On November 4, 2019, the U.S. Securities and Exchange Commission proposed amendments in Release Number IA-5407 to amend rule 206(4)-1) and rule 206(4)-3) under the Investment Advisers Act of 1940 (the “Advisers Act”). These two rules govern advertisements and cash referrals under the Advisers Act. The purpose of this post is to provide my initial impressions of the 500+ page rule release. In the near future, I’ll be participating in a webinar discussing the proposed changes in greater depth. In addition, we may be developing more formal guidance on these issues.
- New Definition of Advertisement – The proposed rule would define “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.” There are 4 specific carve-outs from the definition:
- Certain live, spoken communications that are not broadcast on any medium,
- Responses to unsolicited requests for information (but does not include performance results provided to Retail Investors or communications that include hypothetical performance)
- Investment Company and Business Development Company advertisements, and
- Regulatory notices and filings.
- General Catchall – The proposed rule will continue to have a general catchall against advertising practices that are fraudulent, deceptive, or manipulative. The legal standard will remain a negligence standard, and scienter will not be required to prove violations.
- Prohibition Against Untrue Statements or Omissions – The proposed rule would prohibit advertisements that include any untrue statements of a material fact, or that omit a material fact necessary in order to make the statement made, in the light of the circumstances under which it was made, not misleading.
- Prohibition Against Unsubstantiated Material Claims – The proposed rule would prohibit advertisements that include material claims that are unsubstantiated. Think guarantees and claims about an adviser’s skill that can’t be substantiated (e.g., we are the best in the business at options.).
- Prohibition Against Untrue or Misleading Implications or Inferences – As proposed, the rule would prohibit any advertisement that includes an untrue or misleading implication about, or is reasonably likely to cause an untrue or misleading inference to be drawn concerning, a material fact relating to an investment adviser. This means advisers wouldn’t be able to cherry-pick favorable testimonials or account performance. Account performance and strategy performance selection must be presented “fair and balanced”.
- Failure to Disclose Material Risks or Other Limitations – The proposed rule would prohibit advertisements that discuss or imply any potential benefits without clearly and prominently discussing material risks or other limitations associated with the potential benefits. Hyperlinking to disclosure as proposed would not meet the clear and prominent test as proposed.
- Limits on References to Specific Investment Advice – The proposed rule would prohibit a reference to specific investment advice where such investment advice is not presented in a manner that is fair and balanced. This proposed amendment would open up the door to advisers showing past specific investments that performed favorably if the intent is to show the adviser’s “philosophy and process”. This opens up the door to showing best and worst performers or discussing certain market timing practices. For example, an adviser can specifically discuss pre-2008 investment decisions to exit specific securities and purchase different securities as long as that discussion is fair and balanced. One point to consider is that the proposed rule would extend to past specific investment advice, which is considerably broader than the current prohibition. It would apply regardless of whether the advice was acted upon, or reflected actual portfolio holdings, or was profitable.
- Performance Presentations
- General Standard -The proposed rule would prohibit any advisers from including or excluding performance results, or presenting time periods for performance, in a manner that is not fair and balanced. The proposing release favorably cites to Clover Capital as a good example of disclosures that should be considered in a performance presentation, but does not mandate strict adherence to those requirements.
- Net-of-fee performance presentations would still be required for “Retail Persons” and net performance result would be required in any Retail Advertisement that includes gross performance results. Notably, the threshold for non-Retail Advertisement would be quite high–qualified purchasers and knowledgeable employees. The proposal also would extend to private fund investors and could create some unintended side effects for current fund marketing practices.
- Retail Advertisements would have to be presented net-of-fees and use certain standard performance measures (i.e., 1-5, and 10-year presentations). If showing gross performance, a presentation would also need to present net performance with at least equal prominence and in a format designed to facilitate comparison with gross performance.
- The proposed rule contemplates showing performance net of the deduction of a model fee that is equal to the highest fee charged to the relevant audience of the advertisement.
- The proposed rule introduces a new concept and definition called “extracted performance”. “Extracted performance” would be defined as “the performance results of a subset of investments extracted from a portfolio.” Advisers would be required in the advertisement to provide (or offer to provide promptly) the performance results of the entire portfolio in these circumstances to prevent investment advisers from cherry-picking certain performance results. It remains to be seen whether the Staff would actually be accepting of “offers to provide” the other data.
- The proposed rule would condition the presentation of hypothetical performance on (i) an adviser adopting policies and procedures reasonably designed to ensure that a hypothetical presentation is disseminated only to persons for which it is relevant to their financial situation and investment objectives, and would further require the adviser to provide additional information about the hypothetical performance that is tailored to the audience receiving it, such that the recipient has sufficient information to understand the criteria, assumptions, risks, and limitations, (ii) providing sufficient information to enable the recipient to understand the criteria used and assumptions made in calculating such hypothetical performance, and (iii) the adviser providing (or, when the recipient is a Non-Retail Person, offering) sufficient information to enable the recipient to understand the risks and limitations of using hypothetical performance in making investment decisions.
- The proposed rule with respect to testimonials would apply to targeted or projected performance returns regarding any portfolio or to the investment services offered or promoted in an advertisement. It wouldn’t apply to more general discussions of markets.
- Green-lighting Use of Testimonials – Unlike the current rule, the proposed rule would permit the use of testimonials and endorsements.
- Definitions – The proposed rule would defines “testimonial” as “any statement of a client’s or investor’s experience with the investment adviser or its advisory affiliates, as defined in the Form ADV Glossary of Terms. It would define an “endorsement” as “any statement by a person other than a client or investor indicating approval, support, or recommendation of the investment adviser or its advisory affiliates, as defined in the Form ADV Glossary of Terms.” Client lists and partial client lists would fall outside the bounds of the rule.
- To use a testimonial or endorsement, the proposed rule would require that an adviser clearly and prominently disclose, or the investment adviser reasonably believe that the testimonial or endorsement clearly and prominently discloses, that the testimonial was given by a client or investor, and the endorsement was given by a non-client or non-investor, as applicable.
- Also, the testimonial or endorsement would need to clearly and prominently disclose cash or non-cash compensation being provided. Examples of non-cash compensation in the proposed release include a reduction or waiver of advisory fees or cross-referral relationships.
- Query who the first big name testimonial or endorsement will be?
- Sensible Approach to Social Media – As proposed, the Staff is providing some flexibility for favorable ratings on LinkedIn and other social media review sites. The release states, “[c]ontent regarding the investment adviser on third-party hosted platforms that solicit users to post information, including positive and negative reviews of the adviser, generally would not be ‘by or on behalf of’ the investment adviser unless the adviser took affirmative steps to influence the content of those reviews or posts, such as providing a user with wording to submit as a review or editing the content of a post.” Some other great guidance in the proposed rule: “[S]o long as the adviser does not selectively delete or alter the comments or their presentation. We believe such treatment for third-party content on the adviser’s own website or social media page is appropriate even if the adviser has the ability to influence control over the commentary but does not exercise it. Likewise, we would not consider an adviser that merely permits the use of “like,” “share,” or “endorse” features on a third-party website or social media platform to implicate the proposed rule.” This type of guidance is practical and long overdue.
- Blessings of Yelp and Angie’s List – The proposed rule would permit an adviser to notify clients about the existence of a third party review site without suggesting that the investor leave a positive review or not leave a negative review.
- Approval Process – Similar to FINRA rules, the proposed rule would require there to be a formal review and approval process within an investment adviser for most advertisements (excluding certain one-on-one presentations and oral communications that are broadcast (but not scripts, storyboards or other written preparations)).
- Referrals for Private Funds – The rule release contemplates extending the requirements of the cash solicitation rule to the referrals of investors to private funds. It is silent on whether that practice triggers registration as a broker-dealer under the Securities Exchange Act. However, this is an important issue for “finders” and other distribution channels.
- Changes to Solicitation Rule
- The proposed rule would abandon the requirement for the solicitor to deliver a copy of the adviser’s brochure.
- It would be expanded to cover all cash and non-cash compensation arrangements. It remains to be seen how informal referral relationships with other professionals would work (for example, accountants and lawyers).
- It also would also eliminate the requirement that an adviser obtain a signed and dated acknowledgment from the client. Advisers would be free to create their own policies and procedures to determine whether the solicitor has complied with the rule.
- As proposed, the rule would exempt certain de minimis payments (less than $100 in any 12 month period). It would also permit nonprofit programs the ability to provide a list of advisers to interested parties (Think NFL Players Association or CFP Board referral programs).
- Amendments to Form ADV – As proposed, advisers would be required to report in their Form ADV whether they engage in performance advertising, use testimonials or use what are commonly referred to now as “past specific recommendations”. Presumably this would raise a firm’s risk profile and increase the likelihood of examination.
- New Input Process for Smaller RIAs – In the first of its kind, this rule release has an appendix dedicated to seeking the input of smaller investment advisers. I applaud Chairman Clayton and Director Blass for focusing on smaller advisers.