SEC Adopts Modernized Investment Adviser Marketing Rule Governing Advertisements and Solicitation

On December 22, 2020, the U.S. Securities and Exchange Commission adopted rule and form amendments to modernize the regulatory framework governing investment adviser advertising and payments to solicitors.¹ The rulemaking creates a single rule (Marketing Rule) governing investment adviser marketing by replacing the existing investment adviser advertising and cash solicitation rules.² The following provides an overview of the Marketing Rule and related amendments. An upcoming Dechert OnPoint will address these matters in more detail.

Structure and Scope

The Marketing Rule prohibits investment advisers registered or required to be registered with the SEC from directly or indirectly disseminating any “advertisement” that violates any provision of the Marketing Rule. The Marketing Rule contains: (i) general prohibitions concerning advertisements; (ii) requirements for “testimonials” and “endorsements”; (iii) provisions regarding inclusion of “third-party ratings” in advertisements; and (iv) requirements pertaining to performance advertising.

Under the Marketing Rule, the term “advertisement” is defined to include two broad categories of communications, the first concerning communications by an investment adviser offering advisory services and the second concerning endorsements and testimonials for which the adviser provides compensation. The term “advertisement” is defined under the Marketing Rule to mean:

• An adviser’s direct or indirect communication made to more than one person (or to one or more persons if the communication contains hypothetical performance) that offers: (i) the adviser’s investment advisory services with regard to securities to prospective clients or investors in a private fund³ advised by the adviser; or (ii) new investment advisory services with regard to securities to current clients or investors in a private fund advised by the adviser.
  
  • However, an “advertisement” under the Marketing Rule does not include: (a) extemporaneous, live, oral communications; (b) information contained in a statutory or regulatory notice, filing, or other required communication, provided that such information is reasonably designed to satisfy the requirements of such notice, filing, or other required communication; or (c) a communication that includes hypothetical performance that is provided either (1) in response to an unsolicited request for such information from a prospective or current client or investor in a private fund advised by the adviser, or (2) to a prospective or current investor in a private fund advised by the adviser in a one-on-one communication.
• Any endorsement or testimonial for which an investment adviser provides (cash or non-cash) compensation, directly or indirectly; this part of the definition also excludes information contained in a statutory or regulatory notice, filing, or other required communication that is reasonably designed to satisfy such requirements

General Prohibitions

The Marketing Rule prohibits advertisements from:

• Including any untrue statement of a material fact, or making a material omission;
  
• Including 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 Commission;
  
• Including 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 adviser;
  
• Discussing any potential benefits to clients or investors connected with or resulting from the adviser’s services or methods of operation without providing fair and balanced treatment of any associated material risks or material limitations;
  
• Including a reference to specific investment advice provided by the adviser where such investment advice 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; or
  
• Otherwise being materially misleading.

Testimonials and Endorsements

The Marketing Rule permits advertisements to include “testimonials” and “endorsements,” and permits advisers to provide direct or indirect compensation for testimonials or endorsements, subject to several conditions. The Marketing Rule contains certain related disqualification provisions and exemptions.

Under the Marketing Rule, a “testimonial” means any statement by a current client or investor in a private fund advised by the adviser: (i) about the client or investor’s experience with the adviser or its supervised persons; (ii) that directly or indirectly solicits any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the adviser; or (iii) that refers any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the adviser.

The Marketing Rule defines “endorsement” to mean any statement by a person other than a current client or investor in a private fund advised by the adviser that: (i) indicates approval, support, or recommendation of the adviser or its supervised persons or describes that person’s experience with the adviser or its supervised persons; (ii) directly or indirectly solicits any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the adviser; or (iii) refers any current or prospective client or investor to be a client of, or an investor in a private fund advised by, the adviser.

Conditions. The conditions for including testimonials or endorsements in advertisements, and for providing direct or indirect compensation for testimonials or endorsements, are:

• Required Disclosures. The adviser must disclose, or reasonably believe that the person giving the testimonial or endorsement (the promoter⁴) discloses, at the time the testimonial or endorsement is disseminated:
  
  • clearly and prominently: (a) that the testimonial was given by a current client or investor, and the endorsement was given by a person other than a current client or investor, as applicable; (b) that cash or non-cash compensation was provided for the testimonial or endorsement, if applicable; and (c) 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;
    
  • the material terms of any compensation arrangement, including a description of the compensation provided or to be provided, directly or indirectly, to the person for the testimonial or endorsement; and
    
  • a description 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 and/or any compensation arrangement.
• Adviser Oversight and Compliance. The adviser must have: (i) a reasonable basis for believing that the testimonial or endorsement complies with the requirements of the Marketing Rule; and (ii) a written agreement with any promoter that describes the scope of the agreed-upon activities and the terms of compensation for those activities.

Disqualification Provisions. An adviser may not directly or indirectly compensate a promoter for a testimonial or endorsement if the adviser knows, or in the exercise of reasonable care should know, that the promoter is an “ineligible person” at the time the testimonial or endorsement is disseminated. This prohibition does not disqualify any person for any matter occurring prior to the Marketing Rule’s effective date (which will be 60 days after publication in the Federal Register), if such matter would not have disqualified such person under the existing cash solicitation rule’s disqualification provisions.

Under the Marketing Rule, an “ineligible person” is any person subject to a “disqualifying Commission action” or a “disqualifying event,” and includes certain persons related to the ineligible person.⁵ A “disqualifying Commission Action” is an SEC opinion or order barring, suspending, or prohibiting the person from acting in any capacity under the Federal securities laws. A “disqualifying event” is any of several enumerated events, including certain convictions and orders, that occurred within 10 years prior to the person disseminating an endorsement or testimonial.⁶ The definition of “disqualifying event” also contains certain exclusions.⁷

Exemptions. The Marketing Rule provides certain exemptions related to testimonials and endorsements:

• No Compensation or De Minimis Compensation. A testimonial or endorsement disseminated for no compensation or de minimis compensation⁸ is not required to comply with the written agreement requirement or the disqualification provisions;
  
• Affiliated Promoters. A testimonial or endorsement by the adviser’s partners, officers, directors, or employees, or a person that controls, is controlled by, or is under common control with the investment adviser, or is a partner, officer, director or employee of such a person is not required to comply with the disclosure or written agreement requirements, provided that the affiliation between the 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 that the investment adviser documents such person’s status at the time the testimonial or endorsement is disseminated;
  
• Broker-Dealers. A testimonial or endorsement by an SEC-registered broker-dealer is not required to comply with: (i) the disclosure requirements if the testimonial or endorsement is a recommendation subject to Regulation Best Interest under the Securities Exchange Act of 1934 (“Exchange Act”); (ii) the requirements to disclose the material terms of any compensation arrangement and the material conflicts of interest resulting from the adviser’s relationship with the promoter and/or any compensation arrangement if the testimonial or endorsement is provided to a person that is not a “retail customer” as defined in Regulation Best Interest; and (iii) the disqualification provisions if the broker-dealer is not subject to a statutory disqualification as defined under Exchange Act Section 3(a)(39); and
  
• Reg D “Bad Actors”. A testimonial or endorsement by a person covered under the “bad actor” provisions of Regulation D with respect to a Rule 506 securities offering and whose involvement would not disqualify the offering under Rule 506 is not required to comply with the Marketing Rule’s disqualification provisions.

Third-Party Ratings

The term “third-party rating” is defined in the Marketing Rule to mean 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. Under the Marketing Rule, an advertisement may include any third-party rating only if the adviser:

• Has a reasonable basis for believing that any questionnaire or survey used to prepare 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; and
  
• Clearly and prominently discloses, or the investment adviser reasonably believes that the third-party rating clearly and prominently discloses: (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) that compensation has been provided directly or indirectly by the adviser in connection with obtaining or using the third-party rating, if applicable.

Performance Advertising

The Marketing Rule addresses several perennial issues in performance advertising: the use of gross and net performance; the time periods for performance presentations; statements regarding SEC approval; related performance; extracted performance; hypothetical performance; and predecessor performance.

Gross and Net Performance. Gross performance may not be used in any advertisement unless the advertisement also presents net performance: (i) with at least equal prominence to, and in a format designed to facilitate comparison with, the gross performance; and (ii) calculated over the same time period, and using the same type of return and methodology, as the gross performance.

Under the Marketing Rule, “gross performance” means the performance results of a “portfolio”⁹ (or portions of a portfolio that are included in “extracted performance,”¹⁰ if applicable) before the deduction of all fees and expenses that a client or investor has paid or would have paid in connection with the investment adviser’s investment advisory services to the relevant portfolio. “Net performance” is defined similarly, except to be after the deduction of fees and expenses. Under the Marketing Rule, fees and expenses include, if applicable, advisory fees, advisory fees paid to underlying investment vehicles, and payments by the investment adviser for which the client or investor reimburses the investment adviser.¹¹

Time Periods. Performance results of any portfolio or composite aggregation of related portfolios (other than performance results of any private fund)¹² must include performance results of the same portfolio or composite aggregation for one-, five-, and ten-year periods, each presented with equal prominence and ending on a date that is no less recent than the most recent calendar year-end; except that if the relevant portfolio did not exist for a particular prescribed period, then the life of the portfolio must be substituted for that period.

Statements Regarding SEC Approval. Performance advertising may not contain any express or implied statement that the calculation or presentation of performance results in the advertisement has been approved or reviewed by the SEC.

Related Performance. Under the Marketing Rule, “related performance” means the performance results of one or more related portfolios, either on a portfolio-by-portfolio basis or as a composite aggregation of all portfolios falling within stated criteria. Related performance may be used only if the presentation includes all related portfolios (i.e., those with substantially similar investment policies, objectives, and strategies as those of the services being offered in the advertisement); provided that related performance may exclude any related portfolios if: (i) the advertised performance results are not materially higher than if all related portfolios had been included; and (ii) the exclusion of any related portfolio does not alter the presentation of any applicable time periods prescribed by the Marketing Rule.

Extracted Performance. As previously noted, “extracted performance” is defined in the Marketing Rule to mean the performance results of a subset of investments extracted from a portfolio. Extracted performance may be used in an advertisement only if the advertisement provides, or offers to provide promptly, the performance results of the total portfolio from which the performance was extracted.

Hypothetical Performance. The use of hypothetical performance – defined in the Marketing Rule to mean performance results that were not actually achieved by any portfolio of the investment adviser, and which includes model, backtested and target or projected performance¹³ – requires the adviser to: (i) adopt and implement 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) provide sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating such hypothetical performance; and (iii) provide (or, if the intended audience is an investor in a private fund, provide, or offer to provide promptly) sufficient information to enable the intended audience to understand the risks and limitations of using such hypothetical performance in making investment decisions. When using hypothetical performance, the adviser need not comply with the conditions on performance related to time periods, related performance or extracted performance.

Predecessor Performance. The Marketing Rule defines “predecessor performance” to mean investment performance achieved by a group of investments consisting of an account or a private fund that was not advised at all times during the period shown by the investment adviser advertising the performance. Predecessor performance may be included in an advertisement only when: (i) the person or persons who were primarily responsible for achieving the prior performance results manage accounts at the advertising adviser; (ii) the accounts managed at the predecessor investment adviser are sufficiently similar to the accounts managed at the advertising investment adviser that the performance results would provide relevant information to clients or investors; (iii) 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 any applicable time periods prescribed under the Marketing Rule; and (iv) the advertisement clearly and prominently includes all relevant disclosures, including that the performance results were from accounts managed at another entity.

Amendments to Form ADV and the Advisers Act Recordkeeping Rule

In connection with adopting the Marketing Rule, Form ADV Part 1A was amended by adding Item 5.L. “Marketing Activities,” which will require certain disclosures concerning the adviser’s marketing practices. The Glossary of Terms was revised in light of definitions adopted in the Marketing Rule. Certain technical amendments were made to the Form ADV instructions. The Advisers Act recordkeeping rule (Rule 204-2) was also updated in light of the adoption of the Marketing Rule.

Effective and Compliance Date

The Marketing Rule and related amendments provide for an 18-month transition period following effectiveness. The Marketing Rule and related amendments will be effective 60 days after publication in the Federal Register (effective date). Compliance will be required following the 18-month transition period from the effective date.

Footnotes

1) See Investment Adviser Marketing, Rel. No. IA-5653 (Dec. 22, 2020) (Release). Unless otherwise noted, Section and Rule references are to the Advisers Act and rules thereunder. There may be instances where this NewsFlash tracks the Marketing Rule (defined below) and Release without the use of quotation marks.

2) The SEC is also withdrawing certain no-action letters and other guidance that are either incorporated into the Marketing Rule or will no longer apply. A list of SEC staff no-action letters being withdrawn will be available on the SEC’s website.

3) The Marketing Rule defines “private fund” to mean an issuer that would be an investment company, as defined in Section 3 of the Investment Company Act of 1940, but for section 3(c)(1) or 3(c)(7) of the Investment Company Act.

4) The Release uses the term “promoter” to mean a person providing a testimonial or endorsement, whether compensated or uncompensated. Traditionally, those who engaged in compensated solicitation activities were referred to as “solicitors.”

5) Specifically: (i) any employee, officer, or director of the ineligible person and any other individuals with similar status or functions within the scope of association with the ineligible person; (ii) if the ineligible person is a partnership, all general partners; and (iii) if the ineligible person is a limited liability company managed by elected managers, all elected managers.

6) Under the Marketing Rule, a disqualifying event is any of the following events that occurred within 10 years prior to the person disseminating an endorsement or testimonial: (i) a conviction by a court of competent jurisdiction within the United States of any felony or misdemeanor involving conduct described in Advisers Act Section 203(e)(2)(A)–(D); (ii) a conviction by a court of competent jurisdiction within the United States of engaging in, any of the conduct specified in Advisers Act Section 203(e)(1), (5), or (6); (iii) the entry of any final order by any entity described in Advisers Act Section 203(e)(9) [i.e., certain state securities, banking and insurance regulators, appropriate federal banking agencies, and the National Credit Union Administration], or by the U.S. Commodity Futures Trading Commission or a self-regulatory organization (as defined in the Form ADV Glossary of Terms), of the type described in Advisers Act Section 203(e)(9); (iv) the entry of an order, judgment or decree described in Advisers Act Section 203(e)(4), and still in effect, by any court of competent jurisdiction within the United States; and (v) an SEC order that a person cease and desist from committing or causing a violation or future violation of (A) any scienter-based fraud provision of the Federal securities laws, or (B) Section 5 of the Securities Act of 1933.

7) Under the Marketing Rule, a disqualifying event does not include any of the convictions or orders otherwise defined as a disqualifying event with respect to a person that is also subject to: (i) an order pursuant to Investment Company Act of 1940 Section 9(c) with respect to such event; or (ii) an SEC opinion or order with respect to such event that is not a disqualifying Commission action. In each case, for each applicable type of order or opinion described in these exclusions: (1) the person must be in compliance with the terms of the order or opinion, including, but not limited to, the payment of disgorgement, prejudgment interest, civil or administrative penalties, and fines; and (2) for a period of 10 years following the date of each order or opinion, the advertisement containing the testimonial or endorsement must include a statement that the person providing the testimonial or endorsement is subject to an SEC order or opinion regarding one or more disciplinary action(s), and include the order or opinion or a link to the order or opinion on the SEC’s website.

8) Under the Marketing Rule, de minimis compensation means compensation paid to a person for providing a testimonial or endorsement of a total of $1,000 or less (or the equivalent value in non-cash compensation) during the preceding 12 months.

9) The Marketing Rule defines “portfolio” to mean a group of investments managed by the investment adviser. A portfolio may be an account or a private fund and includes, but is not limited to, a portfolio for the account of the investment adviser or its advisory affiliate (as defined in the Form ADV Glossary of Terms).

10) Under the Marketing Rule, “extracted performance” means the performance results of a subset of investments extracted from a portfolio.

11) For purposes of the Marketing Rule, net performance: (i) may reflect the exclusion of custodian fees paid to a bank or other third-party organization for safekeeping funds and securities; and (ii) if using a model fee, must reflect one of the following: (A) the deduction of a model fee when doing so would result in performance figures that are no higher than if the actual fee had been deducted; or (B) deduction of a model fee that is equal to the highest fee charged to the intended audience to whom the advertisement is disseminated.

12) The exception for private funds applies with respect to performance advertising for any type of private fund. The SEC noted that although it did not mandate “presentation of performance for any specific time periods for [private] funds, presentations of private fund performance are subject to the general antifraud provisions of the Federal securities laws and the general prohibitions in the [Marketing Rule], including the prohibition of including or excluding performance results, or presenting performance time periods, in a manner that is not fair and balanced.” See Release at 183.

13) Under the Marketing Rule, “hypothetical performance” includes, but is not limited to: (i) performance derived from model portfolios; (ii) performance that is backtested by the application of a strategy to data from prior time periods when the strategy was not actually used during those time periods; and (iii) targeted or projected performance returns with respect to any portfolio or to the investment advisory services with regard to securities offered in the advertisement.

The Marketing Rule specifies that “hypothetical performance” does not include: (i) certain interactive analysis tools (described below); or (ii) “predecessor performance” displayed in compliance with the Marketing Rule. The interactive analysis tools noted above are those where a client or investor, or prospective client or investor, uses the tool to produce simulations and statistical analyses that present the likelihood of various investment outcomes if certain investments are made or certain investment strategies or styles are undertaken, thereby serving as an additional resource to investors in the evaluation of the potential risks and returns of investment choices; provided that the investment adviser: (1) provides a description of the criteria and methodology used, including the investment analysis tool’s limitations and key assumptions; (2) explains that the results may vary with each use and over time; (3) if applicable, describes the universe of investments considered in the analysis, explains how the tool determines which investments to select, discloses if the tool favors certain investments and, if so, explains the reason for the selectivity, and states that other investments not considered may have characteristics similar or superior to those being analyzed; and (4) discloses that the tool generates outcomes that are hypothetical in nature.