United States: SEC Adopts New Framework for Investment Adviser Marketing

Baker McKenzie Webinar Series

We invite you to join us on Wednesday, January 6 at 3 pm EST to discuss this New Framework for Investment Adviser Advertising. This is the first of a series of webinars we will host to discuss the different aspects of the Marketing Rule and help our clients prepare for implementation.

In more detail

The final rule transforms the existing regulatory framework by merging the existing Advertising Rule and Solicitation Rules together to create a single rule that governs the full spectrum of investment adviser marketing activities. At a high level, the new Marketing Rule:

• Abandons the proposed requirement for advisers to review and approve all advertisements prior to dissemination, a proposed provision that was highly controversial
• Expands the definition of an advertisement, but excludes one-on-one communications and extemporaneous, live, oral communications
• Applies to communications to prospective clients and investors and offers of new investment advisory services to current clients and investors; however, does not apply to communications designed to retain existing clients and investors
• Does not distinguish between retail and non-retail investors However, the Rule does expressly apply to communications directed to investors in private funds managed by the adviser.
• Eliminates the current prohibitions on the use of testimonials and past specific recommendations, and adopts general content standards based on anti-fraud principles.
• Requires the presentation of net and gross performance side by side and includes additional guidelines for standardized time periods, related performance and extracted performance, but does not dictate the methodology for calculating performance
• Does not prohibit the use of hypothetical performance, but requires advisers to adopt policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the audience, and to disclose the criteria, assumptions, risks, and limitations. The final rule excludes investment analysis tools used by investors from the definition of hypothetical performance.
• Expands the concept of testimonials and endorsements to include solicitation and referral activities, and removes the disclosure delivery and client acknowledgement requirements that currently apply to referral arrangements
• Requires that paid testimonials and endorsements (over the USD 1,000 de minimis threshold) include clear and prominent disclosure of the relationship between the solicitor (or, as the Marketing Rule frames the role, “promoter”) and adviser, direct and indirect compensation, and material conflicts relating to relationship and compensation.
• Expands the disqualification requirements that apply to promoters and covers both cash and non-cash compensation.
• Eliminates the exception for registration for promoters, forcing them to consider whether their referral activities require investment adviser registration
• Updates applicable recordkeeping requirements and withdraws various no-action letters that are either incorporated into the Marketing Rule, or will no longer apply

No requirement for prior review and approval of advertisements

The final rule does not require advisers to review and approve all advertisements prior to dissemination or to retain a copy of all written approvals. Instead, advisers retain the flexibility under the Compliance Rule (Advisers Act Rule 206(4)-7) to design appropriate internal controls governing the review and approval of advertisements based on their business.

For advisers, this is a welcome reversal from the proposed rule. Many commentators criticized the proposed pre-use review requirement as being unworkable and costly. However, Commissioners Lee and Crenshaw made clear in their public statement that the decision to eliminate the pre-use review requirement “is a missed opportunity to promote better compliance in this critical area, and will likely place advertisements on the list of examination and enforcement priorities for years to come.”

Expanded definition of advertisement

The expanded definition of an advertisement contains two parts. The first part covers communications that offer investment advisory services with regard to securities. The second part, which is discussed below, covers paid testimonials and endorsements – essentially, referral activity that was previously governed by Advisers Act Rule 206(4)-3.

Under the first part of the definition, an advertisement is “[a]ny direct or indirect communication an investment adviser makes to more than one person . . . that offers the investment adviser’s investment advisory services with regard to securities to prospective clients or investors in a private fund advised by the investment adviser or offers new investment advisory services with regard to securities to current clients or investors in a private fund advised by the investment adviser.” The second part of the definition covers “any endorsement or testimonial for which an investment adviser provides compensation, directly or indirectly.”

The scope of the definition of an advertisement is key because it establishes the universe of communications subject to the Marketing Rule. There was great concern that the proposed rule would have covered virtually every communication with existing and prospective clients and investors; however, the definition of an advertisement in the final rule reflects a more refined and workable approach.

One-on-one communications are not covered. The final rule retains the exception for one-on-one communications – meaning that communications sent to only one person should not be considered advertisements. The concept of a single person extends to multiple investors that share the same household, as well as multiple natural persons representing a single entity or account. The one-on-one exception does not apply to communications (such as form letters and bulk emails) that are nominally “addressed” to one person or include basic information about an investor, but actually are widely distributed. In addition, “duplicate inserts” that are included in an otherwise customized communication would still be subject to the Marketing Rule because they are sent to more than one person.

Communications containing hypothetical performance do not qualify for the one-on-one exception, except in cases where the hypothetical performance is provided in response to an unsolicited investor request (where an investor is seeking the information for their own purposes) or to a private fund investor (because the investor will have the opportunity to ask questions and assess the limitations of this information during a one-on-one interaction).

Direct and indirect communications. The final rule reformulates the proposed concept of communications “by or on behalf of the adviser” to address any “direct or indirect communication an investment adviser makes.” This includes communications sent by the adviser directly, as well as those that are distributed by intermediaries, consultants, other advisers and promoters. Third-party content may also be attributable to the adviser if the adviser explicitly or implicitly endorses or approves the information after its publication (adoption), or involves itself in the preparation of the information (entanglement).

Ultimately, it is a facts and circumstances analysis as to whether a communication was made by the adviser or whether the adviser should be responsible for third-party content.

In the social media context, the final rule aligns with existing guidance around responsibility for third-party content. An adviser will generally not be responsible for hyperlinked third-party content, unless the adviser knows or has reason to know that third-party content is fraudulent or misleading. An adviser will not be responsible for content posted by third parties on the adviser’s own website so long as the adviser does not selectively delete or alter the comments or their presentation, even if the website gives the adviser the ability to do so. Finally, personal social media posts by associated persons generally will not be attributed to the adviser if the adviser adopts and implements policies and procedures reasonably designed to prevent associated persons from using their personal social media accounts to market the adviser’s services.

Communications to existing investors are not covered. The final rule focuses on communications that offer investment advisory services to prospective clients and investors in private funds, and that offer new or additional investment advisory services to current clients and investors. This formulation effectively excludes communications intended to service existing clients and investors or to provide and report on the advisory services.

Brand communications, general educational information and market commentary are not covered. Importantly, the final rule narrows the definition of an advertisement to focus on communications that “offer advisory services.” This means that more general “brand” content relating to statements about a firm’s culture, philanthropy and community activity, as well as displays of the advisory firm’s name that are simply designed to raise the profile of the adviser would not be covered by the Marketing Rule, so long as they do not offer advisory services. Similarly, communications that provide only general educational information and market commentary generally would not be considered advertisements.

Extemporaneous, live, oral communications are excluded. In recognition of the difficulty of ensuring compliance with the Marketing Rule and in an effort not to chill communications with investors, the final rule excludes extemporaneous, live, oral communications. The exception applies to verbal communications that are “live” meaning effectively that the adviser does not have the time to review and edit the communication before dissemination. However, the exception does not apply to instantaneous written communications (e.g., text messages, chat), nor does it cover prepared remarks, speeches, slides or other written materials distributed to investors as part of a presentation or seminar.

Regulatory communications are excluded. The final rule excludes information contained in a statutory or regulatory notice, filing or other required communication; provided, that such information is reasonably designed to satisfy the requirements of such notice, filing or other required communication. Thus, information that goes beyond the explicit requirements of the regulatory requirement would not be covered unless it actually offers advisory services.

“Buh bye” solicitation rule

Rather than retain a separate rule governing solicitation arrangements, the SEC expanded the definition of testimonials and endorsements to include solicitation activities and rescinds the Solicitation Rule (Rule 206(4)-3). Testimonials refer to statements by current clients or investors about the client or investor’s experience with the investment adviser or its supervised persons. Endorsements refer to statements by a person other than a current client or investor that indicate “approval, support or recommendation of the investment adviser or its supervised persons or describes that person’s experience with the investment adviser or its supervised persons.” Importantly, both definitions now cover statements that “directly or indirectly solicits any current or prospective client or investor…or refers any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the investment adviser.”

In taking this approach, the SEC eliminates the distinction between paid advertisements and lead generation, on the one hand, and referral or solicitation arrangements, on the other. Under the final rule, any paid testimonial or endorsement (in excess of the USD 1,000 de minimis) is essentially considered a solicitation arrangement that is subject to additional requirements under the Marketing Rule so long as the compensation is paid, directly or indirectly, for the testimonial or endorsement.

Cash and non-cash compensation is covered. The concept of compensation now extends to any type of cash and non-cash compensation that is provided in exchange for a testimonial or endorsement. Non-cash compensation includes directed brokerage, sales awards or other prizes, gifts and entertainment. Compensation does not include regular salary or bonuses paid to an adviser’s personnel for their investment advisory activities, or attendance at training and education meetings, provided attendance at these meetings and conferences is not in exchange for solicitation activities.

The SEC believes the timing of compensation is relevant to determining whether an adviser is providing compensation for the testimonial or endorsement, but it declined to provide guidance around either the timing of the compensation or the establishment of a mutual understanding as to whether any such compensation is provided in exchange for testimonials or endorsements.

Inclusion of one-on-one and extemporaneous, live, oral communications. It is important to note that, unlike the first part of the definition of an advertisement, the second part of the definition (which covers any paid testimonial or endorsement) does apply to one-on-one communications and extemporaneous, live, oral communications.

Clear and prominent disclosure. The new Marketing Rule eliminates the prior requirements that solicitors deliver a separate written disclosure statement and Form ADV to prospective clients at the time of the solicitation, as well as the obligation for advisers to receive and retain a signed client acknowledgement of receipt of those documents. Instead, the adviser or promoter needs to clearly and prominently disclose: (i) whether the person giving the testimonial or endorsement is a client or non-client; (ii) that cash or non-cash compensation was provided; (iii) the material terms of any compensation arrangement, including a description of the compensation and the amount of that compensation; and (iv) any material conflicts on the part of the person giving the testimonial or endorsement. These disclosures must be made at the time the testimonial or endorsement is disseminated.

The clear and prominent standard requires the relevant disclosures to be included within the testimonial or endorsement – so that the statements and the related disclosures are read at the same time. The SEC believes that these disclosure can be provided succinctly within the testimonial or endorsement, while other disclosures that are not “integral” to the testimonial or endorsement can be provided by hyperlink.

Adviser oversight and compliance. Any testimonial or endorsement, regardless of whether it is paid or unpaid, is subject to adviser oversight and compliance. Specifically, an adviser must have a reasonable basis for believing that any testimonial or endorsement complies with the Marketing Rule. This reasonable basis could involve making periodic inquiries of investors or pre-reviewing testimonials or endorsements, or imposing contractual limitations on the content of those statements.

Written agreement. Paid testimonials and endorsements above the de minimis requirement are subject to the further requirement that the adviser enter into a written agreement with the promoter that describes the scope of the solicitation or referral activities and the compensation.

Disqualification and ineligible promoters. The Marketing Rule prohibits investment advisers from compensating a promoter for a testimonial or endorsement if the adviser knows, or in the exercise of reasonable care, should know, that the promoter is subject to certain disqualifying SEC actions or disqualifying events at the time the testimonial or endorsement is disseminated. The rule does not require advisers to monitor the eligibility of promoters on a continuous basis. Employees, officers, and directors of an ineligible person (or any other individuals with similar status or functions) are also considered disqualified persons that may not be compensated by the adviser for testimonials and endorsements. Unlike the proposed rule, the Marketing Rule’s definition for ineligible person does not include a disqualified person’s control affiliates. There are certain exceptions under which the Marketing Rule defers to existing disqualification regimes under the Exchange Act and Rule 506(d) of Regulation D with respect to certain promoters in order to avoid duplicative and inconsistent disqualification provisions. The Marketing Rule also provides for a 10-year lookback for disqualifying events and a conditional exemption that permits a promoter to receive compensation if the SEC has issued an opinion or order to that effect.

Regulatory status of promoters. The SEC withdraws its long-standing position that a solicitor is an associated person of an investment adviser and therefore is not required to register individually under the Advisers Act, solely with respect to its solicitation activities, but does not replace this position with an analogous equivalent for promoters. Rather, the guidance notes that, depending on the facts and circumstances, a promoter may be acting as an investment adviser (e.g., in advising clients on the selection of an investment adviser), or as a broker-dealer (e.g., when soliciting investors for a private fund). There is no presumption of investment adviser or broker-dealer status. Instead, promoters will have to consider whether their activities require registration under federal and/or state securities laws.

Affiliated personnel. Testimonials and endorsements provided by affiliates will not be subject to the requirement for a written agreement or the disqualification requirements, so long as the affiliation between the adviser and its affiliated person is readily apparent to, or is disclosed to, the client.

General (content standards) prohibitions

Rather than continuing to rely on general anti-fraud provisions, the final rule includes a number of “general prohibitions” designed to provide greater clarity around misleading advertising practices. These general prohibitions make it unlawful for an investment adviser to disseminate advertisements that include:

• Untrue statements or omissions
• Unsubstantiated statements of material fact
• Untrue or misleading implications or inferences
• Statements that discuss potential benefits connected with or resulting from an investment adviser’s services or methods of operation without providing fair and balanced treatment of any material risks or material limitations associated with those benefits
• References to specific investment advice that are not fair and balanced
• Statements that include or exclude performance results, or present performance time periods, in a manner that is not fair and balanced
• Statements that are otherwise materially misleading

Of particular note is that past specific recommendations are no longer prohibited. Rather, the general prohibitions around communications that are not fair and balanced would govern communications that refer to specific favorable or profitable past specific recommendations, including case studies. These provisions prevent “cherry-picking” – the practice of highlighting specific advice without providing sufficient information and context to evaluate the merits of that advice. Advisers have flexibility to determine how best to meet the fair and balanced standard, and although they can rely on practices developed under the no-action letters governing past specific recommendations, they have the flexibility to rely on other practices.

The Marketing Rule abandons the proposed distinctions between retail and non-retail investors; however, the SEC does explain on more than one occasion that the nature and sophistication of the audience is an important factor in considering the relevant facts and circumstances that determine whether an adviser is complying with the Marketing Rule. Depending on the audience, more or less detailed disclosure may be appropriate.

Third-party ratings

The final rule permits advisers to advertise ratings or rankings provided by a third party that is not a related person, so long as the third party provides ratings in the ordinary course of its business. In order to show the ratings, the adviser must have a reasonable basis for believing that any questionnaire or survey used in the preparation of the rating easily permits a participant to provide favorable and unfavorable results, and is not designed or prepared to produce any predetermined result. The SEC clarified that obtaining the actual survey or questionnaire used in the preparation of the rating is not the only way to satisfy this requirement. The adviser could seek representations from the third party or rely on information the third party makes available about its survey methodology.

The advertisement also must clearly and prominently disclose: (i) the date on which the rating was given and the time period on which the rating is based; (ii) the identity of the third party that created and tabulated the rating; and (iii) if applicable, that compensation was provided directly or indirectly by the adviser in connection with obtaining or using the third-party rating. Like testimonials and endorsements, the disclosure requirement applies to both cash and non-cash compensation.

Performance advertising

The final rule does not dictate the methodology required to calculate performance, but it does incorporate specific requirements that apply to performance advertising. Following are some of the most notable changes:

Side-by-side net and gross of fees. The final rule prohibits any presentation of gross performance in an advertisement, unless the presentation also shows net performance with at least equal prominence to, and in a format designed to facilitate comparison with, gross performance. Further, the net and gross performance must be calculated over the same time period using the same type of return methodology. The calculation of net performance may include the deduction of a model fee when doing so would result in performance that is no higher than if the actual fee had been deducted.

Prescribed time periods. Performance returns must be shown for one-, five-, and 10-year time periods (or since inception), and should be shown as of a date that is no less recent than the most recent calendar year-end. The prescribed time periods must be shown with equal prominence. An adviser can always show performance for additional time periods on a supplemental basis. Importantly, private funds are not subject to this requirement.

Related performance. The final rule permits advisers to show “related performance,” meaning the performance of portfolios with substantially similar investment policies, objectives and strategies as those of the services being offered in the advertisement. In order to prevent cherry-picking, the presentation of related performance must include all related accounts – unless the exclusion of a particular account would not result in materially higher performance results and does not alter the presentation of any applicable time periods.

Extracted performance. Advisers may show “extracted performance” also known as a carve out for the performance of a subset of investments from a single account or fund, so long as the extracted performance is also accompanied by the results of the portfolio from which the performance was extracted.

Hypothetical performance

The final rule includes certain conditions that are specific to the use of hypothetical performance. It also retains the three categories of hypothetical performance: performance derived from model portfolios, back-tested performance that is generated by the application of a strategy to prior time periods when that strategy was not actually used to manage client accounts, and targeted or projected performance of a portfolio or advisory services offered by the adviser.

The final rule reflects the SEC’s concern that hypothetical performance “pose[s] a high risk of misleading investors.” This concern is based on the fact that hypothetical performance generally does not reflect investment decisions made in real-time or the investment results of actual client accounts. Further, particularly in the case of back-tested performance, it can be “optimized through hindsight.” Notwithstanding the SEC’s concerns, the final rule permits advisers to show hypothetical performance, subject to the following conditions:

• Policies and procedures. The adviser must adopt and implement policies and procedures reasonably designed to ensure that the hypothetical performance information is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement. This is a clarification from the proposed rule, which arguably would have required advisers to make the determination that the use of hypothetical performance is appropriate for each individual investor prior to dissemination. Although the SEC provides more flexibility in the final rule, it continues to take the position that advisers generally would not be able to use hypothetical performance in advertisements distributed to a mass audience or intended for general circulation because the adviser would not reasonably be able to form any expectations about the financial situation and investment objectives of a mass audience.
• Disclosure of criteria and assumptions. Advisers must provide sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating the hypothetical performance, including any assumptions that future events will occur.
• Disclosure of risk information. Advisers must provide or, in the case of a private fund investor, offer to provide promptly sufficient information to enable the intended audience to understand the risks and limitations of using hypothetical performance in making investment decisions.

The definition of hypothetical performance expressly excludes interactive tools, where the investor uses the tool (directly, or through an adviser who inputs information into the tool). The use of interactive tools is subject to the general prohibitions, as well as additional conditions that are largely consistent with FINRA Rule 2214.

Portability

The Marketing Rule permits advisers to show “predecessor performance,” meaning performance that was not generated by the adviser showing the performance. This commonly occurs when a portfolio management team leaves one advisory firm and joins another, or when there is a significant acquisition, restructuring or reorganization. The SEC adopted the following conditions, which are largely consistent with prior no-action guidance, for the use of predecessor performance:

• The person or persons who were primarily responsible for achieving the prior performance results manage accounts at the advertising adviser.
• The accounts managed at the predecessor investment adviser are sufficiently similar to the accounts managed at the advertising adviser that the performance results would provide relevant information to investors.
• All accounts that were managed in a substantially similar manner are advertised unless the exclusion of any such account would not result in materially higher performance and the exclusion of any account does not alter the presentation of any prescribed time periods; and
• The advertisement clearly and prominently includes all relevant disclosures, including that the performance results were from accounts managed at another entity.

Amendments to Form ADV

The final rule amends Part 1 of Form ADV to incorporate a new Item 5.L (Marketing Activities) that requires advisers to identify (via a yes/no question) whether their advertisements include: performance results, references to specific investment advice, testimonials, endorsements, third-party ratings, hypothetical performance or predecessor performance. Item 5.L also asks (via a yes/no question) whether the adviser receives cash or non-cash compensation, directly or indirectly, in connection with the use of testimonials, endorsement, or third-party ratings.

The responses to Item 5.L are only required to be updated during the annual update to Form ADV. We expect that these responses will be factored into the risk-based rankings the Division of Examinations (formerly known as OCIE) considers in conducting examinations.

Recordkeeping

The SEC amends various provisions of the books and records rule (Advisers Act Rule 204-2) to conform to the various provisions discussed above.

Next steps

As noted above, the Marketing Rule contains an 18-month transition period prior to the compliance date. The new requirements discussed above apply to advertisements disseminated on or after the compliance date. However, this also includes any advertisements that are available (e.g., online or through third parties) as of the compliance date. Given the scope of the changes, we would recommend that firms begin to think about the following:

• Existing Solicitation Arrangements. Review any solicitation arrangements or referral programs currently structured to comply with the Solicitation Rule. Advisers will want to consider how to modify the existing agreements and operational flow to bring them into compliance with the Marketing Rule. Advisers should also consider any indirect compensation and non-cash compensation that will be covered by the Marketing Rule, as well as the regulatory status of their promoters.
• Online Advertising and Social Media Influencers. Review any online advertising arrangements, relationships with social media “influencers,” or other marketing relationships that involve the payment of cash or non-cash compensation. Although advisers may not treat them as solicitation arrangements under the current rule, these arrangements likely will be considered paid testimonials or endorsements requiring compliance with the Marketing Rule.
• Placement Agent Agreements. Advisers to private funds should be aware that, unlike the existing Solicitation Rule, the Marketing Rule will apply to the solicitation of interests in private funds. Accordingly, advisers should consider updating placement agent agreements and other referral arrangements relating to the promotion of private funds to reflect the application of the Marketing Rule.
• Training. Focus on training business, marketing and compliance professionals as to the new requirements so that they can consider how the Marketing Rule will apply to current and future marketing campaigns.
• Policies and Procedures. Begin updating policies and procedures to reflect changes to the Marketing Rule, including policies and procedures related to the use of hypothetical performance and the retention of books and records.
• Performance Calculations. Engage with performance calculation teams to advise them of the new requirements for performance advertisements, including the requirement to show gross and net performance and to show standardized performance periods.
• Existing Advertisements. Identify and start to develop a process for updating existing advertisements that will continue to be available as of the compliance date. Prioritize communications that will trigger the more specific requirements of the Marketing Rule such as advertisements that contain performance presentations (including hypothetical performance), testimonials, endorsements and third-party ratings, among other things.

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We encourage clients to reach out to us as you evaluate the impact of the new Marketing Rule on your business and consider next steps for implementation.