On December 22, 2020, the U.S. Securities and Exchange Commission adopted amendments to the rules under the Investment Advisers Act of 1940 relating to advertisements. A copy of the adopting release is available here. When news first broke, I provided my initial thoughts via Twitter (which I have included below), but the purpose of this post is to provide a little cleaner overview of the amendments and the new rule.
When are the amendments effective?
The amendments will become effective 60 days after the rule is published in the federal register. It was published in the federal register on March 5, 2021, so it becomes effective on May 4, 2021.
The SEC has provided an eighteen-month transition period between the effective date of the rule and the compliance date, which means compliance is mandatory on November 4, 2021.
How does the Compliance Date and Transition Period Work?
As noted above, the SEC is providing an eighteen-month transition period between the effective date of the rule and the compliance date.
Advertisements published on or after the compliance date by investment advisers registered with the SEC will be subject to the new marketing rule.
The compliance date for the amended recordkeeping rule will also provide an eighteen month transition date from the effective date of the rule.
Advisers filing Form ADV after the eighteen-month transition period will also be required to complete the amended form, but only if they are otherwise required to amend the relevant portion of the form according to the instructions to Form ADV.
Can an investment adviser operate under the new rule during the transition period?
Although the adopting release is not clear, it appears that investment advisers may operate under the new rule immediately upon its effectiveness.
However, I wouldn’t recommend engaging in the use of testimonials without trying to clean up any other outstanding advertisements that might not be compliant.
What will be considered an “advertisement” under the new rule?
Under the new rule, the definition of an advertisement includes two distinct types of communications.
- First, it includes “[a]ny direct or indirect communication an investment adviser makes to more than one person, or to one or more persons if the communication includes “hypothetical performance”, (a) that offers the investment adviser’s investment advisory services with regard to securities to prospective clients or investors in a private fund advised by the investment adviser or (b) offers new investment advisory services with regard to securities to current clients or investors in a private fund advised by the investment adviser.
- Second, it includes “[a]ny “endorsement” or “testimonial” for which an investment adviser provides compensation, directly or indirectly, but does not include any information contained in a statutory or regulatory notice, filing, or other required communication, provided that such information is reasonably designed to satisfy the requirements of such notice, filing, or other required communication.
Are there any exceptions or exclusions to the definition of “advertisement”?
Yes. As noted in the definition above, one-on-one communications that are not “testimonials” or “endorsements” are not subject to the rule, unless they include “hypothetical performance. In addition, the following are excluded from the definition of “advertisement”:
- Extemporaneous, live, oral communications. According to the adopting release, this does not extend to “prepared remarks or speeches, such as those delivered from scripts.” These will be subject to the rule. Also, the adopting release states that “previously prepared live, oral communication in a non-broadcast setting, such as luncheon seminar designed to attract new investors” would be subject to the rule.
- Regulatory Filings. Most, but not all, information in a statutory or regulatory notice, filing, or other required communication (i.e., Form ADV Part 2 or Form CRS).
- Information Provided upon Unsolicited Request. Any communication that includes “hypothetical performance” that an adviser provides (1) “[i]n response to an unsolicited request for such information from a prospective
or current client or investor in a private fund advised by the investment adviser, or (2) To a prospective or current investor in a private fund advised by the investment adviser in a one-on-one communication.
What are the general prohibitions under the new advertising rule?
Under the new rule, there are seven general prohibitions.
An advertisement may not:
- Include any untrue statement of a material fact, or omit to state a material fact necessary in order to make the statement made, in the light of the circumstances under which it was made, not misleading.
- Include a material statement of fact that the adviser does not have a reasonable basis for believing it will be able to substantiate upon demand by the Commission.
- Include information that would reasonably be likely to cause an untrue or misleading implication or inference to be drawn concerning a material fact relating to the investment adviser.
- Discuss any potential benefits to clients or investors connected with or resulting from the investment adviser’s services or methods of operation without providing fair and balanced treatment of any material risks or material limitations associated with the potential benefits.
- Include a reference to specific investment advice provided by the investment adviser where such investment advice is not presented in a manner that is fair and balanced.
- Include or exclude performance results, or present performance time periods, in a manner that is not fair and balanced.
- Otherwise be materially misleading.
What are “testimonials” and “endorsements” under the new rule?
Under the new rule, a “testimonial” is defined as “any statement by a current client or investor in a private fund advised by the investment adviser:
- About the client or investor’s experience with the investment adviser or its supervised persons;
- That 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
- That 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.”
Similarly, an “endorsement” under the new rule is defined as “any statement by a person other than a current client or investor
in a private fund advised by the investment adviser that:
- Indicates approval, support, or recommendation of the investment adviser or its supervised persons or describes that person’s experience with the investment adviser or its supervised persons;
- 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
- 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.”
How can an investment adviser use a “testimonial” or “endorsement” under the new rule?
Under the new rule, “[a]n advertisement may not include any testimonial or endorsement, and an adviser may not provide compensation, directly or indirectly, for a testimonial or endorsement, unless the investment adviser complies” generally with three conditions (unless it meets one of the specific exemptions, which reduces the burden on some, but not all of the conditions).
The Three Conditions
- Mandatory Disclosure. An investment adviser must “disclose, or reasonably believe that the person giving the testimonial or endorsement discloses, the following at the time the testimonial or endorsement is disseminated:
- Clearly and prominently:
- That the testimonial was given by a current client or investor, and the endorsement was given by a person other than a current client or investor, as applicable;
- That cash or non-cash compensation was provided for the testimonial or endorsement, if applicable; and
- A brief statement of any material conflicts of interest on the part of the person giving the testimonial or endorsement resulting from the investment adviser’s relationship with such person.
- The material terms of any compensation arrangement, including a description of the compensation provided or to be provided, directly or indirectly, to the person for the testimonial or endorsement; and
- A description of any material conflicts of interest on the part of the person giving the testimonial or endorsement resulting from the investment adviser’s relationship with such person and/or any compensation arrangement.
- These are collectively referred to as the “Disclosure Requirements”.
- Clearly and prominently:
- Oversight Requirement. An investment adviser must maintain a “reasonable basis” for “believing that the testimonial or endorsement complies with the requirements of [the three conditions] (the “Oversight Requirement”). An adviser must also maintain “a written agreement with any person giving a testimonial or endorsement that describes the scope of the agreed-upon activities and the terms of compensation for those activities. (the “Written Agreement Requirement”).
- Disqualifying Provision. Under the new rule, an investment adviser cannot compensate a person in any manner for a testimonial or endorsement if they know or should know with the exercise of reasonable care that the person providing the testimonial or endorsement is an “ineligible person” when it is disseminated. There is a grandfathering provision in the rule that might provide some relief to “ineligible persons” assuming they were not disqualified under the prior cash solicitation rule (Rule 206(4)-3).
Exemptions from the Conditions
There are a few instances where all of the conditions referenced above are not required for compliance with the rule. Each of these situations is discussed below:
- Free and De Minimis Testimonials and Endorsements. In cases where an adviser disseminates an advertisement containing a testimonial or endorsement for no compensation or $1,000 or less (or the equivalent in non-cash compensation) during the preceding 12 months, the parties do not need to enter into a written agreement outlining the scope of services and the terms of compensation and the person receiving compensation could be an “ineligible person”. Put another way, the adviser must still perform the Oversight Requirement, but is excused from the Written Agreement Requirement and could pay an “ineligible person”.
- Payments to Employees and Related Persons. A testimonial or endorsement by an investment adviser’s “partners, officers, directors, or employees, or a person that controls, is controlled by, or is under common control with the investment adviser, or is a partner, officer, director or employee of such a person” is excused from the Disclosure Requirements and the Written Agreement Requirement, “provided that the affiliation between the investment adviser and such person is readily apparent to or is disclosed to the client or investor at the time the testimonial or endorsement is disseminated and the investment adviser documents such person’s status at the time the testimonial or endorsement is disseminated.”
- Certain Exceptions for Broker-Dealers. For broker-dealers registered with the SEC, they are excused from the Disclosure Requirements if the testimonial or endorsement is a recommendation subject to Regulation Best Interest. In addition, there are exceptions from certain disclosure requirements if the recipient of the testimonial or endorsement is not a retail customer (as defined by Regulation Best Interest). Lastly, they are excused from the disqualification provisions so long as they aren’t subject to the statutory disqualification provisions under section 3(a)(39) of the Securities Exchange Act of 1934.
What is a “Third-Party Rating” and what are the new rules for “Third-Party Ratings”?
Under the new rule, a “third-party rating” is “a rating or ranking of an investment adviser provided by a person who is not a related person (as defined in the Form ADV Glossary of Terms), and such person provides such ratings or rankings in the ordinary course of its business.”
An investment adviser may not include any third-party rating in an advertisement unless they meet two conditions. The first condition is that the investment adviser must maintain a reasonable basis for “believing that any questionnaire or survey used in the preparation of the third-party rating is structured to make it equally easy for a participant to provide favorable and unfavorable responses, and is not designed or prepared to produce any predetermined result.” The second condition requires that an investment adviser “clearly and prominently” disclose or that the rating itself “clearly and prominently” discloses i) the date the rating was given and time period on which the rating was based, ii) the third party that created and tabulated the rating, and iii) whether any compensation was provided directly or indirectly to obtain or use the rating.
What are the new requirements for performance advertising?
There are quite a few new changes under the new advertising rule as it relates to performance advertising. The new rule addresses i) the presentation of gross performance, ii) mandatory prescribed time reporting requirements for portfolios and composite portfolios, iii) and rules on using “related performance”, “extracted performance”, and “hypothetical performance”.
Under the new rule, an investment adviser may not include in any advertisement:
- Gross and Net Performance. Any presentation of gross performance, unless the advertisement also contains a presentation of net performance. Net performance must be displayed with “at least equal prominence” and in a way to “facilitate comparison”. Both presentations must show the same period of time and use the same type of methodology.
- Prescribed Time Period Reporting. Performance for any portfolio or composite portfolio (with the exception of private fund), unless the advertisement includes performance for one-, five-, and ten-year periods. This prescribed time period reporting must not be stale. More specifically, “it must end on a date that is no less recent than the most recent calendar year-end.” In certain instances, it could require a more recent date to avoid being presented in an unfair or unbalanced manner.
- No Representation of SEC Approval. that contains a “statement, express or implied, that the calculation or presentation of performance results in the advertisement has been approved or reviewed by the [SEC].”
- Related Performance. “Related performance”, unless it includes all “related portfolios”. Under the new rule, the term “related performance” “means the performance results of one or more related portfolios, either on a portfolio-by-portfolio basis or as a composite aggregation of all portfolios falling within stated criteria.” The term “related portfolio” means “a portfolio with substantially similar investment policies, objectives, and strategies as those of the services being offered in the advertisement.” In certain instances, the new rule permits the exclusion of a related portfolio if the exclusion doesn’t result in “materially higher” performance results or alter the prescribed time periods referenced above.
- Extracted Performance. “Extracted performance” without providing or offering to provide promptly the total portfolio from which the performance was extracted.
- Hypothetical Performance. “Hypothetical performance” without complying with certain elements described below.
- Predecessor Performance. “Predecessor performance” without complying with certain conditions under the rule. However, this is a fairly unique issue so is beyond the coverage of this post.
What is Hypothetical Performance and what must be done to use it in an Advertisement?
Under the new rule, “hypothetical performance” is defined as “performance results that were not actually achieved by any portfolio of the investment adviser.” There are three categories of performance presentations that are specifically referenced in the new definition:
- Performance derived from model portfolios;
- Performance that is backtested by the application of a strategy to data from prior time periods when the strategy was not actually used during those time periods; and
- Targeted or projected performance returns with respect to any portfolio or to the investment advisory services with regard to securities offered in the advertisement.
Under the new definition, certain interactive analysis tools are excluded from the definition of “hypothetical performance” as long as they meet the following conditions:
- The tool produces simulations and statistical analyses that present the likelihood of various investment outcomes if certain investments are made or certain investment strategies or styles are undertaken, thereby serving as an additional resource to investors in the evaluation of the potential risks and returns of investment choices; provided that the investment adviser:
- Provides a description of the criteria and methodology used, including the investment analysis tool’s limitations and key assumptions;
- Explains that the results may vary with each use and over time;
- If applicable, describes the universe of investments considered in the analysis, explains how the tool determines which investments to select, discloses if the tool favors certain investments and, if so, explains the reason for the selectivity, and states that other investments not considered may have characteristics similar or superior to those being analyzed; and
- Discloses that the tool generates outcomes that are hypothetical in nature.
An investment adviser will be unable to advertise hypothetical performance unless they:
- Adopt and implement policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement,
- Provide sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating such hypothetical performance, and
- Provide (or, if the intended audience is an investor in a private fund provides, or offers to provide promptly) sufficient information to enable the intended audience to understand the risks and limitations of using such hypothetical performance in making investment decisions; Provided that the investment adviser need not comply with the i) prescribed time period condition (i.e., the 1, 5, and 10-year requirement) ii) the “related performance” requirement (i.e., the need to generally include all related performance), and iii) the “extracted performance” requirement (i.e., the need to generally provide or offer to provide the performance for the entire portfolio), each described above.
What impact do the new rules have on Form ADV?
The new rule is accompanied by amendments to Form ADV that are designed to provide the SEC with information about an investment adviser’s advertising practices. These changes can be viewed on Appendix A to the adopting release at page 420. The new Glossary of Terms to Form ADV is found on Appendix B at page 421.
What impact do the new rules have on recordkeeping obligations?
The new rule presents some interesting tweaks for recordkeeping predominantly flowing from the new definition of “advertisement”.
As the adopting release describes, “[i]nvestment advisers must make and keep records of all advertisements they disseminate, and certain alternative methods for complying with this provision are available for oral advertisements, including oral testimonials and oral endorsements. If an adviser provides an advertisement orally, the adviser may, instead of recording and retaining the advertisement, retain a copy of any written or recorded materials used by the adviser in connection with the oral advertisement. If an adviser’s advertisement includes a compensated oral testimonial or endorsement, the adviser may, instead of recording and retaining the advertisement, make and keep a record of the disclosures provided to investors. Further, if an adviser’s disclosures with respect to a testimonial or endorsement are not included in the advertisement, then the adviser must retain copies of such disclosures provided to investors.”
What if I simply want to review the new rules?
Feel free to jump to page 405-419 of the adopting release.