The proposed amendments to Rule 206(4)-1, which governs investment adviser advertising practices, would replace the current rule’s broad restrictions with principles-based provisions. Subject to certain conditions, the proposed rule would permit references to “past specific recommendations,” the use of testimonials, endorsements and third-party ratings and would include tailored requirements for the presentation of performance results based on an advertisement’s intended recipients.
The proposed amendments to Rule 206(4)-3 (commonly referred to as the Cash Solicitation Rule), which addresses the use of solicitors by investment advisers, would expand the current rule to cover solicitation arrangements involving all forms of compensation, rather than only cash, and would apply the rule to the solicitation of investors in private funds. The proposed amendments also would update other aspects of the rule, such as who is disqualified from acting as a solicitor.
The SEC also proposed amendments to Advisers Act Rule 204-2 (the “books and records rule”) relating to the proposed changes to the advertising and solicitation rules.
In the release proposing the amendments (the “Release”)1, the SEC requested comments on most components of the proposals. Comments should be received within 60 days following the publication of the proposals in the Federal Register.
Proposed Amendments to the Advertising Rule
Rule 206(4)-1 has not changed substantively since its adoption in 1961. In the Release, the SEC staff noted that in the nearly 60 years since the current rule’s adoption, issues and questions have arisen about the rule’s application, particularly with respect to the prohibitions of testimonials and past specific recommendations. Many questions also have been raised regarding the appropriate presentation of performance. According to the Release, “The breadth of the current rule’s prohibitions, as well as the lack of explicit prescriptions related to the presentation of performance in the rule, can present compliance challenges and potentially have a chilling effect on advisers’ ability to provide useful information in communications that are considered advertisements.”
The proposed rule incorporates certain principles set forth in no-action letters and guidance issued over the years and provides some flexibility based on the sophistication of the recipients and relevant disclosures. It contains general prohibitions of certain advertising practices, as well as more specific restrictions and requirements that, according to the Release, are reasonably designed to prevent fraud with respect to specific types of advertisements.
The proposed rule also would require internal review and approval of most advertisements and require each adviser to report additional information regarding its advertising practices in its Form ADV.
Definition of “Advertisement”
The proposed rule defines “advertisement” as “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.” The proposed definition reflects several differences from the current rule. The proposed changes expand the types of communications covered to reflect evolving methods of communication, including social media, and explicitly apply the rule to advertisements disseminated to investors in pooled investment vehicles2, with a carve-out for publicly offered investment companies. The proposed definition does not retain the current rule’s “more than one person” element, so a communication provided to one investor that otherwise meets the definition (and is not excluded from the definition) would be deemed an advertisement for purposes of the rule.
The proposed definition excludes:
- Live oral communications that are not broadcast on radio, television, the internet or any other similar medium;
- A communication that does no more than respond to an unsolicited request for specified information about the adviser or its services, other than (i) any communication to a Retail Person (as defined below) that includes performance results or (ii) any communication that includes hypothetical performance;
- Advertisements or sales materials regarding SEC-registered investment companies (“RICs”) and business development companies (“BDCs”) that are within the scope of Rule 482 or Rule 156 under the Securities Act of 1933; and
- Any information required to be contained in a statutory or regulatory notice, filing or other communication.
General Prohibitions of Certain Advertising Practices
The proposed rule generally prohibits:
- Untrue statements and omissions. Any advertisement that includes any untrue statement of a material fact, or that omits a material fact necessary in order to make the statement made, in the light of the circumstances under which it was made, not misleading.
- Unsubstantiated material claims and statements.
- Untrue or misleading implications or references.
- Advertisements that discuss or imply any potential benefits without clearly and prominently discussing associated material risks or other limitations.
- “Cherry-picking” in connection with references to specific investment advice and presentation of performance results.
- Advertisements that are otherwise materially misleading.
References to Specific Investment Advice
The proposed rule generally allows references to specific investment advice where such investment advice is presented in a fair and balanced manner. The SEC staff noted in the Release that over the years since the advertising rule was adopted, “our experience has led us to believe that some information about an adviser’s past advice could be presented without misleading investors.”
The proposed rule would replace the current rule’s general prohibition on “past specific recommendations” with a principles-based restriction on the presentation of specific investment advice. To avoid “cherry picking,” the proposed rule would require advertisements that include specific investment advice to be presented in a manner that is fair and balanced, according to factors that will vary based on the pertinent facts and circumstances, including the nature and sophistication of the audience. The proposed provision applies to any reference to specific investment advice, regardless of whether the investment advice remains current or occurred in the past and whether or not the advice was profitable.
Testimonials, Endorsements and Third-Party Rankings
While the current rule prohibits the use of “testimonials” and does not expressly address endorsements and third-party ratings, the proposed amendments would permit these practices, subject to certain disclosures and other tailored conditions. In addition to adhering to the proposed rule’s general prohibitions, an adviser including any of these components in an advertisement would be required to disclose, for example:
- Whether or not the person making a testimonial or endorsement is a client or investor;
- That cash or non-cash compensation has been provided in connection with the testimonial, endorsement or third-party rating, if applicable; and
- With respect to third-party ratings, the period of time upon which the rating was based and the identity of the third party that created and tabulated the rating.
The proposed rule’s general prohibitions prohibit an adviser from including or excluding performance results, or presenting time periods for performance, in a manner that is not fair and balanced. As with specific investment advice, the factors that are relevant to whether a reference to performance information is presented in a fair and balanced manner will vary based on the facts and circumstances.
In accordance with its principles-based approach, the proposed rule generally would not require specific standardized disclosures or legends in advertisements presenting performance results. The SEC staff stated in the Release, however, that performance advertising in some contexts raises special concerns that warrant additional requirements and restrictions.
Additional Disclosures for Retail Advertisements
“Non-Retail Advertisements” are defined in the proposed rule as advertisements for which an adviser has adopted and implemented policies and procedures reasonably designed to ensure that the advertisements are disseminated solely to qualified purchasers and certain knowledgeable employees3, defined as “Non-Retail Persons.” “Retail Advertisements” are defined as all other advertisements, and the term “Retail Persons” includes all persons who are not Non-Retail Persons.
In the Release, the SEC staff stated its belief that some advertising practices that are likely to be misleading with respect to retail investors may not be misleading for investors with the resources to consider and analyze the performance information. The proposed rule would require certain additional disclosures for Retail Advertisements, designed specifically to enable Retail Persons to understand better the presentation of performance results and the limitations inherent in such presentations.
- Presentation of gross and net performance. An adviser would be required to include performance results net of fees and expenses in any Retail Advertisement that includes gross performance results.
- Prescribed time periods. Performance results in Retail Advertisements would be required to cover one-, five- and 10-year periods.
The proposed rule would treat each investor in a pooled investment vehicle, including a private fund, as a Retail Person or a Non-Retail Person, depending on whether the investor is a qualified purchaser or knowledgeable employee. If a pooled investment vehicle is marketed to both Non-Retail Persons and Retail Persons, the adviser could use a Retail Advertisement for the Retail Persons and a Non-Retail Advertisement for the Non-Retail Persons. Alternatively, to ensure that all investors receive the same information, the adviser could use a Retail Advertisement for all investors in the pooled investment vehicle.
Gross and Net Performance
Under certain conditions, the proposed rule permits an adviser to provide gross investment performance without net performance in Non-Retail Advertisements, since Non-Retail Persons have access to analytical and other resources that allow them to calculate a relevant net performance figure. Under the proposed rule, however, advisers would be required to provide or offer to provide promptly a schedule of fees and expenses to ensure that Non-Retail Persons receiving gross performance information could calculate net performance if they wished.
“Related performance” refers to the presentation of performance results of portfolios managed by an investment adviser that have substantially similar investment policies, objectives and strategies as those of the services being promoted in an advertisement (“related portfolios”). The proposed rule would allow advertisements to include related performance, as long as such performance includes all related portfolios. The proposed rule, however, generally would allow related performance to exclude related portfolios as long as the advertised performance results are no better than they would be if all related portfolios had been included. In proposing the rule amendments, the SEC determined not to adopt the approach of the Financial Industry Regulatory Authority (“FINRA”), which would have entailed prohibiting the presentation of related performance in Retail Advertisements.
“Extracted performance” refers to the performance results of a subset of investments extracted from a portfolio. Similar to the proposed requirement for the presentation of related performance, the proposed rule requires that an advertisement containing extracted performance provide (or offer to provide promptly) the performance results of the entire portfolio to prevent investment advisers from cherry-picking certain investment results.
“Hypothetical performance” refers to performance results that were not actually achieved by any portfolio managed by the adviser. Under the proposed rule, hypothetical performance would include, but not be limited to, backtested performance4, representative performance5 and targeted or projected performance returns6.
Where investors have the resources to conduct appropriate analysis and diligence, the proposed rule permits the presentation of hypothetical performance in advertisements under certain conditions intended to address the potential for hypothetical performance to be misleading7. An adviser using hypothetical performance would be required to:
- Adopt and implement policies and procedures reasonably designed to ensure that the hypothetical performance is disseminated only to persons for which it is relevant to their financial situation and investment objectives;
- Provide sufficient information to enable the recipient to understand the criteria used and assumptions made in calculating the hypothetical performance; and
- Provide (or, when the recipient is a Non-Retail Person, offer to provide promptly) sufficient information to enable the recipient to understand the risks and limitations of using hypothetical performance in making investment decisions.
Portability of Performance, Testimonials, Third Party Ratings and Specific Investment Advice
An adviser may seek to advertise performance results of portfolios or accounts for which the adviser, its personnel or its predecessor firms have provided investment advice in the past as, or at, a different entity (“predecessor performance”).
Advertisements presenting predecessor performance would be subject to all of the proposed rule’s requirements, including general prohibitions of certain practices and specific performance advertising restrictions. In the Release, the SEC staff requested comment on whether the proposed rule should include additional provisions to address specifically the presentation of predecessor performance results.
Similar questions may arise about the use of testimonials and endorsements referring to a predecessor entity, past third-party ratings or specific investment advice given at a previous firm. The Release indicated that the same framework that an adviser applies to whether predecessor performance can be carried forward could also generally be applied when analyzing whether testimonials, endorsements, third-party ratings or specific investment advice applicable to a predecessor entity could be used in advertisements.
SEC Request for Comments
Each section of the Release related to the proposed advertising rule amendments included numerous SEC requests for comments. Examples include:
- Does the definition of advertisement provide sufficient clarity to permit advisers to communicate, in the usual course of business, with existing investors about their accounts or the funds in which they are invested, without those communications being considered advertisements?
- Are there any particular burdens or difficulties that advisers may bear in treating as advertisements communications designed for investors in pooled investment vehicles?
- Should the SEC require advisers that include a reference to specific investment advice to disclose the criteria used to select the specific investment?
- Are there specific disclosures that should be required to prevent performance advertising from being misleading?
- Should the SEC provide further guidance or specify requirements in the proposed rule on how to calculate gross performance or net performance?
- Should additional disclosures be required based on the type of audience to which performance advertising is disseminated? Would such an approach place Retail Persons at an informational disadvantage?
- Are there investors other than qualified purchasers and knowledgeable employees (e.g., accredited investors and qualified clients) that should be treated as Non-Retail Persons?
Proposed Amendments to the Cash Solicitation Rule
In the same Release, the SEC proposed amendments to Rule 206(4)-3 under the Advisers Act (the Cash Solicitation Rule). The Cash Solicitation Rule, which was adopted in 1979, has not been significantly amended since its adoption. The proposed amendments are intended to modernize and refine the scope and requirements of the rule to reflect current industry practice.
The Cash Solicitation Rule is designed to address the inherent conflict of interest that exists when a person is paid to refer advisory clients to an adviser. The current rule seeks to address this conflict of interest by, among other things, prohibiting an adviser from, directly or indirectly, paying a cash fee to a solicitor to refer advisory clients to the adviser unless the solicitor discloses in writing to its clients any cash compensation the solicitor will be paid by the adviser for referrals. Other requirements of the current Cash Solicitation Rule include:
- The agreement between the adviser and the solicitor relating to the solicitation arrangements must be in writing;
- The solicitor must provide clients with a copy of the adviser’s Form ADV Part 2A;
- The adviser must receive a copy of a written acknowledgement from each solicited client that the client has received the disclosures required under the rule; and
- The adviser cannot engage a solicitor subject to statutory disqualification under Section 203 of the Advisers Act.
The proposed amendments would retain several requirements of the current Cash Solicitation Rule, including that an adviser enter into a written agreement with a solicitor to set forth the arrangements between the adviser and the solicitor. The proposed amendments also would expand the scope of the Cash Solicitation Rule in several respects.
Modifications to the Disclosure Requirements, Exemptions and Exclusions Relating to Compensation
- The proposed amendments would require disclosure of non-cash compensation. Examples of non-cash compensation noted in the Release are directed brokerage, training and education meetings and discounted advisory services. Since the adoption of the Cash Solicitation Rule, the SEC has learned that advisers compensate in a wide variety of ways. According to the Release, the proposed amendments acknowledge that non-cash compensation raises conflicts of interest similar to cash compensation and that prospective clients should be made aware of any incentive a solicitor has to refer clients to the adviser.
- The proposed amendments would retain the current exemptions from disclosing compensation arrangements confined to impersonal investment advice.
- The proposed amendments would retain the current partial exemption for solicitors that are employees of, or otherwise affiliated with, the adviser and would expand the exemption to eliminate the requirement to make the detailed solicitor disclosures and to memorialize these arrangements in writing.
- The proposed amendments would add exceptions from the requirement to disclose compensation arrangements for arrangements where the solicitor received de minimis payments (less than $100 in any 12-month period) and for arrangements where the adviser is participating in a nonprofit program.
Expansion of the Rule to Cover the Solicitation of Current and Prospective Investors in Private Funds
- The proposed amendments would expand the rule to apply to the solicitation of current and prospective investors for private funds. Currently the Cash Solicitation Rule applies only to the solicitation of advisory clients. This proposed change reflects the SEC’s view that the same conflict of interest exists when the adviser compensates a solicitor for soliciting investors for the adviser’s funds.
- The proposed amendments would not apply to the solicitation of investors for RICs or BDCs, because other rules and regulations applicable to such funds already require the disclosure of applicable compensation arrangements.
Disclosure of Other Potential Material Conflicts of Interest
The proposed amendments would:
- Require disclosure of any additional costs clients or investors will bear because of such arrangements and of any additional material conflicts of interest relating to the arrangements between the adviser and the solicitor.
- Provide the adviser and the solicitor more flexibility to determine who would be responsible for making all of the required disclosures (under the current rule, these disclosures must be made by the solicitor).
Additional Disqualification Events
The proposed amendments would add additional disciplinary events that would disqualify a person or firm from acting as a solicitor for an adviser, while also adding a limited carve-out for certain types of SEC actions.
The proposed amendments would eliminate the following requirements of the current Cash Solicitation Rule, which effectively would be addressed through other requirements of the amended rule or other regulations;
- The adviser no longer would need to obtain a written acknowledgement from each referred client that the client had received the required disclosures from the solicitor.
- A solicitor would no longer need to deliver a copy of the adviser’s brochure (Form ADV Part 2A) to the prospective client.
- The proposed amendments would allow advisers to develop their own policies and procedures for determining whether a solicitor had adhered to the written agreement between the adviser and the solicitor.
SEC Request for Comments
Each section of the Release related to the proposed amendments to the Cash Solicitation Rule included numerous SEC requests for comments. Examples include:
- Should the proposed rule apply to solicitation of investors in private funds, as proposed?
- Should the proposed rule except, or specifically prohibit, some forms of non-cash compensation?
- How should the rule apply to an adviser that directs client brokerage in exchange for client referrals?
- Should a solicitor disclosure be required to be delivered to investors at the time of any solicitation activities (or, in the case of a mass communication, as soon as reasonably practicable thereafter)? If not, when should the solicitor disclosure be delivered to investors?
1 “Investment Adviser Advertisements; Compensation for Solicitations,” Investment Advisers Act Release No. 5407 (Nov. 4, 2019), https://www.sec.gov/rules/proposed/2019/ia-5407.pdf.
2 For purposes of the proposed rule, “pooled investment vehicle” would be defined in the same way as the definition in Rule 206(4)-8 under the Advisers Act – i.e., publicly offered investment companies and funds relying on Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act.
3 “Qualified purchaser” is defined in Section 2(a)(51) of the Investment Company Act of 1940 (the “Investment Company Act”). The proposed rule also would treat as a Non-Retail Person any “knowledgeable employee,” as defined in Rule 3c-5 under the Investment Company Act, with respect to a fund that relies on Section 3(c)(7) and is advised by the adviser.
4 Backtested performance is achieved by application of an adviser’s investment strategy to market data from prior periods when the strategy was not actually used during these periods.
5 Representative performance, including performance derived from representative “model” portfolios managed contemporaneously alongside portfolios managed by the adviser for actual clients, does not reflect decisions made by the adviser in managing actual accounts.
6 Targeted returns reflect an adviser’s performance target; i.e., the returns that adviser is seeking to achieve over a particular period of time. Projected returns reflect an adviser’s performance estimate; i.e., the returns that the adviser believes can be achieved using the advertised investment services.
7 FINRA rules relating to hypothetical performance have not changed, and advisers that use broker-dealers (affiliated or unaffiliated) to market their funds will need to consider the applicability of FINRA rules to their advertisements.
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