The Office of Chief Counsel, Division of Investment Management of the Securities and Exchange Commission (the “SEC”) has issued an Interpretative Letter (the “Interpretative Letter”) dated July 15, 2008, clarifying its position concerning the applicability of Rule 206(4)-3 under the Investment Advisers Act of 1940 (the “Advisers Act”) in the context of a fund or other investment pool. In the Interpretative Letter, the SEC indicated that it believes Rule 206(4)-3 does not generally apply to a registered investment adviser’s cash payment to a person for soliciting or referring investors for an investment pool managed by that adviser since these investors are not “clients” of the investment adviser.
Rule 206(4)-3 of the Advisers Act (sometimes referred to as the “Cash Solicitation Rule”), prohibits a registered investment adviser from paying a cash fee, directly or indirectly, to any person or company for soliciting or referring clients to such adviser, unless the conditions of Rule 206(4)-3 are satisfied. This Rule is intended to address possible conflicts of interest in cash solicitation arrangements and the need for full disclosure of the arrangements between the solicitor and the investment adviser.
In previous no action letters, such as Dana Investment Advisers, Inc. (October 12, 1994), the SEC had indicated that Rule 206(4)-3 would be applied to investment advisers hiring a person to solicit or refer investors for an investment pool managed by the investment adviser. In such no action letters, the solicited or referred investors were considered indirect clients of the investment adviser because they were subject to the advisory fee charged by the investment adviser for managing the investment pool.
In the Interpretative Letter (Mayer Brown LLP), the SEC stated that it believes that Rule 206(4)-3 does not generally apply to a registered investment adviser’s cash payment to a person solely to compensate that person for soliciting or referring investors for an investment pool which the investment adviser manages. Although the Rule literally could apply to such payments, the SEC indicated that it does not believe such an application was intended and cited three bases for its belief. First, neither of the releases proposing and adopting the Rule contained a statement suggesting such an application. Second, by its terms, the Rule was “designed” to apply to solicitations that might result in the solicited person signing an investment advisory contract with the investment adviser. Investors in investment pools do not “typically” sign investment advisory contacts with the investment adviser for the pool. Finally, in the SEC’s view, the use in the Rule of the terms “client” and “prospective client”, instead of “investor” and “prospective investor”, also “strongly suggests” that the Rule was intended to apply to solicitations and referrals that might result in the signing of an investment advisory contract, which, again, is not typically the case when an investment adviser hires a person to solicit or refer investors for a investment pool it manages.
In the Interpretative Letter, the SEC noted that its analysis of Rule 206(4)-3 is supported by Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), the decision of the United States Court of Appeals for the District of Columbia Circuit which vacated a number of rules and rule amendments under the Advisers Act. The court in Goldstein found that, for the purposes of Section 206 of the Advisers Act, investors in a pooled investment vehicle are not “clients” of the pool’s investment adviser. The SEC stated that references in Rule 206(4)-3 to “client” and “prospective client” should have a similar interpretation.
In the Interpretative Letter, the SEC cautioned that whether a registered investment adviser’s cash payment to a person solely to compensate for soliciting or referring investors for an investment pool which the investment adviser manages, and therefore whether Rule 206(4)-3 applies, will depend on the facts and circumstances of the particular situation. In its view, the “most pertinent facts and circumstances” would relate to the arrangement between the solicitor and the adviser, the nature of the relationship between the adviser and the prospective investor, and the purpose of the cash payment.
The Interpretative Letter does not address whether the person accepting compensation under such an arrangement would be considered a “broker” under the Securities Exchange Act of 1934.