Locke Lord QuickStudy: SEC Adopts amendments to the Books and Records Rule and to Form ADV addressing separately managed accounts, social media, and relying advisers

On August 25, 2016, the Securities and Exchange Commission (the “SEC”) adopted amendments to rules promulgated under the Investment Advisers Act of 1940 (the “Advisers Act”) and the investment adviser registration and reporting form (“Form ADV”) to enhance the reporting and disclosure of information by investment advisers. The primary amendments to the Advisers Act centered around Rule 204-2, which is frequently called the “Books and Records Rule.” The amendments to Form ADV require investment advisers to provide additional disclosure regarding their separately managed accounts, their social media accounts, and specific information on relying advisers. These amendments adopted, with only minor revisions, the amendments put forth in a proposing release issued on May 20, 2015. Advisers will be required to comply with the Rules and Form ADV as amended by this action beginning October 1, 2017.

Books and Records:
The amendments to Rule 204-2 require advisers to maintain additional materials related to the calculation and distribution of performance information. Currently, Rule 204-2(a)(16) provides:

“every investment adviser registered or required to be registered under Section 203 of the Act shall make and keep true, accurate and current the following books and records relating to its investment advisory business. . . (16) all accounts, books, internal working papers, and any other records or documents that are necessary to form the basis for or demonstrate the calculation of the performance or rate of return of any or all managed accounts or securities recommendations in any notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication that the investment adviser circulates or distributes, directly or indirectly, to 10 or more persons (other than persons connected with such investment adviser); provided, however, that, with respect to the performance of managed accounts, the retention of all account statements, if they reflect all debits, credits, and other transactions in a client’s account for the period of the statement, and all worksheets necessary to demonstrate the calculation of the performance or rate of return of all managed accounts shall be deemed to satisfy the requirements of this paragraph.” [emphasis added].

The amendment will remove the “10 or more persons” language in the Rule and replace it with “any person.” The result is that advisers will have to retain the materials listed in Rule 204-2(a)(16) that demonstrate the calculation of the performance or rate of return in any communications that the adviser circulates or distributes to any person, even reaching individualized communications which are not currently covered by the Rule.

The amendment to Rule 204-2(a)(7) adds the requirement that the adviser “maintain originals of all written communications received and copies of written communications sent by an investment adviser relating to the performance or rate of return of any or all managed accounts or securities recommendations.”

These amendments arose from recent enforcement actions in which evidence relating to performance calculations was not available because retention of such information is not required under the current requirements of Rule 204-2. Thus, the one of the rationales for this change is to improve the records that are available to SEC staff and to investors in the case of disputes arising out of these communications.

Separately Managed Accounts:
The amendments to Form ADV focus primarily on expanding the information that advisers report regarding separately managed accounts. This is accomplished through the creation of a new Item 5K in Form ADV Part 1A and a corresponding Section 5.K to Schedule D. These additions primarily address the following items:

• Asset Types – Advisers advising separately managed accounts will be required to report the percentage of their assets under management allocated amongst twelve asset categories. Advisers with at least $10 billion in regulatory assets under management must report midyear and year end percentages, while advisers with less than $10 billion in regulatory assets under management must only report year end percentages. In either case, these reports will be made annually.
• Borrowings and Derivatives – Advisers advising separately managed accounts which utilize borrowing or derivative positions will be required to disclose such activity. In addition to this disclosure, advisers with at least $500 million, but less than $10 billion, in regulatory assets under management attributable to their separately managed accounts will be required to disclose the dollar amount of any borrowing and levels of gross notional exposure of derivatives. Those advisers advising at least $10 billion in regulatory assets under management attributable to separately managed accounts will be required, in addition to the above disclosure, to disclose more detailed information. Such additional information would include the number of accounts, average borrowings, and average derivatives exposures across six derivatives categories, calculated as of the date of the annual amendment and the six months prior to that date. The exposure that will be required to be calculated for purposes of this section is similar to that which is required if a fund is relying on CFTC Rule 4.13(a)(3) to be exempt from registration as a commodity pool operator. If you rely on Rule 4.13(a)(3), you are likely already collecting most, if not all, of the information that will be required to be disclosed in this section.
• Custodians – Advisers advising separately managed accounts will be required to disclose any entities that serve as custodian for at least 10% of their separately managed accounts, and disclose the amount of regulatory AUM and the number of clients that are attributable to such custodian.

Social Media: