If you offer financial advisory services to your clients — either directly or through an investment advisor relationship — I urge you to review your policies, procedures and agreements soon since the rules have changed. The SEC’s new marketing rule (Rule 206(4)-1), which became effective 18 months ago, and required mandatory compliance as of Nov. 4, 2022, changes the way registered investment advisors must treat their compensation agreements for client referrals (aka “solicitor agreements”). It also changes how they can now use endorsements, testimonials and third-party ratings.
Chris Stanley, founding principal at Beach Street Legal in University City, Missouri, told me during a recent panel discussion that a “solicitor” means any person who, directly or indirectly, solicits any client for, or refers any client to, an investment adviser. “Soliciting a client and referring a client are often used interchangeably, but they are actually distinct activities,” noted Stanley. “To solicit” means engaging in sales activities to encourage a client to work with an advisor. “To refer” means introducing a client to an advisor, even if the solicitor does not convince, encourage or recommend the advisor.
According to the SEC, “a person could be a solicitor within the meaning of the rule if he or she supplies the names of clients to an investment advisor, even if they do not specifically recommend to the client that he or she retain that advisor, because a referral alone is sufficient to trigger solicit status even if it is not a full-borne solicitation itself.”
Under the new rules, investment advisors will now be able to supplement their existing advertisements with narrative-based testimonials and endorsements. In addition, investment advisors can utilize more creative ways to communicate and interact with clients and investors, including via oral presentations, recorded materials and social media. As part of these client communication changes, however, there are additional disclosure and recordkeeping requirements designed to help clients, investors and regulators better understand the advisor’s marketing activities and controls.
While performance-based advertisements will likely remain an area of intense focus for regulators, the expanded use of testimonials and endorsements will also draw intense interest. The expanded recordkeeping requirements set forth in the new marketing rule will also put more pressure on an advisor’s legal, compliance and investor relations personnel to maintain and produce records in new areas of communications.
Under the new rule, endorsements (from nonclients) or testimonials (from clients), including payments for referrals of investment advisory clients and for referrals of private fund investors, are permitted, but they 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 (if more than de minimis compensation is paid); and (iv) The promoter not being an “ineligible person” (if more than de minimis compensation is paid).
Stanley said that until the new marketing rule was passed, advisors were not allowed to use “nice comments” made on their behalf by clients (i.e., testimonials) or by nonclients (i.e., endorsements). Now within reason they are.
Clearly, what the SEC is getting after, is the fact that a testimonial or an endorsement very specifically is inclusive of referral activity. “And that’s where firms need to be mindful of how we actually account for [the marketing rule] in our referral relationships?” noted Stanley. “Are we actually engaging in activity already that might be considered a testimonial or endorsement? How do we objectively update our policies and procedures or agreements, etc., to account for that?” asked Stanley.
New rules on CPA-to-investment advisor referrals
For example, an informal relationship between a CPA and an investment advisor, in which client referrals are occasionally exchanged, and for which no direct or indirect compensation is paid, will have a reduced compliance burden compared to a more formalized relationship in which there is direct (or indirect) compensation paid in consideration for the referral. Whether it’s a one-time payment, a revenue-sharing arrangement, an expensive gift or even the provision of free investment advisory services to the referring CPA, if the compensation or benefit is tied to (or contingent on) the referral, then a higher compliance burden will apply. Inevitably there’s going to be a “gray area” in which there are incidental dinners or other activities, asserted Stanley. “Professionals refer business to each other all the time. It’s not uncommon for them to get together for dinner or entertainment outings. But, if there is an explicit [compensation] relationship, whether it’s cash, fee offsets or other benefits, those are intended to be captured by the rule. That’s because the relationship creates a conflict of interest,” he added.
It doesn’t mean advisors can’t send holiday gifts to clients, or lower their advisory fees generally, or can’t treat their clients nicely and express their appreciation. The key, said Stanley, is that they “cannot pay direct compensation in consideration for the referral.” For example, if an advisor has a program in which they tell clients: “I’ll lower your advisory fee by five basis points for $1 million you refer to us,” that’s the key. But sending them a nice wine gift basket around the holidays is not a problem. “If you feel your fees are above market and you’re doing a fee-lowering exercise to bring yourself into a more competitive position, that’s totally permissible,” said Stanley. “But regulators are looking for the nexus between the compensation of the benefit and the generation of the referral.”
Most states specifically include solicitation activity as an activity that requires some combination of licensing, registration and qualification as an investment advisor representative. This could entail, for example, passing the Series 65 exam (or qualifying with a professional exemption like the CFP marks or CFA designation), registering as an IAR of an existing RIA and filing a U4, or registering a new RIA through which to engage in solicitation and referral activity for compensation.
However, not all states consider either in-house or third-party solicitors to be investment advisor representatives (as defined by the particular state). And not all states require licensing or registration of in-house or third-party solicitors. Missouri, for example, explicitly does not require solicitors to register as investment advisor representatives. California, on the other hand, requires solicitor registration as an investment advisor representative but does not necessarily require that the solicitor qualifies as such by taking the series 65.
North Carolina effectively eliminates the entire concept of third-party solicitors and requires solicitors to register as investment advisor representatives with the RIA for which they are soliciting. In other words, all solicitors to North Carolina RIAs must be in-house solicitors and registered or supervised accordingly.
Georgia excludes CPAs and attorneys licensed in Georgia that solicit their own preexisting accounting or legal clients on behalf of an RIA from the definition of investment advisor representative and also has what amounts to a “de minimis” threshold that permits any other Georgia resident to solicit on behalf of an RIA as long as the annual clients solicited is capped at 10.
New Mexico exempts solicitors from registering as investment advisors or investment advisor representatives as long as such solicitors only receive a one-time payment in consideration for the solicitation activity.
Texas is an example of a state that clearly distinguishes between solicitors to state-registered advisors, and solicitors to SEC-registered advisors, as well as in-house and third-party solicitors. Texas-based solicitors should review the helpful FAQs on this topic posted to the Texas State Securities Board’s website.
For CPAs and investment advisors, look carefully at your existing referral agreements. Make sure you’re not offside with respect to any qualification, licensing or registration obligations. And this is a good time just to make sure you’re in a good position to comply fully with the new marketing rule going forward.