SEC Risk Alert: Investment Adviser Compliance Issues Related to the Cash Solicitation Rule

Risk Alert 

While we were busy handing out candy, the SEC was busy handing out advice! The Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert on October 31, 2018 to provide investment advisers, investors and other market participants with information concerning 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 (the “Advisers Act”). The Risk Alert is intended to assist investment advisers in identifying potential issues and adopting and implementing effective compliance programs, and generally pertains to an adviser’s use of third-party solicitors that are subject to the broader requirements of the Cash Solicitation Rule.

Rule Requirement

Rule 206(4)-3 under the Advisers Act prohibits investment advisers from paying a cash fee, directly or indirectly, to an unrelated third party (a “solicitor”) for referring clients to the adviser unless the arrangement complies with certain conditions, as detailed below:

  • Solicitor agreement: a written agreement is executed between the adviser and the solicitor (a copy of which the adviser must retain) detailing the referral arrangement (e.g., a description of the solicitation activities and compensation to be received, as well as obligations of the solicitor under the arrangement);
  • Adviser’s brochure: at the time of any solicitation activities, the solicitor is required to provide the prospective client with a copy of the investment adviser’s brochure and supplements (i.e., Form ADV Part 2);
  • Solicitor disclosure: at the time of any solicitation activities the solicitor is required to provide a separate and written disclosure document to the prospective client which discloses the solicitor’s relationship to the adviser, and clarifies that the solicitor is being compensated for recommending the adviser, specifying the terms of the compensation arrangement;
  • Client acknowledgement: the adviser receives from the client at a time no later than the execution of the investment adviser’s agreement, a signed and dated acknowledgment that the client received the investment adviser’s brochure and the solicitor’s written disclosure document;
  • Solicitor disqualification: the solicitor may not be a person subject to certain disqualifications specified in the Cash Solicitation Rule; and
  • Compliance: 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.

Advisers are subject to narrower requirements under the Solicitation Rule when the solicitor is a partner, officer, director, or employee of the adviser or of an entity that controls, is controlled by, or is under common control with the adviser or if the cash fee is paid with respect to solicitation activities for the provision of impersonal advisory services only. The Risk Alert did not enumerate any observed deficiencies related to this type of arrangement.

Recurring Adviser Deficiencies 

The OCIE staff outlined common deficiencies in the Risk Alert, as noted below:

Solicitor disclosure documents: non-provision of disclosure documents to prospective clients pursuant to rule requirement and/or insufficient or obtuse disclosure of required information. Several deficiencies were noted wherein disclosure language regarding compensation were hypothetical or vague. In other situations, disclosure documents failed to clarify that the client would pay a higher fee for advisory services to essentially cover the solicitation fee. The SEC requires all disclosures to be truthful, complete and in Plain English.

Client acknowledgements: untimely or incomplete execution of required client acknowledgments pursuant to rule requirement wherein advisers did not receive a signed and dated client acknowledgement of receipt of the adviser brochure and the solicitor disclosure document. Furthermore, several advisers had received client acknowledgements, but they were undated or dated after the clients had entered into an investment advisory agreement.

Solicitation agreements: advisers paid cash fees to a solicitor without a duly executed solicitation agreement or paid compensation referencing an agreement that did not contain required provisions pursuant to rule requirement.  The SEC determined that solicitors did not perform their duties referenced in the solicitation agreement in a manner consistent with the instructions of the adviser thereby placing the adviser in deficient status.

Bona fide efforts to ascertain solicitor compliance: adviser compliance with rule 206(4)-3 requires advisers to make a genuine effort to ensure that solicitors are complying with cash solicitation rule requirements. The SEC observed that deficient advisers could not represent that they had a reasonable basis to believe that engaged third party solicitors were in full compliance with rule requirements (e.g., there was no evidence of a compliance audit trail with sufficient documentation attesting to solicitor compliance).

Other regulatory implications: the SEC also cited advisers for non-compliance with other provisions of the Advisers Act, e.g., breach of fiduciary duty under Sections 206(1) and 206(2). For example, OCIE observed advisers that recommended service providers to clients in exchange for client referrals without full and fair disclosure of the conflicts of interest.

Action Plan

We recommend that advisers review and amend, as necessary, disclosure documents and solicitation agreements to be consistent with actual practices.  Payment arrangements must be clear to all parties involved, including solicited clients. We also recommend that advisers adopt an internal control whereby the Chief Compliance Officer or designee performs appropriate due diligence for all engaged third party solicitors to ensure that all parties remain compliant with cash solicitation rule requirements. The frequency of review should be commensurate with the level of activity and risks associated with solicitation arrangements. Of course, all due diligence efforts must be documented in writing, and written policies and procedures must be adopted and implemented to ensure full compliance with the rule. Finally, although the SEC did not call out advisers for solicitation arrangement deficiencies evident with related party solicitors, investment advisers must ensure that related party arrangements follow the requirements of Rule 206(4)-3.

The SEC has stated that examinations within the scope of this review resulted in a range of regulatory actions against advisers, including enforcement actions. As one example, the SEC acted against an adviser deemed to violate the Cash Solicitation Rule by paying a cash fee to a solicitor despite knowing that the solicited clients had not received the necessary disclosures.

For More Information 

View the Risk Alert here: Investment Adviser Compliance Issues Related to the Cash Solicitation Rule (PDF)

Betsy Rathz

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