On July 15, 2008, the staff of the Securities and Exchange Commission (SEC) issued an interpretive letter explaining that Rule 206(4)-3 (the “Rule”) under the Investment Advisers Act of 1940 (the “Act”) generally does not apply to a registered investment adviser that makes cash payments to a person as compensation for the solicitation of investors in an investment pool, such as a hedge fund or private equity fund, managed by the adviser.1
Rule 206(4)-3: The Cash Solicitation Rule
The Rule prevents registered investment advisers from paying cash for “solicitation activities” unless the payment satisfies the conditions set forth in the Rule. Specifically, a registered adviser making cash payments to a third-party solicitor must, among other conditions, enter into a written agreement with such solicitor requiring them to provide prospective clients with both a copy of the adviser’s written disclosure statement required by Rule 204-3 (usually Part II of Form ADV) and a separate written disclosure document containing, among other things, a statement that the solicitor will be compensated by the adviser and the terms of the compensation arrangement. The conditions of the Rule are intended to address the inherent conflicts of interest in situations where a person is being compensated for referring the services of an adviser and, therefore, may not make such recommendation entirely upon the merits of the services to be provided.
Examining both the plain text of the Rule and the legislative history relating to its initial adoption, the SEC staff concluded in its interpretative letter that the Rule may not apply to the solicitation of potential private fund investors. The SEC staff noted that neither the proposing nor the adopting release specifically addressed whether it was the intent of the drafters to include this type of situation. While the lack of reference to investment pools in the adopting and proposing releases was not dispositive, the SEC staff recognized that the Rule, on its face, clearly applied only to instances in which a client would ultimately enter into an advisory contract with the adviser. As investors in investment pools do not enter into contracts with the advisers to such pools directly, the SEC staff felt that the Rule did not intend to cover solicitations for such products. The SEC staff also focused upon the terminology used in the Rule to describe the solicited party. It stated that the Rule’s use of the term “client” rather than “investor” provided additional support for the fact that solicitations for such pools were not intended to be captured by the Rule. This view is further supported by the Goldstein decision, in which the D.C. Circuit court held that investors are not “clients” of the investment pool’s adviser.2
The SEC staff noted, however, that the applicability of the Rule would depend upon all of the facts and circumstances surrounding the relationship between the parties, the purpose of the adviser’s cash payment to the soliciting person, and the nature of the adviser’s business. For instance, situations where an adviser only advises investment pools, and does not engage the referring party to solicit potential investment advisory clients in addition to investors in the investment pool, would likely not be covered by the Rule. On the other hand, if an adviser manages private pools and individual accounts and uses a solicitor to solicit both private pool investors and advisory clients, the Rule may apply.
Section 206 Obligations: Anti-Fraud
Repeating previous oral statements, the SEC staff noted that, even if Rule 206(4)-3 does not apply, advisers are still bound by the anti-fraud obligations imposed by the Act and, pursuant to Section 206 of the Act, a solicitor may still be required to disclose to an investor or prospective investor all potential conflicts of interest inherent in the referral arrangement.
Potential Applicability of Broker-Dealer Regulations
Because no-action relief was specifically requested from the Division of Investment Management and not from any other division, the letter did not address whether solicitors for investment pools could be considered broker-dealers under Section 3(a)(4) of the Securities Exchange Act of 1934. This question would need to be addressed by the Divison of Trading and Markets.