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News September 12, 2005 Issue

The Annual Compliance Package: An Idea to Consider

As you probably know, SEC-registered advisers generally are required to make an annual offer of their Form ADV Part II (or equivalent brochure) to clients and to deliver a copy of their privacy policy to clients who are individuals.

But think about it: if you are going to reach out and touch your clients, why not give them a hug?

Advisers may want to consider whether there is other compliance-related information that clients should or could be receiving, and consider bundling that information in with the annual ADV and privacy mailing. To that end, Adviser Compliance Associates principal Jeff Morton suggests that advisers consider putting together an "annual compliance package."

What would go in to such a package? For starters, consider whether it makes sense to confirm your clientsí specific investment objectives, mandate, and restrictions on an annual basis (or, perhaps, on an every-other-year basis). You may be able to easily create a customized cover letter for each client, setting out their stated investment objectives, mandate, restrictions, and any other guidelines applicable to the management of their account. The letter can contain a statement along the following lines: "According to our records, our management of your account is subject to the following investment parameters. Please review these parameters carefully for accuracy. If any of this information is inaccurate or is in need of updating, please contact [name of individual] at [phone number or e-mail] promptly. If we do not hear back from you within 30 days of the date of this letter, we will continue to assume that this information is correct."

Similarly, you can use the cover letter to confirm the clientís primary address (and mailing address, if different). Again, ask the client to inform you of any inaccuracy.

Whatever you do, donít expect your busy clients to write you back to affirmatively sign off on the information you are attempting to confirm. "As long as thereís no reason to believe that the information you have is inaccurate," said Investment Adviser Association general counsel Karen Barr, the negative consent approach is the way to go. If you require affirmative confirmation, she explained, youíve effectively "put yourself in a hole" until you hear back from the client. And if you donít hear back, it raises questions about how the account should be managed. If a client does not confirm his investment mandate, asked Barr, "what are you going to do?

Of course, if your firm does, in fact, have reason to believe that material information you have on file about a client is inaccurate, you should find out directly from the client what the story is ó donít wait for the annual compliance review to go about updating your records.

The cover letter also can be used to remind clients that have instructed your firm to direct their brokerage to a particular broker that they have, in fact, made that request. Hereís some "Bailey-plus" language to mull over with your favorite lawyer: "Pursuant to your written instruction dated [___] our firm directs all trades for your account to [Broker X]. Your direction supersedes our authority to select broker-dealers on your behalf. As a result of this direction, you may pay higher commissions for your trades than other clients that have not directed us to utilize a specific broker-dealer. Moreover, because we typically do not aggregate directed trades with other trades, your trades will not enjoy the benefits of being aggregated with other trades (such as lower commissions or reduced market impact). Lastly, please be aware that we typically enter directed trades only after trades for other non-directed accounts have been entered. This may subject your trades to greater risk of market impact, particularly in the case of illiquid securities or in times of market volatility. If you wish to discuss your instruction to direct your brokerage, please contact [name of individual] at [phone number or e-mail]. If we do not hear back from you within 30 days of the date of this letter, we will continue to assume that your directed brokerage instruction remains outstanding."

While the "Bailey-plus" disclosures above have been a staple of directed brokerage arrangements for years, Barr noted that a number of firms started making those disclosures on an annual basis after the May 2003 case against Jamison, Eaton & Wood. (Also of note: that case also teed up an adviserís duty to monitor the quality of execution received under a directed brokerage arrangement: If the quality of execution is exceedingly poor, or if it appears that a client is being significantly overcharged relative to other brokers, an adviser should promptly notify the client of that fact ó and not necessarily wait until the annual compliance package to do so.)

Barr also suggested that advisers use the cover letter to highlight any significant changes in their Form ADV made since their previous mailing.

Should the cover letter be used to confirm a clientís status as an accredited investor, qualified purchaser, or qualified client? Sure, it could be, but consider whether thereís even a legal duty to do so. For example, Rule 205-3ís definition of "qualified client" is careful to discuss a clientís status "immediately after entering into the contract" or "immediately prior to entering into the contract." Similarly, ICA Section 3(c)(7) requires that qualified purchaser status be determined only "at the time of acquisition of such securities." Similarly, Rule 506 under Reg. D refers to an issuerís reasonable belief "immediately prior to making any sale" about an accredited investorís status.

The cover letter also should note the remaining contents in the package:

  • an updated Part II of Form ADV (or equivalent) (although only an offer is required, the better practice is to deliver the entire Part II ó that way, clients canít claim they were not informed of the disclosures contained in Part II);
  • the firmís annual privacy notice, which can be part of another document, such as the Part II or equivalent brochure, as long as it is "clear and conspicuous" and not buried in other information. However, if you put your privacy statement in your Part II (or brochure), youíll need to deliver the Part II (or brochure) to all persons who are required to receive the privacy policy on an annual basis.
  • an annual audited financial statement (as applicable, for hedge funds); and
  • the annual NASD 2790 notification letter (as applicable).

And, of course, the adviser can slip in a copy of its regular quarterly client newsletter.

When should the annual compliance package be sent?

Barr noted that most advisers typically send out their annual offer letter with their December 31 account statements. However, firms may want to consider sending out their compliance package in April or May, if possible, after their Form ADV has been updated (assuming a December 31 fiscal year end).

Other odds and ends:

  • Advisers that manage private hedge funds should similarly consider sending an annual compliance package to each investor in their funds.
  • Advisers involved in wrap programs should be aware that ICA Rule 3a-4 requires that wrap clients be contacted annually to determine whether there have been any changes in the clientís financial situation or investment objectives, and whether the client wishes to impose any reasonable restrictions on the management of the account (or reasonably modify existing restrictions). The rule also requires quarterly contacts, where clients must be told, in writing, that they should contact the wrap program sponsor (or other person) if there have been any changes in their financial situation or investment objectives, or if the client wishes to impose any reasonable restrictions on the management of the clientís account (or reasonably modify existing restrictions). The client also must be provided with a means to make that contact. Typically, the contract between the wrap program sponsor and the manager will specify that the sponsor is responsible for making these client communications.
  • What types of advisory clients donít need to receive the annual ADV offer? See Advisers Act Rule 204-3(c)(2), which says that the annual offer doesnít need to be made to advisory clients receiving advisory services solely pursuant to an investment company contract or a contract for impersonal advisory services requiring a payment of less than $200.