Beginning a discussion of third-party marketers requires some definition of what the term means, who may be included and what the discrete functions are that each may provide. Generally, third-party marketers refers to the collection of industry professionals who call themselves “finders,” “solicitors” and “placement agents.” Each serves a separate and distinct constituent base in the investment industry and each offers a different set of services to its target audience. While all three share some similarities, they operate, for the most part, in different spheres.
The similarity involves their role in coming between various parties within the investment world. Where they diverge is in the target audience: placement agents seek out investors for issuers seeking to raise capital in private transactions; solicitors attempt to bring prospective clients to investment management firms; and finders live in the shadowy world of making introductions of investors to issuers while attempting to limit their activities so as to avoid falling within the definition of a broker or dealer. For the purposes of this article, we are limiting our commentary to solicitors.
Solicitors
The SEC defines a solicitor as “any person who, directly or indirectly, solicits any client for, or refers any client to, an investment adviser.” The term is understood to exclude an affiliate of an investment manager such as an officer, director or employee, where such relationship is known to the party being solicited. The solicitation rule, which it should be noted is promulgated under the anti fraud provisions of the Investment Advisers Act, pertains to advisers who are required to be registered.
The rule is designed not so much as to prevent solicitation activities but rather, consistently with the general framework in the securities laws, to ensure that the party being solicited understands all of the relevant facts. The SEC was concerned that prior to the rule’s adoption, a person being referred to an adviser may have believed that the referral was more akin to an endorsement of the adviser’s ability rather than what it actually represented: a sales presentation by someone being compensated for a successful sale. This point raises an important element in the regulation: the solicitation activity is only regulated in those cases where the adviser pays a cash solicitation fee.
Consistent with the disclosure approach in the federal securities laws, the solicitation activity must be made in conjunction with appropriate disclosure. There are three important elements that must be observed when an adviser intends on using a solicitor.
First, there must be a written agreement between the adviser and the solicitor. The agreement must, at a minimum, (i) provide a description of the solicitation activities, (ii) include an undertaking by the solicitor that he or she will perform the activities consistent with the instructions given by the adviser and in compliance with the requirements under the Act and the rules thereunder; and (iii) the solicitor must at the time of the solicitation activities provide the prospective client with the adviser’s brochure, which may be either Part II of Form ADV or the adviser’s own brochure, and a separate written disclosure document.
Secondly, the adviser, prior to or at the time of entering an advisory contract with a referred client, must receive a signed and dated acknowledgement from the client that he or she has received the adviser’s brochure and the written disclosure document.
Thirdly, the adviser must make a bona fide effort to ascertain whether the solicitor has complied with the agreement and the adviser must have a reasonable basis for believing the solicitor has in fact complied.
The written disclosure document is at the heart of the rule; it is where the rubber meets the road. The document is designed to lay bare all of the essential elements of the compensation plan so the prospect can judge for himself what may be driving the solicitor and whether the referral is in his best interest or whether, due to the size or nature of the compensation being paid, the solicitor is simply pushing the adviser in order to get paid, without due regard for whether the adviser’s services are a match for the client’s needs.
The disclosure document must have the usual provisions, including the name of the solicitor and adviser and the relationship between them. There must be a clear statement that the solicitor will be paid for his services by the adviser and a description of the compensation. It is not sufficient to simply say that the solicitor will be paid; rather, the compensation scheme itself must be disclosed. For example, in what is often the compensation component, the adviser will pay the solicitor a percentage of the adviser’s management fee, either for a term or for as long as the prospect remains a client. In this case, the disclosure to be made would include what the percentage is, how it is calculated and how long the solicitor will receive it.
Lastly, if the solicitation compensation would cause the management fee to be greater due to the solicitation activity, it must be disclosed. Experience shows that generally, advisers do not increase their fees and the typical disclosure will include language that the client will not pay fees greater than what would have been charged without the solicitation activities.
Caveats
SEC Proposal
The SEC recently released a proposed rule (Release No. IA-2910) which would, among other things, prohibit an adviser from making any payment to a party with respect to solicitation of advisory business from any governmental entity on behalf of such adviser. This rule proposal follows on the heels of various prohibitions adopted by several states, including New York, New Mexico, Illinois, Ohio, Connecticut and Florida. Recent headlines, particularly with respect to investigations conducted by the New York attorney general, have highlighted practices involving well-connected third parties being engaged to obtain governmental pension plan business, which represents some one-third of all pension plan assets.
The section of the SEC’s proposed rule that most affects third-party marketers involves the ban on the payments to any person to solicit governmental entities for advisory business. While technically the rule does not prohibit the use of third parties, the ban on paying fees effectively has that result.
It will be worth watching to see the public comments on the rule. In fact, the Third Party Marketers Association has already expressed its opposition to the blanket ban. The association has made several points, including what the rule proposal suggests about the industry participants and elected officials who often control these public fund assets. It is, to say the least, a remarkable departure from the regulatory regime for other asset pools.
State Securities Administrators
We have not discussed the very active role that many state securities administrators now play in this area. In certain states, solicitors are included within the definition of investment adviser and some states take the position that the solicitor needs to be separately licensed or registered by the adviser for whom the solicitor may be working. For both the solicitor and the adviser, caution is in order. Further, while the SEC cash solicitation rule applies only to advisers who are required to be registered, no such limitation exists in the Blue Sky arena.
Coming Next Time: Third-Party Marketers to Private Fund Managers
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