SEC Adopts New Marketing Rule for Investment Advisers
The U.S. Securities and Exchange Commission (SEC) has finalized the long-awaited overhaul of the Advertising Rule (Rule 206(4)-1 under the Investment Advisers Act of 1940 (Advisers Act)). The new rule, which is referred to as the “Marketing Rule,” was approved on December 22, 2020, and is intended to modernize the framework for investment adviser advertising and replace the patchwork of cases, no-action letters and SEC staff guidance that has developed in this area since the rule was first adopted in 1961. The new Marketing Rule also eliminates the separate Cash Solicitation Rule (Rule 206(4)-3 under the Advisers Act) by incorporating requirements for compensated solicitation activities within the new rule.
The new Marketing Rule imposes a number of significant changes on the framework for investment adviser advertising that will have material impact on advisers, in some cases affording more flexibility and in others imposing new conditions. Here, we provide a summary of some of the key changes under the new Marketing Rule, highlighting differences from the SEC’s initial proposal, and outline important steps for advisers to begin taking in advance of the rule’s compliance date.
Proposed Rule vs. Final Rule
Amendments to the Advertising and Solicitation Rules were first proposed in November 2019. Commenters generally applauded the SEC’s efforts to modernize the rules and the proposed principles-based approach to the regulation of investment adviser advertising. However, many industry participants expressed concerns over the rule’s proposed scope and several provisions perceived as overly-burdensome and not in the interest of investors. The SEC responded to many of these concerns in the final rule.
Key differences between the proposed rule and the final rule include the following:
|PROPOSED RULE||FINAL RULE|
|Separate Advertising Rule and Solicitation Rule||Single Marketing Rule|
|Advertisements must be reviewed and approved by a designated employee||No pre-use or approval requirement|
|“Advertisement” includes any communication to one or more persons||“Advertisement” generally includes any communication to more than one person|
|Applies to content intended to “obtain or retain” existing clients and investors||Applies to content that offers new or additional advisory services to current clients and investors|
|Clear and prominent risk disclosures||Fair and balanced risk disclosures|
|12-month compliance period||18-month compliance period|
|Material claims and statements prohibited unless substantiated||Reasonable basis for believing adviser can substantiate material facts upon SEC demand|
|Retail and non-retail investor distinction for performance presentation||No bifurcation between retail and non-retail investors|
|Gross performance in retail advertisements only if presented with equal prominence to net performance||Gross performance in any advertisements permissible only if presented with equal prominence to net performance|
|Did not explicitly address use of predecessor performance||Includes standards for use of predecessor performance|
The New Rule Consolidates the Advertising Rule and the Cash Solicitation Rule
The definition of “advertisement” under the new Marketing Rule has two separate prongs. The first prong captures communications traditionally considered advertising, while the second prong is intended to cover compensated solicitation activities previously addressed by the Cash Solicitation Rule.
The first prong of the definition of advertisement includes the following:
Any direct or indirect communication an investment adviser makes to more than one person, or to one or more persons if the communication includes hypothetical performance, 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.
Extemporaneous, live, oral communications and information included in legal and regulatory filings are excluded from the first prong. Certain communications, including hypothetical performance, are also excluded, as discussed below.
The second prong covers the following:
Any endorsement or testimonial for which an investment adviser provides compensation, directly or indirectly, but does not include any 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.
The second prong also excludes information provided in legal and regulatory filings.
The Definition of “Advertisement” is Expanded to Include Communications to Private Fund Investors
“Advertisement” under the new rule explicitly includes communications to private fund investors. While most private fund advisers seek to adhere to the current Advertising Rule and related guidance in their traditional advertising activities as a matter of best practice, the new Marketing Rule mandates compliance. The inclusion of private fund investors under the second prong, bringing them within the rules for solicitation activities, represents a significant change since they are not covered by the current Cash Solicitation Rule.
One-on-One Communications that Include Hypothetical Performance are Advertisements
In a welcome change from the proposal, the final Marketing Rule limits the definition of advertisement to communications to more than one person. Accordingly, one-on-one communications are generally not considered advertisements subject to the rule. However, there is an exception. Communications that include hypothetical performance information are considered advertisements if they are provided to one or more persons, unless they are provided (i) in response to an unsolicited request from a current or prospective client or private fund investor, or (ii) to a current or prospective private fund investor in a one-on-one communication.
Compensated Testimonials and Endorsements are Also Advertisements
The second prong of the definition of “advertisement” includes any endorsement or testimonial for which an investment adviser provides compensation, directly or indirectly. This is intended to capture paid solicitation activities, but it also covers paid endorsements and testimonials. Significantly, unlike the existing Cash Solicitation Rule, the Marketing Rule includes both cash and non-cash compensation. As a result, things of value like fee discounts, directed brokerage, and entertainment may trigger the rule if provided in compensation for a testimonial or endorsement.
Uncompensated testimonials and endorsements are not covered by the second prong of the Marketing Rule, but could be picked up by the first prong if they meet all the criteria. However, the first prong’s requirement that a communication be made directly or indirectly by the adviser means that an uncompensated third-party testimonial should not be an advertisement as long as the adviser did not create, edit, comment on or otherwise “entangle” itself (e.g., by deleting negative testimonials) with the communication. This has implications for social media, as discussed below.
Principles-Based General Standards will Apply to all Advertisements
The new Marketing Rule includes seven principles-based general prohibitions that apply to all advertisements. Specifically, an advertisement may not:
- Include any untrue statement of a material fact, or omit to state a material fact necessary in order to make the statement made, in the light of the circumstances under which it was made, not misleading
- Include 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
- Include information that would reasonably be likely to cause an untrue or misleading implication or inference to be drawn concerning a material fact relating to the investment adviser
- Discuss any potential benefits to clients or investors connected with or resulting from the investment adviser’s services or methods of operation without providing fair and balanced treatment of any material risks or material limitations associated with the potential benefits
- Include a reference to specific investment advice provided by the investment adviser where such investment advice is not presented in a manner that is fair and balanced
- Include or exclude performance results, or present performance time periods, in a manner that is not fair and balanced
- Otherwise be materially misleading
Fair and Balanced Specific Investment Recommendations are Permitted
Significantly, the new Marketing Rule eliminates the flat prohibition in the current Advertising Rule against past specific recommendations, permitting current and past specific investment recommendations to be presented, if they are presented in a fair and balanced manner. Although the new Marketing Rule affords more flexibility in the presentation of specific investment recommendations, the fair and balanced standard will require advisers to ensure that criteria for inclusion of investment examples and case studies are appropriate and that they are not misleading to investors.
The Prohibition on Testimonials is Eliminated
The current Advertising Rule’s ban on the use of testimonials of any kind is also eliminated in the new Marketing Rule. The new Marketing Rule imposes certain disclosure requirements on all testimonials and endorsements, whether or not compensated. Additionally, the new rule adds a further requirement that an adviser must have a reasonable basis for believing the testimonial or endorsement complies with the Marketing Rule requirements. This imposes an oversight obligation with respect to statements of third parties that will necessitate new procedures for any adviser using testimonials or engaging solicitors. With respect to compensated testimonials and endorsements, the adviser also must have a written agreement in place, much like under the current Cash Solicitation Rule.
Third-Party Ratings are Subject to Additional Diligence and Disclosures
Investment advisers are permitted under the new Marketing Rule to use third-party ratings, but only if they satisfy conditions designed to ensure they are not misleading. These conditions require the adviser to have a reasonable basis for believing any relevant questionnaire or survey was not designed to get to a predetermined outcome and equally allowed for favorable and unfavorable responses. An adviser that includes third-party ratings in an advertisement must also include clear and prominent disclosures noting the date, identity of the provider, and any compensation paid.
SEC Provides Guidance Around Social Media and Advertising
The adopting release for the new Marketing Rule provides guidance on social media use by investment advisers and their personnel. The SEC clarified in the release that an adviser is generally not responsible for third-party social media likes, shares, and endorsements if the adviser is not selectively deleting, altering, or prioritizing third-party postings, or otherwise involved in their preparation. The release also recommends advisers consider implementing policies and procedures prohibiting use of personal social media by employees to market advisory services, together with training, periodic certifications, and review of employees’ publicly available social media sites.
Significant New Requirements Apply to the Presentation of Performance Information
Gross and Net Returns Displayed with Equal Prominence
One of the most important substantive provisions relating to performance advertising is the new Marketing Rule’s prohibition on the presentation of gross performance returns in any advertisement unless net returns are presented with equal prominence and in a manner that facilitates comparison. Gross and net returns also must be calculated over the same time periods and using the same type of return methodology.
Prescribed Time Periods (1-, 5-, and 10-Year Performance)
Another significant change is the requirement that advisers present performance for specified time periods, as currently required for registered investment companies. Specifically, advertised performance must show 1-, 5-, and 10-year returns (or returns since inception for accounts not in existence for the prescribed period). We anticipate this will require significant updating of marketing materials by many investment advisers. The 1-, 5-, and 10-year requirement does not apply to private fund returns.
Related Performance Must Include All Accounts
Under the new Marketing Rule, an adviser must show performance of all related portfolios (i.e., those with substantially similar investment policies, objectives, and strategies like those being offered in the advertisement, etc.) and may exclude a related portfolio only if the advertised returns would not be materially higher without it, nor affect the adviser’s ability to present the prescribed time periods. This is likely to be a significant change for many investment advisers, particularly those that do not claim compliance with the Global Investment Performance Standards (GIPS®) or typically calculate composite performance.
Specifically, an adviser may use a representative account only if the performance of that account is not materially higher than that of a composite of all related portfolios. In order to make that determination, an adviser will need to calculate composite performance in order to substantiate the appropriateness of using the representative account’s returns.
Extracted performance is defined by the new Marketing Rule as the performance of a subset of investments from a single portfolio. An adviser using extracted performance will be required to provide, or offer to provide, the performance of the entire portfolio. Additionally, advisers showing extracted performance will now be required to include disclosures about the allocation of cash.
Hypothetical Performance (Model, Back-tested, Target, and Projected Returns)
Under the new rule, hypothetical performance includes model and back-tested performance, as well as targeted and projected returns. The rule prohibits presentation of any of these in advertisements unless an adviser satisfies certain conditions. An adviser that wants to use hypothetical returns must implement new policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the applicable audience. The adviser must also disclose all relevant criteria used and assumptions made in calculating the hypothetical performance. Finally, enough information must be provided (or, for private fund investors, offered) to allow the intended audience to understand the risks and limitations of what is being presented.
New Hurdles for Predecessor Performance
Use of performance results achieved at a predecessor firm is now explicitly covered in the new Marketing Rule, whereas advisers have previously relied on no-action guidance. However, the requirements under the new Marketing Rule impose significant new conditions on advisers seeking to use such predecessor returns. For example, the individual primarily responsible for achieving the prior performance must continue to manage the account at the advertising adviser so that the predecessor performance may no longer be used if that individual leaves the firm. In addition, the rule makes clear that all accounts managed at the predecessor firm must be included unless exclusion would not result in materially higher performance. An adviser using predecessor performance must therefore ensure that it has records supporting all performance. Other conditions include that accounts managed at the predecessor firm are sufficiently similar to accounts managed at the adviser, and that the advertisement includes clear and prominent disclosures indicating the returns were from accounts managed at another adviser.
Advisers who use predecessor performance in their advertising materials will need to carefully review the requirements.
Advisers will be Required to Disclose Advertising and Marketing Practices in Form ADV Part 1A
Part 1A of Form ADV will be updated to include a new Item 5.L, which will require disclosure by advisers of certain advertising practices. The new information will be required in the adviser’s first annual Form ADV update after the Marketing Rule’s transition period ends. For advisers with a calendar fiscal year, this will be March 2023.
Additional Requirements are Implemented for Marketing Books and Records
Finally, several changes have been adopted to the Books and Records Rule (Rule 204-2 under the Advisers Act) to correspond to the new Marketing Rule, which will require retention of additional advertising and marketing records, including the following:
- Records of all advertisements disseminated by the adviser (in contrast to the current rule’s requirement to retain advertisements sent to ten or more persons)
- All written communications relating to the performance or rate of return of any portfolio
- All information provided or offered pursuant to the hypothetical performance provisions, as applicable
- Documentation of communications relating to predecessor performance
- A record of who the “intended audience” is for hypothetical performance
- Any communication or other document related to the adviser’s determination that it has a reasonable basis for believing a testimonial, endorsement or third-party rating complies with the rule’s requirements
- A copy of any questionnaire or survey used in preparing a third-party rating to the extent the adviser has obtained a copy
When Do I Need to Comply?
Fortunately, the SEC provided for an eighteen month transition period for compliance with the new Marketing Rule, which affords advisers time to give thoughtful consideration to the application of the new rule and its implications for their advertising and solicitation practices. Note that early adoption of the rule’s requirements is permitted, but advisers should not roll out updated advertising and marketing procedures and materials until they are in a position to comply with the entirety of the rule.
Given the significant changes that will need to be made to policies, procedures, and advertising materials, advisers should take advantage of the transition period and begin now to evaluate necessary updates. Specifically, advisers should:
- Review and update written policies and procedures addressing advertising and marketing to reflect the new Marketing Rule
- Evaluate existing materials and assess the implications of the new rule, including with respect to the presentation of performance
- Review disclosures and update to ensure they meet the expectations of the new rule in substance and presentation
- Assess use of compensated testimonials, endorsements, and solicitation arrangements
- Train relevant personnel on the new requirements
- Update books and records requirements to ensure all required records are maintained.
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How We Help
ACA can help you understand the requirements of the Marketing Rule as they relate to your business and help you prepare for new regulation. Our risk and compliance management solutions incorporate consulting, managed services, technology, and education to provide our clients with a holistic approach to addressing risk, increasing operational efficiencies, and meeting regulatory requirements while adhering to industry best practices.
- Focused Performance Review: Assists your firm in assessing the gaps related to the various performance components in the new Marketing Rule.
- ComplianceAlpha® Marketing Review Solution: Helps your firm’s marketing and legal teams easily manage workflows for submitting, reviewing, approving, and archiving marketing and advertising materials.
- Marketing and Advertising Review Assistance: Allows your firm to significantly reduce the amount of time and resources devoted to the marketing and advertising review process. ACA’s skilled compliance professionals can step in during periods of high volume or assist your firm with enhancing collateral review workflows and protocols.
For More Information
If you have any questions about the new Marketing Rule or how ACA can help your firm evaluate and update its advertising and solicitation procedures to comply or to assess your broader compliance review resourcing, please reach out to your ACA consultant or contact us below.