A Compliance Guide to the Investment Advisers Act of 1940: Part II

Part Two: How to Register

This article is the second in a series I have designed to give guidance to managers of hedge funds for complying with regulations proposed by the Securities and Exchange Commission, which, if adopted, will require managers and advisers to most hedge funds to register as investment advisers with the SEC. Registration will subject them to the compliance standards under the Investment Advisers Act of 1940. In this series, I present the proposed regulations and registration requirements, addressing key aspects of Advisers Act compliance. Use of defined terms, statutory references and acronyms, while at times unavoidable, will be kept to a minimum. I will focus on the mechanics of registration. Future articles will expand on the requirements of registered investment advisers with greater detail, focusing on the ongoing compliance and reporting requirements to the SEC and on the specific standards that apply to an investment adviser’s relationship with its investors and clients.

As discussed in the first article from this series, under current law, managers and advisers to many hedge funds currently qualify for exemption from registration under the Advisers Act because current rules do not apply to an investment adviser who has advised fewer than 15 clients during the preceding 12 months. Current law considers each corporation, general partnership, limited partnership, limited liability company, trust or other legal organization advised by an investment adviser as a single client. The SEC’s proposed rule, if made final, would change this exemption as it applies only to hedge funds and will require investment advisers to count each limited partner, member or shareholder in the entities it advises as a single client. Once the final rule takes effect, many currently exempt investment advisers will be required to register using the process described below.

Form ADV

To register as an investment adviser, an applicant must complete SEC Form ADV. Form ADV has two parts: Part I is filed electronically with the SEC, and Part II is filed manually. The information submitted in Part I is filed with, and geared toward, the SEC and includes information about the adviser’s business, the persons who own the adviser and whether they have been sanctioned for violating securities or other laws. The information in Part II, also know as the “brochure” is geared primarily toward the adviser’s clients but is subject to review by the SEC. Part II is a paper filing and is not submitted to the SEC but is deemed to be filed so long as a copy of Part II is maintained in the adviser’s files. Part II contains information relating to the business practices, fees and conflicts of interest the adviser may have with its clients.

Filing Form ADV Part I

Part I must be filed electronically through a system called the Investment Adviser Registration Depository, which has been developed and is operated by the National Association of Securities Dealers and the North American Securities Administrators Association. The IARD is accessed electronically at www.iard.com. To make a filing with IARD, a registrant must first establish an account. This happens by completing an SEC Registrant Entitlement Package, which is composed of three forms and can be found at the IARD web site. The Entitlement Package is submitted on paper to the NASD. Once the NASD receives the Entitlement Package, it will send the registrant a confirmation packet within seven to 10 business days. The confirmation packet will include an identification number for the adviser, a user ID code and password and information about the registrant’s IARD financial account. Prior to making any filings, the financial account must have on deposit sufficient funds to cover an adviser’s initial setup fee. Additional fees are charged if the registrant requires state notice filings or registrations to be made through IARD. These fees range depending on an adviser’s assets under management. Current fees for establishing an account and filing the annual update to Part I are set forth below:

Part 1 of Form ADV makes comprehensive inquiry about the adviser’s business, the persons who own or control the adviser and whether the adviser or its key personnel have been sanctioned for violating securities or other laws. Since Form ADV asks for detailed information pertaining to key personnel, each key person must participate in the preparation of Form ADV. Depending on the size, complexity and personnel resources of an investment adviser, the adviser may choose to prepare the form internally or have it prepared by outside counsel or a service bureau that specializes in preparing these filings. A list of service bureaus can be found at the SEC’s web site. The IARD also offers training courses on the use of its software and filing requirements. These may be a good investment for an adviser who chooses to prepare its filing internally.

Whether the preparation of Form ADV is outsourced or prepared internally, management or some other person very familiar with the investment adviser and its business must review the form carefully for accuracy before it is filed. The Advisers Act makes it unlawful to willfully make an untrue statement of material fact or to willfully omit a material fact in any registration application or report filed with the SEC. Since the SEC has named identifying fraud as a primary objective in requiring advisers to register, information submitted to the SEC should be reviewed for accuracy with heightened sensitivity. Sanctions for failure to comply with the Advisers Act range from revocation of registration, administrative proceedings, civil penalties that can range from US$5,000 to US$100,000 for individuals and from US$50,000 to US$500,000 for entities, and even criminal penalties, which would only apply in extreme situations. A draft Form ADV can remain on the IARD system for up to 120 days prior to submission with the SEC, giving sufficient time for a registrant to ensure it is accurate in advance of filing.

Once Form ADV is filed with the SEC, the SEC has 45 days to grant registration or to institute a proceeding to determine whether to deny registration. An applicant will receive an order from the SEC when its registration becomes effective. Bases for rejection of an applicant’s registration include false or misleading statements in the applicant’s form and securities related convictions.

Once an investment registration is effective, the information must be updated at least once a year with the filing of an Annual Update Amendment within 90 days after the end of an investment adviser’s fiscal year. All amendments must be filed electronically through IARD. In addition to the Annual Update Amendment, amendments must be made promptly if material changes have been made to certain sections of the Form ADV on file. No fees are charged in connection with filing amendments except for the Annual Update Amendment. The fee for the Annual Update Amendment is set forth in the chart of fees above.

Form ADV Part II