On June 5, 2019, the Securities and Exchange Commission ("SEC") finalized a new rule that includes a new requirement for SEC-registered investment adviser ("RIA") firms to provide a brief relationship summary to retail investors known as the Form CRS. As originally proposed, the new Form ADV Part 3 ("Form CRS") would have been a highly prescriptive four page document with eight sections. However, the new finalized Form CRS is a somewhat prescriptive two page document with five mandated sections:
- Relationship and Services
- Fees, Costs, Conflicts, and Standard of Conduct
- Disciplinary History
- Additional Information
In general, the final version of the Form CRS highlights the SEC’s preference to apply the concept of “layered disclosure” which leans heavily on the increased use of hyperlinks and other cross-references to more detailed disclosure.
The new Form CRS instructions note:
"In paper format, the relationship summary for broker-dealers and investment advisers must not exceed two pages...You must use reasonable paper size, font size, and margins. If delivered electronically, the relationship summary must not exceed the equivalent of two pages..."
Furthermore, the instructions specify that the document should be crafted in "Plain English" with the following guidance:
"You should include white space and implement other design features to make the relationship summary easy to read. The relationship summary should be concise and direct. Specifically: (i) use short sentences and paragraphs; (ii) use definite, concrete, everyday words; (iii) use active voice; (iv) avoid legal jargon or highly technical business terms unless you clearly explain them; and (v) avoid multiple negatives. You must write your response to each item as if you are speaking to the retail investor, using “you,” “us,” “our firm...”
For most Form CRS-filing RIA firms, Item 3 related to fees, conflicts, and standard of conduct will be the most lengthy section with a mix of highly prescriptive and free form content.
Item 1: Introduction
Firms need to create a prescriptive initial paragraph which includes:
- Name of firm
- Registered as an investment adviser with the SEC
- “Indicate that brokerage and investment advisory services and fees differ and that it is important for the retail investor to understand the differences.”
Firms also need to direct retail investors to investor.gov: "State that free and simple tools are available to research firms and financial professionals at Investor.gov/CRS, which also provides educational materials about broker-dealers, investment advisers, and investing.”
Item 2: Relationships and Services
The heading must read: "What investment services and advice can you provide me?”
Under "Description of Services," firms are instructed to, "state the particular types of principal investment advisory services you offer to retail investors, including, for example, financial planning and wrap fee programs.” In particular, RIA firms need to address:
- Monitoring: If provided, discuss frequency, material limitations, and whether provided as part of standard services.
- Investment Authority: If accepting discretionary authority, describe in detail including any material limitations. If offering non-discretionary services, “explain that the retail investor makes the ultimate decision regarding the purchase or sale of investments.”
Under "Additional Information," advisory firms must provide specific references to the Form ADV Part 2A brochure regarding services offered.
Firms must also include a "Conversation Starters" section to include questions such as: "How will you choose investments to recommend to me?"
Item 3: Fees, Conflicts, and Standard of Conduct
The initial heading must read: "What fees will I pay?"
Under "Description of Principal Fees and Costs," RIA firms are instructed to “Summarize the principal fees and costs that retail investors will incur for your…investment advisory services, including how frequently they are assessed and the conflicts of interest they create.”
In addition, investment advisory firms must describe their ongoing asset-based fees, fixed fees, wrap fee program fees, or other direct fee arrangement. “The principal fees for investment advisory services should align with the type of fee(s) that you report in response to Form ADV Part 1A, Item 5.E.”
In particular, RIA firms with wrap fee program fees are encouraged to explain that asset-based fees associated with the wrap fee program will include most transaction costs and fees to a broker-dealer or bank that has custody of these assets, and therefore are higher than a typical asset-based advisory fee.
In regards to conflicts of interest, an RIA firm “that charges an asset-based fee could, for example, include a statement that the more assets there are in a retail investor’s advisory account, the more a retail investor will pay in fees, and the firm may therefore have an incentive to encourage the retail investor to increase the assets in his or her account.”
RIA firms need to describe other fees and costs related to investment advisory services and investments in addition to the firm’s principal fees and costs disclosed under “Description of Principal Fees and Cost” that the retail investor will pay directly or indirectly. These could include custodian fees, account maintenance fees, fees related to mutual funds and variable annuities, and other transactional fees and product-level fees.
Under "Additional Information," there is prescriptive text which must be included in this section and should include references to more detailed information on fees and costs as “required by the Form ADV, Part 2A brochure (specifically Items 5.A., B., C., and D.)”
Form ADV Part 1A, Item 5.E. Sample Response
Firms need to include a "Conversation Starters" section to include questions such as:
- “Help me understand how these fees and costs might affect my investments. If I give you $10,000 to invest, how much will go to fees and costs, and how much will be invested for me?”
- “What are your legal obligations to me when acting as my investment adviser?”
- “How else does your firm make money and what conflicts of interest do you have?”
Under the "Standard of Conduct" section there is additional prescriptive text required.
For investment advisers, the second heading in Item 3 must read "What are your legal obligations to me when acting as my investment adviser? How else does your firm make money and what conflicts of interest do you have?”
In regard's the firm's standard of conduct, investment advisers must include a statement that reads, "“When we act as your investment adviser, we have to act in your best interest and not put our interest ahead of yours. At the same time, the way we make money creates some conflicts with your
interests. You should understand and ask us about these conflicts because they can affect the investment advice we provide you. Here are some examples to help you understand what this means.”
Firms must address conflicts related to proprietary products, third-party payments, revenue sharing, and principal trading. If none of those conflicts apply, firms should “summarize at least one other material conflict of interest that affects retail investor.”
Firms need to include an additional "Conversation Starters" section to include questions such as “How might your conflicts of interest affect me, and how will you address them?”
Under "Additional Information," firms "must include specific references to more detailed information about your conflicts of interest that, at a minimum, include the same or equivalent information to that required by the Form ADV, Part 2A brochure…”
The third heading in Item 3 must read “How do your financial professionals make money?”
Firms must "summarize how your financial professionals are compensated, including cash and non-cash compensation, and the conflicts of interest those payments create.”
Additional detail is required to be disclosed if your firm's professionals are compensated based on:
- the amount of client assets they service;
- the time and complexity required to meet a client’s needs;
- the product sold (i.e., differential compensation);
- product sales commissions;
- or revenue the firm earns from the financial professional’s advisory services or recommendations.
Item 4: Disciplinary History
The heading must read: "Do you or your financial professionals have legal or disciplinary history?”
Firms must state "Yes" if:
- (i) Disciplinary information is disclosed in your Form ADV (Item 11 of Part 1A or Item 9 of Part 2A).
- (ii) Legal or disciplinary history in your Form BD (Items 11 A–K) (except to the extent such information is not released to BrokerCheck, pursuant to FINRA Rule 8312).
- (iii) Disclosures for any of your financial professionals in Items 14 A–M on Form U4 (Uniform Application for Securities Industry Registration or Transfer), or in Items 7A or 7C–F of Form U5 (Uniform Termination Notice for Securities Industry Registration), or on Form U6 (Uniform Disciplinary Action Reporting Form) (except to the extent such information is not released to BrokerCheck, pursuant to FINRA Rule 8312).
Firms must also direct retail investors to “visit Investor.gov/CRS for a free and simple search tool to research you and your financial professionals.”
In addition, firms must include a "Conversation Starters" section to include questions such as: "As a financial professional, do you have any disciplinary history? For what type of conduct?"
Item 5: Additional Information
RIA firms must note where the retail investor can find additional information and a copy of the Form CRS and include a telephone number to request more information and a copy of the Form CRS.
And once again, firms need to include a "Conversation Starters" section to include questions such as:
- “Who is my primary contact person?”
- “Is he or she a representative of an investment adviser or a broker-dealer?”
- “Who can I talk to if I have concerns about how this person is treating me?”
The above overview is a general summary and is not intended to be a complete overview of all relevant details for a particular firm. We highly encourage the principal and Chief Compliance Officer ("CCO") of all applicable RIA firms to review the SEC's Form CRS instructions in detail.
Be sure to check back soon as we continue to further analyze and provide additional detail on this new investment adviser regulatory requirement including best practices when drafting a Form CRS disclosure document.