary and non-discretionary regulatory assets under management, number of accounts, compensation arrangements, types of services offered, financial planning activities, wrap fee program sponsorship and/or management, separately-managed account clients, and marketing activities (the newest addition to Form ADV Part 1, which is the result of the new SEC Marketing Rule).
Item 5.A – Employee Head Count
In response to this question, list the total number of the advisory firm’s full- and part-time employees, including independent contractors who perform advisory functions on behalf of the advisory firm. This is because the term “employee”, as defined in the Form ADV Glossary, is not limited to statutory W2 employees.
Thus, advisory firms with independent contractor investment adviser representatives that operate their own businesses – perhaps under a different name than the advisory firm itself – should all be included here. Clerical workers, whether employee or independent contractor, can be excluded here.
Item 5.C.(1) – Non-AUM Client Head Count
This question asks for the number of clients to whom the advisory firm provided investment advisory services during the most recent fiscal year, but for whom the advisory firm does not report any Regulatory Assets Under Management (RAUM). These could be, for example, clients to whom the advisory firm provided financial planning services but did not manage any assets or clients to whom the advisory firm managed assets but not to the extent that such management qualified as RAUM.
What constitutes RAUM is somewhat complicated but is explained in the Form ADV Part 1 Instructions (see Section 5(b) on page 19). In a nutshell, only the securities portfolios for which the advisory firm provides continuous and regular supervisory or management services should be included. Client assets managed on a discretionary basis are typically included in RAUM. Client assets managed on a non-discretionary basis may only be included in RAUM if the advisory firm arranges or affects the transactions to be placed in the client’s account(s) (i.e., transactions arranged or effected by the client or another third-party to the exclusion of the advisory firm do not count as RAUM).
For further detail, refer to this August 2016 article, Financial Planning & Regulatory Assets Under Management, published by Beach Street Legal.
Item 5.C.(2) and 5.F.(3) – Non-U.S. Clients
When calculating the percentage of clients that are non-U.S. persons and RAUM attributable to clients that are non-U.S. persons, be sure to include natural persons that are not resident in the U.S. In other words, a non-U.S. person is someone that resides outside the U.S. – regardless of such person’s citizenship, visa status, etc. A U.S. citizen residing in Australia, e.g., is a non-U.S. person for ADV reporting purposes.
Item 5.G – Advisory Services Provided
Subpart (7), “Selection of other advisers (including private fund managers)” should be checked if an advisory firm utilizes the services of a subadviser.
Subpart (8), “Publication of periodicals or newsletters” should not be checked just because an advisory firm publishes a newsletter or blog; this subpart is generally intended to capture periodicals or newsletters only if they constitute the rendering of advisory services (e.g., making buy/sell recommendations or securities analysis via periodical or newsletter).
A similar logic applies to subpart (11), “Educational seminars/workshops”, in that this box need not be checked simply because an advisory firm occasionally hosts a lunch-and-learn event for its clients. If, on the other hand, an advisory firm were to market paid educational seminars and workshops, and such content includes the rendering of advisory services, then it would be a different story.
Item 5.H – Financial Planning Client Head Count
The debate with this question is whether it should be inclusive of clients to whom the advisory firm provided only financial planning services, or also clients to whom the advisory firm provided financial planning and investment management services. My general advice has been the latter. The question does not exclude the contemporaneous provision of investment management services alongside financial planning services, so we advise responding accordingly.
Item 5.J.(2) – Methodology Used To Report Client Assets
If an advisory firm reports “assets under advisement”, “assets under care”, or otherwise reports some metric other than RAUM in Item 4 of its Brochure, this question should be answered “yes”.
Item 5.K.(2) – Borrowing Transactions On Behalf Of Separately Managed Account Clients
To the extent that advisers engage in borrowing transactions on behalf of separately managed account clients (including margin accounts), this question should be answered in the affirmative.
Importantly, note that “borrowing transactions” only includes such transactions of which the advisory firm is aware. Thus, if a client unilaterally invests loan proceeds with the advisory firm without the firm’s knowledge or involvement, this question may be answered “no”.
ITEM 6 AND ITEM 7
I think of Item 6 and Item 7 as doppelgangers, in that they bear a striking resemblance to one another at first glance, yet are at the same time wholly distinct and call for very different responses. They both thematically address activities beyond pure investment advisory activities in an effort to flesh out potential conflicts of interest, but they are far from a mirror image each other.
As described earlier, these are the Form ADV Part 1 Items that mostly directly hinge on the applicability of the term “you” and “your”.
Item 6 is intended to capture the other business activities of the advisory firm, and Item 7 is intended to capture the other business activities of the advisory firm’s related persons. The term “related persons” includes:
- Any person under common control with the advisory firm;
- Officers, partners, or directors (or any person performing similar functions);
- All persons directly or indirectly controlling or controlled by you; and
- All of your current employees (other than employees performing only clerical, administrative, support or similar functions).
However, neither Item 6 nor Item 7 should be used to disclose that some of an advisory firm’s employees perform advisory functions, are registered representatives of a broker-dealer, or are insurance agents. The number of employees that serve in each such capacity should instead be disclosed in Item 5.B.(1), (2), and (5), respectively.
ITEM 8
Item 8 may be entitled “Participation or Interest in Client Transactions,” but it might as well be called “Acute Conflicts of Interest,” as that is the underlying motivation for most of the specific questions in this Item. I don’t have any data or source to support the assertion that follows, but I suspect Item 8.A (Proprietary Interest in Client Transactions) and Item 8.B (Sales Interest in Client Transactions), in particular, are heavily weighted in the SEC’s overall risk assessment of an advisory firm.
Item 8.A.(2) – Purchasing Securities Recommended To Advisory Clients
If an advisory firm or its “related persons” (see the definition immediately above) invest in the same securities that you recommend to clients, then this question should be answered “yes” unless such securities are mutual funds. An advisory firm owner or employee that personally invests using the same securities that are recommended to clients (including exchange traded funds) would cause this question to be answered in the affirmative.
Item 8.C.(3) and (4) – Discretionary Authority To Determine Broker/Dealers Or B/D Commission Rates
It should be fairly easy to discern whether an advisory firm has discretionary authority to determine the securities to be bought or sold for a client’s account, the amount of securities to be bought or sold for a client’s account, and the timing of when such securities should be bought and sold (such authority is typically granted in a standard discretionary advisory agreement with the client).
What may not be as apparent is whether an advisory firm has the discretionary authority to determine the broker or dealer to be used for a purchase or sale of securities for a client’s account (Item 8.C.(3)), and/or the commission rates to be paid to a broker or dealer for a client’s securities transactions (Item 8.C.(4)).
If an advisory firm merely recommends that a client retain a particular broker or dealer to execute the client’s securities transactions (which is also typically coupled with such broker or dealer acting as the qualified custodian of the client’s assets), and the client still has to execute custodial broker-dealer new-account-opening paperwork to engage such custodial broker-dealer, this does not in and of itself trigger discretionary authority over custodial broker-dealer selection or applicable commission rates. This is even the case if the advisory firm assists the client with the new account opening paperwork.
Unless the custodial broker-dealer will open an account on behalf of a client solely upon the adviser’s instruction and without the client’s signature (or the advisory firm is also the general partner of a pooled investment vehicle, e.g.), Items 8.C.(3) and (4) should typically be answered “no”.
Item 8.G – Soft Dollar Benefits Received In Connection With Client Securities Transactions
The term “soft dollar benefits”, as used in Form ADV, is described as “research or other products or services other than execution from a broker-dealer or a third party in connection with client securities transactions.” If an advisory firm receives soft-dollar benefits from a broker-dealer or third party, it should answer this question “yes” and also answer if all such-soft dollar benefits are “eligible research or brokerage services under section 28(e) of the Securities Exchange Act of 1934.”
That said, what is actually considered to be a soft-dollar benefit is muddy at best, and Form ADV’s cursory description compounds this opacity. For those that want to go down a soft-dollar rabbit hole, check out this 1998 SEC Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds, this 2018 SEC Risk Alert entitled Compliance Issues Related to Best Execution by Investment Advisers, and this article entitled Do All Investment Advisers Really Have a Fiduciary Duty to Seek “Best Execution”? that I wrote back in August 2018.
My personal opinion (at least for purposes of responding to Form ADV Part 1, Item 8.G) is that the standard, off-the-shelf suite of services and technology offered by most blue-chip custodial broker-dealers to all advisory firms on its platform were not intended to fall within the soft-dollar benefit construct. Soft dollars (at least historically) have been understood to capture arrangements in which an advisory firm had the discretionary authority to direct client transactions to a variety of brokers or dealers, each of which would earn commissions from the client transactions and provide the advisory firm various research or other products or services specifically in exchange for the advisory firm causing the broker or dealer to earn such commissions.
Since most transaction commissions at the blue-chip custodial broker-dealers have effectively gone to zero, and because advisory firms generally only recommend and do not select custodial broker-dealers through which transactions are to be effected, the old construct of soft dollars is somewhat of a square peg in a round hole given present-day adviser/custodian relationships.
Unless an advisory firm has a special arrangement with a custodial broker-dealer, pursuant to which the custodial broker-dealer provides the adviser additional products, services, or other direct or indirect benefits in exchange for directing a certain amount of brokerage transactions or assets under custody to the custodial broker-dealer (i.e., more than the standard, off-the-shelf suite of services and technology offered to all advisory firms on its platform), Item 8.G can be answered “no”.
Importantly, however, the advisory firm should still disclose the various services, products, or other direct or indirect benefits it receives from the custodial broker-dealers it recommends, even if not technically soft-dollar benefits, in its Form ADV Part 2A, Item 12 and/or Item 14.
ITEM 9.A
Ah yes… custody. The Custody Rule is perhaps the most convoluted rule under the Investment Advisers Act of 1940, and the Form ADV does not do it any favors. This blog article from August 2017, New SEC Custody Rule Requirements For Advisors With Third-Party SLOA Authority, offers a foundational explainer of the Custody Rule and its application specifically to Standing Letters Of Authorization (SLOAs).
For purposes of responding to Item 9.A, however, the Custody Rule can be oversimplified into three different ‘levels’ of custody:
- If an advisory firm has custody of a client’s cash, bank accounts, or securities solely due to its fee-deduction authority, Item 9.A should be answered “no”.
- If an advisory firm has custody due its authority to disburse money to a third-party on the client’s behalf pursuant to a SLOA, Item 9.A should be answered “yes”. To further contextualize this response and make it clear that the advisory firm does not have “full” custody such that it triggers the annual surprise custody examination by an independent accounting firm, an advisory firm should consider adding explanatory language to the Schedule D – Miscellaneous section (which is a catch-all that can be used to explain a response to an ADV item or to provide any other information). This language could read something along the lines of the following:
“Custody is reported in Item 9.A. solely due to certain standing letters of authorization that permit the distribution of client funds to third parties. The firm endeavors to comply with the SEC no-action letter to the Investment Adviser Association dated February 21, 2017 in this regard.”
- If an advisory firm has custody for any other reason (e.g., bill-pay authority, possession of a client’s held-away account username or password, possession of or authority to possess client funds or securities, etc.), Item 9.A (or Item 9.B, if custody is triggered through a related person) should be answered “yes” and Item 9.C should be answered as well.
Importantly, the SEC just recently proposed an overhaul of the Custody Rule on February 15, 2023, so the guidance above may ultimately change if the new Custody Rule is later adopted.
SCHEDULES A & B
Schedule A is to include a list of the advisory firm’s direct owners and executive officers, and Schedule B is to include a list of the advisory firm’s indirect owners. Thus, owners must be disclosed even if not executive officers, and executive officers must be disclosed even if not owners. The Chief Compliance Officer (or “CCO”) must be specifically identified in Schedule A and should always be listed as a title for one of the individuals included in Schedule A (even if that individual also has another title like CEO, e.g.).
In Schedule A, report the name of the natural person or the entity through which the ownership in the advisory firm is actually held. If an advisory firm is owned directly by one or more natural persons (i.e., not through an entity), Schedule B can be left blank.
If, however, an advisory firm owner holds their interest in the advisory firm through an entity like a holding company or a trust, it is the holding company or trust that should be reported in Schedule A. The members (if the ownership is held through an LLC), shareholders (if the ownership is held through a corporation), general partners and limited partners (if ownership is held through a partnership), and trustees (if ownership is held through a trust) of a direct owner holding company or trust reported in Schedule A must be reported in Schedule B, subject to the following Schedule B thresholds:
- If a Direct Owner is a Corporation: Only disclose shareholders that beneficially own, have the right to vote, or have the power to sell or direct the sale of 25% or more voting securities in that corporation.
- If a Direct Owner is an LLC: Only disclose members that have the right to receive upon dissolution, or have contributed, 25% or more of the LLC’s capital. If the direct-owner LLC is manager-managed, all elected managers must be disclosed.
- If a Direct Owner is a Partnership: Disclose all general partners, and only disclose limited partners that have the right to receive upon dissolution, or have contributed, 25% or more of the partnership’s capital.
- If a Direct Owner is a Trust: Disclose all trustees.
Advisory firms must continue to disclose ‘up the chain of ownership’, listing all 25% owners at each level in Schedule B.
SCHEDULE D, SECTION 5.K.(1)
Section 5.K.(1) paints a rudimentary picture of the advisory firm’s investment philosophy, as it calls for a percentage breakdown of the asset types into which separately managed account clients are invested.
Advisory firms with less than $10 billion in RAUM attributable to separately managed accounts are only required to break down asset types held by such separately-managed-account clients in the aggregate as of the end of each year.
Advisory firms with $10 billion or more in RAUM attributable to separately managed accounts are additionally required to break down mid-year asset types as well. The percentage breakdown must add to 100% (rounding to the nearest percent is fine).
A few categorization tips:
- Mutual funds and exchange traded funds should generally be counted in row (ix) – Securities Issued by Registered Investment Companies or Business Development Companies
- Cash equivalents include bank deposits, CDs, bankers’ acceptances, and similar bank instruments
- Advisory firms need not look through mutual funds or ETFs to report their underlying asset type
- If an asset fits into more than one asset type category, advisers should use their best judgment and pick one consistently (just don’t report the same asset in multiple asset type categories)
Does this article represent a comprehensive, hair-splitting analysis of all the vagaries in the Form ADV Part 1? No. Are there other nuances and best practices that should be brought to bear when completing Form ADV Part 1? Absolutely. Are rhetorical questions like these annoying and do they reflect lazy writing? Perhaps.
The good news is that the very same resources that were used to write and fact check this article are publicly available for any advisory firm to read, bookmark, and doze off to use as a guide (all of which are listed and linked below).
Form ADV will always require judgment calls, and I’m sure there are other lawyers and compliance professionals who will interpret certain Form ADV questions differently than I have. This stuff is both art and science.
If you’ve made it this far and are interested in a follow-up article regarding the common missteps and best practices with respect to Form ADV Part 2 and/or the Form CRS, leave a comment below or drop me a line.
Summary of Resources
- Form ADV Part 1
- Form ADV Instructions
- Form ADV Glossary of Terms (starts on p. 26)
- Form ADV FAQs
- 2016 Form ADV Amendments Adopting Release
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This article originally appeared in Michael Kitces’ Nerd’s Eye View on February 22, 2023.