By George W. Karpus
BridgeTower Media Newswires
The SEC is making another attempt to turn retail investors into more informed investors by requiring a new disclosure form known as Form CRS. The new form is intended to help investors understand the differences between registered investment advisors and representatives of broker-dealers (BDs), especially on matters relating to standard of care and compensation. Whether you are currently working with a registered investment adviser or a BD representative, or you are exploring the options, you’ll want to pay attention to the new form.
Much of the regulatory scheme for the investment services business is built around the simple idea of disclosure. The idea is that with adequate disclosure investors can make informed decisions about the investment products or services which serve their best interests. This approach to regulation allows the marketplace to innovate and to provide the retail investor with a range of investment products and services from which to choose. But it requires that sufficient information is disclosed, including information about risks and costs, to allow for an informed decision.
Any investor owning a mutual fund or exchange-traded fund (ETF) should be familiar with this approach. Every fund investor receives a prospectus or a summary prospectus at the time of purchase, and thereafter receives annual prospectus updates and annual reports. Unfortunately, prospectuses too often find their way to the trash bin without having been read much less understood. It appears that many investors find the prospectus — even the shortened summary prospectus — to be too tedious to bother with or too hard to understand if they try.
Some of the blame lies with investors who won’t make the effort. We have written previously about how the fund prospectus can actually be an interesting and useful document if approached from the perspective of “what can go wrong” or “how can I lose money.”
Some of the blame also lies with investment firms who have hijacked the prospectus from its intended purpose as an affirmative benefit for the investor and turned it into a defensive tool to limit their liability. The typical prospectus is too lengthy and legalistic. Although it still contains much good information, an investor could be forgiven for thinking that the document is less about informing them than it is about protecting the “big guys.”
The SEC has made repeated efforts to help investors become informed consumers of financial products and services. Since 1999, the SEC has required investment companies to deliver the prospectus in plain English and in a standardized format. The SEC also permits investment companies to deliver a much shorter version — a summary prospectus — to confirm purchases, so long as the full version is also made available on the web.
In 2010, the SEC revamped the disclosures investment advisers were required to provide to clients. Since 1979, advisers have been required to provide written disclosure to clients in a form known as Form ADV covering such matters as fees, compensation arrangements, investment offerings and methods, and industry affiliations. The form initially used a check-the-box approach that presented a lot of information but in a format that provided little context or explanation for the average investor.
To remedy this, starting in 2010 the SEC has required that the Form ADV disclosures be written in narrative form, in plain English, and cover an expanded range of topics including, a description of the advisory business, investment management practices, disciplinary history, potential conflicts of interest, and brokerage and trading practices. The SEC also has made every firm’s Form ADV available to the pubic via the web.
The narrative form of the Form ADV Part 2 is a vast improvement over earlier disclosures, but whether the SEC’s requirements have contributed to greater financial literacy or savvy of the average investor is an open question. Some would say it’s open and shut — that the SEC has failed to move the needle.
Ever hopeful, the SEC is taking another stab at creating informed investors by further simplification of the Form ADV. Now, in addition to the narrative Form ADV Part 2, investment firms must provide a Part 3 — a two-page “customer relationship summary” to be known as Form CRS. It is analogous to the relationship between the summary prospectus and the full statutory prospectus in that it attempts to summarize and simplify the information provided in the longer Form ADV Part 2.
In style, the Form CRS must be reader friendly. That means it must be in plain English, in short straightforward sentences, and without legal or technical jargon unless they are clearly explained. In substance, the new disclosure should follow a standardized format that summarizes the advisory relationship in a nutshell so that the investor can make an informed decision about hiring or firing an investment adviser. It will also be a useful tool to comparison shop among advisory firms.
Because the new Form CRS is simply an add-on to the existing Form ADV, it will be easily accessible to investors via the website operated by FINRA and found at IARD.com.
The disclosure can be thought of as responses to a series of basic questions. What type of firm is this? Ever wonder if you are dealing with an investment advisory firm, a broker-dealer, or both? Currently, it’s hard to tell, but in the new disclosure investors will be told explicitly whom they are dealing with and will be provided with links to more information about the differences.
What investment services and advice are offered? Advisory accounts and brokerage accounts are very different, with different sets of legal duties on the part of the investment firm. Does the firm monitor its clients’ investments and, if so, how? Does the firm exercise investment discretion or does the client make the ultimate call on buying or selling investments? Does the investment firm act as a fiduciary on behalf of the client?
What are the fees? How is the investment adviser or broker paid and what other costs might the investor incur, such as custodial fees, transaction fees, fund fees and other account related fees?
What potential conflicts of interest are created by the fee arrangement? Every fee arrangement carries with it the potential for some conflict with the best interests of the investor, even the seemingly straightforward fee-only arrangement.
These and other questions and responses need to be packed into a two-page format. The question and answer format is designed to prompt further conversation between the investor and the investment adviser or broker. Form CRS will be challenging for investment firms to draft, but it should be rewarding for investors to read.
Yet another disclosure may seem like more piling on. After all, you already receive a litany of disclosures and reports relating to your investments, including the current Form ADV, your investment management agreement, fund prospectuses, and annual reports. Your tendency may be to ignore this as so many other disclosures have largely been ignored.
Do yourself a big favor and pay attention this time. The SEC might finally have hit upon an effective approach to creating more informed and engaged investors.
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David Peartree JD, CFP® is a registered investment advisor offering fee-only investment and financial planning advice. This column is a collaborative work by David Peartree and Patricia Foster, Esq. Patricia Foster is a securities law attorney whose experience includes representation of clients in various sectors of the financial services industry, including, broker-dealers, investment advisers, and investment companies. The information in this article is provided for educational purposes and does not constitute legal or investment advice.
