Navigating Compensation Regulations for Alternative Investments: Do's and Don'ts for RIAs

Navigating Compensation Regulations for Alternative Investments: Do's and Don'ts for RIAs

Alternative investments such as private funds, private placements, non-traded REITs, and private credit have become increasingly popular among clients seeking diversification and higher returns. However, these investment types come with complex regulatory challenges, especially when it comes to compensation paid by issuers to Registered Investment Advisers (RIAs). Both the Securities and Exchange Commission (SEC) and state regulators scrutinize these compensation arrangements closely to ensure advisers uphold their fiduciary duties.

Understanding the regulatory landscape and how compensation practices differ between SEC-registered and state-registered RIAs is essential for compliance officers. This guide outlines the key do’s and don’ts to help RIAs navigate compensation rules while maintaining client trust and regulatory compliance.

The Universal Standard: Fiduciary Duty Applies to All RIAs

Regardless of whether an RIA is registered with the SEC or at the state level, the fiduciary duty remains the foundation of their responsibilities. This duty requires advisers to:

• Act in the best interest of their clients at all times

• Fully and fairly disclose any conflicts of interest

• Obtain informed consent from clients regarding those conflicts

• Mitigate or eliminate conflicts whenever possible

  
  

This fiduciary standard applies universally, but regulators differ in how strictly they enforce compensation-related rules, especially for alternative investments.

SEC-Registered RIAs Face Higher Scrutiny and Lower Tolerance

The SEC’s Division of Examinations has made alternative investment compensation a top priority. Their focus is on whether issuer-paid compensation creates conflicts that compromise the adviser’s duty to clients.

What the SEC Expects

• Treat issuer compensation as a presumed conflict: The SEC views compensation from issuers as inherently conflicting. Advisers must demonstrate why this compensation does not bias their recommendations.

• Implement institutional-grade controls: Even smaller advisers must have robust compliance programs to monitor and manage conflicts.

• Avoid transaction-based or success-based fees: The SEC strongly discourages compensation tied directly to investment performance or transaction completion, as these can incentivize advisers to recommend unsuitable products.

  
  

Key Do’s for SEC-Registered RIAs

• Disclose compensation arrangements clearly: Provide clients with full details about issuer-paid fees and potential conflicts.

• Document conflict mitigation efforts: Show how your firm manages or eliminates conflicts beyond disclosure.

• Conduct regular compliance reviews: Periodically assess compensation practices and update policies to align with evolving SEC guidance.

  
  

Key Don’ts for SEC-Registered RIAs

• Do not accept compensation that depends on investment success: This includes commissions or fees tied to fundraising milestones or performance.

• Avoid undisclosed compensation: Failing to inform clients about issuer payments can lead to enforcement actions.

• Do not ignore conflicts: Simply disclosing conflicts without managing them is insufficient under SEC standards.

  
  

State-Registered RIAs Have Different Expectations but Must Still Comply

State regulators also focus on compensation practices but often apply a more flexible approach compared to the SEC. However, fiduciary duty remains central.

What State Regulators Look For

• Reasonableness of compensation: States often assess whether fees are fair and reasonable relative to services provided.

• Disclosure and consent: Clear communication about compensation and conflicts is required.

• Conflict management: States expect advisers to have policies to address conflicts but may not require the same level of institutional controls as the SEC.

  
  

Do’s for State-Registered RIAs

• Provide clear disclosures: Explain issuer compensation and any related conflicts in client agreements.

• Obtain informed consent: Ensure clients understand and agree to compensation arrangements.

• Maintain documentation: Keep records of disclosures and consent to demonstrate compliance.

  
  

Don’ts for State-Registered RIAs

• Do not overlook conflicts: Even if state rules are less strict, ignoring conflicts can harm clients and invite regulatory action.

• Avoid excessive fees: Charging unreasonable compensation can trigger state enforcement.

• Do not rely solely on disclosure: States expect some level of conflict mitigation beyond just informing clients.

  
  

Practical Steps to Build a Defensible Compensation Program

To navigate these complex rules, RIAs should take proactive steps:

• Develop a written policy on issuer compensation: Clearly outline how your firm handles compensation from alternative investment issuers.

• Train staff regularly: Ensure everyone understands regulatory expectations and firm policies.

• Use compliance technology: Tools can help track compensation arrangements and flag potential conflicts.

• Engage legal counsel: Consult with compliance experts to tailor policies to your firm’s registration status and business model.

• Conduct mock exams: Prepare for regulatory reviews by simulating examinations focused on compensation practices.

  
  

Examples of Compliance in Action

• An SEC-registered RIA receives a referral fee from a private fund issuer. The firm discloses this fee in client documents, explains the conflict, and implements a review process to ensure recommendations are unbiased. This approach aligns with SEC expectations.

• A state-registered adviser accepts a flat fee from a non-traded REIT issuer. The adviser discloses the fee, obtains client consent, and documents the reasonableness of the fee relative to services. This satisfies state regulatory standards.

  
  
  
  

Compensation from alternative investment issuers presents clear risks to fiduciary duty, but with careful management, RIAs can maintain compliance and client trust. Understanding the differences between SEC and state rules helps advisers tailor their programs effectively.

By treating issuer compensation as a potential conflict, disclosing fully, obtaining informed consent, and implementing strong controls, advisers protect their clients and their firms from regulatory pitfalls.

Take the next step by reviewing your firm’s compensation policies today. Ensure your compliance program meets the highest standards and prepares you for regulatory scrutiny.