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Aug 13 Attorney Articles, Firm Articles

The SEC’s Proposed Changes to the Advertising Rule – Rule 206(4)-1

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At the end of last year, the SEC released proposed rule amendments that modify Rule 206(4)-1 (the Advertising Rule) under the Investment Advisers Act of 1940. The Advertising Rule amendments proposed by the SEC are substantial and, if enacted as proposed, will likely impact the advertising practices of many investment advisers. Among other things, the Advertising Amendments will replace the Advertising Rule’s long-in-place (since 1961!) restrictions on investment advisers using testimonials, endorsements and third-party ratings in their advertising materials. We provide below some pertinent information about the Advertising Rule Amendment and hope you will not be shy in giving us a call with any questions, comments, or requests to help out with your Advertisement Rule needs.

A New Definition of Advertisement

The Advertising Amendment expands the Advertising Rule’s current definition of “advertisement” to include “any communication, disseminated by any means, by or on behalf of an investment adviser, that offers or promotes the investment adviser’s investment advisory services or that seeks to obtain or retain one or more investment advisory clients or investors in any pooled investment vehicle advised by the investment adviser.” This new definition is not limited, like the current Rule 206(4)-1, to written brochures or communications made through media such as radio and television.  Instead, it applies to all types of communication; presumably to capture all web-based advertising.

Interestingly, the new Rule will explicitly include in the definition of “advertisement” communications disseminated to investors in pooled investment vehicles. This brings the requirements of the anti-fraud provisions in Rule 206(4)-8 into the Advertising Rule, which is important from an enforcement perspective, detailed more below.

Importantly, the Advertising Amendment excludes from the definition of advertisement the following types of communications:

  • Live oral communications that are not broadcast by any media;
  • Responses to unsolicited requests for specified information about an adviser or its services (unless such responses provide performance results to retail investors or include hypothetical performance);
  • Advertisements and other sales material concerning registered investment companies (RICs) or business development companies (BDCs) that are within the scope of other SEC rules; and
  • Information required to be included in statutory or regulatory notices, filings or other communications.

An adviser will still need to assess whether “promotional materials” for purposes of the Advisers Act are an advertisement, general solicitation, or public offering for purposes of Section 4(a)(2) of the Securities Act of 1933 or Regulation D.  This can get tricky.  So, if in doubt, contact your lawyer for an opinion on this important distinction.

Advisers Can Use Testimonials, Endorsements and Third-Party Ratings!!!

Most everyone knows that the current Advertising Rule categorically prohibits the use of “testimonials” and SEC guidance establishes that endorsements and third-party ratings are severely disfavored. The SEC’s new Advertising Amendment will now allow investment advisers to use testimonials, endorsements and third-party ratings.  Here’s what you need to know to do so:

  • Testimonials and Endorsements. Advisers will be permitted to use testimonials in their advertisements only if the following are clearly and prominently disclosed: (1) whether the testimonial or endorsement was given by a client/investor or non-client/non-investor and (2) whether cash or non-cash compensation was provided by the adviser in connection with the testimonial or endorsement.
  • Third-Party Ratings. Advisers will also be permitted to use third-party ratings in their advertisements only if they reasonably believe that the third-party rating is designed to produce unbiased results. The new amendments require any third-party ratings used as advertisements to be accompanied by clear and prominent disclosure of: (1) the date on which the rating was given and the time period on which the rating is based, (2) the identity of the third party that created the rating and (3) whether cash or non-cash compensation was provided by (or on behalf of) the adviser in connection with the rating.

As with nearly everything under the Adviser’s Act, the SEC notes that advisers using third-party ratings in advertisements will need to develop policies and procedures for complying with conditions noted above.  Specifically, the standard is a “reasonable belief” that the advertisements comply with the conditions above…a standard that is sometimes difficult to define in the myriad of circumstances adviser’s find themselves in.  The SEC did provide a bit of guidance by stating that “cherry picking” testimonials or otherwise selectively using only the most positive testimonials will not be consistent with a “reasonable” attempt to comply with the pragmatic, principles-based approach to advertising.

Practice Advice – there are tricks of the trade here.  The new Rule will allow you to use testimonials, but you can’t cherry pick the good one out. Instead, what you can do, is respond in a positive, non-defensive manner to the bad reviews.  This is often a great way to show that you care about your clients and their input is important to you.  For other options, give us a call and we can run through the ways you can use negative reviews to your advantage.

Show Them Your Track Record – Revised Performance Information Guidelines

The proposed Advertising Rule amendments will allow the presentation of an investment adviser’s track record under the following conditions:

  • Gross performance information must be accompanied by, or must offer to promptly provide, a schedule of fees and expenses deducted to calculate net performance;
    • with regard to the presentation of performance of related portfolios, advisers can exclude from “related performance” one or more related portfolios so long as the advertised performance results are no higher than if all related portfolios were included;
    • when presenting extracted performance (defined as “performance results of a subset of investments extracted from a portfolio”), an advertisement must provide, or offer to provide, the performance results of all portfolios from which the performance was extracted; and
    • hypothetical performance can only be presented if the adviser (1) adopts policies and procedures designed to ensure that performance information is relevant to the recipient’s financial situation and investment objectives, and (2) provides additional information about criteria, assumptions, risks and limitations in the hypothetical so the recipient understands how the hypothetical performance was calculated.

Of course, when providing the track record information to clients, both current and prospective, an adviser may not include a statement, express or implied, that “the calculation or presentation of performance results in the advertisement has been approved or reviewed by the SEC.”  This is obvious to many…but, not all.

In addition, for advertisements that are only disseminated to retail investors, an adviser may not:

  • Present gross return information that is not accompanied by comparable net returns; and
  • Present performance results for any portfolio or composite portfolio without also including performance results for standardized 1-, 5- and 10-year periods (or the life of the portfolio, if shorter).

Clearly Identified Prohibited Practices

The Advertising Amendment will replace the current Rule’s advertising limitations with a more common-sense, principles-based approach. While this does not substantively change the effect of Rule 206(4)-1, it does provide a clearer picture of what is, and what is not, appropriate advertising.  Under the new Rule, it will be unlawful for investment advisers to publish any advertisement that:

  • Includes an untrue statement of a material fact or omits a material fact necessary to make a statement not misleading, in light of the circumstances;
  • Includes a material claim or statement that is unsubstantiated;
  • Makes an untrue or misleading implication about, or is reasonably likely to cause an untrue or misleading inference to be drawn concerning, a material fact relating to the investment adviser;
  • Discusses or implies potential benefits to clients or investors without clear and prominent discussion of associated material risks or other limitations;
  • Refers to specific investment advice provided by the adviser that is not presented in a fair and balanced manner;
  • Includes or excludes performance results or presents performance time periods in a manner that is not fair and balanced; or
  • Is otherwise materially misleading.

Easier For SEC To Prove Violations of Clearly Identified Prohibited Practices

For legal and compliance geeks, like me, an important effect of clearly identifying prohibited practices comes in the fact that the SEC need only show that an adviser acted negligently in engaging in any of the prohibited advertising practices listed above to prove a violation. While scienter, or intent, has not been required to establish a violation of Section 206(4), it easier for the SEC to prove advertising violations with more clearly identified advertising practices listed in the amendment. Thus, it is more important than ever that advisers be careful not to skirt too close to the proverbial line with any of the elucidated prohibited practices.

Compliance Issues – Advertising Preapproval and Internal Review Requirements

In addition to all of the above, the Advertising Amendment requires advisers to designate an employee who is responsible for reviewing and approving advertisements before their dissemination. Similar to the above, this preapproval requirement will not apply to (1) communications disseminated only to a single person or household or to a single investor in a pooled investment vehicle or (2) live oral communications broadcast on radio, television, the internet or any other similar medium. The SEC noted in its Advertising Amendment guidance that it would not be appropriate for the same person to both create and approve advertisements. However, as a matter of pragmatism, small advisers may not have enough employees to carry out these disparate tasks; so, it may be appropriate in those cases. Nonetheless, the requirement to have advertisements reviewed by a separate employee (an independent CCO is always a good option) reflects industry best practice and is often a good way to prevent rule violations.

Maintain Organized Books and Records Rule

The SEC’s release notes for the Advertising Amendment indicate that the SEC will update the Books and Records requirements of Rule 204-2 to reflect the changes in the amendment.  Thus, it is likely that the SEC will require advisers to maintain books and records to substantiate the applicability and relevance of testimonials, endorsements, and third-party ratings.  Similarly, if an adviser uses performance information from a predecessor firm, it is likely that the SEC will require that adviser to maintain that information in its original books and records.  A thorough review of any modifications to Rule 204-2 resulting from the Advertising Amendment will be required once the amendment is enacted.

Amendments to Form ADV Disclosure

The Advertising Amendment also requires advisers to update Form ADV in a new subsection of Part 1A dedicated to advertisements. This subsection will require advisers to disclose whether any of its advertisements:

  • Contain performance results, and if so, whether the performance results were verified or reviewed by a party unrelated to the adviser;
  • Include testimonials, endorsements or third-party ratings, and if so, whether the adviser provided compensation for the third-party statement; and
  • Include a reference to specific investment advice provided by the adviser.

Written Supervisory Procedures Are Your Friend

All new Rule changes come with a commensurate requirement that advisers update their WSPs. The changes to the Advertising Rule are no exception.  Advisers will have to add sections to their WSPs relating to review of advertisements, testimonials, and performance information in light of the above.  Indeed, when the next SEC examination occurs, advisers would be well regarded if their WSPs contained updated and well-written provisions that specifically identify the new requirements of Advertising Rule.

The SEC has yet to implement the Advertisement Amendment and has requested comments on various aspects of the proposed new rule. Thus, there may be some changes to the details of the Advertisement Amendment based upon comments submitted by industry participants.  When the Advertising Amendment is adopted, advisers will likely have a one-year transition period until they are required to comply. In the meantime, it is a great idea for advisers to go ahead and put into action the new requirements of the Advertising Amendment. Indeed, much of the new rule is a codification of past SEC guidance in this area from No-Action letters and interpretive guidance. Further, by starting now, an adviser can spread out the cost of overall compliance costs necessary to be fully compliant.  As always, do not hesitate to reach out to the lawyers at Higgs Fletcher & Mack for more detailed guidance based upon your specific circumstance.