Michelle L. Jacko, Esq.

For those of us who have focused on performance advertising throughout their careers, we have witnessed many amendments to the Advisers Act – but none which have significantly touched upon advertising. During the last quarter century, there have been new SEC No-Action Letters related to investment adviser advertising, and much talk of how Rule 206(4)-1 of the Investment Adviser Act of 1940 (the “Advertising Rule”) is impractical in application to today’s investment advisory businesses.  At last, on November 4, 2019, the U.S. Securities and Exchange Commission (“SEC”) proposed to modernize the Advertising Rule.  Once announced, the general reaction from the advisory industry was a sigh of relief.  While the new rule may complicate the compliance reviews and marketing efforts for some advisers, we believe that in large part the rule will permit advisers flexibility in advertising and utilizing social media to help promote the firm and its products and services.

In this month’s Legal Risk Management Tip, we will summarize the proposed amendments to the Advertising Rule, discuss how the proposed Advertising Rule will impact governance and provide risk management tips moving forward. 

1. Proposed Amendments to the Advertising Rule

   In the SEC’s press release, the Commission emphasized, “[we] have continued to learn about adviser marketing and solicitation practices, as those practices have evolved significantly with advancements in technology and the changes within the asset management industry and its investor base.”^[1]  The goal of the proposal was simple – to replace the myriad of no-action letters and broad provisions with principle-based rules. Here are the highlights of the proposal:

   1. The Definition of Advertisement Has Changed. The new definition would include any communication, disseminated by any means, by or on behalf of an investment adviser, that offers or promotes investment advisory services^[2] or that seeks to obtain or retain advisory clients or investors in any pooled investment vehicle advised by the adviser. IMPACT: Advisers may have to have compliance reviews for more materials than ever before, with training for employees on what is and is not promotional material.
   2. New Advertising Prohibitions. Because the proposed Advertising Rule is principles based, the prohibitions are not prescriptive. The new prohibitions include the following:
      • 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 (Sample: stating that one has a professional designation or credential which has since expired or been terminated); 
      • Making a material claim or statement that is unsubstantiated (Sample: guaranteeing performance returns); 
      • Making a misleading implication about or misleading inference to a material fact relating to the investment adviser (Sample: stating that you are the best or top money manager without substantiating the claim); 
      • Discussing or implying any potential benefits without clear discussion of associated material risks or other limitations (Sample: comparing performance to a benchmark that has characteristics that differ from your style of management); 
      • Referring to specific investment advice that is not presented in a fair and balanced manner (Sample: only speaking of top performing stocks without reference to the worst performing stocks in a model); 
      • Including or excluding performance results, or presenting performance time periods, in a manner that is not fair and balanced (Sample: showing only performance of end of month and not quarterly or year-end, which was materially different); and 
      • Being materially misleading (Sample: stating firm assets are over $1 Bil when actually they are only at $100,000,0000)
   3. Testimonials, Endorsements and Third-Party Ratings. After the SEC cited numerous deficiencies in its Touting Initiative Examination Sweep, the Commission has proposed that it would now allow testimonials, endorsements and third-party rankings so long as certain disclosures were made. For example, testimonials would require disclosure of whether the testimonial is from a client and whether compensation was received by the person providing the testimonial. For third-party ratings, disclosure would require what criteria was used to prepare the rating.
   4. Performance Information. There are lots of changes here, specifically as it relates to presenting performance results. Some provisions are consistent with current standards, including:
      • Prohibiting gross performance figures without providing a schedule of fees and expenses for calculating net performance
      • Prohibiting any statement that infers that performance shown is approved or revised by the Commission
      • However, several of the provisions go further than current requirements and may dramatically impact advisory firms, including:
      • Prohibiting hypothetical performance without policies and procedures to evaluate that the performance is relevant to the financial situation and investment objectives of the recipient
      • Prohibiting “representative account performance” if performance results from those portfolios with substantially similar investment policies or objectives and strategies is available (and if so, should be included in a composite)
      • Prohibiting the performance of a “subset” of an investment portfolio, unless the adviser provides or offers to provide a copy of “all” investments in the investment portfolio
      • Retail performance advertising pieces should show performance for the 1-, 5- and 10-year periods and presentation of both net and gross performance
2. Governance Considerations

   There are several considerations from a governance perspective that need to be weighed.  In the proposal, the staff stressed that advertisements would require review and approval by designated employees prior to dissemination.  Some advisers currently have procedures whereby certain materials (such as those that are used in multiple client meetings) need only have review of the “new” materials or pages, and not the entire collateral (such as is the case in a pitchbook). While the SEC carved out an exception for communications disseminated to a single client or “live” broadcast-type communications, the impact could be tremendous.

   Moreover, the proposed rule has two types for advertisements, namely retail (for non-sophisticated clients) and non-retail (for institutional and qualified investors). The type of disclosures required will depend upon the audience receiving the piece and will impact the kind of information that will be required in an advertisement.

   Finally, the proposed amendments to Form ADV would amend Item 5 of Form ADV Part 1A and include a new section, “L. Advertising Activities” that would provide important data on the adviser’s use of testimonials, third-party ratings, endorsements and performance results.  Tracking will need to be developed in accordance with the Form ADV instructions to this section. 

3. Risk Management Tips

   It is important to note that the proposal is just that – it is a proposal.  But more likely than not, a substantial portion of the proposed Advertising Rule will go into effect in the short-term.  Consequently, it is recommended that investment advisers take the following steps to evaluate the impact that the proposed rule will have in their organizations.

   • Do you currently track the purposes of business communications and determine if there is an “offer to promote” the firm, its products and services?
   • Are you able to denote what communications are used to gain or to retain your clients?
   • What systems are needed to help classify whether a communication is an advertisement?
   • What training do sales, marketing and client service representatives require for determining if a business communication they are about to send is indeed an advertisement requiring compliance approval?
   • How will the new proposal impact our compliance team’s efforts and workload, and do we have enough resources to cover the required compliance reviews?
   • Is the firm currently using any hypothetical performance and if so, are the existing internal controls within the organization’s policies and procedures strong enough?
   • Do you currently use a representative account to show a particular strategy?  If so, have you considered, and do you have the capabilities of creating a composite (where applicable) to show the performance or all substantially similar portfolios?
   • Is there a desire to show endorsements or testimonials?  If so, how would you gather, and track information related to whether a client or non-client provided such endorsement or testimonial?
   • Who would you designate as the employee responsible for reviewing the advertising materials and do they have the skillset and knowledge to do so?
   • How will the principal-based regulations impact current disclosures and materials that your firm is currently marketing? For example, how do you ensure that all collateral is fair and balanced?

There is much to be considered.  While overall the benefits of having the new principal-based Advertising Rule are many, there remains concern, particularly for smaller advisers, on whether they will have the resources to comply with all requirements, if the Rule is enacted in its entirety.  JLG will be keeping you apprised of new developments as released.

For more information on these and other considerations relating to the Advertising Rule and related compliance considerations, please contact us at info@jackolg.com or at (619) 298-2880.

 Author: Michelle L. Jacko, Esq., Managing Partner, 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/.

The information contained in this article may contain information that is confidential and/or protected by the attorney-client privilege and attorney work product doctrine. This is not intended for transmission to, or receipt by, any unauthorized persons. Inadvertent disclosure of the contents of this article to unintended recipients is not intended to and does not constitute a waiver of attorney-client privilege or attorney work product protections.

The Risk Management Tip is published solely based off the interests and relationship between the clients and friends of the Jacko Law Group P.C. (“JLG”) and in no way be construed as legal advice. The opinions shared in the publication reflect those of the authors, and not necessarily the views of JLG. For more specific information or recent industry developments or particular situations, you should seek legal opinion or counsel.

You hereby are notified that any review, dissemination or copying of this message and its attachments, if any, is strictly prohibited. These materials may be considered ATTORNEY ADVERTISING in some jurisdictions.

[1] See https://www.sec.gov/news/press-release/2019-230.

[2] Exclusions include: (1) live oral communications which are not broadcasted, (2) responses to unsolicited requests for information, (3) sales literature that is about a registered investment company or a business development company which is covered by other Commission rules; and (4) information required to be contained in a statutory or regulatory notice, filing, or other communication; see Id.