United States: Marketing Rule's Transition Period Set To Expire; SEC Enforcement To Follow

Key Takeaways:

• The transition period for compliance with the new Marketing Rule is set to expire on November 4, 2022, at which time all registered investment advisers must be operating in compliance with the revised rule.
• The revised Marketing Rule is a significant overhaul of the rules and regulations governing the marketing and solicitation of investment advisory services.
• The SEC has signaled in a September 19, 2022 risk alert its intention to actively monitor and enforce compliance with the new Marketing Rule.

On December 22, 2020, the U.S. Securities and Exchange Commission ("SEC") announced that it was adopting amendments under the Investment Advisers Act of 1940 (the "Advisers Act") to implement a revised Rule 206(4)-1 (the "Marketing Rule") governing investment adviser advertisements, marketing and client solicitation.¹ The Marketing Rule became effective on May 4, 2021 and provided for an 18-month transition period, ending on November 4, 2022 (the "Compliance Date"). Commencing on the Compliance Date, all registered investment advisers must begin operating in compliance with the Marketing Rule.

The Marketing Rule supersedes the prior Rule 206(4)-1 (the "Advertising Rule"), Rule 206(4)-3 (the "Solicitation Rule") and a series of no-action letters issued by the staff at the SEC relating to investment adviser marketing efforts, seeking instead to regulate investment adviser advertising and solicitation activity through a single rule. Additionally, the SEC adopted related amendments to Form ADV and Rule 204(2)-4 (the "Books and Records Rule") in order to track compliance and gather new information about investment advisory firms' practices.

In its adopting release, the SEC explained that advancements in communications technology, changes in the expectations of investors shopping for investment advisory services and the evolving profiles of investment advisory services necessitated the need for the Marketing Rule and related changes. To do so, the SEC has replaced the four pro se prohibitions of the previous regime with seven principles-based provisions that the SEC hopes will "accommodate the continual evolution and interplay of technology and advice." As set out in more detail below, the Marketing Rule: (i) expands the scope of communications that are considered "advertisements" under the rule; (ii) allows for the use of testimonials, endorsements, third-party ratings and hypothetical performance in advertisement (subject to the principles-based regime); (iii) expands the scope of solicitation activities and applies to solicitations in exchange for compensation; and (iv) expressly applies to communications by advisers of private funds.

The adoption of the Marketing Rule and the related changes is a complete overhaul of the prior regime and one that the SEC has stated it intends to actively monitor and enforce. On September 19, 2022, the SEC's Division of Examinations released a risk alert signaling its intention to conduct specific national initiatives, as well as a broad review through the examination process, for compliance with the Marketing Rule. In particular, the SEC will focus on whether investment advisory firms (i) have implemented written policies and procedures designed to prevent violations, (ii) have a reasonable basis for believing they will be able to substantiate material statements of fact in advertisements, (iii) are in compliance with the performance advertising requirements and (iv) are in compliance with the Books and Records Rule that was adopted to help ensure compliance with the Marketing Rule.

Definition of Advertisement:

Only "advertisements" of investment advisers registered (or required to register) with the SEC will be subject to the specific requirements of the Marketing Rule. The Marketing Rule defines "advertisement" in two prongs.

General Definition. Any direct or indirect communication an investment adviser makes to more than one person offering the adviser's investment advisory services with regard to securities ("Advisory Services") is included in the definition. The communication can be to prospective advisory clients or to prospective investors in a private fund manager by the investment adviser. If such communication includes hypothetical performance, it will be deemed an advertisement if made to just one person (other than with respect to the exceptions noted below). Additionally, if the investment adviser makes a communication, directly or indirectly, to current clients or private fund investors, it will be considered an "advertisement" if it offers new Advisory Services.

Exceptions to the General Definition. There are a few notable exclusions from the definition of an "advertisement" for purposes of the Marketing Rule:

• Extemporaneous, live, oral communications. This exception does not include prepared remarks or speeches. In addition, slides or other written materials that are delivered or presented to the audience are included in the definition of "advertisement."
• Any information contained in a statutory or regulatory notice, filing or other required communications, provided such information is reasonably designed to satisfy the requirements of such notice, filing or other required communication. The SEC explained in its adopting release however that information not reasonably designed to satisfy its obligations under applicable law but that offers the adviser's Advisory Services will be deemed an "advertisement" for purposes of the Marketing Rule.
• Communications that include hypothetical performance that is provided in response to an unsolicited request for such information from a prospective or current client.
• Communications that include hypothetical performance to a prospective or current investor in a private fund advised by the investment adviser in a one-on-one communication.

Endorsements and Testimonials. The second prong of the definition of "advertisement" includes any endorsement or testimonial for which an investment adviser provides compensation, directly or indirectly. The use of a testimonial or an endorsement is subject to compliance with three criteria: disclosure; oversight and compliance; and qualification.

First, an adviser must clearly and prominently disclose (i) whether the testimonial or endorsement was given by a current client or investor or a person that is not a current client or investor, as applicable; (ii) that cash or non-cash compensation was provided for the testimonial or endorsement, if applicable; and (iii) a brief statement of any material conflicts of interest on the part of the person giving the testimonial or endorsement resulting from the investment adviser's relationship with such person.

Second, investment advisers must have a reasonable basis for believing that the testimonial or endorsement complies with the requirements of the Marketing Rule; and a written agreement with any person giving a testimonial or endorsement that describes the scope of the agreed-upon activities and terms of compensation for those activities.

Third, the investment adviser may not compensate a person, directly or indirectly, for a testimonial or endorsement if the adviser knows, or in the exercise of reasonable care should know, that the person giving the testimonial or endorsement is ineligible under the Marketing Rule. Ineligibility may result from an SEC opinion or order barring the applicable person from serving in any capacity under federal securities laws, or from certain criminal convictions or orders from government agencies (such as the Commodity Futures Trading Commission), which occurred within the 10 years prior to giving the applicable endorsement or testimonial. Disqualifying matters align with matters required to be disclosed by a registered investment adviser on Item 11 of Part 1A of Form ADV. To the extent that a testimonial or endorsement is given in connection with a private offering of securities under Rule 506 of Regulation D (including an offering of the interests of a private fund), disqualification will be determined with reference to the "bad actor" rules set forth in Rule 506(d) for any person that would be a "Covered Person" of the manager of the applicable issuer (private fund) within the meaning of Rule 506(d).

Exemptions to Requirements for Testimonials/Endorsements. There are several partial exemptions from the conditions above for testimonials and endorsements:

• A testimonial or endorsement disseminated for no compensation or de minimis compensation (less than $1,000, or property of equivalent value, in the prior 12 month period) is not subject to the written agreement requirement.
• Affiliates, partners, directors, officers and employees of the adviser are exempt from the written agreement requirement provided that the affiliation between the investment adviser and such person is readily apparent to or is disclosed to the client or investor at the time the testimonial or endorsement is disseminated and the investment adviser documents such person's status at the time.
• A testimonial or endorsement provided by a U.S.-registered broker or dealer is not required to comply with: (i) any disclosure requirements if the testimonial or endorsement is a recommendation subject to Regulation Best Interest; (ii) the description of compensation and material conflicts of interest requirements if the testimonial or endorsement is provided to a person that is not a retail customer (as that term is defined in Regulation Best Interest); and (iii) the disqualification provision, if the broker or dealer is not subject to statutory disqualification under the Securities Exchange Act of 1934.

• Update your existing compliance manual to note the definition of advertisement under the Marketing Rule.
• Evaluate the use of testimonials and endorsements. Consider whether they may be attributed to you (as the adviser) and, therefore, become subject to the Marketing Rule.
• Before you provide a benefit to anyone that gives or will give a testimonial or endorsement, consider whether such person is permitted to provide the testimonial or endorsement and evaluate whether the benefit may constitute compensation for such testimonial or endorsement and if a written agreement is required.
• Review written agreements you have entered into with any promoter and revise as necessary to establish a reasonable basis that the Marketing Rule's requirements with respect to any endorsement from such promoter are complied with.
• Adopt and implement policies and procedures designed to prevent an associated person's social media use being attributed to you (as the adviser). Consider prohibiting such communications, conducting periodic training, obtaining attestations and reviewing publicly available content on such associated persons' social media accounts. Review social media account policies with respect to third-party content posted on adviser social media pages with the goal of avoiding the implication that the third-party's actions may be considered "advertisements."

General Prohibitions Relating to Advertisements:

The Marketing Rule will replace the four per se prohibitions with seven principles-based prohibitions (the "General Prohibitions") as a means reasonably designed to prevent fraudulent, deceptive or manipulative acts. Accordingly, an advertisement may not:

1. Include any untrue statement of material fact, or omit to state a material fact necessary in order to make the statement made, in light of the circumstances under which it was made, not misleading;
2. Include 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 SEC;
3. Include 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 investment adviser;
4. Discuss any potential benefits to clients or investors connected with or resulting from the investment adviser's services or methods of operation without providing fair and balanced treatment of any material risks or material limitations associated with the potential benefits;
5. Include a reference to specific investment advice provided by the investment adviser where such investment advice is not presented in a manner that is fair and balanced;
6. Include or exclude performance results, or present performance time periods, in a manner that is not fair and balanced; or
7. Otherwise be materially misleading.

To establish a violation of the Marketing Rule, the SEC will only need to demonstrate that an investment adviser acted with negligence. In applying the general prohibitions above, investment advisers should consider the facts and circumstances of each advertisement. In particular, in the releasing memorandum, the SEC noted that the nature of the audience to which the advertisement is directed is a key factor in determining how the general prohibitions should be applied.

Next Steps.

• Revise your compliance manual to include the text of the General Prohibitions and update specific recommendations to reflect the new Marketing Rule.
• Review and update any investor communications that may fall under the definition of "advertisement," including offering materials. Confirm that you can, and be prepared to, substantiate any statement of material fact that appears in such communications.
• Delegate persons within your organization who will review and approve all advertisements for compliance with the Marketing Rule's new prohibitions, including the SEC's guidance regarding case studies and consideration of the audience for applying content standards.

Third-Party Ratings:

An advertisement may not include third-party ratings unless the adviser has a reasonable basis for believing that any questionnaire or survey used in the preparation of such 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. Moreover, the applicable advertisement must clearly and prominently disclose (i) the date on which the rating was given and the period of time upon which the rating was based; (ii) the identity of the third party that created and tabulated the rating; and (iii) the compensation that has been provided, directly or indirectly, by the adviser in connection with obtaining or using the third-party rating.

Next Steps.

• Revise your compliance manual to include the new requirements.
• Review marketing materials that use third-party ratings and update each to reflect the Marketing Rule's disclosure requirements. Confirm that you have satisfied the Marketing Rule's due diligence requirement and have a reasonable basis for believing that any questionnaire or survey used for obtaining the rating was structured appropriately.

Performance Advertising:

The Marketing Rule includes specific conditions on the presentation of performance. While the Marketing Rule does not set forth separate requirements for performance advertising in materials intended for retail persons and non-retail persons, it does require that certain performance-related requirements primarily intended to protect retail investors must be included in performance advertisements even when directed to more sophisticated, institutional investors.

Prohibited Performance Reporting. In particular, the Marketing Rule prohibits including in any advertisement:

1. Gross performance results (including hypothetical performance and extracted performance presented on a gross basis) unless the advertisement also presents net performance results (i) with at least equal prominence to, and in a format designed to facilitate comparison with, the gross performance results; and (ii) calculated over the same time period, and using the same type of return and methodology as the gross performance results;
2. Any performance results of any portfolio or any composite aggregation of related portfolios, unless they are provided for one-, five- and ten-year periods or are the performance results of a private fund;
3. Any statement, express or implied, that the calculation or presentation of performance results has been approved or reviewed by the SEC;
4. The presentation of "related performance" (the performance of similar portfolios), unless the related performance includes all portfolios with substantially similar investment policies, objectives, and strategies as those of the services being offered in the advertisement, the advertised performance results are not materially higher than if all related portfolios had been included and the exclusion of any related portfolio does not alter the presentation of any applicable time periods described above;
5. Performance results of a subset of investments extracted from a portfolio (extracted performance) unless the advertisement provides or offers to provide promptly the performance results of the total portfolio from which the performance was extracted; and
6. Hypothetical performance, unless the adviser: (i) adopts and implements policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement; (ii) provides sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating such hypothetical performance; and (iii) provides (or, if the intended audience is a private fund investor, provides or offers to provide promptly) sufficient information to enable the intended audience to understand the risks and limitations of using hypothetical performance in making investment decisions.

Predecessor Performance. In addition, the Marketing Rule codifies positions taken in prior no-action letters relating to the portability of investment performance (track record) by advisory professionals when moving firms, by adopting four requirements for presenting predecessor investment performance in all advertisements.

1. The person or persons who were primarily responsible for achieving the prior performance results manage accounts at the advertising adviser;
2. The accounts managed at the predecessor investment adviser are sufficiently similar to the accounts managed at the advertising investment adviser such that the performance results would provide relevant information to clients or investors;
3. All accounts that were managed in a substantially similar manner are advertised unless the exclusion of any such account would not result in materially higher performance and the exclusion of any account does not alter the presentation of the required one-, five- and ten-year time periods, as applicable; and
4. The advertisement clearly and prominently includes all relevant disclosures, including that the performance results were from accounts managed at another entity.

• Review and update your compliance manual to reflect the Marketing Rule's requirements with respect to specific categories of performance information.
• Ensure that you are applying the General Prohibitions to your presentation of performance information and consider whether any disclosures should be included. In addition, ensure that the firm has sufficient records to substantiate any reported performance, including predecessor performance.
• Update marketing materials to ensure compliance with predecessor performance requirements.

Amendments to Form ADV:

Along with the Marketing Rule, the SEC adopted amendments that add a new subsection L to Item 5 of Part 1A of Form ADV. The new subsection L, entitled "Marketing Activities", requires an adviser to disclose whether their advertisements include performance results, specific investment advice, testimonials, endorsements, third-party ratings, and hypothetical performance and predecessor performance. Advisers that have included testimonials, endorsements or third-party ratings in their advertisements will have to disclose whether they have paid any cash or non-cash compensation in connection with their use.

Recordkeeping:

In addition to the Marketing Rule, the SEC has also adopted amendments to Rule 204-2 under the Advisers Act to correspond to the new requirements of the Marketing Rule. Investment advisers are required to make and keep records of all advertisements they distribute, with alternative methods of compliance for oral advertisements, including oral testimonials and oral endorsements.

The revised rule requires that investment advisers retain the following records:

1. Written or recorded materials used or disclosures provided for oral advertisements;
2. Written communications relating to predecessor performance and the performance or rate of return of any managed accounts, portfolios or securities recommendations;
3. Accounts, books, internal working papers, and other documents necessary to form the basis for or demonstrate the calculation of the performance or rate of return of any portfolios;
4. For supporting records that display hypothetical performance, copies of all information provided or offered pursuant to the hypothetical performance provisions of the Marketing Rule;
5. Documentation of communications relating to predecessor performance;
6. Records of who the "intended audience" is pursuant to the hypothetical performance provisions of the Marketing Rule;
7. Documentation substantiating an investment adviser's determination that it has a reasonable basis for believing that a testimonial or endorsement complies with the Marketing Rule and a third-party rating complies with the Marketing Rule's due diligence requirement; and
8. A copy of any questionnaire or survey used in the preparation of a third-party rating included in any advertisement (if a copy has been obtained by the investment advisor).

• Update your compliance manual to reflect the Marketing Rule-related amendments.
• Consider maintaining a file of "as distributed" advertisements to simplify compliance with examination requests.

Conclusion:

As noted above, the adoption of the Marketing Rule represents a sea change in the rules and regulations governing the marketing and solicitation of investment advisory services – one that the SEC intends to monitor and enforce. If you need assistance or have any questions regarding next steps, best practices or general compliance, please know that the Foley Hoag team is ready and able to help.

Footnote

1. See Investment Adviser Marketing, SEC Release No. IA-5653 (Dec. 22, 2020).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.