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Securities Alert

December 3, 2019

Proposed Changes to the SEC Advertising and Solicitation Rules

By Michael E. Hollingsworth II, Kay A. Gordon, Mollie K. Davis

The Securities and Exchange Commission (the “SEC”) announced proposed reforms to the SEC Rule 206(4)-1 (the “Advertising Rule”) and 206(4)-3 (the “Solicitation Rule”) governing the use of marketing and advertisement by SEC-registered investment advisers on November 4, 2019. The proposed rule amendments (the “Marketing Amendment”) will be the first major amendments to these regulations since the adoption of the rules in 1961 and 1979, respectively. This alert summarizes the proposed changes and highlights key planning considerations for advisers.

Proposed Changes to the Advertising Rule

The proposed reforms to the Advertising Rule aim to update the regulation to reflect changes in the industry since the rule’s adoption in 1961. Other than a minor amendment in 1997, the SEC has failed to update the rule to reflect almost 60 years of changes in technology, modes of advertising, and communication expectations between advisers and their target market that have drastically transformed the industry. If accepted, the proposed changes will replace the original per se prohibitions outlined in the Advertising Rule with a more flexible principles-based approach. The following is a list of proposed revisions to the Advertising Rule:

  • Expands the definition of “Advertisement.” The new definition of “Advertisement” in the Marketing Amendment would broaden the Advertising Rule’s applicability to “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.” Instead of limiting this definition to certain modes of advertising (such as through television or radio), this new definition encompasses broader modes of communications between advisers and current and potential investors, including live oral communications that are not broadcast on any media.
     
  • Replaces per se prohibitions on advertising with a principles-based approach. The current Advertising Rule currently imposes a number of per se prohibitions on specific advertising practices that are viewed as potentially misleading to investors. In the proposed Marketing Amendment, these specific prohibitions would be replaced with a principles-based framework that prohibits misleading advertising practices regardless of the mode of communication. Under this new framework, investment advisers must not directly or indirectly disseminate any advertisement which:
  1. Makes an untrue statement of a material fact or omits to state a material fact necessary to make the statement made not misleading in light of the circumstances;
  2. Makes an unsubstantiated material claim or statement;
  3. Makes an untrue or misleading implication (or a statement reasonably likely to cause such implication) about a material fact relating to or concerning the investment adviser;
  4. Implies or discusses potential client benefits without clear and prominent disclosure of associated material risks or other limitations;
  5. Refers to specific investment advice from the adviser without presenting such advice in a fair and balanced manner;
  6. Includes or excludes certain performance results or metrics without presenting such results or metrics in a fair and balanced manner; or
  7. Is otherwise materially misleading.

This broader framework is a clear departure from the current rule’s prohibitions on specific types or modes of advertisements that may be misleading.

  • Instead of an outright prohibition, provides specific restrictions on use of testimonials, endorsements, and third-party ratings. In another significant departure from the current Advertising Rule, the Marketing Amendment proposes to expressly permit the use of testimonials, endorsements, and third-party ratings by investment advisers subject to the following restrictions:
  1. Third-Party Ratings. Third-party ratings are permitted only if the adviser reasonably believes that such rating is designed and prepared to produce unbiased results and is accompanied by certain clear disclosures relating to the timing of the rating, identity of the third party, and any compensation paid in connection with the rating.
  2. Testimonials and Endorsements. As the use of testimonials in advertising materials is prohibited under the current Advertising Rule, the express allowance of testimonials and endorsements in advertising is a notable change in the Marketing Amendment. With the proposed modifications, investment advisers would be able to promote their services using testimonials and endorsements only if advisers clearly and prominently disclose (a) whether such testimonial or endorsement was given by a client/investor or non-client/non-investor and (b) whether any cash or non-cash compensation was provided in connection with such endorsement or testimonial.          
  • Limits use of performance results based on target audience. Under the proposed Marketing Amendment, the following types of past performance information in advertising are prohibited:
  1. Gross performance results, unless accompanied by (or promptly followed by) a schedule of fees and expenses deducted to calculate net performance;
  2. Any statement or implication that the performance information has been reviewed or approved by the SEC;
  3. 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 few exceptions);
  4. Performance results for only a portion of investments within a certain portfolio, unless such advertisement provides or offers to provide such results for the full portfolio; and
  5. Hypothetical performance, unless the adviser (a) adopts and implements policies and procedures reasonably designed to ensure that performance is relevant to the financial situation and investment goals of the target audience of such advertisement and (b) discloses sufficient information relating to the assumptions used to calculate such performance and the attendant risks and limitations of such data.
  • Requires pre-approval before dissemination. Finally, the proposed amendment would require each adviser to appoint an employee responsible for ongoing review and approval of all advertisements before dissemination.

Proposed Changes to the Solicitation Rule

Since its adoption in 1979, the Solicitation Rule has applied to only situations in which advisers pay cash compensation to solicitors for services rendered. The proposed Marketing Amendment expands this rule to also apply to situations in which advisers pay any direct or indirect compensation to solicitors, including directed brokerage or fee-reduction arrangements. In addition, the proposed modifications would apply the Solicitation Rule to cover solicitation of existing and prospective investors in private funds.

Though the Marketing Amendment retains most of the current Solicitation Rule’s partial exemptions (such as for solicitors that refer investors for impersonal advisory services like robo-advice), the proposal includes the two new exemptions for de minimis compensation to solicitors (less than $100 in any 12-month period) and firms that utilize certain nonprofit programs. Other changes to the Solicitation Rule include the following:

  • Requirement of written agreement with solicitors. The Marketing Amendment requires solicitors and advisers enter into a written agreement that specifies (a) which solicitation activities are to be performed and the terms of any related compensation, (b) that the solicitor will perform such activities in compliance with the Solicitation Rule, and (c) that either the solicitor or the adviser will deliver the required disclosures to investors in connection with the solicitation (the “Investor Disclosure”). While the current Solicitation Rule requires the Investor Disclosure to be delivered at the time of solicitation, the Marketing Amendment would also allow the Investor Disclosure to be delivered, in the case of a mass communication, as soon as is reasonably practicable after an investor expresses an initial interest in the adviser’s services.
     
  • Adviser oversight of solicitors. The current Solicitation Rule requires an adviser to make “bona fide effort to ascertain whether the solicitor has complied with” the terms of the written agreement between the adviser and the solicitor. The Marketing Amendment instead requires advisers to confirm that the adviser has “a reasonable basis for believing that a solicitor has complied with the written agreement.” In forming and documenting this “reasonable basis,” advisers should make inquiries of investors to determine whether solicitors are in compliance with their written agreements and the Solicitation Rule.
     
  • Increased disclosure requirements. The Solicitation Rule as modified by the proposal would require additional information relating to a solicitor’s conflict of interest be included in the Investor Disclosure, but would no longer require an adviser to obtain an investor’s acknowledgement of the receipt of such Investor Disclosure.
     
  • Modifications regarding disqualified solicitors. The current Solicitation Rule strictly prohibits advisers from doing business with solicitors who have experienced certain disqualifying disciplinary events. Under the proposed amendment, an adviser would only be prohibited from engaging with such solicitor if the adviser knew (or in the exercise of reasonable care should have known) that the solicitor was a disqualified party. The amendment also expands the list of disqualifying events.

Proposed Changes to the Books and Records Rule; Form ADV Disclosures

In order to track compliance with the aforementioned changes to the Advertising Rule and the Solicitation Rule, the SEC proposed new record-keeping requirements for advisers under Rule 204-2 of the Advisers Act (the “Books and Records Rule”). Under these proposed modifications, each adviser must make and retain records of each of the following:

  • Any advertisement disseminated to one or more persons (the current rule only applies to advertisements sent to ten or more persons);
  • The content of and results from any questionnaire or survey used to create a third-party rating used in an advertisement;
  • Any written approval by the designated employee responsible for approval and compliance with the rules;
  • Underlying data and written documentation relating to or supporting the calculation of any hypothetical performance of a portfolio or a portfolio’s actual performance or rate of return as disclosed in any advertisement;
  • Any Investor Disclosure delivered to investors;
  • Any communication or documentation relating to the adviser’s oversight of a solicitor’s compliance with the terms of its written agreement; and
  • The names of all solicitors who are the adviser’s partners, officers, directors, employees, or other affiliates.

In addition, the Marketing Amendment would require advisers to disclose on Form ADV whether any advertisement:

  • Contains performance results and, if so, whether such results were verified or reviewed by any third party;
  • Includes testimonials, endorsements, or third-party ratings and, if so, any compensation provided for such third-party statements;
  • Refers to any specific past investment advice provided by the adviser.

Practical Ramifications for Investment Advisers

These proposed updates to the Advertising Rule and Solicitation Rule aim to provide a framework that will be more “evergreen” in light of continuing changes in technology within the investment advisory industry, expectations of investors when shopping for advisory services, and the types and sophistication of investors seeking services. Such framework is expected to be much more reliant on compliance and policies and procedures approach than in the past.

If adopted, the Marketing Amendment would drastically change the advertising landscape for advisers today and would require increased record-keeping practices and administrative oversight in order to remain in compliance. These proposed versions are subject to public review and comment for the next 60 days.