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News December 13, 2004 Issue

Paying for Leads: What Advisers Should Know About the Cash Solicitation Rule

Has your firm shied away from referral arrangements because of the complexity and burdens of the Advisers Act cash solicitation rule? Good news: the rule can be translated into plain English, and compliance is not insurmountable.

In any event, itís a good idea to understand the way the rule works. At the recent National Society of Compliance Professionals conference, OCIE general counsel John Walsh warned that SEC examiners will be looking at "hidden payments" made by advisory firms. Organizations, he said, should consider whether they are making "secret" payments of any kind, whether to vendors, service providers, or other parties. "Thatís an issue you really need to be looking at," he said. "Thatís an area of risk." Given this area of focus, advisers that have entered into referral arrangements or affinity deals might want to double check that those arrangements are operating within the parameters of the cash solicitation rule, if required.

Hereís a guide to the rule ó designed for marketers as well as compliance officers.

What does the rule require? In a nutshell, the rule effectively requires SEC-registered advisers that pay for client referrals to:

  • check that the person making the referrals, i.e., the "solicitor," is not disqualified by the rule from acting as a solicitor;
  • enter into a written contract that memorializes the terms of the solicitation arrangement;
  • require the solicitor to provide a copy of the adviserís ADV Part II (or equivalent brochure) to the potential client at the time of the solicitation;
  • require the solicitor to provide a special disclosure document (explaining that the solicitor is being paid for the referral) to the potential client at the time of the solicitation; and
  • obtain a signed acknowledgment from the client that the client received the Part II and special disclosure document.

The rule contains exceptions to some of these requirements if the solicitor is affiliated with the adviser, or if the advisory services being marketed are "impersonal" (More on those exceptions next week). The SEC staff also has granted certain exceptions to the disclosure delivery requirements involving situations where the solicitor broadly markets the adviserís services (i.e., makes a mass mailing) in the hopes that a few prospects will contact the adviser (discussed below).

When does the rule apply? When considering whether a marketing arrangement triggers the cash solicitation rule, think broadly. The rule, Advisers Act Rule 206(4)-3, applies in situations where an adviser pays a solicitor "directly or indirectly." Similarly, the rule applies where a solicitor "directly or indirectly" refers any client to the adviser ó even if none of the potential clients turn into actual clients. For example, the SEC has taken the position that a person can be a solicitor merely by supplying the adviser with names of potential clients, even if the person does not contact the clients to specifically recommend that they retain the adviserís services.

Of course, the rule only applies if the adviser pays the solicitor a "cash fee," which can be a flat fee or a percentage basis. If someone refers clients to your firm simply because they think highly of your firm, out of the goodness of their heart and for no compensation, the rule does not apply. Similarly, if an adviser enters into a reciprocal referral arrangement whereby an accountant sends its clients needing advisory services to the adviser, and the adviser sends its clients to the accountant for tax work, the rule technically would not apply. However, such an arrangement would be subject to the adviserís duty to act in the best interests of its clients (might there be better accountants out there?) and may trigger disclosure obligations.

De minimis gifts to thank a source of client referrals would seem to be fine, and not trigger the requirements of the cash solicitation rule. However, if you tuck a check for $1,000 into a thank-you note, youíll probably have some explaining to do. And, in general, be aware that gifts in the investment management industry currently are under the microscope: in the past few weeks, there have been press reports of the SEC and NASD investigating whether lavish gifts have been made by broker-dealers to fund companies in the hopes that the fund companies will direct their brokerage to the gift-givers.

Hereís another thing to keep in mind: the practice of directing brokerage to particular broker-dealers in exchange for referrals is not covered by the rule. Of course, that practice raises a host of thorny disclosure and fiduciary issues (if you arenít familiar with those issues, youíll want to read the SECís May 2003 case against Jamison, Eaton & Wood, for starters, and perhaps discuss the practice of directing brokerage for referrals with your favorite lawyer).

Who can serve as a solicitor? The general rule: persons and companies with chequered pasts cannot serve as solicitors, unless they have received dispensation in the form of a no-action letter from the Division of Investment Management permitting them to serve as a solicitor.

The rule makes it unlawful for an adviser to hire a solicitor that has been censured under the Advisers Act, suspended or barred from the advisory industry (even if the suspension has since expired), or convicted of certain types of felonies or misdemeanors within the past 10 years. It also disqualifies solicitors that have been found by the SEC to have made a false statement in an SEC filing or otherwise violated the federal securities laws, or aided and abetted anotherís violations, or that have been found to have failed to supervise. A "finding" in a settled administrative proceeding counts for these purposes.

So, for example, any broker-dealer that has ever been found to have failed to supervise technically would be barred from serving as a solicitor under the rule. However, literally dozens of broker-dealers have obtained no-action relief from the Division of Investment Management to serve as solicitors, notwithstanding their past disqualifying events.

Many advisers use a questionnaire to check to make sure a potential solicitor is not disqualified under the rule (a model solicitor questionnaire will appear in an upcoming issue of IM Insight). Itís a good idea to circulate these questionnaires from time to time to make sure that a previously-vetted solicitor hasnít become disqualified, causing the advisory firm to violate the cash solicitation rule. Moreover, note that Section 203(f) of the Advisers Act effectively makes it unlawful for an adviser to permit a person subject to a 203(f) order to remain with the adviser as an "associated person" (which, according to the SEC, most solicitors are) without the SECís consent, if the adviser "knew, or in the exercise of reasonable care, should have known" of the 203(f) order.

What does the solicitation agreement have to contain? The rule says that the cash fee has to be paid pursuant to a written agreement to which the adviser is a party. Unless the arrangement involves an affiliated solicitor or is for impersonal advisory services, the agreement must:

  • Describe the solicitation activities to be engaged in by the solicitor on behalf of the adviser;
  • Describe the compensation to be received by the solicitor for the solicitation activities described in the contract;
  • Contain an undertaking by the solicitor to perform his duties under the agreement in a manner consistent with the adviserís instructions and the provisions of the Advisers Act and rules thereunder;
  • Require that the solicitor, at the time of any solicitation activities for which compensation will be paid by the adviser, provide the client with two documents:

- a current copy of the adviserís Form ADV Part II (or equivalent brochure); and

- a separate solicitor disclosure statement.

What does the solicitor disclosure statement have to contain? The solicitor disclosure statement must provide the following information:

  • The solicitorís name;
  • The adviserís name;
  • The nature of the relationship between the solicitor and the adviser (the rule states that this must include a description of "any affiliation," something that theoretically is applicable to advisers that use a solicitor employed by an loosely-related affiliate (since solicitors employed by control affiliates do not need to hand out the solicitor disclosure documents in the first place, as will be discussed next week);
  • A statement that the solicitor will be compensated for the solicitation services by the adviser;
  • The terms of the compensation arrangement, including a description of the compensation paid (or to be paid) to the solicitor. Hereís what the SEC has said on that score: "[I]f a specific amount of compensation [is] being paid, that amount would be required to be disclosed. If, instead of a specific amount, the solicitorís compensation [is] to take the form of a percentage of the total advisory fee over a period of time, that percentage and the time period would have be disclosed. If all, or part, of the solicitorís compensation is deferred or is contingent upon some future event, such as the clientís continuation or renewal of the advisory relationship or agreement, such terms would also have to be disclosed."
  • If the client, as a result of being a solicited account, will have to pay a specific, additional fee, or a higher advisory fee, that fact must be disclosed. Put another way: if the client is going to have to pay more because his account was solicited, you have to tell them that, and how much. Specifically, the rule requires that the solicitor disclosure statement state "the amount, if any, for the cost of obtaining his account that the client will be charged in addition to the advisory fee, and the differential, if any, among clients with respect to the amount or level of advisory fees charged by the investment adviser if such differential is attributable to the existence of any arrangement pursuant to which the investment adviser has agreed to compensate the solicitor for soliciting clients for, or referring clients to, the investment adviser."

The SEC has said that even if the information required in the solicitorís written disclosure statement is contained in the adviserís Part II, the information nonetheless has to be supplied to the client in a separate document.

Wait a minute. Does this mean our firmís affinity partners will have to mail thousands of copies of our Form ADV Part II to prospects? Mercifully, no. In a series of no-action letters, the SEC has shown flexibility in applying the cash solicitation rule to situations where an adviser enters into an arrangement with a group (such as a professional association) that broadly markets the adviserís services through direct mail or by placing an article in the groupís publication.

The seminal letter on this topic: a 1987 no-action letter to E.F. Hutton (remember them?). The facts: E.F. Hutton entered into affinity arrangements with professional associations (or intermediaries that had their own pre-existing relationship with the association), in which E.F. Hutton targeted the associationís members as potential financial planning clients. The association (or intermediary) would send a mass mailing to the members (the "solicitation") and in turn would receive a percentage of the financial planning fee for each of the members that signed up (the "cash fee"). The initial mailing would contain a general description of the financial planning services, but would not contain any order forms by which the prospect could actually purchase the services.

Importantly, the initial mailing would include a statement that a solicitation agreement existed under which the association or intermediary would be compensated by E.F. Hutton if the member purchased the financial planning services, and that information about the solicitation agreement would be furnished in the materials that would be sent if the reply card was returned. In a subsequent no-action letter to AMA Investment Advisers, discussed below, the staff stated that this statement should be "presented in such a manner ó in terms of placement in the materials and the size of the type ó that it would not be overlooked by a prospective client."

E.F. Hutton told the SEC staff that it would mail out the solicitor disclosure document and its Part II to any prospect that returned the reply card, as part of a package containing the firmís financial planning materials. E.F. Hutton said that mailing out the materials as part of the initial mailing would be "burdensome and unnecessary." And it promised to provide the disclosure before the prospect actually entered into an advisory agreement or paid any fees.

The SEC staff agreed that E.F. Hutton could provide the disclosure statements directly to prospects after the initial mailing, as described in the letter. However, in a 1993 no-action letter to AMA Investment Advisers, the staff imposed some limits on the relief granted in the E.F. Hutton letter. The relief in Hutton, explained the staff, "was intended to be available only in compelling circumstances, such as where the solicitor or adviser proposes to contact a large number of persons, who have not indicated any prior interest in the advisory services, through an impersonal medium such as mass mailings, and the costs of providing the [adviserís Part II and the solicitor disclosure document] with the initial contact outweighs the benefits. So, reasoned the staff, while the Hutton approach makes sense for mass mailings and articles contained in association publications, it may not fly in the context of making the initial contact in person at financial planning seminars or at trade show booths. "It would not be particularly burdensome" to distribute the Part II and solicitor disclosure documents at those events, noted the staff, since "no mailing costs are involved" and copies of disclosure statements prepared for such events would "presumably be available for later use."

The upshot: solicitations by direct mail or by articles appearing in association publications need not be accompanied by the firmís Part II and solicitor disclosure document (although the marketing materials must include the E.F. Hutton disclosure). If your firmís solicitor exhibits at a trade show, or holds seminars, however, theyíd better have a stack of both disclosures handy.

What about referral programs, where investors ask a group to point them to an adviser? If we pay to be listed, is that a solicitation arrangement? In several no-action letters, the SEC staff has taken the position that an adviser does not need to treat the sponsor of a referral program as a solicitor, provided certain conditions are met: the referral program must generate a randomly-selected list of advisers for the investor to choose from, and not "steer" clients towards particular advisers (although the universe of participating advisers may be "screened" by the referral programís sponsor to weed out advisers not meeting certain educational or experience prerequisites, or those that have past disciplinary history). Moreover, the adviserís cost to participate in the program must be based on a flat fee, not on the number of referrals generated. See e.g., National Football League Players Association.

When does the adviser have to receive the client acknowledgement, and what must be in it? The adviser must receive the acknowledgement "prior to, or at the time of, entering into any written or oral investment advisory contract" with the client. The acknowledgement must be signed and dated, and must acknowledge the receipt of the adviserís Part II (or equivalent) and the solicitor disclosure statement.

Does the adviser have any other obligations toward the solicitor? Yes. The rule requires advisers to make a "bona fide effort" to determine whether the solicitor has complied with the solicitation agreement, and have a "reasonable basis" for believing that the solicitors has, in fact, complied. The SEC has provided some guidance on this score: "[I]t would seem that such a bona fide effort would, at a minimum, involve making inquiries of some or all clients referred by the solicitor in order to ascertain whether the solicitor has made improper representations or has otherwise violated the agreement with the investment adviser."

Next week: Affiliated solicitors, applicable books and records requirements, Form ADV disclosures, and more.