RIA Compliance Blog
As discussed in our most recent posting on this blog, the SEC has proposed a wholesale rewrite of its existing advertising and cash solicitation rules. While that last post delved into the specifics of the SEC’s proposed amendment of its advertising rule, in this installment, we take up the Commission’s plans for revamping its cash solicitation rule.
The SEC’s Release No. IA-5407, published on November 4th, aims to modernize both rules to reflect the dramatic changes seen in technology and the advisory industry since the initial adoption of these rules decades ago. While just a proposal for now, it offers the best view into what any ultimate final rules will probably look like. At this stage, RIAs and other industry participants are closely reviewing both proposed rules, and many will be submitting public comments to the SEC as permitted pursuant to the Commission’s public comment process. While the public comment process runs a fixed 60 days, the ultimate publication of final rules is at the SEC’s discretion.
The cash solicitation rule (Advisers Act Rule 206(4)-3), first adopted in 1979, prohibits a federally-registered adviser from paying a cash fee, directly or indirectly, to any person who solicits clients for that RIA, unless a number of conditions are satisfied, most notably that any fee must be paid pursuant to a written agreement between the solicitor and the RIA. Additionally, third-party solicitors (i.e., those not affiliated with the RIA) must provide potential clients with both a copy of the RIA’s brochure and a separate written solicitor’s disclosure document. Third-party solicitors must also collect a signed and dated acknowledgment from every solicited client that such client has in fact received the RIA’s brochure and the solicitor’s disclosure document.
At a macro level, the proposed rule makes two major changes to the scope of the existing rule: (i) it expands applicability to all forms of compensation, not just cash equivalents; and (ii) it sweeps under its coverage the solicitation of private fund investors, not just advisory account clients. As noted by the SEC, non-cash compensation would include directed brokerage, sales awards/prizes, training or education, outings, tours, or other forms of entertainment, and free/discounted advisory services. Under this expanded definition, compensation could also include the RIA providing investment advice that directly or indirectly benefits the solicitor.
Regarding the proposed expansion of solicitation activities to include the solicitation of private fund investors, the SEC cites the need to raise awareness among fund investors as to the solicitor’s financial interest. In proposing the rule the Commission recognized that investors in private funds are often sophisticated in financial matters, but added that those sophisticated investors still may not be aware of the solicitation activity or the financial incentive underlying the recommendation.
As with the current rule, the core of the proposed rule is the requirement that compensation to the solicitor be provided pursuant to a written agreement as between the solicitor and the RIA, describing with specificity the solicitation activities and the terms of the compensation. This written agreement must also explicitly require the solicitor or the RIA to provide to the client (or private fund investor) a separate written disclosure document stating a number of material facts, including:
- the solicitor and RIA’s names;
- a description of the RIA’s relationship with the solicitor;
- the terms of any compensation provided to the solicitor;
- a description of any potential material conflicts of interest; and
- the amount of any additional cost to the client or private fund investor as a result of the solicitation arrangement.
Additionally, the RIA must have a “reasonable basis” for believing that the solicitor has complied with the aforementioned written agreement.
The proposed rule also sets up a revised exemption scheme. In addition to the current exemptions for (i) partners, officers, directors, employees or other affiliates (i.e., “affiliated solicitors”), and (ii) solicitors that refer investors for “impersonal investment advice,” the proposed rule also exempts solicitors receiving de minimis compensation (defined as $100 or less in value), and solicitation for certain nonprofit programs. Notably, solicitation activities conducted pursuant to all of these exemptions would be fully relieved of the written agreement requirement—and commensurate separate written disclosure document obligation.
Our initial take on this solicitation rule proposal is that it does not appear to rework the existing regulatory landscape as much as the advertising rule proposal does. Perhaps the most controversial element of the solicitation proposal will be the planned extension of the rule to private fund investors—in particular, whether it is necessary. On that aspect, we note that persons engaged in solicitation activities may already be subject to broker-dealer registration requirements to the extent that they are effecting transactions in securities (keep in mind that fund investors typically purchase limited partnership or LLC interests, which are “securities”). Indeed, we are surprised at the lack of discussion in the release regarding the rampant violations seen by the SEC over the years in connection with the marketing of hedge fund interests by unlicensed “finders.” It is unclear to what extent the proposal is meant to remedy this. We will obviously follow the public comment process and chronicle material developments in this proceeding as warranted.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.