In November 2019, the SEC released a proposed rule amendment that modifies Rule 206(4)-3 (the Solicitation Rule) under the Investment Advisors Act of 1940.  The proposed amendment (the Solicitation Amendment) modifies the Solicitation Rule in several meaningful ways.  Below, we provide some pertinent information about the Solicitation Amendment and hope you will not be shy in giving us a call with any questions, comments, or requests to help out with your Solicitation Rule needs.

Disclose, Disclose, Disclose

The current Solicitation Rule requires advisers to enter into written agreements with solicitors specifying (a) the scope of the solicitor’s activities; (b) the solicitor will perform any activities consistent with the Investment Advisers Act of 1940; and (c) a covenant by the solicitor to provide the client with specific disclosures (Solicitor Disclosures) at the time of solicitation.  The Solicitation Amendment changes those requirements slightly. Namely, the amendment mandates that either the solicitor or the adviser can deliver the Solicitor Disclosures to investors in connection with a solicitation. Thus, the written agreement between an adviser and solicitor does not need to include a requirement that solicitor provide the Solicitor Disclosures

In that same regard, the Solicitation Amendment allows the delivery of the Solicitor Disclosures either (1) at the time of the solicitation activities (thus, the solicitor must deliver the disclosures), or (2) in the case of a mass communication, as soon as is reasonably practicable after an investor expresses an initial interest in the adviser’s services (now, the adviser can deliver the disclosures).

Additionally, solicitors used to be required to deliver the adviser’s Form ADV brochure as part of their disclosures.  The SEC recognized that action as duplicative of the adviser’s obligation to deliver Form ADV. Thus, solicitors will not have to include in their Solicitor Disclosures the adviser’s Form ADV.  But, the Solicitation Amendment adds a requirement that material conflicts of interest resulting from the solicitor-adviser relationship be included in the Solicitor Disclosures.

In an effort to modernize the Solicitation Rule, the Solicitation Amendment conforms recent SEC guidance on electronic delivery of documents and removes the requirement that all Solicitor Disclosures be on paper. Solicitor Disclosures can be delivered by email and an adviser need not obtain written confirmation from each (prospective) client that they received the Solicitor Disclosures. Irrespective of the format of the Solicitor Disclosures, however, an adviser is required under the Books & Records Rule (Rule 204-1) to keep true, accurate ad current copies of Solicitor Disclosures delivered to investors.

It’s Not Just Cash Anymore…It’s Any Compensation

The current Solicitation Rule applies only to cash payments to solicitors (as opposed to sales awards, entertainment, or directed brokerage). The SEC’s proposed amendment (the “Solicitation Amendment”) will apply the Solicitation Rule to any type of compensation. When the new rule goes into effect, indirect payments such as entertainment expenses, directed brokerage services, or fee-reduction arrangements will be considered compensation under the Solicitation Rule.

On that same note, the Solicitation Amendment adds a de minimus standard that requires advisers to comply with the Solicitation Rule if they pay someone more than $100 for solicitation activities within a 12-month period. If an adviser’s compensation to a solicitor is less than $100 (in cash or any other consideration), the adviser would not need to enter into a written agreement with the solicitor, provide Solicitor Disclosures, or update Form ADV for that solicitor.

Solicitors For Private Fund Will Be Subject To The Solicitation Rule

Solicitors that solicit on behalf of private funds are primarily subject to the anti-fraud provisions of Federal securities laws and rules applicable to private fund offerings made in reliance on Regulation D. However, private funds also make offerings under section 4(a)(2) of the Securities Act, which does not have Federal disqualification provisions, and solicitors for such funds are only subject to state disqualification provisions. The Solicitation Amendment changes that.  Under the Solicitation Amendment solicitors for private funds will be subject to the Solicitation Rule. The SEC’s release notes that the new requirements will enhance investor protection for private fund investors by providing them with a solicitor’s compensation and conflict of interest disclosures providing private fund investors important information when considering a solicitor’s recommendation.

Disqualified Solicitors

The current Solicitation Rule absolutely prohibits an adviser from paying a solicitor that has experienced certain disqualifying disciplinary events. The Solicitation Amendment, on the other hand, would prohibit an adviser from engaging a disqualified solicitor only when the adviser knows, or in the exercise of reasonable care should have known, that the solicitor was a disqualified party. The Solicitation Amendment expands the list of disqualifying disciplinary events rendering a party ineligible to serve as a solicitor, but maintains the 10-year lock-back period. The “reasonable care” standard doesn’t really change the effect of the Solicitation Rule.  Advisers still must investigate the background of its solicitors before engaging them and it is a good policy to have an annual review of all solicitors to ensure they haven’t engaged in any disqualifying activities.

Adviser Oversight of Solicitors

The current Solicitation Rule requires an adviser to make “bona fide effort to ascertain whether the solicitor has complied with” the terms of the written agreement between the adviser and the solicitor. The Solicitation Amendment would require that an adviser “have a reasonable basis for believing that the solicitor has complied with the written agreement.” There’s that “reasonable basis” language again… The SEC’s release relating to the Solicitation Amendment states that, in forming “a reasonable basis” advisers should make periodic inquiries of a sample of investors referred to them by a solicitor to determine whether the solicitor has complied with the Solicitation Rule.  It is our advice to make a similar inquiry of all solicitors activity and even have them certify annually that they are complying with the written contract, the Advisers Act, and all disclosure requirements.

Written Supervisory Procedures Are Your Friend

All new Rule changes come with a commensurate requirement that advisers update their WSPs. The changes to the Solicitation Rule are no exception.  Advisers will have to modify the sections of their WSPs relating to solicitation activities, written contracts, client confirmations of solicitor disclosures, and other disclosure requirements.  Further, it is a best practice, especially in light of the “reasonable care” standard, that advisers document the basis for their conclusions about solicitors’ backgrounds and their solicitation activities.  An adviser’s WSPs should have oversight over such documentation.

The SEC has yet to implement the Solicitation Amendment and has requested comments on various aspects of the proposed new rule. Thus, there may be some changes to the details of the Solicitation Amendment based upon comments submitted by industry participants.  When the Solicitation Amendment is adopted, advisers will likely have a one-year transition period until they are required to comply. In the meantime, it is a great idea for advisers to prepare for the changes to the using solicitors – prepare new written agreements, update Solicitor Disclosures, modify WSPs, etc. As always, do not hesitate to reach out to the lawyers at Higgs Fletcher & Mack for more detailed guidance based upon your specific circumstance.