SEC Proposes to Update Longstanding Investment Adviser Advertising and Solicitation Rules

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On November 4, 2019, the Securities and Exchange Commission (SEC) proposed amendments to both the advertising rule and the cash solicitation rule under the Investment Advisers Act of 1940 (the “Advisers Act”). Neither rule — adopted in 1961 and 1979, respectively — has been amended significantly since it was adopted, although the SEC and its staff have, from time to time, granted no-action relief and otherwise interpreted the application of these rules. According to the SEC, the proposed amendments are intended to update such rules to reflect changes over the past half-century in “technology, the expectations of investors seeking advisory services, and the evolution of industry practices.”

Summary

The proposed amendments to the advertising rule (Rule 206(4)-1) and the solicitation rule (Rule 206(4)-3) would replace the current rules with principles-based rules that reflect the SEC’s experience administering the current advertising and cash solicitation rules.

The proposed changes to the advertising rule seek to address the inherent conflicts of interest between an adviser and its investors or potential investors (including investors in pooled investment vehicles), while at the same time providing flexibility with respect to content and delivery, including the ability to use technology not contemplated when the original rule was adopted. For example, rather than the “one-size-fits-all” approach of the current advertising rule, the SEC proposal would differentiate requirements applicable to advertisements (including the presentation of performance results) depending upon an advertisement’s intended audience. Other major changes contained in the proposed advertising rule include:

  • replacing the current rule’s four per se prohibitions with a set of principles that the SEC believes are reasonably designed to prevent fraudulent or misleading conduct and practices; and
  • permitting—subject to tailored restrictions and conditions—testimonials, endorsements, and third-party ratings.

The proposed changes to the cash solicitation rule would expand the application of the rule to cover solicitation arrangements involving all forms of compensation, rather than only cash compensation, and would apply to solicitation of private fund investors, rather than only to “clients” of the investment adviser. Further, the proposed rule would amend the disqualification provision to expand the types of disciplinary events that would trigger the disqualification of a solicitor under the rule. However, the proposal also cuts back some of the current rule’s requirements. For example:

  • the proposed rule would eliminate the requirement that an adviser obtain a signed and dated acknowledgment from a client that the client has received the solicitor’s disclosure;
  • as proposed, investment advisers would have increased flexibility to develop policies and procedures to ascertain whether the solicitor has complied with the rule’s required written agreement; and
  • the proposed rule also would eliminate the requirement that solicitors provide a client with an adviser’s Form ADV brochure.

Advertising Rule

Key components of the proposed advertising rule include:

Elimination of Existing Prohibitions. The proposed rule would eliminate four per se prohibitions contained in the current rule in favor of a set of principles that the SEC believes are reasonably designed to prevent fraudulent or misleading conduct and practices. Specifically, the proposed rule would eliminate prohibitions on:

  • the use of testimonials;
  • the use of past specific profitable investment recommendations;
  • representations that any graph or chart can by itself be used to determine which securities to buy and sell or when to buy and sell them; and
  • the representation that any service will be provided free of charge unless it is, in fact completely free.

Definition of “Advertisement.” As proposed, an “advertisement” would 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.” Advertisements would specifically not include:

  • live oral communications that are not broadcast on radio, television, the internet, or any other similar medium;
  • communications by an investment adviser that do no more than respond to unsolicited requests for specified information about the investment adviser or its services, other than (i) any communication to a “Retail Person” that includes performance results or (ii) any communication that includes hypothetical performance;
  • sales material related to a registered investment company or business development company that comes within the scope of existing advertising rules applicable to such registered products; or
  • any information required to be contained in a statutory or regulatory notice, filing, or other communication.

According to the SEC, these changes are intended to make the definition more “evergreen.” In other words, the SEC and its staff believe that the proposed definition can remain relevant and effective in the face of advances in technology and evolving industry practices.

General Prohibitions. Paragraph (a) of the proposed rule includes broad prohibitions consistent with the general anti-fraud provisions contained in Section 206 of the Advisers Act. As proposed, the following general advertising practices would be prohibited:

  • making an untrue statement of a material fact, or omission of a material fact necessary to make the statement made, in light of the circumstances under which it was made, not misleading;
  • making an unsubstantiated material claim or statement;
  • making an untrue or misleading implication about, or being reasonably likely to cause an untrue or misleading inference to be drawn concerning, a material fact relating to the investment adviser;
  • discussing or implying any potential benefits without clear and prominent discussion of associated material risks or other limitations;
  • referring to specific investment advice provided by the adviser that is not presented in a fair and balanced manner;
  • including or excluding performance results, or presenting performance time periods, in a manner that is not fair and balanced; and
  • being otherwise materially misleading.

Testimonials and Endorsements. The proposal would permit testimonials and endorsements, subject to disclosing whether the person giving the testimonial or endorsement is a client of the adviser and whether compensation has been paid by or on behalf of the adviser in return for the testimonial or the endorsement.

The SEC’s proposal recognizes that technological advances, such as the development of social media platforms that facilitate the ability to “like” a product of a service, makes the use and dissemination of testimonials easier. Moreover, the SEC acknowledged that testimonials and endorsements can be useful to investors when evaluating investment advisers. However, the SEC remains concerned that in some circumstances this type of information might mislead investors. Accordingly, in addition to ensuring that the use of such information comports with the general prohibitions outlined above, advertisements including testimonials or endorsements would be required to disclose the relationship between an adviser and the individual or entity providing the testimonial or endorsement and whether compensation of any kind was paid for such endorsement or testimonial.

Given the breadth of the revised definition of an advertisement, an adviser would need to carefully consider whether a testimonial or endorsement contained on a third-party site was disseminated “on behalf of” the adviser. If so, the adviser would need to determine, to a level of reasonably certainty, that the third-party site contained appropriate disclosure regarding the testimonial or endorsement. Moreover, the SEC said that “cherry picking” testimonials would not be consistent with the general prohibitions in the proposed rule. Thus, an adviser could be required to include “negative testimonials” in its advertising in order to avoid a misleading inference that the adviser has only received positive testimonials.

Third-Party Ratings. The proposed rule would permit third-party ratings, subject to specified disclosures and certain criteria pertaining to the preparation of a rating. Specifically, in addition to disclosure such as that required with respect to testimonials and endorsements, an adviser would have to clearly and prominently disclose: (i) the date on which the rating was given and the period of time upon which the rating was based; and (ii) the identity of the third party that created and tabulated the rating. Notably, however, these required disclosures would not cure a rating that is otherwise false or misleading under the general prohibitions set forth above.

Under the proposed rule, an investment adviser would need to form a reasonable belief that “any questionnaire or survey used in the preparation of a third-party rating [was] structured to make it equally easy for a participant to provide favorable and unfavorable responses, and [was] not designed or prepared to produce any predetermined result.” According to the SEC, “for an adviser to satisfy the proposed reasonable belief requirement, it would likely need to have access to the questionnaire or survey that was used in the preparation of the rating.”

Performance Information. The proposal acknowledges that advertisements containing performance results “can be a useful source of information for investors when such advertisements are presented in a manner that is neither false nor misleading.” Nonetheless, the SEC remains concerned that “prospective investors may rely particularly heavily on advertised performance results in choosing whether to hire or retain an investment adviser.” Performance advertising may raise particular regulatory concerns when an advertisement targets investors with limited ability to analyze and verify such performance.

To address these concerns, the SEC proposes to distinguish between “Non-Retail Advertisements” and “Retail Advertisements.” Non-Retail Advertisements would be those for which “an adviser has adopted and implemented policies and procedures reasonably designed to ensure that the advertisements are disseminated solely to qualified purchasers and certain knowledgeable employees.” All other advertisements would be defined as Retail Advertisements. Moreover, the proposed rule would require an adviser to treat each investor in a pooled investment vehicle, including in a private fund, as either a “Non-Retail Person” (i.e., a qualified purchaser or a knowledgeable employee) or a “Retail Person.” Investment advisers to pooled investment vehicles other than registered funds or business development companies would be required to “look through” the vehicle to its underlying investors to determine the characterization of such investors for purposes of complying with the proposed rule. For purposes of the proposed rule, accredited investors and qualified clients would be treated as Retail Persons.

The proposed rule would prohibit any Retail Advertisement from containing any presentation of gross performance results unless the advertisement presents net performance results with at least equal prominence and in a format designed to facilitate comparison. Performance results in a Retail Advertisement would be required to be provided for the same portfolio for 1-, 5-, and 10- year periods (if applicable) ending on the most recent practicable date, with each time period being presented with equal prominence. Non-Retail Advertisements could include only gross performance results, provided that an adviser would be required to provide or offer to provide promptly a schedule of fees and expenses adequate to ensure that Non-Retail Persons could calculate net performance if they so desired.

Under the proposed rule, an adviser would be able to include “extracted” performance—that is, “the performance results of a subset of investments extracted from a portfolio—in an advertisement. Such advertisements would be required to provide or offer to provide promptly the performance results of all investments in the portfolio from which the performance was extracted.

The proposed rule identifies three types of hypothetical performance that may be allowed in adviser advertising, if an adviser also provides sufficient information to enable the recipient to understand the criteria used and assumptions made in calculating hypothetical performance. The adviser must also provide (or, if a recipient is a Non-Retail Person, offer to provide promptly) sufficient information to enable the recipient to understand the risks and limitations of using hypothetical performance in making investment decisions. Hypothetical performance would include:

  • “backtested performance” calculated by application of an investment adviser’s investment strategy to market data from prior periods during which the adviser did not actually use such strategy;
  • “representative performance,” including performance derived from “model” portfolios managed contemporaneously alongside portfolios managed by the adviser for actual clients; and
  • returns reflecting an investment adviser’s performance over a particular period of time and projected returns reflecting the returns that the investment adviser believes it can achieve using the advertised investment services.

Regardless of the type of hypothetical performance contained in an advertisement, an adviser would be required to adopt and implement policies and procedures reasonably designed to ensure that such performance is relevant to the financial situation and investment objectives of the person to whom an advertisement is disseminated.

Internal Pre-Use Review and Approval. The proposed amendments would require that a designated employee of the adviser review and approve (in writing) all advertisements other than: (i) communications disseminated only to a single person or household or to a single investor in a pooled investment vehicle; or (ii) live oral communications broadcast on radio, television, the internet, or any other similar medium.

Solicitation Rule

Key components of the proposed solicitation rule include:

Compensation. The SEC said that non-cash compensation for referrals creates the same conflicts of interest as does cash compensation. Accordingly, the proposed rule would apply regardless of whether an adviser pays cash or non-cash compensation to a solicitor. Cash payments covered by the rule would include a percentage of assets under management, flat fees, retainers, hourly fees, and other methods of cash compensation. Non-cash compensation would include directed brokerage, training and education meetings, entertainment, awards or other prizes, and free or discounted services. Moreover, broker-dealers or dual registrants that receive brokerage for solicitation of client accounts in wrap fee programs that they do not sponsor would be subject to the proposed solicitation rule if they solicit clients to participate in the wrap fee program.

Private Fund Solicitors. The proposed rule would apply to the solicitation of current and prospective investors in private funds. The SEC said that this would increase protections to such investors by ensuring that they are aware of a solicitor’s financial interest in an investor making an investment in a private fund. The SEC acknowledged that investors in private funds are often financially sophisticated, but nonetheless suggested that such investors may not be aware that the person engaging in solicitation activity may be compensated by an adviser.

Written Agreement. Under the proposed rule, an adviser that compensates a solicitor for solicitation activities must generally enter into written agreement with the solicitor. The written agreement would be required to include: (1) a description of the solicitation activities and compensation, (2) a requirement that the solicitor perform its solicitation activities in accordance with the anti-fraud provisions of the Advisers Act, and (3) designate either the adviser or the solicitor to deliver required disclosures to investors. Under the proposed rule, solicitors that refer investors for impersonal investment advice and solicitors that are employees or otherwise affiliated with the adviser would not be subject to the rule’s written agreement requirement. The proposal would also add two new exemptions for arrangements involving de minimis compensation to a solicitor ($100 or less in a 12-month period) and advisers that participate in certain nonprofit programs.

Disclosure Requirements. Under the proposed rule, disclosure provided to a potential investor would continue to highlight a solicitor’s financial interest in the investor’s choice of an investment adviser. Additionally, the proposed rule would require that the disclosure include any potential material conflicts of interest resulting from an investment adviser’s relationship with the solicitor and/or the compensation arrangement. The proposal would eliminate the current rule’s requirement that the adviser obtain from each investor acknowledgments of receipt of the disclosures.

Disqualification. Under the proposal, an investment adviser could not compensate, directly or indirectly, a person for any solicitation activities where the adviser knows or, in the exercise of reasonable care, should have known, that such person is an “ineligible solicitor.” An “ineligible solicitor” would be defined as a person who, at the time of the solicitation, is either subject to a disqualifying SEC action or is subject to any disqualifying event.

For these purposes, a disqualifying action would be an SEC opinion or order barring, suspending, or prohibiting a person from acting in any capacity under the federal securities laws, or ordering the person to cease and desist from committing or causing a violation or future violation of (i) any scienter-based anti-fraud provision of the federal securities laws, or (ii) Section 5 of the Securities Act of 1933. A “disqualifying event” would include a finding, order, or conviction by a United States court or certain other regulatory agencies that a person has engaged in an act or omission generally as outlined in Section 203(e) of the Advisers Act.

The inclusion of a reasonable care standard with respect to disqualification would be a change from the current rule, which contains an absolute bar on paying cash for solicitation activities to a person with any disciplinary history enumerated in the rule.

Conclusion

The staff of the Division of Investment Management has, over time, issued no‑action letters and other guidance addressing the application of the current advertising and cash solicitation rules. The SEC said that those letters and guidance are currently under review to determine whether they should be withdrawn if the proposed amendments are adopted. Elimination of such relief and guidance could increase clarity with respect to the rules applicable to adviser advertising and use of solicitors.

That said, there is still work to be done. For example, some of the general provisions of the proposed advertising rule contain unnecessary redundancies that could increase rather than alleviate confusion regarding the standard applicable to certain types of adviser advertising. Similarly, treating accredited investors and qualified clients as Retail Persons for purposes of performance advertising, but not for other provisions of the federal securities laws, may create compliance challenges. It could also be challenging to create policies and procedures reasonably designed to ensure that hypothetical performance is relevant to a recipient’s financial situation and investment objectives. Advisers should therefore carefully review and evaluate the proposed amendments and are encouraged to provide the SEC with specific comments and data to ensure that rules adopted by the SEC appropriately reflect current industry practice and maintain adequate flexibility for the future.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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