On October 31, 2018, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a risk alert providing investment advisors with information regarding the most common deficiencies SEC staff have cited relating to Rule 206(4)-3 (the “Cash Solicitation Rule”) under the Investment Advisers Act of 1940.
Background on the Cash Solicitation Rule
SEC registered investment advisors are prohibited from paying a cash fee, directly or indirectly, to any person who solicits clients for the advisor (a “solicitor”) unless, among other things, the referral fee is paid pursuant to a written agreement between the solicitor and advisor.
Solicitation arrangements with third-party solicitors have additional requirements, including a requirement in the agreement that the solicitor provide the prospective client at the time of solicitation a copy of the advisor’s disclosure brochure and a separate written disclosure document, that the advisor receive from the client a signed and dated acknowledgement that the client received the advisor’s brochure and the solicitor’s disclosure document, and that the advisor make a bona fide effort to determine whether the solicitor has complied with the solicitation agreement and has a reasonable basis for believing that the solicitor has in fact complied.
Most Frequent Deficiencies Identified by OCIE Staff During Examinations
In the Risk Alert, OCIE stated that the most frequent deficiencies observed by its staff included the following:
- Failure by solicitors to provide the solicitor’s disclosure document or inadequate disclosure of the arrangement, including the terms of compensation, in the disclosure document
- Failure by advisors to receive on a timely basis a signed and dated client acknowledgement of receipt from the solicitor of the advisor’s disclosure brochure and the solicitor’s disclosure document
- No solicitation agreement in place or the agreement is lacking certain required provisions
- Failure to make a bona fide effort to determine whether the solicitor is complying with the solicitation agreement
- Failure to disclose related conflicts of interest, such as the recommendation of a service provider to a client in exchange for client referrals without full and fair disclosure
Recommendations by OCIE
In light of their findings, OCIE encourages advisors to review their practices and policies and procedures with regard to solicitation arrangements to determine whether their disclosure brochures and solicitation agreements should be amended and whether their policies and procedures should be revised.
Other Considerations Not Discussed in the Risk Alert
SEC registered investment advisors should also keep in mind the following with respect to the Cash Solicitation Rule:
- Rule 206(4)-3 generally does not apply to a registered investment advisor’s cash payment to a person solely to compensate that person for soliciting investors or prospective investors for, or referring investors or prospective investors to, an investment pool managed by the advisor.
- The Cash Solicitation Rule would likely apply if an investment advisor manages or seeks to manage investment pools and individual accounts, is seeking to enter into investment advisory relationships with other persons, and the advisor’s cash payment, under the advisor’s arrangement with the referring person, compensates the referring person for referring the other persons as prospective advisory clients.
- As a best practice, advisors should consider including in their investment advisory contract the client’s acknowledgement of receipt of the advisor’s disclosure brochure and the solicitor’s separate disclosure document.
- In order to demonstrate that it has made a bona fide effort to determine that the solicitor has complied with the solicitation agreement, an advisor should consider utilizing a due diligence checklist to verify this compliance and to determine whether the solicitor is in compliance with any requirements set forth by states regarding licensing and registration.
To see the SEC’s Risk Alert, click here.
For more information about the Cash Solicitation Rule in general, please contact NCA Compliance.
Hayley Nelson is the President and Principal Consultant of NCA Compliance, Inc., a compliance consulting firm providing a wide range of customized compliance solutions for investment advisors nationwide, including mock audits, forensic testing, email surveillance, and assistance with the annual compliance review. Ms. Nelson previously worked for the Securities and Exchange Commission and a large investment manager in New York.
