On September 11, 2023, the Securities and Exchange Commission (SEC) charged and settled proceedings with nine registered investment advisers for misrepresenting hypothetical performance of advisory products in connection with an ongoing Division of Enforcement (Enforcement) sweep of violations of the Marketing Rule (Rule 206(4)-1 under the Investment Advisers Act of 1940).1 Under the Marketing Rule, amended in December 2020, registered advisers are prohibited from, among other things, including hypothetical performance in their advertisements unless they have adopted and implemented policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the advertisement’s intended audience.
The SEC’s orders, which the firms settled without admitting or denying the SEC’s findings, found that each of the nine firms advertised hypothetical performance to mass audiences on their websites without the required policies and procedures and that two of the firms failed to maintain required copies of their advertisements.2 Citing the Marketing Rule’s adopting release, the SEC’s orders stated that “advisers generally would not be able to include hypothetical performance in advertisements directed to a mass audience or intended for general circulation” because if an advertisement were available to mass audiences, “an adviser generally could not form any expectations about their financial situation or investment objectives.”3 The nine firms agreed to be censured, cease and desist from violating the provisions, comply with undertakings not to advertise hypothetical performance without the requisite policies and procedures in place, and pay civil penalties ranging from $50,000 to $175,000.
Compliance with the Marketing Rule is a high priority for both the Enforcement and the Division of Examination (EXAMS) staff. In addition to conducting the Enforcement sweep, the EXAMS staff recently explained that it is “increasing its focus” on certain Marketing Rule–related areas during its examinations.4 Moreover, in the Division of Examinations’ “2023 Examination Priorities,” examinations for compliance with the Marketing Rule were ranked first in the division’s list of “Notable New and Significant Focus Areas.”5
Commission and Staff Guidance on the Marketing Rule
On December 22, 2020, the SEC adopted a single Marketing Rule that replaced the previous advertising and cash solicitation rules under the Investment Advisers Act.6 The Marketing Rule became effective on May 4, 2021, with a compliance date of November 4, 2022.
Advertisements disseminated on or after the compliance date by advisers required to be registered with the SEC are subject to the Marketing Rule. Among other things, the Marketing Rule (1) prohibits advertisements that “[i]nclude a material statement of fact that the adviser does not have a reasonable basis for believing it will be able to substantiate upon demand by the Commission”; (2) establishes certain performance advertising requirements, which include prohibitions on certain types of representations in investment adviser advertisements; and (3) requires investment advisers to make and keep certain records, such as records of all advertisements they disseminate, including certain internal working papers, performance-related information, and documentation for oral advertisements, testimonials and endorsements.7
In September 2022, the EXAMS staff issued a risk alert stating that the staff was planning to “conduct a number of specific national initiatives, as well as a broad review through the examination process, for compliance with the Marketing Rule.”8 Among other things, the September 2022 risk alert indicated that the staff intended to focus on whether advisers had implemented Marketing Rule–specific policies and procedures; whether advisers had a reasonable basis for believing they would be able to substantiate material statements of facts in advertisements; whether advisers were meeting their performance advertising requirements; and whether advisers were in compliance with the Commission’s adopted amendments to the Books and Records Rule.
In various public speeches, the EXAMS staff assured the industry that it would not be “play[ing] gotcha” in the early days of the new Marketing Rule.9 Rather, the staff stated that it was seeking to ensure that advisers were aware of the amended rule and had engaged in good-faith efforts to comply. The EXAMS initiatives and related sweeps were framed as providing the EXAMS staff with an opportunity to understand the industry’s approach to compliance with the rule. Accordingly, the staff indicated that it did not intend to “pounce immediately on suspected compliance lapses” and suggested that initial enforcement referrals would be limited to those who demonstrated a complete failure to comply with the rule.10 However, while the staff’s initial enforcement referrals appear to be focused on clear failures, advisers can expect more aggressive enforcement of the technical requirements in the future.
The Division of Investment Management (IM) has provided guidance about compliance with the rule’s requirements, both in advance of and after the November 2022 compliance date. In its “Marketing Compliance Frequently Asked Questions,” IM has responded to industry inquiries concerning, among other things, the compliance date for the Marketing Rule, the Marketing Rule’s time period requirement, and the Marketing Rule’s requirements concerning gross and net performance.11 Some key takeaways from the staff’s guidance:
- Advisers should ensure that they implement any revisions to their written compliance policies and procedures so they are reasonably designed to prevent violations of the Marketing Rule.
- The staff would not object if an adviser is unable to calculate their one-, five- and 10-year performance data in accordance with Rule 206(4)-1(d)(2) immediately following a calendar year-end and the adviser uses performance information that is at least as current as the interim performance information in an advertisement until they can comply with the calendar year-end requirement. The staff believe that a reasonable period of time to calculate performance results based on the most recent calendar year-end generally would not exceed one month.
- When an adviser displays the gross performance of one investment or a group (i.e., subset) of investments from a private fund, the adviser also must show the net performance of the single investment or group of investments.
Early Enforcement Action
The proceedings against the nine advisers described above closely followed the SEC’s first action under the new Marketing Rule, brought less than one year after the compliance date against fintech investment adviser Titan Global Capital Management USA LLC.12 In its August 21, 2023 order, the SEC found that Titan advertised hypothetical performance without having adopted and implemented policies and procedures reasonably designed to ensure that the hypothetical performance was relevant to the likely financial situation and investment objectives of the intended audience and by failing to provide certain information underlying the hypothetical performance advertised.13 Specifically, Titan “advertised ‘annualized’ performance results for Titan Crypto as high as 2,700 percent, but its advertisement did not include material information about how the annualized return was calculated, including that the annualized return was based on a purely hypothetical account, rather than an actual account’s performance and that the 2,700 percent annualized return figure was based on the assumption that the strategy’s performance in its first three weeks would continue for an entire year.”14 While Titan provided some information about the assumptions it used to calculate the hypothetical annualized return, that information “was not as clear and prominent as the highlighted 2,700 percent annualized return.”15 The order also found that Titan made conflicting disclosures about how Titan Crypto assets were custodied; included language in its client advisory agreements liability disclaimer language that created a false impression that clients had waived non-waivable causes of action against Titan; failed to adopt policies and procedures related to the accuracy of its disclosures concerning its internal controls regarding Titan representatives’ personal trading in crypto assets held in the Titan Crypto strategy as it had represented to clients; and failed to adopt and implement policies and procedures reasonably designed to ensure that client signatures were obtained to authorize certain types of transactions in client accounts.16 The order required Titan to pay more than $1 million in disgorgement, prejudgment interest and civil penalties.
Practice Points
The following are measures to enhance adviser compliance with the Marketing Rule and reduce the risk of regulatory action:
- Policies and Procedures: Advisers should review their written policies and procedures and assess whether they are reasonably designed to prevent violations of the Marketing Rule by the advisers and their supervised persons. Any outdated references to the prior version of the rule or the Cash Solicitation Rule should be eliminated.
- Substantiation Requirement: Advisers should review prospective advertisements and confirm that they have a reasonable basis for making the material statements of fact in those advertisements.
- Performance Advertising Requirements: Advisers should review prospective advertisements and confirm they are in compliance with the performance advertising requirements in the Marketing Rule. Advisers should ensure that any advertisements that include hypothetical performance (including targeted and projected performance and performance extracted from multiple portfolios) are relevant to the likely financial situation and investment objectives of the advertisement’s intended audience and provide (or, in the case of private funds, offer to provide) sufficient information to enable the intended audience to understand the risks and limitations. In light of the recent enforcement actions described above, particular care should be taken if engaging in advertising to mass audiences on public websites.
- Books and Records: Advisers should take steps to ensure they make and keep records of all advertisements they disseminate.
- Testimonials and Endorsements: Advisers should review prospective advertisements as well as agreements with any compensated or uncompensated promoter and related disclosures and confirm they are in compliance with the testimonials and endorsements requirements of the Marketing Rule.
- Third-Party Ratings: Advisers should review prospective advertisements to determine if they include third-party ratings. If they do, advisers should take steps to ensure the advertisement satisfies the criteria pertaining to the preparation of the rating outlined in the Marketing Rule.
- Form ADV: Advisers should ensure they are completing the amended Form ADV accurately, including the additional questions concerning their marketing practices.
- Continuing Review for Compliance with the General Prohibitions: Advisers should review prospective advertisements to ensure they do not include any of the general prohibitions outlined in the Marketing Rule.
Review of these procedures and records should help reduce advisers’ regulatory risk. The early cases may have focused on conduct that the staff considered complete failures to comply with the Marketing Rule, but staff speeches and guidance suggest that we can expect more aggressive enforcement of the technical requirements in the future.
Footnotes
