New SEC Marketing Rule: A Registered Investment Adviser’s Guide

We caught up with Mark DeAngelis, an Arootah Chief Compliance Officer (CCO) Consultant about the SEC’s new marketing rule around advertising and cash solicitation. Mark has more than 23 years of compliance, legal, and regulatory experience and has served in such roles as CCO for the UIT Division of a global financial institution, ETF asset managers, and private fund advisors. Previously, Mark had a long tenure as Vice President, Legal & Compliance Division for a major investment bank and an Investigator in both the Market Regulation and Advertising Regulation Departments of FINRA. Here’s what he had to say about the rule, the risks it presents and opportunities you may be able to unlock.

Effective November 4, 2022, the Securities and Exchange Commission (the “SEC”) will mandate that all Investment Advisers under its authority operate under a newly revised Rule 206(4)-1 (the “Marketing Rule”) under the Investment Advisers Act of 1940. This new Marketing Rule replaces the current advertising and cash solicitation rules, Rule 206(4)-1 and Rule 206(4)-3, respectively. These amendments reflect market developments and regulatory changes since the advertising rule’s adoption in 1961 and the cash solicitation rule’s adoption in 1979. The Marketing Rule is designed to regulate advisers’ marketing communications comprehensively and efficiently.

The new marketing rule codifies SEC Staff “No-Action” Letters on a variety of advertising-related topics but also increases the risk to registered investment advisers (“RIAs”). RIAs found in non-compliance with the new marketing rule will be in violation of a rule promulgated under the Investment Advisers Act of 1940 (“Advisers Act”) rather than Staff’s interpretive guidance.

Key Specific Changes Impacting RIAs Under the Marketing Rule Include:

• Testimonials and endorsements made by third parties will be considered advertisements of the RIA if the RIA compensates the third party for these activities
• Prescriptive measures for marketing activities related to private funds
• Performance advertising standards requiring display of returns for specific time periods, and conditions for the use of hypothetical performance and extracted returns

The SEC has taken great effort to describe what constitutes an “advertisement” and certain communications that are outside the scope of the rule. The rule itself has two prongs that help RIAs in the evaluation of its advertisements (including those leveraged by third parties) and, by extension, developing policies to conduct oversight.

First Prong — Advertisements

The first prong defines an “advertisement” to include any direct or indirect communication an investment adviser makes that: (i) offers the investment adviser’s investment advisory services with regard to securities to prospective clients or private fund investors, or (ii) offers new investment advisory services with regard to securities to current clients or private fund investors.

• The first prong does not include one-on-one communications. However, hypothetical performance information does not qualify for this one-on-one exclusion unless provided in response to an unsolicited investor request or to a private fund investor.
• The first prong also does not include extemporaneous, live, oral communications, and information contained in a statutory or regulatory notice, filing, or other required communication.

Second Prong — Compensated Testimonials and Endorsements

The second prong defines an “advertisement” to also include: any endorsement or testimonial for which an adviser provides cash or non-cash compensation directly or indirectly (e.g., directed brokerage, awards or other prizes, and reduced advisory fees).

Practices Prohibited in All Advertisements Under the Marketing Rule

The marketing rule contains seven general prohibitions on types of activity that could be false or misleading that apply to all advertisements. It also prohibits advertisements that contain testimonials, endorsements, third-party ratings, and performance information, unless certain conditions are met, as described below.

Under the general prohibitions, an advertisement may not:

• Include an untrue statement of a material fact, or omit to state a material fact necessary to make the statement made, in 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 adviser
• Discuss any potential benefits without providing fair and balanced treatment of any associated material risks or limitations
• Reference specific investment advice provided by the adviser that is not presented in a fair and balanced manner
• Include or exclude performance results, or presenting performance time periods, in a manner that is not fair and balanced
• Otherwise be materially misleading

The types of testimonials and endorsements that may be used in an advertisement under the Marketing Rule

The marketing rule permits the use of testimonials and endorsements in an advertisement, if the adviser satisfies certain disclosure, oversight, and disqualification provisions:

• Disclosure. Advertisements must clearly and prominently disclose whether the person giving the testimonial or endorsement (the “promoter”) is a client and whether the promoter is compensated. Additional disclosures are required regarding compensation and conflicts of interest. There are exceptions from the disclosure requirements under certain circumstances for testimonials or endorsements by SEC-registered broker-dealers and certain personnel and affiliates.
• Oversight and Written Agreement. An adviser that uses testimonials or endorsements in an advertisement must oversee compliance with the marketing rule. An adviser also must enter into a written agreement with promoters, except where the promoter is an affiliate of the adviser, or the promoter receives de minimis compensation
• Disqualification. The rule prohibits certain “bad actors” from acting as promoters for compensation, subject to exceptions where other disqualification provisions apply.

What Performance Information can an Adviser Use in an Advertisement Under the Marketing Rule?

The marketing rule allows the inclusion of performance information in an advertisement if certain conditions are met.

The marketing rule prohibits including in any advertisement:

• Gross performance, unless the advertisement also presents net performance subject to certain conditions
• Any performance results, unless they are provided for specific time periods in most circumstances
• Any statement that the Commission has approved or reviewed any calculation or presentation of performance results
• Performance results from fewer than all portfolios with substantially similar investment policies, objectives, and strategies as those being offered in the advertisement, with limited exceptions
• Performance results of a subset of investments extracted from a portfolio, unless the advertisement provides, or offers to provide promptly, the performance results of the total portfolio
• Hypothetical performance (which does not include performance generated by interactive analysis tools), unless the adviser adopts and implements policies and procedures reasonably designed to ensure that the performance is relevant to the likely financial situation and investment objectives of the intended audience and the adviser provides certain information underlying the hypothetical performance
• Predecessor performance unless there is appropriate similarity with regard to the personnel and accounts at the predecessor adviser and the personnel and accounts at the advertising adviser. In addition, the advertising adviser must include all relevant disclosures clearly and prominently in the advertisement

RIAs that manage registered investment companies (“RICs”), business development companies (“BDCs”), pooled investment vehicles (“PIVs”), and/or private funds (or investment companies exempted by section 3(C)(1) or 3(C)(7) of the Investment Company Act of 1940) also garner more guidance from the newly revised Marketing Rule.

Communications to investors in RICs, BDCS, and PIVs (excluding “private funds”) are outside the scope of the Marketing Rule. Conversely, communications sent to investors in private funds are in the scope of the Marketing Rule. RIAs in this space must be aware that a private placement memorandum (PPM) that includes content that promotes its advisory services would be subject to the Marketing Rule. Hence, RIAs in these circumstances may consider limiting the PPM to include only the attendant material terms, objectives, and risks of the fund offering.

In adopting policies for the SEC’s new Marketing Rule, RIAs are presented with both greater opportunity and greater risk as the rule’s flexible principles-based standards allow for increased latitude but compel more robust controls.

Disclaimer: This article is for general informational purposes only and does not constitute legal, investment, financial, accounting, or tax advice, or establish an attorney-client relationship.  Arootah does not warrant or guarantee the accuracy, reliability, completeness, or suitability of its content for a particular purpose. Please do not act or refrain from acting based on anything you read in our newsletter, blog, or anywhere else on our website.