The Securities and Exchange Commission (the “SEC”) recently proposed amendments (the “Proposed Rule”) to the cash solicitation rule 206(4)-3 under the Investment Advisers Act, as amended (the “Advisers Act”) (the “Solicitation Rule”), with the intent of reflecting changes in industry practices, technology and investors’ expectations, and eliminating redundancies caused by other requirements under the Advisers Act.
Among other things, the Proposed Rule (i) applies the Solicitation Rule to solicitors for private funds—reversing previous SEC guidance; (ii) includes non-cash compensation paid to a solicitor; (iii) adds two new full exemptions for de minimis compensation to solicitors and advisers that participate in certain nonprofit programs; and (iv) expands the list of disciplinary events which would disqualify someone from acting as a solicitor.
Proposed Solicitation Rule Would Apply to Private Funds
The Proposed Rule is particularly relevant to private fund advisers as it would it would apply the Solicitation Rule to the solicitation of investors in private funds, and not just an investment adviser’s clients, which are generally the private funds themselves (unless the adviser also provides separate advice directly to an underlying fund investor). This means that private fund advisers would be prohibited from paying solicitors for referrals unless the private fund adviser and solicitor enter into a written agreement (unless an exemption applies), which would be required to contain:
a description of solicitation activities and compensation;
a requirement that the solicitor perform its solicitation activities in accordance with sections 206(1), (2), and (4) of the Advisers Act; and
a requirement that either the solicitor or the adviser provide investors with a solicitor disclosure, which would be required to include:
the name of the adviser;
the name of the solicitor;
a description of the adviser’s relationship with the solicitor;
the terms of any compensation arrangement, including a description of the compensation provided or to be provided to the solicitor; and
any potential material conflicts of interest resulting from the adviser’s relationship with the solicitor and/or the compensation arrangement.
Unlike the requirements currently applicable to investment advisers, either the solicitor or the adviser would be permitted to deliver the disclosure under the Proposed Rule, as long as the party responsible for delivering the disclosure is specified in the written agreement between the solicitor and adviser. The proposed approach would also no longer require the solicitor to deliver the adviser’s Form ADV with the disclosure, or investors to sign a written acknowledgment in response to such disclosure. While investment advisers for private funds are not currently required to deliver a Form ADV under Rule 204-(3) of the Advisers Act, some elect to deliver a Form ADV to demonstrate their compliance with the anti-fraud provisions applicable to private fund investors under Rule 206(4)-8.
The SEC has requested comment on, among other things, whether: (i) the disclosure should be provided with mass communications to solicit investors or may be provided as reasonably practicable thereafter; (ii) the disclosure should be written; (iii) there should be exceptions to the disclosure requirements for (1) solicitors who are registered with the SEC as investment advisers and disclose relevant conflicts of interest in their brochures or (2) solicitors who are registered as broker-dealers who disclose relevant conflicts of interests under other disclosure regimes; and (iv) private fund investors would incur direct additional costs under the proposed regime as a result of an adviser’s use of a solicitor.
In addition to the Proposed Rule’s expanded application to private funds, private fund managers who use solicitors to market fund interests to investors must also be aware of broker-dealer registration requirements. In Ranieri Partners, the SEC found that a private fund manager had willfully aided and abetted an unregistered broker-dealer’s violation of the Securities Exchange Act registration requirements in connection with the solicitation of investors in the fund.
Proposed Rule Includes All Compensation
While the Solicitation Rule currently only applies to cash payments, the Proposed Rule would apply to all forms of compensation, including directed brokerage, sales awards or other prizes, training or education meetings, outings, tours, or other forms of entertainment and free or discounted advisory services. This would even include investment advice that directly or indirectly benefits the solicitor. For example, if an adviser recommends its investors purchase a broker-dealer’s investment products in exchange for the broker-dealer’s solicitation activities, that relationship would have to be codified in a written agreement, and the potential conflict of interest would have to be disclosed to investors. These requirements would apply to any recommendation to purchase investment products that the adviser knows have revenue sharing or other pecuniary arrangements with the solicitor or its affiliates.
The SEC has requested comment on whether certain forms of non-cash compensation should be exempt from the Proposed Rule and whether certain forms of non-cash compensation should be prohibited.
New Exemptions for De Minimis Compensation and Certain Nonprofit Programs
The Proposed Rule includes two new exemptions in addition to the current ones for solicitors that refer investors for “impersonal investment advice” or are affiliated with the adviser. The proposed approach includes an additional exemption for de minimis compensation aimed at reducing the burden on smaller advisers and facilitating popular “refer a friend” programs, which often involve minimal compensation. Advisers participating in certain nonprofit programs would also be exempt from the Proposed Rule’s substantive requirements.
Expanded List of Disqualified Solicitors
Advisers would have a narrower selection of qualified solicitors under the Proposed Rule since it expands the list of disqualifying events which would prohibit someone from acting as a solicitor with limited carve-outs for ineligibility arising from “non-disqualifying Commission actions” or actions for which the SEC has issued a waiver under the Investment Company Act of 1940.
Conforming Changes to the Books and Records Rule
The SEC is also proposing conforming amendments to the books and records rule 204-2 that would require investment advisers to make and keep records of: (i) copies of the disclosure delivered to investors; (ii) documentation related to the solicitor’s compliance with the written agreement and eligibility as a solicitor; and (iii) the names of all solicitors who are employees of or otherwise affiliated with the adviser.
If adopted, the Proposed Rule could represent the first application of the Solicitation Rule to private fund advisers and will be the first amendment to the Solicitation Rule since it was first adopted in 1979.
The comment period will remain open for 60 days after publication in the Federal Register. The SEC encourages investors and advisers to use the short form “feedback flyers” available on the SEC website to submit information. Smaller advisers, in particular, are encouraged to submit additional information about how they might be affected by the Proposed Rule.