As noted previously, the Securities and Exchange Commission (“SEC”) has announced that it is releasing proposed amendments to the cash solicitation and advertising rules that impact investment advisers. In this discussion, we are focusing on the proposed amendments to the advertising rules under the Investment Advisers Act of 1940 (the “Act”). The advertising rule has not been amended significantly since its adoption in 1961, although there are numerous No-Action Letters and other informal guidance that has been issued over the years by the SEC.
Overview of the Proposed Advertising Rule Amendments
The proposed amendments to the advertising rule would replace the current rule’s broadly drawn limitations with principles-based provisions. The proposed approach would also permit the use of testimonials, endorsements, and third-party ratings, subject to certain conditions, and would include tailored requirements for the presentation of performance results based on an advertisement’s intended audience.
Proposed Structure of the Rule
The proposed advertising rule is organized as follows: (i) general prohibitions of certain advertising practices applicable to all advertisements; (ii) tailored restrictions or conditions on certain practices (testimonials, endorsements, and third-party ratings) applicable to all advertisements; (iii) tailored requirements for the presentation of performance results, based on the advertisement’s intended audience; and (iv) a compliance requirement that most advertisements be reviewed and approved in writing by a designated employee before dissemination. The proposed rule would apply to all investment advisers registered, or required to be registered, with the SEC.
Definition of Advertisement
The proposed rule would update the definition of “advertisement” so that it is flexible enough to remain relevant and effective in the face of advances in technology and evolving industry practices. To that end, the definition would include any communication, disseminated by any means, by or on behalf of an investment adviser, that offers or promotes investment advisory services or that seeks to obtain or retain advisory clients or investors in any pooled investment vehicle advised by the adviser.
Proposed Exclusions from Definition
To clarify certain activities engaged in by advisers, the SEC has proposed exclusions from the definition of advertising. Those exclusions include:
- Live oral communications that are not broadcasted;
- Responses to certain unsolicited requests for specified information;
- Advertisements, other sales material, or sales literature that is about a registered investment company or a business development company, and is within the scope of other SEC rules; and
- Information required to be contained in a statutory or regulatory notice, filing, or other communication.
General Prohibitions Related to Advertising
The proposed rule would specifically prohibit the following advertising practices:
- An adviser 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;
- The making a material claim or statement that is unsubstantiated;
- 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;
- Anti-Cherry-Picking Provisions to address 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.
It is important to note that with respect to the prohibitions, the SEC has noted that to establish a violation of the proposed rule, the SEC would not need to prove intent, only that the adviser was negligent.
Testimonials, Endorsements and Third-Party Ratings
The proposed rule would permit testimonials, endorsements and third-party ratings, subject to specified clear and prominent disclosures. However, under the proposed rule, in all instances where a testimonial, endorsement, or third-party rating would be an advertisement, the adviser would be required to comply with both the tailored conditions of the proposed rule that are discussed below, as well as the proposed rule’s general prohibitions on certain advertising practices.
Definition of testimonial, endorsement, and third-party rating. The proposed rule defines “testimonial” as “any statement of a client’s or investor’s experience with the investment adviser or its advisory affiliates. It defines “endorsement” as “any statement by a person other than a client or investor indicating approval, support, or recommendation of the investment adviser or its advisory affiliates. Finally, it defines “third-party rating” 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.”
Testimonial and Endorsement Disclosures. The proposed rule would require that an investment adviser clearly and prominently disclose, or the investment adviser reasonably believe that the testimonial or endorsement clearly and prominently discloses, that the testimonial was given by a client or investor, and the endorsement was given by a non-client or non-investor, as applicable. The proposed rule would also require that the investment adviser clearly and prominently disclose, or the investment adviser reasonably believe that the testimonial or endorsement clearly and prominently discloses, that cash or non-cash compensation has been provided by or on behalf of the adviser in connection with the testimonial or endorsement. In order to comply with the requirement for the disclosure to be clear and prominent, the disclosure must be at least as prominent as the testimonial, endorsement or third-party rating.
Third-Party Disclosures. The proposed rule would also require that the investment adviser clearly and prominently disclose, or the investment adviser reasonably believe that the third-party rating clearly and prominently discloses, that cash or non-cash compensation has been provided by or on behalf of the adviser in connection with the third-party rating. Additionally, the disclosure for third-party ratings in advertisements would be subject to two additional disclosure requirements. Specifically, the proposed rule would require that the investment adviser clearly and prominently disclose, or the investment adviser must form a reasonable belief, that the third-party rating clearly and prominently discloses: (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. The SEC has noted that an adviser that uses third-party ratings in advertisements should develop policies and procedures to implement this “reasonable belief” provision as part of its compliance program.
Compensation. Unlike FINRA, the SEC is not proposing a de minimis exception for the proposed compensation disclosure because the SEC believes that investors should be made aware when advisers provide even a small amount of compensation in connection with testimonials, endorsements, and third-party ratings in advertisements. To that end, the SEC believes that smaller amounts can also influence a third party to make a favorable statement or a positive rating.
Advertisements containing performance results (“performance advertising”) would be subject to the proposed rule’s general prohibitions. These prohibitions would address the risk of performance advertising containing any untrue statements of material fact or being otherwise materially misleading. Performance advertising raises special concerns, however, that warrant additional requirements and restrictions under the proposed rule. In particular, the SEC believes that the presentation of performance can lead reasonable investors to unwarranted assumptions and thus would result in a misleading advertisement. To address this, and other issues related to performance advertising, the proposed rule contains a list of prohibited advertising practices, rather than permitted subject to specified conditions, and these prohibitions would also apply to performance advertising. The prohibited performance advertising is set forth below.
Prohibited Performance Advertising. The proposed rule would specifically, prohibit any of the following advertisements:
- Gross performance results unless it provides (or offers to provide promptly) a schedule of fees and expenses deducted to calculate net performance;
- Any statement that the calculation or presentation of performance results has been approved or reviewed by the Commission;
- Performance results from fewer than all portfolios with substantially similar investment policies, objectives, and strategies as those being offered or promoted in the advertisement, with limited exceptions;
- Performance results of a subset of investments extracted from a portfolio, unless it provides or offers to provide promptly the performance results of all investments in the portfolio; and
- Hypothetical performance, unless the adviser adopts and implements policies and procedures reasonably designed to ensure that the performance is relevant to the financial situation and investment objectives of the recipient and the adviser provides certain specified information underlying the hypothetical performance.
Retail and Non-Retail Persons. The proposed rule attempts to address the differences in disclosure requirements inherent in performance disclosures to “Retail Persons” and “Non-Retail Persons”. Therefore, the proposed rule defines a “Non-Retail Advertisement” to mean any advertisement for which an adviser has adopted and implemented policies and procedures reasonably designed to ensure that the advertisement is disseminated solely to non-retail persons. For purposes of the rule, “Non-Retail Person” would be defined as two types of investors: “qualified purchasers,” and “knowledgeable employees.”
Performance Information in a Retail Advertisement. The proposed rule would provide additional protections for an advertisement targeted to a retail audience in that it would require (i) the presentation of net performance alongside any presentation of gross performance, and (ii) generally the presentation of the performance results of any portfolio or certain composite aggregations across 1, 5, and 10-year periods. Non-Retail Advertisements would not require these disclosures.
Internal Pre-Use Review and Approval. In addition, the proposed amendments would require advertisements to be reviewed and approved in writing by a designated employee before dissemination. The exception to pre-use review and approval would be for advertisements that are:(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.
Investors and investment advisers are encouraged to provide comments on the proposed changes once the proposed amendments are published on the SEC’s website and in the Federal Register. The public comment period will remain open for 60 days after publication in the Federal Register.
Discussion of the Solicitation Rule Amendment Forthcoming
We will follow-up on the proposed amendments to the solicitation rules in the very near future, so that you can start analyzing the impact of that rule set on your advisory activities. In the interim, should you have any questions regarding this matter, please feel free to contact us.