Revenue Sharing - Paying

Welcome, thank you all for joining our webinar today hosted by MyComplianceOffice and Cipperman Compliance Services. With that I'll hand it over to Todd. Thank you.

We're going to talk a little bit about the advisors act requirements, but some of the state rules, some various ways what I call backdoor payments, ways people have paid affiliated broker/dealers, aiding and abetting liability, and again I'm going to talk a little bit about wrap programs. One of the rules, so obviously one side of this is very simple if you're paying someone to be in your product you got the issue of whether or not that payee needs to be a broker/dealer. Many people take the view if a fund, whether it's a public fund, or a private fund pays a third party that third party needs to be a registered broker/dealer, and you can only pay a registered broker/dealer. That's a whole line of cases we can talk about, but it's certainly an issue you should be aware of. But there are others particularly in the separate account context when you get outside sort of the fund world, in a separate account context what happens if an advisor product sponsor wants to pay a third party advisor to bring assets?

There's a rule, essentially under the advisors act the black letter is you're prohibited, you're not allowed to pay for solicitors, and here's the big except. Except if you follow the solicitation rule. For those of you that don't know that's rule 2064-3. The solicitation rule has specific requirements. If you're going to pay a third party solicitor advisor there are certain things you have to do, and certain things you have to follow. I won't go into each one. One is the solicitor the payee cannot have any sort of bad boy actions against it, him, or her, no enforcement orders, et cetera. You also have to have a written agreement with each solicitor, which has to have certain, as I call, magic words. It has to definitively describe the solicitation activities the solicitor is going to do, require the solicitor follow specific instructions if the payer requires them, and probably most significantly requires the solicitor to deliver the payers form [ADV 00:17:56] to the end clients.

Now, that's sort of easy. Here's where the hard part comes in. The solicitation rule, the underlying fear behind it is the solicitor has a conflict of interest when talking to an end client, the end client may not know that the solicitor has a conflict. Rule 20643 requires the solicitor to get a disclosure statement signed by the end client acknowledging that that end client is getting paid from a third party, and also describing in fairly specific terms the amount being paid, and you need to also indicate whether or not the total advisory fee is going up, because of those solicitation fees. What's really important from a compliance perspective is that the payer collects those disclosure statements. Because if the SEC comes into your shop, and sees you're paying solicitors they want to see that the end clients have signed those disclosure documents, and it's a one pager that says they acknowledge that the solicitor is getting paid. Then it's a very common deficiency if you don't get those.

Obviously if something really goes wrong it can result in enforcement action. Very often they can be done easily. You can even actually roll in solicitation disclosure into an investment advisory agreement, so a paragraph that says, hey, I understand that so and so described on exhibit A made such and such described on exhibit A, and I'm okay with it. That's one way of handling it. But those disclosure statements are really important from a compliance perspective, and you got to maintain those for any kind of exam. One thing that comes up a lot with solicitation disclosure, and third party payees is the registration requirements. What are the rules around ... What if you are paying a solicitor, do you care about that solicitor's particular licensing and registration requirements usually under state law? Must they be a broker/dealer? Must they be a registered investment advisor? The truth is if you're paying a commission amount on the selling of a fund it's very likely that that other side of the transaction has to be affiliated with a registered broker/dealer, and it has to have at least their series six, or series seven.

If it's separate account assets most states require that solicitors for advisory services have to become an investment advisor themselves, and usually it'll be a state registered advisor. Simply because they won't have 100 million dollars in assets under management. Now do you care? Certainly if you're the payee you care, and I get asked a lot, "Well if I'm a solicitor do I have to register?" Most states have a five client de minimis, so if you do it for fewer than five clients in a state you may be able to avoid registration. But if you're in the solicitation business you're a third party marketer, yeah you're going to have to register to take solicitation payments. Then the question becomes does the payer have any liability, or can you just put something in the agreement which says hey you acknowledge that you have all necessary legal requirements met?

There's this case [inaudible 00:21:04] which came up I think about a year ago where the payer was held to be aiding and abetting the failure of the payee to register as a broker/dealer. There was all kinds of evidence that they helped them solicit by supplying PPMs and marketing materials. Essentially the SEC saying they weren't hands off enough. There's always this issue about how much do you want to know. I'm not saying you should be willfully blind, but if you're heavily involved with helping a third party marketer, and you have actual knowledge that they should be registered and they're not you can't avoid liability just by saying they repped to me that everything was okay. It becomes a you want to be careful of how you deal with third party marketers. Obviously if you're paying a third party marketer it's either a broker dealer payment or some sort of solicitation payment, but there's all kinds of what I call backdoor revenue sharing where people try to hide it. This gets really bad, because when you try to hide things to avoid regulatory requirements it always gets you in a lot of trouble.

I'm going to cite the raffle case which came recently. This is sort of the sham invoice case, so there's lots of schemes out there. You know what I'm a solicitor, I don't have to register as an investor and advisor is there anyway we could just sort of back into these numbers. I'll do quote services for you, and we'll just back into the number, and we'll pay a fee. The raffle case had to do with sham legal invoices where a lawyer was serving as a solicitor. Interesting the lawyer may not have had to register anyway, there wasn't an acception from state registration, but instead of paying a solicitation fee, and complying with 20643, the lawyer sort of create sham legal invoices that backed into the acid base number, and actually the SEC went after the CEO of the payer, because he tried to hide this, even during the SEC exam, and he got in trouble. Not really for the 20643 violation, but for misleading the SEC. There's a lot of these kind of cases out there the sort of let's sham consulting invoices. You see that periodically, and the SEC really does see right through that.

Another sort of scheme you see out there is you send commissions to an affiliated BD. I cite the Gavornik case, Gavornik, G-A-V-O-R-N-I-K. Essentially the way they worked out the advisory had an affiliated broker/dealer that they wanted to send revenue to, and what they did was they paid them an override, so the third party clearing firm made X amount for every trade, and all the additional amount went to their affiliated broker/dealer. That was essentially as not disclosed properly in the ADV. Another form of sort of implicit revenue sharing. Actually the CCO got in trouble for that, because the argument was it wasn't proper. The CCO was responsible for the ADV, and the CCO did not properly include the disclosure.

Okay, so before leaving revenue sharing I do want to talk a little bit about wrap programs. Simply because there's been a lot of cases out there about wrap programs. Just in a nutshell I'm defining wrap as sort of these programs with one fee at the program level that includes all the trading, and advisory that underlies that. You can have mutual fund wrap, and you can have separate account wrap. A couple of big cases, a very recent was the Stifel Nicolaus case essentially this was sort of a trading away case in a non traditional sense. Essentially what happened, which is not unusual in wrap programs Stifel allowed the third party sub advisors to place trades with firms outside Stifel, which has an affiliate broker/dealer. As a result the end clients actually paid additional amounts, and additional wrap fee. If they had used the affiliated broker/dealer it would've been all included in the fee.

Essentially, and the reason the SEC has a problem with that is one it benefited Stifel Nicolaus on the theory that if they didn't have to place the trades essentially the program becomes more profitable. They had sort of a financial incentive to allow trading away. Two there was an implication that they were essentially trying to help the advisors, the third party advisors, and broker/dealers, because a lot of these advisors got soft dollar research and such, and then of course the broker/dealers perhaps would be more incented to send people to the programs, so it was a back door revenue sharing. There's been a bunch of other cases in the wrap context abut trading away.

You should all take a look, if you do wrap programs take a look at the Royal Alliance case, which had a couple of different, they had the trading away issue, they also had a revenue sharing issue, but the big deal in the Royal Alliance case was the SEC was very critical of Royal Alliance for very often using B shares, which did not have a front end load, but had a 12B1 as opposed to A shares, which had a front end load. The argument that Royal Alliance made was a lot of clients didn't want a A share with a front end load, and the SEC looked at that and said, "Well, if you look historically a lot of those clients would've been better off in A shares, even if they paid a front end load." It was a sort of retroactive enforcement saying, "Hey, you got to make a decision as to what's going to be right for the client over the long term. Not just right up front." Yet another sort of twist to this. Revenue sharing incentive to use certain funds, but also you got to think about this over time as a fiduciary, not just at the point of sale, but what's better for the client over time.

Just to point a wrap, and I will tell you the SEC has been very aggressive on wrap program enforcement. They've been all over this. If I had editorialized I don't think they particularly like wrap programs, and they've been very critical, and they brought a lot of cases in the wrap context. That's a brief overview of some issues about paying and receiving revenue sharing. We're going to sort of change topics a little bit although the basic concept the same, and we're going to move to pay to play. Which is sort of a revenue sharing in a defined context.