Dramatic new Securities and Exchange Commission (SEC) disclosure requirements will change the way trustees choose and manage financial advisers. These disclosures provide information that trustees may not have been able to cobble together on their own — and perhaps also raise the due diligence bar for trustees.

For the first time, trustees will be able to see a full picture of services, fees, disciplinary history and conflicts of interest — all the things that a dutiful fiduciary must explore, understand and assess before hiring (or continuing to retain) a financial adviser to invest trust assets. That's not to say, however, that the reading will necessarily be easy, as you'll notice from sample disclosures that I've provided (see “Sample Material Relationship Disclosure,” p. 25 and “Sample Interest in Client Transaction Disclosure,” p. 26).

Here's what fiduciaries need to know about these new disclosures and eight issues trustees need to think about before retaining, referring, reviewing or replacing an adviser.

Who's Affected

The new disclosures (Forms ADV Part A and B)1 are mandated by rules the SEC adopted, effective 2011, under the Investment Advisers Act of 1940 (the Advisers Act). Form ADV Part 2A, also called a “brochure,” applies to advisory firms, and Form ADV Part 2B, known as the “brochure supplement,” describes the financial adviser.2

At first blush, the new disclosures may appear to apply to a narrow band3 of financial advisers — only those governed solely by the Advisers Act. That's not the case.

Trustees should know that these disclosure rules also apply to almost all major broker-dealers.4 Firms such as Merrill Lynch and UBS are now “dually registered.” That is, while conducting their primary business activity as broker-dealers, they're regulated under the Securities and Exchange Act of 1934 (the 1934 Act). When their “registered representatives”5 sell investment advisory services such as managed accounts, they're regulated under the Advisers Act and are referred to as “adviser representatives.”6

To give you some perspective on the significance of these new disclosure requirements to dually registered firms, the Securities Industry and Financial Markets Association (SIFMA), representing 650 securities firms, banks and asset managers, anticipated the cost for dually registered firms to prepare the 2011 brochure supplement to be over $100 million.7

Impact on Trustees

Many trustees delegate the investment of trust assets to financial advisers, as permitted by most states (either under The Uniform Prudent Investor Act, which has been adopted in a majority of states, or under other statutes). But the trustee must make an effective delegation.

According to the American College of Trust and Estate Counsel publication, Guide for ACTEC Fellows Serving as Trustees (the Guide) (Dec. 6, 2000):8

[A]n effective delegation of the investment function requires reasonable care, skill and caution in selecting the agent, establishing the scope and terms of the delegation, and monitoring the agent's performance.

Along each step of the investment process, the trustee has to understand that the standard imposed is the degree of care that would be exercised by prudent persons, if not prudent investors, in the management of their own investments. To the extent that the trustee possesses investment management skills, they must be used; to the extent they are below the level required for the needs of the trust, the trustee must seek competent assistance …. Even the most sophisticated trustee relies heavily on outside sources for guidance in making investment decisions.

Having these new disclosure documents will assist trustees in making an effective delegation because they can more easily compare and contrast candidates before making a decision on whom to choose to manage trust assets.

Trustees who have already chosen an adviser will need to determine whether they should continue the engagement depending on whether the disclosures present any surprises. For example, a trustee may want to replace an adviser if the trustee didn't realize that the adviser earned undisclosed commissions, markups or fees. Or, a trustee may choose to avoid an adviser who has complex industry-related disclosure on principal transactions and trading, unless the disclosure addresses those conflicts to the trustee's satisfaction.

The Brochure

The new brochure came about even though financial industry commentators, including my firm,9 strongly opposed the scope of the proposed disclosures. Commentators objected that the new brochure would only increase consumer confusion, as it would be a long, prospectus-like document that few would understand, much less read.

Notwithstanding those objections, the SEC felt that consumers needed this information to make meaningful decisions as to whom to retain as advisers.10

The result is a disclosure that may be long (75 pages) and involved when a firm needs to disclose many business practices and conflicts and short (15 pages) when a firm has less to disclose. The brochure's focus on conflicts is important because studies show that the average person (trustees and lawyers included) believes all financial advisers are conflict-free fiduciaries,11 which isn't the case under the law.12

What's in it? The new brochure requires firms to provide narrative responses to 18 specific items in a prescribed order. As you scan the items below, you'll notice that some stand out as “must-reads” for trustees, namely, the risk discussion and disciplinary information.

  • Cover page;
  • Material changes;
  • Table of contents;
  • Advisory business;
  • Fees and compensation;
  • Performance-based fees;
  • Types of clients;
  • Methods of analysis, investment strategies and risk of loss;
  • Disciplinary information;
  • Other financial industry activities and affiliations;
  • Code of ethics, participation or interest in client transactions and personal trading;
  • Brokerage practices;
  • Review of accounts;
  • Client referrals and other compensation;
  • Custody;
  • Investment discretion;
  • Voting client securities; and
  • Financial information.

What should trustees read? Trustees should study the entire brochure to see whether the services, as described, fit the needs of the trust. Beyond that, they should focus on risk, conflicts and other red flags, such as disciplinary matters.13 They should compare and contrast the disclosures of advisers under consideration. Their ultimate goal should be to find comfort in the disclosure that the adviser is the right one for the job.

An area of great interest will be conflict disclosures, the basis of which is the underlying fiduciary duty owed by the firms governed by the Advisers Act. The SEC's instructions for completing the brochure and brochure supplement state:

Under federal and state law, you are a fiduciary and must make full disclosure to your clients of all material facts relating to the advisory relationship. As a fiduciary, you also must seek to avoid conflicts of interest with your clients, and, at a minimum, make full disclosure of all material conflicts of interest between you and your clients that could affect the advisory relationship.

This obligation requires that you provide the client with sufficiently specific facts so that the client is able to understand the conflicts of interest you have and the business practices in which you engage, and can give informed consent to such conflicts or practices or reject them. To satisfy this obligation, you therefore may have to disclose to clients information not specifically required by Part 2 of Form ADV or in more detail than the brochure items might otherwise require. You may disclose this additional information to clients in your brochure or by some other means.14 [Emphasis added.]

The word “conflict” appears 37 times in the 26 pages of instructions to Form ADV Parts A and B. The Advisers Act exacts a fiduciary standard of care in client dealings, hence the focus on conflict disclosures. A lesser, non-fiduciary standard of “suitability” applies to broker-dealers and their registered representatives under the 1934 Act and Financial Industry Regulatory Authority (FINRA) regulations.

Now, let's focus on a few of the conflict disclosures, all of which trustees must carefully review and understand, starting with the most basic: compensation.

Compensation

Compensation presents a conflict of interest if the adviser is compensated “for the sale of securities or other investment products, including asset-based sales charges or service fees from the sale of mutual funds.” Why? Compensation gives the adviser “an incentive to recommend investment products based on the compensation received, rather than on a client's needs.”15

These firms need to disclose that clients have the option to purchase investment products that the firm recommends through other brokers and agents. They also have to point out if more than 50 percent of the firm's revenue from advisory clients results from commissions and other compensation for the sale of investment products that the firm recommends to its clients — this raises additional conflict issues, especially if commissions provide the firm's primary or exclusive compensation.

Trustees should watch for a firm that charges advisory fees in addition to commissions or markups. If the firm reduces its advisory fees to fully offset the commissions or markups, the conflict is resolved.

The more different types of compensation arrangements that exist, the more disclosure the trustee will find. For example, compensation may go on for 15 pages of a 75-page brochure if the firm engages in conflicted practices or may just take up a few paragraphs if it doesn't.

Performance-based Fees

If a firm charges performance-based fees (a share of capital gains or capital appreciation of the client's assets), trustees should check if the firm does so for all clients. If not, there's a conflict, because there's an incentive to favor performance fee accounts. If so, trustees may ask the firm to provide assurances that lower compensation won't impede management.

Participation in Client Transactions

If a firm participates in client transactions, that's a conflict that the firm must disclose. Here's an example of a firm's conflict-free disclosure:

It is the general policy of [Firm A] for its members to avoid any transactions or situation that contains a conflict of interest or possible conflicts with its clients. The best interests of the clients shall at all times be the guiding principle. Specific policies include:

  1. No member of [Firm A] may purchase for his own account any security in the course of an initial public offering, except to the extent that such securities are deemed by applicant to be unsuitable for the account of any of its clients.

  2. All employees of [Firm A] shall obtain prior written approval of all security transactions with the principal of [Firm A] or its designate.

No red flags are raised when there are no conflicts — assessing the potential impact when such conflicts are present is less clear-cut.

Material Relationships

Trustees should watch for conflicts when a firm has relationships with other investment advisers, attorneys, accountants or banks that are material to the firm's business or clients. Firms with a single line of business, such as “investment counsel”16 and no material relationships, might respond to this disclosure item with a single paragraph citing no conflicts. Others, with significant relationships, might respond to this item with language like that provided in “Sample Material Relationship Disclosure,” this page.

Interest in Client Transactions

If the firm “recommends to clients, or buys or sells for client accounts, securities in which [the firm] or a related person has a material financial interest,” that's a conflict that the firm must disclose (in the item “code of ethics, participation or interest in client transactions and personal trading”).

Trustees should watch for disclosures on: (1) buying securities from (or selling securities to) clients when the firm is acting as principal (not agent); (2) soliciting client investments in a partnership in which the firm is a general partner; (3) acting as an adviser to an investment company recommended to clients; (4) investing in the same securities (or related securities, for example, warrants, options or futures) recommended to clients; and (5) recommending securities to clients or buying or selling securities for client accounts at or about the same time that the firm buys or sells the same securities for its own account.

“Sample Interest in Client Transaction Disclosure,” p. 26, shows a well-constructed disclosure that points out what the firm's practice is, the conflicts presented by that practice and how the firm addresses those conflicts. Based on this information, the trustee will need to ascertain whether the disclosure properly addresses these conflicts. This decision may depend on how the trust is to be managed.

Soft Dollar Arrangements

Firms must disclose soft dollar arrangements in which the firm receives research, products or services from a brokerage firm in exchange for using them to execute client transactions. In reviewing this disclosure, trustees should watch for any incentives to select or recommend a broker-dealer based on the receipt of services, particularly if they cause clients to pay commissions (or markups or markdowns) higher than those charged by other broker-dealers.

Referral Arrangements

Trustees should be alert to all referral arrangements, such as payments to attorneys or accountants for referring clients, which the SEC considers “significant conflicts of interest.”17 Some firms don't permit referrals; others engage in them as a matter of course.

The Brochure Supplement

The brochure supplement focuses on the background of the individual financial adviser, and it comes to the consumer at great cost to the industry.18

Considering that regulators believe that benefits to consumers outweigh these great costs, the trustee should study the brochure supplement closely.

Here's how the SEC describes the benefits of the disclosed information in the adopting release:

This information will allow clients and prospective clients to determine whether there are safeguards or precautions that they would like to take before receiving investment advice from that [financial adviser] or whether they would prefer to receive investment advice from someone else. A prospective client could be satisfied with his selection of an advisory firm based on the firm brochure disclosures, but then determine that the firm is not the right fit once he or she reviewed the supplements of the actual individuals that would provide investment advice to him. Alternatively, the prospective client could retain the firm but request that other individuals provide advice in their place, potentially preventing costly or disruptive replacement or termination at a later date.19

Like the brochure, the brochure supplement must follow the prescribed order set out by the SEC. The brochure supplement must provide information on:

Educational background and business experience — a description of the financial adviser's formal education after high school and five years of business background.

Disciplinary information — legal or disciplinary events material to a client's evaluation of the adviser's integrity. This includes civil and criminal actions and administrative proceedings before the SEC and other self-regulatory agencies, such as FINRA. State-registered advisers are also required to disclose arbitration awards against them and bankruptcies.

Other business activities — a description of the financial adviser's other investment-related business activities addressing the material conflicts of interest that those activities might create between the adviser and his clients.

This item also requires disclosure of other business activities that provide a substantial source of income to the adviser. In addition, the brochure supplement must describe bonus or non-cash compensation the adviser receives based on the sales of securities or other investment products and explain the conflicts this type of compensation creates.

Additional compensation — compensation the financial adviser receives from someone other than the client, such as sales awards or prizes. The advisor must disclose and address this conflict.20

Supervision — a description of how the adviser is supervised and the name, title and telephone number of the adviser's supervisor.

Unanswered Questions

It's too early to tell yet if the information in the new brochures has the potential to hurt trustees. How are a trustee's efforts at due diligence affected by these new disclosures? What's the impact on attorneys who make referrals to financial advisers? The real answers to these questions will most likely be discovered in the future in a court setting. But in the meantime, here are some issues trustees (and attorneys who refer clients to advisers) can think about:

  1. Should trustees limit their choice of adviser to those whose brochures and brochure supplements contain no material disciplinary disclosures?
  2. Should trustees avoid advisers whose business affiliations are too broad for the trustee to fully assess or whose business models are too complex for the trustee to fully comprehend?
  3. Should trustees retain only narrowly focused advisers who have limited conflicts?
  4. If trust documents use the Advisers Act term “investment counsel,” are trustees not permitted to use dually registered firms?
  5. Should trustees demand comparable disclosure from non-fiduciary advisers who aren't required to provide brochures and brochure supplements? Should they be avoided altogether?
  6. Should trustees replace an adviser whose conflict disclosures aren't addressed to the trustee's satisfaction?
  7. Should attorneys who refer advisers to clients review disciplinary and conflict disclosures before making a referral?
  8. Should attorneys who receive compensation for making referrals review the conflicts disclosures relevant to them?

Next Steps

Given that trustees will want to demonstrate prudence in retaining, referring, reviewing or replacing an adviser — regardless of whether the adviser is mandated to provide disclosure under the Advisers Act — here are some steps the trustee will want to take.

When retaining a new adviser, trustees should compare and contrast the brochure and brochure supplements of a short list of advisers under consideration. If considering an adviser who's not required to provide these written disclosures, the trustee will need to unearth conflicts, fees and disciplinary information on his own. I suggest using the SEC's instructions to the brochure and brochure supplement (Forms ADV Parts 2A and 2B) as a guide, since the instructions are very clear in identifying business practices that present conflicts. The trustee will find the instructions at the end of the adopting release and at www.sec.gov/about/forms/formadv-part2.pdf.

The trustee should do the same when reviewing an existing relationship. But now, the trustee will more than likely be looking for surprises — information not in keeping with his expectations. For example, if performance,21 which isn't a disclosure item, is acceptable, but conflicts are a concern, is continued retention justified? Perhaps; perhaps not. Facts and circumstances will dictate the result.

Finally, let's consider the attorney who refers clients to advisers in return for a referral fee or simply as an accommodation. Should he not take the initiative to review the disclosure his clients are reading?

According to Quinnipiac University School of Law Professor Jeffrey A. Cooper, it's crucial for a fiduciary to understand the nature of the investment advice he's receiving. There can be a world of difference between a truly independent investment adviser and a broker who's compensated for selling financial products. Fiduciaries must understand these key differences.

Hopefully, the new disclosures will be a valuable tool in this effort.

Endnotes

  1. Release No. IA-3060; File No.S7-10-00 Amendment to Form ADV Final Rule (the adopting release), adopting amendments to rules 203-1, 204-1, 204-2, and 204-3 under the Investment Advisers Act of 1940 (Advisers Act); and amendments to Form ADV under the Advisers Act, effective Oct. 12, 2010.
  2. Most advisory firms were required to file their brochures with the Securities and Exchange Commission (SEC) before March 31, 2011 and deliver them to existing clients by May 31, 2011. Brochure supplements aren't filed with the SEC, but must be delivered to clients by Sept. 30, 2011. Release No. IA-3129; File No. S7-10-00 Amendments to Form ADV; Extension of Compliance Date.
  3. Before the adoption on July 21, 2010 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which amended certain provisions of the 1940 Act, there were about 11,000 SEC registered investment advisers. Section 401 of the Dodd-Frank Act created a new category of mid-sized advisers (assets under management between $25 million and $100 million), estimated by the SEC to number 3,200. These advisers must withdraw their SEC registrations and register with the states before June 28, 2012, as they're no longer eligible for SEC registration. SEC Release No. IA-3221; File No. S7-36-10, “Rules Implementing Amendments to the Investment Advisers Act of 1940,” June 22, 2011, at p. 11. As a result of the increased threshold for SEC registration from $25 million to $100 million (as provided by new Section 203(A)(a)(2) of the 1940 Act), about 8,000 large advisers will remain registered with the SEC.
  4. According to the SEC's January 2011 Study on Enhancing Investment Adviser Examinations, “almost all of the largest retail broker-dealers are also registered as investment advisers. These dual registrants have a substantial portion of retail advisory clients and employ a significant number of investment adviser representatives.”
  5. Brokerage firms' retail sales forces used to be called “stock brokers” or “rrs” (registered representatives). Now, they're called “wealth managers,” “financial consultants” or “financial advisers” and earn titles such as “VP-Investments” or “Senior-VP Investments” for achieving goals.
  6. In the Securities Industry and Financial Markets Association's (SIFMA's) comment letter to the SEC, “Re: Re-proposal of Amendments to Part 2 of Form ADV” dated May 16, 2008 p. 3, SIFMA noted the:

    significant impact of Rule 202(a)(11)-1 and the Financial Planning Association v. SEC, [482 F.3d 481] (D.C. Cir. 2007) court decision and its aftermath. These developments resulted in the migration of hundreds of thousands of fee-based brokerage accounts to the advisory platform. Because these accounts typically are covered by the same financial professionals who provided fee-based brokerage services, the Financial Planning Association decision has not only expanded the universe of account relationships subject to the Advisers Act, but also brought within that universe many accounts and financial professionals that were already subject to extensive regulatory disclosure requirements under the Securities Exchange Act of 1934 and Financial Industry Regulatory Authority (“FINRA”) rules. These financial professionals are already subject to broker-dealer disclosure requirements, including those related to disciplinary history and conflicts of interest, among others.

  7. Ibid. at p. 6.
  8. www.actec.org/resources/publications/TrusteeGuide/TrusteeGuide.pdf.
  9. Jackson, Grant Investment Advisers, Inc. letter dated May 26, 2008, referred to in the adopting release as the “Jackson letter.”
  10. See p. 1 of the 161 page proposed release (Release No. IA-2711; S7-10-00).
  11. SEC Study on Investment Advisers and Broker-Dealers (January 2011) at p. i.
  12. According to studies such as the 2010 survey conducted by ORC/Infogroup for the Investment Adviser Association, Consumer Federation of America, the North American Securities Administrators, the American Association of Retired Persons and others, there's a disconnect between what the consuming public expects (that every financial adviser, including commissioned sales people, should be held to a fiduciary standard) and the reality (that all advisers aren't fiduciaries). The Rand Report commissioned by the SEC found that “[M]any survey respondents and focus-group participants do not understand key distinctions between investment advisers and broker-dealers — their duties, the titles they use, the firms for which they work, or the services they offer.” See www.sec.gov/news/press/2008/2008-1_randiabdreportpdf.
  13. For example, one firm's disciplinary information disclosure lists 26 items, including a monetary sanction of $21.3 million in remediation plus a $2 million penalty for an action brought by the New York Attorney General alleging fees and commissions were higher for non-discretionary fee-based brokerage accounts. Another disclosure was an action brought by the state of Missouri for conflict of interest violations in research practices resulting in a fine of $431,000, a penalty of $25 million, disgorgement of $25 million, procurement of $25 million and education costs of $5 million.
  14. The SEC's instructions to the brochure at pps. 1-2.
  15. Instructions to Item 5.E.1 Form ADV Part 2A.
  16. “Investment Counsel” is a legally defined term under the Advisers Act and in fact, it's unlawful for advisers to use that term unless they fall within the definition — providing “supervisory services” as a substantial part of their business. Supervisory services involve giving continuous advice on the basis of the client's individual needs.
  17. Adopting release at p. 40.
  18. At the time the rule was adopted, Merrill Lynch estimated that it would require 45,000 hours to prepare the supplement yearly for the 8,000 employees for whom a supplement must be produced. (Footnote 313 on p. 81 of the adopting release). Morgan Stanley estimated that it would take in the range of 30,000 to 35,000 hours to comply with the new rule initially for approximately 14,000 employees and 8,000 to 10,000 hours annually to comply going forward. (Ibid.) Schwab, with 1,600 investment adviser representatives, estimated that it would cost more than $5 million to design, build and implement systems associated with supplement creation and compliance. (Footnote 472 on p. 96 of the adopting release.)
  19. Adopting release at p. 98.
  20. Trustees may want to ask advisers who change firms to disclose recruitment bonuses, which may or may not be picked up by this item. Recruitment arrangements generally require the adviser to generate a certain level of revenue for the firm and thus pose a conflict between the adviser and his clients.
  21. Investment performance needs to be measured based on assumed risk, particularly in today's markets. See Julie Jason, Managing Retirement Wealth: An Expert Guide to Personal Portfolio Management in Good Times and Bad (Sterling 2011).

Julie Jason is an attorney and founder of Jackson, Grant Investment Advisers, Inc. in Stamford, Conn.

Sample Material Relationship Disclosure

Watch out for conflicts

As a full service broker-dealer and investment adviser, we offer our customers and investment advisory clients a broad range of financial services and products, and we are engaged in various aspects of the securities and investment business. Our financial services include:

  • Underwriting securities offerings;
  • Acting as a market maker in securities;
  • Trading for our own account;
  • Acting as a clearing firm for other broker-dealers;
  • Buying or selling securities, commodity futures contracts and other financial instruments for customers as their broker or buying them from or selling them to clients, acting as principal for our own account;
  • Providing investment advice and managing investment accounts or portfolios;
  • Acting as a commodity pool operator, futures commission merchant or commodity trading advisor and providing custodial services;
  • Through our affiliates, we provide clients with trust and custodial services; and
  • We manage, sponsor and distribute registered investment companies and other public and private pooled investment vehicles, including hedge funds, whose shares or other interests are sold to clients.

Currently, our principal business, in terms of its revenues and personnel, is that of a broker-dealer in securities.

The 2011 brochure of a major dually registered firm

Sample Interest in Client Transaction Disclosure

The trustee must assess whether the conflicts are acceptable based on how the trust is to be managed

The practice: [Our Firm] and our affiliates expect to earn a profit whenever we engage in principal transactions with you, and depending on the type of security, we may include a profit margin in the price we pay or charge you, by marking up or marking down the price of the security.

The conflict: The profits we or our affiliates earn on these transactions will be in addition to the fees you pay us under the managed account program for investment advice, trading, execution, custody and other program services. As a result, principal transactions present a conflict between your interests and our interests and those of our affiliates, because we have a financial incentive to recommend these transactions to you when they might not be in your best interest. When we propose a principal transaction to you, it is possible that better prices or other terms for the trade could be obtained from alternative sources not known to [us]. Since there may be securities offered by other dealers only to their clients, you may not be able to compare the price on securities offered by these dealers and to those offered by [us].

How the disclosure addresses the conflict:

  • We have an obligation to provide you with best execution and we believe we can provide best execution to you by routing certain orders to our affiliate … for execution on a principal basis;
  • We monitor our execution services and measure how we meet our best execution obligation by taking into account many factors, including the degree to which our affiliate … executes principal trades in client accounts and, specifically, the pricing and service quality that we receive in connection with principal trades versus the costs associated with foregoing a trade (if [we are] the only dealer in a security) or executing on an agency basis through another dealer;
  • The mark-up or mark-down on securities in [our managed accounts] is not shared with your Financial Advisor;
  • You remain in control of transactions executed through your account and can withhold consent to specific principal trades before each trade is executed or overall upon your notice to us; and
  • Although we are not required to waive or offset our compensation under applicable rules or regulations, for certain security types such as new issue fixed-income securities, we may waive some of the compensation we earn in executing principal trades, or waive a portion of the fee imposed on your account for a period of time as an offset for other compensation we receive.

The 2011 brochure of a major dually registered firm