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News December 20, 2004 Issue

Paying for Leads: What Advisers Should Know About the Cash Solicitation Rule (Part 2 of 2)

Continued from last weekís IM Insight . . .

What if the solicitor is affiliated with my firm?

An adviserís affiliated solicitors include any corporate affiliate controlled, controlling, or under common control with the adviser, as well as those entitiesí partners, officers, directors, and employees. Under the theory that clients will understand that an affiliated solicitor has a natural bias towards recommending its affiliate, the ruleís requirements are significantly relaxed with respect to affiliated solicitors. Specifically, an affiliated solicitor does not have to deliver the adviserís Part II, nor the special solicitation disclosure document, to a solicited client. The adviser does not have to obtain the clientís acknowledgement, nor (at least per the terms of the rule) does it have to make a bona fide effort to determine whether the solicitor is complying with the solicitation agreement.

However, there still are a few hoops that an affiliated solicitation arrangement must jump through:

  • The solicitor must not be disqualified under the rule.
  • The solicitor and adviser must enter into a written solicitation agreement (because of the way the cash solicitation rule operates, the specific elements of cash solicitation agreements described in last weekís article technically are not required by the rule for agreements with affiliated solicitors).
  • The solicitor must disclose its status as a control affiliate (or as partner, officer, director, or employee of the control affiliate) to a potential client at the time of the solicitation activity. If the solicitor is a partner, officer, director, or employee of a control affiliate, the affiliation between the adviser and the control affiliate also must be disclosed.

Lastly, when contemplating an affiliated solicitation arrangement, keep an eye on the status of proposed Regulation S-AM, which, if adopted, will impose limits on information that may be shared in affiliated marketing arrangements.

Does the rule contain other exceptions?

Only one: an exception for solicitations for "impersonal advisory services" (defined in the rule as advice that does not purport to meet the objectives or needs of the specific client, or statistical information containing no expressions of opinions as to the investment merits of particular securities, or any combination of the two). If only impersonal advisory services are being provided, the solicitor does not have to deliver the adviserís Part II and the special solicitation disclosure document. Moreover, the adviser does not have to obtain client acknowledgements nor make a bona fide effort to determine whether the solicitor is complying with the solicitation agreement.

Are there ongoing obligations?

If the solicitor receives separate compensation (in addition to that which had previously been disclosed) for recommending that the client continue an advisory relationship already established, the SEC has taken the position that that payment would constitute payment for another distinct solicitation, and all the requirements for the rule would again have to be complied with.

What additional records must be kept as part of an adviserís required records?

  • Solicitation agreements ó see Rule 204-2(a)(10).
  • Solicitor disclosure documents ó see Rule 204-2(a)(15).
  • Client acknowledgments ó see Rule 204-2(a)(15).
  • Copies of marketing materials sent by solicitors on the adviserís behalf to 10 or more persons ó see Rule 204-2(a)(11).

What items on Form ADV pertain to solicitation?

  • Part 1A Item 5.B.3. asks: "Approximately how many firms or other persons solicit advisory clients on your behalf?" using a range of boxes (0, 1 to 5, 6-10, etc.). An adviserís own employees are not counted, and a firm that solicits on your behalf is counted once (the firmís individual employees, however, are not counted).
  • Part 1A Item 8.F. asks: "Do you or any related person, directly or indirectly, compensate any person for client referrals?" In responding to this question, consider "all cash and non-cash compensation that you or a related person gave any person in exchange for client referrals, including any bonus that is based, at least in part, on the number or amount of client referrals."
  • Part 1A Schedule D Section 7.B. asks advisers that have indicated that they or a related person serve as the general partner to an investment-related limited partnership (or a manager of an investment-related LLC, or that otherwise advise a private fund) a yes/no question: whether the adviserís clients "are solicited to invest in the limited partnership or [LLC]."
  • Part II Item 8.D. asks whether the adviser or a related person is "a general partner in any partnership in which clients are solicited to invest?" (If the answer is yes, the adviser must describe on Schedule F "the partnerships and what they invest in.")
  • Part II Item 13.B. asks whether the adviser or any of its related persons "have any arrangements, oral or in writing, where it directly or indirectly compensates any person for client referrals." Each arrangement must be described on Schedule F.
  • Wrap fee sponsors should see Schedule H Item 7.e.

And lastly . . .

Consider whether your third-party solicitor must be registered in any state as one of your IARs. Some state definitions of "investment adviser representative" pick up third-party solicitors.