SEC Proposes Amendments to Advertising and Client Solicitation Rules under the Investment Advisers Act

Client Alert
November 15, 2019

View PDF The U.S. Securities and Exchange Commission (the “SEC”) proposed on November 4, 2019 significant amendments to its current rules under the Investment Advisers Act of 1940 (the “Advisers Act”) relating to investment adviser advertising and the solicitation of potential investment advisory clients.[1] Those amendments, if adopted as proposed, would go a long way to modernizing current advertising and solicitation regulation, as well as providing clarity on its application to current advertising technology, and imposing new compliance requirements.

Brief Summaries of the Proposed Rule Amendments

Section 206 of the Advisers Act addresses prohibited transactions by investment advisers. Section 206(4) prohibits any investment adviser that is registered, or required to be registered, with the SEC[2] from engaging in any act, practice or course of business that is fraudulent, deceptive or manipulative. Furthermore, it directs the SEC to adopt rules and regulations that prescribe means that are reasonably designed to prevent acts, practices and courses of business that are fraudulent, deceptive or manipulative. In 1961, the SEC adopted Rule 206(4)-1 to address investment adviser advertising practices, and in 1979, it adopted Rule 206(4)-3 to address cash payments for client solicitations. Since adoption, the SEC Staff has provided significant guidance to the investment adviser community to help it comply with those rules, especially the use of performance in advertising.[3]

Proposed Amendments to Rule 206(4)-1 (Investment Adviser Advertising)

Current Rule 206(4)-1 includes four per se advertising prohibitions applicable to investment advisers: (a) a prohibition on testimonials concerning the investment adviser or its services; (b) a prohibition on past specific recommendations, that is, direct or indirect references to specific profitable recommendations made by the investment adviser; (c) a prohibition on any graph or other device that can, by itself, be used to determine which securities to buy and sell or when to buy and sell them; and (d) a prohibition on statements to the effect that a service will be furnished free of charge unless the service is actually or will be furnished entirely free and without further obligation or condition. Current Rule 206(4)-1 also includes a general “catch-all” prohibition, that is, a prohibition on any advertisement that contains any untrue statement of material fact, or which is otherwise false or misleading. Most of the SEC guidance relating to the use of performance in investment adviser advertising has been under that catch-all prohibition.

Proposed Rule 206(4)-1 (the “Proposed Advertising Rule”) would replace current Rule 206(4)-1’s broadly drawn limitations with certain principles that would be applied to all investment adviser advertising. The Proposed Advertising Rule also includes rules that apply in specific situations. Among other things, the Proposed Advertising Rule would clarify the current rule’s prohibitions applying to testimonials (including endorsements and third-party ratings) and past specific recommendations. It also would address the appropriate presentation of performance in advertisements, as well as address the challenges of using social media and other technologies in investment adviser advertising. The Proposed Advertising Rule also expands the application of the advertising rules to advertisements for pooled investment vehicles, such as hedge funds and private equity/venture capital funds.

Definition of an “Advertisement.” In the Proposed Advertising Rule, the definition of what is an advertisement would include any communication, disseminated by any means, by or on behalf of an investment adviser, that offers or promotes investment advisory services or that seeks to obtain or retain advisory clients or investors in any pooled investment vehicle advised by the adviser. The proposed definition is more expansive than the current definition in that it covers more types of communication (such as, social media), explicitly covers advertisements to investors in certain pooled investment vehicles (that is, pooled investment funds that would be investment companies under Section 3(a) of the 1940 Act but for an exclusion under Section 3(c)(1) (generally, fewer than 100 investors and no public offering of interests in the pool) or Section 3(c)(7) (generally, all investors are “qualified purchasers” and no public offering of interests in the pool)), and it could cover an advertisement sent to just one person. Also, any communication to a “retail person” would be an advertisement if it included performance.[4] 

Specifically excluded from that definition would be live oral communications that are not broadcast; responses to certain unsolicited requests for specified information; advertisements, other sales material and sales literature that is about a registered investment company or a business development company and is within the scope of other SEC rules[5]; and information required to be contained in a statutory or regulatory notice, filing, or other communication. In addition, client account statements, including performance information relating to a client’s account, typically would not be treated as advertisements.

Although not specifically addressed in the Proposed Advertising Rule, the Proposing Release notes that whether information prepared by an unaffiliated third party, such hyperlinks, independent webpages and article reprints, would be an advertisement depends on the facts and circumstances, such as whether the investment adviser endorsed or approved the information.

General Advertising Prohibitions. The Proposed Advertising Rule would replace the four current per se prohibitions and the catch-all prohibition with seven broadly worded principles that would apply to all investment adviser advertising. As proposed, an investment adviser’s advertisement would be prohibited from:

Application to Specific Advertising Practices (other than Performance Advertising). In addition to the seven general principles identified above, the Proposed Advertising Rules would expressly permit, subject to conditions, testimonials and endorsements, and it would permit investment advisers to refer to ratings provided by third parties.[6] Currently, Rule 206(4)-1(a)(1) prohibits an investment adviser from referring, directly or indirectly, to a testimonial of any kind regarding the investment adviser, its investment advice or any service that is offered by the investment adviser. The SEC Staff, however, has in the past permitted testimonials (including endorsements and references to third-party ratings), subject to conditions. Under the Proposed Advertising Rule, a testimonial or endorsement subject to specified disclosures, including whether the person giving a testimonial or endorsement is a client and whether such person has been compensated by or on behalf of the investment adviser. The Proposed Advertising Rule also would expressly permit investment advisers to refer to third-party ratings subject to specified disclosures, which would include disclosure of the criteria used to prepare the rating.

Application to Performance Advertising. Currently, Rule 206(4)-1 does not prescribe how an investment adviser must present performance in advertising or how to calculate performance. Investment advisers intending to include performance in their advertising historically have had to rely only on no-action letters and other SEC Staff interpretative guidance, as well as SEC enforcement actions. The Proposed Advertising Rule would change that approach, primarily by codifying and refining many of the principles reflected in the SEC Staff’s previous guidance. Among other things, the Proposed Advertising Rule would prohibit any advertisement from including:

In addition, the Proposed Advertising Rule would require any advertisement that is targeted to retail investors to include a presentation of net performance alongside any presentation of gross performance, as well as a presentation of the performance results of any portfolio or certain composite aggregations across 1-, 5-, and 10-year periods, or for the life of the portfolio, if shorter.

Compliance Requirements. The Proposed Advertising Rule has several compliance requirements, including a new requirement that, according to the SEC, is not only intended to promote compliance with the rule but also permit the SEC’s examination staff to better review investment adviser compliance with the rule. The Proposed Advertising Rule would require all advertisements prepared by or on behalf of an investment adviser to be reviewed and approved in writing by a designated employee of the investment adviser before dissemination. The SEC stated in the Proposing Release that it would expect any designated employee to be qualified, that is, competent and knowledgeable. The Proposed Advertising Rule has two exceptions to the pre-approval requirement. The first exception would be for advertisements that are communications disseminated only to a single person or household or to a single investor in a pooled investment vehicle. The second exception would be for live oral communications broadcast on radio, television, the internet, or any other similar medium (generally, where it is impractical to preview the communication before it is made). The current advertising rule does not have a similar provision.[7] 

Proposed Amendments to Rule 206(4)-3 (Client Solicitations)

Rule 206(4)-3 under the Advisers Act (commonly referred to as the “cash-solicitation” rule) is intended to ensure that prospective clients of an investment adviser who have been referred to the investment adviser by a solicitor are aware that the solicitor, by being paid by or on behalf of the investment adviser, has a conflict of interest. Currently, Rule 206(4)-3 provides that an investment adviser’s payment of a cash fee for referrals for investment advisory clients is a violation of Section 206(4) unless the solicitor and the investment adviser comply with certain conditions. Among other things, the investment adviser and the solicitor must enter into a written agreement. Unless the subject solicitation activities are for the provision of impersonal advisory services, or the solicitor is an affiliate of the investment adviser (such as, a director, officer, or employee), the written agreement must provide that the solicitor is required to provide the prospective client with a copy of the investment adviser’s Form ADV disclosure document (such as, Form ADV, Part 2) and a written solicitor disclosure document, which must include a description of the compensation the solicitor would receive from the investment adviser. The current rule also prescribes certain compliance methods, such as the investment adviser receiving a signed acknowledgement from the client of the receipt of the required disclosures. The current rule also prohibits the investment adviser from paying a solicitor for referrals if the solicitor has been found to have violated the federal securities laws or convicted of a crime.

The proposed amendments to Rule 206(4)-3 (the “Proposed Solicitation Rule”) would make certain refinements in the scope of the rule, the content of the written agreement between the investment adviser and the solicitor, and the current rule’s disclosure requirements. Among other things, the Proposed Solicitation Rule would apply to all types of compensation, not just cash compensation as provided in the current rule. Non-cash compensation would include directed brokerage, awards or other prizes, and free or discounted services. In addition, the Proposed Solicitation Rule would apply to private fund solicitors, that is, solicitors of investors in private funds rather than just clients intending to establish separately managed accounts with the investment adviser.

The Proposed Solicitation Rule generally would retain the current rule’s partial exemptions for solicitors that refer investors for impersonal investment advice (but not, importantly, for solicitors for “robo-advisers” or internet advisers). It also would generally retain the current rule’s partial exemption for solicitors that are affiliated with the investment adviser, provided that the relationship is disclosed to the potential investor or is readily apparent to the potential investor. Neither type of arrangement would be subject to the current rule’s written agreement requirement.

The Proposed Solicitation Rule also would have two new exemptions: one for de minimis compensation paid to solicitors ($100 or less over the most recent a 12-month period), and another for investment advisers that participate in certain nonprofit programs. The Proposed Solicitation Rule also includes an expanded list of disciplinary events for which a person would be disqualified from acting as a solicitor.

Written Agreement. The Proposed Solicitation Rule would eliminate the current rule’s requirements that the written agreement provide that the solicitor must deliver the investment adviser’s brochure (e.g., Form ADV, Part 2) and perform its solicitation activities consistent with the instructions of the investment adviser. Under the Proposed Solicitation Rule, the agreement would have to provide that the solicitor provide each prospective client with a disclosure document, and it generally retains the current rule’s requirement that the agreement include a provision requiring the solicitor to perform its solicitation activities in accordance with the Advisers Act’s anti-fraud provisions.

Disclosure Requirements. The Proposed Solicitation Rule would require the solicitor to continue to disclose the solicitor’s financial interest in the client’s choice of an investment adviser as well as require the solicitor to include additional information about a solicitor’s conflict of interest. However, the Proposed Solicitation Rule would eliminate the current rule’s requirement that the investment adviser obtain from each investor acknowledgments of receipt of the disclosures.

Oversight of Solicitors. The current rule requires an investment adviser to make a bona fide effort to ascertain whether a solicitor is complying with its written agreement and have a reasonable basis for believing that the solicitor has complied with that agreement. The Proposed Solicitation Rule would continue to require that the investment adviser have a reasonable basis for believing that the solicitor has complied with the rule’s written agreement. The Proposing Release states that a reasonable basis would depend on the circumstances, however, it should involve, among other things periodically making inquiries of a sample of investors solicited by the solicitor. As a practical matter, the Proposed Solicitation Rule would allow an investment adviser to tailor compliance as appropriate for the adviser and the risks and operations in its particular solicitation relationships.

Proposed Amendments to Rule 204-2 (Required Books and Records) and Form ADV

The Proposing Release also includes proposed amendments to Rule 204-2 under the Advisers Act, which describes for the books and records that each investment adviser is required to maintain. Those proposed amendments generally are intended to conform the current books and records requirements with the additional books and records requirements in the Proposed Adverting Rule and the Proposed Solicitation Rule. In addition, the Proposing Release includes proposed changes to Form ADV, which are intended provide the SEC Staff with additional information regarding investment advisers’ advertising practices.

When Comments Are Due and How to Submit Comments

Under federal law, the public has a right to comment on these proposed rules. The comment period is open for 60 days after the publication of the Proposing Release in the Federal Register. As of the date of this Client Alert, the Proposing Release had not yet been published in the Federal Register. Comments generally must be submitted through the SEC’s website at https://www.sec.gov/cgi-bin/ruling-comments.

Throughout the Proposing Release, the Commission has asked for comments on a variety of issues, and we would encourage anyone with an interest in this subject to submit comments for the SEC’s consideration.

For Additional Information

If you have any questions or would like to discuss these proposals, please contact John Hunt (617.338.2961 or jhunt@sullivanlaw.com), or any other Sullivan lawyer with whom you regularly work.

sullivanlaw.com/investment-management

Endnotes

[1] “Investment Adviser Advertisements; Compensation for Solicitors,” Release No. IA-5407 (November 4, 2019) [hereinafter, the “Proposing Release”].

[2] Proposed Rules 206(4)-1 and 206(4)-3 also only apply to investment advisers that are registered, or required to be registered, with the SEC. Among the types of investment advisers to which the rules - current and proposed - do not apply are exempt reporting advisers, investment advisers registered only with a state regulator, and investment advisers whose only clients are insurance companies.

[3] The Proposing Release includes a list of no-action letters and other guidance provided by the SEC Staff since the early 1970s that the SEC states it will review to determine whether those letters and guidance should be withdrawn if the proposed rules are adopted. For a list of the letters and guidance currently being reviewed by the SEC, see Proposing Release, Section II.D at 296.

[4] The Proposed Advertising Rule defines a “retail person” as any person who is a “non-retail person,” and it defines a “non-retail person” as a person who is a “qualified purchaser,” as defined in Section 2(a)(51) of the Investment Company Act of 1940 (the “1940 Act”) (generally, individuals with investment assets of at least $5 million, and entities with investment assets of at least $25 million), or a “knowledgeable employee,” as defined in Rule 3c-5 under the 1940 Act (generally, officers, directors, and key employees of the investment adviser). There are no corresponding terms in the current rules, although the SEC Staff has granted investment advisers more flexibility in the types of information that it may distribute to sophisticated investors and consultants than what they are permitted to provide distribute more broadly. See, e.g., Investment Company Institute, SEC No-Action Letter (September 23, 1988).

[5] See Rule 156 (Investment company sales literature) and Rule 482 (advertising by an investment company as satisfying the requirements of Section 10 of the Securities Act of 1933 (the “Securities Act”)), each adopted under the Securities Act. Section 10 of the Securities Act describes the information that must be included in a prospectus offering securities, such as shares of a mutual fund.

[6] The Proposed Advertising Rule defines a “testimonial” as any statement of a client’s or an investor’s experience with an investment adviser, and it defines an “endorsement” as a statement by any person other than a client or an investor that indicates approval, support or a recommendation of the investment adviser or its investment advisory affiliates (generally, its directors, officers, employees, and persons who directly or indirectly control or are controlled by the investment adviser). It also defines a “third-party rating as a rating or ranking of an investment adviser provided by an unrelated person who provides rating or rankings in the ordinary course of its business. The current Rule 206(4)-1 does not define any of those terms, however, these definitions are generally consistent with the interpretative guidance that has been provided by the SEC’s Staff. See, e.g., DALBAR, Inc., SEC No-Action Letter (March 24, 1998); Gallagher & Assoc., Ltd., SEC No-Action Letter (July 10, 1995); Investment Adviser Association, SEC No-Action Letter (December 2, 2005).

[7] Rule 206(4)-7 under the Advisers Act, which requires investment advisers to maintain compliance policies and procedures, also does not impose any requirements specifically related to advertising, although investment advisers are expected to address in their policies and procedures issues relating to the accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements. See “Compliance Programs of Investment Companies and Investment Advisers,” IA-2204 (December 17, 2003) (adopting, among other things, Rule 206(4)-7 under the Advisers Act).

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