Guest post by Ara Jabrayan
SmartRIA Compliance Alert
On December 22, 2020, the SEC enacted the new Marketing Rule, which will have an enormous impact on Registered Investment Advisers (RIAs). The new rule will replace the prior Advertising Rule, as well as the Cash Solicitation Rule. The SEC also amended Form ADV and the Books and Records Rule to implement changes resulting from the Marketing Rule.
The SEC enacted the new Marketing Rule to protect investors from misleading advertisements and solicitations, while accommodating current and evolving marketing practices. The adopting release for the Marketing Rule can be reviewed HERE.


Expanded definition of “advertising”

The new rule’s definition of “advertising” contains two prongs. The first prong includes any direct or indirect communication made by an investment adviser that:
  1. Offers investment advisory services pertaining to securities to prospective clients or investors in a private fund that an investment adviser advises; or
  2. Offers new investment advisory services pertaining to securities to current clients or private fund investors.
The definition excludes one-on-one communications, except with regard to compensated testimonials and endorsements, and certain communications that contain hypothetical performance information. The definition does not include communications designed to retain existing investors.
The new second prong covers compensated testimonials and endorsements and addresses traditional solicitation activities dealt with in the prior Cash Solicitation Rule, which will no longer exist.


Seven general advertising prohibitions found in the new Marketing Rule

The Marketing Rule is principles-based. Pursuant to the rule, RIAs must comply with seven general prohibitions, which are drawn from historic anti-fraud principles under the Federal securities laws and are tailored specifically to the type of covered communications. The prohibitions do not apply to advertisements related to registered investment companies or business development companies.
The following advertising practices are prohibited:
  1. Making untrue statements and omissions of a material fact that are necessary to avoid misleading the investor;
  2. Making unsubstantiated material statements of fact;
  3. Including content that may cause untrue or misleading implications or inferences to be drawn concerning a material fact;
  4. Discussing potential benefits without a fair and balanced discussion of material risks or limitations;
  5. Referring to specific investment advice provided by the RIA and not presenting it in a fair and balanced manner;
  6. Presenting performance returns or presenting performance time periods in a manner that is not fair and balanced; and
  7. Using content that is otherwise materially misleading.
The last prohibition is intended to prevent advertisements that are misleading but are not prohibited elsewhere.


Testimonials and endorsements are permitted if certain conditions are satisfied

Subject to certain conditions, the Marketing Rule permits testimonials and endorsements. A testimonial is a statement made by a current client or investor in a private fund advised by the investment adviser. An endorsement is a statement made by a person other than a current client or investor in a private fund advised by the investment adviser. The Appendix B: Form ADV Glossary of Terms in the adopting release explains what types of statements fall within the definitions of “testimonial” and “endorsement.”


An “endorsement” is defined as any statement by a person other than a current client or investor in a private fund advised by the investment adviser that:
  • Indicates 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;
  • Directly or indirectly solicits any current or prospective client or investor in a private fund for the investment adviser; or
  • Refers any current or prospective client of, or an investor in a private fund advised by, the investment adviser.
A “testimonial” is defined as any statement by a current client or investor in a private fund advised by the investment adviser:
  • About the client or investor’s experience with the investment adviser or its supervised persons
  • That directly or indirectly solicits any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the investment adviser; or
  • That 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.
With regard to testimonials and endorsements, RIAs must address the following areas:
  • Disclosure. Advertisements must clearly and prominently disclose whether the person giving the testimonial or endorsement is a client and is being compensated. The person giving the testimonial or endorsement is referred to as the ‘promoter’.
  • Oversight and Written Agreement. An RIA that uses testimonials or endorsements in an advertisement must oversee compliance with the Marketing Rule. An RIA must enter into a written agreement with promoters, except where the promoter is an affiliate of the adviser or receives de minimis compensation. To qualify as de minimis compensation, the payment must be $1,000 or less during the preceding twelve months. Non-cash compensation must also have a value of $1,000 or less.
  • Disqualification. The SEC believes that compensated testimonials and endorsements present a heightened risk for conflicts of interest and misleading investors. Therefore, the Marketing Rule will prevent RIAs from using compensated testimonials and endorsements made by certain “bad actors” and other ineligible persons. Compensated testimonials and endorsements include traditional referral and solicitation activities. Disqualification provisions are not applicable to uncompensated testimonials and endorsements.


Third-party ratings

The SEC has expressed concern in the past about third-party ratings being misleading. The Marketing Rule stipulates that an RIA may include a third-party rating in an advertisement, as long as the adviser forms a reasonable belief that the rating clearly and prominently discloses certain information.


The Marketing Rule’s impact on performance advertising

Clover Capital and other no-action letters have traditionally provided guidance to RIAs regarding performance advertising. The SEC will be withdrawing several no-action letters related to the Advertising Rule and the Cash Solicitation Rule. The SEC did not adopt proposed separate performance-related requirements for retail and non-retail investors.


The new rule brings certainty to how performance advertising will be treated by SEC examiners. The rule will require presentation of net performance information whenever gross performance returns are presented. The rule will also require RIAs to standardize certain parts of a performance presentation, so investors can evaluate and compare investment opportunities. In addition, the rule will impose requirements on RIAs that display related performance, extracted performance, and hypothetical performance.


In a change from the proposed rule, compliance requirements are imposed on advertisements referencing predecessor performance. Previously, examiners relied on no-action letters to determine if these advertisements were misleading. In order to present predecessor performance in an advertisement, the person or persons who were primarily responsible for achieving the prior performance results while employed at the predecessor firm must manage accounts at the current RIA. The release noted that if testimonials, endorsements, third-party ratings, and specific investment advice contain performance from a predecessor firm, the rule’s general prohibitions apply to them.


Takeaways

The new rule will not require RIAs to review and approve their advertisements prior to dissemination. Nevertheless, most RIAs’ policies and procedures do impose this requirement. Otherwise, there is a grave risk that advertisements will violate the general prohibitions of the Marketing Rule.
It is important for RIAs to familiarize themselves with the new Marketing Rule, because it will impact their ability to attract new clients. Advisers may also see changes in their competitors’ marketing practices.


Note: This compliance alert only provides an overview of the new Marketing Rule, which is 430 pages long.

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