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5 Guideposts for RIAs to Comply With SEC’s Change of Control Rules

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In some form or another, nearly every registered investment advisor will at some point be involved in a merger, acquisition, sale, or restructuring. Whether it’s a simple equity ownership stake by a new financier, the addition of a new partner, a union of two practices, the death of a major shareholder or the full-blown execution of a succession plan, RIAs will inevitably need to navigate SEC “change of control” rules and guidance.

Such rules and guidance are rooted in the requirement that investment advisory contracts may not be assigned without client consent. I discussed the interplay of positive and negative consent a few years back in this article, but left open the question of what actually constitutes an “assignment” that would necessitate client consent. Said another way, what types of mergers, acquisitions, sales, or restructurings are considered an assignment of an advisory contract and therefore require client consent?

For starters, the SEC attempts to define “assignment” in the very first definition of the Investment Advisers Act, Section 202(a)(1): “Assignment includes any direct or indirect transfer or hypothecation of an investment advisory contract by the assignor or of a controlling block of the assignor’s outstanding voting securities by a security holder of the assignor […]”. 

There are a few more sentences specific to partnerships, but we’ll address that later. The general concept of the “assignment” definition is that there are essentially two situations in which an assignment is deemed to have occurred: (1) when advisory contracts are transferred to another RIA or pledged as collateral, or (2) The equity ownership structure of an RIA changes such that a “controlling block” of the RIA’s outstanding voting securities changes hands.

Both situations would trigger the need for client consent. 

With respect to #2, the logical next question is: what constitutes a “controlling block?” What percentage of voting equity interest needs to change hands for the SEC to care? Unfortunately the SEC does not define “controlling block”, but we can cobble together an understanding from a few different guideposts.

The first is Section 202(a)(12) of the Advisers Act, which defines “control” as “the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company”. This is only moderately helpful since “controlling influence” is still left undefined, but at least we can discern that such control should be in relation to management of the RIA or its policies. And just because somebody employed by an RIA has a fancy title doesn’t mean he or she automatically has control over the RIA.

The second is the instructions to Form ADV Part 1, the glossary to which presumes that RIA equity owners with the right to vote 25% or more of the securities of that RIA “control” that RIA. Under this framework, the following persons would be deemed to control an RIA: 

    1. A corporate stockholder that owns 25% of its voting stock
    2. A LLC member that owns 25% of its voting membership units, has contributed 25% of the capital, or has a right to receive 25% of the capital upon dissolution
    3. A partner that has contributed 25% of the partnership’s capital, or has the right to receive 25% of the capital upon dissolution 

The third is actually the section that defines “control” in the Investment Company Act (applicable to mutual funds), not the Advisers Act. In Section 2(a)(9), the SEC establishes a rebuttable presumption that “any person who owns beneficially, either directly or through one or more controlled companies, more than 25% of the voting securities of a company shall be presumed to control such company”. Though technically not applicable to RIA change of control scenarios, many have looked to this percentage as a helpful guidepost regardless.

The fourth is SEC Rule 202(a)(1)-1, which states that “a transaction which does not result in a change of actual control or management of an investment advisor is not an assignment for purposes of section 205(a)(2) of the [Investment Advisors] Act”. This mainly applies to reorganizations, and the SEC cites a scenario in which an RIA changes its state of incorporation as one example of a transaction that would not constitute a change of control.

The fifth and final guidepost is several no-action letters that, though fact-specific to the complex transactions described therein, generally stand for the proposition that the SEC is ultimately concerned with the “trafficking” in investment advisory contracts to the detriment of investors. So long as there is no actual change in control or management of an RIA, the trafficking concern is moot.

And for RIAs Organized as Partnerships…

Minority partners that are admitted to the partnership, die, or otherwise withdraw from the partnership do not trigger an advisory contract assignment. That said, any change in the membership of the partnership triggers a client notification obligation within a reasonable time. 

This is all a tortuous way of saying that determining whether or not an advisory contract assignment or change in control has occurred may not be as straightforward as it seems. Complete lift-outs or cash-for-stock transactions are likely a no-brainer, but private equity infusions, partial buyouts and certain mergers likely require a more nuanced analysis.

The 25% voting security threshold is by analogy only, and higher or lower thresholds may very well be justified given the right facts.

When in doubt, simply send clients a negative consent to borderline control changes (assuming your advisory contracts permit negative consent) and let them decide whether or not to continue the advisory relationship.

Additional Compliance Advisor blogs by Chris Stanley:


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