The staff of the U.S. Securities and Exchange Commission released an interpretive letter, on Tuesday, July 15, 2008, clarifying that Investment Advisers Act Rule 206(4)-3 (generally referred to as the cash solicitation rule) does not apply to solicitations of investors in an investment pool such as a hedge fund.

The interpretive letter, Mayer Brown LLP (July 15, 2008), clarifies that the cash solicitation rule does not apply to a Registered Investment Adviser’s (RIA) cash payment to a person “solely to compensate that person for soliciting investors or prospective investors for, or referring investors or prospective investors to, an investment pool managed by the adviser.” The cash solicitation rule generally prohibits RIAs from paying third parties to solicit advisory clients without meeting certain disclosure and contractual requirements. Previous SEC no-action letters had suggested that the SEC interpreted the rule to apply not only to the solicitation of advisory contracts with an RIA, but also to the marketing of interests in investment pools managed by an RIA.

The staff found that the rule does not apply to solicitations made on behalf of investment pools managed by RIAs for four reasons:

  1. Neither the Proposing Release nor the Adopting Release of the rule mentions solicitations of investment pools managed by RIAs.
  2. The rule is designed clearly to apply to solicitations intended to result in the solicited person entering into an investment advisory contract with the RIA, and investors in pools managed by RIAs do not typically sign advisory contracts with the RIAs.
  3. The rule’s use of the terms “client” and “prospective client” rather than “investor” or “prospective investor” suggests that the rule was intended to apply to situations where the solicited person would become a client of the RIA. 
  4. The Goldstein decision concluded that investors in pools managed by an RIA are not clients of the RIA and thus the term client in the rule should not refer to these investors. Goldstein, et al. v. Sec. & Exch. Comn., 451 F.3d 873 (D.C. Cir. 2006).

The staff was careful to state that the rule may still apply to RIAs who hire third parties to solicit both their hedge fund and their investment advisory services. The staff stated that whether the rule would apply in such a case would depend on the facts and circumstances of the particular situation.

The letter also notes that even if the cash solicitation rule does not apply, the soliciting person may himself be an investment adviser under the Advisers Act and therefore required to disclose any material conflicts of interest – such as that he or she is being compensated by the RIA.

We note that the letter does not address the question of whether a solicitor for an investment pool may be subject to regulation as a “broker” under Section 3(a)(4) of the Securities Exchange Act of 1934.