David S. Rosenthal
New York +1 212 698 3616
The staff of the SEC recently confirmed that Rule 206(4)-3 under the Advisers Act does not apply to a registered investment adviser’s1 cash payments to a person soliciting investors solely to invest in an investment pool2 managed by the investment adviser, such as hedge funds and private equity funds.3
The requesting party had sought no action relief from compliance with the Rule for such payments to cash solicitors. In its response, the staff did not expressly grant the requested no- action relief; but instead “clarified” that the Rule was not intended to apply to such payments. Notwithstanding the inapplicability of the Rule to such payments, the staff said that recipients of such payments may nevertheless be investment advisers and may be required to provide disclosures to solicited investors under Section 206 of the Advisers Act.
The staff also said that to the extent its response to the Letter is “inconsistent or conflicts with” previously expressed views, the staff’s response to the Letter supersedes those views. As discussed below, the Letter does not resolve other regulatory issues that may arise from an investment adviser’s cash payment to a solicitor in exchange for investor referrals, including conflict of interest disclosure and potential adviser registration and broker-dealer registration issues.
The Rule prohibits an investment adviser required to be registered from paying cash compensation to a solicitor for client referrals unless the investment adviser complies with certain conditions specified in the Rule. The Rule is intended to address the conflicts of interest inherent in certain solicitation arrangements and the requirements of the Rule (including that the payment must be pursuant to a written agreement and that clients of the investment adviser must be provided certain prescribed disclosure based on the type of solicitation arrangement) are intended to alert a potential client who is approached by a solicitor that the solicitor is being compensated by the investment adviser for making such a recommendation.
Clarification of Guidance Under the Rule
The definition of “client” was called into question following Goldstein v. SEC,4 in which the U.S. Court of Appeals for the District of Columbia Circuit held that investors in a private investment pool are not “clients” of the pool’s investment adviser for purposes of Section 203 of the Advisers Act. Prior to Goldstein, the SEC staff had issued several no-action letters concerning application of the Rule to payments made by a registered investment adviser to a person soliciting investors to invest in an investment pool managed by the investment adviser.5 Post-Goldstein, some senior SEC officials had commented publicly that the Rule does not apply in that scenario.6 The staff’s response to the Letter confirms their post-Goldstein view that the Rule applies only to the solicitation of direct clients who will enter into an advisory relationship with a registered investment adviser, and not to investors in investment pools managed by the investment adviser.
In the Letter, the SEC staff reasoned that the Rule does not apply in the above scenario because:
The SEC staff emphasized that its interpretation is limited to circumstances in which a registered investment adviser is solely compensating a solicitor for referring investors or potential investors to a registered investment adviser so that they may invest in an investment pool managed by the registered investment adviser. The SEC will look to the facts and circumstances of a particular scenario (such as the nature of the arrangement and relationship between the solicitor and the registered investment adviser, and the purpose for the registered investment adviser’s cash payment to the solicitor) in order to determine if the solicitation relates “solely” to participation in an investment pool.
Conflict of Interest Disclosure
Although registered investment advisers are no longer required to comply with the Rule when making cash payments to a person soliciting investors solely to invest in an investment pool managed by the registered investment adviser, certain disclosures must still be made. All investment advisers, whether or not registered with the SEC, remain subject to the antifraud provisions of the Advisers Act. The SEC recently sought to clarify the parameters of the antifraud provisions of the Advisers Act post-Goldstein by adopting Rule 206(4)-8.7 Rule 206(4)-8 prohibits investment advisers from making false or misleading statements to investors or prospective investors in investment pools managed by the investment adviser or otherwise defrauding those investors or prospective investors. In addition, investment advisers must disclose conflicts of interest to investors in an investment pool. Because cash payments to a solicitor may give rise to conflict of interest situations, such payments should be disclosed to investors in investment pools managed by the investment adviser.
Section 202(a)(11) of the Advisers Act defines an investment adviser as someone who “advis[es] others . . . as to the advisability of investment in . . . securities.” Accordingly, a solicitor may be acting as an investment adviser when directing a potential investor towards a certain investment pool. If so, the solicitor would be subject to the antifraud requirements under the Advisers Act and may be required to register as an investment adviser with the SEC. The SEC staff did not address this particular issue in the Letter.
Further, Section 3(a)(4)(A) of the Securities Exchange Act of 1934, as amended (“Exchange Act”), broadly defines the term “broker” to include “any person engaged in the business of effecting transaction in securities for the account of others.” Persons meeting that definition are required to register as such with the SEC, a self-regulatory organization, and/or a state’s securities regulator, except in certain circumstances. The Letter did not explicitly address whether a solicitor’s receipt of cash compensation in exchange for directing investors to invest in particular investment pools would result in the solicitor being considered a “broker” by the SEC. Depending on the facts, receipt of cash compensation could result in a solicitor being required to register as a broker with the SEC.
The Letter may be viewed as evidence of the SEC’s increasing interest in solicitations. Recent SEC action, such as the Public Alert: Unregistered Soliciting Entities program,8 through which the SEC publishes a list of soliciting firms that have been the subject of investor complaints, as well as recent amendments to Form D under Regulation D of the Securities Act of 1933, as amended, which require investors to provide information about any recipients of direct or indirect cash compensation—including unregistered finders—in connection with the sale of securities in private placement transactions.9 Given the SEC’s increasing focus on this area, soliciting firms may wish to reevaluate the application of SEC registration requirements to their business arrangements.
In addition to compliance with SEC registration requirements, states have their own broker-dealer regulatory regimes, and in some cases certain states take a more restrictive view than the SEC on the activities that may give rise to a registration requirement.
1) The Rule applies only to payments by an investment adviser required to be registered pursuant to Section 203 of the Advisers Act.
2) The SEC staff defined the term “investment pool” to mean an investment company under Section 3(a)(1) of the Investment Company Act of 1940, as amended (“Investment Company Act”), or an investment company relying on any exclusion from the definition of “investment company” found in Section 3(c) of the Investment Company Act. The Mayer Brown inquiry letter sought clarification under the Rule only with respect to private investment pools.
3) Mayer Brown LLP, SEC No-Action Letter (July 15, 2008) (The "Letter)"
4) 451 F.3d 873 (D.C. Cir. 2006).
5) See, e.g., Dana Investment Advisors, Inc., SEC No-Action Letter (Oct. 12, 1994); Dechert Price & Rhoads, SEC No- Action Letter (Dec. 4, 1990); Stein Roe & Farnham Inc., SEC No-Action Letter (June 29, 1990).
6) See, e.g., Plaze Says Letter on Cash Politicians Was Misinterpreted, Compliance Reporter (July 14, 2006).
7) Prohibition of Fraud by Advisors to Certain Pooled Investment Vehicles, Rel. No. IA-2628 (August 3, 2007).
8) New SEC Program Discloses Information about Unregistered Soliciting Entities, Dechert OnPoint (May 2008).
9) SEC Adopts Amendments to Form D and Mandates Electronic Filing, Dechert OnPoint (March 2008), at fn.3.