As the November 4, 2022 (the “Compliance Date”) approaches it 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 amended Rule 206(4)-1, the SEC’s new Marketing Rule. As of that date, investment advisers will be expected to conduct their advertising and solicitation activities in strict accordance with this updated rule.
Amended Rule 206(4)-1 has crucially updated elements of the now departed Rule 206(4)-3 (better known as “the cash solicitation rule”). Specifically, under the Marketing Rule, federally registered investment advisory firms will need to (1) update the firm’s disclosure documents; (2) adopt new policies, procedures, and operational practices; and (3) address promoter supervisory considerations.
This month’s Risk Management Tip will further explore the new requirements for promoters who solicit on behalf of investment advisory firms.
The Marketing Rule creates 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. Thus, the second prong of the Marketing Rule covers solicitation of advisory clients in the form of a testimonial or endorsement. For purposes of the Marketing Rule, a “testimonial” is defined as statements by a current client (or private fund investor) about that his/her experience with that adviser. On the other hand, an “endorsement” is defined as any statement by a person other than a current client 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 of 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.
What Needs to Occur to Comply with the Marketing Rule
A. Update Promoter Agreements and Promoter Disclosures
Maintaining compliance with Rule 206(4)-1 requires similar but more expansive requirements than the former solicitation rule. First, for any the new rule is expanded to include non-cash compensation. Next, an advisory firm must enter into a written contract with anyone who is compensated more than $1,000 during a 12-month period for providing a testimonial or endorsement. Within that agreement, the contract must address scope of services to be provided by the promoter and the related terms for compensation. Moreover, the contract should specify the requirements for being a promoter, including any licensure considerations or disqualification of “ineligible persons” due to disqualification events (such as bars or suspensions from the securities industry).
Similarly, the Promoter’s Agreement should reference the necessity of delivering a Promoter’s Disclosure Statement to a prospective client at or prior to the solicitation. A Specifically, effective delivery of the Promoter Disclosure Statement should also be addressed. Moreover, disclosures in Form ADV, summarizing the promoter’s arrangement with the adviser, must be addressed.
The Promoter’s Disclosure Statement
The Promoter’s Disclosure Statement needs clarity and prominent disclosures as to (i) if the person giving the testimonial is a client of the investment adviser, (ii) if a cash or non-cash compensation was provided in exchange for the testimonial or endorsement, and (iii) a brief statement of any material conflicts. As all compensation arrangements would create a material conflict of interest it will be important that the promoter’s disclosure statement fully discloses the terms of the compensation paid to the promoter. Please note that material conflicts of interests can arise from a variety of situations and thus investment advisers should take care to consult professionals to analyze the specific relationship between themselves and the promoter to determine if a material conflict of interest exists.
Consistent with the SEC’s requirement to disclose any material conflict, the Promoter’s Disclosure Statement must also contain the material terms of any compensation agreement. The material terms must include a description of the compensation that the promoter will receive for giving the endorsement. For investment advisers that may have different fee schedules for different promoters, advisers should customize the fee disclosures that are specific to the individual promoter that is giving the endorsement. A Promoter’s Disclosure Statement also must include a description of any material conflicts of interest. e For example, stating “Promoter is my brother-in-law and will receive, as a promoter’s fee based on Client’s AUM” requires more specificity under the new rules.
Form ADV Amendment
In addition to the other regulatory changes initiated by the Marketing Rule, investment advisers must now also consider the newly added Form ADV, Part 1A, Item 5L. This new section of the Form ADV is specifically tailored to the Marketing Rule and requires disclosures relating to the use of Promoters and whether they pay cash or non-cash compensation to such Promoters
B. Policies and Procedures Manual and Interna Control Updates
The New Marketing Rule clearly creates an abundance of new considerations for investment advisers. With this new landscape of stringent and very technical rules one of the best ways investment advisers can limit their risk is by addressing compliance through a fully thought out and clearly drafted Policies and Procedures Manual. As stated above, both the Promoter’s Disclosure Statement and the agreement that the investment adviser has with the promoter will be specifically tailored to that individual promoter. Operationally, this may cause issues for investment adviser firms in tracking the different agreements, compensation arrangements and relationships they have with their various promoters. In addition to setting forth the adviser’s procedure for tracking promoter arrangements, the compliance policy should clearly delineate the responsibilities of the Promoter and the responsibilities of the adviser. Further, as the New Marketing Rule prohibits certain “bad actors” from being promoters the Policies and Procedures Manual can provide the firm guidelines in reviewing and ensuring that the investment adviser and promoter’s relationship does not violate the “bad actors” prohibition.
C. Promoter Supervisory Obligations (beyond Investment Adviser Registration)
In adopting the New Marketing Rule, the SEC has created new supervisory considerations for investment advisers to consider when utilizing promoters. Analysis of the new regulatory issues will ultimately require an analysis of the applicable facts and circumstances specific to the individual investment adviser and promoter relationship. Similar to the solicitation rule, Promoters will be subject to registration requirements (dependent upon the jurisdiction) as well as adhering to regulatory requirements and specified compliance requirements set forth by the investment advisory firm. Supervisory controls that investment advisers should consider for Promoters include:
- Training its Promoters on the do’s and don’ts for solicitor activities no less than annually;
- Adoption of policies and procedures to oversee that the Promoter activities are aligned with the terms and conditions set forth in the Promoter’s Agreement (e.g., only using marketing collateral as provided by the firm); and
- Annual attestations as to the Promoter’s status of not being statutorily disqualified.
The specific steps and frequency an investment adviser must take in this supervisory role will vary based on the specific set of facts and circumstances, and must be tailored to the firm’s business model.
The New Marketing Rule and specifically the new rules surrounding the use of Promoters is the clear step of the SEC into the future of the industry. As with any innovation and change in the market place, the market place participants should take care both to limit their risk under this new regulatory regime and also set themselves up to thrive with the new rules. Ultimately, investment advisers should consider working with outside counsel to update Promoter Agreements and Promoter Disclosure Statements, amend Form ADV disclosures and implement new operational controls for tracking Promoter compensation arrangements. For more information on how JLG can assist, please contact us.
Author: Jeremiah Baba Pagno, Attorney and 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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