The Securities and Exchange Commission (“SEC”) recently adopted amendments to current Rule 206(4)-1 (the “Advertising Rule”) and rescinded Rule 206(4)-3 (the “Cash Solicitation Rule”) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”).1 The amendments merge the requirements of the Advertising Rule and the Cash Solicitation Rule into new Rule 206(4)-1, which covers investment adviser marketing (the “Marketing Rule”). The Marketing Rule, which applies to SEC-registered investment advisers (“advisers”), is designed to modernize the requirements governing adviser advertising and payments to third-party solicitors. The SEC also adopted related amendments to Rule 204-2 under the Advisers Act (the “Books and Records Rule”) and to Form ADV. The Marketing Rule will not apply to advertisements relating to registered investment companies or business development companies.
The Marketing Rule will take effect sixty (60) days after publication in the Federal Register. In order to provide advisers with a transition period to comply with the Marketing Rule, the compliance date of the Marketing Rule is eighteen (18) months after its effective date.2
This Memorandum provides an overview of the Marketing Rule, including: (i) the definition of “advertisement”; (ii) the Marketing Rule’s general prohibitions; (iii) the requirements applicable to testimonials and endorsements, including with respect to solicitations; (iv) the requirements for using third-party ratings in advertisements; and (v) the requirements applicable to the use of gross performance results, related performance, extracted performance, hypothetical performance and predecessor performance.
I. Definition of Advertisement
The Marketing Rule bifurcates the definition of “advertisement” to include: (i) a modernized definition intended to cover traditional advertising; and (ii) testimonials and endorsements, which include a similar scope of activity as traditional solicitations under the Cash Solicitation Rule.
Modernized Definition of Advertisement
Under the first part of the definition, an advertisement is any direct or indirect communication an adviser makes to more than one person that offers the adviser’s investment advisory services with regard to securities to prospective clients or investors in a private fund advised by the adviser, or offers new investment advisory services with regard to securities to current clients or investors in a private fund advised by the adviser.3 The extent to which an adviser may be held responsible for a communication disseminated by a third-party will turn on the extent to which the adviser was involved in preparing or in endorsing or approving the communication.4 One-on-one communications that include hypothetical performance may also be captured by the definition.
The definition excludes5 the following communications:
- extemporaneous, live, oral communications;
- 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; or
- a communication that includes hypothetical performance that is provided:
- in response to an unsolicited request for such information from a prospective or current client or investor in a private fund advised by the adviser; or
- to a prospective or current investor in a private fund advised by the adviser in a one-on-one communication.
Testimonials and Endorsements
Under the second part of the definition, an advertisement is defined as any endorsement or testimonial for which an adviser directly or indirectly provides compensation.6
- “Endorsement” is defined as a statement by a person who is not a current client or investor in a private fund advised by the adviser indicating approval, support or recommendation of the adviser or its supervised persons.7
- “Testimonial” is defined as a statement by a current client or investor in a private fund about their experience with the adviser or its supervised persons.8
The definitions of “endorsement” and “testimonial” also provide that the statement must directly or indirectly solicit a current or prospective client or private fund investor to be a client of, or an investor in a private fund advised by, the adviser; or refer a current or prospective client or investor to be a client of, or an investor in a private fund advised by, the adviser.
The conditions applicable to testimonials and endorsements, including solicitations, are discussed below.
II. General Prohibitions
The Marketing Rule will replace the broadly drawn limitations of the Advertising Rule with principles-based provisions in order to accommodate what the SEC referred to as “the continual evolution and interplay of technology and advice.”9 Under the Marketing Rule, it will be unlawful for any adviser, directly or indirectly, to disseminate any advertisement that violates any of the seven principles-based general prohibitions set forth in the Marketing Rule. The general prohibitions10 provide that 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 SEC;
- 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 adviser;
- Discuss any potential benefits to clients or investors connected with or resulting from the 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 adviser where such investment advice is not presented in a manner that is fair and balanced;11
- Include or exclude performance results, or present performance time periods, in a manner that is not fair and balanced; or
- Otherwise be materially misleading.
III. Additional Conditions Applicable to Testimonials and Endorsements, Including Solicitations
An advertisement may include a testimonial or endorsement, and an adviser may provide compensation, directly or indirectly, for a testimonial or endorsement, if the adviser complies with the following three conditions: (i) a “Required Disclosures Condition”; (ii) an “Adviser Oversight and Compliance Condition”; and (iii) a “Disqualification Condition”, each of which is described below.12
Required Disclosures Condition
The adviser must disclose, or reasonably believe that the person giving the testimonial or endorsement (such person, a “promoter”) will disclose, 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 or the endorsement was given by a person other than a current client or investor;
- That cash or non-cash compensation was provided for the testimonial or endorsement; and
- A brief statement of any material conflicts of interest on the part of the promoter resulting from the 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 promoter; and
- A description of any material conflicts of interest on the part of the promoter resulting from the adviser’s relationship with such person and/or any compensation arrangement.
Adviser Oversight and Compliance Condition
The adviser must have:
- a reasonable basis for believing that the testimonial or endorsement complies with the requirements of the Marketing Rule; and
- a written agreement with any promoter that describes the scope of the agreed-upon activities and the terms of compensation for those activities.
The adviser may not compensate a person, directly or indirectly, for a testimonial or endorsement if the adviser knows, or in the exercise of reasonable care should know, that the promoter is an ineligible person13 at the time the testimonial or endorsement is disseminated.
The Marketing Rule provides exemptions from certain of the requirements described above to testimonials and endorsements disseminated:
- for no compensation or de minimis compensation;14
- by a partner, officer, director or employee of the adviser or its affiliates;15
- by an SEC-registered broker-dealer;16 or
- by a person that is covered by rule 506(d) of the Securities Act of 1933 (the “Securities Act”) with respect to a rule 506 securities offering and whose involvement would not disqualify the offering under the rule.17
For example, an adviser need not comply with the written agreement requirement of the Adviser Oversight and Compliance Condition and the Disqualification Condition in connection with the dissemination of a testimonial for no compensation.
IV. Third-Party Ratings
The Marketing Rule defines a “third-party rating” as a rating or ranking of an adviser provided by a person who is not a “related person” of the advisor18, and the person provides such ratings or rankings in the ordinary course of its business.19 An advertisement may not include any third-party ratings unless the adviser:
- Has 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; and
- Clearly and prominently discloses, or the adviser reasonably believes that the third-party rating clearly and prominently discloses: (i) the date on which the rating was given and the period of time upon which the rating was based; (ii) the identity of the third party that created and tabulated the rating; and (iii) if applicable, that compensation has been provided directly or indirectly by the adviser in connection with obtaining or using the third-party rating. 20
V. Performance Advertising
The Marketing Rule permits the use of performance results in advertisements, but imposes tailored requirements on the use of the following types of performance results in advertisements: gross performance results; related performance; extracted performance; hypothetical performance; and predecessor performance.
Net Performance Requirement
An adviser may include a presentation of gross performance in an advertisement provided that the advertisement also presents net performance that: (i) is presented with at least equal prominence to, and in a format designed to facilitate comparison with, the gross performance; and (ii) is calculated over the same time period, and using the same return methodology, as the gross performance.21
Prescribed Time Periods
An adviser may not include in any advertisement any performance results of any portfolio or any composite aggregation of related portfolios, unless:
- the advertisement includes performance results of the same portfolio or composite aggregation for one-, five- and ten- year time periods; 22 and
- the results are presented with equal prominence and end on a date that is no less recent than the most recent calendar year-end.23
The prescribed time periods requirement, however, does not apply to the presentation in advertisements of the performance results of private funds.
An adviser may use “related performance” results in an advertisement provided that the performance results of all “related portfolios” are included. Notwithstanding the foregoing, the performance of any related portfolios can be excluded if:
- the advertised performance results are not materially higher than if all related portfolios had been included; and
- the exclusion of any related portfolio does not alter the presentation of any applicable prescribed time periods.
The Marketing Rule defines “related performance” as 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 and a “related portfolio” as a portfolio with substantially similar investment policies, objectives, and strategies as those of the services being offered in the advertisement.
An adviser may include “extracted performance” results in an advertisement only if the advertisement provides, or offers to provide promptly, the performance results of the total portfolio.24 The Marketing Rule defines “extracted performance” as the performance results of a subset of investments extracted from a portfolio.25
The Marketing Rule permits the use of hypothetical performance in advertisements subject to certain requirements described below.
Hypothetical performance is defined as performance results that were not actually achieved by any portfolio of the adviser.26 Hypothetical performance includes, but is not limited to:
- performance derived from model portfolios;27
- 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.
An adviser may include “hypothetical performance” in an advertisement only if the adviser:28
- Adopts and implements 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;
- Provides sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating such hypothetical performance; and
- Provides (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.
The definition of hypothetical performance under the Marketing Rule includes a carve out for interactive analysis tools that permit clients or prospective clients to produce certain kinds of simulations and statistical analyses, subject to additional requirements.29
An adviser may use “predecessor performance” in advertisements only if:
- The person or persons who were primarily responsible for achieving the prior performance results manage accounts at the advertising adviser;
- The accounts managed at the predecessor adviser are sufficiently similar to the accounts managed at the advertising adviser that the performance results would provide relevant information to clients or investors;
- All accounts that were managed in a substantially similar manner are advertised unless the exclusion of any such account (i) would not result in materially higher performance and (ii) does not alter the presentation of any applicable prescribed time periods; and
- The advertisement clearly and prominently includes all relevant disclosures, including that the performance results were from accounts managed at another entity.
Statements about SEC Approval
An adviser may not include in any advertisement any statement, express or implied, that the calculation or presentation of performance results in the advertisement has been approved or reviewed by the SEC.
VI. Related Amendments to Form ADV and Books and Records Rule
The SEC also adopted: (i) changes to Item 5 of Form ADV Part 1A30 that will require an adviser to report its use of certain advertising practices, including, for example, the extent to which the adviser uses performance results or references to specific investment advice, among other kinds of advertising practices; and (ii) amendments to the Books and Records Rule31 that will require an adviser to maintain certain records regarding all advertisements it disseminates, subject to certain exemptions or different requirements with respect to oral advertisements.
VII. S&K Observations
We believe the amendments to the Advertising Rule will likely result in substantial changes to an adviser’s marketing practices and compliance program. In the coming months, Seward & Kissel LLP will be providing additional analysis of the Marketing Rule and its implications for advisers.