As noted in our earlier articles, the Securities and Exchange Commission (“SEC”) adopted reforms under the Investment Advisers Act of 1940 (“Act”) to modernize rules that govern investment adviser advertisements and payments to solicitors (collectively the “Rule”). In those articles we discussed the Rule from a 50,000-foot level, and then we drilled down into the operational ramifications inherent in the definition of “advertisement” as set forth in the Rule.
This article focuses on the testimonials, endorsements and third-party ratings, which come under the second prong of the definition of advertising (to wit, the definition of advertising generally includes any endorsement or testimonial for which an adviser provides cash and non-cash compensation directly or indirectly (e.g., directed brokerage, awards or other prizes, and reduced advisory fees). This section of the rule merges the current advertising rule with the current cash solicitation rule, covering solicitation activity under the definitions of testimonials and endorsements, and applying the certain specific requirements described below.
With the above in mind, it is important to note for our purposes here, that the Rule now permits the use of testimonials, endorsements, and third-party ratings, subject to certain disclosures and other specific conditions discussed below.
The Rule defines testimonials and endorsements as follows:
A testimonial is any statement by a current client or investor in a private fund advised by the investment adviser: (i) about the client or investor’s experience with the investment adviser or its supervised persons; (ii) 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 (iii) 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.
An endorsement is any statement by a person other than a current client or investor in a private fund advised by the investment adviser that: (i) 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; (ii) 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 (iii) 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.
Cash and Non-Cash Compensation
The second prong of the final marketing rule’s definition of advertisement is triggered by any form of compensation – whether cash or non-cash – that an adviser provides, directly or indirectly, for an endorsement or testimonial.
The forms of compensation covered by the Rule will include fees based on a percentage of assets under management or amounts invested, flat fees, retainers, hourly fees, reduced advisory fees, fee waivers, and any other methods of cash compensation, and cash or non-cash rewards that advisers provide for endorsements and testimonials, including referral and solicitation activities. They also include directed brokerage that compensates brokers for soliciting investors, sales awards or other prizes, gifts and entertainment, such as outings, tours, or other forms of entertainment that an adviser provides as compensation for testimonials and endorsements.
It should also be noted that compensation for endorsements and testimonials may or may not be contingent on the endorsement or testimonial resulting in a new advisory relationship or a new investment in a private fund.
Activities that Constitute a Testimonial or Endorsement
Under the Rule, testimonials and endorsements will include opinions or statements by persons about the investment advisory expertise or capabilities of the adviser or its supervised persons. Testimonials and endorsements also include statements in an advertisement about an adviser or its supervised person’s qualities (e.g., trustworthiness, diligence, or judgment) or expertise or capabilities in other contexts, when the statements suggest that the qualities, capabilities, or expertise are relevant to the advertised investment advisory services.
With that in mind, a compensated testimonial or endorsement will meet the definition of advertisement’s second prong regardless of whether the communication is made orally or in writing, to one or more persons. By contrast, an uncompensated testimonial or endorsement would have to meet the elements of prong one of the Rule in order to be considered an “advertisement.”
Additionally, the SEC offered examples of activities likely to be an endorsement or testimonial (provided such activities involve direct or indirect compensation), including:
- Websites of adviser referral networks or lead-generation firms (endorsement).
- Blogger’s website reviews of an adviser’s advisory service (testimonial or endorsement).
- A lawyer or other service provider that refers an investor to an adviser, even if on an infrequent basis, depending on the facts and circumstances (testimonial or endorsement).
Examples of activities not likely to be an endorsement or testimonial included:
- An adviser pays a third-party marketing service or news publication to prepare content for and/or disseminate a communication.
- A non-investor sells an adviser a list containing the names and contact information of prospective investors.
Exclusion for Regulatory Communications
The second prong of the definition of advertisement excludes 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. As with the same exclusion in the first prong of the definition, this exclusion reflects our belief that communications that are prepared as a requirement of statutes, rules, or regulations should not be viewed as advertisements under the rule.
Inclusion of One-on-one and Extemporaneous, Live, Oral Communications
Unlike the first prong of the definition of advertisement, however, this prong does not exclude extemporaneous, live, oral communications or one-on-one communications. The SEC notes that these types of communications are precisely what the second prong of the definition seeks to address, along with other types of endorsement and testimonial activities.
Conditions Applicable to Testimonials and Endorsements
The adviser must “clearly and prominently” disclose, or reasonably believe that the person giving the testimonial or endorsement discloses, at the time the testimonial or endorsement is disseminated, whether the person giving the testimonial or endorsement is a client and whether such person is compensated. Additional disclosures are required regarding the material terms of the compensation arrangement (including a description of the compensation provided or to be provided, directly or indirectly) and a description of the “material” conflicts of interest on the part of the person giving the testimonial or endorsement resulting from the adviser’s relationship with such person and or any compensation arrangement. There are exceptions from the disclosure requirements for SEC-registered broker-dealers under certain circumstances.
As a final note, it is important to acknowledge that the SEC guidance regarding “clear and prominent” is that the required disclosure must be at least as prominent as the testimonial or endorsement. In other words, the SEC believes that “the clear and prominent standard requires that the disclosures be included within the testimonial or endorsement, or in the case of an oral testimonial or endorsement, provided at the same time.”
Oversight and Written Agreement
An adviser that uses testimonials or endorsements in an advertisement must oversee compliance with the Rule. Additionally, the adviser must enter into a written agreement with any person giving a testimonial or endorsement, which agreement describes the agreed-upon activities and the terms of compensation for such activities. The exceptions to this requirement occurs where the person giving the testimonial or endorsement is an affiliate of the adviser or such person receives de minimis compensation (i.e., $1,000 or less, or the equivalent value in non-cash compensation, during the preceding twelve months).
Disqualification for Person Who Engaged in Misconduct
The Rule prohibits an adviser from compensating a person, directly or indirectly, for a testimonial or endorsement if the adviser knows, or in the exercise of reasonable care should know, that the person giving the testimonial or endorsement is an ineligible person at the time the testimonial or endorsement is disseminated. An ineligible person includes a person who is subject to a disqualifying Commission action or is subject to any disqualifying event that occurred within 10 years prior to the endorsement of testimonial. It also includes any employee, officer, or director of an ineligible person and any other individuals with similar status or functions within the scope of association with an ineligible person. For purposes of the Rule, a disqualifying Commission action is any Commission opinion or order barring, suspending, or prohibiting a person from acting in any capacity under the Federal securities laws.
For purposes of the Rule, “third-party rating” is defined as a “rating or ranking of an investment adviser provided by a person who is not a related person (as defined in the Form ADV Glossary of Terms), and such person provides such ratings or rankings in the ordinary course of its business.”
With that in mind, the Rule prohibits third-party ratings in an advertisement unless they comply with the rule’s general prohibitions and additional conditions. To that end, an investment adviser may not include a third-party rating in its advertisement unless the adviser has a reasonable basis for believing that (i) any questionnaire or survey used in the preparation of the third-party rating is structured to make it equally easy for a participant to provide favorable and unfavorable responses, and is not designed or prepared to produce any predetermined result; and (ii) it clearly and prominently discloses, or the investment adviser reasonably believes that the third-party rating clearly and prominently discloses: (a) the date on which the rating was given and the period of time upon which the rating was based; (b) the identity of the third-party that created and tabulated the rating; and (c) if applicable, that compensation has been provided directly or indirectly by the adviser in connection with obtaining or using the third-party rating.
Performance Advertising and Solicitation Arrangements
As we continue to build on the ramifications of the Rule, our next article will address performance advertising by advisers, which will be followed by an article discussing the utilization of solicitors pursuant to the Rule.