The SEC, a sleeping giant for most of 2018, has suddenly awoken. It’s most recent activity has come in the form of a National Exam Program Risk Alert (“the Alert”). The Alert targets registered investment advisers and focuses on Rule 206(4)-3, the Cash Solicitation Rule (“the Rule”). SEC’s OCIE based its Alert on findings from its investment adviser examinations that took place over the past three years.
Rule 206(4)-3 requirements typically affect retail advisers or advisers to separately managed accounts more so than private fund advisers. Private fund advisers must follow Rule 3a-4 of the Exchange Act for employee or internal solicitors. As for external solicitors, in an interpretive letter issued to Mayer Brown LLP on July 15, 2008, the staff of the SEC described how referrals of investors to private funds would not be subject to the Cash Solicitation Rule. The interpretive letter states that the referrals are exempt so long as the compensation paid by an investment adviser to a solicitor is solely for referrals of private funds and the investor does not have an investment adviser agreement that would deem the investor a “client” under the Advisers Act. Typically, private fund advisers do not have agreements with investors as clients.
The Rule can be challenging to follow due to its multi-layer components. It has two parts, one for employee or internal solicitors and another for external or third party solicitors. This particular Alert covers exam findings from advisers’ use of third party solicitors, which is comprised of four components in the Rule. In summary, they are as follows:
- Written solicitation agreement must exist between investment adviser and solicitor that covers the type of solicitation activity to be performed and the compensation to be received for that activity;
- The agreement must provide for the delivery (at the time of solicitation) of the adviser’s Form ADV Part 2A brochure along with a separate written disclosure document to the client that describes the solicitor’s role and compensation (“Solicitor Disclosure Document”);
- Adviser must receive a signed and dated acknowledgement form from the client either at or before entering into an advisory contract with the adviser (whether oral or written), which states the client received the Form ADV Part 2A brochure and the Solicitor Disclosure Document (at the time of solicitation); and
- Adviser must have a reasonable belief that the solicitor has complied with the Rule and must make an effort to determine if the solicitor has abided by the solicitation agreement.
There are several ways in which an adviser can run afoul of the Rule. The SEC found certain violations associated with the Solicitor Disclosure Document to be more common occurrences, such as:
- Lack of disclosures regarding affiliations between the adviser and the solicitor;
- Failure to disclose compensation arrangements in enough detail for the client to understand the terms or exact amount paid; and
- Failure to disclose any additional costs paid by the client because of the solicitor fee.
In addition, OCIE found that client acknowledgement forms were often not dated or were dated after the client had signed an advisory contract with the adviser.
Concerns regarding the actual solicitation agreements between the adviser and the solicitor were also discovered by the Staff and those included:
- Agreements that did not include a provision that the solicitor must perform its duties at the instruction of the adviser;
- Lack of detail regarding the solicitation activities to be performed and the compensation paid; and
- Failure to include provisions on the requirement to provide the Form ADV Part 2A brochure and the Solicitor Disclosure Document to the client or prospect.
The fourth criteria of the Rule, which puts a burden on the adviser to take action to determine solicitor compliance with the solicitation agreement, was also cited by OCIE as concerning where advisers could not provide proof of any efforts taken to oversee this compliance.
The Staff also noted in the Alert that adviser recommendations or referrals to certain service providers (i.e. brokers, custodians, etc.) in exchange for client referrals from those entities do not fall under the Rule. These types of referral relationships are related to an adviser’s fiduciary duty and come under Sections 206(1) and 206(2) of the Advisers Act. Service provider referral arrangements should be disclosed to clients as actual or potential conflicts of interest and should contain enough detail for the client to understand the risks involved.
View the National Exam Program Risk Alert, “Investment Adviser Compliance Issues Related to the Cash Solicitation Rule,” October 31, 2018.