A publication of THE SECURITIES LAW GROUP | James E. Grand | July 2018
As registered investment advisers (“RIAs”) attempt to grow their businesses, they often consider whether to use third-party solicitors. RIAs must take care to understand the compliance obligations they will face when they choose to enter into a solicitation arrangement. The compliance obligations are complex, often dependent upon where the solicitor is located and the particular facts and circumstances surrounding the relationship, and they differ from state to state.
For purposes of this blog, we define “solicitor” as any person who is compensated for referring clients to an RIA.
When considering whether to compensate a person for referrals, the first thing an RIA should consider is the nature of the RIA/solicitor relationship. The RIA’s compliance obligations depend in part upon the type of solicitation arrangement being utilized. For example, a solicitor might be a partner, officer, director or employee of the RIA who receives compensation and/or bonuses based on originating new business. These persons would be considered “affiliated solicitors.” Affiliated solicitors face fewer compliance obligations than non-affiliated third-party solicitors. Most of the confusion and questions that arise in this area involve the latter so this blog focuses on the particular rules that apply to compensating non-affiliated third-party solicitors.
Overview of the Rules Governing Solicitors – the “Cash Solicitation Rule”
Rule 206(4)-3 under the Investment Advisers Act of 1940 (commonly referred to as the “cash solicitation rule”) makes it unlawful for an RIA to pay a cash fee to a solicitor for soliciting clients unless the cash fee is paid in accordance with a written agreement between the RIA and the solicitor, the solicitor meets certain other requirements, and the solicitor is not subject to statutory disqualification. The cash solicitation rule, which is followed by most states, requires the written agreement referred to above to contain at least the following information. It must:
- Describe the solicitor’s activities on behalf of the RIA and the compensation to be paid;
- Require the solicitor to comply with the RIA’s instructions and the Advisers Act;
- Stipulate that the solicitor, at the time of solicitation, will provide the client with a current copy of the RIA’s FORM ADV—Part 2 and a separate written disclosure statement.
The separate written disclosure statement to be provided by the solicitor is at the heart of the rule. If properly drafted, the disclosure statement details the compensation plan so prospects can evaluate the solicitor’s motivation and whether the referral is in the prospect’s best interest. At a minimum, it must contain the following information:
- The name of the solicitor;
- The name of the RIA;
- The nature of the relationship, including any affiliation between the solicitor and the RIA;
- A statement that the RIA will be compensating the solicitor for solicitation activities;
- The terms of the compensation agreement; and
- The cost, if any, to the client that is attributable to the solicitation arrangement.
Before entering into an advisory contract, the rule requires the RIA to be in possession of the client’s written acknowledgement that it received the RIA’s Form ADV—Part 2 and the solicitor’s disclosure statement.
A Word about State Regulation
State securities regulations dictate whether the act of soliciting clients for an RIA falls within the definition of an Investment Adviser Representative. Depending on the state, a solicitor might be required to register as an IAR, even if the RIA is SEC-registered. The majority of states view the solicitation or referral of clients as an investment advisory activity. Therefore, in those states, non-affiliated third-party solicitors must be registered as IARs. States such as New York, for example, do not register IARs. Solicitors there are not subject to a registration requirement.
Most states require IARs to pass a qualifying examination such as Series 65. Others do not require solicitors to pass an examination if they are merely soliciting and do not give investment advice. Some states distinguish between SEC and state-registered advisers. In Pennsylvania, for example, solicitors who refer clients to SEC-registered RIAs are not required to be registered. However, registration is required for solicitors who refer clients to state-registered firms.
When considering its obligations under the SEC’s cash solicitation rule, the RIA must not overlook its obligations under correlating state rule.
RIAs must make a good faith effort to determine whether the solicitor has complied with their written agreement. They also must have a reasonable basis for believing that the solicitor has complied with the terms of that agreement. RIA’s utilizing solicitors—especially non-affiliated third-party solicitors–must implement policies and procedures designed to ensure compliance. They must also make specific disclosures in their FORM ADV if they utilize solicitors. As in so many other areas, before onboarding a solicitor, RIAs should conduct a thorough background check to ensure that the individual is not subject to statutory disqualification, and otherwise verify the individual’s credentials.
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The Securities Law Group
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