September 14, 2017: The SEC Advertising Rule 206(4)-1 governing investment advisers is perhaps the most challenging aspect of the investment adviser regulatory regime. The fact that it is a component of the anti-fraud provisions of the Investment Advisers Act makes it only more so.
The Advertising Rule prohibits an adviser, directly or indirectly, from publishing, circulating, or distributing any advertisement that contains any untrue statement of material fact, or that is otherwise false or misleading. The Advertising Rule also includes four key directives wherein advisers are prohibited from:
- Issuing advertisements that refer, directly or indirectly, to any testimonial concerning the adviser or any advice, analysis, report, or other service rendered by the adviser;
- Advertising past specific recommendations of the adviser that were or would have been profitable to any person;
- Issuing advertisements claiming that any graph, chart, formula, or other device can by itself determine whether to buy or sell a security; and
- Issuing advertisements that offer purportedly free reports, analyses, or services.
Best practice argues for advisers to broadly interpret the definition of an advertisement to include not only traditional marketing materials like pitch books and tear sheets, but also offering circulars, commentary letters and websites to preclude regulatory sanctions.
New Risk Alert Guidance
On September 14, 2017, the SEC issued a National Exam Program Risk Alert, entitled The Most Frequent Advertising Rule Compliance Issues Identified in OCIE Examinations of Investment Advisers which addressed many areas of non-compliance uncovered by the Office of Compliance Inspections and Examinations (“OCIE”) pursuant to the examination of investment advisory compliance programs over the course of 2017.
The most frequent adviser compliance issues relating to the Advertising Rule were as follows:
- Misleading performance results
- Misleading one-on-one presentations
- Misleading claims of compliance with voluntary performance standards (such as GIPS)
- Cherry picking investment performance attributes
- Misleading selection of recommendations
- Inadequate compliance policy
Additionally, the Risk Alert referenced results of the OCIE “Touting Initiative”. This initiative focused upon disclosures made by advisers who “tout’ awards, promote ranking lists, and identify professional designations (collectively “accolades”) in their firm’s marketing/advertising materials and regulatory disclosures.
The touting inquiry revealed the following non-compliant activity:
- Misleading Use of Third Party Rankings or Awards
- Misleading Use of Professional Designations
- Prohibited Testimonials
The fact that the OCIE continues to see broad and systemic non-compliance with the Advertising Rule after over two decades of rule promulgation and enforcement impels us to the conclusion that the rule is complex and therefore subject to misinterpretation. When systemic and ongoing non-compliance occur, best-in-breed compliance risk management practice will often present solutions based upon the implementation of appropriate internal controls. Internal controls monitor, measure and/or generally gauge the performance of certain aspects of the adviser’s compliance risk management program. In this respect, internal controls are critical to ensure that policies and procedures remain relevant to the underlying regulatory regime and the registrant business model.
In lieu of reprinting the Risk Alert, we urge you to read the guidance by following this link: https://www.sec.gov/files/risk-alert-advertising.pdf.
In this section, we suggest scenario-based controls and policies to address the SEC’s concerns. The following advertising scenarios with attendant internal controls to mitigate the posited non- compliant activity does not represent the full spectrum of Rule 206(4)-1 violations but should kick start the enhancement of investment adviser advertising policies, procedures, and internal controls.
Scenario 1: Advertising and Marketing Standards are not the Same
Many advisers broadly interpret that which constitutes advertising content to preclude an OCIE deficiency finding. In this regard it is helpful to consider the SEC no-action letter issued to the Investment Counsel Association of America, Inc. (“ICAA”) stating that the provision of information by the adviser in response to a request by a client, prospective client, or consultant shall not be deemed an advertisement under the Advisers Act (e.g., when responding to DDQ or RFP inquiries).
However, these ‘one-off’ scenarios may be construed by regulators to be marketing events and as such, the content and representations made will continue to be subject to the anti-fraud provisions of Section 206 of the Advisers Act. This distinction is important for advisers to private funds relying on the no-action letter, wherein such communication intended to solicit an investor to subscribe to the fund or stay invested in the fund, the communication will be regarded by regulators as marketing content with attendant anti-fraud risk.
Further and very importantly, any reliance upon the ICAA no-action letter relative to mitigating Rule 206(4)-1 risk has created knock-on compliance risk wherein CCOs find that the ‘one-off’ response to a client/prospect inquiry often may be recirculated by the adviser to an audience of more than one person, apart from the client/prospect request. This scenario alters the original content status which was classified as marketing content to become a regulated advertisement, thereby placing the adviser in non-compliance.
Suggested internal control: All content approved for one-off responses to client inquiries should be watermarked ‘single-use only’ and subjected to limited access retention (e.g., portioned hard drive separate from approved advertising material).
Suggested policy amendment: If not a component of current policy, posit language which prohibits the use or dissemination of material designated for single-use application and amend procedures to include limited access retention requirements.
Scenario 2: Develop Content Approval Log
Advertising and marketing content tends to correlate very highly with the ongoing development and offering of products and services by the advisory firm. As advertising and marketing content applications grow due to product and service expansion and/or as client diversity expands (i.e., ERISA, institutional, qualified investor, sovereign wealth, etc.), the document review and record retention process may become unwieldy.
Bearing in mind that the OCIE document request list for advertising and marketing materials is substantial and growing year-over-year, and considering that the regulator’s request for evidence of the adviser approval/retention protocol expands concomitantly, the onus on the marketing team and CCO to provide the information to the OCIE continues to be a significant challenge. Most advisers have less than two weeks to compile this information in the requested OCIE format.
Suggested internal control: The creation of a central electronic repository for approved content with attendant approvals, usage restrictions, and content deployment status provides a necessary compliance internal control which integrates myriad compliance action items attendant to Rule 206(4)-1. The repository is useful not only in Rule 206(4)-1 compliance but in the event of a regulatory inquiry wherein the OCIE will submit a document request list requiring all marketing and advertising content for a 2-year period, along with evidence of mandatory compliance review.
Suggested policy amendment: If not a component of current policy, posit language which requires compliance to preapprove all advertising and marketing content and to retain records of approval/review and the regulated content in a central electronic repository for a period of not less than five years after the end of the year in which the piece was last disseminated.
Scenario 3: Disclosure Inventory and Checklist
Conflicts of interest and advertising are inherently related in the investment advisory business. Whether the advertisement is oriented towards a new product, existing products and services, or the general orientation of the advisory firm, all scenarios represent a conflict of interest. The fiduciary standard of care incumbent upon all investment advisers, without exception, requires conflicts of interest to be appropriately identified, mitigated, and subsequently disclosed to clients and prospects to the extent they are material and not fully mitigated. Disclosures must include a description of the conflict and the measures taken by the adviser to mitigate the conflict which in the case of Rule 206(4)-1, is essentially the means whereby the adviser complies with the advertising rule.
The SEC requires disclosures to be thorough, accurate and most importantly, relevant to the conflict at hand. Advisers have been sanctioned for over disclosing, i.e., providing too much information that simply does not correlate to the conflict at hand. Customizing certain advertising conflicts which clearly relate to more sophisticated and complex aspects of the adviser’s business will substantially mitigate the risk of over- or irrelevant disclosure. Recurring disclosures for advertising content such as quarterly composite start dates, bench mark definitions, etc., may be “inventoried” and utilized repeatedly with minimal compliance oversight until the adviser’s business model changes.
There are however conflicts whose origin and nature require a customized disclosure due to the sophistication and complexity of the underlying conflict. For example, back-tested model performance data utilizing hypothetical transactions which is then posited as a new product or strategy will require extensive and unique disclosure pursuant to Rule 206(4)-1 requirements. To apply a standard performance disclosure to this scenario would invite serious regulatory consequences. The implementation of procedures and internal controls wherein CCO engagement of the advertising disclosure process is risk based, like the compliance program itself, will ensure more efficient and compliant advertising and marketing.
Suggested internal control: The CCO should develop and inventory disclosures for recurring marketing and advertising scenarios. The control should include provision whereby changes to the adviser business model as referenced in Form ADV are cross referenced against the disclosure inventory to ensure that the disclosures remain relevant to the conflict. The CCO should develop a reference guide to assist marketing personnel in the proper use of disclosures.
Suggested policy amendment: If not a component of current policy, posit language which requires the adviser to identify all conflicts of interest and subsequently develop accurate and relevant disclosures of same, posting them by topic to a risk matrix which maps them to required disclosures.
Scenario 4: Dedicated E-mail Address
All client communications must be retained for a period of five years after the end of the year in which the communications occurred. A basic procedure which most advisers have adopted entails the review of client directed email to ensure that advertising/marketing staff are not violating Rule 206(4)-1 policy provisions. This is a very onerous process, whether the compliance team is one CCO monitoring two marketing members or a staff of dozens monitoring hundreds of marketers. Key word searches or algorithmic-based inquiry are often used to execute this procedure.
Suggested internal control: Implementation of policies and procedures is essentially an “all or none” proposition insofar as, excluding the occasional “exception” to policy, the intent of compliance risk management is to ensure that all policy is followed without violations. The fact remains, however, that policy will be violated, knowingly or unknowingly … the question is what will the reputational and regulatory consequences of non-compliance be?
When dealing with the antifraud provisions of the Advisers Act, it can be argued that the consequences may be quite significant, i.e., one email conveyed to a client or group of clients whose content violates the anti-fraud provisions places very significant consequences upon the advisory firm and therefore places a significant burden upon the email review procedure itself. The implementation of a dedicated email address from advertising and marketing to the compliance team greatly facilitates the email review process by automatically separating advertising/marketing from general purpose client communications while mitigating the “all or none” consequences of non-compliance.
Suggested policy amendment: If not a component of current policy, posit language which requires marketing personnel to blind copy compliance when sending electronic advertising and solicitation. Alternatively, work with the firm’s IT resources to create a program which automatically flags emails that meet certain criteria.
Scenario 5: Template Development
A critical element of advertising centers upon the consistency of information contained in advertising/marketing content. This is especially the case with performance presentations. Section 206 of the Advisers Act prohibits misstatements or misleading omissions of material facts and other fraudulent acts and practices when conducting investment advisory business.
Suggested internal control: The use of document templates, which have been pre-approved by the CCO, is a significant internal control that may be utilized to ensure that the context in which data is conveyed in specific advertisement scenarios remains consistent and on-point relative to the client “message” (advertisement) or inquiry (marketing). Once the template content has been approved by compliance, it is retained in secured access format and cannot be changed without CCO approval. The individual(s) responsible for keeping the document current may update performance figures (and other statistics) without requiring re-approved by compliance. Any other changes to the template, however, would require the further review and approval of compliance.
One key benefit of using templates is the provision of consistent information by the adviser in response to recurring requests (remember, while the SEC has provided limited relief for client originated inquiries relative to compliance with Rule 206(4)-1, one-on-one presentations and responses to client directed inquiry are clearly covered under anti-fraud provisions). For example, explanations on how performance information has been calculated will generally not deviate from quarter to quarter. A second benefit to using templates resides in the fact that the CCO does not have to approve the template every time a change is made to performance figures, such that information can be efficiently conveyed to clients and prospects.
Suggested policy amendment: If not a component of current policy, posit language which requires the adviser to provide consistent and accurate information relative to all client disclosures, marketing, and advertisement content. Reference the preparation of document templates in procedures to be implemented relative to complying with this policy.
Scenario 6: Touting/Accolades Controls
Advisers desire to establish competitive differentials relative to competing advisers. Many advisers publish or overtly display in advertising content or public venues (such as websites, social media, and email signatures) third-party recognition such as awards, rankings, certifications etc. The Risk Alert indicated that the Commission is intent on sanctioning advisers that do not invoke appropriate self-discipline when publishing accolades or other “touts”.
The following controls are recommended for this advertising area receiving growing SEC scrutiny:
- Establish a policy which requires accolades to be current, i.e., within the prior 24 months. The Commission cited several advisers that published accolades “several years old thereby potentially misleading clients and prospective clients”.
- Ascertain the ranking methodology utilized by the third party to establish ranking criteria and disclose same; failure to do so represents a violation of the Advertising Rule.
- “Personal touting” has become a problem wherein new hires or aggressive professionals will exaggerate their professional qualifications. OCIE staff observed advertisements and disclosures made in Form ADV Part 2B Brochure Supplements that contained potentially false or misleading references to employee professional designations, such as, for example, references to professional designations that have lapsed or that did not explain the minimum qualifications required to attain such designations. Institute an internal control which requires all Form ADV 2B Brochure Supplements to be vetted annually by the employee and his/her immediate manager before submission to the CCO.
- Testimonials are prohibited and have been for some time. Ensure that employees are aware of this and reinforce requirements during annual compliance training sessions.
This bulletin is more extensive than the standard HRL news blast due to the expansive nature of Rule 206(4)-1, the large body of related no-action letters, and the myriad applications to the advisory model. This operational and regulatory reality drives the imperative for advisers to develop and implement risk management efficiencies in their endeavor to comply with the advertising rule.
SEC Risk Alerts and IM Guidance Updates carry a strong message – the SEC Staff expect advisers to read and understand their guidance. CCOs – don’t keep this Risk Alert to yourselves. Distribute it to all marketing staff and require them to certify to their review and understanding.
September 20, 2017
prepared by Horrigan Resources, Ltd.
Not customized advice. Not legal advice.
 See Investment Counsel Association of America, Inc., SEC Staff No-Action Letter (Mar. 1, 2004).