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A deep dive into the SEC’s new Marketing Rule

Published on November 4, 2022 by Jayraj Gohil and Wilfred Peter

With the compliance date for the US Securities and Exchange Commission’s (SEC’s) new Marketing Rule being 4 November 2022, all advisory firms have updated their compliance programmes. After a gap of a few decades, the SEC has made major changes on advertising rules, including what defines “advertising”.

An glimpse into the new rule:

The new single rule replaces the previous advertising and cash solicitation rules (Rule 206(4)-1 and Rule 206(4)-3), with the SEC taking into consideration the active use of social media by investment adviser firms.

It states, “The changes are brought into place keeping the interest of investors in mind.”

The new changes mainly relate to the following:

  • Expanding the definition “advertising”

    • Direct or indirect communication made by an investment adviser to prospective clients

    • Direct or indirect communication made by an investment adviser in relation to securities to existing clients

  • Expanding the use of testimonials, endorsements, hypothetical performance and third-party ratings in advertisements, subject to the regime of changes to marketing rules

  • Scoping out wider solicitation activities, including solicitation of existing or prospective investors in private funds; it also applies to solicitation in exchange for compensation –both cash and non-cash incentives

  • Modifying the solicitation rule, impacting all forms of compensation (cash or non-cash) made to a solicitor

  • Definition of “advertisement”:

  • In the new rule, the definition of “advertisement” is two-pronged:

  • i) Communications traditionally covered by the advertising rule

  • ii) Solicitation activities previously covered by the solicitation rule

  • The first prong contains the definition that includes any direct or indirect communication an investment adviser makes that a) Offers the investment adviser’s investment advisory services with regard to securities to prospective clients or private fund investors, or b) Offers new investment advisory services with regard to securities to current clients or private fund investors. The first prong of the definition excludes most one-on-one communications.

  • The second prong contains the definition that generally includes any endorsement or testimonial for which an adviser provides cash or non-cash compensation directly or indirectly (e.g., directed brokerage, awards or other prizes, and reduced advisory fees).

Notable differences

1. Generally, will be considered as an “advertisements” if directed to more than one person

2. The scope of “communication” extends to text messages, oral statements, social media, podcasts and other “indirect” communications through intermediaries that may include affiliates

3. One-on-one presentations are not “advertisements” unless they contain hypothetical performance or are directed to prospective investors

 

General prohibitions:

  • Making an untrue statement of a material fact or omitting a material fact

  • The advisers not having a reasonable basis for believing the material statement they make

  • Providing information that will likely cause an untrue or misleading implication or inference concerning an adviser’s material facts

  • Discussing any potential benefits without providing fair and balanced disclosure of material risks or limitations

  • Referencing specific investment advice, i.e., not in a fair and balanced manner

  • Including or excluding performance results and performance duration in a manner that is not fair and balanced (cherry picking)

  • Including information that is otherwise materially misleading

Notable differences:

1. The SEC specified seven prohibited marketing activities in addition to the existing anti-fraud rule (206)

2. It has made the general prohibition more specific to prohibit any kind of untrue statement or omission

 

Testimonials and endorsements:

New definitions:

A “testimonial” is any statement made by an current client or investor in a private fund advised by the investment adviser

(i) About an experience with the investment adviser or its supervised persons

(ii) That directly or indirectly solicits others to become clients of the investment adviser or be invested in a private fund being advised by the adviser

(iii) That refers any client or investor to become a client of the adviser or invest in a private fund the adviser advises

An “endorsement” is any statement by an individual who is not a current client or investor in a private fund advised by the investment adviser that

1) Indicates recommendation and their experience with the investment adviser or its supervised persons

2) Directly or indirectly solicits any current or prospective client of the investment adviser or investor of a fund the adviser advises

3) Refers any current or prospective client or investor to become a client of, or an investor in, a private fund advised by the investment adviser

The Marketing Rule now allows the use of testimonials and endorsements, subject to certain conditions and disclosures.

Disclosures:

An adviser must clearly disclose

  • Whether the testimonial provider is a client of the adviser

  • Whether the promoter is being compensated (in cash or kind)

  • Material conflicts of interest

  • Oversight and written agreement: An adviser must have a written agreement in place with the promoter, unless the promoter is an affiliate of the adviser or he/she receives de minimis compensation, i.e., USD1,000 or less, during the preceding 12 months. An adviser that uses testimonials or endorsements in an advertisement must also ensure compliance with the Marketing Rule.

  • Disqualification: As defined under Rule 506 of Regulation D, certain “bad actors” are no’t allowed to be promoters.

Notable differences:

1. Testimonials are now permitted, subject to the conditions of Rule 206(4): Scoping “Indirect Communications” and extends to third parties acting on behalf of the adviser

2. Extended and specific disclosure requirements; the rules also apply to placement agents

 

Third-party ratings:

The Marketing Rule prohibits the use of third-party ratings in an advertisement unless the necessary disclosures are provided and certain criteria are considered while preparing the ratings. The following criteria will be considered when providing third-party ratings:

   1) The third-party rating has to be fair/unbiased so investors can make the right decision, and should not intend to provide predetermined outcomes

   2) The date of the rating needs to be provided along with the time period on which the rating is based

   3) The identity of the third party that specified the rating needs to be provided

   4) It needs to disclosed whether the third party was compensated directly or indirectly for the rating provided

Performance

   1) Net performance is mandatory; gross performance may accompany net performance, but both net and gross performance must be given equal prominence.

   2) Except for private funds, performance results in advertisements are required to be for 1-, 5- and 10-year periods (or cover the life of the portfolio, if shorter). Private funds are exempt, as the performance results for the past years of a private equity fund may not be meaningful for investors.

   3) No statement to the effect that performance numbers/results are reviewed or approved by the SEC must be entertained.

   4) Performance numbers of more than one portfolio may be mentioned only if the marketing material covers all portfolios with considerably similar investment processes, policies, objectives and strategies as the one being originally offered in the advertisement.

   5) The Marketing Rule permits depicting hypothetical performance, i.e., results that may have not been achieved by the portfolio manager. This may include returns achieved by modelling or back-testing, or targeted results.

Notable differences:

1. Alignment of performance standards with GIPS compliance firms

2. Allowing hypothetical performance subject to certain provisions mentioned in the Rule

3. Standardises reporting-related performance by adviser firms

 

Recordkeeping

Books and Records Rule:The SEC has also changed Rule 204-2 under the Advisers Act (Books and Records Rule). It now requires advisory firms to maintain records of all advertisements they distribute, including oral advertisements.

Form ADV: Under this provision, Item 5 of Part 1A of Form ADV has a new section titled “Marketing Activities”. This requires advisers to mention the following:

  Form ADV:

    1) If the advertisements include performance results, specific investment advice, testimonials, endorsements or third-party ratings

    2) If they provide compensation (cash or non-cash, and directly or indirectly), related to the use of testimonials, endorsements or third-party ratings

    3) If the advertisements include hypothetical performance

    4) If their advertisements include predecessor performance

Notable differences:

1. Recordkeeping of certain oral advertisements

2. New performance-/testimonial-/endorsement-related section in Form ADV

 

How are firms planning to comply with this new regulation?

Firms across the sector are in the final stages of fine-tuning their programmes to meet the deadline for ensuring compliance. A handful have written to the SEC, stating that reflecting net performance on all scenarios may not be realistically viable. Companies such as Acuity Knowledge Partners can help you manage and review all marketing-related content in line with the latest regulations.

How Acuity Knowledge Partners can help

Acuity Knowledge Partners is an influential player in the global market, offering compliance expertise and a wide array of other services. We enable our compliance clients to manage increasing demands on their teams by providing customised managed services solutions, based on specialised skills and technology, and by delivering operational efficiency, resilience and significant cost savings. Our experts in the areas of marketing compliance can help assess the gaps between current marketing practices and the new Marketing Rule and review your marketing material and social media content in periods of high volumes. BEAT AdInspect, our proprietary marketing material review tool, can help with a number of services ranging from workflow management and archiving to providing a metrics dashboard.

Sources:


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About the Authors

Jayraj Gohil has over 10+ years of experience in compliance, having worked for various firms including State Street Global Advisors and Goldman Sachs. His expertise spans across the risk and compliance sector, focusing on compliance reviews of marketing/advertising materials. At Acuity Knowledge Partners he is part of the central compliance team and specializing in marketing material review. Jayraj is an MBA from Global Academy of Technology, Bengaluru (VTU).

Wilfred Peter has over 11+ years of experience in compliance and Investment banking having worked for firms including State Street Global Advisors and HSBC. His expertise spans across compliance and risk sector, focusing on compliance reviews of marketing/advertising materials and social media contents. At Acuity Knowledge Partners he is part of the central compliance team and specializes in marketing material review and social media reviews. Wilfred is a graduate (Bachelors of commerce) and hold a degree from St Joseph’s College of Commerce Bengaluru.

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