In November 2019, the Securities and Exchange Commission released proposed amendments to Rule 206(4)-1 (Advertising Rule) under the Investment Advisers Act of 1940 (Advisers Act). The Advertising Rule was first adopted in 1961 and has not changed substantively since then. The SEC noted that the proposed Advertising Rule amendments recognize “changes in the technology used for communications, the expectations of investors shopping for advisory services, and the nature of the investment advisory industry, including the types of investors seeking and receiving investment advisory services.”

Additionally, the SEC proposed to amend Rule 206(4)-3 under the Advisers Act (Solicitation Rule), as well as to amend Form ADV. Last but not least, the SEC proposed to amend its books-and-records rule under the Advisers Act to reflect the proposed rules.

This article highlights our preliminary observations of the proposed rules, focusing first and foremost on revisions that would have practical implications for private fund advisers. The SEC release runs more than 500 pages and provides in-depth discussion of the issues presented by the proposed rules. In connection with the proposed rules, the SEC is reviewing related no-action letters and other guidance to determine whether any of them should be withdrawn. The SEC is soliciting comments, which may be submitted until February 10, 2020.

Highlights for Sponsors of Private Investment Funds

The proposed Advertising Rule amendments would explicitly apply to pooled investment vehicles, commonly referred to as “private funds.”¹ The practical implications of their application may be limited, as the proposed requirements are consistent with those that currently apply to pooled investment vehicles under the antifraud provisions of the Advisers Act. However, there are some notable differences.

• Distinction between retail and non-retail investors. Advertisements may be misleading to certain investors, but not to others who have the resources to analyze and consider the performance information presented. In order to better protect presumably less sophisticated “retail” investors, the proposed Advertising Rule amendments distinguish between “retail advertisements” and “non-retail advertisements.” Dissemination of non-retail advertisements would be limited to “qualified purchasers”² and “knowledgeable employees”³ (collectively, non-retail investors), who typically invest in private funds that rely on the section 3(c)(7) exemption under the Investment Company Act. All investment advisers would have to adopt and implement policies and procedures reasonably designed to ensure that non-retail advertisements are disseminated solely to non-retail investors. Investment advisers to private funds would be required to “look through” the fund to its investors, and, if the fund has both retail investors and non-retail investors, the adviser would have the option of either distributing retail advertisements to retail investors and non-retail advertisements to non-retail investors, or distributing retail advertisements to all investors in the fund.

• Presentation of gross and net performance. The Advertising Rule does not address the presentation of performance results. While in no-action letters⁴ the SEC has recommended a number of disclosures that should accompany the presentation of performance results, the proposed Advertising Rule amendments would adopt a principles-based approach and would not require any specific legends or disclosures. However, the proposed Advertising Rule amendments would require that certain additional information be included in retail advertisements that include gross performance results, in order to better protect retail investors: (1) net performance results, to be presented alongside and in a format designed to facilitate comparison with gross performance results; (2) performance over specified time periods (one, five and 10 years), and (3) additional disclosures when hypothetical information is included. For non-retail advertisements, gross performance results may be provided without including the net performance, provided that advisers provide or offer to provide promptly a schedule of fees and expenses so that non-retail investors are able to calculate net performance if they desire to do so.

• Restrictions and conditions on the use of testimonials, endorsements and third-party ratings. The Advertising Rule currently prohibits outright the use of testimonials and does not expressly address the use of endorsements and third-party ratings. Under the proposed Advertising Rule amendments, endorsements and third-party ratings would be allowed, subject to certain disclosures and other tailored conditions. The SEC noted that, in today’s changing world, people continue to seek out reviews of others when making decisions, and, therefore, testimonials, endorsements and third-party ratings should be allowed with tailored disclosures and other safeguards. Among other requirements, the proposed Advertising Rule amendments would require that investment advisers prominently disclose cash or noncash compensation provided with regard to the testimonial, endorsement or third-party rating and whether the person providing it is a client. Unlike FINRA, the SEC is not proposing a de minimis exception relating to disclosure of compensation. When an investment adviser references a third-party rating, that adviser must reasonably believe that any questionnaire or survey used in the preparation of the third-party rating has been structured to make it equally easy for a participant to provide favorable and unfavorable responses, and has not been prepared with the intention to produce a predetermined result.

• Hypothetical performance, “extracted” performance and related performance. The proposed Advertising Rule amendments would allow the presentation of an investment adviser’s track record with the following three conditions:

  • with regard to the presentation of performance of related portfolios, the proposed Advertising Rule amendments would allow investment advisers to exclude from “related performance” one or more related portfolios so long as the advertised performance results are no higher than if all related portfolios had been included;

  • when presenting extracted performance (defined as “performance results of a subset of investments extracted from a portfolio”), the advertisement must provide or offer to provide promptly the performance results of all portfolios from which the performance was extracted; and

  • hypothetical performance should be presented only if the investment adviser has adopted policies and procedures reasonably designed to ensure that performance information is relevant to the recipient’s financial situation and investment objectives and the investment adviser provides additional information about the hypothetical performance such that the audience receiving the information understands the criteria, assumptions, risks and limitations.

Policies and procedures adopted for dissemination of hypothetical performance information do not need to inquire into the specific financial situation of each (potential) investor and instead may be based on past dealings with groups of investors with similar characteristics. While hypothetical information is often more relevant to non-retail investors because they have the tools and resources to analyze it, an investment adviser’s policies and procedures may allow dissemination of hypothetical performance to a retail investor, provided that these policies and procedures include parameters to determine whether the retail investor has the resources to analyze the underlying assumptions and qualifications of the hypothetical performance, as well as the investment’s objectives. In view of this requirement, hypothetical performance information may never be distributed in a mass mailing.

Finally, when providing the track record to (potential) investors, the investment adviser may not include “any statement, express or implied, that the calculation or presentation of performance results in the advertisement has been approved or reviewed by the [SEC].”

Definition of 'Advertisement'

It is critical to understand what is an “advertisement” when applying the current broadly drawn limitations and the proposed rule’s principles-based provisions. The current definition includes “a written communication” that is “addressed to more than one person” or “any notice or other announcement in any publication or by radio or television.”⁵ Thus, the current Advertising Rule prohibits:

• testimonials concerning the investment adviser or its services⁶

• any direct or indirect references to specific profitable recommendations that the investment adviser has made in the past⁷

• representations that any graph or other device being offered can by itself be used to determine which securities to buy and sell or when to buy and sell them⁸

• any statement offering to provide services free of charge unless the service is actually being provided free of charge, without any condition or obligation.⁹

These specific prohibitions are in addition to the general prohibition of any advertisement that contains an untrue statement of material fact, or that is otherwise false or misleading.¹⁰ Notwithstanding these specific prohibitions, the Advertising Rule currently does not address a number of issues frequently raised by investment advisers. For example, it does not address whether investment performance may be presented and, if it may, how it should be presented in advertisements. The proposed Advertising Rule amendments aim to rectify that.

The proposed amendments would define “advertisement” as

any communication, disseminated by any means, by or on behalf of an investment adviser, that offers or promotes the investment adviser’s investment advisory services or that seeks to obtain or retain one or more investment advisory clients or investors in any pooled investment vehicle advised by the investment adviser.

The proposed definition differs from the current definition by (1) expanding the types of communications covered under the current rule (e.g., newspapers, television and radio is expanded to “disseminated by any means”) in order to keep up with advances in technology and the types of communications prevalent today, such as social media; (2) applying to advertisements disseminated to investors in pooled investment vehicles, with the exception of communications of publicly offered investment companies, which are subject to restrictions under the Securities Act of 1933 and the Investment Company Act as discussed above; (3) eliminating the requirement that an advertisement apply to “more than one person,” however, the definition excludes nonbroadcast live, oral communications or responses to certain unsolicited requests; and (4) carving out information required to be disseminated to investors by applicable statutory or regulatory requirements, for example, information required by Part 2 of Form ADV or Form CRS. The proposed definition also expands the set of communications that would be considered advertisements by adding ones that are made “on behalf of” an investment adviser, as discussed below.

• General prohibition of certain advertising practices. The proposed Advertising Rule amendments redefine certain expressly prohibited practices to include untrue statements and omissions, unsubstantiated material claims and statements, untrue or misleading implications or inferences, failure to disclose material risks or other limitations, references to specific investment advice and presentation of performance results in a manner that is not fair and balanced (“cherry picking”), and otherwise materially misleading advertisements. With respect to “cherry picking,” although the proposed Advertising Rule amendments require that references to specific investment advice and performance results be presented in a manner that is fair and balanced, they do not prescribe any specific disclosures that need to be included in these advertisements, aside from specific requirements for presenting certain types of performance to different audiences as discussed above, and will allow portfolio performance to be left out if leaving it out does not improve the track record being presented. 

• “On behalf of.” The proposed definition of “advertisement” would apply to advertisements disseminated “on behalf of” investment advisers, such as when they are delivered by solicitors and consultants. While the “on behalf of” element codifies what is currently required by previous SEC guidance in this area, the November 2019 release provides detailed discussion on which communications provided through intermediaries would fall under the purview of the proposed Advertising Rule amendments. Facts and circumstances showing the adviser’s involvement (or lack of it) in the preparation, or approval, of the information distributed by third parties would be the determining factors. For example, the fact that an adviser permits all third parties to publicly comment on the adviser’s social media page or its website would not, by itself, attribute that content to the investment adviser, so long as the adviser does not selectively edit or delete the comments. Most investment advisers are well-acquainted with the requirements applicable to them under the Advertising Rule when distributing pitch books and private placement memoranda; however, advisers will need to pay closer attention to their compliance policies and procedures when advertising on LinkedIn, social media and other third-party websites to determine what challenges the proposed Advertising Rule amendments would pose. In its release, the SEC asked investment advisers to comment on whether they would be able to comply with the proposed Advertising Rule amendments (and the “on behalf of” element) when advertising through intermediaries.

Review and Approval

The proposed Advertising Rule amendments would require an investment adviser to have a new advertisement (or any updates to existing advertisements) reviewed and approved for regulatory compliance by a designated employee, except when communications are disseminated only to a single person or household or to a single investor in a pooled investment vehicle. This requirement would not apply to live, oral communications that are broadcast on radio, television, the internet or any other similar medium. An adviser may designate one or more employees to perform the reviews. The release further noted that it would not be appropriate for the same person to both create and approve the advertisements; however, small advisers may not have enough employees to carry out these disparate tasks. In light of this issue, the SEC asked that commenters provide their opinions on potential approaches to the review requirement. The requirement to have advertisements internally reviewed by a separate employee (e.g., the CCO of a private fund manager) reflects industry best practice and is often a proactive way to prevent inadvertent rule violations.

Proposed Amendments to Form ADV

In connection with the proposed Advertising Rule amendments, the SEC proposed that Form ADV be updated (by adding a subsection L to Item 5 of Part 1A) to include questions on an investment adviser’s advertising practices, including its use of performance results, testimonials, endorsements, third-party ratings and past specific investments.

Proposed Solicitation Rule Amendments

Similar to the Advertising Rule, the SEC also proposed updating and amending the Solicitation Rule to bring it in line with current industry practices and recent regulatory guidance. Currently, the Solicitation Rule does not apply to solicitations of private fund investors. The Solicitation Rule covers cash payments only and does not apply to other forms of compensation, such as directed brokerage, sales awards or entertainment. Under the Solicitation Rule, an investment adviser must enter into a written agreement with a solicitor, and the solicitor must provide a copy of the investment adviser’s Form ADV brochure to the clients. Key elements of the proposed Solicitation Rule amendments are:

• Cash and noncash compensation. The proposed Solicitation Rule amendments would expand the Solicitation Rule’s coverage to noncash compensation (such as directed brokerage, sales awards, various forms of entertainment and discounted or free advisory services).

• Definition of “solicitor.” As revised, the definition of “solicitor” would include persons who solicit investors in private funds, as the current rule only covers persons soliciting an investment adviser’s “clients” and not persons soliciting investors to invest in those private fund clients. While the SEC acknowledged that investors in private funds are often financially sophisticated, the release stated that those investors do not always know that the person engaging in the solicitation is receiving compensation from the investment adviser. Broker-dealers or dual registrants that receive brokerage for solicitation of client accounts in wrap fee programs that they do not sponsor would be subject to the proposed Solicitation Rule amendments if they solicit those clients to participate in the wrap fee program. In-house solicitors and affiliated solicitors are currently partially exempt from the Solicitation Rule, meaning that the requirements of detailed written agreements, adviser oversight and solicitor disclosure do not apply to them. Under the proposed Solicitation Rule amendments, these persons would continue to be partially exempt, with one new requirement — the relationship between these solicitors and the investment adviser would have to be disclosed to the investor at the time of the solicitation, or otherwise be readily apparent.

• Written agreement. The SEC proposed to eliminate certain requirements applicable to written agreements between solicitors and investment advisers, namely, the requirement that the solicitor deliver the adviser’s Form ADV brochure and the requirement that the solicitor undertake to perform its duties consistent with the instructions of the adviser. The SEC noted that requiring solicitors to deliver the investment adviser’s brochure was no longer necessary because investment advisers are also required to do that; moreover, it may even be confusing to investors who receive duplicate copies of the brochure from both the investment adviser and the solicitor.

• Disclosures. Under the proposed Solicitation Rule amendments, either the solicitor or the investment adviser at the time of solicitation would have to deliver a note to investors disclosing certain information about the solicitor and the relationship between the solicitor and the adviser. A material departure from the current Solicitation Rule is the requirement to list any potential material conflicts of interest stemming from the investment adviser’s relationship with the solicitor. Additionally, the SEC proposed to eliminate the requirement that the investment adviser obtain a signed and dated acknowledgment from the client that the client has received the solicitor’s disclosure. A solicitor’s disclosure to investors would not be required to be physical, henceforth allowing solicitors to deliver their disclosures via electronic or recorded media, provided that the investment advisers keep true, accurate and current copies of the solicitor’s disclosure, in compliance with the SEC’s books-and-records rule.

• Exemptions. The proposed Solicitation Rule amendments would provide partial exemptions from the rule for (1) solicitors providing impersonal investment advice (however, the proposed exemption would not apply to so-called robo-advisers and internet advisers) and (2) in-house solicitors and other affiliated solicitors, provided that the affiliation is disclosed when the relationship is not readily apparent and certain other documentation requirements are met. Lastly, the proposed Solicitation Rule amendments would exempt arrangements with solicitors who receive de minimis compensation (i.e., compensation of $100 or less during the preceding 12-month period), as well as certain nonprofit programs that meet specified requirements.

• Disqualification. In lieu of the current Solicitation Rule’s absolute bar on payments to solicitors with a specified disciplinary history, under the proposed Solicitation Rule amendments, investment advisers would be tasked with exercising reasonable care to determine whether a solicitor is an “ineligible solicitor,” as this term is defined in the proposed Solicitation Rule amendments. The proposed Solicitation Rule amendments would also expand the list of disciplinary events that would render a solicitor “ineligible” but would not prescribe what method or level of due diligence is sufficient to satisfy the reasonable care standard.

Takeaways

The proposed rules, if adopted, may increase an investment adviser’s overall compliance costs, including by requiring additional disclosures to retail investors (and related due diligence to determine whether the intended recipients of advertisements are, in fact, retail investors) and internal review and approval of new advertisements. In addition, because the SEC has adopted a broad, principles-based approach in the proposed rules, many advisers will not have the hoped-for certainty in deciding whether specific advertising practices or performance-based marketing materials are compliant (e.g., hypothetical or back-tested performance).

On the other hand, the proposed rules codify much of the SEC’s prior no-action letter and interpretive guidance over the years, such as those pertaining to social media endorsements and third-party ratings. The proposed rules also provide additional clarity on how to lawfully disclose past performance data on specific investments without violating the anti-cherry picking rules, while relaxing the mandatory net performance disclosure requirements in the case of non-retail investors. In the case of private funds in formation, however, a fund manager often does not know whether each of its investors will qualify as a non-retail investor, entitling the manager to avoid the more onerous disclosure requirements applicable to retail investors, and thus the manager may be forced to take a conservative approach and follow the retail investor requirements in such circumstances.

The SEC has requested comments on various aspects of the proposed rules, and the final rules will likely reflect input by investment management industry professionals. If the proposed rules are adopted, starting from their effective date, advisers would have a one-year transition period until they are required to comply. In the interim, because in many respects the proposed rules are a codification of past SEC guidance in this area, they should serve as an important benchmark of industry best practices.

Endnotes

⁶ Rule 206(4)-1(a)(1).

⁷ Rule 206(4)-1(a)(2).

⁸ Rule 206(4)-1(a)(3).

⁹ Rule 206(4)-1(a)(4).

¹⁰ Rule 206(4)-1(a)(5).

*Julia D. Corelli, co-chair of Pepper's Private Fund Services Group, a core constituent of the firm’s Investment Funds Industry Group (IFIG), contributed to the drafting of the article.