Is It Okay for Sub-Advisers to Rely on Investment Advisers for Form ADV Delivery?

Can a sub-adviser or unaffiliated adviser, selected by an investment adviser to help manage client assets, deliver its Form ADV Part 2 to the adviser, instead of the client? Yes, they can, according to a recently issued SEC no-action letter  to Goldman, Sachs & Co.

Generally, under Rule 204-3 of the Advisers Act, the “Brochure Rule,” an investment adviser must deliver a copy of its Form ADV (Part 2A) brochure  and any required supplements (Part 2B) to each of its advisory clients or prospective clients before or at the time of entering into an advisory contract with them.  This includes sub-advisers who are required to deliver their own brochure to the advisory client.

Goldman operates discretionary wrap-fee or managed account programs that employ the services of over 40 unaffiliated sub-advisers.  The programs hire and allocate Goldman’s client assets across multiple sub-advisers.  The fact that these sub-advisers managed client assets, establishes a fiduciary relationship with the client, and makes them also responsible for complying with the Brochure Rule.

Goldman sought assurances that permitting clients to elect not to receive the brochure documents but, instead, rely on Goldman to receive them on the client’s behalf would not result in the SEC bringing an enforcement action.In support, Goldman pointed to several examples of so-called “constructive delivery” where the SEC has permitted delivery of documents to a properly authorized agent — thus, constituting delivery to the agent’s principal  in accordance with well-established common-law agency principles.

Examples of  this in other contexts, Goldman noted, included, the SEC permitting investment advisers to receive offering prospectuses on behalf of their clients; the SEC approving various SROs rules allowing broker-dealers to satisfy their proxy delivery obligations, annual and semi-annual reports, and other shareholder communications obligations to customers by sending the materials to the customers’ investment advisers instead of the customers;  under Regulation S-P, the SEC permitting advisers to satisfy their obligations to deliver initial and opt-out notices to consumers by sending the notices to the consumers’ legal representatives; and under rule 206(4)-2, the Custody Rule, the SEC permitting advisers to satisfy their obligations to send notices of custodial arrangements and any required account statements to a client by sending them to an “independent representative” designated by the client.

Investment advisers relying on the Goldman no-action letter should consider implementing, among others, the following  steps:

1.  Offer the client, in writing, the choice of appointing you,  the adviser,  to receive the brochure document from sub-advisers and briefly explain, in plain English, the information in the sub-adviser’s brochure document. This can be done in the investment management agreement or a separate agreement;

2. Inform the client of the identity of any sub-advisers you engage to manage the client’s assets, and inform the client  that allowing you to receive the brochure does not waive or diminish their right to receive the brochure if they so choose;

3. Preserve the brochure documents that you receive and make them available to clients upon request.  Clients should be free to change their minds at any time and request, at no additional cost, that the  sub-advisers’ brochure documents be delivered to them directly;

4. Maintain policies and procedures designed to ensure that the sub-adviser’s brochure documents are appropriately reviewed by the adviser, and ensure that such policies address and manage any conflicts related to any business relationship the adviser has with a sub-adviser; and

5. Finally, when evaluating a particular sub-adviser’s disclosure for material conflicts, consider whether to (a) not retain the sub-adviser or (b) inform affected clients of a specific conflict and seek the client’s consent, even though the client may have elected not to receive brochure documents.

With New SEC Unit and Data Mining, Advisers Face Closer Scrutiny in 2012

With a renewed focus on analytics and more readily available data, expect the SEC’s scrutiny of investment advisers, including advisers to mutual funds, hedge funds, and private equity funds, to get  tougher.

In December, in a speech before the Consumer Federation of America’s Financial Services Conference, the SEC’s Director of Enforcement, Robert Khuzami, once again emphasized many of the organizational and structural changes that have already occurred and that will continue to impact the way investment advisers and mutual funds will be watched and regulated going forward.  Moreover, advisers may begin to feel the heat from these changes in a deeper, and for their investment adviser reps, and more personal way.  With changes to its organizational structure, the SEC created the Asset Management Specialized Unit to evaluate data and risk-based analytics.  One of the investigative practices the unit is implementing involves adopting a kind of early-warning framework to detect what Khuzami says is the kind of “retail fraud” that may foreshadow more serious problems within assets management and mutual funds.    

Utilizing a retail approach, what might the SEC’s enforcement division be looking at for potential signs of fraud?  Khuzami gives a few examples.  One involves the SEC scouring an adviser’s Form ADV to determine if they’ve lied about their educational achievements, their business affiliations, and their assets under management.  “For us, it’s advisers who lie about graduating Phi Beta Kappa, conceal their association in a past failed business venture, or inflate their assets under management who might well be the same persons who outright steal your money when the markets turn against them,” says Khuzami.

A second approach, for mutual funds, might involve the SEC reviewing databases in an effort to identify poor performance, when at the same time, the fund has relatively high fee arrangements, for them and their sub-advisers.  This, Khuzami says, may suggest excessive fee arrangements that can eat away at the mutual fund investment returns.  See More……