The staff (the “Staff”) of the SEC’s Office of Compliance Inspections and Examinations recently issued a Risk Alert regarding the most common deficiencies that the Staff has cited relating to Rule 206(4)-3 (the “Cash Solicitation Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”).
An SEC-registered investment adviser (an “adviser”) is prohibited from paying a cash fee, directly or indirectly, to any person who solicits clients for the adviser (a “solicitor”) unless the arrangement complies with the conditions of the Cash Solicitation Rule. Among other things, the cash fee must be paid to a solicitor pursuant to a written solicitation agreement, and third-party solicitors must provide the prospective client with a copy of the adviser’s Form ADV Part 2 (the “brochure”) and a separate written disclosure document (the “solicitor disclosure document”) that highlights the solicitor’s financial interest.1
In the Risk Alert, the Staff observed the following most common deficiencies.
- Solicitor disclosure documents.
Third-party solicitors either did not provide, or provided inadequate solicitor disclosure documents to prospective clients. The Staff observed solicitor disclosure documents that failed to disclose the nature of the relationship, including any affiliation, between the solicitor and the adviser; contain the terms of the compensation arrangement between the adviser and the solicitor; or specify the actual compensation terms of the solicitation agreement or the additional solicitation cost the client will be charged in addition to the advisory fee.
- Client acknowledgements.
Advisers failed to receive in a timely manner a signed and dated client acknowledgement of receipt of the adviser’s brochure and the solicitor disclosure document.
- Solicitation agreements.
Advisers paid cash fees to a solicitor without a solicitation agreement in effect or pursuant to an agreement that did not contain certain required provisions, such as a description of the solicitor’s activities and compensation; or a requirement that the solicitor provide clients with a copy of the adviser’s brochure and the solicitor disclosure document.
- Bona fide efforts to ascertain solicitor compliance.
Advisers did not make a bona fide effort to ascertain whether third-party solicitors complied with solicitation agreements.
In addition to deficiencies relating to the Cash Solicitation Rule, the Staff observed similar conflicts that may implicate other provisions of the Advisers Act, such as an adviser’s fiduciary duty under Sections 206(1) and 206(2). For example, the Staff observed advisers that recommended service providers to clients in exchange for client referrals without full and fair disclosure of the conflicts of interest.
S&K Observations
In light of the common deficiencies and disclosure issues identified in the Risk Alert, advisers should carefully review the adequacy and effectiveness of their policies and procedures, and client disclosures, relating to the Cash Solicitation Rule and client referrals.
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1 Under the Mayer Brown LLP SEC Staff No-Action Letter (July 15, 2008, amended July 28, 2008), the staff of the SEC’s Division of Investment Management stated that the Cash Solicitation Rule does not apply to solicitation arrangements solely to compensate a person for soliciting investors or prospective investors for a pooled investment vehicle managed by the adviser.
