Know What Your Firm Solicits Before Moving on Compliance
There are two kinds of solicitation that advisory firms might pursue: seeking new advisory clients, and finding new investors for private funds. In terms of compliance, while the two solicitation types share some requirements, they don’t share them all – and, in fact, there are some compliance requirements that are unique to each. It is essential that advisory firms design compliance procedures that address the type of solicitation they perform.
"Overall, there is sometimes not a good intuitive understanding among advisers of how the solicitation requirements are applied," said Morgan Lewis consultant attorney Steven Hansen. Advisers need to familiarize themselves with what constitutes solicitation in different circumstances, and when different requirements apply. Otherwise, an adviser may allow a solicitor to move forward unaware of compliance risks involved. "Someone with good contacts in the investment community may be able and interested in helping an adviser expand its client base or bring investors into a private fund but the adviser may not realize that there are legal requirements that may turn on the circumstances and nature of that person’s activity," he said.
Step number one in solicitation compliance is for investment advisory firms to determine just what type of solicitation they are doing or plan to do: soliciting new advisory clients or soliciting fund investors, said Mayer Brown attorney Adam Kanter. Most of the other compliance steps, he said, flow from the answer to this question.
Once that is established, advisers need to determine which compliance requirements apply. Some apply just to solicitation of advisory clients, others apply just to solicitation of investors for funds, and others apply to both, said Hansen.
Following are the best practices for each type of solicitation.
Advisers seeking new advisory clients
Consider the following:
Determine state registration requirements. States differ in this. "One mistake that I see advisers make when soliciting for advisory clients is that they aren’t familiar with the type of activity that would require registration," said Hansen. "For example, since there is not a federal registration requirement for a solicitor seeking solely new clients for the adviser, potential state registration requirements are forgotten or are assumed not to exist." Once you determine whether state registration is required, "work only with entities that are properly registered," said Kanter. "That means your firm might not be able to hire a trusted friend or former colleague who is not registered. Some states provide exemptions for solicitors that are registered in other capacities (such as broker-dealers). When dealing with foreign solicitors, you should similarly be concerned that they are properly registered in the country or countries [in which] they will be
soliciting for you, if required under local law."
Comply with Rule 206(4)-3, the Cash Solicitation Rule. The Rule has several requirements, among them that the adviser require a written agreement between the advisory firm and the solicitor, and that the solicitor needs to provide those he is soliciting with a disclosure statement, stating that he is soliciting for, and being compensated by, the advisory firm, said Kanter.
Comply with Rule 206(4)-5, the Pay-to-Play Rule. This Rule applies if a solicitor is going to seek a public pension fund or other government entity as a client (it also applies for advisory firms seeking investments for funds). Under the Rule, government entities can be solicited only by a "regulated person" (e.g., an SEC-registered investment adviser, broker-dealer or municipal adviser) or by employees of the investment adviser on whose behalf the employee is soliciting. "Be forward thinking," Kanter said. "Include representations in the solicitation agreement that the solicitor hasn’t made a contribution that would cause you, the party doing the hiring, to violate the Pay-to-Play Rule."
Beware of bad actors. If a solicitor has had previous regulatory trouble, he or she may not be eligible to act as a solicitor, the Cash Solicitation Rule states. What constitutes previous regulatory trouble? The solicitor cannot be a person subject to a Commission order; convicted within the previous 10 years of any felony or misdemeanor involving fraud; found by the Commission to have engaged in fraudulent conduct; or subject to any order, judgment or decree barring the solicitor from the securities industry, according to the Rule. Large entities that have been involved in a settlement sometimes get around this problem by seeking a no-action letter from the SEC staff so this provision will not prevent them from being hired as solicitors, Kanter said. Keep in mind that the definition of a bad actor under the Cash Solicitation Rule, which advisers must use when soliciting advisory clients, is different from the definition of a bad actor
under Regulation D of the Securities Act of 1933, which advisers must follow if they are soliciting investors for funds they manage.
Disclose the solicitor’s compensation. Another requirement from the Cash Solicitation Rule, which states that the written disclosure document noted above must contain "the terms of such compensation arrangement, including a description of the compensation paid or to be paid to the solicitor."
Advisers seeking fund investors
While a number of the requirements listed for advisers seeking new advisory clients apply here, not all do, most notably the Cash Solicitation Rule, said Kanter. Here are some of the requirements that are unique to fund investor solicitation:
Register as a broker-dealer or be an employee of a registered broker-dealer. Generally, anyone who solicits fund investors on an adviser’s behalf needs to register as a broker-dealer, which involves several layers of registration. "Unlike for advisers, where there is federal preemption (i.e., division of responsibility between state and SEC based on assets under management, for brokers there isn’t, so a broker registers with the SEC, one or more states, and also has to be a member of FINRA," Kanter said.
The Paul Anka exception. There is one known instance when the SEC found that a solicitor did not have to register as a broker-dealer. That situation involved the singer Paul Anka, who asked the SEC staff if it would not recommend enforcement action against him if he provided, for transaction-based compensation, a list of names to a hockey club that was selling securities. In a July 1991 no-action the letter, the SEC staff said that it would not. The staff did, however, place a number of conditions on its decision, including that Anka would not participate in any negotiations between the hockey club and potential investors; that he would not solicit these persons, make any recommendations to them regarding an investment in the hockey club, or have any contact with them concerning the hockey club. He also agreed not to take part in any advertisement, endorsement or general solicitation regarding the class A or class B units being sold by the club, and not to participate in the preparation of any materials related to the sale or purchase of the units or in their distribution to potential investors. Whether the agency staff would take the same position today is uncertain, said Hansen, as he said the SEC has "pushed back" in the intervening years since it took this position.
Watch out for Regulation D bad actors. "Most private fund issuances are done under Reg D, so the bad actor provisions are particularly important," said Hansen. The Regulation has its own list of bad actors, different from those in the list under the Cash Solicitation Rule. These include: a person who is the subject of a criminal conviction involving any security sale, false filing with the SEC, or "arising out of the conduct" of being an underwriter, broker, dealer, municipal securities dealer, investment adviser, or paid solicitor to securities purchasers. Also on the list of bad actor defining events are a court injunction or restraining order that prevents a person from being involved with the purchase or sale of a security, involving a false filing with the SEC; a final order of a state securities, banking or insurance regulator, a federal banking agency, the National Credit Union Administration, or the CFTC; and a Commission disciplinary order that suspends or revokes a person’s registration as a broker, dealer, municipal securities dealer, or investment adviser. Finally, the list includes a Commission cease-and-desist order requiring a person to stop committing a violation, or preventing a person from committing a future violation, of any scienter-based anti-fraud provision of the federal securities laws; and suspension or expulsion from a self-regulatory organization.
Adviser soliciting both clients and fund investors
"If the solicitor is doing both, then the adviser and the solicitor will need to apply the requirements from both column A and column B," said Hansen, meaning they will need to meet both sets of requirements.
In addition, all advisory firms, whether soliciting potential clients, fund investors or both, would be wise to consider the following best practices:
Monitor the solicitor. Due diligence must be performed on the solicitor so you can be sure that it is providing potential clients with the required disclosures. Methods to do this include speaking to a sample of clients directly, or by having the solicitor certify in writing that he or she delivered the disclosure documents to the solicited clients.
Anti-bribery. If the solicitation involves activities in non-U.S. jurisdictions, particularly if they potentially involve sovereign wealth funds or other contacts with foreign government institutions, Kanter said, consider including representations and warranties and other provisions to require the solicitor comply with the Foreign Corrupt Practices Act of 1977 and other anti-bribery and anti-corruption requirements.
Direct payments to the solicitation firm, not the individual. Consider stating in writing, as part of the agreement with the solicitor, that your advisory firm will pay the solicitation firm, not the individual, if only to protect yourself. This may come in handy if an employee at the soliciting firm who referred a large number of clients to you decides to leave the firm and wants you to continue to pay him or her.
Include termination provisions that benefit your advisory firm. Your firm may need to end a solicitor agreement if the solicitor engages in improper activity that violates the Cash Solicitation Rule, for instance. You want to be able to cut the solicitor’s compensation immediately in such cases.