In November 2019, the U.S. Securities and Exchange Commission (the “SEC” or the “Commission”) released proposed amendments to the rules governing advertisments and solicitations under the Investment Advisers Act of 1940 (the “Advisers Act”). The proposed revisions are subject to a public comment period which will be open for 60 days after publication in the Federal Register. Based on initial indications, we expect substantial comment from the industry, which could both impact the substance of the amendments and delay the date on which they go into effect. We reasonably anticipate an effective date sometime in the first half of 2020 and the SEC has proposed a compliance date of one year from adoption of the final rule, so there will be sufficient time for advisers to implement changes to their compliance programs.
We have collectively reviewed the 507-page release and assessed its potential impact on the investment adviser community. While the amendments, as currently proposed, will result in tweaks to both written policies and internal procedures, the fundamental framework governing both advertising and solicitations will remain largely unchanged. Overall, the SEC’s modernization efforts reaffirm many established marketing practices while granting firms considerable discretion under a principles-based regulatory structure. While the front of the house is certain to embrace the added flexibility, compliance professionals will likely be less enthusiastic considering they will be tasked with determining what is equitable under the new “fair and balanced” standard.
The following is a high-level overview of the notable proposed changes, as well as Greyline’s view on the anticipated impact on the industry:
New Definition of an “Advertisement.” The new definition includes “any communication, disseminated by any means, by or on behalf of an investment adviser, that offers or promotes the investment adviser’s advisory services or seeks to retain one or more investment advisory clients or investors in any pooled investment vehicle advised by the investment adviser.” There are a few departures from the existing definition, so we break out each element below. While there is a definite expansion of the scope of what is considered an advertisement under the Advisers Act, the SEC also explicitly excludes several categories which largely reinforces the stance that the Commission has taken historically.
- “… by any means…”
In practice, the elimination of specific mediums for dissemination will have no impact, as the industry has already treated emails, text messages, electronic presentations and other modern methods of communication as advertisements under the Advisers Act.
- “…by or on behalf of an investment adviser…”
The proposing release stipulates that materials and information created by third parties could under certain circumstances be viewed as an adviser’s advertisement. Ghostwriting or affirmatively taking steps to edit or censor third-party content (including portfolio companies or performance databases) could be considered an adviser’s advertising. This is a concept about which Greyline has cautioned our clients for some time, so this revision is unlikely to have a major impact on those firms that already adhere to this principle. This clause could, however, operate to exclude unsolicited third-party communications which are not controlled or otherwise influenced by an adviser, such as posts on a firm’s website or social media profile (see “Testimonials, Endorsements and Third-Party Ratings” below).
- “…to offer or promote advisory services or seek to obtain or retain clients or investors in any pooled investment vehicle…”
This clause will be impactful for several reasons. First, it eliminates the requirement that an advertisement be sent to more than one recipient and now also includes, in many cases, communications sent to retain existing clients or investors. Additionally, it expressly includes promotional materials sent to existing or prospective investors in a pooled investment vehicle managed by the adviser, subject to several exceptions. Investment managers will likely struggle trying to define which materials “offer or promote” advisory services, considering that single recipient and fund-level communications will now be swept up under the definition. Fully incorporating compliance into the investor relations and fundraising functions will likely become a necessity.
Express Exclusions from the Definition of “Advertisement.” The proposed rule has four exclusions from the definition of advertisement: (i) non-broadcast, live oral communications; (ii) responses to certain unsolicited requests; (iii) communications relating to registered investment companies (“RICs”) and business development companies (“BDCs”); and (iv) information required by statute or regulation. Some of these exclusions are not new concepts but now contain some slight differences. Additionally, even the exclusions contain exclusions. It’s important to not use these as a blanket exclusion but to go through each. Likewise, even though these are not advertisements they are still subject to the anti-fraud provisions and cannot be misleading.
- Non-Broadcast Live Communications
This exclusion is not necessarily a new concept. Under the current advertising rule, non-live broadcasts over television or radio are considered advertisements, and this will now be expanded to cover “the internet or any other similar means.” While live presentations or communications do not fit within the definition of an advertisement, recordings and reproductions are subject to the rule. For example, if a portfolio manager is speaking at a conference, that speech would not be an advertisement. If someone at the firm records the portfolio manager and then posts it on LinkedIn, this would then become an advertisement. Similarly, written and electronic materials used and/or displayed during a live presentation (e.g., annual meeting decks) will be captured.
- Responses to Unsolicited Requests
The proposed rule carves out replies to unsolicited requests for information about an adviser or its services. There are however contextual limitations to this exclusion and the same anti-fraud principles will nonetheless apply to all such materials. This exclusion would not apply if the communication involves a “Retail Person” (defined as anyone who is not a “qualified purchaser”) that includes performance results or a communication that includes hypothetical performance results. Ultimately, the Commission’s objective is to allow certain routine communications, but at the same time recognize that some of these communications should still be considered advertisements. In practice, this change broadens the scope of an advertisement slightly, mainly with regard to retail communications; however, the practical impact will be nominal.
- Advertisement, Other Sales Materials and Sales Literature of RICs and BDCs
Due to overlapping rules under the Securities Act of 1933 and Investment Company Act of 1940, the Commission is seeking to minimize regulatory redundancy. Nevertheless, it is worth noting that an adviser who advises both RICs/BDCs and private funds will still be subject to the proposed rule with respect to communications regarding the latter.
- Information Required by Statute or Regulation
Information that is provided by law or is filed with a regulatory body (e.g., Form ADV) will be excluded from the definition. There will be no practical impact on investment managers.
General Prohibitions. The general prohibitions under this proposed rule are not all that different from the current regulatory framework. Untrue statements and omissions, unsubstantiated material claims and statements, untrue or misleading implications, failure to disclose risks or other limitations and anti-cherry-picking rules all still apply. The only aspects to note are in a couple of areas. The Commission stated that risks and limitations must be “clearly and prominently” displayed. The SEC gave the example that providing a link for an advertisement on a mobile device is not sufficient and the disclosure should be viewed prior to accessing the information. Another area where this can be applicable is if an adviser uses a data room to share information with potential investors or clients. Based on the example provided to the SEC, providing a document in a data room that has disclaimers intended to cover all materials, may not meet the standard of “clearly and prominently” displayed. Instead, the disclaimers should be a pop-up before any of the documents can be viewed or could be provided in the body of an email when sharing information on how to access the data room. With regard to cherry-picking, the previous rule still broadly applies; however, there is some additional latitude afforded under the “fair and balanced” standard, which gives some level of comfort around the presentation of case studies and illustrative investment examples.
Testimonials, Endorsements and Third-Party Ratings. The proposed rules will relax the Commission’s fairly restrictive posture on testimonials, endorsements and third-party ratings. To date, many advisers either shied away from referencing them or proceeded with extreme caution. The SEC appears to be lightening its stance and shifting our conventional understanding. The proposed rule will permit an adviser to use them in advertisements, subject to general prohibitions of certain advertising practices and additional conditions. The basis for this shift is due to the extent to which consumer preferences have shifted since 1961 when the rule was drafted. Under the proposed rule the complete ban would be lifted in favor of specifically enumerated limitations and disclosure requirements.
- Definition of Testimonial, Endorsement and Third-Party Ratings
The proposed rule defined a testimonial as any statements of a client’s or investor’s experience with the investment adviser or its advisory affiliate(s). Endorsements are defined as any statement by a person other than a client or investor which indicates approval, support or recommendation of the investment adviser or its advisory affiliates. In essence, both terms cover any investor or non-investor’s experience with the adviser. Excluded are similar statements about an adviser’s related persons (e.g., an affiliated accounting firm, actuarial firm, etc.).
- Conditions on Testimonials, Endorsements and Third-Party Ratings
Although endorsements and testimonials are permitted, there are guidelines to which advisers will need to abide. The disclosures must include the status of the person making the testimonial or endorsement (e.g. investor, non-investor, client, non-client, etc.) and whether any cash or non-cash compensation has been provided by or on behalf of the adviser. The compensation disclosure would also extend to third-party ratings. There are also two additional disclosures that will only be required for (i) the date the rating was given and the period it covers; and (ii) the identity of the third party who created the rating. These disclaimers tend to match what are now used for awards in that advisers disclaim more details on the nature of the award and other information regarding the institution who issued the award. This is not a major departure from current practice, but does lend certain assurances where there previously existed some level of perceived risk.
Performance Advertising: The section on performance advertising will present the biggest change for investment managers and will likely elicit the most feedback from the industry during the comment period.
- Application of the General Prohibitions to Performance Advertisings
The SEC is taking a principled and disclosure-based approach to performance advertising. This is a not a major departure from current practice, but managers will need to revisit their disclaimers to ensure that all material assumptions, limitations and points of clarification are properly disclosed.
- Non-Retail and Retails Persons and Advertisements
The proposed rules present four new defined terms that are important when considering what type of information can be presented to retail versus non-retail investors. A Non-Retail Person is a qualified purchaser or knowledgeable employee – i.e., an investor who can participate in a 3(c)(7) offering. A Retail Person is anyone who is not a Non-Retail Person. A Non-Retail Advertisement is any advertisement solely distributed to Non-Retail Persons and a Retail Advertisements are any advertisement that is also distributed to Retail Persons. These distinctions are important because the way that performance can be presented can vary between Retail and Non-Retail. Advisers will then need to develop policies and procedures as to how they “reasonably believe” a Non-Retail Person meets those standards. In addition, advisers may want to consider developing separate forms of advertising based on recipient investor qualifications; however, fund sponsors need to be cognizant of the issues related to securities offerings when there is not privity of information amongst investors.
- Presenting Gross and Net Performance Change
Presenting performance has long been a place of conventional practice. The existing rule made it clear that performance should be net and if gross is presented, net performance would have to be included alongside with equal prominence. That convention will still remain for Retail Advertisements. However, Non-Retail Advertisements will be allowed to present solely gross performance. If only gross is provided, a fee schedule needs to accompany the performance so that the Non-Retail Person can calculate the net return. The rationale behind allowing Non-Retail to include gross is because the SEC believes that Non-Retail Persons are more sophisticated, can understand and use gross returns better, and are more likely to negotiate fees paid. Worth noting is the fact that the proposed rule failed to speak to the permissibility of presenting a subset of portfolio investments on a net basis. The assumption is that the status quo will be preserved and funds will be able to present gross IRR for individual investments provided that net performance of the fund in the aggregate is shown.
- Performance of Related Portfolios
The proposed rule prohibits the inclusion of any “related performance” – meaning other portfolios or funds managed by the adviser with substantially similar investment policies, objectives and strategies as those being offered or promoted – unless all such related portfolios or funds are referenced. While separately managed accounts are not specifically referenced, it is logical that they would be captured. This is currently a best practice, but not a hard and fast rule, so this represent a tightening of the existing state of affairs.
- Hypothetical Performance
The proposal expressly allows the presentation of hypothetical performance, including models, projections and targeted returns, provided that the adviser (i) adopts and implements policies and procedures reasonably designed to ensure that hypothetical performance is relevant to the financial situation and investment objectives of the recipient; and (ii) discloses key assumptions used in calculating the hypothetical performance. This revision simply formalizes current practice and will not have an impact on firms in this regard. It is worth noting that the proposed rule will not impact the broker-dealer limitations enforced by FINRA.
- Review and Approval of Advertisements.
In a surprising formalization of most internal procedures, the new rule includes a requirement that all advertisements be reviewed by a designated party of the adviser. Certain communications will be carved out of this requirement, such as single recipient communications with an investor in a private fund. The Commission went on record to state that it would be inappropriate for the author of a communication to also be the reviewer. Firms will be further obligated to maintain documentation of the actual review and approval as well. We expect substantial comment from the industry on this point.
- New Form ADV Disclosures.
Advisers will be required to make disclosures on Form ADV regarding the use of performance results, testimonials, endorsements, third-party ratings and previous investment advice in its advertisements. Reading between the lines, the objective of these changes is to provide the SEC with a profiling tool for examination purposes, as this sort of transparency provides very little, if any, benefit to investors.
Proposed Amendments to the Solicitation Rule. Much of the proposed regulation aims to refine existing requirements under the today’s cash solicitation rule with one notable exception. Under current no-action guidance and case law, the rule only reaches “client” solicitations and, given that the client of a fund manager is in the fact the fund and not underlying investors, the requirements do not pertain to placement agents or third-party marketers/brokers seeking fund investors. If adopted, the adviser would have to ensure that solicited investors are provided with a separate solicitors disclosure document prior to subscription, which describes the relationship, compensation, fee impact and associated conflicts of interest. The rule also extends the allowances for internal solicitors and expands the scope of covered compensation to include all forms of remuneration, not simply cash as currently stated.
