November 4, 2022, the compliance date for the Securities and Exchange Commission’s (the “SEC”) new marketing rule (Rule 206(4)-1 under the Advisers Act) (the “Marketing Rule”), is quickly approaching. Have you reviewed your firm’s agreements related to payments for investment advisory client referrals (commonly referred to as “solicitor agreements”) and considered any updates needed as a result of the Marketing Rule?

In this blog post we discuss the implications of the Marketing Rule on investment adviser solicitation agreements and provide related practical tips and key considerations.

While Rule 206(4)-1 under the Investment Advisers Act of 1940 (the “Advisers Act”) has been effective since May 2021, the mandatory compliance date for SEC registered investment advisers (“RIAs”) is November 4, 2022.[1] The Marketing Rule has broad implications for RIA advertising, including new rules related to advertisements on social media, testimonials and endorsements, use of third-party ratings, and performance advertising. Notably, the Marketing Rule also replaces Rule 206(4)-3 under the Advisers Act (the “Cash Solicitation Rule”), which has historically regulated RIA’s compensation of solicitors for referrals of investment advisory clients.[2] While the Marketing Rule’s approach to payment for client referrals has many similarities with the Cash Solicitation Rule, including the requirement for a written agreement between an RIA and a compensated party, there are additional requirements and disclosures that RIA’s agreements related to payments for client referrals must address under the new Marketing Rule.

General Scope of Marketing Rule with regards to Client Referrals[3]

One of the broad categories of marketing activities regulated by the Marketing Rule is the use of “endorsements or testimonials”[4], particularly those where an RIA provides cash or non-cash compensation, directly or indirectly, to the person providing the endorsement or testimonial (“Compensated Endorsements or Testimonials”). Referrals of investment advisory clients are among the activities included in the definition of endorsements and testimonials.

Thus, instead of treating payments for client referrals as a separate category of marketing activity subject to a separate set of requirements (like the current Cash Solicitation Rule), the Marketing Rule treats payments for referrals of investment advisory clients as simply one type of Compensated Endorsement or Testimonial. Likewise, the Marketing Rule adopting release refers generally to persons providing testimonials or endorsements for an RIA (including persons who the Cash Solicitation Rule would have referred to as “solicitors”) as “promoters”.[5] Notably, the Marketing Rule also broadens the scope of regulation to include referrals of investors in “private funds”[6] advised by an RIA, which were historically excluded from the scope of the Cash Solicitation Rule, within the definition of an endorsement or testimonial.

Under the Marketing Rule, Compensated Endorsements or Testimonials, including payments for referrals of investment advisory clients and for referrals of private fund investors, are permitted, but are subject to: (i) certain disclosure requirements; (ii) the RIA having a reasonable basis that the testimonial or endorsement is in compliance with the Marketing Rule; (iii) the RIA having a written agreement with the promoter, and (iv) the promoter not being an “ineligible person”.[7]

Disclosure Obligations

The Marketing Rule requires that certain disclosures be made at the time a Compensated Endorsement or Testimonial is made to a potential client/investor and that certain disclosures be made “clearly and prominently”. The required disclosures must be given by the RIA unless the RIA has a reasonable basis for believing that the promoter makes the required disclosures.

The RIA or promoter must clearly and prominently disclose:

• Whether or not the promoter is a current client or private fund investor;
• That cash/non-cash compensation was paid; and
• A brief statement of any material conflicts of interests resulting from the RIA’s relationship with the promoter.[8]

To meet the “clear and prominent” standard, the disclosures should be “within the testimonial or endorsement,” such that a potential client/investor receives the disclosures at the same time and with equal prominence as the testimonial/endorsement itself.[9]

In addition to the disclosures above that are required to be displayed “clearly and prominently”, the RIA or promoter also must disclose,[10] at the same time the testimonial/endorsement is made:

• The material terms of compensation provided to the promoter, including the specific type and amount of compensation to be paid to the promoter for the client engaging the RIA.[11]
• Detailed description of material conflicts of interest, including, without limitation, that the promoter has a conflict of interest due to the fact the promoter will receive compensation.[12]

–>KTS Practical Tips:

o RIAs should consider whether their existing agreements adequately address the Marketing Rule’s explicit requirements as to the timing and prominence of disclosures to be provided to referred clients/investors.

o To the extent that RIAs’ existing agreements include forms of the disclosures to be provided to referred clients, RIAs should review such disclosures for compliance with the Market Rule’s requirements, including, without limitation, disclosures regarding the material terms of the compensation payable to the promoter and appropriate descriptions of conflicts of interest.

o The Marketing Rule (unlike the current Cash Solicitation Rule) does not require that a promoter deliver the RIA’s Form ADV brochure. However, this requirement in the Cash Solicitation Rule was duplicative of the RIA’s delivery obligation under Rule 204-3 of the Advisers Act. Thus, while this requirement is not in the Marketing Rule, RIA’s nonetheless are still subject to the Advisers Act delivery obligation and may wish to continue to require that a promoter deliver the RIA’s brochure on their behalf.

Written Agreements and Ineligible Persons

The Marketing Rule requires that an RIA have a written agreement with any person providing a Compensated Testimonial or Endorsement that describes the scope of the agreed-upon activities and the terms of compensation for those activities. The Marketing Rule also provides that “ineligible persons” cannot be compensated by RIAs for making a testimonial or endorsement (i.e., solicitation activities).[13] “Ineligible Persons” include persons subject to an action on opinion or order barring, suspending, or prohibiting a person from acting in any capacity under the Federal securities laws or subject to any of five categories of actions, with a ten year look back period to the time the advertisement is disseminated.[14] To determine whether a corporate entity providing a testimonial or endorsement is an “ineligible person” requires consideration of whether certain control persons (e.g., managers, officers or directors) and employees are ineligible persons.[15] RIA’s should ensure that their agreements contain adequate representations and warranties from the promoter that the promoter is not (or none of their relevant control persons or employees are) an “ineligible person”, along with other representations and warranties regarding the promoter’s actions and status under other applicable laws and regulations.

–>KTS Practical Tip: The Marketing Rule provides that a promoter’s status as an ineligible person is measured from the time any advertisement is disseminated. Accordingly, RIAs should ensure that their agreements adequately address the need for ongoing confirmation of a promoter’s eligible status.

Adviser Oversight and Compliance

Unlike the Cash Solicitation Rule, the Marketing Rule does not require that a promoter obtain a signed and dated acknowledgment from a prospective client confirming that the disclosures were timely given.[16] However, the Marketing Rule does place an oversight burden on the RIA to ensure that it has a reasonable basis for believing that testimonials/endorsements comply with the requirements of the Marketing Rule, including the requirement that prospective clients timely receive the required disclosures.[17]

–>KTS Practical Tip: In order to create documentation of fulfilling their oversight requirements, RIAs may wish to maintain the practice of having promoters obtain a prospective client/investor’s signature, as this process would be documentation that the Prospective Client has received the disclosures. However, the absence of a signed acknowledgement requirement in the Marketing Rule may allow flexibility for RIAs and promoters to operate without the signature requirement, provided that the RIA takes, and documents, alternative steps to form a reasonable basis for concluding that prospective clients/investors timely received the disclosures.

Other Noteworthy Considerations

While the Cash Solicitation Rule, as its name suggests, only applied to cash payments for client referrals, the Marketing Rule defines “compensation” more broadly, including any form of quid pro quo arrangement, including, without limitation, traditional cash payments, various forms of fees (e.g., commission-based fees, asset-based fees), and non-cash compensation such as gifts, entertainment and advisory fee reductions.[18] RIAs should carefully consider whether they have any non-cash compensation arrangements related to client/investor referrals that would fall within the scope of the Marketing Rule.

RIAs should further note the recordkeeping requirements associated with the Marketing Rule, which, among other things, require that an RIA must make and keep records of all advertisements they disseminate (and certain alternative methods for keeping records of oral advertisements).[19]

***

As November 4, 2022, approaches, RIA should examine their existing agreements related to client referrals and consider the need to update these agreements in light of the Marketing Rule’s requirements.

While this Blog Post highlights a few items that RIAs should consider regarding their current client referral arrangements, each arrangement is different and must be analyzed on a case-by-case basis.

[1] SEC, Adopting Release, Investment Adviser Marketing, Release No. IA-5653; File No. S7-21-19, available at https://www.sec.gov/rules/final/2020/ia-5653.pdf, (hereafter, the “Adopting Release”).

[2] See Adopting Release at 86.

[3] We note, however, that there are exemptions from certain of the requirements discussed herein for testimonials/endorsements provided: (1) for no compensation or de minims compensation, (2) by affiliated persons of an RIA; or (3) by a registered broker-dealer.

[4] Testimonial: a statement by current client or private fund investor:

(i) About the client or investor's experience with the investment adviser or its supervised persons;

(ii) That directly or indirectly solicits any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the investment adviser; or

(iii) That refers any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the investment adviser.

Endorsement: any statement made by someone other than a current client or private fund investor that:

(i) Indicates approval, support, or recommendation of the investment adviser or its supervised persons or describes that person's experience with the investment adviser or its supervised persons;

(ii) Directly or indirectly solicits any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the investment adviser; or

(iii) Refers any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the investment adviser. See 17 CFR § 275.206(4)-1(e)(5) and (17).

[5] See Adopting Release at 8, footnote 6.

[6] See, e.g., 17 CFR § 275.206(4)-1(e)(1)(i). A “private fund” means an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a–3), but for section 3(c)(1) or 3(c)(7) of that Act. 15 U.S. Code § 80b–2(a)(29). Accordingly, the provisions of the Marketing Rule that apply to client referrals also apply to referrals of investors for private funds.

[7] See Adopting Release at 85.

[8] 17 CFR § 275.206(4)-1(b)(1)(i).

[9] See Adopting Release at 89-90. In the event of an oral testimony/endorsement with written disclosures – disclosures should be delivered at the same time, with equal prominence. See Adopting Release at 90.

[10] While the Marketing Rule allows for the RIA to make the disclosures itself, practical considerations suggest that due to the nature of promoter solicitations, it may be the promoter itself in the best position to make the required disclosures at the time of the solicitation.

[11] 17 CFR § 275.206(4)-1(b)(1)(ii). For example, must disclose if promoter will receive a fixed amount, a percentage of total adviser fee over a period of time (including the amount and the time period), and if the agreement provides for reimbursement of expenses. See Adopting Release at 172.

[12] 17 CFR § 275.206(4)-1(b)(1)(iii). There should be explicit disclosure that the promoter, due to the compensation, has an incentive to recommend the adviser, resulting in a material conflict of interest, and any other conflicts of interest based on the promoter’s relationship with the adviser that could affect the credibility of the testimonial or endorsement. See Adopting Release at 97.

[13] 17 CFR § 275.206(4)-1(b)(3).

[14] 17 CFR § 275.206(4)-1(e)(11). Registered broker-dealers are subject to the disqualifications under the Exchange Act and promoters involved in an offering for a private fund are subject to all the bad actor disqualifications under Rule 501.

[15] 17 CFR § 275.206(4)-1(e)(11).

[16] See Adopting Release at 111-112.

[17] See Adopting Release at 110. Accordingly, RIAs will need written policies and procedures that allow the RIA to ensure that the promoter properly provided the disclosures.

[18] See Adopting Release at 46-47.