Investment Adviser Compliance Issues Related to the Cash Solicitation Rule

On October 31, 2018, the staff in the Office of Compliance Inspections and Examinations (the “Staff”) of the U.S. Securities and Exchange Commission (the “SEC”) issued a risk alert (the “Risk Alert”)[1] describing some of the most common deficiencies the Staff has cited relating to Rule 206(4)-3 (the “Cash Solicitation Rule”) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), in examinations of investment advisers completed during the past three years.

Background – The Cash Solicitation Rule

Generally, registered investment advisers are prohibited from paying a cash fee for solicitation activities, directly or indirectly, to any person who solicits clients for the adviser unless the arrangement complies with the conditions specified in the Cash Solicitation Rule.

In particular, the Risk Alert focuses on compliance with the broader requirements of the Cash Solicitation Rule applicable to advisers’ use of third-party solicitors, placement agents, finders or other marketers (collectively, “solicitors”), including:

• the cash fee must be paid pursuant to a written agreement between the adviser and the solicitor that includes certain specified provisions (including a description of the solicitation activities and compensation to be received, as well as an undertaking by the solicitor to perform its duties in a manner consistent with the instructions of the adviser);
• the solicitation agreement must require that, at the time of any solicitation activities, the solicitor must provide the prospective client with (i) a copy of the adviser’s Form ADV Part 2A (“brochure”) and (ii) a separate, written disclosure document containing required information that highlights the solicitor’s financial interest in the client’s choice of an adviser (“disclosure document”);
• the adviser must receive from the client, before or at the time of entering into any written or oral agreement with the client, a signed and dated acknowledgment that the client received the brochure and disclosure document (“client acknowledgment”);
• the solicitor may not be a person subject to certain specified disqualifications; and
• the adviser must make a bona fide effort to ascertain whether the solicitor has complied with the solicitation agreement, and must have a reasonable basis for believing that the solicitor has so complied.

Most Frequent Deficiencies

Below are the most frequent deficiencies pertaining to the Cash Solicitation Rule identified by the Staff in the Risk Alert:

• Disclosure documents. Solicitors did not provide disclosure documents to prospective clients of the adviser or provided disclosure documents that did not contain all the information required by the Cash Solicitation Rule. For example, the disclosure document did not (i) disclose the nature of the relationship (including any affiliation) between the solicitor and the adviser, (ii) contain the terms of the compensation arrangement between the adviser and the solicitor, (iii) specify the actual compensation terms agreed to in the solicitation agreement and instead used vague or hypothetical terms to describe the solicitor’s compensation, and/or (iv) specify any additional solicitation cost that the client will be charged in addition to the adviser’s advisory fee.
• Client acknowledgments. Advisers either did not timely receive a signed and dated client acknowledgment, or received a client acknowledgment that was undated or dated after the client had entered into an investment advisory contract.
• Solicitation agreements. Advisers paid cash fees to a solicitor without a solicitation agreement in effect or pursuant to an agreement that did not contain specific provisions required by the Cash Solicitation Rule. For example, the solicitation agreements did not (i) contain an undertaking by the solicitor to perform its duties in a manner consistent with the instructions of the adviser, (ii) describe the solicitor’s activities and the compensation to be paid and/or (iii) oblige solicitors to provide clients with a current copy of the brochure and the disclosure document.
• Bona fide efforts to ascertain solicitor compliance. Advisers did not make a bona fide effort to ascertain whether solicitors complied with solicitation agreements and appeared not to have a reasonable basis for believing that the solicitors in fact complied. For example, advisers were unable to describe any efforts they took to confirm compliance with solicitation agreements.

The Staff also noted in the Risk Alert that it observed advisers with conflicts similar to the above that may implicate other provisions in the Advisers Act (e.g., an adviser’s fiduciary duty under Advisers Act Sections 206(1) and 206(2)), such as advisers that recommended service providers to clients in exchange for client referrals without full and fair disclosure of the relevant conflicts of interest.

According to the Risk Alert, the examined advisers took a range of actions in response to the Staff’s observations, including amending their disclosure documents and solicitation agreements, revising their compliance policies and procedures, or otherwise changing their practices regarding the Cash Solicitation Rule.

Solicitation of Private Fund Investors

In an interpretive letter preceding the Risk Alert, the SEC staff confirmed that the Cash Solicitation Rule does not apply to cash payments by a registered adviser to a solicitor that relate solely to the solicitation of investors in a fund managed by the adviser.[2] Nonetheless, it is important to note that the anti-fraud provisions of the Advisers Act (including under Section 206 and Rule 206(4)-8) prohibit all advisers (including unregistered fund managers) from making any untrue statement of a material fact or omitting a material fact necessary to make the statements not misleading, including when soliciting prospective fund investors. Under those provisions, advisers are required to disclose material facts relating to conflicts of interest to fund investors. Therefore, fund managers should include appropriate disclosure regarding solicitor arrangements and related conflicts of interest in the manager’s brochure (if the manager is registered) and the fund’s private placement memorandum. Fund managers should also consider including language in solicitation agreements requiring solicitors to make such disclosures in writing to prospective fund investors before they subscribe for a fund interest.

In addition, before hiring a solicitor to market to prospective fund investors, a fund manager should consider whether the solicitor is required to be registered as a broker-dealer or an investment adviser based on the nature of the arrangement.

Key Takeaways

There are a number of takeaways from the Risk Alert. For example, registered advisers who use solicitors to solicit managed account clients should ensure that they comply with all applicable requirements of the Cash Solicitation Rule. In addition, advisers should review their current policies and procedures and disclosure documents to confirm that they comply with the Cash Solicitation Rule to the extent applicable and that they are being followed. Advisers who have policies and procedures that are “off-the-shelf” or that have not been reviewed in some time should evaluate whether those policies and procedures require updating to comply with the Cash Solicitation Rule. Furthermore, unregistered advisers and fund managers who are not required to comply with the Cash Solicitation Rule should nevertheless make certain that they are adequately disclosing conflicts of interest and material facts concerning their use of solicitors to prospective clients and fund investors.
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[1] Securities and Exchange Commission, Office of Compliance Inspections and Examinations, Risk Alert: Investment Adviser Compliance Issues Related to the Cash Solicitation Rule (Oct. 31, 2018), available here.
[2] Mayer Brown LLP, SEC Interpretive Letter (Jul. 15, 2008), available here.