As noted in our earlier articles, the reforms made to the Investment Advisers Act of 1940 (“Act”) that were adopted by the Securities and Exchange Commission (“SEC”) to modernize rules that govern investment adviser adverting, also impacted testimonials, endorsements, and integrated solicitor activities into that rule (collectively the “Rule”). This article focuses specifically on the impact that the Rule has on solicitor relationships for investment advisers.
Of primary significance is that the cash solicitation rule has been merged into the Rule, with solicitation activity being covered under the definition of endorsements. That definition includes any statement by a person, other than a current client or investor in a private fund advised by the investment adviser, that directly or indirectly solicits any current or prospective client or investor to be (i) a client of the investment adviser; or (ii) an investor in a private fund advised by the investment adviser. While there are a number of aspects of the retired solicitation rule that are still relevant, the merger of the rules does give rise to a number of new issues related to solicitation activities.
With the above in mind, the following sets forth a number of the significant aspects of the new Rule that you should be aware of.
Unlike the current solicitation rule, which was triggered only by cash compensation, the Rule requires disclosure of both cash and non-cash compensation. Therefore, a solicitor relationship will exist regardless of whether the solicitor is compensated with cash or with non-cash compensation. In addition to fees based on a percentage of assets under management, the compensation covered by the Rule includes flat fees, retainers, hourly fees, reduced advisory fees, fee waivers, and any other methods of cash compensation. Additionally non-cash compensation that advisers provide for referrals include directed brokerage that compensates brokers for soliciting investors, sales awards or other prizes, gifts and entertainment, such as outings, tours, or other forms of entertainment that an adviser provides as compensation for testimonials and endorsements. As such, the requirement to include non-cash compensation will require advisers to focus on the benefits they provide individuals and companies for referrals, to catch hybrid solicitor situations.
The Rule still requires that a solicitor relationship be documented in a written agreement between the adviser and the solicitor. While the agreement is still required to address the agreed-on activities and terms of compensation, the adviser no longer needs to obtain a written acknowledgement from each referred client that the client has received the required disclosures from the solicitor, and the solicitor no longer needs to deliver a copy of the adviser’s brochure (Form ADV Part 2A) to the prospective client. As a result, language requiring same in existing solicitor agreements should be modified to reflect the action to be taken by the adviser to make sure the disclosures are made.
The exceptions to this requirement occurs where the person giving the endorsement / solicitation is an affiliate of the adviser, or such person receives de minimis compensation (i.e., $1,000 or less, or the equivalent value in non-cash compensation, during the preceding twelve months).
Mirroring elements of the current solicitation rule, certain information must be disclosed, either in writing or verbally, in connection with a solicitation pursuant to the Rule.
“Clear and Prominent.”
Advisers must “clearly and prominently” disclose, or reasonably believe that the person giving the endorsement discloses, at the time the endorsement is disseminated, whether the person giving the testimonial or endorsement is a client or private fund investor, a description of the compensation provided or to be provided, directly or indirectly, and a description of the “material” conflicts of interest on the part of the person giving the endorsement resulting from the adviser’s relationship with such person and or any compensation arrangement. It should be noted that there are exceptions from the disclosure requirements for SEC-registered broker-dealers in limited certain circumstances and the Rule does not require to disclose the amount of any additional cost to the investor as a result of solicitation for the reasons discussed below.
As a final note, it is important to acknowledge that the SEC guidance regarding “clear and prominent” is that the required disclosure must be at least as prominent as the endorsement. In other words, the SEC believes that the clear and prominent standard requires that the disclosures be included within the endorsement and referral, or in the case of an oral referral, provided at the same time.
Timing and responsibility.
The required disclosures should be provided at the time such testimonial or endorsement is disseminated. Either the adviser or the solicitor may make the required disclosures (under the current cash solicitation rule, these disclosures must be made by the solicitor). If the adviser does not make the disclosures, it must have a reasonable belief that the solicitor is doing so.
The Rule prohibits an adviser from compensating a person, directly or indirectly, for an endorsement (and thus, solicitation) if the adviser knows, or in the exercise of reasonable care should know, that the person giving the endorsement is subject to an SEC opinion or order barring, suspending, or prohibiting the person from acting in any capacity under the federal securities laws or that the person giving the endorsement is subject to an enumerated “disqualifying event”. This provision is broader than the current cash solicitation rule in that if the ineligible person is an entity, the disqualification extends to the entity’s employees, officers, directors, general partners, and elected managers, as applicable. Additionally, certain actions by the Commodity Futures Trading Commission and self-regulatory organizations also are disqualifying pursuant to the Rule. Finally, it should be noted that the Rule applies a 10-year look-back period to all disqualifying events.
The Rule will be effective May 4, 2021; however, the SEC has adopted a compliance date that is 18 months after the effective date (November 4, 2022), to give advisers a transition period to comply with the amendments.
By November 4, 2022, all solicitor relationships will need to comply with the Rule. However, prior to that time, advisers utilizing individuals and or companies for client referrals should consider the following action items:
- Review all referral relationships, including those where no cash compensation is paid, to determine if they are subject to the Rule. If there are existing relationships where non-cash compensation or benefits are involved, those relationships need to be documented in compliance with the Rule no later than the compliance date.
- Review all existing solicitor agreements that were prepared in conformity with the prior solicitor rule and revise accordingly by the compliance date.
- Any solicitor relationships entered into after May 4th, 2021 should be drafted in compliance with the Rule.
- The compliance procedures of the adviser should be reviewed and revised to address the Advertising Rule, the firm’s solicitation activities and the recordkeeping activities impacted by the Rule.