Renewed SEC Scrutiny of Registered Investment Advisors Using Solicitors

August 05, 2009

Reading time : 4 minutes

We frequently hear stories and receive questions from our registered investment advisor clients about the benefits of receiving client referrals from outside professional sources. Such outside professionals can include CPAs, attorneys, and insurance agents. While the U.S. Securities and Exchange Commission (“SEC”) does not generally have an issue when an SEC registered investment advisor uses employees or outside sources to generate client referrals, the SEC has taken the position that a line is crossed when payment is provided for such referrals. When fees (including non-cash payments) are paid by an SEC registered investment advisor for client referrals, SEC Rule 206(4)-3 sets forth specific requirements that must be followed. The requirements are different depending on whether the solicitor is affiliated or unaffiliated with the registered investment advisor. For example, when an unaffiliated solicitor refers a client to an SEC registered investment advisor, the unaffiliated solicitor is required to provide written disclosures to the prospective client outlining the unaffiliated solicitor’s arrangement with the firm and the compensation that may be received. The disclosure must be provided at the time of solicitation.

In addition to requirements under SEC Rule 206(4)-3, SEC registered investment advisor firms must have a thorough understanding of applicable state rules. The majority of state securities regulators include the terms solicitor or referral in the definition of investment advisor representative and therefore require the referring party to be licensed as such. This means passing the Series 65 exam, filing a Form U4, paying the licensing fee, and receiving approval by the state securities regulator; all prior to soliciting the first client for a fee. Some state securities regulators even require companies that receive solicitor fees to be registered as an investment advisor even though they may provide no other advisory services. In these cases, the referring firm would need to file a Form ADV and other required documents in order to register directly with the state securities regulator.

From our experience, non-compliance with SEC Rule 206(4)-3 will all-too-often result in deficiencies during SEC examinations. Some of the specific deficiencies include failing to have an adequate agreement with the solicitor; failure to require that the solicitor provide written disclosures; and failure to maintain all required books and records related to the solicitor arrangement. Inadequate disclosure in the firm’s Form ADV Part II, Schedule F or similar disclosure document is another common deficiency. In more egregious situations, registered investment advisors have been cited for altogether failing to disclose to clients the fees paid to solicitors.

More recently, we have seen the SEC initiate administrative and enforcement proceedings citing SEC Rule 206(4)-3. One such case was in June of this year when the SEC charged Cohmad Securities Corporation and some of its personnel alleging that they collectively raised billions of dollars from investors for Bernard Madoff’s Ponzi scheme. Given the fact that paid solicitor programs present an inherent conflict of interest between registered investment advisors and their clients and given the fact that solicitors (i.e. feeder funds) played such a significant role in the Madoff scandal, we fully expect the SEC to increase scrutiny on paid solicitor arrangements.

If your firm has an active solicitor program, is considering such a program or if you just want to learn more about SEC Rule 206(4)-3, please join us for our August 19 webinar titled “Establishing & Supervising Solicitor Arrangements”. This timely webinar is being presented by Jarrod James, Vice President and Senior Compliance Consultant at RIA Compliance Consultants, Inc. The cost of the webinar is $59.95 and will detail the requirements of SEC Rule 206(4)-3, discuss best tips for complying with the rule and provide opportunity for attendees to pose specific questions.

*The webinar has been accepted by the CFP Board for 1 hour of General CFP® continuing education credit.

Posted by Bryan Hill
Labels: Solicitors