The SEC's New Marketing Rule, Explained

On December 22, 2020, the SEC announced the finalized amendments to its proposed advertising rules and rules pertaining to solicitor’s arrangements applied to Registered Investment Advisers under the Adviser’s Act. The final rule has been long-awaited to modernize rules that have not been changed since their adoption in 1961 and 1979, respectively. Advisors have been trying to navigate best practices with respect to social media advertising and marketing strategies that have been limited by the SEC’s current rule on the prohibition of testimonials and endorsements. 

Below are highlights of the new rule:

New Definition of Advertisement

The new rule will merge the now separate rules regarding advertisements and cash solicitation. The new definition of “advertisement” contains two prongs. 

The first prong includes direct and indirect communication to more than one person that offers advisory services with regards to securities to prospective clients or offers new investment advisory services with regard to securities to current clients.

• Exclusions include: one-on-one communication and extemporaneous, live, or oral communication
• Includes any communication with hypothetical investment performance, even if it is to one client
• “Indirect Communication” would be if the Advisor implicitly or explicitly endorses or approves the information or involves itself in the preparation of the information 

The second prong includes compensation (cash and non-cash) for testimonials and endorsements (whether orally or in writing).

• Non-cash can include: reduced advisory fees, fee waivers, directed brokerage, sales awards, prizes, gifts and entertainment, and training and education meetings where attendance is provided in exchange for solicitation activities

NOTE: There are many common communications that would not be included in the definition of ‘advertisement’ such as: account statements to current clients and general statements about the advisory firm such as the firm’s culture, community activity, educational content, and market commentary (that does not offer new advisory services) to current clients. 

General Prohibitions 

All advertisements will be subject to the following general prohibitions:

• Making an untrue statement of a material fact, or omitting a material fact necessary to make the statement made, in light of the circumstances under which it was made, not misleading;
• Making 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;
• Including 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;
• Discussing any potential benefits without providing fair and balanced treatment of any associated material risks or limitations;
• Referencing specific investment advice provided by the adviser that is not presented in a fair and balanced manner;
• Including or excluding performance results, or presenting performance time periods, in a manner that is not fair and balanced; and
• Including information that is otherwise materially misleading.

Testimonials and Endorsements

The most ground-breaking new change is around the subject of testimonials and endorsements. The new rule will allow testimonials and endorsements PROVIDED that the Advisor satisfies certain disclosure, supervision, and disqualification requirements. 

Testimonial – any statement by a current client or investor in a private fund advised by the investment adviser (i) about the client or investor’s experience with the investment adviser or its supervised persons (ii) 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 (iii) 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.

Endorsement – any statement by a person other than a current client or investor in a private fund advised by the investment adviser that (i) 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; (ii) 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 (iii) 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.

• Any such testimonial or endorsement must clearly and prominently disclose whether the person giving the testimonial or endorsement (the “promoter”) is a client and whether that promoter is compensated. 
• A written agreement must be in place between any promoter and the Advisor if the promoter receives compensation of more than $1,000 or more (or the equivalent in non-cash compensation) during a 12-month period. 
• Disclosure regarding any conflict of interests must be made regarding such compensation arrangements.
  • Previously, Advisors had to obtain a signed client acknowledgment regarding their receipt of a ‘Solicitor’s Disclosure,’ which is no longer the case.
  • Previously, solicitors to Advisors had to deliver the Form ADV Part 2A, however, the new rules allow for either to Advisor or the solicitor to make such delivery
• Promoters can be disqualified from giving such testimonials or endorsements if they are “bad actors” as defined in the final rule. 

Third-Party Ratings

“Third-party rating” - the rating must be provided by a person who is not a related person (as defined in Form ADV) of the adviser and who provides ratings or rankings in the ordinary course of business.

Similar to the testimonial and endorsement rule, third-party ratings are now permitted PROVIDED that Advisors follow certain disclosure and criteria requirements.

• Advisors must have 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.
• Advisors must clearly and prominently disclose, or reasonably believe that the third-party rating clearly and prominently discloses, (i) the date on which the rating was given and the time period covered, (ii) the identity of the third party that created the rating, and, (iii) if applicable, that the Advisor has compensated the rating provider, directly or indirectly, in connection with obtaining or using the rating.

Performance Information

As stated in the General Provisions, any performance advertising must be done in a fair and balanced manner. What is considered to be fair and balanced varies, but an example includes presenting performance in an inconsistent time period (i.e. cherry-picking time frames). 

Advisors must also provide specific disclosures regarding: gross and net performance, prescribed time periods, statements about the SEC’s approval, related performance, extracted performance, hypothetical performance, and predecessor performance. 

Form ADV and Record-Keeping

The new rule will effect Form ADV Part 1A (the online questionnaire) by adding new questions to Item 5 regarding marketing activities. A sample of questions are below:

Item 5.L: Marketing Activities

• Do any of your advertisements include:
  • Performance results? (Y/N)
  • A reference to specific investment advice provided by you (as that phrase is used in rule 206(4)-1(a)(5))? (Y/N)
  • Testimonials (other than those that satisfy rule 206(4)-1(b)(4)(ii))? (Y/N)
  • Endorsements (other than those that satisfy rule 206(4)-1(b)(4)(ii))?(Y/N)
  • Third-party ratings? (Y/N)
• If you answer “yes” to L(1)(c), (d), or (e) above, do you pay or otherwise provide cash or non-cash compensation, directly or indirectly, in connection with the use of testimonials, endorsements, or third-party ratings? (Y/N)
• Do any of your advertisements include hypothetical performance? (Y/N)
• Do any of your advertisements include predecessor performance? (Y/N)

The SEC also changed its books and records requirement to include all advertisements Advisors disseminate. Previously, advisors only had to keep copies of advertisements sent to 10 or more people. The SEC has stated archiving emails sent as advertisements are acceptable for maintaining books and records so long as it can be retrieved in a timely manner and kept for the required time period. 

FAQs

What are examples of an endorsement or testimonial?

Examples of endorsements and testimonials include:

• Lead-generation firms or adviser referral networks (“operators”)
• A blogger’s website review of an adviser’s advisory service 
• Depending on the facts and circumstances, a lawyer or other service provider that refers an investor to an adviser, even infrequently

When does the rule go into effect?

The rule goes into effect 60 days after publication in the Federal Register. We have no information on when that publishing date will be. 

Can I make changes to my website now?

No. The rule does not go into effect until 60 days after being published in the Federal Register and the SEC has yet to publish this. So currently the current rules regarding advertising stands and exams conducted that cover this time period will be under the current advertising rules. 

How does this effect State-Registered Investment Advisers?

In short, we don’t know. Neither NASAA nor any state has publicly made any statement in regards to the new rule (that we know of).

The SEC Final Rule specifically states: “The final rule will apply to all investment advisers registered, or required to be registered, with the Commission. Like the proposal, the final rule will not apply to advisers that are not required to register as investment advisers with the Commission, such as exempt reporting advisers or state-registered advisers.” (See footnote 21, page. 12)

What we do know is that some states have rules that are written in a manner that ‘defaults’ to the SEC advertising rules.  For example, some states do not have an advertising provision in their rules but simply state something similar to the effect of: “The following are deemed to be unethical or dishonest practices by an investment adviser or investment adviser representative: Publishing, circulating or distributing any advertisement which does not comply with SEC Rule 17 C.F.R. § 275.206(4)” In those states, naturally the advertising rules will default to the new rules outlined herein.

Conversely, some states have their own specific advertising rules that, although are almost identical to the current SEC rules, would require that state to amend their actual Rules and Regulations or Securities Act.

For many wondering how to navigate CURRENT advertising rules in regards to social media advertising, Massachusetts published a helpful guide dated December 2019.     

For now, we are advising financial professionals to keep in place their current practices on advertising until we hear further clarification on the matter.                                            

What happens AFTER the rules go into effect?

The compliance deadline for the final marketing rule is not until 18 months after the effective date. This means SEC-registered firms have up to 20 months from when the SEC publishes the final rule to the Federal Register to update their compliance rules, train any employees regarding the new rules, and begin monitoring advertisements to comply with the new rules. 

The above is a general overview of the new rule and does not contain all of the provisions outlined (the Final Rule is 430 pages!). Particularly there are many new provisions specific to advertisements related to private funds.

About the Author
Terria Heng has spent her career in financial regulatory compliance. She started out as a compliance consultant at a boutique compliance firm located in Beverly Hills, CA, where she assisted breakaway brokers in transitioning from wirehouses to the independent RIA space. Prior to joining XYPN, Terria was a financial examiner at the Texas State Securities Board for 6 years. Terria has extensive knowledge in state compliance examinations, including effectively communicating with regulators, responding to regulatory inquiries, and best practices in practice management. Currently living in Portland, Oregon, Terria enjoys hiking the Columbia Gorge with her dog Kuba or going on long road trips with her partner in their Sprinter van.