November 4, 2022 (the “Compliance Date”) marks the official day when all investment advisers registered or required to be registered with the U. S. Securities and Exchange Commission (“SEC”) under Section 203 of the Investment Advisers Act of 1940 (the “Advisers Act”) must comply with the SEC’s new “Marketing Rule,” pursuant to amended Rule 206(4)-1. As of that date, investment advisers will be expected to conduct their advertising and solicitation activities in strict accordance with this updated rule.
Amongst other things, the Marketing Rule sets forth new guidance for solicitors. Crucial elements of the now departed Rule 206(4)-3 (better known as “the cash solicitation rule”) are set forth in the Marketing Rule, which necessitates, among other things, amendment of solicitor agreements to “promoter” agreements, additional terms for the promoter agreement, amendments to the promoter disclosure statement and adoption of new policies, procedures, and operational practices.
This month’s Risk Management Tip will focus on the new requirements for Promotors including its applicability to investment advisers and advisers to private funds.
Solicitor Requirements Outlined within the Marketing Rule
Within the Marketing Rule there are two prongs to the definition of advertisement. The first prong of the definition deals with the direct and indirect communications an investment adviser may make. The second prong generally includes any endorsement or testimonial for which the adviser provides cash or non-cash compensation directly or indirectly, such as when providing an award, prize or reduced advisory fees. Within the testimonials and endorsements prong of the New Marketing Rule, solicitation of advisory clients and investors as a form of testimonial and endorsement, triggers additional considerations and oversight as further described below.
Notably, the Marketing Rule defines 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 either: (i) indicates approval, support or recommendation of the investment adviser or its supervised persons or describe 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 in a private fund advised by the investment adviser. Based upon this definition, solicitor arrangements previously made in accordance with prior Rule 206(4)-3 under the Advisers Act would fall under the definition of endorsement.
On the other hand, the definition of Testimonial includes statements made by a current client or investor in a private fund advised by the investment adviser that: (i) is about a client experience with the investment adviser or its supervised persons, (ii) directly or indirectly solicits any current or prospective client or investor to become 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. Examples of activities likely to be testimonials include client quotes on a firm’s website or social media and direct or indirect recommendations provided by clients.
To satisfy the regulatory requirements under the Marketing Rule, the following four conditions must be satisfied:
The new disclosure condition requires that all advertisements clearly and prominently disclose whether the individual(s) providing the testimonial and/or endorsement (aka, the “Promoter”) is a client of the investment adviser he is representing, as well as whether the Promoter is being compensated, and precisely how much, for his role as a Promoter. Unsurprisingly, any potential conflicts of interest on the part of the solicitor that result from his or her relationship with the investment adviser, or due to the compensation he or she is receiving, must also be prominently disclosed.
The New Marketing Rule has made things a bit easier for the investment advisers because, unlike previous regulations, the new solicitor rule states that the promoter is no longer required to deliver a written disclosure document to the client if an endorsement or testimonial is given orally. Additionally, the former requirement of obtaining a signed and dated acknowledgement form from the client confirming receipt of such disclosures has been eliminated.
The new Marketing Rule permits either the investment adviser OR the solicitor to provide the written disclosure to the client, if and when necessary.
One limited exemption to this Disclosure Requirement is the Broker-Dealer Exemption:
Broker-Dealer Exemption. A testimonial or endorsement from a broker-dealer making a recommendation pursuant to Regulation Best Interest or to a non-retail customer as defined by Regulation Best Interest does not need to comply with certain disclosure requirements and will be exempt from the disqualification requirements if the broker is not subject to statutory disqualification under Section 3(a)(39) of the Securities Exchange Act of 1934. However, the written agreement and oversight requirements apply.
B. Written Agreement
Prior to the establishment of any relationship between an Investment Adviser and a Promoter, each party must enter into a written agreement which describes the scope of their respective activities, as well as the agreed-upon compensation. There are two limited exemptions that apply to this Written Agreement requirement:
Affiliate Exemption. If the Promoter is an affiliate of the investment adviser, then there is no need for a formalized agreement (however, the investment adviser must still comply with the “Disqualification” and “Oversight” requirements discussed below); and
De Minimis Exemption. If the Promotor, whether affiliated with the investment adviser or not, receives de minimis compensation-defined as $1,000 or less, or the equivalent value in noncash compensation during the preceding 12 months- then he is exempt from the disqualification requirement (discussed below), and no formalized agreement is required. However, the investment advisor must still be sure to comply with the disclosure and oversight requirements.
An investment adviser is strictly prohibited from providing compensation to a solicitor if the investment adviser knows, or reasonably should have known, that the solicitor is an ineligible person at the time the solicitation occurs. An individual is deemed “ineligible” if he or she is subject to any disqualifying event or SEC action.
A disqualifying event includes, but is not limited to:
- criminal convictions;
- court injunctions and restraining orders;
- “final orders” of certain state regulators (such as securities, banking and insurance) and federal regulators, including the U.S. Commodity Futures Trading Commission (“CFTC”) and the National Credit Union Administration (“NCUA”);
- SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers, and investment companies and their associated persons;
- certain SEC cease and desist orders;
A disqualifying SEC action is an SEC opinion or order barring, suspending or prohibiting a person from acting in any capacity under the federal securities laws.
The investment adviser must have appropriate written policies and procedures which specifically outline how it will satisfy the written agreement component of this reformed solicitation rule.
In order to comply with the stringent requirements of the new Marketing Rule, financial entities should consider working with outside counsel to review their current agreements in place with solicitors, as well as their disclosure statements. Firms must also consider updating their policies and procedures to better comply with the new Marketing Rule, which will help eliminate the antiquated guidelines that the SEC has provided in the past. Updating the necessary policies and procedures will further assist in investor transparency while staying up to date with the latest industry trends.
Author: Michael Blackburn, Senior Attorney; Editor: Michelle L. Jacko, Managing Partner of Jacko Law Group, PC (“JLG”). JLG works extensively with investment advisers, broker-dealers, investment companies, private equity and hedge funds, banks and corporate clients on securities and corporate counsel matters. For more information, please visit https://www.jackolg.com/.
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