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Investment Funds, Digital Stock

Nov 18, 2019

SEC Proposes Solicitation Rule Amendments

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On November 4, 2019, the U.S. Securities and Exchange Commission (SEC) proposed amendments to rules governing investment adviser advertisements and payment to solicitors under the Investment Advisers Act. The comment period for both rulemakings is expected to close in January 2020. In this client alert, we summarize the proposed amendments to the solicitation rule (Rule 206(4)-3). A separate alert, SEC To Overhaul Investment Adviser Advertising Rule, covers the advertising rule proposal.

As background, the solicitor rule requires that an adviser paying a firm or individual to solicit clients to take specific steps in engaging and monitoring the solicitor. Among other things, the adviser must confirm that the solicitor is not disqualified from serving in the role, require a written engagement with the solicitor, and require that the solicitor disclose specific information to the prospective clients.[1]

Key elements of the current proposal are:

  • A broader definition of a solicitor (which notably captures persons who solicit investors in private funds);
  • Revised requirements for disclosures to be made by the solicitor; and
  • Expanded solicitor disqualification terms.

Broader Definition of a Solicitor

The current rule defines a “solicitor” as “any person who, directly or indirectly, solicits any client for, or refers any client to, an investment adviser.”

The proposal would expand on this in the following ways:

  • Private funds: The proposed definition would include persons who solicit investors in private funds sponsored by an investment adviser, whereas under the current rule that is not necessarily the case.
  • All forms of solicitation included: The revised rule would apply whether an adviser is providing a solicitor with cash or non-cash compensation. In conjunction with this amendment, the SEC also proposes a de minimis provision exempting compensation of $100 or less over a period of one year from the new rule.
  • Promoters: In certain cases, persons providing compensated endorsements or testimonials would be solicitors. The SEC release identifies social media promoters as well as refer-a-friend program participants as likely to be solicitors subject to the revised rule.

The proposed rule largely maintains the current exemption from the rule for affiliated or in-house solicitors so long as that relationship between the solicitor and the adviser is “readily apparent” to the prospect. The proposed rule also largely maintains the current exemption for solicitation of impersonal investment services. (The rule’s disqualification terms still apply to these otherwise exempt solicitors.)

Revised Disclosure Requirements

The proposed disclosure requirements largely track the current rule. Solicitors would be required to disclose the name of the adviser, name of the solicitor, a description of the relationship between them, the terms of any compensation to be received by the solicitor, and any potential material conflicts of interest for the solicitor. The rule also would require disclosure of any additional cost to the prospect as a result of the solicitation. Only the requirement to disclose potential material conflicts of interest would be wholly new.

The new rule would keep the requirement that the disclosure package should be “separate” from other information received by the prospect in connection with the advisory relationship. Unlike in the current rule, the SEC proposes that the disclosure could be made either by the solicitor or the adviser. The proposed rule also would provide more flexibility as to the timing of when the disclosure is made. The proposal specifically recognizes that disclosures might be made in electronic means including through chat and “pop-up” messages.

The proposal also would eliminate the longstanding requirement that the solicitor deliver the adviser’s Form ADV brochure to prospects. This addresses the redundancy of current practice in which the same brochure may be provided by both solicitor and adviser.

Finally, while the current rule requires that an adviser must make a bona fide effort to confirm compliance with the rule’s requirements by a solicitor, including obtaining a signed and dated acknowledgment of receipt of the disclosures from each solicited client, the proposal would substitute a general “reasonable belief” standard (i.e., that the adviser takes steps sufficient to give it a reasonable belief that the solicitor is meeting the requirements).

Expanded Disqualification Terms for Solicitors

Advisers are prohibited from engaging solicitors that have committed various kinds of bad acts (generally referred to in this context as disqualifications). Such a disqualification would apply at the time of solicitation. As proposed, if disqualification arises subsequent to solicitation, payments could continue to be made to a solicitor for its past solicitation activity.

The proposed new disqualification terms generally are as follows:

  • Additional disqualifying events: A greater range of judicial and regulatory actions involving a solicitor would give rise to disqualification. The expanded scope is similar to that under the Regulation D “Bad Actor Rule.”
  • Reasonable care standard for advisers: The proposal would establish a reasonable care standard to evaluate when compensation to ineligible solicitors will (or will not) represent a violation of the rule by an adviser. This signifies a shift from the current rule, which imposes an absolute bar on cash compensation to ineligible solicitors. While the proposed rule would not require any specific procedures to be taken by advisers, the SEC commented approvingly on its experience with the Regulation D Bad Actor Rule’s parallel reasonable care standard.
  • Collective culpability: The SEC proposes to disqualify individuals within a firm that is determined to be an ineligible solicitor. The proposed rule would, depending on the nature of the firm, cover all employees, officers, and directors of the ineligible firm, as well as all general partners, all elected managers, and any persons in control of or controlled by the persons listed. The SEC justifies this broad sanction by citing the responsibility of firms to maintain a compliance regime and ensuring conformity with the regulatory regime. (Importantly, the reverse may not apply; designation of any of the listed individuals as ineligible solicitors would not necessarily lead to the firm as a whole becoming an ineligible solicitor.)
  • Prior disqualification no-action letters: The SEC asks whether firms should be grandfathered if they received no-action letters in the past allowing them to continue to serve as solicitors notwithstanding a potential disqualification. This is in part based on the recognition that those letters may have contemplated specific procedures or conditions that will differ from the proposed rule. A list of the no-action letters at issue is included in the proposing release.

Transition Periods

The SEC proposes a one-year transition period from the effective date of the rule to full implementation. Advisers would be permitted to rely on the amended rule during the period after the effective date but before the compliance date.

Regarding disqualification, the SEC proposes a form of grandfathering in which a solicitor that would be disqualified solely as a result of the expanded definition of disqualifying events will be disqualified only for new disqualifying events occurring after the rule’s adoption. The SEC also indicates that it is open to other types of transition rules associated with new disqualification terms.

Our Take

The proposal generally would ease operational burdens associated with the solicitor rule and will be viewed as a welcome modernization for many. The proposed changes would be less welcome for firms covered by new terms of the rule, such as advisers using solicitors only to solicit private fund investors or paying only non-cash compensation (both of which are exempt under the current rule). Updates to the disqualification rules also would require care for both advisers and solicitors.

Footnotes

[1]  We previously wrote on the solicitor rule and common compliance deficiencies identified by the SEC staff in 2018, see OCIE Highlights Investment Adviser Compliance Issues Related to the Cash Solicitation Rule.

Authors and Contributors

John Adams

Partner

Investment Funds

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+44 20 7655 5740

London

Jay G. Baris

Partner

Investment Funds

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+1 212 848 4100

New York

Lorna Xin Chen

Partner

Investment Funds

+852 2978 8001

+852 2978 8001

Hong Kong

John (Sean) Finley

Partner

Investment Funds

+1 212 848 4346

+1 212 848 4346

New York

Laura Friedrich

Partner

Investment Funds

+1 212 848 7411

+1 212 848 7411

New York

Nathan Greene

Partner

Investment Funds

+1 212 848 4668

+1 212 848 4668

New York

Russell Sacks

Partner

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7585

+1 212 848 7585

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Paul Schreiber

Of Counsel

Investment Funds

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+1 212 848 8920

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Leon Hirth

Counsel

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+1 212 848 4128

+1 212 848 4128

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Thomas Majewski

Counsel

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+1 212 848 7182

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Jennifer D. Morton

Counsel

Financial Institutions Advisory & Financial Regulatory

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+1 212 848 5187

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Sean Murphy

Counsel

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+852 2978 8011

Hong Kong

Ted Randolph

Counsel

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+1 212 848 7260

New York