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News March 16, 2015 Issue

Form ADV Changes, Transition Plans, Stress Tests Coming

There’s more work coming your way.

The SEC staff, responding to changes in the asset management industry, plans to recommend new requirements and other changes in a number of areas, including amending Form ADV, requiring advisers to create transition plans to protect client assets in the event of a major disruption, and implementing Dodd-Frank Act requirements for annual stress testing by large advisers and funds.

These recommendations are likely to be finalized this year and were discussed by Division of Investment Management acting director David Grim in two venues, first on March 5 at the PLI Investment Management Institute in New York City, then on March 6 at the Investment Adviser Association Compliance Conference in Arlington, Va.

The SEC staff, he said, "has been developing three sets of recommendations to help ensure that the Commission’s regulatory program addresses the increasingly complex portfolio composition and operations of today’s asset management industry." Those three recommendations, first discussed by SEC chair Mary Jo White in a December 11 speech (ACA Insight, 12/22/14) are to:

  • Modernize and enhance data reporting for both funds and investment advisers;
  • Require registered funds to have controls in place to more effectively identify and manage the risks related to the diverse composition of their portfolios, including liquidity management and the use of derivatives in mutual funds and ETFs; and
  • Focus on planning for the impact on investors of market stress events or when an adviser is no longer able to serve its clients.

While not providing a lot of additional detail on just how the SEC would address these three challenges, Grim did say it would be through rulemaking and provided some parameters as to just what types of advisers would be affected.

Enhanced data reporting

The SEC is considering changes to a variety of its forms, including Form ADV, Form PF and Form N-SAR, all designed to "improve the information reported on these forms for analysis both of individual funds and across multiple funds, increased transparency of how funds are implementing their investment strategies and to help staff assess the adequacy of a fund’s disclosures in its registration statement, as well as to enhance the ability of the Commission and investors to better understand the risks funds face," said Grim. He added that the SEC staff is also looking at ways to standardize the information required for certain investments, such as derivatives.

The need to change the forms comes from the agency’s need to update its data collection to match the changing nature of the securities world. For instance, noted Grim, "exchange traded funds did not exist when Form N-SAR was created. ETFs emerged in the 1990s and have grown significantly since then."

Just what will the specific changes to each form be? Grim did not say, most likely because the SEC staff has not yet made final recommendations.

One thing is clear, however, said IAA president and chief executive officer

Karen Barr. The changes to Form ADV will affect all advisers, not just the largest asset managers.

A specific change that the staff is considering is requiring additional information about separately
managed accounts. "Collecting more data on separately managed accounts, where the adviser manages assets on behalf of a particular client, may also better inform the Commission about the totality of the advisory industry and inform examination priorities and the assessment of the risks associated with those accounts, which are a significant portion of the business of many investment advisers," Grim said.

There’s nothing new about the SEC updating its forms. Form ADV registration and reporting requirements have been updated several times by the SEC as the investment advisory industry has evolved, said Grim, noting that in 2000 the Commission required it to be filed electronically, and that in 2010, Part 2 was amended and divided into two sections – Part 2A, which requires an adviser to prepare a narrative brochure, and Part 2B, which provides supplemental information to the brochure. In 2011, Part 1 of the Form was modified to allow for the registration of investment advisers to private funds.

"Enhancing the information disclosed by investment advisers is expected to assist risk profiling for examinations, enhance the staff’s overall understanding of asset management activities, and allow advisory clients and potential advisory clients to make more informed decisions about the selection and retention of investment advisers," Grim said.

Transition plans

The SEC staff is developing a recommendation that would require advisers to create transition plans to prepare for a major disruption in their business, Grim said.

The recommendation will:

  • "Be informed" by current requirements for registered advisers and will complement existing compliance programs required under Advisers Act Rule 206(4)-7, the Compliance Program Rule; and
  • Recognize that the "unique aspects" associated with winding down an investment adviser "are different than those associated with other kinds of financial firms."

"What’s new here is that the Division of Investment Management is not just looking at the loss of key personnel, but is also looking at the restraints on investor ability to access or move assets away from an adviser, such as de facto limitations imposed by illiquid assets or market conditions," said Barr.

Stress tests

Here the SEC will be implementing Dodd-Frank Act requirements for annual stress testing by large investment advisers and large funds. "Implementing this new mandate in asset management, while relatively novel, will help large advisers and funds and the Commission better understand the potential impact of stress events," Grim said. "The staff is evaluating what protocols may be appropriate for investment advisers and investment companies."

Grim said that any recommendations made by the staff will be tailored for asset management, as well as for different types of firms, and that the staff is currently considering just how to do this. This is significant, said Barr, as it shows that "the staff recognizes that the asset management industry is different from banks, for example, and intends to tailor stress testing to our business."

Portfolio composition risk

The recommendations that the staff is considering here involve investment companies. They fall into two areas: risks associated with derivatives and risks associated with liquidity.

Derivatives. Firms that invest in derivatives raise portfolio composition risk, said Grim, as well as leverage limitation issues under Section 18 of the Investment Company Act, involving the extent to which a fund may issue what are known as senior securities, which have priority over other securities in the event of a claim or bankruptcy liquidation. Some of the SEC’s concerns in this regard include potential abuse of the purchasers of senior securities, excessive borrowing and the issuance of excessive amounts of senior securities by funds, and funds operating without adequate assets and reserves. Almost 30 no-action letters and responses to numerous additional questions have been issued by SEC staff on the subject. Two of the questions the agency has asked – and which Grim said the staff is now considering addressing in rulemaking – are whether the current approach of segregating assets adequately addresses the investor protection concerns underlying Section 18, and what the appropriate limitation on a fund’s use of leverage ought to be so that it balances investor protection with facilitating fund innovation. In addition, "the staff is also now considering whether funds should be required to establish broad risk management programs to address risks related to their derivative use," he said.

  • Liquidity. Grim addressed liquidity in terms of mutual funds, noting that "the staff is considering recommending a new comprehensive approach to the management of liquidity risks associated with fund portfolio composition," something he said has not been revisited by the SEC for "many years." The staff is focused on the redemption rights of fund investors and is looking at issues including enhancing investment companies’ management of liquidity risk and updating liquidity standards and disclosures of liquidity risks. "Such changes could better protect investors and provide better transparency about
    liquidity risks associated with various funds," he said.


"It will be interesting to see what the Division actually proposes for liquidity risk and derivatives," said Rogers & Hardin partner Stephen Councill. "I certainly expect more guidance and specificity on disclosures, but the real question is whether they will change or add to the rule that open end funds have no more than 15 percent of their net assets in illiquid securities or assets."

"Grim’s comments on derivatives suggest that the Division is grappling with all kinds of derivatives implications," he said. "The real question here is how specific the SEC will be in dictating how the broad risk management programs that Grim mentioned operate. I agree it’s a good idea to require such programs, but believe each fund/adviser complex should be allowed to tailor its own program to meet its individual circumstances."