As noted previously, the Securities and Exchange Commission (“SEC”) announced that it is releasing proposed amendments to the advertising and cash solicitation rules that currently provide for the regulatory framework impacting investment advisers on these issues. In this review, we are focusing on the proposed amendments to the cash solicitation rule under the Investment Advisers Act of 1940 (the “Act”).
Overview of the Proposed Cash Solicitation Rule Amendments
While current framework of the current rule would remain in place, the proposed amendments to the current cash solicitation rule would expand the current rule to cover solicitation arrangements involving all forms of compensation, rather than only cash, would expand the definition of solicitor to cover private funds, would include a new de minimus threshold and expand the solicitor disqualification rules. Beyond that, the proposed amendments would largely make refinements in scope, written agreement content and disclosure requirements.
The -proposed solicitation rule would apply regardless of whether an adviser pays cash or non-cash compensation to a solicitor. Currently, Rule 206(4)-3 prohibits an adviser from paying a cash fee, directly or indirectly, to a solicitor with respect to solicitation activities unless the adviser complies with the terms of the rule. While the proposed rule would continue to apply to cash payments to a solicitor, including a percentage of assets under management, flat fees, retainers, hourly fees and other methods of cash compensation, the proposed rule would also apply to non-cash compensation provided to solicitors. Non-cash compensation for client referrals takes many forms, including directed brokerage, refer-a-friend programs, sales awards or other prizes, training or education meetings, outings, tours, or other forms of entertainment, and free or discounted advisory services. As the SEC believes that the provision of non-cash compensation for referrals creates the same conflicts of interest as cash compensation for referrals, that being that the solicitor has an economic interest in steering the investor to the adviser and may be biased by this interest. To resolve that conflict, the SEC is requiring that investors be made aware of the solicitor’s conflict of interest regardless of the form of compensation.
Additionally, compensation could also include the adviser providing investment advice that directly or indirectly benefits the solicitor. It was also noted that compensation provided by the adviser may occur before or after the solicitor engages in its referral activities, but regardless of when the compensation for solicitation is provided, such compensation would be within the scope of the proposed rule.
Private Fund Solicitors
The proposed rule retains the current rule’s definition of “solicitor,” which is “any person who, directly or indirectly, solicits any client for, or refers any client to, an investment adviser.” However, the proposed rule would expand the scope of the rule to the solicitation to apply to investors in private funds, and not just to the adviser’s clients, which are generally the private funds themselves. The SEC believes that this is necessary to increase protections to such investors primarily by making them aware of a solicitor’s financial interest in the investor’s investment in a private fund and prohibiting the use of disqualified solicitors under the proposed rule. While investors in private funds may often be financially sophisticated, they may not be aware that the person engaging in the solicitation activity may be compensated by the adviser, and the SEC believes investors in such funds should be informed of that fact and the related conflicts.
Additionally, the inclusion of private funds solicitation attempts to address an interesting historical gray area issue for the regulators. This issue stems from the role the solicitor takes in the transaction. Thus, in some circumstances, based on the actual solicitation activities, the solicitor may be acting as an investment adviser within the meaning of section 202(a)(11) of the Act, or as a broker or dealer within the meaning of section 202(a)(11) of the Act or section 3(a)(4) or 3(a)(5) of the Exchange Act, respectively.
With that said, it is interesting to note that the proposed rule provides no “white line” guidance regarding this issue, but rests on the historical approach to the issue, to wit, it looks to a fact and circumstance determination based upon a review of type and amount of compensation (incentive, fixed fee or based on AUM), means of solicitation (individual solicitation, third party promoter, social media “influencer”, endorsements, statutory or regulatory requirements under Federal law, and/or state law, certain FINRA rules. With that said, each situation in which a private fund utilizes solicitors will now be subject to higher scrutiny as to its sales practices … that being, is it offering an investment advisory opportunity, or a security
The proposed rule would substantially retain the current rule’s partial exemptions for (1) solicitors that refer investors for impersonal investment advice, and (2) solicitors that are employees or otherwise affiliated with the adviser. The proposal would also add two new full exemptions for: (1) de minimis compensation to solicitors, and (2) advisers that participate in certain nonprofit programs.
Impersonal Investment Advice
The proposed rule would continue to partially exempt from the rule solicitors that refer investors for the provision of impersonal investment advice. This exemption would cover solicitation activities for investment advisory services that do not purport to meet the objectives or needs of specific individuals or accounts. The definition of “impersonal advisory services” would be incorporated into the Form ADV definition, which would replace the current rule’s definition of “impersonal advisory services,” to achieve consistency with Form ADV. However, modifying the definition for consistency will not change the types of persons to whom the exemption would apply, and as such, the proposed exemption would be inapplicable to automated and internet advisers that use technologies to provide discretionary asset management services to their clients through online algorithmic-based programs.
Additionally, while the proposed rule would maintain the current rule’s partial exemption for compensated solicitors of impersonal investment advice, one major modification is that such solicitors would not be required to enter into a written agreement with the investment adviser. A final note is that a registered investment adviser that offers a full line of advisory services, including personal and impersonal investment advice, may only rely on the partial exemption when the solicitation activities relate exclusively to the investment adviser’s impersonal investment advice. It would not be permitted to rely on the partial exemption under the proposed rule when an investor is solicited for both impersonal and personal investment advice, even if that investor receives only impersonal investment advice.
In-House Solicitors and other Affiliated Solicitors
The proposed rule will continue to provide a partial exemption for an adviser’s solicitation relationship with any person that is an adviser’s partner, officer, director and employee (sometimes referred to as in-house solicitors), and any partner, officer, director, or employee of a person which controls, is controlled by, or is under common control with the adviser (sometimes referred to as affiliated solicitors), provided that the affiliation is disclosed to the client at the time of the solicitation or referral. Additionally, it would generally maintain the central elements of the current rule’s partial exemption for affiliated solicitors: that the solicitor disclosure, adviser oversight and the detailed provisions of the written agreement are not required with respect to affiliated solicitors under certain conditions.
The partial exemption, with some modifications, will require that the status of such solicitor as in-house or affiliated is disclosed to the investor at the time of the solicitation unless such relationship is readily apparent, and the adviser documents such solicitor’s status at the time of entering into the solicitation arrangement. Thus, under the proposed rule, an adviser can rely on the rule’s partial exemption for in-house and affiliated solicitors not only when the status of such solicitor is in-house or an affiliate is disclosed to the investor at the time of the solicitation or referral, but also when such relationship is readily apparent to the investor at the time of solicitation, such as when the in-house solicitor shares the same name as the advisory firm, or clearly identifies itself as related to the adviser in its communications with the investor.
De minimus Compensation
The proposed rule contains an exemption for de minimis compensation. Specifically, the rule would not apply if the solicitor has performed solicitation activities for the investment adviser during the preceding twelve months and the investment adviser’s compensation payable to the solicitor for those solicitation activities is $100 or less (or the equivalent value in non-cash compensation). An adviser must come into compliance with the solicitation rule if it makes any compensation to a solicitor that, together with all compensation provided to that solicitor in the preceding 12-month period, exceeds the de minimis amount. Accordingly, if an adviser expects to make payments to a solicitor in excess of the de minimis amount, even though it has not yet done so, advisers are recommended to carefully consider whether it wishes to avail itself of the exemption.
Under the proposed rule, certain types of nonprofit programs would be exempt from the substantive requirements of the rule. Specifically, the rule would not apply to an adviser’s participation in a program, (i) when the adviser has a reasonable basis for believing that (a) the solicitor is a nonprofit program, (b) participating advisers compensate the solicitor only for the costs reasonably incurred in operating the program; and (c) the solicitor provides clients a list of at least two advisers the inclusion of which is based on non-qualitative criteria such as, but not limited to, type of advisory services provided, geographic proximity, and lack of disciplinary history; and (ii) the solicitor or the investment adviser prominently discloses to the client at the time of any solicitation activities: (a) the criteria for inclusion on the list of investment advisers, and (b) that investment advisers reimburse the solicitor for the costs reasonably incurred in operating the program.
The proposed rule would prohibit an adviser from compensating solicitors unless the adviser and solicitor have, in the written agreement, designated the solicitor or the adviser to provide to investors at the time of any solicitation activities (or in the case of a mass communication, as soon as reasonably practicable thereafter), a separate disclosure containing specified information (the “solicitor disclosure”). The proposed rule would require that the solicitor disclosure state: (i) the name of the investment adviser; (ii) the name of the solicitor; (iii) a description of the investment adviser’s relationship with the solicitor; (iv) the terms of any compensation arrangement, including a description of the compensation provided or to be provided to the solicitor; and (v) any potential material conflicts of interest on the part of the solicitor resulting from the investment adviser’s relationship with the solicitor and/or the compensation arrangement. The disclosure would also require disclosure of the amount of any additional cost to the investor as a result of solicitation.
Conflicts of Interest
While the proposed rule is substantially derived from the current rule’s required disclosures, it also includes a new requirement to disclose any potential material conflicts of interest on the part of the solicitor resulting from the investment adviser’s relationship with the solicitor and/or the compensation arrangement.
Finally, unlike the current rule, the proposed rule would (i) permit either the solicitor or the adviser to deliver the solicitor disclosure, rather than requiring that the solicitor deliver it, provided the written agreement designates the party responsible for delivering the disclosure; and (ii) remove the current rule’s requirement that the solicitor disclosure be “written”, and as such it could also be presented in any other electronic or recorded media format. Irrespective of the format, however, the adviser would be required, under the Act’s books and records rule, to make and keep true, accurate and current copies of the solicitor disclosure delivered to investors under the solicitation rule. Accordingly, under the proposed rule the solicitor disclosure could not be delivered orally unless the oral disclosure is recorded and retained.
Disqualification of Solicitors
The proposed rule contains an expanded list of disciplinary events for which persons would be disqualified from acting as a solicitor, with a limited exception. In addition to the current disqualification provisions, the proposed disqualification provisions include statutory changes and SEC rules regarding limitations on activities since the rule was promulgated. Those provisions include the Dodd-Frank Act and the rules disqualifying felons and other “bad actors” from certain securities offerings, and adding the types of disciplinary events that would disqualify a person from acting as a solicitor, including by adding certain disciplinary actions by other regulators and self-regulatory organizations.
The proposed rule contains an absolute bar on paying cash for solicitation activities to a person with any disciplinary history enumerated in the rule. To this end, an “ineligible solicitor” would be defined to mean a person who, at the time of the solicitation, is either subject to a disqualifying SEC action or is subject to any disqualifying event. To the extent a solicitor is deemed to be an ineligible solicitor, the following persons would also be ineligible solicitors: (i) any employee, officer or director of an ineligible solicitor and any other individuals with similar status or functions; (ii) if the ineligible solicitor is a partnership, all general partners; (iii) if the ineligible solicitor is a limited liability company managed by elected managers, all elected managers; (iv) any person directly or indirectly controlling or controlled by the ineligible solicitor as well as any person listed in (i) – (iii) with respect to such person. These persons would therefore be ineligible solicitors even if they do not themselves have any of the rule’s disqualifying events.
Reasonable Care Standard
Additionally, the proposal includes a reasonable care standard, which would be a change from the current rule. Such a standard would require the adviser to exercise reasonable care to confirm that the solicitor is not ineligible, both at the time of the engagement of the solicitor relationship, and during the course of the solicitor relationship. Thus, while factual inquiry by means of questionnaires or certifications, may be sufficient, the frequency of inquiry could vary depending upon, for example, the risk of using an ineligible solicitor, the impact of other screening and compliance mechanisms already in place, and the cost and burden of the inquiry.
Finally, the SEC has noted that the time of solicitation, rather than the time the adviser compensates, or engages, the solicitor for solicitation, is the appropriate point in time to tie the disqualifying event or action to the solicitor’s status as an ineligible solicitor.
Under the proposed rule, an adviser that compensates a solicitor for solicitation activities would be required to enter into written agreement with the solicitor, unless an exemption applies. The proposed rule would require that the written agreement include: (i) a description of the solicitation activities and compensation, (ii) a requirement that the solicitor perform its solicitation activities in accordance with certain provisions of the Advisers Act, and (iii) a requirement that solicitor disclosure be delivered to investors. As noted earlier, the proposed rule would eliminate the current rule’s requirements that the solicitor agree to deliver the adviser’s Form ADV brochure and perform its solicitation activities consistent with the instructions of the adviser.
Elimination of Additional Provisions
The proposed rule would eliminate the current rule’s (i) requirement for the adviser to obtain a signed and dated acknowledgment from the client that the client has received the solicitor’s disclosure; and (ii) explicit reminders of advisers’ requirements under the Act’s special rule for solicitation of government entity clients and their fiduciary and other legal obligations.
The public comment period on the Solicitation Rule will remain open for 60 days after publication in the Federal Register. To make comments, you can (1) utilize the SEC’s comment form which is located on the internet at http://www.sec.gov/rules/proposed.shtml; or (2) send an email to firstname.lastname@example.org (and include File Number S7-21-19 on the subject line).