This Alert is the second of a series analyzing the Marketing Rule and its impact on advisers to private funds. In this Alert, we consider how the Marketing Rule will impact placement and solicitation activities for private funds.
1. Does the Marketing Rule expand upon the persons and activities to which the Cash Solicitation Rule applied? If so, how will these requirements potentially impact an adviser to private funds and related placement and solicitation activities?
Yes. The Marketing Rule expands upon the persons and activities to which the Cash Solicitation Rule1 applied. As we indicated in our first alert, both prongs of the definition of advertisement expressly include marketing communications to private fund investors. The second prong of the definition of advertisement – which addresses testimonials2 and endorsements3 for which the adviser provides compensation (directly or indirectly) –includes referrals and solicitations of investors to private funds. Accordingly, traditional private fund placement arrangements involving broker-dealers and other intermediaries, which were not covered by the Cash Solicitation Rule,4 fall within the requirements of the Marketing Rule.
In addition, the Marketing Rule could impact the placement and solicitation activities of an adviser to private funds in the following ways:
- Definition of Testimonial. A testimonial includes any statement by a current private fund investor that directly or indirectly solicits any investor to be an investor in a private fund advised by the adviser. Accordingly, this definition could apply to any unaffiliated fund-of-funds or a feeder fund that solicits investors in an underlying fund or a master fund, respectively.
- Compensation. The second prong of the definition of advertisement is triggered by any form of compensation that an adviser provides directly or indirectly for an endorsement or testimonial. Compensation can take many forms, including fees, retainers, reduced advisory fees, fee waivers, directed brokerage, prizes and gifts and entertainment.5 Consequently, the Marketing Rule covers a broad range of activities and types of promoters,6 including website operators that match a potential investor with one or more advisers compensating it to participate in the service.
A private fund adviser should inventory and then assess its current placement agent, solicitation and other arrangements to determine whether such arrangements fall within the requirements of the Marketing Rule. In particular, the adviser should consider and assess (i) other methods by which investors are referred to its private funds, such as through fund-of-fund arrangements, and (ii) the types of compensation – direct and indirect and cash and non-cash – that it may be deemed to have paid, to determine whether these arrangements may be subject to the requirements of the Marketing Rule.
2. What are the basic conditions of the Marketing Rule that apply to solicitations that constitute endorsements or testimonials?
The Marketing Rule imposes the following conditions on an adviser’s use of endorsements and testimonials:
- Disclosure. The adviser must disclose, or reasonably believe that the promoter discloses, certain information at the time of solicitation (the “Disclosure Requirements”).
The following must be clearly and prominently7 disclosed:
(i) if a testimonial, that it was given by a current client or investor, or if an endorsement, that it was given by a person other than a current client or investor;
(ii) if applicable, that cash or non-cash compensation was provided for the testimonial or endorsement; and
(iii) a brief statement of any material conflicts of interest on the part of the person giving the testimonial or endorsement resulting from the adviser’s relationship with such person.
The adviser must also disclose, or reasonably believe that the promoter discloses, information regarding material terms of compensation and material conflicts of interest, as described below.8
- Material Terms. The material terms of any compensation arrangement must be disclosed, including a description of the compensation provided or to be provided, directly or indirectly, to the promoter. The Release describes several specific points that the SEC believes must be disclosed, if applicable.9
- Material Conflicts. The material conflicts of interest on the part of the promoter resulting from (i) the adviser’s relationship with the promoter and/or (ii) any compensation arrangement must be disclosed. At a minimum, if the promoter is receiving compensation for its solicitation services, there should be explicit disclosure stating that the promoter, due to the compensation, has an incentive to recommend the adviser, resulting in a material conflict of interest. In addition, an adviser should consider whether its relationship with the promoter creates any other material conflicts that could affect the credibility of the testimonial or endorsement.
• Oversight and Compliance. Testimonials and endorsements are subject to an “oversight and compliance” provision, which includes two separate requirements:
(A) Reasonable Basis. The adviser must have a reasonable basis for believing that any testimonial or endorsement complies with the requirements of the Marketing Rule (the “Reasonable Basis Requirement”). What constitutes a “reasonable basis” depends on the facts and circumstances, but the SEC has stated that an adviser could, for example:
(i) periodically make inquiries of a sample of investors solicited or referred by the promoter in order to assess whether that promoter’s statements comply with the Marketing Rule;
(ii) implement policies and procedures; or
(iii) include terms in its written agreement with the promoter to help form a reasonable basis (e.g., permitting the adviser to pre-review or impose limitations on the promoter’s statements).10
(B) Written Agreement. The adviser must have a written agreement with any person giving a compensated testimonial or endorsement that describes the scope of the agreed upon activities and the terms of the compensation for those activities (the “Written Agreement Requirement”).11 For example, an adviser could satisfy this requirement by entering into a private placement agreement (relating to interests in the private fund) that describes the scope of the solicitation/placement activities and the terms of the compensation.
• Disqualification. The adviser may not compensate certain “bad actors” and other ineligible persons for their solicitation activities (e.g., giving testimonials or endorsements) (the “Disqualification Provision”). In particular, the adviser is prohibited from compensating a person, directly or indirectly, for a testimonial or endorsement if the adviser knows, or in the exercise of reasonable care should know, that the person giving the testimonial or endorsement is an ineligible person at the time of solicitation. An “ineligible person” is a person who is subject either to a disqualifying Commission action12 or a disqualifying event,13 and certain of that person’s employees and other persons associated with an ineligible person.
If an adviser engages a promoter to solicit investors for private funds managed by the adviser, the adviser’s written agreement with the promoter should be designed to address the Reasonable Basis Requirement, the Written Agreement Requirement and the Disqualification Provision. An adviser will also need to adopt policies and procedures concerning how the adviser will comply with the new requirements, and should review its existing solicitation/placement agent agreements and modify them, as necessary, in order to address the new requirements. An adviser might consider updating its investment management agreements or private fund subscription documents to include certifications concerning clients’ and investors’ receipt of disclosures.
3. Are there any exemptions from the Disclosure Requirements?
Yes. There are three exemptions from the Disclosure Requirements:
(i) Affiliates. Testimonials and endorsements by certain affiliates14 of an adviser are exempt from the Disclosure Requirements if (a) the affiliation between the adviser and the affiliate is “readily apparent” to or is disclosed to the client or investor at the time of solicitation, and (b) the adviser documents the affiliate’s status at the time of solicitation. (See Question 4 below.)
(ii) Recommendations Subject to Regulation Best Interest. If an SEC-registered broker-dealer provides a testimonial or endorsement that is a recommendation subject to Regulation Best Interest (“Regulation BI”), the testimonial or endorsement is exempt from all of the Disclosure Requirements.15 This is because Regulation BI imposes its own disclosure obligations, which are similar to the Marketing Rule’s Disclosure Requirements.16
(iii) Persons Who are Not “Retail Customers”. If an SEC-registered broker-dealer provides a testimonial or endorsement to a person that is not a “retail customer” (as defined in Regulation BI)17, the testimonial or endorsement is exempt from two of the Disclosure Requirements: (a) material terms of any compensation arrangement and (b) material conflicts of interest. Such broker-dealer is still required to make the disclosures that are subject to the “clear and prominent” standard.18
In order to rely on one or more of these exemptions, it will be important for an adviser to understand (i) the status of the person it has engaged to serve as a promoter (e.g., whether the promoter is an affiliate) and (ii) the nature of the relationship between the promoter and the individuals or entities being solicited (e.g., if the promoter is a broker-dealer, how Regulation BI applies to the promoter’s relationship with such individuals or entities).
An adviser that wishes to conduct solicitation activities for private funds (by itself or through a third party) without complying with all of the Disclosure Requirements should review the solicitation activities that it proposes to undertake and then design policies and procedures that address the applicable exemptions. For example, an adviser employing an affiliate to solicit private funds investors should consider whether the affiliate’s status is “readily apparent” to prospective investors and consider how such status will be documented as required in order to rely on the exemption. Where certain disclosures are required (e.g., the “clear and prominent” disclosures), an adviser should tailor its disclosures based on the specific type of arrangement and coordinate with the promoter to seek to ensure that such disclosures are provided in a timely manner.
4. Does the Marketing Rule apply to an adviser’s employees and other affiliates who are compensated by the adviser to solicit investors for a private fund to which it serves as adviser?
It depends on the type of compensation. For purposes of the second prong of the definition of advertisement, “compensation” does not include “regular salary or bonuses” paid to an adviser’s personnel for their investment advisory activities or clerical, administrative, support or similar functions.19
Where an adviser provides an employee or other affiliate with other types of compensation,20 the Marketing Rule provides a partial exemption for solicitations by an adviser’s affiliates, including employees.21 Such solicitations are exempt from the Disclosure Requirements and the Written Agreement Requirement,22 provided that:
(i) the affiliation between the adviser and the affiliate is “readily apparent” to or is disclosed to the client or investor at the time of solicitation; and
(ii) the adviser documents the affiliate’s status at the time of solicitation.23
Although what constitutes “readily apparent” depends on the facts and circumstances, the SEC has provided examples of circumstances where the relationship between an adviser and an affiliate may be deemed to be readily apparent, such as when:
(i) an in-house promoter and the adviser share the same name;
(ii) the affiliate (either a firm or an individual) operates under the same name brand as the adviser; and
(iii) the affiliate is clearly identified as related to the adviser in its communications with the investor at the time of solicitation (e.g., a business card clearly and prominently states that the affiliate is a representative of the adviser).
If an adviser compensates its employees or other affiliates for soliciting investors and wishes to be exempt from the Disclosure Requirements and the Written Agreement Requirement, the adviser should adopt policies and procedures that are designed to address solicitations by such persons and should document the availability of the exemptions, including (i) how the affiliation between the adviser and the affiliate is “readily apparent” to or is disclosed to the client or investor at the time of solicitation; and (ii) the affiliate’s status (such as an employee) at the time of solicitation.
5. Are there partial exemptions for certain persons from the Disqualification Provisions?
Yes. Under the Marketing Rule, there are partial exemptions from the Disqualification Provisions for eligible promoters who are registered broker-dealers and covered persons. Specifically, the Marketing Rule exempts from the Disqualification Provisions:
(i) any testimonial or endorsement by an SEC-registered broker-dealer if the broker-dealer is not subject to statutory disqualification under Section 3(a)(39) of the Securities Exchange Act of 1934;24 and
(ii) any testimonial or endorsement by a “covered person”25 under Rule 506(d) of Regulation D with respect to a Rule 506 offering, provided that the person’s involvement would not disqualify the offering under Rule 506.26
The SEC provided these partial exemptions for these persons because there are existing requirements applicable to them that further the policy goals of the requirements. Importantly, these partial exemptions from the Disqualification Provisions do not, however, relieve an adviser from the other requirements of the Marketing Rule.
If an adviser intends to engage an SEC-registered broker-dealer to act as a promoter, the adviser can obtain in its agreement with the broker-dealer representations from the broker-dealer regarding its status under Section 3(a)(39). If an adviser intends to engage a “covered person” to act as a promoter with respect to a Rule 506 offering, the adviser should obtain written confirmation from the covered person that he or she is in compliance with the Rule 506 disqualification provision – that is, the person is not a “bad actor” under Regulation D requirements.
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If you have any questions regarding the matters covered in this e-mail, please contact any of the partners and counsel listed below or your primary attorney in Seward & Kissel’s Investment Management Group.