SEC Proposes to Modernize the Advertising and Cash Solicitation Rules for Investment Advisers

By November 11, 2019Uncategorized

The U.S. Securities and Exchange Commission (“SEC”) announced on November 4, 2019 that it has voted to propose amendments to modernize the rules under the Investment Advisers Act of 1940, as amended (“Advisers Act”) addressing investment adviser advertisements and payments to solicitors. The proposed amendments (all 507 pages) are intended to update these rules to reflect changes in technology, the expectations of investors seeking advisory services, and the evolution of industry practices.

Changes to these rules have been a long time coming … the advertising rule was last amended in a meaningful way back in 1961, while the solicitation rule was last amended in 1979. So much has changed in the industry since then … from the explosion in the investment adviser landscape and capital market wealth, to the wide array of new investment vehicles, not to mention the age of the Internet and social media.

The proposed amendments to the advertising rule would replace the current rule’s broad limitations with principles-based provisions. The proposed approach would also permit the use of testimonials, endorsements, and third-party ratings, subject to certain conditions, and would include tailored requirements for the presentation of performance results based on an advertisement’s intended audience.

The proposed amendments to the solicitation rule would expand the current rule to cover solicitation arrangements involving all forms of compensation, rather than only cash compensation, subject to a new de minimis threshold. They also would sweep in private fund investor solicitation arrangements, and update other aspects of the rule, such as who is disqualified from acting as a solicitor under the rule.

The public comment period is a short 60 days following publication of the proposal in the Federal Register (which has not yet occurred as of the date of this newsletter).

Proposed Amendments to Advertising Rule 206(4)-1

Definition of Advertisement

The proposal redefines the term “advertisement” to 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 SEC has proposed certain exclusions from this definition for:  (1) live oral communications that are not broadcast, (2) responses to certain unsolicited requests for specified information, (3) advertisements, other sales material, or sales literature that is about a registered investment company or a business development company and is within the scope of other Commission rules; and (4) information required to be contained in a statutory or regulatory notice, filing, or other communication (such as Form ADV or Form CRS).

This proposed definition reflects several differences from the current rule. One is the expansion of the types of communications addressed to reflect evolving methods of communication, rather than the methods that were most common when the current rule was adopted (e.g., newspapers, television, and radio). Secondly, the definition applies explicitly to advertisements disseminated to investors in pooled investment vehicles, with a carve-out for publicly offered investment companies. Thirdly, the proposed definition does not keep the current rule’s “more than one person” element, but, consistent with the effect of that element, does not apply to non-broadcast live oral communications or responses to certain unsolicited requests.

What Does ‘By or on Behalf of’ an Adviser Mean?

Because investment advisers often provide advertisements for dissemination to intermediaries, such as consultants and solicitors, the proposed rule would treat those as communications “by or on behalf of” the advisers. Furthermore, an adviser might incorporate third-party content into its communication by including a hyperlink to an independent webpage on which third-party content sits in the adviser’s communication. Or an adviser might allow third parties to post commentary on the adviser’s website or social media page. In both cases, the third-party content may be a communication “by or on behalf of” the adviser, and therefore an “advertisement” subject to the restrictions in the proposed rule.

An adviser’s hyperlink to third-party content within the adviser’s press release generally would not, by itself, make the hyperlinked content part of the advertisement, provided that the third party, and not the adviser or its affiliate, drafted the hyperlinked content and is free to modify it. At the same time, an adviser’s hyperlink to third-party content that the adviser knows or has reason to know contains an untrue statement of material fact or materially misleading information would be fraudulent or deceptive under section 206 of the Act.

Importantly, the proposed rule would not consider an adviser that merely permits the use of “like,” “share,” or “endorse” features on a third-party website or social media platform to implicate the proposed rule. Conversely, if the investment adviser took affirmative steps to involve itself in the

preparation of the comments or to endorse or approve the comments, those comments could be

communications “by or on behalf of” the adviser.

The Commission opines in its proposed rule that defining an “advertisement” as a communication that “offers or promotes” services would allow investment advisers to continue to deliver to existing investors account statements or transaction reports that are intended to provide only details regarding those accounts and investments without those communications being considered advertisements. Typically, a communication to an existing investor about the performance of the investor’s account would not be for promoting the adviser’s services or be used to obtain or retain investors. Accordingly, the Commission would not view information typically included in an account statement, such as inflows, outflows, and account performance, as qualifying as advertisements under the proposed rule.

However, investment advisers also may choose to deliver to existing investors communications that include promotional information that is neither account information nor educational material. Such additional promotional information may make the communication an advertisement, if that additional information “offers or promotes” the adviser’s advisory services under the facts and circumstances. So … including promotional material with a client statement would revert the communication to advertising.

General Prohibitions

The proposed rule would prohibit the following advertising practices: 

  • Making an untrue statement of a material fact, or omission of a material fact necessary to make the statement made, in light of the circumstances under which it was made, not misleading; 
  • Making a material claim or statement that is unsubstantiated; 
  • Making an untrue or misleading implication about, or being reasonably likely to cause an untrue or misleading inference to be drawn concerning, a material fact relating to the investment adviser; 
  • Discussing or implying any potential benefits without clear and prominent discussion of associated material risks or other limitations; 
  • Referring to 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 
  • Being otherwise materially misleading.

Testimonials and Endorsements 

The proposal would permit testimonials and endorsements, subject to specified disclosures, including whether the person giving the testimonial or endorsement is a client and whether compensation has been provided by or on behalf of the adviser.

Unlike the current rule’s broad restrictions on the use of testimonials, the proposed provision would permit testimonials, endorsements, and third-party ratings, subject to disclosures and other tailored conditions. The proposal would recognize that while consumers and businesses often look to the experiences and recommendations of others in making informed decisions, there may be times when these tools are less credible or less valuable than they appear to be.

The proposed rule defines “testimonial” as “any statement of a client’s or investor’s experience with the investment adviser or its advisory affiliates, as defined in the Form ADV Glossary of Terms.” It defines “endorsement” as “any statement by a person other than a client or investor indicating approval, support, or recommendation of the investment adviser or its advisory affiliates, as defined in the Form ADV Glossary of Terms.”

The proposed rule would require that an adviser clearly and prominently disclose, or the adviser reasonably believe that the testimonial or endorsement clearly and prominently discloses, that the testimonial was given by a client or investor, and the endorsement was given by a non-client or non-investor, as applicable. Disclosure about the status of the person making the testimonial or endorsement (e.g., investor or non-investor) would provide investors with important context for weighing the relevance of the statement.

Third-Party Ratings 

The proposed rule would permit third-party ratings, subject to specified disclosures and certain criteria pertaining to the preparation of the rating. The proposed rule defines “third-party rating” as 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.”

The proposal for third-party ratings in advertisements would be subject to two additional disclosure requirements to provide context for evaluating the merits of the third-party rating. Specifically, it would require that the adviser clearly and prominently disclose, or the adviser must form a reasonable belief, that the third-party rating clearly and prominently discloses: (1) the date on which the rating was given and the period of time upon which the rating was based; and (2) the identity of the third party that created and tabulated the rating.

The proposed rule would require that the adviser reasonably believe 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.

Performance Information Generally

The proposal would prohibit including in any advertisement:

  • Gross performance results unless it provides (or offers to provide promptly) a schedule of fees and expenses deducted to calculate net performance;
  • Any statement that the calculation or presentation of performance results has been approved or reviewed by the Commission;
  • Performance results from fewer than all portfolios with substantially similar investment policies, objectives, and strategies as those being offered or promoted in the advertisement, with limited exceptions;
  • Performance results of a subset of investments extracted from a portfolio, unless it provides or offers to provide promptly the performance results of all investments in the portfolio; and
  • Hypothetical performance, unless the adviser adopts and implements policies and procedures reasonably designed to ensure that the performance is relevant to the financial situation and investment objectives of the recipient and the adviser provides certain specified information underlying the hypothetical performance.

Performance Information in a Retail Advertisement

The proposed rule would provide additional protections for an advertisement targeted to a retail audience:  (1) requiring the presentation of net performance alongside any presentation of gross performance, and (2) requiring generally the presentation of the performance results of any portfolio or certain composite aggregations across 1-, 5-, and 10-year periods.

Internal Pre-Use Review and Approval

The proposed amendments would require advertisements to be reviewed and approved in writing by a designated employee before dissemination, except for advertisements that are: (1) communications disseminated only to a single person or household or to a single investor in a pooled investment vehicle; or (2) live oral communications broadcast on radio, television, the internet, or any other similar medium.  Under the proposal, similar to new advertisements, updates to existing advertisements would also require review and approval.

Proposed Amendments to Solicitation Rule 206(4)-3

Scope – All Forms of Compensation 

The proposed solicitation rule would apply regardless of whether an adviser pays cash or non-cash compensation to a solicitor.  The proposed rule would continue to apply to cash payments to a solicitor, including a percentage of assets under management, flat fees, retainers, hourly fees, and other methods of cash compensation. The proposed rule would also apply to non-cash compensation provided to solicitors such that an adviser would be prohibited from paying a solicitor any form of compensation, directly or indirectly, for any solicitation activities unless the adviser complies with the terms of the rule. Non-cash compensation would include directed brokerage, awards, or other prizes, and free or discounted services.

Scope – Private Fund Solicitors

The rule proposes to retain, with certain revisions, the current rule’s definition of “solicitor,” which is “any person who, directly or indirectly, solicits any client for, or refers any client to, an investment adviser.” In a change from the current definition, the proposed definition would also include persons who solicit investors in private funds. As with the current rule, a solicitor might be a firm (such as a broker-dealer or a bank), an individual at a firm who engages in solicitation activities for an adviser (such as a bank representative or an individual registered representative of a broker-dealer), or both.

The proposal would expand the scope of the rule to the solicitation of existing and prospective private fund investors. The Commission believes this would increase protections to such investors primarily by making them aware of a solicitor’s financial interest in the investor’s investment in a private fund and prohibiting the use of disqualified solicitors under the proposed rule. While investors in private funds may often be financially sophisticated, they may not be aware that the person engaging in the solicitation activity may be compensated by the adviser, and the SEC believes investors in such funds should be informed of that fact and the related conflicts.

Scope – Exempt Arrangements

The proposed rule would substantially retain the current rule’s partial exemptions for: (1) solicitors that refer investors for impersonal investment advice, and (2) solicitors that are employees or otherwise affiliated with the adviser.  However, these arrangements would no longer be subject to the current rule’s written agreement requirement.  The proposal would also add two new full exemptions for: (1) de minimis compensation to solicitors, and (2) advisers that participate in certain nonprofit programs.

Scope – Disqualified Solicitors 

The proposed rule contains an expanded list of disciplinary events for which persons would be disqualified from acting as a solicitor, with a limited exception.

Written Agreement

Under the proposed rule, an adviser that compensates a solicitor for solicitation activities would be required to enter into a written agreement with the solicitor, unless an exemption applies.  The proposed rule would require that the written agreement include: (1) a description of the solicitation activities and compensation, (2) a requirement that the solicitor perform its solicitation activities in accordance with certain provisions of the Advisers Act, and (3) a requirement that solicitor disclosure be delivered to investors.  The proposed rule would eliminate the current rule’s requirements that the solicitor agree to deliver the adviser’s Form ADV brochure and perform its solicitation activities consistent with the instructions of the adviser. 

Disclosure Requirements

The solicitor disclosure required under the proposed rule would continue to highlight for investors the solicitor’s financial interest in the client’s choice of an investment adviser.  The proposal would modify the current solicitor disclosure to include additional information about a solicitor’s conflict of interest and eliminate the current rule’s requirement that the adviser obtain from each investor acknowledgments of receipt of the disclosures.

Oversight of Solicitors

The proposed rule would require that the adviser have a reasonable basis for believing that the solicitor has complied with the rule’s written agreement, including complying with the solicitor disclosure requirement. This requirement would be largely the same as the current rule.

De Minimis Compensation

The proposed rule contains an exemption for de minimis compensation. Specifically, the rule would not apply if the solicitor has performed solicitation activities for the investment adviser during the preceding twelve months and the investment adviser’s compensation payable to the solicitor for those solicitation activities is $100 or less (or the equivalent value in non-cash compensation).

Proposed Amendments to the Books and Records Rule and to Form ADV

Books and Records

The proposed amendments to Books and Records Rule 204-2 stem from the proposed amendments to the advertising and solicitation rules. The SEC is proposing to amend the current rule to require investment advisers to make and keep records of all advertisements they disseminate to one or more persons. The current rule requires investment advisers to keep a record of advertisements sent to 10 or more persons. The Commission is  also proposing to add a provision to the books and records rule that would explicitly require investment advisers to maintain records related to third-party questionnaires and surveys, as applicable. The SEC is proposing to add a provision to the books and records rule that would require investment advisers to maintain a copy of all written approvals of advertisements by designated employees.

Form ADV Enhancements

The proposal would amend Form ADV to provide additional information regarding advisers’ advertising practices to help facilitate the Commission’s inspection and enforcement capabilities.  The SEC proposes to add a subsection L (“Advertising Activities”) to require information about an adviser’s use in its advertisements of performance results, testimonials, endorsements, third-party ratings, and its previous investment advice. Specifically, the proposed rule would require an adviser to state whether any of its advertisements contain performance results, and if so, whether all of the performance results were verified or reviewed by a person who is not a related person. The proposal would also require an adviser to state whether any of its advertisements includes testimonials or endorsements, or includes a third-party rating, and if so, whether the adviser pays or otherwise provides compensation or anything of value, directly or indirectly, in connection with their use. The proposal would require an adviser to state whether any of its advertisements includes a reference to specific investment advice provided by the adviser.

Review of Relevant Staff Guidance

Over the years, the Division of Investment Management staff members have issued a number of no-action letters and other guidance addressing the application of the current advertising and solicitation rules.  The Commission’s release accompanying the proposed amendments includes a list of the relevant letters and guidance.  The staff is reviewing these letters to determine whether any should be withdrawn in connection with adoption of the proposed amendments.

More Information

To read the SEC’s press release and Fact Sheet related to these proposed rule changes, follow this link:

To read the riveting 507 pages of the proposed rule amendments, follow this link:

Betsy Rathz

Author Betsy Rathz

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