This is the third in a three-part series discussing the new and amended rules (collectively the “Rules”) adopted by the Colorado Division of Securities (“Division”) effective as of March 30, 2023 (the “Effective Date”). The series discusses the new and amended rules under the Colorado Securities Act (the “Colorado Act”) applicable to certain Colorado investment advisers and their registered representatives (“IARs”). Part 3 reviews the Division’s amendments to the requirements of advisory contracts under Rule 51-4.8(IA)(P)[1], mandatory disclosures related to Form ADV Part 2 under Rule 51-4.7(IA) (the “Mandatory Disclosure Rule”), and maintenance of books and records under Rule 51-4.6(IA) (the “Books and Records Rule”) (collectively the “Amended Rules”) and provides best practices and compliance recommendations.
Part 1 of this three-part series focused on the new Continuing Education Rule and offered practical guidance to advisers and their IARs for meeting the new requirements. Part 2 provided a comprehensive analysis of the Compliance Rule, and offered concrete recommendations to investment advisers registered with the State of Colorado (such advisers, “Colorado Licensed Advisers”) for their compliance programs.
Requirements of Advisory Contracts
Rule 51-4.8(IA)(P) was amended to clarify the information that an adviser must disclose in its advisory contracts with its clients. The amendment removes previous language embedded in the Rule that required advisory contacts or alternative disclosure documents to contain “the information required by Form ADV Part 2.” Form ADV is the uniform form used by investment advisers to register with both the U.S. Securities and Exchange Commission (the “SEC”) and state securities authorities. The form consists of three parts, Part 1, Part 2, and Part 3. Form ADV Part 2 serves as the primary disclosure document for advisers and sets forth requirements for narrative disclosures about the investment advisory firm and the business practices of its principals, fees, conflicts of interest, and disciplinary information.[2]
In its Cost-Benefit Analysis of the proposed rule changes, the Division acknowledged that Form ADV Part 2 provides more detailed information and disclosures than what is typically material in an advisory contract.[3] The Division further explained its removal of the provision should make it clear that material terms of an advisory contract should be in contained within the contract itself and should include terms consistent with but not necessarily identical to those disclosed in Form ADV Part 2. Accordingly, under amended subsection (P) of Rule 51-4.8(IA), an advisory contract must be in writing and must disclose or address the following components: (1) the services to be provided, (2) the term of the contract, (3) the advisory fee, (4) the formula for computing the fee, 5) the amount of prepaid fees to be returned in the event of contract termination or non-performance, (6) whether the contract grants discretionary power to the adviser, and (7) a non-assignment provision in favor of the client.
Mandatory Disclosures Related To Form ADV Part 2
The Division adopted changes to Rule 51-4.7(IA) to clarify mandatory disclosures and the delivery to clients of an updated Part 2 of an adviser’s Form ADV. Form ADV Part 2 is divided into Part 2A and Part 2B and sets forth the information required in “client brochures” and “brochure supplements.” Under the “Mandatory Disclosure Rule,” an investment adviser and its investment adviser representative are obligated to furnish each advisory client and prospective advisory client with a copy of Part 2 of the investment adviser’s Form ADV. The Division’s amendments add language regarding the annual delivery of Part 2: advisers must deliver within 120 days of their fiscal year-end, an updated Form ADV Part 2 “disclosure statement” or a summary of material changes to the investment adviser’s Form ADV Part 2 that includes an offer to provide a copy of the updated Form ADV Part 2.
Amendments With Respect To Maintaining Books And Records Under Rule 51-4.6(IA)
The Division adopted changes to Rule 51-4.6(IA), the Books and Records Rule, which requires advisers to keep and maintain certain books and records relating to their investment advisory business. Rule 51-4.6(IA) subsection (3) was amended to require investment advisers to provide and keep additional information on their memorandum of trade orders (or trade blotters). Rule 51-4.6(IA) subsection (5) was amended to require firms to maintain copies of “invoices” in addition to bills and other financial statements. In addition, new recordkeeping obligations added to the Books and Records include Rule 51-4.6(IA)(7), which was amended to expand the records requirement of firms to all written communications relating to the business of the investment adviser and Rule 51-4.6(IA)(16), which was added to require advisers to maintain a written summary of all oral complaints in addition to the current requirement to maintain written communications concerning litigation and customer complaints. Advisers will thus be required to take the time to memorialize verbal complaints.
Takeaways for Amended Rules
- Consider the Scope and Applicability of the New and Amended Division Rules: Investment advisers licensed with the State of Colorado should bear in mind the scope and applicability of the Amended Rules, particularly with respect to Form ADV Part 2.
- Review and Update All Advisory Contracts: Colorado Licensed Advisers should consider providing addendums or supplements to advisory contracts that no longer meet the new requirements of Rule 51-4.8(IA)(P). Advisers should also consider reviewing their contracts on a recurring basis to seek to ensure those agreements are compliant with the Division’s regulatory requirements, reflect the adviser’s current business model, and are, most critically, consistent with the practices and fee structures disclosed in other advisory documents, such as Form ADV Part 2A and the adviser’s marketing materials.
- Review Recordkeeping Practices: Colorado Licensed Advisers should also consider whether their recordkeeping practices are consonant with the requirements of the amended Rule. As part of this determination, a Colorado Licensed Adviser should also consider whether (and to what extent) they are sufficiently positioned to promptly provide the firm’s books and records to the Division, preferably in an electronic format, if requested.
Conclusion
The topics highlighted in Parts 1 & 2 of this series (and other regulatory elements that were also part of the recent amendments) deserve attention by all investment advisers whose operations relate in some way to the state of Colorado. These new amendments will investment advisers differently.
Should you have a question about the contents of this article please contact Peter Schwartz, Martine Ventello, or any other member of the DGS Asset Management team.
[1] Section (P) falls under the larger umbrella of Division Rule 51-4.8(IA), which is a catch-all rule governing investment advisers’ dishonest or ethical conduct.
[2] General Instructions for Part 2 of Form ADV are available at https://www.sec.gov/about/forms/formadv-part2.pdf
[3] See the Division’s Cost-Benefit Analysis associated with these Amended Rules here: https://drive.google.com/file/d/1exIuxL_-wT4wYSKdRd6pqaikL5W80sLE/view